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2024-06-25T00:00:00	Michelle W Bowman: Opening remarks - Midwest Cyber Workshop	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2nd annual Midwest Cyber Workshop, hosted by the Federal Reserve Banks of St Louis, Chicago, and Kansas City, St Louis, Missouri, 25 June 2024.	Michelle W Bowman: Opening remarks - Midwest Cyber Workshop Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2nd annual Midwest Cyber Workshop, hosted by the Federal Reserve Banks of St Louis, Chicago, and Kansas City, St Louis, Missouri, 25 June 2024. * * * Good afternoon and welcome to the 2nd annual Midwest Cyber Workshop hosted by 1 the Federal Reserve Banks of Chicago, Kansas City, and St. Louis. This workshop was launched last year to further the conversation on cyber risks between community bankers, regulators, law enforcement, and industry stakeholders. It is an honor to be a part of this workshop again and to kickoff this year's event. Cybersecurity continues to be a key risk area for the banking industry and for regulators. Cyber-related events, including ransomware attacks and business email compromises, are extremely costly and time-consuming experiences. For community banks, maintaining the necessary resources and technology to support a successful cybersecurity program can feel especially challenging and financially burdensome. The evolving nature of cyberthreats requires banks to continually review and enhance processes and procedures to protect, detect, and respond to an incident, even if the operating environment has not significantly changed. Ten years ago, immutable backups and multifactor authentication on privileged access accounts were not common controls deployed by community banks. Today, they are considered to be standard elements of a cyber risk management strategy. Financial industry vendors and service providers add an additional layer of cyberrelated vulnerability. Attacks on these third parties have enabled bad actors to create operational incidents and breaches of customer information at financial institutions. Effectively managing and monitoring third-party relationships is an essential component of a bank's broader risk management function. Given the increased adoption of cloudbased solutions, outsourcing of critical functions, and exploration of the use of artificial intelligence (AI), banks must have robust strategies for cyber resilience. Generative AI has the potential to transform operations and the customer experience. But it is also vulnerable to cyberthreats and will require an ongoing analysis of risk-identification and management. Last year, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency jointly issued new guidance titled "Interagency Guidance on Third-Party Relationships: Risk Management," which was recently supplemented by a community bank guide meant to assist these banks in tailoring their third-party risk management programs. Later this afternoon, you will hear more on this from our panel of IT examiners on these resources, recent observations from the field, and risks associated with AI. Ransomware attacks continue to target individuals, businesses, and governments across the country and often result in significant financial and operational harm. Combating ransomware requires that an organization make investments in people, processes, and technology. Often, these attacks are successful because wellintentioned staff have their guard down, or they are not effectively trained to identify and respond to a potential incident. Employees can be your greatest strength, but also your weakest link when it comes to protecting digital assets. That's why it is critical that cyberprograms are built upon a solid foundation that includes training staff to quickly respond to suspicious activity. This reinforces the importance of a skeptical approach in helping to safeguard information. Today and tomorrow, Federal Reserve staff, law enforcement, and industry stakeholders will share their perspectives on ransomware incidents, including restoration of key payments-related functions, cyberinsurance, payments-related risks, and financial considerations during an incident. Finally, a cybersecurity program would not be complete without a comprehensive testing and exercise plan. By incorporating regular testing, a bank can identify strengths and weaknesses in their current strategies. They can then leverage this information to enhance resiliency, resulting in a higher level of preparedness when an incident occurs. Tabletop exercises like the one facilitated tomorrow with IBM are an excellent way to test a cyberdefense strategy against multiple scenarios, including those involving a third party and payment systems. In closing, outreach events like this workshop, the February 2024 Ask the Fed® session with the Cybersecurity and Infrastructure Security Agency, and our recent virtual "office hours" on the 2023 third-party risk management guidance enable us to connect and share resources. These opportunities help us to better support industry management of cybersecurity and other operational risks. I would like to thank the Federal Reserve Banks of Chicago, Kansas City, and St. Louis for organizing this event, and I hope you enjoy the workshop. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	---[PAGE_BREAK]--- # Michelle W Bowman: Opening remarks - Midwest Cyber Workshop Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2nd annual Midwest Cyber Workshop, hosted by the Federal Reserve Banks of St Louis, Chicago, and Kansas City, St Louis, Missouri, 25 June 2024. Good afternoon and welcome to the 2nd annual Midwest Cyber Workshop hosted by the Federal Reserve Banks of Chicago, Kansas City, and St. Louis. ${ }^{1}$ This workshop was launched last year to further the conversation on cyber risks between community bankers, regulators, law enforcement, and industry stakeholders. It is an honor to be a part of this workshop again and to kickoff this year's event. Cybersecurity continues to be a key risk area for the banking industry and for regulators. Cyber-related events, including ransomware attacks and business email compromises, are extremely costly and time-consuming experiences. For community banks, maintaining the necessary resources and technology to support a successful cybersecurity program can feel especially challenging and financially burdensome. The evolving nature of cyberthreats requires banks to continually review and enhance processes and procedures to protect, detect, and respond to an incident, even if the operating environment has not significantly changed. Ten years ago, immutable backups and multifactor authentication on privileged access accounts were not common controls deployed by community banks. Today, they are considered to be standard elements of a cyber risk management strategy. Financial industry vendors and service providers add an additional layer of cyberrelated vulnerability. Attacks on these third parties have enabled bad actors to create operational incidents and breaches of customer information at financial institutions. Effectively managing and monitoring third-party relationships is an essential component of a bank's broader risk management function. Given the increased adoption of cloudbased solutions, outsourcing of critical functions, and exploration of the use of artificial intelligence (AI), banks must have robust strategies for cyber resilience. Generative AI has the potential to transform operations and the customer experience. But it is also vulnerable to cyberthreats and will require an ongoing analysis of risk-identification and management. Last year, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency jointly issued new guidance titled "Interagency Guidance on Third-Party Relationships: Risk Management," which was recently supplemented by a community bank guide meant to assist these banks in tailoring their third-party risk management programs. Later this afternoon, you will hear more on this from our panel of IT examiners on these resources, recent observations from the field, and risks associated with AI. Ransomware attacks continue to target individuals, businesses, and governments across the country and often result in significant financial and operational harm. Combating ransomware requires that an organization make investments in people, ---[PAGE_BREAK]--- processes, and technology. Often, these attacks are successful because wellintentioned staff have their guard down, or they are not effectively trained to identify and respond to a potential incident. Employees can be your greatest strength, but also your weakest link when it comes to protecting digital assets. That's why it is critical that cyberprograms are built upon a solid foundation that includes training staff to quickly respond to suspicious activity. This reinforces the importance of a skeptical approach in helping to safeguard information. Today and tomorrow, Federal Reserve staff, law enforcement, and industry stakeholders will share their perspectives on ransomware incidents, including restoration of key payments-related functions, cyberinsurance, payments-related risks, and financial considerations during an incident. Finally, a cybersecurity program would not be complete without a comprehensive testing and exercise plan. By incorporating regular testing, a bank can identify strengths and weaknesses in their current strategies. They can then leverage this information to enhance resiliency, resulting in a higher level of preparedness when an incident occurs. Tabletop exercises like the one facilitated tomorrow with IBM are an excellent way to test a cyberdefense strategy against multiple scenarios, including those involving a third party and payment systems. In closing, outreach events like this workshop, the February 2024 Ask the Fed ${ }^{\circledR}$ session with the Cybersecurity and Infrastructure Security Agency, and our recent virtual "office hours" on the 2023 third-party risk management guidance enable us to connect and share resources. These opportunities help us to better support industry management of cybersecurity and other operational risks. I would like to thank the Federal Reserve Banks of Chicago, Kansas City, and St. Louis for organizing this event, and I hope you enjoy the workshop. [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	Michelle W Bowman	United States	https://www.bis.org/review/r240701a.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2nd annual Midwest Cyber Workshop, hosted by the Federal Reserve Banks of St Louis, Chicago, and Kansas City, St Louis, Missouri, 25 June 2024. Good afternoon and welcome to the 2nd annual Midwest Cyber Workshop hosted by the Federal Reserve Banks of Chicago, Kansas City, and St. Louis. This workshop was launched last year to further the conversation on cyber risks between community bankers, regulators, law enforcement, and industry stakeholders. It is an honor to be a part of this workshop again and to kickoff this year's event. Cybersecurity continues to be a key risk area for the banking industry and for regulators. Cyber-related events, including ransomware attacks and business email compromises, are extremely costly and time-consuming experiences. For community banks, maintaining the necessary resources and technology to support a successful cybersecurity program can feel especially challenging and financially burdensome. The evolving nature of cyberthreats requires banks to continually review and enhance processes and procedures to protect, detect, and respond to an incident, even if the operating environment has not significantly changed. Ten years ago, immutable backups and multifactor authentication on privileged access accounts were not common controls deployed by community banks. Today, they are considered to be standard elements of a cyber risk management strategy. Financial industry vendors and service providers add an additional layer of cyberrelated vulnerability. Attacks on these third parties have enabled bad actors to create operational incidents and breaches of customer information at financial institutions. Effectively managing and monitoring third-party relationships is an essential component of a bank's broader risk management function. Given the increased adoption of cloudbased solutions, outsourcing of critical functions, and exploration of the use of artificial intelligence (AI), banks must have robust strategies for cyber resilience. Generative AI has the potential to transform operations and the customer experience. But it is also vulnerable to cyberthreats and will require an ongoing analysis of risk-identification and management. Last year, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency jointly issued new guidance titled "Interagency Guidance on Third-Party Relationships: Risk Management," which was recently supplemented by a community bank guide meant to assist these banks in tailoring their third-party risk management programs. Later this afternoon, you will hear more on this from our panel of IT examiners on these resources, recent observations from the field, and risks associated with AI. Ransomware attacks continue to target individuals, businesses, and governments across the country and often result in significant financial and operational harm. Combating ransomware requires that an organization make investments in people, processes, and technology. Often, these attacks are successful because wellintentioned staff have their guard down, or they are not effectively trained to identify and respond to a potential incident. Employees can be your greatest strength, but also your weakest link when it comes to protecting digital assets. That's why it is critical that cyberprograms are built upon a solid foundation that includes training staff to quickly respond to suspicious activity. This reinforces the importance of a skeptical approach in helping to safeguard information. Today and tomorrow, Federal Reserve staff, law enforcement, and industry stakeholders will share their perspectives on ransomware incidents, including restoration of key payments-related functions, cyberinsurance, payments-related risks, and financial considerations during an incident. Finally, a cybersecurity program would not be complete without a comprehensive testing and exercise plan. By incorporating regular testing, a bank can identify strengths and weaknesses in their current strategies. They can then leverage this information to enhance resiliency, resulting in a higher level of preparedness when an incident occurs. Tabletop exercises like the one facilitated tomorrow with IBM are an excellent way to test a cyberdefense strategy against multiple scenarios, including those involving a third party and payment systems. In closing, outreach events like this workshop, the February 2024 Ask the Fed session with the Cybersecurity and Infrastructure Security Agency, and our recent virtual "office hours" on the 2023 third-party risk management guidance enable us to connect and share resources. These opportunities help us to better support industry management of cybersecurity and other operational risks. I would like to thank the Federal Reserve Banks of Chicago, Kansas City, and St. Louis for organizing this event, and I hope you enjoy the workshop.
2024-06-26T00:00:00	Michelle W Bowman: The consequences of bank capital reform	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the International Swaps and Derivatives Association (ISDA) Board of Directors, London, England, 26 June 2024.	Michelle W Bowman: The consequences of bank capital reform Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the International Swaps and Derivatives Association (ISDA) Board of Directors, London, England, 26 June 2024. * * * I would like to thank the International Swaps and Derivatives Association (ISDA) for the 1 invitation to speak to you today. I appreciate the opportunity to engage with you on matters that affect the swaps and derivatives industry, specifically how we can best consider and address the potential consequences of bank capital reform measures, both in the United States and around the world. Before doing so, I will share my views on the economy and monetary policy in the United States. Update on the Economy and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures (PCE) inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 and older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As I've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the target range for the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward as supply chains have largely normalized; the labor force participation rate has leveled off in recent months below pre-pandemic levels; and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal, given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. Grappling with the Unintended Consequences of Bank Capital Reform I will turn now to the issue of bank capital reform, and the implications of adopting and implementing the Basel III "endgame" standards both in the United States and around the world. Considering capital and debt requirements in the aggregate Capital requirements are an important component of the prudential regulatory frameworks and interconnected banking and financial systems around the world. As you know, the U.S. has lagged our E.U. and U.K. counterparts in fully implementing the Basel III capital standards. In July 2023, the U.S. federal banking agencies issued a public consultation on implementing what the U.S. calls the Basel III "endgame" capital 2 reforms. The response to the U.S. capital proposal has been overwhelmingly negative, including from a broad range of stakeholders. I have previously spoken at length about my concerns with the proposal, and as public commenters have reviewed it, they have identified additional areas of concern.3 In my view, the concerns are well-founded. The proposal acknowledged that the revisions, if implemented, would result in an estimated 20 percent aggregate increase in total risk-weighted assets across bank holding companies subject to the rule. Individual impacts would vary not only by firm, but also by business line. For any particular business line or product, the aggregate impact of the proposed capital changes could result in a more significant increase, depending upon the firm's characteristics. Consider the impact on business lines subject to the market risk capital rule. As noted in the proposal, the revisions to the market risk rule alone would increase risk-weighted assets from $430 billion to $760 billion for Category I and II firms, and from $130 billion to $220 billion for Category III and IV firms.4 Even this example ignores the additive capital increases from other aspects of the rule, such as the operational risk charge "overlay" that may separately result in a higher capital charge for the same business line, if that line is also generating fee income. The changes that may affect any particular financial product or service vary but could include impacts across all aspects of the proposal. For many of the derivatives and swaps activities in which banking entities engage, the aggregate impacts on different business lines could result from changes to the market risk rule, the calculation of credit valuation adjustments, and the treatment of securities financing transactions, among others. So far, what I have described are just the aggregate effects of capital increases that would appear within the four corners of the U.S. Basel III endgame proposal. We know that these changes do not exist in a vacuum. A particular firm can also be impacted by changes to the global systemically important bank (G-SIB) surcharge and long-term debt requirements. The firm's business planning would also need to consider existing requirements, such as leverage and "total loss-absorbing capacity" requirements. By design, these elements are intended to be complementary, often seeking to capture different risks, operate as "backstop" capital standards, promote resiliency, and be available for recapitalization in resolution. Despite the goal that the capital framework operates in a holistic fashion, the rulemaking process in the United States has taken a fragmented approach. This process has seemed to ignore the interrelationships of the requirements. We cannot fully understand the intended and unintended consequences of any regulatory reform, including capital reform, without using a broader lens to consider the interconnections and interrelationships among different capital and debt requirements that apply in the banking system. This narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework-has created a corresponding narrowness when we think about the consequences of regulatory reform. This challenge has been particularly acute in the capital and debt space simply because there are so many requirements that are intended to operate in a complementary way, and that in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital 5 requirements. And yet, the discussions of costs and benefits of reform tend to disregard the aggregate impact across rules, even when related reforms are proposed at the same time and the aggregate impacts can be identified and assessed.6 Considering direct and indirect consequences With respect to the Basel III "endgame" reforms, much of the discussion of consequences has focused on the direct consequences to the availability and price of credit, resulting from the proposed changes to risk-weighted assets. These issues resonate with households and businesses. Everyone understands the direct impact on their own household finances or their business's bottom line from higher costs of lending. Often overlooked are the direct and indirect consequences of capital reforms on financial products such as derivatives and swaps. These products can seem exotic to the public, but we know they play a significant role in the financial system and the broader economy, including commodities price hedging by end-users, such as agricultural producers. And it is certainly foreseeable that proposed capital reforms could impair market liquidity. We also know that regulatory reforms-especially capital reforms with a direct link to particular products, services, and markets-can cause broader changes in firm behavior. Some banks may raise prices on particular products based on their internal allocation of increased capital charges. And some banks may discontinue certain products or services that cannot be offered in a cost-effective way. These choices will impact the competitive landscape into the future, and in some cases-such as where significant economies of scale are required to offer a product or service-the end result may be that some banks exit certain product markets, resulting in increased concentration and higher prices for households and businesses. While I am acutely aware of our need to consider these costs and price effects, I am also aware that regulators sitting in Washington, D.C. are not well-equipped to query and understand these real-world consequences of reform. In my view, the commenter feedback we have received on these issues has helped to illuminate these consequences. My hope is that we take them into account when moving forward to implement the Basel III endgame standards. The path forward I do see a path forward to implement Basel III, one that not only addresses the overall calibration and international consistency and comparability, but also makes more granular changes that will improve the effectiveness and efficiency of the rule. In terms of this path, I will briefly outline what I see as necessary procedural steps, while also providing a non-exclusive list of substantive changes that I believe are necessary to improve the proposal. In October 2023, the Federal Reserve initiated a data collection to gather information from the banks affected by the U.S. proposal. I am hopeful that these data will allow regulators to better understand the proposal's impact and identify areas for revision. Any next step in this rulemaking process will require broad and material changes. It should also be accompanied by a data-driven analysis of the proposal and be informed by the significant public input received during the rulemaking process. This should assist policymakers in creating a path to improve the rulemaking. My hope is that policymakers pay closer attention to the balance of costs and benefits while considering the direct and indirect consequences of the capital reform. I have previously identified a number of specific areas and procedural steps that would be necessary to address in any future efforts to revise this proposal. Some of these issues include addressing redundancy in the capital framework (for example, between the new market risk and operational risk requirements, and the stress capital buffer); recalibrating the market risk rule specifically, where some of the biggest outlier increases in risk-weighted assets would appear; adopting a more reasonable treatment for non-interest and fee-based income through the operational risk requirements, which could deter banks from diversifying revenue streams, even though such diversification can enhance an institution's stability and resilience; reviewing the impact of capital requirements, including leverage ratio requirements, on U.S. Treasury market intermediation and liquidity; incorporating tailoring in the applicability of Basel III capital reforms, specifically looking at whether each element of the Basel III capital proposal is appropriate for non-G-SIB firms that are not internationally active; and re-proposing the Basel III standards to address the broad and material reforms that I believe should be included in any final rule, including granular changes to address the specific issues raised by commenters, as appropriate.7 While these steps would be a reasonable starting place, they are not a replacement for a data-driven analysis and a careful review of the comments submitted. This would result in a better proposal that includes not only changes to address these concerns, but also the many other concerns raised by the public. Closing Thoughts It has been a pleasure speaking with you today. Your industry plays an important role not only in the U.S. economy, but also in the broader world economy. It is imperative that regulators not lose sight of the practical implications of regulatory reform, even as the U.S. considers the next steps in moving forward to adopt the final Basel III capital reforms. 1 The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors of the Federal Reserve System. 2 Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC), "Agencies Request Comment on Proposed Rules to Strengthen Capital Requirements for Large Banks," news release, July 27, 2023; OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. 64,028- 64,343 (September 18, 2023). 3 See dissenting statement, " Statement by Governor Michelle W. Bowman " on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023 ; Michelle W. Bowman, " Remarks on the Economy and Prioritization of Bank Supervision and Regulation (PDF)" (speech at the New York Bankers Association's Financial Services Forum, Palm Beach, Florida, November 9, 2023); Michelle W. Bowman, " The Path Forward for Bank Capital Reform (PDF) " (speech at Protect Main Street, sponsored by the Center for Capital Markets at the U.S. Chamber of Commerce, Washington, D.C., January 17, 2024). 4 OCC, Board of Governors of the Federal Reserve System, and FDIC, Notice of Proposed Rulemaking, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Signfiicant Trading Activity," 88 Fed. Reg. 64,028, 64,168, table 11 (September 18, 2023). 5 See, e.g., Board of Governors of the Federal Reserve System, Interim Final Rule and Request for Comment, "Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio (PDF)," 85 Fed. Reg. 20,578, 20,579 (April 14, 2020) ("This interim final rule does not affect the tier 1 leverage ratio, which will continue to serve as a backstop for all banking organizations subject to the capital rule."). 6 See, e.g., OCC, Board of Governors of the Federal Reserve System, and FDIC, Notice of Proposed Rulemaking, "Long-Term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions (PDF)," 88 Fed. Reg. 64,524, 64,551, n. 97 ("The agencies recognize that their Basel III reforms proposal would, if adopted, increase risk-weighted assets across covered entities. The increased riskweighted assets would lead mechanically to increased requirements for LTD under the LTD proposal. The increased capital that would be required under the Basel III proposal could also reduce the cost of various forms of debt for impacted firms due to the increased resilience that accompanies additional capital (which is sometimes referred to as the Modigliani-Miller offset).The size of the estimated LTD needs and costs presented in this section do not account for either of these potential effects of the Basel III proposal.") (emphasis added). Even when the agencies estimate the effect of a proposal on other rules, the impact analysis tends to be narrow, such as focusing on the estimated shortfall that would be created by the interrelated rules and may overlook other pending rules. See, e.g., OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. at 64,171 (noting that the proposed revisions to the calculation of risk-weighted assets under the Basel III endgame proposal would affect the risk-based TLAC and LTD requirements applicable to Category I bank holding companies but disregarding the pending proposal that would expand long-term debt requirements to a broader set of firms). 7 See dissenting statement, " Statement by Governor Michelle W. Bowman " on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023; Michelle W. Bowman, "Remarks on the Economy and Prioritization of Bank Supervision and Regulation (PDF)"; Michelle W. Bowman, " The Path Forward for Bank Capital Reform (PDF)."	---[PAGE_BREAK]--- # Michelle W Bowman: The consequences of bank capital reform Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the International Swaps and Derivatives Association (ISDA) Board of Directors, London, England, 26 June 2024. I would like to thank the International Swaps and Derivatives Association (ISDA) for the invitation to speak to you today. I appreciate the opportunity to engage with you on matters that affect the swaps and derivatives industry, specifically how we can best consider and address the potential consequences of bank capital reform measures, both in the United States and around the world. Before doing so, I will share my views on the economy and monetary policy in the United States. ## Update on the Economy and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures (PCE) inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the ---[PAGE_BREAK]--- number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 and older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As l've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the target range for the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward as supply chains have largely normalized; the labor force participation rate has leveled off in recent months below pre-pandemic levels; and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal, given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for ---[PAGE_BREAK]--- and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. # Grappling with the Unintended Consequences of Bank Capital Reform I will turn now to the issue of bank capital reform, and the implications of adopting and implementing the Basel III "endgame" standards both in the United States and around the world. ## Considering capital and debt requirements in the aggregate Capital requirements are an important component of the prudential regulatory frameworks and interconnected banking and financial systems around the world. As you know, the U.S. has lagged our E.U. and U.K. counterparts in fully implementing the Basel III capital standards. In July 2023, the U.S. federal banking agencies issued a public consultation on implementing what the U.S. calls the Basel III "endgame" capital reforms. ${ }^{2}$ The response to the U.S. capital proposal has been overwhelmingly negative, including from a broad range of stakeholders. I have previously spoken at length about my concerns with the proposal, and as public commenters have reviewed it, they have identified additional areas of concern. ${ }^{3}$ In my view, the concerns are well-founded. The proposal acknowledged that the revisions, if implemented, would result in an estimated 20 percent aggregate increase in total risk-weighted assets across bank holding companies subject to the rule. Individual impacts would vary not only by firm, but also by business line. For any particular business line or product, the aggregate impact of the proposed capital changes could result in a more significant increase, depending upon the firm's characteristics. Consider the impact on business lines subject to the market risk capital rule. As noted in the proposal, the revisions to the market risk rule alone would increase risk-weighted assets from $\$ 430$ billion to $\$ 760$ billion for Category I and II firms, and from $\$ 130$ billion to $\$ 220$ billion for Category III and IV firms. ${ }^{4}$ Even this example ignores the additive capital increases from other aspects of the rule, such as the operational risk charge "overlay" that may separately result in a higher capital charge for the same business line, if that line is also generating fee income. The changes that may affect any particular financial product or service vary but could include impacts across all aspects of the proposal. For many of the derivatives and swaps activities in which banking entities engage, the aggregate impacts on different business lines could result from changes to the market risk rule, the calculation of credit valuation adjustments, and the treatment of securities financing transactions, among others. So far, what I have described are just the aggregate effects of capital increases that would appear within the four corners of the U.S. Basel III endgame proposal. We know that these changes do not exist in a vacuum. A particular firm can also be impacted by changes to the global systemically important bank (G-SIB) surcharge and long-term debt requirements. The firm's business planning would also need to consider existing ---[PAGE_BREAK]--- requirements, such as leverage and "total loss-absorbing capacity" requirements. By design, these elements are intended to be complementary, often seeking to capture different risks, operate as "backstop" capital standards, promote resiliency, and be available for recapitalization in resolution. Despite the goal that the capital framework operates in a holistic fashion, the rulemaking process in the United States has taken a fragmented approach. This process has seemed to ignore the interrelationships of the requirements. We cannot fully understand the intended and unintended consequences of any regulatory reform, including capital reform, without using a broader lens to consider the interconnections and interrelationships among different capital and debt requirements that apply in the banking system. This narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework-has created a corresponding narrowness when we think about the consequences of regulatory reform. This challenge has been particularly acute in the capital and debt space simply because there are so many requirements that are intended to operate in a complementary way, and that in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital requirements. $\underline{5}$ And yet, the discussions of costs and benefits of reform tend to disregard the aggregate impact across rules, even when related reforms are proposed at the same time and the aggregate impacts can be identified and assessed. $\underline{6}$ # Considering direct and indirect consequences With respect to the Basel III "endgame" reforms, much of the discussion of consequences has focused on the direct consequences to the availability and price of credit, resulting from the proposed changes to risk-weighted assets. These issues resonate with households and businesses. Everyone understands the direct impact on their own household finances or their business's bottom line from higher costs of lending. Often overlooked are the direct and indirect consequences of capital reforms on financial products such as derivatives and swaps. These products can seem exotic to the public, but we know they play a significant role in the financial system and the broader economy, including commodities price hedging by end-users, such as agricultural producers. And it is certainly foreseeable that proposed capital reforms could impair market liquidity. We also know that regulatory reforms-especially capital reforms with a direct link to particular products, services, and markets-can cause broader changes in firm behavior. Some banks may raise prices on particular products based on their internal allocation of increased capital charges. And some banks may discontinue certain products or services that cannot be offered in a cost-effective way. These choices will impact the competitive landscape into the future, and in some cases-such as where significant economies of scale are required to offer a product or service-the end result may be that some banks exit certain product markets, resulting in increased concentration and higher prices for households and businesses. While I am acutely aware of our need to consider these costs and price effects, I am also aware that regulators sitting in Washington, D.C. are not well-equipped to query ---[PAGE_BREAK]--- and understand these real-world consequences of reform. In my view, the commenter feedback we have received on these issues has helped to illuminate these consequences. My hope is that we take them into account when moving forward to implement the Basel III endgame standards. # The path forward I do see a path forward to implement Basel III, one that not only addresses the overall calibration and international consistency and comparability, but also makes more granular changes that will improve the effectiveness and efficiency of the rule. In terms of this path, I will briefly outline what I see as necessary procedural steps, while also providing a non-exclusive list of substantive changes that I believe are necessary to improve the proposal. In October 2023, the Federal Reserve initiated a data collection to gather information from the banks affected by the U.S. proposal. I am hopeful that these data will allow regulators to better understand the proposal's impact and identify areas for revision. Any next step in this rulemaking process will require broad and material changes. It should also be accompanied by a data-driven analysis of the proposal and be informed by the significant public input received during the rulemaking process. This should assist policymakers in creating a path to improve the rulemaking. My hope is that policymakers pay closer attention to the balance of costs and benefits while considering the direct and indirect consequences of the capital reform. I have previously identified a number of specific areas and procedural steps that would be necessary to address in any future efforts to revise this proposal. Some of these issues include - addressing redundancy in the capital framework (for example, between the new market risk and operational risk requirements, and the stress capital buffer); - recalibrating the market risk rule specifically, where some of the biggest outlier increases in risk-weighted assets would appear; - adopting a more reasonable treatment for non-interest and fee-based income through the operational risk requirements, which could deter banks from diversifying revenue streams, even though such diversification can enhance an institution's stability and resilience; - reviewing the impact of capital requirements, including leverage ratio requirements, on U.S. Treasury market intermediation and liquidity; - incorporating tailoring in the applicability of Basel III capital reforms, specifically looking at whether each element of the Basel III capital proposal is appropriate for non-G-SIB firms that are not internationally active; and - re-proposing the Basel III standards to address the broad and material reforms that I believe should be included in any final rule, including granular changes to address the specific issues raised by commenters, as appropriate. $\underline{7}$ While these steps would be a reasonable starting place, they are not a replacement for a data-driven analysis and a careful review of the comments submitted. This would result in a better proposal that includes not only changes to address these concerns, but also the many other concerns raised by the public. ## Closing Thoughts ---[PAGE_BREAK]--- It has been a pleasure speaking with you today. Your industry plays an important role not only in the U.S. economy, but also in the broader world economy. It is imperative that regulators not lose sight of the practical implications of regulatory reform, even as the U.S. considers the next steps in moving forward to adopt the final Basel III capital reforms. ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors of the Federal Reserve System. ${ }^{2}$ Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC), "Agencies Request Comment on Proposed Rules to Strengthen Capital Requirements for Large Banks," news release, July 27, 2023; OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. 64,02864,343 (September 18, 2023). ${ }^{3}$ See dissenting statement, "Statement by Governor Michelle W. Bowman" on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023;Michelle W. Bowman, "Remarks on the Economy and Prioritization of Bank Supervision and Regulation (PDF)" (speech at the New York Bankers Association's Financial Services Forum, Palm Beach, Florida, November 9, 2023); Michelle W. Bowman, "The Path Forward for Bank Capital Reform (PDF)" (speech at Protect Main Street, sponsored by the Center for Capital Markets at the U.S. Chamber of Commerce, Washington, D.C., January 17, 2024). ${ }^{4}$ OCC, Board of Governors of the Federal Reserve System, and FDIC, Notice of Proposed Rulemaking, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Signfiicant Trading Activity," 88 Fed. Reg. 64,028, 64,168, table 11 (September 18, 2023). ${ }^{5}$ See, e.g., Board of Governors of the Federal Reserve System, Interim Final Rule and Request for Comment, "Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio (PDF)," 85 Fed. Reg. 20,578, 20,579 (April 14, 2020) ("This interim final rule does not affect the tier 1 leverage ratio, which will continue to serve as a backstop for all banking organizations subject to the capital rule."). ${ }^{6}$ See, e.g., OCC, Board of Governors of the Federal Reserve System, and FDIC, Notice of Proposed Rulemaking, "Long-Term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions (PDF)," 88 Fed. Reg. 64,524, 64,551, n. 97 ("The agencies recognize that their Basel III reforms proposal would, if adopted, increase risk-weighted assets across covered entities. The increased riskweighted assets would lead mechanically to increased requirements for LTD under the LTD proposal. The increased capital that would be required under the Basel III proposal ---[PAGE_BREAK]--- could also reduce the cost of various forms of debt for impacted firms due to the increased resilience that accompanies additional capital (which is sometimes referred to as the Modigliani-Miller offset). The size of the estimated LTD needs and costs presented in this section do not account for either of these potential effects of the Basel III proposal.") (emphasis added). Even when the agencies estimate the effect of a proposal on other rules, the impact analysis tends to be narrow, such as focusing on the estimated shortfall that would be created by the interrelated rules and may overlook other pending rules. See, e.g., OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. at 64,171 (noting that the proposed revisions to the calculation of risk-weighted assets under the Basel III endgame proposal would affect the risk-based TLAC and LTD requirements applicable to Category I bank holding companies but disregarding the pending proposal that would expand long-term debt requirements to a broader set of firms). 7 See dissenting statement, "Statement by Governor Michelle W. Bowman" on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023; Michelle W. Bowman, "Remarks on the Economy and Prioritization of Bank Supervision and Regulation (PDF)"; Michelle W. Bowman, "The Path Forward for Bank Capital Reform (PDF)."	Michelle W Bowman	United States	https://www.bis.org/review/r240701b.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the International Swaps and Derivatives Association (ISDA) Board of Directors, London, England, 26 June 2024. I would like to thank the International Swaps and Derivatives Association (ISDA) for the invitation to speak to you today. I appreciate the opportunity to engage with you on matters that affect the swaps and derivatives industry, specifically how we can best consider and address the potential consequences of bank capital reform measures, both in the United States and around the world. Before doing so, I will share my views on the economy and monetary policy in the United States. Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures (PCE) inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 and older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As l've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the target range for the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward as supply chains have largely normalized; the labor force participation rate has leveled off in recent months below pre-pandemic levels; and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal, given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. I will turn now to the issue of bank capital reform, and the implications of adopting and implementing the Basel III "endgame" standards both in the United States and around the world. Capital requirements are an important component of the prudential regulatory frameworks and interconnected banking and financial systems around the world. As you know, the U.S. has lagged our E.U. and U.K. counterparts in fully implementing the Basel III capital standards. In July 2023, the U.S. federal banking agencies issued a public consultation on implementing what the U.S. calls the Basel III "endgame" capital reforms. In my view, the concerns are well-founded. The proposal acknowledged that the revisions, if implemented, would result in an estimated 20 percent aggregate increase in total risk-weighted assets across bank holding companies subject to the rule. Individual impacts would vary not only by firm, but also by business line. For any particular business line or product, the aggregate impact of the proposed capital changes could result in a more significant increase, depending upon the firm's characteristics. Consider the impact on business lines subject to the market risk capital rule. As noted in the proposal, the revisions to the market risk rule alone would increase risk-weighted assets from $\$ 430$ billion to $\$ 760$ billion for Category I and II firms, and from $\$ 130$ billion to $\$ 220$ billion for Category III and IV firms. Even this example ignores the additive capital increases from other aspects of the rule, such as the operational risk charge "overlay" that may separately result in a higher capital charge for the same business line, if that line is also generating fee income. The changes that may affect any particular financial product or service vary but could include impacts across all aspects of the proposal. For many of the derivatives and swaps activities in which banking entities engage, the aggregate impacts on different business lines could result from changes to the market risk rule, the calculation of credit valuation adjustments, and the treatment of securities financing transactions, among others. So far, what I have described are just the aggregate effects of capital increases that would appear within the four corners of the U.S. Basel III endgame proposal. We know that these changes do not exist in a vacuum. A particular firm can also be impacted by changes to the global systemically important bank (G-SIB) surcharge and long-term debt requirements. The firm's business planning would also need to consider existing requirements, such as leverage and "total loss-absorbing capacity" requirements. By design, these elements are intended to be complementary, often seeking to capture different risks, operate as "backstop" capital standards, promote resiliency, and be available for recapitalization in resolution. Despite the goal that the capital framework operates in a holistic fashion, the rulemaking process in the United States has taken a fragmented approach. This process has seemed to ignore the interrelationships of the requirements. We cannot fully understand the intended and unintended consequences of any regulatory reform, including capital reform, without using a broader lens to consider the interconnections and interrelationships among different capital and debt requirements that apply in the banking system. This narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework-has created a corresponding narrowness when we think about the consequences of regulatory reform. This challenge has been particularly acute in the capital and debt space simply because there are so many requirements that are intended to operate in a complementary way, and that in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital requirements. With respect to the Basel III "endgame" reforms, much of the discussion of consequences has focused on the direct consequences to the availability and price of credit, resulting from the proposed changes to risk-weighted assets. These issues resonate with households and businesses. Everyone understands the direct impact on their own household finances or their business's bottom line from higher costs of lending. Often overlooked are the direct and indirect consequences of capital reforms on financial products such as derivatives and swaps. These products can seem exotic to the public, but we know they play a significant role in the financial system and the broader economy, including commodities price hedging by end-users, such as agricultural producers. And it is certainly foreseeable that proposed capital reforms could impair market liquidity. We also know that regulatory reforms-especially capital reforms with a direct link to particular products, services, and markets-can cause broader changes in firm behavior. Some banks may raise prices on particular products based on their internal allocation of increased capital charges. And some banks may discontinue certain products or services that cannot be offered in a cost-effective way. These choices will impact the competitive landscape into the future, and in some cases-such as where significant economies of scale are required to offer a product or service-the end result may be that some banks exit certain product markets, resulting in increased concentration and higher prices for households and businesses. While I am acutely aware of our need to consider these costs and price effects, I am also aware that regulators sitting in Washington, D.C. are not well-equipped to query and understand these real-world consequences of reform. In my view, the commenter feedback we have received on these issues has helped to illuminate these consequences. My hope is that we take them into account when moving forward to implement the Basel III endgame standards. I do see a path forward to implement Basel III, one that not only addresses the overall calibration and international consistency and comparability, but also makes more granular changes that will improve the effectiveness and efficiency of the rule. In terms of this path, I will briefly outline what I see as necessary procedural steps, while also providing a non-exclusive list of substantive changes that I believe are necessary to improve the proposal. In October 2023, the Federal Reserve initiated a data collection to gather information from the banks affected by the U.S. proposal. I am hopeful that these data will allow regulators to better understand the proposal's impact and identify areas for revision. Any next step in this rulemaking process will require broad and material changes. It should also be accompanied by a data-driven analysis of the proposal and be informed by the significant public input received during the rulemaking process. This should assist policymakers in creating a path to improve the rulemaking. My hope is that policymakers pay closer attention to the balance of costs and benefits while considering the direct and indirect consequences of the capital reform. I have previously identified a number of specific areas and procedural steps that would be necessary to address in any future efforts to revise this proposal. Some of these issues include addressing redundancy in the capital framework (for example, between the new market risk and operational risk requirements, and the stress capital buffer);. recalibrating the market risk rule specifically, where some of the biggest outlier increases in risk-weighted assets would appear;. adopting a more reasonable treatment for non-interest and fee-based income through the operational risk requirements, which could deter banks from diversifying revenue streams, even though such diversification can enhance an institution's stability and resilience;. reviewing the impact of capital requirements, including leverage ratio requirements, on U.S. Treasury market intermediation and liquidity;. incorporating tailoring in the applicability of Basel III capital reforms, specifically looking at whether each element of the Basel III capital proposal is appropriate for non-G-SIB firms that are not internationally active; and. re-proposing the Basel III standards to address the broad and material reforms that I believe should be included in any final rule, including granular changes to address the specific issues raised by commenters, as appropriate. . While these steps would be a reasonable starting place, they are not a replacement for a data-driven analysis and a careful review of the comments submitted. This would result in a better proposal that includes not only changes to address these concerns, but also the many other concerns raised by the public. It has been a pleasure speaking with you today. Your industry plays an important role not only in the U.S. economy, but also in the broader world economy. It is imperative that regulators not lose sight of the practical implications of regulatory reform, even as the U.S. considers the next steps in moving forward to adopt the final Basel III capital reforms.
2024-06-26T00:00:00	Philip R Lane: Modern monetary analysis	Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the 3rd Bank of Finland International Monetary Policy Conference "Monetary Policy in Low and High Inflation Environments", Helsinki, 26 June 2024.	SPEECH Modern monetary analysis Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Bank of Finland's International Monetary Policy Conference Helsinki, 26 June 2024 Introduction My aim today is to discuss the modern role of monetary analysis at the ECB." I will first review how monetary analysis has advanced over the twenty-five year history of the euro. Second, I will discuss how monetary analysis contributed to the assessment of financing conditions during the pandemic. Third, I will explain how monetary analysis has informed the diagnosis of the post-pandemic surges in inflation. Fourth, I will examine the contributions of monetary analysis to the calibration of the tightening cycle. Finally, I will speculate on the future role of monetary analysis. The evolving role of monetary analysis The initial monetary policy strategy of the ECB was based on a two-pillar framework to identify risks to price stability: economic analysis and monetary analysis. The two analytical domains essentially provided complementary perspectives on the economy.2] For the monetary pillar, the ECB's Governing Council initially chose to emphasise the quantity of money among the key indicators to be closely monitored and established a reference value for the growth of a broad monetary aggregate (M3). This approach was in line with the views of early-day monetarists who considered money growth the primary source of inflation. Milton Friedman famously captured this in the adage that "inflation is always and everywhere a monetary phenomenon". In an admittedly restrictive interpretation of Friedman's statement, this is reflected in the quantity identity Mv=PY.4! This school of thought saw money as an imperfect substitute for a wide range of financial and real assets. A policy-induced injection of money into the economy would trigger complex and inter-related portfolio rebalancing across asset categories. This rebalancing would then lead to widespread changes in asset prices, yields and spreads across the economy. These mechanisms are well described in the classic 1988 monetarist account of transmission by Karl Brunner and Alan Meltzer. Especially after the end of the Bretton Woods system in 1973, some stability-oriented central banks - most notably the Deutsche Bundesbank - were looking for a substitute anchor, and these monetarist considerations played a significant role in the conduct of monetary policy throughout the 1970s, 1980s and 1990s. The result of that intellectual legacy was the prominent role that the ECB assigned to a reference value for money growth as an anchor back in 1998.5] Deviations from that reference value and the associated "monetary overhang/shortfall" were, at the time, generally considered to signal risks to price stability. However, a consistent record of difficulties within central banks in interpreting swings in monetary aggregates and in relying on them for predicting inflation at the horizons relevant for monetary policy contributed to a declining emphasis on money in policy making. As early as 1983, Bank of Canada Governor Gerald Bouey famously quipped "/ would not say that we abandoned M1; I would say that M1 abandoned us, because of changes in banking practices" Even though Bouey was speaking about M1, the same instability problem applied to M3. Moreover, by the time Michael Woodford came to write his seminal text Interest and Prices in 2003, there was a wide-spread view that it was not necessary to incorporate money in modern macroeconomic models. 21 Rather, the monetary policy stance could be summarised by the setting of interest rates alone. Accordingly, money was all but removed from the modern monetary economics synthesis. Against this background, the ECB conducted a review of its monetary policy strategy in 2003. This resulted in a revised approach to monetary analysis under the monetary pillar, with the adoption of a broader view of the role of money in the economy and the financial system. The long-term empirical relation between money and inflation had consistently been proven unhelpful in quantifying the scale of price pressures on a meeting-by-meeting basis. This realisation led to the discontinuation of the earlier practice of reviewing the reference value for M3, with a shift towards treating money aggregates as indicator variables rather than intermediate targets for monetary policy. The 2003 strategy review also clarified that monetary analysis served as a tool for cross-checking the short to medium-term indications from the economic analysis, from a medium to long-term perspective 10] After 2003, two significant developments led to an increased focus of monetary analysis on monetary policy transmission. First, the global financial crisis and the euro area sovereign debt crisis highlighted the vulnerability of the transmission mechanism. This, in turn, prompted policymakers to place greater reliance on monetary analysis in navigating the resulting challenges. Second, the adoption of unconventional monetary policy tools by the ECB of required monetary analysis to broaden its scope to better understand the many new transmission channels that the adoption of unconventional instruments had set in motion, including the analysis of potential side effects of those measures. Overall, the shift in focus of monetary analysis towards monetary policy transmission represented a natural evolution in line with the changing monetary policy landscape. These developments were incorporated in monetary analysis during the latest strategy review conducted in 2021. In the new framework, "economic analysis" and "monetary analysis" no longer represent distinct perspectives on inflation. Instead, the interrelations between economic developments and monetary and financial developments are explicitly integrated into the overall assessment of inflation risks and the formulation of monetary policy.) Accordingly, monetary analysis has expanded from a narrow focus on the quantity of money to the wider mechanism by which monetary policy actions transmit to the financing conditions faced by households and firms in the real economy.12] This approach often employs monetarist concepts, formalised within modern structural models, to analyse changes in spreads and asset prices linked to portfolio rebalancing across imperfectly substitutable financial assets, including money and money-type assets.{3] Monetary analysis played a particularly salient role in policy decision-making when the policy rate approached the effective lower bound. This period saw a significant expansion of liquidity in the financial system through central bank lending programmes and outright asset purchases, underscoring the importance of informed decision-making based on monetary analysis. In the quantity identity (MV=PY), the traditional emphasis had primarily been on the growth rate of money, M. However, the bi-variate relation between inflation and money growth had not only always been elusive but also weakened over time, before disappearing altogether in the first decade of the 2000s (Chart 4)04) Past studies had found a significant and stable relation between broad money growth and inflation across several economies and monetary regimes. However, this relation was observed at very low frequency over extremely long periods, limiting the degree to which it can be used in practice at the meeting-by-meeting frequency required for policy decisions." Moreover, research incorporating recent experiences finds that structural shifts in banking and the financial system have destabilised the relation between money supply and inflation." Precisely for these reasons, since the global financial crisis, the importance of the bank lending channel and other transmission mechanisms has become more prominent. Monetary analysis has adapted by increasing the emphasis on analysing the credit-creation process, its relation with liquidity conditions and the various frictions affecting the financial system. All these elements affect the transmission of monetary policy to the real economy and thereby contribute to inflation dynamics. Chart 1 Money growth and inflation (annual percentage changes) == M3 annual growth == HICP inflation 20 15 10 5 1971 1981 1991 2001 2011 2021 Sources: ECB (BSI), Eurostat and ECB calculations. The latest observations are for 2024 Q1. From this perspective, it would be overly reductive to interpret the rise of money growth during the pandemic and the subsequent rise in inflation that is shown in Chart 1 as a causal relation. In fact, the strong money growth in the early phase of the pandemic was driven by the build-up of liquidity buffers, which is not inherently inflationary." This is consistent with the view that the surges in inflation in 2021 and 2022 were mostly related to supply-side factors, such as global supply bottlenecks and increases in energy and commodity prices, rather than an increased stock of money. This view is further reinforced by the nature of the inflation shock which involved large relative price movements, whereas money-induced inflation should have been associated with a more uniform increase in prices across categories. I will return to the pandemic episode later in this speech. The wider availability of timely granular information on balance sheets, lending rates and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening."8] More recently, the availability of loan- and transaction-level information on banks and firms has further enhanced the analysis of the monetary policy transmission mechanism along several dimensions, including: heterogeneity in the transmission of monetary policy across regions and sectors, the impact of monetary policy on bank risk-taking, and the sources of changes in credit developments.4 Financing conditions during the pandemic The pandemic period was marked by extraordinarily high liquidity demand, triggering a global dash for cash by investors. Lockdowns, social distancing measures and travel restrictions led many firms to experience a reduction in consumer demand and to reduce or halt their operations. This triggered a substantial decline in revenue for businesses across a wide range of sectors. However, firms still had to meet operating expenses and short-term obligations, such as the maintenance of inventories, payments to suppliers, salaries, taxes and fixed operational expenses. These needs showed up very clearly in the replies by banks to the ECB bank lending survey (BLS), which documented a surge in loan demand by firms to finance working capital, while financing needs linked to investment weakened considerably (Chart 2).!20 Chart 2 Financing needs for inventories and working capital and loan demand by enterprises (net percentages) <== Loan demand === Inventories and working capital Fixed investment 80 60 40 20 40 -60 Q1 2015 Q2 2016 Q3 2017 Q4 2018 Q1 2020 Q2 2021 Q3 2022 Q4 2023 Source: ECB (BLS). Notes: Net percentages for the questions on demand for loans are defined as the difference between the sum of the percentages of banks responding "increased considerably" and "increased somewhat" and the sum of the percentages of banks responding "decreased somewhat" and "decreased considerably". The net percentages for responses to questions relating to contributing factors are defined as the difference between the percentage of banks reporting that the given factor contributed to increasing demand and the percentage of banks reporting that it contributed to decreasing demand. The latest observations are for Q1 2024. In this environment, employment and total hours worked declined at the sharpest rates on record, with many employees being furloughed or having their working hours reduced. Consequently, salary incomes were dented. Banks across the euro area faced rising funding costs due to a climate of heightened uncertainty in the market and concerns about borrower creditworthiness. This led to a reassessment of risk, affecting not only banks but also the broader financial markets, as evidenced by the increase in corporate bond yields. In the absence of countervailing measures, banks would have struggled to secure funding, which would have limited their ability to meet the high demand for emergency loans, potentially crippling their lending capacity. Accordingly, it was crucial for our monetary policy to maintain favourable financing conditions and the effective transmission of monetary policy, in order to avert a monetary squeeze that would have exacerbated adverse effects from the pandemic on the economy and price stability. The experience gained over the preceding decade allowed us to respond swiftly and decisively, deploying essentially two types of instruments. The first type was intended to maintain an accommodative monetary policy stance and, in parallel, stem the tide of an impending meltdown in financial markets as investors were pulling back from riskier assets. Here the main measures were the recalibration of the asset purchase programme (APP) and the introduction of the pandemic emergency purchase programme (PEPP).21[22] The second group of instruments was deployed to ensure that the accommodative impulse would reach the broader economy. Notable examples include the recalibrations of the targeted longer-term refinancing operations (TLTROs) for banks at attractive conditions.25] These term credit operations were aimed at expanding the quantity of central bank reserves, subject to the condition that banks would lend them on and keep credit flowing to the economy. As a facilitating measure, the targeted lending programme was accompanied by a temporary easing of collateral and regulatory constraints. The interplay between policies to keep the risk-free curve low and steady across maturities, and instruments to unclog the transmission pipes worked as intended. The economics of the portfolio rebalancing channel learned during the first wave of the APP net purchases, over the period 2015- 2018, as well as the experience of the portfolio movements during the sovereign debt crisis, were instrumental for the design of the PEPP. The portfolio rebalancing channel is the key mechanism through which central bank asset purchases transmits monetary policy to the broader economy. 4] This channel functions through the principle of imperfect substitutability among financial instruments, coupled with investor preferences for certain assets, known as preferred habitats. !25] Monetary analysis studied how portfolio allocations can change directions both across instruments and between euro-denominated domestic assets and foreign assets. Within the euro area, the APP had led to a rebalancing of bank exposures from sovereign securities towards corporate securities and from bonds to real-sector loans, easing financing conditions to corporates and households in the process. 24] The shift towards foreign assets had been more pronounced among foreign investors, who were the main selling sector counterpart in the APP during the pre-pandemic period, but it was also evident among euro area investors (Chart 3).!24] This had played a significant role in explaining the limited effect that the APP had on the expansion of broad money supply before the pandemic, a phenomenon that was similarly observed during the third round of quantitative easing in the United States (Chart 4). In other words, the APP had exerted robust monetary transmission even in the absence of a strong expansion in the money supply, because the exchange rate channel had become a powerful substitute for the traditional money-creation mechanism that worked through the liability side of bank balance sheets. Chart 3 Net portfolio investment in debt securities by euro area non-MF Is (12-month flows in EUR bn) = Total @ Net purchases by euro area non-MFls of debt securities issued by non-euro area residents tm@ Net purchases by non-euro area residents of debt securities issued by euro area general government @ Net purchases by non-euro area residents of debt securities issued by euro area non-MFls other than general government 400 -400 i -600 -800 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Sources: ECB (BPS) and ECB calculations. Notes: As is common in the monetary presentation of the balance of payments, the b.o.p. items correspond to the non-MFI sector and display the sign that matches the related monetary flows, i.e. monetary inflows are shown with a positive sign and monetary outflows are shown with a negative sign. The latest observations are for April 2024. Chart 4 Sources of money creation Euro area United States (annual percentage changes and contributions) I (annual percentage changes and contributions) = M3 = M2 © Loans to firms and households © Business, mortgage and consumer loans @ Net external monetary flows @ Net external monetary flows ® Eurosystemnet purchases ®@ Fed net purchases of securities Other counterparts Other counterparts 15 30 10 20 5 10 I fl I I I AT ill = aE I ° a 6 2013 2015 2017 2019 2021 2023 WLU mn" wn i Ht HU wy -10 2013 2015 2017 2019 2021 2023 Sources: Left panel: ECB (BSI) and ECB calculations; right panel: Federal Reserve Board/Haver Analytics, Bureau of Economic Analysis and ECB calculations. Notes: Panel a: Figures for M3 are adjusted for the operational incident in TARGET2 which inflated the September 2022 figures for OFI deposits and loans, reversing them in October and November 2022. Panel b: Net external monetary flows (which are the exchanges between the non-MFI sector and the rest of the world) are obtained by subtracting the contribution of deposit-taking institutions and central bank (where available) to the US b.o.p. They display the sign that matches the related monetary flows, i.e. monetary inflows are shown with a positive sign, monetary outflows are shown with a negative sign. The latest observation for that series is for Q1 2024, but the monthly flow for April 2024 is kept equal to that of March 2024. As required by the monetary framework, Eurosystem purchases includes securities issued by euro area non-MFls. The latest observations are for April 2024. The long-standing internal monetary analysis of the factors explaining the setting of bank lending rates was critical in the recalibration of existing TLTROs during the pandemic. In particular, the pricing of the new wave of TLTROs following the outbreak of the pandemic relied on the accumulated evidence that the unconventional policies deployed by the ECB had lowered various components of bank funding costs in the aftermath of the euro area sovereign debt crisis (Chart 5), (28) Empirical estimates indicate that, in the absence of the recalibration of the targeted lending programme, the ability of banks to supply credit would have been severely affected. Importantly, the lower amount of lending to firms would have led to a significantly larger decline in employment by firms.22] Chart 5 Lending rate to non-financial corporations and its components (percentages per annum) m Realised lending rate @ Cost of credit risk = OS 3Y @ Money market and ECB borrowing tm@ Bank bonds Residual @ Deposits 2 2004 2008 2012 2016 2020 2024 Sources: ECB (BSI, MIR), Bloomberg, Moody's and ECB calculations. Notes: The chart decomposes the realised lending rate on new loans to non-financial corporations (blue line) into contributions from bank cost components. The residual between the realised lending rate and the various cost components identifies a measure of intermediation margin. Deposits, bank bonds and money market and ECB borrowing are expressed as spreads vis-a-vis the base rate (i.e., the three-year overnight index swap (OIS), black line), weighted by their respective importance in banks' funding mix. The latest observations are for April 2024. The post-pandemic surges in inflation The combination of extraordinarily high liquidity needs and our monetary policy measures to maintain favourable financing conditions boosted broad money growth. As a result, credit to firms and central bank purchases became the main sources of money creation. This composition reflected the broad division of tasks in the support given to the euro area economy, with the support to the corporate sector mostly channelled via bank credit (whose conditions were eased by monetary policy, government guarantees and regulatory measures) while the support to households was mostly channelled via the government sector. The latter, and thus the liquidity needs of the economy, explain the marked impact of central bank purchases on money growth in the early stages of the pandemic. In contrast to the 2015-2018 period, these purchases occurred alongside an increase in government borrowing. Such borrowing prevented the bond scarcity that large-scale asset purchases can imply, thereby averting the usual financial outflows to the rest of the world (Chart 4, left panel). As economic activity resumed and lockdown restrictions were lifted, emergency liquidity needs declined and money growth also slowed. By October 2020, the three-month annualised growth rate of M3 had dropped to 7.5 per cent, which was about one-third of the 21.9 per cent rate seen at the peak of the lockdowns, and just somewhat above the historical average. The growth rate continued to decrease until mid-2022 even in the face of increased borrowing prompted by liquidity demands from the energy crisis. Shortly after we started hiking rates in July 2022, M3 growth even dipped into negative territory before recovering somewhat in the second half of 2023. Inflation began to rise just as money growth slowed down. Initially, these price increases were concentrated in specific sectors, particularly affecting energy and food prices, rather than showing a broad-based increase across all goods and services, which would have been more consistent with a monetary origin for the inflation surge (Chart 6). These heterogeneous price increases align with the view that inflation was largely due to specific cost-push shocks passing through to the wider consumption basket. This perspective is supported by structural analyses identifying energy and food price shocks together with supply chain disruptions as the main culprits of the inflationary pressures. (29) It is also consistent with the interpretation that the robust money growth during the early stages of the pandemic was a result of accumulating liquidity reserves, which in turn were not inherently inflationary. Taken together, the evidence indicates that the recent inflation surge is primarily attributable to rising commodity prices and global supply constraints, rather than an expanding money supply.24) Chart 6 Headline inflation, money growth and commodity prices, and headline inflation and subcomponents Headline inflation, money growth _IHeadline inflation and and commodity prices subcomponents (left-hand scale: annual percentage changes; (annual percentage changes) right-hand scale: index in USD) HICP - Food incl. alcohol and tobacco HICP - Energy HICP - Services HICP - Overall index HICP - Overall index Energy commodity prices (right-hand scale) M3 Non-energy commodity prices (right-hand scale) 16 160 HICP - All-items excluding energy and food 14 140 50 12 120 10 100 40 8 80 6 60 30 4 40 20 2 20 ° o 10 2 -20 4 40 0 6 60 8 -80 10 2019 2021 2023 -20 2019 2021 2023 Sources: ECB (BSI), Eurostat, World Bank and ECB calculations. The latest observations are for April 2024. The surge in borrowing by firms, which peaked during the second quarter of 2020 amid the initial lockdowns, was primarily driven by need for working capital and precautionary reasons. Borrowing by firms closely matched their increases in cash reserves. Since this borrowing was not for investment purposes, it did not stimulate aggregate demand. Household behaviour points to a similar message. Government aid to households served to cushion their reduced income rather than to increase spending: fiscal transfers only covered part of the slowdown in household income over the pandemic period. Most of the excess savings accumulated during the pandemic resulted from falling consumption, which was much larger than the drop in income (Chart 7, left panel). This decline in consumption was partly forced by the reduced consumption opportunities due to the pandemic restrictions but it is likely to have also reflected precautionary behaviour related to uncertainty about the future. The latter led to an increased preference for liquidity, and indeed a large part of household excess savings were accumulated in the form of overnight deposits, especially in the initial phases of the pandemic (Chart 7, right panel).[22] Chart 7 Savings over the pandemic period Sources of savings Uses of excess savings (quarterly flows in EUR bn compared to the (percentage points of disposable income and same quarter of two years before) percentage point contributions; changes with respect to the corresponding quarter in 2019) == Gross savings © Currency and deposits © Consumption (-) © Loan repayments Compensation of employees ® Housing investments @ Net gov. transfers © Other financial assets Mi Other income @ Excess savings 400 14 6 4 2 -200 = - SNmMernmMerameraae ooooocooooc oc oo oc"? -2 Seeere2e22Rh8S8RRRRRS 2020 2020 2020 2020 2021 2021 2021 2021 RRARRARAKRARKRAKRRAAT ao@ @ a4 ai @ @ a Sources: ECB (QSA), Eurostat and ECB calculations. Notes: right side: The chart compares the ratio of savings to disposable income and its contributions, to the same ratio and contributions in the corresponding quarters in 2019. The latest observations are for 2021 Q4. Consumption only started to approach its pre-pandemic level by the middle of 2021, but households continued to express their willingness to maintain a higher level of savings or financial investments, a considerable part of which remained in overnight deposits. This composition also reflected the flattening yield curve and the low opportunity cost of holding those deposits. !$3] Chart 8 Individual consumption of selected goods and services and corresponding price developments (left-hand scale: chain-linked EUR bn; right-hand scale: annual percentage changes) = Real food expenditures = Real energy expenditures = Real other expenditures == Price index (right-hand scale) m= Price index (right-hand scale) w= Price index (right-hand scale) 750 12 260 50 6,000 6 250 40 5.500 5 700 8 240 30 5,000 3 650 4 230 20 4500 2 220 10 4,000 0 600 0 210 0 3,500 -2 550 4 200 -10 3,000 -3 BR5g5e2e2N BR5ggee2e2N 885s5ec¢e2q SFRARRARRAS SFRRARRARAAS S2RRRRRARA Sources: Eurostat and ECB calculations. The latest observations are for 2022. As energy and food prices began to rise, households moderated their accumulation of deposits but also reduced the real consumption of those products (Chart 8). The configuration of falling consumption and rising prices for energy and food is consistent with supply shocks driving energy and food prices rather than reflecting a surge in domestic demand.4I In addition, falling consumption also indicates that the excess deposits accumulated during the pandemic did not lead to households being insensitive to more expensive and energy and food bills. Chart 8 also shows that, as the economy reopened and uncertainty receded, household consumption volumes of items other than energy and food rebounded towards pre-pandemic levels despite the price increases in those items in the course of 2021 and 2022. While the configuration of rising consumption and rising prices might suggest some role for domestic demand, consumption of these items remained clearly below the previous trend. It is certainly the case that, for a given surge in supply-driven inflation, excess savings allowed households to cut consumption by less than if the supply shock had happened at a time when excess savings were lower. The coexistence of high inflation and only a moderate consumption recovery serves to underline the scale of supply-driven cost pressures during 2021 and 2022: only a dramatic monetary and/or fiscal tightening would have been needed to eliminate the inflation surge by reducing domestic demand sufficiently (involving a severe drop in domestic incomes) to match the reduction in supply capacity. Overall, although real private consumption and investment have rebounded in the post-pandemic period, these have not reached the levels projected in mid-2021 when excess savings were at their highest, and real private consumption continues to trail the forecasts made before the pandemic. In this context a dramatic recession would have been required to fully avoid an inflation surge. 25] The tightening cycle Monetary analysis has been central to the regular assessment of the state of the monetary policy transmission, which has been a key guiding principle in calibrating the speed and scale of the monetary policy tightening over the last couple of years. 38] Focusing on the propagation of that tightening impulse through the banks, both the rate hikes that started in July 2022 and the sustained upshift in the yield curve that preceded and accompanied that process led to a significant rise in bank funding costs, initially driven by bonds and subsequently by deposit rates (Chart 9). The latter adjusted with a lag, owing to the atypical interest rate configuration during the negative rate period, but eventually aligned with our policy signal (Chart 10). Chart 9 Bank funding costs (percentages per annum) ees Interbank rate == Composite funding cost = Deposit rate ee= Bank bond yields 5 4 3 2 1 0 -1 Jan-22 Oct-22 Jul-23 17 June 2024 Sources: ECB (BSI, MIR, CSDB, MMSR) and ECB calculations. For monthly data, the latest observations are for April 2024, for daily data, the latest observations are for 17" June. In parallel, loan volumes in the euro area have experienced a marked decline since late 2022. After dropping sharply, credit flows have remained stagnant for both loans and bonds (Chart 11, left panel). The pronounced decline in credit compared to previous hiking cycles (Chart 11, right panel) was largely due to the sharp increase in interest rates, which has significantly dampened demand, as also reflected in the ECB bank lending survey (BLS). Initially, credit demand showed some resilience, primarily driven by the liquidity needs of firms during the peak of the energy crisis. However, it began to contract in the last quarter of 2022 and continued to do so for several months after the last rate hike in September 2023. The primary drivers behind the weakness in demand were elevated interest rates and reduced recourse to credit for financing investments, which reflects the "cost of capital" channel of monetary policy (Chart 12). Chart 10 Transmission to deposit rates (percentages per annum) = ECB relevant policy rate - Overnight deposits = Time deposits up to 2 years Firms 6 6 5 5 4 4 3 3 2 2 1 a 1 0 0 I 1 1999 2002 2005 2008 Jan-22 Aug-22 Mar-23 Oct-23 Households 6 6 5 5 4 4 3 3 2 2 1 oS ee) 1 0 i) 1 4 1999 2002 2005 2008 Jan-22 Aug-22 Mar-23 Oct-23 Sources: ECB (MIR, FM) and ECB calculations. Notes: The ECB relevant policy rate is the MRO for the 1999-2008 panels and the DFR for the panels starting on 2022. The latest observations are for April 2024. Chart 11 Firm debt financing (left side), and comparison of slowdown in loan dynamics to past regularities (right side) Firm debt financing Comparison of slowdown in loan dynamics to past regularities (12-month flows in EUR bn) © Borrowing from banks @ Netissuance of debt securities 600 500 ohh Jan-19 Jan-20. Jan-21. = Jan-22)- Jan-23 40 Ss 30 Ss 20 Ss 10 Ss Jan-24 (x-axis: years, y-axis: growth rate of credit in deviation from its growth rate at the start of the cycle (t), in pp) Range of past hiking cycles ee= Current hiking cycle = = =~ = Counterfactual conditional only on policy rate changes 8 +3 +2 t+ t+2 +3 +1 Sources: ECB (BSI, CSEC) and ECB calculations. Notes: MFI loans are adjusted for sales and securitisation and cash pooling. The seasonal adjustment of the net issuance of debt securities is not official. The dotted line corresponds to a BVAR counterfactual for lending volumes, taking December 2021 as the latest observation and projecting volumes conditional on the path of monetary policy rates. The type of BVAR used is the one used by Giannone, D,, Lenza, M. & Primiceri, G., (2015),"Prior Selection for Vector Autoregressions", The Review of Economics and Statistics, 97, issue 2, p. 436-451; and Altavilla C., Giannone D. & Lenza M. (2016), "Ihe financial and macroeconomic effects of OMT announcements", International Journal of Central Banking, vol. 12(3), pages 29-57. The latest observations are for April 2024. Chart 12 Loan demand by firms and contributing factors during the tightening cycle (net percentages of banks reporting an increase in demand, and contributing factors) memes Other factors mums Use of alternative finance mums Other financing needs meme General level of interest rates msumeees Inventories and working capital mum Fixed investment ome Demand -100 2022 Q1 2022 Q2 2022 Q3 2022 Q4 2023 Q1 2023 Q2 2023 Q3 2023 Q4 2024 Q1 Source: ECB (BLS). Notes: Net percentages for the questions on demand for loans are defined as the difference between the sum of the percentages of banks responding "increased considerably" and "increased somewhat" and the sum of the percentages of banks responding "decreased somewhat" and "decreased considerably". The net percentages for responses to questions relating to contributing factors are defined as the difference between the percentage of banks reporting that the given factor contributed to increasing demand and the percentage of banks reporting that it contributed to decreasing demand. "Other financing needs" is the unweighted average of "mergers/acquisitions and corporate restructuring" and "debt refinancing/restructuring and renegotiation"; and "Use of alternative finance" is the unweighted average of "internal financing", "loans from other banks', "loans from non-banks", "issuance/redemption of debt securities" and "issuance/redemption of equity'. The net percentages for "Other factors" refer to an average of the further factors which were mentioned by banks as having contributed to changes in loan demand. The latest observations are for 2024 Q1. At the same time, a decline in the supply of credit from banks has also played a large role in the recent credit slowdown. Credit supply effects primarily stemmed from a decreasing willingness of banks to take risks. This, in turn, has affected lending conditions for firms and households. The start of the reimbursement phase for TLTROs and the change in the conditions applied by on TLTRO borrowings reinforced the incentives for banks to scale down loan exposures. 24 Studies using granular data to control for demand conditions indicate that increased borrowing costs for banks have resulted in a significant reduction in lending volumes. In other words, the significant decrease in loans was partly due to the tighter lending conditions, rather than being solely due to lower credit demand. Our bank lending survey corroborates this view, highlighting that heightened risk perception and reduced risk tolerance on the part of banks were significant factors influencing the tightening of credit standards during the hiking cycle. In parallel, money growth, which had been declining rapidly from its 2021 peak, saw its decline accelerate, mirroring the contemporary contraction in bank lending and the progressive reduction of the monetary policy securities portfolio of the Eurosystem. Two liability-side factors reinforced the contraction in the availability of cheap funding: first, banks substituting TLTRO funding for long-term bonds; and second, a strong portfolio rebalancing by households and firms on the liability side of bank balance sheets. In particular, the increased remuneration of time deposits and bonds after a long period of low or negative interest rates has incentivised shifts to these instruments from overnight deposits and other low-remuneration deposits. During the period of low interest rates, the opportunity cost of holding overnight deposits was very low, causing households and firms to prefer overnight deposits. The monetary policy tightening and its transmission to deposit rates and yields on other financial assets, has increased the opportunity cost of holding overnight deposits to levels similar to those seen in previous hiking cycles. This has led households and firms to move a significant portion of their unusually large stock of overnight deposits to time deposits and bonds (Chart 13). The high level of liquidity within the banking system has not impeded the transmission of our monetary policy tightening to households and businesses. Although in the cross-section banks with greater excess liquidity at the onset of the tightening cycle have reduced their lending to a lesser extent than their less liquid peers, the overall transmission of monetary policy has been robust and, if anything, been stronger than in previous cycles. The apparent differences between the cross-sectional and time series results can be reconciled as follows. From a theoretical standpoint, excess reserves on the balance sheets of banks exert dual effects during a period of monetary tightening. On one side, the initiation of an unexpected tightening phase allows banks with excess reserves to benefit from higher returns on these reserves. This helps bolster their profits, potentially augments their capital buffers, relaxes constraints and ultimately expands the supply of lending. This wealth effect is in line with the results of the cross-sectional analysis.22] At the same time, as the remuneration of reserves increases, these reserves become increasingly attractive to banks, as these represent a highly remunerated, secure and liquid asset. As a result, banks may be reluctant to extend their lending or to invest in bonds unless the price of these financial instruments is sufficiently attractive. This substitution effect may well have been the prevailing force in the aggregate transmission of our monetary policy.4°lThat is to say, while the wealth effect may explain the cross-sectional variation in lending behaviour among banks with differing levels of excess liquidity, the substitution effect likely contributed to the strong transmission of monetary tightening on an aggregate level. As the quantity-theory expression MV=PY makes clear, the connection between outside money - the currency and reserves supplied by the central bank - and prices is mediated by adjustments in velocity. Velocity is a complex function of a host of factors, some of which pertain to the decisions by banks to intermediate credit, others having to do with the decisions by different types of money holders on the financial instruments in which they want to keep their wealth. All else equal, credit creation pushes up velocity and thereby, for a given level of real income, generates price pressures. Conversely, portfolio reallocations towards larger money holdings serves to reduce velocity and weaken inflation for a given stock of outside money. In a nutshell, these two factors have been offsetting each other in recent years. When loans were rapidly expanding in the early phase of the pandemic crisis, a sharp rise in liquidity preference - and the short-term bridging nature of the loans themselves - attenuated the inflationary potential of money growth. When eventually portfolios started shedding excess liquidity - a potential source of inflation - loans began to decline in parallel, providing a cushion against money-generated inflationary pressures. Chart 13 Financial investment by households (for bars: quarterly flows as percentage of annual GDP; for lines: percentage points) @ Overnight and redeemable at notice deposits @ Total financial assets Time deposits = Time dep - overnight spread (rhs) @ Money market funds = Gov bonds - ovemight spread (rhs) @ Debt securities Other assets 15 6.0 10 40 § 20 0 0.0 2.0 46 2019Q1 2020 Q1 2021 Q1 2022 Q1 2023 Q1 Sources: ECB (BSI, QSA, MIR, FM), Eurostat and ECB calculations Notes: 'Government bonds' yields used for the spread calculation are those on 2-year government bonds. The latest observations are for 2023 Q4. Future challenges Looking ahead, a prominent challenge for monetary analysis is to understand how the normalisation of the balance sheets of central banks may affect transmission in the years to come. Measures that expand the central bank balance sheet stimulate bank lending and risk-taking through three main channels."4! First, the decrease in long-term interest rates associated with the purchases of long-term securities by the central bank lowers borrowing costs for businesses and consumers, ultimately stimulating their loan demand. Second, investors (including banks and other financial institutions) that sell assets to the central bank try to rebalance their portfolio towards higher-yielding investments, which can also lead to increased lending supply. 42] Third, the liquidity injected into the banking system via central bank purchases of financial assets can enhance the capacity of banks to lend because that type of liquidity, perceived to remain in the system for a long time, may be seen as providing a permanent means to service the mobile type of deposits that are the by-product of an extension of bank credit. In studying this critical nexus with the help of monetary analysis, it is worth recalling the notion of the "money multiplier'. Based on this mechanism, in a fractional reserve banking system a policy-induced expansion of the free reserves of cash held by the banks spurs, through successive rounds of loan and deposit creation, increasing volumes of credit and inside money. Outright central bank asset purchases increase bank reserve holdings and prompt banks to try to minimise the associated liquidity surplus - which is costly - by creating credit and other claims on those surplus reserves in an effort to enhance shareholder returns. This mechanism helps explain the strong connection of credit with reserve creation in times of QE, even when controlling for demand-for-credit effects as lending rates decline as a result of QE. In the other direction, a withdrawal of reserves sets in motion a cumulative process by which credit and deposits shrink by a multiple of the original negative shock to the reserve holdings. 43] It follows that, in order to assess the implications of QT, it is important to trace all the implications of the central bank balance sheet contraction for asset prices and credit in an encompassing framework and to take into account the relation between central bank liquidity and bank intermediation capacity,"4] The relevance of the money multiplier is also supported by recent empirical analysis using comprehensive bank-level and loan-level data on lending from euro area banks to firms. A recent ECB study draws two main conclusions. First, the availability of central bank liquidity significantly influences banks' credit provision, in what the authors call a "reserve availability channel" of monetary policy. Second, the source of central bank reserves affects their impact on bank intermediation: non-borrowed reserves - those created as a result of a securities purchase programme - have very strong empirical connection with bank loans, whereas this is not the case for borrowed reserves drawn by banks from a short-term refinancing facility (Chart 14).!45) Chart 14 Response of bank loans to an increase in borrowed and non-borrowed reserves a) Non-borrowed reserves b) Borrowed reserves (x-axis: months after the increase in reserves, (x-axis: months after the increase in reserves, y-axis: percentage points) y-axis: percentage points) oe Estimated response = Estimated response 25 = = = = 95% confidence interval 25 = = = = 95% confidence interval 20 20 eee rw wwe -* -" 15 7 Cd o 10 -- Pid 05 Pd - -- 00 es - *,. -0.5 Ss. "ee 1.0 10 aden Cd 15 15 2.0 -2.0 13 5 7 9 141 13 15 17 19 21 23 1 3 5 7 9 11 13°15 17 19 21 23 Sources: Altavilla, Rostagno, Schumacher (2024). Notes: The chart reports the response of bank loans after a 1pp increase in non-borrowed reserves (left side) and borrowed reserves (right side). The solid lines report the estimated response, while the dashed lines report the 95% confidence intervals for each horizon. These mechanisms are in line with a growing body of empirical studies focusing on the relation between central bank reserves and bank lending. Examples include analyses that show that: (a) banks that increased their reserve holdings, following the third round of quantitative easing announced by the Federal Reserve, increased lending; (b) banks with higher excess reserve holdings grant more credit lines and take more risk; (c) the reallocation of central bank reserves towards banks with higher liquidity needs fosters credit supply; and (d) the credit supply of reserve-rich banks is less sensitive to monetary policy tightening than that of other banks. 46] Conclusions As I have covered in this lecture, modern monetary analysis is helping policymakers to analyse the nexus of money, credit and the economy. Moreover, the frontier in modern monetary analysis is continuing to expand: the enhanced availability of granular data, filtered through an expanding computation capacity and new machine learning techniques, is further broadening its scope and the relevance of its findings for the calibration of monetary policy. For these reasons, monetary analysis plays a central role at the ECB, with a data-dependent approach to assessing the effectiveness of monetary policy transmission a key element in our reaction function. 1. I am grateful to Ramon Adalid, Alessandro Ferrari, Andrew Hannon and Sofia Velasco for their contributions in preparing these remarks and also the assistance of Lucia Kazarian, Silvia Scopel, Marina Dimitriou, Andreas Kapounek, Nikoleta Tushteva, Emma Vergauwen and Wouter Wakker. The term "modern monetary analysis" is intended to capture the current role of monetary analysis in central banking, as opposed to a traditional interpretation of the role of monetary analysis. The framework of modern monetary analysis is not to be confused with the much-discussed framework of modern monetary theory. 2. For a review of the evolution of ECB policy instruments and targets during its first two decades of existence, see Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Saint Guilhem, A. and Yiangou, J. (2021). "Monetary policy in times of crisis: A tale of two decades of the European Central Bank", Oxford University Press. See also Papademos, L., & Stark, J. (2010), "Enhancing monetary analysis", European Central Bank; Issing, O. (2000), "Communication challenges for the ECB", speech at the CFS research conference "The ECB and its watchers II",Panel Il: "The ECB and Its Communication Strategy", Frankfurt, 26 June 2000; and European Central Bank. (1999), "The stability- oriented monetary policy strategy of the eurosystem", ECB Monthly Bulletin, (January), 39-50. 3. See Kléckers, H.-J., and Willeke, C. (2001), "Monetary analysis: Tools and applications", ECB. 4. To be sure, the quantity identity predates Friedman's statement by a couple of centuries, as it is already clearly implicit in David Hume's "Political Discourses" (1752), although the "V" part of the equation was certainly under-appreciated and the identity tended to be understood as a casual relationship rather than an identity. In the equation, "M' is the total stock of outside money, i.e. the monetary aggregate that reflects liquidity injections by the central bank: in modern times, currency and reserves. "V" is the velocity with which money circulates, "P" is a price index, and "Y" is a measure of real economic activity. See Lucas, R. E., Jr. (1980)," Two illustrations of the quantity theory of money", American Economic Review, 70(5), 1005-1014; and Sargent, T. J., and Surico, P. (2011), "Two illustrations of the quantity theory of money: Breakdowns and revivals", American Economic Review, 101(1), 109-128. 5. See Brunner, K., and Meltzer, A. H. (1988)," Money and credit in the monetary transmission process", American Economic Review, 78(2), 446-451. 6. The Deutsche Bundesbank continued to announce a target for the growth rate of its broad monetary aggregate M3 until the end of 1998, when the responsibility for monetary policy passed to the ECB. Other European central banks, including the Banque de France, the Banca d'ltalia, and the Banco de Espafia, also announced monetary targets or reference ranges complementing other aspects of their monetary policy strategies, such as exchange rate targets and/or direct inflation targets. See Gerlach, S., and Svensson, L. E. O. (2003), "Money and inflation in the euro area: A case for monetary indicators?", Journal of Monetary Economics, Vol. 50, Issue 8, pp. 1649-1672. 7. House of Commons Committees (1983), Minutes of Proceedings and Evidence, Standing Committee on Finance, Trade and Economic Affairs, Vol. 6, No 134, 28 March, p. 12. 8. See, for example, Goodfriend, M. and King, R.G. (1997), "The New Neoclassical Synthesis and the Role of Monetary Policy", in Bernanke, B.S. and Rotemberg, J.J. (eds.), NBER Macroeconomics Annual: 1997, Cambridge, MA: MIT Press; Clarida, R., Gali, J. and Gertler, M. (1999), "The Science of Monetary Policy: A New Keynesian Perspective", Journal of Economic Literature, Vol. 37(4), pp. 1661- 1707. 9. See Woodford, M. (2003), "Interest and prices: Foundations of a theory of monetary policy", Princeton University Press. He explains that, in a world where financial markets had become highly efficient, it is sufficient to limit attention to the overnight rate and let financial markets take care of arbitraging across any opportunities created by discrepancies in the yields on different market instruments. See also Orphanides, A. (2007), "Taylor rules", in Blume, L. and Durlauf, S. (eds.), The New Palgrave: A Dictionary of Economics, Houndmills, Basingstoke: Palgrave Macmillan. 10. Other central banks had followed the same paradigm shift in parallel to the adoption of explicit inflation targets, like the Bank of England and the central banks of New Zealand and Canada in the early 1990s. See King, M. (2005), "Monetary Policy: Practice Ahead of Theory", speech by Mervyn King at the Mais Lecture, Cass Business School, City University, London, 17 May, and Goodfriend, M. (2007), "How the World Achieved Consensus on Monetary Policy", Journal of Economic Perspectives, Vol. 21(4), pp. 47- 68. Real money balances continued to play a role in macroeconomic models, however; see, for example, Ireland, P.N. (2004), "Money's Role in the Monetary Business Cycle", Journal of Money, Credit and Banking, Vol. 36(6), pp. 969-983; Christiano, L., Motto, R. and Rostagno, M. (2003), "The Great Depression and the Friedman-Schwartz Hypothesis", Journal of Money, Credit and Banking, Vol. 35(6), pp. 1119-1197; and Andrés, J., Lopez-Salido, J.D. and Vallés, J. (2006), "Money in an Estimated Business Cycle Model of the Euro Area", Economic Journal, Royal Economic Society, Vol. 116(511), pp. 457-477, April. 11. See Holm-Hadulla, F., Musso, A., Rodriguez Palenzuela, D. and Vlassopoulos, T. (2021), "Evolution of the ECB's analytical framework", Occasional Paper Series, No 277, ECB; Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January; and Schnabel, I. (2023), "Money and inflation", lecture at the annual conference of the Verein fur Socialpolitik, Regensburg, 25 September. 12. This remedied a clear lack of banks as key agents in the transmission of monetary policy even in the new paradigm, as noted in Goodhart, C.A.E. (2004), "Review of Interest and Prices by M. Woodford", Journal of Economics, Vol. 82(2), 195200. See also Goodfriend, M. and McCallum, B.T. (2007), "Banking_and interest rates in monetary policy analysis: A quantitative exploration", Journal of Monetary Economics, Vol. 54, Issue 5, pp. 1480-1507; Canzoneri, M., Cumby, R., Diba, B. and Lopez-Salido, D. (2008), "Monetary Aggregates and Liquidity in a Neo-Wicksellian Framework", Journal of Money, Credit and Banking, Vol. 40(8), pp. 1667-1698, December. 13. See also Christiano, L. and Rostagno, M. (2001), "Money Growth Monitoring and the Taylor Rule", NBER Working Paper Series, No 8539, National Bureau of Economic Research; Goodhart, C. (2007), "Whatever became of the monetary aggregates?", National Institute Economic Review, No 200, pp. 56- 61; and Pill, H. (2022), "What did the monetarists ever do for us?", speech by Huw Pill at Walter Eucken Institut / Stifung Geld und Wahrung Conference - Inflation and Debt: Challenges for Monetary Policy after Covid-19, Freiburg im Breisgau, 24 June. 14. See, for instance, De Grauwe, P. and Polan, M. (2005), "Is inflation always and everywhere a monetary phenomenon?", Scandinavian Journal of Economics, Vol. 107(2), pp. 239-259; Berger, H., Karlsson, S. and Osterholm, P. (2023), "A note of caution on the relation between money growth and inflation", IMF Working Papers, No 2023/137, International Monetary Fund; and Jung, A. (2024), "The quantity theory of money, 1870-2020", Working Paper Series, No 2940, ECB. 15. See, for instance, Benati, L. (2009), "Long run evidence on money growth and inflation", Working Paper Series, No 1027, ECB; Borio, C., Hofmann, B. & ZakrajSek, E. (2024), "Money growth and the post- pandemic surge in inflation", VoxEu, January 2024. 16. King, M.A. (2024), "Inflation Targets: Practice Ahead of Theory", NBER Working Paper Series, No 32594, National Bureau of Economic Research. 17. This is in line with the results set out in Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January, which also concludes that it is unlikely that the high money growth in 2020 caused the rise in inflation seen in 2021-2022. Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech at the National Institute of Economic and Social Research, London, 25 April, also argues that those buffers could not account for the subsequent upside surprise in inflation. 18. Following monetary policy tightening, the transmission of monetary policy is found to be stronger for banks that are (i) poorly capitalised (e.g. Van den Heuvel, S. (2002), "Does bank capital matter for monetary transmission?", Federal Reserve Bank of New York Economic Policy Review, Vol. 8); (ii) small (e.g. Kashyap, A. and Stein, J. (1995), "The Impact of Monetary Policy on Bank Balance Sheets", Carnegie-Rochester Conference Series on Public Policy, Vol. 42); and (iii) illiquid (e.g. Bernanke, B. and Gertler, M. (1990), "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105). 19. See Altavilla, C., Glirkaynak, R. and Quaedvlieg, R. (forthcoming), "Macro and Micro of External Finance Premium and Monetary Policy Transmission', Journal of Monetary Economics. 20. See Acharya, V.V. and Steffen, S. (2020), "The Risk of Being_a Fallen Angel and the Corporate Dash for Cash in the Midst of COVID", The Review of Corporate Finance Studies, Vol. 9, Issue 3, pp. 430- 447. 21. See Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R. and Saint Guilhem, A. (2021), "Combining negative rates, forward guidance and asset purchases: identification and impacts of the ECB's unconventional policies", Working Paper Series, No 2564, ECB. 22. The PEPP was designed to ensure that the monetary policy stance of the ECB was transmitted effectively across the euro area, especially in a situation where financial markets were experiencing significant stress. In particular, the PEPP was designed to allow for fluctuations in the volume of purchases across time, asset classes and jurisdictions. This flexibility was key in addressing the specific transmission challenges posed by the pandemic, ensuring that the ECB's monetary policy stance was felt uniformly across the euro area economy. 23. See Benetton, M. and Fantino, D. (2021), "Targeted monetary policy and bank lending behavior', Journal of Financial Economics, Vol. 142, Issue 1, October 2021, pp. 404-429; Barbiero, F., Boucinha, M. and Burlon, L. (2021), "TLTRO III and bank lending conditions", Economic Bulletin, Issue 6, ECB; and Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through", Journal of Monetary Economics, Vol. 110(C), pp. 81- 98. 24. See Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Saint Guilhem, A. and Yiangou, J. (2021), "Monetary policy in times of crisis: A tale of two decades of the European Central Bank", Oxford University Press; Altavilla, C., Carboni, G. and Motto, R. (2015), "Asset purchase programmes and financial markets: lessons from the euro area", Working Paper Series, No 1864, ECB; for Japan, see Bowman, D., Cai, F., Davies, S. and Kamin, S. (2015), "Quantitative easing and bank lending: Evidence from Japan", Journal of International Money and Finance, Vol. 57, pp. 15-30; for the United States, see Rodnyansky, A. and Darmouni, O.M. (2017), "The Effects of Quantitative Easing on Bank Lending Behavior", The Review of Financial Studies, Vol. 30, Issue 11, pp. 3858-3887; and for the United Kingdom, see Joyce, M. and Spaltro, M. (2014), "Quantitative easing and bank lending: a panel data approach", Working Papers, No 504, Bank of England. 25. See D.Vayanos and J.-L. Vila (2021), "A Preferred-Habitat Model of the Term Structure of Interest Rates," Econometrica 89(1), 77-112; and Fabian Eser & Wolfgang Lemke & Ken Nyholm & Séren Radde & Andreea Liliana Vladu, 2023. "Tracing the Impact of the ECB's Asset Purchase Program on the Yield Curve", International Journal of Central Banking, vol. 19(3), pages 359-422, August. 26. See Albertazzi, U., Becker, B. and Boucinha, M. (2021), "Portfolio rebalancing _and the transmission of large-scale asset purchase programs: Evidence from the Euro area", Journal of Financial Intermediation, Vol. 48, 100896. 27. See Adalid, R. and Palligkinis, S. (2016), "Sectoral Sales of Government Securities During the ECB's Asset Purchase Programme", SSRN; and Picon, C., Oliveira-Soares, R. and Adalid, R. (2020), "Revisiting the monetary presentation of the euro area balance of payments", Occasional Paper Series, No 238, ECB. 28. This enhanced support led to a substantial take-up in TLTRO III operations, with banks borrowing a record €1.3 trillion in June 2020, which increased to €1.8 trillion by December 2020. Altogether, the volume of borrowing under the TLTROs in the euro area was notably larger than that of comparable programmes in the United States or the United Kingdom. 29. See Altavilla, C., Barbiero, F., Boucinha, M. and Burlon, L. (2023), "The Great Lockdown: Pandemic response policies and bank lending conditions", European Economic Review, Vol. 156(C). 30. See Banbura, M., Bobeica, E. and Martinez Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB. The authors show that the increase in the inflation rate in the euro area since the onset of the pandemic was predominantly due to energy price shocks, food price shocks and supply chain disruptions. For the role of labour market dynamics, see also Bernanke, B. and Blanchard, O. (2023), "What Caused the U.S. Pandemic-Era Inflation?", NBER Working Paper Series, No 31417, National Bureau of Economic Research; Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdon, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB; and Menz, J.-O. (2024), "Sources of post-pandemic inflation in Germany and the euro area: An application of Bernanke and Blanchard (2023)", Technical Paper, No 02/2024, Deutsche Bundesbank. 31. See also Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January; Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech by Ben Broadbent at the National Institute of Economic and Social Research, London, 25 April; and King, M.A. (2024), "Inflation Targets: Practice Ahead of Theory", NBER Working Paper Series, No 32594, National Bureau of Economic Research. 32. Chart 7 also shows that the allocation of excess savings to housing investment was relatively minor. 33. For the planned allocation of household net savings in the next 12 months, see Dossche, M., Georgarakos, D., Kolndrekaj, A. and Tavares, F. (2022), "Household saving during the COVID-19 pandemic and implications for the recovery of consumption", Economic Bulletin, Issue 5, ECB. 34. Of course, an increase in global demand (relative to constrained supply) played a part in the rise in energy and food prices. 35. This is a view shared with policymakers from other jurisdictions. Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech at the National Institute of Economic and Social Research, London, 25 April, also argues that those buffers could not account for the subsequent upside surprise in inflation. 36. For a comprehensive discussion of the tightening cycle, see Lane, P.R. (2022), "Monetary policy in the euro area: the next phase", remarks for high-level panel "High Inflation and Other Challenges for Monetary Policy" by Philip R. Lane, Member of the Executive Board of the ECB, Annual Meeting 2022 of the Central Bank Research Association (CEBRA), Barcelona, 29 August; Lane, P.R. (2023), "The banking channel of monetary policy tightening in the euro area", remarks by P.R. Lane, Member of the Executive Board of the ECB, at the Panel Discussion on Banking Solvency and Monetary Policy, NBER Summer Institute 2023 Macro, Money and Financial Frictions Workshop, 12 July; and Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", guest lecture by Philip R. Lane at Stanford Graduate School of Business, Stanford, 2 May. 37. TLTRO III consists of ten operations with a maturity of three years, starting in September 2019 at quarterly frequency. When initially launched, the first seven TLTRO III operations could be voluntarily repaid after two years from the settlement of each operation. In March 2020 the early repayment option was adjusted to give counterparties the possibility to voluntarily repay funds already one year after settlement, starting in September 2021. Three more operations were introduced in December 2020, with an early repayment option at quarterly frequency starting in June 2022. On 27 October 2022 the ECB's Governing Council announced a recalibration of all existing TLTRO Ill operations to ensure consistency with broader monetary policy normalisation process. From 23 November 2022 interest rates on all remaining TLTRO III operations were indexed to average applicable key ECB interest rates from that date onward, in practice increasing their price. Modifications were accompanied by three additional voluntary early repayment dates introduced for banks wishing to terminate or reduce borrowings before maturity. In response to the change in pricing conditions, large voluntary repayments were done in November and December 2022. Currently, only two operations are still outstanding for a total amount of €76.4 billion and they will be repaid in September and December 2024. 38. See Adalid, R., Lampe, M. and Scopel, S. (2023), "Monetary dynamics during the tightening cycle", Economic Bulletin, Ilssue 8, ECB. 39. See Fricke, D., Greppmair, S., and Paludkiewicz, K. (2024), "Excess reserves and monetary policy tightening", Deutsche Bundesbank Discussion Paper, no. 5. 40. When the interest rate paid on reserves was negative, this substitution effect constituted a "hot potato" mechanism by which individual banks sought to shed reserves by increasing lending or bond purchases. See E. Ryan and K. Whelan (2021), "Quantitative Easing and the Hot Potato Effect: Evidence from euro area banks," Journal of International Money and Finance 115, 102354. 41. See Altavilla, C., Lemke, W., Linzert, T., Tapking, J. and von Landesberger, J. (2021), "Assessing the efficacy, efficiency and potential side effects of the ECB's monetary policy instruments since 2014", Occasional Paper Series, No 278, ECB, and Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R. and Saint Guilhem, A. (2021), "Combining negative rates, forward guidance and asset purchases: identification and impacts of the ECB's unconventional policies", Working Paper Series, No 2564, ECB. 42. See Ray, W., Droste, M. and Gorodnichenko, Y. (forthcoming), "Unbundling of Quantitative Easing: Taking a Cue from Treasury Auctions", Journal of Political Economy. 43. For a contemporary definition and rehabilitation of the "money multiplier' theory of transmission, see Altavilla, C., Rostagno, M. and Schumacher. J. (2023), "Anchoring QT: Liquidity, credit and monetary policy implementation", Discussion Paper, No 18581, Centre for Economic Policy Research. 44. Arisk surrounding QT that has recently been emphasised is the possibility that the reserve balances created in QE times might have been hypothecated by banks writing off-balance-sheet claims on them, thus making the system vulnerable to a sustained loss of liquidity under QT. See recent work by Acharya, V.V. and Rajan, R. (2022), "Liquidity, liquidity everywhere, not a drop to use-Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research; and Acharya, V.V., Chauhan, R.S., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing and waning _of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research. According to these studies, this phenomenon might explain the money market tensions observed in September 2019, as the amount of fed funds - being withdrawn from the system by the Federal Reserve in the context of its first phase of QT- dropped to a minimum threshold at which scarcity produced a generalised seizing up of transactions and a surge in money market interest rates. 45. See Altavilla, C., Rostagno, M. and Schumacher, J. (2023), "Anchoring QT: Liquidity, credit and monetary policy implementation", Discussion Paper, No 18581, Centre for Economic Policy Research. This study does not examine the impact of reserves created by longer-term refinancing operations (such as the TLTRO programmes), which might be viewed as an intermediate case between the polar cases of liquidity created by asset purchase and liquidity created by short-term refinancing operations. 46. On (a), see Rodnyansky, A. and Darmouni, O.M. (2017), "The Effects of Quantitative Easing on Bank Lending Behavior", The Review of Financial Studies, Vol. 30, Issue 11, pp. 3858-3887; Kandrac, J. and Schlusche, B. (2021), "Quantitative Easing_and Bank Risk Taking: Evidence from Lending", Journal of Money, Credit and Banking, Vol. 53(4), pp. 635-676; on (b), see Acharya, V.V. and Rajan, R. (2022), "Liquidity, liquidity everywhere, not a drop to use-Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research, and Acharya, V.V., Chauhan, R.S., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing _and waning of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research; on (c), see Altavilla, C., Boucinha, M., Burlon, L., Giannetti, M. and Schumacher, J. (2022), "Money markets and bank lending: evidence from the adoption of tiering", Working Paper Series, No 2649, ECB; on (d), see Fricke, D., Greppmair, S. and Paludkiewicz, K. (2023), "Excess Reserves and Monetary Policy Tightening', SSRN. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # Modern monetary analysis ## Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Bank of Finland's International Monetary Policy Conference Helsinki, 26 June 2024 ## Introduction My aim today is to discuss the modern role of monetary analysis at the ECB. ${ }^{[1]}$ I will first review how monetary analysis has advanced over the twenty-five year history of the euro. Second, I will discuss how monetary analysis contributed to the assessment of financing conditions during the pandemic. Third, I will explain how monetary analysis has informed the diagnosis of the post-pandemic surges in inflation. Fourth, I will examine the contributions of monetary analysis to the calibration of the tightening cycle. Finally, I will speculate on the future role of monetary analysis. ## The evolving role of monetary analysis The initial monetary policy strategy of the ECB was based on a two-pillar framework to identify risks to price stability: economic analysis and monetary analysis. The two analytical domains essentially provided complementary perspectives on the economy. ${ }^{[2]}$ For the monetary pillar, the ECB's Governing Council initially chose to emphasise the quantity of money among the key indicators to be closely monitored and established a reference value for the growth of a broad monetary aggregate (M3). ${ }^{[3]}$ This approach was in line with the views of early-day monetarists who considered money growth the primary source of inflation. Milton Friedman famously captured this in the adage that "inflation is always and everywhere a monetary phenomenon". In an admittedly restrictive interpretation of Friedman's statement, this is reflected in the quantity identity $\mathrm{MV}=\mathrm{PY}$. ${ }^{[4]}$ This school of thought saw money as an imperfect substitute for a wide range of financial and real assets. A policy-induced injection of money into the economy would trigger complex and inter-related portfolio rebalancing across asset categories. This rebalancing would then lead to widespread changes in asset prices, yields and spreads across the economy. These mechanisms are well described in the classic 1988 monetarist account of transmission by Karl Brunner and Alan Meltzer. ${ }^{[5]}$ Especially after the end of the Bretton Woods system in 1973, some stability-oriented central banks most notably the Deutsche Bundesbank - were looking for a substitute anchor, and these monetarist considerations played a significant role in the conduct of monetary policy throughout the 1970s, 1980s and 1990s. The result of that intellectual legacy was the prominent role that the ECB assigned to a reference value for money growth as an anchor back in 1998. ${ }^{[6]}$ Deviations from that reference value ---[PAGE_BREAK]--- and the associated "monetary overhang/shortfall" were, at the time, generally considered to signal risks to price stability. However, a consistent record of difficulties within central banks in interpreting swings in monetary aggregates and in relying on them for predicting inflation at the horizons relevant for monetary policy contributed to a declining emphasis on money in policy making. As early as 1983, Bank of Canada Governor Gerald Bouey famously quipped "I would not say that we abandoned M1; I would say that M1 abandoned us, because of changes in banking practices". ${ }^{[7]}$ Even though Bouey was speaking about M1, the same instability problem applied to M3. Moreover, by the time Michael Woodford came to write his seminal text Interest and Prices in 2003, there was a wide-spread view that it was not necessary to incorporate money in modern macroeconomic models. ${ }^{[8]}$ Rather, the monetary policy stance could be summarised by the setting of interest rates alone. ${ }^{[9]}$ Accordingly, money was all but removed from the modern monetary economics synthesis. Against this background, the ECB conducted a review of its monetary policy strategy in 2003. This resulted in a revised approach to monetary analysis under the monetary pillar, with the adoption of a broader view of the role of money in the economy and the financial system. The long-term empirical relation between money and inflation had consistently been proven unhelpful in quantifying the scale of price pressures on a meeting-by-meeting basis. This realisation led to the discontinuation of the earlier practice of reviewing the reference value for M3, with a shift towards treating money aggregates as indicator variables rather than intermediate targets for monetary policy. The 2003 strategy review also clarified that monetary analysis served as a tool for cross-checking the short to medium-term indications from the economic analysis, from a medium to long-term perspective. ${ }^{[10]}$ After 2003, two significant developments led to an increased focus of monetary analysis on monetary policy transmission. First, the global financial crisis and the euro area sovereign debt crisis highlighted the vulnerability of the transmission mechanism. This, in turn, prompted policymakers to place greater reliance on monetary analysis in navigating the resulting challenges. Second, the adoption of unconventional monetary policy tools by the ECB of required monetary analysis to broaden its scope to better understand the many new transmission channels that the adoption of unconventional instruments had set in motion, including the analysis of potential side effects of those measures. Overall, the shift in focus of monetary analysis towards monetary policy transmission represented a natural evolution in line with the changing monetary policy landscape. These developments were incorporated in monetary analysis during the latest strategy review conducted in 2021. In the new framework, "economic analysis" and "monetary analysis" no longer represent distinct perspectives on inflation. Instead, the interrelations between economic developments and monetary and financial developments are explicitly integrated into the overall assessment of inflation risks and the formulation of monetary policy. ${ }^{[11]}$ Accordingly, monetary analysis has expanded from a narrow focus on the quantity of money to the wider mechanism by which monetary policy actions transmit to the financing conditions faced by households and firms in the real economy. ${ }^{[12]}$ This approach often employs monetarist concepts, ---[PAGE_BREAK]--- formalised within modern structural models, to analyse changes in spreads and asset prices linked to portfolio rebalancing across imperfectly substitutable financial assets, including money and money-type assets. ${ }^{[13]}$ Monetary analysis played a particularly salient role in policy decision-making when the policy rate approached the effective lower bound. This period saw a significant expansion of liquidity in the financial system through central bank lending programmes and outright asset purchases, underscoring the importance of informed decision-making based on monetary analysis. In the quantity identity (MV=PY), the traditional emphasis had primarily been on the growth rate of money, M. However, the bi-variate relation between inflation and money growth had not only always been elusive but also weakened over time, before disappearing altogether in the first decade of the 2000s (Chart 1). ${ }^{[14]}$ Past studies had found a significant and stable relation between broad money growth and inflation across several economies and monetary regimes. However, this relation was observed at very low frequency over extremely long periods, limiting the degree to which it can be used in practice at the meeting-by-meeting frequency required for policy decisions. ${ }^{[15]}$ Moreover, research incorporating recent experiences finds that structural shifts in banking and the financial system have destabilised the relation between money supply and inflation. ${ }^{[16]}$ Precisely for these reasons, since the global financial crisis, the importance of the bank lending channel and other transmission mechanisms has become more prominent. Monetary analysis has adapted by increasing the emphasis on analysing the credit-creation process, its relation with liquidity conditions and the various frictions affecting the financial system. All these elements affect the transmission of monetary policy to the real economy and thereby contribute to inflation dynamics. ---[PAGE_BREAK]--- # Chart 1 Money growth and inflation ![img-0.jpeg](img-0.jpeg) Sources: ECB (BSI), Eurostat and ECB calculations. The latest observations are for 2024 Q1. From this perspective, it would be overly reductive to interpret the rise of money growth during the pandemic and the subsequent rise in inflation that is shown in Chart 1 as a causal relation. In fact, the strong money growth in the early phase of the pandemic was driven by the build-up of liquidity buffers, which is not inherently inflationary. ${ }^{[17]}$ This is consistent with the view that the surges in inflation in 2021 and 2022 were mostly related to supply-side factors, such as global supply bottlenecks and increases in energy and commodity prices, rather than an increased stock of money. This view is further reinforced by the nature of the inflation shock which involved large relative price movements, whereas money-induced inflation should have been associated with a more uniform increase in prices across categories. I will return to the pandemic episode later in this speech. The wider availability of timely granular information on balance sheets, lending rates and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening. ${ }^{[18]}$ More recently, the availability of loan- and transaction-level information on banks and firms has further enhanced the analysis of the monetary policy transmission mechanism along several dimensions, including: heterogeneity in the transmission of monetary policy across regions and sectors, the impact of monetary policy on bank risk-taking, and the sources of changes in credit developments. ${ }^{[19]}$ ## Financing conditions during the pandemic ---[PAGE_BREAK]--- The pandemic period was marked by extraordinarily high liquidity demand, triggering a global dash for cash by investors. Lockdowns, social distancing measures and travel restrictions led many firms to experience a reduction in consumer demand and to reduce or halt their operations. This triggered a substantial decline in revenue for businesses across a wide range of sectors. However, firms still had to meet operating expenses and short-term obligations, such as the maintenance of inventories, payments to suppliers, salaries, taxes and fixed operational expenses. These needs showed up very clearly in the replies by banks to the ECB bank lending survey (BLS), which documented a surge in loan demand by firms to finance working capital, while financing needs linked to investment weakened considerably (Chart 2). ${ }^{[20]}$ # Chart 2 Financing needs for inventories and working capital and loan demand by enterprises (net percentages) ![img-1.jpeg](img-1.jpeg) Source: ECB (BLS). Notes: Net percentages for the questions on demand for loans are defined as the difference between the sum of the percentages of banks responding "increased considerably" and "increased somewhat" and the sum of the percentages of banks responding "decreased somewhat" and "decreased considerably". The net percentages for responses to questions relating to contributing factors are defined as the difference between the percentage of banks reporting that the given factor contributed to increasing demand and the percentage of banks reporting that it contributed to decreasing demand. The latest observations are for Q1 2024. In this environment, employment and total hours worked declined at the sharpest rates on record, with many employees being furloughed or having their working hours reduced. Consequently, salary incomes were dented. Banks across the euro area faced rising funding costs due to a climate of heightened uncertainty in the market and concerns about borrower creditworthiness. This led to a ---[PAGE_BREAK]--- reassessment of risk, affecting not only banks but also the broader financial markets, as evidenced by the increase in corporate bond yields. In the absence of countervailing measures, banks would have struggled to secure funding, which would have limited their ability to meet the high demand for emergency loans, potentially crippling their lending capacity. Accordingly, it was crucial for our monetary policy to maintain favourable financing conditions and the effective transmission of monetary policy, in order to avert a monetary squeeze that would have exacerbated adverse effects from the pandemic on the economy and price stability. The experience gained over the preceding decade allowed us to respond swiftly and decisively, deploying essentially two types of instruments. The first type was intended to maintain an accommodative monetary policy stance and, in parallel, stem the tide of an impending meltdown in financial markets as investors were pulling back from riskier assets. Here the main measures were the recalibration of the asset purchase programme (APP) and the introduction of the pandemic emergency purchase programme (PEPP). ${ }^{[21]}$ [22] The second group of instruments was deployed to ensure that the accommodative impulse would reach the broader economy. Notable examples include the recalibrations of the targeted longer-term refinancing operations (TLTROs) for banks at attractive conditions. ${ }^{[23]}$ These term credit operations were aimed at expanding the quantity of central bank reserves, subject to the condition that banks would lend them on and keep credit flowing to the economy. As a facilitating measure, the targeted lending programme was accompanied by a temporary easing of collateral and regulatory constraints. The interplay between policies to keep the risk-free curve low and steady across maturities, and instruments to unclog the transmission pipes worked as intended. The economics of the portfolio rebalancing channel learned during the first wave of the APP net purchases, over the period 20152018, as well as the experience of the portfolio movements during the sovereign debt crisis, were instrumental for the design of the PEPP. The portfolio rebalancing channel is the key mechanism through which central bank asset purchases transmits monetary policy to the broader economy. ${ }^{[24]}$ This channel functions through the principle of imperfect substitutability among financial instruments, coupled with investor preferences for certain assets, known as preferred habitats. ${ }^{[25]}$ Monetary analysis studied how portfolio allocations can change directions both across instruments and between euro-denominated domestic assets and foreign assets. Within the euro area, the APP had led to a rebalancing of bank exposures from sovereign securities towards corporate securities and from bonds to real-sector loans, easing financing conditions to corporates and households in the process. ${ }^{[26]}$ The shift towards foreign assets had been more pronounced among foreign investors, who were the main selling sector counterpart in the APP during the pre-pandemic period, but it was also evident among euro area investors (Chart 3). ${ }^{[27]}$ This had played a significant role in explaining the limited effect that the APP had on the expansion of broad money supply before the pandemic, a phenomenon that was similarly observed during the third round of quantitative easing in the United States (Chart 4). In other words, the APP had exerted robust monetary transmission even in the absence of a strong expansion in the money supply, because the exchange rate channel had become a powerful substitute for the traditional money-creation mechanism that worked through the liability side of bank balance sheets. ---[PAGE_BREAK]--- # Chart 3 Net portfolio investment in debt securities by euro area non-MFIs (12-month flows in EUR bn) Total - Net purchases by euro area non-MFIs of debt securities issued by non-euro area residents - Net purchases by non-euro area residents of debt securities issued by euro area general government - Net purchases by non-euro area residents of debt securities issued by euro area non-MFIs other than general government ![img-2.jpeg](img-2.jpeg) Sources: ECB (BPS) and ECB calculations. Notes: As is common in the monetary presentation of the balance of payments, the b.o.p. items correspond to the non-MFI sector and display the sign that matches the related monetary flows, i.e. monetary inflows are shown with a positive sign and monetary outflows are shown with a negative sign. The latest observations are for April 2024. ---[PAGE_BREAK]--- # Chart 4 ## Sources of money creation ## Euro area (annual percentage changes and contributions) ![img-3.jpeg](img-3.jpeg) ## United States (annual percentage changes and contributions) - M2 Business, mortgage and consumer loans - Net external monetary flows - Fed net purchases of securities Other counterparts ![img-4.jpeg](img-4.jpeg) Sources: Left panel: ECB (BSI) and ECB calculations; right panel: Federal Reserve Board/Haver Analytics, Bureau of Economic Analysis and ECB calculations. Notes: Panel a: Figures for M3 are adjusted for the operational incident in TARGET2 which inflated the September 2022 figures for OFI deposits and loans, reversing them in October and November 2022. Panel b: Net external monetary flows (which are the exchanges between the non-MFI sector and the rest of the world) are obtained by subtracting the contribution of deposit-taking institutions and central bank (where available) to the US b.o.p. They display the sign that matches the related monetary flows, i.e. monetary inflows are shown with a positive sign, monetary outflows are shown with a negative sign. The latest observation for that series is for Q1 2024, but the monthly flow for April 2024 is kept equal to that of March 2024. As required by the monetary framework, Eurosystem purchases includes securities issued by euro area non-MFIs. The latest observations are for April 2024. The long-standing internal monetary analysis of the factors explaining the setting of bank lending rates was critical in the recalibration of existing TLTROs during the pandemic. In particular, the pricing of the new wave of TLTROs following the outbreak of the pandemic relied on the accumulated evidence that the unconventional policies deployed by the ECB had lowered various components of bank funding costs in the aftermath of the euro area sovereign debt crisis (Chart 5). ${ }^{[28]}$ Empirical estimates indicate that, in the absence of the recalibration of the targeted lending programme, the ability of banks to supply credit would have been severely affected. Importantly, the lower amount of lending to firms would have led to a significantly larger decline in employment by firms. ${ }^{[29]}$ ---[PAGE_BREAK]--- Chart 5 Lending rate to non-financial corporations and its components (percentages per annum) ![img-5.jpeg](img-5.jpeg) Sources: ECB (BSI, MIR), Bloomberg, Moody's and ECB calculations. Notes: The chart decomposes the realised lending rate on new loans to non-financial corporations (blue line) into contributions from bank cost components. The residual between the realised lending rate and the various cost components identifies a measure of intermediation margin. Deposits, bank bonds and money market and ECB borrowing are expressed as spreads vis-à-vis the base rate (i.e., the three-year overnight index swap (OIS), black line), weighted by their respective importance in banks' funding mix. The latest observations are for April 2024. # The post-pandemic surges in inflation The combination of extraordinarily high liquidity needs and our monetary policy measures to maintain favourable financing conditions boosted broad money growth. As a result, credit to firms and central bank purchases became the main sources of money creation. This composition reflected the broad division of tasks in the support given to the euro area economy, with the support to the corporate sector mostly channelled via bank credit (whose conditions were eased by monetary policy, government guarantees and regulatory measures) while the support to households was mostly channelled via the government sector. The latter, and thus the liquidity needs of the economy, explain the marked impact of central bank purchases on money growth in the early stages of the pandemic. In contrast to the 2015-2018 period, these purchases occurred alongside an increase in government borrowing. Such borrowing prevented the bond scarcity that large-scale asset purchases can imply, thereby averting the usual financial outflows to the rest of the world (Chart 4, left panel). As economic activity resumed and lockdown restrictions were lifted, emergency liquidity needs declined and money growth also slowed. By October 2020, the three-month annualised growth rate of M3 had dropped to 7.5 per cent, which was about one-third of the 21.9 per cent rate seen at the peak of the lockdowns, and just somewhat above the historical average. The growth rate continued to decrease until mid-2022 even in the face of increased borrowing prompted by liquidity demands from the energy ---[PAGE_BREAK]--- crisis. Shortly after we started hiking rates in July 2022, M3 growth even dipped into negative territory before recovering somewhat in the second half of 2023. Inflation began to rise just as money growth slowed down. Initially, these price increases were concentrated in specific sectors, particularly affecting energy and food prices, rather than showing a broad-based increase across all goods and services, which would have been more consistent with a monetary origin for the inflation surge (Chart 6). These heterogeneous price increases align with the view that inflation was largely due to specific cost-push shocks passing through to the wider consumption basket. This perspective is supported by structural analyses identifying energy and food price shocks together with supply chain disruptions as the main culprits of the inflationary pressures. $\frac{[30]}{}$ It is also consistent with the interpretation that the robust money growth during the early stages of the pandemic was a result of accumulating liquidity reserves, which in turn were not inherently inflationary. Taken together, the evidence indicates that the recent inflation surge is primarily attributable to rising commodity prices and global supply constraints, rather than an expanding money supply. ${ }^{[31]}$ ---[PAGE_BREAK]--- # Chart 6 Headline inflation, money growth and commodity prices, and headline inflation and subcomponents ## Headline inflation, money growth and commodity prices (left-hand scale: annual percentage changes; right-hand scale: index in USD) ![img-6.jpeg](img-6.jpeg) Headline inflation and subcomponents (annual percentage changes) - HICP - Food incl. alcohol and tobacco - HICP - Energy - HICP - Services - HICP - Overall index - HICP - All items excluding energy and food ![img-7.jpeg](img-7.jpeg) Sources: ECB (BSI), Eurostat, World Bank and ECB calculations. The latest observations are for April 2024. The surge in borrowing by firms, which peaked during the second quarter of 2020 amid the initial lockdowns, was primarily driven by need for working capital and precautionary reasons. Borrowing by firms closely matched their increases in cash reserves. Since this borrowing was not for investment purposes, it did not stimulate aggregate demand. Household behaviour points to a similar message. Government aid to households served to cushion their reduced income rather than to increase spending: fiscal transfers only covered part of the slowdown in household income over the pandemic period. Most of the excess savings accumulated during the pandemic resulted from falling consumption, which was much larger than the drop in income (Chart 7, left panel). This decline in consumption was partly forced by the reduced consumption opportunities due to the pandemic restrictions but it is likely to have also reflected precautionary behaviour related to uncertainty about the future. The latter led to an increased preference for liquidity, ---[PAGE_BREAK]--- and indeed a large part of household excess savings were accumulated in the form of overnight deposits, especially in the initial phases of the pandemic (Chart 7, right panel). ${ }^{[32]}$ # Chart 7 Savings over the pandemic period ## Sources of savings (quarterly flows in EUR bn compared to the same quarter of two years before) ![img-8.jpeg](img-8.jpeg) ## Uses of excess savings (percentage points of disposable income and percentage point contributions; changes with respect to the corresponding quarter in 2019) ![img-9.jpeg](img-9.jpeg) Sources: ECB (QSA), Eurostat and ECB calculations. Notes: right side: The chart compares the ratio of savings to disposable income and its contributions, to the same ratio and contributions in the corresponding quarters in 2019. The latest observations are for 2021 Q4. Consumption only started to approach its pre-pandemic level by the middle of 2021, but households continued to express their willingness to maintain a higher level of savings or financial investments, a considerable part of which remained in overnight deposits. This composition also reflected the flattening yield curve and the low opportunity cost of holding those deposits. ${ }^{[33]}$ ---[PAGE_BREAK]--- # Chart 8 Individual consumption of selected goods and services and corresponding price developments (left-hand scale: chain-linked EUR bn; right-hand scale: annual percentage changes) ![img-10.jpeg](img-10.jpeg) Sources: Eurostat and ECB calculations. The latest observations are for 2022. As energy and food prices began to rise, households moderated their accumulation of deposits but also reduced the real consumption of those products (Chart 8). The configuration of falling consumption and rising prices for energy and food is consistent with supply shocks driving energy and food prices rather than reflecting a surge in domestic demand. ${ }^{[54]}$ In addition, falling consumption also indicates that the excess deposits accumulated during the pandemic did not lead to households being insensitive to more expensive and energy and food bills. Chart 8 also shows that, as the economy reopened and uncertainty receded, household consumption volumes of items other than energy and food rebounded towards pre-pandemic levels despite the price increases in those items in the course of 2021 and 2022. While the configuration of rising consumption and rising prices might suggest some role for domestic demand, consumption of these items remained clearly below the previous trend. It is certainly the case that, for a given surge in supply-driven inflation, excess savings allowed households to cut consumption by less than if the supply shock had happened at a time when excess savings were lower. The coexistence of high inflation and only a moderate consumption recovery serves to underline the scale of supply-driven cost pressures during 2021 and 2022: only a dramatic monetary and/or fiscal tightening would have been needed to eliminate the inflation surge by reducing domestic demand sufficiently (involving a severe drop in domestic incomes) to match the reduction in supply capacity. Overall, although real private consumption and investment have rebounded in the post-pandemic period, these have not reached the levels projected in mid-2021 when excess savings were at their ---[PAGE_BREAK]--- highest, and real private consumption continues to trail the forecasts made before the pandemic. In this context a dramatic recession would have been required to fully avoid an inflation surge. ${ }^{[35]}$ # The tightening cycle Monetary analysis has been central to the regular assessment of the state of the monetary policy transmission, which has been a key guiding principle in calibrating the speed and scale of the monetary policy tightening over the last couple of years. ${ }^{[36]}$ Focusing on the propagation of that tightening impulse through the banks, both the rate hikes that started in July 2022 and the sustained upshift in the yield curve that preceded and accompanied that process led to a significant rise in bank funding costs, initially driven by bonds and subsequently by deposit rates (Chart 9). The latter adjusted with a lag, owing to the atypical interest rate configuration during the negative rate period, but eventually aligned with our policy signal (Chart 10). ## Chart 9 Bank funding costs ![img-11.jpeg](img-11.jpeg) Sources: ECB (BSI, MIR, CSDB, MMSR) and ECB calculations. For monthly data, the latest observations are for April 2024, for daily data, the latest observations are for $17^{\text {th }}$ June. In parallel, loan volumes in the euro area have experienced a marked decline since late 2022. After dropping sharply, credit flows have remained stagnant for both loans and bonds (Chart 11, left panel). The pronounced decline in credit compared to previous hiking cycles (Chart 11, right panel) was largely due to the sharp increase in interest rates, which has significantly dampened demand, as also reflected in the ECB bank lending survey (BLS). Initially, credit demand showed some resilience, primarily driven by the liquidity needs of firms during the peak of the energy crisis. However, it began to contract in the ---[PAGE_BREAK]--- last quarter of 2022 and continued to do so for several months after the last rate hike in September 2023. The primary drivers behind the weakness in demand were elevated interest rates and reduced recourse to credit for financing investments, which reflects the "cost of capital" channel of monetary policy (Chart 12). # Chart 10 Transmission to deposit rates (percentages per annum) ![img-12.jpeg](img-12.jpeg) Sources: ECB (MIR, FM) and ECB calculations. Notes: The ECB relevant policy rate is the MRO for the 1999-2008 panels and the DFR for the panels starting on 2022. The latest observations are for April 2024. ---[PAGE_BREAK]--- # Chart 11 Firm debt financing (left side), and comparison of slowdown in loan dynamics to past regularities (right side) ## Firm debt financing ![img-13.jpeg](img-13.jpeg) ## Comparison of slowdown in loan dynamics to past regularities (x-axis: years, y-axis: growth rate of credit in deviation from its growth rate at the start of the cycle (t), in pp) ![img-14.jpeg](img-14.jpeg) Sources: ECB (BSI, CSEC) and ECB calculations. Notes: MFI loans are adjusted for sales and securitisation and cash pooling. The seasonal adjustment of the net issuance of debt securities is not official. The dotted line corresponds to a BVAR counterfactual for lending volumes, taking December 2021 as the latest observation and projecting volumes conditional on the path of monetary policy rates. The type of BVAR used is the one used by Giannone, D., Lenza, M. \& Primiceri, G., (2015),"Prior Selection for Vector Autoregressions", The Review of Economics and Statistics, 97, issue 2, p. 436-451; and Altavilla C., Giannone D. \& Lenza M. (2016), "The financial and macroeconomic effects of OMT announcements", International Journal of Central Banking, vol. 12(3), pages 29-57. The latest observations are for April 2024. ---[PAGE_BREAK]--- # Chart 12 ## Loan demand by firms and contributing factors during the tightening cycle (net percentages of banks reporting an increase in demand, and contributing factors) ![img-15.jpeg](img-15.jpeg) Source: ECB (BLS). Notes: Net percentages for the questions on demand for loans are defined as the difference between the sum of the percentages of banks responding "increased considerably" and "increased somewhat" and the sum of the percentages of banks responding "decreased somewhat" and "decreased considerably". The net percentages for responses to questions relating to contributing factors are defined as the difference between the percentage of banks reporting that the given factor contributed to increasing demand and the percentage of banks reporting that it contributed to decreasing demand. "Other financing needs" is the unweighted average of "mergers/acquisitions and corporate restructuring" and "debt refinancing/restructuring and renegotiation"; and "Use of alternative finance" is the unweighted average of "internal financing", "loans from other banks", "loans from non-banks", "issuance/redemption of debt securities" and "issuance/redemption of equity". The net percentages for "Other factors" refer to an average of the further factors which were mentioned by banks as having contributed to changes in loan demand. The latest observations are for 2024 Q1. At the same time, a decline in the supply of credit from banks has also played a large role in the recent credit slowdown. Credit supply effects primarily stemmed from a decreasing willingness of banks to take risks. This, in turn, has affected lending conditions for firms and households. The start of the reimbursement phase for TLTROs and the change in the conditions applied by on TLTRO borrowings reinforced the incentives for banks to scale down loan exposures. ${ }^{[37]}$ Studies using granular data to control for demand conditions indicate that increased borrowing costs for banks have resulted in a significant reduction in lending volumes. In other words, the significant decrease in loans was partly due to the tighter lending conditions, rather than being solely due to lower credit demand. Our bank lending survey corroborates this view, highlighting that heightened risk perception and reduced risk tolerance on the part of banks were significant factors influencing the tightening of credit standards during the hiking cycle. ---[PAGE_BREAK]--- In parallel, money growth, which had been declining rapidly from its 2021 peak, saw its decline accelerate, mirroring the contemporary contraction in bank lending and the progressive reduction of the monetary policy securities portfolio of the Eurosystem. Two liability-side factors reinforced the contraction in the availability of cheap funding: first, banks substituting TLTRO funding for long-term bonds; and second, a strong portfolio rebalancing by households and firms on the liability side of bank balance sheets. In particular, the increased remuneration of time deposits and bonds after a long period of low or negative interest rates has incentivised shifts to these instruments from overnight deposits and other low-remuneration deposits. During the period of low interest rates, the opportunity cost of holding overnight deposits was very low, causing households and firms to prefer overnight deposits. The monetary policy tightening and its transmission to deposit rates and yields on other financial assets, has increased the opportunity cost of holding overnight deposits to levels similar to those seen in previous hiking cycles. This has led households and firms to move a significant portion of their unusually large stock of overnight deposits to time deposits and bonds (Chart 13). ${ }^{[38]}$ The high level of liquidity within the banking system has not impeded the transmission of our monetary policy tightening to households and businesses. Although in the cross-section banks with greater excess liquidity at the onset of the tightening cycle have reduced their lending to a lesser extent than their less liquid peers, the overall transmission of monetary policy has been robust and, if anything, been stronger than in previous cycles. The apparent differences between the cross-sectional and time series results can be reconciled as follows. From a theoretical standpoint, excess reserves on the balance sheets of banks exert dual effects during a period of monetary tightening. On one side, the initiation of an unexpected tightening phase allows banks with excess reserves to benefit from higher returns on these reserves. This helps bolster their profits, potentially augments their capital buffers, relaxes constraints and ultimately expands the supply of lending. This wealth effect is in line with the results of the cross-sectional analysis. ${ }^{[39]}$ At the same time, as the remuneration of reserves increases, these reserves become increasingly attractive to banks, as these represent a highly remunerated, secure and liquid asset. As a result, banks may be reluctant to extend their lending or to invest in bonds unless the price of these financial instruments is sufficiently attractive. This substitution effect may well have been the prevailing force in the aggregate transmission of our monetary policy. ${ }^{[40]}$ That is to say, while the wealth effect may explain the cross-sectional variation in lending behaviour among banks with differing levels of excess liquidity, the substitution effect likely contributed to the strong transmission of monetary tightening on an aggregate level. As the quantity-theory expression MV=PY makes clear, the connection between outside money - the currency and reserves supplied by the central bank - and prices is mediated by adjustments in velocity. Velocity is a complex function of a host of factors, some of which pertain to the decisions by banks to intermediate credit, others having to do with the decisions by different types of money holders on the financial instruments in which they want to keep their wealth. All else equal, credit creation pushes up velocity and thereby, for a given level of real income, generates price pressures. Conversely, portfolio reallocations towards larger money holdings serves to reduce velocity and weaken inflation for a given stock of outside money. ---[PAGE_BREAK]--- In a nutshell, these two factors have been offsetting each other in recent years. When loans were rapidly expanding in the early phase of the pandemic crisis, a sharp rise in liquidity preference - and the short-term bridging nature of the loans themselves - attenuated the inflationary potential of money growth. When eventually portfolios started shedding excess liquidity - a potential source of inflation loans began to decline in parallel, providing a cushion against money-generated inflationary pressures. # Chart 13 Financial investment by households ![img-16.jpeg](img-16.jpeg) Sources: ECB (BSI, QSA, MIR, FM), Eurostat and ECB calculations Notes: 'Government bonds' yields used for the spread calculation are those on 2-year government bonds. The latest observations are for 2023 Q4. ## Future challenges Looking ahead, a prominent challenge for monetary analysis is to understand how the normalisation of the balance sheets of central banks may affect transmission in the years to come. Measures that expand the central bank balance sheet stimulate bank lending and risk-taking through three main channels. ${ }^{[41]}$ First, the decrease in long-term interest rates associated with the purchases of long-term securities by the central bank lowers borrowing costs for businesses and consumers, ultimately stimulating their loan demand. Second, investors (including banks and other financial institutions) that sell assets to the central bank try to rebalance their portfolio towards higher-yielding investments, which can also lead to increased lending supply. ${ }^{[42]}$ Third, the liquidity injected into the banking system via central bank purchases of financial assets can enhance the capacity of banks to lend because that type of liquidity, perceived to remain in the system for a long time, may be seen as providing a permanent means to service the mobile type of deposits that are the by-product of an extension of bank credit. ---[PAGE_BREAK]--- In studying this critical nexus with the help of monetary analysis, it is worth recalling the notion of the "money multiplier". Based on this mechanism, in a fractional reserve banking system a policy-induced expansion of the free reserves of cash held by the banks spurs, through successive rounds of loan and deposit creation, increasing volumes of credit and inside money. Outright central bank asset purchases increase bank reserve holdings and prompt banks to try to minimise the associated liquidity surplus which is costly - by creating credit and other claims on those surplus reserves in an effort to enhance shareholder returns. This mechanism helps explain the strong connection of credit with reserve creation in times of QE, even when controlling for demand-for-credit effects as lending rates decline as a result of QE. In the other direction, a withdrawal of reserves sets in motion a cumulative process by which credit and deposits shrink by a multiple of the original negative shock to the reserve holdings. ${ }^{[43]}$ It follows that, in order to assess the implications of QT, it is important to trace all the implications of the central bank balance sheet contraction for asset prices and credit in an encompassing framework and to take into account the relation between central bank liquidity and bank intermediation capacity. ${ }^{[44]}$ The relevance of the money multiplier is also supported by recent empirical analysis using comprehensive bank-level and loan-level data on lending from euro area banks to firms. A recent ECB study draws two main conclusions. First, the availability of central bank liquidity significantly influences banks' credit provision, in what the authors call a "reserve availability channel" of monetary policy. Second, the source of central bank reserves affects their impact on bank intermediation: non-borrowed reserves - those created as a result of a securities purchase programme - have very strong empirical connection with bank loans, whereas this is not the case for borrowed reserves drawn by banks from a short-term refinancing facility (Chart 14). ${ }^{[45]}$ ---[PAGE_BREAK]--- # Chart 14 Response of bank loans to an increase in borrowed and non-borrowed reserves ## a) Non-borrowed reserves (x-axis: months after the increase in reserves, $y$-axis: percentage points) ![img-17.jpeg](img-17.jpeg) b) Borrowed reserves (x-axis: months after the increase in reserves, $y$-axis: percentage points) ![img-18.jpeg](img-18.jpeg) Sources: Altavilla, Rostagno, Schumacher (2024). Notes: The chart reports the response of bank loans after a 1pp increase in non-borrowed reserves (left side) and borrowed reserves (right side). The solid lines report the estimated response, while the dashed lines report the $95 \%$ confidence intervals for each horizon. These mechanisms are in line with a growing body of empirical studies focusing on the relation between central bank reserves and bank lending. Examples include analyses that show that: (a) banks that increased their reserve holdings, following the third round of quantitative easing announced by the Federal Reserve, increased lending; (b) banks with higher excess reserve holdings grant more credit lines and take more risk; (c) the reallocation of central bank reserves towards banks with higher liquidity needs fosters credit supply; and (d) the credit supply of reserve-rich banks is less sensitive to monetary policy tightening than that of other banks. ${ }^{[55]}$ ## Conclusions As I have covered in this lecture, modern monetary analysis is helping policymakers to analyse the nexus of money, credit and the economy. Moreover, the frontier in modern monetary analysis is continuing to expand: the enhanced availability of granular data, filtered through an expanding computation capacity and new machine learning techniques, is further broadening its scope and the relevance of its findings for the calibration of monetary policy. For these reasons, monetary analysis ---[PAGE_BREAK]--- plays a central role at the ECB, with a data-dependent approach to assessing the effectiveness of monetary policy transmission a key element in our reaction function. # 1. I am grateful to Ramón Adalid, Alessandro Ferrari, Andrew Hannon and Sofía Velasco for their contributions in preparing these remarks and also the assistance of Lucía Kazarian, Silvia Scopel, Marina Dimitriou, Andreas Kapounek, Nikoleta Tushteva, Emma Vergauwen and Wouter Wakker. The term "modern monetary analysis" is intended to capture the current role of monetary analysis in central banking, as opposed to a traditional interpretation of the role of monetary analysis. The framework of modern monetary analysis is not to be confused with the much-discussed framework of modern monetary theory. 2. For a review of the evolution of ECB policy instruments and targets during its first two decades of existence, see Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Saint Guilhem, A. and Yiangou, J. (2021). "Monetary policy in times of crisis: A tale of two decades of the European Central Bank", Oxford University Press. See also Papademos, L., \& Stark, J. (2010), "Enhancing monetary analysis", European Central Bank; Issing, O. (2000), "Communication challenges for the ECB", speech at the CFS research conference "The ECB and its watchers II",Panel II: "The ECB and Its Communication Strategy", Frankfurt, 26 June 2000; and European Central Bank. (1999), "The stabilityoriented monetary policy strategy of the eurosystem", ECB Monthly Bulletin, (January), 39-50. 3. See Klöckers, H.-J., and Willeke, C. (2001), "Monetary analysis: Tools and applications", ECB. 4. To be sure, the quantity identity predates Friedman's statement by a couple of centuries, as it is already clearly implicit in David Hume's "Political Discourses" (1752), although the "V" part of the equation was certainly under-appreciated and the identity tended to be understood as a casual relationship rather than an identity. In the equation, " $M$ " is the total stock of outside money, i.e. the monetary aggregate that reflects liquidity injections by the central bank: in modern times, currency and reserves. "V" is the velocity with which money circulates, "P" is a price index, and "Y" is a measure of real economic activity. See Lucas, R. E., Jr. (1980),"Two illustrations of the quantity theory of money", American Economic Review, 70(5), 1005-1014; and Sargent, T. J., and Surico, P. (2011), "Two illustrations of the quantity theory of money: Breakdowns and revivals", American Economic Review, 101(1), 109-128. 5. See Brunner, K., and Meltzer, A. H. (1988)," Money and credit in the monetary transmission process", American Economic Review, 78(2), 446-451. ---[PAGE_BREAK]--- 6. The Deutsche Bundesbank continued to announce a target for the growth rate of its broad monetary aggregate M3 until the end of 1998, when the responsibility for monetary policy passed to the ECB. Other European central banks, including the Banque de France, the Banca d'Italia, and the Banco de España, also announced monetary targets or reference ranges complementing other aspects of their monetary policy strategies, such as exchange rate targets and/or direct inflation targets. See Gerlach, S., and Svensson, L. E. O. (2003), "Money and inflation in the euro area: A case for monetary indicators?", Journal of Monetary Economics, Vol. 50, Issue 8, pp. 1649-1672. 7. House of Commons Committees (1983), Minutes of Proceedings and Evidence, Standing Committee on Finance, Trade and Economic Affairs, Vol. 6, No 134, 28 March, p. 12. 8. See, for example, Goodfriend, M. and King, R.G. (1997), "The New Neoclassical Synthesis and the Role of Monetary Policy", in Bernanke, B.S. and Rotemberg, J.J. (eds.), NBER Macroeconomics Annual: 1997, Cambridge, MA: MIT Press; Clarida, R., Galí, J. and Gertler, M. (1999), "The Science of Monetary Policy: A New Keynesian Perspective", Journal of Economic Literature, Vol. 37(4), pp. 16611707. 9. See Woodford, M. (2003), "Interest and prices: Foundations of a theory of monetary policy", Princeton University Press. He explains that, in a world where financial markets had become highly efficient, it is sufficient to limit attention to the overnight rate and let financial markets take care of arbitraging across any opportunities created by discrepancies in the yields on different market instruments. See also Orphanides, A. (2007), "Taylor rules", in Blume, L. and Durlauf, S. (eds.), The New Palgrave: A Dictionary of Economics, Houndmills, Basingstoke: Palgrave Macmillan. 10. Other central banks had followed the same paradigm shift in parallel to the adoption of explicit inflation targets, like the Bank of England and the central banks of New Zealand and Canada in the early 1990s. See King, M. (2005), "Monetary Policy: Practice Ahead of Theory", speech by Mervyn King at the Mais Lecture, Cass Business School, City University, London, 17 May, and Goodfriend, M. (2007), "How the World Achieved Consensus on Monetary Policy", Journal of Economic Perspectives, Vol. 21(4), pp. 4768. Real money balances continued to play a role in macroeconomic models, however; see, for example, Ireland, P.N. (2004), "Money's Role in the Monetary Business Cycle", Journal of Money, Credit and Banking, Vol. 36(6), pp. 969-983; Christiano, L., Motto, R. and Rostagno, M. (2003), "The Great Depression and the Friedman-Schwartz Hypothesis", Journal of Money, Credit and Banking, Vol. 35(6), pp. 1119-1197; and Andrés, J., López-Salido, J.D. and Vallés, J. (2006), "Money in an Estimated ---[PAGE_BREAK]--- Business Cycle Model of the Euro Area", Economic Journal, Royal Economic Society, Vol. 116(511), pp. 457-477, April. 11. See Holm-Hadulla, F., Musso, A., Rodriguez Palenzuela, D. and Vlassopoulos, T. (2021), "Evolution of the ECB's analytical framework", Occasional Paper Series, No 277, ECB; Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January; and Schnabel, I. (2023), "Money and inflation", lecture at the annual conference of the Verein für Socialpolitik, Regensburg, 25 September. 12. This remedied a clear lack of banks as key agents in the transmission of monetary policy even in the new paradigm, as noted in Goodhart, C.A.E. (2004), "Review of Interest and Prices by M. Woodford", Journal of Economics, Vol. 82(2), 195200. See also Goodfriend, M. and McCallum, B.T. (2007), "Banking and interest rates in monetary policy analysis: A quantitative exploration", Journal of Monetary Economics, Vol. 54, Issue 5, pp. 1480-1507; Canzoneri, M., Cumby, R., Diba, B. and López-Salido, D. (2008), "Monetary Aggregates and Liquidity in a Neo-Wicksellian Framework", Journal of Money, Credit and Banking, Vol. 40(8), pp. 1667-1698, December. 13. See also Christiano, L. and Rostagno, M. (2001), "Money Growth Monitoring and the Taylor Rule", NBER Working Paper Series, No 8539, National Bureau of Economic Research; Goodhart, C. (2007), "Whatever became of the monetary aggregates?", National Institute Economic Review, No 200, pp. 5661; and Pill, H. (2022), "What did the monetarists ever do for us?", speech by Huw Pill at Walter Eucken Institut / Stifung Geld und Währung Conference - Inflation and Debt: Challenges for Monetary Policy after Covid-19, Freiburg im Breisgau, 24 June. 14. See, for instance, De Grauwe, P. and Polan, M. (2005), "Is inflation always and everywhere a monetary phenomenon?", Scandinavian Journal of Economics, Vol. 107(2), pp. 239-259; Berger, H., Karlsson, S. and Osterholm, P. (2023), "A note of caution on the relation between money growth and inflation", IMF Working Papers, No 2023/137, International Monetary Fund; and Jung, A. (2024), "The quantity theory of money, 1870-2020", Working Paper Series, No 2940, ECB. 15. See, for instance, Benati, L. (2009), "Long run evidence on money growth and inflation", Working Paper Series, No 1027, ECB; Borio, C., Hofmann, B. \& Zakrajšek, E. (2024), "Money growth and the postpandemic surge in inflation", VoxEu, January 2024. ---[PAGE_BREAK]--- King, M.A. (2024), "Inflation Targets: Practice Ahead of Theory", NBER Working Paper Series, No 32594, National Bureau of Economic Research. 17. This is in line with the results set out in Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January, which also concludes that it is unlikely that the high money growth in 2020 caused the rise in inflation seen in 2021-2022. Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech at the National Institute of Economic and Social Research, London, 25 April, also argues that those buffers could not account for the subsequent upside surprise in inflation. 18. Following monetary policy tightening, the transmission of monetary policy is found to be stronger for banks that are (i) poorly capitalised (e.g. Van den Heuvel, S. (2002), "Does bank capital matter for monetary transmission?", Federal Reserve Bank of New York Economic Policy Review, Vol. 8); (ii) small (e.g. Kashyap, A. and Stein, J. (1995), "The Impact of Monetary Policy on Bank Balance Sheets", Carnegie-Rochester Conference Series on Public Policy, Vol. 42); and (iii) illiquid (e.g. Bernanke, B. and Gertler, M. (1990), "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105). 19. See Altavilla, C., Gürkaynak, R. and Quaedvlieg, R. (forthcoming), "Macro and Micro of External Finance Premium and Monetary Policy Transmission", Journal of Monetary Economics. 20. See Acharya, V.V. and Steffen, S. (2020), "The Risk of Being a Fallen Angel and the Corporate Dash for Cash in the Midst of COVID", The Review of Corporate Finance Studies, Vol. 9, Issue 3, pp. 430447. 21. See Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R. and Saint Guilhem, A. (2021), "Combining negative rates, forward guidance and asset purchases: identification and impacts of the ECB's unconventional policies", Working Paper Series, No 2564, ECB. 22. The PEPP was designed to ensure that the monetary policy stance of the ECB was transmitted effectively across the euro area, especially in a situation where financial markets were experiencing significant stress. In particular, the PEPP was designed to allow for fluctuations in the volume of purchases across time, asset classes and jurisdictions. This flexibility was key in addressing the specific transmission challenges posed by the pandemic, ensuring that the ECB's monetary policy stance was felt uniformly across the euro area economy. ---[PAGE_BREAK]--- 23. See Benetton, M. and Fantino, D. (2021), "Targeted monetary policy and bank lending behavior", Journal of Financial Economics, Vol. 142, Issue 1, October 2021, pp. 404-429; Barbiero, F., Boucinha, M. and Burlon, L. (2021), "TLTRO III and bank lending conditions", Economic Bulletin, Issue 6, ECB; and Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through", Journal of Monetary Economics, Vol. 110(C), pp. 8198. 24. See Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Saint Guilhem, A. and Yiangou, J. (2021), "Monetary policy in times of crisis: A tale of two decades of the European Central Bank", Oxford University Press; Altavilla, C., Carboni, G. and Motto, R. (2015), "Asset purchase programmes and financial markets: lessons from the euro area", Working Paper Series, No 1864, ECB; for Japan, see Bowman, D., Cai, F., Davies, S. and Kamin, S. (2015), "Quantitative easing and bank lending: Evidence from Japan", Journal of International Money and Finance, Vol. 57, pp. 15-30; for the United States, see Rodnyansky, A. and Darmouni, O.M. (2017), "The Effects of Quantitative Easing on Bank Lending Behavior", The Review of Financial Studies, Vol. 30, Issue 11, pp. 3858-3887; and for the United Kingdom, see Joyce, M. and Spaltro, M. (2014), "Quantitative easing and bank lending: a panel data approach", Working Papers, No 504, Bank of England. 25. See D.Vayanos and J.-L. Vila (2021), "A Preferred-Habitat Model of the Term Structure of Interest Rates," Econometrica 89(1), 77-112; and Fabian Eser \& Wolfgang Lemke \& Ken Nyholm \& Sören Radde \& Andreea Liliana Vladu, 2023. "Tracing the Impact of the ECB's Asset Purchase Program on the Yield Curve", International Journal of Central Banking, vol. 19(3), pages 359-422, August. 26. See Albertazzi, U., Becker, B. and Boucinha, M. (2021), "Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area", Journal of Financial Intermediation, Vol. 48, 100896. 27. See Adalid, R. and Palligkinis, S. (2016), "Sectoral Sales of Government Securities During the ECB's Asset Purchase Programme", SSRN; and Picón, C., Oliveira-Soares, R. and Adalid, R. (2020), "Revisiting the monetary presentation of the euro area balance of payments", Occasional Paper Series, No 238, ECB. 28. This enhanced support led to a substantial take-up in TLTRO III operations, with banks borrowing a record $€ 1.3$ trillion in June 2020, which increased to $€ 1.8$ trillion by December 2020. Altogether, the ---[PAGE_BREAK]--- volume of borrowing under the TLTROs in the euro area was notably larger than that of comparable programmes in the United States or the United Kingdom. 29. See Altavilla, C., Barbiero, F., Boucinha, M. and Burlon, L. (2023), "The Great Lockdown: Pandemic response policies and bank lending conditions", European Economic Review, Vol. 156(C). 30. See Bańbura, M., Bobeica, E. and Martínez Hernández, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB. The authors show that the increase in the inflation rate in the euro area since the onset of the pandemic was predominantly due to energy price shocks, food price shocks and supply chain disruptions. For the role of labour market dynamics, see also Bernanke, B. and Blanchard, O. (2023), "What Caused the U.S. Pandemic-Era Inflation?", NBER Working Paper Series, No 31417, National Bureau of Economic Research; Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdón, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB; and Menz, J.-O. (2024), "Sources of post-pandemic inflation in Germany and the euro area: An application of Bernanke and Blanchard (2023)", Technical Paper, No 02/2024, Deutsche Bundesbank. 31. See also Deutsche Bundesbank (2023), "From the monetary pillar to the monetary and financial analysis", Monthly Report, January; Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech by Ben Broadbent at the National Institute of Economic and Social Research, London, 25 April; and King, M.A. (2024), "Inflation Targets: Practice Ahead of Theory", NBER Working Paper Series, No 32594, National Bureau of Economic Research. 32. Chart 7 also shows that the allocation of excess savings to housing investment was relatively minor. 33. For the planned allocation of household net savings in the next 12 months, see Dossche, M., Georgarakos, D., Kolndrekaj, A. and Tavares, F. (2022), "Household saving during the COVID-19 pandemic and implications for the recovery of consumption", Economic Bulletin, Issue 5, ECB. 34. Of course, an increase in global demand (relative to constrained supply) played a part in the rise in energy and food prices. 35. This is a view shared with policymakers from other jurisdictions. Broadbent, B. (2023), "Monetary policy: prices versus quantities", speech at the National Institute of Economic and Social Research, ---[PAGE_BREAK]--- London, 25 April, also argues that those buffers could not account for the subsequent upside surprise in inflation. 36. For a comprehensive discussion of the tightening cycle, see Lane, P.R. (2022), "Monetary policy in the euro area: the next phase", remarks for high-level panel "High Inflation and Other Challenges for Monetary Policy" by Philip R. Lane, Member of the Executive Board of the ECB, Annual Meeting 2022 of the Central Bank Research Association (CEBRA), Barcelona, 29 August; Lane, P.R. (2023), "The banking channel of monetary policy tightening in the euro area", remarks by P.R. Lane, Member of the Executive Board of the ECB, at the Panel Discussion on Banking Solvency and Monetary Policy, NBER Summer Institute 2023 Macro, Money and Financial Frictions Workshop, 12 July; and Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", guest lecture by Philip R. Lane at Stanford Graduate School of Business, Stanford, 2 May. 37. TLTRO III consists of ten operations with a maturity of three years, starting in September 2019 at quarterly frequency. When initially launched, the first seven TLTRO III operations could be voluntarily repaid after two years from the settlement of each operation. In March 2020 the early repayment option was adjusted to give counterparties the possibility to voluntarily repay funds already one year after settlement, starting in September 2021. Three more operations were introduced in December 2020, with an early repayment option at quarterly frequency starting in June 2022. On 27 October 2022 the ECB's Governing Council announced a recalibration of all existing TLTRO III operations to ensure consistency with broader monetary policy normalisation process. From 23 November 2022 interest rates on all remaining TLTRO III operations were indexed to average applicable key ECB interest rates from that date onward, in practice increasing their price. Modifications were accompanied by three additional voluntary early repayment dates introduced for banks wishing to terminate or reduce borrowings before maturity. In response to the change in pricing conditions, large voluntary repayments were done in November and December 2022. Currently, only two operations are still outstanding for a total amount of $€ 76.4$ billion and they will be repaid in September and December 2024. 38. See Adalid, R., Lampe, M. and Scopel, S. (2023), "Monetary dynamics during the tightening cycle", Economic Bulletin, Issue 8, ECB. 39. See Fricke, D., Greppmair, S., and Paludkiewicz, K. (2024), "Excess reserves and monetary policy tightening", Deutsche Bundesbank Discussion Paper, no. 5. 40. ---[PAGE_BREAK]--- When the interest rate paid on reserves was negative, this substitution effect constituted a "hot potato" mechanism by which individual banks sought to shed reserves by increasing lending or bond purchases. See E. Ryan and K. Whelan (2021), "Quantitative Easing and the Hot Potato Effect: Evidence from euro area banks," Journal of International Money and Finance 115, 102354. 41. See Altavilla, C., Lemke, W., Linzert, T., Tapking, J. and von Landesberger, J. (2021), "Assessing the efficacy, efficiency and potential side effects of the ECB's monetary policy instruments since 2014", Occasional Paper Series, No 278, ECB, and Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R. and Saint Guilhem, A. (2021), "Combining negative rates. forward guidance and asset purchases: identification and impacts of the ECB's unconventional policies", Working Paper Series, No 2564, ECB. 42. See Ray, W., Droste, M. and Gorodnichenko, Y. (forthcoming), "Unbundling of Quantitative Easing: Taking a Cue from Treasury Auctions", Journal of Political Economy. 43. For a contemporary definition and rehabilitation of the "money multiplier" theory of transmission, see Altavilla, C., Rostagno, M. and Schumacher. J. (2023), "Anchoring QT: Liquidity. credit and monetary policy implementation", Discussion Paper, No 18581, Centre for Economic Policy Research. 44. A risk surrounding QT that has recently been emphasised is the possibility that the reserve balances created in QE times might have been hypothecated by banks writing off-balance-sheet claims on them, thus making the system vulnerable to a sustained loss of liquidity under QT. See recent work by Acharya, V.V. and Rajan, R. (2022), "Liquidity. liquidity everywhere. not a drop to use-Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research; and Acharya, V.V., Chauhan, R.S., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing and waning of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research. According to these studies, this phenomenon might explain the money market tensions observed in September 2019, as the amount of fed funds - being withdrawn from the system by the Federal Reserve in the context of its first phase of QT- dropped to a minimum threshold at which scarcity produced a generalised seizing up of transactions and a surge in money market interest rates. 45. See Altavilla, C., Rostagno, M. and Schumacher, J. (2023), "Anchoring QT: Liquidity. credit and monetary policy implementation", Discussion Paper, No 18581, Centre for Economic Policy Research. This study does not examine the impact of reserves created by longer-term refinancing operations ---[PAGE_BREAK]--- (such as the TLTRO programmes), which might be viewed as an intermediate case between the polar cases of liquidity created by asset purchase and liquidity created by short-term refinancing operations. 46. On (a), see Rodnyansky, A. and Darmouni, O.M. (2017), "The Effects of Quantitative Easing on Bank Lending Behavior", The Review of Financial Studies, Vol. 30, Issue 11, pp. 3858-3887; Kandrac, J. and Schlusche, B. (2021), "Quantitative Easing and Bank Risk Taking: Evidence from Lending", Journal of Money, Credit and Banking, Vol. 53(4), pp. 635-676; on (b), see Acharya, V.V. and Rajan, R. (2022), "Liquidity, liquidity everywhere, not a drop to use--Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research, and Acharya, V.V., Chauhan, R.S., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing and waning of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research; on (c), see Altavilla, C., Boucinha, M., Burlon, L., Giannetti, M. and Schumacher, J. (2022), "Money markets and bank lending: evidence from the adoption of tiering", Working Paper Series, No 2649, ECB; on (d), see Fricke, D., Greppmair, S. and Paludkiewicz, K. (2023), "Excess Reserves and Monetary Policy Tightening", SSRN.	Philip R Lane	Euro area	https://www.bis.org/review/r240627b.pdf	Helsinki, 26 June 2024 My aim today is to discuss the modern role of monetary analysis at the ECB. I will first review how monetary analysis has advanced over the twenty-five year history of the euro. Second, I will discuss how monetary analysis contributed to the assessment of financing conditions during the pandemic. Third, I will explain how monetary analysis has informed the diagnosis of the post-pandemic surges in inflation. Fourth, I will examine the contributions of monetary analysis to the calibration of the tightening cycle. Finally, I will speculate on the future role of monetary analysis. The initial monetary policy strategy of the ECB was based on a two-pillar framework to identify risks to price stability: economic analysis and monetary analysis. The two analytical domains essentially provided complementary perspectives on the economy. For the monetary pillar, the ECB's Governing Council initially chose to emphasise the quantity of money among the key indicators to be closely monitored and established a reference value for the growth of a broad monetary aggregate (M3). This approach was in line with the views of early-day monetarists who considered money growth the primary source of inflation. Milton Friedman famously captured this in the adage that "inflation is always and everywhere a monetary phenomenon". In an admittedly restrictive interpretation of Friedman's statement, this is reflected in the quantity identity $\mathrm{MV}=\mathrm{PY}$. Especially after the end of the Bretton Woods system in 1973, some stability-oriented central banks most notably the Deutsche Bundesbank - were looking for a substitute anchor, and these monetarist considerations played a significant role in the conduct of monetary policy throughout the 1970s, 1980s and 1990s. The result of that intellectual legacy was the prominent role that the ECB assigned to a reference value for money growth as an anchor back in 1998. Deviations from that reference value and the associated "monetary overhang/shortfall" were, at the time, generally considered to signal risks to price stability. However, a consistent record of difficulties within central banks in interpreting swings in monetary aggregates and in relying on them for predicting inflation at the horizons relevant for monetary policy contributed to a declining emphasis on money in policy making. As early as 1983, Bank of Canada Governor Gerald Bouey famously quipped "I would not say that we abandoned M1; I would say that M1 abandoned us, because of changes in banking practices". Even though Bouey was speaking about M1, the same instability problem applied to M3. Moreover, by the time Michael Woodford came to write his seminal text Interest and Prices in 2003, there was a wide-spread view that it was not necessary to incorporate money in modern macroeconomic models. Accordingly, money was all but removed from the modern monetary economics synthesis. Against this background, the ECB conducted a review of its monetary policy strategy in 2003. This resulted in a revised approach to monetary analysis under the monetary pillar, with the adoption of a broader view of the role of money in the economy and the financial system. The long-term empirical relation between money and inflation had consistently been proven unhelpful in quantifying the scale of price pressures on a meeting-by-meeting basis. This realisation led to the discontinuation of the earlier practice of reviewing the reference value for M3, with a shift towards treating money aggregates as indicator variables rather than intermediate targets for monetary policy. The 2003 strategy review also clarified that monetary analysis served as a tool for cross-checking the short to medium-term indications from the economic analysis, from a medium to long-term perspective. After 2003, two significant developments led to an increased focus of monetary analysis on monetary policy transmission. First, the global financial crisis and the euro area sovereign debt crisis highlighted the vulnerability of the transmission mechanism. This, in turn, prompted policymakers to place greater reliance on monetary analysis in navigating the resulting challenges. Second, the adoption of unconventional monetary policy tools by the ECB of required monetary analysis to broaden its scope to better understand the many new transmission channels that the adoption of unconventional instruments had set in motion, including the analysis of potential side effects of those measures. Overall, the shift in focus of monetary analysis towards monetary policy transmission represented a natural evolution in line with the changing monetary policy landscape. These developments were incorporated in monetary analysis during the latest strategy review conducted in 2021. In the new framework, "economic analysis" and "monetary analysis" no longer represent distinct perspectives on inflation. Instead, the interrelations between economic developments and monetary and financial developments are explicitly integrated into the overall assessment of inflation risks and the formulation of monetary policy. Accordingly, monetary analysis has expanded from a narrow focus on the quantity of money to the wider mechanism by which monetary policy actions transmit to the financing conditions faced by households and firms in the real economy. This approach often employs monetarist concepts, formalised within modern structural models, to analyse changes in spreads and asset prices linked to portfolio rebalancing across imperfectly substitutable financial assets, including money and money-type assets. Monetary analysis played a particularly salient role in policy decision-making when the policy rate approached the effective lower bound. This period saw a significant expansion of liquidity in the financial system through central bank lending programmes and outright asset purchases, underscoring the importance of informed decision-making based on monetary analysis. In the quantity identity (MV=PY), the traditional emphasis had primarily been on the growth rate of money, M. However, the bi-variate relation between inflation and money growth had not only always been elusive but also weakened over time, before disappearing altogether in the first decade of the 2000s. Precisely for these reasons, since the global financial crisis, the importance of the bank lending channel and other transmission mechanisms has become more prominent. Monetary analysis has adapted by increasing the emphasis on analysing the credit-creation process, its relation with liquidity conditions and the various frictions affecting the financial system. All these elements affect the transmission of monetary policy to the real economy and thereby contribute to inflation dynamics. The latest observations are for 2024 Q1. From this perspective, it would be overly reductive to interpret the rise of money growth during the pandemic and the subsequent rise in inflation that is shown in Chart 1 as a causal relation. In fact, the strong money growth in the early phase of the pandemic was driven by the build-up of liquidity buffers, which is not inherently inflationary. This is consistent with the view that the surges in inflation in 2021 and 2022 were mostly related to supply-side factors, such as global supply bottlenecks and increases in energy and commodity prices, rather than an increased stock of money. This view is further reinforced by the nature of the inflation shock which involved large relative price movements, whereas money-induced inflation should have been associated with a more uniform increase in prices across categories. I will return to the pandemic episode later in this speech. The wider availability of timely granular information on balance sheets, lending rates and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening. The pandemic period was marked by extraordinarily high liquidity demand, triggering a global dash for cash by investors. Lockdowns, social distancing measures and travel restrictions led many firms to experience a reduction in consumer demand and to reduce or halt their operations. This triggered a substantial decline in revenue for businesses across a wide range of sectors. However, firms still had to meet operating expenses and short-term obligations, such as the maintenance of inventories, payments to suppliers, salaries, taxes and fixed operational expenses. These needs showed up very clearly in the replies by banks to the ECB bank lending survey (BLS), which documented a surge in loan demand by firms to finance working capital, while financing needs linked to investment weakened considerably. Financing needs for inventories and working capital and loan demand by enterprises The latest observations are for Q1 2024. In this environment, employment and total hours worked declined at the sharpest rates on record, with many employees being furloughed or having their working hours reduced. Consequently, salary incomes were dented. Banks across the euro area faced rising funding costs due to a climate of heightened uncertainty in the market and concerns about borrower creditworthiness. This led to a reassessment of risk, affecting not only banks but also the broader financial markets, as evidenced by the increase in corporate bond yields. In the absence of countervailing measures, banks would have struggled to secure funding, which would have limited their ability to meet the high demand for emergency loans, potentially crippling their lending capacity. Accordingly, it was crucial for our monetary policy to maintain favourable financing conditions and the effective transmission of monetary policy, in order to avert a monetary squeeze that would have exacerbated adverse effects from the pandemic on the economy and price stability. The experience gained over the preceding decade allowed us to respond swiftly and decisively, deploying essentially two types of instruments. The first type was intended to maintain an accommodative monetary policy stance and, in parallel, stem the tide of an impending meltdown in financial markets as investors were pulling back from riskier assets. Here the main measures were the recalibration of the asset purchase programme (APP) and the introduction of the pandemic emergency purchase programme (PEPP). These term credit operations were aimed at expanding the quantity of central bank reserves, subject to the condition that banks would lend them on and keep credit flowing to the economy. As a facilitating measure, the targeted lending programme was accompanied by a temporary easing of collateral and regulatory constraints. The interplay between policies to keep the risk-free curve low and steady across maturities, and instruments to unclog the transmission pipes worked as intended. The economics of the portfolio rebalancing channel learned during the first wave of the APP net purchases, over the period 20152018, as well as the experience of the portfolio movements during the sovereign debt crisis, were instrumental for the design of the PEPP. The portfolio rebalancing channel is the key mechanism through which central bank asset purchases transmits monetary policy to the broader economy. Monetary analysis studied how portfolio allocations can change directions both across instruments and between euro-denominated domestic assets and foreign assets. Within the euro area, the APP had led to a rebalancing of bank exposures from sovereign securities towards corporate securities and from bonds to real-sector loans, easing financing conditions to corporates and households in the process. This had played a significant role in explaining the limited effect that the APP had on the expansion of broad money supply before the pandemic, a phenomenon that was similarly observed during the third round of quantitative easing in the United States. In other words, the APP had exerted robust monetary transmission even in the absence of a strong expansion in the money supply, because the exchange rate channel had become a powerful substitute for the traditional money-creation mechanism that worked through the liability side of bank balance sheets. Net portfolio investment in debt securities by euro area non-MFIs Total Net purchases by euro area non-MFIs of debt securities issued by non-euro area residents. Net purchases by non-euro area residents of debt securities issued by euro area general government. The latest observations are for April 2024. M2. Business, mortgage and consumer loans Net external monetary flows. The latest observations are for April 2024. The long-standing internal monetary analysis of the factors explaining the setting of bank lending rates was critical in the recalibration of existing TLTROs during the pandemic. In particular, the pricing of the new wave of TLTROs following the outbreak of the pandemic relied on the accumulated evidence that the unconventional policies deployed by the ECB had lowered various components of bank funding costs in the aftermath of the euro area sovereign debt crisis. Lending rate to non-financial corporations and its components The combination of extraordinarily high liquidity needs and our monetary policy measures to maintain favourable financing conditions boosted broad money growth. As a result, credit to firms and central bank purchases became the main sources of money creation. This composition reflected the broad division of tasks in the support given to the euro area economy, with the support to the corporate sector mostly channelled via bank credit (whose conditions were eased by monetary policy, government guarantees and regulatory measures) while the support to households was mostly channelled via the government sector. The latter, and thus the liquidity needs of the economy, explain the marked impact of central bank purchases on money growth in the early stages of the pandemic. In contrast to the 2015-2018 period, these purchases occurred alongside an increase in government borrowing. Such borrowing prevented the bond scarcity that large-scale asset purchases can imply, thereby averting the usual financial outflows to the rest of the world (Chart 4, left panel). As economic activity resumed and lockdown restrictions were lifted, emergency liquidity needs declined and money growth also slowed. By October 2020, the three-month annualised growth rate of M3 had dropped to 7.5 per cent, which was about one-third of the 21.9 per cent rate seen at the peak of the lockdowns, and just somewhat above the historical average. The growth rate continued to decrease until mid-2022 even in the face of increased borrowing prompted by liquidity demands from the energy crisis. Shortly after we started hiking rates in July 2022, M3 growth even dipped into negative territory before recovering somewhat in the second half of 2023. Inflation began to rise just as money growth slowed down. Initially, these price increases were concentrated in specific sectors, particularly affecting energy and food prices, rather than showing a broad-based increase across all goods and services, which would have been more consistent with a monetary origin for the inflation surge. These heterogeneous price increases align with the view that inflation was largely due to specific cost-push shocks passing through to the wider consumption basket. This perspective is supported by structural analyses identifying energy and food price shocks together with supply chain disruptions as the main culprits of the inflationary pressures. $\frac{}{}$ It is also consistent with the interpretation that the robust money growth during the early stages of the pandemic was a result of accumulating liquidity reserves, which in turn were not inherently inflationary. Taken together, the evidence indicates that the recent inflation surge is primarily attributable to rising commodity prices and global supply constraints, rather than an expanding money supply. Headline inflation, money growth and commodity prices, and headline inflation and subcomponents Headline inflation and subcomponents HICP - Food incl. alcohol and tobacco. HICP - Energy. HICP - Services. HICP - Overall index. The latest observations are for April 2024. The surge in borrowing by firms, which peaked during the second quarter of 2020 amid the initial lockdowns, was primarily driven by need for working capital and precautionary reasons. Borrowing by firms closely matched their increases in cash reserves. Since this borrowing was not for investment purposes, it did not stimulate aggregate demand. Household behaviour points to a similar message. Government aid to households served to cushion their reduced income rather than to increase spending: fiscal transfers only covered part of the slowdown in household income over the pandemic period. Most of the excess savings accumulated during the pandemic resulted from falling consumption, which was much larger than the drop in income (Chart 7, left panel). This decline in consumption was partly forced by the reduced consumption opportunities due to the pandemic restrictions but it is likely to have also reflected precautionary behaviour related to uncertainty about the future. The latter led to an increased preference for liquidity, and indeed a large part of household excess savings were accumulated in the form of overnight deposits, especially in the initial phases of the pandemic (Chart 7, right panel). Savings over the pandemic period The latest observations are for 2021 Q4. Consumption only started to approach its pre-pandemic level by the middle of 2021, but households continued to express their willingness to maintain a higher level of savings or financial investments, a considerable part of which remained in overnight deposits. This composition also reflected the flattening yield curve and the low opportunity cost of holding those deposits. Individual consumption of selected goods and services and corresponding price developments The latest observations are for 2022. As energy and food prices began to rise, households moderated their accumulation of deposits but also reduced the real consumption of those products. The configuration of falling consumption and rising prices for energy and food is consistent with supply shocks driving energy and food prices rather than reflecting a surge in domestic demand. In addition, falling consumption also indicates that the excess deposits accumulated during the pandemic did not lead to households being insensitive to more expensive and energy and food bills. The coexistence of high inflation and only a moderate consumption recovery serves to underline the scale of supply-driven cost pressures during 2021 and 2022: only a dramatic monetary and/or fiscal tightening would have been needed to eliminate the inflation surge by reducing domestic demand sufficiently (involving a severe drop in domestic incomes) to match the reduction in supply capacity. Overall, although real private consumption and investment have rebounded in the post-pandemic period, these have not reached the levels projected in mid-2021 when excess savings were at their highest, and real private consumption continues to trail the forecasts made before the pandemic. In this context a dramatic recession would have been required to fully avoid an inflation surge. Monetary analysis has been central to the regular assessment of the state of the monetary policy transmission, which has been a key guiding principle in calibrating the speed and scale of the monetary policy tightening over the last couple of years. Focusing on the propagation of that tightening impulse through the banks, both the rate hikes that started in July 2022 and the sustained upshift in the yield curve that preceded and accompanied that process led to a significant rise in bank funding costs, initially driven by bonds and subsequently by deposit rates. The latter adjusted with a lag, owing to the atypical interest rate configuration during the negative rate period, but eventually aligned with our policy signal. For monthly data, the latest observations are for April 2024, for daily data, the latest observations are for $17^{\text {th }}$ June. In parallel, loan volumes in the euro area have experienced a marked decline since late 2022. After dropping sharply, credit flows have remained stagnant for both loans and bonds (Chart 11, left panel). The pronounced decline in credit compared to previous hiking cycles (Chart 11, right panel) was largely due to the sharp increase in interest rates, which has significantly dampened demand, as also reflected in the ECB bank lending survey (BLS). Initially, credit demand showed some resilience, primarily driven by the liquidity needs of firms during the peak of the energy crisis. However, it began to contract in the last quarter of 2022 and continued to do so for several months after the last rate hike in September 2023. The primary drivers behind the weakness in demand were elevated interest rates and reduced recourse to credit for financing investments, which reflects the "cost of capital" channel of monetary policy. Transmission to deposit rates The latest observations are for April 2024. The latest observations are for 2024 Q1. At the same time, a decline in the supply of credit from banks has also played a large role in the recent credit slowdown. Credit supply effects primarily stemmed from a decreasing willingness of banks to take risks. This, in turn, has affected lending conditions for firms and households. The start of the reimbursement phase for TLTROs and the change in the conditions applied by on TLTRO borrowings reinforced the incentives for banks to scale down loan exposures. Studies using granular data to control for demand conditions indicate that increased borrowing costs for banks have resulted in a significant reduction in lending volumes. In other words, the significant decrease in loans was partly due to the tighter lending conditions, rather than being solely due to lower credit demand. Our bank lending survey corroborates this view, highlighting that heightened risk perception and reduced risk tolerance on the part of banks were significant factors influencing the tightening of credit standards during the hiking cycle. In parallel, money growth, which had been declining rapidly from its 2021 peak, saw its decline accelerate, mirroring the contemporary contraction in bank lending and the progressive reduction of the monetary policy securities portfolio of the Eurosystem. Two liability-side factors reinforced the contraction in the availability of cheap funding: first, banks substituting TLTRO funding for long-term bonds; and second, a strong portfolio rebalancing by households and firms on the liability side of bank balance sheets. In particular, the increased remuneration of time deposits and bonds after a long period of low or negative interest rates has incentivised shifts to these instruments from overnight deposits and other low-remuneration deposits. During the period of low interest rates, the opportunity cost of holding overnight deposits was very low, causing households and firms to prefer overnight deposits. The monetary policy tightening and its transmission to deposit rates and yields on other financial assets, has increased the opportunity cost of holding overnight deposits to levels similar to those seen in previous hiking cycles. This has led households and firms to move a significant portion of their unusually large stock of overnight deposits to time deposits and bonds. The high level of liquidity within the banking system has not impeded the transmission of our monetary policy tightening to households and businesses. Although in the cross-section banks with greater excess liquidity at the onset of the tightening cycle have reduced their lending to a lesser extent than their less liquid peers, the overall transmission of monetary policy has been robust and, if anything, been stronger than in previous cycles. The apparent differences between the cross-sectional and time series results can be reconciled as follows. From a theoretical standpoint, excess reserves on the balance sheets of banks exert dual effects during a period of monetary tightening. On one side, the initiation of an unexpected tightening phase allows banks with excess reserves to benefit from higher returns on these reserves. This helps bolster their profits, potentially augments their capital buffers, relaxes constraints and ultimately expands the supply of lending. This wealth effect is in line with the results of the cross-sectional analysis. That is to say, while the wealth effect may explain the cross-sectional variation in lending behaviour among banks with differing levels of excess liquidity, the substitution effect likely contributed to the strong transmission of monetary tightening on an aggregate level. As the quantity-theory expression MV=PY makes clear, the connection between outside money - the currency and reserves supplied by the central bank - and prices is mediated by adjustments in velocity. Velocity is a complex function of a host of factors, some of which pertain to the decisions by banks to intermediate credit, others having to do with the decisions by different types of money holders on the financial instruments in which they want to keep their wealth. All else equal, credit creation pushes up velocity and thereby, for a given level of real income, generates price pressures. Conversely, portfolio reallocations towards larger money holdings serves to reduce velocity and weaken inflation for a given stock of outside money. In a nutshell, these two factors have been offsetting each other in recent years. When loans were rapidly expanding in the early phase of the pandemic crisis, a sharp rise in liquidity preference - and the short-term bridging nature of the loans themselves - attenuated the inflationary potential of money growth. When eventually portfolios started shedding excess liquidity - a potential source of inflation loans began to decline in parallel, providing a cushion against money-generated inflationary pressures. Looking ahead, a prominent challenge for monetary analysis is to understand how the normalisation of the balance sheets of central banks may affect transmission in the years to come. Measures that expand the central bank balance sheet stimulate bank lending and risk-taking through three main channels. Third, the liquidity injected into the banking system via central bank purchases of financial assets can enhance the capacity of banks to lend because that type of liquidity, perceived to remain in the system for a long time, may be seen as providing a permanent means to service the mobile type of deposits that are the by-product of an extension of bank credit. In studying this critical nexus with the help of monetary analysis, it is worth recalling the notion of the "money multiplier". Based on this mechanism, in a fractional reserve banking system a policy-induced expansion of the free reserves of cash held by the banks spurs, through successive rounds of loan and deposit creation, increasing volumes of credit and inside money. Outright central bank asset purchases increase bank reserve holdings and prompt banks to try to minimise the associated liquidity surplus which is costly - by creating credit and other claims on those surplus reserves in an effort to enhance shareholder returns. This mechanism helps explain the strong connection of credit with reserve creation in times of QE, even when controlling for demand-for-credit effects as lending rates decline as a result of QE. In the other direction, a withdrawal of reserves sets in motion a cumulative process by which credit and deposits shrink by a multiple of the original negative shock to the reserve holdings. The relevance of the money multiplier is also supported by recent empirical analysis using comprehensive bank-level and loan-level data on lending from euro area banks to firms. A recent ECB study draws two main conclusions. First, the availability of central bank liquidity significantly influences banks' credit provision, in what the authors call a "reserve availability channel" of monetary policy. Second, the source of central bank reserves affects their impact on bank intermediation: non-borrowed reserves - those created as a result of a securities purchase programme - have very strong empirical connection with bank loans, whereas this is not the case for borrowed reserves drawn by banks from a short-term refinancing facility. Response of bank loans to an increase in borrowed and non-borrowed reserves b) Borrowed reserves These mechanisms are in line with a growing body of empirical studies focusing on the relation between central bank reserves and bank lending. Examples include analyses that show that: (a) banks that increased their reserve holdings, following the third round of quantitative easing announced by the Federal Reserve, increased lending; (b) banks with higher excess reserve holdings grant more credit lines and take more risk; (c) the reallocation of central bank reserves towards banks with higher liquidity needs fosters credit supply; and (d) the credit supply of reserve-rich banks is less sensitive to monetary policy tightening than that of other banks. As I have covered in this lecture, modern monetary analysis is helping policymakers to analyse the nexus of money, credit and the economy. Moreover, the frontier in modern monetary analysis is continuing to expand: the enhanced availability of granular data, filtered through an expanding computation capacity and new machine learning techniques, is further broadening its scope and the relevance of its findings for the calibration of monetary policy. For these reasons, monetary analysis plays a central role at the ECB, with a data-dependent approach to assessing the effectiveness of monetary policy transmission a key element in our reaction function. I am grateful to Ramón Adalid, Alessandro Ferrari, Andrew Hannon and Sofía Velasco for their contributions in preparing these remarks and also the assistance of Lucía Kazarian, Silvia Scopel, Marina Dimitriou, Andreas Kapounek, Nikoleta Tushteva, Emma Vergauwen and Wouter Wakker. The term "modern monetary analysis" is intended to capture the current role of monetary analysis in central banking, as opposed to a traditional interpretation of the role of monetary analysis. The framework of modern monetary analysis is not to be confused with the much-discussed framework of modern monetary theory. Business Cycle Model of the Euro Area", Economic Journal, Royal Economic Society, Vol. 116(511), pp. 457-477, April. 32. London, 25 April, also argues that those buffers could not account for the subsequent upside surprise in inflation. See Ray, W., Droste, M. and Gorodnichenko, Y. (forthcoming), "Unbundling of Quantitative Easing: Taking a Cue from Treasury Auctions", Journal of Political Economy. (such as the TLTRO programmes), which might be viewed as an intermediate case between the polar cases of liquidity created by asset purchase and liquidity created by short-term refinancing operations. 46.
2024-06-27T00:00:00	Frank Elderson: Preparing for the next decade of European banking supervision - risk-focused, impactful and legally sound	Speech by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the "10 years Single Supervisory Mechanism (SSM) and beyond" event, organised by Allen & Overy, Frankfurt am Main, 27 June 2024.	SPEECH Preparing for the next decade of European banking supervision: risk-focused, impactful and legally sound Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the "10 years SSM and beyond" event organised by Allen & Overy Frankfurt, 27 June 2024 Introduction Thank you for inviting me to this conference on ten years of European banking supervision. It is hard to believe that it's only a decade since supervisors from across Europe first came together in truly European supervisory teams on a Tuesday morning in November 2014. Just like the first ten years of a child's life, the first decade of European banking supervision has also been a period of growth and development. During this time, we have matured from a start-up into a well-established, effective supervisor, building on the best practices of supervisors across Europe. And this is more relevant than ever given the increasingly complex external risk landscape. Think about heightening risks from geopolitical shocks, cyber risks and the climate and nature crises. These evolving risks require supervision to evolve, too. This is why we have embarked on a journey to make European banking supervision more risk-focused, efficient and effective. For example, we recently announced change to the Supervisory Review and Evaluation Process (SREP) - our annual health check of banks - making it more targeted and more risk-focused in a new risk environment.4] The revised SREP also puts greater emphasis on impact and effectiveness, which is the focus of my remarks today. In this context, I am pleased to be speaking to an audience of general counsels from the banks under our supervision. The way we - ECB Banking Supervision - interact with you - representatives of the banks we supervise - is of paramount importance for our shared goal of safe and sound banks. Our supervisory toolkit: broad, effective and going beyond capital So, what does effective supervision mean in practice? Our experience of almost ten years of European supervision shows that, in most cases, banks address the root causes of supervisors' findings and that's the end of the story. If banks remediate shortcomings in a timely manner based on what we refer to as "supervisory dialogue", we have a very efficient and effective way of supervising. But there are also cases where banks fail to address deficiencies in good time. For these cases, the legislator has given the ECB a very broad supervisory toolbox that we are able and willing to use - always in a proportionate manner. Internationally, various reports on the lessons from the banking turmoil in March 2023 all explicitly recommended that supervisors should make active use of their supervisory tools to compel banks to take timely and concrete remedial action.! In fact, International Monetary Fund staff concluded in a paper published in 2010 that a willingness to act is a key ingredient for good supervision.) Moreover, in 2022 we took the initiative to ask a group of independent experts to review our SREP. In their report, which was published last year, they also urged the ECB to use the full range of supervisory tools available./4] The use of supervisory powers to compel banks to make concrete improvements is therefore not merely a nice-to-have - it is international best practice to ensure that banks remain safe and sound, which is the ultimate goal of prudential supervision. So, when and how do we use these tools? We act fully in line with the principle of proportionality, using supervisory tools as appropriate, as necessary and - once the appropriateness and need has been established - decisively. Central to this approach is an escalation ladder, giving banks the opportunity to address shortcomings and their root causes within a defined time frame, with interim deadlines if and when appropriate. If using a less intrusive tool does not lead to the desired outcome being achieved in a timely manner, we will expeditiously deploy more intrusive tools to compel banks to take the necessary remedial actions in time. The escalation process is not, however, automatic and it always depends on the specific circumstances. This means that some serious issues requiring immediate remediation could lead to more intrusive supervisory measures being used at an early stage. The tools available to us range from binding quantitative and qualitative supervisory measures to sanctions and enforcement measures such as periodic penalty payments. !&] Let's look at these tools more closely. Some might think of Pillar 2 capital add-ons", the most common quantitative supervisory measure, as the sharpest tool that a supervisor has. But while setting bank-specific Pillar 2 capital requirements is undoubtedly a vital element of our toolbox, it is far from being the only one. Article 16 of the SSM Regulation gives the ECB the power to impose a wide range of what we call "qualitative requirements", based on a bank's specific circumstances. These tools are particularly relevant for addressing the root causes of weaknesses, for instance in internal governance or risk management. These qualitative areas are very often the source of problems that subsequently materialise in risks to capital and liquidity. The banking turmoil in March 2023, for instance, was a clear reminder that shortcomings stemming from weak governance can, if left unaddressed, later resurface in quantitative areas such as banks liquidity positions. Consider Silicon Valley Bank, which had significant interest rate risk as a result of holding long-term securities. Despite the bank having repeatedly breached internal risk limits, its management did not adequately address these issues and supervisors did not escalate their concerns until it was too late. As interest rates rose, the value of those securities fell, and SVB incurred substantial losses when it was forced to sell them to cover withdrawals.!&] Periodic penalty payments, an example of an enforcement measure, are another vital part of our toolbox. They are an effective tool that we can use as part of an escalation process to compel individual banks to comply, by a specific date, with our requirements in respect of any prudential risk that is not properly covered and managed. While the decision to impose periodic penalty payments is always specific to an individual bank, if there are breaches of requirements related to risks that affect several institutions simultaneously, we may need to consider imposing this measure on various banks at the same time. And this is precisely what we have been doing in the area of climate-related and environmental (C&E) risks. Let me focus on this example. Considering the clear requirements set out in the Capital Requirements Directive and the need for banks to implement a regular process for identifying all material risks, we have been clear that all banks under our supervision must ensure that their practices are fully aligned with the sound management of C&E risks. Building on what banks themselves considered reasonable, we have set a series of (interim) deadlines by which banks have to reach certain milestones. As a first step, we asked all banks to ensure that they had sound and comprehensive materiality assessments in place, which is the basis for managing any kind of risk. We were clear that we expected all banks to meet this deadline by March 2023 and that, if necessary, we would use all the tools at our disposal to enforce it, as well as any subsequent deadlines. Most, but not all, of the banks under our supervision made significant strides in advancing their materiality assessments by the March 2023 deadline. So, it should be no surprise that we took action on this: we moved further up the supervisory escalation ladder and issued binding supervisory decisions for 23 banks, which included the potential imposition of periodic penalty payments for 18 banks if they failed to comply with the requirements by the deadlines set out in these decisions. Encouragingly, most banks have now submitted a meaningful materiality assessment. This shows that our supervisory pressure has been effective and has led to the desired outcome for the majority of banks. In parallel to our actions in relation to the first interim deadline, we are currently concluding our assessment of banks' progress in meeting the second interim deadline. For this second deadline, we asked banks to clearly include C&E risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, if we see that banks have not satisfactorily delivered, we will consider adopting supervisory measures that already contain an enforcement measure. In other words, we may tell those banks to remedy the shortcoming by a certain date and, if they don't comply, they will have to pay a penalty for every day the shortcoming remains unresolved. The last tool that I would like to mention is sanctions, which are intended to punish banks for misconduct and to deter future infringements." For instance, we have imposed penalties on banks that failed to comply with the requirements set out in binding ECB decisions" or with EU prudential requirements. Legal considerations for effective supervision Let me now turn to the legal considerations that constitute our guiding principles for exercising our supervisory powers. When we - European banking supervisors - are using our rich supervisory toolkit and exercising our margin of discretion in imposing supervisory and enforcement measures, as well as sanctions, we take great care to remain within our mandate, to act in accordance with the relevant EU law and to act proportionally. We make sure that both our findings and the requirements we impose in our supervisory decisions fall squarely within the prudential tasks conferred on us under Article 4 of the SSM Regulation. We use all powers available to us to ensure that banks manage and cover their risks properly and that they comply with the applicable prudential legislation. Our underlying objective is to ensure the safety and soundness of credit institutions and the stability of the financial system. When deploying our supervisory toolkit in the exercise of our mandate, we apply the relevant Union law. We carefully analyse EU and national legislative texts, when applicable, taking into account the wording, context and objectives of the legislative provisions. We consider relevant case-law and general principles of law. We state the reasons on which our decisions are based with the aim that banks understand what we perceive their shortcomings to be and what we expect from them. When we issue sanctions or impose periodic penalty payments, we use a coherent methodology. We always make sure that we use our tools in line with the principle of proportionality. In other words, we consider whether the powers we use at any given time are appropriate for attaining our prudential objectives. We ascertain that we are not going beyond what is necessary and that the effects of our measures are not disproportionate to the prudential objective we are pursuing. Accordingly, one of the objectives when escalating supervisory action is to enable us to act swiftly and proportionally. In doing all this, we also ensure that our decisions are based only on facts and findings on which the banks have been able to comment.121 The right to be heard is a key procedural safeguard. We take it seriously and are committed to listening to banks' arguments and comments. In a number of cases we have changed supervisory decisions based on the comments made during the right to be heard process. For example, there have been cases where we have changed requirements into recommendations or prolonged the deadlines for compliance with our requirements, reflecting our willingness to consider the specific circumstances and arguments of individual banks. We - as European banking supervisors - believe that both the supervisory dialogue and banks' comments during the drafting phase of the decision can lead to increased mutual understanding and better decisions with better calibrated measures. Finally, if after those exchanges you - the supervised banks - still doubt the substantive and procedural conformity of the ECB's decision with the SSM Regulation, you may request an internal administrative review at the Administrative Board of Review,."3] While we do everything we can to ensure that we act within our mandate, correctly apply the relevant Union law, act proportionally and listen to your arguments, we note that banks are fully within their rights to ask EU courts to review our decisions. Litigation is, ina sense, a natural aspects of supervision, with supervisors actually using the tools they have been granted by the legislator to ensure compliance and timely remediation. Indeed, in the past ten years the ECB has been involved in 98 cases involving 102 actions requesting either annulment or damages, or alleging that the ECB was failing to act. So far, in most cases the courts have upheld our decisions in which we exercised our supervisory powers. And whenever one of our decisions has been annulled, we have drawn lessons from that experience to further improve the way we work. Avery recent example I can mention is the ECB decisions requiring part of the prefunding given to the national deposit guarantee schemes and the Single Resolution Fund to be deducted from banks' capital in cases when the banks did not reflect the loss of economic resources from this funding in their capital. These decisions revolved around the technicalities of the so-called irrevocable payment commitments, how these commitments are secured by collateral and how banks reflect the loss of economic resources in their capital, liquidity and internal arrangements. Our first set of decisions was annulled in 2020 by the General Court!4], which considered that our reasoning for imposing these measures lacked an individual assessment of how the risk we identified was managed and covered by the arrangements implemented by the banks and the capital and liquidity held by them. Following these judgments of the General Court, the ECB improved its methodology to better cater for this individual assessment and took new decisions in relation to the irrevocable payment commitments with an improved motivation. These new decisions were again challenged by some banks, but this time the General Court upheld the new decisions with our improved methodology.) This learning process is part of us striving to be an effective supervisor that, while always acting legally and proportionally, never rests until material prudential risks are covered and managed, necessary compliance has been achieved and remediation has been ensured. In this sense, we will not stop using our toolbox for fear of litigation, as we firmly believe that we can also learn when subject to judicial scrutiny. Conclusion Let me conclude. As we approach the next decade of European banking supervision, the fundamental objective of supervision - ensuring safe and sound banks - will not change. To achieve this objective, we are putting greater emphasis on impact and effectiveness. We need to have a razor-sharp analytical focus on risks, and we need to insist that the weaknesses we identify are remedied in good time. Ensuring timely remediation is more relevant than ever considering the fast-evolving environment that we live in. And crucially, we have an extensive toolkit at our disposal that we are willing to use to meet that objective. In our supervisory process, we listen to you - representatives of the banks we supervise - because, ultimately, both supervisors and banks have a common objective: ensuring that the banks remain safe and sound. So let us make good use of every aspect of our supervisory dialogue, including the right to be heard, so you - the banks we supervise - can better understand our prudential concerns and we - European banking supervisors - can better understand the implementation challenges you may face. Together, we can navigate the challenges of this new risk environment. Together, we can make sure that European banks are also able to weather these storms. Together, we can ensure that banks remain safe and sound in the decades to come. Thank you for your attention. 1. Buch, C. (2024), "Reforming the SREP: an important milestone towards more efficient and effective supervision in a new risk environment", The Supervision Blog, 28 May. 2. Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April, p. 8; Basel Committee on Banking Supervision (2023), Report on the 2023 banking turmoil, October, p. 26; International Monetary Fund (2023), Good Supervision: Lessons from the Field, September, pp. 4 et seq. 3. Vifials, J. et al. (2010), "The Making of Good Supervision: Learning to Say "No", IMF Staff Position Note, International Monetary Fund, 18 May. 4. ECB (2023), "ECB welcomes expert group recommendations on European banking supervision', press release, 17 April. 5. Elderson, F. (2024), "You have to know your risks to manage them - banks' materiality assessments as a crucial precondition for managing climate and environmental risks", The Supervision Blog, 8 May. 6. Article 16(2)(a) of the SSM Regulation (Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (OJ L 287, 29.10.2013, p. 63). 7. Elderson, F. (2023), "Powers, ability and willingness to act - the mainstay of effective banking supervision", speech at the House of the Euro, 7 December. 8. Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April. 9. Periodic penalty payments require the bank concerned to pay a daily amount - up to 5% of its average daily turnover - for every day the infringement continues during a maximum period of six months. 10. Sanctioning proceedings can be initiated both in the case of ongoing breaches and after the breach has ceased. The ECB can impose pecuniary penalties on banks for failing to comply with EU prudential requirements. The ECB may impose penalties of up to 10% of a bank's total annual turnover in the preceding business year, or twice the amount of profits gained or losses avoided as a result of the breach, where those can be determined. 11. See the ECB's banking supervision website for an overview of sanctions imposed by the ECB and the national competent authorities in proceedings opened at the ECB's request, as well as statistics on sanctioning activities in the context of European banking supervision. 12. Article 22(1) of the SSM Regulation. 13. To date the Administrative Board of Review has delivered 36 opinions. 14. See the judgments of the General Court in cases T-143/18, T-144/18, T-145/18, T-146/18, T-149/18 and T-150/18. 15. See the judgments of the General Court in cases T-182/22, T-186/22, T-187/22, T-188/22, T-189/22, T- 190/22 and T-191/22. CONTACT European Central Bank	---[PAGE_BREAK]--- # Preparing for the next decade of European banking supervision: risk-focused, impactful and legally sound ## Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the "10 years SSM and beyond" event organised by Allen \& Overy Frankfurt, 27 June 2024 ## Introduction Thank you for inviting me to this conference on ten years of European banking supervision. It is hard to believe that it's only a decade since supervisors from across Europe first came together in truly European supervisory teams on a Tuesday morning in November 2014. Just like the first ten years of a child's life, the first decade of European banking supervision has also been a period of growth and development. During this time, we have matured from a start-up into a well-established, effective supervisor, building on the best practices of supervisors across Europe. And this is more relevant than ever given the increasingly complex external risk landscape. Think about heightening risks from geopolitical shocks, cyber risks and the climate and nature crises. These evolving risks require supervision to evolve, too. This is why we have embarked on a journey to make European banking supervision more risk-focused, efficient and effective. For example, we recently announced change to the Supervisory Review and Evaluation Process (SREP) - our annual health check of banks - making it more targeted and more risk-focused in a new risk environment. $\underline{[1]}$ The revised SREP also puts greater emphasis on impact and effectiveness, which is the focus of my remarks today. In this context, I am pleased to be speaking to an audience of general counsels from the banks under our supervision. The way we - ECB Banking Supervision - interact with you - representatives of the banks we supervise - is of paramount importance for our shared goal of safe and sound banks. ## Our supervisory toolkit: broad, effective and going beyond capital So, what does effective supervision mean in practice? Our experience of almost ten years of European supervision shows that, in most cases, banks address the root causes of supervisors' findings and that's the end of the story. If banks remediate shortcomings in a timely manner based on what we refer to as "supervisory dialogue", we have a very efficient and effective way of supervising. ---[PAGE_BREAK]--- But there are also cases where banks fail to address deficiencies in good time. For these cases, the legislator has given the ECB a very broad supervisory toolbox that we are able and willing to use always in a proportionate manner. Internationally, various reports on the lessons from the banking turmoil in March 2023 all explicitly recommended that supervisors should make active use of their supervisory tools to compel banks to take timely and concrete remedial action. ${ }^{[2]}$ In fact, International Monetary Fund staff concluded in a paper published in 2010 that a willingness to act is a key ingredient for good supervision. ${ }^{[3]}$ Moreover, in 2022 we took the initiative to ask a group of independent experts to review our SREP. In their report, which was published last year, they also urged the ECB to use the full range of supervisory tools available. ${ }^{[4]}$ The use of supervisory powers to compel banks to make concrete improvements is therefore not merely a nice-to-have - it is international best practice to ensure that banks remain safe and sound, which is the ultimate goal of prudential supervision. So, when and how do we use these tools? We act fully in line with the principle of proportionality, using supervisory tools as appropriate, as necessary and - once the appropriateness and need has been established - decisively. Central to this approach is an escalation ladder, giving banks the opportunity to address shortcomings and their root causes within a defined time frame, with interim deadlines if and when appropriate. If using a less intrusive tool does not lead to the desired outcome being achieved in a timely manner, we will expeditiously deploy more intrusive tools to compel banks to take the necessary remedial actions in time. The escalation process is not, however, automatic and it always depends on the specific circumstances. This means that some serious issues requiring immediate remediation could lead to more intrusive supervisory measures being used at an early stage. The tools available to us range from binding quantitative and qualitative supervisory measures to sanctions and enforcement measures such as periodic penalty payments. ${ }^{[5]}$ Let's look at these tools more closely. Some might think of Pillar 2 capital add-ons ${ }^{[6]}$, the most common quantitative supervisory measure, as the sharpest tool that a supervisor has. But while setting bank-specific Pillar 2 capital requirements is undoubtedly a vital element of our toolbox, it is far from being the only one. Article 16 of the SSM Regulation gives the ECB the power to impose a wide range of what we call "qualitative requirements", based on a bank's specific circumstances. ${ }^{[7]}$ These tools are particularly relevant for addressing the root causes of weaknesses, for instance in internal governance or risk management. These qualitative areas are very often the source of problems that subsequently materialise in risks to capital and liquidity. The banking turmoil in March 2023, for instance, was a clear reminder that shortcomings stemming from weak governance can, if left unaddressed, later resurface in quantitative areas such as banks' liquidity positions. Consider Silicon Valley Bank, which had significant interest rate risk as a result of holding long-term securities. Despite the bank having ---[PAGE_BREAK]--- repeatedly breached internal risk limits, its management did not adequately address these issues and supervisors did not escalate their concerns until it was too late. As interest rates rose, the value of those securities fell, and SVB incurred substantial losses when it was forced to sell them to cover withdrawals. $\underline{[5]}$ Periodic penalty payments, an example of an enforcement measure, are another vital part of our toolbox. $\underline{[6]}$ They are an effective tool that we can use as part of an escalation process to compel individual banks to comply, by a specific date, with our requirements in respect of any prudential risk that is not properly covered and managed. While the decision to impose periodic penalty payments is always specific to an individual bank, if there are breaches of requirements related to risks that affect several institutions simultaneously, we may need to consider imposing this measure on various banks at the same time. And this is precisely what we have been doing in the area of climate-related and environmental (C\&E) risks. Let me focus on this example. Considering the clear requirements set out in the Capital Requirements Directive and the need for banks to implement a regular process for identifying all material risks, we have been clear that all banks under our supervision must ensure that their practices are fully aligned with the sound management of C\&E risks. Building on what banks themselves considered reasonable, we have set a series of (interim) deadlines by which banks have to reach certain milestones. As a first step, we asked all banks to ensure that they had sound and comprehensive materiality assessments in place, which is the basis for managing any kind of risk. We were clear that we expected all banks to meet this deadline by March 2023 and that, if necessary, we would use all the tools at our disposal to enforce it, as well as any subsequent deadlines. Most, but not all, of the banks under our supervision made significant strides in advancing their materiality assessments by the March 2023 deadline. So, it should be no surprise that we took action on this: we moved further up the supervisory escalation ladder and issued binding supervisory decisions for 23 banks, which included the potential imposition of periodic penalty payments for 18 banks if they failed to comply with the requirements by the deadlines set out in these decisions. Encouragingly, most banks have now submitted a meaningful materiality assessment. This shows that our supervisory pressure has been effective and has led to the desired outcome for the majority of banks. In parallel to our actions in relation to the first interim deadline, we are currently concluding our assessment of banks' progress in meeting the second interim deadline. For this second deadline, we asked banks to clearly include C\&E risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, if we see that banks have not satisfactorily delivered, we will consider adopting supervisory measures that already contain an enforcement measure. In other words, we may tell those banks to remedy the shortcoming by a certain date and, if they don't comply, they will have to pay a penalty for every day the shortcoming remains unresolved. The last tool that I would like to mention is sanctions, which are intended to punish banks for misconduct and to deter future infringements. $\underline{[10]}$ For instance, we have imposed penalties on banks ---[PAGE_BREAK]--- that failed to comply with the requirements set out in binding ECB decisions ${ }^{[11]}$ or with EU prudential requirements. # Legal considerations for effective supervision Let me now turn to the legal considerations that constitute our guiding principles for exercising our supervisory powers. When we - European banking supervisors - are using our rich supervisory toolkit and exercising our margin of discretion in imposing supervisory and enforcement measures, as well as sanctions, we take great care to remain within our mandate, to act in accordance with the relevant EU law and to act proportionally. We make sure that both our findings and the requirements we impose in our supervisory decisions fall squarely within the prudential tasks conferred on us under Article 4 of the SSM Regulation. We use all powers available to us to ensure that banks manage and cover their risks properly and that they comply with the applicable prudential legislation. Our underlying objective is to ensure the safety and soundness of credit institutions and the stability of the financial system. When deploying our supervisory toolkit in the exercise of our mandate, we apply the relevant Union law. We carefully analyse EU and national legislative texts, when applicable, taking into account the wording, context and objectives of the legislative provisions. We consider relevant case-law and general principles of law. We state the reasons on which our decisions are based with the aim that banks understand what we perceive their shortcomings to be and what we expect from them. When we issue sanctions or impose periodic penalty payments, we use a coherent methodology. We always make sure that we use our tools in line with the principle of proportionality. In other words, we consider whether the powers we use at any given time are appropriate for attaining our prudential objectives. We ascertain that we are not going beyond what is necessary and that the effects of our measures are not disproportionate to the prudential objective we are pursuing. Accordingly, one of the objectives when escalating supervisory action is to enable us to act swiftly and proportionally. In doing all this, we also ensure that our decisions are based only on facts and findings on which the banks have been able to comment. ${ }^{[12]}$ The right to be heard is a key procedural safeguard. We take it seriously and are committed to listening to banks' arguments and comments. In a number of cases we have changed supervisory decisions based on the comments made during the right to be heard process. For example, there have been cases where we have changed requirements into recommendations or prolonged the deadlines for compliance with our requirements, reflecting our willingness to consider the specific circumstances and arguments of individual banks. We - as European banking supervisors - believe that both the supervisory dialogue and banks' comments during the drafting phase of the decision can lead to increased mutual understanding and better decisions with better calibrated measures. ---[PAGE_BREAK]--- Finally, if after those exchanges you - the supervised banks - still doubt the substantive and procedural conformity of the ECB's decision with the SSM Regulation, you may request an internal administrative review at the Administrative Board of Review. ${ }^{[13]}$ While we do everything we can to ensure that we act within our mandate, correctly apply the relevant Union law, act proportionally and listen to your arguments, we note that banks are fully within their rights to ask EU courts to review our decisions. Litigation is, in a sense, a natural aspects of supervision, with supervisors actually using the tools they have been granted by the legislator to ensure compliance and timely remediation. Indeed, in the past ten years the ECB has been involved in 98 cases involving 102 actions requesting either annulment or damages, or alleging that the ECB was failing to act. So far, in most cases the courts have upheld our decisions in which we exercised our supervisory powers. And whenever one of our decisions has been annulled, we have drawn lessons from that experience to further improve the way we work. A very recent example I can mention is the ECB decisions requiring part of the prefunding given to the national deposit guarantee schemes and the Single Resolution Fund to be deducted from banks' capital in cases when the banks did not reflect the loss of economic resources from this funding in their capital. These decisions revolved around the technicalities of the so-called irrevocable payment commitments, how these commitments are secured by collateral and how banks reflect the loss of economic resources in their capital, liquidity and internal arrangements. Our first set of decisions was annulled in 2020 by the General Court ${ }^{[14]}$, which considered that our reasoning for imposing these measures lacked an individual assessment of how the risk we identified was managed and covered by the arrangements implemented by the banks and the capital and liquidity held by them. Following these judgments of the General Court, the ECB improved its methodology to better cater for this individual assessment and took new decisions in relation to the irrevocable payment commitments with an improved motivation. These new decisions were again challenged by some banks, but this time the General Court upheld the new decisions with our improved methodology. ${ }^{[15]}$ This learning process is part of us striving to be an effective supervisor that, while always acting legally and proportionally, never rests until material prudential risks are covered and managed, necessary compliance has been achieved and remediation has been ensured. In this sense, we will not stop using our toolbox for fear of litigation, as we firmly believe that we can also learn when subject to judicial scrutiny. # Conclusion Let me conclude. As we approach the next decade of European banking supervision, the fundamental objective of supervision - ensuring safe and sound banks - will not change. To achieve this objective, we are putting greater emphasis on impact and effectiveness. We need to have a razor-sharp analytical focus on risks, and we need to insist that the weaknesses we identify are remedied in good time. Ensuring timely remediation is more relevant than ever considering the fast-evolving environment that we live in. ---[PAGE_BREAK]--- And crucially, we have an extensive toolkit at our disposal that we are willing to use to meet that objective. In our supervisory process, we listen to you - representatives of the banks we supervise - because, ultimately, both supervisors and banks have a common objective: ensuring that the banks remain safe and sound. So let us make good use of every aspect of our supervisory dialogue, including the right to be heard, so you - the banks we supervise - can better understand our prudential concerns and we - European banking supervisors - can better understand the implementation challenges you may face. Together, we can navigate the challenges of this new risk environment. Together, we can make sure that European banks are also able to weather these storms. Together, we can ensure that banks remain safe and sound in the decades to come. Thank you for your attention. 1. Buch, C. (2024), "Reforming the SREP: an important milestone towards more efficient and effective supervision in a new risk environment", The Supervision Blog, 28 May. 2. Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April, p. 8; Basel Committee on Banking Supervision (2023), Report on the 2023 banking turmoil, October, p. 26; International Monetary Fund (2023), Good Supervision: Lessons from the Field, September, pp. 4 et seq. 3. Viñals, J. et al. (2010), "The Making of Good Supervision: Learning to Say "No"", IMF Staff Position Note, International Monetary Fund, 18 May. 4. ECB (2023), "ECB welcomes expert group recommendations on European banking supervision", press release, 17 April. 5. Elderson, F. (2024), "You have to know your risks to manage them - banks' materiality assessments as a crucial precondition for managing climate and environmental risks", The Supervision Blog, 8 May. 6. Article 16(2)(a) of the SSM Regulation (Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (OJ L 287, 29.10.2013, p. 63). 7. ---[PAGE_BREAK]--- Elderson, F. (2023), "Powers. ability and willingness to act - the mainstay of effective banking supervision", speech at the House of the Euro, 7 December. 8. Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April. 9. Periodic penalty payments require the bank concerned to pay a daily amount - up to $5 \%$ of its average daily turnover - for every day the infringement continues during a maximum period of six months. 10. Sanctioning proceedings can be initiated both in the case of ongoing breaches and after the breach has ceased. The ECB can impose pecuniary penalties on banks for failing to comply with EU prudential requirements. The ECB may impose penalties of up to $10 \%$ of a bank's total annual turnover in the preceding business year, or twice the amount of profits gained or losses avoided as a result of the breach, where those can be determined. 11. See the ECB's banking supervision website for an overview of sanctions imposed by the ECB and the national competent authorities in proceedings opened at the ECB's request, as well as statistics on sanctioning activities in the context of European banking supervision. 12. Article 22(1) of the SSM Regulation. 13. To date the Administrative Board of Review has delivered 36 opinions. 14. See the judgments of the General Court in cases T-143/18, T-144/18, T-145/18, T-146/18, T-149/18 and T-150/18. 15. See the judgments of the General Court in cases T-182/22, T-186/22, T-187/22, T-188/22, T-189/22, T190/22 and T-191/22. # CONTACT <br> European Central Bank	Frank Elderson	Euro area	https://www.bis.org/review/r240701d.pdf	Frankfurt, 27 June 2024 Thank you for inviting me to this conference on ten years of European banking supervision. It is hard to believe that it's only a decade since supervisors from across Europe first came together in truly European supervisory teams on a Tuesday morning in November 2014. Just like the first ten years of a child's life, the first decade of European banking supervision has also been a period of growth and development. During this time, we have matured from a start-up into a well-established, effective supervisor, building on the best practices of supervisors across Europe. And this is more relevant than ever given the increasingly complex external risk landscape. Think about heightening risks from geopolitical shocks, cyber risks and the climate and nature crises. These evolving risks require supervision to evolve, too. This is why we have embarked on a journey to make European banking supervision more risk-focused, efficient and effective. For example, we recently announced change to the Supervisory Review and Evaluation Process (SREP) - our annual health check of banks - making it more targeted and more risk-focused in a new risk environment. The revised SREP also puts greater emphasis on impact and effectiveness, which is the focus of my remarks today. In this context, I am pleased to be speaking to an audience of general counsels from the banks under our supervision. The way we - ECB Banking Supervision - interact with you - representatives of the banks we supervise - is of paramount importance for our shared goal of safe and sound banks. So, what does effective supervision mean in practice? Our experience of almost ten years of European supervision shows that, in most cases, banks address the root causes of supervisors' findings and that's the end of the story. If banks remediate shortcomings in a timely manner based on what we refer to as "supervisory dialogue", we have a very efficient and effective way of supervising. But there are also cases where banks fail to address deficiencies in good time. For these cases, the legislator has given the ECB a very broad supervisory toolbox that we are able and willing to use always in a proportionate manner. Internationally, various reports on the lessons from the banking turmoil in March 2023 all explicitly recommended that supervisors should make active use of their supervisory tools to compel banks to take timely and concrete remedial action. Moreover, in 2022 we took the initiative to ask a group of independent experts to review our SREP. In their report, which was published last year, they also urged the ECB to use the full range of supervisory tools available. The use of supervisory powers to compel banks to make concrete improvements is therefore not merely a nice-to-have - it is international best practice to ensure that banks remain safe and sound, which is the ultimate goal of prudential supervision. So, when and how do we use these tools? We act fully in line with the principle of proportionality, using supervisory tools as appropriate, as necessary and - once the appropriateness and need has been established - decisively. Central to this approach is an escalation ladder, giving banks the opportunity to address shortcomings and their root causes within a defined time frame, with interim deadlines if and when appropriate. If using a less intrusive tool does not lead to the desired outcome being achieved in a timely manner, we will expeditiously deploy more intrusive tools to compel banks to take the necessary remedial actions in time. The escalation process is not, however, automatic and it always depends on the specific circumstances. This means that some serious issues requiring immediate remediation could lead to more intrusive supervisory measures being used at an early stage. The tools available to us range from binding quantitative and qualitative supervisory measures to sanctions and enforcement measures such as periodic penalty payments. Let's look at these tools more closely. Some might think of Pillar 2 capital add-ons , the most common quantitative supervisory measure, as the sharpest tool that a supervisor has. But while setting bank-specific Pillar 2 capital requirements is undoubtedly a vital element of our toolbox, it is far from being the only one. Article 16 of the SSM Regulation gives the ECB the power to impose a wide range of what we call "qualitative requirements", based on a bank's specific circumstances. Periodic penalty payments, an example of an enforcement measure, are another vital part of our toolbox. They are an effective tool that we can use as part of an escalation process to compel individual banks to comply, by a specific date, with our requirements in respect of any prudential risk that is not properly covered and managed. While the decision to impose periodic penalty payments is always specific to an individual bank, if there are breaches of requirements related to risks that affect several institutions simultaneously, we may need to consider imposing this measure on various banks at the same time. And this is precisely what we have been doing in the area of climate-related and environmental (C\&E) risks. Let me focus on this example. Considering the clear requirements set out in the Capital Requirements Directive and the need for banks to implement a regular process for identifying all material risks, we have been clear that all banks under our supervision must ensure that their practices are fully aligned with the sound management of C\&E risks. Building on what banks themselves considered reasonable, we have set a series of (interim) deadlines by which banks have to reach certain milestones. As a first step, we asked all banks to ensure that they had sound and comprehensive materiality assessments in place, which is the basis for managing any kind of risk. We were clear that we expected all banks to meet this deadline by March 2023 and that, if necessary, we would use all the tools at our disposal to enforce it, as well as any subsequent deadlines. Most, but not all, of the banks under our supervision made significant strides in advancing their materiality assessments by the March 2023 deadline. So, it should be no surprise that we took action on this: we moved further up the supervisory escalation ladder and issued binding supervisory decisions for 23 banks, which included the potential imposition of periodic penalty payments for 18 banks if they failed to comply with the requirements by the deadlines set out in these decisions. Encouragingly, most banks have now submitted a meaningful materiality assessment. This shows that our supervisory pressure has been effective and has led to the desired outcome for the majority of banks. In parallel to our actions in relation to the first interim deadline, we are currently concluding our assessment of banks' progress in meeting the second interim deadline. For this second deadline, we asked banks to clearly include C\&E risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, if we see that banks have not satisfactorily delivered, we will consider adopting supervisory measures that already contain an enforcement measure. In other words, we may tell those banks to remedy the shortcoming by a certain date and, if they don't comply, they will have to pay a penalty for every day the shortcoming remains unresolved. The last tool that I would like to mention is sanctions, which are intended to punish banks for misconduct and to deter future infringements. For instance, we have imposed penalties on banks that failed to comply with the requirements set out in binding ECB decisions or with EU prudential requirements. Let me now turn to the legal considerations that constitute our guiding principles for exercising our supervisory powers. When we - European banking supervisors - are using our rich supervisory toolkit and exercising our margin of discretion in imposing supervisory and enforcement measures, as well as sanctions, we take great care to remain within our mandate, to act in accordance with the relevant EU law and to act proportionally. We make sure that both our findings and the requirements we impose in our supervisory decisions fall squarely within the prudential tasks conferred on us under Article 4 of the SSM Regulation. We use all powers available to us to ensure that banks manage and cover their risks properly and that they comply with the applicable prudential legislation. Our underlying objective is to ensure the safety and soundness of credit institutions and the stability of the financial system. When deploying our supervisory toolkit in the exercise of our mandate, we apply the relevant Union law. We carefully analyse EU and national legislative texts, when applicable, taking into account the wording, context and objectives of the legislative provisions. We consider relevant case-law and general principles of law. We state the reasons on which our decisions are based with the aim that banks understand what we perceive their shortcomings to be and what we expect from them. When we issue sanctions or impose periodic penalty payments, we use a coherent methodology. We always make sure that we use our tools in line with the principle of proportionality. In other words, we consider whether the powers we use at any given time are appropriate for attaining our prudential objectives. We ascertain that we are not going beyond what is necessary and that the effects of our measures are not disproportionate to the prudential objective we are pursuing. Accordingly, one of the objectives when escalating supervisory action is to enable us to act swiftly and proportionally. In doing all this, we also ensure that our decisions are based only on facts and findings on which the banks have been able to comment. The right to be heard is a key procedural safeguard. We take it seriously and are committed to listening to banks' arguments and comments. In a number of cases we have changed supervisory decisions based on the comments made during the right to be heard process. For example, there have been cases where we have changed requirements into recommendations or prolonged the deadlines for compliance with our requirements, reflecting our willingness to consider the specific circumstances and arguments of individual banks. We - as European banking supervisors - believe that both the supervisory dialogue and banks' comments during the drafting phase of the decision can lead to increased mutual understanding and better decisions with better calibrated measures. Finally, if after those exchanges you - the supervised banks - still doubt the substantive and procedural conformity of the ECB's decision with the SSM Regulation, you may request an internal administrative review at the Administrative Board of Review. While we do everything we can to ensure that we act within our mandate, correctly apply the relevant Union law, act proportionally and listen to your arguments, we note that banks are fully within their rights to ask EU courts to review our decisions. Litigation is, in a sense, a natural aspects of supervision, with supervisors actually using the tools they have been granted by the legislator to ensure compliance and timely remediation. Indeed, in the past ten years the ECB has been involved in 98 cases involving 102 actions requesting either annulment or damages, or alleging that the ECB was failing to act. So far, in most cases the courts have upheld our decisions in which we exercised our supervisory powers. And whenever one of our decisions has been annulled, we have drawn lessons from that experience to further improve the way we work. A very recent example I can mention is the ECB decisions requiring part of the prefunding given to the national deposit guarantee schemes and the Single Resolution Fund to be deducted from banks' capital in cases when the banks did not reflect the loss of economic resources from this funding in their capital. These decisions revolved around the technicalities of the so-called irrevocable payment commitments, how these commitments are secured by collateral and how banks reflect the loss of economic resources in their capital, liquidity and internal arrangements. Our first set of decisions was annulled in 2020 by the General Court This learning process is part of us striving to be an effective supervisor that, while always acting legally and proportionally, never rests until material prudential risks are covered and managed, necessary compliance has been achieved and remediation has been ensured. In this sense, we will not stop using our toolbox for fear of litigation, as we firmly believe that we can also learn when subject to judicial scrutiny. Let me conclude. As we approach the next decade of European banking supervision, the fundamental objective of supervision - ensuring safe and sound banks - will not change. To achieve this objective, we are putting greater emphasis on impact and effectiveness. We need to have a razor-sharp analytical focus on risks, and we need to insist that the weaknesses we identify are remedied in good time. Ensuring timely remediation is more relevant than ever considering the fast-evolving environment that we live in. And crucially, we have an extensive toolkit at our disposal that we are willing to use to meet that objective. In our supervisory process, we listen to you - representatives of the banks we supervise - because, ultimately, both supervisors and banks have a common objective: ensuring that the banks remain safe and sound. So let us make good use of every aspect of our supervisory dialogue, including the right to be heard, so you - the banks we supervise - can better understand our prudential concerns and we - European banking supervisors - can better understand the implementation challenges you may face. Together, we can navigate the challenges of this new risk environment. Together, we can make sure that European banks are also able to weather these storms. Together, we can ensure that banks remain safe and sound in the decades to come. Thank you for your attention.
2024-06-27T00:00:00	Michelle W Bowman: Brief remarks on the economy, monetary policy and bank regulation	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Idaho, Nevada, Oregon and Washington Bankers Associations 2024 Annual Convention, Stevenson, Washington DC, 27 June 2024.	Michelle W Bowman: Brief remarks on the economy, monetary policy and bank regulation Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Idaho, Nevada, Oregon and Washington Bankers Associations 2024 Annual Convention, Stevenson, Washington DC, 27 June 2024. * * * I would like to thank the Idaho, Nevada, Oregon, and Washington Bankers Associations 1 for the invitation to join you this morning. It's a pleasure to be here in Washington State to speak with your members. Direct interactions like this, outside of Washington, D.C., enable me to develop a deeper understanding of what is happening in the banking industry and the regional economy. Before sharing some thoughts about the current trajectory of regulatory approvals and bank merger policy, I will discuss my views on the economy and monetary policy. Update on the Economy and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 or older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As I've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. Regulatory Approvals in the Banking System Before turning directly to regulatory approvals in the banking system and merger and acquisition policy, it is important to consider these issues in the broader context. Regulatory approvals and bank mergers and acquisitions do not occur in a vacuum. The choices that regulators make on regulatory and supervisory policy issues have profound implications for mergers and acquisitions and for the appetite of bank management to engage in those transactions. In recent months, the banking agencies have issued or finalized a large number of regulatory changes. These changes are shaping the future of the banking system. From bank capital requirements to liquidity reform, significant revisions to the Community Reinvestment Act, a regulatory attack on banks charging fees for services (including debit card interchange fees), the trend of dialing supervision up to "11" for banks of all sizes, and the ongoing erosion of tailoring all shape the contours of the banking system, including bank size, the activities in which 2 they engage, and where activities occur within the broader financial system. These policy decisions also create incentives and impacts that we must acknowledge and understand. When policymakers flatten and standardize regulations and supervisory expectations, we create strong incentives for banks to achieve greater economies of scale through merger and make it harder for new banks to successfully compete with existing banks. Actually implementing clear merger standards would reduce the number of necessary application denials and withdrawals. Where clear standards exist, those seeking regulatory approval will only file for approval of those transactions that will meet the banking agency standards. In my mind, this would be responsible and effective public policy. De Novo Bank Formation I continue to be concerned about the decline in the number of banks in the U.S. As I have noted in the past, there are several indications that there is an unmet demand for new bank creation demonstrated by the ongoing preference for "charter strip" acquisitions, the ongoing shift of activities out of the banking system, and the rising demand for banking-as-a-service partnerships.3 For the past decade, de novo bank formation has been largely stagnant, even as the banking industry has rapidly evolved over the same time. Many factors influence the pursuit of de novo bank charters, including the interest rate environment, business opportunities, the intense competition for qualified bank management and staff, and potentially less onerous alternatives for financial services to be provided outside of the regulated banking system. The decision to form a de novo bank is also informed by normal business considerations, including identifying investors, establishing a viable business plan, and ensuring the ability to navigate the "start-up" phase of a new bank and manage upfront operational costs, all while being subjected to intense supervisory oversight over the first several years of operation. Yet perhaps the most important factor that influences de novo bank formation is the regulatory and supervisory framework. This includes the application process and receipt of regulatory approval. This application process can be a significant obstacle to de novo bank formation. Applications often experience significant delays between the initial charter application filing with the chartering authority and the Federal Deposit Insurance Corporation application for deposit insurance. It often takes well in excess of a year to receive all of the required regulatory approvals to open for business. Of course, this uncertainty remains after the initial capital has been raised, shareholders identified, and a management team is ready to begin work. These delays present unique challenges for de novo founders, including incurrence of more start-up expenses, difficulty recruiting and retaining qualified management to obtain approval, and challenges in raising additional start-up capital investment. In my view, the absence of de novo bank formation over the long run will create a void in the banking system, a void that could contribute to a decline in the availability of reliable and fairly priced credit, the absence of financial services in underserved markets, and the continued shift of banking activities outside the banking system. Bank Mergers and Acquisitions Another pressing area of concern is the rapidly shifting approach to bank mergers and 4 acquisitions (M&A) by some prudential regulators. M&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote the long-term health and viability of banks. M&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and zombie banks that continue to exist but have no competitive viability or exit strategy. The impact of a more restrictive M&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks. They may choose to pursue M&A to remain competitive with larger peers who can achieve growth organically through sheer scale. M&A is an important part of a healthy banking system. So when considering changes to the framework, I think we need to first identify the problem that needs to be solved and then ask whether any proposed solution is fair, transparent, and consistent with applicable statutes-and, critically, whether the proposed solution has the potential to damage the long-term viability of the banking system. Are there identified shortcomings in the current process or standards, and are the proposed reforms targeted and effective to address these shortcomings? One argument I have heard about the M&A regulatory approval process is that the lack of application pressuredenials demonstrates that regulators are failing to meaningfully review and test proposals and have effectively become a rubber stamp. I think this argument lacks a strong foundation. There is ample evidence that undermines this argument, including the resource demands on institutions pursuing M&A activity and the extended time it takes to complete the regulatory review and approval process (and the not insignificant failure rate we see represented in withdrawn applications). We also have to acknowledge that choosing the path of a merger or acquisition is not undertaken lightly. These transactions require significant upfront and ongoing investment and commitment of resources. At the outset, this includes finding an appropriate acquisition target, conducting due diligence, and negotiating the terms of the transaction. Once a target is identified, the banks must prepare appropriate regulatory filings, engage with regulators during the application process, and prepare for post-approval business processes, including scheduling necessary and costly systems conversions and customer transition. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. One would also expect to see different patterns emerging if regulators were truly acting as a rubber stamp for banking applications. We know from data published by the Federal Reserve that filing an application does not guarantee approval, even in the absence of a regulatory denial. The Federal Reserve's most recent report on banking applications activity identifies a significant portion of bank M&A transactions in which applications have been withdrawn.5 The processing timelines we see also seem inconsistent with a process that is operating truly as a rubber stamp. To be clear, I think we have room to do better when it comes to timely regulatory action, while maintaining a rigorous review of applications. But extended review periods are not uncommon, particularly when you include preliminary discussions and pre-filings with regulators in the published processing timelines. Some contemplated regulatory reform efforts will likely make the M&A application process slower and less efficient. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. Reducing the efficiency of bank M&A can be a deterrent to healthy bank transactions. This inefficiency limits activity that ensures the value of community banks located in underserved areas, prevents institutions from pursuing prudent growth strategies, and undermines competition by preventing firms from growing to a larger scale, effectively creating a "protected class" of larger institutions. At the same time some federal regulatory agencies are imposing more onerous 6 requirements, credit unions have increased their acquisitions of banks. While this could solve some succession planning concerns, it is not clear how these acquisitions will ultimately impact the banking system going forward. Could these acquisitions reduce the availability of certain products and services? Will these institutions have the same incentives to serve all of the consumers in a particular community? If there are fewer banks and more credit unions, how will this data impact the competitive analysis of traditional banks merging? Historically, credit unions have had limited membership requirements and have not engaged in the same wide range of activities as banks. But in recent years, their memberships have expanded, and they are offering more of the same products and services that banks provide. Yet, unlike banks, credit unions are not required to meet the requirements of the Community Reinvestment Act or other laws that apply to banks. As some prudential regulators continue to increase the regulatory scrutiny of bank M&A, it may increase the incentives for credit unions to acquire banks if there are fewer delays and more regulatory certainty related to those transactions. Unfortunately, the past year has shown that regulatory attention is increasingly focused on other issues, with the timeliness of processing regulatory applications by banking regulators appearing to be lower on the list of priorities. Closing Thoughts The bank regulatory reform agenda has many implications for banks of all sizes. As regulators continue to propose and make changes to the regulatory and supervisory processes, it is vital that policymakers understand the tradeoffs between the costs and benefits of what they are changing. It is equally important that policymakers also understand the unintended consequences of their decisions. While some of the proposed changes may be designed to address particular issues, they will have broader follow-on consequences. Because of these potentially broader consequences, we must address policy from a holistic perspective rather than in a piecemeal fashion. One way to better understand the outcomes of our decisions is to hear directly from you and other stakeholders about the specific impacts-intended and unintended-of changes to the bank regulatory framework. Your feedback helps us to understand the real-world impacts of regulatory and supervisory reforms. Thank you, and I look forward to discussing these and other important issues with you today. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 See Michelle W. Bowman (2024), " The Path Forward for Bank Capital Reform (PDF) ," speech delivered at Protect Main Street, sponsored by the Center for Capital Markets at the U.S. Chamber of Commerce, Washington, January 17; Michelle W. Bowman (2024), " Reflections on the Economy and Bank Regulation (PDF) ," speech delivered at the Florida Bankers Association Leadership Luncheon Events, Miami, February 27; Michelle W. Bowman (2024), "Reflections on the Economy and Bank Regulation (PDF) ," speech delivered at the New Jersey Bankers Association Annual Economic Leadership Forum, Somerset, N.J., March 7; and Michelle W. Bowman (2024), " Tailoring, Fidelity to the Rule of Law, and Unintended Consequences (PDF)," speech delivered at the Harvard Law School Faculty Club, Cambridge, Mass., March 5. 3 See Michelle W. Bowman (2023), "The Consequences of Fewer Banks in the U.S. Banking System (PDF)," speech delivered at the Wharton Financial Regulation Conference, Philadelphia, April 14. See Jonathan Kanter (2023), "Merger Enforcement Sixty Years after Philadelphia National Bank," speech delivered at the Brookings Institution's Center on Regulation and Markets Event "Promoting Competition in Banking," Washington, June 20; Office of the Comptroller of the Currency (2024), "Business Combinations under the Bank Merger Act: Notice of Proposed Rulemaking ," OCC Bulletin 2024-4, January 29; and Federal Deposit Insurance Corporation (2024), "FDIC Seeks Public Comment on Proposed Revisions to Its Statement of Policy on Bank Merger Transactions," press release, March 21. 5 See Board of Governors of the Federal Reserve System (2023), Banking Applications Activity Semiannual Report, January 1-June 30, 2023 (PDF)(Washington: Board of Governors, September). This report notes that in the first half of 2023, 46 M&A applications were approved by the Federal Reserve, while 12 such applications were withdrawn. 6 See Alex Graf, Zuhaib Gull, and Gaby Villaluz (2024), "Credit Unions Dominate EarlyYear Bank M&A in Washington State," S&P Global, April 15; and Arizent (2024), "15 Credit Unions That Have Acquired Banks since 2023," American Banker, February 12.	---[PAGE_BREAK]--- # Michelle W Bowman: Brief remarks on the economy, monetary policy and bank regulation Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Idaho, Nevada, Oregon and Washington Bankers Associations 2024 Annual Convention, Stevenson, Washington DC, 27 June 2024. I would like to thank the Idaho, Nevada, Oregon, and Washington Bankers Associations for the invitation to join you this morning. ${ }^{1}$ It's a pleasure to be here in Washington State to speak with your members. Direct interactions like this, outside of Washington, D.C., enable me to develop a deeper understanding of what is happening in the banking industry and the regional economy. Before sharing some thoughts about the current trajectory of regulatory approvals and bank merger policy, I will discuss my views on the economy and monetary policy. ## Update on the Economy and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. ---[PAGE_BREAK]--- Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 or older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As l've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how ---[PAGE_BREAK]--- the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. # Regulatory Approvals in the Banking System Before turning directly to regulatory approvals in the banking system and merger and acquisition policy, it is important to consider these issues in the broader context. Regulatory approvals and bank mergers and acquisitions do not occur in a vacuum. The choices that regulators make on regulatory and supervisory policy issues have profound implications for mergers and acquisitions and for the appetite of bank management to engage in those transactions. In recent months, the banking agencies have issued or finalized a large number of regulatory changes. These changes are shaping the future of the banking system. From bank capital requirements to liquidity reform, significant revisions to the Community Reinvestment Act, a regulatory attack on banks charging fees for services (including debit card interchange fees), the trend of dialing supervision up to "11" for banks of all sizes, and the ongoing erosion of tailoring all shape the contours of the banking system, including bank size, the activities in which they engage, and where activities occur within the broader financial system. $\underline{2}$ These policy decisions also create incentives and impacts that we must acknowledge and understand. When policymakers flatten and standardize regulations and supervisory expectations, we create strong incentives for banks to achieve greater economies of scale through merger and make it harder for new banks to successfully compete with existing banks. Actually implementing clear merger standards would reduce the number of necessary application denials and withdrawals. Where clear standards exist, those seeking regulatory approval will only file for approval of those transactions that will meet the banking agency standards. In my mind, this would be responsible and effective public policy. ## De Novo Bank Formation I continue to be concerned about the decline in the number of banks in the U.S. As I have noted in the past, there are several indications that there is an unmet demand for new bank creation demonstrated by the ongoing preference for "charter strip" acquisitions, the ongoing shift of activities out of the banking system, and the rising demand for banking-as-a-service partnerships. $\underline{3}$ For the past decade, de novo bank formation has been largely stagnant, even as the banking industry has rapidly evolved over the same time. Many factors influence the pursuit of de novo bank charters, including the interest rate environment, business opportunities, the intense competition for qualified bank management and staff, and potentially less onerous alternatives for financial services to be provided outside of the regulated banking system. ---[PAGE_BREAK]--- The decision to form a de novo bank is also informed by normal business considerations, including identifying investors, establishing a viable business plan, and ensuring the ability to navigate the "start-up" phase of a new bank and manage upfront operational costs, all while being subjected to intense supervisory oversight over the first several years of operation. Yet perhaps the most important factor that influences de novo bank formation is the regulatory and supervisory framework. This includes the application process and receipt of regulatory approval. This application process can be a significant obstacle to de novo bank formation. Applications often experience significant delays between the initial charter application filing with the chartering authority and the Federal Deposit Insurance Corporation application for deposit insurance. It often takes well in excess of a year to receive all of the required regulatory approvals to open for business. Of course, this uncertainty remains after the initial capital has been raised, shareholders identified, and a management team is ready to begin work. These delays present unique challenges for de novo founders, including incurrence of more start-up expenses, difficulty recruiting and retaining qualified management to obtain approval, and challenges in raising additional start-up capital investment. In my view, the absence of de novo bank formation over the long run will create a void in the banking system, a void that could contribute to a decline in the availability of reliable and fairly priced credit, the absence of financial services in underserved markets, and the continued shift of banking activities outside the banking system. # Bank Mergers and Acquisitions Another pressing area of concern is the rapidly shifting approach to bank mergers and acquisitions (M\&A) by some prudential regulators. ${ }^{4}$ M\&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote the long-term health and viability of banks. M\&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M\&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and zombie banks that continue to exist but have no competitive viability or exit strategy. The impact of a more restrictive M\&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks. They may choose to pursue M\&A to remain competitive with larger peers who can achieve growth organically through sheer scale. M\&A is an important part of a healthy banking system. So when considering changes to the framework, I think we need to first identify the problem that needs to be solved and then ask whether any proposed solution is fair, transparent, and consistent with applicable statutes-and, critically, whether the proposed solution has the potential to damage the long-term viability of the banking system. Are there identified shortcomings in the current process or standards, and are the proposed reforms targeted and effective to address these shortcomings? One argument I have heard about the M\&A regulatory approval process is that the lack of application denials demonstrates that regulators are failing to meaningfully review and pressure- ---[PAGE_BREAK]--- test proposals and have effectively become a rubber stamp. I think this argument lacks a strong foundation. There is ample evidence that undermines this argument, including the resource demands on institutions pursuing M\&A activity and the extended time it takes to complete the regulatory review and approval process (and the not insignificant failure rate we see represented in withdrawn applications). We also have to acknowledge that choosing the path of a merger or acquisition is not undertaken lightly. These transactions require significant upfront and ongoing investment and commitment of resources. At the outset, this includes finding an appropriate acquisition target, conducting due diligence, and negotiating the terms of the transaction. Once a target is identified, the banks must prepare appropriate regulatory filings, engage with regulators during the application process, and prepare for post-approval business processes, including scheduling necessary and costly systems conversions and customer transition. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. One would also expect to see different patterns emerging if regulators were truly acting as a rubber stamp for banking applications. We know from data published by the Federal Reserve that filing an application does not guarantee approval, even in the absence of a regulatory denial. The Federal Reserve's most recent report on banking applications activity identifies a significant portion of bank M\&A transactions in which applications have been withdrawn. $\underline{5}$ The processing timelines we see also seem inconsistent with a process that is operating truly as a rubber stamp. To be clear, I think we have room to do better when it comes to timely regulatory action, while maintaining a rigorous review of applications. But extended review periods are not uncommon, particularly when you include preliminary discussions and pre-filings with regulators in the published processing timelines. Some contemplated regulatory reform efforts will likely make the M\&A application process slower and less efficient. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. Reducing the efficiency of bank M\&A can be a deterrent to healthy bank transactions. This inefficiency limits activity that ensures the value of community banks located in underserved areas, prevents institutions from pursuing prudent growth strategies, and undermines competition by preventing firms from growing to a larger scale, effectively creating a "protected class" of larger institutions. At the same time some federal regulatory agencies are imposing more onerous requirements, credit unions have increased their acquisitions of banks. $\underline{6}$ While this could solve some succession planning concerns, it is not clear how these acquisitions will ultimately impact the banking system going forward. Could these acquisitions reduce the availability of certain products and services? Will these institutions have the same incentives to serve all of the consumers in a particular community? If there are fewer banks and more credit unions, how will this data impact the competitive analysis ---[PAGE_BREAK]--- of traditional banks merging? Historically, credit unions have had limited membership requirements and have not engaged in the same wide range of activities as banks. But in recent years, their memberships have expanded, and they are offering more of the same products and services that banks provide. Yet, unlike banks, credit unions are not required to meet the requirements of the Community Reinvestment Act or other laws that apply to banks. As some prudential regulators continue to increase the regulatory scrutiny of bank M\&A, it may increase the incentives for credit unions to acquire banks if there are fewer delays and more regulatory certainty related to those transactions. Unfortunately, the past year has shown that regulatory attention is increasingly focused on other issues, with the timeliness of processing regulatory applications by banking regulators appearing to be lower on the list of priorities. # Closing Thoughts The bank regulatory reform agenda has many implications for banks of all sizes. As regulators continue to propose and make changes to the regulatory and supervisory processes, it is vital that policymakers understand the tradeoffs between the costs and benefits of what they are changing. It is equally important that policymakers also understand the unintended consequences of their decisions. While some of the proposed changes may be designed to address particular issues, they will have broader follow-on consequences. Because of these potentially broader consequences, we must address policy from a holistic perspective rather than in a piecemeal fashion. One way to better understand the outcomes of our decisions is to hear directly from you and other stakeholders about the specific impacts-intended and unintended-of changes to the bank regulatory framework. Your feedback helps us to understand the real-world impacts of regulatory and supervisory reforms. Thank you, and I look forward to discussing these and other important issues with you today. ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See Michelle W. Bowman (2024), "The Path Forward for Bank Capital Reform (PDF)," speech delivered at Protect Main Street, sponsored by the Center for Capital Markets at the U.S. Chamber of Commerce, Washington, January 17; Michelle W. Bowman (2024), "Reflections on the Economy and Bank Regulation (PDF)," speech delivered at the Florida Bankers Association Leadership Luncheon Events, Miami, February 27; Michelle W. Bowman (2024), "Reflections on the Economy and Bank Regulation (PDF) ," speech delivered at the New Jersey Bankers Association Annual Economic Leadership Forum, Somerset, N.J., March 7; and Michelle W. Bowman (2024), " Tailoring, Fidelity to the Rule of Law, and Unintended Consequences (PDF)," speech delivered at the Harvard Law School Faculty Club, Cambridge, Mass., March 5. ${ }^{3}$ See Michelle W. Bowman (2023), "The Consequences of Fewer Banks in the U.S. Banking System (PDF)," speech delivered at the Wharton Financial Regulation Conference, Philadelphia, April 14. ---[PAGE_BREAK]--- ${ }^{4}$ See Jonathan Kanter (2023), "Merger Enforcement Sixty Years after Philadelphia National Bank," speech delivered at the Brookings Institution's Center on Regulation and Markets Event "Promoting Competition in Banking," Washington, June 20; Office of the Comptroller of the Currency (2024), "Business Combinations under the Bank Merger Act: Notice of Proposed Rulemaking," OCC Bulletin 2024-4, January 29; and Federal Deposit Insurance Corporation (2024), "FDIC Seeks Public Comment on Proposed Revisions to Its Statement of Policy on Bank Merger Transactions," press release, March 21. ${ }^{5}$ See Board of Governors of the Federal Reserve System (2023), Banking Applications Activity Semiannual Report, January 1-June 30, 2023 (PDF) (Washington: Board of Governors, September). This report notes that in the first half of 2023, 46 M\&A applications were approved by the Federal Reserve, while 12 such applications were withdrawn. ${ }^{6}$ See Alex Graf, Zuhaib Gull, and Gaby Villaluz (2024), "Credit Unions Dominate EarlyYear Bank M\&A in Washington State," S\&P Global, April 15; and Arizent (2024), "15 Credit Unions That Have Acquired Banks since 2023," American Banker, February 12.	Michelle W Bowman	United States	https://www.bis.org/review/r240701c.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Idaho, Nevada, Oregon and Washington Bankers Associations 2024 Annual Convention, Stevenson, Washington DC, 27 June 2024. I would like to thank the Idaho, Nevada, Oregon, and Washington Bankers Associations for the invitation to join you this morning. It's a pleasure to be here in Washington State to speak with your members. Direct interactions like this, outside of Washington, D.C., enable me to develop a deeper understanding of what is happening in the banking industry and the regional economy. Before sharing some thoughts about the current trajectory of regulatory approvals and bank merger policy, I will discuss my views on the economy and monetary policy. Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our meeting earlier this month, the FOMC voted to continue to hold the federal funds rate target range at 51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress on slowing inflation last year, we have seen only modest further progress this year. The 12-month measures of total and core personal consumption expenditures inflation have moved roughly sideways or slightly down since December and remained elevated at 2.7 percent and 2.8 percent, respectively, in April. The consumer price index (CPI) report for May showed 12-month core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with average core CPI inflation this year through May running at an annualized rate of 3.8 percent, notably above average inflation in the second half of last year, I expect inflation to remain elevated for some time. The recent pickup in inflation in the first several months of 2024 was evident across many goods and services categories, suggesting that inflation was temporarily lower in the latter half of last year. Prices continue to be much higher than before the pandemic, which is weighing on consumer sentiment. Inflation has hit lower-income households hardest since food, energy, and housing services price increases far outpaced overall inflation throughout this episode. Economic activity increased at a strong pace last year but appears to have moderated early this year. First-quarter gross domestic product growth was slower than in the second half of last year, though private domestic final purchases continued to rise at a solid pace. Continued softness in consumer spending and weaker housing activity early in the second quarter also suggest less momentum in economic activity so far this year. Payroll employment continued to rise at a solid pace in April and May, though slightly slower than in the first quarter, partly reflecting increased immigrant labor supply. Despite some further rebalancing between supply and demand, the labor market remains tight. The unemployment rate edged up to 4.0 percent in May, while the number of job openings relative to unemployed workers declined further to near its prepandemic level. Labor force participation dropped back to 62.5 percent in May, which suggests no further improvement in labor supply along this margin, as labor force participation among those aged 55 or older has been persistently low. At its current setting, our monetary policy stance appears to be restrictive, and I will continue to monitor the incoming data to assess whether monetary policy is sufficiently restrictive to bring inflation down to our target. As l've noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady. And should the incoming data indicate that inflation is moving sustainably toward our 2 percent goal, it will eventually become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive. However, we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation. First, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due in part to immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and an open U.S. immigration policy over the past few years, which added millions of new immigrants in the U.S., may become more restrictive. Geopolitical developments could also pose upside risks to inflation, including the risk that spillovers from regional conflicts could disrupt global supply chains, putting additional upward pressure on food, energy, and commodity prices. There is also the risk that the loosening in financial conditions since late last year, reflecting considerable gains in equity valuations, and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate. Finally, there is a risk that increased immigration and continued labor market tightness could lead to persistently high core services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. With labor markets remaining tight, wage growth has been elevated at around or above 4 percent, still higher than the pace consistent with our 2 percent inflation goal given trend productivity growth. In light of these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. The frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how the economy will evolve even more challenging. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook. While the current stance of monetary policy appears to be at a restrictive level, I remain willing to raise the target range for the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment over the longer run. Before turning directly to regulatory approvals in the banking system and merger and acquisition policy, it is important to consider these issues in the broader context. Regulatory approvals and bank mergers and acquisitions do not occur in a vacuum. The choices that regulators make on regulatory and supervisory policy issues have profound implications for mergers and acquisitions and for the appetite of bank management to engage in those transactions. In recent months, the banking agencies have issued or finalized a large number of regulatory changes. These changes are shaping the future of the banking system. From bank capital requirements to liquidity reform, significant revisions to the Community Reinvestment Act, a regulatory attack on banks charging fees for services (including debit card interchange fees), the trend of dialing supervision up to "11" for banks of all sizes, and the ongoing erosion of tailoring all shape the contours of the banking system, including bank size, the activities in which they engage, and where activities occur within the broader financial system. These policy decisions also create incentives and impacts that we must acknowledge and understand. When policymakers flatten and standardize regulations and supervisory expectations, we create strong incentives for banks to achieve greater economies of scale through merger and make it harder for new banks to successfully compete with existing banks. Actually implementing clear merger standards would reduce the number of necessary application denials and withdrawals. Where clear standards exist, those seeking regulatory approval will only file for approval of those transactions that will meet the banking agency standards. In my mind, this would be responsible and effective public policy. I continue to be concerned about the decline in the number of banks in the U.S. As I have noted in the past, there are several indications that there is an unmet demand for new bank creation demonstrated by the ongoing preference for "charter strip" acquisitions, the ongoing shift of activities out of the banking system, and the rising demand for banking-as-a-service partnerships. For the past decade, de novo bank formation has been largely stagnant, even as the banking industry has rapidly evolved over the same time. Many factors influence the pursuit of de novo bank charters, including the interest rate environment, business opportunities, the intense competition for qualified bank management and staff, and potentially less onerous alternatives for financial services to be provided outside of the regulated banking system. The decision to form a de novo bank is also informed by normal business considerations, including identifying investors, establishing a viable business plan, and ensuring the ability to navigate the "start-up" phase of a new bank and manage upfront operational costs, all while being subjected to intense supervisory oversight over the first several years of operation. Yet perhaps the most important factor that influences de novo bank formation is the regulatory and supervisory framework. This includes the application process and receipt of regulatory approval. This application process can be a significant obstacle to de novo bank formation. Applications often experience significant delays between the initial charter application filing with the chartering authority and the Federal Deposit Insurance Corporation application for deposit insurance. It often takes well in excess of a year to receive all of the required regulatory approvals to open for business. Of course, this uncertainty remains after the initial capital has been raised, shareholders identified, and a management team is ready to begin work. These delays present unique challenges for de novo founders, including incurrence of more start-up expenses, difficulty recruiting and retaining qualified management to obtain approval, and challenges in raising additional start-up capital investment. In my view, the absence of de novo bank formation over the long run will create a void in the banking system, a void that could contribute to a decline in the availability of reliable and fairly priced credit, the absence of financial services in underserved markets, and the continued shift of banking activities outside the banking system. Another pressing area of concern is the rapidly shifting approach to bank mergers and acquisitions (M\&A) by some prudential regulators. M\&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote the long-term health and viability of banks. M\&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M\&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and zombie banks that continue to exist but have no competitive viability or exit strategy. The impact of a more restrictive M\&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks. They may choose to pursue M\&A to remain competitive with larger peers who can achieve growth organically through sheer scale. M\&A is an important part of a healthy banking system. So when considering changes to the framework, I think we need to first identify the problem that needs to be solved and then ask whether any proposed solution is fair, transparent, and consistent with applicable statutes-and, critically, whether the proposed solution has the potential to damage the long-term viability of the banking system. Are there identified shortcomings in the current process or standards, and are the proposed reforms targeted and effective to address these shortcomings? One argument I have heard about the M\&A regulatory approval process is that the lack of application denials demonstrates that regulators are failing to meaningfully review and pressure- test proposals and have effectively become a rubber stamp. I think this argument lacks a strong foundation. There is ample evidence that undermines this argument, including the resource demands on institutions pursuing M\&A activity and the extended time it takes to complete the regulatory review and approval process (and the not insignificant failure rate we see represented in withdrawn applications). We also have to acknowledge that choosing the path of a merger or acquisition is not undertaken lightly. These transactions require significant upfront and ongoing investment and commitment of resources. At the outset, this includes finding an appropriate acquisition target, conducting due diligence, and negotiating the terms of the transaction. Once a target is identified, the banks must prepare appropriate regulatory filings, engage with regulators during the application process, and prepare for post-approval business processes, including scheduling necessary and costly systems conversions and customer transition. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. One would also expect to see different patterns emerging if regulators were truly acting as a rubber stamp for banking applications. We know from data published by the Federal Reserve that filing an application does not guarantee approval, even in the absence of a regulatory denial. The Federal Reserve's most recent report on banking applications activity identifies a significant portion of bank M\&A transactions in which applications have been withdrawn. The processing timelines we see also seem inconsistent with a process that is operating truly as a rubber stamp. To be clear, I think we have room to do better when it comes to timely regulatory action, while maintaining a rigorous review of applications. But extended review periods are not uncommon, particularly when you include preliminary discussions and pre-filings with regulators in the published processing timelines. Some contemplated regulatory reform efforts will likely make the M\&A application process slower and less efficient. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. Reducing the efficiency of bank M\&A can be a deterrent to healthy bank transactions. This inefficiency limits activity that ensures the value of community banks located in underserved areas, prevents institutions from pursuing prudent growth strategies, and undermines competition by preventing firms from growing to a larger scale, effectively creating a "protected class" of larger institutions. At the same time some federal regulatory agencies are imposing more onerous requirements, credit unions have increased their acquisitions of banks. While this could solve some succession planning concerns, it is not clear how these acquisitions will ultimately impact the banking system going forward. Could these acquisitions reduce the availability of certain products and services? Will these institutions have the same incentives to serve all of the consumers in a particular community? If there are fewer banks and more credit unions, how will this data impact the competitive analysis of traditional banks merging? Historically, credit unions have had limited membership requirements and have not engaged in the same wide range of activities as banks. But in recent years, their memberships have expanded, and they are offering more of the same products and services that banks provide. Yet, unlike banks, credit unions are not required to meet the requirements of the Community Reinvestment Act or other laws that apply to banks. As some prudential regulators continue to increase the regulatory scrutiny of bank M\&A, it may increase the incentives for credit unions to acquire banks if there are fewer delays and more regulatory certainty related to those transactions. Unfortunately, the past year has shown that regulatory attention is increasingly focused on other issues, with the timeliness of processing regulatory applications by banking regulators appearing to be lower on the list of priorities. The bank regulatory reform agenda has many implications for banks of all sizes. As regulators continue to propose and make changes to the regulatory and supervisory processes, it is vital that policymakers understand the tradeoffs between the costs and benefits of what they are changing. It is equally important that policymakers also understand the unintended consequences of their decisions. While some of the proposed changes may be designed to address particular issues, they will have broader follow-on consequences. Because of these potentially broader consequences, we must address policy from a holistic perspective rather than in a piecemeal fashion. One way to better understand the outcomes of our decisions is to hear directly from you and other stakeholders about the specific impacts-intended and unintended-of changes to the bank regulatory framework. Your feedback helps us to understand the real-world impacts of regulatory and supervisory reforms. Thank you, and I look forward to discussing these and other important issues with you today.
2024-07-01T00:00:00	Christine Lagarde: Monetary policy in an unusual cycle - the risks, the path and the costs	Introductory speech by Ms Christine Lagarde, President of the European Central Bank, at the opening reception of the European Central Bank Forum on Central Banking "Monetary policy in an era of transformation", Sintra, 1 July 2024.	Christine Lagarde: Monetary policy in an unusual cycle - the risks, the path and the costs Introductory speech by Ms Christine Lagarde, President of the European Central Bank, at the opening reception of the European Central Bank Forum on Central Banking "Monetary policy in an era of transformation", Sintra, 1 July 2024. * * * First of all, I would like to welcome you all to this year's ECB Forum. The theme of the conference is "Monetary policy in an era of transformation", and we have a rich programme ahead of us, exploring the changes that are taking place. But even if most of us can agree that the economy is undergoing substantial change, I imagine there are more diverging views about where it will end up. This lack of clarity presents a profound challenge for policymakers, as we must try at once to understand these transformations and to steer the economy through them. Indeed, much of the policy challenge over the last few years has involved stabilising inflation while facing fundamental uncertainty about the economy. Nevertheless, we have managed to chart a path through this uncertainty, and we have come a long way in the fight against inflation. In October 2022, inflation peaked at 10.6%. By September 2023, the last time we raised rates, it had fallen by more than half, to 5.2%. And then after nine months of holding rates steady, we saw inflation halve again to 2.6%, which led us to cut rates for the first time in June. Our work is not done, and we need to remain vigilant. But this progress allows us to look back and reflect on the path we have taken. This evening I would like to talk about three specific features that have defined this policy cycle: the risks, the path and the costs.1 The risks Let me start with the risks. In a typical policy cycle, when fluctuations are driven by moderate and short-lived shocks, inflation expectations are usually not at risk. Central banks' price stability mandates and reaction functions ensure confidence in the inflation target. When faced with typical demand shocks, central banks reach their target by stabilising demand around potential output. And when faced with supply shocks, central banks can in principle "look through" them, as these shocks will usually leave no lasting imprint on inflation. But this low risk to inflation expectations only applies when shocks are indeed moderate and short-lived. In situations where there is a risk of shocks becoming larger and more persistent, inflation expectations can de-anchor regardless of whether the shocks are demand-led or supply-led. Central banks must then react forcefully to prevent above-target inflation becoming entrenched. This was the lesson of the 1970s, when a sequence of supply shocks caused by rising oil prices ultimately morphed into a lasting inflationary shock. And with central banks at the time being seen as ambivalent about bringing down inflation, people revised their expectations about medium-term inflation. Different studies reach different conclusions about the origin of the current inflation episode. ECB analysis finds that, at the peak, supply shocks were three times more important than demand shocks in explaining the deviation of inflation from its mean.2 Other research puts a greater emphasis on demand shocks.3 But this delineation between supply and demand, while relevant, has not been the most important factor in our current cycle. We needed to base our decisions not only on the source of the shocks, but also on their size and persistence. This was because the shocks were so large and persistent that we faced a genuine risk to inflation expectations. Two features could have provided fertile ground for people to lose confidence in the monetary anchor. First, the shocks were large enough to make many households switch their attention to inflation. At the start of 2023, over 60% of respondents in our consumer expectations survey reported that they were paying more attention to inflation than in the past.4 Second, the inflationary impact of the shocks risked becoming endogenously persistent, owing mainly to the staggered wage bargaining process in the euro area. Although there is large variation across countries, the average duration of wage contracts is two years, effectively guaranteeing a drawn-out process to "catch up" with past inflation.5 We did see some signs that the anchoring of inflation expectations was becoming more vulnerable, especially via a fattening of the "right tail" of the distribution. In October 2022, around four in ten consumers expected medium-term inflation to be at or above 5% and professional forecasters assigned a 30% probability of inflation being at or above 3% two years later.6 So, monetary policy had to send a strong signal that permanent overshoots of the inflation target would not be tolerated. As a result, we strongly emphasised our determination to ensure a "timely" return to target. Our aim was to convey our commitment to ensuring that the period of high inflation would be limited and signal a sense of urgency. The path But how does monetary policy anchor inflation expectations? It is not only about the policy destination, but also about setting the right trajectory of rates to get there. This brings me to the second specific feature of this cycle: the rate path. It was clear from the outset that merely communicating our commitment to reaching our target would not have been enough. ECB analysis shows that, if we had not reacted at all, the risk of de-anchoring would have been above 30% in 2023 and 2024.7 It is likely that even moderate policy action would have been insufficient. For example, if rates had stopped at 2%, the risk of de-anchoring would still have been around 24%. So, when we first started raising rates, we knew that we were far from where we needed to be. The most important factor was therefore to close the gap as quickly as possible. This is why we had a historically steep climb at the start of our rate path, using increments of 75 and 50 basis points for our first six rate increases. But as policy rates moved towards restrictive territory, the challenge shifted from acting quickly to calibrating the path precisely. In particular, we needed to set a rate path that both delivered a "timely" return to 2% and did so with a high degree of confidence. This path also required us to take a different approach from the past. Faced with multiple large shocks, there was significant uncertainty about how to interpret and rank the information we were receiving from the economy. On the one hand, it would have been risky to rely too much on models trained on historical data, as those data may no longer have been valid. We could not know, for instance, whether shifts in preferences, higher energy prices and geopolitics had changed the structure of the economy. On the other hand, relying too much on current data might have been equally misleading if they had turned out to have little predictive power for the medium term. As shocks worked their way through the economy, current data could also have reflected lags more than actual inflation trends. So we constructed a framework to hedge against this uncertainty, blending projections with current data about underlying inflation and monetary transmission. The aim was to combine various pieces of information about the medium-term outlook into a single assessment that could be updated swiftly. Our forecasts provided a comprehensive assessment of future inflation, assuming the underlying parameters of the economy remained stable. At the same time, looking at current data allowed us to identify the persistent components of inflation and account for structural changes that might have been missing from our forecast models.8 In this reaction function, our assessment of the inflation outlook is informed by, but not limited to, our projections. We use various measures to gauge underlying inflation. And when assessing the strength of monetary policy, we consider banks, capital markets and the real economy. As a result, while the flow of new information constantly adds to and improves our picture of medium-term inflation, we are not pushed around by any specific data point. Data dependence does not mean data point dependence. This framework helped us navigate the "tightening" and "holding" phases of our policy cycle, and it gave us the confidence to deliver a first rate cut at our last policy meeting. During these phases, we have seen the "right tail" of the distribution of inflation expectations narrow, consistent with a timely return of inflation to target. The costs But while our policy path has helped to tame inflation, it has also dampened economic growth. Interest rates rose steadily and remained high while the economy was stagnating for five straight quarters. This pattern is unavoidable when central banks face shocks that push inflation and output in opposing directions. But this time, the costs of disinflation have been contained compared with similar episodes in the past. This brings me to the third specific feature of this cycle. Given the magnitude of the shock to inflation, a "soft landing" is still not guaranteed. If we look at historical rate cycles since 1970, we can see that when major central banks hiked interest rates while energy prices were high, the costs for the economy were usually quite steep.9 Only around 15% of the successful soft landings in this period - defined as avoiding either a recession or a major deterioration of employment - have been achieved following energy price shocks. But this cycle has so far not followed past patterns. Inflation peaked at a much higher point than during previous soft landings, but it also decelerated faster. Growth has remained within the range of previous soft landing episodes, albeit near the bottom of that range. And the performance of the labour market has been exceptionally benign. Employment has grown despite slowing GDP growth, rising by 2.6 million people since the end of 2022. And unemployment is at historical lows for the euro area, and well within the range observed during previous soft landings across major economies. The resilience of the labour market is itself a reflection of the unusual mix of shocks that have hit the euro area, with labour shortages leading firms to hoard more labour, and higher profits and lower real wages making it easier for them to do so.10 As a result, the usual propagation from slower growth to heightened unemployment risks and lower demand did not happen to the same extent. Now, we are still facing several uncertainties regarding future inflation, especially in terms of how the nexus of profits, wages and productivity will evolve and whether the economy will be hit by new supply-side shocks. And it will take time for us to gather sufficient data to be certain that the risks of above-target inflation have passed. The strong labour market means that we can take time to gather new information, but we also need to be mindful of the fact that the growth outlook remains uncertain. All of this underpins our determination to be data dependent and to take our policy decisions meeting by meeting. Conclusion Let me conclude. Our policy decisions have successfully kept inflation expectations anchored, and inflation is projected to return to 2% in the latter part of next year. Considering the size of the inflation shock, this unwinding is remarkable in many ways. Even though millions of businesses and workers have been independently striving to protect their profits and incomes, our 2% inflation target has remained credible and has continued to anchor the inflation process. This speaks to the value of the policy frameworks that central banks have built up over the last 30 years, focusing on price stability and central bank independence. And it is why we will not waver from our commitment to bring inflation back down to our target for the benefit of all Europeans. As the late footballer and manager Sir Bobby Robson said, "the first 90 minutes are the most important". Similarly, we will not rest until the match is won and inflation is back at 2%. 1 For a complementary discussion about how monetary policy cycles have evolved during the last half century in many advanced economies and how the current cycle in those countries differs from the past, see Forbes, K., Ha, J. and Kose, M.A. (2024), " Rate cycles ", paper presented at the ECB Forum on Central Banking, Sintra. 2 Babura, M. et al. (2023), " What drives core inflation? The role of supply shocks ", Working Paper Series , No 2875, ECB. 3 Giannone, D. and Primiceri, G. (2024), " The drivers of post-pandemic inflation ", paper presented at the ECB Forum on Central Banking, Sintra. D'Acunto, F., Charalambakis, E., Georgarakos, D., Kenny, G., Meyer, J. and Weber, M. (2024), "Household inflation expectations: an overview of recent insights for Discussion Paper Series monetary policy ", , No 24, ECB. 5 Górnicka, L. and Koester, G. (eds) (2024), "A forward-looking tracker of negotiated wages in the euro area", Occasional Paper Series , No 338, ECB. 6 ECB (2022), " Inflation perceptions and expectations ", 7 December; and ECB (2022), " The ECB Survey of Professional Forecasters - Fourth quarter of 2022 ", October. 7 Christoffel, K. and Farkas, M. (2024), "Monetary policy and the risks of de-anchoring of inflation expectations", IMF Working Papers , forthcoming. 8 Lagarde, C. (2024), " Policymaking in a new risk environment ", speech at the 30th Dubrovnik Economic Conference, 14 June. 9 According to ECB analysis based on a sample of 48 monetary policy cycles across nine inflation-targeting central banks covering the period 1970-2022. See the forthcoming post on The ECB Blog entitled "Navigating inflation: a historical perspective of monetary policy cycles". 10 Arce, O. and Sondermann, D. (2024), "Low for long? Reasons for the recent decline in productivity ", The ECB Blog, 6 May.	---[PAGE_BREAK]--- # Christine Lagarde: Monetary policy in an unusual cycle - the risks, the path and the costs Introductory speech by Ms Christine Lagarde, President of the European Central Bank, at the opening reception of the European Central Bank Forum on Central Banking "Monetary policy in an era of transformation", Sintra, 1 July 2024. First of all, I would like to welcome you all to this year's ECB Forum. The theme of the conference is "Monetary policy in an era of transformation", and we have a rich programme ahead of us, exploring the changes that are taking place. But even if most of us can agree that the economy is undergoing substantial change, I imagine there are more diverging views about where it will end up. This lack of clarity presents a profound challenge for policymakers, as we must try at once to understand these transformations and to steer the economy through them. Indeed, much of the policy challenge over the last few years has involved stabilising inflation while facing fundamental uncertainty about the economy. Nevertheless, we have managed to chart a path through this uncertainty, and we have come a long way in the fight against inflation. In October 2022, inflation peaked at 10.6\%. By September 2023, the last time we raised rates, it had fallen by more than half, to $5.2 \%$. And then after nine months of holding rates steady, we saw inflation halve again to $2.6 \%$, which led us to cut rates for the first time in June. Our work is not done, and we need to remain vigilant. But this progress allows us to look back and reflect on the path we have taken. This evening I would like to talk about three specific features that have defined this policy cycle: the risks, the path and the costs. ${ }^{1}$ ## The risks Let me start with the risks. In a typical policy cycle, when fluctuations are driven by moderate and short-lived shocks, inflation expectations are usually not at risk. Central banks' price stability mandates and reaction functions ensure confidence in the inflation target. When faced with typical demand shocks, central banks reach their target by stabilising demand around potential output. And when faced with supply shocks, central banks can in principle "look through" them, as these shocks will usually leave no lasting imprint on inflation. ---[PAGE_BREAK]--- But this low risk to inflation expectations only applies when shocks are indeed moderate and short-lived. In situations where there is a risk of shocks becoming larger and more persistent, inflation expectations can de-anchor regardless of whether the shocks are demand-led or supply-led. Central banks must then react forcefully to prevent above-target inflation becoming entrenched. This was the lesson of the 1970s, when a sequence of supply shocks caused by rising oil prices ultimately morphed into a lasting inflationary shock. And with central banks at the time being seen as ambivalent about bringing down inflation, people revised their expectations about medium-term inflation. Different studies reach different conclusions about the origin of the current inflation episode. ECB analysis finds that, at the peak, supply shocks were three times more important than demand shocks in explaining the deviation of inflation from its mean. $\underline{2}$ Other research puts a greater emphasis on demand shocks. $\underline{3}$ But this delineation between supply and demand, while relevant, has not been the most important factor in our current cycle. We needed to base our decisions not only on the source of the shocks, but also on their size and persistence. This was because the shocks were so large and persistent that we faced a genuine risk to inflation expectations. Two features could have provided fertile ground for people to lose confidence in the monetary anchor. First, the shocks were large enough to make many households switch their attention to inflation. At the start of 2023, over 60\% of respondents in our consumer expectations survey reported that they were paying more attention to inflation than in the past. $\underline{4}$ Second, the inflationary impact of the shocks risked becoming endogenously persistent, owing mainly to the staggered wage bargaining process in the euro area. Although there is large variation across countries, the average duration of wage contracts is two years, effectively guaranteeing a drawn-out process to "catch up" with past inflation. $\underline{5}$ We did see some signs that the anchoring of inflation expectations was becoming more vulnerable, especially via a fattening of the "right tail" of the distribution. In October 2022, around four in ten consumers expected medium-term inflation to be at or above $5 \%$ and professional forecasters assigned a $30 \%$ probability of inflation being at or above $3 \%$ two years later. $\underline{6}$ So, monetary policy had to send a strong signal that permanent overshoots of the inflation target would not be tolerated. As a result, we strongly emphasised our determination to ensure a "timely" return to target. Our aim was to convey our commitment to ensuring that the period of high inflation would be limited and signal a sense of urgency. ---[PAGE_BREAK]--- # The path But how does monetary policy anchor inflation expectations? It is not only about the policy destination, but also about setting the right trajectory of rates to get there. This brings me to the second specific feature of this cycle: the rate path. It was clear from the outset that merely communicating our commitment to reaching our target would not have been enough. ECB analysis shows that, if we had not reacted at all, the risk of de-anchoring would have been above $30 \%$ in 2023 and 2024. 7 It is likely that even moderate policy action would have been insufficient. For example, if rates had stopped at $2 \%$, the risk of de-anchoring would still have been around $24 \%$. So, when we first started raising rates, we knew that we were far from where we needed to be. The most important factor was therefore to close the gap as quickly as possible. This is why we had a historically steep climb at the start of our rate path, using increments of 75 and 50 basis points for our first six rate increases. But as policy rates moved towards restrictive territory, the challenge shifted from acting quickly to calibrating the path precisely. In particular, we needed to set a rate path that both delivered a "timely" return to $2 \%$ and did so with a high degree of confidence. This path also required us to take a different approach from the past. Faced with multiple large shocks, there was significant uncertainty about how to interpret and rank the information we were receiving from the economy. On the one hand, it would have been risky to rely too much on models trained on historical data, as those data may no longer have been valid. We could not know, for instance, whether shifts in preferences, higher energy prices and geopolitics had changed the structure of the economy. On the other hand, relying too much on current data might have been equally misleading if they had turned out to have little predictive power for the medium term. As shocks worked their way through the economy, current data could also have reflected lags more than actual inflation trends. So we constructed a framework to hedge against this uncertainty, blending projections with current data about underlying inflation and monetary transmission. The aim was to combine various pieces of information about the medium-term outlook into a single assessment that could be updated swiftly. Our forecasts provided a comprehensive assessment of future inflation, assuming the underlying parameters of the economy remained stable. At the same time, looking at current data allowed us to identify the persistent components of inflation and account for structural changes that might have been missing from our forecast models. $\underline{8}$ In this reaction function, our assessment of the inflation outlook is informed by, but not limited to, our projections. We use various measures to gauge underlying inflation. And ---[PAGE_BREAK]--- when assessing the strength of monetary policy, we consider banks, capital markets and the real economy. As a result, while the flow of new information constantly adds to and improves our picture of medium-term inflation, we are not pushed around by any specific data point. Data dependence does not mean data point dependence. This framework helped us navigate the "tightening" and "holding" phases of our policy cycle, and it gave us the confidence to deliver a first rate cut at our last policy meeting. During these phases, we have seen the "right tail" of the distribution of inflation expectations narrow, consistent with a timely return of inflation to target. # The costs But while our policy path has helped to tame inflation, it has also dampened economic growth. Interest rates rose steadily and remained high while the economy was stagnating for five straight quarters. This pattern is unavoidable when central banks face shocks that push inflation and output in opposing directions. But this time, the costs of disinflation have been contained compared with similar episodes in the past. This brings me to the third specific feature of this cycle. Given the magnitude of the shock to inflation, a "soft landing" is still not guaranteed. If we look at historical rate cycles since 1970, we can see that when major central banks hiked interest rates while energy prices were high, the costs for the economy were usually quite steep. $\underline{9}$ Only around $15 \%$ of the successful soft landings in this period - defined as avoiding either a recession or a major deterioration of employment - have been achieved following energy price shocks. But this cycle has so far not followed past patterns. Inflation peaked at a much higher point than during previous soft landings, but it also decelerated faster. Growth has remained within the range of previous soft landing episodes, albeit near the bottom of that range. And the performance of the labour market has been exceptionally benign. Employment has grown despite slowing GDP growth, rising by 2.6 million people since the end of 2022. And unemployment is at historical lows for the euro area, and well within the range observed during previous soft landings across major economies. The resilience of the labour market is itself a reflection of the unusual mix of shocks that have hit the euro area, with labour shortages leading firms to hoard more labour, and higher profits and lower real wages making it easier for them to do so. $\underline{10}$ ---[PAGE_BREAK]--- As a result, the usual propagation from slower growth to heightened unemployment risks and lower demand did not happen to the same extent. Now, we are still facing several uncertainties regarding future inflation, especially in terms of how the nexus of profits, wages and productivity will evolve and whether the economy will be hit by new supply-side shocks. And it will take time for us to gather sufficient data to be certain that the risks of above-target inflation have passed. The strong labour market means that we can take time to gather new information, but we also need to be mindful of the fact that the growth outlook remains uncertain. All of this underpins our determination to be data dependent and to take our policy decisions meeting by meeting. # Conclusion Let me conclude. Our policy decisions have successfully kept inflation expectations anchored, and inflation is projected to return to $2 \%$ in the latter part of next year. Considering the size of the inflation shock, this unwinding is remarkable in many ways. Even though millions of businesses and workers have been independently striving to protect their profits and incomes, our 2\% inflation target has remained credible and has continued to anchor the inflation process. This speaks to the value of the policy frameworks that central banks have built up over the last 30 years, focusing on price stability and central bank independence. And it is why we will not waver from our commitment to bring inflation back down to our target for the benefit of all Europeans. As the late footballer and manager Sir Bobby Robson said, "the first 90 minutes are the most important". Similarly, we will not rest until the match is won and inflation is back at $2 \%$. 1 For a complementary discussion about how monetary policy cycles have evolved during the last half century in many advanced economies and how the current cycle in those countries differs from the past, see Forbes, K., Ha, J. and Kose, M.A. (2024), " Rate cycles", paper presented at the ECB Forum on Central Banking, Sintra. ${ }^{2}$ Babura, M. et al. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB. ${ }^{3}$ Giannone, D. and Primiceri, G. (2024), "The drivers of post-pandemic inflation", paper presented at the ECB Forum on Central Banking, Sintra. ---[PAGE_BREAK]--- ${ }^{4}$ D'Acunto, F., Charalambakis, E., Georgarakos, D., Kenny, G., Meyer, J. and Weber, M. (2024), "Household inflation expectations: an overview of recent insights for monetary policy", Discussion Paper Series, No 24, ECB. ${ }^{5}$ Górnicka, L. and Koester, G. (eds) (2024), "A forward-looking tracker of negotiated wages in the euro area", Occasional Paper Series, No 338, ECB. ${ }^{6}$ ECB (2022), "Inflation perceptions and expectations", 7 December; and ECB (2022), " The ECB Survey of Professional Forecasters - Fourth quarter of 2022", October. ${ }^{7}$ Christoffel, K. and Farkas, M. (2024), "Monetary policy and the risks of de-anchoring of inflation expectations", IMF Working Papers, forthcoming. ${ }^{8}$ Lagarde, C. (2024), "Policymaking in a new risk environment", speech at the 30th Dubrovnik Economic Conference, 14 June. ${ }^{9}$ According to ECB analysis based on a sample of 48 monetary policy cycles across nine inflation-targeting central banks covering the period 1970-2022. See the forthcoming post on The ECB Blog entitled "Navigating inflation: a historical perspective of monetary policy cycles". ${ }^{10}$ Arce, O. and Sondermann, D. (2024), "Low for long? Reasons for the recent decline in productivity", The ECB Blog, 6 May.	Christine Lagarde	Euro area	https://www.bis.org/review/r240702a.pdf	Introductory speech by Ms Christine Lagarde, President of the European Central Bank, at the opening reception of the European Central Bank Forum on Central Banking "Monetary policy in an era of transformation", Sintra, 1 July 2024. First of all, I would like to welcome you all to this year's ECB Forum. The theme of the conference is "Monetary policy in an era of transformation", and we have a rich programme ahead of us, exploring the changes that are taking place. But even if most of us can agree that the economy is undergoing substantial change, I imagine there are more diverging views about where it will end up. This lack of clarity presents a profound challenge for policymakers, as we must try at once to understand these transformations and to steer the economy through them. Indeed, much of the policy challenge over the last few years has involved stabilising inflation while facing fundamental uncertainty about the economy. Nevertheless, we have managed to chart a path through this uncertainty, and we have come a long way in the fight against inflation. In October 2022, inflation peaked at 10.6\%. By September 2023, the last time we raised rates, it had fallen by more than half, to $5.2 \%$. And then after nine months of holding rates steady, we saw inflation halve again to $2.6 \%$, which led us to cut rates for the first time in June. Our work is not done, and we need to remain vigilant. But this progress allows us to look back and reflect on the path we have taken. This evening I would like to talk about three specific features that have defined this policy cycle: the risks, the path and the costs. Let me start with the risks. In a typical policy cycle, when fluctuations are driven by moderate and short-lived shocks, inflation expectations are usually not at risk. Central banks' price stability mandates and reaction functions ensure confidence in the inflation target. When faced with typical demand shocks, central banks reach their target by stabilising demand around potential output. And when faced with supply shocks, central banks can in principle "look through" them, as these shocks will usually leave no lasting imprint on inflation. But this low risk to inflation expectations only applies when shocks are indeed moderate and short-lived. In situations where there is a risk of shocks becoming larger and more persistent, inflation expectations can de-anchor regardless of whether the shocks are demand-led or supply-led. Central banks must then react forcefully to prevent above-target inflation becoming entrenched. This was the lesson of the 1970s, when a sequence of supply shocks caused by rising oil prices ultimately morphed into a lasting inflationary shock. And with central banks at the time being seen as ambivalent about bringing down inflation, people revised their expectations about medium-term inflation. Different studies reach different conclusions about the origin of the current inflation episode. ECB analysis finds that, at the peak, supply shocks were three times more important than demand shocks in explaining the deviation of inflation from its mean. But this delineation between supply and demand, while relevant, has not been the most important factor in our current cycle. We needed to base our decisions not only on the source of the shocks, but also on their size and persistence. This was because the shocks were so large and persistent that we faced a genuine risk to inflation expectations. Two features could have provided fertile ground for people to lose confidence in the monetary anchor. First, the shocks were large enough to make many households switch their attention to inflation. At the start of 2023, over 60\% of respondents in our consumer expectations survey reported that they were paying more attention to inflation than in the past. Second, the inflationary impact of the shocks risked becoming endogenously persistent, owing mainly to the staggered wage bargaining process in the euro area. Although there is large variation across countries, the average duration of wage contracts is two years, effectively guaranteeing a drawn-out process to "catch up" with past inflation. We did see some signs that the anchoring of inflation expectations was becoming more vulnerable, especially via a fattening of the "right tail" of the distribution. In October 2022, around four in ten consumers expected medium-term inflation to be at or above $5 \%$ and professional forecasters assigned a $30 \%$ probability of inflation being at or above $3 \%$ two years later. So, monetary policy had to send a strong signal that permanent overshoots of the inflation target would not be tolerated. As a result, we strongly emphasised our determination to ensure a "timely" return to target. Our aim was to convey our commitment to ensuring that the period of high inflation would be limited and signal a sense of urgency. But how does monetary policy anchor inflation expectations? It is not only about the policy destination, but also about setting the right trajectory of rates to get there. This brings me to the second specific feature of this cycle: the rate path. It was clear from the outset that merely communicating our commitment to reaching our target would not have been enough. ECB analysis shows that, if we had not reacted at all, the risk of de-anchoring would have been above $30 \%$ in 2023 and 2024. It is likely that even moderate policy action would have been insufficient. For example, if rates had stopped at $2 \%$, the risk of de-anchoring would still have been around $24 \%$. So, when we first started raising rates, we knew that we were far from where we needed to be. The most important factor was therefore to close the gap as quickly as possible. This is why we had a historically steep climb at the start of our rate path, using increments of 75 and 50 basis points for our first six rate increases. But as policy rates moved towards restrictive territory, the challenge shifted from acting quickly to calibrating the path precisely. In particular, we needed to set a rate path that both delivered a "timely" return to $2 \%$ and did so with a high degree of confidence. This path also required us to take a different approach from the past. Faced with multiple large shocks, there was significant uncertainty about how to interpret and rank the information we were receiving from the economy. On the one hand, it would have been risky to rely too much on models trained on historical data, as those data may no longer have been valid. We could not know, for instance, whether shifts in preferences, higher energy prices and geopolitics had changed the structure of the economy. On the other hand, relying too much on current data might have been equally misleading if they had turned out to have little predictive power for the medium term. As shocks worked their way through the economy, current data could also have reflected lags more than actual inflation trends. So we constructed a framework to hedge against this uncertainty, blending projections with current data about underlying inflation and monetary transmission. The aim was to combine various pieces of information about the medium-term outlook into a single assessment that could be updated swiftly. Our forecasts provided a comprehensive assessment of future inflation, assuming the underlying parameters of the economy remained stable. At the same time, looking at current data allowed us to identify the persistent components of inflation and account for structural changes that might have been missing from our forecast models. In this reaction function, our assessment of the inflation outlook is informed by, but not limited to, our projections. We use various measures to gauge underlying inflation. And when assessing the strength of monetary policy, we consider banks, capital markets and the real economy. As a result, while the flow of new information constantly adds to and improves our picture of medium-term inflation, we are not pushed around by any specific data point. Data dependence does not mean data point dependence. This framework helped us navigate the "tightening" and "holding" phases of our policy cycle, and it gave us the confidence to deliver a first rate cut at our last policy meeting. During these phases, we have seen the "right tail" of the distribution of inflation expectations narrow, consistent with a timely return of inflation to target. But while our policy path has helped to tame inflation, it has also dampened economic growth. Interest rates rose steadily and remained high while the economy was stagnating for five straight quarters. This pattern is unavoidable when central banks face shocks that push inflation and output in opposing directions. But this time, the costs of disinflation have been contained compared with similar episodes in the past. This brings me to the third specific feature of this cycle. Given the magnitude of the shock to inflation, a "soft landing" is still not guaranteed. If we look at historical rate cycles since 1970, we can see that when major central banks hiked interest rates while energy prices were high, the costs for the economy were usually quite steep. Only around $15 \%$ of the successful soft landings in this period - defined as avoiding either a recession or a major deterioration of employment - have been achieved following energy price shocks. But this cycle has so far not followed past patterns. Inflation peaked at a much higher point than during previous soft landings, but it also decelerated faster. Growth has remained within the range of previous soft landing episodes, albeit near the bottom of that range. And the performance of the labour market has been exceptionally benign. Employment has grown despite slowing GDP growth, rising by 2.6 million people since the end of 2022. And unemployment is at historical lows for the euro area, and well within the range observed during previous soft landings across major economies. The resilience of the labour market is itself a reflection of the unusual mix of shocks that have hit the euro area, with labour shortages leading firms to hoard more labour, and higher profits and lower real wages making it easier for them to do so. As a result, the usual propagation from slower growth to heightened unemployment risks and lower demand did not happen to the same extent. Now, we are still facing several uncertainties regarding future inflation, especially in terms of how the nexus of profits, wages and productivity will evolve and whether the economy will be hit by new supply-side shocks. And it will take time for us to gather sufficient data to be certain that the risks of above-target inflation have passed. The strong labour market means that we can take time to gather new information, but we also need to be mindful of the fact that the growth outlook remains uncertain. All of this underpins our determination to be data dependent and to take our policy decisions meeting by meeting. Let me conclude. Our policy decisions have successfully kept inflation expectations anchored, and inflation is projected to return to $2 \%$ in the latter part of next year. Considering the size of the inflation shock, this unwinding is remarkable in many ways. Even though millions of businesses and workers have been independently striving to protect their profits and incomes, our 2\% inflation target has remained credible and has continued to anchor the inflation process. This speaks to the value of the policy frameworks that central banks have built up over the last 30 years, focusing on price stability and central bank independence. And it is why we will not waver from our commitment to bring inflation back down to our target for the benefit of all Europeans. As the late footballer and manager Sir Bobby Robson said, "the first 90 minutes are the most important". Similarly, we will not rest until the match is won and inflation is back at $2 \%$.
2024-07-03T00:00:00	John C Williams: R-star - a global perspective	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the European Central Bank Forum on Central Banking "Monetary policy in an era of transformation", Sintra, 3 July 2024.	FEDERAL RESERVE BANK of NEW YORK Serving the Second District and the Nation SPEECH R-Star: A Global Perspective July 03, 2024 John C. Williams, President and Chief Executive Officer Remarks at the ECB Forum on Central Banking, Sintra, Portugal As prepared for delivery For over 125 years, economists have grappled with a dilemma: How can a concept at the very heart of monetary theory be so vexing to quantify? I'm talking, of course, about r-star, the natural rate of interest. The quotations listed in Table 1 reflect the age- old challenges surrounding it.' Recently, r-star has been in the spotlight once again. Today, my remarks will focus on longer-run r-star, which is the real interest rate expected to prevail when shocks to the economy have receded and the economy is growing at its potential rate. Before I go further, I'll provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Three Approaches Subsequent to Milton Friedman's claim to the contrary," there are now three common approaches to inferring r-star from data: using a statistical method to extract a longer-run trend, basing it on financial market or survey data, or looking at r-star's effects on economic data. Each provides useful information, but each also poses significant challenges. As discussed in one of my papers with Thomas Laubach, univariate statistical methods do not adequately control for economic factors that influence interest rates. And these estimates can be overly influenced by large macroeconomic disturbances, such as the inflation of the 1970s or the pandemic.? Financial market and survey data are subject to measurement issues and, in any case, tell us what people are thinking about r-star, rather than act as an independent source of information on r-star. This is what I have referred to as a "hall of mirrors."4 For these reasons, I will focus my remarks on estimates of r-star gleaned from macroeconomic models that do not rely on financial market or survey data-in particular, the Holston-Laubach-Williams (HLW) model, which infers the natural rate of interest through the behavior of interest rates, inflation, and GDP.5 Or, as the economist John H. Williams put it, "by its works."° A Global Supply and Demand for Savings Our estimates of r-star in the euro area and the United States fell dramatically over the quarter century leading up to the pandemic, and they are currently near the estimates from prior to the pandemic. Figure 1 shows the time series of r-star estimates for the euro area and the United States. I'll focus first on the euro area. The estimate of r-star in the euro area is 0.5 percent in 2023, equal to its average over the five years prior to the outbreak of COVID. This assessment of a very low r-star is broadly consistent with analysis by ECB economists using a variety of models." The sizable decline in estimates of r-star during the decades prior to the pandemic is common to many advanced and emerging economies. It reflects developments related to the global supply and demand for savings.® These include falling birth rates and relatively low productivity growth that both reduce demand for savings, as well as increases in longevity and wealth inequality that increase the supply of savings. I emphasize the word global, because in a world of open capital markets, one should expect r-star to be highly correlated across countries. Indeed, there is evidence that r-star estimates are highly interconnected in advanced economies, although local factors play a role as well.9 The role of common and idiosyncratic factors is seen by comparing the estimates for the euro area to those for the United States, also shown in Figure 1. Although the two sets of estimates display some shorter-term wiggles, the dominant shared feature is the sustained two-percentage-point decline in r-star over the past 30 years. The same pattern is true of our estimates for Canada. Hence, according to these estimates, the low r-star regime endures. Is R-Star Rising? This finding runs counter to recent commentary suggesting that r-star has risen due to persistent changes in the balance between the supply and demand for savings, such as higher investment in AI and renewable energy, as well as larger government debt. In fact, some measures of longer-run r-star have risen to levels well above those directly prior to the pandemic. For example, market- based measures of five-year, five-year-forward real rates for the euro area and the United States have risen well above the HLW estimates, as shown in Figure 2. Two things stand out from this figure. First, until recently, far-forward real rates displayed a broadly similar pattern of decline as the model estimates of r-star. Second, the market-based measures are volatile. Indeed, in the years before the recent rise, they had fallen to very low levels, well below the corresponding model estimates. This points to a significant time-varying risk premium, which interferes with taking market-based measures at face value in assessing what markets are telling us about their perceptions of r-star. For example, based on the D'Amico, Kim, and Wei term structure model, the estimated rise in U.S. far-forward expected real yields since the onset of the pandemic is significantly smaller than that implied by a direct read of real yields.*° Where does this leave us regarding r-star? Although the value of r-star is always highly uncertain, the case for a sizable increase in r-star has yet to meet two important tests. First, owing to the interconnectedness of r-star across countries, plausible factors pushing up r-star on a sustained basis are likely to be global in nature. This highlights a tension between the evidence from Europe that r-star is still very low and arguments in the United States that r-star is now closer to levels seen 20 years ago. Second, any increase in r-star must overcome the forces that have been pushing r-star down for decades." In this regard, recent data reinforce the continuation of pre-pandemic trends in global demographics and productivity growth. One lens through which to see this is our model estimates of potential GDP, or y-star, which is a key factor that affects r-star. Many of the explanations arguing for a higher r-star would likely show up in higher potential output growth. However, the HLW estimates of euro area and U.S. trend potential GDP growth in 2023 are nearly unchanged from their respective 2019 values. This is consistent with other estimates of potential GDP growth for the euro area and the United States. '? R-Star and Monetary Policy I will end with a brief comment on the usefulness of estimates of r-star for policymaking. First, as the Swedish economist Knut Wicksell and others have stressed, r-star is either explicitly or implicitly at the core of any macroeconomic model or framework one can imagine. Pretending it doesn't exist or wishing it away does not change that. In that context, it is important that we do our best to understand the factors that affect r-star and the uncertainties related to it, so that we have the best understanding possible of the forces affecting the longer-term evolution of the economy. Second, and equally important, as shown in my work with Athanasios Orphanides, the high degree of uncertainty about r-star means that one should not overly rely on estimates of r-star in determining the appropriate setting of monetary policy at a given point in time.' Instead, such determinations must be, and are, based on a wide range of information and assessments, including those related to risks. Presentation por 1 The original sources of the quotations are the following: Knut Wicksell, 1898. Interest and Prices: A Study of the Causes Regulating the Value of Money. Translated by R. F. Kahn, London: Macmillan, published 1936. Gustav Cassel, 1928. "The Rate of Interest, the Bank Rate, and the Stabilization of Prices," The Quarterly Journal of Economics 42(4): 511-29. John H. Williams, 1931. "The Monetary Doctrines of J. M. Keynes," The Quarterly Journal of Economics 45(4): 547-87. Milton Friedman, 1968. "The Role of Monetary Policy," The American Economic Review58(1): 1-17. Thomas Laubach and John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics 85(4): 1063-70. The first four quotations were originally compiled in Athanasios Orphanides and John C. Williams, 2002. "Robust Monetary Policy Rules with Unknown Natural Rates," Brookings Papers on Economic Activity, 2: pp. 63-145. ? Milton Friedman, 1968. "The Role of Monetary Policy," The American Economic Review 58(1): 1-17. 3 Thomas Laubach and John C. Williams, 2016. "Measuring the Natural Rate of Interest Redux," Business Economics, 51: 51-67. 4 John C. Williams, 2017. Comment on "Safety, Liquidity, and the Natural Rate of Interest," by Marco Del Negro, Marc P. Giannoni, Domenico Giannone, and Andrea Tambalotti, Brookings Papers on Economic Activity, 1: pp. 235-316. 5 Kathryn Holston, Thomas Laubach, and John C. Williams, 2017. "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics 559-75; Kathryn Holston, Thomas Laubach, and John C. Williams, 2023. "Measuring the Natural Rate of Interest after COVID-19," Federal Reserve Bank of New York, Staff Reports, no. 1063. 6 John H. Williams, 1931. "The Monetary Doctrines of J. M. Keynes," The Quarterly Journal of Economics 45(4): 547-87- 7 Claus Brand, Noémie Lisack, and Falk Mazelis, 2024. "Estimates of the Natural Interest Rate for the Euro Area: An Update," European Central Bank, Economic Bulletin, Issue 1, Box 7. 8 See John C. Williams, 2018. "The Future Fortunes of R-star: Are They Really Rising?," Federal Reserve Bank of San Francisco, FRBSF Economic Letter (May 21). ° Kathryn Holston, Thomas Laubach, and John C. Williams, 2017. "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics 559-75. Philip Barrett, Christoffer Koch, Jean-Marc Natal, Diaa Noureldin, and Josef Platzer, "The Natural Rate of Interest: Drivers and Implications for Policy," World Economic Outlook, Chapter 2. International Monetary Fund: April 2023. 10 Stefania D'Amico, Don H. Kim, and Min Wei, 2018. "Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices," Journal of Financial and Quantitative Analysis, 53(1): 395-436. 4 Or as Ken Rogoff and co-authors have claimed, for centuries. See Kenneth S. Rogoff, Barbara Rossi, and Paul Schmelzing, 2024. "Long-Run Trends in Long-Maturity Real Rates 1311-2022," American Economic Review (forthcoming). 12 In fact, the HLW estimate of the level of y-star is now close to its pre-pandemic trend in the United States, and only slightly below it in the Euro Area. 13 Athanasios Orphanides and John C. Williams, 2002. "Robust Monetary Policy Rules with Unknown Natural Rates," Brookings Papers on Economic Activity, 2: pp. 63-145; Athanasios Orphanides and Jhon C. Williams, 2007, Robust monetary policy with imperfect knowledge," Journal of Monetary Economics, 54 (2007) 1406-1435.	---[PAGE_BREAK]--- # R-Star: A Global Perspective July 03, 2024 John C. Williams, President and Chief Executive Officer ## Remarks at the ECB Forum on Central Banking, Sintra, Portugal As prepared for delivery For over 125 years, economists have grappled with a dilemma: How can a concept at the very heart of monetary theory be so vexing to quantify? I'm talking, of course, about r-star, the natural rate of interest. The quotations listed in Table 1 reflect the ageold challenges surrounding it. ${ }^{1}$ Recently, r-star has been in the spotlight once again. Today, my remarks will focus on longer-run r-star, which is the real interest rate expected to prevail when shocks to the economy have receded and the economy is growing at its potential rate. Before I go further, I'll provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. ## Three Approaches Subsequent to Milton Friedman's claim to the contrary, ${ }^{2}$ there are now three common approaches to inferring r-star from data: using a statistical method to extract a longer-run trend, basing it on financial market or survey data, or looking at r-star's effects on economic data. Each provides useful information, but each also poses significant challenges. As discussed in one of my papers with Thomas Laubach, univariate statistical methods do not adequately control for economic factors that influence interest rates. And these estimates can be overly influenced by large macroeconomic disturbances, such as the inflation of the 1970s or the pandemic. ${ }^{3}$ Financial market and survey data are subject to measurement issues and, in any case, tell us what people are thinking about r-star, rather than act as an independent source of information on r-star. This is what I have referred to as a "hall of mirrors." ${ }^{4}$ For these reasons, I will focus my remarks on estimates of r-star gleaned from macroeconomic models that do not rely on financial market or survey data-in particular, the Holston-Laubach-Williams (HLW) model, which infers the natural rate of interest through the behavior of interest rates, inflation, and GDP. ${ }^{5}$ Or, as the economist John H. Williams put it, "by its works." ${ }^{6}$ ## A Global Supply and Demand for Savings Our estimates of r-star in the euro area and the United States fell dramatically over the quarter century leading up to the pandemic, and they are currently near the estimates from prior to the pandemic. Figure 1 shows the time series of r-star estimates for the euro area and the United States. I'll focus first on the euro area. The estimate of r -star in the euro area is 0.5 percent in 2023 , equal to its average over the five years prior to the outbreak of COVID. This assessment of a very low r-star is broadly consistent with analysis by ECB economists using a variety of models. ${ }^{7}$ The sizable decline in estimates of r-star during the decades prior to the pandemic is common to many advanced and emerging economies. It reflects developments related to the global supply and demand for savings. ${ }^{8}$ These include falling birth rates and relatively low productivity growth that both reduce demand for savings, as well as increases in longevity and wealth inequality that increase the supply of savings. I emphasize the word global, because in a world of open capital markets, one should expect r-star to be highly correlated across countries. Indeed, there is evidence that r-star estimates are highly interconnected in advanced economies, although local factors play a role as well. ${ }^{9}$ The role of common and idiosyncratic factors is seen by comparing the estimates for the euro area to those for the United States, also shown in Figure 1. Although the two sets of estimates display some shorter-term wiggles, the dominant shared feature is the sustained two-percentage-point decline in r-star over the past 30 years. The same pattern is true of our estimates for Canada. Hence, according to these estimates, the low r-star regime endures. ## Is R-Star Rising? This finding runs counter to recent commentary suggesting that r-star has risen due to persistent changes in the balance between the supply and demand for savings, such as higher investment in AI and renewable energy, as well as larger government debt. In fact, some measures of longer-run r-star have risen to levels well above those directly prior to the pandemic. For example, marketbased measures of five-year, five-year-forward real rates for the euro area and the United States have risen well above the HLW estimates, as shown in Figure 2. Two things stand out from this figure. First, until recently, far-forward real rates displayed a broadly similar pattern of decline as the model estimates of r -star. Second, the market-based measures are volatile. Indeed, in the years before the recent rise, they had fallen to very low levels, well below the corresponding model estimates. This points to a significant time-varying risk premium, which interferes with taking market-based measures at face value in assessing what markets are telling us about their perceptions ---[PAGE_BREAK]--- of r-star. For example, based on the D'Amico, Kim, and Wei term structure model, the estimated rise in U.S. far-forward expected real yields since the onset of the pandemic is significantly smaller than that implied by a direct read of real yields. ${ }^{10}$ Where does this leave us regarding r-star? Although the value of r-star is always highly uncertain, the case for a sizable increase in r-star has yet to meet two important tests. First, owing to the interconnectedness of r-star across countries, plausible factors pushing up r-star on a sustained basis are likely to be global in nature. This highlights a tension between the evidence from Europe that r-star is still very low and arguments in the United States that r-star is now closer to levels seen 20 years ago. Second, any increase in r-star must overcome the forces that have been pushing r-star down for decades. ${ }^{11}$ In this regard, recent data reinforce the continuation of pre-pandemic trends in global demographics and productivity growth. One lens through which to see this is our model estimates of potential GDP, or y-star, which is a key factor that affects r-star. Many of the explanations arguing for a higher r-star would likely show up in higher potential output growth. However, the HLW estimates of euro area and U.S. trend potential GDP growth in 2023 are nearly unchanged from their respective 2019 values. This is consistent with other estimates of potential GDP growth for the euro area and the United States. ${ }^{12}$ # R-Star and Monetary Policy I will end with a brief comment on the usefulness of estimates of r-star for policymaking. First, as the Swedish economist Knut Wicksell and others have stressed, r-star is either explicitly or implicitly at the core of any macroeconomic model or framework one can imagine. Pretending it doesn't exist or wishing it away does not change that. In that context, it is important that we do our best to understand the factors that affect r-star and the uncertainties related to it, so that we have the best understanding possible of the forces affecting the longer-term evolution of the economy. Second, and equally important, as shown in my work with Athanasios Orphanides, the high degree of uncertainty about r-star means that one should not overly rely on estimates of r-star in determining the appropriate setting of monetary policy at a given point in time. ${ }^{13}$ Instead, such determinations must be, and are, based on a wide range of information and assessments, including those related to risks. ## Presentation [^0][^1] [^0]: ${ }^{1}$ The original sources of the quotations are the following: Knut Wicksell, 1898. Interest and Prices: A Study of the Causes Regulating the Value of Money. Translated by R. F. Kahn, London: Macmillan, published 1936. Gustav Cassel, 1928. "The Rate of Interest, the Bank Rate, and the Stabilization of Prices," The Quarterly Journal of Economics 42(4): 511-29. John H. Williams, 1931. "The Monetary Doctrines of J. M. Keynes," The Quarterly Journal of Economics 45(4): 547-87. Milton Friedman, 1968. "The Role of Monetary Policy," The American Economic Review(66): 1-17. Thomas Laubach and John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics 85(4): 1063-70. The first four quotations were originally compiled in Athanasios Orphanides and John C. Williams, 2002. "Robust Monetary Policy Rules with Unknown Natural Rates," Brookings Papers on Economic Activity, 2: pp. 63-145. ${ }^{2}$ Milton Friedman, 1968. "The Role of Monetary Policy," The American Economic Review 58(1): 1-17. ${ }^{3}$ Thomas Laubach and John C. Williams, 2016. "Measuring the Natural Rate of Interest Redux," Business Economics, 51: 51-67. ${ }^{4}$ John C. Williams, 2017. Comment on "Safety, Liquidity, and the Natural Rate of Interest," by Marco Del Negro, Marc P. Giannoni, Domenico Giannone, and Andrea Tambalotti, Brookings Papers on Economic Activity, 1: pp. 233-316. ${ }^{5}$ Kathryn Holston, Thomas Laubach, and John C. Williams, 2017. "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics 559-75; Kathryn Holston, Thomas Laubach, and John C. Williams, 2023. "Measuring the Natural Rate of Interest after COVID-19," Federal Reserve Bank of New York, Staff Reports, no. 1063. ${ }^{6}$ John H. Williams, 1931. "The Monetary Doctrines of J. M. Keynes," The Quarterly Journal of Economics 45(4): 547-87. ${ }^{7}$ Claus Brand, Noémie Lisack, and Falk Mazelis, 2024. "Estimates of the Natural Interest Rate for the Euro Area: An Update," European Central Bank, Economic Bulletin, Issue 1, Box 7 . ${ }^{8}$ See John C. Williams, 2018. "The Future Fortunes of R-star: Are They Really Rising?," Federal Reserve Bank of San Francisco, FRBSF Economic Letter (May 21). ${ }^{9}$ Kathryn Holston, Thomas Laubach, and John C. Williams, 2017. "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics 559-75; Philip Barrett, Christoffer Koch, Jean-Marc Natal, Diua Noureldin, and Josef Platzer, "The Natural Rate of Interest: Drivers and Implications for Policy," World Economic Outlook, Chapter 2. International Monetary Fund: April 2023. ${ }^{10}$ Stefania D'Amico, Don H. Kim, and Min Wei, 2018. "Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices," Journal of Financial and Quantitative Analysis, 53(1): 395-436. ${ }^{11}$ Or as Ken Rogoff and co-authors have claimed, for centuries. See Kenneth S. Rogoff, Barbara Rossi, and Paul Schmelzing, 2024. "Long-Run Trends in Long-Maturity Real Rates 1311-2022," American Economic Review (forthcoming). ${ }^{12}$ In fact, the HLW estimate of the level of y-star is now close to its pre-pandemic trend in the United States, and only slightly below it in the Euro Area. ${ }^{13}$ Athanasios Orphanides and John C. Williams, 2002. "Robust Monetary Policy Rules with Unknown Natural Rates," Brookings Papers on Economic Activity, 2: pp. 63-145; Athanasios Orphanides and Jhon C. Williams, 2007, Robust monetary policy with imperfect knowledge," Journal of Monetary Economics, 54 (2007) 1406-1435.	John C Williams	United States	https://www.bis.org/review/r240703f.pdf	July 03, 2024 John C. Williams, President and Chief Executive Officer As prepared for delivery For over 125 years, economists have grappled with a dilemma: How can a concept at the very heart of monetary theory be so vexing to quantify? I'm talking, of course, about r-star, the natural rate of interest. The quotations listed in Table 1 reflect the ageold challenges surrounding it. Recently, r-star has been in the spotlight once again. Today, my remarks will focus on longer-run r-star, which is the real interest rate expected to prevail when shocks to the economy have receded and the economy is growing at its potential rate. Before I go further, I'll provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Subsequent to Milton Friedman's claim to the contrary, For these reasons, I will focus my remarks on estimates of r-star gleaned from macroeconomic models that do not rely on financial market or survey data-in particular, the Holston-Laubach-Williams (HLW) model, which infers the natural rate of interest through the behavior of interest rates, inflation, and GDP. Our estimates of r-star in the euro area and the United States fell dramatically over the quarter century leading up to the pandemic, and they are currently near the estimates from prior to the pandemic. Figure 1 shows the time series of r-star estimates for the euro area and the United States. I'll focus first on the euro area. The estimate of r -star in the euro area is 0.5 percent in 2023 , equal to its average over the five years prior to the outbreak of COVID. This assessment of a very low r-star is broadly consistent with analysis by ECB economists using a variety of models. The sizable decline in estimates of r-star during the decades prior to the pandemic is common to many advanced and emerging economies. It reflects developments related to the global supply and demand for savings. The role of common and idiosyncratic factors is seen by comparing the estimates for the euro area to those for the United States, also shown in Figure 1. Although the two sets of estimates display some shorter-term wiggles, the dominant shared feature is the sustained two-percentage-point decline in r-star over the past 30 years. The same pattern is true of our estimates for Canada. Hence, according to these estimates, the low r-star regime endures. This finding runs counter to recent commentary suggesting that r-star has risen due to persistent changes in the balance between the supply and demand for savings, such as higher investment in AI and renewable energy, as well as larger government debt. In fact, some measures of longer-run r-star have risen to levels well above those directly prior to the pandemic. For example, marketbased measures of five-year, five-year-forward real rates for the euro area and the United States have risen well above the HLW estimates, as shown in Figure 2. Two things stand out from this figure. First, until recently, far-forward real rates displayed a broadly similar pattern of decline as the model estimates of r -star. Second, the market-based measures are volatile. Indeed, in the years before the recent rise, they had fallen to very low levels, well below the corresponding model estimates. This points to a significant time-varying risk premium, which interferes with taking market-based measures at face value in assessing what markets are telling us about their perceptions of r-star. For example, based on the D'Amico, Kim, and Wei term structure model, the estimated rise in U.S. far-forward expected real yields since the onset of the pandemic is significantly smaller than that implied by a direct read of real yields. Where does this leave us regarding r-star? Although the value of r-star is always highly uncertain, the case for a sizable increase in r-star has yet to meet two important tests. First, owing to the interconnectedness of r-star across countries, plausible factors pushing up r-star on a sustained basis are likely to be global in nature. This highlights a tension between the evidence from Europe that r-star is still very low and arguments in the United States that r-star is now closer to levels seen 20 years ago. Second, any increase in r-star must overcome the forces that have been pushing r-star down for decades. I will end with a brief comment on the usefulness of estimates of r-star for policymaking. First, as the Swedish economist Knut Wicksell and others have stressed, r-star is either explicitly or implicitly at the core of any macroeconomic model or framework one can imagine. Pretending it doesn't exist or wishing it away does not change that. In that context, it is important that we do our best to understand the factors that affect r-star and the uncertainties related to it, so that we have the best understanding possible of the forces affecting the longer-term evolution of the economy. Second, and equally important, as shown in my work with Athanasios Orphanides, the high degree of uncertainty about r-star means that one should not overly rely on estimates of r-star in determining the appropriate setting of monetary policy at a given point in time. Instead, such determinations must be, and are, based on a wide range of information and assessments, including those related to risks. Knut Wicksell, 1898. Interest and Prices: A Study of the Causes Regulating the Value of Money. Translated by R. F. Kahn, London: Macmillan, published 1936. Gustav Cassel, 1928. "The Rate of Interest, the Bank Rate, and the Stabilization of Prices," The Quarterly Journal of Economics 42(4): 511-29. John H. Williams, 1931. "The Monetary Doctrines of J. M. Keynes," The Quarterly Journal of Economics 45(4): 547-87. Milton Friedman, 1968. "The Role of Monetary Policy," The American Economic Review(66): 1-17. Thomas Laubach and John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics 85(4): 1063-70. The first four quotations were originally compiled in Athanasios Orphanides and John C. Williams, 2002. "Robust Monetary Policy Rules with Unknown Natural Rates," Brookings Papers on Economic Activity, 2: pp. 63-145.
2024-07-04T00:00:00	Piero Cipollone: Artificial intelligence - a central bank's view	Keynote speech by Mr Piero Cipollone, Member of the Executive Board of the European Central Bank, at the National Conference of Statistics on official statistics at the time of artificial intelligence, Rome, 4 July 2024.	SPEECH Artificial intelligence: a central bank's view Keynote speech by Piero Cipollone, Member of the Executive Board of the European Central Bank, at the National Conference of Statistics on official statistics at the time of artificial intelligence Rome, 4 July 2024 It is a pleasure to be here today to discuss the implications of artificial intelligence (Al) from a central bank's perspective. The world is witnessing extraordinary advances in the field of Al.!2] We are moving from analytical Al models designed to perform specific tasks"! to generative Al models capable of creating human-like content. The burgeoning interest in generative Al has boosted Al adoption. A recent international survey revealed that almost three-quarters of organisations had adopted Al for one or more business functions, and around two-thirds of them are using generative Al. Nevertheless, just 8% reported using Al for five or more business functions - suggesting that we are still in the initial stages of Al integration. [5] Al can be applied to a wide spectrum of activities, from routine and repetitive tasks to knowledge- based and creative work. It has been argued that Al is a general-purpose technology - akin to the steam engine, electricity or the computer - with the potential to transform our economies in the long run But, like the computer before it, Al may involve a paradox similar to the one made famous by the economist Robert Solow: "You can see the computer age everywhere but in the productivity statistics." (4 The dawn of the computer era saw information and communication technology (ICT) profoundly alter our personal lives and the economy. Today, our workplaces, homes and social lives are interwoven with digitalisation. At the European Central Bank (ECB), our Information Systems department has become the largest business area within the institution. ICT has become key to our core tasks, from the economic models that underpin our forecasts to monetary policy implementation and the operation of market infrastructures. Yet technology has not fundamentally changed the way we think about monetary policy. Moreover, just as Solow observed, the macroeconomic impact of ICT on productivity has not been as large as might have been expected - at least outside of the tech sector. Indeed, the transformative potential of Al may not always be productivity-enhancing. Consider, for example, a recent Al-generated deepfake video of the actor Tom Cruise dressed in a bathrobe and singing Elton John's "Tiny Dancer' to Paris Hilton that went viral on TikTok./& Might we see another Solow paradox emerge in the context of Al? In other words, what is the potential of Al to boost the productive capacity of the economy, as well as that of central banks? Today I will take stock of what we know about the impact of Al on the economy and discuss its possible implications for our monetary policy. I will then share the ECB's perspective on how we can best use Al in our central banking tasks, while putting in place the necessary safeguards for its responsible use. The macroeconomic impact of Al and its implications for monetary policy The macroeconomic impact of Al Al could affect the economy in several areas that are particularly relevant for the conduct of monetary policy. Today I will highlight just three of them. Al and productivity The first area relates to productivity. The potential of Al to raise productivity is undeniable - from acting as a powerful coding assistant to running autonomous "smart factories". Al could increase productivity through various channels - for example, via direct productivity effects that boost total factor productivity or through individual production factors. Indeed, several studies already point to sizeable Al-induced productivity gains at firm level. But estimates of aggregate effects over the coming decade differ markedly across studies - from an increase in annual total factor productivity growth of less than 0.1 percentage points to annual labour productivity growth of up to 1.5 percentage points. The eventual outcome will depend on whether we see a rapid and broad-based adoption and diffusion of Al across all sectors of the economy. Up until now, the sheer speed of diffusion across sectors and firms has little historical precedent." And survey evidence suggests that adoption by European firms nearly matches that of North America.12] But a key risk stems from the possibility that most of the value created by Al is extracted by a few companies that end up dominating the Al ecosystem.13] This is a key reason why productivity gains from Al at firm level may not translate into sustained value-added gains at the aggregate level, as market power increases costs. We saw this happen already with the rise of IT"4], which resulted in productivity gains being concentrated in the IT sector and primarily benefiting countries with large, successful tech firms. This is also reflected in the unprecedented concentration of market value in the "Magnificent Seven" firms in the United States."5] These are currently benefiting from the Al boom and making higher yearly profits than all the listed companies of France, Germany and Italy combined. This has important implications for Europe. As Mario Draghi recently observed, EU productivity growth over the past twenty years would have been on a par with that of the United States if it were not for the tech sector." Current data point to the euro area trailing behind the United States in terms of private investment in Al"), as well as patent applications and journal publications in the field. It is therefore critical to devise a European Al strategy with a threefold aim: to preserve competition in the Al space U9}. to create an ecosystem that supports' European Al firms' competitiveness, generating sectoral productivity gains over time!22!: and to support the diffusion of Al across the economy, facilitating the development of Al-supported products and services. I21] Al and the labour market The labour market is the second area of the economy that is likely to be affected by Al 22] New technologies can substitute or complement labour. On the one hand, automation implies capital taking over a task previously performed by a worker. On the other, productivity tends to increase with the automation of tasks, which may contribute to increased labour demand for non-automated tasks if price reduction brought about by productivity-improving technology spurs strong demand growth.I23] And new technology can lead to the creation of new kinds of jobs.!24] Whether Al represents an opportunity or risk for employment depends on the net effect. ECB staff analysis suggests that around 25% of jobs in European countries are in occupations that are highly exposed to Al-enabled automation, while another 30% have a medium degree of exposure. /25] Other research finds that knowledge-intensive services in particular - including finance and insurance, advertising, consultancy and IT - are most likely to be affected by A 24 Initial evidence for Europe suggests that, on average, occupations more exposed to Al have seen an increase in their share in total employment - although mostly for highly skilled occupations and younger workers, and with significant heterogeneity across countries.24 But the ultimate impact on employment remains uncertain and is likely to hinge on equipping the workforce with skills that complement Al.!28] Al and financial stability The third area of the economy that may be affected by Al is financial stability. Certainly, Al can bring benefits to the table. The application of Al could allow banks to conduct more efficient risk assessments and capital and liquidity planning.!22 But there are also risks. If new Al tools are used widely in the financial system and Al suppliers are concentrated, operational risk, market concentration and too-big-to-fail externalities may increase. Furthermore, widespread Al adoption could heighten the potential for herd behaviour, market correlation, deception, manipulation and conflicts of interest. Implications for monetary policy Central banks, including the ECB, are monitoring these developments closely.!24] Not only does Al influence the environment in which we operate, it also affects how that environment interacts with our monetary policy. Inflation First, Al could affect cost pressures in the economy in both directions. We may see Al exerting downward pressure on prices in various ways. For instance, if the net effect of Al is that it substitutes labour and increases productivity, we could see a reduced risk of labour shortages and downward pressure on unit labour cost growth. This is especially relevant in the euro area, where unemployment is at a record low and the working age population is projected to decline by 19% by the end of the century as a result of population ageing. 2] Al could also lead to a decline in energy prices through its impact on the supply side, for instance through enhanced grid management and more efficient energy consumption. And it could provide consumers with better tools for price comparison. But Al could also create upward price pressures. For instance, the uptake of Al will also have an impact on global energy demand, with the computational power required for sustaining Al's rise doubling every 100 days. 33] This could push up energy costs. Moreover, Al may encourage discriminatory pricing by facilitating the real-time analysis of consumer demand and price elasticities. And algorithms consistently learn to charge collusive prices that are higher than competitive ones, even without communicating with one another - in part by exploiting well-known biases that deviate from rational consumer behaviour. 241 Monetary policy transmission Second, we may see Al affect monetary policy transmission. Al is likely to create new winners and losers in the labour and capital market, with consequences for income and wealth distribution.25] This matters for monetary policy because it can influence people's marginal propensity to consume and their access to credit, which in turn affect how demand responds to changes in monetary policy. Moreover, if Al leads to a change in financial structures, such as an increase in non-bank intermediation, © it may have further implications for monetary policy transmission. There is evidence to suggest that compared with banks, non-banks are more responsive to monetary policy measures that influence longer-term interest rates, such as asset purchases. Non-banks also exhibit higher levels of credit, liquidity and duration risk compared with the banking sector.24 The natural rate of interest Third, Al may go on to influence the natural rate of interest. [28] If Al boosts productivity growth and potential output, we may see upward pressure being exerted on the natural rate of interest, as demand increases for capital to invest in new technologies and expand production capabilities. But if Al leads to higher rates of labour displacement and causes rising income inequality, we may see some downward pressure on the natural rate, owing to an increase in precautionary savings and a subsequent boost to the supply of loanable funds. Using Al in central banking: Al at the ECB These developments will play out over time outside the walls of the ECB, and we will be monitoring them closely. But within the ECB's walls, Al also has the potential to help with multiple tasks. Let me give you a few examples. Statistics Given that we are here at the National Conference of Statistics, it is fitting to begin with statistics. The ECB needs trustworthy and high-quality statistical products, services and a wide range of data to inform its monetary policy decisions. A key lesson from the global financial crisis was that aggregate statistics alone are insufficient to grasp the complexity of financial markets. We need more granular data. As you can imagine, the resulting datasets are so vast in terms of the number of observations they contain that collecting and disseminating them requires the use of statistical processes and analytical methods that surpass traditional statistical approaches. Around six years ago the ECB began exploring the application of Al to improve the efficiency and effectiveness of its statistical processes. And these efforts are reaping dividends. We use Al to improve the quality of our datasets, from identifying and matching observations across datasets to using modern machine learning techniques for quality assurance. [4° Moreover, large language models (LLMs) can support statistical processes in ways that were once simply not feasible. These include unlocking new and non-traditional data sources - for instance, unstructured data like text, image, video or audio. These sources can complement and enhance our existing data collections. Economic analysis Al is also increasingly being incorporated into the economic analyses we carry out to help us prepare our monetary policy decisions. Al can identify patterns in data more effectively than traditional methods. This is particularly true for non-linearities, which have been playing a bigger role in an environment that is becoming more shock prone. Al also enables the real-time analysis of economic indicators, helping central banks to make more timely policy decisions - a particularly valuable capability in times of crisis. What do these applications look like in practice? ECB staff use Al to nowcast inflation. This includes web-scraping price data and using LLMs for data classification. We are currently exploring the use of Big Data and new generative Al models in close cooperation with the BIS Innovation Hub.44) Staff are also applying machine learning models to euro area inflation forecasting, accounting for possible non-linearities.42] These models are already performing well compared with our conventional forecast and survey-based measures of inflation expectations. Another project is employing machine learning techniques to nowcast global trade. 43) Staff are also exploring the possibilities opened up by innovative datasets. For instance, projects include using a combination of text data and machine learning techniques to quantify risks and tensions in the global economy and exploring the use of satellite data to track economic activity.44] Communication Central bank communication is another area in which Al can contribute. Al could help in areas where central bank communication is key, such as ensuring that policy decisions are well understood and keeping inflation expectations anchored. With Al, we can rapidly analyse vast volumes of media reporting and market commentary. Moreover, Al can help us communicate with the public in all parts of the euro area. As a European institution, the ECB communicates in all 24 official languages of the EU. Even today, Al and machine translation are helping us meet a demand for translation that exceeds 6 million pages per year. Without those tools, the ECB's language services would be limited to covering around 150,000 pages per year. Al can also help broaden our reach by simplifying key messages and communication products for targeted audiences!"4 that have less awareness or knowledge of the ECB.4° And it could help us answer any questions the public may have. All these innovations could ultimately make the ECB better understood, facilitate the effectiveness of our monetary policy and boost our accountability. Market infrastructures and payments Al might also bring profound changes to the field of market infrastructures and payments. The technology could help design and develop innovative payments services customised to consumers' needs and preferences. And it could help foster financial inclusion, for example, by facilitating voice activated payments. These potential developments are clearly relevant when it comes to the ECB's role in promoting efficient, integrated and inclusive payments. Moreover, Al could also help us oversee payment systems. There is an opportunity to use Al as part of early warning models that aim to identify financial stability risks related to financial market infrastructures before these risks materialise. And it could play a supporting role in the scrutiny of information provided by overseen entities, helping us ensure that their practices align with the applicable regulatory frameworks. The ECB has developed an Al action plan to facilitate the adoption of Al wherever it is relevant to our tasks. It aims to develop and deploy the necessary Al tools and infrastructure, while fostering Al skills and ensuring the technology is used safely and responsibly. The limits of Al: putting the necessary safeguards in place Let me now turn to the limits of Al. A key strength of human intelligence is the ability to reflect on its limits. As the philosopher Immanuel Kant once wrote, "we can cognize of things a priori only what we ourselves have put into them'. But Al does not have this capacity for self-reflection. Nor does it have the ability to produce its own safeguards independently of human critical thinking. We therefore need to be aware of the limits of Al and their implications for the ECB, so that we can put the necessary guardrails in place. First, we need to ensure confidentiality and privacy. Given the sensitivity of central banks' decisions, guaranteeing confidentiality is a key condition for the in-house use of Al. Likewise, when it comes to data use, Al will increase concerns about privacy, underlining the importance of applying technological and governance safeguards and complying with regulations such as the EU Al Act. Take, for instance, the Al solutions we use for our statistics. These tools need to provide comprehensive documentation. This is a prerequisite for clarifying how Al solutions have been used to assess, improve or integrate data. Trust in these solutions comes from first understanding them. The second risk stemming from Al is the degree to which it can be used to spread false information and data, facilitate fraud or launch cyberattacks. Since late 2022 there has been a 53-fold increase in generative Al-related incidents and hazards reported in the media./48] It is one thing for an Al-generated deepfake video of Tom Cruise to go viral. But it is quite another when a deepfake of a policymaker goes viral - particularly at moments of crisis, when attention levels are high and volatility and uncertainty are already pronounced. At the same time, Al can be used to detect and address such risks. It can help prevent and detect cyberattacks by identifying anomalies in user, system and network behaviours in real time./42] The third risk emerges from what we might describe as an over-arching dependence on Al. And this can manifest itself in several ways. For instance, a greater dependence on Al may inadvertently increase the risk of falling into an "echo chamber' trap. Given that LLMs are trained using available data and information - which, over time, will increasingly be produced by Al - there is a risk of Al becoming self-referential or repeating existing biases. To the extent that this dynamic increases the impact of central bank communication on markets, while central banks look to the markets for information, it could increase the risk of central bank echo chambers emerging. This could, for instance, increase the risks of using forward guidance. 54] An excessive reliance on Al could also reduce our own operational resilience. As Al becomes a bigger part of our way of working, we may find ourselves growing more dependent on it for core tasks. That is why it is so important to understand the properties of the Al algorithms and models we use to reduce the risks of a potential "black box" effect. Similarly, if it is not used responsibly, Al could also suppress the diversity and originality of thought, thereby increasing the risk of groupthink and confirmation bias. The mathematician Alan Turing once famously asked, "Can machines think?"24] The last thing we want is for the same question to be asked about central bankers who end up being too reliant on Al. A key feature of human cognition is the ability to question existing theories, produce new ones and identify data to test them. This ability needs to be preserved. ECB Governing Council meetings are best understood as a process of comparing views on the economy, considering alternative interpretations of economic developments and assessing risks from multiple perspectives. The ongoing uncertainty in the economy shows that we need to do this more, rather than less. The overall lesson is that humans need to remain firmly in control, not only to ensure a trustworthy use of Al systems, but also to address questions of accountability and maintain the public's trust in the central bank. Conclusion To conclude, as we enter the Al age, we face the challenge of realising its potential while managing its risks. Whether Al will show up in productivity statistics or create a new paradox remains uncertain. To an extent, whether we face an Al productivity paradox will partly depend on our ability to accurately measure its contribution - and statisticians have an important role to play given the complexity of measuring intangible capital.4] But as with other technologies, for Al to be able to produce its full effects, the right ecosystem must be in place - one that facilitates competition in the Al sphere, ensures a fair distribution of possible productivity gains, establishes robust regulatory and ethical safeguards and fosters the corresponding skills in the labour market. For central banks, Al offers opportunities for innovation and efficiency gains, from economic analysis to communication. But there are also risks that must be considered, and we are duly building appropriate safeguards. As we integrate Al into our processes, we must ensure that human judgement and critical thinking remain at the forefront. This balance will be essential to maintaining trust in our data, our decisions and the broader financial system. Thank you. 1. I would like to thank Jean-Francois Jamet and Simon Mee for their help in preparing this speech, and Siria Angino, Katrin Arnold, Maciej Brzezinski, Antonio Dias Da Silva, Ferdinand Dreher, Maximilian Freier, Gabriel Gl6ckler, Guzman Gonzalez-Torres, Alexander Hodbod, Daniel Kapp, Baptiste Meunier, Roberto Motto, Chiara Osbat, Tom Sanders, Jurgen Schaff, Hanni Schélermann, David Sondermann, Anton Van der Kraaij and Balazs Zsamboki for their input and comments. 2. Artificial intelligence is a collective term for machine-enabled cognitive processing. The Organisation for Economic Co-operation and Development (OECD) defines artificial intelligence as "a machine- based system that, for explicit or implicit objectives, infers, from the input it receives, how to generate outputs such as predictions, content, recommendations, or decisions that can influence physical or virtual environments." See OECD (2024), "OECD Al Principles", May. 3. For instance, shopping recommendations or text analysis. 4. Within two months of its launch in late 2022, ChatGPT had already attracted 100 million users. See The Economist (2023), "ChatGPT mania may be cooling, but a serious new industry is taking shape", 21 September. 5. See McKinsey (2024), "The state of Al in early 2024: Gen Al adoption spikes and starts to generate value", 30 May. 6. See Crafts, N. (2021), "Artificial intelligence as a general-purpose technology: an historical perspective", Oxford Review of Economic Policy, Vol. 37, Issue 3, Autumn 2021, pp. 521-536 and Agrawal, A. et al. (2019), "Economic Policy for Artificial Intelligence", Innovation Policy and the Economy, Vol. 19. 7. Solow, R.M. (1987), "We'd Better Watch Out", New York Times Book Review. 8. See TikTok, @ParisHilton and Forbes (2022), "The Story Behind Paris Hilton's Viral TikTok With DeepTomCruise", 22 November. 9. See, for example, Dell'Acqua, F. et al. (2023), "Navigating the Jagged Technological Frontier: Field Experimental Evidence of the Effects of Alon Knowledge Worker Productivity and Quality", Harvard Business School Technology & Operations Management Unit Working Paper, No 24-013. 10. For instance, see Acemoglu, D. (2024), "The Simple Macroeconomics of Al', MIT, 5 April; Briggs, J. and Kodnani, D. (2023), "The Potentially Large Effects of Artificial Intelligence on Economic Growth", Goldman Sachs, 26 March. For an overview, see Filippucci, F. et al. (2024), "Should Al stay or should Al go: The promises and perils of Al for productivity and growth", VoxEU, 2 May. 11. One international survey finds that three out of every five white-collar workers are already using generative Al on a weekly basis. The survey encompasses 16 countries spanning the Americas, Europe, Asia and Oceania. See Oliver Wyman Forum (2024), "How generative Al is transforming business and society: the good, the bad, and everything in between", p. 23. 12. In 2023 the proportion of European firms reporting the use of Al technologies stood at 57%, compared with 61% in North America, 58% in Asia Pacific and 48% in China. See Maslej, N. et al. (2024) "The Al Index 2024 Annual Report', Al Index Steering Committee, Institute for Human-Centered Al, Stanford University, Stanford, CA, April. 13. Acemoglu, D. and Johnson, S. (2023), "Big Tech Is Bad. Big A.I. Will Be Worse", The New York Times, 9 June. 14. De Ridder, M. (2024), "Market Power and Innovation in the Intangible Economy", American Economic Review, Vol. 114, Issue 1, pp. 199-251. See also Philippon, T. (2019), The great reversal: How America gave up on free markets, Harvard University Press. 15. The "Magnificent Seven" comprise Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta and Tesla. These companies now make up close to one-third of the market value of the S&P index. 16. See Draghi, M. (2024), "An Industrial Strategy For Europe", acceptance speech at the Monastery of San Jeronimo de Yuste for the Carlos V European Award, 14 June: "If we were to exclude the tech sector, EU productivity growth over the past twenty years would be on par with that of the United States." Empirical evidence also indicates that the ICT-intensive sector in the United States has experienced a much higher increase in labour productivity than in Europe: euro area countries have been less efficient than the United States in both adopting IT technologies and leveraging them to productivity", paper presented at the ECB Forum on Central Banking 2024. 17. In 2023 private investment in Al reached USD 67 billion in the United States compared with USD 11 billion in the EU and the United Kingdom combined. See Mastlej, N. et al. (2024), Ibid. 18. Euro area firms filed on average 475 Al-related patents per year from 2002 to 2022, three times less than the United States and twice less than China. In terms of citation-adjusted Al journal publications, the United States also took the lead over the euro area and China. See Bergeaud (2024), Ibid. 19. See Coeuré, B. (2024), "Comments on 'The simple macroeconomics of transformative Al' by Daron Acemoglu", Economic Policy Panel, Brussels, 4 April and Coeuré, B. (2024), "Artificial intelligence: making sure it's not a walled garden", keynote address at the Bank for International Settlements - Financial Stability Institute policy implementation meeting on big tech in insurance, 19 March. 20. Measures in that direction include investing in Al education, encouraging venture capital investment and an environment that supports Al startups, increasing the mobility of financial capital across EU countries, and strengthening the link between European universities and European Al firms to convert Al research into marketable innovations. See Bergeaud (2024), Ibid. 21. See Meyers, Z. and Springford, J. (2023), "How Europe can make the most of Al', Centre for European Reform Policy Brief, 14 September. 22. See Albanesi, S. et al. (2023), "Reports of Al ending human labour may be greatly exaggerated", Research Bulletin, No 113, ECB, 28 November. 23. An elastic demand may support employment even in the face of automation, as productivity growth is reflected in prices and product demand increases. See, for example, Bessen, J. (2020). "Automation 24. About 60% of employment in 2018 can be classified under job titles that did not exist back in 1940. See Autor, D. et al. (2021), "New frontiers: the origin and content of new work, 1940-2018", MIT Working Paper, July. 25. Albanesi, S. et al. (2023) "New technologies and jobs in Europe" Working Paper Series, No 2831, ECB. 26. See Figure 8 in Organisation for Economic Co-operation and Development (2024), "The impact of Artificial Intelligence on productivity, distribution and growth: Key mechanisms, initial evidence and policy challenges", OECD Artificial Intelligence Papers, No 15, 16 April. 27. Albanesi, S. et al. (2023) "New technologies and jobs in Europe", Working Paper Series, No 2831, ECB. 28. See Green, A. (2024), "Artificial intelligence and the changing demand for skills in the labour market", OECD Artificial Intelligence Papers, No 14, OECD Publishing, Paris. 29. See Figure B.2 in Leitner, G. et al. (2024), "The rise of artificial intelligence: benefits and risks for financial stability", Financial Stability Review, ECB, May. 30. See Leitner, G. et al. (2024), "The rise of artificial intelligence: benefits and risks for financial stability", Financial Stability Review, ECB, May; Gensler, G. (2023), "Isaac Newton to Al', Remarks before the National Press Club, 17 July; Gensler, G. and Bailey, L. (2020), "Deep Learning_and Financial Stability', 1 November; and Gensler, G. (2024), "Al, Finance, Movies, and the Law", Prepared Remarks before the Yale Law School. 31. Bank for International Settlements (2024), "Artificial intelligence and the economy: implications for central banks", BIS Annual Economic Report 2024, Chapter III, 25 June. 32. As noted in Freier, M. et al. (2023), "EUROPOP2023 demographic trends and their euro area economic implications", Economic Bulletin, Ilssue 3, ECB. 33. See Ammanath, B. (2024), "How to manage Al's energy demand - today, tomorrow and in the future", World Economic Forum, 25 April. 34. See Calvano, E. et al. (2020), "Artificial Intelligence, Algorithmic Pricing, and Collusion", American Economic Review, Vol. 110, Issue 10, pp. 3267-97; for biases, see OECD (2024), "The impact of Artificial Intelligence on productivity, distribution and growth: Key mechanisms, initial evidence and policy challenges", OECD Artificial Intelligence Papers, No 15, 16 April, pp. 33-34. 35. See Cazzaniga, M. et al. (2024), "Gen-Al: Artificial Intelligence and the Future of Work", IMF Staff Discussion Notes, No 2024/001. 36. The use of artificial intelligence for credit scoring could allow big tech with access to large consumer data to rapidly expand in the area of financial services and to challenge banks' traditional role in financing the economy and serving as the first point of contact for financial services. See Boot, A., Hoffmann, P., Laeven, L. and Ratnovski, L. (2021), "Fintech: what's old, what's new?", Journal of Financial Stability, Vol. 53. 37. See Work stream on non-bank financial intermediation (2021), "Non-bank financial intermediation in Series, No 270. 38. The natural rate of interest is the real rate of interest that is neither expansionary nor contractionary. 39. See also Moufakkir, M. (2023), "Careful embrace: Al and the ECB", The ECB Blog. 40. This allows us to identify and prioritise anomalous observations and outliers that require further attention, assessment and potential treatment. 41. Osbat, C. (2022), "What micro price data teach us about the inflation process: web-scraping in PRISMA", SUERF Policy Brief, No 470, 17 November. 42. See, for instance, Lenza, M. et al. (2023), "Forecasting euro area inflation with machine learning models", Research Bulletin, No 112, ECB, 17 October. 43. For example, see Menzie, C. et al. (2023), "Nowcasting world trade with machine learning: a three- step approach", Working Paper Series, No 2836, ECB. 44. See, for instance, d'Aspremont, A. (2024), "Satellites turn "concrete": tracking cement with satellite data and neural networks", Working Paper Series, No 2900, ECB. 45. On layered communication, see Work stream on monetary policy communications (2021), "Clear, consistent and engaging: ECB monetary policy communication in a changing world", Occasional Paper Series, No 274, ECB; see also Bholat, D. et al. (2018), "Enhancing central bank communications with behavioural insights", Staff Working Paper Series, Bank of England, No 750, August. 46. Survey evidence suggests that there is a lack of understanding of the ECB's tasks. Two-thirds of euro area citizens believe that it is the ECB's task to stabilise the foreign exchange rate, while over one- third think that the ECB's role is to finance governments. See Chart 7 in Gardt, M. et al. (2021), "ECB communication with the wider public", Economic Bulletin, Issue 8, ECB. 47. Kant, I. (1781), Critique of pure reason. 48. OCED (2024), "OECD Digital Economy Outlook 2024 (Volume 1): Embracing The Technology Frontier', 14 May, p. 38. 49. introductory remarks at the ninth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures, 17 January; and Bank for International Settlements, "Project Raven: using Al to assess financial system's cyber security and resilience". 50. The central bank may no longer observe independent signals about the state of the economy from financial markets, instead mainly seeing the mirror image of its own communications. 51. Echo chamber dynamics can create a circularity between market prices and forward guidance. See Morris, S. and Shin, H. S. (2018), "Central Bank Forward Guidance and the Signal Value of Market Prices", AEA Papers and Proceedings, Vol. 108, May, pp. 572-577. 52. Turing, A. (1950), "Computing Machinery and Intelligence", Mind, Vol. LIX, Issue 236, October, pp. 433-460. 53. For instance, see the role of paradigm shifts in scientific development in Kuhn, T. (1962), The structure of scientific revolutions. See also Felin, T. and Holweg, M. (2024), "Theory Is All You Need: Al, Human Cognition, and Decision Making", 24 February. 54. See Brynjolfsson, E. et al. (2017), "Artificial Intelligence and the Modern Productivity Paradox: A Clash of Expectations and Statistics", NBER Working Paper Series, No 24001, November. CONTACT European Central Bank	---[PAGE_BREAK]--- # Artificial intelligence: a central bank's view ## Keynote speech by Piero Cipollone, Member of the Executive Board of the European Central Bank, at the National Conference of Statistics on official statistics at the time of artificial intelligence Rome, 4 July 2024 It is a pleasure to be here today to discuss the implications of artificial intelligence (AI) from a central bank's perspective. ${ }^{[1]}$ The world is witnessing extraordinary advances in the field of AI. ${ }^{[2]}$ We are moving from analytical AI models designed to perform specific tasks ${ }^{[3]}$ to generative AI models capable of creating human-like content. The burgeoning interest in generative AI has boosted AI adoption. ${ }^{[4]}$ A recent international survey revealed that almost three-quarters of organisations had adopted AI for one or more business functions, and around two-thirds of them are using generative AI. Nevertheless, just 8\% reported using AI for five or more business functions - suggesting that we are still in the initial stages of AI integration. 5 AI can be applied to a wide spectrum of activities, from routine and repetitive tasks to knowledgebased and creative work. It has been argued that AI is a general-purpose technology - akin to the steam engine, electricity or the computer - with the potential to transform our economies in the long run. ${ }^{[6]}$ But, like the computer before it, AI may involve a paradox similar to the one made famous by the economist Robert Solow: "You can see the computer age everywhere but in the productivity statistics." [7] The dawn of the computer era saw information and communication technology (ICT) profoundly alter our personal lives and the economy. Today, our workplaces, homes and social lives are interwoven with digitalisation. At the European Central Bank (ECB), our Information Systems department has become the largest business area within the institution. ICT has become key to our core tasks, from the economic models that underpin our forecasts to monetary policy implementation and the operation of market infrastructures. Yet technology has not fundamentally changed the way we think about monetary policy. Moreover, just as Solow observed, the macroeconomic impact of ICT on productivity has not been as large as might have been expected - at least outside of the tech sector. Indeed, the transformative potential of AI may not always be productivity-enhancing. Consider, for example, a recent AI-generated deepfake video of the actor Tom Cruise dressed in a bathrobe and ---[PAGE_BREAK]--- singing Elton John's "Tiny Dancer" to Paris Hilton that went viral on TikTok. ${ }^{[8]}$ Might we see another Solow paradox emerge in the context of AI? In other words, what is the potential of AI to boost the productive capacity of the economy, as well as that of central banks? Today I will take stock of what we know about the impact of AI on the economy and discuss its possible implications for our monetary policy. I will then share the ECB's perspective on how we can best use AI in our central banking tasks, while putting in place the necessary safeguards for its responsible use. # The macroeconomic impact of AI and its implications for monetary policy ## The macroeconomic impact of Al Al could affect the economy in several areas that are particularly relevant for the conduct of monetary policy. Today I will highlight just three of them. ## AI and productivity The first area relates to productivity. The potential of AI to raise productivity is undeniable - from acting as a powerful coding assistant to running autonomous "smart factories". AI could increase productivity through various channels - for example, via direct productivity effects that boost total factor productivity or through individual production factors. Indeed, several studies already point to sizeable AI-induced productivity gains at firm level. ${ }^{[9]}$ But estimates of aggregate effects over the coming decade differ markedly across studies - from an increase in annual total factor productivity growth of less than 0.1 percentage points to annual labour productivity growth of up to 1.5 percentage points. ${ }^{[10]}$ The eventual outcome will depend on whether we see a rapid and broad-based adoption and diffusion of AI across all sectors of the economy. Up until now, the sheer speed of diffusion across sectors and firms has little historical precedent. ${ }^{[11]}$ And survey evidence suggests that adoption by European firms nearly matches that of North America. ${ }^{[12]}$ But a key risk stems from the possibility that most of the value created by AI is extracted by a few companies that end up dominating the AI ecosystem. ${ }^{[13]}$ This is a key reason why productivity gains from AI at firm level may not translate into sustained value-added gains at the aggregate level, as market power increases costs. We saw this happen already with the rise of IT ${ }^{[14]}$, which resulted in productivity gains being concentrated in the IT sector and primarily benefiting countries with large, successful tech firms. This is also reflected in the unprecedented concentration of market value in the "Magnificent Seven" firms in the United States. ${ }^{[15]}$ These are currently benefiting from the AI boom and making higher yearly profits than all the listed companies of France, Germany and Italy combined. This has important implications for Europe. As Mario Draghi recently observed, EU productivity growth over the past twenty years would have been on a par with that of the United States if it were not for the ---[PAGE_BREAK]--- tech sector. ${ }^{[16]}$ Current data point to the euro area trailing behind the United States in terms of private investment in $\mathrm{Al}^{[17]}$, as well as patent applications and journal publications in the field. ${ }^{[18]}$ It is therefore critical to devise a European AI strategy with a threefold aim: to preserve competition in the AI space [19]; to create an ecosystem that supports' European AI firms' competitiveness, generating sectoral productivity gains over time ${ }^{[20]}$; and to support the diffusion of Al across the economy, facilitating the development of Al-supported products and services. ${ }^{[21]}$ # Al and the labour market The labour market is the second area of the economy that is likely to be affected by Al. ${ }^{[22]}$ New technologies can substitute or complement labour. On the one hand, automation implies capital taking over a task previously performed by a worker. On the other, productivity tends to increase with the automation of tasks, which may contribute to increased labour demand for non-automated tasks if price reduction brought about by productivity-improving technology spurs strong demand growth. ${ }^{[23]}$ And new technology can lead to the creation of new kinds of jobs. ${ }^{[24]}$ Whether Al represents an opportunity or risk for employment depends on the net effect. ECB staff analysis suggests that around $25 \%$ of jobs in European countries are in occupations that are highly exposed to Al-enabled automation, while another 30\% have a medium degree of exposure. ${ }^{[25]}$ Other research finds that knowledge-intensive services in particular - including finance and insurance, advertising, consultancy and IT - are most likely to be affected by Al. ${ }^{[26]}$ Initial evidence for Europe suggests that, on average, occupations more exposed to Al have seen an increase in their share in total employment - although mostly for highly skilled occupations and younger workers, and with significant heterogeneity across countries. ${ }^{[27]}$ But the ultimate impact on employment remains uncertain and is likely to hinge on equipping the workforce with skills that complement Al. ${ }^{[28]}$ ## Al and financial stability The third area of the economy that may be affected by Al is financial stability. Certainly, Al can bring benefits to the table. The application of Al could allow banks to conduct more efficient risk assessments and capital and liquidity planning. ${ }^{[29]}$ But there are also risks. If new Al tools are used widely in the financial system and Al suppliers are concentrated, operational risk, market concentration and too-big-to-fail externalities may increase. Furthermore, widespread Al adoption could heighten the potential for herd behaviour, market correlation, deception, manipulation and conflicts of interest. ${ }^{[30]}$ ## Implications for monetary policy Central banks, including the ECB, are monitoring these developments closely. ${ }^{[31]}$ Not only does AI influence the environment in which we operate, it also affects how that environment interacts with our monetary policy. ---[PAGE_BREAK]--- # Inflation First, Al could affect cost pressures in the economy in both directions. We may see Al exerting downward pressure on prices in various ways. For instance, if the net effect of Al is that it substitutes labour and increases productivity, we could see a reduced risk of labour shortages and downward pressure on unit labour cost growth. This is especially relevant in the euro area, where unemployment is at a record low and the working age population is projected to decline by $19 \%$ by the end of the century as a result of population ageing. ${ }^{[32]}$ Al could also lead to a decline in energy prices through its impact on the supply side, for instance through enhanced grid management and more efficient energy consumption. And it could provide consumers with better tools for price comparison. But Al could also create upward price pressures. For instance, the uptake of Al will also have an impact on global energy demand, with the computational power required for sustaining Al's rise doubling every 100 days. ${ }^{[33]}$ This could push up energy costs. Moreover, Al may encourage discriminatory pricing by facilitating the real-time analysis of consumer demand and price elasticities. And algorithms consistently learn to charge collusive prices that are higher than competitive ones, even without communicating with one another - in part by exploiting well-known biases that deviate from rational consumer behaviour. ${ }^{[34]}$ ## Monetary policy transmission Second, we may see Al affect monetary policy transmission. Al is likely to create new winners and losers in the labour and capital market, with consequences for income and wealth distribution. ${ }^{[35]}$ This matters for monetary policy because it can influence people's marginal propensity to consume and their access to credit, which in turn affect how demand responds to changes in monetary policy. Moreover, if Al leads to a change in financial structures, such as an increase in non-bank intermediation, ${ }^{[36]}$ it may have further implications for monetary policy transmission. There is evidence to suggest that compared with banks, non-banks are more responsive to monetary policy measures that influence longer-term interest rates, such as asset purchases. Non-banks also exhibit higher levels of credit, liquidity and duration risk compared with the banking sector. ${ }^{[37]}$ ## The natural rate of interest Third, Al may go on to influence the natural rate of interest. ${ }^{[38]}$ If Al boosts productivity growth and potential output, we may see upward pressure being exerted on the natural rate of interest, as demand increases for capital to invest in new technologies and expand production capabilities. But if Al leads to higher rates of labour displacement and causes rising income inequality, we may see some downward pressure on the natural rate, owing to an increase in precautionary savings and a subsequent boost to the supply of loanable funds. ---[PAGE_BREAK]--- # Using AI in central banking: AI at the ECB These developments will play out over time outside the walls of the ECB, and we will be monitoring them closely. But within the ECB's walls, AI also has the potential to help with multiple tasks. ${ }^{[39]}$ Let me give you a few examples. ## Statistics Given that we are here at the National Conference of Statistics, it is fitting to begin with statistics. The ECB needs trustworthy and high-quality statistical products, services and a wide range of data to inform its monetary policy decisions. A key lesson from the global financial crisis was that aggregate statistics alone are insufficient to grasp the complexity of financial markets. We need more granular data. As you can imagine, the resulting datasets are so vast in terms of the number of observations they contain that collecting and disseminating them requires the use of statistical processes and analytical methods that surpass traditional statistical approaches. Around six years ago the ECB began exploring the application of AI to improve the efficiency and effectiveness of its statistical processes. And these efforts are reaping dividends. We use AI to improve the quality of our datasets, from identifying and matching observations across datasets to using modern machine learning techniques for quality assurance. ${ }^{[40]}$ Moreover, large language models (LLMs) can support statistical processes in ways that were once simply not feasible. These include unlocking new and non-traditional data sources - for instance, unstructured data like text, image, video or audio. These sources can complement and enhance our existing data collections. ## Economic analysis AI is also increasingly being incorporated into the economic analyses we carry out to help us prepare our monetary policy decisions. AI can identify patterns in data more effectively than traditional methods. This is particularly true for non-linearities, which have been playing a bigger role in an environment that is becoming more shock prone. AI also enables the real-time analysis of economic indicators, helping central banks to make more timely policy decisions - a particularly valuable capability in times of crisis. What do these applications look like in practice? ECB staff use AI to nowcast inflation. This includes web-scraping price data and using LLMs for data classification. We are currently exploring the use of Big Data and new generative AI models in close cooperation with the BIS Innovation Hub. ${ }^{[41]}$ Staff are also applying machine learning models to euro area inflation forecasting, accounting for possible non-linearities. ${ }^{[42]}$ These models are already performing well compared with our conventional forecast and survey-based measures of inflation expectations. Another project is employing machine learning techniques to nowcast global trade. ${ }^{[43]}$ ---[PAGE_BREAK]--- Staff are also exploring the possibilities opened up by innovative datasets. For instance, projects include using a combination of text data and machine learning techniques to quantify risks and tensions in the global economy and exploring the use of satellite data to track economic activity. ${ }^{[44]}$ # Communication Central bank communication is another area in which AI can contribute. AI could help in areas where central bank communication is key, such as ensuring that policy decisions are well understood and keeping inflation expectations anchored. With AI, we can rapidly analyse vast volumes of media reporting and market commentary. Moreover, AI can help us communicate with the public in all parts of the euro area. As a European institution, the ECB communicates in all 24 official languages of the EU. Even today, AI and machine translation are helping us meet a demand for translation that exceeds 6 million pages per year. Without those tools, the ECB's language services would be limited to covering around 150,000 pages per year. AI can also help broaden our reach by simplifying key messages and communication products for targeted audiences ${ }^{[45]}$ that have less awareness or knowledge of the ECB. ${ }^{[46]}$ And it could help us answer any questions the public may have. All these innovations could ultimately make the ECB better understood, facilitate the effectiveness of our monetary policy and boost our accountability. ## Market infrastructures and payments AI might also bring profound changes to the field of market infrastructures and payments. The technology could help design and develop innovative payments services customised to consumers' needs and preferences. And it could help foster financial inclusion, for example, by facilitating voice activated payments. These potential developments are clearly relevant when it comes to the ECB's role in promoting efficient, integrated and inclusive payments. Moreover, AI could also help us oversee payment systems. There is an opportunity to use AI as part of early warning models that aim to identify financial stability risks related to financial market infrastructures before these risks materialise. And it could play a supporting role in the scrutiny of information provided by overseen entities, helping us ensure that their practices align with the applicable regulatory frameworks. The ECB has developed an AI action plan to facilitate the adoption of AI wherever it is relevant to our tasks. It aims to develop and deploy the necessary AI tools and infrastructure, while fostering AI skills and ensuring the technology is used safely and responsibly. ## The limits of AI: putting the necessary safeguards in place Let me now turn to the limits of AI. A key strength of human intelligence is the ability to reflect on its limits. As the philosopher Immanuel Kant once wrote, "we can cognize of things a priori only what we ourselves have put into them". ${ }^{[47]}$ But ---[PAGE_BREAK]--- AI does not have this capacity for self-reflection. Nor does it have the ability to produce its own safeguards independently of human critical thinking. We therefore need to be aware of the limits of AI and their implications for the ECB, so that we can put the necessary guardrails in place. First, we need to ensure confidentiality and privacy. Given the sensitivity of central banks' decisions, guaranteeing confidentiality is a key condition for the in-house use of AI. Likewise, when it comes to data use, AI will increase concerns about privacy, underlining the importance of applying technological and governance safeguards and complying with regulations such as the EU AI Act. Take, for instance, the AI solutions we use for our statistics. These tools need to provide comprehensive documentation. This is a prerequisite for clarifying how AI solutions have been used to assess, improve or integrate data. Trust in these solutions comes from first understanding them. The second risk stemming from AI is the degree to which it can be used to spread false information and data, facilitate fraud or launch cyberattacks. Since late 2022 there has been a 53-fold increase in generative AI-related incidents and hazards reported in the media. ${ }^{[48]}$ It is one thing for an AI-generated deepfake video of Tom Cruise to go viral. But it is quite another when a deepfake of a policymaker goes viral - particularly at moments of crisis, when attention levels are high and volatility and uncertainty are already pronounced. At the same time, AI can be used to detect and address such risks. It can help prevent and detect cyberattacks by identifying anomalies in user, system and network behaviours in real time. ${ }^{[49]}$ The third risk emerges from what we might describe as an over-arching dependence on AI. And this can manifest itself in several ways. For instance, a greater dependence on AI may inadvertently increase the risk of falling into an "echo chamber" trap. Given that LLMs are trained using available data and information - which, over time, will increasingly be produced by AI - there is a risk of AI becoming self-referential or repeating existing biases. To the extent that this dynamic increases the impact of central bank communication on markets, while central banks look to the markets for information, it could increase the risk of central bank echo chambers emerging. ${ }^{[50]}$ This could, for instance, increase the risks of using forward guidance. ${ }^{[51]}$ An excessive reliance on AI could also reduce our own operational resilience. As AI becomes a bigger part of our way of working, we may find ourselves growing more dependent on it for core tasks. That is why it is so important to understand the properties of the AI algorithms and models we use to reduce the risks of a potential "black box" effect. Similarly, if it is not used responsibly, AI could also suppress the diversity and originality of thought, thereby increasing the risk of groupthink and confirmation bias. The mathematician Alan Turing once famously asked, "Can machines think?" ${ }^{[52]}$ The last thing we want is for the same question to be asked about central bankers who end up being too reliant on AI. A key feature of human cognition is the ability to question existing theories, produce new ones and identify data to test them. ${ }^{[53]}$ This ability needs to be preserved. ECB Governing Council meetings are ---[PAGE_BREAK]--- best understood as a process of comparing views on the economy, considering alternative interpretations of economic developments and assessing risks from multiple perspectives. The ongoing uncertainty in the economy shows that we need to do this more, rather than less. The overall lesson is that humans need to remain firmly in control, not only to ensure a trustworthy use of AI systems, but also to address questions of accountability and maintain the public's trust in the central bank. # Conclusion To conclude, as we enter the AI age, we face the challenge of realising its potential while managing its risks. Whether AI will show up in productivity statistics or create a new paradox remains uncertain. To an extent, whether we face an AI productivity paradox will partly depend on our ability to accurately measure its contribution - and statisticians have an important role to play given the complexity of measuring intangible capital. ${ }^{[54]}$ But as with other technologies, for AI to be able to produce its full effects, the right ecosystem must be in place - one that facilitates competition in the AI sphere, ensures a fair distribution of possible productivity gains, establishes robust regulatory and ethical safeguards and fosters the corresponding skills in the labour market. For central banks, AI offers opportunities for innovation and efficiency gains, from economic analysis to communication. But there are also risks that must be considered, and we are duly building appropriate safeguards. As we integrate AI into our processes, we must ensure that human judgement and critical thinking remain at the forefront. This balance will be essential to maintaining trust in our data, our decisions and the broader financial system. Thank you. ## 1. I would like to thank Jean-Francois Jamet and Simon Mee for their help in preparing this speech, and Siria Angino, Katrin Arnold, Maciej Brzezinski, António Dias Da Silva, Ferdinand Dreher, Maximilian Freier, Gabriel Glöckler, Guzmán González-Torres, Alexander Hodbod, Daniel Kapp, Baptiste Meunier, Roberto Motto, Chiara Osbat, Tom Sanders, Jürgen Schaff, Hanni Schölermann, David Sondermann, Anton Van der Kraaij and Balázs Zsámboki for their input and comments. ## 2. Artificial intelligence is a collective term for machine-enabled cognitive processing. The Organisation for Economic Co-operation and Development (OECD) defines artificial intelligence as "a machinebased system that, for explicit or implicit objectives, infers, from the input it receives, how to generate outputs such as predictions, content, recommendations, or decisions that can influence physical or virtual environments." See OECD (2024), "OECD AI Principles", May. ---[PAGE_BREAK]--- 3. For instance, shopping recommendations or text analysis. 4. Within two months of its launch in late 2022, ChatGPT had already attracted 100 million users. See The Economist (2023), "ChatGPT mania may be cooling, but a serious new industry is taking shape", 21 September. 5. See McKinsey (2024), "The state of AI in early 2024: Gen AI adoption spikes and starts to generate value", 30 May. 6. See Crafts, N. (2021), "Artificial intelligence as a general-purpose technology: an historical perspective", Oxford Review of Economic Policy, Vol. 37, Issue 3, Autumn 2021, pp. 521-536 and Agrawal, A. et al. (2019), "Economic Policy for Artificial Intelligence", Innovation Policy and the Economy, Vol. 19. 7. Solow, R.M. (1987), "We'd Better Watch Out", New York Times Book Review. 8. See TikTok, @ParisHilton and Forbes (2022), "The Story Behind Paris Hilton's Viral TikTok With DeepTomCruise", 22 November. 9. See, for example, Dell'Acqua, F. et al. (2023), "Navigating the Jagged Technological Frontier: Field Experimental Evidence of the Effects of AI on Knowledge Worker Productivity and Quality", Harvard Business School Technology \& Operations Management Unit Working Paper, No 24-013. 10. For instance, see Acemoglu, D. (2024), "The Simple Macroeconomics of AI", MIT, 5 April; Briggs, J. and Kodnani, D. (2023), "The Potentially Large Effects of Artificial Intelligence on Economic Growth", Goldman Sachs, 26 March. For an overview, see Filippucci, F. et al. (2024), "Should AI stay or should AI go: The promises and perils of AI for productivity and growth", VoxEU, 2 May. 11. One international survey finds that three out of every five white-collar workers are already using generative AI on a weekly basis. The survey encompasses 16 countries spanning the Americas, Europe, Asia and Oceania. See Oliver Wyman Forum (2024), "How generative AI is transforming business and society: the good, the bad, and everything in between", p. 23. ---[PAGE_BREAK]--- In 2023 the proportion of European firms reporting the use of AI technologies stood at 57\%, compared with 61\% in North America, 58\% in Asia Pacific and 48\% in China. See Maslej, N. et al. (2024) "The Al Index 2024 Annual Report", AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April. 13. Acemoglu, D. and Johnson, S. (2023), "Big Tech Is Bad, Big A.I. Will Be Worse", The New York Times, 9 June. 14. De Ridder, M. (2024), "Market Power and Innovation in the Intangible Economy", American Economic Review, Vol. 114, Issue 1, pp. 199-251. See also Philippon, T. (2019), The great reversal: How America gave up on free markets, Harvard University Press. 15. The "Magnificent Seven" comprise Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta and Tesla. These companies now make up close to one-third of the market value of the S\&P index. 16. See Draghi, M. (2024), "An Industrial Strategy For Europe", acceptance speech at the Monastery of San Jeronimo de Yuste for the Carlos V European Award, 14 June: "If we were to exclude the tech sector, EU productivity growth over the past twenty years would be on par with that of the United States." Empirical evidence also indicates that the ICT-intensive sector in the United States has experienced a much higher increase in labour productivity than in Europe: euro area countries have been less efficient than the United States in both adopting IT technologies and leveraging them to achieve labour productivity gains. See Bergeaud (2024), "The past, present and future of European productivity", paper presented at the ECB Forum on Central Banking 2024. 17. In 2023 private investment in AI reached USD 67 billion in the United States compared with USD 11 billion in the EU and the United Kingdom combined. See Maslej, N. et al. (2024), Ibid. 18. Euro area firms filed on average 475 Al-related patents per year from 2002 to 2022, three times less than the United States and twice less than China. In terms of citation-adjusted AI journal publications, the United States also took the lead over the euro area and China. See Bergeaud (2024), Ibid. 19. See Coeuré, B. (2024), "Comments on 'The simple macroeconomics of transformative AI' by Daron Acemoglu", Economic Policy Panel, Brussels, 4 April and Coeuré, B. (2024), "Artificial intelligence: ---[PAGE_BREAK]--- making sure it's not a walled garden", keynote address at the Bank for International Settlements Financial Stability Institute policy implementation meeting on big tech in insurance, 19 March. 20. Measures in that direction include investing in AI education, encouraging venture capital investment and an environment that supports AI startups, increasing the mobility of financial capital across EU countries, and strengthening the link between European universities and European AI firms to convert AI research into marketable innovations. See Bergeaud (2024), Ibid. 21. See Meyers, Z. and Springford, J. (2023), "How Europe can make the most of AI", Centre for European Reform Policy Brief, 14 September. 22. See Albanesi, S. et al. (2023), "Reports of AI ending human labour may be greatly exaggerated", Research Bulletin, No 113, ECB, 28 November. 23. An elastic demand may support employment even in the face of automation, as productivity growth is reflected in prices and product demand increases. See, for example, Bessen, J. (2020). "Automation and jobs: when technology boosts employment", Economic Policy, Volume 34, Issue 100, pp. 589-626. 24. About 60\% of employment in 2018 can be classified under job titles that did not exist back in 1940. See Autor, D. et al. (2021), "New frontiers: the origin and content of new work. 1940-2018", MIT Working Paper, July. 25. Albanesi, S. et al. (2023) "New technologies and jobs in Europe" Working Paper Series, No 2831, ECB. 26. See Figure 8 in Organisation for Economic Co-operation and Development (2024), "The impact of Artificial Intelligence on productivity, distribution and growth: Key mechanisms, initial evidence and policy challenges", OECD Artificial Intelligence Papers, No 15, 16 April. 27. Albanesi, S. et al. (2023) "New technologies and jobs in Europe", Working Paper Series, No 2831, ECB. 28. See Green, A. (2024), "Artificial intelligence and the changing demand for skills in the labour market", OECD Artificial Intelligence Papers, No 14, OECD Publishing, Paris. ---[PAGE_BREAK]--- 29. See Figure B. 2 in Leitner, G. et al. (2024), "The rise of artificial intelligence: benefits and risks for financial stability", Financial Stability Review, ECB, May. 30. See Leitner, G. et al. (2024), "The rise of artificial intelligence: benefits and risks for financial stability", Financial Stability Review, ECB, May; Gensler, G. (2023), "Isaac Newton to Al", Remarks before the National Press Club, 17 July; Gensler, G. and Bailey, L. (2020), "Deep Learning and Financial Stability", 1 November; and Gensler, G. (2024), "Al. Finance. Movies. and the Law", Prepared Remarks before the Yale Law School. 31. Bank for International Settlements (2024), "Artificial intelligence and the economy: implications for central banks", BIS Annual Economic Report 2024, Chapter III, 25 June. 32. As noted in Freier, M. et al. (2023), "EUROPOP2023 demographic trends and their euro area economic implications", Economic Bulletin, Issue 3, ECB. 33. See Ammanath, B. (2024), "How to manage Al's energy demand — today, tomorrow and in the future", World Economic Forum, 25 April. 34. See Calvano, E. et al. (2020), "Artificial Intelligence. Algorithmic Pricing, and Collusion", American Economic Review, Vol. 110, Issue 10, pp. 3267-97; for biases, see OECD (2024), "The impact of Artificial Intelligence on productivity, distribution and growth: Key mechanisms, initial evidence and policy challenges", OECD Artificial Intelligence Papers, No 15, 16 April, pp. 33-34. 35. See Cazzaniga, M. et al. (2024), "Gen-Al: Artificial Intelligence and the Future of Work", IMF Staff Discussion Notes, No 2024/001. 36. The use of artificial intelligence for credit scoring could allow big tech with access to large consumer data to rapidly expand in the area of financial services and to challenge banks' traditional role in financing the economy and serving as the first point of contact for financial services. See Boot, A., Hoffmann, P., Laeven, L. and Ratnovski, L. (2021), "Fintech: what's old, what's new?", Journal of Financial Stability, Vol. 53. 37. ---[PAGE_BREAK]--- See Work stream on non-bank financial intermediation (2021), "Non-bank financial intermediation in the euro area: implications for monetary policy transmission and key vulnerabilities", Occasional Paper Series, No 270. 38 . The natural rate of interest is the real rate of interest that is neither expansionary nor contractionary. 39. See also Moufakkir, M. (2023), "Careful embrace: AI and the ECB", The ECB Blog. 40. This allows us to identify and prioritise anomalous observations and outliers that require further attention, assessment and potential treatment. 41. Osbat, C. (2022), "What micro price data teach us about the inflation process: web-scraping in PRISMA", SUERF Policy Brief, No 470, 17 November. 42. See, for instance, Lenza, M. et al. (2023), "Forecasting euro area inflation with machine learning models", Research Bulletin, No 112, ECB, 17 October. 43. For example, see Menzie, C. et al. (2023), "Nowcasting world trade with machine learning: a threestep approach", Working Paper Series, No 2836, ECB. 44. See, for instance, d'Aspremont, A. (2024), "Satellites turn "concrete": tracking cement with satellite data and neural networks", Working Paper Series, No 2900, ECB. 45. On layered communication, see Work stream on monetary policy communications (2021), "Clear. consistent and engaging: ECB monetary policy communication in a changing world", Occasional Paper Series, No 274, ECB; see also Bholat, D. et al. (2018), "Enhancing central bank communications with behavioural insights", Staff Working Paper Series, Bank of England, No 750, August. 46. Survey evidence suggests that there is a lack of understanding of the ECB's tasks. Two-thirds of euro area citizens believe that it is the ECB's task to stabilise the foreign exchange rate, while over onethird think that the ECB's role is to finance governments. See Chart 7 in Gardt, M. et al. (2021), "ECB communication with the wider public", Economic Bulletin, Issue 8, ECB. 47. ---[PAGE_BREAK]--- Kant, I. (1781), Critique of pure reason. 48. OCED (2024), "OECD Digital Economy Outlook 2024 (Volume 1): Embracing The Technology Frontier", 14 May, p. 38. 49. See Cipollone, P. (2024), "One step ahead: protecting the cyber resilience of financial infrastructures", introductory remarks at the ninth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures, 17 January; and Bank for International Settlements, "Project Raven: using AI to assess financial system's cyber security and resilience". 50. The central bank may no longer observe independent signals about the state of the economy from financial markets, instead mainly seeing the mirror image of its own communications. 51. Echo chamber dynamics can create a circularity between market prices and forward guidance. See Morris, S. and Shin, H. S. (2018), "Central Bank Forward Guidance and the Signal Value of Market Prices", AEA Papers and Proceedings, Vol. 108, May, pp. 572-577. 52. Turing, A. (1950), "Computing Machinery and Intelligence", Mind, Vol. LIX, Issue 236, October, pp. 433-460. 53. For instance, see the role of paradigm shifts in scientific development in Kuhn, T. (1962), The structure of scientific revolutions. See also Felin, T. and Holweg, M. (2024), "Theory Is All You Need: AI. Human Cognition. and Decision Making", 24 February. 54. See Brynjolfsson, E. et al. (2017), "Artificial Intelligence and the Modern Productivity Paradox: A Clash of Expectations and Statistics", NBER Working Paper Series, No 24001, November.	Piero Cipollone	Euro area	https://www.bis.org/review/r240709c.pdf	Rome, 4 July 2024 It is a pleasure to be here today to discuss the implications of artificial intelligence (AI) from a central bank's perspective. The world is witnessing extraordinary advances in the field of AI. to generative AI models capable of creating human-like content. The burgeoning interest in generative AI has boosted AI adoption. A recent international survey revealed that almost three-quarters of organisations had adopted AI for one or more business functions, and around two-thirds of them are using generative AI. Nevertheless, just 8\% reported using AI for five or more business functions - suggesting that we are still in the initial stages of AI integration. AI can be applied to a wide spectrum of activities, from routine and repetitive tasks to knowledgebased and creative work. It has been argued that AI is a general-purpose technology - akin to the steam engine, electricity or the computer - with the potential to transform our economies in the long run. But, like the computer before it, AI may involve a paradox similar to the one made famous by the economist Robert Solow: "You can see the computer age everywhere but in the productivity statistics." The dawn of the computer era saw information and communication technology (ICT) profoundly alter our personal lives and the economy. Today, our workplaces, homes and social lives are interwoven with digitalisation. At the European Central Bank (ECB), our Information Systems department has become the largest business area within the institution. ICT has become key to our core tasks, from the economic models that underpin our forecasts to monetary policy implementation and the operation of market infrastructures. Yet technology has not fundamentally changed the way we think about monetary policy. Moreover, just as Solow observed, the macroeconomic impact of ICT on productivity has not been as large as might have been expected - at least outside of the tech sector. Indeed, the transformative potential of AI may not always be productivity-enhancing. Consider, for example, a recent AI-generated deepfake video of the actor Tom Cruise dressed in a bathrobe and singing Elton John's "Tiny Dancer" to Paris Hilton that went viral on TikTok. Might we see another Solow paradox emerge in the context of AI? In other words, what is the potential of AI to boost the productive capacity of the economy, as well as that of central banks? Today I will take stock of what we know about the impact of AI on the economy and discuss its possible implications for our monetary policy. I will then share the ECB's perspective on how we can best use AI in our central banking tasks, while putting in place the necessary safeguards for its responsible use. Al could affect the economy in several areas that are particularly relevant for the conduct of monetary policy. Today I will highlight just three of them. The first area relates to productivity. The potential of AI to raise productivity is undeniable - from acting as a powerful coding assistant to running autonomous "smart factories". AI could increase productivity through various channels - for example, via direct productivity effects that boost total factor productivity or through individual production factors. Indeed, several studies already point to sizeable AI-induced productivity gains at firm level. The eventual outcome will depend on whether we see a rapid and broad-based adoption and diffusion of AI across all sectors of the economy. Up until now, the sheer speed of diffusion across sectors and firms has little historical precedent. But a key risk stems from the possibility that most of the value created by AI is extracted by a few companies that end up dominating the AI ecosystem. The labour market is the second area of the economy that is likely to be affected by Al. New technologies can substitute or complement labour. On the one hand, automation implies capital taking over a task previously performed by a worker. On the other, productivity tends to increase with the automation of tasks, which may contribute to increased labour demand for non-automated tasks if price reduction brought about by productivity-improving technology spurs strong demand growth. Whether Al represents an opportunity or risk for employment depends on the net effect. ECB staff analysis suggests that around $25 \%$ of jobs in European countries are in occupations that are highly exposed to Al-enabled automation, while another 30\% have a medium degree of exposure. Initial evidence for Europe suggests that, on average, occupations more exposed to Al have seen an increase in their share in total employment - although mostly for highly skilled occupations and younger workers, and with significant heterogeneity across countries. The third area of the economy that may be affected by Al is financial stability. Certainly, Al can bring benefits to the table. The application of Al could allow banks to conduct more efficient risk assessments and capital and liquidity planning. Central banks, including the ECB, are monitoring these developments closely. Not only does AI influence the environment in which we operate, it also affects how that environment interacts with our monetary policy. First, Al could affect cost pressures in the economy in both directions. We may see Al exerting downward pressure on prices in various ways. For instance, if the net effect of Al is that it substitutes labour and increases productivity, we could see a reduced risk of labour shortages and downward pressure on unit labour cost growth. This is especially relevant in the euro area, where unemployment is at a record low and the working age population is projected to decline by $19 \%$ by the end of the century as a result of population ageing. Al could also lead to a decline in energy prices through its impact on the supply side, for instance through enhanced grid management and more efficient energy consumption. And it could provide consumers with better tools for price comparison. But Al could also create upward price pressures. For instance, the uptake of Al will also have an impact on global energy demand, with the computational power required for sustaining Al's rise doubling every 100 days. Second, we may see Al affect monetary policy transmission. Al is likely to create new winners and losers in the labour and capital market, with consequences for income and wealth distribution. This matters for monetary policy because it can influence people's marginal propensity to consume and their access to credit, which in turn affect how demand responds to changes in monetary policy. Moreover, if Al leads to a change in financial structures, such as an increase in non-bank intermediation, Third, Al may go on to influence the natural rate of interest. If Al boosts productivity growth and potential output, we may see upward pressure being exerted on the natural rate of interest, as demand increases for capital to invest in new technologies and expand production capabilities. But if Al leads to higher rates of labour displacement and causes rising income inequality, we may see some downward pressure on the natural rate, owing to an increase in precautionary savings and a subsequent boost to the supply of loanable funds. These developments will play out over time outside the walls of the ECB, and we will be monitoring them closely. But within the ECB's walls, AI also has the potential to help with multiple tasks. Let me give you a few examples. Given that we are here at the National Conference of Statistics, it is fitting to begin with statistics. The ECB needs trustworthy and high-quality statistical products, services and a wide range of data to inform its monetary policy decisions. A key lesson from the global financial crisis was that aggregate statistics alone are insufficient to grasp the complexity of financial markets. We need more granular data. As you can imagine, the resulting datasets are so vast in terms of the number of observations they contain that collecting and disseminating them requires the use of statistical processes and analytical methods that surpass traditional statistical approaches. Around six years ago the ECB began exploring the application of AI to improve the efficiency and effectiveness of its statistical processes. And these efforts are reaping dividends. We use AI to improve the quality of our datasets, from identifying and matching observations across datasets to using modern machine learning techniques for quality assurance. Moreover, large language models (LLMs) can support statistical processes in ways that were once simply not feasible. These include unlocking new and non-traditional data sources - for instance, unstructured data like text, image, video or audio. These sources can complement and enhance our existing data collections. AI is also increasingly being incorporated into the economic analyses we carry out to help us prepare our monetary policy decisions. AI can identify patterns in data more effectively than traditional methods. This is particularly true for non-linearities, which have been playing a bigger role in an environment that is becoming more shock prone. AI also enables the real-time analysis of economic indicators, helping central banks to make more timely policy decisions - a particularly valuable capability in times of crisis. What do these applications look like in practice? ECB staff use AI to nowcast inflation. This includes web-scraping price data and using LLMs for data classification. We are currently exploring the use of Big Data and new generative AI models in close cooperation with the BIS Innovation Hub. Staff are also applying machine learning models to euro area inflation forecasting, accounting for possible non-linearities. Staff are also exploring the possibilities opened up by innovative datasets. For instance, projects include using a combination of text data and machine learning techniques to quantify risks and tensions in the global economy and exploring the use of satellite data to track economic activity. Central bank communication is another area in which AI can contribute. AI could help in areas where central bank communication is key, such as ensuring that policy decisions are well understood and keeping inflation expectations anchored. With AI, we can rapidly analyse vast volumes of media reporting and market commentary. Moreover, AI can help us communicate with the public in all parts of the euro area. As a European institution, the ECB communicates in all 24 official languages of the EU. Even today, AI and machine translation are helping us meet a demand for translation that exceeds 6 million pages per year. Without those tools, the ECB's language services would be limited to covering around 150,000 pages per year. AI can also help broaden our reach by simplifying key messages and communication products for targeted audiences And it could help us answer any questions the public may have. All these innovations could ultimately make the ECB better understood, facilitate the effectiveness of our monetary policy and boost our accountability. AI might also bring profound changes to the field of market infrastructures and payments. The technology could help design and develop innovative payments services customised to consumers' needs and preferences. And it could help foster financial inclusion, for example, by facilitating voice activated payments. These potential developments are clearly relevant when it comes to the ECB's role in promoting efficient, integrated and inclusive payments. Moreover, AI could also help us oversee payment systems. There is an opportunity to use AI as part of early warning models that aim to identify financial stability risks related to financial market infrastructures before these risks materialise. And it could play a supporting role in the scrutiny of information provided by overseen entities, helping us ensure that their practices align with the applicable regulatory frameworks. The ECB has developed an AI action plan to facilitate the adoption of AI wherever it is relevant to our tasks. It aims to develop and deploy the necessary AI tools and infrastructure, while fostering AI skills and ensuring the technology is used safely and responsibly. Let me now turn to the limits of AI. A key strength of human intelligence is the ability to reflect on its limits. As the philosopher Immanuel Kant once wrote, "we can cognize of things a priori only what we ourselves have put into them". But AI does not have this capacity for self-reflection. Nor does it have the ability to produce its own safeguards independently of human critical thinking. We therefore need to be aware of the limits of AI and their implications for the ECB, so that we can put the necessary guardrails in place. First, we need to ensure confidentiality and privacy. Given the sensitivity of central banks' decisions, guaranteeing confidentiality is a key condition for the in-house use of AI. Likewise, when it comes to data use, AI will increase concerns about privacy, underlining the importance of applying technological and governance safeguards and complying with regulations such as the EU AI Act. Take, for instance, the AI solutions we use for our statistics. These tools need to provide comprehensive documentation. This is a prerequisite for clarifying how AI solutions have been used to assess, improve or integrate data. Trust in these solutions comes from first understanding them. The second risk stemming from AI is the degree to which it can be used to spread false information and data, facilitate fraud or launch cyberattacks. Since late 2022 there has been a 53-fold increase in generative AI-related incidents and hazards reported in the media. It is one thing for an AI-generated deepfake video of Tom Cruise to go viral. But it is quite another when a deepfake of a policymaker goes viral - particularly at moments of crisis, when attention levels are high and volatility and uncertainty are already pronounced. At the same time, AI can be used to detect and address such risks. It can help prevent and detect cyberattacks by identifying anomalies in user, system and network behaviours in real time. The third risk emerges from what we might describe as an over-arching dependence on AI. And this can manifest itself in several ways. For instance, a greater dependence on AI may inadvertently increase the risk of falling into an "echo chamber" trap. Given that LLMs are trained using available data and information - which, over time, will increasingly be produced by AI - there is a risk of AI becoming self-referential or repeating existing biases. To the extent that this dynamic increases the impact of central bank communication on markets, while central banks look to the markets for information, it could increase the risk of central bank echo chambers emerging. An excessive reliance on AI could also reduce our own operational resilience. As AI becomes a bigger part of our way of working, we may find ourselves growing more dependent on it for core tasks. That is why it is so important to understand the properties of the AI algorithms and models we use to reduce the risks of a potential "black box" effect. Similarly, if it is not used responsibly, AI could also suppress the diversity and originality of thought, thereby increasing the risk of groupthink and confirmation bias. The mathematician Alan Turing once famously asked, "Can machines think?" The last thing we want is for the same question to be asked about central bankers who end up being too reliant on AI. A key feature of human cognition is the ability to question existing theories, produce new ones and identify data to test them. This ability needs to be preserved. ECB Governing Council meetings are best understood as a process of comparing views on the economy, considering alternative interpretations of economic developments and assessing risks from multiple perspectives. The ongoing uncertainty in the economy shows that we need to do this more, rather than less. The overall lesson is that humans need to remain firmly in control, not only to ensure a trustworthy use of AI systems, but also to address questions of accountability and maintain the public's trust in the central bank. To conclude, as we enter the AI age, we face the challenge of realising its potential while managing its risks. Whether AI will show up in productivity statistics or create a new paradox remains uncertain. To an extent, whether we face an AI productivity paradox will partly depend on our ability to accurately measure its contribution - and statisticians have an important role to play given the complexity of measuring intangible capital. But as with other technologies, for AI to be able to produce its full effects, the right ecosystem must be in place - one that facilitates competition in the AI sphere, ensures a fair distribution of possible productivity gains, establishes robust regulatory and ethical safeguards and fosters the corresponding skills in the labour market. For central banks, AI offers opportunities for innovation and efficiency gains, from economic analysis to communication. But there are also risks that must be considered, and we are duly building appropriate safeguards. As we integrate AI into our processes, we must ensure that human judgement and critical thinking remain at the forefront. This balance will be essential to maintaining trust in our data, our decisions and the broader financial system. Thank you. I would like to thank Jean-Francois Jamet and Simon Mee for their help in preparing this speech, and Siria Angino, Katrin Arnold, Maciej Brzezinski, António Dias Da Silva, Ferdinand Dreher, Maximilian Freier, Gabriel Glöckler, Guzmán González-Torres, Alexander Hodbod, Daniel Kapp, Baptiste Meunier, Roberto Motto, Chiara Osbat, Tom Sanders, Jürgen Schaff, Hanni Schölermann, David Sondermann, Anton Van der Kraaij and Balázs Zsámboki for their input and comments. making sure it's not a walled garden", keynote address at the Bank for International Settlements Financial Stability Institute policy implementation meeting on big tech in insurance, 19 March. 20. 38 . The natural rate of interest is the real rate of interest that is neither expansionary nor contractionary.
2024-07-05T00:00:00	Frank Elderson: Embedding a strong data culture in supervision - another stepping stone towards effective supervision	Introductory remarks by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the Data Innovation for the Future of Regulation (DIFoR) conference, organised by the Financial Conduct Authority, London, 5 July 2024.	Frank Elderson: Embedding a strong data culture in supervision - another stepping stone towards effective supervision Introductory remarks by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the Data Innovation for the Future of Regulation (DIFoR) conference, organised by the Financial Conduct Authority, London, 5 July 2024. * * * Introduction Thank you for inviting me to join this panel on a topic that is of paramount importance for us at ECB Banking Supervision: embedding a strong data culture in the very fabric of our supervisory work. The data revolution is already producing seismic shifts in our societies. New data are being generated at an unprecedented pace. By 2025, the total global amount of data created, captured, copied and consumed is expected to reach 181 zettabytes, up from just two zettabytes in 2010. One zettabyte is equivalent to one trillion gigabytes. If each gigabyte in a zettabyte were a brick, we are talking about enough data to build the Great Wall of China 258 times over. And we are also seeing considerable strides in data innovation. For instance, researchers from the University of Chicago recently found that generative artificial intelligence outperformed financial analysts in predicting future earnings.1 So, what does this avalanche of data and innovation mean for banking supervision? And more importantly, how can prudential supervisors reap the benefits? Why embedding a strong data culture in supervision is crucial The question is no longer about whether we should use these data. It is about how we can use them in the most effective way possible. And for this we need technology, as it is simply not possible to analyse this avalanche of data manually. Embedding a strong data culture and using appropriate technology therefore go hand in hand. The use of data and innovative tools in the banks we supervise is expanding at an astonishing pace. As supervisors, we must remain at the forefront of these 2 technological developments. Data and technology do not only offer substantial efficiency gains. They also improve risk identification processes, helping us to keep a closer grip on the risks in the banks we supervise. This is why we are making greater use of digital tools in our Supervisory Review and 3 Evaluation Process (SREP), which we recently updated. For instance, we are exploring how supervisors can use artificial intelligence and large language models for 4 routine yet often time-consuming tasks. In an increasingly complex risk landscape, this gives supervisors more time to focus on the most material risks facing banks. So, embedding a strong data culture in supervision is no longer a choice. It is an unquestionable business need. But how exactly do we go about it? Supervision at your fingertips: suptech tools Clearly, not all supervisors are data scientists. Their job is to scrutinise the health of the banks they supervise. Bearing in mind the challenges they may face, our goal must be to implement data-driven solutions in a safe and user-friendly way. At ECB Banking Supervision, a key element of our new Digital Strategy 2024-28 is the idea of "'supervision at your fingertips". The aim is to enable supervisors to access key information about the risks facing the banks they supervise in just a few clicks, combining the powers of technology, data and innovation. Think of it as a "smartphone for supervisors" with a wide range of applications that supervisors can customise to their tasks and preferences. Over the past three years, we have been working with national supervisors to develop supervisory technology (suptech) tools in order to address a number of pressing 5 business needs. More than a dozen of these tools have already gone live and are making the daily work of supervisors easier. Today, over 3,500 colleagues across European banking supervision can use them to improve risk analysis, the consistency of decision-making and collaboration. Athena, a platform driven by artificial intelligence, is one example. It helps supervisors find, extract and compare information from a wide variety of sources, ranging from bank documents and supervisory reports to news articles and other external data. Think of it as ChatGPT for supervision - helping supervisors identify patterns, extract key insights and improve the quality of their work. But with the development of generative AI, we are also entering uncharted waters. As with any new technology, it brings the challenge of the unknown. This means we have to take all the necessary steps to guard against potential risks. For this reason, Athena operates in a safe and secure environment tailored to our supervisory needs, providing supervisors with robust results while ensuring data confidentiality. Moreover, we have been clear that supervisors will remain in the driving seat when it comes to taking final supervisory decisions. Supervisory judgement is - and always will be - at the core of effective, risk-based supervision. At the same time, the potential risks associated with new technologies should not be a source of fear. Fear of artificial intelligence and innovation should not be an obstacle to unlocking the considerable potential of these tools to improve the way we work. International cooperation and sharing good practices We are committed to making our supervision more effective through the use of data and innovative tools. And we are doing so together with our partners around the world. We are all facing similar challenges - from Mexico to South Africa, from the United Kingdom to India. This is why, in my view, working closely with other supervisors and central banks and sharing our knowledge is crucial.6 And in recent years we have in fact strengthened our cooperation with our partners. Together with the Bank of England and the Financial Conduct Authority, for example, we have identified some initial areas in which we can collaborate to develop suptech tools. Let us - together - have an open dialogue about good practices and use cases for suptech tools. Let us unlock the considerable potential of data and innovative tools to chart the future course of banking supervision. And let us prepare for any potential risks that the technological revolution may bring. Embedding a strong data culture in supervision will be key if we are to continue delivering high-quality, efficient and effective supervision in the years to come. Thank you for your attention. 1 Kim, A., Muhn, M. and Nikolaev, V.V. (2024), "Financial Statement Analysis with Large Language Models ", 20 May. 2 At ECB Banking Supervision we have therefore established links with leading academic institutions, research centres and course providers such as MIT, INSEAD and Coursera. 3 Buch, C. (2024), "Reforming the SREP: an important milestone towards more efficient The Supervision Blog and effective supervision in a new risk environment ", , 28 May. 4 Supervisory technology tools such as Athena and Delphi, which make use of artificial intelligence to understand and analyse text, are already being used to support supervisors. See ECB (2023), " Suptech: thriving in the digital age ", Supervision Newsletter , ECB, 15 November. 5 McCaul, E. (2024), " SSM digitalisation - from exploration to full-scale adoption ", presentation at Central Banking's Summer Meetings, 12 June. 6 As the Bank for International Settlements also recently highlighted, noting that "central banks need to come together and foster a "community of practice" to share knowledge, data, best practices and AI tools". See Bank for International Settlements (2024), " Artificial intelligence and the economy: implications for central banks ", BIS Annual Economic Report, 25 June.	---[PAGE_BREAK]--- # Frank Elderson: Embedding a strong data culture in supervision another stepping stone towards effective supervision Introductory remarks by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the Data Innovation for the Future of Regulation (DIFoR) conference, organised by the Financial Conduct Authority, London, 5 July 2024. ## Introduction Thank you for inviting me to join this panel on a topic that is of paramount importance for us at ECB Banking Supervision: embedding a strong data culture in the very fabric of our supervisory work. The data revolution is already producing seismic shifts in our societies. New data are being generated at an unprecedented pace. By 2025, the total global amount of data created, captured, copied and consumed is expected to reach 181 zettabytes, up from just two zettabytes in 2010. One zettabyte is equivalent to one trillion gigabytes. If each gigabyte in a zettabyte were a brick, we are talking about enough data to build the Great Wall of China 258 times over. And we are also seeing considerable strides in data innovation. For instance, researchers from the University of Chicago recently found that generative artificial intelligence outperformed financial analysts in predicting future earnings. ${ }^{1}$ So, what does this avalanche of data and innovation mean for banking supervision? And more importantly, how can prudential supervisors reap the benefits? ## Why embedding a strong data culture in supervision is crucial The question is no longer about whether we should use these data. It is about how we can use them in the most effective way possible. And for this we need technology, as it is simply not possible to analyse this avalanche of data manually. Embedding a strong data culture and using appropriate technology therefore go hand in hand. The use of data and innovative tools in the banks we supervise is expanding at an astonishing pace. As supervisors, we must remain at the forefront of these technological developments. ${ }^{2}$ Data and technology do not only offer substantial efficiency gains. They also improve risk identification processes, helping us to keep a closer grip on the risks in the banks we supervise. This is why we are making greater use of digital tools in our Supervisory Review and Evaluation Process (SREP), which we recently updated. ${ }^{3}$ For instance, we are exploring how supervisors can use artificial intelligence and large language models for routine yet often time-consuming tasks. ${ }^{4}$ In an increasingly complex risk landscape, this gives supervisors more time to focus on the most material risks facing banks. ---[PAGE_BREAK]--- So, embedding a strong data culture in supervision is no longer a choice. It is an unquestionable business need. But how exactly do we go about it? # Supervision at your fingertips: suptech tools Clearly, not all supervisors are data scientists. Their job is to scrutinise the health of the banks they supervise. Bearing in mind the challenges they may face, our goal must be to implement data-driven solutions in a safe and user-friendly way. At ECB Banking Supervision, a key element of our new Digital Strategy 2024-28 is the idea of "supervision at your fingertips". The aim is to enable supervisors to access key information about the risks facing the banks they supervise in just a few clicks, combining the powers of technology, data and innovation. Think of it as a "smartphone for supervisors" with a wide range of applications that supervisors can customise to their tasks and preferences. Over the past three years, we have been working with national supervisors to develop supervisory technology (suptech) tools in order to address a number of pressing business needs. ${ }^{5}$ More than a dozen of these tools have already gone live and are making the daily work of supervisors easier. Today, over 3,500 colleagues across European banking supervision can use them to improve risk analysis, the consistency of decision-making and collaboration. Athena, a platform driven by artificial intelligence, is one example. It helps supervisors find, extract and compare information from a wide variety of sources, ranging from bank documents and supervisory reports to news articles and other external data. Think of it as ChatGPT for supervision - helping supervisors identify patterns, extract key insights and improve the quality of their work. But with the development of generative AI, we are also entering uncharted waters. As with any new technology, it brings the challenge of the unknown. This means we have to take all the necessary steps to guard against potential risks. For this reason, Athena operates in a safe and secure environment tailored to our supervisory needs, providing supervisors with robust results while ensuring data confidentiality. Moreover, we have been clear that supervisors will remain in the driving seat when it comes to taking final supervisory decisions. Supervisory judgement is - and always will be - at the core of effective, risk-based supervision. At the same time, the potential risks associated with new technologies should not be a source of fear. Fear of artificial intelligence and innovation should not be an obstacle to unlocking the considerable potential of these tools to improve the way we work. ## International cooperation and sharing good practices We are committed to making our supervision more effective through the use of data and innovative tools. And we are doing so together with our partners around the world. We ---[PAGE_BREAK]--- are all facing similar challenges - from Mexico to South Africa, from the United Kingdom to India. This is why, in my view, working closely with other supervisors and central banks and sharing our knowledge is crucial. $\underline{6}$ And in recent years we have in fact strengthened our cooperation with our partners. Together with the Bank of England and the Financial Conduct Authority, for example, we have identified some initial areas in which we can collaborate to develop suptech tools. Let us - together - have an open dialogue about good practices and use cases for suptech tools. Let us unlock the considerable potential of data and innovative tools to chart the future course of banking supervision. And let us prepare for any potential risks that the technological revolution may bring. Embedding a strong data culture in supervision will be key if we are to continue delivering high-quality, efficient and effective supervision in the years to come. Thank you for your attention. ${ }^{1}$ Kim, A., Muhn, M. and Nikolaev, V.V. (2024), "Financial Statement Analysis with Large Language Models", 20 May. ${ }^{2}$ At ECB Banking Supervision we have therefore established links with leading academic institutions, research centres and course providers such as MIT, INSEAD and Coursera. ${ }^{3}$ Buch, C. (2024), "Reforming the SREP: an important milestone towards more efficient and effective supervision in a new risk environment", The Supervision Blog, 28 May. ${ }^{4}$ Supervisory technology tools such as Athena and Delphi, which make use of artificial intelligence to understand and analyse text, are already being used to support supervisors. See ECB (2023), "Suptech: thriving in the digital age", Supervision Newsletter, ECB, 15 November. ${ }^{5}$ McCaul, E. (2024), "SSM digitalisation - from exploration to full-scale adoption", presentation at Central Banking's Summer Meetings, 12 June. ${ }^{6}$ As the Bank for International Settlements also recently highlighted, noting that "central banks need to come together and foster a "community of practice" to share knowledge, data, best practices and AI tools". See Bank for International Settlements (2024), " Artificial intelligence and the economy: implications for central banks", BIS Annual Economic Report, 25 June.	Frank Elderson	Euro area	https://www.bis.org/review/r240709e.pdf	Introductory remarks by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the Data Innovation for the Future of Regulation (DIFoR) conference, organised by the Financial Conduct Authority, London, 5 July 2024. Thank you for inviting me to join this panel on a topic that is of paramount importance for us at ECB Banking Supervision: embedding a strong data culture in the very fabric of our supervisory work. The data revolution is already producing seismic shifts in our societies. New data are being generated at an unprecedented pace. By 2025, the total global amount of data created, captured, copied and consumed is expected to reach 181 zettabytes, up from just two zettabytes in 2010. One zettabyte is equivalent to one trillion gigabytes. If each gigabyte in a zettabyte were a brick, we are talking about enough data to build the Great Wall of China 258 times over. And we are also seeing considerable strides in data innovation. For instance, researchers from the University of Chicago recently found that generative artificial intelligence outperformed financial analysts in predicting future earnings. So, what does this avalanche of data and innovation mean for banking supervision? And more importantly, how can prudential supervisors reap the benefits? The question is no longer about whether we should use these data. It is about how we can use them in the most effective way possible. And for this we need technology, as it is simply not possible to analyse this avalanche of data manually. Embedding a strong data culture and using appropriate technology therefore go hand in hand. The use of data and innovative tools in the banks we supervise is expanding at an astonishing pace. As supervisors, we must remain at the forefront of these technological developments. Data and technology do not only offer substantial efficiency gains. They also improve risk identification processes, helping us to keep a closer grip on the risks in the banks we supervise. This is why we are making greater use of digital tools in our Supervisory Review and Evaluation Process (SREP), which we recently updated. In an increasingly complex risk landscape, this gives supervisors more time to focus on the most material risks facing banks. So, embedding a strong data culture in supervision is no longer a choice. It is an unquestionable business need. But how exactly do we go about it? Clearly, not all supervisors are data scientists. Their job is to scrutinise the health of the banks they supervise. Bearing in mind the challenges they may face, our goal must be to implement data-driven solutions in a safe and user-friendly way. At ECB Banking Supervision, a key element of our new Digital Strategy 2024-28 is the idea of "supervision at your fingertips". The aim is to enable supervisors to access key information about the risks facing the banks they supervise in just a few clicks, combining the powers of technology, data and innovation. Think of it as a "smartphone for supervisors" with a wide range of applications that supervisors can customise to their tasks and preferences. Over the past three years, we have been working with national supervisors to develop supervisory technology (suptech) tools in order to address a number of pressing business needs. More than a dozen of these tools have already gone live and are making the daily work of supervisors easier. Today, over 3,500 colleagues across European banking supervision can use them to improve risk analysis, the consistency of decision-making and collaboration. Athena, a platform driven by artificial intelligence, is one example. It helps supervisors find, extract and compare information from a wide variety of sources, ranging from bank documents and supervisory reports to news articles and other external data. Think of it as ChatGPT for supervision - helping supervisors identify patterns, extract key insights and improve the quality of their work. But with the development of generative AI, we are also entering uncharted waters. As with any new technology, it brings the challenge of the unknown. This means we have to take all the necessary steps to guard against potential risks. For this reason, Athena operates in a safe and secure environment tailored to our supervisory needs, providing supervisors with robust results while ensuring data confidentiality. Moreover, we have been clear that supervisors will remain in the driving seat when it comes to taking final supervisory decisions. Supervisory judgement is - and always will be - at the core of effective, risk-based supervision. At the same time, the potential risks associated with new technologies should not be a source of fear. Fear of artificial intelligence and innovation should not be an obstacle to unlocking the considerable potential of these tools to improve the way we work. We are committed to making our supervision more effective through the use of data and innovative tools. And we are doing so together with our partners around the world. We are all facing similar challenges - from Mexico to South Africa, from the United Kingdom to India. This is why, in my view, working closely with other supervisors and central banks and sharing our knowledge is crucial. And in recent years we have in fact strengthened our cooperation with our partners. Together with the Bank of England and the Financial Conduct Authority, for example, we have identified some initial areas in which we can collaborate to develop suptech tools. Let us - together - have an open dialogue about good practices and use cases for suptech tools. Let us unlock the considerable potential of data and innovative tools to chart the future course of banking supervision. And let us prepare for any potential risks that the technological revolution may bring. Embedding a strong data culture in supervision will be key if we are to continue delivering high-quality, efficient and effective supervision in the years to come. Thank you for your attention.
2024-07-05T00:00:00	John C Williams: Managing the known unknowns	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Suresh Tendulkar Memorial Lecture, organised by the Reserve Bank of India, Mumbai, 5 July 2024.	FEDERAL RESERVE BANK of NEW YORK Serving the Second District and the Nation SPEECH Managing the Known Unknowns July 05, 2024 John C. Williams, President and Chief Executive Officer Remarks at the Suresh Tendulkar Memorial Lecture, Reserve Bank of India, Mumbai, India As prepared for delivery Introduction Good afternoon. It's a privilege to speak at this lecture series in honor of Professor Suresh Tendulkar, the esteemed economist and policymaker. And I'm pleased to be here with my counterparts at the Reserve Bank of India. We all operate in a highly interconnected global economy. So, meeting with and learning from central bankers and other experts from around the world is an important part of my job. Many of the issues we face are unique, but many are similar, too. One theme that spans the globe has to do with managing the "known unknowns" of monetary policy. Alan Greenspan, the former Chair of the Federal Reserve, once said: "Uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape."* That certainly sums up our experience since the outbreak of the COVID-19 pandemic four and a half years ago. And uncertainty will continue to be the defining characteristic of the monetary policy landscape for the foreseeable future. This is especially true as we face issues like artificial intelligence, climate change, deglobalization, and innovations in the financial system-not to mention the perennial challenges of measuring the so-called star variables such as r-star. Today, I'm going to discuss several key principles that are at the heart of inflation targeting strategies and have proven foundational and invaluable in managing extreme uncertainty. These include accountability, transparency, and well-anchored inflation expectations. While my remarks in important ways are based on the experience of the U.S., these principles have much broader application in preparing policymakers for an uncertain future. Before I go further, I need to provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. The Pandemic Shocks To start today's discussion, I want to set the context by illustrating the impact of just one facet of the extraordinary shocks and extreme uncertainty we've faced since the onset of the COVID-19 pandemic. In this case, I'll look at the path of the New York Fed's Global Supply Chain Pressure Index, which gauges global supply-chain disruptions." In the spring of 2020, this index shot up to a level more than three standard deviations above its historical average. That fall, it plummeted to normal levels. By late 2021, it rose to more than four standard deviations above the historical average. It finally returned to normal levels last year. To put the rarity of such events in perspective, a single four-standard-deviation event would occur about once every 2,500 years based on a standard normal distribution. Global supply-chain disruptions, along with acute imbalances between supply and demand exacerbated by Russia's war on Ukraine, caused inflation to skyrocket around the world. Inflation began to rise in 2021, peaking at over 7 percent in the U.S. in June 2022, the highest rate recorded in over 40 years. It followed a similar pattern in most OECD economies. But its trajectories were different across Asia. For example, in India, inflation was mostly fueled by rising food prices. While there are important differences in the sources of inflation, many central banks-including the Reserve Bank of India-have been faced with the same issue: How to restore price stability at a time when so many parts of our economies are spinning in unpredictable ways? Owning the Responsibility At the Federal Reserve, we did this by relying on central tenets of inflation targeting practiced in the U.S. and many other countries. In particular, I will emphasize three key principles that contributed to a prolonged period of price stability in the U.S. during the quarter century leading up to the pandemic.# The first principle is responsibility: Central banks must own the responsibility to deliver price stability and have independence to act to achieve it. This is a shift in thinking in many economies from prior decades, particularly the 1970s. During that time, many central bankers By continuing to use our site, you agree to our Terms of Use and Privacy Statement. You can learn more about how we use cookies by reviewing our Privacy Statement P<] outside of their control.5 This led to finger-pointing and confusion about whose job it was to restore price stability. The end result was persistent high inflation and economic stagnation. But history taught us that central banks can be more successful at delivering sustainably low inflation when they are accountable and independent.' Today, regardless of economic shocks, changes in fiscal policy, or globalization and deglobalization swings, central banks recognize that attaining and maintaining price stability is their job to do. In the U.S., this responsibility is crystal clear.® Price stability and maximum employment together make up the FOMC's dual mandate. When inflation rose persistently above our target, we acted decisively to bring inflation back down. Commitment to Transparency The second principle that helped us manage the known unknowns is transparency-including the clear communication of a central bank's strategy, policy decisions, and an explicit numerical longer-run inflation target. For central banks, transparency enhances accountability and keeps them clearly focused on achieving their goals. For households and businesses, an explicit and credible inflation target helps take some of the uncertainty off the table so they can focus on planning for their future without having to worry about what will happen to inflation. By improving the public's understanding of a central bank's goals and actions, the central bank can enhance the effectiveness of monetary policy at stabilizing inflation and the economy.910>11 For the Federal Reserve, these concepts-including a 2 percent longer-run inflation target-are outlined in the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy, which it first announced in January 2012.*° In public communications throughout this latest inflationary episode, the FOMC has clearly, consistently, and repeatedly emphasized its strong commitment to its 2 percent inflation target, as well as its monetary policy strategy and decisions to achieve that goal.13 Inflation is now around 2-1/2 percent, so we have seen significant progress in bringing it down. But we still have a way to go to reach our 2 percent target on a sustained basis. We are committed to getting the job done. Importance of Inflation Expectations The third key principle is well-anchored inflation expectations. This principle has become a bedrock of modern central banking, as economic analysis and history have shown that anchoring inflation expectations is important in maintaining low and stable inflation.'4-'5 It is now evident that in the 1960s and 1970s, both short- and longer-term inflation expectations in the U.S. became unmoored, rising as actual inflation rose.!° This made it even more difficult for policymakers to maintain stable prices amid the shocks of that period. In contrast, well-anchored inflation expectations short-circuit so-called second-round effects in wage and price setting that exacerbate and prolong the effects of shocks like we saw during the 1970s. They also create a more favorable short-run trade-off in balancing inflation and employment objectives.'" Central banks help anchor expectations by owning the responsibility to deliver price stability, publicly committing to an explicit inflation target, and taking the actions needed to ensure price stability. The connections between policy communications and actions, inflation outcomes, and expectations are at the core of policy strategies that are robust to extreme uncertainty, a topic that Athanasios Orphanides and I studied in a sequence of research papers.!® Unlike the stylized textbook model of monetary policy, this approach recognizes the high degree of uncertainty in the economy. It also views the anchoring of expectations, or the lack thereof, as the outcome of monetary policy actions and communications. We show that when uncertainty is extreme, policies that are focused on keeping inflation near target-and do not rely too much on hard-to-measure variables like the natural rates of unemployment and interest-perform well at stabilizing inflation and unemployment. So, what do well-anchored inflation expectations look like? In practice, short- and, to some extent, medium-term expectations will be sensitive to economic shocks, rising and falling as inflation increases and moderates, even with well-anchored expectations. But if a central bank has credibility in achieving price stability, longer-term expectations should remain consistent with its inflation target, and the deviation of short- and medium-run expectations from levels consistent with the target should be temporary.'? We saw this pattern reflected in the data from the New York Fed's Survey of Consumer Expectations. As inflation started to rise in 2021, medium- and particularly short-term expectations increased considerably. But despite the severity of the shocks, longer- term inflation expectations remained remarkably stable and close to the FOMC's 2 percent goal.?° Medium-term expectations returned to pre-pandemic levels in 2022. And short-term expectations followed suit in 2023. When the Facts Change Our three principles provide a strong framework to manage shocks and uncertainty. But they are not meant to be overly prescriptive on tactics. In monetary policy, it's important to be nimble in execution even as one is steady in strategy. As John Maynard Keynes is often credited with saying, "When the facts change, I change my mind. What do you do, sir?" By continuing to use our site, you agree to our Terms of Use and Privacy Statement. You can learn more about how we use cookies by reviewing our Privacy Statement P<] Policymakers base their decisions on the totality of the data. When the facts dictate a change, it's crucial to discuss the reasons behind the changes and explain how we anticipate the economy will evolve. The FOMC does this through its post-meeting statements, the Chair's press conferences, the quarterly Summary of Economic Projections, detailed FOMC meeting minutes, and policymaker speeches. Uncertainty in the Years Ahead Ihave talked about how the key tenets of inflation targeting-ownership of price stability and independence of action, transparency about goals and strategy, and a focus on anchored inflation expectations-have served us well in managing the extreme shocks and uncertainty of the past four and a half years. But uncertainty does not only dwell in the past. Despite the very best efforts of economists and others to understand how the economic environment is changing and what it means for monetary policy, we must accept that uncertainty will continue to define the future. These principles and lessons provide a strong foundation for monetary policy that is robust to uncertainty. And I am confident they will continue to serve us well against any challenges and uncertainties we may face ahead. 1 Alan Greenspan, Risk and Uncertainty in Monetary Policy, remarks at the Meetings of the American Economic Association, San Diego, California, January 3, 2004. ? Federal Reserve Bank of New York, Global Supply Chain Pressure Index. 3 As measured by 12-month change in the Personal Consumption Expenditures Price Index. 4 John C. Williams, Connecting Theory and Practice, remarks at Hoover Institution Monetary Policy Conference, Stanford, California, May 3, 2024. 5 Christina D. Romer and David H. Romer, "Lessons from History for Successful Disinflation," University of California, Berkeley, May 12, 2024. 6 Luis I. Jacome and Samuel Pienknagura, Central Bank Independence and Inflation in Latin America-Through the Lens of History, International Monetary Fund Working Paper Number 2022/186 (September 2022). 7 D. Filiz Unsal and Chris Papageorgiou, Monetary Policy Frameworks: An Index and New Evidence, November 7, 2023. 8 Jerome H. Powell, Monetary Policy and Price Stability, remarks at Reassessing Constraints on the Economy and Policy, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022. 9° Anthanasios Orphanides and John C. Williams, 2005. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," in The Inflation-Targeting Debate, Ben S. Bernanke and Michael Woodford (eds.). Chicago: University of Chicago Press for NBER, pp. 201 - 234. Glenn D. Rudebusch and John C. Williams, 2008. Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections, in Asset Prices and Monetary Policy, John Y. Campbell (ed.), Chicago: University of Chicago Press for NBER, pp. 247-284. 10 Michael Woodford, 2012. Methods of Policy Accommodation at the Interest-Rate Lower Bound, in The Changing Policy Landscape, proceedings of the Federal Reserve Bank of Kansas City Jackson Hole Economic Policy Symposium, August 30 - September 1, pp. 185 - 288. 41 Eric T. Swanson and John C. Williams (2014), "Measuring the Effect of the Zero Lower Bound On Medium- and Longer-Term Interest Rates," American Economic Review 104(10): 3154-3185. 2 Board of Governors of the Federal Reserve System, Statement on Longer-Run Goals and Monetary Policy Strategy, January 24, 2012. 13 Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, June 12, 2024. 14 John C. Williams, Inflation Targeting and the Global Financial Crisis: Successes and Challenges, Essay presentation for the South African Reserve Bank, "Conference on Fourteen Years of Inflation Targeting in South Africa and the Challenge of a Changing Mandate," Pretoria, South Africa, October 31, 2014. 415 See Orphanides and Williams (2004, 2005, and 2007). There is a large theoretical and empirical literature on the formation of expectations. See, for example, Evans and Honkapohja (2001), Malmendier and Nagel (2016) , Coiboin et al. (2022), and references therein. 16 Compared to today, measures of inflation expectations in the 1960s and 1970s, especially for longer-term horizons, were more limited. Even so, those data point to inflation expectations becoming unanchored then. For a more formal analysis of inflation expectations since the late 1960s, see Carlos Carvalho, Stefano Eusepi, Emanuel Moench, and Bruce Preston (2023), Anchored Inflation Expectations, American Economic Journal: Macroeconomics, 15(1): 1-47. 17 Athanasios Orphanides and John C. Williams, 2013. "Monetary Policy Mistakes and the Evolution of Inflation Expectations," in The Great Inflation: The Rebirth of Modern Central Banking, ed. by Michael D. Bordo and Athanasios Orphanides, Chicago: University of Chicago Press, 255-97. 18 Athanasios Orphanides and John C. Williams, 2005. Inflation Scares and Forecast-Based Monetary Policy, Review of Economic Dynamics, 8(2): 498-527; Anthanasios Orphanides and John C. Williams, 2005. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," in The Inflation-Targeting Debate, Ben S. Bernanke and Michael Woodford (eds.). Chicago: University of Chicago Press for NBER, pp. 201 - 234; Athanasios Orphanides and John C. Williams, 2007. Inflation Targeting under Imperfect Knowledge, Economic Review (Federal Reserve Bank of San Francisco), 1-61; Athanasios Orphanides and John C. Williams, 2013. "Monetary Policy Mistakes and the Evolution of Inflation Expectations," in The Great Inflation: The Rebirth of Modern Central Banking, ed. by Michael D. Bordo and Athanasios Orphanides, Chicago: University of Chicago Press, 255-97. 19 Athanasios Orphanides and John C. Williams, 2005. Inflation Scares and Forecast-Based Monetary Policy, Review of Economic Dynamics, 8(2): 498-527; John C. Williams, A Steady Anchor in a Stormy Sea, remarks at SNB-FRB-BIS High-Level Conference on Global Risk, Uncertainty, and Volatility, Zurich, Switzerland, November 9, 2022. 20 Federal Reserve Bank of New York, Survey of Consumer Expectations, (May 2024 Survey). By continuing to use our site, you agree to our Terms of Use and Privacy Statement. You can learn more about how we use cookies by reviewing our Privacy Statement P<]	---[PAGE_BREAK]--- # VEDERAL RESERVE BANK of NEW YORK Serving the Second District and the Nation SPEECH ## Managing the Known Unknowns July 05, 2024 John C. Williams, President and Chief Executive Officer ## Remarks at the Suresh Tendulkar Memorial Lecture, Reserve Bank of India, Mumbai, India As prepared for delivery ## Introduction Good afternoon. It's a privilege to speak at this lecture series in honor of Professor Suresh Tendulkar, the esteemed economist and policymaker. And I'm pleased to be here with my counterparts at the Reserve Bank of India. We all operate in a highly interconnected global economy. So, meeting with and learning from central bankers and other experts from around the world is an important part of my job. Many of the issues we face are unique, but many are similar, too. One theme that spans the globe has to do with managing the "known unknowns" of monetary policy. Alan Greenspan, the former Chair of the Federal Reserve, once said: "Uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape." ${ }^{1}$ That certainly sums up our experience since the outbreak of the COVID-19 pandemic four and a half years ago. And uncertainty will continue to be the defining characteristic of the monetary policy landscape for the foreseeable future. This is especially true as we face issues like artificial intelligence, climate change, deglobalization, and innovations in the financial system-not to mention the perennial challenges of measuring the so-called star variables such as r -star. Today, I'm going to discuss several key principles that are at the heart of inflation targeting strategies and have proven foundational and invaluable in managing extreme uncertainty. These include accountability, transparency, and well-anchored inflation expectations. While my remarks in important ways are based on the experience of the U.S., these principles have much broader application in preparing policymakers for an uncertain future. Before I go further, I need to provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. ## The Pandemic Shocks To start today's discussion, I want to set the context by illustrating the impact of just one facet of the extraordinary shocks and extreme uncertainty we've faced since the onset of the COVID-19 pandemic. In this case, I'll look at the path of the New York Fed's Global Supply Chain Pressure Index, which gauges global supply-chain disruptions. ${ }^{2}$ In the spring of 2020, this index shot up to a level more than three standard deviations above its historical average. That fall, it plummeted to normal levels. By late 2021, it rose to more than four standard deviations above the historical average. It finally returned to normal levels last year. To put the rarity of such events in perspective, a single four-standard-deviation event would occur about once every 2,500 years based on a standard normal distribution. Global supply-chain disruptions, along with acute imbalances between supply and demand exacerbated by Russia's war on Ukraine, caused inflation to skyrocket around the world. Inflation began to rise in 2021, peaking at over 7 percent in the U.S. in June 2022, ${ }^{3}$ the highest rate recorded in over 40 years. It followed a similar pattern in most OECD economies. But its trajectories were different across Asia. For example, in India, inflation was mostly fueled by rising food prices. While there are important differences in the sources of inflation, many central banks-including the Reserve Bank of India-have been faced with the same issue: How to restore price stability at a time when so many parts of our economies are spinning in unpredictable ways? ## Owning the Responsibility At the Federal Reserve, we did this by relying on central tenets of inflation targeting practiced in the U.S. and many other countries. In particular, I will emphasize three key principles that contributed to a prolonged period of price stability in the U.S. during the quarter century leading up to the pandemic. ${ }^{4}$ The first principle is responsibility: Central banks must own the responsibility to deliver price stability and have independence to act to achieve it. This is a shift in thinking in many economies from prior decades, particularly the 1970s. During that time, many central bankers ---[PAGE_BREAK]--- outside of their control. ${ }^{5}$ This led to finger-pointing and confusion about whose job it was to restore price stability. The end result was persistent high inflation and economic stagnation. But history taught us that central banks can be more successful at delivering sustainably low inflation when they are accountable and independent. ${ }^{6,7}$ Today, regardless of economic shocks, changes in fiscal policy, or globalization and deglobalization swings, central banks recognize that attaining and maintaining price stability is their job to do. In the U.S., this responsibility is crystal clear. ${ }^{8}$ Price stability and maximum employment together make up the FOMC's dual mandate. When inflation rose persistently above our target, we acted decisively to bring inflation back down. # Commitment to Transparency The second principle that helped us manage the known unknowns is transparency-including the clear communication of a central bank's strategy, policy decisions, and an explicit numerical longer-run inflation target. For central banks, transparency enhances accountability and keeps them clearly focused on achieving their goals. For households and businesses, an explicit and credible inflation target helps take some of the uncertainty off the table so they can focus on planning for their future without having to worry about what will happen to inflation. By improving the public's understanding of a central bank's goals and actions, the central bank can enhance the effectiveness of monetary policy at stabilizing inflation and the economy. ${ }^{9,10,11}$ For the Federal Reserve, these concepts-including a 2 percent longer-run inflation target-are outlined in the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy, which it first announced in January 2012. ${ }^{12}$ In public communications throughout this latest inflationary episode, the FOMC has clearly, consistently, and repeatedly emphasized its strong commitment to its 2 percent inflation target, as well as its monetary policy strategy and decisions to achieve that goal. ${ }^{13}$ Inflation is now around 2-1/2 percent, so we have seen significant progress in bringing it down. But we still have a way to go to reach our 2 percent target on a sustained basis. We are committed to getting the job done. ## Importance of Inflation Expectations The third key principle is well-anchored inflation expectations. This principle has become a bedrock of modern central banking, as economic analysis and history have shown that anchoring inflation expectations is important in maintaining low and stable inflation. ${ }^{14,15}$ It is now evident that in the 1960 and 1970s, both short- and longer-term inflation expectations in the U.S. became unmoored, rising as actual inflation rose. ${ }^{16}$ This made it even more difficult for policymakers to maintain stable prices amid the shocks of that period. In contrast, well-anchored inflation expectations short-circuit so-called second-round effects in wage and price setting that exacerbate and prolong the effects of shocks like we saw during the 1970s. They also create a more favorable short-run trade-off in balancing inflation and employment objectives. ${ }^{17}$ Central banks help anchor expectations by owning the responsibility to deliver price stability, publicly committing to an explicit inflation target, and taking the actions needed to ensure price stability. The connections between policy communications and actions, inflation outcomes, and expectations are at the core of policy strategies that are robust to extreme uncertainty, a topic that Athanasios Orphanides and I studied in a sequence of research papers. ${ }^{18}$ Unlike the stylized textbook model of monetary policy, this approach recognizes the high degree of uncertainty in the economy. It also views the anchoring of expectations, or the lack thereof, as the outcome of monetary policy actions and communications. We show that when uncertainty is extreme, policies that are focused on keeping inflation near target-and do not rely too much on hard-to-measure variables like the natural rates of unemployment and interest-perform well at stabilizing inflation and unemployment. So, what do well-anchored inflation expectations look like? In practice, short- and, to some extent, medium-term expectations will be sensitive to economic shocks, rising and falling as inflation increases and moderates, even with well-anchored expectations. But if a central bank has credibility in achieving price stability, longer-term expectations should remain consistent with its inflation target, and the deviation of short- and medium-run expectations from levels consistent with the target should be temporary. ${ }^{19}$ We saw this pattern reflected in the data from the New York Fed's Survey of Consumer Expectations. As inflation started to rise in 2021, medium- and particularly short-term expectations increased considerably. But despite the severity of the shocks, longerterm inflation expectations remained remarkably stable and close to the FOMC's 2 percent goal. ${ }^{20}$ Medium-term expectations returned to pre-pandemic levels in 2022. And short-term expectations followed suit in 2023. ## When the Facts Change Our three principles provide a strong framework to manage shocks and uncertainty. But they are not meant to be overly prescriptive on tactics. In monetary policy, it's important to be nimble in execution even as one is steady in strategy. As John Maynard Keynes is often credited with saying, "When the facts change, I change my mind. What do you do, sir?" ---[PAGE_BREAK]--- Policymakers base their decisions on the totality of the data. When the facts dictate a change, it's crucial to discuss the reasons behind the changes and explain how we anticipate the economy will evolve. The FOMC does this through its post-meeting statements, the Chair's press conferences, the quarterly Summary of Economic Projections, detailed FOMC meeting minutes, and policymaker speeches. # Uncertainty in the Years Ahead I have talked about how the key tenets of inflation targeting-ownership of price stability and independence of action, transparency about goals and strategy, and a focus on anchored inflation expectations-have served us well in managing the extreme shocks and uncertainty of the past four and a half years. But uncertainty does not only dwell in the past. Despite the very best efforts of economists and others to understand how the economic environment is changing and what it means for monetary policy, we must accept that uncertainty will continue to define the future. These principles and lessons provide a strong foundation for monetary policy that is robust to uncertainty. And I am confident they will continue to serve us well against any challenges and uncertainties we may face ahead. [^0] [^0]: ${ }^{1}$ Alan Greenspan, Risk and Uncertainty in Monetary Policy, remarks at the Meetings of the American Economic Association, San Diego, California, January 3, 2004. ${ }^{2}$ Federal Reserve Bank of New York, Global Supply Chain Pressure Index. ${ }^{3}$ As measured by 12-month change in the Personal Consumption Expenditures Price Index. ${ }^{4}$ John C. Williams, Connecting Theory and Practice, remarks at Hoover Institution Monetary Policy Conference, Stanford, California, May 3, 2024. ${ }^{5}$ Christina D. Romer and David H. Romer, "Lessons from History for Successful Disinflation," University of California, Berkeley, May 12, 2024. ${ }^{6}$ Luis I. Jácome and Samuel Pienknagura, Central Bank Independence and Inflation in Latin America—Through the Lens of History, International Monetary Fund Working Paper Number 2022/186 (September 2022). ${ }^{7}$ D. Filiz Unsal and Chris Papageorgiou, Monetary Policy Framework: An Index and New Evidence, November 7, 2023. ${ }^{8}$ Jerome H. Powell, Monetary Policy and Price Stability, remarks at Reassessing Constraints on the Economy and Policy, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022. ${ }^{9}$ Anthanasios Orphanides and John C. Williams, 2005, "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," in The Inflation-Targeting Debate, Ben S. Bernanke and Michael Woodford (eds.), Chicago: University of Chicago Press for NBER, pp. 201 - 234. Glenn D. Rudebusch and John C. Williams, 2008. Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections, in Asset Prices and Monetary Policy, John Y. Campbell (ed.), Chicago: University of Chicago Press for NBER, pp. 247-284. ${ }^{10}$ Michael Woodford, 2012. Methods of Policy Accommodation at the Interest-Rate Lower Bound, in The Changing Policy Landscape, proceedings of the Federal Reserve Bank of Kansas City Jackson Hole Economic Policy Symposium, August 30 - September 1, pp. 185 - 288. ${ }^{11}$ Eric T. Swanson and John C. Williams (2014), "Measuring the Effect of the Zero Lower Bound On Medium- and Longer-Term Interest Rates," American Economic Review 104(10): 3154-3185. ${ }^{12}$ Board of Governors of the Federal Reserve System, Statement on Longer-Run Goals and Monetary Policy Strategy, January 24, 2012. ${ }^{13}$ Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, June 12, 2024. ${ }^{14}$ John C. Williams, Inflation Targeting and the Global Financial Crisis: Successes and Challenges, Essay presentation for the South African Reserve Bank, "Conference on Fourteen Years of Inflation Targeting in South Africa and the Challenge of a Changing Mandate," Pretoria, South Africa, October 31, 2014. ${ }^{15}$ See Orphanides and Williams (2004, 2005, and 2007). There is a large theoretical and empirical literature on the formation of expectations. See, for example, Evans and Honkapohja (2001), Malmendler and Nagel (2016), Colboin et al. (2022), and references therein. ${ }^{16}$ Compared to today, measures of inflation expectations in the 1960 and 1970s, especially for longer-term horizons, were more limited. Even so, those data point to inflation expectations becoming unanchored then. For a more formal analysis of inflation expectations since the late 1960s, see Carlos Carvalho, Stefano Eusepi, Emanuel Moench, and Bruce Preston (2023), Anchored Inflation Expectations, American Economic Journal: Macroeconomics, 15(1): 1-47. ${ }^{17}$ Athanasios Orphanides and John C. Williams, 2013, "Monetary Policy Mistakes and the Evolution of Inflation Expectations," in The Great Inflation: The Rebirth of Modern Central Banking, ed. by Michael D. Bordo and Athanasios Orphanides, Chicago: University of Chicago Press, 255-97. ${ }^{18}$ Athanasios Orphanides and John C. Williams, 2005. Inflation Scares and Forecast-Based Monetary Policy, Review of Economic Dynamics, 8(2): 498-527; Anthanasios Orphanides and John C. Williams, 2005, "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," in The Inflation-Targeting Debate, Ben S. Bernanke and Michael Woodford (eds.), Chicago: University of Chicago Press for NBER, pp. 201 - 234; Athanasios Orphanides and John C. Williams, 2007. Inflation Targeting under Imperfect Knowledge, Economic Review (Federal Reserve Bank of San Francisco), 1-61; Athanasios Orphanides and John C. Williams, 2013. "Monetary Policy Mistakes and the Evolution of Inflation Expectations," in The Great Inflation: The Rebirth of Modern Central Banking, ed. by Michael D. Bordo and Athanasios Orphanides, Chicago: University of Chicago Press, 255-97. ${ }^{19}$ Athanasios Orphanides and John C. Williams, 2005. Inflation Scares and Forecast-Based Monetary Policy, Review of Economic Dynamics, 8(2): 498-527; John C. Williams, A Steady Anchor in a Stormy Sea, remarks at SNB-FRB-BIS High-Level Conference on Global Risk, Uncertainty, and Volatility, Zurich, Switzerland, November 9, 2022. ${ }^{20}$ Federal Reserve Bank of New York, Survey of Consumer Expectations, (May 2024 Survey).	John C Williams	United States	https://www.bis.org/review/r240709b.pdf	July 05, 2024 John C. Williams, President and Chief Executive Officer As prepared for delivery Good afternoon. It's a privilege to speak at this lecture series in honor of Professor Suresh Tendulkar, the esteemed economist and policymaker. And I'm pleased to be here with my counterparts at the Reserve Bank of India. We all operate in a highly interconnected global economy. So, meeting with and learning from central bankers and other experts from around the world is an important part of my job. Many of the issues we face are unique, but many are similar, too. One theme that spans the globe has to do with managing the "known unknowns" of monetary policy. Alan Greenspan, the former Chair of the Federal Reserve, once said: "Uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape." That certainly sums up our experience since the outbreak of the COVID-19 pandemic four and a half years ago. And uncertainty will continue to be the defining characteristic of the monetary policy landscape for the foreseeable future. This is especially true as we face issues like artificial intelligence, climate change, deglobalization, and innovations in the financial system-not to mention the perennial challenges of measuring the so-called star variables such as r -star. Today, I'm going to discuss several key principles that are at the heart of inflation targeting strategies and have proven foundational and invaluable in managing extreme uncertainty. These include accountability, transparency, and well-anchored inflation expectations. While my remarks in important ways are based on the experience of the U.S., these principles have much broader application in preparing policymakers for an uncertain future. Before I go further, I need to provide the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. To start today's discussion, I want to set the context by illustrating the impact of just one facet of the extraordinary shocks and extreme uncertainty we've faced since the onset of the COVID-19 pandemic. In this case, I'll look at the path of the New York Fed's Global Supply Chain Pressure Index, which gauges global supply-chain disruptions. In the spring of 2020, this index shot up to a level more than three standard deviations above its historical average. That fall, it plummeted to normal levels. By late 2021, it rose to more than four standard deviations above the historical average. It finally returned to normal levels last year. To put the rarity of such events in perspective, a single four-standard-deviation event would occur about once every 2,500 years based on a standard normal distribution. Global supply-chain disruptions, along with acute imbalances between supply and demand exacerbated by Russia's war on Ukraine, caused inflation to skyrocket around the world. Inflation began to rise in 2021, peaking at over 7 percent in the U.S. in June 2022, the highest rate recorded in over 40 years. It followed a similar pattern in most OECD economies. But its trajectories were different across Asia. For example, in India, inflation was mostly fueled by rising food prices. While there are important differences in the sources of inflation, many central banks-including the Reserve Bank of India-have been faced with the same issue: How to restore price stability at a time when so many parts of our economies are spinning in unpredictable ways? At the Federal Reserve, we did this by relying on central tenets of inflation targeting practiced in the U.S. and many other countries. In particular, I will emphasize three key principles that contributed to a prolonged period of price stability in the U.S. during the quarter century leading up to the pandemic. The first principle is responsibility: Central banks must own the responsibility to deliver price stability and have independence to act to achieve it. This is a shift in thinking in many economies from prior decades, particularly the 1970s. During that time, many central bankers outside of their control. This led to finger-pointing and confusion about whose job it was to restore price stability. The end result was persistent high inflation and economic stagnation. But history taught us that central banks can be more successful at delivering sustainably low inflation when they are accountable and independent. Today, regardless of economic shocks, changes in fiscal policy, or globalization and deglobalization swings, central banks recognize that attaining and maintaining price stability is their job to do. In the U.S., this responsibility is crystal clear. Price stability and maximum employment together make up the FOMC's dual mandate. When inflation rose persistently above our target, we acted decisively to bring inflation back down. The second principle that helped us manage the known unknowns is transparency-including the clear communication of a central bank's strategy, policy decisions, and an explicit numerical longer-run inflation target. For central banks, transparency enhances accountability and keeps them clearly focused on achieving their goals. For households and businesses, an explicit and credible inflation target helps take some of the uncertainty off the table so they can focus on planning for their future without having to worry about what will happen to inflation. By improving the public's understanding of a central bank's goals and actions, the central bank can enhance the effectiveness of monetary policy at stabilizing inflation and the economy. For the Federal Reserve, these concepts-including a 2 percent longer-run inflation target-are outlined in the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy, which it first announced in January 2012. Inflation is now around 2-1/2 percent, so we have seen significant progress in bringing it down. But we still have a way to go to reach our 2 percent target on a sustained basis. We are committed to getting the job done. The third key principle is well-anchored inflation expectations. This principle has become a bedrock of modern central banking, as economic analysis and history have shown that anchoring inflation expectations is important in maintaining low and stable inflation. It is now evident that in the 1960 and 1970s, both short- and longer-term inflation expectations in the U.S. became unmoored, rising as actual inflation rose. This made it even more difficult for policymakers to maintain stable prices amid the shocks of that period. In contrast, well-anchored inflation expectations short-circuit so-called second-round effects in wage and price setting that exacerbate and prolong the effects of shocks like we saw during the 1970s. They also create a more favorable short-run trade-off in balancing inflation and employment objectives. Central banks help anchor expectations by owning the responsibility to deliver price stability, publicly committing to an explicit inflation target, and taking the actions needed to ensure price stability. The connections between policy communications and actions, inflation outcomes, and expectations are at the core of policy strategies that are robust to extreme uncertainty, a topic that Athanasios Orphanides and I studied in a sequence of research papers. Unlike the stylized textbook model of monetary policy, this approach recognizes the high degree of uncertainty in the economy. It also views the anchoring of expectations, or the lack thereof, as the outcome of monetary policy actions and communications. We show that when uncertainty is extreme, policies that are focused on keeping inflation near target-and do not rely too much on hard-to-measure variables like the natural rates of unemployment and interest-perform well at stabilizing inflation and unemployment. So, what do well-anchored inflation expectations look like? In practice, short- and, to some extent, medium-term expectations will be sensitive to economic shocks, rising and falling as inflation increases and moderates, even with well-anchored expectations. But if a central bank has credibility in achieving price stability, longer-term expectations should remain consistent with its inflation target, and the deviation of short- and medium-run expectations from levels consistent with the target should be temporary. We saw this pattern reflected in the data from the New York Fed's Survey of Consumer Expectations. As inflation started to rise in 2021, medium- and particularly short-term expectations increased considerably. But despite the severity of the shocks, longerterm inflation expectations remained remarkably stable and close to the FOMC's 2 percent goal. Medium-term expectations returned to pre-pandemic levels in 2022. And short-term expectations followed suit in 2023. Our three principles provide a strong framework to manage shocks and uncertainty. But they are not meant to be overly prescriptive on tactics. In monetary policy, it's important to be nimble in execution even as one is steady in strategy. As John Maynard Keynes is often credited with saying, "When the facts change, I change my mind. What do you do, sir?" Policymakers base their decisions on the totality of the data. When the facts dictate a change, it's crucial to discuss the reasons behind the changes and explain how we anticipate the economy will evolve. The FOMC does this through its post-meeting statements, the Chair's press conferences, the quarterly Summary of Economic Projections, detailed FOMC meeting minutes, and policymaker speeches. I have talked about how the key tenets of inflation targeting-ownership of price stability and independence of action, transparency about goals and strategy, and a focus on anchored inflation expectations-have served us well in managing the extreme shocks and uncertainty of the past four and a half years. But uncertainty does not only dwell in the past. Despite the very best efforts of economists and others to understand how the economic environment is changing and what it means for monetary policy, we must accept that uncertainty will continue to define the future. These principles and lessons provide a strong foundation for monetary policy that is robust to uncertainty. And I am confident they will continue to serve us well against any challenges and uncertainties we may face ahead.
2024-07-09T00:00:00	Michael S Barr: Financial inclusion - past, present, and hopes for the future	Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the Financial Inclusion Practices and Innovations Conference, organised by the Board of Governors of the Federal Reserve System, Washington DC, 9 July 2024.	For release on delivery 9:15 a.m. EDT July 9, 2024 Financial Inclusion: Past, Present, and Hopes for the Future Remarks by Michael S. Barr Vice Chair for Supervision Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Conference Board of Governors of the Federal Reserve System Washington, D.C. July 9, 2024 Thank you, Art, and let me say how excited I am to be a part of the Federal Reserve Board's inaugural conference on financial inclusion and innovation.! Financial inclusion is central to the Federal Reserve's mission of promoting a strong and stable financial system and a healthy economy that works for everyone. This event brings together academics, practitioners, and thought leaders to discuss how financial products and practices are evolving to better meet the needs of individuals and businesses historically underserved by the financial system. I have spent much of my career in the public sector and academia working on topics related to financial inclusion. I've found that projects that bring together public, private, academic, and nonprofit perspectives are often the most productive, since we all approach the issue differently and can learn from each other's perspectives. Forums like these provide good opportunities to form connections and spark collaboration. Looking over the past few decades, significant progress has been made in improving financial inclusion, including progress on many of the issues that will be discussed at this conference. And yet we still have further to go. Continued support for responsible innovation in this space is needed and can benefit from engagement across industry, academia, and regulators. This morning, I will touch on how approaches to financial inclusion have evolved, where things stand today, and how we can continue progress toward a more inclusive financial system. Advancing the Goals of Financial Inclusion The goal of financial inclusion is to improve access to affordable financial services that meet the needs of individuals and businesses. Banking the unbanked is part ' The views here are my own and do not necessarily reflect those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. -2- of that, but we also need to make sure that both bank and nonbank products and services are designed to meet the financial service needs of low- and moderate-income households. And we need strong consumer protections to guard against abuse. Banks are playing a pivotal role in innovating to serve low- and moderate-income households, sometimes in partnership with financial technology companies, or fintechs. For example, we have seen a growing number of banks offering small-dollar loans, expanding use of alternative data to underwrite and price their credit products, and investing in tools to help better understand consumers' financial health. When adopted in a responsible and well-managed manner-with systems, processes, and policies in place to monitor and manage related risks-these innovations can broaden access to fair, affordable, and transparent bank-provided credit. This in turn can create financial resilience among small businesses and help individuals and families become homeowners, build wealth, and become financially empowered. The Importance of Durable Inclusion Innovations in banking services are important to improving financial inclusion. But to have a durable impact on society, innovations must be adopted responsibly. Banks must have controls to manage risks and prevent violations of law, and their approach must keep pace with the growth of new products and services. Complexity can exacerbate risks and requires banks to pay particular attention to ensure that laws are followed and customers protected. To the extent banks are working with fintech partners, banks have a responsibility to manage the risks associated with the third parties they partner with to serve their customers. -3- We have, unfortunately, seen examples of failures of banks to effectively manage the risks of partnerships with other companies that support services to their end customers, and these failures have resulted in customer harm. In communities where people are living on tight budgets or with limited access to financial services, disruptions of this kind can be catastrophic. These examples are a reminder that providing innovative financial services comes with responsibilities to ensure that risks are appropriately controlled. Durably supporting financial inclusion means ensuring that necessary controls grow in step. Use of Alternative Data We do see great promise to improve financial access when innovation is done with the appropriate risk controls in place. One such promising avenue is the use of alternative data in credit decisions involving small-dollar loans. Historically, access to the financial system was limited for many households and small businesses that lacked key financial credentials. For example, traditional credit models favor an applicant that already has a sufficient credit history and a file from a credit reporting bureau to qualify for lending. This leads to a catch-22 where lower-income applicants with scant credit history but ample ability to repay are denied access to credit because they do not have a credit history.? As a result, many lower-income households, both banked and unbanked, ? The Consumer Financial Protection Bureau reports that, as of 2016, 26 million Americans (11 percent of adults) do not have a credit record at one of the three national credit reporting agencies. See Kenneth P. Brevoort and Michelle Kambara, CF'PB Data Point: Becoming Credit Visible (Washington: Consumer Financial Protection Bureau, June 2017), https://files.consumerfinance.gov/f/documents/BecomingCreditVisible_Data_Point_Final.pdf. -4- end up using a range of formal and informal services outside the banking system that too often keep households in a cycle of debt.? Actions by the Federal Reserve have supported the opportunities, as well as identified potential risks, associated with innovations in bank products and practices marketed to those who have limited access to the financial system. In 2019, the Federal Reserve's alternative data statement highlighted the benefits and risks when banks and nonbank firms leverage alternative data in credit underwriting, particularly for borrowers that have been locked out of conventional borrowing.* This guidance underscored the potential benefit of using data that has a clear connection to creditworthiness, such as information on inflows and outflows from a bank customer's deposit account. With the share of households with bank accounts much larger than the share with credit scores and especially with prime or near-prime credit scores, this information has the potential to allow underwriting of a much larger pool of potential reliable borrowers. In addition, in 2020, the Federal Reserve issued principles for responsible small-dollar lending, typically uncollateralized loans of less than $2,000 that often leverage alternative data while being underwritten.> This guidance has encouraged the spread of these types of loans to households and small businesses that otherwise have had limited access to credit.® In 3 For example, see Michael S. Barr, "Financial Services, Savings and Borrowing Among Low- and Moderate-Income Households: Evidence from the Detroit Area Household Financial Services Survey" (3rd Annual Conference on Empirical Legal Studies Papers, March 30, 2008), https://dx.doi.org/10.2139/ssrn.1121195. 4 See Board of Governors of the Federal Reserve System, "Interagency Statement on the Use of Alternative Data in Credit Underwriting," CA letter 19-11 (December 12, 2019), https://www. federalreserve.gov/supervisionreg/caletters/caltr1911.htm. 5 See Board of Governors of the Federal Reserve System, "Interagency Lending Principles for Making Responsible Small-Dollar Loans," SR letter 20-14 / CA 20-8 (May 20, 2020), https://www. federalreserve.gov/supervisionreg/srletters/SR2014.htm. ° For more details on the impact of small-dollar loan guidance, see Daniel Gorin, Sarah Gosky, and Michael Suher, "Empirical Assessment of SR/CA Small-Dollar Lending Letter Impact," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 28, 2023), https://doi.org/10.17016/2380-7172.3329. -5- addition, given the small but growing number of banks partnering with fintechs for alternative data and small-dollar lending, among other things, the Federal Reserve issued guidance in 2023 and 2024 on how to responsibly manage these third-party relationships.' Taken together, these statements are helpful resources to ensure that banks are using the technological innovations from these third parties in safe and responsible ways. As noted in the alternative data guidance, alternative data can be sourced from a bank's own relationship with its customers. And evidence from research and industry experimentation suggests that information on cash flow from an individual's bank account can help predict credit risk while expanding credit access.® We are already seeing progress in this space. Banks and credit unions of all sizes are starting to use alternative data to offer small-dollar loans to their existing customers with short-term liquidity needs. Given the early promise of these loans, this area seems particularly suitable for banks to innovate and experiment safely and fairly, within the confines of safety and soundness standards and consumer protection laws. In addition, banks and others have done extensive work over the past few years to measure the impact of bank products on the financial outcomes of customers. Among those metrics are a set of financial health indicators around a customer's cash flow and payment history that capture their ability to meet their own short-term liquidity needs, 7 See Board of Governors of the Federal Reserve System, "Interagency Guidance on Third-Party Relationships: Risk Management," SR letter 23-4 (June 7, 2023), https://www.federalreserve.gov/supervisionreg/srletters/SR2304.htm; and Board of Governors of the Federal Reserve System, "Third-Party Risk Management: A Guide for Community Banks," SR letter 24-2 / CA 24-1 (May 7, 2024), https://www.federalreserve.gov/supervisionreg/srletters/SR2402.htm. 8 For example, see FinRegLab, "The Use of Cash-Flow Data in Underwriting Credit: Empirical Research Findings," https://finreglab.org/wp-content/uploads/2023/12/FinRegLab_2019-07-25_Research- Report_The-Use-of-Cash-Flow-Data-in-Underwriting-Credit_Empirical-Research-Findings.pdf. -6- build financial capacity, and affordably access financial services over time.? Such indicators can help banks better understand the impact of their products and services on their customers, so that they support their customers' longer-term financial resilience. These indicators can also equip customers with the transparency and tools to assess financial service offerings. Potential of Instant Payments I'd also like to highlight the potential for real-time payment systems-including FedNow® and private sector systems-to advance financial inclusion. These services will enable banks to offer customers the ability to send and receive money immediately, which can help customers weather income disruption and unexpected expenses. By reducing payment delays and the high costs for consumers associated with those delays, FedNow can over time improve access to the financial system and lower costs. Increased Access to Consumer Data I'm also interested to see how increased access to consumer-authorized data will change the landscape for innovation. As the rules, regulations, and practices related to expanded access and sharing of customer-permissioned data flows evolve, consumers may benefit from having a fuller picture of their financial life to better understand ways to improve their financial health. Customer-permissioned data access, alongside innovations in digital identity, also has the potential to allow banks to better assess a borrower's creditworthiness, increase customer access to financial services, offer customized and innovative financial products, and empower individuals to move more freely in the emerging digital financial system. Of course, bank adoption will play a key ° Examples of financial health indicators include a customer earning more than they spend monthly, having access to adequate savings, and maintaining a prime credit score. -7- role in unlocking the power of such innovation. As with most innovations, regulators will need to ensure appropriate measures are in place to protect consumers and promote financial stability. For example, regulators will need to be diligent so that the entities to which consumers grant access to their data safeguard privacy and data security. Community Reinvestment Act: Past, Present, and Future Let me turn now to the importance of the Community Reinvestment Act (CRA) and its role in advancing financial inclusion. As we know well, access to financial services and credit is fundamental to economic security and vital to strong communities. This access is the foundation of homeownership, education, small business development, and other economic activities that improve our lives and neighborhoods. I want to relate these values to the CRA and the Federal Reserve's commitment to encourage access to credit in low- and moderate-income communities. Congress enacted the CRA in 1977 as one of a set of laws, together with the Home Mortgage Disclosure Act, the Fair Housing Act, and the Equal Credit Opportunity Act, to address redlining, other forms of racial discrimination, and lack of access to credit in low- and moderate-income communities. Fair lending laws set the unequivocal standard that there is no place for such discrimination in the financial system. Federal banking agencies reinforce this standard by taking a bank's fair lending record into account when assigning a CRA rating and evaluating whether banks meet the credit needs in low- and moderate-income communities, consistent with safe and sound lending. Through the enactment of the CRA, Congress charged the Federal Reserve and other federal bank regulators with the responsibility of assessing the performance of banks in meeting the credit needs of low- and moderate-income communities. -8- Throughout the CRA's nearly 50 years of supervisory history, the agencies have strived to provide guidance that reflected dynamic changes in the financial landscape and at some points in time revise the regulations to do so. Last October, the federal bank regulatory agencies issued a final rule to strengthen and modernize the regulations implementing the CRA.'° Prior to the issuance of the final tule, the regulations had not been significantly updated since 1995. Throughout the rulemaking process, bankers and community groups consistently emphasized the need for greater clarity, consistency, and transparency than was provided under the existing rules and guidance. In response, much of the detail in the final rule is designed to provide the desired additional clarity. The final rule standardizes the evaluation approach so that it is more consistent across the agencies and more transparent to banks and the public. It does this in a way that builds on how CRA examinations are conducted today. The final rule includes several provisions intended to advance financial inclusion. For example, it emphasizes the work that minority depository institutions (MDIs) and community development financial institutions do to expand access to credit and opportunity in underserved communities. It also includes a focus on activities that serve Native Land Areas, persistent poverty areas, and other high-need areas. We take our supervisory responsibilities under the CRA seriously, knowing that it helps to foster real opportunity for consumers and communities. The CRA has served as a critical tool to support financial inclusion across the country since its passage and will remain a vital tool for bankers and community organizations to work together to promote '0 Community Reinvestment Act, 89 Fed. Reg. 6,574 (February 1, 2024), https://www.govinfo.gov/content/pkg/FR-2024-02-01/pdf/2023-25797.pdf. -9- financial inclusion and economic development in low- and moderate-income communities. The Future of Financial Inclusion Given the importance of innovation to the goal of financial inclusion, I am grateful that we have been able to gather so many experts on topics related to it. While we have made considerable progress, we need to continue our efforts to support greater inclusion and a financial system that meets the needs of all Americans. At the Federal Reserve, we will continue to work to improve our understanding of the innovations in financial inclusion, and the intersection of payments innovation and financial inclusion, among others. We also will use our position to monitor innovations that have financial inclusion implications-such as alternative data use and financial health measurement-and keep the public informed on the evolving industry practices that help meet the needs of the financially underserved. For example, we expect to provide additional resources on alternative data use in the coming months. In addition, the Fed's Partnership for Progress program helps MDIs and women's depository institutions (WDIs) navigate their unique business challenges, provides MDIs and WDIs with resources for technical assistance, and conducts research on the unique challenges faced by low- and moderate-income communities.!! We also actively partner with Native American communities to better understand their financial needs. "I Details about the Partnership for Progress program for MDIs and WDIs can be found in SR letter 21-6 / CA 21-4. See Board of Governors of the Federal Reserve System, "Highlighting the Federal Reserve System's Partnership for Progress Program for Minority Depository Institutions and Women's Depository Institutions," SR letter 21-6 / CA 21-4 (March 5, 2021), https://www. federalreserve.gov/supervisionreg/srletters/SR2106.htm. -10- In addition to the Federal Reserve's role, the private sector is a key source for financial innovation, and we encourage businesses to responsibly innovate so that new tools that can increase financial inclusiveness are safe for customers and consistent with financial stability. We would all benefit from additional research in this area. For instance, how do we help ensure that expanding access to fair and affordable credit advances safe and sound lending? Empirically, which innovations are best able to meet customer needs safely and affordably, maintain bank safety and soundness, and promote a healthier economy? And how can we leverage concepts in behavioral economics to improve the effectiveness of credit products? I hope the conversations in today's conference can spark productive dialogue and spur potential research in these areas. Conclusion In closing, my hope is that these kinds of efforts, as well as continued innovation in the banking system, can bring us closer to a time when all families and communities in our country have adequate access to credit and financial services on fair, affordable, transparent, and accessible terms.	---[PAGE_BREAK]--- For release on delivery 9:15 a.m. EDT July 9, 2024 Financial Inclusion: Past, Present, and Hopes for the Future Remarks by Michael S. Barr Vice Chair for Supervision Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Conference Board of Governors of the Federal Reserve System Washington, D.C. ---[PAGE_BREAK]--- Thank you, Art, and let me say how excited I am to be a part of the Federal Reserve Board's inaugural conference on financial inclusion and innovation. ${ }^{1}$ Financial inclusion is central to the Federal Reserve's mission of promoting a strong and stable financial system and a healthy economy that works for everyone. This event brings together academics, practitioners, and thought leaders to discuss how financial products and practices are evolving to better meet the needs of individuals and businesses historically underserved by the financial system. I have spent much of my career in the public sector and academia working on topics related to financial inclusion. I've found that projects that bring together public, private, academic, and nonprofit perspectives are often the most productive, since we all approach the issue differently and can learn from each other's perspectives. Forums like these provide good opportunities to form connections and spark collaboration. Looking over the past few decades, significant progress has been made in improving financial inclusion, including progress on many of the issues that will be discussed at this conference. And yet we still have further to go. Continued support for responsible innovation in this space is needed and can benefit from engagement across industry, academia, and regulators. This morning, I will touch on how approaches to financial inclusion have evolved, where things stand today, and how we can continue progress toward a more inclusive financial system. # Advancing the Goals of Financial Inclusion The goal of financial inclusion is to improve access to affordable financial services that meet the needs of individuals and businesses. Banking the unbanked is part [^0] [^0]: ${ }^{1}$ The views here are my own and do not necessarily reflect those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- of that, but we also need to make sure that both bank and nonbank products and services are designed to meet the financial service needs of low- and moderate-income households. And we need strong consumer protections to guard against abuse. Banks are playing a pivotal role in innovating to serve low- and moderate-income households, sometimes in partnership with financial technology companies, or fintechs. For example, we have seen a growing number of banks offering small-dollar loans, expanding use of alternative data to underwrite and price their credit products, and investing in tools to help better understand consumers' financial health. When adopted in a responsible and well-managed manner-with systems, processes, and policies in place to monitor and manage related risks-these innovations can broaden access to fair, affordable, and transparent bank-provided credit. This in turn can create financial resilience among small businesses and help individuals and families become homeowners, build wealth, and become financially empowered. # The Importance of Durable Inclusion Innovations in banking services are important to improving financial inclusion. But to have a durable impact on society, innovations must be adopted responsibly. Banks must have controls to manage risks and prevent violations of law, and their approach must keep pace with the growth of new products and services. Complexity can exacerbate risks and requires banks to pay particular attention to ensure that laws are followed and customers protected. To the extent banks are working with fintech partners, banks have a responsibility to manage the risks associated with the third parties they partner with to serve their customers. ---[PAGE_BREAK]--- We have, unfortunately, seen examples of failures of banks to effectively manage the risks of partnerships with other companies that support services to their end customers, and these failures have resulted in customer harm. In communities where people are living on tight budgets or with limited access to financial services, disruptions of this kind can be catastrophic. These examples are a reminder that providing innovative financial services comes with responsibilities to ensure that risks are appropriately controlled. Durably supporting financial inclusion means ensuring that necessary controls grow in step. # Use of Alternative Data We do see great promise to improve financial access when innovation is done with the appropriate risk controls in place. One such promising avenue is the use of alternative data in credit decisions involving small-dollar loans. Historically, access to the financial system was limited for many households and small businesses that lacked key financial credentials. For example, traditional credit models favor an applicant that already has a sufficient credit history and a file from a credit reporting bureau to qualify for lending. This leads to a catch- 22 where lower-income applicants with scant credit history but ample ability to repay are denied access to credit because they do not have a credit history. ${ }^{2}$ As a result, many lower-income households, both banked and unbanked, [^0] [^0]: ${ }^{2}$ The Consumer Financial Protection Bureau reports that, as of 2016, 26 million Americans (11 percent of adults) do not have a credit record at one of the three national credit reporting agencies. See Kenneth P. Brevoort and Michelle Kambara, CFPB Data Point: Becoming Credit Visible (Washington: Consumer Financial Protection Bureau, June 2017), https://files.consumerfinance.gov/f/documents/BecomingCreditVisible_Data_Point_Final.pdf. ---[PAGE_BREAK]--- end up using a range of formal and informal services outside the banking system that too often keep households in a cycle of debt. ${ }^{3}$ Actions by the Federal Reserve have supported the opportunities, as well as identified potential risks, associated with innovations in bank products and practices marketed to those who have limited access to the financial system. In 2019, the Federal Reserve's alternative data statement highlighted the benefits and risks when banks and nonbank firms leverage alternative data in credit underwriting, particularly for borrowers that have been locked out of conventional borrowing. ${ }^{4}$ This guidance underscored the potential benefit of using data that has a clear connection to creditworthiness, such as information on inflows and outflows from a bank customer's deposit account. With the share of households with bank accounts much larger than the share with credit scores and especially with prime or near-prime credit scores, this information has the potential to allow underwriting of a much larger pool of potential reliable borrowers. In addition, in 2020, the Federal Reserve issued principles for responsible small-dollar lending, typically uncollateralized loans of less than $\$ 2,000$ that often leverage alternative data while being underwritten. ${ }^{5}$ This guidance has encouraged the spread of these types of loans to households and small businesses that otherwise have had limited access to credit. ${ }^{6}$ In [^0] [^0]: ${ }^{3}$ For example, see Michael S. Barr, "Financial Services, Savings and Borrowing Among Low- and Moderate-Income Households: Evidence from the Detroit Area Household Financial Services Survey" (3rd Annual Conference on Empirical Legal Studies Papers, March 30, 2008), https://dx.doi.org/10.2139/ssrn. 1121195. ${ }^{4}$ See Board of Governors of the Federal Reserve System, "Interagency Statement on the Use of Alternative Data in Credit Underwriting," CA letter 19-11 (December 12, 2019), https://www.federalreserve.gov/supervisionreg/caletters/caltr1911.htm. ${ }^{5}$ See Board of Governors of the Federal Reserve System, "Interagency Lending Principles for Making Responsible Small-Dollar Loans," SR letter 20-14 / CA 20-8 (May 20, 2020), https://www.federalreserve.gov/supervisionreg/arletters/SR2014.htm. ${ }^{6}$ For more details on the impact of small-dollar loan guidance, see Daniel Gorin, Sarah Gosky, and Michael Suher, "Empirical Assessment of SR/CA Small-Dollar Lending Letter Impact," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 28, 2023), https://doi.org/10.17016/2380-7172.3329. ---[PAGE_BREAK]--- addition, given the small but growing number of banks partnering with fintechs for alternative data and small-dollar lending, among other things, the Federal Reserve issued guidance in 2023 and 2024 on how to responsibly manage these third-party relationships. ${ }^{7}$ Taken together, these statements are helpful resources to ensure that banks are using the technological innovations from these third parties in safe and responsible ways. As noted in the alternative data guidance, alternative data can be sourced from a bank's own relationship with its customers. And evidence from research and industry experimentation suggests that information on cash flow from an individual's bank account can help predict credit risk while expanding credit access. ${ }^{8}$ We are already seeing progress in this space. Banks and credit unions of all sizes are starting to use alternative data to offer small-dollar loans to their existing customers with short-term liquidity needs. Given the early promise of these loans, this area seems particularly suitable for banks to innovate and experiment safely and fairly, within the confines of safety and soundness standards and consumer protection laws. In addition, banks and others have done extensive work over the past few years to measure the impact of bank products on the financial outcomes of customers. Among those metrics are a set of financial health indicators around a customer's cash flow and payment history that capture their ability to meet their own short-term liquidity needs, [^0] [^0]: ${ }^{7}$ See Board of Governors of the Federal Reserve System, "Interagency Guidance on Third-Party Relationships: Risk Management," SR letter 23-4 (June 7, 2023), https://www.federalreserve.gov/supervisionreg/srletters/SR2304.htm; and Board of Governors of the Federal Reserve System, "Third-Party Risk Management: A Guide for Community Banks," SR letter 24-2 / CA 24-1 (May 7, 2024), https://www.federalreserve.gov/supervisionreg/srletters/SR2402.htm. ${ }^{8}$ For example, see FinRegLab, "The Use of Cash-Flow Data in Underwriting Credit: Empirical Research Findings," https://finreglab.org/wp-content/uploads/2023/12/FinRegLab_2019-07-25_Research-Report_The-Use-of-Cash-Flow-Data-in-Underwriting-Credit_Empirical-Research-Findings.pdf. ---[PAGE_BREAK]--- build financial capacity, and affordably access financial services over time. ${ }^{9}$ Such indicators can help banks better understand the impact of their products and services on their customers, so that they support their customers' longer-term financial resilience. These indicators can also equip customers with the transparency and tools to assess financial service offerings. # Potential of Instant Payments I'd also like to highlight the potential for real-time payment systems-including FedNow ${ }^{\circledR}$ and private sector systems-to advance financial inclusion. These services will enable banks to offer customers the ability to send and receive money immediately, which can help customers weather income disruption and unexpected expenses. By reducing payment delays and the high costs for consumers associated with those delays, FedNow can over time improve access to the financial system and lower costs. ## Increased Access to Consumer Data I'm also interested to see how increased access to consumer-authorized data will change the landscape for innovation. As the rules, regulations, and practices related to expanded access and sharing of customer-permissioned data flows evolve, consumers may benefit from having a fuller picture of their financial life to better understand ways to improve their financial health. Customer-permissioned data access, alongside innovations in digital identity, also has the potential to allow banks to better assess a borrower's creditworthiness, increase customer access to financial services, offer customized and innovative financial products, and empower individuals to move more freely in the emerging digital financial system. Of course, bank adoption will play a key [^0] [^0]: ${ }^{9}$ Examples of financial health indicators include a customer earning more than they spend monthly, having access to adequate savings, and maintaining a prime credit score. ---[PAGE_BREAK]--- role in unlocking the power of such innovation. As with most innovations, regulators will need to ensure appropriate measures are in place to protect consumers and promote financial stability. For example, regulators will need to be diligent so that the entities to which consumers grant access to their data safeguard privacy and data security. # Community Reinvestment Act: Past, Present, and Future Let me turn now to the importance of the Community Reinvestment Act (CRA) and its role in advancing financial inclusion. As we know well, access to financial services and credit is fundamental to economic security and vital to strong communities. This access is the foundation of homeownership, education, small business development, and other economic activities that improve our lives and neighborhoods. I want to relate these values to the CRA and the Federal Reserve's commitment to encourage access to credit in low- and moderate-income communities. Congress enacted the CRA in 1977 as one of a set of laws, together with the Home Mortgage Disclosure Act, the Fair Housing Act, and the Equal Credit Opportunity Act, to address redlining, other forms of racial discrimination, and lack of access to credit in low- and moderate-income communities. Fair lending laws set the unequivocal standard that there is no place for such discrimination in the financial system. Federal banking agencies reinforce this standard by taking a bank's fair lending record into account when assigning a CRA rating and evaluating whether banks meet the credit needs in low- and moderate-income communities, consistent with safe and sound lending. Through the enactment of the CRA, Congress charged the Federal Reserve and other federal bank regulators with the responsibility of assessing the performance of banks in meeting the credit needs of low- and moderate-income communities. ---[PAGE_BREAK]--- Throughout the CRA's nearly 50 years of supervisory history, the agencies have strived to provide guidance that reflected dynamic changes in the financial landscape and at some points in time revise the regulations to do so. Last October, the federal bank regulatory agencies issued a final rule to strengthen and modernize the regulations implementing the CRA. ${ }^{10}$ Prior to the issuance of the final rule, the regulations had not been significantly updated since 1995. Throughout the rulemaking process, bankers and community groups consistently emphasized the need for greater clarity, consistency, and transparency than was provided under the existing rules and guidance. In response, much of the detail in the final rule is designed to provide the desired additional clarity. The final rule standardizes the evaluation approach so that it is more consistent across the agencies and more transparent to banks and the public. It does this in a way that builds on how CRA examinations are conducted today. The final rule includes several provisions intended to advance financial inclusion. For example, it emphasizes the work that minority depository institutions (MDIs) and community development financial institutions do to expand access to credit and opportunity in underserved communities. It also includes a focus on activities that serve Native Land Areas, persistent poverty areas, and other high-need areas. We take our supervisory responsibilities under the CRA seriously, knowing that it helps to foster real opportunity for consumers and communities. The CRA has served as a critical tool to support financial inclusion across the country since its passage and will remain a vital tool for bankers and community organizations to work together to promote [^0] [^0]: ${ }^{10}$ Community Reinvestment Act, 89 Fed. Reg. 6,574 (February 1, 2024), https://www.govinfo.gov/content/pkg/FR-2024-02-01/pdf/2023-25797.pdf. ---[PAGE_BREAK]--- financial inclusion and economic development in low- and moderate-income communities. # The Future of Financial Inclusion Given the importance of innovation to the goal of financial inclusion, I am grateful that we have been able to gather so many experts on topics related to it. While we have made considerable progress, we need to continue our efforts to support greater inclusion and a financial system that meets the needs of all Americans. At the Federal Reserve, we will continue to work to improve our understanding of the innovations in financial inclusion, and the intersection of payments innovation and financial inclusion, among others. We also will use our position to monitor innovations that have financial inclusion implications - such as alternative data use and financial health measurement - and keep the public informed on the evolving industry practices that help meet the needs of the financially underserved. For example, we expect to provide additional resources on alternative data use in the coming months. In addition, the Fed's Partnership for Progress program helps MDIs and women's depository institutions (WDIs) navigate their unique business challenges, provides MDIs and WDIs with resources for technical assistance, and conducts research on the unique challenges faced by low- and moderate-income communities. ${ }^{11}$ We also actively partner with Native American communities to better understand their financial needs. [^0] [^0]: ${ }^{11}$ Details about the Partnership for Progress program for MDIs and WDIs can be found in SR letter 21-6 / CA 21-4. See Board of Governors of the Federal Reserve System, "Highlighting the Federal Reserve System's Partnership for Progress Program for Minority Depository Institutions and Women's Depository Institutions," SR letter 21-6 / CA 21-4 (March 5, 2021), https://www.federalreserve.gov/supervisionreg/srletters/SR2106.htm. ---[PAGE_BREAK]--- In addition to the Federal Reserve's role, the private sector is a key source for financial innovation, and we encourage businesses to responsibly innovate so that new tools that can increase financial inclusiveness are safe for customers and consistent with financial stability. We would all benefit from additional research in this area. For instance, how do we help ensure that expanding access to fair and affordable credit advances safe and sound lending? Empirically, which innovations are best able to meet customer needs safely and affordably, maintain bank safety and soundness, and promote a healthier economy? And how can we leverage concepts in behavioral economics to improve the effectiveness of credit products? I hope the conversations in today's conference can spark productive dialogue and spur potential research in these areas. # Conclusion In closing, my hope is that these kinds of efforts, as well as continued innovation in the banking system, can bring us closer to a time when all families and communities in our country have adequate access to credit and financial services on fair, affordable, transparent, and accessible terms.	Michael S Barr	United States	https://www.bis.org/review/r240715a.pdf	For release on delivery 9:15 a.m. EDT July 9, 2024 Financial Inclusion: Past, Present, and Hopes for the Future Remarks by Michael S. Barr Vice Chair for Supervision Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Conference Board of Governors of the Federal Reserve System Washington, D.C. Thank you, Art, and let me say how excited I am to be a part of the Federal Reserve Board's inaugural conference on financial inclusion and innovation. Financial inclusion is central to the Federal Reserve's mission of promoting a strong and stable financial system and a healthy economy that works for everyone. This event brings together academics, practitioners, and thought leaders to discuss how financial products and practices are evolving to better meet the needs of individuals and businesses historically underserved by the financial system. I have spent much of my career in the public sector and academia working on topics related to financial inclusion. I've found that projects that bring together public, private, academic, and nonprofit perspectives are often the most productive, since we all approach the issue differently and can learn from each other's perspectives. Forums like these provide good opportunities to form connections and spark collaboration. Looking over the past few decades, significant progress has been made in improving financial inclusion, including progress on many of the issues that will be discussed at this conference. And yet we still have further to go. Continued support for responsible innovation in this space is needed and can benefit from engagement across industry, academia, and regulators. This morning, I will touch on how approaches to financial inclusion have evolved, where things stand today, and how we can continue progress toward a more inclusive financial system. The goal of financial inclusion is to improve access to affordable financial services that meet the needs of individuals and businesses. Banking the unbanked is part of that, but we also need to make sure that both bank and nonbank products and services are designed to meet the financial service needs of low- and moderate-income households. And we need strong consumer protections to guard against abuse. Banks are playing a pivotal role in innovating to serve low- and moderate-income households, sometimes in partnership with financial technology companies, or fintechs. For example, we have seen a growing number of banks offering small-dollar loans, expanding use of alternative data to underwrite and price their credit products, and investing in tools to help better understand consumers' financial health. When adopted in a responsible and well-managed manner-with systems, processes, and policies in place to monitor and manage related risks-these innovations can broaden access to fair, affordable, and transparent bank-provided credit. This in turn can create financial resilience among small businesses and help individuals and families become homeowners, build wealth, and become financially empowered. Innovations in banking services are important to improving financial inclusion. But to have a durable impact on society, innovations must be adopted responsibly. Banks must have controls to manage risks and prevent violations of law, and their approach must keep pace with the growth of new products and services. Complexity can exacerbate risks and requires banks to pay particular attention to ensure that laws are followed and customers protected. To the extent banks are working with fintech partners, banks have a responsibility to manage the risks associated with the third parties they partner with to serve their customers. We have, unfortunately, seen examples of failures of banks to effectively manage the risks of partnerships with other companies that support services to their end customers, and these failures have resulted in customer harm. In communities where people are living on tight budgets or with limited access to financial services, disruptions of this kind can be catastrophic. These examples are a reminder that providing innovative financial services comes with responsibilities to ensure that risks are appropriately controlled. Durably supporting financial inclusion means ensuring that necessary controls grow in step. We do see great promise to improve financial access when innovation is done with the appropriate risk controls in place. One such promising avenue is the use of alternative data in credit decisions involving small-dollar loans. Historically, access to the financial system was limited for many households and small businesses that lacked key financial credentials. For example, traditional credit models favor an applicant that already has a sufficient credit history and a file from a credit reporting bureau to qualify for lending. This leads to a catch- 22 where lower-income applicants with scant credit history but ample ability to repay are denied access to credit because they do not have a credit history. As a result, many lower-income households, both banked and unbanked, end up using a range of formal and informal services outside the banking system that too often keep households in a cycle of debt. Actions by the Federal Reserve have supported the opportunities, as well as identified potential risks, associated with innovations in bank products and practices marketed to those who have limited access to the financial system. In 2019, the Federal Reserve's alternative data statement highlighted the benefits and risks when banks and nonbank firms leverage alternative data in credit underwriting, particularly for borrowers that have been locked out of conventional borrowing. In addition, given the small but growing number of banks partnering with fintechs for alternative data and small-dollar lending, among other things, the Federal Reserve issued guidance in 2023 and 2024 on how to responsibly manage these third-party relationships. Taken together, these statements are helpful resources to ensure that banks are using the technological innovations from these third parties in safe and responsible ways. As noted in the alternative data guidance, alternative data can be sourced from a bank's own relationship with its customers. And evidence from research and industry experimentation suggests that information on cash flow from an individual's bank account can help predict credit risk while expanding credit access. We are already seeing progress in this space. Banks and credit unions of all sizes are starting to use alternative data to offer small-dollar loans to their existing customers with short-term liquidity needs. Given the early promise of these loans, this area seems particularly suitable for banks to innovate and experiment safely and fairly, within the confines of safety and soundness standards and consumer protection laws. In addition, banks and others have done extensive work over the past few years to measure the impact of bank products on the financial outcomes of customers. Among those metrics are a set of financial health indicators around a customer's cash flow and payment history that capture their ability to meet their own short-term liquidity needs, build financial capacity, and affordably access financial services over time. Such indicators can help banks better understand the impact of their products and services on their customers, so that they support their customers' longer-term financial resilience. These indicators can also equip customers with the transparency and tools to assess financial service offerings. I'd also like to highlight the potential for real-time payment systems-including FedNow and private sector systems-to advance financial inclusion. These services will enable banks to offer customers the ability to send and receive money immediately, which can help customers weather income disruption and unexpected expenses. By reducing payment delays and the high costs for consumers associated with those delays, FedNow can over time improve access to the financial system and lower costs. I'm also interested to see how increased access to consumer-authorized data will change the landscape for innovation. As the rules, regulations, and practices related to expanded access and sharing of customer-permissioned data flows evolve, consumers may benefit from having a fuller picture of their financial life to better understand ways to improve their financial health. Customer-permissioned data access, alongside innovations in digital identity, also has the potential to allow banks to better assess a borrower's creditworthiness, increase customer access to financial services, offer customized and innovative financial products, and empower individuals to move more freely in the emerging digital financial system. Of course, bank adoption will play a key role in unlocking the power of such innovation. As with most innovations, regulators will need to ensure appropriate measures are in place to protect consumers and promote financial stability. For example, regulators will need to be diligent so that the entities to which consumers grant access to their data safeguard privacy and data security. Let me turn now to the importance of the Community Reinvestment Act (CRA) and its role in advancing financial inclusion. As we know well, access to financial services and credit is fundamental to economic security and vital to strong communities. This access is the foundation of homeownership, education, small business development, and other economic activities that improve our lives and neighborhoods. I want to relate these values to the CRA and the Federal Reserve's commitment to encourage access to credit in low- and moderate-income communities. Congress enacted the CRA in 1977 as one of a set of laws, together with the Home Mortgage Disclosure Act, the Fair Housing Act, and the Equal Credit Opportunity Act, to address redlining, other forms of racial discrimination, and lack of access to credit in low- and moderate-income communities. Fair lending laws set the unequivocal standard that there is no place for such discrimination in the financial system. Federal banking agencies reinforce this standard by taking a bank's fair lending record into account when assigning a CRA rating and evaluating whether banks meet the credit needs in low- and moderate-income communities, consistent with safe and sound lending. Through the enactment of the CRA, Congress charged the Federal Reserve and other federal bank regulators with the responsibility of assessing the performance of banks in meeting the credit needs of low- and moderate-income communities. Throughout the CRA's nearly 50 years of supervisory history, the agencies have strived to provide guidance that reflected dynamic changes in the financial landscape and at some points in time revise the regulations to do so. Last October, the federal bank regulatory agencies issued a final rule to strengthen and modernize the regulations implementing the CRA. Prior to the issuance of the final rule, the regulations had not been significantly updated since 1995. Throughout the rulemaking process, bankers and community groups consistently emphasized the need for greater clarity, consistency, and transparency than was provided under the existing rules and guidance. In response, much of the detail in the final rule is designed to provide the desired additional clarity. The final rule standardizes the evaluation approach so that it is more consistent across the agencies and more transparent to banks and the public. It does this in a way that builds on how CRA examinations are conducted today. The final rule includes several provisions intended to advance financial inclusion. For example, it emphasizes the work that minority depository institutions (MDIs) and community development financial institutions do to expand access to credit and opportunity in underserved communities. It also includes a focus on activities that serve Native Land Areas, persistent poverty areas, and other high-need areas. We take our supervisory responsibilities under the CRA seriously, knowing that it helps to foster real opportunity for consumers and communities. The CRA has served as a critical tool to support financial inclusion across the country since its passage and will remain a vital tool for bankers and community organizations to work together to promote financial inclusion and economic development in low- and moderate-income communities. Given the importance of innovation to the goal of financial inclusion, I am grateful that we have been able to gather so many experts on topics related to it. While we have made considerable progress, we need to continue our efforts to support greater inclusion and a financial system that meets the needs of all Americans. At the Federal Reserve, we will continue to work to improve our understanding of the innovations in financial inclusion, and the intersection of payments innovation and financial inclusion, among others. We also will use our position to monitor innovations that have financial inclusion implications - such as alternative data use and financial health measurement - and keep the public informed on the evolving industry practices that help meet the needs of the financially underserved. For example, we expect to provide additional resources on alternative data use in the coming months. In addition, the Fed's Partnership for Progress program helps MDIs and women's depository institutions (WDIs) navigate their unique business challenges, provides MDIs and WDIs with resources for technical assistance, and conducts research on the unique challenges faced by low- and moderate-income communities. We also actively partner with Native American communities to better understand their financial needs. In addition to the Federal Reserve's role, the private sector is a key source for financial innovation, and we encourage businesses to responsibly innovate so that new tools that can increase financial inclusiveness are safe for customers and consistent with financial stability. We would all benefit from additional research in this area. For instance, how do we help ensure that expanding access to fair and affordable credit advances safe and sound lending? Empirically, which innovations are best able to meet customer needs safely and affordably, maintain bank safety and soundness, and promote a healthier economy? And how can we leverage concepts in behavioral economics to improve the effectiveness of credit products? I hope the conversations in today's conference can spark productive dialogue and spur potential research in these areas. In closing, my hope is that these kinds of efforts, as well as continued innovation in the banking system, can bring us closer to a time when all families and communities in our country have adequate access to credit and financial services on fair, affordable, transparent, and accessible terms.
2024-07-09T00:00:00	Michelle W Bowman: Promoting an inclusive financial system	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the conference "Financial Inclusion Practices and Innovations", Washington DC, 9 July 2024.	For release on delivery 1:30 p.m. EDT July 9, 2024 Promoting an Inclusive Financial System Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Washington, D.C. July 9, 2024 Good afternoon and welcome back to the second half of today's conference on Financial Inclusion Practices and Innovations.1 It is really a pleasure to join you to discuss this important topic. This morning, our panelists provided their perspectives on issues related to supervision and regulation and payment frictions and innovations both domestically and internationally. The research and perspectives they discussed can certainly help to broaden our understanding of financial inclusion and all of the associated challenges. Together, our work to promote initiatives that further this work will enable greater access to financial services. An economy that works for everyone necessarily includes a more inclusive financial system. More expansive inclusion opportunities improve the financial well-being of both consumers and small businesses, thereby contributing to overall economic growth. Today, I would like to highlight the excellent work being done in this area by our Division of Consumer and Community Affairs (DCCA). I will also touch on some ways that the banking system and private sector can support financial inclusion. of DCCA's Promoting an Inclusive Financial System Is a Foundational Element Work Before discussing our work at the Federal Reserve, I would like to first take a step back to anchor financial inclusion within the broader objective of fostering an economy that works for everyone. A healthy and robust U.S. economy relies upon broad access to financial resources and education. Bringing consumers and small businesses into the financial mainstream helps them more fully engage in the financial system and the economy and should help to facilitate the more effective operation of the U.S. economy. Through its responsibility for community affairs, - 2 - DCCA works to achieve a thorough understanding of current community conditions and best practices by conducting research and convening relevant private sector participants. Today, we will focus on their important work to enhance financial access. As the chair of the Consumer and Community Affairs Committee, I oversee these efforts. As many of you know well, DCCA's financial inclusion work is expansive, and I look forward to highlighting these contributions with you today. First, DCCA informs internal and external stakeholders by leveraging its research and analysis to provide information that can be utilized by external stakeholders to support their work. For example, one of the Fed's most important contributions to the study of financial well- being is the annual Survey of Household Economics and Decisionmaking, or the SHED. We published the 11th annual report in May. The report addresses topics including financial well- being, savings, retirement, economic fragility, education, and student loans.2 The Federal Reserve System also conducts an annual Small Business Credit Survey (SBCS), which is a survey of over 6,000 firms with fewer than 500 employees located throughout the country. This year's survey found that many small businesses were experiencing tight financial conditions and often had to rely on personal financial resources, such as personal funds or a loan from family or friends, to support their businesses.3 Because access to credit is fundamental to broader financial access and inclusion, this experience of reliance on personal - 3 - financial resources shows that the credit needs of small businesses may not be fully met by the financial industry. Another way DCCA pursues greater financial inclusion is by convening, informing, and engaging with stakeholders. For example, the Community Advisory Council (CAC), which consists of members of the non-profit sector and hands-on community development practitioners, meets with the Board of Governors twice each year to share their experiences and observations and to engage on challenges facing the consumers and communities they serve. The CAC focuses on the concerns of low- and moderate-income people, and at its most recent meeting in May, the CAC focused on a range of economic matters continuing to affect financially vulnerable communities. DCCA also prioritizes the work of mission-driven organizations in its efforts to expand financial inclusion. The Partnership for Progress (PFP) program is the Federal Reserve's System's Minority Depository Institution (MDI) outreach program created to support the mandate to preserve and promote MDIs. DCCA, in collaboration with other areas of the Federal Reserve, engages MDIs and Women-Owned Depository Institutions (WDIs) through national outreach efforts. The PFP provides technical assistance to help MDIs and WDIs address unique business model challenges, enabling these institutions to compete more effectively in the marketplace.4 Third, DCCA ensures that financial institutions under the Fed's jurisdiction comply with laws and regulations that protect consumers and promote community development, including fair lending laws and the prohibition on unfair and deceptive acts and practices. For example, DCCA examines state member banks for compliance with the Equal Credit Opportunity Act, which - 4 - prohibits discrimination in any aspect of a credit transaction based on race, gender, marital The division's work to protect consumers from harm status, age, or another prohibited basis. furthers our goal to create an economy that works for everyone. Regulated Financial Institutions and Financial Inclusion I would like to turn now to share some thoughts about how the private sector can engage to support financial inclusion. The U.S. banking system is well-positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. For example, banks help consumers and small businesses by providing financial products and services that are safe, fair, and responsive, including through small dollar loan products. These types of loans can help consumers and small businesses access credit for unexpected expenses. Data from the most recent SHED report found that 10 percent of adults with family incomes less than $50,000 per year used payday, pawn, auto title, or tax refund anticipation loans to obtain needed funds.5 These types of products often carry high or even punitive direct and indirect costs and risks to the consumer. For example, non-repayment of an auto title loan can lead to vehicle repossession further complicating the consumer's financial situation. When banks offer small dollar loans, they can often do so on terms that are safer and at lower cost than other types of loans.6 5 Board of Governors of the Federal Reserve System, "2023 Survey of Household Economics and Decisionmaking" (2024), https://www.federalreserve.gov/consumerscommunities/shed.htm. Board of Governors of the Federal Reserve, Economic Well-Being of U.S. Households in 2023 (Washinton: Board of Governors, May 2014), https://www.federalreserve.gov/publications/files/2023-report-economic-well-being-us-households-202405.pdf. 6 Banks can look for guidance on small dollar loans through interagency statements related to alternative data and Board of Governors of the Federal Reserve System, small dollar loans. See "Interagency Statement on the Use of Alternative Data in Credit Underwriting," CA letter 19-11 (December 12, 2019), https://www.federalreserve.gov/supervisionreg/caletters/caltr1911.htm, and Board of Governors of the Federal Reserve, "Interagency Lending Principles for Making Responsible Small-Dollar Loans," SR letter 20-14/CA letter 20-8 (December 12, 2019), https://www.federalreserve.gov/supervisionreg/srletters/SR2014.htm. - 5 - Some banks that offer small dollar loan products often use automated underwriting based on alternative information that can include consumer-permissioned cash-flow data. If used appropriately, this approach can reduce bank underwriting costs, potentially making affordably priced loans available to consumers on a more timely basis. If these loans were more available in the banking system, they could serve as an alternative to more costly options from alternative financial services providers. Small dollar loans targeted to low- and moderate-income consumers have the potential to provide an accessible and more fairly priced alternative when consumers experience a financial emergency. Remittances and Financial Inclusion As we heard from our panelists earlier today, payments inclusion can look different in domestic and international contexts, but a reliable, safe, and cost-efficient payment system that minimizes unintended frictions is important to consumers around the world. International remittances can serve an important role in enhancing financial inclusion, especially in countries where these funds are a significant source of household financial support. And some research indicates that the ability to receive remittances increases the likelihood of bank account ownership, which furthers economic engagement.7 However, for those who send funds abroad using remittances, the costs can be substantial. For example, the average cost of sending $200 internationally from the U.S. is nearly 6 percent.8 In addition to broader work on cross-border payments, the G20 countries have - 6 - reaffirmed a commitment to reducing average remittance fees to below 3 percent by 2030. This could result in a greater proportion of funds reaching recipients.9 Continued improvements to domestic and international payment systems and responsible innovation can further support our work on financial inclusion. Conclusion Greater inclusiveness in the financial system is an ongoing priority for the Federal Reserve. While we have made great progress, there is more to be done for both the public and private sectors. We should be open to considering how new or innovative products and services could promote financial inclusion. We should also be willing to engage with a wide range of stakeholders. Financial access and inclusion are not one-size-fits-all and can look very different to each consumer. Therefore, involving consumers and communities in identifying issues and crafting solutions is critical to success. Advancing financial inclusion will clearly take many hands and a diverse set of stakeholders, including everyone participating here today.	---[PAGE_BREAK]--- For release on delivery 1:30 p.m. EDT July 9, 2024 Promoting an Inclusive Financial System Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Washington, D.C. ---[PAGE_BREAK]--- Good afternoon and welcome back to the second half of today's conference on Financial Inclusion Practices and Innovations. ${ }^{1}$ It is really a pleasure to join you to discuss this important topic. This morning, our panelists provided their perspectives on issues related to supervision and regulation and payment frictions and innovations both domestically and internationally. The research and perspectives they discussed can certainly help to broaden our understanding of financial inclusion and all of the associated challenges. Together, our work to promote initiatives that further this work will enable greater access to financial services. An economy that works for everyone necessarily includes a more inclusive financial system. More expansive inclusion opportunities improve the financial well-being of both consumers and small businesses, thereby contributing to overall economic growth. Today, I would like to highlight the excellent work being done in this area by our Division of Consumer and Community Affairs (DCCA). I will also touch on some ways that the banking system and private sector can support financial inclusion. # Promoting an Inclusive Financial System Is a Foundational Element of DCCA's Work Before discussing our work at the Federal Reserve, I would like to first take a step back to anchor financial inclusion within the broader objective of fostering an economy that works for everyone. A healthy and robust U.S. economy relies upon broad access to financial resources and education. Bringing consumers and small businesses into the financial mainstream helps them more fully engage in the financial system and the economy and should help to facilitate the more effective operation of the U.S. economy. Through its responsibility for community affairs, [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- DCCA works to achieve a thorough understanding of current community conditions and best practices by conducting research and convening relevant private sector participants. Today, we will focus on their important work to enhance financial access. As the chair of the Consumer and Community Affairs Committee, I oversee these efforts. As many of you know well, DCCA's financial inclusion work is expansive, and I look forward to highlighting these contributions with you today. First, DCCA informs internal and external stakeholders by leveraging its research and analysis to provide information that can be utilized by external stakeholders to support their work. For example, one of the Fed's most important contributions to the study of financial wellbeing is the annual Survey of Household Economics and Decisionmaking, or the SHED. We published the 11th annual report in May. The report addresses topics including financial wellbeing, savings, retirement, economic fragility, education, and student loans. ${ }^{2}$ The Federal Reserve System also conducts an annual Small Business Credit Survey (SBCS), which is a survey of over 6,000 firms with fewer than 500 employees located throughout the country. This year's survey found that many small businesses were experiencing tight financial conditions and often had to rely on personal financial resources, such as personal funds or a loan from family or friends, to support their businesses. ${ }^{3}$ Because access to credit is fundamental to broader financial access and inclusion, this experience of reliance on personal [^0] [^0]: ${ }^{2}$ Board of Governors of the Federal Reserve System, "2023 Survey of Household Economics and Decisionmaking," (2024), https://www.federalreserve.gov/consumerscommunities/shed.htm. Board of Governors of the Federal Reserve System, Economic Well-Being of U.S. Households in 2023 (Washington: Board of Governors, May 2024), https://www.federalreserve.gov/publications/files/2023-report-economic-well-being-us-households202405.pdf. ${ }^{3}$ Federal Reserve Banks, 2024 Report on Employer Firms: Findings from the 2023 Small Business Credit Survey (Federal Reserve Banks, March 2024), https://doi.org/10.55350/sbcs-20240307. ---[PAGE_BREAK]--- financial resources shows that the credit needs of small businesses may not be fully met by the financial industry. Another way DCCA pursues greater financial inclusion is by convening, informing, and engaging with stakeholders. For example, the Community Advisory Council (CAC), which consists of members of the non-profit sector and hands-on community development practitioners, meets with the Board of Governors twice each year to share their experiences and observations and to engage on challenges facing the consumers and communities they serve. The CAC focuses on the concerns of low- and moderate-income people, and at its most recent meeting in May, the CAC focused on a range of economic matters continuing to affect financially vulnerable communities. DCCA also prioritizes the work of mission-driven organizations in its efforts to expand financial inclusion. The Partnership for Progress (PFP) program is the Federal Reserve's Minority Depository Institution (MDI) outreach program created to support the System's mandate to preserve and promote MDIs. DCCA, in collaboration with other areas of the Federal Reserve, engages MDIs and Women-Owned Depository Institutions (WDIs) through national outreach efforts. The PFP provides technical assistance to help MDIs and WDIs address unique business model challenges, enabling these institutions to compete more effectively in the marketplace. ${ }^{4}$ Third, DCCA ensures that financial institutions under the Fed's jurisdiction comply with laws and regulations that protect consumers and promote community development, including fair lending laws and the prohibition on unfair and deceptive acts and practices. For example, DCCA examines state member banks for compliance with the Equal Credit Opportunity Act, which [^0] [^0]: ${ }^{4}$ See the Federal Reserve's Partnership for Progress website at https://www.fedpartnership.gov. ---[PAGE_BREAK]--- prohibits discrimination in any aspect of a credit transaction based on race, gender, marital status, age, or another prohibited basis. The division's work to protect consumers from harm furthers our goal to create an economy that works for everyone. # Regulated Financial Institutions and Financial Inclusion I would like to turn now to share some thoughts about how the private sector can engage to support financial inclusion. The U.S. banking system is well-positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. For example, banks help consumers and small businesses by providing financial products and services that are safe, fair, and responsive, including through small dollar loan products. These types of loans can help consumers and small businesses access credit for unexpected expenses. Data from the most recent SHED report found that 10 percent of adults with family incomes less than $\$ 50,000$ per year used payday, pawn, auto title, or tax refund anticipation loans to obtain needed funds. ${ }^{5}$ These types of products often carry high or even punitive direct and indirect costs and risks to the consumer. For example, non-repayment of an auto title loan can lead to vehicle repossession further complicating the consumer's financial situation. When banks offer small dollar loans, they can often do so on terms that are safer and at lower cost than other types of loans. ${ }^{6}$ [^0] [^0]: ${ }^{5}$ Board of Governors of the Federal Reserve System, "2023 Survey of Household Economics and Decisionmaking" (2024), https://www.federalreserve.gov/consumerscommunities/shed.htm. Board of Governors of the Federal Reserve, Economic Well-Being of U.S. Households in 2023 (Washinton: Board of Governors, May 2014), https://www.federalreserve.gov/publications/files/2023-report-economic-well-being-us-households-202405.pdf. ${ }^{6}$ Banks can look for guidance on small dollar loans through interagency statements related to alternative data and small dollar loans. See Board of Governors of the Federal Reserve System, "Interagency Statement on the Use of Alternative Data in Credit Underwriting," CA letter 19-11 (December 12, 2019), https://www.federalreserve.gov/supervisionreg/caletters/caltr1911.htm, and Board of Governors of the Federal Reserve, "Interagency Lending Principles for Making Responsible Small-Dollar Loans," SR letter 20-14/CA letter 20-8 (December 12, 2019), https://www.federalreserve.gov/supervisionreg/srletters/SR2014.htm. ---[PAGE_BREAK]--- Some banks that offer small dollar loan products often use automated underwriting based on alternative information that can include consumer-permissioned cash-flow data. If used appropriately, this approach can reduce bank underwriting costs, potentially making affordably priced loans available to consumers on a more timely basis. If these loans were more available in the banking system, they could serve as an alternative to more costly options from alternative financial services providers. Small dollar loans targeted to low- and moderate-income consumers have the potential to provide an accessible and more fairly priced alternative when consumers experience a financial emergency. # Remittances and Financial Inclusion As we heard from our panelists earlier today, payments inclusion can look different in domestic and international contexts, but a reliable, safe, and cost-efficient payment system that minimizes unintended frictions is important to consumers around the world. International remittances can serve an important role in enhancing financial inclusion, especially in countries where these funds are a significant source of household financial support. And some research indicates that the ability to receive remittances increases the likelihood of bank account ownership, which furthers economic engagement. ${ }^{7}$ However, for those who send funds abroad using remittances, the costs can be substantial. For example, the average cost of sending $\$ 200$ internationally from the U.S. is nearly 6 percent. ${ }^{8}$ In addition to broader work on cross-border payments, the G20 countries have [^0] [^0]: ${ }^{7}$ Gemechu Ayana Aga and Maria Soledad Martinez Peria, "International Remittances and Financial Inclusion in Sub-Saharan Africa," Policy Research Working Paper 6991 (Washington: World Bank Group, Development Research Group, July 2014), https://openknow/edge.worldbank.org/server/api/core/bitstreams/19e5d9c1-cabd-5c54-a4c2-fd2f12964b61/content. David Malpass, "Remittances Are a Critical Economic Stabilizer," World Bank Blog, December 6, 2022, https://blogs.worldbank.org/en/voices/remittances-are-critical-economic-stabilizer. ${ }^{8}$ The World Bank, Remittance Prices Worldwide Quarterly, Issue 48, December 2023, p. 11, https://remittanceprices.worldbank.org/sites/default/files/rpw_main_report_and_annex_q423_final.pdf. ---[PAGE_BREAK]--- reaffirmed a commitment to reducing average remittance fees to below 3 percent by 2030. This could result in a greater proportion of funds reaching recipients. ${ }^{9}$ Continued improvements to domestic and international payment systems and responsible innovation can further support our work on financial inclusion. # Conclusion Greater inclusiveness in the financial system is an ongoing priority for the Federal Reserve. While we have made great progress, there is more to be done for both the public and private sectors. We should be open to considering how new or innovative products and services could promote financial inclusion. We should also be willing to engage with a wide range of stakeholders. Financial access and inclusion are not one-size-fits-all and can look very different to each consumer. Therefore, involving consumers and communities in identifying issues and crafting solutions is critical to success. Advancing financial inclusion will clearly take many hands and a diverse set of stakeholders, including everyone participating here today. [^0] [^0]: ${ }^{9}$ For more information on the G20 cross-border payments improvement roadmap and its progress, see Financial Stability Board, Enhancing Cross-Border Payments: Stage 3 Roadmap (Financial Stability Board, October 2020), https://www.fsb.org/wp-content/uploads/P131020-1.pdf, and Financial Stability Board, G20 Roadmap for Enhancing Cross-Border Payments: Consolidated Progress Report for 2023 (Financial Stability Board, October 2023), https://www.fsb.org/wp-content/uploads/P091023-2.pdf. For more information on the United Nations Sustainable Development Goals, see "Transforming Our World: the 2030 Agenda for Sustainable Development, Department of Economic and Social Affairs, United Nations, https://sdgs.un.org/2030agenda, and Financial Stability Board, Targets for Addressing the Four Challenges of Cross-Border Payments: Final Report (Financial Stability Board, October 2021), https://www.fsb.org/wp-content/uploads/P131021-2.pdf.	Michelle W Bowman	United States	https://www.bis.org/review/r240716a.pdf	For release on delivery 1:30 p.m. EDT July 9, 2024 Promoting an Inclusive Financial System Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Financial Inclusion Practices and Innovations Washington, D.C. Good afternoon and welcome back to the second half of today's conference on Financial Inclusion Practices and Innovations. It is really a pleasure to join you to discuss this important topic. This morning, our panelists provided their perspectives on issues related to supervision and regulation and payment frictions and innovations both domestically and internationally. The research and perspectives they discussed can certainly help to broaden our understanding of financial inclusion and all of the associated challenges. Together, our work to promote initiatives that further this work will enable greater access to financial services. An economy that works for everyone necessarily includes a more inclusive financial system. More expansive inclusion opportunities improve the financial well-being of both consumers and small businesses, thereby contributing to overall economic growth. Today, I would like to highlight the excellent work being done in this area by our Division of Consumer and Community Affairs (DCCA). I will also touch on some ways that the banking system and private sector can support financial inclusion. Before discussing our work at the Federal Reserve, I would like to first take a step back to anchor financial inclusion within the broader objective of fostering an economy that works for everyone. A healthy and robust U.S. economy relies upon broad access to financial resources and education. Bringing consumers and small businesses into the financial mainstream helps them more fully engage in the financial system and the economy and should help to facilitate the more effective operation of the U.S. economy. Through its responsibility for community affairs, DCCA works to achieve a thorough understanding of current community conditions and best practices by conducting research and convening relevant private sector participants. Today, we will focus on their important work to enhance financial access. As the chair of the Consumer and Community Affairs Committee, I oversee these efforts. As many of you know well, DCCA's financial inclusion work is expansive, and I look forward to highlighting these contributions with you today. First, DCCA informs internal and external stakeholders by leveraging its research and analysis to provide information that can be utilized by external stakeholders to support their work. For example, one of the Fed's most important contributions to the study of financial wellbeing is the annual Survey of Household Economics and Decisionmaking, or the SHED. We published the 11th annual report in May. The report addresses topics including financial wellbeing, savings, retirement, economic fragility, education, and student loans. The Federal Reserve System also conducts an annual Small Business Credit Survey (SBCS), which is a survey of over 6,000 firms with fewer than 500 employees located throughout the country. This year's survey found that many small businesses were experiencing tight financial conditions and often had to rely on personal financial resources, such as personal funds or a loan from family or friends, to support their businesses. Because access to credit is fundamental to broader financial access and inclusion, this experience of reliance on personal financial resources shows that the credit needs of small businesses may not be fully met by the financial industry. Another way DCCA pursues greater financial inclusion is by convening, informing, and engaging with stakeholders. For example, the Community Advisory Council (CAC), which consists of members of the non-profit sector and hands-on community development practitioners, meets with the Board of Governors twice each year to share their experiences and observations and to engage on challenges facing the consumers and communities they serve. The CAC focuses on the concerns of low- and moderate-income people, and at its most recent meeting in May, the CAC focused on a range of economic matters continuing to affect financially vulnerable communities. DCCA also prioritizes the work of mission-driven organizations in its efforts to expand financial inclusion. The Partnership for Progress (PFP) program is the Federal Reserve's Minority Depository Institution (MDI) outreach program created to support the System's mandate to preserve and promote MDIs. DCCA, in collaboration with other areas of the Federal Reserve, engages MDIs and Women-Owned Depository Institutions (WDIs) through national outreach efforts. The PFP provides technical assistance to help MDIs and WDIs address unique business model challenges, enabling these institutions to compete more effectively in the marketplace. Third, DCCA ensures that financial institutions under the Fed's jurisdiction comply with laws and regulations that protect consumers and promote community development, including fair lending laws and the prohibition on unfair and deceptive acts and practices. For example, DCCA examines state member banks for compliance with the Equal Credit Opportunity Act, which prohibits discrimination in any aspect of a credit transaction based on race, gender, marital status, age, or another prohibited basis. The division's work to protect consumers from harm furthers our goal to create an economy that works for everyone. I would like to turn now to share some thoughts about how the private sector can engage to support financial inclusion. The U.S. banking system is well-positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. For example, banks help consumers and small businesses by providing financial products and services that are safe, fair, and responsive, including through small dollar loan products. These types of loans can help consumers and small businesses access credit for unexpected expenses. Data from the most recent SHED report found that 10 percent of adults with family incomes less than $\$ 50,000$ per year used payday, pawn, auto title, or tax refund anticipation loans to obtain needed funds. Some banks that offer small dollar loan products often use automated underwriting based on alternative information that can include consumer-permissioned cash-flow data. If used appropriately, this approach can reduce bank underwriting costs, potentially making affordably priced loans available to consumers on a more timely basis. If these loans were more available in the banking system, they could serve as an alternative to more costly options from alternative financial services providers. Small dollar loans targeted to low- and moderate-income consumers have the potential to provide an accessible and more fairly priced alternative when consumers experience a financial emergency. As we heard from our panelists earlier today, payments inclusion can look different in domestic and international contexts, but a reliable, safe, and cost-efficient payment system that minimizes unintended frictions is important to consumers around the world. International remittances can serve an important role in enhancing financial inclusion, especially in countries where these funds are a significant source of household financial support. And some research indicates that the ability to receive remittances increases the likelihood of bank account ownership, which furthers economic engagement. However, for those who send funds abroad using remittances, the costs can be substantial. For example, the average cost of sending $\$ 200$ internationally from the U.S. is nearly 6 percent. In addition to broader work on cross-border payments, the G20 countries have reaffirmed a commitment to reducing average remittance fees to below 3 percent by 2030. This could result in a greater proportion of funds reaching recipients. Continued improvements to domestic and international payment systems and responsible innovation can further support our work on financial inclusion. Greater inclusiveness in the financial system is an ongoing priority for the Federal Reserve. While we have made great progress, there is more to be done for both the public and private sectors. We should be open to considering how new or innovative products and services could promote financial inclusion. We should also be willing to engage with a wide range of stakeholders. Financial access and inclusion are not one-size-fits-all and can look very different to each consumer. Therefore, involving consumers and communities in identifying issues and crafting solutions is critical to success. Advancing financial inclusion will clearly take many hands and a diverse set of stakeholders, including everyone participating here today.
2024-07-10T00:00:00	Lisa D Cook: Common inflation and monetary policy challenges across countries	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the Australian Conference of Economists 2024, Adelaide, Australia, 10 July 2024.	For release on delivery 7:30 p.m. EDT (9:00 a.m., July 11, local time) July 10, 2024 Common Inflation and Monetary Policy Challenges across Countries Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the Australian Conference of Economists 2024 Adelaide, Australia July 11, 2024 Thank you, Jacky. Iam happy to be here in Adelaide and appreciate the opportunity to speak with all of you.! Considering the significant developments in the global economy over the past few years, now is an appropriate time to reflect on the economic reverberations the COVID-19 shock caused around the world. Examining the common inflation experiences and monetary policy challenges across several countries, including Australia and the United States, is a helpful exercise for policymakers and economists alike. Today, I will first talk about how monetary policymakers responded in similar fashion to the COVID-19 pandemic and, later, to high inflation during the recovery. I will discuss common features of the recent inflation experience across countries and the importance of global shocks. With disinflation in train across most countries, I will consider what we can learn from past cycles of monetary easing. I will finish with a discussion of how the use of alternative scenarios could help monetary policymakers communicate how they might respond to a range of possible economic outcomes. Common Monetary Policy Response to the Pandemic In the spring of 2020, economies around the world shut down or sharply limited business activity, especially for in-person services, including dining out and traveling. Governments introduced extraordinary fiscal support aimed at alleviating the socioeconomic effects of the pandemic. And, to prevent sharp financial and economic deterioration, most central banks responded aggressively by lowering policy rates, ramping up asset purchases, and taking other actions to support the flow of credit to households and businesses. Those efforts were sustained throughout 2020 and much of ' The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. -2- 2021, as the initial turmoil in financial markets subsided but the health situation remained uncertain. Advanced economy central banks that had positive policy rates before the pandemic, including the Fed and the central banks of Australia, Canada, and the United Kingdom, cut these rates to near zero, as shown in figure 1. Central banks that entered the pandemic with policy rates already at zero, such as Sweden, or negative-including the euro area, Japan, and Switzerland-teft their rates unchanged. Meanwhile, almost all emerging market economy (EME) central banks cut their policy rates. Although central banks acted quickly to reduce rates, policymakers cited a few reasons to refrain from deeper cuts: Among EME policymakers, concerns were expressed that further lowering rates risked exacerbating capital outflows, while some advanced economy central banks commented that further rate cuts, particularly in negative territory, could harm banks' financial health or would provide little additional monetary stimulus. Many central banks also conducted significant asset purchases. These purchases were initially aimed at restoring market functioning and providing liquidity, but they also were seen as lowering long-term yields and easing broader financial conditions. The Fed and the Bank of England (BOE) restarted their purchases, while the European Central Bank (ECB) and the Swedish Riksbank increased the pace of their existing programs. And here, the Reserve Bank of Australia began asset purchases and introduced a target for the three-year government bond yield at the same level as its overnight rate. The Rise of Inflation and the Common Monetary Policy Response Over the course of 2021, as financial conditions improved, a strong recovery in consumer demand outpaced still constrained supply capacity in many countries, leading -3- to production and transportation bottlenecks, which ultimately resulted in inflation. The surge in inflation was initially mostly concentrated in finished goods and commodities but later spread to services." As the economy started reopening with the lifting of lockdowns and rollout of vaccines, demand for services picked up. Similar to what played out with goods, the pickup in demand for services ran into a constrained supply of service workers. As services are more labor intensive than goods, and labor supply was still reeling from the consequences of the pandemic, the rebalancing of consumption from goods to services led to higher rates of inflation and nominal wage growth. In response to rising inflation, central banks around the world started to remove some of the support that they provided during the height of the pandemic. As a first step, central banks let many of the emergency support programs-in which they had bought assets other than national government bonds-expire. Next, central banks generally began to taper their purchases of government securities and then to end net purchases late in 2021 or the first half of 2022. Then some central banks began to raise interest rates. The first to do so were EME central banks that saw particularly sharp increases in inflation driven by exchange rate depreciation and by the surge in prices for food, which makes up a large part of the consumption baskets in their economies. Advanced economy central banks generally were more patient on raising interest rates in 2021, as inflation expectations in their economies were better anchored than in emerging economies. Among advanced economy central banks, the first to hike in the autumn of 2021 were central banks in > See Francois de Soyres, Alexandre Gaillard, Ana Maria Santacreu, and Dylan Moore (2024), "Supply Disruptions and Fiscal Stimulus: Transmission through Global Value Chains," AEA Papers and Proceedings, vol. 114 (May), pp. 112-17. -4- Norway and New Zealand, whose economies had strong recoveries. The BOE first raised its policy rate in December 2021, citing a strong labor market and sharply rising inflation. The Bank of Canada and the Fed began to raise rates in March 2022, and the ECB first raised its deposit rate (from negative 0.5 percent to zero) in July 2022. Most advanced economy central banks undertook a sequence of policy actions in which they first began to raise their policy rates and later began to reduce the size of their balance sheets over time. Understanding the Rise and Fall of Inflation in Recent Years The inflation surge in the aftermath of the COVID-19 pandemic was synchronized across advanced and emerging economies, as figure 2 illustrates. The rapid increase in prices reflected an upswing in demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices exacerbated by Russia's February 2022 invasion of Ukraine. The run-up was not only for overall headline inflation, but also for its core components. A plethora of factors can explain the global co-movement in headline and core inflation. First, fluctuations in global food and energy prices broadly pass through to consumer prices in individual countries. But there are other possible explanations, including global supply constraints and synchronous policy responses. The pandemic experience was also a stark reminder of the importance of international trade and input- output linkages for the propagation of supply shocks-for example, production and shipping disruptions in the semiconductor industry in Asia constraining production and creating important price pressures in downstream markets, such as motor vehicles in the US. -5- Research on the recent inflation episode is still very much in its infancy, and I look forward to learning from the ongoing work on the subject. One important contribution already is Ben Bernanke and Olivier Blanchard's analysis of pandemic-era inflation in 11 economies. Separate teams for each of the 11 economies estimated a comparable model of inflation and its drivers. They find for the U.S. and, with some variation, for other countries that "relative price shocks and sectoral shortages drove the initial surge in inflation, but as these effects have reversed, tight labor markets in most (although not all) countries have become a relatively more important factor." In a recent FEDS Notes article, economists at the Federal Reserve Board took head-on the task of decomposing world inflation into common and country-specific components and using this decomposition to analyze the sources of inflation around the world.* Despite the different approach, they reached conclusions broadly in line with those of Bernanke and Blanchard. As shown in figure 3, they find that the global components of inflation accounted for a large part of the variation in the average inflation around the world during the post-COVID period. This is an experience with precedents during the oil price shocks of the 1970s and the 1980s. This study also found that the global components of inflation also predict the path of near-term inflation. Historically, once global components start moving, they maintain the course and take time to reverse. This persistence and the recent decline in global components of core and noncore inflation suggest that the world disinflationary process 3 See Ben Bernanke and Olivier Blanchard (2024), "An Analysis of Pandemic-Era Inflation in 11 Economies," Hutchins Center Working Paper 91 (Washington: Brookings Institution, May), quoted text on p. 1, https://www.brookings.edu/wp-content/uploads/2024/05/WP91_Bernanke-Blanchard.pdf. 4 See Danilo Cascaldi-Garcia, Luca Guerrieri, Matteo Iacoviello, and Michele Modugno (2024), "Lessons from the Co-Movement of Inflation around the World," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, June 28), https://www.federalreserve.gov/econres/notes/feds-notes/lessons- from-the-co-movement-of-inflation-around-the-world-20240628.html. -6- will continue, as shown in figure 4. The predicted path is in line with a gradual return of inflation toward central bank targets. Of note, as shown in figure 5, the authors find that the post-pandemic rise in global inflation was linked to both commodity-driven price shocks and shocks to global economic activity-such as the sharp decline and rebound in activity due to the COVID-19 pandemic and the associated labor market shortages. This situation contrasts with the 1970s and 1980s, when commodity price shocks played a prominent role in inflation's fluctuations. Additionally, idiosyncratic shocks were important drivers of the surge in global inflation in 2022 and its decline in 2023. These shocks may capture economy-specific forces, including natural gas disruptions that more greatly affected European economies than others in the aftermath of Russia's war on Ukraine. In sum, through the lens of the model, the ongoing disinflation is driven by waning effects of commodity price shocks and by a gradual normalization of global economic activity, amid the resolution of shortages and imbalances in labor markets. Current Common Monetary Policy Challenges With global components of inflation turning down, most countries have experienced a significant fall in inflation relative to its peak. Similarly, most central banks stopped raising their policy rates over the past year. Some are considering how long to keep rates at restrictive levels or, if inflation picks up again, whether to raise rates further. The Bank of Canada, the ECB, the Swedish Riksbank, and the Swiss National Bank, have begun to cut policy rates, highlighting progress toward meeting inflation goals amid sustained softness in economic activity. Indeed, unlike in the U.S., the level of gross domestic product (GDP) in some advanced economies remains well below what -7- would be implied by their respective pre-COVID GDP trends.° Even among those cutting rates, however, the future path of the policy rate is generally seen as dependent on a continuing decline of inflation toward target levels. For all central banks, the question is how best to ensure continued disinflation while avoiding unnecessary damage to the economy. The generally desired outcome is a soft landing, in which inflation returns to the central bank's target inflation level or range without inducing a recession or a large increase in unemployment. How likely is such a scenario? It may be too soon to definitively say for the current economic cycle. But Fed Board staff have examined past episodes of monetary policy easing in 13 advanced economies over the past five decades. They find that soft landings are rare, according to their analysis published in another recent FEDS Notes article.® In most of the cases that they studied, central banks were not successful in bringing inflation back to near target in a timely manner. And when they were successful in taming inflation, it often was associated with a recession. However, soft landings are not unprecedented. When such a landing occurred, on average it was associated with a smaller preceding policy tightening. Soft landings were also more likely when policy easing began with inflation already close to target and when there was a relatively firm growth backdrop. In the U.S., what I have seen so far appears to be consistent with a soft landing: Inflation has fallen significantly from its peak, and 5 See Francois de Soyres, Joaquin Garcia-~Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why Is the U.S. GDP Recovering Faster Than Other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://doi.org/10.17016/2380-7172.3495. ® See Francois de Soyres and Zina Saijid (2024), "Lessons from Past Monetary Easing Cycles," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 31), https://doi.org/10.17016/2380-7172.3504. -8- the labor market has gradually cooled but remains strong. Of course, I am closely monitoring incoming data to see how the economy further develops. It is possible that some features of the recent inflation episode may make a soft landing more likely in countries around the globe. As I discussed, Bernanke and Blanchard found that much of the inflation episode came from relative price shocks and sectoral shortages that have since been resolved. And while they found that tight labor markets have since taken over as the main drivers of inflation, there are signs that such tightness is easing. For instance, in the U.S., the ratio of vacancies to unemployment has fallen back to its pre-pandemic level and the rate of voluntary quits has declined, as workers are less confident of finding a better job. Thus, my baseline forecast (and that of many outside observers) is that inflation will continue to move toward target over time, without much further rise in unemployment. Monetary Policy Communications Of course, forecasts are subject to considerable uncertainty, and policymakers must consider a range of possible outcomes. A key challenge of monetary policy communications is discussing how policy would respond to changes in the economic outlook. Central bankers are faced with a tradeoff between predictability and flexibility. On the one hand, many observers would like to know in advance what the path for the policy rate will be, while, on the other hand, a central bank needs to remain nimble and data dependent. As a result, central bankers often try to convey their "reaction function" so observers understand how policy might adapt to incoming data and the implications for the economic outlook. -9- In his recent review of forecasting for monetary policymaking and communications at the BOE, Ben Bernanke suggested that the Bank consider supplementing its published forecasts with the use of alternative scenarios to help the public understand its policy reaction function.' For similar reasons I try to incorporate a discussion of alternative scenarios in my own speeches. Fed policymakers, like those at many other central banks, also benefit from staff analysis using models to explore how the forecast would change relative to the baseline if certain assumptions are changed. The challenge is how to use such alternative scenarios in our official communications. Policy communications are an area where we can learn a lot from what other central banks have done, and communication practices have developed over time. The BOE was an early innovator with its fan charts, which emphasized that its forecasts for GDP and inflation were subject to growing uncertainty the longer the time horizon. Of course, forecasts for economic variables need to be conditioned on some assumption of the path of policy rates. While early practice was to condition on unchanged rates or on the path of rates implied by market pricing, some central banks innovated by publishing their own forecasts for policy rates. This was originally done by the Reserve Bank of New Zealand and later by the Norges Bank and the Riksbank. Since 2012, the Federal Reserve's Summary of Economic Projections also includes the path of the policy rate that each policymaker "deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to 7 See Ben S. Bernanke (2024), Forecasting for Monetary Policy Making and Communication at the Bank of England: A Review (London: Bank of England, April), https://www.bankofengland.co.uk/independent- evaluation-office/forecasting-for-monetary-policy-making-and-communication-at-the-bank-of-england-a- review/forecasting-for-monetary-policy-making-and-communication-at-the-bank-of-england-a-review. -10- promote maximum employment and price stability."* I continue to take great interest in communications and other monetary policy practices by foreign central banks. In conclusion, I think it is clear we have learned much from the experience of the past few years. I must stress that the human toll of the pandemic cannot and should not be overlooked. Purely in terms of economics, the recent period does stand out as an unusual case study. Economies around the world effectively faced the same shock at nearly the same moment. We were then able to observe how various economies around the world responded to the shock, including the actions of central banks and fiscal policymakers. I am glad to have highlighted some of the interesting research that has begun to explore this space, and I am sure much more study on this unique time in our history will soon occur, and that can be powerful. What is not unique to the pandemic is that we often have common macroeconomic experiences and face common monetary policy challenges, which is what makes discussions like the one today so valuable. Thank you. It is a pleasure to be here in Adelaide. I look forward to continuing our conversation. 8 See the June 2024 Summary of Economic Projections (quoted text on p. 1), available on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240612.pdf. Common Inflation and Monetary Policy Challenges Across Countries LISA D. COOK MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM PRESENTATION TO THE AUSTRALIAN CONFERENCE OF ECONOMISTS JULY 11, 2024 Figure 1: Policy Rates across Selected Advanced Economies --- Australia - Canada - Euro area - - Japan --: UK. - US. Percent Lt 2009 I 2012 Lt Lt 2015 2018 Note: Data extend through July 2024. Source: National sources via Haver Analytics. I__I 2021 I I I -1 2024 Figure 2: Headline Inflation =- Australia « « U.K. - == Germany U.S. - = Korea - + Mexico == World Inflation across Selected Economies since 2008 4-quarter percent change dojo pp 2008 2010 2012 2014 2016 2018 2020 2022 2024 12 10 2 Core Inflation =- Australia « - U.K. = = Germany U.S. = = Korea » +» Mexico == World 4-quarter percent change ee ee {I I I I - 2008 2010 2012 2014 2016 2018 2020 2022 2024 Note: Inflation series are 4-quarter percent changes of consumer price indexes, and world inflation is GDP-weighted 4-quarter percent change of consumer price indexes for selected economies. Data extend through 2024:Q1. Shaded area refers to period in which the World Health Organization declared COVID-19 a public health emergency. World inflation, the red line, isa GDP-weighted average of the inflation measures for 26 economies. Source: National sources via Haver Analytics; FRB staff calculations; World Health Organization. 8 2 Figure 3: Global Components of World Inflation Headline Core Noncore 4-quarter percent change 4-quarter percent change 1 4-quarter percent change 1 l [oe] l a foe) 1 foe) - World headline inflation - World core inflation - World noncore inflation == Global component == Global component 415 ==Global component I 15 = 4 -6 = 4 -6 = Pi ty I yp ty ty tf ptr tsrtytytirtieg I J 73 1983 1993 2003 2013 2023 1963 1973 1983 1993 2003 2013 2023 9 1963 1973 1983 1993 2003 2013 2023 2 1963 19 Note: World inflation is the GDP (gross domestic product)-weighted, 4-quarter percent change of consumer price indexes for selected economies. Global components are GDP-weighted aggregates of each economy's common component. Noncore inflation encompasses food and energy categories. Headline inflation is the aggregate of core and noncore inflation using economy-specific weights. Data extend through 2024:Q1. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. Figure 4: Model-Based Forecast of the Global Components of Inflation 4-quarter percent change 9 = = = Core Headline = = Noncore 6 3 0 3 2019 2021 2023 2025 2027 Note: Global components are GDP (gross domestic product)-weighted components estimated through a factor model that isolates co-movement from economy-specific trends and transitory movements. Noncore inflation encompasses food and energy categories. Forecast shown is derived from the factor model and driven by the statistical persistence of the global components. Headline global component is the weighted average of core and noncore global components using economy-specific weights. Data extend through 2027:Q4. Shaded area refers to the forecast period. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. Figure 5: Drivers of World Headline Inflation 1970s to Early 1980s 2020s Deviation from 1972:Q4 Deviation from 2019:Q4 Percentage points Percentage points - World headline inflation 16 - World headline inflation 79 Idiosyncratic shocks Idiosyncratic shocks Commodity shocks 42 Commodity shocks Global activity shocks Global activity shocks 8 4 0 4 phlipiutipyitipyitipritis.s 1973 1975 1977 1979 1981 1983 2020 2021 2022 2023 Note: Figure 4 illustrates decomposition for selected inflationary periods stemming from vector autoregressive models estimated from 1961:Q1 to 1994:Q4 (left panel) and from 1995:Q1 to 2024:Q1 (right panel). Global component of headline inflation and its decomposition are constructed from economy-specific core inflation weights and aggregated with gross domestic product (GDP) weights. Global activity shocks combine shocks to the global component of core inflation, to global GDP, and to labor market shortages. Commodity shocks combine shocks to the global component of noncore inflation, to oil prices, and to global commodity prices. Noncore inflation encompasses food and energy categories. Data extend through 2024:Q1. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations.	---[PAGE_BREAK]--- For release on delivery 7:30 p.m. EDT (9:00 a.m., July 11, local time) July 10, 2024 # Common Inflation and Monetary Policy Challenges across Countries Remarks by<br>Lisa D. Cook<br>Member<br>Board of Governors of the Federal Reserve System<br>at the<br>Australian Conference of Economists 2024<br>Adelaide, Australia July 11, 2024 ---[PAGE_BREAK]--- Thank you, Jacky. I am happy to be here in Adelaide and appreciate the opportunity to speak with all of you. ${ }^{1}$ Considering the significant developments in the global economy over the past few years, now is an appropriate time to reflect on the economic reverberations the COVID-19 shock caused around the world. Examining the common inflation experiences and monetary policy challenges across several countries, including Australia and the United States, is a helpful exercise for policymakers and economists alike. Today, I will first talk about how monetary policymakers responded in similar fashion to the COVID-19 pandemic and, later, to high inflation during the recovery. I will discuss common features of the recent inflation experience across countries and the importance of global shocks. With disinflation in train across most countries, I will consider what we can learn from past cycles of monetary easing. I will finish with a discussion of how the use of alternative scenarios could help monetary policymakers communicate how they might respond to a range of possible economic outcomes. # Common Monetary Policy Response to the Pandemic In the spring of 2020, economies around the world shut down or sharply limited business activity, especially for in-person services, including dining out and traveling. Governments introduced extraordinary fiscal support aimed at alleviating the socioeconomic effects of the pandemic. And, to prevent sharp financial and economic deterioration, most central banks responded aggressively by lowering policy rates, ramping up asset purchases, and taking other actions to support the flow of credit to households and businesses. Those efforts were sustained throughout 2020 and much of [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. ---[PAGE_BREAK]--- 2021, as the initial turmoil in financial markets subsided but the health situation remained uncertain. Advanced economy central banks that had positive policy rates before the pandemic, including the Fed and the central banks of Australia, Canada, and the United Kingdom, cut these rates to near zero, as shown in figure 1. Central banks that entered the pandemic with policy rates already at zero, such as Sweden, or negative-including the euro area, Japan, and Switzerland—left their rates unchanged. Meanwhile, almost all emerging market economy (EME) central banks cut their policy rates. Although central banks acted quickly to reduce rates, policymakers cited a few reasons to refrain from deeper cuts: Among EME policymakers, concerns were expressed that further lowering rates risked exacerbating capital outflows, while some advanced economy central banks commented that further rate cuts, particularly in negative territory, could harm banks' financial health or would provide little additional monetary stimulus. Many central banks also conducted significant asset purchases. These purchases were initially aimed at restoring market functioning and providing liquidity, but they also were seen as lowering long-term yields and easing broader financial conditions. The Fed and the Bank of England (BOE) restarted their purchases, while the European Central Bank (ECB) and the Swedish Riksbank increased the pace of their existing programs. And here, the Reserve Bank of Australia began asset purchases and introduced a target for the three-year government bond yield at the same level as its overnight rate. # The Rise of Inflation and the Common Monetary Policy Response Over the course of 2021, as financial conditions improved, a strong recovery in consumer demand outpaced still constrained supply capacity in many countries, leading ---[PAGE_BREAK]--- to production and transportation bottlenecks, which ultimately resulted in inflation. The surge in inflation was initially mostly concentrated in finished goods and commodities but later spread to services. ${ }^{2}$ As the economy started reopening with the lifting of lockdowns and rollout of vaccines, demand for services picked up. Similar to what played out with goods, the pickup in demand for services ran into a constrained supply of service workers. As services are more labor intensive than goods, and labor supply was still reeling from the consequences of the pandemic, the rebalancing of consumption from goods to services led to higher rates of inflation and nominal wage growth. In response to rising inflation, central banks around the world started to remove some of the support that they provided during the height of the pandemic. As a first step, central banks let many of the emergency support programs-in which they had bought assets other than national government bonds-expire. Next, central banks generally began to taper their purchases of government securities and then to end net purchases late in 2021 or the first half of 2022 . Then some central banks began to raise interest rates. The first to do so were EME central banks that saw particularly sharp increases in inflation driven by exchange rate depreciation and by the surge in prices for food, which makes up a large part of the consumption baskets in their economies. Advanced economy central banks generally were more patient on raising interest rates in 2021, as inflation expectations in their economies were better anchored than in emerging economies. Among advanced economy central banks, the first to hike in the autumn of 2021 were central banks in [^0] [^0]: ${ }^{2}$ See François de Soyres, Alexandre Gaillard, Ana Maria Santacreu, and Dylan Moore (2024), "Supply Disruptions and Fiscal Stimulus: Transmission through Global Value Chains," AEA Papers and Proceedings, vol. 114 (May), pp. 112-17. ---[PAGE_BREAK]--- Norway and New Zealand, whose economies had strong recoveries. The BOE first raised its policy rate in December 2021, citing a strong labor market and sharply rising inflation. The Bank of Canada and the Fed began to raise rates in March 2022, and the ECB first raised its deposit rate (from negative 0.5 percent to zero) in July 2022. Most advanced economy central banks undertook a sequence of policy actions in which they first began to raise their policy rates and later began to reduce the size of their balance sheets over time. # Understanding the Rise and Fall of Inflation in Recent Years The inflation surge in the aftermath of the COVID-19 pandemic was synchronized across advanced and emerging economies, as figure 2 illustrates. The rapid increase in prices reflected an upswing in demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices exacerbated by Russia's February 2022 invasion of Ukraine. The run-up was not only for overall headline inflation, but also for its core components. A plethora of factors can explain the global co-movement in headline and core inflation. First, fluctuations in global food and energy prices broadly pass through to consumer prices in individual countries. But there are other possible explanations, including global supply constraints and synchronous policy responses. The pandemic experience was also a stark reminder of the importance of international trade and inputoutput linkages for the propagation of supply shocks-for example, production and shipping disruptions in the semiconductor industry in Asia constraining production and creating important price pressures in downstream markets, such as motor vehicles in the U.S. ---[PAGE_BREAK]--- Research on the recent inflation episode is still very much in its infancy, and I look forward to learning from the ongoing work on the subject. One important contribution already is Ben Bernanke and Olivier Blanchard's analysis of pandemic-era inflation in 11 economies. Separate teams for each of the 11 economies estimated a comparable model of inflation and its drivers. They find for the U.S. and, with some variation, for other countries that "relative price shocks and sectoral shortages drove the initial surge in inflation, but as these effects have reversed, tight labor markets in most (although not all) countries have become a relatively more important factor.,"3 In a recent FEDS Notes article, economists at the Federal Reserve Board took head-on the task of decomposing world inflation into common and country-specific components and using this decomposition to analyze the sources of inflation around the world. ${ }^{4}$ Despite the different approach, they reached conclusions broadly in line with those of Bernanke and Blanchard. As shown in figure 3, they find that the global components of inflation accounted for a large part of the variation in the average inflation around the world during the post-COVID period. This is an experience with precedents during the oil price shocks of the 1970s and the 1980s. This study also found that the global components of inflation also predict the path of near-term inflation. Historically, once global components start moving, they maintain the course and take time to reverse. This persistence and the recent decline in global components of core and noncore inflation suggest that the world disinflationary process [^0] [^0]: ${ }^{3}$ See Ben Bernanke and Olivier Blanchard (2024), "An Analysis of Pandemic-Era Inflation in 11 Economies," Hutchins Center Working Paper 91 (Washington: Brookings Institution, May), quoted text on p. 1, https://www.brookings.edu/wp-content/uploads/2024/05/WP91_Bernanke-Blanchard.pdf. ${ }^{4}$ See Danilo Cascaldi-Garcia, Luca Guerrieri, Matteo Iacoviello, and Michele Modugno (2024), "Lessons from the Co-Movement of Inflation around the World," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, June 28), https://www.federalreserve.gov/econres/notes/feds-notes/lessons-from-the-co-movement-of-inflation-around-the-world-20240628.html. ---[PAGE_BREAK]--- will continue, as shown in figure 4. The predicted path is in line with a gradual return of inflation toward central bank targets. Of note, as shown in figure 5, the authors find that the post-pandemic rise in global inflation was linked to both commodity-driven price shocks and shocks to global economic activity—such as the sharp decline and rebound in activity due to the COVID-19 pandemic and the associated labor market shortages. This situation contrasts with the 1970s and 1980s, when commodity price shocks played a prominent role in inflation's fluctuations. Additionally, idiosyncratic shocks were important drivers of the surge in global inflation in 2022 and its decline in 2023. These shocks may capture economy-specific forces, including natural gas disruptions that more greatly affected European economies than others in the aftermath of Russia's war on Ukraine. In sum, through the lens of the model, the ongoing disinflation is driven by waning effects of commodity price shocks and by a gradual normalization of global economic activity, amid the resolution of shortages and imbalances in labor markets. # Current Common Monetary Policy Challenges With global components of inflation turning down, most countries have experienced a significant fall in inflation relative to its peak. Similarly, most central banks stopped raising their policy rates over the past year. Some are considering how long to keep rates at restrictive levels or, if inflation picks up again, whether to raise rates further. The Bank of Canada, the ECB, the Swedish Riksbank, and the Swiss National Bank, have begun to cut policy rates, highlighting progress toward meeting inflation goals amid sustained softness in economic activity. Indeed, unlike in the U.S., the level of gross domestic product (GDP) in some advanced economies remains well below what ---[PAGE_BREAK]--- would be implied by their respective pre-COVID GDP trends. ${ }^{5}$ Even among those cutting rates, however, the future path of the policy rate is generally seen as dependent on a continuing decline of inflation toward target levels. For all central banks, the question is how best to ensure continued disinflation while avoiding unnecessary damage to the economy. The generally desired outcome is a soft landing, in which inflation returns to the central bank's target inflation level or range without inducing a recession or a large increase in unemployment. How likely is such a scenario? It may be too soon to definitively say for the current economic cycle. But Fed Board staff have examined past episodes of monetary policy easing in 13 advanced economies over the past five decades. They find that soft landings are rare, according to their analysis published in another recent FEDS Notes article. ${ }^{6}$ In most of the cases that they studied, central banks were not successful in bringing inflation back to near target in a timely manner. And when they were successful in taming inflation, it often was associated with a recession. However, soft landings are not unprecedented. When such a landing occurred, on average it was associated with a smaller preceding policy tightening. Soft landings were also more likely when policy easing began with inflation already close to target and when there was a relatively firm growth backdrop. In the U.S., what I have seen so far appears to be consistent with a soft landing: Inflation has fallen significantly from its peak, and [^0] [^0]: ${ }^{5}$ See François de Soyres, Joaquin Garcia-Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why Is the U.S. GDP Recovering Faster Than Other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://doi.org/10.17016/2380-7172.3495. ${ }^{6}$ See François de Soyres and Zina Saijid (2024), "Lessons from Past Monetary Easing Cycles," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 31), https://doi.org/10.17016/2380-7172.3504. ---[PAGE_BREAK]--- the labor market has gradually cooled but remains strong. Of course, I am closely monitoring incoming data to see how the economy further develops. It is possible that some features of the recent inflation episode may make a soft landing more likely in countries around the globe. As I discussed, Bernanke and Blanchard found that much of the inflation episode came from relative price shocks and sectoral shortages that have since been resolved. And while they found that tight labor markets have since taken over as the main drivers of inflation, there are signs that such tightness is easing. For instance, in the U.S., the ratio of vacancies to unemployment has fallen back to its pre-pandemic level and the rate of voluntary quits has declined, as workers are less confident of finding a better job. Thus, my baseline forecast (and that of many outside observers) is that inflation will continue to move toward target over time, without much further rise in unemployment. # Monetary Policy Communications Of course, forecasts are subject to considerable uncertainty, and policymakers must consider a range of possible outcomes. A key challenge of monetary policy communications is discussing how policy would respond to changes in the economic outlook. Central bankers are faced with a tradeoff between predictability and flexibility. On the one hand, many observers would like to know in advance what the path for the policy rate will be, while, on the other hand, a central bank needs to remain nimble and data dependent. As a result, central bankers often try to convey their "reaction function" so observers understand how policy might adapt to incoming data and the implications for the economic outlook. ---[PAGE_BREAK]--- In his recent review of forecasting for monetary policymaking and communications at the BOE, Ben Bernanke suggested that the Bank consider supplementing its published forecasts with the use of alternative scenarios to help the public understand its policy reaction function. ${ }^{7}$ For similar reasons I try to incorporate a discussion of alternative scenarios in my own speeches. Fed policymakers, like those at many other central banks, also benefit from staff analysis using models to explore how the forecast would change relative to the baseline if certain assumptions are changed. The challenge is how to use such alternative scenarios in our official communications. Policy communications are an area where we can learn a lot from what other central banks have done, and communication practices have developed over time. The BOE was an early innovator with its fan charts, which emphasized that its forecasts for GDP and inflation were subject to growing uncertainty the longer the time horizon. Of course, forecasts for economic variables need to be conditioned on some assumption of the path of policy rates. While early practice was to condition on unchanged rates or on the path of rates implied by market pricing, some central banks innovated by publishing their own forecasts for policy rates. This was originally done by the Reserve Bank of New Zealand and later by the Norges Bank and the Riksbank. Since 2012, the Federal Reserve's Summary of Economic Projections also includes the path of the policy rate that each policymaker "deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to [^0] [^0]: ${ }^{7}$ See Ben S. Bernanke (2024), Forecasting for Monetary Policy Making and Communication at the Bank of England: A Review (London: Bank of England, April), https://www.bankofengland.co.uk/independentevaluation-office/forecasting-for-monetary-policy-making-and-communication-at-the-bank-of-england-areview/forecasting-for-monetary-policy-making-and-communication-at-the-bank-of-england-a-review. ---[PAGE_BREAK]--- promote maximum employment and price stability."8 I continue to take great interest in communications and other monetary policy practices by foreign central banks. In conclusion, I think it is clear we have learned much from the experience of the past few years. I must stress that the human toll of the pandemic cannot and should not be overlooked. Purely in terms of economics, the recent period does stand out as an unusual case study. Economies around the world effectively faced the same shock at nearly the same moment. We were then able to observe how various economies around the world responded to the shock, including the actions of central banks and fiscal policymakers. I am glad to have highlighted some of the interesting research that has begun to explore this space, and I am sure much more study on this unique time in our history will soon occur, and that can be powerful. What is not unique to the pandemic is that we often have common macroeconomic experiences and face common monetary policy challenges, which is what makes discussions like the one today so valuable. Thank you. It is a pleasure to be here in Adelaide. I look forward to continuing our conversation. [^0] [^0]: ${ }^{8}$ See the June 2024 Summary of Economic Projections (quoted text on p. 1), available on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240612.pdf. ---[PAGE_BREAK]--- # Common Inflation and Monetary Policy Challenges Across Countries LISA D. COOK MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM PRESENTATION TO THE AUSTRALIAN CONFERENCE OF ECONOMISTS JULY 11, 2024 ![img-0.jpeg](img-0.jpeg) ---[PAGE_BREAK]--- # Figure 1: Policy Rates across Selected Advanced Economies ![img-1.jpeg](img-1.jpeg) Note: Data extend through July 2024. Source: National sources via Haver Analytics. ---[PAGE_BREAK]--- # Figure 2: Inflation across Selected Economies since 2008 Headline Inflation ![img-2.jpeg](img-2.jpeg) Note: Inflation series are 4-quarter percent changes of consumer price indexes, and world inflation is GDP-weighted 4-quarter percent change of consumer price indexes for selected economies. Data extend through 2024:Q1. Shaded area refers to period in which the World Health Organization declared COVID-19 a public health emergency. World inflation, the red line, is a GDP-weighted average of the inflation measures for 26 economies. Source: National sources via Haver Analytics; FRB staff calculations; World Health Organization. ---[PAGE_BREAK]--- # Figure 3: Global Components of World Inflation Headline ![img-3.jpeg](img-3.jpeg) Core ![img-4.jpeg](img-4.jpeg) Noncore ![img-5.jpeg](img-5.jpeg) 4-quarter percent change ![img-6.jpeg](img-6.jpeg) Note: World inflation is the GDP (gross domestic product)-weighted, 4-quarter percent change of consumer price indexes for selected economies. Global components are GDP-weighted aggregates of each economy's common component. Noncore inflation encompasses food and energy categories. Headline inflation is the aggregate of core and noncore inflation using economy-specific weights. Data extend through 2024:Q1. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- Figure 4: Model-Based Forecast of the Global Components of Inflation ![img-7.jpeg](img-7.jpeg) Note: Global components are GDP (gross domestic product)-weighted components estimated through a factor model that isolates co-movement from economy-specific trends and transitory movements. Noncore inflation encompasses food and energy categories. Forecast shown is derived from the factor model and driven by the statistical persistence of the global components. Headline global component is the weighted average of core and noncore global components using economy-specific weights. Data extend through 2027:Q4. Shaded area refers to the forecast period. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- Figure 5: Drivers of World Headline Inflation 1970s to Early 1980s Deviation from 1972:Q4 ![img-8.jpeg](img-8.jpeg) Deviation from 2019:Q4 Percentage points ![img-9.jpeg](img-9.jpeg) Note: Figure 4 illustrates decomposition for selected inflationary periods stemming from vector autoregressive models estimated from 1961:Q1 to 1994:Q4 (left panel) and from 1995:Q1 to 2024:Q1 (right panel). Global component of headline inflation and its decomposition are constructed from economy-specific core inflation weights and aggregated with gross domestic product (GDP) weights. Global activity shocks combine shocks to the global component of core inflation, to global GDP, and to labor market shortages. Commodity shocks combine shocks to the global component of noncore inflation, to oil prices, and to global commodity prices. Noncore inflation encompasses food and energy categories. Data extend through 2024:Q1. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations.	Lisa D Cook	United States	https://www.bis.org/review/r240715d.pdf	For release on delivery 7:30 p.m. EDT (9:00 a.m., July 11, local time) July 10, 2024 Remarks by<br>Lisa D. Cook<br>Member<br>Board of Governors of the Federal Reserve System<br>at the<br>Australian Conference of Economists 2024<br>Adelaide, Australia July 11, 2024 Thank you, Jacky. I am happy to be here in Adelaide and appreciate the opportunity to speak with all of you. Considering the significant developments in the global economy over the past few years, now is an appropriate time to reflect on the economic reverberations the COVID-19 shock caused around the world. Examining the common inflation experiences and monetary policy challenges across several countries, including Australia and the United States, is a helpful exercise for policymakers and economists alike. Today, I will first talk about how monetary policymakers responded in similar fashion to the COVID-19 pandemic and, later, to high inflation during the recovery. I will discuss common features of the recent inflation experience across countries and the importance of global shocks. With disinflation in train across most countries, I will consider what we can learn from past cycles of monetary easing. I will finish with a discussion of how the use of alternative scenarios could help monetary policymakers communicate how they might respond to a range of possible economic outcomes. In the spring of 2020, economies around the world shut down or sharply limited business activity, especially for in-person services, including dining out and traveling. Governments introduced extraordinary fiscal support aimed at alleviating the socioeconomic effects of the pandemic. And, to prevent sharp financial and economic deterioration, most central banks responded aggressively by lowering policy rates, ramping up asset purchases, and taking other actions to support the flow of credit to households and businesses. Those efforts were sustained throughout 2020 and much of 2021, as the initial turmoil in financial markets subsided but the health situation remained uncertain. Advanced economy central banks that had positive policy rates before the pandemic, including the Fed and the central banks of Australia, Canada, and the United Kingdom, cut these rates to near zero, as shown in figure 1. Central banks that entered the pandemic with policy rates already at zero, such as Sweden, or negative-including the euro area, Japan, and Switzerland—left their rates unchanged. Meanwhile, almost all emerging market economy (EME) central banks cut their policy rates. Although central banks acted quickly to reduce rates, policymakers cited a few reasons to refrain from deeper cuts: Among EME policymakers, concerns were expressed that further lowering rates risked exacerbating capital outflows, while some advanced economy central banks commented that further rate cuts, particularly in negative territory, could harm banks' financial health or would provide little additional monetary stimulus. Many central banks also conducted significant asset purchases. These purchases were initially aimed at restoring market functioning and providing liquidity, but they also were seen as lowering long-term yields and easing broader financial conditions. The Fed and the Bank of England (BOE) restarted their purchases, while the European Central Bank (ECB) and the Swedish Riksbank increased the pace of their existing programs. And here, the Reserve Bank of Australia began asset purchases and introduced a target for the three-year government bond yield at the same level as its overnight rate. Over the course of 2021, as financial conditions improved, a strong recovery in consumer demand outpaced still constrained supply capacity in many countries, leading to production and transportation bottlenecks, which ultimately resulted in inflation. The surge in inflation was initially mostly concentrated in finished goods and commodities but later spread to services. As the economy started reopening with the lifting of lockdowns and rollout of vaccines, demand for services picked up. Similar to what played out with goods, the pickup in demand for services ran into a constrained supply of service workers. As services are more labor intensive than goods, and labor supply was still reeling from the consequences of the pandemic, the rebalancing of consumption from goods to services led to higher rates of inflation and nominal wage growth. In response to rising inflation, central banks around the world started to remove some of the support that they provided during the height of the pandemic. As a first step, central banks let many of the emergency support programs-in which they had bought assets other than national government bonds-expire. Next, central banks generally began to taper their purchases of government securities and then to end net purchases late in 2021 or the first half of 2022 . Then some central banks began to raise interest rates. The first to do so were EME central banks that saw particularly sharp increases in inflation driven by exchange rate depreciation and by the surge in prices for food, which makes up a large part of the consumption baskets in their economies. Advanced economy central banks generally were more patient on raising interest rates in 2021, as inflation expectations in their economies were better anchored than in emerging economies. Among advanced economy central banks, the first to hike in the autumn of 2021 were central banks in Norway and New Zealand, whose economies had strong recoveries. The BOE first raised its policy rate in December 2021, citing a strong labor market and sharply rising inflation. The Bank of Canada and the Fed began to raise rates in March 2022, and the ECB first raised its deposit rate (from negative 0.5 percent to zero) in July 2022. Most advanced economy central banks undertook a sequence of policy actions in which they first began to raise their policy rates and later began to reduce the size of their balance sheets over time. The inflation surge in the aftermath of the COVID-19 pandemic was synchronized across advanced and emerging economies, as figure 2 illustrates. The rapid increase in prices reflected an upswing in demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices exacerbated by Russia's February 2022 invasion of Ukraine. The run-up was not only for overall headline inflation, but also for its core components. A plethora of factors can explain the global co-movement in headline and core inflation. First, fluctuations in global food and energy prices broadly pass through to consumer prices in individual countries. But there are other possible explanations, including global supply constraints and synchronous policy responses. The pandemic experience was also a stark reminder of the importance of international trade and inputoutput linkages for the propagation of supply shocks-for example, production and shipping disruptions in the semiconductor industry in Asia constraining production and creating important price pressures in downstream markets, such as motor vehicles in the U.S. Research on the recent inflation episode is still very much in its infancy, and I look forward to learning from the ongoing work on the subject. One important contribution already is Ben Bernanke and Olivier Blanchard's analysis of pandemic-era inflation in 11 economies. Separate teams for each of the 11 economies estimated a comparable model of inflation and its drivers. They find for the U.S. and, with some variation, for other countries that "relative price shocks and sectoral shortages drove the initial surge in inflation, but as these effects have reversed, tight labor markets in most (although not all) countries have become a relatively more important factor.,"3 In a recent FEDS Notes article, economists at the Federal Reserve Board took head-on the task of decomposing world inflation into common and country-specific components and using this decomposition to analyze the sources of inflation around the world. Despite the different approach, they reached conclusions broadly in line with those of Bernanke and Blanchard. As shown in figure 3, they find that the global components of inflation accounted for a large part of the variation in the average inflation around the world during the post-COVID period. This is an experience with precedents during the oil price shocks of the 1970s and the 1980s. This study also found that the global components of inflation also predict the path of near-term inflation. Historically, once global components start moving, they maintain the course and take time to reverse. This persistence and the recent decline in global components of core and noncore inflation suggest that the world disinflationary process will continue, as shown in figure 4. The predicted path is in line with a gradual return of inflation toward central bank targets. Of note, as shown in figure 5, the authors find that the post-pandemic rise in global inflation was linked to both commodity-driven price shocks and shocks to global economic activity—such as the sharp decline and rebound in activity due to the COVID-19 pandemic and the associated labor market shortages. This situation contrasts with the 1970s and 1980s, when commodity price shocks played a prominent role in inflation's fluctuations. Additionally, idiosyncratic shocks were important drivers of the surge in global inflation in 2022 and its decline in 2023. These shocks may capture economy-specific forces, including natural gas disruptions that more greatly affected European economies than others in the aftermath of Russia's war on Ukraine. In sum, through the lens of the model, the ongoing disinflation is driven by waning effects of commodity price shocks and by a gradual normalization of global economic activity, amid the resolution of shortages and imbalances in labor markets. With global components of inflation turning down, most countries have experienced a significant fall in inflation relative to its peak. Similarly, most central banks stopped raising their policy rates over the past year. Some are considering how long to keep rates at restrictive levels or, if inflation picks up again, whether to raise rates further. The Bank of Canada, the ECB, the Swedish Riksbank, and the Swiss National Bank, have begun to cut policy rates, highlighting progress toward meeting inflation goals amid sustained softness in economic activity. Indeed, unlike in the U.S., the level of gross domestic product (GDP) in some advanced economies remains well below what would be implied by their respective pre-COVID GDP trends. Even among those cutting rates, however, the future path of the policy rate is generally seen as dependent on a continuing decline of inflation toward target levels. For all central banks, the question is how best to ensure continued disinflation while avoiding unnecessary damage to the economy. The generally desired outcome is a soft landing, in which inflation returns to the central bank's target inflation level or range without inducing a recession or a large increase in unemployment. How likely is such a scenario? It may be too soon to definitively say for the current economic cycle. But Fed Board staff have examined past episodes of monetary policy easing in 13 advanced economies over the past five decades. They find that soft landings are rare, according to their analysis published in another recent FEDS Notes article. In most of the cases that they studied, central banks were not successful in bringing inflation back to near target in a timely manner. And when they were successful in taming inflation, it often was associated with a recession. However, soft landings are not unprecedented. When such a landing occurred, on average it was associated with a smaller preceding policy tightening. Soft landings were also more likely when policy easing began with inflation already close to target and when there was a relatively firm growth backdrop. In the U.S., what I have seen so far appears to be consistent with a soft landing: Inflation has fallen significantly from its peak, and the labor market has gradually cooled but remains strong. Of course, I am closely monitoring incoming data to see how the economy further develops. It is possible that some features of the recent inflation episode may make a soft landing more likely in countries around the globe. As I discussed, Bernanke and Blanchard found that much of the inflation episode came from relative price shocks and sectoral shortages that have since been resolved. And while they found that tight labor markets have since taken over as the main drivers of inflation, there are signs that such tightness is easing. For instance, in the U.S., the ratio of vacancies to unemployment has fallen back to its pre-pandemic level and the rate of voluntary quits has declined, as workers are less confident of finding a better job. Thus, my baseline forecast (and that of many outside observers) is that inflation will continue to move toward target over time, without much further rise in unemployment. Of course, forecasts are subject to considerable uncertainty, and policymakers must consider a range of possible outcomes. A key challenge of monetary policy communications is discussing how policy would respond to changes in the economic outlook. Central bankers are faced with a tradeoff between predictability and flexibility. On the one hand, many observers would like to know in advance what the path for the policy rate will be, while, on the other hand, a central bank needs to remain nimble and data dependent. As a result, central bankers often try to convey their "reaction function" so observers understand how policy might adapt to incoming data and the implications for the economic outlook. In his recent review of forecasting for monetary policymaking and communications at the BOE, Ben Bernanke suggested that the Bank consider supplementing its published forecasts with the use of alternative scenarios to help the public understand its policy reaction function. For similar reasons I try to incorporate a discussion of alternative scenarios in my own speeches. Fed policymakers, like those at many other central banks, also benefit from staff analysis using models to explore how the forecast would change relative to the baseline if certain assumptions are changed. The challenge is how to use such alternative scenarios in our official communications. Policy communications are an area where we can learn a lot from what other central banks have done, and communication practices have developed over time. The BOE was an early innovator with its fan charts, which emphasized that its forecasts for GDP and inflation were subject to growing uncertainty the longer the time horizon. Of course, forecasts for economic variables need to be conditioned on some assumption of the path of policy rates. While early practice was to condition on unchanged rates or on the path of rates implied by market pricing, some central banks innovated by publishing their own forecasts for policy rates. This was originally done by the Reserve Bank of New Zealand and later by the Norges Bank and the Riksbank. Since 2012, the Federal Reserve's Summary of Economic Projections also includes the path of the policy rate that each policymaker "deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to promote maximum employment and price stability."8 I continue to take great interest in communications and other monetary policy practices by foreign central banks. In conclusion, I think it is clear we have learned much from the experience of the past few years. I must stress that the human toll of the pandemic cannot and should not be overlooked. Purely in terms of economics, the recent period does stand out as an unusual case study. Economies around the world effectively faced the same shock at nearly the same moment. We were then able to observe how various economies around the world responded to the shock, including the actions of central banks and fiscal policymakers. I am glad to have highlighted some of the interesting research that has begun to explore this space, and I am sure much more study on this unique time in our history will soon occur, and that can be powerful. What is not unique to the pandemic is that we often have common macroeconomic experiences and face common monetary policy challenges, which is what makes discussions like the one today so valuable. Thank you. It is a pleasure to be here in Adelaide. I look forward to continuing our conversation. LISA D. COOK Deviation from 2019:Q4
2024-07-10T00:00:00	Michelle W Bowman: Opening remarks - "Fed Listens"	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at a Fed Listens event on "Exploring Challenges Facing the Childcare Industry, Working Parents, and Employers", Chicago, Illinois, 10 July 2024.	Michelle W Bowman: Opening remarks - "Fed Listens" Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at a Fed Listens event on "Exploring Challenges Facing the Childcare Industry, Working Parents, and Employers", Chicago, Illinois, 10 July 2024. * * * Thank you, Austan, for the warm welcome. It is really a pleasure to join you in Chicago 1 for this year's Fed Listens event. When we started Fed Listens back in 2019, the initiative was part of a broad, comprehensive review of the decisionmaking framework we use to pursue our monetary policy goals of maximum employment and price stability. In the years that followed, we have met with people from across the country and from a wide variety of backgrounds and experiences to learn about how the economy has been recovering from the COVID experience. Each Fed Listens event created a wonderful opportunity to take a step back, to ask questions of those who are directly impacted by our policies and the prevailing economic conditions, and then really listen to their feedback. I am extremely proud that Fed Listens has grown and developed into an ongoing venue for the Federal Reserve Board and the Reserve Banks to foster an ongoing conversation and discussion with those who are directly experiencing current economic conditions. As many of you may recall, at last year's Fed Listens event here in Chicago, we discussed youth employment and joining the labor force following the pandemic, which were especially inspiring. So, in that spirit, today is not only a wonderful opportunity to continue this important conversation in the Seventh District, but also an opportunity to dig deeper into issues that affect local families through the childcare industry, working parents, and employers. Austan and I enjoyed getting to know our panelists better earlier today, and I am looking forward to learning more about their experiences through the upcoming panels and discussions. I am also very pleased to welcome our audience-both in person and those tuning in online. I view Fed Listens as an excellent example of Board and System convenings that enable us to gain important insights about economic conditions by engaging directly with those experiencing the economy. As you all know, Fed officials and economists review a vast amount of economic data on a regular basis. Discussions like those we will engage in today provide color and context to supplement the other economic data we monitor. Your perspectives help us gain deeper insights into how we are meeting our dual mandate of maintaining maximum employment and stable prices. A better understanding of a wide variety of this type of data, from the considerations families face in making spending decisions (including the costs of childcare) to factors weighed by business owners in applying for loans and offering benefits to help attract top talent, all provide better insight into our data collection. These conversations help us to gain perspective on how Americans in different areas of the country are faring. Some of the issues discussed today may be unique to the Seventh District, but certainly many of these themes and dynamics are present throughout the country and across all 12 Federal Reserve Districts. Seeking out local perspectives is one of the great advantages of the Federal Reserve System's regional structure and of the Fed Listens structure in particular. Earlier, I had the pleasure to meet each of the panelists you'll hear from today. Their varied experiences and backgrounds across sectors lay an important foundation for today's discussion. We hope that our attendees will also join in to share your own observations as you experience these issues in your own lives, businesses, and communities. Your perspective will help to inform our work as policymakers with the responsibility to promote a strong and vibrant economy for all Americans. So with that, I would like to say, thank you again, Austan, and especially to recognize your entire Chicago Fed team for hosting this Fed Listens event today and for the opportunity to be part of this discussion. Without further ado, I am delighted to get our conversation started by turning things over to Robin Newberger, who is a policy advisor here at the Chicago Fed. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	---[PAGE_BREAK]--- # Michelle W Bowman: Opening remarks - "Fed Listens" Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at a Fed Listens event on "Exploring Challenges Facing the Childcare Industry, Working Parents, and Employers", Chicago, Illinois, 10 July 2024. Thank you, Austan, for the warm welcome. It is really a pleasure to join you in Chicago for this year's Fed Listens event. ${ }^{1}$ When we started Fed Listens back in 2019, the initiative was part of a broad, comprehensive review of the decisionmaking framework we use to pursue our monetary policy goals of maximum employment and price stability. In the years that followed, we have met with people from across the country and from a wide variety of backgrounds and experiences to learn about how the economy has been recovering from the COVID experience. Each Fed Listens event created a wonderful opportunity to take a step back, to ask questions of those who are directly impacted by our policies and the prevailing economic conditions, and then really listen to their feedback. I am extremely proud that Fed Listens has grown and developed into an ongoing venue for the Federal Reserve Board and the Reserve Banks to foster an ongoing conversation and discussion with those who are directly experiencing current economic conditions. As many of you may recall, at last year's Fed Listens event here in Chicago, we discussed youth employment and joining the labor force following the pandemic, which were especially inspiring. So, in that spirit, today is not only a wonderful opportunity to continue this important conversation in the Seventh District, but also an opportunity to dig deeper into issues that affect local families through the childcare industry, working parents, and employers. Austan and I enjoyed getting to know our panelists better earlier today, and I am looking forward to learning more about their experiences through the upcoming panels and discussions. I am also very pleased to welcome our audience-both in person and those tuning in online. I view Fed Listens as an excellent example of Board and System convenings that enable us to gain important insights about economic conditions by engaging directly with those experiencing the economy. As you all know, Fed officials and economists review a vast amount of economic data on a regular basis. Discussions like those we will engage in today provide color and context to supplement the other economic data we monitor. Your perspectives help us gain deeper insights into how we are meeting our dual mandate of maintaining maximum employment and stable prices. A better understanding of a wide variety of this type of data, from the considerations families face in making spending decisions (including the costs of childcare) to factors weighed by business owners in applying for loans and offering benefits to help attract top talent, all provide better insight into our data collection. These conversations help us to gain perspective on how Americans in different areas of the country are faring. Some of the issues discussed today may be unique to the Seventh District, but certainly many ---[PAGE_BREAK]--- of these themes and dynamics are present throughout the country and across all 12 Federal Reserve Districts. Seeking out local perspectives is one of the great advantages of the Federal Reserve System's regional structure and of the Fed Listens structure in particular. Earlier, I had the pleasure to meet each of the panelists you'll hear from today. Their varied experiences and backgrounds across sectors lay an important foundation for today's discussion. We hope that our attendees will also join in to share your own observations as you experience these issues in your own lives, businesses, and communities. Your perspective will help to inform our work as policymakers with the responsibility to promote a strong and vibrant economy for all Americans. So with that, I would like to say, thank you again, Austan, and especially to recognize your entire Chicago Fed team for hosting this Fed Listens event today and for the opportunity to be part of this discussion. Without further ado, I am delighted to get our conversation started by turning things over to Robin Newberger, who is a policy advisor here at the Chicago Fed. $\underline{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	Michelle W Bowman	United States	https://www.bis.org/review/r240715b.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at a Fed Listens event on "Exploring Challenges Facing the Childcare Industry, Working Parents, and Employers", Chicago, Illinois, 10 July 2024. Thank you, Austan, for the warm welcome. It is really a pleasure to join you in Chicago for this year's Fed Listens event. When we started Fed Listens back in 2019, the initiative was part of a broad, comprehensive review of the decisionmaking framework we use to pursue our monetary policy goals of maximum employment and price stability. In the years that followed, we have met with people from across the country and from a wide variety of backgrounds and experiences to learn about how the economy has been recovering from the COVID experience. Each Fed Listens event created a wonderful opportunity to take a step back, to ask questions of those who are directly impacted by our policies and the prevailing economic conditions, and then really listen to their feedback. I am extremely proud that Fed Listens has grown and developed into an ongoing venue for the Federal Reserve Board and the Reserve Banks to foster an ongoing conversation and discussion with those who are directly experiencing current economic conditions. As many of you may recall, at last year's Fed Listens event here in Chicago, we discussed youth employment and joining the labor force following the pandemic, which were especially inspiring. So, in that spirit, today is not only a wonderful opportunity to continue this important conversation in the Seventh District, but also an opportunity to dig deeper into issues that affect local families through the childcare industry, working parents, and employers. Austan and I enjoyed getting to know our panelists better earlier today, and I am looking forward to learning more about their experiences through the upcoming panels and discussions. I am also very pleased to welcome our audience-both in person and those tuning in online. I view Fed Listens as an excellent example of Board and System convenings that enable us to gain important insights about economic conditions by engaging directly with those experiencing the economy. As you all know, Fed officials and economists review a vast amount of economic data on a regular basis. Discussions like those we will engage in today provide color and context to supplement the other economic data we monitor. Your perspectives help us gain deeper insights into how we are meeting our dual mandate of maintaining maximum employment and stable prices. A better understanding of a wide variety of this type of data, from the considerations families face in making spending decisions (including the costs of childcare) to factors weighed by business owners in applying for loans and offering benefits to help attract top talent, all provide better insight into our data collection. These conversations help us to gain perspective on how Americans in different areas of the country are faring. Some of the issues discussed today may be unique to the Seventh District, but certainly many of these themes and dynamics are present throughout the country and across all 12 Federal Reserve Districts. Seeking out local perspectives is one of the great advantages of the Federal Reserve System's regional structure and of the Fed Listens structure in particular. Earlier, I had the pleasure to meet each of the panelists you'll hear from today. Their varied experiences and backgrounds across sectors lay an important foundation for today's discussion. We hope that our attendees will also join in to share your own observations as you experience these issues in your own lives, businesses, and communities. Your perspective will help to inform our work as policymakers with the responsibility to promote a strong and vibrant economy for all Americans. So with that, I would like to say, thank you again, Austan, and especially to recognize your entire Chicago Fed team for hosting this Fed Listens event today and for the opportunity to be part of this discussion. Without further ado, I am delighted to get our conversation started by turning things over to Robin Newberger, who is a policy advisor here at the Chicago Fed.
2024-07-16T00:00:00	Adriana D Kugler: The challenges facing economic measurement and creative solutions	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the 21st Annual Economic Measurement Seminar, organised by the National Association for Business Economics Foundation, Washington DC, 16 July 2024.	For release on delivery 2:45 p.m. EDT July 16, 2024 The Challenges Facing Economic Measurement and Creative Solutions Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at 21st Annual Economic Measurement Seminar, National Association for Business Economics Foundation Washington, D.C. July 16, 2024 Thank you for your generous introduction, Ellen. I am delighted to be here with the National Association for Business Economics (NABE), and, in particular, I am pleased to be speaking at a conference covering an issue that is close to my heart and on which I have spent many years working: economic measurement. When Federal Reserve officials tell audiences that their judgments are data dependent, some skeptics perhaps presume that monetary policy is already on a path set in stone. But most in this room likely know what I mean when I talk about data dependence. I am a member of the Federal Open Market Committee (FOMC), which, of course, pursues a dual mandate of maximum employment and stable prices.1 When I say I am data dependent, that means I am considering the totality of the data-the full range of economic indicators that provide a sense of where the labor market, economic activity, financial conditions, and inflation have been and where they might be going. Policymakers must have high-quality and accurate data to understand the economy and set the correct policy. The truth is that it is not just the Fed that needs data. Consumers, businesses, investors, and others have access to more information than ever before when making decisions. It is incumbent on economists, private- and public-sector data collectors, and others to ensure that available data are carefully collected, accurately measured, and clearly presented, and that data collection and measurement efforts are further enhanced and continue to improve. To be sure, data collection and economic measurement can be challenging, and different types of data face pros and cons, which is why I take an expansive approach to - 2 - using data, as I will explain a bit later. But I will begin by highlighting a few challenges to economic measurement. I will then provide some examples of how those challenges might be addressed. I will also provide examples of how nontraditional data generated by the private sector can help provide additional angles from which to view aspects of the economy that may not be clear in data produced by government statistical agencies. Finally, I will offer some examples of how, in recent years, our statistical agencies have adapted and innovated, sometimes by incorporating private-sector data to address specific measurement challenges I have in mind. To be clear, my interest in nontraditional data is not a critique of the statistical agencies. To the contrary, official data are critically important to policymakers, researchers, and the public. Rather, I view public and private data as being complementary and helping to provide a more complete picture of the economy. Importance of Data Economic measurement, the task some of you contribute to every day, is at the core of real-time policy analysis and forecasting. We at the Board of Governors rely on a broad array of data produced by both government and the private sector. And we carefully scrutinize every important economic release and are very familiar with the methodological details of those reports. Suffice it to say, we care a lot about economic measurement at the Fed. And the Fed itself produces many important data series, including two principal federal economic indicators: the Industrial Production and Capacity Utilization report - 3 - and the Consumer Credit statistical releases.2 In addition, our website features numerous other data products that look at bank assets, liabilities, and structure; monetary aggregates; international finance; business finance; and household finance-including data on the level, share, and composition of wealth for households at different points in the wealth and income distribution, as well as for different demographic groups.3 The Board also conducts separate surveys of consumers and household economic decision making and surveys of loan officers and credit officers, well known as the SLOOS and the SCOOS. Beyond the Federal Reserve Board, each of the Federal Reserve Banks engages in measurement and data production of various kinds, including closely watched surveys of firms and households. For example, the New York Fed conducts a survey of consumer expectations, which was just released last week, the Atlanta Fed tracks wage data, the Richmond Fed surveys firms on price-setting behavior, among other things, and several Reserve Banks publish alternative measures of inflation and reports on factory and business activity in their regions. Challenges with Measurement Of course, as one reviews various sources of data, one can see that there are some common measurement challenges. I will mention a few. These are not new, nor is my list exhaustive. My intent here is to focus on challenges that highlight the tradeoffs in using public and private data and to show how these sources of data complement each other. - 4 - The first challenge I will identify is that traditional measurement approaches sometimes struggle to track rapidly changing economic developments. This was the case early in the pandemic and is often true at turning points in the business cycle. Of course, it is at those very moments when policymakers, and the public, are most critically interested in how the economy is faring. The reasons for this lag are well known. Statistical agencies can only survey households and businesses every so often, and it takes time to compile and publish high-quality statistics. However, financial markets and business decisions move quickly. Reports produced on a monthly or quarterly basis, often with a multi-week lag, may not be available with sufficient frequency to inform real-time decisions. Also, some indicators, by design, take on new market information slowly. A recent and relevant example is housing services inflation, as measured as part of the consumer price index (CPI) and the personal consumption expenditures price index. Both rely heavily on slowly changing leasing agreements that only adjust to market conditions over many months. Business entries and exits, sometimes called births and deaths, are similar in that they take time to appear in surveys that underlie important statistical products. I will touch on that a bit more later. A second challenge is that many statistical reports were created decades ago and may not be focused on newer or growing sectors of the economy. For example, there are monthly reports on factory orders, shipments, inventories, and output among the principal economic indicators. Because developments in the goods sector can matter importantly for economic fluctuations, that level of detail is indeed helpful to have. But we would benefit from the same depth of information on domestically produced services, too. While service-sector output constitutes a larger share of U.S. gross domestic product - 5 - (GDP), the category has only one single dedicated quarterly report, even though much of the post-pandemic recovery requires us to understand how services consumption and employment have evolved. For example, did you know that quarterly hog and pig counts are a principal economic indicator? Yet, there is not a regular government report specifically dedicated to the gig economy. I am certainly glad we collect data for important agricultural commodities, but I think we should probably be examining the large and diverse gig economy as much as we do the pig economy. I believe the statistical agencies grapple with these issues, and it takes time to lay the groundwork and develop new data series, but this challenge is a real one. If reports are built for the past, that may mean they struggle to capture big developments today and in the future, such as the changing nature of where and how people work or the rising use of artificial intelligence (AI) technology. Finally, there is an impediment that everyone here is acutely aware of: These challenges are made even more difficult because official surveys have seen declining survey response rates. That results in lower precision of statistical estimates and can lead to the need for further, costly surveys to collect the necessary amount of information, as one may need to conduct several rounds of data collection before having sufficiently large samples that can provide reliable estimates. Declining response rates may also be selective and pose a challenge to representing the broader population. Innovative methods for data collection and behavioral interventions to encourage survey responses can be used to address concerns and are being tried in some cases by statistical agencies. - 6 - A Data Explosion While these challenges in traditional data that I have described may take some time to be addressed, I am encouraged by the explosion in data produced by the private sector over the past decade or so that can greatly enhance our understanding of the economy. Such data give an opportunity to measure economic developments with greater timeliness, at a higher frequency, and with more granularity. That said, those data often face their own challenges, including issues with representativeness, the lack of methodological consistency, and a short time-series history. Nevertheless, such nontraditional data can be helpful, especially when used jointly with official statistics to which these new sources can be benchmarked. A prominent example of valuable private-sector data is employment statistics from payroll providers. Such weekly data allowed economists at the Federal Reserve Board to understand, essentially in real time, employment losses when the pandemic first took hold in the United States in March 2020. In comparison, it took until early May to get similar information from the Bureau of Labor Statistics' (BLS) employment report.4 Indeed, in trying to understand the rapidly changing economy during the pandemic, Fed economists closely followed a variety of privately produced higher-frequency data. These included reports on restaurant reservations, hotel occupancy, and airport - 7 - passengers. Economists even used anonymized phone-tracking data to estimate business shutdown rates and trends in retail spending.5 Credit and debit card transaction data are another example of a helpful, private- sector tool that economists use to understand consumer behavior in various sectors or regions in close to real time. These figures provided what proved to be a pretty reliable picture of economic developments during the pandemic, well before traditional statistics-such as quarterly GDP and monthly retail sales-became available.6 The need for timely, high-frequency information is not limited to pandemics and turns in the national business cycle. For example, Federal Reserve Board economists have used credit and debit card transaction data to estimate the effects of local natural disasters almost in real time when official statistics are often not available.7 When we look at economic turning points, it is also important to consider reports on expectations and anticipated outcomes from nongovernment sources. Those include surveys of expectations of future inflation, anticipated hiring or layoffs, and consumer and business sentiment on the economy or the path of the economy. I pay close attention to these surveys because they are forward looking and help inform where behaviors by businesses and households may be trending. 5 See Leland D. Crane, Ryan A. Decker, Aaron Flaaen, Adrian Hamins-Puertolas, and Christopher Kurz (2022), "Business Exit during the COVID-19 Pandemic: Non-traditional Measures in Historical Context," Journal of Macroeconomics, vol. 72 (June), 103419. 6 See Tomaz Cajner, Laura J. Feiveson, Christopher J. Kurz, and Stacey Tevlin (2022), "Lessons Learned from the Use of Nontraditional Data during COVID-19," in Wendy Edelberg, Louise Sheiner, and David Wessel, eds., Recession Remedies: Lessons Learned from the U.S. Economic Policy Response to COVID19 (Washington: Hamilton Project and Hutchins Center on Fiscal and Monetary Policy at Brookings), pp. 315-346, https://www.brookings.edu/wp-content/uploads/2022/04/RR-Chapter-9-Use-of-NontraditionalData.pdf. 7 See, for example, Aditya Aladangady, Shifrah Aron-Dine, Wendy Dunn, Laura Feiveson, Paul Lengermann, and Claudia Sahm (2016), "The Effect of Hurricane Matthew on Consumer Spending," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, December 2), https://doi.org/10.17016/2380-7172.1888. - 8 - Tracking supply chains is another area where private-sector sources have proved extremely valuable, especially during the COVID-19 pandemic. One important source of such data is the Institute for Supply Management's surveys of purchasing managers. While those series are well established and closely followed, Fed economists found them particularly helpful in recent years to observe supplier delivery times, order backlogs, items in short supply, and measures of inventory satisfaction. Other private-sector data give economists insight into supply chains as well, including measures of air, sea and overland freight costs; the number of waiting container ships; and the volume of railroad traffic. These data series offered additional details on the level of constraint in supply chains following the pandemic shock, alongside reports from official statistical agencies. I will offer two additional examples of how I use nontraditional data at the Fed- one from each side of our dual mandate. To better understand the labor market, I have been watching job vacancy, quit, and layoff data closely for many years. The official government source for this information is the Job Openings and Labor Turnover Survey (JOLTS). While extremely important, JOLTS data are released with a lag of more than a month. And this survey has seen a particularly large decline in response rates.8 This instance turned out to be another example of where private data could enhance my understanding. Job search sites' data on postings are updated more frequently than the federal report and generally confirm that JOLTS measurement appears to be accurate. Similarly, JOLTS data on layoffs are lagged. That is why I also look at other figures, including unemployment insurance claims; Worker Adjustment and Retraining Notification, or WARN, notices; employment reductions from the Institute for Supply - 9 - Management; anticipated layoffs from outplacement firm Challenger, Gray and Christmas; and mentions of layoffs in earnings reports and the Beige Book. With inflation, an important component to track recently has been housing services costs, which is typically the single largest expense for U.S. households. Housing services are a big reason why the overall inflation rate remains above our 2 percent target. The official measures of housing services inflation are intended to capture overall growth of housing costs-that is, costs incurred by owners and renters-drawing from a survey of rental lease terms. But rental leases tend to change only gradually, so the official measures can significantly lag current market conditions. That is why policymakers can also rely on current market rent data, showing what landlords charge new tenants, information that is available from multiple private-sector sources. Those data can provide some early signal of where official housing inflation series are likely headed. Here I have mentioned just a handful of private-sector data examples. But each of these helps address measurement challenges I mentioned earlier. From these data, we can gain timeliness and higher frequency, with a better read on underlying economic dynamics like market pricing. And with often low survey response rates in official data, these private-sector sources may provide another perspective on underlying economic developments. Official Innovations While I see great value in considering data produced outside of statistical agencies, the private sector is not the only place where innovation in economic measurement is occurring. Statistical agencies have long made use of private-sector data, so there is nothing "nontraditional" about using private-sector data to shed more light on economic measurement; in fact, it is a long tradition. I can think of several examples. The Bureau of Economic Analysis (BEA) taps many private-sector sources in its compilation of GDP statistics, covering topics ranging from oil and gas drilling to insurance premiums.9 At the Board, the Industrial Production and Capacity Utilization report features a long list of private data sources for the output of products ranging from semiconductors to lumber.10 And our Consumer Credit statistics rely in part on data from a large credit bureau and an association of credit unions.11 I could go on, but the broader point is that our country's statistical agencies do not ignore valuable sources of economic measurement that the private sector has to offer-far from it. They make significant use of private information in combination with official surveys and administrative data. And they are actively advancing that practice further. Economic developments in recent years have been met by a flurry of innovation and adaptation from statistical agencies, relying not only on private-sector sources but also on novel uses or production of government data. One notable product that I have mentioned in past speeches is the Census Bureau's Business Formation Statistics (BFS). First published in 2018, the BFS series was developed in collaboration with the Board's 9 National income and product accounts (NIPA) data sources are listed in detail in the NIPA handbook; see Bureau of Economic Analysis (2023), Concepts and Methods of the U.S. National Income and Product Accounts (Washington: BEA, December), https://www.bea.gov/resources/methodologies/nipahandbook/pdf/all-chapters.pdf. Some private-sector data are retrieved by the BEA itself, while others are already incorporated into statistical products the BEA obtains from other agencies. For example, the BEA uses Census Bureau data on construction value put in place to construct estimates of nonresidential structures investment; the Census Bureau, in turn, uses private-sector data on construction starts to build the sampling frame for its construction survey. 10 The data sources for Industrial Production and Capacity Utilization can be found at Board of Governors of the Federal Reserve System (2024), "Industrial Production and Capacity Utilization - G.17," webpage, https://www.federalreserve.gov/releases/g17/About.htm. 11 The data sources for Consumer Credit can be found at Board of Governors of the Federal Reserve System (2022), "Consumer Credit - G.19," webpage, https://www.federalreserve.gov/releases/g19/about.htm. staff and relies on new business applications for Employer Identification Numbers, or EINs.12 During the early months of the pandemic, weekly data from the BFS provided a timely indicator of the initial decline in economic activity, and then later the figures likewise documented the rebound.13 Another measurement invention was created during the early months of the pandemic: the Census Bureau's high-frequency "Pulse" surveys-one each for households and businesses. Those surveys leveraged existing Census Bureau resources to provide quick-turnaround information about the rapidly evolving health and economic situations.14 The Household Pulse Survey was rapidly developed shortly after the pandemic struck the U.S., with participation from a broad set of government agencies.15 The survey provides a range of economic information about Americans, including the pandemic-induced jump in remote work. The survey has adapted over time as the health and economic situations have evolved, incorporating questions about vaccination, access to infant formula during a product shortage, inflation, and other issues. The Small Business Pulse Survey provided timely information about employment, revenue, financial conditions, and expectations for future growth, survival, and needs in the highly 12 See Kimberly Bayard, Emin Dinlersoz, Timothy Dunne, John Haltiwanger, Javier Miranda, and John Stevens (2018), "Early-Stage Business Formation: An Analysis of Applications for Employer Identification Numbers," NBER Working Paper Series 24364 (Cambridge, Mass.: National Bureau of Economic Research, March), https://www.nber.org/papers/w24364. 13 See the box "Small Businesses during the COVID-19 Crisis" in Board of Governors of the Federal Reserve System (2020), Monetary Policy Report (Washington: Board of Governors, June), pp. 24-26, https://www.federalreserve.gov/monetarypolicy/files/20200612_mprfullreport.pdf. 14 See Census Bureau (2022), "Small Business Pulse Survey: Tracking Changes during the Coronavirus Pandemic," webpage, February 11, https://www.census.gov/data/experimental-data-products/smallbusiness-pulse-survey.html. 15 See documentation at Census Bureau (2024), "Household Pulse Survey Technical Documentation: Methodology," webpage, https://www.census.gov/programs-surveys/household-pulse-survey/technicaldocumentation/methodology.html. uncertain pandemic environment. Later iterations of the survey shed light on supply chains, as the United States grappled with input shortages and disrupted freight networks. The Small Business Pulse Survey was discontinued, but it planted the seeds for the current Business Trends and Outlook Survey, which provides a similar wealth of information about business conditions and is already the gold standard for understanding trends such as business-level implementation of AI technologies.16 The national accountants at the BEA have also shown a flair for innovation. For example, the bureau has introduced many "satellite accounts" and other special series over the years-some still in experimental form-with national account-style information about special topics, including health care, income distribution, global value chains, small business, the digital economy, and the space economy, among others.17 Thinking of special-topic national accounts is a way the statistical agencies can keep up with an ever-evolving economy. In fact, the treatment of research and development investment in current GDP methodology originated as a satellite account.18 Another example comes from the BLS and, specifically, how the agency tracks market rents as part of its inflation data series, an issue I mentioned earlier. While the official statistics on housing services inflation do not break out new tenant market rents 16 See Kathryn Bonney, Cory Breaux, Cathy Buffington, Emin Dinlersoz, Lucia S. Foster, Nathan Goldschlag, John C. Haltiwanger, Zachary Kroff, and Keith Savage (2024), "Tracking Firm Use of AI in Real Time: A Snapshot from the Business Trends and Outlook Survey," NBER Working Paper Series 32319 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w32319. 17 Other topics with satellite accounts or similar products include arts and culture, outdoor recreation, travel and tourism, household production, marine economy, and coastal areas. Related special topics are covered by the integrated macroeconomic accounts and the integrated industry-level production account (KLEMS). For descriptions, see Bureau of Economic Analysis (2024), "Special Topics," webpage, https://www.bea.gov/data/special-topics. 18 See Carol E. Moylan and Sumiye Okubo (2020), "The Evolving Treatment of R&D in the U.S. National Economic Accounts" (Washington: Bureau of Economic Analysis, March), https://www.bea.gov/system/files/2020-04/the-evolving-treatment-of-rd-in-the-us-national-economicaccounts.pdf. from the rest of the index, BLS staff recently began exploiting the housing survey data that underlie the CPI to construct a New Tenant Rent Index (NTRI).19 The NTRI looks at quarterly changes in the terms offered in new leases. Data users are still learning how to best combine the signal from the NTRI with other measures of market rents, but this research effort shows the agility of the statistical agencies in responding to current needs of understanding inflation dynamics. These are but a few of the many innovations that have arisen from statistical agencies. Regarding the measurement challenges I mentioned earlier, the examples I just listed have helped observers better track the economy during periods of rapid change or when there are shifts in the structure of the economy, such as increased remote work or the rise of AI, changes to immigration patterns, and supply bottlenecks. A harder nut to crack is declining response rates, but it may be that more integration of private-sector data with official data provides an avenue for addressing this problem as well.20 Seeing Where the Economy Stands I hope my discussion today highlights the tremendous innovation in economic measurement in recent years, supplied by both inventive private-sector data generation and nimble statistical agencies. It is incumbent on economists, researchers, and officials from statistical agencies around the world-many of you who are here today-to be open to new and diverse ways to measure the economy so that this healthy pace of innovation can continue. I want to again stress two things. First, the United States has world-class statistical agencies that have both a long history of rigorously constructing government data sources and adapting and combining information from private-sector with official sources. And, second, private-sector data will continue to be useful for providing granularity, timeliness, and frequency advantages that can complement official statistics, so long as data users are appropriately cautious. Despite the many challenges, the future of economic measurement is bright. The statistical agencies have already proven their ability to innovate and adapt, even under tight resource constraints. And the wealth of private-sector data sources will only expand in the future. When I form my economic outlook and policy assessments, my approach is to watch a wide range of indicators, both official and unofficial, with a focus on the strengths and weaknesses of each. All the data I carefully examine in my current role allow me to better understand where the economy stands. My colleagues on the FOMC and I make determinations on the policy actions that will be most appropriate for achieving our dual mandate, and so I would like to briefly share my views on how I see the economy evolving and how I see appropriate monetary policy. Despite a few bumps at the beginning of the year, inflation has continued to trend down in all price categories. But inflation remains above our target. I do believe that supply and demand are gradually coming into better balance. Supply-side bottlenecks continue to heal, and demand has moderated amid high interest rates and as households' excess savings have depleted. The labor market likewise has seen substantial rebalancing and nominal wage growth moderating as a result-even while keeping up with inflation. Job vacancies and the quits rate have come down from their historically high levels from a couple years ago, and the vacancy-to-unemployment ratio is now back at its pre- pandemic level. On the labor supply side, the increased entry of prime-age workers and immigration have both helped to expand the labor force and compensate for excess retirements we saw during the pandemic. This continued rebalancing suggests that inflation will continue to move down toward our 2 percent target. As I have discussed in recent remarks, if economic conditions continue to evolve in this favorable manner with more rapid disinflation, as evidenced in the inflation data of the past three months, and employment softening but remaining resilient as seen in the past few jobs reports, I anticipate that it will be appropriate to begin easing monetary policy later this year. But my approach to this policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is evolving, especially as upside risks to inflation and downside risks to employment have become much more balanced. If the labor market cools too much and unemployment continues to increase and is driven by layoffs, I would see it as appropriate to cut rates sooner rather than later. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to hold rates steady for a little longer. As I conclude, I want to thank those of you in this room who do the hard work each day to create and analyze the economic data that allow not only policymakers like me, but also consumers and businesses, to gain a better understanding of ongoing developments in the U.S. economy. And let me thank NABE again for having me. It was a pleasure to speak with you today.	---[PAGE_BREAK]--- For release on delivery 2:45 p.m. EDT July 16, 2024 The Challenges Facing Economic Measurement and Creative Solutions Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at 21st Annual Economic Measurement Seminar, National Association for Business Economics Foundation Washington, D.C. ---[PAGE_BREAK]--- Thank you for your generous introduction, Ellen. I am delighted to be here with the National Association for Business Economics (NABE), and, in particular, I am pleased to be speaking at a conference covering an issue that is close to my heart and on which I have spent many years working: economic measurement. When Federal Reserve officials tell audiences that their judgments are data dependent, some skeptics perhaps presume that monetary policy is already on a path set in stone. But most in this room likely know what I mean when I talk about data dependence. I am a member of the Federal Open Market Committee (FOMC), which, of course, pursues a dual mandate of maximum employment and stable prices. ${ }^{1}$ When I say I am data dependent, that means I am considering the totality of the data-the full range of economic indicators that provide a sense of where the labor market, economic activity, financial conditions, and inflation have been and where they might be going. Policymakers must have high-quality and accurate data to understand the economy and set the correct policy. The truth is that it is not just the Fed that needs data. Consumers, businesses, investors, and others have access to more information than ever before when making decisions. It is incumbent on economists, private- and public-sector data collectors, and others to ensure that available data are carefully collected, accurately measured, and clearly presented, and that data collection and measurement efforts are further enhanced and continue to improve. To be sure, data collection and economic measurement can be challenging, and different types of data face pros and cons, which is why I take an expansive approach to [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Board of Governors and the Federal Open Market Committee. ---[PAGE_BREAK]--- using data, as I will explain a bit later. But I will begin by highlighting a few challenges to economic measurement. I will then provide some examples of how those challenges might be addressed. I will also provide examples of how nontraditional data generated by the private sector can help provide additional angles from which to view aspects of the economy that may not be clear in data produced by government statistical agencies. Finally, I will offer some examples of how, in recent years, our statistical agencies have adapted and innovated, sometimes by incorporating private-sector data to address specific measurement challenges I have in mind. To be clear, my interest in nontraditional data is not a critique of the statistical agencies. To the contrary, official data are critically important to policymakers, researchers, and the public. Rather, I view public and private data as being complementary and helping to provide a more complete picture of the economy. # Importance of Data Economic measurement, the task some of you contribute to every day, is at the core of real-time policy analysis and forecasting. We at the Board of Governors rely on a broad array of data produced by both government and the private sector. And we carefully scrutinize every important economic release and are very familiar with the methodological details of those reports. Suffice it to say, we care a lot about economic measurement at the Fed. And the Fed itself produces many important data series, including two principal federal economic indicators: the Industrial Production and Capacity Utilization report ---[PAGE_BREAK]--- and the Consumer Credit statistical releases. ${ }^{2}$ In addition, our website features numerous other data products that look at bank assets, liabilities, and structure; monetary aggregates; international finance; business finance; and household finance-including data on the level, share, and composition of wealth for households at different points in the wealth and income distribution, as well as for different demographic groups. ${ }^{3}$ The Board also conducts separate surveys of consumers and household economic decision making and surveys of loan officers and credit officers, well known as the SLOOS and the SCOOS. Beyond the Federal Reserve Board, each of the Federal Reserve Banks engages in measurement and data production of various kinds, including closely watched surveys of firms and households. For example, the New York Fed conducts a survey of consumer expectations, which was just released last week, the Atlanta Fed tracks wage data, the Richmond Fed surveys firms on price-setting behavior, among other things, and several Reserve Banks publish alternative measures of inflation and reports on factory and business activity in their regions. # Challenges with Measurement Of course, as one reviews various sources of data, one can see that there are some common measurement challenges. I will mention a few. These are not new, nor is my list exhaustive. My intent here is to focus on challenges that highlight the tradeoffs in using public and private data and to show how these sources of data complement each other. [^0] [^0]: ${ }^{2}$ See Executive Office of the President, Office of Management and Budget, Office of Information and Regulatory Affairs, and Office of the Chief Statistician of the United States (n.d.), "Schedule of Release Dates for Principal Federal Economic Indicators for 2024" (Washington: OMB), https://www.whitehouse.gov/wp-content/uploads/2023/09/pfei_schedule_release_dates_2024.pdf. ${ }^{3}$ Board of Governors of the Federal Reserve System (2024), "Data," webpage, https://www.federalreserve.gov/data.htm. ---[PAGE_BREAK]--- The first challenge I will identify is that traditional measurement approaches sometimes struggle to track rapidly changing economic developments. This was the case early in the pandemic and is often true at turning points in the business cycle. Of course, it is at those very moments when policymakers, and the public, are most critically interested in how the economy is faring. The reasons for this lag are well known. Statistical agencies can only survey households and businesses every so often, and it takes time to compile and publish high-quality statistics. However, financial markets and business decisions move quickly. Reports produced on a monthly or quarterly basis, often with a multi-week lag, may not be available with sufficient frequency to inform real-time decisions. Also, some indicators, by design, take on new market information slowly. A recent and relevant example is housing services inflation, as measured as part of the consumer price index (CPI) and the personal consumption expenditures price index. Both rely heavily on slowly changing leasing agreements that only adjust to market conditions over many months. Business entries and exits, sometimes called births and deaths, are similar in that they take time to appear in surveys that underlie important statistical products. I will touch on that a bit more later. A second challenge is that many statistical reports were created decades ago and may not be focused on newer or growing sectors of the economy. For example, there are monthly reports on factory orders, shipments, inventories, and output among the principal economic indicators. Because developments in the goods sector can matter importantly for economic fluctuations, that level of detail is indeed helpful to have. But we would benefit from the same depth of information on domestically produced services, too. While service-sector output constitutes a larger share of U.S. gross domestic product ---[PAGE_BREAK]--- (GDP), the category has only one single dedicated quarterly report, even though much of the post-pandemic recovery requires us to understand how services consumption and employment have evolved. For example, did you know that quarterly hog and pig counts are a principal economic indicator? Yet, there is not a regular government report specifically dedicated to the gig economy. I am certainly glad we collect data for important agricultural commodities, but I think we should probably be examining the large and diverse gig economy as much as we do the pig economy. I believe the statistical agencies grapple with these issues, and it takes time to lay the groundwork and develop new data series, but this challenge is a real one. If reports are built for the past, that may mean they struggle to capture big developments today and in the future, such as the changing nature of where and how people work or the rising use of artificial intelligence (AI) technology. Finally, there is an impediment that everyone here is acutely aware of: These challenges are made even more difficult because official surveys have seen declining survey response rates. That results in lower precision of statistical estimates and can lead to the need for further, costly surveys to collect the necessary amount of information, as one may need to conduct several rounds of data collection before having sufficiently large samples that can provide reliable estimates. Declining response rates may also be selective and pose a challenge to representing the broader population. Innovative methods for data collection and behavioral interventions to encourage survey responses can be used to address concerns and are being tried in some cases by statistical agencies. ---[PAGE_BREAK]--- # A Data Explosion While these challenges in traditional data that I have described may take some time to be addressed, I am encouraged by the explosion in data produced by the private sector over the past decade or so that can greatly enhance our understanding of the economy. Such data give an opportunity to measure economic developments with greater timeliness, at a higher frequency, and with more granularity. That said, those data often face their own challenges, including issues with representativeness, the lack of methodological consistency, and a short time-series history. Nevertheless, such nontraditional data can be helpful, especially when used jointly with official statistics to which these new sources can be benchmarked. A prominent example of valuable private-sector data is employment statistics from payroll providers. Such weekly data allowed economists at the Federal Reserve Board to understand, essentially in real time, employment losses when the pandemic first took hold in the United States in March 2020. In comparison, it took until early May to get similar information from the Bureau of Labor Statistics' (BLS) employment report. ${ }^{4}$ Indeed, in trying to understand the rapidly changing economy during the pandemic, Fed economists closely followed a variety of privately produced higher-frequency data. These included reports on restaurant reservations, hotel occupancy, and airport [^0] [^0]: ${ }^{4}$ Both the private-sector data-based measure and the official payroll survey are eventually benchmarked to official data from the BLS. See Tomaz Cajner, Leland D. Crane, Ryan A. Decker, Adrian Hamins-Puertolas, and Christopher Kurz (2023), "Payroll Employment at the Weekly Frequency," AEA Papers and Proceedings, vol. 113 (May), pp. 145-50; and Tomaz Cajner, Leland D. Crane, Ryan A. Decker, John Grigsby, Adrian Hamins-Puertolas, Erik Hurst, Christopher Kurz, and Ahu Yildirmaz (2020), "The U.S. Labor Market during the Beginning of the Pandemic Recession," BPEA Conference Drafts, Brookings Papers on Economic Activity, June 25, pp. 1-46, https://www.brookings.edu/wp-content/uploads/2020/06/Cajner-et-al-Conference-Draft.pdf. ---[PAGE_BREAK]--- passengers. Economists even used anonymized phone-tracking data to estimate business shutdown rates and trends in retail spending. ${ }^{5}$ Credit and debit card transaction data are another example of a helpful, privatesector tool that economists use to understand consumer behavior in various sectors or regions in close to real time. These figures provided what proved to be a pretty reliable picture of economic developments during the pandemic, well before traditional statistics—such as quarterly GDP and monthly retail sales-became available. ${ }^{6}$ The need for timely, high-frequency information is not limited to pandemics and turns in the national business cycle. For example, Federal Reserve Board economists have used credit and debit card transaction data to estimate the effects of local natural disasters almost in real time when official statistics are often not available. ${ }^{7}$ When we look at economic turning points, it is also important to consider reports on expectations and anticipated outcomes from nongovernment sources. Those include surveys of expectations of future inflation, anticipated hiring or layoffs, and consumer and business sentiment on the economy or the path of the economy. I pay close attention to these surveys because they are forward looking and help inform where behaviors by businesses and households may be trending. [^0] [^0]: ${ }^{5}$ See Leland D. Crane, Ryan A. Decker, Aaron Flaaen, Adrian Hamins-Puertolas, and Christopher Kurz (2022), "Business Exit during the COVID-19 Pandemic: Non-traditional Measures in Historical Context," Journal of Macroeconomics, vol. 72 (June), 103419. ${ }^{6}$ See Tomaz Cajner, Laura J. Feiveson, Christopher J. Kurz, and Stacey Tevlin (2022), "Lessons Learned from the Use of Nontraditional Data during COVID-19," in Wendy Edelberg, Louise Sheiner, and David Wessel, eds., Recession Remedies: Lessons Learned from the U.S. Economic Policy Response to COVID19 (Washington: Hamilton Project and Hutchins Center on Fiscal and Monetary Policy at Brookings), pp. 315-346, https://www.brookings.edu/wp-content/uploads/2022/04/RR-Chapter-9-Use-of-NontraditionalData.pdf. ${ }^{7}$ See, for example, Aditya Aladangady, Shifrah Aron-Dine, Wendy Dunn, Laura Feiveson, Paul Lengermann, and Claudia Sahm (2016), "The Effect of Hurricane Matthew on Consumer Spending," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, December 2), https://doi.org/10.17016/2380-7172.1888. ---[PAGE_BREAK]--- Tracking supply chains is another area where private-sector sources have proved extremely valuable, especially during the COVID-19 pandemic. One important source of such data is the Institute for Supply Management's surveys of purchasing managers. While those series are well established and closely followed, Fed economists found them particularly helpful in recent years to observe supplier delivery times, order backlogs, items in short supply, and measures of inventory satisfaction. Other private-sector data give economists insight into supply chains as well, including measures of air, sea and overland freight costs; the number of waiting container ships; and the volume of railroad traffic. These data series offered additional details on the level of constraint in supply chains following the pandemic shock, alongside reports from official statistical agencies. I will offer two additional examples of how I use nontraditional data at the Fed—one from each side of our dual mandate. To better understand the labor market, I have been watching job vacancy, quit, and layoff data closely for many years. The official government source for this information is the Job Openings and Labor Turnover Survey (JOLTS). While extremely important, JOLTS data are released with a lag of more than a month. And this survey has seen a particularly large decline in response rates. ${ }^{8}$ This instance turned out to be another example of where private data could enhance my understanding. Job search sites' data on postings are updated more frequently than the federal report and generally confirm that JOLTS measurement appears to be accurate. Similarly, JOLTS data on layoffs are lagged. That is why I also look at other figures, including unemployment insurance claims; Worker Adjustment and Retraining Notification, or WARN, notices; employment reductions from the Institute for Supply [^0] [^0]: ${ }^{8}$ See Bureau of Labor Statistics (2024), "Household and Establishment Survey Response Rates," webpage, https://www.bls.gov/osmr/response-rates/home.htm. ---[PAGE_BREAK]--- Management; anticipated layoffs from outplacement firm Challenger, Gray and Christmas; and mentions of layoffs in earnings reports and the Beige Book. With inflation, an important component to track recently has been housing services costs, which is typically the single largest expense for U.S. households. Housing services are a big reason why the overall inflation rate remains above our 2 percent target. The official measures of housing services inflation are intended to capture overall growth of housing costs-that is, costs incurred by owners and renters-drawing from a survey of rental lease terms. But rental leases tend to change only gradually, so the official measures can significantly lag current market conditions. That is why policymakers can also rely on current market rent data, showing what landlords charge new tenants, information that is available from multiple private-sector sources. Those data can provide some early signal of where official housing inflation series are likely headed. Here I have mentioned just a handful of private-sector data examples. But each of these helps address measurement challenges I mentioned earlier. From these data, we can gain timeliness and higher frequency, with a better read on underlying economic dynamics like market pricing. And with often low survey response rates in official data, these private-sector sources may provide another perspective on underlying economic developments. # Official Innovations While I see great value in considering data produced outside of statistical agencies, the private sector is not the only place where innovation in economic measurement is occurring. Statistical agencies have long made use of private-sector data, ---[PAGE_BREAK]--- so there is nothing "nontraditional" about using private-sector data to shed more light on economic measurement; in fact, it is a long tradition. I can think of several examples. The Bureau of Economic Analysis (BEA) taps many private-sector sources in its compilation of GDP statistics, covering topics ranging from oil and gas drilling to insurance premiums. ${ }^{9}$ At the Board, the Industrial Production and Capacity Utilization report features a long list of private data sources for the output of products ranging from semiconductors to lumber. ${ }^{10}$ And our Consumer Credit statistics rely in part on data from a large credit bureau and an association of credit unions. ${ }^{11}$ I could go on, but the broader point is that our country's statistical agencies do not ignore valuable sources of economic measurement that the private sector has to offer-far from it. They make significant use of private information in combination with official surveys and administrative data. And they are actively advancing that practice further. Economic developments in recent years have been met by a flurry of innovation and adaptation from statistical agencies, relying not only on private-sector sources but also on novel uses or production of government data. One notable product that I have mentioned in past speeches is the Census Bureau's Business Formation Statistics (BFS). First published in 2018, the BFS series was developed in collaboration with the Board's [^0] [^0]: ${ }^{9}$ National income and product accounts (NIPA) data sources are listed in detail in the NIPA handbook; see Bureau of Economic Analysis (2023), Concepts and Methods of the U.S. National Income and Product Accounts (Washington: BEA, December), https://www.bea.gov/resources/methodologies/nipahandbook/pdf/all-chapters.pdf. Some private-sector data are retrieved by the BEA itself, while others are already incorporated into statistical products the BEA obtains from other agencies. For example, the BEA uses Census Bureau data on construction value put in place to construct estimates of nonresidential structures investment; the Census Bureau, in turn, uses private-sector data on construction starts to build the sampling frame for its construction survey. ${ }^{10}$ The data sources for Industrial Production and Capacity Utilization can be found at Board of Governors of the Federal Reserve System (2024), "Industrial Production and Capacity Utilization - G.17," webpage, https://www.federalreserve.gov/releases/g17/About.htm. ${ }^{11}$ The data sources for Consumer Credit can be found at Board of Governors of the Federal Reserve System (2022), "Consumer Credit - G.19," webpage, https://www.federalreserve.gov/releases/g19/about.htm. ---[PAGE_BREAK]--- staff and relies on new business applications for Employer Identification Numbers, or EINs. ${ }^{12}$ During the early months of the pandemic, weekly data from the BFS provided a timely indicator of the initial decline in economic activity, and then later the figures likewise documented the rebound. ${ }^{13}$ Another measurement invention was created during the early months of the pandemic: the Census Bureau's high-frequency "Pulse" surveys-one each for households and businesses. Those surveys leveraged existing Census Bureau resources to provide quick-turnaround information about the rapidly evolving health and economic situations. ${ }^{14}$ The Household Pulse Survey was rapidly developed shortly after the pandemic struck the U.S., with participation from a broad set of government agencies. ${ }^{15}$ The survey provides a range of economic information about Americans, including the pandemic-induced jump in remote work. The survey has adapted over time as the health and economic situations have evolved, incorporating questions about vaccination, access to infant formula during a product shortage, inflation, and other issues. The Small Business Pulse Survey provided timely information about employment, revenue, financial conditions, and expectations for future growth, survival, and needs in the highly [^0] [^0]: ${ }^{12}$ See Kimberly Bayard, Emin Dinlersoz, Timothy Dunne, John Haltiwanger, Javier Miranda, and John Stevens (2018), "Early-Stage Business Formation: An Analysis of Applications for Employer Identification Numbers," NBER Working Paper Series 24364 (Cambridge, Mass.: National Bureau of Economic Research, March), https://www.nber.org/papers/w24364. ${ }^{13}$ See the box "Small Businesses during the COVID-19 Crisis" in Board of Governors of the Federal Reserve System (2020), Monetary Policy Report (Washington: Board of Governors, June), pp. 24-26, https://www.federalreserve.gov/monetarypolicy/files/20200612_mprfullreport.pdf. ${ }^{14}$ See Census Bureau (2022), "Small Business Pulse Survey: Tracking Changes during the Coronavirus Pandemic," webpage, February 11, https://www.census.gov/data/experimental-data-products/small-business-pulse-survey.html. ${ }^{15}$ See documentation at Census Bureau (2024), "Household Pulse Survey Technical Documentation: Methodology," webpage, https://www.census.gov/programs-surveys/household-pulse-survey/technicaldocumentation/methodology.html. ---[PAGE_BREAK]--- uncertain pandemic environment. Later iterations of the survey shed light on supply chains, as the United States grappled with input shortages and disrupted freight networks. The Small Business Pulse Survey was discontinued, but it planted the seeds for the current Business Trends and Outlook Survey, which provides a similar wealth of information about business conditions and is already the gold standard for understanding trends such as business-level implementation of AI technologies. ${ }^{16}$ The national accountants at the BEA have also shown a flair for innovation. For example, the bureau has introduced many "satellite accounts" and other special series over the years-some still in experimental form-with national account-style information about special topics, including health care, income distribution, global value chains, small business, the digital economy, and the space economy, among others. ${ }^{17}$ Thinking of special-topic national accounts is a way the statistical agencies can keep up with an ever-evolving economy. In fact, the treatment of research and development investment in current GDP methodology originated as a satellite account. ${ }^{18}$ Another example comes from the BLS and, specifically, how the agency tracks market rents as part of its inflation data series, an issue I mentioned earlier. While the official statistics on housing services inflation do not break out new tenant market rents [^0] [^0]: ${ }^{16}$ See Kathryn Bonney, Cory Breaux, Cathy Buffington, Emin Dinlersoz, Lucia S. Foster, Nathan Goldschlag, John C. Haltiwanger, Zachary Kroff, and Keith Savage (2024), "Tracking Firm Use of AI in Real Time: A Snapshot from the Business Trends and Outlook Survey," NBER Working Paper Series 32319 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w32319. ${ }^{17}$ Other topics with satellite accounts or similar products include arts and culture, outdoor recreation, travel and tourism, household production, marine economy, and coastal areas. Related special topics are covered by the integrated macroeconomic accounts and the integrated industry-level production account (KLEMS). For descriptions, see Bureau of Economic Analysis (2024), "Special Topics," webpage, https://www.bea.gov/data/special-topics. ${ }^{18}$ See Carol E. Moylan and Sumiye Okubo (2020), "The Evolving Treatment of R\&D in the U.S. National Economic Accounts" (Washington: Bureau of Economic Analysis, March), https://www.bea.gov/system/files/2020-04/the-evolving-treatment-of-rd-in-the-us-national-economicaccounts.pdf. ---[PAGE_BREAK]--- from the rest of the index, BLS staff recently began exploiting the housing survey data that underlie the CPI to construct a New Tenant Rent Index (NTRI). ${ }^{19}$ The NTRI looks at quarterly changes in the terms offered in new leases. Data users are still learning how to best combine the signal from the NTRI with other measures of market rents, but this research effort shows the agility of the statistical agencies in responding to current needs of understanding inflation dynamics. These are but a few of the many innovations that have arisen from statistical agencies. Regarding the measurement challenges I mentioned earlier, the examples I just listed have helped observers better track the economy during periods of rapid change or when there are shifts in the structure of the economy, such as increased remote work or the rise of AI, changes to immigration patterns, and supply bottlenecks. A harder nut to crack is declining response rates, but it may be that more integration of private-sector data with official data provides an avenue for addressing this problem as well. ${ }^{20}$ # Seeing Where the Economy Stands I hope my discussion today highlights the tremendous innovation in economic measurement in recent years, supplied by both inventive private-sector data generation and nimble statistical agencies. It is incumbent on economists, researchers, and officials from statistical agencies around the world—many of you who are here today-to be open [^0] [^0]: ${ }^{19}$ See Bureau of Labor Statistics (n.d.), "New Tenant Rent Index," webpage, https://www.bls.gov/pir/new-tenant-rent.htm. ${ }^{20}$ For helpful discussions of traditional and nontraditional data and their potential relationship, see Katharine G. Abraham (2022), "Big Data and Official Statistics," Review of Income and Wealth, vol. 68 (December), pp. 835-61; and Katharine G. Abraham, Ron S. Jarmin, Brian C. Moyer, and Matthew D. Shapiro (2022), "Introduction: Big Data for Twenty-First-Century Economic Statistics: The Future Is Now," in Big Data for Twenty-First-Century Economic Statistics, National Bureau of Economic Research, Studies in Income and Wealth (Chicago: University of Chicago Press), pp. 1-22, https://www.nber.org/system/files/chapters/c14265/c14265.pdf. ---[PAGE_BREAK]--- to new and diverse ways to measure the economy so that this healthy pace of innovation can continue. I want to again stress two things. First, the United States has world-class statistical agencies that have both a long history of rigorously constructing government data sources and adapting and combining information from private-sector with official sources. And, second, private-sector data will continue to be useful for providing granularity, timeliness, and frequency advantages that can complement official statistics, so long as data users are appropriately cautious. Despite the many challenges, the future of economic measurement is bright. The statistical agencies have already proven their ability to innovate and adapt, even under tight resource constraints. And the wealth of private-sector data sources will only expand in the future. When I form my economic outlook and policy assessments, my approach is to watch a wide range of indicators, both official and unofficial, with a focus on the strengths and weaknesses of each. All the data I carefully examine in my current role allow me to better understand where the economy stands. My colleagues on the FOMC and I make determinations on the policy actions that will be most appropriate for achieving our dual mandate, and so I would like to briefly share my views on how I see the economy evolving and how I see appropriate monetary policy. Despite a few bumps at the beginning of the year, inflation has continued to trend down in all price categories. But inflation remains above our target. I do believe that supply and demand are gradually coming into better balance. Supply-side bottlenecks continue to heal, and demand has moderated amid high interest rates and as households' excess savings have depleted. The labor market likewise has seen substantial rebalancing ---[PAGE_BREAK]--- and nominal wage growth moderating as a result—even while keeping up with inflation. Job vacancies and the quits rate have come down from their historically high levels from a couple years ago, and the vacancy-to-unemployment ratio is now back at its prepandemic level. On the labor supply side, the increased entry of prime-age workers and immigration have both helped to expand the labor force and compensate for excess retirements we saw during the pandemic. This continued rebalancing suggests that inflation will continue to move down toward our 2 percent target. As I have discussed in recent remarks, if economic conditions continue to evolve in this favorable manner with more rapid disinflation, as evidenced in the inflation data of the past three months, and employment softening but remaining resilient as seen in the past few jobs reports, I anticipate that it will be appropriate to begin easing monetary policy later this year. But my approach to this policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is evolving, especially as upside risks to inflation and downside risks to employment have become much more balanced. If the labor market cools too much and unemployment continues to increase and is driven by layoffs, I would see it as appropriate to cut rates sooner rather than later. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to hold rates steady for a little longer. As I conclude, I want to thank those of you in this room who do the hard work each day to create and analyze the economic data that allow not only policymakers like me, but also consumers and businesses, to gain a better understanding of ongoing ---[PAGE_BREAK]--- developments in the U.S. economy. And let me thank NABE again for having me. It was a pleasure to speak with you today.	Adriana D Kugler	United States	https://www.bis.org/review/r240717a.pdf	For release on delivery 2:45 p.m. EDT July 16, 2024 The Challenges Facing Economic Measurement and Creative Solutions Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at 21st Annual Economic Measurement Seminar, National Association for Business Economics Foundation Washington, D.C. Thank you for your generous introduction, Ellen. I am delighted to be here with the National Association for Business Economics (NABE), and, in particular, I am pleased to be speaking at a conference covering an issue that is close to my heart and on which I have spent many years working: economic measurement. When Federal Reserve officials tell audiences that their judgments are data dependent, some skeptics perhaps presume that monetary policy is already on a path set in stone. But most in this room likely know what I mean when I talk about data dependence. I am a member of the Federal Open Market Committee (FOMC), which, of course, pursues a dual mandate of maximum employment and stable prices. When I say I am data dependent, that means I am considering the totality of the data-the full range of economic indicators that provide a sense of where the labor market, economic activity, financial conditions, and inflation have been and where they might be going. Policymakers must have high-quality and accurate data to understand the economy and set the correct policy. The truth is that it is not just the Fed that needs data. Consumers, businesses, investors, and others have access to more information than ever before when making decisions. It is incumbent on economists, private- and public-sector data collectors, and others to ensure that available data are carefully collected, accurately measured, and clearly presented, and that data collection and measurement efforts are further enhanced and continue to improve. To be sure, data collection and economic measurement can be challenging, and different types of data face pros and cons, which is why I take an expansive approach to using data, as I will explain a bit later. But I will begin by highlighting a few challenges to economic measurement. I will then provide some examples of how those challenges might be addressed. I will also provide examples of how nontraditional data generated by the private sector can help provide additional angles from which to view aspects of the economy that may not be clear in data produced by government statistical agencies. Finally, I will offer some examples of how, in recent years, our statistical agencies have adapted and innovated, sometimes by incorporating private-sector data to address specific measurement challenges I have in mind. To be clear, my interest in nontraditional data is not a critique of the statistical agencies. To the contrary, official data are critically important to policymakers, researchers, and the public. Rather, I view public and private data as being complementary and helping to provide a more complete picture of the economy. Economic measurement, the task some of you contribute to every day, is at the core of real-time policy analysis and forecasting. We at the Board of Governors rely on a broad array of data produced by both government and the private sector. And we carefully scrutinize every important economic release and are very familiar with the methodological details of those reports. Suffice it to say, we care a lot about economic measurement at the Fed. And the Fed itself produces many important data series, including two principal federal economic indicators: the Industrial Production and Capacity Utilization report and the Consumer Credit statistical releases. The Board also conducts separate surveys of consumers and household economic decision making and surveys of loan officers and credit officers, well known as the SLOOS and the SCOOS. Beyond the Federal Reserve Board, each of the Federal Reserve Banks engages in measurement and data production of various kinds, including closely watched surveys of firms and households. For example, the New York Fed conducts a survey of consumer expectations, which was just released last week, the Atlanta Fed tracks wage data, the Richmond Fed surveys firms on price-setting behavior, among other things, and several Reserve Banks publish alternative measures of inflation and reports on factory and business activity in their regions. Of course, as one reviews various sources of data, one can see that there are some common measurement challenges. I will mention a few. These are not new, nor is my list exhaustive. My intent here is to focus on challenges that highlight the tradeoffs in using public and private data and to show how these sources of data complement each other. The first challenge I will identify is that traditional measurement approaches sometimes struggle to track rapidly changing economic developments. This was the case early in the pandemic and is often true at turning points in the business cycle. Of course, it is at those very moments when policymakers, and the public, are most critically interested in how the economy is faring. The reasons for this lag are well known. Statistical agencies can only survey households and businesses every so often, and it takes time to compile and publish high-quality statistics. However, financial markets and business decisions move quickly. Reports produced on a monthly or quarterly basis, often with a multi-week lag, may not be available with sufficient frequency to inform real-time decisions. Also, some indicators, by design, take on new market information slowly. A recent and relevant example is housing services inflation, as measured as part of the consumer price index (CPI) and the personal consumption expenditures price index. Both rely heavily on slowly changing leasing agreements that only adjust to market conditions over many months. Business entries and exits, sometimes called births and deaths, are similar in that they take time to appear in surveys that underlie important statistical products. I will touch on that a bit more later. A second challenge is that many statistical reports were created decades ago and may not be focused on newer or growing sectors of the economy. For example, there are monthly reports on factory orders, shipments, inventories, and output among the principal economic indicators. Because developments in the goods sector can matter importantly for economic fluctuations, that level of detail is indeed helpful to have. But we would benefit from the same depth of information on domestically produced services, too. While service-sector output constitutes a larger share of U.S. gross domestic product (GDP), the category has only one single dedicated quarterly report, even though much of the post-pandemic recovery requires us to understand how services consumption and employment have evolved. For example, did you know that quarterly hog and pig counts are a principal economic indicator? Yet, there is not a regular government report specifically dedicated to the gig economy. I am certainly glad we collect data for important agricultural commodities, but I think we should probably be examining the large and diverse gig economy as much as we do the pig economy. I believe the statistical agencies grapple with these issues, and it takes time to lay the groundwork and develop new data series, but this challenge is a real one. If reports are built for the past, that may mean they struggle to capture big developments today and in the future, such as the changing nature of where and how people work or the rising use of artificial intelligence (AI) technology. Finally, there is an impediment that everyone here is acutely aware of: These challenges are made even more difficult because official surveys have seen declining survey response rates. That results in lower precision of statistical estimates and can lead to the need for further, costly surveys to collect the necessary amount of information, as one may need to conduct several rounds of data collection before having sufficiently large samples that can provide reliable estimates. Declining response rates may also be selective and pose a challenge to representing the broader population. Innovative methods for data collection and behavioral interventions to encourage survey responses can be used to address concerns and are being tried in some cases by statistical agencies. While these challenges in traditional data that I have described may take some time to be addressed, I am encouraged by the explosion in data produced by the private sector over the past decade or so that can greatly enhance our understanding of the economy. Such data give an opportunity to measure economic developments with greater timeliness, at a higher frequency, and with more granularity. That said, those data often face their own challenges, including issues with representativeness, the lack of methodological consistency, and a short time-series history. Nevertheless, such nontraditional data can be helpful, especially when used jointly with official statistics to which these new sources can be benchmarked. A prominent example of valuable private-sector data is employment statistics from payroll providers. Such weekly data allowed economists at the Federal Reserve Board to understand, essentially in real time, employment losses when the pandemic first took hold in the United States in March 2020. In comparison, it took until early May to get similar information from the Bureau of Labor Statistics' (BLS) employment report. Indeed, in trying to understand the rapidly changing economy during the pandemic, Fed economists closely followed a variety of privately produced higher-frequency data. These included reports on restaurant reservations, hotel occupancy, and airport passengers. Economists even used anonymized phone-tracking data to estimate business shutdown rates and trends in retail spending. Credit and debit card transaction data are another example of a helpful, privatesector tool that economists use to understand consumer behavior in various sectors or regions in close to real time. These figures provided what proved to be a pretty reliable picture of economic developments during the pandemic, well before traditional statistics—such as quarterly GDP and monthly retail sales-became available. When we look at economic turning points, it is also important to consider reports on expectations and anticipated outcomes from nongovernment sources. Those include surveys of expectations of future inflation, anticipated hiring or layoffs, and consumer and business sentiment on the economy or the path of the economy. I pay close attention to these surveys because they are forward looking and help inform where behaviors by businesses and households may be trending. Tracking supply chains is another area where private-sector sources have proved extremely valuable, especially during the COVID-19 pandemic. One important source of such data is the Institute for Supply Management's surveys of purchasing managers. While those series are well established and closely followed, Fed economists found them particularly helpful in recent years to observe supplier delivery times, order backlogs, items in short supply, and measures of inventory satisfaction. Other private-sector data give economists insight into supply chains as well, including measures of air, sea and overland freight costs; the number of waiting container ships; and the volume of railroad traffic. These data series offered additional details on the level of constraint in supply chains following the pandemic shock, alongside reports from official statistical agencies. I will offer two additional examples of how I use nontraditional data at the Fed—one from each side of our dual mandate. To better understand the labor market, I have been watching job vacancy, quit, and layoff data closely for many years. The official government source for this information is the Job Openings and Labor Turnover Survey (JOLTS). While extremely important, JOLTS data are released with a lag of more than a month. And this survey has seen a particularly large decline in response rates. This instance turned out to be another example of where private data could enhance my understanding. Job search sites' data on postings are updated more frequently than the federal report and generally confirm that JOLTS measurement appears to be accurate. Similarly, JOLTS data on layoffs are lagged. That is why I also look at other figures, including unemployment insurance claims; Worker Adjustment and Retraining Notification, or WARN, notices; employment reductions from the Institute for Supply Management; anticipated layoffs from outplacement firm Challenger, Gray and Christmas; and mentions of layoffs in earnings reports and the Beige Book. With inflation, an important component to track recently has been housing services costs, which is typically the single largest expense for U.S. households. Housing services are a big reason why the overall inflation rate remains above our 2 percent target. The official measures of housing services inflation are intended to capture overall growth of housing costs-that is, costs incurred by owners and renters-drawing from a survey of rental lease terms. But rental leases tend to change only gradually, so the official measures can significantly lag current market conditions. That is why policymakers can also rely on current market rent data, showing what landlords charge new tenants, information that is available from multiple private-sector sources. Those data can provide some early signal of where official housing inflation series are likely headed. Here I have mentioned just a handful of private-sector data examples. But each of these helps address measurement challenges I mentioned earlier. From these data, we can gain timeliness and higher frequency, with a better read on underlying economic dynamics like market pricing. And with often low survey response rates in official data, these private-sector sources may provide another perspective on underlying economic developments. While I see great value in considering data produced outside of statistical agencies, the private sector is not the only place where innovation in economic measurement is occurring. Statistical agencies have long made use of private-sector data, so there is nothing "nontraditional" about using private-sector data to shed more light on economic measurement; in fact, it is a long tradition. I can think of several examples. The Bureau of Economic Analysis (BEA) taps many private-sector sources in its compilation of GDP statistics, covering topics ranging from oil and gas drilling to insurance premiums. I could go on, but the broader point is that our country's statistical agencies do not ignore valuable sources of economic measurement that the private sector has to offer-far from it. They make significant use of private information in combination with official surveys and administrative data. And they are actively advancing that practice further. Economic developments in recent years have been met by a flurry of innovation and adaptation from statistical agencies, relying not only on private-sector sources but also on novel uses or production of government data. One notable product that I have mentioned in past speeches is the Census Bureau's Business Formation Statistics (BFS). First published in 2018, the BFS series was developed in collaboration with the Board's staff and relies on new business applications for Employer Identification Numbers, or EINs. Another measurement invention was created during the early months of the pandemic: the Census Bureau's high-frequency "Pulse" surveys-one each for households and businesses. Those surveys leveraged existing Census Bureau resources to provide quick-turnaround information about the rapidly evolving health and economic situations. The Household Pulse Survey was rapidly developed shortly after the pandemic struck the U.S., with participation from a broad set of government agencies. The survey provides a range of economic information about Americans, including the pandemic-induced jump in remote work. The survey has adapted over time as the health and economic situations have evolved, incorporating questions about vaccination, access to infant formula during a product shortage, inflation, and other issues. The Small Business Pulse Survey provided timely information about employment, revenue, financial conditions, and expectations for future growth, survival, and needs in the highly uncertain pandemic environment. Later iterations of the survey shed light on supply chains, as the United States grappled with input shortages and disrupted freight networks. The Small Business Pulse Survey was discontinued, but it planted the seeds for the current Business Trends and Outlook Survey, which provides a similar wealth of information about business conditions and is already the gold standard for understanding trends such as business-level implementation of AI technologies. The national accountants at the BEA have also shown a flair for innovation. For example, the bureau has introduced many "satellite accounts" and other special series over the years-some still in experimental form-with national account-style information about special topics, including health care, income distribution, global value chains, small business, the digital economy, and the space economy, among others. Thinking of special-topic national accounts is a way the statistical agencies can keep up with an ever-evolving economy. In fact, the treatment of research and development investment in current GDP methodology originated as a satellite account. Another example comes from the BLS and, specifically, how the agency tracks market rents as part of its inflation data series, an issue I mentioned earlier. While the official statistics on housing services inflation do not break out new tenant market rents from the rest of the index, BLS staff recently began exploiting the housing survey data that underlie the CPI to construct a New Tenant Rent Index (NTRI). The NTRI looks at quarterly changes in the terms offered in new leases. Data users are still learning how to best combine the signal from the NTRI with other measures of market rents, but this research effort shows the agility of the statistical agencies in responding to current needs of understanding inflation dynamics. These are but a few of the many innovations that have arisen from statistical agencies. Regarding the measurement challenges I mentioned earlier, the examples I just listed have helped observers better track the economy during periods of rapid change or when there are shifts in the structure of the economy, such as increased remote work or the rise of AI, changes to immigration patterns, and supply bottlenecks. A harder nut to crack is declining response rates, but it may be that more integration of private-sector data with official data provides an avenue for addressing this problem as well. I hope my discussion today highlights the tremendous innovation in economic measurement in recent years, supplied by both inventive private-sector data generation and nimble statistical agencies. It is incumbent on economists, researchers, and officials from statistical agencies around the world—many of you who are here today-to be open to new and diverse ways to measure the economy so that this healthy pace of innovation can continue. I want to again stress two things. First, the United States has world-class statistical agencies that have both a long history of rigorously constructing government data sources and adapting and combining information from private-sector with official sources. And, second, private-sector data will continue to be useful for providing granularity, timeliness, and frequency advantages that can complement official statistics, so long as data users are appropriately cautious. Despite the many challenges, the future of economic measurement is bright. The statistical agencies have already proven their ability to innovate and adapt, even under tight resource constraints. And the wealth of private-sector data sources will only expand in the future. When I form my economic outlook and policy assessments, my approach is to watch a wide range of indicators, both official and unofficial, with a focus on the strengths and weaknesses of each. All the data I carefully examine in my current role allow me to better understand where the economy stands. My colleagues on the FOMC and I make determinations on the policy actions that will be most appropriate for achieving our dual mandate, and so I would like to briefly share my views on how I see the economy evolving and how I see appropriate monetary policy. Despite a few bumps at the beginning of the year, inflation has continued to trend down in all price categories. But inflation remains above our target. I do believe that supply and demand are gradually coming into better balance. Supply-side bottlenecks continue to heal, and demand has moderated amid high interest rates and as households' excess savings have depleted. The labor market likewise has seen substantial rebalancing and nominal wage growth moderating as a result—even while keeping up with inflation. Job vacancies and the quits rate have come down from their historically high levels from a couple years ago, and the vacancy-to-unemployment ratio is now back at its prepandemic level. On the labor supply side, the increased entry of prime-age workers and immigration have both helped to expand the labor force and compensate for excess retirements we saw during the pandemic. This continued rebalancing suggests that inflation will continue to move down toward our 2 percent target. As I have discussed in recent remarks, if economic conditions continue to evolve in this favorable manner with more rapid disinflation, as evidenced in the inflation data of the past three months, and employment softening but remaining resilient as seen in the past few jobs reports, I anticipate that it will be appropriate to begin easing monetary policy later this year. But my approach to this policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is evolving, especially as upside risks to inflation and downside risks to employment have become much more balanced. If the labor market cools too much and unemployment continues to increase and is driven by layoffs, I would see it as appropriate to cut rates sooner rather than later. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to hold rates steady for a little longer. As I conclude, I want to thank those of you in this room who do the hard work each day to create and analyze the economic data that allow not only policymakers like me, but also consumers and businesses, to gain a better understanding of ongoing developments in the U.S. economy. And let me thank NABE again for having me. It was a pleasure to speak with you today.
2024-07-17T00:00:00	Christopher J Waller: Getting closer	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Federal Reserve Bank of Kansas City, Kansas City, Missouri, 17 July 2024.	Christopher J Waller: Getting closer Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Federal Reserve Bank of Kansas City, Kansas City, Missouri, 17 July 2024. * * * Thank you, Jeff, and thank you to the Federal Reserve Bank of Kansas City for the 1 opportunity to speak to you today. So far, 2024 has been a challenging year for economic forecasters, and for monetary policymakers. After significant progress in 2023 toward the Federal Open Market Committee's (FOMC) price-stability goal, inflation jumped in the first quarter. At the same time, both the labor market and economic growth ran strong enough that some commentators wondered whether monetary policy was restrictive enough and whether rate hikes should be back on the table. These twists and turns in the economic data shifted everyone's expectations back and forth as to when the FOMC might begin lowering its policy interest rate and how many cuts there would be this year. During this time, my consistent view was that there was no urgency to cut rates until the Committee is confident that inflation is returning sustainably to 2 percent. Then, in the second quarter, data on inflation and the labor market moderated in a way that suggests progress toward price stability has resumed. The data over the past couple months shows the economy growing at a more moderate pace, labor supply and demand apparently in balance, and inflation slowing from earlier this year. These are all developments that support progress toward achieving the FOMC's dual-mandate goals. For reasons that I will elaborate on later, I believe current data are consistent with achieving a soft landing, and I will be looking for data over the next couple months to buttress this view. So, while I don't believe we have reached our final destination, I do believe we are getting closer to the time when a cut in the policy rate is warranted. Before turning to the economic outlook, let me say a word about central bank communication-in particular, communication about the policy path. Central bankers use communications to try, as much as possible, to describe the extent of progress, and even more importantly, the remaining path to the ultimate destination. The problem is that there may not be just one path to the ultimate destination-it depends on the incoming data. For example, when leaving work, you have a normal route to get home, and that is the base case for your estimated commuting time. But that day's traffic conditions will dictate whether you should take that route or an alternative to get home. You need to think about the alternative routes to get home and how long they will take if you are confronted with unexpected congestion. And, most likely, you will also have to communicate these alternative travel plans to family members so they have an idea of when you will arrive and how you will get the kids to after school activities. Central bankers face the same problem: How will you set policy if the data come in different than you expected? It is important to not only lay out your base case, but also alternative paths for policy if your base case is disrupted by incoming data. And for monetary policy, it is even more important to communicate those alternative policy paths to the public so that they can also make plans. So, after reviewing the economic outlook, I will explore three possible data scenarios about inflation for the second half of 2024 and how those differing scenarios affect my view of the appropriate stance of policy. Economic Activity Let me start with the economic outlook. Real gross domestic product (GDP) grew at about a 4 percent annual pace in the second half of 2023 and then significantly slowed to a 1.4 percent rate in the first quarter. Recent forecasts indicate that output grew a little faster in the second quarter. We will get an initial estimate of second-quarter GDP next week, but the Blue Chip average of private-sector forecasts estimates that GDP grew at a 1.8 percent pace in the second quarter, and the Atlanta Fed's GDPNow model estimates growth at 2.5 percent. A big reason for the higher GDPNow estimate is because it was updated after yesterday's retail sales report. Digging into that report, one finds that the data directly informing the Bureau of Economic Analysis's estimate of consumer spending posted solid gains for June and revised up sales for both April and May. I suspect that this moderate consumption growth may continue in the second half of the year because personal income data is holding up. A signal of possible slowing in economic activity comes from the Institute for Supply Management's (ISM) survey of purchasing managers for non-manufacturing firms. Nonmanufacturing firms constitute the large majority of businesses in the economy. The non-manufacturing index fell below 50 in June, suggesting a contraction in activity. As a part of that survey, "business activity," corresponding to production or sales, fell below 50 for the first time since May 2020. The index for new orders fell especially sharply and the employment index fell further into contractionary territory. Clearly, economic activity among these businesses is slowing, but it is too soon to say by how much. Previous months when the overall index fell below 50 were followed by sustained periods above that threshold, so we will have to wait and see what this current reading means for a slowing in this sector. Meanwhile activity among manufacturing businesses has been fairly steady this year after contracting from late 2022 through 2023. New orders and most other readings are close to 50. The Labor Market One development in the past few months with significant implications for monetary policy is that labor supply and demand have finally come into rough balance. Demand of workers exceeded supply for several years, contributing significantly to high wage inflation, which inevitably fed through into services inflation. Supply was damaged after the pandemic, as many people left the workforce to care for family, older workers retired, and immigration fell significantly. At the same time, the economy grew solidly, and labor demand rose at a brisk pace. The imbalance in the labor market was reflected in a surge in job openings, with two vacant jobs for each worker counted as looking for work, nearly double the rate prior to the pandemic. There was also a surge in the number of people quitting their jobs, most of them to take a higher-paying job elsewhere. But now that situation has changed dramatically. Labor supply has improved, with a higher labor force participation rate and much higher rates of immigration. Not long ago, I would have been concerned that the high levels of job creation reported recently were inconsistent with a labor market coming into better balance, but the high pace of immigration in recent quarters helped accommodate the strong demand. And, more recently, as restrictive monetary policy has put downward pressure on aggregate demand, the demand for labor has moderated. The unemployment rate has risen from a 50-year low to 4.1 percent, still low in historical terms but the highest since late 2021. In May, the ratio of job vacancies to unemployed people stood at 1.2, which was the average in the year before the pandemic. The share of workers who quit their jobs is now slightly below the prepandemic level. One indication that this is a loosening, rather than a weakening, of the labor market is that layoff rates have been more or less steady at the low rate of around 1 percent. To me, this is all evidence of labor supply and demand in balance. Back in 2022, I wrote a research note with Fed economist Andrew Figura on the Beveridge curve, which is the relationship between unemployment and the job vacancy 2 rate. In that research, we projected that, if layoffs were steady, the unemployment rate would rise to around 4.5 percent if the job vacancy rate dropped back to its prepandemic level of 4.6 percent. The latest data estimated the vacancy rate in May as 4.9 percent, pretty close to the pre-pandemic level. There were some prominent skeptics, but this data tells us that if inflation continues to moderate as it has since May, then we may achieve the soft landing in the labor market that I said back then was possible, with even less of a tradeoff in terms of unemployment. Another sign of balance in the labor market is that wage growth has continued to slow. The twelve-month change in average hourly earnings has slowed from its peak of about 6 percent in March 2022, to 4.3 percent by December 2023, and is down to 3.9 percent as of June. The three-month increase through June was running at an annual pace of 3.6 percent, which is close to what I judge is the rate needed to support inflation running at 2 percent in a sustained way. And this interpretation is consistent with other measures that suggest wage growth is back to its pre-pandemic level. So what lies ahead for the labor market? Right now, the labor market is in a sweet spotemployment growth is not excessive when accounting for immigration, nominal wage growth is near the rate consistent with price stability, the unemployment rate is close to what is thought of as its long run value, the job vacancy rate is near its pre-pandemic level and the involuntary layoff rate has held steady at 1 percent for over 2 years. In terms of the employment leg of the dual mandate, we may well be able to achieve the soft landing. But we need to keep the labor market in this sweet spot. As my research note highlighted, the history of the Beveridge curve indicates that, given the normalization of the labor market, a continued decline in the job vacancy rate and the vacancy-tounemployment ratio may lead to a larger increase in unemployment than we have seen the past two years. In short, one implication of a balanced labor market is that the risk too loose of it becoming is more closely balanced with the risk of it being too tight. This is a policy challenge that we have not faced for the past couple years. As of today, I see there is more upside risk to unemployment than we have seen for a long time. Inflation Let me now turn to the outlook for inflation. After making progress last year toward our 2 percent goal, early this year I was concerned that progress might have stalled. But data in recent months has been reassuring. Last week's consumer price index (CPI) report was the second month of very good news. It showed that total consumer prices fell in June, after staying flat in May. This means that CPI inflation for the 12-months through June declined to 3 percent, while the 3-month annualized change dropped to 1.1 percent. For consumers who have been dealing with prices that are still significantly higher than before the pandemic, this is good news, and with continuing solid gains in wages and other income, over time I hope it will begin to feel like the level of prices is becoming more manageable. For policymakers, this was also welcome news. Factoring out energy and food prices, which tend to be volatile, core CPI inflation rose only 0.1 percent last month, the slowest pace since the pandemic. This brings 3-month annualized core inflation down to an annual rate of 2.1 percent. Based on the consumer and producer price data reported last week, private sector forecasters are predicting that the FOMC's preferred inflation gauge based on personal consumer expenditures (PCE) rose 0.1 percent in June and that core PCE inflation rose 0.2 percent. So, after disappointing data to begin 2024, we now have a couple of months of data that I view as being more consistent with the steady progress we saw last year in reducing inflation, and also consistent with the FOMC's price stability goal. The evidence is mounting that the first quarter inflation data may have been an aberration and that the effects of tighter monetary policy have corralled high inflation. To see this, consider the average monthly rate of core PCE inflation over the past 18 months. In the first quarter of 2023 it averaged 0.4 percent, and then 0.3 percent, 0.2 percent and 0.1 percent over the remaining quarters of the year. Core PCE inflation jumped to a monthly average of 0.4 percent in the first quarter of this year but is now estimated to be back to 0.2 percent last quarter. Most importantly, I don't have to look at the second decimal place to see progress! The recent data are making me more confident we will achieve the inflation goal of our dual mandate. Monetary Policy Now let me turn to the implications of this data for monetary policy. As I noted earlier, the changes in the data this year have made it hard to formulate an outlook for policy that would apply to the range of possible paths the economy may take. That range of possibilities must consider two risks. On the one hand, it is essential that monetary policy get inflation down to a sustained level of 2 percent. If we start to loosen policy too soon, and allow inflation to flare up again, we risk losing credibility with the public and allowing expectations of future inflation to become unanchored. That credibility has helped inflation fall as quickly as it has in the past 18 months and squandering it would be a grave mistake. Monthly PCE inflation has very recently been running near 2 percent at an annual rate, but I need to see a bit more evidence that this will be sustained. The other risk is that we wait too long to ease monetary policy and contribute to a significant economic slowdown or a recession, with unemployment rising notably. With those two risks in mind, let me lay out three scenarios for the economy this year that would result in leading me to different views about appropriate policy. One assumption I make is that there is no significant deterioration in the labor market in the next several months-that we are able to keep the labor market in its current sweet spot. While I believe this is likely, I will be paying close attention to the employment side of our mandate. The first scenario is the optimistic one. Here we continue to receive more very favorable CPI inflation reports, with implications for very favorable PCE inflation readings as well. This would give us a nice run of inflation data starting in May. I see a significant but not high probability of this scenario occurring. And, in that circumstance, I would have much greater confidence in inflation moving sustainably toward 2 percent. In this scenario, I could envision a rate cut in the not-too-distant future. The second scenario is a bit less optimistic but probably more likely to occur. In this case, the inflation data comes in uneven-not as good as the previous few months but still consistent overall with progress on bringing inflation down toward 2 percent. Here, with the uneven data, it would be a matter of timing as to when I thought we are making sustainable progress to 2 percent inflation. In this case, a rate cut in the near future is more uncertain. The final scenario is the one that I certainly don't want to see but have to worry about. In this case, if we were to see a significant resurgence in inflation in the second half of 2024, it would be tough to conclude we were making sustainable progress on inflation this year. While this pessimistic outcome is possible, I put a low probability on it happening given the recent data we have received. These scenarios highlight that the data will influence how my confidence in inflation returning sustainably to 2 percent could evolve over time. And this will then influence my view of the appropriate path of policy. This all goes to say that my view of the appropriate path of policy is data dependent. In laying out these scenarios, I don't mean to suggest that I will ignore other data and what they tell us about economic and financial conditions. As always, my judgments about appropriate policy will consider the totality of the data, including importantly the signals we receive about the state of the labor market, which has eased and now looks to be in balance. But for the purpose of clearly communicating my thinking about the stance of policy over the next several months, I think these scenarios are helpful. And given that I believe the first two scenarios have the highest probability of occurring, I believe the time to lower the policy rate is drawing closer. Thank you. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. Return to text See Andrew Figura and Chris Waller (2022), "What Does the Beveridge Curve Tell Us about the Likelihood of a Soft Landing?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 29). Return to text	---[PAGE_BREAK]--- # Christopher J Waller: Getting closer Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Federal Reserve Bank of Kansas City, Kansas City, Missouri, 17 July 2024. Thank you, Jeff, and thank you to the Federal Reserve Bank of Kansas City for the opportunity to speak to you today. ${ }^{1}$ So far, 2024 has been a challenging year for economic forecasters, and for monetary policymakers. After significant progress in 2023 toward the Federal Open Market Committee's (FOMC) price-stability goal, inflation jumped in the first quarter. At the same time, both the labor market and economic growth ran strong enough that some commentators wondered whether monetary policy was restrictive enough and whether rate hikes should be back on the table. These twists and turns in the economic data shifted everyone's expectations back and forth as to when the FOMC might begin lowering its policy interest rate and how many cuts there would be this year. During this time, my consistent view was that there was no urgency to cut rates until the Committee is confident that inflation is returning sustainably to 2 percent. Then, in the second quarter, data on inflation and the labor market moderated in a way that suggests progress toward price stability has resumed. The data over the past couple months shows the economy growing at a more moderate pace, labor supply and demand apparently in balance, and inflation slowing from earlier this year. These are all developments that support progress toward achieving the FOMC's dual-mandate goals. For reasons that I will elaborate on later, I believe current data are consistent with achieving a soft landing, and I will be looking for data over the next couple months to buttress this view. So, while I don't believe we have reached our final destination, I do believe we are getting closer to the time when a cut in the policy rate is warranted. Before turning to the economic outlook, let me say a word about central bank communication-in particular, communication about the policy path. Central bankers use communications to try, as much as possible, to describe the extent of progress, and even more importantly, the remaining path to the ultimate destination. The problem is that there may not be just one path to the ultimate destination-it depends on the incoming data. For example, when leaving work, you have a normal route to get home, and that is the base case for your estimated commuting time. But that day's traffic conditions will dictate whether you should take that route or an alternative to get home. You need to think about the alternative routes to get home and how long they will take if you are confronted with unexpected congestion. And, most likely, you will also have to communicate these alternative travel plans to family members so they have an idea of when you will arrive and how you will get the kids to after school activities. Central bankers face the same problem: How will you set policy if the data come in different than you expected? It is important to not only lay out your base case, but also alternative paths for policy if your base case is disrupted by incoming data. And for monetary policy, it is even more important to communicate those alternative policy paths to the public so that they can also make plans. So, after reviewing the economic ---[PAGE_BREAK]--- outlook, I will explore three possible data scenarios about inflation for the second half of 2024 and how those differing scenarios affect my view of the appropriate stance of policy. # Economic Activity Let me start with the economic outlook. Real gross domestic product (GDP) grew at about a 4 percent annual pace in the second half of 2023 and then significantly slowed to a 1.4 percent rate in the first quarter. Recent forecasts indicate that output grew a little faster in the second quarter. We will get an initial estimate of second-quarter GDP next week, but the Blue Chip average of private-sector forecasts estimates that GDP grew at a 1.8 percent pace in the second quarter, and the Atlanta Fed's GDPNow model estimates growth at 2.5 percent. A big reason for the higher GDPNow estimate is because it was updated after yesterday's retail sales report. Digging into that report, one finds that the data directly informing the Bureau of Economic Analysis's estimate of consumer spending posted solid gains for June and revised up sales for both April and May. I suspect that this moderate consumption growth may continue in the second half of the year because personal income data is holding up. A signal of possible slowing in economic activity comes from the Institute for Supply Management's (ISM) survey of purchasing managers for non-manufacturing firms. Nonmanufacturing firms constitute the large majority of businesses in the economy. The non-manufacturing index fell below 50 in June, suggesting a contraction in activity. As a part of that survey, "business activity," corresponding to production or sales, fell below 50 for the first time since May 2020. The index for new orders fell especially sharply and the employment index fell further into contractionary territory. Clearly, economic activity among these businesses is slowing, but it is too soon to say by how much. Previous months when the overall index fell below 50 were followed by sustained periods above that threshold, so we will have to wait and see what this current reading means for a slowing in this sector. Meanwhile activity among manufacturing businesses has been fairly steady this year after contracting from late 2022 through 2023. New orders and most other readings are close to 50 . ## The Labor Market One development in the past few months with significant implications for monetary policy is that labor supply and demand have finally come into rough balance. Demand of workers exceeded supply for several years, contributing significantly to high wage inflation, which inevitably fed through into services inflation. Supply was damaged after the pandemic, as many people left the workforce to care for family, older workers retired, and immigration fell significantly. At the same time, the economy grew solidly, and labor demand rose at a brisk pace. The imbalance in the labor market was reflected in a surge in job openings, with two vacant jobs for each worker counted as looking for work, nearly double the rate prior to the pandemic. There was also a surge in the number of people quitting their jobs, most of them to take a higher-paying job elsewhere. But now that situation has changed dramatically. Labor supply has improved, with a higher labor force participation rate and much higher rates of immigration. Not long ago, I would have been concerned that the high levels of job creation reported recently were ---[PAGE_BREAK]--- inconsistent with a labor market coming into better balance, but the high pace of immigration in recent quarters helped accommodate the strong demand. And, more recently, as restrictive monetary policy has put downward pressure on aggregate demand, the demand for labor has moderated. The unemployment rate has risen from a 50-year low to 4.1 percent, still low in historical terms but the highest since late 2021. In May, the ratio of job vacancies to unemployed people stood at 1.2, which was the average in the year before the pandemic. The share of workers who quit their jobs is now slightly below the prepandemic level. One indication that this is a loosening, rather than a weakening, of the labor market is that layoff rates have been more or less steady at the low rate of around 1 percent. To me, this is all evidence of labor supply and demand in balance. Back in 2022, I wrote a research note with Fed economist Andrew Figura on the Beveridge curve, which is the relationship between unemployment and the job vacancy rate. ${ }^{2}$ In that research, we projected that, if layoffs were steady, the unemployment rate would rise to around 4.5 percent if the job vacancy rate dropped back to its prepandemic level of 4.6 percent. The latest data estimated the vacancy rate in May as 4.9 percent, pretty close to the pre-pandemic level. There were some prominent skeptics, but this data tells us that if inflation continues to moderate as it has since May, then we may achieve the soft landing in the labor market that I said back then was possible, with even less of a tradeoff in terms of unemployment. Another sign of balance in the labor market is that wage growth has continued to slow. The twelve-month change in average hourly earnings has slowed from its peak of about 6 percent in March 2022, to 4.3 percent by December 2023, and is down to 3.9 percent as of June. The three-month increase through June was running at an annual pace of 3.6 percent, which is close to what I judge is the rate needed to support inflation running at 2 percent in a sustained way. And this interpretation is consistent with other measures that suggest wage growth is back to its pre-pandemic level. So what lies ahead for the labor market? Right now, the labor market is in a sweet spotemployment growth is not excessive when accounting for immigration, nominal wage growth is near the rate consistent with price stability, the unemployment rate is close to what is thought of as its long run value, the job vacancy rate is near its pre-pandemic level and the involuntary layoff rate has held steady at 1 percent for over 2 years. In terms of the employment leg of the dual mandate, we may well be able to achieve the soft landing. But we need to keep the labor market in this sweet spot. As my research note highlighted, the history of the Beveridge curve indicates that, given the normalization of the labor market, a continued decline in the job vacancy rate and the vacancy-tounemployment ratio may lead to a larger increase in unemployment than we have seen the past two years. In short, one implication of a balanced labor market is that the risk of it becoming too loose is more closely balanced with the risk of it being too tight. This is a policy challenge that we have not faced for the past couple years. As of today, I see there is more upside risk to unemployment than we have seen for a long time. # Inflation ---[PAGE_BREAK]--- Let me now turn to the outlook for inflation. After making progress last year toward our 2 percent goal, early this year I was concerned that progress might have stalled. But data in recent months has been reassuring. Last week's consumer price index (CPI) report was the second month of very good news. It showed that total consumer prices fell in June, after staying flat in May. This means that CPI inflation for the 12-months through June declined to 3 percent, while the 3-month annualized change dropped to 1.1 percent. For consumers who have been dealing with prices that are still significantly higher than before the pandemic, this is good news, and with continuing solid gains in wages and other income, over time I hope it will begin to feel like the level of prices is becoming more manageable. For policymakers, this was also welcome news. Factoring out energy and food prices, which tend to be volatile, core CPI inflation rose only 0.1 percent last month, the slowest pace since the pandemic. This brings 3-month annualized core inflation down to an annual rate of 2.1 percent. Based on the consumer and producer price data reported last week, private sector forecasters are predicting that the FOMC's preferred inflation gauge based on personal consumer expenditures (PCE) rose 0.1 percent in June and that core PCE inflation rose 0.2 percent. So, after disappointing data to begin 2024, we now have a couple of months of data that I view as being more consistent with the steady progress we saw last year in reducing inflation, and also consistent with the FOMC's price stability goal. The evidence is mounting that the first quarter inflation data may have been an aberration and that the effects of tighter monetary policy have corralled high inflation. To see this, consider the average monthly rate of core PCE inflation over the past 18 months. In the first quarter of 2023 it averaged 0.4 percent, and then 0.3 percent, 0.2 percent and 0.1 percent over the remaining quarters of the year. Core PCE inflation jumped to a monthly average of 0.4 percent in the first quarter of this year but is now estimated to be back to 0.2 percent last quarter. Most importantly, I don't have to look at the second decimal place to see progress! The recent data are making me more confident we will achieve the inflation goal of our dual mandate. # Monetary Policy Now let me turn to the implications of this data for monetary policy. As I noted earlier, the changes in the data this year have made it hard to formulate an outlook for policy that would apply to the range of possible paths the economy may take. That range of possibilities must consider two risks. On the one hand, it is essential that monetary policy get inflation down to a sustained level of 2 percent. If we start to loosen policy too soon, and allow inflation to flare up again, we risk losing credibility with the public and allowing expectations of future inflation to become unanchored. That credibility has helped inflation fall as quickly as it has in the past 18 months and squandering it would be a grave mistake. Monthly PCE inflation has very recently been running near 2 percent at an annual rate, but I need to see a bit more evidence that this will be sustained. The other risk is that we wait too long to ease monetary policy and contribute to a significant economic slowdown or a recession, with unemployment rising notably. ---[PAGE_BREAK]--- With those two risks in mind, let me lay out three scenarios for the economy this year that would result in leading me to different views about appropriate policy. One assumption I make is that there is no significant deterioration in the labor market in the next several months-that we are able to keep the labor market in its current sweet spot. While I believe this is likely, I will be paying close attention to the employment side of our mandate. The first scenario is the optimistic one. Here we continue to receive more very favorable CPI inflation reports, with implications for very favorable PCE inflation readings as well. This would give us a nice run of inflation data starting in May. I see a significant but not high probability of this scenario occurring. And, in that circumstance, I would have much greater confidence in inflation moving sustainably toward 2 percent. In this scenario, I could envision a rate cut in the not-too-distant future. The second scenario is a bit less optimistic but probably more likely to occur. In this case, the inflation data comes in uneven-not as good as the previous few months but still consistent overall with progress on bringing inflation down toward 2 percent. Here, with the uneven data, it would be a matter of timing as to when I thought we are making sustainable progress to 2 percent inflation. In this case, a rate cut in the near future is more uncertain. The final scenario is the one that I certainly don't want to see but have to worry about. In this case, if we were to see a significant resurgence in inflation in the second half of 2024, it would be tough to conclude we were making sustainable progress on inflation this year. While this pessimistic outcome is possible, I put a low probability on it happening given the recent data we have received. These scenarios highlight that the data will influence how my confidence in inflation returning sustainably to 2 percent could evolve over time. And this will then influence my view of the appropriate path of policy. This all goes to say that my view of the appropriate path of policy is data dependent. In laying out these scenarios, I don't mean to suggest that I will ignore other data and what they tell us about economic and financial conditions. As always, my judgments about appropriate policy will consider the totality of the data, including importantly the signals we receive about the state of the labor market, which has eased and now looks to be in balance. But for the purpose of clearly communicating my thinking about the stance of policy over the next several months, I think these scenarios are helpful. And given that I believe the first two scenarios have the highest probability of occurring, I believe the time to lower the policy rate is drawing closer. Thank you. [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. ---[PAGE_BREAK]--- ${ }^{2}$ See Andrew Figura and Chris Waller (2022), "What Does the Beveridge Curve Tell Us about the Likelihood of a Soft Landing?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 29).	Christopher J Waller	United States	https://www.bis.org/review/r240718a.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Federal Reserve Bank of Kansas City, Kansas City, Missouri, 17 July 2024. Thank you, Jeff, and thank you to the Federal Reserve Bank of Kansas City for the opportunity to speak to you today. So far, 2024 has been a challenging year for economic forecasters, and for monetary policymakers. After significant progress in 2023 toward the Federal Open Market Committee's (FOMC) price-stability goal, inflation jumped in the first quarter. At the same time, both the labor market and economic growth ran strong enough that some commentators wondered whether monetary policy was restrictive enough and whether rate hikes should be back on the table. These twists and turns in the economic data shifted everyone's expectations back and forth as to when the FOMC might begin lowering its policy interest rate and how many cuts there would be this year. During this time, my consistent view was that there was no urgency to cut rates until the Committee is confident that inflation is returning sustainably to 2 percent. Then, in the second quarter, data on inflation and the labor market moderated in a way that suggests progress toward price stability has resumed. The data over the past couple months shows the economy growing at a more moderate pace, labor supply and demand apparently in balance, and inflation slowing from earlier this year. These are all developments that support progress toward achieving the FOMC's dual-mandate goals. For reasons that I will elaborate on later, I believe current data are consistent with achieving a soft landing, and I will be looking for data over the next couple months to buttress this view. So, while I don't believe we have reached our final destination, I do believe we are getting closer to the time when a cut in the policy rate is warranted. Before turning to the economic outlook, let me say a word about central bank communication-in particular, communication about the policy path. Central bankers use communications to try, as much as possible, to describe the extent of progress, and even more importantly, the remaining path to the ultimate destination. The problem is that there may not be just one path to the ultimate destination-it depends on the incoming data. For example, when leaving work, you have a normal route to get home, and that is the base case for your estimated commuting time. But that day's traffic conditions will dictate whether you should take that route or an alternative to get home. You need to think about the alternative routes to get home and how long they will take if you are confronted with unexpected congestion. And, most likely, you will also have to communicate these alternative travel plans to family members so they have an idea of when you will arrive and how you will get the kids to after school activities. Central bankers face the same problem: How will you set policy if the data come in different than you expected? It is important to not only lay out your base case, but also alternative paths for policy if your base case is disrupted by incoming data. And for monetary policy, it is even more important to communicate those alternative policy paths to the public so that they can also make plans. So, after reviewing the economic outlook, I will explore three possible data scenarios about inflation for the second half of 2024 and how those differing scenarios affect my view of the appropriate stance of policy. Let me start with the economic outlook. Real gross domestic product (GDP) grew at about a 4 percent annual pace in the second half of 2023 and then significantly slowed to a 1.4 percent rate in the first quarter. Recent forecasts indicate that output grew a little faster in the second quarter. We will get an initial estimate of second-quarter GDP next week, but the Blue Chip average of private-sector forecasts estimates that GDP grew at a 1.8 percent pace in the second quarter, and the Atlanta Fed's GDPNow model estimates growth at 2.5 percent. A big reason for the higher GDPNow estimate is because it was updated after yesterday's retail sales report. Digging into that report, one finds that the data directly informing the Bureau of Economic Analysis's estimate of consumer spending posted solid gains for June and revised up sales for both April and May. I suspect that this moderate consumption growth may continue in the second half of the year because personal income data is holding up. A signal of possible slowing in economic activity comes from the Institute for Supply Management's (ISM) survey of purchasing managers for non-manufacturing firms. Nonmanufacturing firms constitute the large majority of businesses in the economy. The non-manufacturing index fell below 50 in June, suggesting a contraction in activity. As a part of that survey, "business activity," corresponding to production or sales, fell below 50 for the first time since May 2020. The index for new orders fell especially sharply and the employment index fell further into contractionary territory. Clearly, economic activity among these businesses is slowing, but it is too soon to say by how much. Previous months when the overall index fell below 50 were followed by sustained periods above that threshold, so we will have to wait and see what this current reading means for a slowing in this sector. Meanwhile activity among manufacturing businesses has been fairly steady this year after contracting from late 2022 through 2023. New orders and most other readings are close to 50 . One development in the past few months with significant implications for monetary policy is that labor supply and demand have finally come into rough balance. Demand of workers exceeded supply for several years, contributing significantly to high wage inflation, which inevitably fed through into services inflation. Supply was damaged after the pandemic, as many people left the workforce to care for family, older workers retired, and immigration fell significantly. At the same time, the economy grew solidly, and labor demand rose at a brisk pace. The imbalance in the labor market was reflected in a surge in job openings, with two vacant jobs for each worker counted as looking for work, nearly double the rate prior to the pandemic. There was also a surge in the number of people quitting their jobs, most of them to take a higher-paying job elsewhere. But now that situation has changed dramatically. Labor supply has improved, with a higher labor force participation rate and much higher rates of immigration. Not long ago, I would have been concerned that the high levels of job creation reported recently were inconsistent with a labor market coming into better balance, but the high pace of immigration in recent quarters helped accommodate the strong demand. And, more recently, as restrictive monetary policy has put downward pressure on aggregate demand, the demand for labor has moderated. The unemployment rate has risen from a 50-year low to 4.1 percent, still low in historical terms but the highest since late 2021. In May, the ratio of job vacancies to unemployed people stood at 1.2, which was the average in the year before the pandemic. The share of workers who quit their jobs is now slightly below the prepandemic level. One indication that this is a loosening, rather than a weakening, of the labor market is that layoff rates have been more or less steady at the low rate of around 1 percent. To me, this is all evidence of labor supply and demand in balance. Back in 2022, I wrote a research note with Fed economist Andrew Figura on the Beveridge curve, which is the relationship between unemployment and the job vacancy rate. In that research, we projected that, if layoffs were steady, the unemployment rate would rise to around 4.5 percent if the job vacancy rate dropped back to its prepandemic level of 4.6 percent. The latest data estimated the vacancy rate in May as 4.9 percent, pretty close to the pre-pandemic level. There were some prominent skeptics, but this data tells us that if inflation continues to moderate as it has since May, then we may achieve the soft landing in the labor market that I said back then was possible, with even less of a tradeoff in terms of unemployment. Another sign of balance in the labor market is that wage growth has continued to slow. The twelve-month change in average hourly earnings has slowed from its peak of about 6 percent in March 2022, to 4.3 percent by December 2023, and is down to 3.9 percent as of June. The three-month increase through June was running at an annual pace of 3.6 percent, which is close to what I judge is the rate needed to support inflation running at 2 percent in a sustained way. And this interpretation is consistent with other measures that suggest wage growth is back to its pre-pandemic level. So what lies ahead for the labor market? Right now, the labor market is in a sweet spotemployment growth is not excessive when accounting for immigration, nominal wage growth is near the rate consistent with price stability, the unemployment rate is close to what is thought of as its long run value, the job vacancy rate is near its pre-pandemic level and the involuntary layoff rate has held steady at 1 percent for over 2 years. In terms of the employment leg of the dual mandate, we may well be able to achieve the soft landing. But we need to keep the labor market in this sweet spot. As my research note highlighted, the history of the Beveridge curve indicates that, given the normalization of the labor market, a continued decline in the job vacancy rate and the vacancy-tounemployment ratio may lead to a larger increase in unemployment than we have seen the past two years. In short, one implication of a balanced labor market is that the risk of it becoming too loose is more closely balanced with the risk of it being too tight. This is a policy challenge that we have not faced for the past couple years. As of today, I see there is more upside risk to unemployment than we have seen for a long time. Let me now turn to the outlook for inflation. After making progress last year toward our 2 percent goal, early this year I was concerned that progress might have stalled. But data in recent months has been reassuring. Last week's consumer price index (CPI) report was the second month of very good news. It showed that total consumer prices fell in June, after staying flat in May. This means that CPI inflation for the 12-months through June declined to 3 percent, while the 3-month annualized change dropped to 1.1 percent. For consumers who have been dealing with prices that are still significantly higher than before the pandemic, this is good news, and with continuing solid gains in wages and other income, over time I hope it will begin to feel like the level of prices is becoming more manageable. For policymakers, this was also welcome news. Factoring out energy and food prices, which tend to be volatile, core CPI inflation rose only 0.1 percent last month, the slowest pace since the pandemic. This brings 3-month annualized core inflation down to an annual rate of 2.1 percent. Based on the consumer and producer price data reported last week, private sector forecasters are predicting that the FOMC's preferred inflation gauge based on personal consumer expenditures (PCE) rose 0.1 percent in June and that core PCE inflation rose 0.2 percent. So, after disappointing data to begin 2024, we now have a couple of months of data that I view as being more consistent with the steady progress we saw last year in reducing inflation, and also consistent with the FOMC's price stability goal. The evidence is mounting that the first quarter inflation data may have been an aberration and that the effects of tighter monetary policy have corralled high inflation. To see this, consider the average monthly rate of core PCE inflation over the past 18 months. In the first quarter of 2023 it averaged 0.4 percent, and then 0.3 percent, 0.2 percent and 0.1 percent over the remaining quarters of the year. Core PCE inflation jumped to a monthly average of 0.4 percent in the first quarter of this year but is now estimated to be back to 0.2 percent last quarter. Most importantly, I don't have to look at the second decimal place to see progress! The recent data are making me more confident we will achieve the inflation goal of our dual mandate. Now let me turn to the implications of this data for monetary policy. As I noted earlier, the changes in the data this year have made it hard to formulate an outlook for policy that would apply to the range of possible paths the economy may take. That range of possibilities must consider two risks. On the one hand, it is essential that monetary policy get inflation down to a sustained level of 2 percent. If we start to loosen policy too soon, and allow inflation to flare up again, we risk losing credibility with the public and allowing expectations of future inflation to become unanchored. That credibility has helped inflation fall as quickly as it has in the past 18 months and squandering it would be a grave mistake. Monthly PCE inflation has very recently been running near 2 percent at an annual rate, but I need to see a bit more evidence that this will be sustained. The other risk is that we wait too long to ease monetary policy and contribute to a significant economic slowdown or a recession, with unemployment rising notably. With those two risks in mind, let me lay out three scenarios for the economy this year that would result in leading me to different views about appropriate policy. One assumption I make is that there is no significant deterioration in the labor market in the next several months-that we are able to keep the labor market in its current sweet spot. While I believe this is likely, I will be paying close attention to the employment side of our mandate. The first scenario is the optimistic one. Here we continue to receive more very favorable CPI inflation reports, with implications for very favorable PCE inflation readings as well. This would give us a nice run of inflation data starting in May. I see a significant but not high probability of this scenario occurring. And, in that circumstance, I would have much greater confidence in inflation moving sustainably toward 2 percent. In this scenario, I could envision a rate cut in the not-too-distant future. The second scenario is a bit less optimistic but probably more likely to occur. In this case, the inflation data comes in uneven-not as good as the previous few months but still consistent overall with progress on bringing inflation down toward 2 percent. Here, with the uneven data, it would be a matter of timing as to when I thought we are making sustainable progress to 2 percent inflation. In this case, a rate cut in the near future is more uncertain. The final scenario is the one that I certainly don't want to see but have to worry about. In this case, if we were to see a significant resurgence in inflation in the second half of 2024, it would be tough to conclude we were making sustainable progress on inflation this year. While this pessimistic outcome is possible, I put a low probability on it happening given the recent data we have received. These scenarios highlight that the data will influence how my confidence in inflation returning sustainably to 2 percent could evolve over time. And this will then influence my view of the appropriate path of policy. This all goes to say that my view of the appropriate path of policy is data dependent. In laying out these scenarios, I don't mean to suggest that I will ignore other data and what they tell us about economic and financial conditions. As always, my judgments about appropriate policy will consider the totality of the data, including importantly the signals we receive about the state of the labor market, which has eased and now looks to be in balance. But for the purpose of clearly communicating my thinking about the stance of policy over the next several months, I think these scenarios are helpful. And given that I believe the first two scenarios have the highest probability of occurring, I believe the time to lower the policy rate is drawing closer. Thank you.
2024-07-18T00:00:00	Christine Lagarde: ECB press conference - introductory statement	Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 18 July 2024.	Christine Lagarde: ECB press conference - introductory statement Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 18 July 2024. * * * Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports our previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above our target well into next year. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meetingby-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. Economic activity The incoming information indicates that the euro area economy grew in the second quarter, but likely at a slower pace than in the first quarter. Services continue to lead the recovery, while industrial production and goods exports have been weak. Investment indicators point to muted growth in 2024, amid heightened uncertainty. Looking ahead, we expect the recovery to be supported by consumption, driven by the strengthening of real incomes resulting from lower inflation and higher nominal wages. Moreover, exports should pick up alongside a rise in global demand. Finally, monetary policy should exert less of a drag on demand over time. The labour market remains resilient. The unemployment rate was unchanged, at 6.4 per cent in May, remaining at its lowest level since the start of the euro. Employment, which grew by 0.3 per cent in the first quarter, was supported by a further increase in the labour force, which expanded at the same rate. More jobs are likely to have been created in the second quarter, mainly in the services sector. Firms are gradually reducing their job postings, but from high levels. National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. An effective, speedy and full implementation of the Next Generation EU programme, progress towards capital markets union and the completion of banking union, and a strengthening of the Single Market are key factors that would help foster innovation and increase investment in the green and digital transitions. We welcome the European Commission's recent guidance calling for EU Member States to strengthen fiscal sustainability and the Eurogroup's statement on the fiscal stance for the euro area in 2025. Implementing the EU's revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Inflation Annual inflation eased to 2.5 per cent in June, from 2.6 per cent in May. Food prices went up by 2.4 per cent in June - which is 0.2 percentage points less than in May - while energy prices remained essentially flat. Both goods price inflation and services price inflation were unchanged in June, at 0.7% and 4.1% respectively. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. Domestic inflation remains high. Wages are still rising at an elevated rate, making up for the past period of high inflation. Higher nominal wages, alongside weak productivity, have added to unit labour cost growth, although it decelerated somewhat in the first quarter of this year. Owing to the staggered nature of wage adjustments and the large contribution of one-off payments, growth in labour costs will likely remain elevated over the near term. At the same time, recent data on compensation per employee have been in line with expectations and the latest survey indicators signal that wage growth will moderate over the course of next year. Moreover, profits contracted in the first quarter, helping to offset the inflationary effects of higher unit labour costs, and survey evidence suggests that profits should continue to be dampened in the near term. Inflation is expected to fluctuate around current levels for the rest of the year, partly owing to energy-related base effects. It is then expected to decline towards our target over the second half of next year, owing to weaker growth in labour costs, the effects of our restrictive monetary policy and the fading impact of the past inflation surge. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2 per cent. Risk assessment The risks to economic growth are tilted to the downside. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia's unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected. Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Financial and monetary conditions The policy rate cut in June has been transmitted smoothly to money market interest rates, while broader financial conditions have been somewhat volatile. Financing costs remain restrictive as our previous policy rate increases continue to work their way through the transmission chain. The average interest rate on new loans to firms edged down to 5.1 per cent in May, while mortgage rates remained unchanged at 3.8 per cent. Credit standards for loans remain tight. According to our latest bank lending survey, standards for lending to firms tightened slightly in the second quarter, while standards for mortgages eased moderately. Firms' demand for loans fell slightly, while households' demand for mortgages rose for the first time since early 2022. Overall, credit dynamics remain weak. Bank lending to firms and households grew at an annual rate of 0.3 per cent in May, only marginally up from the previous month. The annual growth in broad money - as measured by M3 - rose to 1.6 per cent in May, from 1.3 per cent in April. Conclusion The Governing Council today decided to keep the three key ECB interest rates unchanged. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a datadependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.	---[PAGE_BREAK]--- # Christine Lagarde: ECB press conference - introductory statement Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 18 July 2024. Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports our previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above our target well into next year. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. ## Economic activity The incoming information indicates that the euro area economy grew in the second quarter, but likely at a slower pace than in the first quarter. Services continue to lead the recovery, while industrial production and goods exports have been weak. Investment indicators point to muted growth in 2024, amid heightened uncertainty. Looking ahead, we expect the recovery to be supported by consumption, driven by the strengthening of real incomes resulting from lower inflation and higher nominal wages. Moreover, exports should pick up alongside a rise in global demand. Finally, monetary policy should exert less of a drag on demand over time. The labour market remains resilient. The unemployment rate was unchanged, at 6.4 per cent in May, remaining at its lowest level since the start of the euro. Employment, which grew by 0.3 per cent in the first quarter, was supported by a further increase in the ---[PAGE_BREAK]--- labour force, which expanded at the same rate. More jobs are likely to have been created in the second quarter, mainly in the services sector. Firms are gradually reducing their job postings, but from high levels. National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. An effective, speedy and full implementation of the Next Generation EU programme, progress towards capital markets union and the completion of banking union, and a strengthening of the Single Market are key factors that would help foster innovation and increase investment in the green and digital transitions. We welcome the European Commission's recent guidance calling for EU Member States to strengthen fiscal sustainability and the Eurogroup's statement on the fiscal stance for the euro area in 2025. Implementing the EU's revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. # Inflation Annual inflation eased to 2.5 per cent in June, from 2.6 per cent in May. Food prices went up by 2.4 per cent in June - which is 0.2 percentage points less than in May while energy prices remained essentially flat. Both goods price inflation and services price inflation were unchanged in June, at $0.7 \%$ and $4.1 \%$ respectively. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. Domestic inflation remains high. Wages are still rising at an elevated rate, making up for the past period of high inflation. Higher nominal wages, alongside weak productivity, have added to unit labour cost growth, although it decelerated somewhat in the first quarter of this year. Owing to the staggered nature of wage adjustments and the large contribution of one-off payments, growth in labour costs will likely remain elevated over the near term. At the same time, recent data on compensation per employee have been in line with expectations and the latest survey indicators signal that wage growth will moderate over the course of next year. Moreover, profits contracted in the first quarter, helping to offset the inflationary effects of higher unit labour costs, and survey evidence suggests that profits should continue to be dampened in the near term. Inflation is expected to fluctuate around current levels for the rest of the year, partly owing to energy-related base effects. It is then expected to decline towards our target over the second half of next year, owing to weaker growth in labour costs, the effects of our restrictive monetary policy and the fading impact of the past inflation surge. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2 per cent. ## Risk assessment The risks to economic growth are tilted to the downside. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia's unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth ---[PAGE_BREAK]--- could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected. Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. # Financial and monetary conditions The policy rate cut in June has been transmitted smoothly to money market interest rates, while broader financial conditions have been somewhat volatile. Financing costs remain restrictive as our previous policy rate increases continue to work their way through the transmission chain. The average interest rate on new loans to firms edged down to 5.1 per cent in May, while mortgage rates remained unchanged at 3.8 per cent. Credit standards for loans remain tight. According to our latest bank lending survey, standards for lending to firms tightened slightly in the second quarter, while standards for mortgages eased moderately. Firms' demand for loans fell slightly, while households' demand for mortgages rose for the first time since early 2022. Overall, credit dynamics remain weak. Bank lending to firms and households grew at an annual rate of 0.3 per cent in May, only marginally up from the previous month. The annual growth in broad money - as measured by M3 - rose to 1.6 per cent in May, from 1.3 per cent in April. ## Conclusion The Governing Council today decided to keep the three key ECB interest rates unchanged. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a datadependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.	Christine Lagarde	Euro area	https://www.bis.org/review/r240723c.pdf	Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 18 July 2024. Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports our previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above our target well into next year. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. The incoming information indicates that the euro area economy grew in the second quarter, but likely at a slower pace than in the first quarter. Services continue to lead the recovery, while industrial production and goods exports have been weak. Investment indicators point to muted growth in 2024, amid heightened uncertainty. Looking ahead, we expect the recovery to be supported by consumption, driven by the strengthening of real incomes resulting from lower inflation and higher nominal wages. Moreover, exports should pick up alongside a rise in global demand. Finally, monetary policy should exert less of a drag on demand over time. The labour market remains resilient. The unemployment rate was unchanged, at 6.4 per cent in May, remaining at its lowest level since the start of the euro. Employment, which grew by 0.3 per cent in the first quarter, was supported by a further increase in the labour force, which expanded at the same rate. More jobs are likely to have been created in the second quarter, mainly in the services sector. Firms are gradually reducing their job postings, but from high levels. National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. An effective, speedy and full implementation of the Next Generation EU programme, progress towards capital markets union and the completion of banking union, and a strengthening of the Single Market are key factors that would help foster innovation and increase investment in the green and digital transitions. We welcome the European Commission's recent guidance calling for EU Member States to strengthen fiscal sustainability and the Eurogroup's statement on the fiscal stance for the euro area in 2025. Implementing the EU's revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Annual inflation eased to 2.5 per cent in June, from 2.6 per cent in May. Food prices went up by 2.4 per cent in June - which is 0.2 percentage points less than in May while energy prices remained essentially flat. Both goods price inflation and services price inflation were unchanged in June, at $0.7 \%$ and $4.1 \%$ respectively. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. Domestic inflation remains high. Wages are still rising at an elevated rate, making up for the past period of high inflation. Higher nominal wages, alongside weak productivity, have added to unit labour cost growth, although it decelerated somewhat in the first quarter of this year. Owing to the staggered nature of wage adjustments and the large contribution of one-off payments, growth in labour costs will likely remain elevated over the near term. At the same time, recent data on compensation per employee have been in line with expectations and the latest survey indicators signal that wage growth will moderate over the course of next year. Moreover, profits contracted in the first quarter, helping to offset the inflationary effects of higher unit labour costs, and survey evidence suggests that profits should continue to be dampened in the near term. Inflation is expected to fluctuate around current levels for the rest of the year, partly owing to energy-related base effects. It is then expected to decline towards our target over the second half of next year, owing to weaker growth in labour costs, the effects of our restrictive monetary policy and the fading impact of the past inflation surge. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2 per cent. The risks to economic growth are tilted to the downside. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia's unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected. Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. The policy rate cut in June has been transmitted smoothly to money market interest rates, while broader financial conditions have been somewhat volatile. Financing costs remain restrictive as our previous policy rate increases continue to work their way through the transmission chain. The average interest rate on new loans to firms edged down to 5.1 per cent in May, while mortgage rates remained unchanged at 3.8 per cent. Credit standards for loans remain tight. According to our latest bank lending survey, standards for lending to firms tightened slightly in the second quarter, while standards for mortgages eased moderately. Firms' demand for loans fell slightly, while households' demand for mortgages rose for the first time since early 2022. Overall, credit dynamics remain weak. Bank lending to firms and households grew at an annual rate of 0.3 per cent in May, only marginally up from the previous month. The annual growth in broad money - as measured by M3 - rose to 1.6 per cent in May, from 1.3 per cent in April. The Governing Council today decided to keep the three key ECB interest rates unchanged. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a datadependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.
2024-07-18T00:00:00	Michelle W Bowman: Liquidity, supervision, and regulatory reform	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the research conference "Exploring Conventional Bank Funding Regimes in an Unconventional World", co-sponsored by the Federal Reserve Banks of Dallas and Atlanta, Dallas, Texas, 18 July 2024.	Michelle W Bowman: Liquidity, supervision, and regulatory reform Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the research conference "Exploring Conventional Bank Funding Regimes in an Unconventional World", co-sponsored by the Federal Reserve Banks of Dallas and Atlanta, Dallas, Texas , 18 July 2024. * * * Earlier this year, we passed the one-year anniversary of the failures of Silicon Valley Bank (SVB) and Signature Bank. The failure of these banks, and the subsequent failure of First Republic Bank, prompted a discussion of the regulatory framework. These failures have also frequently been cited as the basis for a number of matters on the current regulatory reform agenda. Over time, this agenda has expanded to include bank capital regulation, the role of supervision, the potential vulnerabilities to the banking system created by bank-fintech partnerships, and bank liquidity and funding, among other topics.1 This conference covers a number of important issues that touch on many aspects of this regulatory reform agenda. Earlier today, panelists discussed the 2023 regional banking stress, the history of financial crises, and deposit insurance reform. Tomorrow we will hear about the discount window and a discussion on the future of contingent liquidity. A further panel will consider what may be next in terms of regulatory reforms. In considering this last topic, conferences like this serve an important role-encouraging us to pause and reflect upon these efforts, and providing an opportunity to share thoughts in full public view about what is working and not working within the bank regulatory framework. These discussions also allow us to consider a range of options to both enhance banking system resiliency and to better prepare for future stress in the system. I am especially pleased that we have an opportunity to publicly confront difficult questions, like probing the link between last year's banking stress and elements of the reform agenda purportedly aimed at addressing identified deficiencies. As we think about reform of the bank regulatory framework, including changes designed to maintain a robust and responsive approach, what are the principles that should guide our thinking? What lessons should we take from past financial crises in terms of the causality and related bank management and supervisory lessons learned? Were those reforms responsive, successful, and durable over time? When we consider the Federal Reserve's operational infrastructure, including Fedwire® and discount window lending, were its tools effective and complementary to other funding sources (including Federal Home Loan Bank (FHLB) funding) during times of stress, and if not, how could they be improved? My hope is that in discussing these issues we can develop a better and deeper understanding about sources of bank funding, financial stability, and the future of the banking system. This complex set of issues can be open to interpretation, and as a result, can lead policymakers to different policy prescriptions for how to make the banking system more resilient, and the regulatory response to financial stress more effective. Conversations like those that we are having today and tomorrow can help us find consensus both in identifying the risks to the financial system and coming to agreement on policy reforms to address them, if needed. As the discussions continue following this conference, it is essential that we include the experience and perspective of state bank commissioners. I look forward to the opportunity to engage with them more fully on these issues. As a former bank commissioner, I greatly value this perspective. I am hopeful that all of these conversations can help us to understand differing perspectives and enable us to examine the full extent of the underlying issues before we implement reforms that do not address identified problems or do not adequately consider the underlying risks and unintended consequences. When I think about regulatory reform and the future of the banking system, I begin with the foundational elements that promote accountability in banking regulation: a deep understanding of the banking system; a thorough analysis of the underlying facts; a careful identification of how elements of the banking system interact and perform over time, especially during stress; and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. These same elements should be the foundational elements of any reform agenda. They should apply not just to changes that I will call "responsive" changes-those designed to mitigate the risks exposed during the spring 2023 banking stress-but also to any other contemplated reforms of the bank regulatory framework. If we approach this task with humility and with full accountability of unintended consequences, I expect that we will find opportunities in a number of areas. These involve not only imposing new requirements and expectations on individual banks, but also opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. Both approaches may be equally effective in enhancing the resilience of the banking system and promoting U.S. financial stability. In my remarks this evening, I will reflect on these elements, as I share my views on the Fed's lender of last resort function, payments infrastructure, supervision, and regulation. Lender of Last Resort and Payments Infrastructure As part of the reform agenda, we must consider how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. This must include ensuring the payments infrastructure that supports bank funding mechanisms is equipped to operate not just during business-as-usual conditions, but especially during stress events. Last year's banking stress clearly demonstrated the need for reforms and updates, but these issues existed long before the bank failures. Some banks encountered frictions in using the discount window that made it less effective, and these frictions potentially exacerbated the stress that some institutions experienced. Limits on the availability of payments services, including Fedwire, may also have interfered with the ability to effectively manage bank liquidity. These issues require a careful and impartial review to understand the facts, particularly if we base reform efforts on the recent events. Addressing operational readiness Maintenance of existing infrastructure is an often overlooked and sometimes thankless job. When the payments infrastructure works "well enough," as it seemed to do in the lead-up to the spring banking stress, it is easy to take for granted that it will work during times of stress. However, this is an area where we must become more vigilant and avoid complacency. We know that SVB experienced difficulties in accessing discount window loans before its failure. Certainly, there are ways in which the Fed can enhance the technology, the operational readiness, and the services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service (NSS), to 2 operate 22 hours per day, 7 days per week, on a year-round basis. The proposal also requested feedback on whether the discount window should operate during these same expanded hours. The comment period remains open on this proposal, but this seems like it would be a critical improvement, and one that would be responsive to identified shortcomings.3 Other changes are also needed to bring payment services and discount window lending into the 21st century, including modernizing the technology banks use to request loans electronically rather than relying upon a person to answer a telephone call, ensuring that collateral can move freely from the bank or FHLB to the Reserve Bank when needed, and identifying and reducing other areas of friction that banks experience in the use of the discount window. Operational improvements-including technology enhancements and investments-and improving operational readiness within the Federal Reserve System, should underpin any approach to improvements. Bank liquidity sources A critical component of the current reform agenda focuses on the ongoing evolution of bank funding and liquidity sources and mechanisms. Of course, any discussion about the discount window would be incomplete without considering these sources and mechanisms. The discount window is a critical tool, but it does not operate in isolation. It is also intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. While discount window lending can support bank liquidity, it is best thought of as an additional resource in the federal safety net that allows eligible institutions to weather disruptions in liquidity markets and access other resources. Banks have a range of options to manage liquidity needs during business-as-usual operations and during times of stress, including repo markets and FHLB advances. Within this framework, the discount window operates as a backup liquidity authority, a "last resort" for funding needs. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning.4 These resources are complementary, so they must be thought about holistically when discussing and seriously considering changes to requirements. Yet, discussions about reforms are often approached in a piecemeal way. Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window. The notion is that by forcing banks to preposition collateral in this way, banks will have a ready pool of liquidity to draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window, and thereby improve its effectiveness. So, we must also ask if the perceived stigma of taking loans from the discount window will be mitigated by requirements to preposition collateral. If the stigma of receiving a discount window loan continues to impede the effectiveness of the Fed serving as a lender of last resort, we must consider other ways to address these stigma concerns. There is no reason for a bank to take a loan at a penalty rate or preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it will not succeed. Investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of their contingency funding plans, could be explored more thoroughly. If a bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful. There are a number of reasons a bank could choose to borrow from the discount window, including market disruptions in liquidity access or a scarcity in the total amount of reserves in the banking system and a specific borrower's growing financial stress. To access primary discount window credit, a borrower must meet financial standards for borrowing. In some ways, these financial requirements to access primary credit suggest that an important "market signal" of discount window borrowing is related to a market liquidity disruption and may be less of a signal about any individual institution's financial condition. But discount window lending is an additional data point for the market and may be read as a sign of financial distress. This possible interpretation alone may be enough to deter usage of the discount window. As we consider the future of the discount window, we should explore ways to validate the use of discount window lending in our regulatory framework. For example, are there ways to better recognize discount window borrowing capacity in our assessment of a firm's liquidity resources, for example in calculating a firm's compliance with the Liquidity Coverage Ratio? As the resources available for bank funding continue to evolve, including the Federal Housing Finance Administration's (FHFA) active consideration of reforms to FHLB lending standards, we see direct impacts on access to liquidity. Even though the comment period for these changes just concluded on July 15, these significant shifts are already affecting how FHLB members will need to plan to use FHLB advances for liquidity funding. Making regulatory changes to liquidity requirements while the FHFA is shifting FHLB funding prioritization for its members leads to several questions that would need to be 5 answered before engaging in prudent policy-making. How would required collateral prepositioning at the discount window affect the availability or amount of FHLB advances that a bank can rely on for funding purposes? More broadly speaking, how will any requirement to preposition collateral at the discount window affect the availability and use of other funding resources or the day-to-day liquidity management practices of banks? A better approach would be to recognize and understand how the FHLBs support bank liquidity and work together with each FHLB through the Reserve Banks in advance of a bank stress to ensure that mechanisms are in place to facilitate the transfer of collateral to the discount window, and that the Reserve Banks have the appropriate seniority over such collateral. A practical and pragmatic approach will work to preserve the stability of the banking system much more effectively than disrupting the bank liquidity operations of the FHLB system that have been in place since the 1930s. When it comes to the next steps in liquidity reform, I think it is imperative that we tackle known and identified issues that were exposed during the banking stress in the spring of 2023. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. Reform of Supervision Banking regulators play a vital role in promoting the safe and sound operation of individual banks and the stability of the U.S. financial system. These statutory responsibilities require banking regulators to ensure that banks are held to high standards: bank regulators enforce regulation to promote safety and soundness, engage in periodic examinations of banks and their holding companies, and require periodic reporting by regulated institutions. When a bank fails to meet these high standards, supervisory action can be taken to force remediation or, in some cases, impose an enforcement action that includes a civil money penalty. Last year's banking stress highlighted the need for improvements in bank supervision, with several notable failures to identify and appropriately escalate issues during the examination process. Supervision that is not focused on core risks erodes the resiliency in the banking system. Bank failures and losses to the deposit insurance fund certainly demand attention, review, and accountability, but the underlying issues suggest we need to ensure that supervision works appropriately over time. Many of the reforms targeted in this conference address broader structural concernslike imposing sweeping new regulatory reforms, or broad changes to laws like those governing deposit insurance. I applaud the engagement on these issues, but often the most effective regulatory tool is supervision. Effective supervision requires transparency in expectations and an approach that incorporates remediating deficiencies as a part of meeting those expectations. Many of the risks identified during last year's banking stress did not involve novel or unique risks. Addressing concentration risk, interest rate risk, and liquidity risk are all key risks that have long been elements deemed critical for effective supervision in bank examinations. These risks are known to create significant vulnerabilities and can be fatal to individual institutions if not managed appropriately over time. It is clear in the case of SVB that these risks were not managed appropriately. Bank regulators and supervisors also failed to sufficiently identify and prioritize the appropriate risks. Instead, the focus was on broader, qualitative, and process- and policy-oriented risks. Ultimately, both the bank's management and examiners failed to appropriately emphasize these key issues. An important step in the reform agenda-and one of the most effective reforms to build resilience against future banking stress-is to improve the prioritization of safety and soundness in the examination process, ensuring a careful focus on core financial risks. In my mind, successful prioritization involves increased transparency of expectations and a renewed focus on core financial risks. This includes avoiding issues that are only tangential to statutory mandates and critical areas of responsibility. Where necessary, it also includes adopting a more proactive approach for bank management and bank supervisors to deal with identified risks. Our goal must be to avoid straying from these core issues to focus on less foundational and less pressing areas. There have been some notable examples of regulatory mission creep, including the 6 climate guidance introduced last year by the banking agencies. I have no doubt that this guidance is well-intended, and that climate change is an important public policy issue. But the question should be whether banks should be required to divert limited risk management resources away from critical, near-term risk management, with a parallel shift in focus by bank examiners. Looking at this guidance through the lens of prioritization, one could reasonably conclude that climate change is not currently a financial risk to the banking system and does not justify a shift in prioritization. While some may view this position as provocative, my goal is to demonstrate a more foundational point-mis-prioritizing supervisory objectives will have consequences, making banks riskier and the U.S. financial system less resilient over time. Regulatory Reform When it comes to regulatory reform efforts, we should acknowledge, as a starting point, that the bank regulatory system has undergone significant transformation since the passage of the Dodd-Frank Act, in response to the 2008 financial crisis. This has resulted in significantly increased liquidity and bank capital, new stress testing and resolution planning requirements, and several other improvements designed to promote bank resiliency. Not only the quantum, but the quality, of bank capital has also improved. Common equity tier 1 capital is now codified as the highest quality form of regulatory capital and is included within a capital framework that already includes gold plating over international capital standards. Measured against this baseline of resiliency, we need to carefully assess the need for regulatory improvements, while maintaining those elements of the bank regulatory framework that have proven durable and successful over time. I have not previously argued nor am I arguing today that the regulatory framework is perfect and beyond reproach. Or that there is no room for improvement or evolution over time. Where we find opportunities for needed improvements-either to maintain the system's effectiveness or respond to identified weaknesses-we should make those changes. But these changes should be motivated by a clear-eyed assessment of the facts, if the goal is to achieve changes that are focused, efficient, and durable over the long run. Before proposing regulatory reform measures to remediate or address issues identified during the spring 2023 banking stress, we should first reflect on the causes that contributed to the failures of SVB and Signature Bank. These bank failures were followed by government intervention in the form of a guarantee on uninsured deposits at these institutions, and the creation of a broad-based emergency lending facility-the Bank Term Funding Program-designed to reassure the market about the underlying strength of the U.S. banking system. Other characteristics of these bank failures-the rapid pace of depositors withdrawing uninsured deposits-appeared to deviate from the patterns seen in prior bank failures (in degree, if not in kind). But many of the core problems of these banks stemmed from well-known, core banking risks-interest rate risk, liquidity risk, and poor risk management. Each of these can be addressed effectively and efficiently through targeted improvements to the supervisory process. Supplementary leverage ratio Our current narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework or context within which these rules exist-has created a corresponding narrowness when we think about the consequences of regulatory reform. An efficient regulatory system can build resilience both for bank safety and soundness and financial stability. Take for example missed opportunities in capital reform. The current set of capital reform proposals does not address or propose changes to leverage requirements, including the 5 percent leverage ratio that applies to U.S. global systemically important banks, commonly referred to as the enhanced supplementary leverage ratio (or eSLR). Treasury market intermediation can be disrupted by constraints imposed by the eSLR, as occurred during the early days of market stress during the pandemic. It seems prudent to address this known leverage rule constraint before future stresses emerge that would likely disrupt market functioning. This narrow focus ignores that many requirements are intended to operate in a complementary way, and that these requirements in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital 7 requirements. And yet, the discussions of costs and benefits of reform tend to disregard the aggregate impact across rules, even when related reforms are proposed at the same time and the aggregate impacts can be identified and assessed.8 When policymakers publicly discuss changes to liquidity and capital, industry participants will modify their behavior in part to meet anticipated regulatory requirements, despite the regulatory uncertainty that accompanies reform efforts. While this response by banks is unfortunate, it is also predictable. Regulatory process My remarks this evening have primarily focused on the substance of reforms and the importance of demonstrating a case to support the changes. But it is also necessary to pause and reflect on the importance of following established process and procedure. This is especially important as we think about the choice between making policy reforms through supervision or regulation. Passing regulations under the Administrative Procedure Act requires agencies to follow specific notice-and-comment rulemaking procedures. I think we should approach this process through the most stringent and conservative lens, particularly when it comes to some of the most consequential rulemakings of the last decade. Rulemaking entails publishing rationales for agency action and seeking public input. These procedural requirements serve an important purpose and ultimately promote better agency decisionmaking. One of the most effective tools we have for doing so is the use of public Board meetings to address matters of significant public interest. My hope is that material items on the reform agenda will continue to be handled through public meetings that give greater visibility and insight into the thinking and rationales of different policymakers. Closing Thoughts I will conclude today's remarks by thanking all of our participants for joining us in Dallas and contributing to these important discussions. The elements that facilitate accountability parallel those elements necessary for effective reform-a deep understanding of facts, a careful identification of how elements of the banking system perform over time and during stress, and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. As we engage in a review of our regulatory framework for liquidity and more broadly, these elements should serve as a guide to understanding the past and help us chart a path forward. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 Federal Reserve System, Request for Comment, "Expansion of Fedwire® Funds Service and National Settlement Service Operating Hours," 89 Fed. Reg. 39,613 (May 9, 2024). 3 The comment period on this proposal has been extended until September 6, 2024. Federal Reserve System, Request for comment; extension of comment period, " Expanded Hours for Fedwire® Funds Service and National Settlement Service (PDF)" (June 21, 2024). 4 Michelle W. Bowman, "Bank Liquidity, Regulation, and the Fed's Role as Lender of Last Resort" (speech at The Roundtable on the Lender of Last Resort: The 2023 Banking Crisis and COVID, sponsored by the Committee on Capital Markets Regulation, Washington, D.C., April 3, 2024). 5 The Federal Housing Finance Administration (FHFA) published a request for input on the core mission activities and mission achievement of the FHLBs. As noted in the request, the FHFA had previously found in the FHLBank System at 100: Focusing on the Future report that FHLBs should increase their support for housing and community development. See FHFA, "Request for Input: Federal Home Loan Bank Core Mission Activities and Mission Achievement (PDF)" (May 16, 2024). The comment period on this request for information closed on July 15, 2024. 6 Principles for Climate-Related Financial Risk Management for Large Financial Institutions, 88 Fed. Reg. 74,183 (October 30, 2023). 7 See, e.g., Board of Governors of the Federal Reserve System, Interim Final Rule and Request for Comment, "Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio (PDF)," 85 Fed. Reg. 20,578, 20,579 (April 14, 2020) ("This interim final rule does not affect the tier 1 leverage ratio, which will continue to serve as a backstop for all banking organizations subject to the capital rule."). 8 See, e.g., Office of the Comptroller of the Currency(OCC), Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation (FDIC), Notice of Proposed Rulemaking, "Long-Term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions (PDF)," 88 Fed. Reg. 64,524, 64,551, n. 97 ("The agencies recognize that their Basel III reforms proposal would, if adopted, increase risk-weighted assets across covered entities. The increased riskweighted assets would lead mechanically to increased requirements for LTD under the LTD proposal. The increased capital that would be required under the Basel III proposal could also reduce the cost of various forms of debt for impacted firms due to the increased resilience that accompanies additional capital (which is sometimes referred to as the Modigliani-Miller offset). The size of the estimated LTD needs and costs presented in this section do not account for either of these potential effects of the Basel III proposal."). Even when the agencies estimate the effect of a proposal on other rules, the impact analysis tends to be narrow, such as focusing on the estimated shortfall that would be created by the interrelated rules and may overlook other pending rules. See, e. g., OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. at 64,171 (Noting that the proposed revisions to the calculation of risk-weighted assets under the Basel III endgame proposal would affect the risk-based total loss-absorbing capacity and long-term debt requirements applicable to Category I bank holding companies but disregarding the pending proposal that would expand long-term debt requirements to a broader set of firms).	---[PAGE_BREAK]--- # Michelle W Bowman: Liquidity, supervision, and regulatory reform Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the research conference "Exploring Conventional Bank Funding Regimes in an Unconventional World", co-sponsored by the Federal Reserve Banks of Dallas and Atlanta, Dallas, Texas, 18 July 2024. Earlier this year, we passed the one-year anniversary of the failures of Silicon Valley Bank (SVB) and Signature Bank. The failure of these banks, and the subsequent failure of First Republic Bank, prompted a discussion of the regulatory framework. These failures have also frequently been cited as the basis for a number of matters on the current regulatory reform agenda. Over time, this agenda has expanded to include bank capital regulation, the role of supervision, the potential vulnerabilities to the banking system created by bank-fintech partnerships, and bank liquidity and funding, among other topics. ${ }^{1}$ This conference covers a number of important issues that touch on many aspects of this regulatory reform agenda. Earlier today, panelists discussed the 2023 regional banking stress, the history of financial crises, and deposit insurance reform. Tomorrow we will hear about the discount window and a discussion on the future of contingent liquidity. A further panel will consider what may be next in terms of regulatory reforms. In considering this last topic, conferences like this serve an important role-encouraging us to pause and reflect upon these efforts, and providing an opportunity to share thoughts in full public view about what is working and not working within the bank regulatory framework. These discussions also allow us to consider a range of options to both enhance banking system resiliency and to better prepare for future stress in the system. I am especially pleased that we have an opportunity to publicly confront difficult questions, like probing the link between last year's banking stress and elements of the reform agenda purportedly aimed at addressing identified deficiencies. As we think about reform of the bank regulatory framework, including changes designed to maintain a robust and responsive approach, what are the principles that should guide our thinking? What lessons should we take from past financial crises in terms of the causality and related bank management and supervisory lessons learned? Were those reforms responsive, successful, and durable over time? When we consider the Federal Reserve's operational infrastructure, including Fedwire ${ }^{\circledR}$ and discount window lending, were its tools effective and complementary to other funding sources (including Federal Home Loan Bank (FHLB) funding) during times of stress, and if not, how could they be improved? My hope is that in discussing these issues we can develop a better and deeper understanding about sources of bank funding, financial stability, and the future of the banking system. This complex set of issues can be open to interpretation, and as a result, can lead policymakers to different policy prescriptions for how to make the banking system more resilient, and the regulatory response to financial stress more effective. ---[PAGE_BREAK]--- Conversations like those that we are having today and tomorrow can help us find consensus both in identifying the risks to the financial system and coming to agreement on policy reforms to address them, if needed. As the discussions continue following this conference, it is essential that we include the experience and perspective of state bank commissioners. I look forward to the opportunity to engage with them more fully on these issues. As a former bank commissioner, I greatly value this perspective. I am hopeful that all of these conversations can help us to understand differing perspectives and enable us to examine the full extent of the underlying issues before we implement reforms that do not address identified problems or do not adequately consider the underlying risks and unintended consequences. When I think about regulatory reform and the future of the banking system, I begin with the foundational elements that promote accountability in banking regulation: a deep understanding of the banking system; a thorough analysis of the underlying facts; a careful identification of how elements of the banking system interact and perform over time, especially during stress; and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. These same elements should be the foundational elements of any reform agenda. They should apply not just to changes that I will call "responsive" changes-those designed to mitigate the risks exposed during the spring 2023 banking stress-but also to any other contemplated reforms of the bank regulatory framework. If we approach this task with humility and with full accountability of unintended consequences, I expect that we will find opportunities in a number of areas. These involve not only imposing new requirements and expectations on individual banks, but also opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. Both approaches may be equally effective in enhancing the resilience of the banking system and promoting U.S. financial stability. In my remarks this evening, I will reflect on these elements, as I share my views on the Fed's lender of last resort function, payments infrastructure, supervision, and regulation. # Lender of Last Resort and Payments Infrastructure As part of the reform agenda, we must consider how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. This must include ensuring the payments infrastructure that supports bank funding mechanisms is equipped to operate not just during business-as-usual conditions, but especially during stress events. Last year's banking stress clearly demonstrated the need for reforms and updates, but these issues existed long before the bank failures. Some banks encountered frictions in using the discount window that made it less effective, and these frictions potentially exacerbated the stress that some institutions experienced. Limits on the availability of payments services, including Fedwire, may also have interfered with the ability to effectively manage bank liquidity. These issues require a careful and impartial review to understand the facts, particularly if we base reform efforts on the recent events. Addressing operational readiness Maintenance of existing infrastructure is an often overlooked and sometimes thankless ---[PAGE_BREAK]--- job. When the payments infrastructure works "well enough," as it seemed to do in the lead-up to the spring banking stress, it is easy to take for granted that it will work during times of stress. However, this is an area where we must become more vigilant and avoid complacency. We know that SVB experienced difficulties in accessing discount window loans before its failure. Certainly, there are ways in which the Fed can enhance the technology, the operational readiness, and the services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service (NSS), to operate 22 hours per day, 7 days per week, on a year-round basis. ${ }^{2}$ The proposal also requested feedback on whether the discount window should operate during these same expanded hours. The comment period remains open on this proposal, but this seems like it would be a critical improvement, and one that would be responsive to identified shortcomings. ${ }^{3}$ Other changes are also needed to bring payment services and discount window lending into the 21st century, including modernizing the technology banks use to request loans electronically rather than relying upon a person to answer a telephone call, ensuring that collateral can move freely from the bank or FHLB to the Reserve Bank when needed, and identifying and reducing other areas of friction that banks experience in the use of the discount window. Operational improvements-including technology enhancements and investments-and improving operational readiness within the Federal Reserve System, should underpin any approach to improvements. # Bank liquidity sources A critical component of the current reform agenda focuses on the ongoing evolution of bank funding and liquidity sources and mechanisms. Of course, any discussion about the discount window would be incomplete without considering these sources and mechanisms. The discount window is a critical tool, but it does not operate in isolation. It is also intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. While discount window lending can support bank liquidity, it is best thought of as an additional resource in the federal safety net that allows eligible institutions to weather disruptions in liquidity markets and access other resources. Banks have a range of options to manage liquidity needs during business-as-usual operations and during times of stress, including repo markets and FHLB advances. Within this framework, the discount window operates as a backup liquidity authority, a "last resort" for funding needs. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning. 4 These resources are complementary, so they must be thought about holistically when discussing and seriously considering changes to requirements. Yet, discussions about reforms are often approached in a piecemeal way. Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window. The ---[PAGE_BREAK]--- notion is that by forcing banks to preposition collateral in this way, banks will have a ready pool of liquidity to draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window, and thereby improve its effectiveness. So, we must also ask if the perceived stigma of taking loans from the discount window will be mitigated by requirements to preposition collateral. If the stigma of receiving a discount window loan continues to impede the effectiveness of the Fed serving as a lender of last resort, we must consider other ways to address these stigma concerns. There is no reason for a bank to take a loan at a penalty rate or preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it will not succeed. Investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of their contingency funding plans, could be explored more thoroughly. If a bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful. There are a number of reasons a bank could choose to borrow from the discount window, including market disruptions in liquidity access or a scarcity in the total amount of reserves in the banking system and a specific borrower's growing financial stress. To access primary discount window credit, a borrower must meet financial standards for borrowing. In some ways, these financial requirements to access primary credit suggest that an important "market signal" of discount window borrowing is related to a market liquidity disruption and may be less of a signal about any individual institution's financial condition. But discount window lending is an additional data point for the market and may be read as a sign of financial distress. This possible interpretation alone may be enough to deter usage of the discount window. As we consider the future of the discount window, we should explore ways to validate the use of discount window lending in our regulatory framework. For example, are there ways to better recognize discount window borrowing capacity in our assessment of a firm's liquidity resources, for example in calculating a firm's compliance with the Liquidity Coverage Ratio? As the resources available for bank funding continue to evolve, including the Federal Housing Finance Administration's (FHFA) active consideration of reforms to FHLB lending standards, we see direct impacts on access to liquidity. Even though the comment period for these changes just concluded on July 15, these significant shifts are already affecting how FHLB members will need to plan to use FHLB advances for liquidity funding. Making regulatory changes to liquidity requirements while the FHFA is shifting FHLB funding prioritization for its members leads to several questions that would need to be answered before engaging in prudent policy-making. ${ }^{5}$ How would required collateral prepositioning at the discount window affect the availability or amount of FHLB ---[PAGE_BREAK]--- advances that a bank can rely on for funding purposes? More broadly speaking, how will any requirement to preposition collateral at the discount window affect the availability and use of other funding resources or the day-to-day liquidity management practices of banks? A better approach would be to recognize and understand how the FHLBs support bank liquidity and work together with each FHLB through the Reserve Banks in advance of a bank stress to ensure that mechanisms are in place to facilitate the transfer of collateral to the discount window, and that the Reserve Banks have the appropriate seniority over such collateral. A practical and pragmatic approach will work to preserve the stability of the banking system much more effectively than disrupting the bank liquidity operations of the FHLB system that have been in place since the 1930s. When it comes to the next steps in liquidity reform, I think it is imperative that we tackle known and identified issues that were exposed during the banking stress in the spring of 2023. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. # Reform of Supervision Banking regulators play a vital role in promoting the safe and sound operation of individual banks and the stability of the U.S. financial system. These statutory responsibilities require banking regulators to ensure that banks are held to high standards: bank regulators enforce regulation to promote safety and soundness, engage in periodic examinations of banks and their holding companies, and require periodic reporting by regulated institutions. When a bank fails to meet these high standards, supervisory action can be taken to force remediation or, in some cases, impose an enforcement action that includes a civil money penalty. Last year's banking stress highlighted the need for improvements in bank supervision, with several notable failures to identify and appropriately escalate issues during the examination process. Supervision that is not focused on core risks erodes the resiliency in the banking system. Bank failures and losses to the deposit insurance fund certainly demand attention, review, and accountability, but the underlying issues suggest we need to ensure that supervision works appropriately over time. Many of the reforms targeted in this conference address broader structural concernslike imposing sweeping new regulatory reforms, or broad changes to laws like those governing deposit insurance. I applaud the engagement on these issues, but often the most effective regulatory tool is supervision. Effective supervision requires transparency in expectations and an approach that incorporates remediating deficiencies as a part of meeting those expectations. Many of the risks identified during last year's banking stress did not involve novel or unique risks. Addressing concentration risk, interest rate risk, and liquidity risk are all key risks that have long been elements deemed critical for effective supervision in bank examinations. These risks are known to create significant vulnerabilities and can be fatal to individual institutions if not managed appropriately over time. ---[PAGE_BREAK]--- It is clear in the case of SVB that these risks were not managed appropriately. Bank regulators and supervisors also failed to sufficiently identify and prioritize the appropriate risks. Instead, the focus was on broader, qualitative, and process- and policy-oriented risks. Ultimately, both the bank's management and examiners failed to appropriately emphasize these key issues. An important step in the reform agenda-and one of the most effective reforms to build resilience against future banking stress-is to improve the prioritization of safety and soundness in the examination process, ensuring a careful focus on core financial risks. In my mind, successful prioritization involves increased transparency of expectations and a renewed focus on core financial risks. This includes avoiding issues that are only tangential to statutory mandates and critical areas of responsibility. Where necessary, it also includes adopting a more proactive approach for bank management and bank supervisors to deal with identified risks. Our goal must be to avoid straying from these core issues to focus on less foundational and less pressing areas. There have been some notable examples of regulatory mission creep, including the climate guidance introduced last year by the banking agencies. ${ }^{6}$ I have no doubt that this guidance is well-intended, and that climate change is an important public policy issue. But the question should be whether banks should be required to divert limited risk management resources away from critical, near-term risk management, with a parallel shift in focus by bank examiners. Looking at this guidance through the lens of prioritization, one could reasonably conclude that climate change is not currently a financial risk to the banking system and does not justify a shift in prioritization. While some may view this position as provocative, my goal is to demonstrate a more foundational point-mis-prioritizing supervisory objectives will have consequences, making banks riskier and the U.S. financial system less resilient over time. # Regulatory Reform When it comes to regulatory reform efforts, we should acknowledge, as a starting point, that the bank regulatory system has undergone significant transformation since the passage of the Dodd-Frank Act, in response to the 2008 financial crisis. This has resulted in significantly increased liquidity and bank capital, new stress testing and resolution planning requirements, and several other improvements designed to promote bank resiliency. Not only the quantum, but the quality, of bank capital has also improved. Common equity tier 1 capital is now codified as the highest quality form of regulatory capital and is included within a capital framework that already includes goldplating over international capital standards. Measured against this baseline of resiliency, we need to carefully assess the need for regulatory improvements, while maintaining those elements of the bank regulatory framework that have proven durable and successful over time. I have not previously argued nor am I arguing today that the regulatory framework is perfect and beyond reproach. Or that there is no room for improvement or evolution over time. Where we find opportunities for needed improvements-either to maintain the system's ---[PAGE_BREAK]--- effectiveness or respond to identified weaknesses-we should make those changes. But these changes should be motivated by a clear-eyed assessment of the facts, if the goal is to achieve changes that are focused, efficient, and durable over the long run. Before proposing regulatory reform measures to remediate or address issues identified during the spring 2023 banking stress, we should first reflect on the causes that contributed to the failures of SVB and Signature Bank. These bank failures were followed by government intervention in the form of a guarantee on uninsured deposits at these institutions, and the creation of a broad-based emergency lending facility-the Bank Term Funding Program-designed to reassure the market about the underlying strength of the U.S. banking system. Other characteristics of these bank failures-the rapid pace of depositors withdrawing uninsured deposits-appeared to deviate from the patterns seen in prior bank failures (in degree, if not in kind). But many of the core problems of these banks stemmed from well-known, core banking risks-interest rate risk, liquidity risk, and poor risk management. Each of these can be addressed effectively and efficiently through targeted improvements to the supervisory process. # Supplementary leverage ratio Our current narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework or context within which these rules exist-has created a corresponding narrowness when we think about the consequences of regulatory reform. An efficient regulatory system can build resilience both for bank safety and soundness and financial stability. Take for example missed opportunities in capital reform. The current set of capital reform proposals does not address or propose changes to leverage requirements, including the 5 percent leverage ratio that applies to U.S. global systemically important banks, commonly referred to as the enhanced supplementary leverage ratio (or eSLR). Treasury market intermediation can be disrupted by constraints imposed by the eSLR, as occurred during the early days of market stress during the pandemic. It seems prudent to address this known leverage rule constraint before future stresses emerge that would likely disrupt market functioning. This narrow focus ignores that many requirements are intended to operate in a complementary way, and that these requirements in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital requirements. ${ }^{7}$ And yet, the discussions of costs and benefits of reform tend to disregard the aggregate impact across rules, even when related reforms are proposed at the same time and the aggregate impacts can be identified and assessed. $\underline{8}$ When policymakers publicly discuss changes to liquidity and capital, industry participants will modify their behavior in part to meet anticipated regulatory requirements, despite the regulatory uncertainty that accompanies reform efforts. While this response by banks is unfortunate, it is also predictable. ## Regulatory process My remarks this evening have primarily focused on the substance of reforms and the ---[PAGE_BREAK]--- importance of demonstrating a case to support the changes. But it is also necessary to pause and reflect on the importance of following established process and procedure. This is especially important as we think about the choice between making policy reforms through supervision or regulation. Passing regulations under the Administrative Procedure Act requires agencies to follow specific notice-and-comment rulemaking procedures. I think we should approach this process through the most stringent and conservative lens, particularly when it comes to some of the most consequential rulemakings of the last decade. Rulemaking entails publishing rationales for agency action and seeking public input. These procedural requirements serve an important purpose and ultimately promote better agency decisionmaking. One of the most effective tools we have for doing so is the use of public Board meetings to address matters of significant public interest. My hope is that material items on the reform agenda will continue to be handled through public meetings that give greater visibility and insight into the thinking and rationales of different policymakers. # Closing Thoughts I will conclude today's remarks by thanking all of our participants for joining us in Dallas and contributing to these important discussions. The elements that facilitate accountability parallel those elements necessary for effective reform-a deep understanding of facts, a careful identification of how elements of the banking system perform over time and during stress, and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. As we engage in a review of our regulatory framework for liquidity and more broadly, these elements should serve as a guide to understanding the past and help us chart a path forward. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ Federal Reserve System, Request for Comment, "Expansion of Fedwire® Funds Service and National Settlement Service Operating Hours," 89 Fed. Reg. 39,613 (May 9, 2024). ${ }^{3}$ The comment period on this proposal has been extended until September 6, 2024. Federal Reserve System, Request for comment; extension of comment period, " Expanded Hours for Fedwire® Funds Service and National Settlement Service (PDF)" (June 21, 2024). ${ }^{4}$ Michelle W. Bowman, "Bank Liquidity, Regulation, and the Fed's Role as Lender of Last Resort" (speech at The Roundtable on the Lender of Last Resort: The 2023 Banking Crisis and COVID, sponsored by the Committee on Capital Markets Regulation, Washington, D.C., April 3, 2024). ${ }^{5}$ The Federal Housing Finance Administration (FHFA) published a request for input on the core mission activities and mission achievement of the FHLBs. As noted in the request, the FHFA had previously found in the FHLBank System at 100: Focusing on the Future report that FHLBs should increase their support for housing and community ---[PAGE_BREAK]--- development. See FHFA, "Request for Input: Federal Home Loan Bank Core Mission Activities and Mission Achievement (PDF)" (May 16, 2024). The comment period on this request for information closed on July 15, 2024. ${ }^{6}$ Principles for Climate-Related Financial Risk Management for Large Financial Institutions, 88 Fed. Reg. 74,183 (October 30, 2023). ${ }^{7}$ See, e.g., Board of Governors of the Federal Reserve System, Interim Final Rule and Request for Comment, "Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio (PDF)," 85 Fed. Reg. 20,578, 20,579 (April 14, 2020) ("This interim final rule does not affect the tier 1 leverage ratio, which will continue to serve as a backstop for all banking organizations subject to the capital rule."). ${ }^{8}$ See, e.g., Office of the Comptroller of the Currency(OCC), Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation (FDIC), Notice of Proposed Rulemaking, "Long-Term Debt Requirements for Large Bank Holding. Companies, Certain Intermediate Holding Companies of Foreign Banking. Organizations, and Large Insured Depository Institutions (PDF)," 88 Fed. Reg. 64,524, 64,551, n. 97 ("The agencies recognize that their Basel III reforms proposal would, if adopted, increase risk-weighted assets across covered entities. The increased riskweighted assets would lead mechanically to increased requirements for LTD under the LTD proposal. The increased capital that would be required under the Basel III proposal could also reduce the cost of various forms of debt for impacted firms due to the increased resilience that accompanies additional capital (which is sometimes referred to as the Modigliani-Miller offset). The size of the estimated LTD needs and costs presented in this section do not account for either of these potential effects of the Basel III proposal."). Even when the agencies estimate the effect of a proposal on other rules, the impact analysis tends to be narrow, such as focusing on the estimated shortfall that would be created by the interrelated rules and may overlook other pending rules. See, e. g., OCC, Board of Governors of the Federal Reserve System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. at 64,171 (Noting that the proposed revisions to the calculation of risk-weighted assets under the Basel III endgame proposal would affect the risk-based total loss-absorbing capacity and long-term debt requirements applicable to Category I bank holding companies but disregarding the pending proposal that would expand long-term debt requirements to a broader set of firms).	Michelle W Bowman	United States	https://www.bis.org/review/r240722b.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the research conference "Exploring Conventional Bank Funding Regimes in an Unconventional World", co-sponsored by the Federal Reserve Banks of Dallas and Atlanta, Dallas, Texas, 18 July 2024. Earlier this year, we passed the one-year anniversary of the failures of Silicon Valley Bank (SVB) and Signature Bank. The failure of these banks, and the subsequent failure of First Republic Bank, prompted a discussion of the regulatory framework. These failures have also frequently been cited as the basis for a number of matters on the current regulatory reform agenda. Over time, this agenda has expanded to include bank capital regulation, the role of supervision, the potential vulnerabilities to the banking system created by bank-fintech partnerships, and bank liquidity and funding, among other topics. This conference covers a number of important issues that touch on many aspects of this regulatory reform agenda. Earlier today, panelists discussed the 2023 regional banking stress, the history of financial crises, and deposit insurance reform. Tomorrow we will hear about the discount window and a discussion on the future of contingent liquidity. A further panel will consider what may be next in terms of regulatory reforms. In considering this last topic, conferences like this serve an important role-encouraging us to pause and reflect upon these efforts, and providing an opportunity to share thoughts in full public view about what is working and not working within the bank regulatory framework. These discussions also allow us to consider a range of options to both enhance banking system resiliency and to better prepare for future stress in the system. I am especially pleased that we have an opportunity to publicly confront difficult questions, like probing the link between last year's banking stress and elements of the reform agenda purportedly aimed at addressing identified deficiencies. As we think about reform of the bank regulatory framework, including changes designed to maintain a robust and responsive approach, what are the principles that should guide our thinking? What lessons should we take from past financial crises in terms of the causality and related bank management and supervisory lessons learned? Were those reforms responsive, successful, and durable over time? When we consider the Federal Reserve's operational infrastructure, including Fedwire and discount window lending, were its tools effective and complementary to other funding sources (including Federal Home Loan Bank (FHLB) funding) during times of stress, and if not, how could they be improved? My hope is that in discussing these issues we can develop a better and deeper understanding about sources of bank funding, financial stability, and the future of the banking system. This complex set of issues can be open to interpretation, and as a result, can lead policymakers to different policy prescriptions for how to make the banking system more resilient, and the regulatory response to financial stress more effective. Conversations like those that we are having today and tomorrow can help us find consensus both in identifying the risks to the financial system and coming to agreement on policy reforms to address them, if needed. As the discussions continue following this conference, it is essential that we include the experience and perspective of state bank commissioners. I look forward to the opportunity to engage with them more fully on these issues. As a former bank commissioner, I greatly value this perspective. I am hopeful that all of these conversations can help us to understand differing perspectives and enable us to examine the full extent of the underlying issues before we implement reforms that do not address identified problems or do not adequately consider the underlying risks and unintended consequences. When I think about regulatory reform and the future of the banking system, I begin with the foundational elements that promote accountability in banking regulation: a deep understanding of the banking system; a thorough analysis of the underlying facts; a careful identification of how elements of the banking system interact and perform over time, especially during stress; and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. These same elements should be the foundational elements of any reform agenda. They should apply not just to changes that I will call "responsive" changes-those designed to mitigate the risks exposed during the spring 2023 banking stress-but also to any other contemplated reforms of the bank regulatory framework. If we approach this task with humility and with full accountability of unintended consequences, I expect that we will find opportunities in a number of areas. These involve not only imposing new requirements and expectations on individual banks, but also opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. Both approaches may be equally effective in enhancing the resilience of the banking system and promoting U.S. financial stability. In my remarks this evening, I will reflect on these elements, as I share my views on the Fed's lender of last resort function, payments infrastructure, supervision, and regulation. As part of the reform agenda, we must consider how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. This must include ensuring the payments infrastructure that supports bank funding mechanisms is equipped to operate not just during business-as-usual conditions, but especially during stress events. Last year's banking stress clearly demonstrated the need for reforms and updates, but these issues existed long before the bank failures. Some banks encountered frictions in using the discount window that made it less effective, and these frictions potentially exacerbated the stress that some institutions experienced. Limits on the availability of payments services, including Fedwire, may also have interfered with the ability to effectively manage bank liquidity. These issues require a careful and impartial review to understand the facts, particularly if we base reform efforts on the recent events. Addressing operational readiness Maintenance of existing infrastructure is an often overlooked and sometimes thankless job. When the payments infrastructure works "well enough," as it seemed to do in the lead-up to the spring banking stress, it is easy to take for granted that it will work during times of stress. However, this is an area where we must become more vigilant and avoid complacency. We know that SVB experienced difficulties in accessing discount window loans before its failure. Certainly, there are ways in which the Fed can enhance the technology, the operational readiness, and the services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service (NSS), to operate 22 hours per day, 7 days per week, on a year-round basis. Other changes are also needed to bring payment services and discount window lending into the 21st century, including modernizing the technology banks use to request loans electronically rather than relying upon a person to answer a telephone call, ensuring that collateral can move freely from the bank or FHLB to the Reserve Bank when needed, and identifying and reducing other areas of friction that banks experience in the use of the discount window. Operational improvements-including technology enhancements and investments-and improving operational readiness within the Federal Reserve System, should underpin any approach to improvements. A critical component of the current reform agenda focuses on the ongoing evolution of bank funding and liquidity sources and mechanisms. Of course, any discussion about the discount window would be incomplete without considering these sources and mechanisms. The discount window is a critical tool, but it does not operate in isolation. It is also intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. While discount window lending can support bank liquidity, it is best thought of as an additional resource in the federal safety net that allows eligible institutions to weather disruptions in liquidity markets and access other resources. Banks have a range of options to manage liquidity needs during business-as-usual operations and during times of stress, including repo markets and FHLB advances. Within this framework, the discount window operates as a backup liquidity authority, a "last resort" for funding needs. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning. These resources are complementary, so they must be thought about holistically when discussing and seriously considering changes to requirements. Yet, discussions about reforms are often approached in a piecemeal way. Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window. The notion is that by forcing banks to preposition collateral in this way, banks will have a ready pool of liquidity to draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window, and thereby improve its effectiveness. So, we must also ask if the perceived stigma of taking loans from the discount window will be mitigated by requirements to preposition collateral. If the stigma of receiving a discount window loan continues to impede the effectiveness of the Fed serving as a lender of last resort, we must consider other ways to address these stigma concerns. There is no reason for a bank to take a loan at a penalty rate or preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it will not succeed. Investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of their contingency funding plans, could be explored more thoroughly. If a bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful. There are a number of reasons a bank could choose to borrow from the discount window, including market disruptions in liquidity access or a scarcity in the total amount of reserves in the banking system and a specific borrower's growing financial stress. To access primary discount window credit, a borrower must meet financial standards for borrowing. In some ways, these financial requirements to access primary credit suggest that an important "market signal" of discount window borrowing is related to a market liquidity disruption and may be less of a signal about any individual institution's financial condition. But discount window lending is an additional data point for the market and may be read as a sign of financial distress. This possible interpretation alone may be enough to deter usage of the discount window. As we consider the future of the discount window, we should explore ways to validate the use of discount window lending in our regulatory framework. For example, are there ways to better recognize discount window borrowing capacity in our assessment of a firm's liquidity resources, for example in calculating a firm's compliance with the Liquidity Coverage Ratio? As the resources available for bank funding continue to evolve, including the Federal Housing Finance Administration's (FHFA) active consideration of reforms to FHLB lending standards, we see direct impacts on access to liquidity. Even though the comment period for these changes just concluded on July 15, these significant shifts are already affecting how FHLB members will need to plan to use FHLB advances for liquidity funding. Making regulatory changes to liquidity requirements while the FHFA is shifting FHLB funding prioritization for its members leads to several questions that would need to be answered before engaging in prudent policy-making. How would required collateral prepositioning at the discount window affect the availability or amount of FHLB advances that a bank can rely on for funding purposes? More broadly speaking, how will any requirement to preposition collateral at the discount window affect the availability and use of other funding resources or the day-to-day liquidity management practices of banks? A better approach would be to recognize and understand how the FHLBs support bank liquidity and work together with each FHLB through the Reserve Banks in advance of a bank stress to ensure that mechanisms are in place to facilitate the transfer of collateral to the discount window, and that the Reserve Banks have the appropriate seniority over such collateral. A practical and pragmatic approach will work to preserve the stability of the banking system much more effectively than disrupting the bank liquidity operations of the FHLB system that have been in place since the 1930s. When it comes to the next steps in liquidity reform, I think it is imperative that we tackle known and identified issues that were exposed during the banking stress in the spring of 2023. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. Banking regulators play a vital role in promoting the safe and sound operation of individual banks and the stability of the U.S. financial system. These statutory responsibilities require banking regulators to ensure that banks are held to high standards: bank regulators enforce regulation to promote safety and soundness, engage in periodic examinations of banks and their holding companies, and require periodic reporting by regulated institutions. When a bank fails to meet these high standards, supervisory action can be taken to force remediation or, in some cases, impose an enforcement action that includes a civil money penalty. Last year's banking stress highlighted the need for improvements in bank supervision, with several notable failures to identify and appropriately escalate issues during the examination process. Supervision that is not focused on core risks erodes the resiliency in the banking system. Bank failures and losses to the deposit insurance fund certainly demand attention, review, and accountability, but the underlying issues suggest we need to ensure that supervision works appropriately over time. Many of the reforms targeted in this conference address broader structural concernslike imposing sweeping new regulatory reforms, or broad changes to laws like those governing deposit insurance. I applaud the engagement on these issues, but often the most effective regulatory tool is supervision. Effective supervision requires transparency in expectations and an approach that incorporates remediating deficiencies as a part of meeting those expectations. Many of the risks identified during last year's banking stress did not involve novel or unique risks. Addressing concentration risk, interest rate risk, and liquidity risk are all key risks that have long been elements deemed critical for effective supervision in bank examinations. These risks are known to create significant vulnerabilities and can be fatal to individual institutions if not managed appropriately over time. It is clear in the case of SVB that these risks were not managed appropriately. Bank regulators and supervisors also failed to sufficiently identify and prioritize the appropriate risks. Instead, the focus was on broader, qualitative, and process- and policy-oriented risks. Ultimately, both the bank's management and examiners failed to appropriately emphasize these key issues. An important step in the reform agenda-and one of the most effective reforms to build resilience against future banking stress-is to improve the prioritization of safety and soundness in the examination process, ensuring a careful focus on core financial risks. In my mind, successful prioritization involves increased transparency of expectations and a renewed focus on core financial risks. This includes avoiding issues that are only tangential to statutory mandates and critical areas of responsibility. Where necessary, it also includes adopting a more proactive approach for bank management and bank supervisors to deal with identified risks. Our goal must be to avoid straying from these core issues to focus on less foundational and less pressing areas. There have been some notable examples of regulatory mission creep, including the climate guidance introduced last year by the banking agencies. I have no doubt that this guidance is well-intended, and that climate change is an important public policy issue. But the question should be whether banks should be required to divert limited risk management resources away from critical, near-term risk management, with a parallel shift in focus by bank examiners. Looking at this guidance through the lens of prioritization, one could reasonably conclude that climate change is not currently a financial risk to the banking system and does not justify a shift in prioritization. While some may view this position as provocative, my goal is to demonstrate a more foundational point-mis-prioritizing supervisory objectives will have consequences, making banks riskier and the U.S. financial system less resilient over time. When it comes to regulatory reform efforts, we should acknowledge, as a starting point, that the bank regulatory system has undergone significant transformation since the passage of the Dodd-Frank Act, in response to the 2008 financial crisis. This has resulted in significantly increased liquidity and bank capital, new stress testing and resolution planning requirements, and several other improvements designed to promote bank resiliency. Not only the quantum, but the quality, of bank capital has also improved. Common equity tier 1 capital is now codified as the highest quality form of regulatory capital and is included within a capital framework that already includes goldplating over international capital standards. Measured against this baseline of resiliency, we need to carefully assess the need for regulatory improvements, while maintaining those elements of the bank regulatory framework that have proven durable and successful over time. I have not previously argued nor am I arguing today that the regulatory framework is perfect and beyond reproach. Or that there is no room for improvement or evolution over time. Where we find opportunities for needed improvements-either to maintain the system's effectiveness or respond to identified weaknesses-we should make those changes. But these changes should be motivated by a clear-eyed assessment of the facts, if the goal is to achieve changes that are focused, efficient, and durable over the long run. Before proposing regulatory reform measures to remediate or address issues identified during the spring 2023 banking stress, we should first reflect on the causes that contributed to the failures of SVB and Signature Bank. These bank failures were followed by government intervention in the form of a guarantee on uninsured deposits at these institutions, and the creation of a broad-based emergency lending facility-the Bank Term Funding Program-designed to reassure the market about the underlying strength of the U.S. banking system. Other characteristics of these bank failures-the rapid pace of depositors withdrawing uninsured deposits-appeared to deviate from the patterns seen in prior bank failures (in degree, if not in kind). But many of the core problems of these banks stemmed from well-known, core banking risks-interest rate risk, liquidity risk, and poor risk management. Each of these can be addressed effectively and efficiently through targeted improvements to the supervisory process. Our current narrow approach to rulemaking-focusing on a specific reform, without considering the broader framework or context within which these rules exist-has created a corresponding narrowness when we think about the consequences of regulatory reform. An efficient regulatory system can build resilience both for bank safety and soundness and financial stability. Take for example missed opportunities in capital reform. The current set of capital reform proposals does not address or propose changes to leverage requirements, including the 5 percent leverage ratio that applies to U.S. global systemically important banks, commonly referred to as the enhanced supplementary leverage ratio (or eSLR). Treasury market intermediation can be disrupted by constraints imposed by the eSLR, as occurred during the early days of market stress during the pandemic. It seems prudent to address this known leverage rule constraint before future stresses emerge that would likely disrupt market functioning. This narrow focus ignores that many requirements are intended to operate in a complementary way, and that these requirements in the aggregate may overlap or conflict, generating unintended consequences. The Federal Reserve has expressly acknowledged the complementary nature of these requirements, for example in noting that some leverage ratio requirements operate as a backstop to risk-based capital requirements. When policymakers publicly discuss changes to liquidity and capital, industry participants will modify their behavior in part to meet anticipated regulatory requirements, despite the regulatory uncertainty that accompanies reform efforts. While this response by banks is unfortunate, it is also predictable. My remarks this evening have primarily focused on the substance of reforms and the importance of demonstrating a case to support the changes. But it is also necessary to pause and reflect on the importance of following established process and procedure. This is especially important as we think about the choice between making policy reforms through supervision or regulation. Passing regulations under the Administrative Procedure Act requires agencies to follow specific notice-and-comment rulemaking procedures. I think we should approach this process through the most stringent and conservative lens, particularly when it comes to some of the most consequential rulemakings of the last decade. Rulemaking entails publishing rationales for agency action and seeking public input. These procedural requirements serve an important purpose and ultimately promote better agency decisionmaking. One of the most effective tools we have for doing so is the use of public Board meetings to address matters of significant public interest. My hope is that material items on the reform agenda will continue to be handled through public meetings that give greater visibility and insight into the thinking and rationales of different policymakers. I will conclude today's remarks by thanking all of our participants for joining us in Dallas and contributing to these important discussions. The elements that facilitate accountability parallel those elements necessary for effective reform-a deep understanding of facts, a careful identification of how elements of the banking system perform over time and during stress, and a commitment to take ownership of identified problems with targeted reforms that are commensurate with the underlying risks. As we engage in a review of our regulatory framework for liquidity and more broadly, these elements should serve as a guide to understanding the past and help us chart a path forward.
2024-07-23T00:00:00	Philip R Lane: Opening remarks at the ECB-IMF-IMFER conference	Welcome address by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the Joint European Central Bank, the International Monetary Fund (IMF) and the IMF Economic Review Conference 2024, Frankfurt am Main, 23 July 2024.	SPEECH Opening remarks Welcome address by Philip R. Lane, Member of the Executive Board of the ECB, at the Joint ECB-IMF-IMFER Conference 2024 Frankfurt am Main, 23 July 2024 I am pleased to welcome you to this research conference, jointly organised by the European Central Bank, the International Monetary Fund (IMF) and the IMF Economic Review. The focus of this conference on new global challenges for international fiscal and monetary policy is directly relevant to the work of the ECB. Policy institutions rely on academic research for the analytical foundations that guide our economic and financial assessments and our policy decisions", In looking at the programme for this conference, I was impressed by the progress that is evident across several research dimensions. The combination of methodological developments and the increased availability of granular data is facilitating much richer analysis and more informative quantitative estimation of the impact of various types of shocks and, crucially, the impact of various types of policy measures./2] In particular, it is increasingly feasible to move beyond representative- agent, representative-product macroeconomic models by incorporating various types of heterogeneity. Heterogeneity matters across many dimensions - I will list just a few examples. The consumption and labour supply decisions of households differ across income brackets and lifecycle stages.) The pricing, investment, production and financing decisions of corporations depends on the size distribution and balance sheets of individual firms. The exposure of a firm to a sectoral shock depends on the patterns of complementarities and substitution possibilities across sectors, in addition to where the firm is located in the production network - whether it is upstream or downstream of the affected sector.4] The vulnerability of a region to an external shock depends not only on direct trade linkages but also on exposures via integrated supply chains. Similarly, the impact of a financial shock depends on the nature of the frictions that determine access to finance, together with the network of bilateral financial linkages that lie beneath the international financial system. Of course, any individual research contribution will have to focus on the types of heterogeneity that are most relevant for the question being studied - not all types of heterogeneity are equally important for all shocks. From my perspective, it is essential that the ECB both supports these research developments and incorporates the emerging insights into the policy process. In terms of macroeconomic analysis, a range of multi-sectoral, multi-country and heterogeneous-agent models are in development at the EcB./4 In terms of the information set that forms the basis for our monetary policy meetings, surveys are playing an increasingly prominent role. Typically, these are analysed in combination with bank-level, firm-level and household-level datasets. The surveys conducted by the ECB are central to the policy process: the bank lending survey (BLS); the survey on the access to finance of enterprises (SAFE); the Household Finance and Consumption Survey (HFCS); the Corporate Telephone Survey (CTS); the Consumer Expectations Survey (CES); the Survey of Monetary Analysts (SMA); and the Survey of Professional Forecasters (SPF)./! More recently, the European System of Central Banks has developed the Distributional Wealth Accounts, a dataset that provides new experimental quarterly statistics on household wealth. With respect to wages, the newly-developed ECB wage tracker is based on granular data on collective bargaining agreements, allowing the ECB to interpret the latest signals on developments in wages in the euro area and conduct sectoral analysis that can shed light on the connection between wages and prices. In addition, micro price data can enhance our understanding of how firms set prices. The analytical and policy value of these surveys and granular datasets is increasing in the breadth and credibility of research that provides a guide to understanding the macroeconomic impact of heterogeneity." I am confident that the papers presented at this conference will make a valuable contribution to advancing this exciting research programme. The wider availability of timely granular information on balance sheets, millions of individual loans and their lending rates (for example in the European AnaCredit credit register) and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening.) Access to granular survey data, for example the individual replies to the bank lending survey, also helps disentangle credit supply from demand to understand the transmission of shocks to the real economy via banks."2] More recently, the availability of security-level data as well as loan- and transaction-level information on banks and firms has further enhanced the analysis of the monetary policy transmission mechanism along several dimensions, including: heterogeneity in the transmission of monetary policy across regions and sectors; the impact of monetary policy on bank risk-taking; and the sources of changes in credit developments.4314] Annexes 23 July 2024 Slides 1. It is beyond the scope of these opening remarks to review last week's monetary policy meetings. However, a set of background slides are available on the ECB's website. 2. For instance, see Ferrando, A. and Forti Grazzini, C. (2023), "Monetary policy shocks and firms' bank loan expectations", Working Paper Series, No 2838, ECB; Banbura, M., Bobeica, E. and Martinez Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875. 3. In the euro area, households in the bottom income quintile spend about 50% of their total expenditure on rent, food and utilities, double the expenditure share for households in the top income quintile. See Bobasu, A., di Nino, V. and Osbat, C. (2023), "The impact of the recent inflation surge across households", Economic Bulletin, Issue 3, ECB. 4. Battistini, N. and Gareis, J. (2024), "Sectoral dynamics and the business cycle in the euro area", Economic Bulletin, issue 4, ECB. The role of production networks in monetary policy transmission is also a topic in the European System of Central Banks ChaMP research network ("Challenges for Monetary Policy Transmission in a Changing World"). The network is also working on extending detailed business-to-business production network data to several more euro area countries. 5. For instance, see Bobasu, A., Dobrew, M. and Repele, A. (2024), "Energy price shocks, monetary policy and inequality" (forthcoming in the ECB's Working Paper Series); Ciccarelli, M., Darracq Pariés, M., Priftis, R. (eds) (2024): ECB macroeconometric models for forecasting and policy analysis, Occasional Paper Series, No 344. 6. Regarding the Corporate Telephone Survey, see Healy, P., Kuik, F., Morris, R. and Slavik, M. (2024), "Main findings from the ECB's recent contacts with non-financial companies", Economic Bulletin, Issue 3, ECB. Regarding the Consumer Expectations Surveys, see Bobasu, A., Charalampakis, E. and Kouvavas, O. (2024), "How have households adjusted their spending and saving behaviour to cope with high inflation?", Economic Bulletin, Issue 2, ECB; Kouvavas, O. and Rusinova, D. (2024), "How big_is the household housing burden? Evidence from the ECB Consumer Expectations Survey", Economic Bulletin, lssue 3, ECB; Georgarakos, D., Kouvavas, O., Meyler, A. and Neves, P. (2023), "What do consumers think is the main driver of recent inflation?", Economic Bulletin, Ilssue 6, ECB; Kouvavas, O. and Tsiortas, A. (2024), "Consumer credit: Who's applying for loans now?", The ECB Blog, 15 May. 7. This dataset will be introduced to the public, along with its main features and use cases, ina contribution entitled "Introducing the Distributional Wealth Accounts for euro area households' in the forthcoming issue of the ECB's Economic Bulletin in August 2024. 8. See Gornicka, L. and G. Koester (eds.) (2024): A forward-looking tracker of negotiated wages in the euro area", Occasional Paper Series, No 338; ECB; Bing, M., Holton, S., Koester, G. and Llevadot, M.R.I. (2024), "Tracking euro area wages in exceptional times", The ECB Blog, 23 May, and Ampudia, M. Lombardi, M. J. and Renault, T. (2024), "The wage-price pass-through across sectors: evidence from the euro area," Working Paper Series, No 2948, ECB. 9. Dedola, L., Henkel, L., Hdynck, C., Osbat, C., Santoro, S. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?," Economic Bulletin, Issue 3, ECB. 10. Baumann, U., Ferrando, A., Georgarakos, D., Gorodnichenko, Y. and Reinelt, T. (2024), "SAFE to update inflation expectations? New survey evidence on euro area firms", Working Paper Series, No 2949, ECB, June; Durante, E., Ferrando, A. and Vermeulen, P. (2022), "Monetary policy, investment and firm heterogeneity", European Economic Review, Vol. 148, September. 11. Altavilla, C., Burlon, L., Holton, S., and Giannetti M., (2022) Is there a zero lower bound? The effects of negative policy rates on banks and firms, Journal of Financial Economics, Vol. 144, No 3, June, pp. 885-907; Holton, S. and Rodriguez d'Acri, C. (2018), "Interest rate pass-through since the euro area crisis", Journal of Banking & Finance, Vol. 96, November, pp. 277-291; Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through", Journal of Monetary Economics, Vol. 110, April, pp. 81-98; Albertazzi, U., Burlon, L., Jankauskas, T. and Pavanini, N. (2022), "The Shadow Value of Unconventional Monetary Policy", CEPR Discussion Paper, No 17053, 20 February; Altavilla, C., Boucinha, M. and Peydro, J.-L. (2018), "Monetary policy and bank profitability in a low interest rate environment', Economic Policy, Vol. 33, No 96, pp. 531-586. And the ESCB ChaMP network is further deepening this type of analysis, exploiting for example the European AnaCredit database and national credit registers. 12. Altavilla, C., Boucinha, M., Holton, S. and Ongena, S. (2021), "Credit Supply and Demand in Unconventional Times", Journal of Money, Credit and Banking, Vol. 53, No 8, December, pp. 2071- 2098; Faccia, D., Hlinnekes, F. and Kohler-Ulbrich, P. (2024), "What drives banks' credit standards? An analysis based on a large bank-firm panel", Working Paper Series, No 2902, ECB, February. 13. Amador, S. and Elfsbacka-SchmGller, M. (2024): "Monetary Policy, Growth, and Sectoral Reallocation", mimeo. 14. Albertazzi, U., Becker, B. and Boucinha, M. (2021), "Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area', Journal of Financial Intermediation, Vol. 48, October; Koijen, R.S.J., Koulischer, F., Nguyen, B. and Yogo, M. (2017), "Euro- Area Quantitative Easing and Portfolio Rebalancing", American Economic Review, Vol. 107, No 5, pp. 621-627; Altavilla, C., Girkaynak, R. and Quaedvlieg, R. (2024), "Macro and Micro of External Finance Premium and Monetary Policy Transmission", Journal of Monetary Economics, forthcoming; Barbiero, F., Burlon, L., Dimou, M. and Toczynski, J. (2024), "Targeted monetary policy, dual rates and bank risk taking", European Economic Review, forthcoming; Altavilla, C., Laeven, L. and Peydro, J.-L. (2020), "Monetary and Macroprudential Policy Complementarities: evidence from European credit registers', CEPR Discussion Paper, No 15539, 11 December; Battistini, N., Falagiarda, M., Hackmann, A. and Roma, M. (2022), "Navigating the housing channel of monetary policy across euro area regions", Working Paper Series, No 2752, ECB, November. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # Opening remarks ## Welcome address by Philip R. Lane, Member of the Executive Board of the ECB, at the Joint ECB-IMF-IMFER Conference 2024 Frankfurt am Main, 23 July 2024 I am pleased to welcome you to this research conference, jointly organised by the European Central Bank, the International Monetary Fund (IMF) and the IMF Economic Review. The focus of this conference on new global challenges for international fiscal and monetary policy is directly relevant to the work of the ECB. Policy institutions rely on academic research for the analytical foundations that guide our economic and financial assessments and our policy decisions ${ }^{[1]}$. In looking at the programme for this conference, I was impressed by the progress that is evident across several research dimensions. The combination of methodological developments and the increased availability of granular data is facilitating much richer analysis and more informative quantitative estimation of the impact of various types of shocks and, crucially, the impact of various types of policy measures. ${ }^{[2]}$ In particular, it is increasingly feasible to move beyond representativeagent, representative-product macroeconomic models by incorporating various types of heterogeneity. Heterogeneity matters across many dimensions - I will list just a few examples. The consumption and labour supply decisions of households differ across income brackets and lifecycle stages. ${ }^{[3]}$ The pricing, investment, production and financing decisions of corporations depends on the size distribution and balance sheets of individual firms. The exposure of a firm to a sectoral shock depends on the patterns of complementarities and substitution possibilities across sectors, in addition to where the firm is located in the production network - whether it is upstream or downstream of the affected sector. ${ }^{[4]}$ The vulnerability of a region to an external shock depends not only on direct trade linkages but also on exposures via integrated supply chains. Similarly, the impact of a financial shock depends on the nature of the frictions that determine access to finance, together with the network of bilateral financial linkages that lie beneath the international financial system. Of course, any individual research contribution will have to focus on the types of heterogeneity that are most relevant for the question being studied - not all types of heterogeneity are equally important for all shocks. From my perspective, it is essential that the ECB both supports these research developments and incorporates the emerging insights into the policy process. In terms of macroeconomic analysis, a range of multi-sectoral, multi-country and heterogeneous-agent models are in development at the ECB. ${ }^{[5]}$ In terms of the information set that forms the basis for our monetary policy meetings, surveys are playing an increasingly prominent role. Typically, these are analysed in combination with bank-level, firm-level and household-level datasets. The surveys conducted by the ECB are central to the policy process: the bank lending survey (BLS); the survey on the access to finance of enterprises (SAFE); ---[PAGE_BREAK]--- the Household Finance and Consumption Survey (HFCS); the Corporate Telephone Survey (CTS); the Consumer Expectations Survey (CES); the Survey of Monetary Analysts (SMA); and the Survey of Professional Forecasters (SPF). ${ }^{[6]}$ More recently, the European System of Central Banks has developed the Distributional Wealth Accounts, a dataset that provides new experimental quarterly statistics on household wealth. ${ }^{[7]}$ With respect to wages, the newly-developed ECB wage tracker is based on granular data on collective bargaining agreements, allowing the ECB to interpret the latest signals on developments in wages in the euro area and conduct sectoral analysis that can shed light on the connection between wages and prices. ${ }^{[8]}$ In addition, micro price data can enhance our understanding of how firms set prices. ${ }^{[9]}$ The analytical and policy value of these surveys and granular datasets is increasing in the breadth and credibility of research that provides a guide to understanding the macroeconomic impact of heterogeneity. ${ }^{[10]}$ I am confident that the papers presented at this conference will make a valuable contribution to advancing this exciting research programme. The wider availability of timely granular information on balance sheets, millions of individual loans and their lending rates (for example in the European AnaCredit credit register) and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening. ${ }^{[11]}$ Access to granular survey data, for example the individual replies to the bank lending survey, also helps disentangle credit supply from demand to understand the transmission of shocks to the real economy via banks. ${ }^{[12]}$ More recently, the availability of security-level data as well as loan- and transaction-level information on banks and firms has further enhanced the analysis of the monetary policy transmission mechanism along several dimensions, including: heterogeneity in the transmission of monetary policy across regions and sectors; the impact of monetary policy on bank risk-taking; and the sources of changes in credit developments. ${ }^{[13]}$ [14] # Annexes 23 July 2024 Slides 1. It is beyond the scope of these opening remarks to review last week's monetary policy meetings. However, a set of background slides are available on the ECB's website. 2. For instance, see Ferrando, A. and Forti Grazzini, C. (2023), "Monetary policy shocks and firms' bank loan expectations", Working Paper Series, No 2838, ECB; Banbura, M., Bobeica, E. and Martínez ---[PAGE_BREAK]--- Hernández, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875. 3. In the euro area, households in the bottom income quintile spend about 50\% of their total expenditure on rent, food and utilities, double the expenditure share for households in the top income quintile. See Bobasu, A., di Nino, V. and Osbat, C. (2023), "The impact of the recent inflation surge across households", Economic Bulletin, Issue 3, ECB. 4. Battistini, N. and Gareis, J. (2024), "Sectoral dynamics and the business cycle in the euro area", Economic Bulletin, Issue 4, ECB. The role of production networks in monetary policy transmission is also a topic in the European System of Central Banks ChaMP research network ("Challenges for Monetary Policy Transmission in a Changing World"). The network is also working on extending detailed business-to-business production network data to several more euro area countries. 5. For instance, see Bobasu, A., Dobrew, M. and Repele, A. (2024), "Energy price shocks, monetary policy and inequality" (forthcoming in the ECB's Working Paper Series); Ciccarelli, M., Darracq Pariès, M., Priftis, R. (eds) (2024): ECB macroeconometric models for forecasting and policy analysis, Occasional Paper Series, No 344. 6. Regarding the Corporate Telephone Survey, see Healy, P., Kuik, F., Morris, R. and Slavík, M. (2024), "Main findings from the ECB's recent contacts with non-financial companies", Economic Bulletin, Issue 3, ECB. Regarding the Consumer Expectations Surveys, see Bobasu, A., Charalampakis, E. and Kouvavas, O. (2024), "How have households adjusted their spending and saving behaviour to cope with high inflation?", Economic Bulletin, Issue 2, ECB; Kouvavas, O. and Rusinova, D. (2024), "How big is the household housing burden? Evidence from the ECB Consumer Expectations Survey", Economic Bulletin, Issue 3, ECB; Georgarakos, D., Kouvavas, O., Meyler, A. and Neves, P. (2023), "What do consumers think is the main driver of recent inflation?", Economic Bulletin, Issue 6, ECB; Kouvavas, O. and Tsiortas, A. (2024), "Consumer credit: Who's applying for loans now?", The ECB Blog, 15 May. 7. This dataset will be introduced to the public, along with its main features and use cases, in a contribution entitled "Introducing the Distributional Wealth Accounts for euro area households" in the forthcoming issue of the ECB's Economic Bulletin in August 2024. 8. ---[PAGE_BREAK]--- See Gornicka, L. and G. Koester (eds.) (2024): A forward-looking tracker of negotiated wages in the euro area", Occasional Paper Series, No 338; ECB; Bing, M., Holton, S., Koester, G. and Llevadot, M.R.I. (2024), "Tracking euro area wages in exceptional times", The ECB Blog, 23 May, and Ampudia, M. Lombardi, M. J. and Renault, T. (2024), "The wage-price pass-through across sectors: evidence from the euro area," Working Paper Series, No 2948, ECB. 9. Dedola, L., Henkel, L., Höynck, C., Osbat, C., Santoro, S. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?," Economic Bulletin, Issue 3, ECB. 10. Baumann, U., Ferrando, A., Georgarakos, D., Gorodnichenko, Y. and Reinelt, T. (2024), "SAFE to update inflation expectations? New survey evidence on euro area firms", Working Paper Series, No 2949, ECB, June; Durante, E., Ferrando, A. and Vermeulen, P. (2022), "Monetary policy, investment and firm heterogeneity", European Economic Review, Vol. 148, September. 11. Altavilla, C., Burlon, L., Holton, S., and Giannetti M., (2022) Is there a zero lower bound? The effects of negative policy rates on banks and firms, Journal of Financial Economics, Vol. 144, No 3, June, pp. 885-907; Holton, S. and Rodriguez d'Acri, C. (2018), "Interest rate pass-through since the euro area crisis", Journal of Banking \& Finance, Vol. 96, November, pp. 277-291; Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through", Journal of Monetary Economics, Vol. 110, April, pp. 81-98; Albertazzi, U., Burlon, L., Jankauskas, T. and Pavanini, N. (2022), "The Shadow Value of Unconventional Monetary Policy", CEPR Discussion Paper, No 17053, 20 February; Altavilla, C., Boucinha, M. and Peydró, J.-L. (2018), "Monetary policy and bank profitability in a low interest rate environment", Economic Policy, Vol. 33, No 96, pp. 531-586. And the ESCB ChaMP network is further deepening this type of analysis, exploiting for example the European AnaCredit database and national credit registers. 12. Altavilla, C., Boucinha, M., Holton, S. and Ongena, S. (2021), "Credit Supply and Demand in Unconventional Times", Journal of Money, Credit and Banking, Vol. 53, No 8, December, pp. 20712098; Faccia, D., Hünnekes, F. and Köhler-Ulbrich, P. (2024), "What drives banks' credit standards? An analysis based on a large bank-firm panel", Working Paper Series, No 2902, ECB, February. 13. Amador, S. and Elfsbacka-Schmöller, M. (2024): "Monetary Policy, Growth, and Sectoral Reallocation", mimeo. ---[PAGE_BREAK]--- Albertazzi, U., Becker, B. and Boucinha, M. (2021), "Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area", Journal of Financial Intermediation, Vol. 48, October; Koijen, R.S.J., Koulischer, F., Nguyen, B. and Yogo, M. (2017), "EuroArea Quantitative Easing and Portfolio Rebalancing", American Economic Review, Vol. 107, No 5, pp. 621-627; Altavilla, C., Gürkaynak, R. and Quaedvlieg, R. (2024), "Macro and Micro of External Finance Premium and Monetary Policy Transmission", Journal of Monetary Economics, forthcoming; Barbiero, F., Burlon, L., Dimou, M. and Toczynski, J. (2024), "Targeted monetary policy, dual rates and bank risk taking", European Economic Review, forthcoming; Altavilla, C., Laeven, L. and Peydró, J.-L. (2020), "Monetary and Macroprudential Policy Complementarities: evidence from European credit registers", CEPR Discussion Paper, No 15539, 11 December; Battistini, N., Falagiarda, M., Hackmann, A. and Roma, M. (2022), "Navigating the housing channel of monetary policy across euro area regions", Working Paper Series, No 2752, ECB, November.	Philip R Lane	Euro area	https://www.bis.org/review/r240729d.pdf	Frankfurt am Main, 23 July 2024 I am pleased to welcome you to this research conference, jointly organised by the European Central Bank, the International Monetary Fund (IMF) and the IMF Economic Review. The focus of this conference on new global challenges for international fiscal and monetary policy is directly relevant to the work of the ECB. Policy institutions rely on academic research for the analytical foundations that guide our economic and financial assessments and our policy decisions . In looking at the programme for this conference, I was impressed by the progress that is evident across several research dimensions. The combination of methodological developments and the increased availability of granular data is facilitating much richer analysis and more informative quantitative estimation of the impact of various types of shocks and, crucially, the impact of various types of policy measures. The vulnerability of a region to an external shock depends not only on direct trade linkages but also on exposures via integrated supply chains. Similarly, the impact of a financial shock depends on the nature of the frictions that determine access to finance, together with the network of bilateral financial linkages that lie beneath the international financial system. Of course, any individual research contribution will have to focus on the types of heterogeneity that are most relevant for the question being studied - not all types of heterogeneity are equally important for all shocks. From my perspective, it is essential that the ECB both supports these research developments and incorporates the emerging insights into the policy process. In terms of macroeconomic analysis, a range of multi-sectoral, multi-country and heterogeneous-agent models are in development at the ECB. In terms of the information set that forms the basis for our monetary policy meetings, surveys are playing an increasingly prominent role. Typically, these are analysed in combination with bank-level, firm-level and household-level datasets. The surveys conducted by the ECB are central to the policy process: the bank lending survey (BLS); the survey on the access to finance of enterprises (SAFE); the Household Finance and Consumption Survey (HFCS); the Corporate Telephone Survey (CTS); the Consumer Expectations Survey (CES); the Survey of Monetary Analysts (SMA); and the Survey of Professional Forecasters (SPF). With respect to wages, the newly-developed ECB wage tracker is based on granular data on collective bargaining agreements, allowing the ECB to interpret the latest signals on developments in wages in the euro area and conduct sectoral analysis that can shed light on the connection between wages and prices. I am confident that the papers presented at this conference will make a valuable contribution to advancing this exciting research programme. The wider availability of timely granular information on balance sheets, millions of individual loans and their lending rates (for example in the European AnaCredit credit register) and deposit rates for euro area monetary financial institutions has offered increasingly detailed insights into bank-based transmission. We now have evidence that firm and bank balance sheet constraints can amplify the contraction in credit availability brought about by policy tightening. Slides
2024-07-24T00:00:00	Michelle W Bowman: Opening remarks - "Advance together: celebrating the achievements of Texas Community Partnerships"	Opening remarks (via pre-recorded video) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the "Advance Together: Celebrating the Achievements of Texas Community Partnerships," a public event at the Federal Reserve Bank of Dallas, Dallas, Texas, 24 July 2024.	Michelle W Bowman: Opening remarks Opening remarks (via pre-recorded video) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the "Advance Together: Celebrating the Achievements of Texas Community Partnerships," a public event at the Federal Reserve Bank of Dallas, Dallas, Texas , 24 July 2024. * * * I'd like to thank everyone for joining us today to celebrate the achievements of Texas community partnerships. I am so excited to be a part of this important milestone, marking the end of the pilot round of Advance Together and to announce a second round for this initiative. Back in 2021, during the depths of COVID, I took part in the Dallas Fed's Advance Together launch event, welcoming the awardees into the initiative and looking ahead to their success. This is truly a special opportunity to recognize the progress and achievements of the four participating partnerships, each representing their diverse communities and regions in the great state of Texas. Advance Together is an accelerator program for regional public-private-nonprofit partnerships seeking to improve education and employment outcomes for lower-income communities in Texas. The Dallas Fed and the Federal Reserve System are focused on reducing and removing barriers to education attainment and workforce development to foster a strong, resilient economy. As the nation's central bank, the Federal Reserve Board is focused on our dual mandate of price stability and maximum employment. When we think about maximum employment, we also need to consider how to foster an inclusive economy that provides economic opportunities for everyone regardless of their circumstances. Every Reserve Bank relies on its community development function to understand the economic circumstances of communities through community initiatives and research. In response to local needs in their respective Districts, each Reserve Bank develops initiatives and focus areas to support these efforts. Collaboration Matters for Better Community Outcomes Advance Together was designed to address core challenges in education and workforce development. Often, a lack of coordination among key organizations, fragmentation across existing resources, or incomplete approaches that don't fully identify or address the root causes of community issues lead to less successful outcomes. Research from the Boston Fed has found that durable economic success throughout economic cycles is less dependent on factors like industry mix, demographics, or even geographic location. Instead, it is the ability of local leaders to work together across different sectors that leads to economic resilience. Leaders that collaborate with an identified plan and path over a sustained period of time toward a comprehensive vision achieve better outcomes and more inclusive economic growth. A few years ago, the Dallas Fed identified an opportunity in Texas to support community partnerships, specifically in education and workforce development. Working across different sectors and industries brings its own set of unique challenges. Each brings different goals, operations, and even terminology to the discussion. We know that collaboration is necessary, and it is achievable. Advance Together provides the structure, ongoing support, and investment from external partners to support communities in strengthening their collaborative work. It takes time and skill to build deep and trusting partnerships. It also takes time and resources for communities to agree upon a common understanding of complex, local needs like improving college and career readiness or developing pathways to living wage employment. This work requires that all partners move in the same direction, toward those common strategies and goals. When communities collaborate effectively, the results can lead to broader access to economic opportunity. AT Team Introductions We are here today to celebrate the success of our pilot participants; I'd like to reintroduce each of them: The Big Country Manufacturing Alliance is building awareness and creating accessible pathways to well-paying manufacturing careers through training, recruitment, and retention. The Deep East Texas College & Career Alliance supports rural and firstgeneration college students in attaining postsecondary credentials that employers seek in their workforce. The Education Partnership of the Permian Basin is developing a cradle-to-career continuum of support by working to improve early childhood outcomes and college and career readiness in the region. The Travis County 2-Gen Coalition is expanding practices and policies to support dual generations of parents and children in education attainment and achieving long-term financial stability. Conclusion As we begin today's celebration, I'd like to recognize the vision of the Dallas Fed team for creating this incredible opportunity for our partners. I'd also like to thank our Advance Together partnerships for their hard work and progress. I also want to recognize them for the work that they will continue to accomplish in their communities as they move forward. This work is challenging and will continue to build pathways to a more inclusive economy.	---[PAGE_BREAK]--- # Michelle W Bowman: Opening remarks Opening remarks (via pre-recorded video) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the "Advance Together: Celebrating the Achievements of Texas Community Partnerships," a public event at the Federal Reserve Bank of Dallas, Dallas, Texas, 24 July 2024. I'd like to thank everyone for joining us today to celebrate the achievements of Texas community partnerships. I am so excited to be a part of this important milestone, marking the end of the pilot round of Advance Together and to announce a second round for this initiative. Back in 2021, during the depths of COVID, I took part in the Dallas Fed's Advance Together launch event, welcoming the awardees into the initiative and looking ahead to their success. This is truly a special opportunity to recognize the progress and achievements of the four participating partnerships, each representing their diverse communities and regions in the great state of Texas. Advance Together is an accelerator program for regional public-private--nonprofit partnerships seeking to improve education and employment outcomes for lower-income communities in Texas. The Dallas Fed and the Federal Reserve System are focused on reducing and removing barriers to education attainment and workforce development to foster a strong, resilient economy. As the nation's central bank, the Federal Reserve Board is focused on our dual mandate of price stability and maximum employment. When we think about maximum employment, we also need to consider how to foster an inclusive economy that provides economic opportunities for everyone regardless of their circumstances. Every Reserve Bank relies on its community development function to understand the economic circumstances of communities through community initiatives and research. In response to local needs in their respective Districts, each Reserve Bank develops initiatives and focus areas to support these efforts. ## Collaboration Matters for Better Community Outcomes Advance Together was designed to address core challenges in education and workforce development. Often, a lack of coordination among key organizations, fragmentation across existing resources, or incomplete approaches that don't fully identify or address the root causes of community issues lead to less successful outcomes. Research from the Boston Fed has found that durable economic success throughout economic cycles is less dependent on factors like industry mix, demographics, or even geographic location. Instead, it is the ability of local leaders to work together across ---[PAGE_BREAK]--- different sectors that leads to economic resilience. Leaders that collaborate with an identified plan and path over a sustained period of time toward a comprehensive vision achieve better outcomes and more inclusive economic growth. A few years ago, the Dallas Fed identified an opportunity in Texas to support community partnerships, specifically in education and workforce development. Working across different sectors and industries brings its own set of unique challenges. Each brings different goals, operations, and even terminology to the discussion. We know that collaboration is necessary, and it is achievable. Advance Together provides the structure, ongoing support, and investment from external partners to support communities in strengthening their collaborative work. It takes time and skill to build deep and trusting partnerships. It also takes time and resources for communities to agree upon a common understanding of complex, local needs like improving college and career readiness or developing pathways to living wage employment. This work requires that all partners move in the same direction, toward those common strategies and goals. When communities collaborate effectively, the results can lead to broader access to economic opportunity. # AT Team Introductions We are here today to celebrate the success of our pilot participants; l'd like to reintroduce each of them: - The Big Country Manufacturing Alliance is building awareness and creating accessible pathways to well-paying manufacturing careers through training, recruitment, and retention. - The Deep East Texas College \& Career Alliance supports rural and firstgeneration college students in attaining postsecondary credentials that employers seek in their workforce. - The Education Partnership of the Permian Basin is developing a cradle-to-career continuum of support by working to improve early childhood outcomes and college and career readiness in the region. - The Travis County 2-Gen Coalition is expanding practices and policies to support dual generations of parents and children in education attainment and achieving long-term financial stability. ## Conclusion As we begin today's celebration, I'd like to recognize the vision of the Dallas Fed team for creating this incredible opportunity for our partners. I'd also like to thank our Advance Together partnerships for their hard work and progress. I also want to recognize them for the work that they will continue to accomplish in their communities as they move forward. This work is challenging and will continue to build pathways to a more inclusive economy. ---[PAGE_BREAK]--- BIS - Central bankers' speeches	Michelle W Bowman	United States	https://www.bis.org/review/r240725a.pdf	Opening remarks (via pre-recorded video) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the "Advance Together: Celebrating the Achievements of Texas Community Partnerships," a public event at the Federal Reserve Bank of Dallas, Dallas, Texas, 24 July 2024. I'd like to thank everyone for joining us today to celebrate the achievements of Texas community partnerships. I am so excited to be a part of this important milestone, marking the end of the pilot round of Advance Together and to announce a second round for this initiative. Back in 2021, during the depths of COVID, I took part in the Dallas Fed's Advance Together launch event, welcoming the awardees into the initiative and looking ahead to their success. This is truly a special opportunity to recognize the progress and achievements of the four participating partnerships, each representing their diverse communities and regions in the great state of Texas. Advance Together is an accelerator program for regional public-private--nonprofit partnerships seeking to improve education and employment outcomes for lower-income communities in Texas. The Dallas Fed and the Federal Reserve System are focused on reducing and removing barriers to education attainment and workforce development to foster a strong, resilient economy. As the nation's central bank, the Federal Reserve Board is focused on our dual mandate of price stability and maximum employment. When we think about maximum employment, we also need to consider how to foster an inclusive economy that provides economic opportunities for everyone regardless of their circumstances. Every Reserve Bank relies on its community development function to understand the economic circumstances of communities through community initiatives and research. In response to local needs in their respective Districts, each Reserve Bank develops initiatives and focus areas to support these efforts. Advance Together was designed to address core challenges in education and workforce development. Often, a lack of coordination among key organizations, fragmentation across existing resources, or incomplete approaches that don't fully identify or address the root causes of community issues lead to less successful outcomes. Research from the Boston Fed has found that durable economic success throughout economic cycles is less dependent on factors like industry mix, demographics, or even geographic location. Instead, it is the ability of local leaders to work together across different sectors that leads to economic resilience. Leaders that collaborate with an identified plan and path over a sustained period of time toward a comprehensive vision achieve better outcomes and more inclusive economic growth. A few years ago, the Dallas Fed identified an opportunity in Texas to support community partnerships, specifically in education and workforce development. Working across different sectors and industries brings its own set of unique challenges. Each brings different goals, operations, and even terminology to the discussion. We know that collaboration is necessary, and it is achievable. Advance Together provides the structure, ongoing support, and investment from external partners to support communities in strengthening their collaborative work. It takes time and skill to build deep and trusting partnerships. It also takes time and resources for communities to agree upon a common understanding of complex, local needs like improving college and career readiness or developing pathways to living wage employment. This work requires that all partners move in the same direction, toward those common strategies and goals. When communities collaborate effectively, the results can lead to broader access to economic opportunity. We are here today to celebrate the success of our pilot participants; l'd like to reintroduce each of them: The Big Country Manufacturing Alliance is building awareness and creating accessible pathways to well-paying manufacturing careers through training, recruitment, and retention. The Deep East Texas College \& Career Alliance supports rural and firstgeneration college students in attaining postsecondary credentials that employers seek in their workforce. The Education Partnership of the Permian Basin is developing a cradle-to-career continuum of support by working to improve early childhood outcomes and college and career readiness in the region. The Travis County 2-Gen Coalition is expanding practices and policies to support dual generations of parents and children in education attainment and achieving long-term financial stability. As we begin today's celebration, I'd like to recognize the vision of the Dallas Fed team for creating this incredible opportunity for our partners. I'd also like to thank our Advance Together partnerships for their hard work and progress. I also want to recognize them for the work that they will continue to accomplish in their communities as they move forward. This work is challenging and will continue to build pathways to a more inclusive economy. BIS - Central bankers' speeches
2024-08-10T00:00:00	Michelle W Bowman: Update on the economic outlook, and perspective on bank culture, M&A, and liquidity	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 CEO and Senior Management Summit and Annual Meeting, sponsored by the Kansas Bankers Association, Colorado Springs, Colorado, 10 August 2024.	For release on delivery 12:10 p.m. EDT (10:10 a.m. MDT time) August 10, 2024 Update on the Economic Outlook, and Perspective on Bank Culture, M&A, and Liquidity Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the 2024 CEO and Senior Management Summit and Annual Meeting, sponsored by the Kansas Bankers Association Colorado Springs, Colorado August 10, 2024 Thank you for the invitation to join you again this year.! Just as banking and economic conditions continue to evolve, so too do bank regulatory and supervisory standards. I look forward to learning your perspectives on the evolving banking and economic conditions, and the banking agencies' approaches to regulation and supervision. Economic and Monetary Policy Outlook Before discussing my thoughts on bank regulatory matters, and in light of our recent Federal Open Market Committee (FOMC) meeting, I will begin by sharing my current views on the economy and monetary policy. Over the past two years, the FOMC has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at 5-1/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, we have seen some further progress on lowering inflation in recent months. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer relative to more volatile higher- frequency readings, have moved down since April, although they have remained somewhat elevated and stood at 2.5 percent and 2.6 percent in June, respectively. The progress in lowering inflation during May and June is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Despite the recent good data reports, core PCE inflation averaged an annualized 3.4 percent over the first half of the year. And given that supply constraints have now largely ' The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. -2- normalized, I am not confident that inflation will decline in the same way as in the second half of last year. More importantly, prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Gross domestic product (GDP) growth moved up in the second quarter, following a soft reading in the first quarter, while private domestic final purchases (PDFP) increased at a solid pace in both quarters. During the first half of 2024, PDFP slowed much less than GDP, as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Although consumer spending strengthened in the second quarter, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined-showing signs that the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in -3- July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains are still above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation. First, as I noted earlier, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due both to increased labor force participation and strong immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and significantly higher U.S. immigration over the past few years may decrease going forward. Geopolitical developments could also pose upside risks to inflation, as the recent surge in container shipping costs originating in Asia suggest that global supply chains remain susceptible to disruptions, which could put upward pressure on food, energy, and commodity prices. There -4. is also the risk that additional fiscal stimulus could add momentum to demand, impeding further progress on reducing inflation. Finally, there continues to be a risk that the increased immigration could lead to persistently high housing services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. There are also risks that the labor market has not been as strong as the payroll data have been indicating, but it also appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report implies that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become less accurate as response rates have appreciably declined since the pandemic." Moreover, the rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find a job, while layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was centered in workers experiencing a temporary layoff, who are more likely to be rehired in coming months, and Hurricane Beryl likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. ? The Q4 Quarterly Census of Employment and Wages (QCEW) administrative data show employment gains that are about 110,000 per month lower than what the Current Employment Statistics (CES) survey reported from March 2023 to December 2023. Although the Bureau of Labor Statistics benchmarks CES payroll employment based on the Ql QCEW, to be released on August 21, the Q4 QCEW data point to a substantial downward revision to CES employment gains last year. -5- In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook, with a focus on the dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen a range of additional economic data and information, including one employment and two inflation reports. We will also have a wider view of how developments in broader financial conditions might influence the economic outlook. In particular, equity prices have been volatile recently but are still higher than at the end of last year. I will continue to closely monitor the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. Banking Regulation and Supervision I will turn now to bank regulation and supervision. Today I would like to address a few topics that I expect will be of interest to those in this room, starting with the issue of culture both within banks and at bank and other financial regulatory agencies. I will then briefly discuss mergers and acquisitions (M&A) activity in the banking industry, and the current and expected outlook for bank transactions. I will close with a discussion on bank liquidity regulation. The Role of Culture at Banks and at Regulators In recent years, regulatory approaches have included regulators seeking to influence the culture within banks, specifically large banks, focusing on matters like building a culture that promotes compliance or effective risk management, including operational risk. A bank's culture drives its sense of ownership and a collective purpose that is common among many successful organizations, where a bank's board, management, and employees all work together in support of the bank's business purpose and mission. Bank culture can have a strong influence on both business outcomes and on compliance and risk-management outcomes. Bank culture starts with bank leadership, the so-called tone from the top. Strong bank culture demands accountability for bank leadership teams and for the entire workforce. A bank's management is responsible for setting the strategic direction of the company, including which business lines to pursue, expand, or eliminate. But bank leaders also have a responsibility to empower employees to raise issues and concerns, allowing them to identify and escalate emerging business, risk-management, or compliance matters that may require management's attention or intervention. While regulators have sought to influence bank culture over time, ultimately culture is most heavily influenced and shaped by the example set by bank leaders and by the actions of each bank employee. -7- Regulatory agency culture can be similarly impactful in shaping bank regulation and supervision to promote safety and soundness and consumer compliance in an effective and efficient manner. In contrast to regulators, bank management may choose to modify or reshape their mission and objectives over time-evolving their business goals, risk-management policies and processes, and compliance standards as conditions change. For regulators, the overarching regulatory and supervisory mission and related institutional goals are prescribed by statute. While bank regulators lack the flexibility to change the mission, they have significant flexibility in the execution of that mission. This often involves broad policy goals-for example, promoting the safety and soundness of the banking system, and the stability of the financial system. Similar to bank culture, regulatory agency culture begins with its leadership and is then carried out by the individual members of the organization's workforce. Culture plays a significant role in how well bank regulators pursue their statutory objectives and the manner in which they perform the related mission. Have regulators created a culture that allows the staff to identify and escalate issues of concern? Have regulators oriented the mission of the institution around core statutory goals and avoided the temptation to stray from this mission into other matters of public policy? Have regulators created a culture of accountability for leaders and employees, where shortcomings can be fairly identified and actions can be taken to remediate problems? While the value of culture is widely acknowledged, both among banks and among bank regulators, we have seen some recent high-profile examples of culture falling short, and with -8- serious consequences.? Responsible banking involves not only finding and pursuing opportunities to serve customers and grow the business, but also balancing these business priorities with a firm commitment to risk management and compliance, including consumer compliance. While banks are free to pursue growth, in some instances this growth has come without accompanying development of and investment in risk management and legal compliance, to the detriment of the bank and its customers. In the case of Silicon Valley Bank's (SVB) failure in 2023, rapid growth was certainly a factor that contributed to the firm's fragility. The bank's management failed to properly manage its development of contingent liquidity planning, funding, and risk-management capabilities in light of its rapid growth. While this failure revealed problems with bank leadership in promoting a compliance and risk-management culture commensurate with growth, supervisors directly overseeing the bank's expansion were also late to act in the face of emerging firm risks. I think we should question whether we have learned all of the right lessons from SVB's failure. We know that rapid growth is a known risk factor that should result in additional supervisory scrutiny. But some of the post-failure SVB reviews conducted internally by Federal Reserve staff cited rapid growth as a contributing factor for the inadequacy of the supervisory approach.* Among other things, these internal reports suggested that the shift of SVB from one supervisory portfolio to another somehow frustrated appropriate supervision. We need to ask 3 Board of Governors of the Federal Reserve System, Consent Order with Green Dot Bank and Green Dot Corporation (July 19, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240719b 1 .pdf; Consent Order with Silvergate Capital Corporation and Silvergate Bank, (June 4, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240701al.pdf; Consent Order with Evolve Bancorp, Inc. and Evolve Bank & Trust (June 11, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240614al .pdf. 4 See Vice Chair for Supervision Barr, "Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank" at 35 (April 28, 2023), https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf; Material Loss Review of Silicon Valley Bank at 38 (September 25, 2023), https://oig.federalreserve.gov/reports/board-material-loss-review-silicon-valley-bank-sep2023.pdf. -9- whether supervisors are empowered to appropriately supervise firms that experience rapid growth and other emerging risks. Each regulatory agency has an obligation to facilitate an environment that can help the agency best fulfill its mission. It must take care to maintain a positive and productive culture over time by listening intently to concerns that are raised, ensuring that employees are empowered to raise issues of concern (including reporting of personnel issues), and taking appropriate actions to remediate those concerns. Regulators are certainly not immune from problems arising with institutional culture. Recently, we have seen a high-profile example of problems with the culture at the Federal Deposit Insurance Corporation (FDIC). I commend the FDIC for engaging an independent third party to assist them in their investigation; this is an important first step toward accountability and addressing these issues. We must not lose sight of the lesson that cultural problems at both banks and regulators can compound cyclical downturns in the banking environment and pose more serious risks to the banking system. Cultivating a positive culture, one that values accountability and the contributions of both management and staff to an organization's mission, can serve as a buffer against future stresses. Bank Mergers and Acquisitions Another area of ongoing interest among regulators is the approach to banking industry M&A transactions.> The significant shift in regulatory approaches is concerning. As a threshold 5 See Jonathan Kanter (2023), "Merger Enforcement Sixty Years after Philadelphia National Bank," speech delivered at the Brookings Institution's Center on Regulation and Markets Event "Promoting Competition in Banking," Washington, June 20, https://www.justice.gov/opa/speech/assistant-attorney-general-jonathan-kanter- delivers-keynote-address-brookings-institution; Office of the Comptroller of the Currency (2024), "Business Combinations under the Bank Merger Act: Notice of Proposed Rulemaking," OCC Bulletin 2024-4, January 29, https://occ.gov/news-issuances/bulletins/2024/bulletin-2024-4 html; and Federal Deposit Insurance Corporation -10- matter, any discussion of regulatory approval standards should begin with an understanding of the critical role bank M&A transactions play in a healthy banking system. M&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote their long-term health and viability. M&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and leaving zombie banks that have no competitive viability or exit strategy to continue operations. The impact of a more restrictive M&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks (G-SIBs). Banks of all sizes may choose to pursue M&A to pursue strategic growth opportunities and to remain competitive with larger peers that can achieve growth organically through sheer scale. The consequence of limiting the growth options for any bank hoping to compete with the largest G-SIBs has the perverse, and unintended, consequence of actually further insulating the very largest institutions from competition. Against this backdrop, and while recognizing the value of M&A to the banking system, regulators must be pragmatic and thoughtful about reforms. As first steps, we must define the desired end state we are seeking to achieve with any changes. We must then identify the problem that needs to be solved and proffer a solution that is fair, transparent, consistent with applicable statutes, tailored for each bank category, and efficient. We should not propose a cure without first identifying an ailment and a reasoned basis for the prescribed outcome. (2024), "FDIC Seeks Public Comment on Proposed Revisions to Its Statement of Policy on Bank Merger Transactions," press release, March 21, https://www.fdic.gov/news/press-releases/2024/pr24017. html. -ll- The primary argument raised by proponents of reform is that the regulatory approval process has become a rubber stamp, one in which regulators do not conduct a meaningful review against the statutory factors laid out by Congress. Bankers who have been through the M&A approval process would almost certainly disagree with the notion that regulators take a light- touch approach in reviewing banking transactions. There is ample evidence to undermine this argument. Let's consider just the process of filing an application. It begins with identifying an M&A target, conducting due diligence, and negotiating the terms of the transaction. The next steps are preparing and filing the application, and engaging with regulators throughout the review process and beyond approval, in anticipation of post-approval business processes, including systems conversions and customer transitions. The costs of M&A can be substantial, and banks do not enter into transactions without significant preparation and planning, including an informed analysis that any proposal would be likely to result in regulatory approval. The demands of the process act as a self-selection mechanism, with only institutions that see both value in the transaction and a strong likelihood of regulatory approval going through the process. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. Federal Reserve data support the view that even for the self-selected population who files an application, the process does not always lead to approval. To the contrary, based on the most recent data reported for 2023, a significant portion of M&A applications were withdrawn before approval, and the average processing time in the second half of 2023 was 87 days.° The number ® See Board of Governors of the Federal Reserve System (2023), Banking Applications Activity Semiannual Report, July 1-December 31, 2023 (Washington: Board of Governors, April 2024) Table 2 ("Semiannual Applications Report"). While average processing times in 2023 showed a decrease as compared to 2022, the report notes that this was primarily due to fewer proposals receiving adverse public comments. Semiannual Applications Report, at 3. -12- of approved M&A transactions was also significantly lower in 2023 than it was in 2020, 2021, or 2022.7 When we talk about M&A process reform, it can feel like bankers and regulators are living in different worlds. Bankers seek to conclude the process in a timely way, enabling them to move forward from the uncertainty of the application process to the important work of integrating the banks' operations as quickly as possible. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. In contrast, some regulators feel pressure to revisit well-established regulatory approval standards relating to statutory factors, such as the effect of a transaction on competition, or to even expand the use of M&A review to accomplish other objectives, like forcing banks to adopt regulatory standards that would not otherwise apply by regulation as a condition of approval.® Regulatory reforms should promote a healthy banking system and must acknowledge the important role M&A activity plays in keeping the system healthy. Unfortunately, reform efforts, and the existing record of performance on banking M&A transactions, show a concerning trend that the barriers to bank M&A activity remain substantial. 71d. 8 See, e.g., FRB Order No. 2022-22 (October 14, 2022), U.S. Bancorp, Minneapolis, Minnesota, Order Approving the Acquisition of a Bank, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg2022 1014a3.pdf; Statement by Governor Michelle W. Bowman on advance notice of proposed rulemaking on resolution requirements for large Banks and application by U.S. Bancorp (October 14, 2022), https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20221014.htm (expressing concern about the potential accelerated imposition of regulatory standards on a firm that would not otherwise apply by operation of existing applicability thresholds). -13- Liquidity Since last spring, regulators have also focused on revisiting bank liquidity requirements. Last month, the Federal Reserve Banks of Dallas and Atlanta hosted a research conference to discuss the Federal Reserve's traditional role as a "lender of last resort," the payments infrastructure, deposit insurance reform, and the sources of bank liquidity." The discussions included a broad range of views on all of these topics, highlighting the need for a thorough understanding of all of the issues before moving forward with any proposals for solutions. The failures of SVB, Signature Bank, and First Republic Bank have prompted discussion among policymakers about the need for even more regulation. It's important to emphasize here that the conditions for failure, and the subsequent banking stress, could not have occurred without bank management and supervisory failures. Therefore, identifying and remediating these known and identifiable issues to the greatest extent possible should continue to be a priority as we engage in serious discussions about regulatory reforms. Those events also highlighted the need to revisit bank liquidity and funding as part of our review of the regulatory framework. When we consider the Federal Reserve's operational infrastructure, including Fedwire® and discount window lending, we must ask if the Federal Reserve's tools were effective and complementary to other funding sources (including Federal Home Loan Bank funding) during times of stress, and if not, we must ask how they could be improved. Reform discussions should include not only thinking about new and revised requirements and expectations that would apply to individual banks, but also identifying ° See Federal Reserve Bank of Dallas, "Exploring Conventional Bank Funding Regimes in an Unconventional World" (July 18-19, 2024, Dallas, Texas), https://www.dallasfed.org/research/events/2024/24deposit. -14- opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. Lender of Last Resort and Payments Infrastructure One area in need of attention is considering how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. The payments infrastructure that supports bank funding mechanisms must be prepared to operate effectively both during business-as-usual conditions and during stress events. Yet during the banking stress in 2023 and the unprecedented speed of the bank runs that occurred, some banks experienced frictions in using the discount window and limits on the availability of payment services. These issues may have interfered with liquidity management activity and exacerbated the banking stress. The Fed must continue to enhance the technology, operational readiness, and services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service, to operate 22 hours per day, 7 days per week, on a year-round basis.!° The proposal also requested feedback on whether the discount window should operate during these same expanded hours. Expanded service hours are a concrete example of a change that is responsive to the issues experienced last spring, but my hope is that these changes are accompanied by other important operational improvements, including improved technology and operational readiness within the Federal Reserve System. 10 Federal Reserve System, Request for Comment, "Expansion of Fedwire® Funds Service and National Settlement Service Operating Hours," 89 Fed. Reg. 39,613 (May 9, 2024) -15- Bank Liquidity Bank liquidity has also been a prominent feature in reform discussions, focusing on whether the calibration and scope of the regulatory framework is appropriate. This includes the discussion of possible revisions to liquidity-related regulatory requirements, including liquidity stress testing and the liquidity coverage ratio, as well as shifting supervisory expectations for contingent funding plans and the availability of alternative liquidity sources. As we consider the requirements and expectations for banks, we should also consider the availability of funding and liquidity sources and mechanisms-for example, the role of repo (repurchase agreement) markets and the standing repo facility, extension of credit from the Federal Home Loan Banks, and, of course, the role of the Fed's discount window. While the Federal Reserve considers reforms specifically to the discount window, it is important to frame these discussions within a broader context of other sources, and in light of the unique position of the discount window in this framework. The discount window is a critical tool, but it does not operate in isolation. It is intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning.'! Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window, and while policymakers have discussed potential regulatory reforms to implement this change, supervisory "I Michelle W. Bowman, "Bank Liquidity, Regulation, and the Fed's Role as Lender of Last Resort" (speech at The Roundtable on the Lender of Last Resort: The 2023 Banking Crisis and COVID, sponsored by the Committee on Capital Markets Regulation, Washington, D.C., April 3, 2024), https://www.federalreserve.gov/newsevents/speech/bowman20240403a.htm, -16- communications have already begun directing collateral prepositioning as a supervisory best practice. As a policy reform, the notion is that forcing banks to preposition collateral in this way will create a ready pool of liquidity those banks can draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window and thereby improve its effectiveness. The effectiveness of a prepositioning requirement as a solution to perceived stigma concerns remains to be seen, but one can reasonably question if compulsory prepositioning or compulsory use of the discount window would materially change market perceptions and resolve bank concerns about stigma. There is no reason for a bank to take a loan at a penalty rate or to preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it more frequently will not address these underlying operational issues. To the contrary, investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of banks' contingency funding plans, could be explored more thoroughly. Ifa bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we must recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful, and that perhaps resources would be better devoted to making sure the discount window is prepared to act in a timely way, rather than adding even more regulatory requirements or supervisory expectations to banks that may complicate day-to-day liquidity management, with uncertain liquidity benefits during stress. -17- When it comes to the next steps in liquidity reform, it is imperative that we tackle known and identified issues that were exposed during the banking stress last year. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. In my view, remediation of known issues must remain a key priority. Closing Thoughts The federal banking agencies' reform agenda has recently been directed toward rapid and transformational change, rather than deliberate and incremental change. Just as a bank's rapid growth may increase the risks of outgrowing risk-management and compliance frameworks, rapid regulatory reforms increase the risk of regulation resulting in harmful unintended consequences to the banking and financial system. Banks are already experiencing the effects of this "rapid change" approach through the supervisory process. And it will become increasingly clear as the reform agenda continues on its current path. Bankers should be concerned about significant swings of the regulatory pendulum, swings that increase financial system uncertainty and instability and that complicate day-to-day operations and long-term planning. Deliberate, thoughtful change allows the Federal Reserve to demonstrate that it executes its duties in an independent manner, focusing on its statutory obligations, and helps build public support and trust. I look forward to our conversation.	---[PAGE_BREAK]--- For release on delivery 12:10 p.m. EDT (10:10 a.m. MDT time) August 10, 2024 Update on the Economic Outlook, and Perspective on Bank Culture, M\&A, and Liquidity Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the 2024 CEO and Senior Management Summit and Annual Meeting, sponsored by the Kansas Bankers Association Colorado Springs, Colorado August 10, 2024 ---[PAGE_BREAK]--- Thank you for the invitation to join you again this year. ${ }^{1}$ Just as banking and economic conditions continue to evolve, so too do bank regulatory and supervisory standards. I look forward to learning your perspectives on the evolving banking and economic conditions, and the banking agencies' approaches to regulation and supervision. # Economic and Monetary Policy Outlook Before discussing my thoughts on bank regulatory matters, and in light of our recent Federal Open Market Committee (FOMC) meeting, I will begin by sharing my current views on the economy and monetary policy. Over the past two years, the FOMC has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at $5-1 / 4$ to $5-1 / 2$ percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, we have seen some further progress on lowering inflation in recent months. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer relative to more volatile higherfrequency readings, have moved down since April, although they have remained somewhat elevated and stood at 2.5 percent and 2.6 percent in June, respectively. The progress in lowering inflation during May and June is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Despite the recent good data reports, core PCE inflation averaged an annualized 3.4 percent over the first half of the year. And given that supply constraints have now largely [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. ---[PAGE_BREAK]--- normalized, I am not confident that inflation will decline in the same way as in the second half of last year. More importantly, prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Gross domestic product (GDP) growth moved up in the second quarter, following a soft reading in the first quarter, while private domestic final purchases (PDFP) increased at a solid pace in both quarters. During the first half of 2024, PDFP slowed much less than GDP, as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Although consumer spending strengthened in the second quarter, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined - showing signs that the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in ---[PAGE_BREAK]--- July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains are still above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation. First, as I noted earlier, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due both to increased labor force participation and strong immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and significantly higher U.S. immigration over the past few years may decrease going forward. Geopolitical developments could also pose upside risks to inflation, as the recent surge in container shipping costs originating in Asia suggest that global supply chains remain susceptible to disruptions, which could put upward pressure on food, energy, and commodity prices. There ---[PAGE_BREAK]--- is also the risk that additional fiscal stimulus could add momentum to demand, impeding further progress on reducing inflation. Finally, there continues to be a risk that the increased immigration could lead to persistently high housing services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. There are also risks that the labor market has not been as strong as the payroll data have been indicating, but it also appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report implies that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become less accurate as response rates have appreciably declined since the pandemic. ${ }^{2}$ Moreover, the rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find a job, while layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was centered in workers experiencing a temporary layoff, who are more likely to be rehired in coming months, and Hurricane Beryl likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. [^0] [^0]: ${ }^{2}$ The Q4 Quarterly Census of Employment and Wages (QCEW) administrative data show employment gains that are about 110,000 per month lower than what the Current Employment Statistics (CES) survey reported from March 2023 to December 2023. Although the Bureau of Labor Statistics benchmarks CES payroll employment based on the Q1 QCEW, to be released on August 21, the Q4 QCEW data point to a substantial downward revision to CES employment gains last year. ---[PAGE_BREAK]--- In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook, with a focus on the dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen a range of additional economic data and information, including one employment and two inflation reports. We will also have a wider view of how developments in broader financial conditions might influence the economic outlook. In particular, equity prices have been volatile recently but are still higher than at the end of last year. I will continue to closely monitor the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. ---[PAGE_BREAK]--- # Banking Regulation and Supervision I will turn now to bank regulation and supervision. Today I would like to address a few topics that I expect will be of interest to those in this room, starting with the issue of culture both within banks and at bank and other financial regulatory agencies. I will then briefly discuss mergers and acquisitions (M\&A) activity in the banking industry, and the current and expected outlook for bank transactions. I will close with a discussion on bank liquidity regulation. ## The Role of Culture at Banks and at Regulators In recent years, regulatory approaches have included regulators seeking to influence the culture within banks, specifically large banks, focusing on matters like building a culture that promotes compliance or effective risk management, including operational risk. A bank's culture drives its sense of ownership and a collective purpose that is common among many successful organizations, where a bank's board, management, and employees all work together in support of the bank's business purpose and mission. Bank culture can have a strong influence on both business outcomes and on compliance and risk-management outcomes. Bank culture starts with bank leadership, the so-called tone from the top. Strong bank culture demands accountability for bank leadership teams and for the entire workforce. A bank's management is responsible for setting the strategic direction of the company, including which business lines to pursue, expand, or eliminate. But bank leaders also have a responsibility to empower employees to raise issues and concerns, allowing them to identify and escalate emerging business, risk-management, or compliance matters that may require management's attention or intervention. While regulators have sought to influence bank culture over time, ultimately culture is most heavily influenced and shaped by the example set by bank leaders and by the actions of each bank employee. ---[PAGE_BREAK]--- Regulatory agency culture can be similarly impactful in shaping bank regulation and supervision to promote safety and soundness and consumer compliance in an effective and efficient manner. In contrast to regulators, bank management may choose to modify or reshape their mission and objectives over time-evolving their business goals, risk-management policies and processes, and compliance standards as conditions change. For regulators, the overarching regulatory and supervisory mission and related institutional goals are prescribed by statute. While bank regulators lack the flexibility to change the mission, they have significant flexibility in the execution of that mission. This often involves broad policy goals-for example, promoting the safety and soundness of the banking system, and the stability of the financial system. Similar to bank culture, regulatory agency culture begins with its leadership and is then carried out by the individual members of the organization's workforce. Culture plays a significant role in how well bank regulators pursue their statutory objectives and the manner in which they perform the related mission. Have regulators created a culture that allows the staff to identify and escalate issues of concern? Have regulators oriented the mission of the institution around core statutory goals and avoided the temptation to stray from this mission into other matters of public policy? Have regulators created a culture of accountability for leaders and employees, where shortcomings can be fairly identified and actions can be taken to remediate problems? While the value of culture is widely acknowledged, both among banks and among bank regulators, we have seen some recent high-profile examples of culture falling short, and with ---[PAGE_BREAK]--- serious consequences. ${ }^{3}$ Responsible banking involves not only finding and pursuing opportunities to serve customers and grow the business, but also balancing these business priorities with a firm commitment to risk management and compliance, including consumer compliance. While banks are free to pursue growth, in some instances this growth has come without accompanying development of and investment in risk management and legal compliance, to the detriment of the bank and its customers. In the case of Silicon Valley Bank's (SVB) failure in 2023, rapid growth was certainly a factor that contributed to the firm's fragility. The bank's management failed to properly manage its development of contingent liquidity planning, funding, and risk-management capabilities in light of its rapid growth. While this failure revealed problems with bank leadership in promoting a compliance and risk-management culture commensurate with growth, supervisors directly overseeing the bank's expansion were also late to act in the face of emerging firm risks. I think we should question whether we have learned all of the right lessons from SVB's failure. We know that rapid growth is a known risk factor that should result in additional supervisory scrutiny. But some of the post-failure SVB reviews conducted internally by Federal Reserve staff cited rapid growth as a contributing factor for the inadequacy of the supervisory approach. ${ }^{4}$ Among other things, these internal reports suggested that the shift of SVB from one supervisory portfolio to another somehow frustrated appropriate supervision. We need to ask [^0] [^0]: ${ }^{3}$ Board of Governors of the Federal Reserve System, Consent Order with Green Dot Bank and Green Dot Corporation (July 19, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240719b1.pdf; Consent Order with Silvergate Capital Corporation and Silvergate Bank, (June 4, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240701a1.pdf; Consent Order with Evolve Bancorp, Inc. and Evolve Bank \& Trust (June 11, 2024), https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240614a1.pdf. ${ }^{4}$ See Vice Chair for Supervision Barr, "Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank" at 35 (April 28, 2023), https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf; Material Loss Review of Silicon Valley Bank at 38 (September 25, 2023), https://oig.federalreserve.gov/reports/board-material-loss-review-silicon-valley-bank-sep2023.pdf. ---[PAGE_BREAK]--- whether supervisors are empowered to appropriately supervise firms that experience rapid growth and other emerging risks. Each regulatory agency has an obligation to facilitate an environment that can help the agency best fulfill its mission. It must take care to maintain a positive and productive culture over time by listening intently to concerns that are raised, ensuring that employees are empowered to raise issues of concern (including reporting of personnel issues), and taking appropriate actions to remediate those concerns. Regulators are certainly not immune from problems arising with institutional culture. Recently, we have seen a high-profile example of problems with the culture at the Federal Deposit Insurance Corporation (FDIC). I commend the FDIC for engaging an independent third party to assist them in their investigation; this is an important first step toward accountability and addressing these issues. We must not lose sight of the lesson that cultural problems at both banks and regulators can compound cyclical downturns in the banking environment and pose more serious risks to the banking system. Cultivating a positive culture, one that values accountability and the contributions of both management and staff to an organization's mission, can serve as a buffer against future stresses. # Bank Mergers and Acquisitions Another area of ongoing interest among regulators is the approach to banking industry M\&A transactions. ${ }^{5}$ The significant shift in regulatory approaches is concerning. As a threshold [^0] [^0]: ${ }^{5}$ See Jonathan Kanter (2023), "Merger Enforcement Sixty Years after Philadelphia National Bank," speech delivered at the Brookings Institution's Center on Regulation and Markets Event "Promoting Competition in Banking," Washington, June 20, https://www.justice.gov/opa/speech/assistant-attorney-general-jonathan-kanter-delivers-keynote-address-brookings-institution; Office of the Comptroller of the Currency (2024), "Business Combinations under the Bank Merger Act: Notice of Proposed Rulemaking," OCC Bulletin 2024-4, January 29, https://occ.gov/news-issuances/bulletins/2024/bulletin-2024-4.html; and Federal Deposit Insurance Corporation ---[PAGE_BREAK]--- matter, any discussion of regulatory approval standards should begin with an understanding of the critical role bank M\&A transactions play in a healthy banking system. M\&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote their long-term health and viability. M\&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M\&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and leaving zombie banks that have no competitive viability or exit strategy to continue operations. The impact of a more restrictive M\&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks (G-SIBs). Banks of all sizes may choose to pursue M\&A to pursue strategic growth opportunities and to remain competitive with larger peers that can achieve growth organically through sheer scale. The consequence of limiting the growth options for any bank hoping to compete with the largest G-SIBs has the perverse, and unintended, consequence of actually further insulating the very largest institutions from competition. Against this backdrop, and while recognizing the value of M\&A to the banking system, regulators must be pragmatic and thoughtful about reforms. As first steps, we must define the desired end state we are seeking to achieve with any changes. We must then identify the problem that needs to be solved and proffer a solution that is fair, transparent, consistent with applicable statutes, tailored for each bank category, and efficient. We should not propose a cure without first identifying an ailment and a reasoned basis for the prescribed outcome. [^0] [^0]: (2024), "FDIC Seeks Public Comment on Proposed Revisions to Its Statement of Policy on Bank Merger Transactions," press release, March 21, https://www.fdic.gov/news/press-releases/2024/pr24017.html. ---[PAGE_BREAK]--- The primary argument raised by proponents of reform is that the regulatory approval process has become a rubber stamp, one in which regulators do not conduct a meaningful review against the statutory factors laid out by Congress. Bankers who have been through the M\&A approval process would almost certainly disagree with the notion that regulators take a lighttouch approach in reviewing banking transactions. There is ample evidence to undermine this argument. Let's consider just the process of filing an application. It begins with identifying an M\&A target, conducting due diligence, and negotiating the terms of the transaction. The next steps are preparing and filing the application, and engaging with regulators throughout the review process and beyond approval, in anticipation of post-approval business processes, including systems conversions and customer transitions. The costs of M\&A can be substantial, and banks do not enter into transactions without significant preparation and planning, including an informed analysis that any proposal would be likely to result in regulatory approval. The demands of the process act as a self-selection mechanism, with only institutions that see both value in the transaction and a strong likelihood of regulatory approval going through the process. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. Federal Reserve data support the view that even for the self-selected population who files an application, the process does not always lead to approval. To the contrary, based on the most recent data reported for 2023, a significant portion of M\&A applications were withdrawn before approval, and the average processing time in the second half of 2023 was 87 days. ${ }^{6}$ The number [^0] [^0]: ${ }^{6}$ See Board of Governors of the Federal Reserve System (2023), Banking Applications Activity Semiannual Report, July 1-December 31, 2023 (Washington: Board of Governors, April 2024) Table 2 ("Semiannual Applications Report"). While average processing times in 2023 showed a decrease as compared to 2022, the report notes that this was primarily due to fewer proposals receiving adverse public comments. Semiannual Applications Report, at 3 . ---[PAGE_BREAK]--- of approved M\&A transactions was also significantly lower in 2023 than it was in 2020, 2021, or $2022 .{ }^{7}$ When we talk about M\&A process reform, it can feel like bankers and regulators are living in different worlds. Bankers seek to conclude the process in a timely way, enabling them to move forward from the uncertainty of the application process to the important work of integrating the banks' operations as quickly as possible. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. In contrast, some regulators feel pressure to revisit well-established regulatory approval standards relating to statutory factors, such as the effect of a transaction on competition, or to even expand the use of M\&A review to accomplish other objectives, like forcing banks to adopt regulatory standards that would not otherwise apply by regulation as a condition of approval. ${ }^{8}$ Regulatory reforms should promote a healthy banking system and must acknowledge the important role M\&A activity plays in keeping the system healthy. Unfortunately, reform efforts, and the existing record of performance on banking M\&A transactions, show a concerning trend that the barriers to bank M\&A activity remain substantial. [^0] [^0]: ${ }^{7}$ Id. ${ }^{8}$ See, e.g., FRB Order No. 2022-22 (October 14, 2022), U.S. Bancorp, Minneapolis, Minnesota, Order Approving the Acquisition of a Bank, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20221014a3.pdf; Statement by Governor Michelle W. Bowman on advance notice of proposed rulemaking on resolution requirements for large Banks and application by U.S. Bancorp (October 14, 2022), https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20221014.htm (expressing concern about the potential accelerated imposition of regulatory standards on a firm that would not otherwise apply by operation of existing applicability thresholds). ---[PAGE_BREAK]--- # Liquidity Since last spring, regulators have also focused on revisiting bank liquidity requirements. Last month, the Federal Reserve Banks of Dallas and Atlanta hosted a research conference to discuss the Federal Reserve's traditional role as a "lender of last resort," the payments infrastructure, deposit insurance reform, and the sources of bank liquidity. ${ }^{9}$ The discussions included a broad range of views on all of these topics, highlighting the need for a thorough understanding of all of the issues before moving forward with any proposals for solutions. The failures of SVB, Signature Bank, and First Republic Bank have prompted discussion among policymakers about the need for even more regulation. It's important to emphasize here that the conditions for failure, and the subsequent banking stress, could not have occurred without bank management and supervisory failures. Therefore, identifying and remediating these known and identifiable issues to the greatest extent possible should continue to be a priority as we engage in serious discussions about regulatory reforms. Those events also highlighted the need to revisit bank liquidity and funding as part of our review of the regulatory framework. When we consider the Federal Reserve's operational infrastructure, including Fedwire ${ }^{\circledR}$ and discount window lending, we must ask if the Federal Reserve's tools were effective and complementary to other funding sources (including Federal Home Loan Bank funding) during times of stress, and if not, we must ask how they could be improved. Reform discussions should include not only thinking about new and revised requirements and expectations that would apply to individual banks, but also identifying [^0] [^0]: ${ }^{9}$ See Federal Reserve Bank of Dallas, "Exploring Conventional Bank Funding Regimes in an Unconventional World" (July 18-19, 2024, Dallas, Texas), https://www.dallasfed.org/research/events/2024/24deposit. ---[PAGE_BREAK]--- opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. # Lender of Last Resort and Payments Infrastructure One area in need of attention is considering how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. The payments infrastructure that supports bank funding mechanisms must be prepared to operate effectively both during business-as-usual conditions and during stress events. Yet during the banking stress in 2023 and the unprecedented speed of the bank runs that occurred, some banks experienced frictions in using the discount window and limits on the availability of payment services. These issues may have interfered with liquidity management activity and exacerbated the banking stress. The Fed must continue to enhance the technology, operational readiness, and services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service, to operate 22 hours per day, 7 days per week, on a year-round basis. ${ }^{10}$ The proposal also requested feedback on whether the discount window should operate during these same expanded hours. Expanded service hours are a concrete example of a change that is responsive to the issues experienced last spring, but my hope is that these changes are accompanied by other important operational improvements, including improved technology and operational readiness within the Federal Reserve System. [^0] [^0]: ${ }^{10}$ Federal Reserve System, Request for Comment, "Expansion of Fedwire® Funds Service and National Settlement Service Operating Hours," 89 Fed. Reg. 39,613 (May 9, 2024) ---[PAGE_BREAK]--- # Bank Liquidity Bank liquidity has also been a prominent feature in reform discussions, focusing on whether the calibration and scope of the regulatory framework is appropriate. This includes the discussion of possible revisions to liquidity-related regulatory requirements, including liquidity stress testing and the liquidity coverage ratio, as well as shifting supervisory expectations for contingent funding plans and the availability of alternative liquidity sources. As we consider the requirements and expectations for banks, we should also consider the availability of funding and liquidity sources and mechanisms-for example, the role of repo (repurchase agreement) markets and the standing repo facility, extension of credit from the Federal Home Loan Banks, and, of course, the role of the Fed's discount window. While the Federal Reserve considers reforms specifically to the discount window, it is important to frame these discussions within a broader context of other sources, and in light of the unique position of the discount window in this framework. The discount window is a critical tool, but it does not operate in isolation. It is intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning. ${ }^{11}$ Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window, and while policymakers have discussed potential regulatory reforms to implement this change, supervisory [^0] [^0]: ${ }^{11}$ Michelle W. Bowman, "Bank Liquidity, Regulation, and the Fed's Role as Lender of Last Resort" (speech at The Roundtable on the Lender of Last Resort: The 2023 Banking Crisis and COVID, sponsored by the Committee on Capital Markets Regulation, Washington, D.C., April 3, 2024), https://www.federalreserve.gov/newsevents/speech/bowman20240403a.htm. ---[PAGE_BREAK]--- communications have already begun directing collateral prepositioning as a supervisory best practice. As a policy reform, the notion is that forcing banks to preposition collateral in this way will create a ready pool of liquidity those banks can draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window and thereby improve its effectiveness. The effectiveness of a prepositioning requirement as a solution to perceived stigma concerns remains to be seen, but one can reasonably question if compulsory prepositioning or compulsory use of the discount window would materially change market perceptions and resolve bank concerns about stigma. There is no reason for a bank to take a loan at a penalty rate or to preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it more frequently will not address these underlying operational issues. To the contrary, investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of banks' contingency funding plans, could be explored more thoroughly. If a bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we must recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful, and that perhaps resources would be better devoted to making sure the discount window is prepared to act in a timely way, rather than adding even more regulatory requirements or supervisory expectations to banks that may complicate day-to-day liquidity management, with uncertain liquidity benefits during stress. ---[PAGE_BREAK]--- When it comes to the next steps in liquidity reform, it is imperative that we tackle known and identified issues that were exposed during the banking stress last year. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. In my view, remediation of known issues must remain a key priority. # Closing Thoughts The federal banking agencies' reform agenda has recently been directed toward rapid and transformational change, rather than deliberate and incremental change. Just as a bank's rapid growth may increase the risks of outgrowing risk-management and compliance frameworks, rapid regulatory reforms increase the risk of regulation resulting in harmful unintended consequences to the banking and financial system. Banks are already experiencing the effects of this "rapid change" approach through the supervisory process. And it will become increasingly clear as the reform agenda continues on its current path. Bankers should be concerned about significant swings of the regulatory pendulum, swings that increase financial system uncertainty and instability and that complicate day-to-day operations and long-term planning. Deliberate, thoughtful change allows the Federal Reserve to demonstrate that it executes its duties in an independent manner, focusing on its statutory obligations, and helps build public support and trust. I look forward to our conversation.	Michelle W Bowman	United States	https://www.bis.org/review/r240812b.pdf	For release on delivery 12:10 p.m. EDT (10:10 a.m. MDT time) August 10, 2024 Update on the Economic Outlook, and Perspective on Bank Culture, M\&A, and Liquidity Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the Colorado Springs, Colorado August 10, 2024 Thank you for the invitation to join you again this year. Just as banking and economic conditions continue to evolve, so too do bank regulatory and supervisory standards. I look forward to learning your perspectives on the evolving banking and economic conditions, and the banking agencies' approaches to regulation and supervision. Before discussing my thoughts on bank regulatory matters, and in light of our recent Federal Open Market Committee (FOMC) meeting, I will begin by sharing my current views on the economy and monetary policy. Over the past two years, the FOMC has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at $5-1 / 4$ to $5-1 / 2$ percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, we have seen some further progress on lowering inflation in recent months. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer relative to more volatile higherfrequency readings, have moved down since April, although they have remained somewhat elevated and stood at 2.5 percent and 2.6 percent in June, respectively. The progress in lowering inflation during May and June is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Despite the recent good data reports, core PCE inflation averaged an annualized 3.4 percent over the first half of the year. And given that supply constraints have now largely normalized, I am not confident that inflation will decline in the same way as in the second half of last year. More importantly, prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Gross domestic product (GDP) growth moved up in the second quarter, following a soft reading in the first quarter, while private domestic final purchases (PDFP) increased at a solid pace in both quarters. During the first half of 2024, PDFP slowed much less than GDP, as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Although consumer spending strengthened in the second quarter, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined - showing signs that the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains are still above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation. First, as I noted earlier, much of the progress on inflation last year was due to supply-side improvements, including easing of supply chain constraints; increases in the number of available workers, due both to increased labor force participation and strong immigration; and lower energy prices. It is unlikely that further improvements along this margin will continue to lower inflation going forward, as supply chains have largely normalized, the labor force participation rate has leveled off in recent months below pre-pandemic levels, and significantly higher U.S. immigration over the past few years may decrease going forward. Geopolitical developments could also pose upside risks to inflation, as the recent surge in container shipping costs originating in Asia suggest that global supply chains remain susceptible to disruptions, which could put upward pressure on food, energy, and commodity prices. There is also the risk that additional fiscal stimulus could add momentum to demand, impeding further progress on reducing inflation. Finally, there continues to be a risk that the increased immigration could lead to persistently high housing services inflation. Given the current low inventory of affordable housing, the inflow of new immigrants to some geographic areas could result in upward pressure on rents, as additional housing supply may take time to materialize. There are also risks that the labor market has not been as strong as the payroll data have been indicating, but it also appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report implies that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become less accurate as response rates have appreciably declined since the pandemic. Moreover, the rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find a job, while layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was centered in workers experiencing a temporary layoff, who are more likely to be rehired in coming months, and Hurricane Beryl likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook, with a focus on the dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen a range of additional economic data and information, including one employment and two inflation reports. We will also have a wider view of how developments in broader financial conditions might influence the economic outlook. In particular, equity prices have been volatile recently but are still higher than at the end of last year. I will continue to closely monitor the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. I will turn now to bank regulation and supervision. Today I would like to address a few topics that I expect will be of interest to those in this room, starting with the issue of culture both within banks and at bank and other financial regulatory agencies. I will then briefly discuss mergers and acquisitions (M\&A) activity in the banking industry, and the current and expected outlook for bank transactions. I will close with a discussion on bank liquidity regulation. In recent years, regulatory approaches have included regulators seeking to influence the culture within banks, specifically large banks, focusing on matters like building a culture that promotes compliance or effective risk management, including operational risk. A bank's culture drives its sense of ownership and a collective purpose that is common among many successful organizations, where a bank's board, management, and employees all work together in support of the bank's business purpose and mission. Bank culture can have a strong influence on both business outcomes and on compliance and risk-management outcomes. Bank culture starts with bank leadership, the so-called tone from the top. Strong bank culture demands accountability for bank leadership teams and for the entire workforce. A bank's management is responsible for setting the strategic direction of the company, including which business lines to pursue, expand, or eliminate. But bank leaders also have a responsibility to empower employees to raise issues and concerns, allowing them to identify and escalate emerging business, risk-management, or compliance matters that may require management's attention or intervention. While regulators have sought to influence bank culture over time, ultimately culture is most heavily influenced and shaped by the example set by bank leaders and by the actions of each bank employee. Regulatory agency culture can be similarly impactful in shaping bank regulation and supervision to promote safety and soundness and consumer compliance in an effective and efficient manner. In contrast to regulators, bank management may choose to modify or reshape their mission and objectives over time-evolving their business goals, risk-management policies and processes, and compliance standards as conditions change. For regulators, the overarching regulatory and supervisory mission and related institutional goals are prescribed by statute. While bank regulators lack the flexibility to change the mission, they have significant flexibility in the execution of that mission. This often involves broad policy goals-for example, promoting the safety and soundness of the banking system, and the stability of the financial system. Similar to bank culture, regulatory agency culture begins with its leadership and is then carried out by the individual members of the organization's workforce. Culture plays a significant role in how well bank regulators pursue their statutory objectives and the manner in which they perform the related mission. Have regulators created a culture that allows the staff to identify and escalate issues of concern? Have regulators oriented the mission of the institution around core statutory goals and avoided the temptation to stray from this mission into other matters of public policy? Have regulators created a culture of accountability for leaders and employees, where shortcomings can be fairly identified and actions can be taken to remediate problems? While the value of culture is widely acknowledged, both among banks and among bank regulators, we have seen some recent high-profile examples of culture falling short, and with serious consequences. Responsible banking involves not only finding and pursuing opportunities to serve customers and grow the business, but also balancing these business priorities with a firm commitment to risk management and compliance, including consumer compliance. While banks are free to pursue growth, in some instances this growth has come without accompanying development of and investment in risk management and legal compliance, to the detriment of the bank and its customers. In the case of Silicon Valley Bank's (SVB) failure in 2023, rapid growth was certainly a factor that contributed to the firm's fragility. The bank's management failed to properly manage its development of contingent liquidity planning, funding, and risk-management capabilities in light of its rapid growth. While this failure revealed problems with bank leadership in promoting a compliance and risk-management culture commensurate with growth, supervisors directly overseeing the bank's expansion were also late to act in the face of emerging firm risks. I think we should question whether we have learned all of the right lessons from SVB's failure. We know that rapid growth is a known risk factor that should result in additional supervisory scrutiny. But some of the post-failure SVB reviews conducted internally by Federal Reserve staff cited rapid growth as a contributing factor for the inadequacy of the supervisory approach. Among other things, these internal reports suggested that the shift of SVB from one supervisory portfolio to another somehow frustrated appropriate supervision. We need to ask whether supervisors are empowered to appropriately supervise firms that experience rapid growth and other emerging risks. Each regulatory agency has an obligation to facilitate an environment that can help the agency best fulfill its mission. It must take care to maintain a positive and productive culture over time by listening intently to concerns that are raised, ensuring that employees are empowered to raise issues of concern (including reporting of personnel issues), and taking appropriate actions to remediate those concerns. Regulators are certainly not immune from problems arising with institutional culture. Recently, we have seen a high-profile example of problems with the culture at the Federal Deposit Insurance Corporation (FDIC). I commend the FDIC for engaging an independent third party to assist them in their investigation; this is an important first step toward accountability and addressing these issues. We must not lose sight of the lesson that cultural problems at both banks and regulators can compound cyclical downturns in the banking environment and pose more serious risks to the banking system. Cultivating a positive culture, one that values accountability and the contributions of both management and staff to an organization's mission, can serve as a buffer against future stresses. Another area of ongoing interest among regulators is the approach to banking industry M\&A transactions. The significant shift in regulatory approaches is concerning. As a threshold M\&A transactions allow banks to evolve and thrive in our dynamic banking system and can promote their long-term health and viability. M\&A also ensures that banks have a meaningful path to transitioning bank ownership. The absence of a viable M\&A framework increases the potential for additional risks, including limited opportunities for succession planning, especially in smaller or rural communities, and leaving zombie banks that have no competitive viability or exit strategy to continue operations. The impact of a more restrictive M\&A framework affects institutions of all sizes, including larger institutions that are vying to compete with the very largest global systemically important banks (G-SIBs). Banks of all sizes may choose to pursue M\&A to pursue strategic growth opportunities and to remain competitive with larger peers that can achieve growth organically through sheer scale. The consequence of limiting the growth options for any bank hoping to compete with the largest G-SIBs has the perverse, and unintended, consequence of actually further insulating the very largest institutions from competition. Against this backdrop, and while recognizing the value of M\&A to the banking system, regulators must be pragmatic and thoughtful about reforms. As first steps, we must define the desired end state we are seeking to achieve with any changes. We must then identify the problem that needs to be solved and proffer a solution that is fair, transparent, consistent with applicable statutes, tailored for each bank category, and efficient. We should not propose a cure without first identifying an ailment and a reasoned basis for the prescribed outcome. The primary argument raised by proponents of reform is that the regulatory approval process has become a rubber stamp, one in which regulators do not conduct a meaningful review against the statutory factors laid out by Congress. Bankers who have been through the M\&A approval process would almost certainly disagree with the notion that regulators take a lighttouch approach in reviewing banking transactions. There is ample evidence to undermine this argument. Let's consider just the process of filing an application. It begins with identifying an M\&A target, conducting due diligence, and negotiating the terms of the transaction. The next steps are preparing and filing the application, and engaging with regulators throughout the review process and beyond approval, in anticipation of post-approval business processes, including systems conversions and customer transitions. The costs of M\&A can be substantial, and banks do not enter into transactions without significant preparation and planning, including an informed analysis that any proposal would be likely to result in regulatory approval. The demands of the process act as a self-selection mechanism, with only institutions that see both value in the transaction and a strong likelihood of regulatory approval going through the process. This is an expensive and reputationally risky process that bankers and their boards of directors take extremely seriously. Federal Reserve data support the view that even for the self-selected population who files an application, the process does not always lead to approval. To the contrary, based on the most recent data reported for 2023, a significant portion of M\&A applications were withdrawn before approval, and the average processing time in the second half of 2023 was 87 days. The number of approved M\&A transactions was also significantly lower in 2023 than it was in 2020, 2021, or $2022 .{ }^{7}$ When we talk about M\&A process reform, it can feel like bankers and regulators are living in different worlds. Bankers seek to conclude the process in a timely way, enabling them to move forward from the uncertainty of the application process to the important work of integrating the banks' operations as quickly as possible. One of the key risks to an effective process is a lack of timely regulatory action. The consequences of delays can significantly harm both the acquiring institution and the target, causing greater operational risk (including the risk of a failed merger), increased expenses, reputational risk, and staff attrition in the face of prolonged uncertainty. In contrast, some regulators feel pressure to revisit well-established regulatory approval standards relating to statutory factors, such as the effect of a transaction on competition, or to even expand the use of M\&A review to accomplish other objectives, like forcing banks to adopt regulatory standards that would not otherwise apply by regulation as a condition of approval. Regulatory reforms should promote a healthy banking system and must acknowledge the important role M\&A activity plays in keeping the system healthy. Unfortunately, reform efforts, and the existing record of performance on banking M\&A transactions, show a concerning trend that the barriers to bank M\&A activity remain substantial. Since last spring, regulators have also focused on revisiting bank liquidity requirements. Last month, the Federal Reserve Banks of Dallas and Atlanta hosted a research conference to discuss the Federal Reserve's traditional role as a "lender of last resort," the payments infrastructure, deposit insurance reform, and the sources of bank liquidity. The discussions included a broad range of views on all of these topics, highlighting the need for a thorough understanding of all of the issues before moving forward with any proposals for solutions. The failures of SVB, Signature Bank, and First Republic Bank have prompted discussion among policymakers about the need for even more regulation. It's important to emphasize here that the conditions for failure, and the subsequent banking stress, could not have occurred without bank management and supervisory failures. Therefore, identifying and remediating these known and identifiable issues to the greatest extent possible should continue to be a priority as we engage in serious discussions about regulatory reforms. Those events also highlighted the need to revisit bank liquidity and funding as part of our review of the regulatory framework. When we consider the Federal Reserve's operational infrastructure, including Fedwire and discount window lending, we must ask if the Federal Reserve's tools were effective and complementary to other funding sources (including Federal Home Loan Bank funding) during times of stress, and if not, we must ask how they could be improved. Reform discussions should include not only thinking about new and revised requirements and expectations that would apply to individual banks, but also identifying opportunities to remediate deficiencies and overlapping requirements within the regulatory framework. One area in need of attention is considering how to operationally enhance and optimize tools like the discount window to meet banking system liquidity needs more effectively. The payments infrastructure that supports bank funding mechanisms must be prepared to operate effectively both during business-as-usual conditions and during stress events. Yet during the banking stress in 2023 and the unprecedented speed of the bank runs that occurred, some banks experienced frictions in using the discount window and limits on the availability of payment services. These issues may have interfered with liquidity management activity and exacerbated the banking stress. The Fed must continue to enhance the technology, operational readiness, and services underpinning discount window loans and payment services to ensure that they are available when needed. On this front, I would note that the Federal Reserve recently published a proposal to expand the operating hours of the Fedwire Funds Service and the National Settlement Service, to operate 22 hours per day, 7 days per week, on a year-round basis. The proposal also requested feedback on whether the discount window should operate during these same expanded hours. Expanded service hours are a concrete example of a change that is responsive to the issues experienced last spring, but my hope is that these changes are accompanied by other important operational improvements, including improved technology and operational readiness within the Federal Reserve System. Bank liquidity has also been a prominent feature in reform discussions, focusing on whether the calibration and scope of the regulatory framework is appropriate. This includes the discussion of possible revisions to liquidity-related regulatory requirements, including liquidity stress testing and the liquidity coverage ratio, as well as shifting supervisory expectations for contingent funding plans and the availability of alternative liquidity sources. As we consider the requirements and expectations for banks, we should also consider the availability of funding and liquidity sources and mechanisms-for example, the role of repo (repurchase agreement) markets and the standing repo facility, extension of credit from the Federal Home Loan Banks, and, of course, the role of the Fed's discount window. While the Federal Reserve considers reforms specifically to the discount window, it is important to frame these discussions within a broader context of other sources, and in light of the unique position of the discount window in this framework. The discount window is a critical tool, but it does not operate in isolation. It is intended to be a source of liquidity as a last resort and at a penalty rate, not as a primary funding resource in the normal course of business at a market rate. In evaluating the bank liquidity framework, it is imperative that we consider and understand the interrelationships among these resources, liquidity requirements and regulations, and bank liquidity planning. Some policymakers have stated that a potential response to the 2023 banking stress would be to require banks to preposition collateral at the Fed's discount window, and while policymakers have discussed potential regulatory reforms to implement this change, supervisory communications have already begun directing collateral prepositioning as a supervisory best practice. As a policy reform, the notion is that forcing banks to preposition collateral in this way will create a ready pool of liquidity those banks can draw from during times of stress. This compulsory requirement to preposition collateral, it is argued, could also mitigate some of the stigma associated with using the discount window and thereby improve its effectiveness. The effectiveness of a prepositioning requirement as a solution to perceived stigma concerns remains to be seen, but one can reasonably question if compulsory prepositioning or compulsory use of the discount window would materially change market perceptions and resolve bank concerns about stigma. There is no reason for a bank to take a loan at a penalty rate or to preposition collateral during periods of calm if the discount window operates effectively and communicates with banks on a regular basis. If the issue is that the window does not operate in an effective manner, requirements to use it more frequently will not address these underlying operational issues. To the contrary, investments must be made to address its operational shortcomings. Some reforms, like encouraging bank readiness to borrow from the discount window if that is part of banks' contingency funding plans, could be explored more thoroughly. If a bank includes the discount window in these plans and intends to use it during stress, the bank should be prepared to do so. But if we are honest, we must recognize that our prior efforts to reduce discount window stigma, as during the COVID period, have not been durable or successful, and that perhaps resources would be better devoted to making sure the discount window is prepared to act in a timely way, rather than adding even more regulatory requirements or supervisory expectations to banks that may complicate day-to-day liquidity management, with uncertain liquidity benefits during stress. When it comes to the next steps in liquidity reform, it is imperative that we tackle known and identified issues that were exposed during the banking stress last year. This must include updating discount window operations and technology and making sure that payment services are available when needed. But for other reforms, a number of important questions remain unanswered, including understanding both where there are frictions and weaknesses in the current bank funding landscape, and what the potential impact (including intended and unintended consequences) of these reforms on the banking industry could be. In my view, remediation of known issues must remain a key priority. The federal banking agencies' reform agenda has recently been directed toward rapid and transformational change, rather than deliberate and incremental change. Just as a bank's rapid growth may increase the risks of outgrowing risk-management and compliance frameworks, rapid regulatory reforms increase the risk of regulation resulting in harmful unintended consequences to the banking and financial system. Banks are already experiencing the effects of this "rapid change" approach through the supervisory process. And it will become increasingly clear as the reform agenda continues on its current path. Bankers should be concerned about significant swings of the regulatory pendulum, swings that increase financial system uncertainty and instability and that complicate day-to-day operations and long-term planning. Deliberate, thoughtful change allows the Federal Reserve to demonstrate that it executes its duties in an independent manner, focusing on its statutory obligations, and helps build public support and trust. I look forward to our conversation.
2024-08-19T00:00:00	Christopher J Waller: Opening remarks - summer workshop on money, banking, payments, and finance	Opening remarks by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the summer workshop on money, banking, payments and finance, jointly organised by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee, Washington DC, 19 August 2024.	Christopher J Waller: Opening remarks - summer workshop on money, banking, payments, and finance Opening remarks by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the summer workshop on money, banking, payments and finance, jointly organised by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee, Washington DC, 19 August 2024. * * * Thank you, Matt. I am delighted to welcome you all in person to the 2024 Summer Workshop on Money, Banking, Payments, and Finance, jointly organized by the Federal 1 Reserve Board, the Bank of Canada, and the Study Center Gerzensee. I want to thank the organizers for putting together such an interesting program and also thank the participants for their contributions. The evolving nature of money and banking creates new channels through which financial markets and institutions can affect the economy, with implications for all five of the Federal Reserve's functions, which are monetary policy, financial stability, supervision and regulation, payment systems, and consumers and communities. Relatedly, the emergence of new technologies can generate complex economic interactions, and theoretical research and analytical work are crucial to understanding the implications. Many of the concepts underlying such economic interactions have for years been the study of this workshop. When I was research director at the Federal Reserve Bank of St. Louis, I put together several iterations of this gathering. As the organization of the workshop has passed to a new generation, I continue to find it to be a leading venue for studying the economic mechanisms through which money, financial markets, contracts, and institutions affect economic activity and economic welfare. Past participants have advanced modern money and banking theory, bringing new insights to real-world economic problems and policy analysis. Numerous research papers presented in these workshops have been published in prestigious economics journals and influenced scholarship in this area. If I had to describe the work that has been presented at this conference over the last 20plus years, I would say it focuses on the economics of exchange and payment. Walrasian supply and demand models describe how an equilibrium quantity and price are determined but it is silent on two key questions: how do the goods get from seller to buyer and how is payment made from buyer to seller? In short, standard supply and demand analyses have nothing to say about the actual exchange process and how payment is made-in a sense, exchange and payment are viewed as trivial issues. By delving into the micro-foundations of exchange and payment, researchers in this area were able to identify key frictions that make exchange and payment far from trivial. This is not just a theoretical issue that is only relevant to economists in ivory towers. Payments and the exchange process are multibillion-dollar businesses and private sector firms are constantly innovating in this area to overcome the types of frictions that are well-known to this group. The knowledge that I have gained from interacting with researchers in this area for the last 20 years has aided me in one of my roles as a Federal Reserve governor, supporting the Fed's oversight of the U.S. payment system. It also guides my thinking about how to make global payments cheaper and faster, which is a key objective adopted by the G20 countries in 2020 and is one fully supported by the Federal Reserve. Keeping with the tradition of studying exchange and payment, several papers to be presented this year focus on how frictions in financial markets, such as asymmetric information or asset illiquidity, matter for the transmission and implementation of monetary policy as well as unemployment and inflation. Similarly, it is great to continue seeing work studying frictional intermediation in asset markets and the implications for asset prices and the efficient sharing of risk. These contributions push the frontier of our knowledge, facilitate our understanding of real-world complexities, and inform policy thinking. The workshop's focus on broader financial stability issues is also very important. Financial stability vulnerabilities, such as run risk, excessive leverage, and bubbly valuations, could amplify the effect of adverse shocks, potentially resulting in big economic losses and a slowdown in economic activity. Understanding the mechanisms that allow these vulnerabilities to grow and transmit stress to the rest of the financial system requires rigorous theoretical research and solid micro-foundations. Over the course of this week, we will hear interesting work on this topic that includes research questions such as how a central bank can balance interventions for financial stability and interventions to achieve a certain stance of monetary policy, how banks take risks, and understanding the risk of runs on banks, non-banks, and stablecoins. Other concepts are newer and more novel. As the monetary and financial ecosystem has evolved, so has this workshop, bringing together many perspectives and modeling approaches to money and banking theory and its applications. One recurring theme has been to pay special attention to micro-foundations and institutional details, which is important to rigorously analyze and understand today's financial innovations and evaluate their implications for welfare and policy. This year's workshop continues in that innovative spirit, keeping an eye on the future of money and banking. The papers to be presented span areas including decentralized ledgers, exchanges for crypto assets, and the impact of certain protocols on financial stability. Researching these new technologies helps us deepen our understanding of the implications for the broader financial system. An important point to remember this week is that no single field of study can give the answers to all of the big questions we face relating to the evolution of money and banking. Commingling of insights and techniques from monetary theory, finance theory, and other fields is vital in studying the complex interactions of modern financial systems. Of course, it is also important to test our theories with available data, and many papers we will see this week deliver on that count as well. Without further ado, let's get started. I hope you have a great week of engaging discussions, and I'm sure we will learn a lot from this year's workshop. The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	---[PAGE_BREAK]--- # Christopher J Waller: Opening remarks - summer workshop on money, banking, payments, and finance Opening remarks by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the summer workshop on money, banking, payments and finance, jointly organised by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee, Washington DC, 19 August 2024. Thank you, Matt. I am delighted to welcome you all in person to the 2024 Summer Workshop on Money, Banking, Payments, and Finance, jointly organized by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee. I I want to thank the organizers for putting together such an interesting program and also thank the participants for their contributions. The evolving nature of money and banking creates new channels through which financial markets and institutions can affect the economy, with implications for all five of the Federal Reserve's functions, which are monetary policy, financial stability, supervision and regulation, payment systems, and consumers and communities. Relatedly, the emergence of new technologies can generate complex economic interactions, and theoretical research and analytical work are crucial to understanding the implications. Many of the concepts underlying such economic interactions have for years been the study of this workshop. When I was research director at the Federal Reserve Bank of St. Louis, I put together several iterations of this gathering. As the organization of the workshop has passed to a new generation, I continue to find it to be a leading venue for studying the economic mechanisms through which money, financial markets, contracts, and institutions affect economic activity and economic welfare. Past participants have advanced modern money and banking theory, bringing new insights to real-world economic problems and policy analysis. Numerous research papers presented in these workshops have been published in prestigious economics journals and influenced scholarship in this area. If I had to describe the work that has been presented at this conference over the last 20plus years, I would say it focuses on the economics of exchange and payment. Walrasian supply and demand models describe how an equilibrium quantity and price are determined but it is silent on two key questions: how do the goods get from seller to buyer and how is payment made from buyer to seller? In short, standard supply and demand analyses have nothing to say about the actual exchange process and how payment is made-in a sense, exchange and payment are viewed as trivial issues. By delving into the micro-foundations of exchange and payment, researchers in this area were able to identify key frictions that make exchange and payment far from trivial. This is not just a theoretical issue that is only relevant to economists in ivory towers. Payments and the exchange process are multibillion-dollar businesses and private sector firms are constantly innovating in this area to overcome the types of frictions that are well-known to this group. The knowledge that I have gained from interacting with ---[PAGE_BREAK]--- researchers in this area for the last 20 years has aided me in one of my roles as a Federal Reserve governor, supporting the Fed's oversight of the U.S. payment system. It also guides my thinking about how to make global payments cheaper and faster, which is a key objective adopted by the G20 countries in 2020 and is one fully supported by the Federal Reserve. Keeping with the tradition of studying exchange and payment, several papers to be presented this year focus on how frictions in financial markets, such as asymmetric information or asset illiquidity, matter for the transmission and implementation of monetary policy as well as unemployment and inflation. Similarly, it is great to continue seeing work studying frictional intermediation in asset markets and the implications for asset prices and the efficient sharing of risk. These contributions push the frontier of our knowledge, facilitate our understanding of real-world complexities, and inform policy thinking. The workshop's focus on broader financial stability issues is also very important. Financial stability vulnerabilities, such as run risk, excessive leverage, and bubbly valuations, could amplify the effect of adverse shocks, potentially resulting in big economic losses and a slowdown in economic activity. Understanding the mechanisms that allow these vulnerabilities to grow and transmit stress to the rest of the financial system requires rigorous theoretical research and solid micro-foundations. Over the course of this week, we will hear interesting work on this topic that includes research questions such as how a central bank can balance interventions for financial stability and interventions to achieve a certain stance of monetary policy, how banks take risks, and understanding the risk of runs on banks, non-banks, and stablecoins. Other concepts are newer and more novel. As the monetary and financial ecosystem has evolved, so has this workshop, bringing together many perspectives and modeling approaches to money and banking theory and its applications. One recurring theme has been to pay special attention to micro-foundations and institutional details, which is important to rigorously analyze and understand today's financial innovations and evaluate their implications for welfare and policy. This year's workshop continues in that innovative spirit, keeping an eye on the future of money and banking. The papers to be presented span areas including decentralized ledgers, exchanges for crypto assets, and the impact of certain protocols on financial stability. Researching these new technologies helps us deepen our understanding of the implications for the broader financial system. An important point to remember this week is that no single field of study can give the answers to all of the big questions we face relating to the evolution of money and banking. Commingling of insights and techniques from monetary theory, finance theory, and other fields is vital in studying the complex interactions of modern financial systems. Of course, it is also important to test our theories with available data, and many papers we will see this week deliver on that count as well. Without further ado, let's get started. I hope you have a great week of engaging discussions, and I'm sure we will learn a lot from this year's workshop. ---[PAGE_BREAK]--- 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee.	Christopher J Waller	United States	https://www.bis.org/review/r240828m.pdf	Opening remarks by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the summer workshop on money, banking, payments and finance, jointly organised by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee, Washington DC, 19 August 2024. Thank you, Matt. I am delighted to welcome you all in person to the 2024 Summer Workshop on Money, Banking, Payments, and Finance, jointly organized by the Federal Reserve Board, the Bank of Canada, and the Study Center Gerzensee. I I want to thank the organizers for putting together such an interesting program and also thank the participants for their contributions. The evolving nature of money and banking creates new channels through which financial markets and institutions can affect the economy, with implications for all five of the Federal Reserve's functions, which are monetary policy, financial stability, supervision and regulation, payment systems, and consumers and communities. Relatedly, the emergence of new technologies can generate complex economic interactions, and theoretical research and analytical work are crucial to understanding the implications. Many of the concepts underlying such economic interactions have for years been the study of this workshop. When I was research director at the Federal Reserve Bank of St. Louis, I put together several iterations of this gathering. As the organization of the workshop has passed to a new generation, I continue to find it to be a leading venue for studying the economic mechanisms through which money, financial markets, contracts, and institutions affect economic activity and economic welfare. Past participants have advanced modern money and banking theory, bringing new insights to real-world economic problems and policy analysis. Numerous research papers presented in these workshops have been published in prestigious economics journals and influenced scholarship in this area. If I had to describe the work that has been presented at this conference over the last 20plus years, I would say it focuses on the economics of exchange and payment. Walrasian supply and demand models describe how an equilibrium quantity and price are determined but it is silent on two key questions: how do the goods get from seller to buyer and how is payment made from buyer to seller? In short, standard supply and demand analyses have nothing to say about the actual exchange process and how payment is made-in a sense, exchange and payment are viewed as trivial issues. By delving into the micro-foundations of exchange and payment, researchers in this area were able to identify key frictions that make exchange and payment far from trivial. This is not just a theoretical issue that is only relevant to economists in ivory towers. Payments and the exchange process are multibillion-dollar businesses and private sector firms are constantly innovating in this area to overcome the types of frictions that are well-known to this group. The knowledge that I have gained from interacting with researchers in this area for the last 20 years has aided me in one of my roles as a Federal Reserve governor, supporting the Fed's oversight of the U.S. payment system. It also guides my thinking about how to make global payments cheaper and faster, which is a key objective adopted by the G20 countries in 2020 and is one fully supported by the Federal Reserve. Keeping with the tradition of studying exchange and payment, several papers to be presented this year focus on how frictions in financial markets, such as asymmetric information or asset illiquidity, matter for the transmission and implementation of monetary policy as well as unemployment and inflation. Similarly, it is great to continue seeing work studying frictional intermediation in asset markets and the implications for asset prices and the efficient sharing of risk. These contributions push the frontier of our knowledge, facilitate our understanding of real-world complexities, and inform policy thinking. The workshop's focus on broader financial stability issues is also very important. Financial stability vulnerabilities, such as run risk, excessive leverage, and bubbly valuations, could amplify the effect of adverse shocks, potentially resulting in big economic losses and a slowdown in economic activity. Understanding the mechanisms that allow these vulnerabilities to grow and transmit stress to the rest of the financial system requires rigorous theoretical research and solid micro-foundations. Over the course of this week, we will hear interesting work on this topic that includes research questions such as how a central bank can balance interventions for financial stability and interventions to achieve a certain stance of monetary policy, how banks take risks, and understanding the risk of runs on banks, non-banks, and stablecoins. Other concepts are newer and more novel. As the monetary and financial ecosystem has evolved, so has this workshop, bringing together many perspectives and modeling approaches to money and banking theory and its applications. One recurring theme has been to pay special attention to micro-foundations and institutional details, which is important to rigorously analyze and understand today's financial innovations and evaluate their implications for welfare and policy. This year's workshop continues in that innovative spirit, keeping an eye on the future of money and banking. The papers to be presented span areas including decentralized ledgers, exchanges for crypto assets, and the impact of certain protocols on financial stability. Researching these new technologies helps us deepen our understanding of the implications for the broader financial system. An important point to remember this week is that no single field of study can give the answers to all of the big questions we face relating to the evolution of money and banking. Commingling of insights and techniques from monetary theory, finance theory, and other fields is vital in studying the complex interactions of modern financial systems. Of course, it is also important to test our theories with available data, and many papers we will see this week deliver on that count as well. Without further ado, let's get started. I hope you have a great week of engaging discussions, and I'm sure we will learn a lot from this year's workshop.
2024-08-20T00:00:00	Michelle W Bowman: Remarks on the economic outlook and financial inclusion	Remarks by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Alaska Bankers Association, Anchorage, Alaska, 20 August 2024.	For release on delivery 2:00 p.m. EDT (10:00 a.m. AKDT) August 20, 2024 Remarks on the Economic Outlook and Financial Inclusion by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the Alaska Bankers Association Anchorage, Alaska August 20, 2024 Good morning. It is really a pleasure to join you here in Alaska.'! Getting outside of Washington, D.C. and hearing about the unique issues that affect Alaskans provides valuable insights that inform my work at the Federal Reserve. A part of the mission of the Federal Reserve is to support an economy that works for everyone. Consumers and communities are more successful when they have access to financial products and services that meet their needs. While many of these products and services are available online, as Alaskans know better than most Americans, geography and location are also important. This access often looks very different in places with many remote and rural communities. Today, I will discuss the Federal Reserve's work to promote a more inclusive financial system, including our work on financial inclusion for Indigenous communities. Before diving into those topics, I will share my current views on the economy and monetary policy. Economic and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at 5/4 to 5'4 percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, in recent months we have seen some further progress on lowering inflation. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer to the more volatile higher-frequency readings, have moved down since April, although they have remained somewhat elevated at 2.5 percent and 2.6 percent in June, respectively. In addition, the latest consumer and producer price index reports ' The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. -2- indicate that 12-month core PCE inflation likely remained a bit above 2.5 percent in July. The progress in lowering inflation since April is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Private domestic final purchases (PDFP) growth was solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Goods spending rebounded in the second quarter and retail sales continued to rise at a solid pace in July. Consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined-signs that illustrate the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in -3- July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains remain above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation as supply conditions have now largely normalized and any further improvements to supply seem less likely to offset price pressures arising from increasing geopolitical tensions, additional fiscal stimulus, and increased demand for housing due to immigration. There are also risks that the labor market has not been as strong as the payroll data have been indicating, and it appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report suggests that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become -4. less accurate as response rates have appreciably declined since the pandemic." The rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find work, and layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was largely accounted for by workers who are experiencing a temporary layoff and are more likely to be rehired in coming months. Hurricane Beryl also likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen additional economic data and information, 2 The Q4 Quarterly Census of Employment and Wages (QCEW) administrative data show employment gains that are about 110,000 per month lower than what the Current Employment Statistics (CES) survey reported from March 2023 to December 2023. Although the Bureau of Labor Statistics benchmarks CES payroll employment based on the Ql QCEW,, to be released on August 21, the Q4 QCEW data point to a substantial downward revision to CES employment gains last year. -5- including one employment and one inflation report. We will also monitor how developments in broader financial conditions might influence the economic outlook. I will continue to closely watch the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. Focus on Financial Inclusion I will turn now to discuss our work to promote financial inclusion. An inclusive financial system enables access to financial services that enhance the financial well-being of consumers and businesses. Consumers come from a wide range of economic circumstances, with varied perceptions of and experiences with the banking system and different financial needs. All consumers should have access to the financial services and products they need. The U.S. economy benefits when more households achieve financial stability. Yet, while we have made significant progress in expanding access to financial services and deposit accounts in the United States, the remaining challenges often include geographic location, products that meet specific customer needs, the absence of financial literacy education, lack of access to technology and reliable internet, and in some cases, language. These challenges are even more acute in providing access to financial services to Indigenous populations like those here in Alaska. It is impressive to see that many financial services providers, including banks and Community Development Financial Institutions (CDFIs), are working to address these challenges and making significant inroads. -6- Importance of banks in furthering financial inclusion The U.S. financial system is uniquely positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. Banks and other depository institutions assist consumers and small businesses by providing financial products and services that are safe, fair, and responsive. In doing so, they serve a critical role in connecting consumers to the financial system and to the economy. Smaller banks, including community banks, are indispensable in providing access to financial products and services, especially in more remote or rural areas. Here, in Alaska, your banks are the front-line providers for your communities. As you know well, community banks support small businesses through credit and technical assistance and targeted support specific to customers in their communities. As a former community banker, I know firsthand that smaller banks deeply understand their communities because they live in the local economy and know their customers well. This was especially apparent during the COVID pandemic. Community banks rose to the challenge and continued to support the needs of their customers and communities. One of the programs first made available in response to the pandemic was the Paycheck Protection Program (PPP), which was geared to small businesses and was necessarily dependent on community banks. The PPP was timely and effective in helping millions of businesses weather the initial -7- phase of the pandemic, and community banks were absolutely essential to the success of the program.' This successful outcome is probably not surprising to this audience, because when it comes to lending to small businesses, community banks have always been an outsized source of credit, relative to their size in the banking system. Before the pandemic, community banks accounted for over 40 percent of all small business lending, while they only accounted for roughly 15 percent of total assets in the banking system.* This trend has continued. An analysis of June 2023 call report data showed that community banks had larger shares of small-business loans relative to their total assets than larger institutions.° Community banks know their customers, and they know their communities. During that challenging time, community bank CEOs told me that early in the pandemic they directly contacted every single one of their business and consumer loan customers. They took the time to check in with each one to see how they were doing, and what they needed. They encouraged customers to keep in touch with the bank, and they noted the available opportunities for payment deferrals and other options that customers might not have been aware of. Because of this 3 Allen N. Berger, Maryann P. Feldman, W. Scott Langford, and Raluca A. Roman, "Let Us Put Our Moneys Together: Minority-Owned Banks and Resilience to Crises," WP-2313 (Federal Reserve Bank of Philadelphia, June 2023), https://www.philadelphiafed.org/-/media/frbp/assets/working-papers/2023/wp23-13.pdf. 4 Governor Michelle W. Bowman, "Community Banks Rise to the Challenge" (speech at the Community Banking in the 21st Century Research Conference, St. Louis, MO, September 30, 2020), https://www.federalreserve.gov/newsevents/speech/bowman20200930a.htm 5 See Eldar Beiseitov, "Small Banks, Big Impact: Community Banks and Their Role in Small Business Lending," October 20, 2023, https://www.stlouisfed.org/publications/regional-economist/2023/oct/small-banks-big-impact- community-banks-small-business-lending. -8- relationship banking model, small banks were and continue to be able to provide more tailored financial products and services that are designed to meet the specific needs of their customers.° We all recognize the important role of small banks in the functioning of the U.S. economy by supporting the financial needs of their customers and communities. The Federal Reserve relies on insights from community banks and created a mechanism to formalize the views and feedback from community banks on a regular basis through our Reserve Bank and Board Community Depository Institutions Advisory Councils (CDIAC). The Board CDIAC includes a representative from each of the local advisory councils at the 12 Reserve Banks. CDIAC members are bankers from community banks, thrifts, and credit unions who provide insight and information about the economy, lending conditions, and other issues that they see firsthand in their communities. This perspective helps us gain insights into economic activity and the impact of our policies on rural and underserved communities. Central Bank Network for Indigenous Inclusion I will turn now to highlight our efforts in providing broader access to financial services. In 2021, the Federal Reserve became a member of the Central Bank Network for Indigenous Inclusion (CBNII).' This group brings together the central banks of the United States, Canada, New Zealand, and Australia. The network enabled us to initiate an ongoing international dialogue to raise awareness of economic and financial issues in Indigenous populations. This ® Governor Michelle W. Bowman, "The Role of Research, Data, and Analysis in Banking Reforms" (speech at the 2023 Community Banking Research Conference, St. Louis, MO, October 4, 2023), https://www.federalreserve.gov/newsevents/speech/bowman20231004a.htm 7 Board of Governors of the Federal Reserve System, "Federal Reserve Board Announces It Has Joined the Central Bank Network for Indigenous Inclusion, Which Will Foster Ongoing Dialogue, Research, and Education to Raise Awareness of Economic and Financial Issues and Opportunities around Indigenous Economies," news release, October 13, 2021, https://www.federalreserve.gov/newsevents/pressreleases/other20211013a.htm -9- allows us to share knowledge and best practices, promote engagement and education, and work together with Indigenous communities. As the Federal Reserve's representative to the network, I have prioritized expanding our outreach and engagement efforts to include all U.S. Native populations, Native Alaskan, Native Hawaiian, and Native American. Coming here to Alaska is a key part of this role to ensure that the Federal Reserve continues to expand our firsthand knowledge and understanding of the issues and barriers that may prevent full engagement in the economy. I take these responsibilities seriously and have made meeting with and learning from Indigenous groups and leaders a priority in my work. In October 2021, I met with Native American leaders in South Dakota and on the Pine Ridge Reservation. These tribal leaders highlighted the importance of building understanding by meeting with people in their communities to enhance our knowledge of their social and economic circumstances. Earlier this year and last year, I met with members of the Native Hawaiian community and a range of community organizations to learn about the issues and challenges they face, in addition to the recovery efforts following the devastating wildfire in Lahaina. And yesterday, I met with Native Alaskan leaders to learn about Alaska Native corporations and other initiatives here in Alaska. These convenings and conversations help to inform our work at the Federal Reserve to ensure that the financial system is accessible to everyone, including Indigenous communities. The Fed's work in this area is supported by many of our Reserve Bank teams, including the San Francisco Reserve Bank, the Minneapolis Center for Indian Country Development, and the St. Louis Native Economic and Financial Education Empowerment program. Together, these teams and programs support Indigenous organizations and tribal nations by providing actionable -10- data and research, economic and personal finance education, and other resources to advance opportunities for prosperity in Indigenous communities. We know that the economic well-being of all Americans is an important aspect of the Federal Reserve's goal to increase economic inclusion, and it is one of the reasons we began participating in the CBNII. Even with all of its tools, the Federal Reserve cannot fully succeed until all Americans, including our Native populations and those existing on the margins of the economy, have the opportunity to fully participate. Engagement in these learning opportunities, including these meetings, will help to advance this goal. Mission-driven organizations Finally, I would like to briefly address the Federal Reserve's efforts to build the institutional capacity of another set of key stakeholders: Minority Depository Institutions, Women-Owned Depository Institutions, and CDFIs, whose missions are to reach historically underserved populations. Providing support for these institutions is an important part of the Federal Reserve's responsibility to provide a safe, sound, and accessible banking system that protects consumers.*® These mission-driven banks and CDFIs are often vital sources of capital to many underrepresented small businesses. CDFIs generally target specific underserved markets. For example, there are many Native CDFIs, including several here in Alaska, that support Native communities by providing access to credit, capital, and financial services.? While there has been some significant growth in Native CDFIs,'° they cannot singlehandedly resolve the credit needs of this population. This effort will require partnerships with banks, state and local governments, 8 See the Federal Reserve's Partnership for Progress website at https://www.fedpartnership.gov. > See https://Avww.cdfifund.gov/programs-training/programs/native-initiatives. 10 See https://www.minneapolisfed.org/article/2024/native-cdfis-connect-indian-country-to-credit-and-capital. -ll- and community stakeholders. As an example, the Federal Reserve convened a small business lending working group that brought together local, state, and federal partners to address challenges with access to capital for Alaskan small businesses, especially those owned by Native Alaskans.!! This group has helped connect local Native CDFIs to banks and state and federal partners for funding and technical assistance. Finally, I will close with a brief note on the revisions to the CDFI Certification Application recently released by the Treasury's CDFI Fund." There are significant benefits to being a certified CDFI, including access to federal, state, and local governmental funds, philanthropic support, and private sector investment. While the certification process is overseen by the CDFI Fund, I encourage CDFI banks to review the new certification application and share feedback on whether the requirements are attainable and remain compatible with the bank's existing business model. Closing Thoughts In closing, thank you again for welcoming me here today. I am very pleased to have the opportunity to learn from your experiences and incorporate these lessons into our work. The unique challenges that you face here in Alaska will help to inform and expand the Federal Reserve's understanding of how we can make the financial system more inclusive. Our meetings over the past few days with state government officials, Native Alaskan leaders, small business owners, and financial institutions provide many different perspectives to help inform our work to achieve an economy that works for everyone. 'l Governor Michelle W. Bowman, panel remarks at the 2023 Symposium on Indigenous Inclusion, Te Piitea Matua, Auckland, New Zealand, September 27, 2023, https://www.federalreserve.gov/newsevents/speech/bowman20230927a.htm, 2 See https://www.cdfifund.gov/news/553.	---[PAGE_BREAK]--- For release on delivery 2:00 p.m. EDT (10:00 a.m. AKDT) August 20, 2024 Remarks on the Economic Outlook and Financial Inclusion by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the Alaska Bankers Association Anchorage, Alaska August 20, 2024 ---[PAGE_BREAK]--- Good morning. It is really a pleasure to join you here in Alaska. ${ }^{1}$ Getting outside of Washington, D.C. and hearing about the unique issues that affect Alaskans provides valuable insights that inform my work at the Federal Reserve. A part of the mission of the Federal Reserve is to support an economy that works for everyone. Consumers and communities are more successful when they have access to financial products and services that meet their needs. While many of these products and services are available online, as Alaskans know better than most Americans, geography and location are also important. This access often looks very different in places with many remote and rural communities. Today, I will discuss the Federal Reserve's work to promote a more inclusive financial system, including our work on financial inclusion for Indigenous communities. Before diving into those topics, I will share my current views on the economy and monetary policy. # Economic and Monetary Policy Outlook Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at $51 / 4$ to $51 / 2$ percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, in recent months we have seen some further progress on lowering inflation. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer to the more volatile higher-frequency readings, have moved down since April, although they have remained somewhat elevated at 2.5 percent and 2.6 percent in June, respectively. In addition, the latest consumer and producer price index reports [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. ---[PAGE_BREAK]--- indicate that 12-month core PCE inflation likely remained a bit above 2.5 percent in July. The progress in lowering inflation since April is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Private domestic final purchases (PDFP) growth was solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Goods spending rebounded in the second quarter and retail sales continued to rise at a solid pace in July. Consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined-signs that illustrate the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in ---[PAGE_BREAK]--- July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains remain above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation as supply conditions have now largely normalized and any further improvements to supply seem less likely to offset price pressures arising from increasing geopolitical tensions, additional fiscal stimulus, and increased demand for housing due to immigration. There are also risks that the labor market has not been as strong as the payroll data have been indicating, and it appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report suggests that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become ---[PAGE_BREAK]--- less accurate as response rates have appreciably declined since the pandemic. ${ }^{2}$ The rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find work, and layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was largely accounted for by workers who are experiencing a temporary layoff and are more likely to be rehired in coming months. Hurricane Beryl also likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen additional economic data and information, [^0] [^0]: ${ }^{2}$ The Q4 Quarterly Census of Employment and Wages (QCEW) administrative data show employment gains that are about 110,000 per month lower than what the Current Employment Statistics (CES) survey reported from March 2023 to December 2023. Although the Bureau of Labor Statistics benchmarks CES payroll employment based on the Q1 QCEW, to be released on August 21, the Q4 QCEW data point to a substantial downward revision to CES employment gains last year. ---[PAGE_BREAK]--- including one employment and one inflation report. We will also monitor how developments in broader financial conditions might influence the economic outlook. I will continue to closely watch the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. # Focus on Financial Inclusion I will turn now to discuss our work to promote financial inclusion. An inclusive financial system enables access to financial services that enhance the financial well-being of consumers and businesses. Consumers come from a wide range of economic circumstances, with varied perceptions of and experiences with the banking system and different financial needs. All consumers should have access to the financial services and products they need. The U.S. economy benefits when more households achieve financial stability. Yet, while we have made significant progress in expanding access to financial services and deposit accounts in the United States, the remaining challenges often include geographic location, products that meet specific customer needs, the absence of financial literacy education, lack of access to technology and reliable internet, and in some cases, language. These challenges are even more acute in providing access to financial services to Indigenous populations like those here in Alaska. It is impressive to see that many financial services providers, including banks and Community Development Financial Institutions (CDFIs), are working to address these challenges and making significant inroads. ---[PAGE_BREAK]--- # Importance of banks in furthering financial inclusion The U.S. financial system is uniquely positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. Banks and other depository institutions assist consumers and small businesses by providing financial products and services that are safe, fair, and responsive. In doing so, they serve a critical role in connecting consumers to the financial system and to the economy. Smaller banks, including community banks, are indispensable in providing access to financial products and services, especially in more remote or rural areas. Here, in Alaska, your banks are the front-line providers for your communities. As you know well, community banks support small businesses through credit and technical assistance and targeted support specific to customers in their communities. As a former community banker, I know firsthand that smaller banks deeply understand their communities because they live in the local economy and know their customers well. This was especially apparent during the COVID pandemic. Community banks rose to the challenge and continued to support the needs of their customers and communities. One of the programs first made available in response to the pandemic was the Paycheck Protection Program (PPP), which was geared to small businesses and was necessarily dependent on community banks. The PPP was timely and effective in helping millions of businesses weather the initial ---[PAGE_BREAK]--- phase of the pandemic, and community banks were absolutely essential to the success of the program. ${ }^{3}$ This successful outcome is probably not surprising to this audience, because when it comes to lending to small businesses, community banks have always been an outsized source of credit, relative to their size in the banking system. Before the pandemic, community banks accounted for over 40 percent of all small business lending, while they only accounted for roughly 15 percent of total assets in the banking system. ${ }^{4}$ This trend has continued. An analysis of June 2023 call report data showed that community banks had larger shares of small-business loans relative to their total assets than larger institutions. ${ }^{5}$ Community banks know their customers, and they know their communities. During that challenging time, community bank CEOs told me that early in the pandemic they directly contacted every single one of their business and consumer loan customers. They took the time to check in with each one to see how they were doing, and what they needed. They encouraged customers to keep in touch with the bank, and they noted the available opportunities for payment deferrals and other options that customers might not have been aware of. Because of this [^0] [^0]: ${ }^{3}$ Allen N. Berger, Maryann P. Feldman, W. Scott Langford, and Raluca A. Roman, "Let Us Put Our Moneys Together: Minority-Owned Banks and Resilience to Crises," WP-2313 (Federal Reserve Bank of Philadelphia, June 2023), https://www.philadelphiafed.org/ media/frbp/assets/working-papers/2023/wp23-13.pdf. ${ }^{4}$ Governor Michelle W. Bowman, "Community Banks Rise to the Challenge" (speech at the Community Banking in the 21st Century Research Conference, St. Louis, MO, September 30, 2020), https://www.federalreserve.gov/newsevents/speech/bowman20200930a.htm ${ }^{5}$ See Eldar Beiseitov, "Small Banks, Big Impact: Community Banks and Their Role in Small Business Lending," October 20, 2023, https://www.stlouisfed.org/publications/regional-economist/2023/oct/small-banks-big-impact-community-banks-small-business-lending. ---[PAGE_BREAK]--- relationship banking model, small banks were and continue to be able to provide more tailored financial products and services that are designed to meet the specific needs of their customers. ${ }^{6}$ We all recognize the important role of small banks in the functioning of the U.S. economy by supporting the financial needs of their customers and communities. The Federal Reserve relies on insights from community banks and created a mechanism to formalize the views and feedback from community banks on a regular basis through our Reserve Bank and Board Community Depository Institutions Advisory Councils (CDIAC). The Board CDIAC includes a representative from each of the local advisory councils at the 12 Reserve Banks. CDIAC members are bankers from community banks, thrifts, and credit unions who provide insight and information about the economy, lending conditions, and other issues that they see firsthand in their communities. This perspective helps us gain insights into economic activity and the impact of our policies on rural and underserved communities. # Central Bank Network for Indigenous Inclusion I will turn now to highlight our efforts in providing broader access to financial services. In 2021, the Federal Reserve became a member of the Central Bank Network for Indigenous Inclusion (CBNII). ${ }^{7}$ This group brings together the central banks of the United States, Canada, New Zealand, and Australia. The network enabled us to initiate an ongoing international dialogue to raise awareness of economic and financial issues in Indigenous populations. This [^0] [^0]: ${ }^{6}$ Governor Michelle W. Bowman, "The Role of Research, Data, and Analysis in Banking Reforms" (speech at the 2023 Community Banking Research Conference, St. Louis, MO, October 4, 2023), https://www.federalreserve.gov/newsevents/speech/bowman20231004a.htm ${ }^{7}$ Board of Governors of the Federal Reserve System, "Federal Reserve Board Announces It Has Joined the Central Bank Network for Indigenous Inclusion, Which Will Foster Ongoing Dialogue, Research, and Education to Raise Awareness of Economic and Financial Issues and Opportunities around Indigenous Economies," news release, October 13, 2021, https://www.federalreserve.gov/newsevents/pressreleases/other20211013a.htm ---[PAGE_BREAK]--- allows us to share knowledge and best practices, promote engagement and education, and work together with Indigenous communities. As the Federal Reserve's representative to the network, I have prioritized expanding our outreach and engagement efforts to include all U.S. Native populations, Native Alaskan, Native Hawaiian, and Native American. Coming here to Alaska is a key part of this role to ensure that the Federal Reserve continues to expand our firsthand knowledge and understanding of the issues and barriers that may prevent full engagement in the economy. I take these responsibilities seriously and have made meeting with and learning from Indigenous groups and leaders a priority in my work. In October 2021, I met with Native American leaders in South Dakota and on the Pine Ridge Reservation. These tribal leaders highlighted the importance of building understanding by meeting with people in their communities to enhance our knowledge of their social and economic circumstances. Earlier this year and last year, I met with members of the Native Hawaiian community and a range of community organizations to learn about the issues and challenges they face, in addition to the recovery efforts following the devastating wildfire in Lahaina. And yesterday, I met with Native Alaskan leaders to learn about Alaska Native corporations and other initiatives here in Alaska. These convenings and conversations help to inform our work at the Federal Reserve to ensure that the financial system is accessible to everyone, including Indigenous communities. The Fed's work in this area is supported by many of our Reserve Bank teams, including the San Francisco Reserve Bank, the Minneapolis Center for Indian Country Development, and the St. Louis Native Economic and Financial Education Empowerment program. Together, these teams and programs support Indigenous organizations and tribal nations by providing actionable ---[PAGE_BREAK]--- data and research, economic and personal finance education, and other resources to advance opportunities for prosperity in Indigenous communities. We know that the economic well-being of all Americans is an important aspect of the Federal Reserve's goal to increase economic inclusion, and it is one of the reasons we began participating in the CBNII. Even with all of its tools, the Federal Reserve cannot fully succeed until all Americans, including our Native populations and those existing on the margins of the economy, have the opportunity to fully participate. Engagement in these learning opportunities, including these meetings, will help to advance this goal. # Mission-driven organizations Finally, I would like to briefly address the Federal Reserve's efforts to build the institutional capacity of another set of key stakeholders: Minority Depository Institutions, Women-Owned Depository Institutions, and CDFIs, whose missions are to reach historically underserved populations. Providing support for these institutions is an important part of the Federal Reserve's responsibility to provide a safe, sound, and accessible banking system that protects consumers. ${ }^{8}$ These mission-driven banks and CDFIs are often vital sources of capital to many underrepresented small businesses. CDFIs generally target specific underserved markets. For example, there are many Native CDFIs, including several here in Alaska, that support Native communities by providing access to credit, capital, and financial services. ${ }^{9}$ While there has been some significant growth in Native CDFIs, ${ }^{10}$ they cannot singlehandedly resolve the credit needs of this population. This effort will require partnerships with banks, state and local governments, [^0] [^0]: ${ }^{8}$ See the Federal Reserve's Partnership for Progress website at https://www.fedpartnership.gov. ${ }^{9}$ See https://www.cdfifund.gov/programs-training/programs/native-initiatives. ${ }^{10}$ See https://www.minneapolisfed.org/article/2024/native-cdfis-connect-indian-country-to-credit-and-capital. ---[PAGE_BREAK]--- and community stakeholders. As an example, the Federal Reserve convened a small business lending working group that brought together local, state, and federal partners to address challenges with access to capital for Alaskan small businesses, especially those owned by Native Alaskans. ${ }^{11}$ This group has helped connect local Native CDFIs to banks and state and federal partners for funding and technical assistance. Finally, I will close with a brief note on the revisions to the CDFI Certification Application recently released by the Treasury's CDFI Fund. ${ }^{12}$ There are significant benefits to being a certified CDFI, including access to federal, state, and local governmental funds, philanthropic support, and private sector investment. While the certification process is overseen by the CDFI Fund, I encourage CDFI banks to review the new certification application and share feedback on whether the requirements are attainable and remain compatible with the bank's existing business model. # Closing Thoughts In closing, thank you again for welcoming me here today. I am very pleased to have the opportunity to learn from your experiences and incorporate these lessons into our work. The unique challenges that you face here in Alaska will help to inform and expand the Federal Reserve's understanding of how we can make the financial system more inclusive. Our meetings over the past few days with state government officials, Native Alaskan leaders, small business owners, and financial institutions provide many different perspectives to help inform our work to achieve an economy that works for everyone. [^0] [^0]: ${ }^{11}$ Governor Michelle W. Bowman, panel remarks at the 2023 Symposium on Indigenous Inclusion, Te Pūtea Matua, Auckland, New Zealand, September 27, 2023, https://www.federalreserve.gov/newsevents/speech/bowman20230927a.htm. 12 See https://www.cdfifund.gov/news/553.	Michelle W Bowman	United States	https://www.bis.org/review/r240828h.pdf	For release on delivery 2:00 p.m. EDT (10:00 a.m. AKDT) August 20, 2024 Remarks on the Economic Outlook and Financial Inclusion by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at the Alaska Bankers Association Anchorage, Alaska August 20, 2024 Good morning. It is really a pleasure to join you here in Alaska. Getting outside of Washington, D.C. and hearing about the unique issues that affect Alaskans provides valuable insights that inform my work at the Federal Reserve. A part of the mission of the Federal Reserve is to support an economy that works for everyone. Consumers and communities are more successful when they have access to financial products and services that meet their needs. While many of these products and services are available online, as Alaskans know better than most Americans, geography and location are also important. This access often looks very different in places with many remote and rural communities. Today, I will discuss the Federal Reserve's work to promote a more inclusive financial system, including our work on financial inclusion for Indigenous communities. Before diving into those topics, I will share my current views on the economy and monetary policy. Over the past two years, the Federal Open Market Committee (FOMC) has significantly tightened the stance of monetary policy to address high inflation. At our July meeting, the FOMC voted to continue to hold the federal funds rate target range at $51 / 4$ to $51 / 2$ percent and to continue to reduce the Federal Reserve's securities holdings. After seeing considerable progress last year, in recent months we have seen some further progress on lowering inflation. The 12-month measures of total and core personal consumption expenditures (PCE) inflation, which I prefer to the more volatile higher-frequency readings, have moved down since April, although they have remained somewhat elevated at 2.5 percent and 2.6 percent in June, respectively. In addition, the latest consumer and producer price index reports indicate that 12-month core PCE inflation likely remained a bit above 2.5 percent in July. The progress in lowering inflation since April is a welcome development, but inflation is still uncomfortably above the Committee's 2 percent goal. Prices continue to be much higher than before the pandemic, which continues to weigh on consumer sentiment. Inflation has hit lower-income households hardest, since food, energy, and housing services price increases far outpaced overall inflation over the past few years. Economic activity moderated in the first half of this year after increasing at a strong pace last year. Private domestic final purchases (PDFP) growth was solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories such as net exports, suggesting that underlying economic growth was stronger than GDP indicated. Unusually strong consumer goods spending last year softened in the first quarter of this year, largely accounting for the step-down in PDFP growth. Goods spending rebounded in the second quarter and retail sales continued to rise at a solid pace in July. Consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have savings to support this type of spending, and we've seen a normalization of loan delinquency rates as they have risen from historically low levels during the pandemic. The labor market continues to loosen, as the number of available workers has increased and the number of available jobs has declined-signs that illustrate the labor market is coming into better balance. After slowing in the second quarter, payroll employment gains eased to a more modest pace in July, even as job openings are being filled by the increased immigrant labor supply. The latest labor market report shows that the unemployment rate stood at 4.3 percent in July. Although notably higher than a year ago, this is still a historically low unemployment rate. In addition, the ratio of job vacancies to unemployed workers has declined to its pre-pandemic level. We are also seeing a slowing in wage growth, which now stands at just under 4 percent as measured by the employment cost index. However, given trend productivity, wage gains remain above the pace consistent with our inflation goal. My baseline outlook is that inflation will decline further with the current stance of monetary policy. Should the incoming data continue to show that inflation is moving sustainably toward our 2 percent goal, it will become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive on economic activity and employment. But we need to be patient and avoid undermining continued progress on lowering inflation by overreacting to any single data point. Instead, we must view the data in their totality as the risks to the Committee's employment and price-stability mandates continue to move into better balance. That said, I still see some upside risks to inflation as supply conditions have now largely normalized and any further improvements to supply seem less likely to offset price pressures arising from increasing geopolitical tensions, additional fiscal stimulus, and increased demand for housing due to immigration. There are also risks that the labor market has not been as strong as the payroll data have been indicating, and it appears that the recent rise in unemployment may be exaggerating the degree of cooling in labor markets. The Q4 Quarterly Census of Employment and Wages (QCEW) report suggests that job gains have been consistently overstated in the establishment survey since March of last year, while the household survey unemployment data have become less accurate as response rates have appreciably declined since the pandemic. The rise in the unemployment rate this year largely reflects weaker hiring, as job searchers entering the labor force are taking longer to find work, and layoffs remain low. It is also likely that some temporary factors contributed to the soft July employment report. The rise in the unemployment rate in July was largely accounted for by workers who are experiencing a temporary layoff and are more likely to be rehired in coming months. Hurricane Beryl also likely contributed to weaker job gains, as the number of workers not working due to bad weather increased significantly last month. In light of upside risks to inflation and uncertainty regarding labor market conditions and the economic outlook, I will continue to watch the data closely as I assess the appropriate path of monetary policy. Increased measurement challenges and the frequency and extent of data revisions over the past few years make the task of assessing the current state of the economy and predicting how it will evolve even more challenging. I will remain cautious in my approach to considering adjustments to the current stance of policy. It is important to note that monetary policy is not on a preset course. In my view, we should consider a range of possible scenarios that could unfold when assessing how the FOMC's monetary policy decisions may evolve. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. By the time of our September meeting, we will have seen additional economic data and information, including one employment and one inflation report. We will also monitor how developments in broader financial conditions might influence the economic outlook. I will continue to closely watch the data and visit with a broad range of contacts as I assess economic conditions and the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as somewhat elevated. And with some upside risks to inflation, I still see the need to pay close attention to the price-stability side of our mandate while watching for risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. I will turn now to discuss our work to promote financial inclusion. An inclusive financial system enables access to financial services that enhance the financial well-being of consumers and businesses. Consumers come from a wide range of economic circumstances, with varied perceptions of and experiences with the banking system and different financial needs. All consumers should have access to the financial services and products they need. The U.S. economy benefits when more households achieve financial stability. Yet, while we have made significant progress in expanding access to financial services and deposit accounts in the United States, the remaining challenges often include geographic location, products that meet specific customer needs, the absence of financial literacy education, lack of access to technology and reliable internet, and in some cases, language. These challenges are even more acute in providing access to financial services to Indigenous populations like those here in Alaska. It is impressive to see that many financial services providers, including banks and Community Development Financial Institutions (CDFIs), are working to address these challenges and making significant inroads. The U.S. financial system is uniquely positioned to bring consumers into the financial mainstream by providing innovative solutions to meet the credit needs of their communities. Banks and other depository institutions assist consumers and small businesses by providing financial products and services that are safe, fair, and responsive. In doing so, they serve a critical role in connecting consumers to the financial system and to the economy. Smaller banks, including community banks, are indispensable in providing access to financial products and services, especially in more remote or rural areas. Here, in Alaska, your banks are the front-line providers for your communities. As you know well, community banks support small businesses through credit and technical assistance and targeted support specific to customers in their communities. As a former community banker, I know firsthand that smaller banks deeply understand their communities because they live in the local economy and know their customers well. This was especially apparent during the COVID pandemic. Community banks rose to the challenge and continued to support the needs of their customers and communities. One of the programs first made available in response to the pandemic was the Paycheck Protection Program (PPP), which was geared to small businesses and was necessarily dependent on community banks. The PPP was timely and effective in helping millions of businesses weather the initial phase of the pandemic, and community banks were absolutely essential to the success of the program. This successful outcome is probably not surprising to this audience, because when it comes to lending to small businesses, community banks have always been an outsized source of credit, relative to their size in the banking system. Before the pandemic, community banks accounted for over 40 percent of all small business lending, while they only accounted for roughly 15 percent of total assets in the banking system. Community banks know their customers, and they know their communities. During that challenging time, community bank CEOs told me that early in the pandemic they directly contacted every single one of their business and consumer loan customers. They took the time to check in with each one to see how they were doing, and what they needed. They encouraged customers to keep in touch with the bank, and they noted the available opportunities for payment deferrals and other options that customers might not have been aware of. Because of this relationship banking model, small banks were and continue to be able to provide more tailored financial products and services that are designed to meet the specific needs of their customers. We all recognize the important role of small banks in the functioning of the U.S. economy by supporting the financial needs of their customers and communities. The Federal Reserve relies on insights from community banks and created a mechanism to formalize the views and feedback from community banks on a regular basis through our Reserve Bank and Board Community Depository Institutions Advisory Councils (CDIAC). The Board CDIAC includes a representative from each of the local advisory councils at the 12 Reserve Banks. CDIAC members are bankers from community banks, thrifts, and credit unions who provide insight and information about the economy, lending conditions, and other issues that they see firsthand in their communities. This perspective helps us gain insights into economic activity and the impact of our policies on rural and underserved communities. I will turn now to highlight our efforts in providing broader access to financial services. In 2021, the Federal Reserve became a member of the Central Bank Network for Indigenous Inclusion (CBNII). This group brings together the central banks of the United States, Canada, New Zealand, and Australia. The network enabled us to initiate an ongoing international dialogue to raise awareness of economic and financial issues in Indigenous populations. This As the Federal Reserve's representative to the network, I have prioritized expanding our outreach and engagement efforts to include all U.S. Native populations, Native Alaskan, Native Hawaiian, and Native American. Coming here to Alaska is a key part of this role to ensure that the Federal Reserve continues to expand our firsthand knowledge and understanding of the issues and barriers that may prevent full engagement in the economy. I take these responsibilities seriously and have made meeting with and learning from Indigenous groups and leaders a priority in my work. In October 2021, I met with Native American leaders in South Dakota and on the Pine Ridge Reservation. These tribal leaders highlighted the importance of building understanding by meeting with people in their communities to enhance our knowledge of their social and economic circumstances. Earlier this year and last year, I met with members of the Native Hawaiian community and a range of community organizations to learn about the issues and challenges they face, in addition to the recovery efforts following the devastating wildfire in Lahaina. And yesterday, I met with Native Alaskan leaders to learn about Alaska Native corporations and other initiatives here in Alaska. These convenings and conversations help to inform our work at the Federal Reserve to ensure that the financial system is accessible to everyone, including Indigenous communities. The Fed's work in this area is supported by many of our Reserve Bank teams, including the San Francisco Reserve Bank, the Minneapolis Center for Indian Country Development, and the St. Louis Native Economic and Financial Education Empowerment program. Together, these teams and programs support Indigenous organizations and tribal nations by providing actionable data and research, economic and personal finance education, and other resources to advance opportunities for prosperity in Indigenous communities. We know that the economic well-being of all Americans is an important aspect of the Federal Reserve's goal to increase economic inclusion, and it is one of the reasons we began participating in the CBNII. Even with all of its tools, the Federal Reserve cannot fully succeed until all Americans, including our Native populations and those existing on the margins of the economy, have the opportunity to fully participate. Engagement in these learning opportunities, including these meetings, will help to advance this goal. Finally, I would like to briefly address the Federal Reserve's efforts to build the institutional capacity of another set of key stakeholders: Minority Depository Institutions, Women-Owned Depository Institutions, and CDFIs, whose missions are to reach historically underserved populations. Providing support for these institutions is an important part of the Federal Reserve's responsibility to provide a safe, sound, and accessible banking system that protects consumers. These mission-driven banks and CDFIs are often vital sources of capital to many underrepresented small businesses. CDFIs generally target specific underserved markets. For example, there are many Native CDFIs, including several here in Alaska, that support Native communities by providing access to credit, capital, and financial services. they cannot singlehandedly resolve the credit needs of this population. This effort will require partnerships with banks, state and local governments, and community stakeholders. As an example, the Federal Reserve convened a small business lending working group that brought together local, state, and federal partners to address challenges with access to capital for Alaskan small businesses, especially those owned by Native Alaskans. This group has helped connect local Native CDFIs to banks and state and federal partners for funding and technical assistance. Finally, I will close with a brief note on the revisions to the CDFI Certification Application recently released by the Treasury's CDFI Fund. There are significant benefits to being a certified CDFI, including access to federal, state, and local governmental funds, philanthropic support, and private sector investment. While the certification process is overseen by the CDFI Fund, I encourage CDFI banks to review the new certification application and share feedback on whether the requirements are attainable and remain compatible with the bank's existing business model. In closing, thank you again for welcoming me here today. I am very pleased to have the opportunity to learn from your experiences and incorporate these lessons into our work. The unique challenges that you face here in Alaska will help to inform and expand the Federal Reserve's understanding of how we can make the financial system more inclusive. Our meetings over the past few days with state government officials, Native Alaskan leaders, small business owners, and financial institutions provide many different perspectives to help inform our work to achieve an economy that works for everyone. See https://www.cdfifund.gov/news/553.
2024-08-23T00:00:00	Jerome H Powell: Review and outlook	Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at "Reassessing the Effectiveness and Transmission of Monetary Policy", an economic symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 23 August 2024.	For release on delivery 10:00 a.m. EDT (8:00 a.m. MDT) August 23, 2024 Review and Outlook Remarks by Jerome H. Powell Chair Board of Governors of the Federal Reserve System at "Reassessing the Effectiveness and Transmission of Monetary Policy," an economic symposium sponsored by the Federal Reserve Bank of Kansas City Jackson Hole, Wyoming August 23, 2024 Four and a half years after COVID-19's arrival, the worst of the pandemic-related economic distortions are fading. Inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalized. And the balance of the risks to our two mandates has changed. Our objective has been to restore price stability while maintaining a strong labor market, avoiding the sharp increases in unemployment that characterized earlier disinflationary episodes when inflation expectations were less well anchored. While the task is not complete, we have made a good deal of progress toward that outcome. Today, I will begin by addressing the current economic situation and the path ahead for monetary policy. I will then turn to a discussion of economic events since the pandemic arrived, exploring why inflation rose to levels not seen in a generation, and why it has fallen so much while unemployment has remained low. Near-Term Outlook for Policy Let's begin with the current situation and the near-term outlook for policy. For much of the past three years, inflation ran well above our 2 percent goal, and labor market conditions were extremely tight. The Federal Open Market Committee's (FOMC) primary focus has been on bringing down inflation, and appropriately so. Prior to this episode, most Americans alive today had not experienced the pain of high inflation for a sustained period. Inflation brought substantial hardship, especially for those least able to meet the higher costs of essentials like food, housing, and transportation. High inflation triggered stress and a sense of unfairness that linger today.1 Our restrictive monetary policy helped restore balance between aggregate supply and demand, easing inflationary pressures and ensuring that inflation expectations remained well anchored. Inflation is now much closer to our objective, with prices having risen 2.5 percent over the past 12 months (figure 1).2 After a pause earlier this year, progress toward our 2 percent objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2 percent. Turning to employment, in the years just prior to the pandemic, we saw the significant benefits to society that can come from a long period of strong labor market conditions: low unemployment, high participation, historically low racial employment gaps, and, with inflation low and stable, healthy real wage gains that were increasingly concentrated among those with lower incomes.3 Today, the labor market has cooled considerably from its formerly overheated state. The unemployment rate began to rise over a year ago and is now at 4.3 percent- still low by historical standards, but almost a full percentage point above its level in early 2023 (figure 2). Most of that increase has come over the past six months. So far, rising 1 Shiller (1997) and Stantcheva (2024) study why people dislike inflation. Pfafjar and Winkler (2024) study households' attitudes toward inflation and unemployment. Binetti, Nuzzi, and Stantcheva (2024) investigate households' attitudes toward, and understanding of, inflation. Kaplan and Schulhofer-Wohl (2017) and Jaravel (2021) document heterogeneity in the inflation rate experienced by households across the income distribution. 2 The data for the personal consumption expenditures (PCE) price index is available for June 2024. Over the 12 months to June 2024, the PCE price index increased 2.5 percent. Data for the consumer price index and producer price index are available through July 2024 and can be used to estimate the level of the PCE price index through July. While such an estimate is subject to uncertainty, it suggests that inflation remained near 2.5 percent through July. 3 Research documenting such benefits include Aaronson and others (2019), who discuss the experience in the 2010s and review related historical evidence. unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn. Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring. Even so, the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year.4 Job vacancies have fallen, and the ratio of vacancies to unemployment has returned to its pre-pandemic range. The hiring and quits rates are now below the levels that prevailed in 2018 and 2019. Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019-a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions. Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased. As we highlighted in our last FOMC statement, we are attentive to the risks to both sides of our dual mandate. The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. We will do everything we can to support a strong labor market as we make further progress toward price stability. With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market. The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions. The Rise and Fall of Inflation Let's now turn to the questions of why inflation rose, and why it has fallen so significantly even as unemployment has remained low. There is a growing body of research on these questions, and this is a good time for this discussion.5 It is, of course, too soon to make definitive assessments. This period will be analyzed and debated long after we are gone. The arrival of the COVID-19 pandemic led quickly to shutdowns in economies around the world. It was a time of radical uncertainty and severe downside risks. As so often happens in times of crisis, Americans adapted and innovated. Governments responded with extraordinary force, especially in the U.S. Congress unanimously passed the CARES Act. At the Fed, we used our powers to an unprecedented extent to stabilize the financial system and help stave off an economic depression. After a historically deep but brief recession, in mid-2020 the economy began to grow again. As the risks of a severe, extended downturn receded, and as the economy reopened, we faced the risk of replaying the painfully slow recovery that followed the Global Financial Crisis. Congress delivered substantial additional fiscal support in late 2020 and again in early 2021. Spending recovered strongly in the first half of 2021. The ongoing pandemic shaped the pattern of the recovery. Lingering concerns over COVID weighed on spending on in-person services. But pent-up demand, stimulative policies, pandemic changes in work and leisure practices, and the additional savings associated with constrained services spending all contributed to a historic surge in consumer spending on goods. The pandemic also wreaked havoc on supply conditions. Eight million people left the workforce at its onset, and the size of the labor force was still 4 million below its pre- pandemic level in early 2021. The labor force would not return to its pre-pandemic trend until mid-2023 (figure 3).6 Supply chains were snarled by a combination of lost workers, disrupted international trade linkages, and tectonic shifts in the composition and level of demand (figure 4). Clearly, this was nothing like the slow recovery after the Global Financial Crisis. Enter inflation. After running below target through 2020, inflation spiked in March and April 2021. The initial burst of inflation was concentrated rather than broad based, with extremely large price increases for goods in short supply, such as motor vehicles. My colleagues and I judged at the outset that these pandemic-related factors would not be persistent and, thus, that the sudden rise in inflation was likely to pass through fairly quickly without the need for a monetary policy response-in short, that the inflation would be transitory. Standard thinking has long been that, as long as inflation expectations remain well anchored, it can be appropriate for central banks to look through a temporary rise in inflation.7 The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board.8 The common expectation was that supply conditions would improve reasonably quickly, that the rapid recovery in demand would run its course, and that demand would rotate back from goods to services, bringing inflation down. For a time, the data were consistent with the transitory hypothesis. Monthly readings for core inflation declined every month from April to September 2021, although progress came slower than expected (figure 5). The case began to weaken around midyear, as was reflected in our communications. Beginning in October, the data turned hard against the transitory hypothesis.9 Inflation rose and broadened out from goods into 7 For example, former Chair Ben Bernanke and Olivier Blanchard summarize the standard approach in their work on inflation the following way: "Standard central banking doctrine holds that, so long as inflation expectations are reasonably well anchored, there is a case for 'looking through' temporary supply shocks rather than responding to the short-run increase in inflation" (Blanchard and Bernanke, 2024, p. 2). Clarida (forthcoming) notes how central banks around the world faced a sharp rise in the relative price of goods and chose, at least initially, to accommodate the price pressures with an expected transitory increase in inflation. 8 In the September 2021 Summary of Economic Projections (SEP), the median projection for headline inflation in 2022 was 2.2 percent. In the August 2021 Survey of Professional Forecasters (the closest survey to the September SEP), the median projection for headline inflation in 2022 was also 2.2 percent. Projections from the Blue Chip survey were similar around this time. 9 Beginning with the data for October, readings for monthly core PCE jumped to 0.4 percent or higher and inflationary pressures broadened out across goods and services categories. And monthly job gains, already strong, were consistently revised higher over the second half of 2021. Measures of wage inflation also accelerated. services. It became clear that the high inflation was not transitory, and that it would require a strong policy response if inflation expectations were to remain well anchored. We recognized that and pivoted beginning in November. Financial conditions began to tighten. After phasing out our asset purchases, we lifted off in March 2022. By early 2022, headline inflation exceeded 6 percent, with core inflation above 5 percent. New supply shocks appeared. Russia's invasion of Ukraine led to a sharp increase in energy and commodity prices. The improvements in supply conditions and rotation in demand from goods to services were taking much longer than expected, in part due to further COVID waves in the U.S.10 And COVID continued to disrupt production globally, including through new and extended lockdowns in China.11 High rates of inflation were a global phenomenon, reflecting common experiences: rapid increases in the demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices.12 The global nature of inflation was unlike any period since the 1970s. Back then, high inflation became entrenched-an outcome we were utterly committed to avoiding. By mid-2022, the labor market was extremely tight, with employment increasing by over 61⁄2 million from the middle of 2021. This increase in labor demand was met, in part, by workers rejoining the labor force as health concerns began to fade. But labor supply remained constrained, and, in the summer of 2022, labor force participation remained well below pre-pandemic levels. There were nearly twice as many job openings as unemployed persons from March 2022 through the end of the year, signaling a severe labor shortage (figure 6).13 Inflation peaked at 7.1 percent in June 2022. At this podium two years ago, I discussed the possibility that addressing inflation could bring some pain in the form of higher unemployment and slower growth. Some argued that getting inflation under control would require a recession and a lengthy period of high unemployment.14 I expressed our unconditional commitment to fully restoring price stability and to keeping at it until the job is done. The FOMC did not flinch from carrying out our responsibilities, and our actions forcefully demonstrated our commitment to restoring price stability. We raised our policy rate by 425 basis points in 2022 and another 100 basis points in 2023. We have held our policy rate at its current restrictive level since July 2023 (figure 7). The summer of 2022 proved to be the peak of inflation. The 4-1/2 percentage point decline in inflation from its peak two years ago has occurred in a context of low unemployment-a welcome and historically unusual result. How did inflation fall without a sharp rise in unemployment above its estimated natural rate? Pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline. The unwinding of these factors took much longer than expected but ultimately played a large role in the subsequent disinflation. Our restrictive monetary policy contributed to a moderation in aggregate demand, which combined with improvements in aggregate supply to reduce inflationary pressures while allowing growth to continue at a healthy pace. As labor demand also moderated, the historically high level of vacancies relative to unemployment has normalized primarily through a decline in vacancies, without sizable and disruptive layoffs, bringing the labor market to a state where it is no longer a source of inflationary pressures. A word on the critical importance of inflation expectations. Standard economic models have long reflected the view that inflation will return to its objective when product and labor markets are balanced-without the need for economic slack-so long as inflation expectations are anchored at our objective. That's what the models said, but the stability of longer-run inflation expectations since the 2000s had not been tested by a persistent burst of high inflation. It was far from assured that the inflation anchor would hold. Concerns over de-anchoring contributed to the view that disinflation would require slack in the economy and specifically in the labor market. An important takeaway from recent experience is that anchored inflation expectations, reinforced by vigorous central bank actions, can facilitate disinflation without the need for slack. This narrative attributes much of the increase in inflation to an extraordinary collision between overheated and temporarily distorted demand and constrained supply. While researchers differ in their approaches and, to some extent, in their conclusions, a consensus seems to be emerging, which I see as attributing most of the rise in inflation to this collision.15 All told, the healing from pandemic distortions, our efforts to moderate aggregate demand, and the anchoring of expectations have worked together to put inflation on what increasingly appears to be a sustainable path to our 2 percent objective. Disinflation while preserving labor market strength is only possible with anchored inflation expectations, which reflect the public's confidence that the central bank will bring about 2 percent inflation over time. That confidence has been built over decades and reinforced by our actions. That is my assessment of events. Your mileage may vary. Conclusion Let me wrap up by emphasizing that the pandemic economy has proved to be unlike any other, and that there remains much to be learned from this extraordinary period. Our Statement on Longer-Run Goals and Monetary Policy Strategy emphasizes our commitment to reviewing our principles and making appropriate adjustments through a thorough public review every five years. As we begin this process later this year, we will be open to criticism and new ideas, while preserving the strengths of our framework. The limits of our knowledge-so clearly evident during the pandemic-demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges. References Aaronson, Stephanie R., Mary C. Daly, William L. Wascher, and David W. Wilcox (2019). "Okun Revisited: Who Benefits Most from a Strong Economy," Finance and Economics Discussion Series 2019-072. Washington: Board of Governors of the Federal Reserve System, September, http://dx.doi.org/10.17016/FEDS.2019.072. Bai, Xiwen, Jesus Fernandez-Villaverde, Yiliang Li, and Francesco Zanetti (2024). "The Causal Effects of Global Supply Chain Disruptions on Macroeconomic Outcomes: Evidence and Theory," NBER Working Paper Series 32098. Cambridge, Mass.: National Bureau of Economic Research, February, https://www.nber.org/papers/w32098. Ball, Laurence, Daniel Leigh, and Prachi Mishra (2022). "Understanding US Inflation during the COVID-19 Era," Brookings Papers on Economic Activity, Fall, pp. 1- 54, https://www.brookings.edu/articles/understanding-u-s-inflation-during-thecovid-era. Benigno, Pierpaolo, and Gauti B. Eggertsson (2023). "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve," NBER Working Paper Series 31197. Cambridge, Mass.: National Bureau of Economic Research, April, https://www.nber.org/papers/w31197. --- (2024). "Insights from the 2020s Inflation Surge: A Tale of Two Curves," paper presented at "Reassessing the Effectiveness and Transmission of Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 22-24. Binetti, Alberto, Francesco Nuzzi, and Stefanie Stantcheva (2024). "People's Understanding of Inflation," NBER Working Paper Series 32497. Cambridge, Mass.: National Bureau of Economic Research, June, https://www.nber.org/papers/w32497. Blanchard, Olivier. J., and Ben S. Bernanke (2023). "What Caused the US Pandemic-Era Inflation?" NBER Working Paper Series 31417. Cambridge, Mass.: National Bureau of Economic Research, June, http://www.nber.org/papers/w31417. --- (2024). "An Analysis of Pandemic-Era Inflation in 11 Economies," NBER Working Paper Series 32532. Cambridge, Mass.: National Bureau of Economic Research, May, http://www.nber.org/papers/w32532. Cascaldi-Garcia. Danilo, Luca Guerrieri, Matteo Iacoviello, and Michele Modugno (2024). "Lessons from the Co-Movement of Inflation around the World," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 28, https://doi.org/10.17016/2380-7172.3543. Cecchetti, Stephen G., Michael E. Feroli, Peter Hooper, Frederic S. Mishkin, and Kermit L. Schoenholtz (2023). "Managing Disinflations," paper presented at the U.S. Monetary Policy Forum, New York, February 24. Clarida, Richard (forthcoming). "A Global Perspective on Post Pandemic Inflation and its Retreat: Remarks Prepared for NBER Conference on 'Inflation in the Covid Era'," Journal of Monetary Economics. Crump, Richard K., Stefano Eusepi, Marc Giannoni, and Ayşegül Şahin, (2024). "The Unemployment-Inflation Trade-Off Revisited: The Phillips Curve in COVID Times," Journal of Monetary Economics, vol. 145, Supplement (July), 103580. Dao, Mai Chi, Pierre-Olivier Gourinchas, Daniel Leigh, and Prachi Mishra (forthcoming). "Understanding the International Rise and Fall of Inflation since 2020," Journal of Monetary Economics. di Giovanni, Julian, Sebnem Kalemli-Ozcan, Alvaro Silva, and Muhammed A. Yildirim (2022). "Global Supply Chain Pressures, International Trade, and Inflation," NBER Working Paper Series 30240. Cambridge, Mass.: National Bureau of Economic Research, July, https://www.nber.org/papers/w30240. Jaravel, Xavier (2021). "Inflation Inequality: Measurement, Causes, and Policy Implications," Annual Review of Economics, vol. 13, pp. 599-629. Kaplan, Greg, and Sam Schulhofer-Wohl (2017). "Inflation at the Household Level," Journal of Monetary Economics, vol. 91 (November), pp. 19-38. Pfajfar, Damjan, and Fabian Winkler (2024). "Households' Preferences over Inflation and Monetary Policy Tradeoffs," Finance and Economics Discussion Series 2024-036. Washington: Board of Governors of the Federal Reserve System, May, https://doi.org/10.17016/FEDS.2024.036. Shiller, Robert J. (1997). "Why Do People Dislike Inflation?" in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy. Chicago: University of Chicago Press, pp. 13-65. Stantcheva, Stefanie (2024). "Why Do We Dislike Inflation?" NBER Working Paper Series 32300. Cambridge, Mass.: National Bureau of Economic Research, April, https://www.nber.org/papers/w32300. Public 8 7 6 5 4 3 2 1 0 index 2024 change Bureau percent 2 price the percent National at 2023 is the consumer by line on 12-month 2022 defined dashed based as The estimates 2021 recession are expenditures. 2024 business July of 2020 for 1 period consumption data a The 2019 personal Analytics. Index Figure indicates is 2024. bar Haver July PCE Price via 2018 2020. shaded through PCE, extend outlined 2020-April Analysis, 2017 Expenditures and The data. 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Research: the as 2022 Economic current-month of calculated by is 6 Bureau ratio divided The National month Figure 2021 2024. the by July previous Analytics. the defined through of Haver as via end extend the 2020 at and recession Statistics Unemployment monthly Labor openings business of to are of job data period Bureau he : 2019 enings Survey) a Public 6 5 4 3 2 1 0 as Percent recession 2024 business of period 2023 a indicates bar shaded 2022 2020. 7 outlined Rate The 2020-April Funds 2024. Figure 22, February 2021 Federal August Research: the for through Economic extend 2020 of Range Board. and Bureau daily Target Reserve are the National data of Federal the t he :	---[PAGE_BREAK]--- For release on delivery 10:00 a.m. EDT (8:00 a.m. MDT) August 23, 2024 Review and Outlook Remarks by Jerome H. Powell Chair Board of Governors of the Federal Reserve System at "Reassessing the Effectiveness and Transmission of Monetary Policy," an economic symposium sponsored by the Federal Reserve Bank of Kansas City Jackson Hole, Wyoming August 23, 2024 ---[PAGE_BREAK]--- Four and a half years after COVID-19's arrival, the worst of the pandemic-related economic distortions are fading. Inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalized. And the balance of the risks to our two mandates has changed. Our objective has been to restore price stability while maintaining a strong labor market, avoiding the sharp increases in unemployment that characterized earlier disinflationary episodes when inflation expectations were less well anchored. While the task is not complete, we have made a good deal of progress toward that outcome. Today, I will begin by addressing the current economic situation and the path ahead for monetary policy. I will then turn to a discussion of economic events since the pandemic arrived, exploring why inflation rose to levels not seen in a generation, and why it has fallen so much while unemployment has remained low. # Near-Term Outlook for Policy Let's begin with the current situation and the near-term outlook for policy. For much of the past three years, inflation ran well above our 2 percent goal, and labor market conditions were extremely tight. The Federal Open Market Committee's (FOMC) primary focus has been on bringing down inflation, and appropriately so. Prior to this episode, most Americans alive today had not experienced the pain of high inflation for a sustained period. Inflation brought substantial hardship, especially for those least ---[PAGE_BREAK]--- able to meet the higher costs of essentials like food, housing, and transportation. High inflation triggered stress and a sense of unfairness that linger today. ${ }^{1}$ Our restrictive monetary policy helped restore balance between aggregate supply and demand, easing inflationary pressures and ensuring that inflation expectations remained well anchored. Inflation is now much closer to our objective, with prices having risen 2.5 percent over the past 12 months (figure 1). ${ }^{2}$ After a pause earlier this year, progress toward our 2 percent objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2 percent. Turning to employment, in the years just prior to the pandemic, we saw the significant benefits to society that can come from a long period of strong labor market conditions: low unemployment, high participation, historically low racial employment gaps, and, with inflation low and stable, healthy real wage gains that were increasingly concentrated among those with lower incomes. ${ }^{3}$ Today, the labor market has cooled considerably from its formerly overheated state. The unemployment rate began to rise over a year ago and is now at 4.3 percentstill low by historical standards, but almost a full percentage point above its level in early 2023 (figure 2). Most of that increase has come over the past six months. So far, rising [^0] [^0]: ${ }^{1}$ Shiller (1997) and Stantcheva (2024) study why people dislike inflation. Pfafjar and Winkler (2024) study households' attitudes toward inflation and unemployment. Binetti, Nuzzi, and Stantcheva (2024) investigate households' attitudes toward, and understanding of, inflation. Kaplan and Schulhofer-Wohl (2017) and Jaravel (2021) document heterogeneity in the inflation rate experienced by households across the income distribution. ${ }^{2}$ The data for the personal consumption expenditures (PCE) price index is available for June 2024. Over the 12 months to June 2024, the PCE price index increased 2.5 percent. Data for the consumer price index and producer price index are available through July 2024 and can be used to estimate the level of the PCE price index through July. While such an estimate is subject to uncertainty, it suggests that inflation remained near 2.5 percent through July. ${ }^{3}$ Research documenting such benefits include Aaronson and others (2019), who discuss the experience in the 2010s and review related historical evidence. ---[PAGE_BREAK]--- unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn. Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring. Even so, the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year. ${ }^{4}$ Job vacancies have fallen, and the ratio of vacancies to unemployment has returned to its pre-pandemic range. The hiring and quits rates are now below the levels that prevailed in 2018 and 2019. Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019-a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions. Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased. As we highlighted in our last FOMC statement, we are attentive to the risks to both sides of our dual mandate. The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. [^0] [^0]: ${ }^{4}$ Payroll employment grew by an average of 170,000 per month over the three months ending in July. On August 21, the Bureau of Labor Statistics released the preliminary estimate of the upcoming annual benchmark revision to the establishment survey data, which will be issued in February 2025. The preliminary estimate indicates a downward adjustment to March 2024 total nonfarm employment of 818,000 . ---[PAGE_BREAK]--- We will do everything we can to support a strong labor market as we make further progress toward price stability. With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market. The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions. # The Rise and Fall of Inflation Let's now turn to the questions of why inflation rose, and why it has fallen so significantly even as unemployment has remained low. There is a growing body of research on these questions, and this is a good time for this discussion. ${ }^{5}$ It is, of course, too soon to make definitive assessments. This period will be analyzed and debated long after we are gone. The arrival of the COVID-19 pandemic led quickly to shutdowns in economies around the world. It was a time of radical uncertainty and severe downside risks. As so often happens in times of crisis, Americans adapted and innovated. Governments responded with extraordinary force, especially in the U.S. Congress unanimously passed the CARES Act. At the Fed, we used our powers to an unprecedented extent to stabilize the financial system and help stave off an economic depression. After a historically deep but brief recession, in mid-2020 the economy began to grow again. As the risks of a severe, extended downturn receded, and as the economy [^0] [^0]: ${ }^{5}$ Early examples include Ball, Leigh, and Mishra (2022) and di Giovanni and others (2022). More recent work includes Benigno and Eggertsson (2023, 2024), Blanchard and Bernanke (2023, 2024), Crump and others (2024), Bai and others (2024), and Dao and others (forthcoming). ---[PAGE_BREAK]--- reopened, we faced the risk of replaying the painfully slow recovery that followed the Global Financial Crisis. Congress delivered substantial additional fiscal support in late 2020 and again in early 2021. Spending recovered strongly in the first half of 2021. The ongoing pandemic shaped the pattern of the recovery. Lingering concerns over COVID weighed on spending on in-person services. But pent-up demand, stimulative policies, pandemic changes in work and leisure practices, and the additional savings associated with constrained services spending all contributed to a historic surge in consumer spending on goods. The pandemic also wreaked havoc on supply conditions. Eight million people left the workforce at its onset, and the size of the labor force was still 4 million below its prepandemic level in early 2021. The labor force would not return to its pre-pandemic trend until mid-2023 (figure 3). ${ }^{6}$ Supply chains were snarled by a combination of lost workers, disrupted international trade linkages, and tectonic shifts in the composition and level of demand (figure 4). Clearly, this was nothing like the slow recovery after the Global Financial Crisis. Enter inflation. After running below target through 2020, inflation spiked in March and April 2021. The initial burst of inflation was concentrated rather than broad based, with extremely large price increases for goods in short supply, such as motor [^0] [^0]: ${ }^{6}$ The Federal Reserve Board staff's estimate of the labor force makes two adjustments to the Bureau of Labor Statistics' published estimates: (i) reweighing Current Population Survey respondents such that the labor force estimates in all years reflect the Census Bureau's latest vintage of population estimates; and (ii) accounting for net immigration that is likely not fully reflected in the Census Bureau's latest population estimates, as detailed in the CBO's 2024 Demographic Outlook (see https://www.cbo.gov/publication/59899). The pre-pandemic trend described here is calculated by appending the CBO's January 2020 projected labor force growth from the start of the pandemic through 2024:Q2 onto the level of the labor force just before the start of the pandemic. (See Congressional Budget Office (2020), The Budget and Economic Outlook: 2020 to 2030; https://www.cbo.gov/publication/56073.) ---[PAGE_BREAK]--- vehicles. My colleagues and I judged at the outset that these pandemic-related factors would not be persistent and, thus, that the sudden rise in inflation was likely to pass through fairly quickly without the need for a monetary policy response - in short, that the inflation would be transitory. Standard thinking has long been that, as long as inflation expectations remain well anchored, it can be appropriate for central banks to look through a temporary rise in inflation. ${ }^{7}$ The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board. ${ }^{8}$ The common expectation was that supply conditions would improve reasonably quickly, that the rapid recovery in demand would run its course, and that demand would rotate back from goods to services, bringing inflation down. For a time, the data were consistent with the transitory hypothesis. Monthly readings for core inflation declined every month from April to September 2021, although progress came slower than expected (figure 5). The case began to weaken around midyear, as was reflected in our communications. Beginning in October, the data turned hard against the transitory hypothesis. ${ }^{9}$ Inflation rose and broadened out from goods into [^0] [^0]: ${ }^{7}$ For example, former Chair Ben Bernanke and Olivier Blanchard summarize the standard approach in their work on inflation the following way: "Standard central banking doctrine holds that, so long as inflation expectations are reasonably well anchored, there is a case for 'looking through' temporary supply shocks rather than responding to the short-run increase in inflation" (Blanchard and Bernanke, 2024, p. 2). Clarida (forthcoming) notes how central banks around the world faced a sharp rise in the relative price of goods and chose, at least initially, to accommodate the price pressures with an expected transitory increase in inflation. ${ }^{8}$ In the September 2021 Summary of Economic Projections (SEP), the median projection for headline inflation in 2022 was 2.2 percent. In the August 2021 Survey of Professional Forecasters (the closest survey to the September SEP), the median projection for headline inflation in 2022 was also 2.2 percent. Projections from the Blue Chip survey were similar around this time. ${ }^{9}$ Beginning with the data for October, readings for monthly core PCE jumped to 0.4 percent or higher and inflationary pressures broadened out across goods and services categories. And monthly job gains, already strong, were consistently revised higher over the second half of 2021. Measures of wage inflation also accelerated. ---[PAGE_BREAK]--- services. It became clear that the high inflation was not transitory, and that it would require a strong policy response if inflation expectations were to remain well anchored. We recognized that and pivoted beginning in November. Financial conditions began to tighten. After phasing out our asset purchases, we lifted off in March 2022. By early 2022, headline inflation exceeded 6 percent, with core inflation above 5 percent. New supply shocks appeared. Russia's invasion of Ukraine led to a sharp increase in energy and commodity prices. The improvements in supply conditions and rotation in demand from goods to services were taking much longer than expected, in part due to further COVID waves in the U.S. ${ }^{10}$ And COVID continued to disrupt production globally, including through new and extended lockdowns in China. ${ }^{11}$ High rates of inflation were a global phenomenon, reflecting common experiences: rapid increases in the demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices. ${ }^{12}$ The global nature of inflation was unlike any period since the 1970s. Back then, high inflation became entrenched-an outcome we were utterly committed to avoiding. By mid-2022, the labor market was extremely tight, with employment increasing by over $61 / 2$ million from the middle of 2021 . This increase in labor demand was met, in part, by workers rejoining the labor force as health concerns began to fade. But labor supply remained constrained, and, in the summer of 2022, labor force participation [^0] [^0]: ${ }^{10}$ For example, labor supply continued to be materially affected by COVID even after vaccines became broadly available in the U.S. By late 2021, anticipated increases in labor force participation had not yet materialized, likely owing, in part, to the rise of the Delta and Omicron COVID variants. ${ }^{11}$ For example, in March 2022, lockdowns were imposed in the Jilin province, the largest center for auto production. Authorities also ramped up or extended restrictions in manufacturing hubs in the southeast and in Shanghai, where lockdowns had initially been scheduled to end in April 2022. ${ }^{12}$ The global nature of this inflationary episode is emphasized in Cascaldi-Garcia and others (2024) and Clarida (forthcoming), among others. ---[PAGE_BREAK]--- remained well below pre-pandemic levels. There were nearly twice as many job openings as unemployed persons from March 2022 through the end of the year, signaling a severe labor shortage (figure 6). ${ }^{13}$ Inflation peaked at 7.1 percent in June 2022. At this podium two years ago, I discussed the possibility that addressing inflation could bring some pain in the form of higher unemployment and slower growth. Some argued that getting inflation under control would require a recession and a lengthy period of high unemployment. ${ }^{14}$ I expressed our unconditional commitment to fully restoring price stability and to keeping at it until the job is done. The FOMC did not flinch from carrying out our responsibilities, and our actions forcefully demonstrated our commitment to restoring price stability. We raised our policy rate by 425 basis points in 2022 and another 100 basis points in 2023. We have held our policy rate at its current restrictive level since July 2023 (figure 7). The summer of 2022 proved to be the peak of inflation. The $4-1 / 2$ percentage point decline in inflation from its peak two years ago has occurred in a context of low unemployment-a welcome and historically unusual result. How did inflation fall without a sharp rise in unemployment above its estimated natural rate? Pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their [^0] [^0]: ${ }^{13}$ It has been argued that the natural rate of unemployment had risen, and that the unemployment rate was less informative about tightness in labor market than other measures such as those involving vacancies. For example, see Crump and others (2024). More generally, research has emphasized that the unemployment rate and the ratio of vacancies to unemployment often provide similar signals, but the signals differed in the pandemic period, and the ratio of vacancies to unemployment is a better overall indicator. For example, see Ball, Leigh, and Mishra (2022) and Benigno and Eggertsson (2023, 2024). ${ }^{14}$ For example, Ball, Leigh, and Mishra (2022) and Cecchetti and others (2023) present analyses emphasizing that disinflation would require economic slack. ---[PAGE_BREAK]--- reversal has been a key part of the story of its decline. The unwinding of these factors took much longer than expected but ultimately played a large role in the subsequent disinflation. Our restrictive monetary policy contributed to a moderation in aggregate demand, which combined with improvements in aggregate supply to reduce inflationary pressures while allowing growth to continue at a healthy pace. As labor demand also moderated, the historically high level of vacancies relative to unemployment has normalized primarily through a decline in vacancies, without sizable and disruptive layoffs, bringing the labor market to a state where it is no longer a source of inflationary pressures. A word on the critical importance of inflation expectations. Standard economic models have long reflected the view that inflation will return to its objective when product and labor markets are balanced-without the need for economic slack-so long as inflation expectations are anchored at our objective. That's what the models said, but the stability of longer-run inflation expectations since the 2000s had not been tested by a persistent burst of high inflation. It was far from assured that the inflation anchor would hold. Concerns over de-anchoring contributed to the view that disinflation would require slack in the economy and specifically in the labor market. An important takeaway from recent experience is that anchored inflation expectations, reinforced by vigorous central bank actions, can facilitate disinflation without the need for slack. This narrative attributes much of the increase in inflation to an extraordinary collision between overheated and temporarily distorted demand and constrained supply. While researchers differ in their approaches and, to some extent, in their conclusions, a consensus seems to be emerging, which I see as attributing most of the rise in inflation to ---[PAGE_BREAK]--- this collision. ${ }^{15}$ All told, the healing from pandemic distortions, our efforts to moderate aggregate demand, and the anchoring of expectations have worked together to put inflation on what increasingly appears to be a sustainable path to our 2 percent objective. Disinflation while preserving labor market strength is only possible with anchored inflation expectations, which reflect the public's confidence that the central bank will bring about 2 percent inflation over time. That confidence has been built over decades and reinforced by our actions. That is my assessment of events. Your mileage may vary. # Conclusion Let me wrap up by emphasizing that the pandemic economy has proved to be unlike any other, and that there remains much to be learned from this extraordinary period. Our Statement on Longer-Run Goals and Monetary Policy Strategy emphasizes our commitment to reviewing our principles and making appropriate adjustments through a thorough public review every five years. As we begin this process later this year, we will be open to criticism and new ideas, while preserving the strengths of our framework. The limits of our knowledge-so clearly evident during the pandemic-demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges. [^0] [^0]: ${ }^{15}$ Blanchard and Bernanke (2023) use a traditional (flexible) Phillips curve approach to reach this conclusion for the U.S. Blanchard and Bernanke (2024) and Dao and others (forthcoming) examine a broader set of countries using similar approaches. Di Giovanni and others (2022) and Bai and others (2024) use different techniques and emphasize supply constraints and shocks in the increase in inflation over 2021 and 2022. ---[PAGE_BREAK]--- # References Aaronson, Stephanie R., Mary C. Daly, William L. Wascher, and David W. Wilcox (2019). "Okun Revisited: Who Benefits Most from a Strong Economy," Finance and Economics Discussion Series 2019-072. Washington: Board of Governors of the Federal Reserve System, September, http://dx.doi.org/10.17016/FEDS.2019.072. Bai, Xiwen, Jesus Fernandez-Villaverde, Yiliang Li, and Francesco Zanetti (2024). "The Causal Effects of Global Supply Chain Disruptions on Macroeconomic Outcomes: Evidence and Theory," NBER Working Paper Series 32098. Cambridge, Mass.: National Bureau of Economic Research, February, https://www.nber.org/papers/w32098. Ball, Laurence, Daniel Leigh, and Prachi Mishra (2022). "Understanding US Inflation during the COVID-19 Era," Brookings Papers on Economic Activity, Fall, pp. 154, https://www.brookings.edu/articles/understanding-u-s-inflation-during-the-covid-era. Benigno, Pierpaolo, and Gauti B. Eggertsson (2023). "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve," NBER Working Paper Series 31197. Cambridge, Mass.: National Bureau of Economic Research, April, https://www.nber.org/papers/w31197. (2024). "Insights from the 2020s Inflation Surge: A Tale of Two Curves," paper presented at "Reassessing the Effectiveness and Transmission of Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 22-24. Binetti, Alberto, Francesco Nuzzi, and Stefanie Stantcheva (2024). "People's Understanding of Inflation," NBER Working Paper Series 32497. Cambridge, Mass.: National Bureau of Economic Research, June, https://www.nber.org/papers/w32497. Blanchard, Olivier. J., and Ben S. Bernanke (2023). "What Caused the US Pandemic-Era Inflation?" NBER Working Paper Series 31417. Cambridge, Mass.: National Bureau of Economic Research, June, http://www.nber.org/papers/w31417. (2024). "An Analysis of Pandemic-Era Inflation in 11 Economies," NBER Working Paper Series 32532. Cambridge, Mass.: National Bureau of Economic Research, May, http://www.nber.org/papers/w32532. Cascaldi-Garcia. Danilo, Luca Guerrieri, Matteo Iacoviello, and Michele Modugno (2024). "Lessons from the Co-Movement of Inflation around the World," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 28, https://doi.org/10.17016/2380-7172.3543. ---[PAGE_BREAK]--- Cecchetti, Stephen G., Michael E. Feroli, Peter Hooper, Frederic S. Mishkin, and Kermit L. Schoenholtz (2023). "Managing Disinflations," paper presented at the U.S. Monetary Policy Forum, New York, February 24. Clarida, Richard (forthcoming). "A Global Perspective on Post Pandemic Inflation and its Retreat: Remarks Prepared for NBER Conference on 'Inflation in the Covid Era'," Journal of Monetary Economics. Crump, Richard K., Stefano Eusepi, Marc Giannoni, and Ayşegül Şahin, (2024). "The Unemployment-Inflation Trade-Off Revisited: The Phillips Curve in COVID Times," Journal of Monetary Economics, vol. 145, Supplement (July), 103580. Dao, Mai Chi, Pierre-Olivier Gourinchas, Daniel Leigh, and Prachi Mishra (forthcoming). "Understanding the International Rise and Fall of Inflation since 2020," Journal of Monetary Economics. di Giovanni, Julian, Sebnem Kalemli-Ozcan, Alvaro Silva, and Muhammed A. Yildirim (2022). "Global Supply Chain Pressures, International Trade, and Inflation," NBER Working Paper Series 30240. Cambridge, Mass.: National Bureau of Economic Research, July, https://www.nber.org/papers/w30240. Jaravel, Xavier (2021). "Inflation Inequality: Measurement, Causes, and Policy Implications," Annual Review of Economics, vol. 13, pp. 599-629. Kaplan, Greg, and Sam Schulhofer-Wohl (2017). "Inflation at the Household Level," Journal of Monetary Economics, vol. 91 (November), pp. 19-38. Pfajfar, Damjan, and Fabian Winkler (2024). "Households' Preferences over Inflation and Monetary Policy Tradeoffs," Finance and Economics Discussion Series 2024-036. Washington: Board of Governors of the Federal Reserve System, May, https://doi.org/10.17016/FEDS.2024.036. Shiller, Robert J. (1997). "Why Do People Dislike Inflation?" in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy. Chicago: University of Chicago Press, pp. 13-65. Stantcheva, Stefanie (2024). "Why Do We Dislike Inflation?" NBER Working Paper Series 32300. Cambridge, Mass.: National Bureau of Economic Research, April, https://www.nber.org/papers/w32300. ---[PAGE_BREAK]--- Figure 1 # Personal Consumption Expenditures Price Index ![img-0.jpeg](img-0.jpeg) Note: The data are monthly and extend through July 2024. The data for July 2024 are estimates based on consumer price index and producer price index data. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. PCE is personal consumption expenditures. The dashed line is at the 2 percent longer-run inflation target. Source: Bureau of Economic Analysis, PCE, via Haver Analytics. ---[PAGE_BREAK]--- Figure 2 ## Unemployment Rate ![img-1.jpeg](img-1.jpeg) Note: The data are monthly and extend through July 2024. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. The unemployment rate peaked at 14.8 percent in April 2020. Unemployment rates for April-July 2020 are omitted for readability. Source: Bureau of Labor Statistics via Haver Analytics. ## Hiring and Quits Rates ![img-2.jpeg](img-2.jpeg) Note: The data are monthly and extend through June 2024. Rates are measured as percent of private employment. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. Source: Bureau of Labor Statistics via Haver Analytics. ---[PAGE_BREAK]--- Figure 3 # Civilian Labor Force ![img-3.jpeg](img-3.jpeg) Note: Quarterly and seasonally adjusted data extending through 2024:Q2. The black line is a Federal Reserve Board staff estimate of the labor force, making two adjustments to the Bureau of Labor Statistics' published estimates: (i) reweighing Current Population Survey respondents such that the labor force estimates in all years reflect the Census Bureau's latest population estimates; and (ii) accounting for net immigration that is likely not fully reflected in the Census Bureau's latest population estimates, as detailed in the Congressional Budget Office's (CBO) The Demographic Outlook: 2024 to 2054, https://www.cbo.gov/publication/59899. The pre-pandemic trend is calculated by appending the CBO's January 2020 projected labor force growth from the start of the pandemic through 2024:Q2 onto the level of the labor force just before the start of the pandemic. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. Source: Bureau of Labor Statistics via Haver Analytics; CBO; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- Figure 4 # Global Supply Chain Pressure Index ![img-4.jpeg](img-4.jpeg) Note: The data are monthly and extend through July 2024. The index is presented as the number of standard deviations from its average value. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. Source: Federal Reserve Bank of New York. ---[PAGE_BREAK]--- Figure 5 # Core PCE Prices ![img-5.jpeg](img-5.jpeg) Note: The data are monthly and extend through December 2021. PCE is personal consumption expenditures. The gray outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020April 2020. The light-green outlined shaded region highlights the period from April 2021 to September 2021. Source: Bureau of Economic Analysis, PCE, via Haver Analytics. ---[PAGE_BREAK]--- Figure 6 # Job Openings to Unemployment ![img-6.jpeg](img-6.jpeg) Note: The data are monthly and extend through July 2024. The ratio is calculated as the JOLTS (Job Openings and Labor Turnover Survey) job openings at the end of the previous month divided by current-month unemployed. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. Source: Bureau of Labor Statistics via Haver Analytics. ---[PAGE_BREAK]--- Figure 7 Midpoint of the Target Range for the Federal Funds Rate ![img-7.jpeg](img-7.jpeg) Note: The data are daily and extend through August 22, 2024. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020. Source: Federal Reserve Board.	Jerome H Powell	United States	https://www.bis.org/review/r240826a.pdf	For release on delivery 10:00 a.m. EDT (8:00 a.m. MDT) August 23, 2024 Review and Outlook Remarks by Jerome H. Powell Chair Board of Governors of the Federal Reserve System at "Reassessing the Effectiveness and Transmission of Monetary Policy," an economic symposium sponsored by the Federal Reserve Bank of Kansas City Jackson Hole, Wyoming August 23, 2024 Four and a half years after COVID-19's arrival, the worst of the pandemic-related economic distortions are fading. Inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalized. And the balance of the risks to our two mandates has changed. Our objective has been to restore price stability while maintaining a strong labor market, avoiding the sharp increases in unemployment that characterized earlier disinflationary episodes when inflation expectations were less well anchored. While the task is not complete, we have made a good deal of progress toward that outcome. Today, I will begin by addressing the current economic situation and the path ahead for monetary policy. I will then turn to a discussion of economic events since the pandemic arrived, exploring why inflation rose to levels not seen in a generation, and why it has fallen so much while unemployment has remained low. Let's begin with the current situation and the near-term outlook for policy. For much of the past three years, inflation ran well above our 2 percent goal, and labor market conditions were extremely tight. The Federal Open Market Committee's (FOMC) primary focus has been on bringing down inflation, and appropriately so. Prior to this episode, most Americans alive today had not experienced the pain of high inflation for a sustained period. Inflation brought substantial hardship, especially for those least able to meet the higher costs of essentials like food, housing, and transportation. High inflation triggered stress and a sense of unfairness that linger today. Our restrictive monetary policy helped restore balance between aggregate supply and demand, easing inflationary pressures and ensuring that inflation expectations remained well anchored. Inflation is now much closer to our objective, with prices having risen 2.5 percent over the past 12 months. After a pause earlier this year, progress toward our 2 percent objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2 percent. Turning to employment, in the years just prior to the pandemic, we saw the significant benefits to society that can come from a long period of strong labor market conditions: low unemployment, high participation, historically low racial employment gaps, and, with inflation low and stable, healthy real wage gains that were increasingly concentrated among those with lower incomes. Today, the labor market has cooled considerably from its formerly overheated state. The unemployment rate began to rise over a year ago and is now at 4.3 percentstill low by historical standards, but almost a full percentage point above its level in early 2023. Most of that increase has come over the past six months. So far, rising unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn. Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring. Even so, the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year. Job vacancies have fallen, and the ratio of vacancies to unemployment has returned to its pre-pandemic range. The hiring and quits rates are now below the levels that prevailed in 2018 and 2019. Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019-a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions. Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased. As we highlighted in our last FOMC statement, we are attentive to the risks to both sides of our dual mandate. The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. We will do everything we can to support a strong labor market as we make further progress toward price stability. With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market. The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions. Let's now turn to the questions of why inflation rose, and why it has fallen so significantly even as unemployment has remained low. There is a growing body of research on these questions, and this is a good time for this discussion. It is, of course, too soon to make definitive assessments. This period will be analyzed and debated long after we are gone. The arrival of the COVID-19 pandemic led quickly to shutdowns in economies around the world. It was a time of radical uncertainty and severe downside risks. As so often happens in times of crisis, Americans adapted and innovated. Governments responded with extraordinary force, especially in the U.S. Congress unanimously passed the CARES Act. At the Fed, we used our powers to an unprecedented extent to stabilize the financial system and help stave off an economic depression. After a historically deep but brief recession, in mid-2020 the economy began to grow again. As the risks of a severe, extended downturn receded, and as the economy reopened, we faced the risk of replaying the painfully slow recovery that followed the Global Financial Crisis. Congress delivered substantial additional fiscal support in late 2020 and again in early 2021. Spending recovered strongly in the first half of 2021. The ongoing pandemic shaped the pattern of the recovery. Lingering concerns over COVID weighed on spending on in-person services. But pent-up demand, stimulative policies, pandemic changes in work and leisure practices, and the additional savings associated with constrained services spending all contributed to a historic surge in consumer spending on goods. The pandemic also wreaked havoc on supply conditions. Eight million people left the workforce at its onset, and the size of the labor force was still 4 million below its prepandemic level in early 2021. The labor force would not return to its pre-pandemic trend until mid-2023. Supply chains were snarled by a combination of lost workers, disrupted international trade linkages, and tectonic shifts in the composition and level of demand. Clearly, this was nothing like the slow recovery after the Global Financial Crisis. Enter inflation. After running below target through 2020, inflation spiked in March and April 2021. The initial burst of inflation was concentrated rather than broad based, with extremely large price increases for goods in short supply, such as motor vehicles. My colleagues and I judged at the outset that these pandemic-related factors would not be persistent and, thus, that the sudden rise in inflation was likely to pass through fairly quickly without the need for a monetary policy response - in short, that the inflation would be transitory. Standard thinking has long been that, as long as inflation expectations remain well anchored, it can be appropriate for central banks to look through a temporary rise in inflation. The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board. The common expectation was that supply conditions would improve reasonably quickly, that the rapid recovery in demand would run its course, and that demand would rotate back from goods to services, bringing inflation down. For a time, the data were consistent with the transitory hypothesis. Monthly readings for core inflation declined every month from April to September 2021, although progress came slower than expected. The case began to weaken around midyear, as was reflected in our communications. Beginning in October, the data turned hard against the transitory hypothesis. Inflation rose and broadened out from goods into services. It became clear that the high inflation was not transitory, and that it would require a strong policy response if inflation expectations were to remain well anchored. We recognized that and pivoted beginning in November. Financial conditions began to tighten. After phasing out our asset purchases, we lifted off in March 2022. By early 2022, headline inflation exceeded 6 percent, with core inflation above 5 percent. New supply shocks appeared. Russia's invasion of Ukraine led to a sharp increase in energy and commodity prices. The improvements in supply conditions and rotation in demand from goods to services were taking much longer than expected, in part due to further COVID waves in the U.S. High rates of inflation were a global phenomenon, reflecting common experiences: rapid increases in the demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices. The global nature of inflation was unlike any period since the 1970s. Back then, high inflation became entrenched-an outcome we were utterly committed to avoiding. By mid-2022, the labor market was extremely tight, with employment increasing by over $61 / 2$ million from the middle of 2021 . This increase in labor demand was met, in part, by workers rejoining the labor force as health concerns began to fade. But labor supply remained constrained, and, in the summer of 2022, labor force participation remained well below pre-pandemic levels. There were nearly twice as many job openings as unemployed persons from March 2022 through the end of the year, signaling a severe labor shortage. Inflation peaked at 7.1 percent in June 2022. At this podium two years ago, I discussed the possibility that addressing inflation could bring some pain in the form of higher unemployment and slower growth. Some argued that getting inflation under control would require a recession and a lengthy period of high unemployment. I expressed our unconditional commitment to fully restoring price stability and to keeping at it until the job is done. The FOMC did not flinch from carrying out our responsibilities, and our actions forcefully demonstrated our commitment to restoring price stability. We raised our policy rate by 425 basis points in 2022 and another 100 basis points in 2023. We have held our policy rate at its current restrictive level since July 2023. The summer of 2022 proved to be the peak of inflation. The $4-1 / 2$ percentage point decline in inflation from its peak two years ago has occurred in a context of low unemployment-a welcome and historically unusual result. How did inflation fall without a sharp rise in unemployment above its estimated natural rate? Pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline. The unwinding of these factors took much longer than expected but ultimately played a large role in the subsequent disinflation. Our restrictive monetary policy contributed to a moderation in aggregate demand, which combined with improvements in aggregate supply to reduce inflationary pressures while allowing growth to continue at a healthy pace. As labor demand also moderated, the historically high level of vacancies relative to unemployment has normalized primarily through a decline in vacancies, without sizable and disruptive layoffs, bringing the labor market to a state where it is no longer a source of inflationary pressures. A word on the critical importance of inflation expectations. Standard economic models have long reflected the view that inflation will return to its objective when product and labor markets are balanced-without the need for economic slack-so long as inflation expectations are anchored at our objective. That's what the models said, but the stability of longer-run inflation expectations since the 2000s had not been tested by a persistent burst of high inflation. It was far from assured that the inflation anchor would hold. Concerns over de-anchoring contributed to the view that disinflation would require slack in the economy and specifically in the labor market. An important takeaway from recent experience is that anchored inflation expectations, reinforced by vigorous central bank actions, can facilitate disinflation without the need for slack. This narrative attributes much of the increase in inflation to an extraordinary collision between overheated and temporarily distorted demand and constrained supply. While researchers differ in their approaches and, to some extent, in their conclusions, a consensus seems to be emerging, which I see as attributing most of the rise in inflation to this collision. All told, the healing from pandemic distortions, our efforts to moderate aggregate demand, and the anchoring of expectations have worked together to put inflation on what increasingly appears to be a sustainable path to our 2 percent objective. Disinflation while preserving labor market strength is only possible with anchored inflation expectations, which reflect the public's confidence that the central bank will bring about 2 percent inflation over time. That confidence has been built over decades and reinforced by our actions. That is my assessment of events. Your mileage may vary. Let me wrap up by emphasizing that the pandemic economy has proved to be unlike any other, and that there remains much to be learned from this extraordinary period. Our Statement on Longer-Run Goals and Monetary Policy Strategy emphasizes our commitment to reviewing our principles and making appropriate adjustments through a thorough public review every five years. As we begin this process later this year, we will be open to criticism and new ideas, while preserving the strengths of our framework. The limits of our knowledge-so clearly evident during the pandemic-demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges. Clarida, Richard (forthcoming). "A Global Perspective on Post Pandemic Inflation and its Retreat: Remarks Prepared for NBER Conference on 'Inflation in the Covid Era'," Journal of Monetary Economics. Dao, Mai Chi, Pierre-Olivier Gourinchas, Daniel Leigh, and Prachi Mishra (forthcoming). "Understanding the International Rise and Fall of Inflation since 2020," Journal of Monetary Economics. Turnover Survey) job openings at the end of the previous month divided by current-month unemployed. The outlined shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020-April 2020.
2024-08-24T00:00:00	Philip R Lane: The effectiveness and transmission of monetary policy in the euro area	Contribution by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the panel on "Reassessing the Effectiveness and Transmission of Monetary Policy", an economic symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 24 August 2024.	SPEECH The effectiveness and transmission of monetary policy in the euro area Contribution by Philip R. Lane, Member of the Executive Board of the ECB, to the panel on "Reassessing the effectiveness and transmission of monetary policy" at the Federal Reserve Bank of Kansas City Economic Symposium Jackson Hole, 24 August 2024 Introduction My aim in this contribution is to provide a euro area perspective on the effectiveness and transmission of monetary policy." As expressed in the monetary policy statements of the ECB's Governing Council, the aim of monetary policy tightening has been to deliver a timely return of inflation to the medium-term two per cent target by dampening demand and guarding against the risk of a persistent upward shift in inflation expectations. Even if sectoral shocks had played an important role in triggering the initial 2021- 2022 inflation surges, monetary policy tightening was necessary in order to contain domestic demand and to signal clearly to price and wage-setters that monetary policymakers would not tolerate inflation remaining above the target for an excessively-long period. 2] In this contribution, I will report on the transmission of monetary policy, via financial markets and the banking system, to domestic demand and inflation expectations during this tightening episode. My interim conclusion is that monetary policy has been effective in underpinning the disinflation process, with the transmission of monetary tightening operating to restrict demand and stabilise inflation expectations. The effectiveness and efficiency of monetary policy has required a data-dependent approach to the calibration of the monetary stance. To this end, I will also discuss the importance for the calibration of monetary policy of fully recognising the asymmetric sectoral nature of the pandemic and energy shocks that triggered the initial inflation surges and the impact of sectoral balance sheets on macroeconomic dynamics. These considerations have shaped the monetary policy reaction function of the ECB during this episode, which has been guided by the incoming evidence on: (a) the unfolding inflation outlook; (b) the evolution of underlying inflation; and (c) the strength of monetary transmission (which, inter alia, depends on sectoral balance sheets). Monetary transmission Chart 1 shows the evolution of the euro short-term rate (ESTR) forward curve since December 2021. In terms of the adjustment in policy rates, there were several distinct phases. Early in 2022, the yield curve shifted up in anticipation of future rate hikes, with the markets anticipating that the ECB would respond forcefully to the building inflation shock. In the second half of 2022, there was an accelerated campaign of outsized hikes in order to move sharply away from an accommodative stance. In the first nine months of 2023, further hikes brought the policy rate to a level that was assessed to be sufficiently restrictive, if held for a sufficiently long duration, to underpin a timely disinflation process. The policy rate was then held at its peak of 4 per cent from September 2023 to June 2024. Chart 1 Policy rate path and risk-free curve over time (percentages per annum) Realised DFR wee Dec 2021 = Dec 2022 eee Sep 2023 === Latest 45 4.0 3.5 3.0 25 2.0 1.5 1.0 0.5 0.0 + -0.5 -1.0 2022 2023 2024 2025 2026 2027 Sources: Bloomberg and ECB calculations. Notes: "DFR" stands for "deposit facility rate'. The cut-off dates for the data used for the €STR forward curves are 17 December 2021, 16 December 2022, 15 September 2023, and 13 August 2024. Astriking feature of Chart 1 is that the inflation shock triggered a repricing of not only the near-term policy rate path but also the long-term policy rate path. At the end of 2021, the policy rate was expected to remain negative even in 2027 according to market pricing (and expert surveys). The re-pricing occurred in early 2022 and has persisted, with the 2027 (and longer-horizon) policy rate expected to settle in the neighbourhood of two per cent, which is consistent with market views of a near-zero equilibrium real rate and the successful delivery of the inflation target in the medium term. This has meant the inflation shock triggered a fundamental re-setting of the interest rate path, with no expectation of a return to the extraordinarily accommodative monetary stance that had been in place since 2014/2015. At the same time, Chart 2 shows the longer-term yields rose by much less than short- term yields. The negative slope of the yield curve reflects the market assessment that inflation would normalise relatively quickly, such that the cumulative increase in policy rates also had a significant cyclical component that would be unwound. At the same time, this inversion of the yield curve also masked a marked increase in the term premium, including due to the significant decline in the bond market footprint of the Eurosystem (Chart 3): since December 2021, quantitative tightening is estimated to have raised the term premium in the overnight index swap (OIS) curve by about 55 basis points.) Chart 2 Slope of the risk-free yield curve (percentage points) 1 08 2019 2020 2021 2022 2023 2024 13-Aug-24 Sources: Bloomberg and ECB calculations. Notes: The slope of the risk-free yield curve is calculated as the difference between the ten-year and two-year OIS rates. The latest observation is for 13 August 2024. Chart 3 Eurosystem balance sheet (EUR trillions) mAPP =PEPP = TLTROs 2020 2021 2022 2023 2024 2-Aug-24 Sources: ECB calculations. Notes: "APP" stands for "asset purchase programme", "PEPP" for "pandemic emergency purchase programme" and "TLTROs" for "targeted longer-term refinancing operations". Purchase programmes are based on book value at amortised cost.The latest observations are for 2 August 2024. In the bank-based European financial system, the transmission of the restrictive monetary policy stance to bank lending conditions plays a central role.4] As shown in Chart 4, banks have faced higher funding costs (due to the combination of a rapid increase in bank bond yields and an increase (even if slower) in bank deposit rates) and bank lending rates to firms and households for new loans increased significantly (the prevalence of fixed-rate mortgages has meant that the lending rates facing existing household customers have increased far more slowly). Banks have also tightened their credit standards applied to the approval of loans, as shown in Chart 5.5 Credit volumes moderated rapidly and nominal credit growth has been very low since 2022, as shown in Chart 64 Chart 4 Bank lending rates to firms and households, plus bank funding costs (percentages per annum) New business volumes - firms New business volumes - households Outstanding amounts - firms Outstanding amounts - households == --_ Bank funding cost Jan-22 Jul-22 Jan-23 Jul-23 Jan-24 Jun-24 Sources: ECB (BSI, MIR, MMSR) and ECB calculations. Notes: The indicators for the total cost of borrowing for firms and households are calculated by aggregating short- term and long-term rates using a 24-month moving average of new business volumes. The bank funding cost series is a weighted average of new business costs for overnight deposits, deposits redeemable at notice, time deposits, bonds, and interbank borrowing, weighted by outstanding amounts. The latest observations are for June 2024. Chart 5 Evolution of bank credit standards (cumulated net percentages of banks reporting a tightening of credit standards) ---= Loans to firms ees Loans to households for house purchase 150 100 50 -50 -100 2014 2015 2017 2018 2020 2021 2023 2024Q2 Sources: ECB (BLS) and ECB calculations. Notes: Net percentages for credit standards are defined as the difference between the sum of the percentages of banks responding "tightened considerably" and "tightened somewhat" and the sum of the percentages of banks responding "eased somewhat" and "eased considerably". Cumulation starts in the first quarter of 2014. The latest observations are for the second quarter of 2024. Chart 6 Credit volumes to firms and households (annual percentage changes) == Bank loans to households = Bank loans to firms Q4 2021 Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024 Source: ECB (BSI). Notes: Bank loans to firms are adjusted for sales, securitisation and cash pooling. Bank loans to households are adjusted for sales and securitisation. The latest observations are for the second quarter of 2024. The decline in credit observed so far in the current cycle has been stronger than historical regularities, based on linear models, would have suggested. The particularly large and rapid increase in policy rates may have amplified the tightening impulse. Moreover, the perceived and abrupt end of the "low for long" era reduced the incentives to search for yield, further contributing to a pullback in risk taking by banks and customers. 2] Large policy rate hikes (including a persistent component) increased the riskiness of borrowers, reducing the willingness to lend. The combination of the war impact and rapid rate hikes also signalled a less positive economic future, reducing the expected revenues and increasing the expected future funding costs of potential borrowers, leading them to reduce their demand for credit. The dampening of demand Through the tightening of market-based and bank-based financing conditions, the restrictive policy stance has fed through to economic activity. Chart 7 shows that, the recovery in output over the period 2022-2024 has been much weaker than expected. Despite the impact of the war-related energy shock, the post-pandemic reopening did allow GDP to grow during the first nine months of 2022 (when monetary policy was not yet restrictive). Subsequently, economic activity stagnated between late 2022 and late 2023, with only a limited recovery during the first half of 2024. In terms of demand components, public consumption has been the main consistent driver of growth, while private consumption and external demand have remained subdued in recent quarters (Chart 8). Investment has also been weak: a decline in housing investment has been a persistent drag on growth; while business investment was also hit, the impact was mitigated during 2022-2023 by past order backlogs that somewhat supported the production of capital goods.44 Chart 7 Real GDP growth and projections (annual percentage changes) @ December 2021 projections m December 2022 projections tm® December 2023 projections @ June 2024 projections 5 @ GDP outcome 4 3 I i; I Lo i ; a _ 7 2022 2023 2024 Sources: Eurostat; June 2024, December 2023, December 2022 and December 2021 Eurosystem staff projections; and ECB calculations. Notes: The latest observations are for 2023 for GDP and 2024 for projections. Chart 8 GDP growth contributions (quarter-on-quarter percentage changes and contributions) GDP at market prices Private consumption Government consumption Total investment Changes in inventories Net exports BEEBE Q1 2021 Q3 2021 Q1 2022 Q3 2022 Q1 2023 Q3 2023 Q1 2024 Q2 2024 Sources: Eurostat and ECB calculations. Notes: The latest observations are for the second quarter of 2024 for GDP and the first quarter of 2024 for the contributions. The subdued economic performance is also clearly connected to the uncertainty shock and the energy price and terms of trade shocks triggered by the unjustified invasion of Ukraine by Russia. For instance, Chart 9 shows that, despite the post-pandemic output recovery and strong increase in employment, real disposable income stagnated during 2022 as inflation rose far more quickly than wages. The decline in real incomes would have been more severe in the absence of the countervailing fiscal measures that were widely introduced during 2022 and that boosted transfers to households and suppressed the most intense impact of rising energy prices on households. Indicators of consumer confidence fell at the onset of the war and, despite some gradual improvement, still remain below the pre-war level. Together with the contribution of the restrictive monetary stance, this helps to explain the still-limited response of consumption to the improvement in real disposable income that has been in train since the middle of 2023, due to the recovery in wages, the decline in inflation and the improvement in the terms of trade. Chart 9 Private consumption, real disposable income and consumer confidence (left scale: index Q4 2019 = 100, right scale: net percentage balance) tm Private consumption tm Real disposable income == Consumer confidence (rhs) 106 0 105 5 104 -10 103 -15 102 -20 104 100 2 99 -30 98 Dec-21 Jun-22 Dec-22 Jun-23 Dec-23 Aug-24 Sources: Eurostat and European Commission. Notes: The latest observations are for the first quarter of 2024 for private consumption and disposable income, and August 2024 for consumer confidence. Put differently, the adverse war-related 2022 shocks to household incomes, the terms of trade and confidence indicators for both households and firms served as countervailing influences on demand conditions and thereby reduced the extent of demand dampening that needed to be generated by monetary tightening. While employment growth also decelerated, it remained above the rate of output growth. Unemployment has remained broadly stable at a historically-low level, with employment growth accommodated by an increase in the labour force through a mix of rising participation and a recovery in immigration. This robust labour market performance (which has also mitigated the impact of rising interest rates on consumption) reflects the composition of activity, with services (including public services) more robust than manufacturing. It also reflects labour hoarding, with the anticipation of future recovery motivating firms to retain workers. In turn, labour hoarding was supported in 2022-2023 by strong profitability levels, the decline in real wages and the rise in interest rates (such that the relative price of labour versus capital declined). The moderation in the labour market in 2024 is consistent with a weakening of these forces, with profitability declining, real wages rising and a turn in the interest rate cycle. Monetary policy affects demand and prices through multiple channels: someare more direct (via intertemporal substitution) and others are more indirect (via growth and employment). This means that the full impact of changes in monetary policy on aggregate inflation occurs only with long and variable lags. As consumers rein in their spending in response to monetary policy tightening, they start by consuming fewer goods with a high intertemporal elasticity of substitution, such as durables and non- essential items. They also reduce spending on goods that are more interest-rate sensitive, such as durable goods purchased using credit, including housing. Analysis by ECB staff suggests that the peak price response of items most sensitive to monetary policy shocks, which tend to include durables and non-essential items, is around three times larger than for less sensitive items." The price reaction to monetary policy shocks of these more sensitive consumer items has been stronger in the recent tightening cycle than in past episodes of monetary restraint, reflecting the effectiveness of the steep and decisive hiking policy in dampening demand. In summary, monetary tightening has restricted domestic demand, especially since late 2022. A dampened-demand environment directly reduces the capacity of firms to raise prices and workers to obtain wage increases. It also contributes to the stabilisation of inflation expectations, to which we now turn. The anchoring of inflation expectations A primary task for monetary policy in the disinflation process has been to ensure that the large pandemic and sectoral shocks did not translate into an increase in the medium-term inflation trend by fostering an upward de-anchoring of inflation expectations that could persist even after the unwinding of the sectoral shocks. In particular, the very sharp rise in actual and projected inflation in the course of 2022 put a premium on guarding against the de-anchoring of inflation expectations and motivated an accelerated approach to monetary tightening between July 2022 and March 2023, with the policy rate hiked by 350 basis points over six meetings. In the post-crisis years before the pandemic, expectations had become de-anchored to the downside. The pre-pandemic distribution of long-term inflation expectations in the Survey of Professional Forecasters (SPF) was skewed to the left, as shown in Chart 10, and had a median expectation of 1.7 per cent. A similar pattern was evident in market-based indicators."2] Between the middle of 2021 and early 2022, there was a remarkable shift in long-term inflation expectations, with survey respondents moving away from the long-held views that inflation would remain below two per cent indefinitely.3] In essence, the majority of respondents assessed that the inflation shock opportunistically served to re- anchor long-term inflation expectations at the target by demonstrating that target risks were two-sided. [14] This is in line with the behaviour of market interest rates shown in Chart 1: the re-anchoring of medium-term inflation expectations has removed the need for an open-ended accommodative underlying monetary stance. Chart 10 Survey of Professional Forecasters: distribution of longer-term inflation expectations (percentages of respondents) @ 242019 ® 42022 @ 32024 60 £15 16 17 18 19 20 24 22 23 24 225 Sources: SPF and ECB calculations. Notes: The vertical axis shows the percentages of respondents; the horizontal axis shows the HICP inflation rate. Longer-term inflation expectations refer to four to five years ahead. The latest observations are for the third quarter of 2024. Reinforced by the target-consistent monetary policy decisions during this period, the stabilisation of medium-term inflation expectations has provided an important anchor in the disinflation process. 15] The sheer magnitude of the inflation surge, the successive upward price shocks and the shifts in the short-term inflation outlook clearly could have generated upside de-anchoring risks. Instead, as shown in Chart 11, throughout this period the high-inflation phase has been expected to be relatively short- lived, supporting the timely return of inflation to the target. As shown in Charts 12 and 13, there has also been a decline in the medium-term inflation expectations reported by firms in the survey on the access to finance of enterprises (SAFE) and by households in the Consumer Expectations Survey (CES). Chart 11 Term structure of inflation expectations from professional forecasters (annual percentage changes) Term structure inflation expectations (Q3 2021 to Q3 2024) -HicP 12 10 2 0 2 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Sources: Eurostat, SPF and ECB calculations. Notes: The term structure of inflation expectations shows expectations for different horizons in past rounds of the SPF. Chart 12 Consumer Expectations Survey (annual percentage changes) === Perception of past inflation === Inflation expectations three years ahead === Inflation expectations one year ahead =-= HICP 10 0 Jan-23 Apr-23 Jul-23 Oct-23 Jan-24 Apr-24 Jul-24 Sources: Eurostat and CES. Notes: The series refer to the median value. The latest observations are for July 2024. Chart 13 Firms' expectations for euro area inflation at different horizons (annual percentages) @ Median @ Mode © Interquartile range Jun-23 Dec-23 Mar-24 Jun-24 Jun-23 Dec-23 Mar-24 Jun-24 Jun-23 Dec-23 Mar-24 Jun-24 re Ce 1 year 3 year 5 year Sources: SAFE and ECB calculations. Notes: Survey-weighted median, mode and interquartile ranges of firms' expectations for euro area inflation in one year, three years and five years. Quantiles are computed by linear interpolation of the mid-distribution function. The statistics are computed after trimming the data at the country-specific 1st and 99th percentiles. Base: all enterprises. In turn, the anticipation of the monetary policy response helped to reduce the scale and duration of the inflation response to the large shocks. This anticipation effect was plausibly stronger during this episode, since the large shocks in 2021 and especially 2022 triggered an increase in the frequency of price adjustment.) A monetary policy stance that is clearly committed to the timely return of inflation to the target is especially powerful under state-dependent pricing."41 An increase in the frequency of price changes represents both an extra cost from high inflation (since there are economic costs - including management costs - from adjusting prices more frequently) but also an opportunity: if price setters understand that the central bank is committed to returning inflation to the target in a timely manner through an aggressive interest rate response to the large shock, the phase of intense inflation will be shorter and the sacrifice ratio in terms of lost output will be lower since price setters only have to focus on adjusting prices to the cost shock rather than also having to incorporate an excessively- prolonged aftershock phase of second round effects. In summary, the risk of an upside de-anchoring of inflation expectations has been contained. This has certainly been facilitated by the nature of the initial inflation shocks, with the relative price shifts triggered by the pandemic and the war-related energy shock reversing fairly quickly and disinflation being further supported by the innate demand-dampening characteristics of the war and the terms of trade deterioration. The historical evidence and model-based counterfactual analyses clearly indicate that an insufficiently -vigorous monetary policy response could have resulted in a persistent increase in the inflation trend. At the same time, the calibration of the monetary policy response also needed to contain the risk of returning to the downside-deanchored equilibrium that had prevailed in the euro area before the pandemic. Sectoral shocks and disinflation dynamics During the disinflation process, the calibration of monetary policy needed to take into account the reversal in energy inflation, the easing of pipeline pressures and the relaxation of supply bottlenecks. The pandemic and the subsequent energy shock triggered by Russia's unjustified invasion of Ukraine had asymmetric and time-varying effects on different sectors. During 2020 and 2021, the impact of the pandemic on activity was most severe for contact-intensive services, while the goods sector was overwhelmed by the mismatch between a positive global demand shift and a decline in global supply capacity due to pandemic-related shutdowns and supply-chain interruptions. During 2022, the dislocations in the oil and gas sectors due to the Russia-Ukraine war were associated with an extraordinary surge in energy prices, which also constituted a severe terms of trade shock for the euro area as a net energy importer. In Europe, the full relaxation of pandemic-related lockdown measures also occurred only in spring 2022, after the subsidence of the Omicron variant. Accordingly, in 2022, the mis-match in the goods sector was succeeded by a mis-match in the services sector, with demand for contact-intensive services rising more quickly than supply capacity in the immediate aftermath of the full post-pandemic reopening that spring. Subsequently, the improvement in supply capacity and the unwinding of the adverse terms of trade shock has both supported economic activity and contributed to disinflation. In particular, the normalisation of demand and the expansion in supply capacity reduced these sectoral mismatches. After peaking in 2021, supply chain bottlenecks gradually eased during the course of 2022 and 2023, contributing to a decline in the relative price of goods. The decline in energy demand and the increase in energy supply capacity, together with the contribution from the various subsidy schemes that limited the impact of the shocks on retail energy prices, meant that energy prices fell by 14 per cent between their peak in October 2022 and July 2023. The easing of bottlenecks and the decline in the relative price of energy also helped to calm food inflation and, via lower cost pressures, services inflation.42] In addition, the reversal of the adverse supply shocks also boosted activity and employment, with the fading of the pandemic in particular supporting activity in 2021 and 2022, and falling energy prices and the receding impact of past bottlenecks boosting activity in 2023 and 2024. Compared to a purely demand-driven inflation episode, the nature of this inflation shock limited the extent to which disinflation would necessarily be accompanied by a severe economic contraction: rather, the aim of monetary policy was to make sure that demand grew more slowly than supply capacity during the disinflation phase. The euro area implementation of the Bernanke-Blanchard model provides a useful organising device to represent the contribution of sectoral shocks." The left panel of Chart 14 shows that shocks to energy and food prices, together with pandemic-related shortages, accounted for the largest part of the 2021- 2022 inflation surges and the subsequent disinflation can largely be attributed to the fading of these shocks. In contrast, labour market tightness has played a comparatively minor role in inflation dynamics. The right panel of Chart 14 shows that the phase of above-target inflation has primarily been prolonged by the lagged adjustment of wages (and prices) to the initial inflation shocks. The aim of monetary tightening has been to contain this adjustment phase by making sure that the post-shock rounds of wage and price adjustments were limited by dampened demand and underpinned by stable longer-term inflation expectations. Chart 14 Sectoral shocks HICP inflation Negotiated wage growth (year-on-year growth rate, pp contributions) (year-on-year growth rate, pp contributions) @ Initial conditions tm Food @ Lockdown @ Initialconditions tm Food @ Lockdown @ Labour market tm@ Shortages @ Residuals © Labour market @ Shortages @ Residuals Hm Energy I Productivity HICP inflation Energy tm@ Productivity = Wage growth 11 6 10 9 5 8 7 4 6 3 5 4 2 3 2 1 1 0 0 A 4 2 3 2 2020 2021 2022 2023 2024 2025 2026 2020 2021 2022 2023 2024 2025 2026 Source: ECB calculations based on Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdon, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB. Notes: The figures show decompositions of the sources of seasonally adjusted annual wage growth and HICP inflation based on the solution of the full model and the implied impulse response functions. The out-sample projection is constructed by performing a conditional forecast starting in Q1 2020, conditional on realised variables between Q1 2020 and Q1 2024 and technical assumptions and inverted residuals between Q2 2024 and Q4 2026 such that HICP in the conditional projection is equal to the seasonally adjusted June 2024 Eurosystem staff projections. Assumptions from the June 2024 projections baseline correspond to energy and food price inflation and productivity growth. Labour market tightness is assumed to remain constant. The "shortages" (measured by the Global Supply Chain Pressure Index) are known up to Q2 2024 and projected according to an AR(3) process thereafter. The historical decomposition treats the projection as data and is carried out from Q1 2020 onwards to compute the contributions of the initial conditions and of the exogenous variables. According to this analytical framework, the bulk of disinflation could be expected to take place relatively quickly with the fading of the sectoral shocks, but full convergence back to the target would be slower due to the lagged nature of wage adjustments and the staggered pattern of economy-wide price adjustments to cost increases. In turn, these characteristics of the disinflation process (an initial rapid phase, followed by a slower convergence phase) have informed the calibration of monetary tightening. The nature of the disinflation process has been recognised in the Eurosystem staff projections. For instance, the December 2022 projections foresaw that inflation would decline from the quarterly peak of 10 per cent in Q4 2022 to 3.6 per cent in Q4 2023, 3.3 per cent in Q4 2024 and 2.0 per cent in Q4 2025. Disinflation turned out to be even more rapid during 2023, with Q4 inflation at 2.7 per cent. The June 2024 projections foresee inflation at 2.5 per cent in Q4 2024 and 2.0 per cent in Q4 2025. In summary, diagnosing the nature of inflation dynamics has been essential in calibrating monetary tightening. Conditional on inflation expectations remaining anchored, the fading out of the initial shocks that triggered the steep rise in inflation could be expected to deliver a two-phase disinflation process, with an initial steep decline followed by a slower convergence phase as wage-price and price-price staggered adjustment dynamics played out.25 The role of a demand-dampening monetary stance has been to make sure that inflation did not remain too far above the target for too long and to reinforce the commitment to a timely return to the inflation target, such that price and wage-setters could focus on "backward" adjustment dynamics - aimed at recovering lost purchasing power and re-establishing optimal relative prices - without worrying about the "forward" adjustment dynamics that would be generated by any de-anchoring of inflation expectations. Sectoral balance sheets In calibrating the monetary stance, it is also essential to take into account that the impact of monetary policy depends on the condition of sectoral balance sheets. These encompass the balance sheets of firms, households, banks, the public sector and the rest of the world.24) Chart 15 Euro area net lending / net borrowing (as a percent of nominal GDP - four quarter sums) Households ®@ Non-financial corporations Financial corporations @ General government = Euro area Ss ora kK HON FD @ Ss 2019 2020 2021 2022 2023 2024 Sources: Eurostat and ECB. Note: The latest observations are for the first quarter of 2024. Chart 16 Sectoral leverage (percentages of nominal GDP - four-quarter sums) = Government tm Households (rhs) tm Non-financial corporations 180 80 160 75 140 70 120 65 100 60 80 55 60 50 2000 2003 2006 2009 2012 2015 2018 2021 2024 Sources: Eurostat, ECB and ECB calculations. Note: Leverage is defined as total non-equity liabilities divided by the four-quarter sum of nominal GDP. The latest observations are for the first quarter of 2024. Chart 17 Non-financial corporations' margins and saving ratio (percentages - four quarter moving averages) tm Net operating surplus to value added tm Net retained earnings to value added 30 8 28 6 26 4 24 2 8 ss -__ 0 2017 2018 2019 2020 2021 2022 2023 2024 Sources: ECB and ECB calculations. Note: The latest observations are for the first quarter of 2024. Chart 18 Net worth of households (annual changes as percentages of nominal disposable income) Change due to holding gains and losses on financial assets Change due to holding gains and losses on non-financial assets 50 Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Sources: Eurostat, ECB and ECB calculations. Note: Changes are mainly due to movements in real estate and share prices. The latest observations are for the first quarter of 2024. Chart 15 shows that households had exceptionally high savings rates in 2020 and 2021. While firms were net borrowers during the initial months of the pandemic in 2020, corporate debt was contained by significant fiscal transfers and de-risked through extensive public loan guarantees. Taking a longer-term perspective, Chart 16 shows that household leverage before the pandemic had declined relative to the 2010 peak but was still elevated compared to the initial years of the euro; although there had been some decline since 2016, the pre-pandemic level of corporate leverage was much higher than at the start of the euro. While the collapse of GDP meant that these leverage ratios jumped during 2020, both now stand well below their pre-pandemic levels, also due to the significant rise in nominal GDP. These balance sheet improvements have helped to cushion the financial impact of monetary policy tightening on households and firms. In addition, the trend shift towards fixed-rate mortgages also meant that fewer euro area households faced an immediate cash flow burden due to higher mortgage servicing costs. Moreover, in contrast to an inflation scenario in which the unwinding of a demand shock means that monetary tightening is accompanied by economic contraction, the improvement in supply capacity after the pandemic, the easing of bottlenecks and the 2023-2024 unwinding of the 2021-2022 energy shocks meant that there was underlying positive momentum in employment and output. This further contained credit risk premia, in contrast to tightening cycles triggered by excess demand episodes (often accompanied also by financial excess). One illustration is provided by Chart 17, which shows that corporate profitability was above the pre-pandemic level in 2021 and 2022, also boosted by prices adjusting more rapidly to the inflation surge than wages. While the monetary tightening and rising labour costs have seen a decline in corporate profitability, it only just returned to the pre-pandemic level in early 2024. At the same time, the financial exposure to rising interest rates that was embedded in the holdings of non-bank financial intermediaries was ultimately held either by euro area households or the global investor community. Chart 18 shows that housing assets served as a partial inflation hedge during 2022 even if higher interests rates resulted in some reversal in valuations in 2023. At the same time, there were net capital losses on household financial portfolios during 2022. The sharp increase in inflation also eroded the real value of household deposits. The losses on financial portfolios are likely to have been disproportionately absorbed by higher-income households with relatively low marginal propensities to consume, with cushioning provided by the high share of this group in pandemic-era excess savings./22] In the aftermath of the 2008-2012 global and euro area crises, the resilience of the euro area banking system has been improved through a mix of higher regulatory requirements, more intensive bank supervision, the rolling-out of more extensive macroprudential regulations and greater managerial risk aversion. As an illustration, Chart 19 shows the marked improvement in capital ratios in the banking system between 2015 and 2019. Simultaneously, liquidity ratios improved significantly, further increasing the overall resilience of the banking sector. Pandemic-related excess savings by households, extensive fiscal transfers to households and firms, public loan guarantees, the reversal of the pandemic and energy shocks and low-cost funding from the ECB meant that banks did not suffer significant credit impairments during the 2020-2021 period. Chart 19 Capital ratio of the banking system (percentages) -_---= Common Equity Tier 1 ratio 16 12 Q2 2015 Q4 2016 Q2 2018 Q4 2019 Q2 2021 Q4 2022 Q1 2024 Source: ECB supervisory reporting. Notes: The sample consists of significant institutions under the supervision of the ECB (changing composition). The latest observations are for the first quarter of 2024. Chart 20 Gross debt (percentage of euro area GDP) = EA sovereign debt + EU supranational debt 100 95 90 86 80 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Source: June 2024 Eurosystem staff macroeconomic projections. Notes: Supranational EU debt (not reflected in the euro area aggregate) is the gross outstanding debt of the EU institutions, including Next Generation EU financing. Supranational EU debt is not an official statistic, but an internal estimate. Chart 21 Euro area net international investment position (percentage of GDP) 5 -10 -15 -20 -25 Q1 2013 Q1 2014 Q1 2015 Q1 2016 Q1 2017 Q1 2018 Q1 2019 Q1 2020 Q1 2021 Q1 2022 Q1 2023 Q1 2024 Sources: ECB (balance of payments) and Eurostat (national accounts). Note: The latest observation is for the first quarter of 2024. The robust state of bank balance sheets meant that the transmission of rate hikes to banks could proceed in an orderly manner. In particular, the increases in risk-free rates were not amplified by an outsized increase in credit risk premia or a severe contraction in credit supply. Moreover, the capital losses on the bonds held by the banking sector were contained by the relatively low bond allocation in the asset holdings of euro area banks./25] In a related manner, the high share of central bank reserves in the asset holdings of banks meant that the overall duration risk was relatively limited. Bank profitability improved substantially due to the shift to a higher interest rate environment and was further bolstered by the increase in interest paid on central bank reserves.!4I In effect, the resilience of the banking sector, together with the highly-liquid composition of bank assets, has increased the feasible monetary policy space by muting concerns about the financial stability impact of rate hikes.25] The highly-liquid state of the asset side of bank balance sheets meant that losses from fixed rate mortgage assets were compensated by rising income from central bank reserve holdings. While the level of central bank excess reserves in the euro area remains high at around €3.1 trillion, these have declined by more than a third, or €1.7 trillion, since the peak reached in the second half of 2022. This has mostly been the result of the repayment of funding from targeted longer-term refinancing operations (TLTRO), which fell from €2.2 trillion in June 2022 to a mere €76 billion in July 2024 and will reach zero in December 2024.25] The reinvestment of the asset purchase programme (APP) portfolio stopped in June 2023, with the APP portfolio dropping from a peak of €3.3 trillion in June 2022 to €2.8 trillion in July 2024. The pandemic emergency purchase programme (PEPP) portfolio started to shrink in July, with the intention to discontinue reinvestments altogether at the end of this year. From a macroeconomic perspective, the transition from a high-reserves environment to a lower- reserves environment can trigger a shift in the risk-taking strategies of banks (vis-a-vis both lending and bond purchasing), in relation to a decline in the stock of reserves that might have been expected to remain in the banking system for an extended period as the funding counterparts to asset purchase programmes or long-term refinancing operations (sometimes described as "non-borrowed" reserves). (271[28][29] Directionally, this contraction in liquidity may have contributed to the relatively-strong decline in lending volumes in the euro area during this tightening episode. In particular, estimates by ECB staff suggest that banks with lower excess liquidity are more likely to reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is likely to be larger. This means that, as aggregate liquidity shrinks, the transmission of the restrictive monetary policy stance to bank lending may strengthen further. The counterpart to the insulation of household, bank and corporate balance sheets during the pandemic was an expansion in sovereign debt (see Chart 20). The surprise inflation, together with the output recovery, has partially offset the increase in debt-output ratios but these remain above their pre- pandemic levels. In addition, the considerable fiscal response to the energy shock in 2022 increased public debt levels, even if many of these temporary measures have now been reversed. Naturally, an integrated view of the consolidated public sector balance sheet should take into account the decline in the net equity position of central banks but any evaluation of the impact of monetary tightening via this channel will depend on the specification of the relevant counterfactual scenario. Despite some volatility episodes, the combination of higher policy rates, quantitative tightening and an increase in public debt levels has not triggered a substantial increase in sovereign risk premia in the euro area, while so far there has only been a limited increase in term premia. This likely reflects several factors. First, as indicated by the anchoring of longer-term inflation expectations, this inflation episode has been interpreted throughout as a temporary phase, with a sufficient response from central banks to ensure that the initial inflation shocks do not mutate into permanent inflation. In turn, this has meant that longer-term bond yields rose by less than shorter-term interest rates Second, the 2020 launch of the Next Generation EU (NGEU) programme of joint debt and grants caused a reassessment of country-level risk premia by investors, in view of the solidarity demonstrated by EU Member States in the face of a severe tail risk. Third, the flexible design of the 2020 PEPP and 2022 announcement of the transmission protection instrument (TPI) provided reassurance to investors that unwarranted, disorderly dynamics in sovereign debt markets posing a serious threat to the transmission of monetary policy would not be tolerated, provided that countries comply with a set of established "prudent policy" criteria. Finally, it is important to take into account the external balance sheet of the euro area, in view of its role in the international transmission of domestic and foreign monetary tightening. In line with the impact of the severe decline in the terms of trade on import payments relative to export revenues, Chart 15 shows that the current account surplus of the euro area declined between the middle of 2021 and early 2023, which is also reflected in the decline in the net international investment position during this period, temporarily interrupting the rising trend observed since 2013, in Chart 21. Aside from the terms of trade channel, the global nature of the inflation shock and the similar monetary policy responses across countries meant that the composition of foreign assets and foreign liabilities played only a limited role in determining the international impact of monetary tightening. For instance, debt-related international investment income inflows and outflows increased by similar amounts between 2021 and 2024. Of course, taking a wider perspective, the global element of the inflation shock and the monetary policy response has shaped the disinflation process and the calibration of monetary policy. All else equal, the tightening moves by foreign central banks limited the required scale of domestic monetary tightening by slowing down global activity, containing globally-determined commodity prices and pushing up the common component in term premia. At the same time, if domestic monetary tightening had been too limited relative to foreign monetary tightening, exchange rate depreciation might have exerted a larger influence on the domestic disinflation process. Conclusions At the time of writing (August 2024), my interim assessment of the effectiveness of ECB monetary policy in responding to the 2021-2022 inflation surges is that there has been good progress in delivering the overriding goal of making sure that inflation returns to target in a timely manner. Crucially, this disinflation process has been underpinned by the forceful transmission of monetary policy to the financial system, the level of demand and inflation expectations. This has required the ECB to appropriately calibrate its monetary policy stance to ensure that demand has been sufficiently dampened and the anchoring of medium-term inflation expectations sufficiently protected, while also containing the economic costs of a restrictive monetary stance. Among other factors, this calibration needed to take into account: the "re-anchoring from below" of medium-term inflation expectations and the associated pricing-out of low-for-long rate scenarios; the multiple channels by which the unjustified Russian invasion of Ukraine directly served to moderate demand; the inflation-disinflation cycles generated by the pandemic and the energy shock; the interactions between monetary policy and sectoral balance sheets; and the global dimensions of the inflation shock and the international policy response. Of course, this assessment is necessarily interim: the return to target is not yet secure. In particular, the monetary stance will have to remain in restrictive territory for as long as is needed to shepherd the disinflation process towards a timely return to the target. Equally, the return to target needs to be sustainable: a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimising the side effects on output and employment. The data-dependent challenge for monetary policy will be to chart the sustainable and efficient path to the target. 1. The views expressed in this contribution are my own and should not be interpreted as representing the collective view of the ECB's Governing Council. In the nature of a panel contribution, I will not try to provide a comprehensive account. For a more extensive discussion, see Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", speech at Stanford Graduate School of Business, 2 May. 2. It is beyond the scope of this contribution to review the origins of the inflation shock (including the relative contributions of cost-push shocks, sectoral demand-supply imbalances and aggregate demand dynamics at both domestic and global levels) and the optimal timing of the monetary policy response. Rather, I focus on the response of ECB monetary policy from December 2021 onwards. See also Lane, PR. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", The ECB Blog, ECB, 11 March (also published as Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", in English, B., Forbes, K. and Ubide, A. (eds.), Monetary Policy Responses to the Post-Pandemic Inflation, Centre for Economic Policy Research, 13 February, pp. 65-95). 3. Our policy tightening has also been reflected in sovereign bond markets, which have coped well with the rapid increase in interest rates. It is plausible that the remarkably smooth transmission of the forceful tightening cycle to the sovereign bond market would not have been possible to the same extent without pandemic emergency purchase programme (PEPP) flexibility and the Transmission Protection Instrument (TPI). The EU-wide solidarity embodied in the Next Generation EU programme has also played a vital role in reducing risk premia. 4. Given the much shorter average duration of commercial credit in the euro area relative to the United States, the transmission of our policy rate hikes to the lending rates on loans to firms was much more forceful than transmission in the United States, where the average maturity of firm loans is longer and loans are priced off the long-end Treasury curve that has been quick to invert in anticipation of lower inflation and future rate cuts. In other words, the borrowing conditions faced by our companies have evolved in much tighter sync with the ECB's policy intentions. 5. With some lag, also due to the initial conditions of negative interest rates, time deposit rates - particularly those for firms - have closely followed policy rate hikes. However, the substantial central bank liquidity and low credit demand have reduced the pressure to raise deposit rates. There has been substantial variation in the response of deposit and lending rates across the member countries, driven in part by differences in competition within national banking systems. 6. This indicator is based on the responses to the euro area bank lending survey. See also Dimou, M., Ferrante, L., Kohler-Ulbrich, P. and Parle, C. (2023), "Happy anniversary, BLS - 20 years of the euro area bank lending survey", Economic Bulletin, Ilssue 7, ECB. 7. During the phase of policy rate hikes, the weakening in euro area monetary dynamics was primarily driven by the sharp adjustment in bank lending, while in the United States it reflected other sources of money creation (such as bank purchases of securities, external monetary flows and banks' wholesale funding, as well as quantitative tightening), with bank lending contributing only at a later stage. 8. One driver of the drop in credit was the significant adjustment seen in the real estate market, exacerbated by an initial condition of exuberance in some residential segments/countries and the structural fall in the demand for some commercial real estate after the pandemic. 9. Since there were extensive mobility restrictions in late 2021 and early 2022 due to concerns about the Omicron variant, the full pandemic reopening in Europe only took hold around March 2022 (by coincidence at the same time as the Russian invasion of Ukraine). The pandemic reopening was associated with strong demand-supply mismatches in contact-intensive services, as strong demand outpaced initially limited supply. The easing of supply chain bottlenecks and a strong backorder book allowed the manufacturing sector to grow during this period. 10. In terms of the sectoral impact, monetary policy has had a stronger direct impact on activity levels in interest-sensitive sectors such as construction, capital goods and consumer durables and a slower impact on activity levels in the services sector. Estimates suggest that the peak impact of policy tightening on activity levels is larger for manufacturing than for services, with the peak impact occurring in the fourth quarter of 2023, and larger for business and housing investment than for private consumption, with the transmission to business investment strengthening further in the first quarter of 2024. 11. Allayioti, A., Gdrnicka, L., Holton, S. and Martinez Hernandez, C. (2024), "Monetary policy pass- through to consumer prices: evidence from granular price data", Working Paper Series, ECB, forthcoming. 12. The accommodative policy stance since 2014 indicates that the Governing Council did not consider 1.7 per cent to be sufficiently close to two per cent to meet the goal of delivering inflation "below, but close to, two per cent'. 13. This was also facilitated by the explicit commitment to a symmetric two per cent inflation target in the ECB's monetary policy strategy statement that was published in July 2021. 14. There was also a marked increase in the proportion of survey respondents that expected inflation to remain above target in the long-term: the evolution of the right-tail of the distribution has been closely monitored throughout the tightening campaign. 15. The right tail of the distribution of long-term inflation expectations in the SPF has diminished markedly compared with the peak inflation phase in late 2022. The inflation risk premium embedded in five-year- on-five-year inflation swaps has declined by about 40 basis points since last summer. ECB staff have also conducted a model-based exercise on the development of upside de-anchoring risks under the actual interest rate path during the hiking phase, as well as a counterfactual analysis where the rate is assumed to have remained on the path underlying the December 2021 staff projections (Christoffel, K. and Farkas, M. (2024), "Monetary policy and the risks of de-anchoring of inflation expectations", /MF Working Papers, IInternational Monetary Fund, forthcoming). In the anchored regime, the perceived inflation target is in line with the actual two per cent target. In contrast, in the de-anchored regime, inflation expectations are driven by past and current inflation realisations, even though the central bank continues to pursue the unchanged two per cent target. Due to the tightening of monetary policy, the credibility of the central bank has been maintained by containing upside de-anchoring risks. If rates had been kept at the level of December 2021, the risks would have increased considerably. 16. Cavallo, A., Lippi, F. and Miyahara, K. (2024), "Large Shocks Travel Fast," American Economic Review: Insights, forthcoming; L'Huillier, J.-P. and Phelan, G. (2024), "Can Supply Shocks Be Inflationary with a Flat Phillips Curve?", mimeo, Brandeis University. 17. Karadi, P., Nakov, A., Nufio, G., Pasten, E. and Thaler, D. (2024), "Strike while the iron is hot: optimal monetary policy with a nonlinear Phillips Curve", CEPR Discussion Papers, No 19339, Centre for Economic Policy Research. 18. The notable impact of sectoral shocks on the overall price level via cost channels and relative price rigidities meant that exclusion-type measures (such as core inflation) did not provide a good proxy for properly-measured underlying inflation dynamics. In order to capture the indirect impact of bottlenecks and energy inflation on measures of underlying inflation, ECB staff developed adjusted measures of underlying inflation that "partial out" these indirect influences. See Banbura, M., Bobeica, E., Bodnar, K., Fagandini, B., Healy, P. and Paredes, J. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB; and Banbura, M., Bobeica, E. and Martinez Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB. See also Lane, P.R. (2022), "Inflation Diagnostics", The ECB Blog, 22 November; and Lane, P.R. (2023), "Underlying inflation", lecture at Trinity College Dublin, 3 March. 19. Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdon, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB. Important other contributions include Guerrieri, V., Marcussen, M., Reichlin, L. and Tenreyro, S. (2023), "The Art and Science of Patience: Relative Prices and Inflation", Geneva Reports on the World Economy, No 26; Di Giovanni, J., Kalemli-Ozcan, S., Silva, A. and Yildirim, M.A. (2024), "Global supply chain pressures, international trade, and inflation', mimeo, Brown University; Dao, M., Gourinchas, P.-O., Leigh, D. and Mistra, P. (2024), "Understanding the International Rise and Fall of Inflation Since 2020", Journal of Monetary Economics, in press; Forbes, K., Ha, J. and Kose, M.A. (2024), "Demand versus supply: drivers of the post-pandemic inflation and interest rates", VOXEU, 9 August. 20. The array of fiscal subsidies that were introduced in late 2022 to contain the peak impact of the energy shock on households have been an additional factor in shaping the intensity and duration of the disinflation process in the euro area. Many of these temporary measures are expiring in the course of 2024, which is putting temporary upward pressure on the price level. This process will continue to play out during 2025. 21. On the role of bank balance sheets, see: Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: heterogeneous bank lending rates and monetary policy pass-through", Journal of Monetary Economics, Vol. 110, pp. 81-98; Bernanke, B. and Gertler, M. (1990), "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105, No 1, pp. 87-114; Bernanke, B. and Blinder A. (1988), "Credit, Money, and Aggregate Demand", American Economic Review, Vol. 78, No 2, pp. 435-439; Jiménez, G. et al. (2012), "Hazardous Times for monetary policy: what do twenty- three million bank loans say about the effects of monetary policy on credit-risk taking?", Econometrica, Vol. 82, No 2, pp. 463-505; Kashyap, A. and Stein, J. (1995), "The impact of monetary policy on bank balance sheets", Carnegie-Rochester Conference Series on Public Policy, Vol. 42, pp. 151-195; Kashyap, A. and Stein, J. (2000), "What Do a Million Observations on Banks Say about the Transmission of Monetary Policy?", American Economic Review, Vol. 90, No 3, pp. 407-428; Kishan, R. and Opiela, T. (2000), "Bank Size, Bank Capital, and the Bank Lending Channel", Journal of Money, Credit and Banking, Vol. 32, No 1, pp. 121-141; Peek, J. and Rosengren, E. (1995), "Bank regulation and the credit crunch", Journal of Banking & Finance, Vol. 19, No 3-4, pp. 679-692; Stein, J. (1998), "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy', The RAND Journal of Economics, Vol. 29, No 3, pp. 466-486; Van den Heuvel, S. (2002), "Does bank capital matter for monetary transmission?", Economic Policy Review, Vol. 8, No 1, pp. 259-265.On the role of household balance sheets, see: Auclert, A. (2019), "Monetary Policy and the Redistribution Channel', American Economic Review, Vol. 109, No 6, pp. 2333-2367; Carroll, C., Slacalek, J., Tokuoka, K. and White, M.N. (2017), "The distribution of wealth and the marginal propensity to consume", Quantitative Economics, Vol. 8, No 3, pp. 977-1020; Crawley, E. and Kuchler, A. (2023), "Consumption Heterogeneity: Micro Drivers and Macro Implications", American Economic Journal: Macroeconomics, Vol. 15, No 1, pp. 314-341; Jappelli, T. and Pistaferri, L. (2010), "The Consumption Response to Income Changes", Annual Review of Economics, Vol. 2, pp. 479-506; Slacalek, J., Tristani, O. and Violante, G.L. (2020), "Household balance sheet channels of monetary policy: a back of the envelope calculation for the euro area', Journal of Economic Dynamics and Control, Vol. 115, No 103879.On the role of firm balance sheets, see: Altavilla, C., Burlon, L., Giannetti, M. and Holton, S. (2022), "Is there a zero lower bound? The effects of negative policy rates on banks and firms", Journal of Financial Economics, Vol. 144, No 3, pp. 885-907; Altavilla, C., Girkaynak, R.S. and Quaedvlieg, R. (2024), "Macro and micro of external finance premium and monetary policy transmission", Journal of Monetary Economics, forthcoming; Cloyne, J., Ferreira, C., Froemel, M. and Surico, P. (2023), "Monetary Policy, Corporate Finance, and Investment", Journal of the European Economic Association, Vol. 21, No 6, pp. 2586-2634; Caglio, C.R., Darst, R.M. and Kalemli-Ozcan, $. (2021), "Collateral Heterogeneity and Monetary Policy Transmission: Evidence from Loans to SMEs and Large Firms", NBER Working Papers, No 28685, National Bureau of Economic Research; Ippolito, F., Ozdagli, A.K. and Perez-Orive, A. (2018), "The transmission of monetary policy through bank lending: the floating rate channel", Journal of Monetary Economics, Vol. 95, pp. 49-71; Jeenas, P. and Lagos, R. (2024), "Q-Monetary Transmission", Journal of Political Economy, Vol. 132, No 3; Ottonello, P. and Winberry, T. (2020), "Financial Heterogeneity and the Investment Channel of Monetary Policy", Econometrica, Vol. 88, No 6, pp. 2473-2502. 22. There were significant differences across the member countries. See also Pallotti, F., Paz-Pardo, G., Slacalek, J., Tristani, O. and Violante, G.L. (2023), "Who bears the costs of inflation? Euro area households and the 2021-2022 shock," Working Paper Series, No 2877, ECB. 23. For example, in May 2022, credit to the general government constituted approximately 7 per cent of total bank assets. 24. In terms of bank lending, higher interest payments on central bank reserves exert both income and substitution effects. While the former might boost bank lending by relaxing capital constraints via higher profitability, the latter effect seems to dominate: bank lending in the euro area fell sharply, in part due to the reduced incentive for banks to lend when simply holding central bank reserves offers an increased payoff. 25. Akinci, O., Benigno, G., Del Negro, G., Queralto, A. (2023), "The Financial (In)Stability Real Interest Rate, r**", Staff Report, No 946, Federal Reserve Bank of New York, demonstrate via model simulations that more resilient banking sectors (proxied by higher asset quality and equity ratios) can withstand larger policy rate increases without triggering financial instability events. The transmission of monetary policy tightening is generally stronger for poorly capitalised banks (see for example Peek, J. and Rosengren, E. (1995) "Bank regulation and the credit crunch", Journal of Banking & Finance, Vol. 19; Kishan, R. and Opiela, T. (2000) "Bank Size, Bank Capital, and the Bank Lending Channel." Journal of Money, Credit and Banking, Vol. 32; Van den Heuvel, S. (2002) "Does bank capital matter for monetary transmission?" Economic Policy Review, Vol. 8; Jiménez G. et al (2012) "Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit-risk taking?" Econometrica; Altavilla, C., Canova, F. and Ciccarelli, M. (2020) "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through." Journal of Monetary Economics, Vol. 110) and illiquid banks (Stein, J. (1998) "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy', The RAND Journal of Economics, Vol. 29; Kashyap, A. and Stein, J. (2000) "What Do a Million Observations on Banks Say about the Transmission of Monetary Policy?", American Economic Review, Vol. 90; Bernanke, B. and Gertler, M. (1990) "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105, Bernanke, B. and Blinder A. (1988) "Credit, Money and Aggregate Demand", The American Economic Review, Vol. 78). In this regard, the ample central bank reserves play an important role in maintaining high bank liquidity buffers with lower sovereign-bank nexus, and contribute to decrease the financial vulnerability of the banking system to interest rate hikes (Greenwood, R., Hansen, S. and Stein, J. (2016), "The Federal Reserve's Balance Sheet as a Financial Stability Tool', Designing Resilient Monetary Policy Frameworks for the Future, Federal Reserve Bank of Kansas City; Altavilla, C., Rostagno, M., Schumacher, J. (2023), "Anchoring QT: Liquidity, credit and monetary policy implementation", Discussion Paper, No 18581, CEPR). 26. Whereas the decline in total Eurosystem assets since summer 2022 amounts to around €2.4 trillion, the decline in excess reserves is noticeably smaller than the sum of the decline in monetary policy assets due to partially offsetting changes in autonomous factors, notably the decline in government deposits held with the Eurosystem. 27. See Altavilla, C., Rostagno, M. and Schumacher, J., op. cit. See also Acharya, V. and Rajan, R. (2022), "Liquidity, liquidity everywhere, not a drop to use - Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research; Acharya, V., Chauhan, R., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing and waning of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research. 28. Of course, the counterpart to the high stock of central bank reserves at the start of the tightening cycle was the high stock of assets held by the central bank. For the ECB, the bond holdings associated with monetary policy peaked at €4.96 billion in June 2022, while the long-term refinancing loans to the banking system peaked at €2.22 billion in June 2021. The gap between the low yields on the purchased bonds and the high interest rate paid out on central bank reserves resulted in negative net income for the Eurosystem. Initially, there were also negative net income flows from the TLTRO programme, since the interest rate received on these loans had been set during the pandemic at a rate of DFR - 50 basis points for banks fulfilling the lending benchmarks. However, this interest rate was adjusted to equal the DFR by November 2022, such that the negative income flows from this programme were limited. Until the recalibration of its conditions that became effective on 23 November 2022, there were also negative net income flows from the TLTRO programme due to the pricing incentives put in place earlier on to support lending to the economy during the pandemic period. The decision to recalibrate TLTRO-III to align with the broader monetary policy normalisation process was made on 27 October 2022. It was determined that, starting from 23 November 2022, the interest rate on all remaining TLTRO-III operations would be indexed to the average of the applicable key ECB interest rates from that date onward. 29. In relation to asset purchase programmes, the extent of the net fiscal impact depends on whether the maturity structure of government debt would have been different in the absence of a quantitative easing programme. More generally, an accurate assessment would also have taken into account the extent to which the level of GDP and thereby the overall level of tax revenue would have been different in the absence of a quantitative easing programme. See, for example, Del Negro, M. and Sims, C. A. (2015), "When Does a Central Bank's Balance Sheet Require Fiscal Support?" Journal of Monetary Economics, No 73, pp.1-19; Reis, R. (2015), "Different Types of Central Bank Insolvency and the Central Role of Seignorage", NBER Working Paper Series, No 21226; Belhocine, N., Bhatia, A. V. and Frie, J. (2023) "Raising Rates with a Large Balance Sheet: The Eurosystem's Net Income and its Fiscal Implications", IMF Working Paper Series, No 2023/145, Garcia-Escudero, E.E. and Romo Gonzalez, L.A. (2024), "Why a central bank's bottom line doesn't matter (that much)', Economic Bulletin, Banco de Espafia, 2024Q2 and Gebauer, S., Pool, S. and Schumacher, J. (2024), "The Inflationary Consequences of Prioritising Central Bank Profits', ECB, mimeo. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # The effectiveness and transmission of monetary policy in the euro area ## Contribution by Philip R. Lane, Member of the Executive Board of the ECB, to the panel on "Reassessing the effectiveness and transmission of monetary policy" at the Federal Reserve Bank of Kansas City Economic Symposium Jackson Hole, 24 August 2024 ## Introduction My aim in this contribution is to provide a euro area perspective on the effectiveness and transmission of monetary policy. ${ }^{[1]}$ As expressed in the monetary policy statements of the ECB's Governing Council, the aim of monetary policy tightening has been to deliver a timely return of inflation to the medium-term two per cent target by dampening demand and guarding against the risk of a persistent upward shift in inflation expectations. Even if sectoral shocks had played an important role in triggering the initial 20212022 inflation surges, monetary policy tightening was necessary in order to contain domestic demand and to signal clearly to price and wage-setters that monetary policymakers would not tolerate inflation remaining above the target for an excessively-long period. ${ }^{[2]}$ In this contribution, I will report on the transmission of monetary policy, via financial markets and the banking system, to domestic demand and inflation expectations during this tightening episode. My interim conclusion is that monetary policy has been effective in underpinning the disinflation process, with the transmission of monetary tightening operating to restrict demand and stabilise inflation expectations. The effectiveness and efficiency of monetary policy has required a data-dependent approach to the calibration of the monetary stance. To this end, I will also discuss the importance for the calibration of monetary policy of fully recognising the asymmetric sectoral nature of the pandemic and energy shocks that triggered the initial inflation surges and the impact of sectoral balance sheets on macroeconomic dynamics. These considerations have shaped the monetary policy reaction function of the ECB during this episode, which has been guided by the incoming evidence on: (a) the unfolding inflation outlook; (b) the evolution of underlying inflation; and (c) the strength of monetary transmission (which, inter alia, depends on sectoral balance sheets). ## Monetary transmission Chart 1 shows the evolution of the euro short-term rate (€STR) forward curve since December 2021. In terms of the adjustment in policy rates, there were several distinct phases. Early in 2022, the yield curve shifted up in anticipation of future rate hikes, with the markets anticipating that the ECB would respond forcefully to the building inflation shock. In the second half of 2022, there was an accelerated ---[PAGE_BREAK]--- campaign of outsized hikes in order to move sharply away from an accommodative stance. In the first nine months of 2023, further hikes brought the policy rate to a level that was assessed to be sufficiently restrictive, if held for a sufficiently long duration, to underpin a timely disinflation process. The policy rate was then held at its peak of 4 per cent from September 2023 to June 2024. # Chart 1 Policy rate path and risk-free curve over time ![img-0.jpeg](img-0.jpeg) Sources: Bloomberg and ECB calculations. Notes: "DFR" stands for "deposit facility rate".The cut-off dates for the data used for the €STR forward curves are 17 December 2021, 16 December 2022, 15 September 2023, and 13 August 2024. A striking feature of Chart 1 is that the inflation shock triggered a repricing of not only the near-term policy rate path but also the long-term policy rate path. At the end of 2021, the policy rate was expected to remain negative even in 2027 according to market pricing (and expert surveys). The re-pricing occurred in early 2022 and has persisted, with the 2027 (and longer-horizon) policy rate expected to settle in the neighbourhood of two per cent, which is consistent with market views of a near-zero equilibrium real rate and the successful delivery of the inflation target in the medium term. This has meant the inflation shock triggered a fundamental re-setting of the interest rate path, with no expectation of a return to the extraordinarily accommodative monetary stance that had been in place since 2014/2015. At the same time, Chart 2 shows the longer-term yields rose by much less than shortterm yields. The negative slope of the yield curve reflects the market assessment that inflation would normalise relatively quickly, such that the cumulative increase in policy rates also had a significant cyclical component that would be unwound. At the same time, this inversion of the yield curve also masked a marked increase in the term premium, including due to the significant decline in the bond market footprint of the Eurosystem (Chart 3): since December 2021, quantitative tightening is estimated to have raised the term premium in the overnight index swap (OIS) curve by about 55 basis points. ${ }^{[3]}$ ---[PAGE_BREAK]--- # Chart 2 Slope of the risk-free yield curve (percentage points) ![img-1.jpeg](img-1.jpeg) Sources: Bloomberg and ECB calculations. Notes: The slope of the risk-free yield curve is calculated as the difference between the ten-year and two-year OIS rates. The latest observation is for 13 August 2024. ## Chart 3 ## Eurosystem balance sheet (EUR trillions) ![img-2.jpeg](img-2.jpeg) Sources: ECB calculations. Notes: "APP" stands for "asset purchase programme", "PEPP" for "pandemic emergency purchase programme" and "TLTROs" for "targeted longer-term refinancing operations". Purchase programmes are based on book value at amortised cost. The latest observations are for 2 August 2024. In the bank-based European financial system, the transmission of the restrictive monetary policy stance to bank lending conditions plays a central role. ${ }^{[4]}$ As shown in Chart 4, banks have faced higher funding costs (due to the combination of a rapid increase in bank bond yields and an increase (even if slower) ---[PAGE_BREAK]--- in bank deposit rates) and bank lending rates to firms and households for new loans increased significantly (the prevalence of fixed-rate mortgages has meant that the lending rates facing existing household customers have increased far more slowly). ${ }^{[5]}$ Banks have also tightened their credit standards applied to the approval of loans, as shown in Chart 5. ${ }^{[6]}$ Credit volumes moderated rapidly and nominal credit growth has been very low since 2022, as shown in Chart 6. ${ }^{[7]}$ # Chart 4 Bank lending rates to firms and households, plus bank funding costs (percentages per annum) ![img-3.jpeg](img-3.jpeg) Sources: ECB (BSI, MIR, MMSR) and ECB calculations. Notes: The indicators for the total cost of borrowing for firms and households are calculated by aggregating shortterm and long-term rates using a 24 -month moving average of new business volumes. The bank funding cost series is a weighted average of new business costs for overnight deposits, deposits redeemable at notice, time deposits, bonds, and interbank borrowing, weighted by outstanding amounts. The latest observations are for June 2024. ---[PAGE_BREAK]--- # Chart 5 ## Evolution of bank credit standards (cumulated net percentages of banks reporting a tightening of credit standards) ![img-4.jpeg](img-4.jpeg) Sources: ECB (BLS) and ECB calculations. Notes: Net percentages for credit standards are defined as the difference between the sum of the percentages of banks responding "tightened considerably" and "tightened somewhat" and the sum of the percentages of banks responding "eased somewhat" and "eased considerably". Cumulation starts in the first quarter of 2014. The latest observations are for the second quarter of 2024. ## Chart 6 Credit volumes to firms and households (annual percentage changes) ![img-5.jpeg](img-5.jpeg) Source: ECB (BSI). Notes: Bank loans to firms are adjusted for sales, securitisation and cash pooling. Bank loans to households are adjusted for sales and securitisation. The latest observations are for the second quarter of 2024. The decline in credit observed so far in the current cycle has been stronger than historical regularities, based on linear models, would have suggested. The particularly large and rapid increase in policy rates may have amplified the tightening impulse. Moreover, the perceived and abrupt end of the "low for long" ---[PAGE_BREAK]--- era reduced the incentives to search for yield, further contributing to a pullback in risk taking by banks and customers. ${ }^{[8]}$ Large policy rate hikes (including a persistent component) increased the riskiness of borrowers, reducing the willingness to lend. The combination of the war impact and rapid rate hikes also signalled a less positive economic future, reducing the expected revenues and increasing the expected future funding costs of potential borrowers, leading them to reduce their demand for credit. # The dampening of demand Through the tightening of market-based and bank-based financing conditions, the restrictive policy stance has fed through to economic activity. Chart 7 shows that, the recovery in output over the period 2022-2024 has been much weaker than expected. Despite the impact of the war-related energy shock, the post-pandemic reopening did allow GDP to grow during the first nine months of 2022 (when monetary policy was not yet restrictive). Subsequently, economic activity stagnated between late 2022 and late 2023, with only a limited recovery during the first half of 2024. ${ }^{[9]}$ In terms of demand components, public consumption has been the main consistent driver of growth, while private consumption and external demand have remained subdued in recent quarters (Chart 8). Investment has also been weak: a decline in housing investment has been a persistent drag on growth; while business investment was also hit, the impact was mitigated during 2022-2023 by past order backlogs that somewhat supported the production of capital goods. ${ }^{[10]}$ ## Chart 7 Real GDP growth and projections ![img-6.jpeg](img-6.jpeg) Sources: Eurostat; June 2024, December 2023, December 2022 and December 2021 Eurosystem staff projections; and ECB calculations. Notes: The latest observations are for 2023 for GDP and 2024 for projections. ---[PAGE_BREAK]--- # Chart 8 <br> GDP growth contributions (quarter-on-quarter percentage changes and contributions) - GDP at market prices - Private consumption - Government consumption ■ Total investment ■ Changes in inventories ■ Net exports ![img-7.jpeg](img-7.jpeg) Sources: Eurostat and ECB calculations. Notes: The latest observations are for the second quarter of 2024 for GDP and the first quarter of 2024 for the contributions. The subdued economic performance is also clearly connected to the uncertainty shock and the energy price and terms of trade shocks triggered by the unjustified invasion of Ukraine by Russia. For instance, Chart 9 shows that, despite the post-pandemic output recovery and strong increase in employment, real disposable income stagnated during 2022 as inflation rose far more quickly than wages. The decline in real incomes would have been more severe in the absence of the countervailing fiscal measures that were widely introduced during 2022 and that boosted transfers to households and suppressed the most intense impact of rising energy prices on households. Indicators of consumer confidence fell at the onset of the war and, despite some gradual improvement, still remain below the pre-war level. Together with the contribution of the restrictive monetary stance, this helps to explain the still-limited response of consumption to the improvement in real disposable income that has been in train since the middle of 2023, due to the recovery in wages, the decline in inflation and the improvement in the terms of trade. ---[PAGE_BREAK]--- # Chart 9 Private consumption, real disposable income and consumer confidence (left scale: index Q4 $2019=100$, right scale: net percentage balance) ![img-8.jpeg](img-8.jpeg) Sources: Eurostat and European Commission. Notes: The latest observations are for the first quarter of 2024 for private consumption and disposable income, and August 2024 for consumer confidence. Put differently, the adverse war-related 2022 shocks to household incomes, the terms of trade and confidence indicators for both households and firms served as countervailing influences on demand conditions and thereby reduced the extent of demand dampening that needed to be generated by monetary tightening. While employment growth also decelerated, it remained above the rate of output growth. Unemployment has remained broadly stable at a historically-low level, with employment growth accommodated by an increase in the labour force through a mix of rising participation and a recovery in immigration. This robust labour market performance (which has also mitigated the impact of rising interest rates on consumption) reflects the composition of activity, with services (including public services) more robust than manufacturing. It also reflects labour hoarding, with the anticipation of future recovery motivating firms to retain workers. In turn, labour hoarding was supported in 2022-2023 by strong profitability levels, the decline in real wages and the rise in interest rates (such that the relative price of labour versus capital declined). The moderation in the labour market in 2024 is consistent with a weakening of these forces, with profitability declining, real wages rising and a turn in the interest rate cycle. Monetary policy affects demand and prices through multiple channels: someone more direct (via intertemporal substitution) and others are more indirect (via growth and employment). This means that the full impact of changes in monetary policy on aggregate inflation occurs only with long and variable lags. As consumers rein in their spending in response to monetary policy tightening, they start by consuming fewer goods with a high intertemporal elasticity of substitution, such as durables and non- ---[PAGE_BREAK]--- essential items. They also reduce spending on goods that are more interest-rate sensitive, such as durable goods purchased using credit, including housing. Analysis by ECB staff suggests that the peak price response of items most sensitive to monetary policy shocks, which tend to include durables and non-essential items, is around three times larger than for less sensitive items. ${ }^{[11]}$ The price reaction to monetary policy shocks of these more sensitive consumer items has been stronger in the recent tightening cycle than in past episodes of monetary restraint, reflecting the effectiveness of the steep and decisive hiking policy in dampening demand. In summary, monetary tightening has restricted domestic demand, especially since late 2022. A dampened-demand environment directly reduces the capacity of firms to raise prices and workers to obtain wage increases. It also contributes to the stabilisation of inflation expectations, to which we now turn. # The anchoring of inflation expectations A primary task for monetary policy in the disinflation process has been to ensure that the large pandemic and sectoral shocks did not translate into an increase in the medium-term inflation trend by fostering an upward de-anchoring of inflation expectations that could persist even after the unwinding of the sectoral shocks. In particular, the very sharp rise in actual and projected inflation in the course of 2022 put a premium on guarding against the de-anchoring of inflation expectations and motivated an accelerated approach to monetary tightening between July 2022 and March 2023, with the policy rate hiked by 350 basis points over six meetings. In the post-crisis years before the pandemic, expectations had become de-anchored to the downside. The pre-pandemic distribution of long-term inflation expectations in the Survey of Professional Forecasters (SPF) was skewed to the left, as shown in Chart 10, and had a median expectation of 1.7 per cent. A similar pattern was evident in market-based indicators. ${ }^{[12]}$ Between the middle of 2021 and early 2022, there was a remarkable shift in long-term inflation expectations, with survey respondents moving away from the long-held views that inflation would remain below two per cent indefinitely. ${ }^{[13]}$ In essence, the majority of respondents assessed that the inflation shock opportunistically served to reanchor long-term inflation expectations at the target by demonstrating that target risks were two-sided. ${ }^{[14]}$ This is in line with the behaviour of market interest rates shown in Chart 1: the re-anchoring of medium-term inflation expectations has removed the need for an open-ended accommodative underlying monetary stance. ---[PAGE_BREAK]--- # Chart 10 Survey of Professional Forecasters: distribution of longer-term inflation expectations ![img-9.jpeg](img-9.jpeg) Sources: SPF and ECB calculations. Notes: The vertical axis shows the percentages of respondents; the horizontal axis shows the HICP inflation rate. Longer-term inflation expectations refer to four to five years ahead. The latest observations are for the third quarter of 2024 . Reinforced by the target-consistent monetary policy decisions during this period, the stabilisation of medium-term inflation expectations has provided an important anchor in the disinflation process. ${ }^{[15]}$ The sheer magnitude of the inflation surge, the successive upward price shocks and the shifts in the short-term inflation outlook clearly could have generated upside de-anchoring risks. Instead, as shown in Chart 11, throughout this period the high-inflation phase has been expected to be relatively shortlived, supporting the timely return of inflation to the target. As shown in Charts 12 and 13, there has also been a decline in the medium-term inflation expectations reported by firms in the survey on the access to finance of enterprises (SAFE) and by households in the Consumer Expectations Survey (CES). ---[PAGE_BREAK]--- # Chart 11 ## Term structure of inflation expectations from professional forecasters (annual percentage changes) Term structure inflation expectations (Q3 2021 to Q3 2024) ![img-10.jpeg](img-10.jpeg) Sources: Eurostat, SPF and ECB calculations. Notes: The term structure of inflation expectations shows expectations for different horizons in past rounds of the SPF. ## Chart 12 ## Consumer Expectations Survey (annual percentage changes) ![img-11.jpeg](img-11.jpeg) Sources: Eurostat and CES. Notes: The series refer to the median value. The latest observations are for July 2024. ---[PAGE_BREAK]--- # Chart 13 Firms' expectations for euro area inflation at different horizons (annual percentages) ![img-12.jpeg](img-12.jpeg) Sources: SAFE and ECB calculations. Notes: Survey-weighted median, mode and interquartile ranges of firms' expectations for euro area inflation in one year, three years and five years. Quantiles are computed by linear interpolation of the mid-distribution function. The statistics are computed after trimming the data at the country-specific 1st and 99th percentiles. Base: all enterprises. In turn, the anticipation of the monetary policy response helped to reduce the scale and duration of the inflation response to the large shocks. This anticipation effect was plausibly stronger during this episode, since the large shocks in 2021 and especially 2022 triggered an increase in the frequency of price adjustment. ${ }^{[16]}$ A monetary policy stance that is clearly committed to the timely return of inflation to the target is especially powerful under state-dependent pricing. ${ }^{[17]}$ An increase in the frequency of price changes represents both an extra cost from high inflation (since there are economic costs including management costs - from adjusting prices more frequently) but also an opportunity: if price setters understand that the central bank is committed to returning inflation to the target in a timely manner through an aggressive interest rate response to the large shock, the phase of intense inflation will be shorter and the sacrifice ratio in terms of lost output will be lower since price setters only have to focus on adjusting prices to the cost shock rather than also having to incorporate an excessivelyprolonged aftershock phase of second round effects. In summary, the risk of an upside de-anchoring of inflation expectations has been contained. This has certainly been facilitated by the nature of the initial inflation shocks, with the relative price shifts triggered by the pandemic and the war-related energy shock reversing fairly quickly and disinflation being further supported by the innate demand-dampening characteristics of the war and the terms of trade deterioration. The historical evidence and model-based counterfactual analyses clearly indicate that an insufficiently -vigorous monetary policy response could have resulted in a persistent increase in the inflation trend. At the same time, the calibration of the monetary policy response also needed to contain the risk of returning to the downside-deanchored equilibrium that had prevailed in the euro area before the pandemic. ---[PAGE_BREAK]--- # Sectoral shocks and disinflation dynamics During the disinflation process, the calibration of monetary policy needed to take into account the reversal in energy inflation, the easing of pipeline pressures and the relaxation of supply bottlenecks. The pandemic and the subsequent energy shock triggered by Russia's unjustified invasion of Ukraine had asymmetric and time-varying effects on different sectors. During 2020 and 2021, the impact of the pandemic on activity was most severe for contact-intensive services, while the goods sector was overwhelmed by the mismatch between a positive global demand shift and a decline in global supply capacity due to pandemic-related shutdowns and supply-chain interruptions. During 2022, the dislocations in the oil and gas sectors due to the Russia-Ukraine war were associated with an extraordinary surge in energy prices, which also constituted a severe terms of trade shock for the euro area as a net energy importer. In Europe, the full relaxation of pandemic-related lockdown measures also occurred only in spring 2022, after the subsidence of the Omicron variant. Accordingly, in 2022, the mis-match in the goods sector was succeeded by a mis-match in the services sector, with demand for contact-intensive services rising more quickly than supply capacity in the immediate aftermath of the full post-pandemic reopening that spring. Subsequently, the improvement in supply capacity and the unwinding of the adverse terms of trade shock has both supported economic activity and contributed to disinflation. In particular, the normalisation of demand and the expansion in supply capacity reduced these sectoral mismatches. After peaking in 2021, supply chain bottlenecks gradually eased during the course of 2022 and 2023, contributing to a decline in the relative price of goods. The decline in energy demand and the increase in energy supply capacity, together with the contribution from the various subsidy schemes that limited the impact of the shocks on retail energy prices, meant that energy prices fell by 14 per cent between their peak in October 2022 and July 2023. The easing of bottlenecks and the decline in the relative price of energy also helped to calm food inflation and, via lower cost pressures, services inflation. ${ }^{[18]}$ In addition, the reversal of the adverse supply shocks also boosted activity and employment, with the fading of the pandemic in particular supporting activity in 2021 and 2022, and falling energy prices and the receding impact of past bottlenecks boosting activity in 2023 and 2024. Compared to a purely demand-driven inflation episode, the nature of this inflation shock limited the extent to which disinflation would necessarily be accompanied by a severe economic contraction: rather, the aim of monetary policy was to make sure that demand grew more slowly than supply capacity during the disinflation phase. The euro area implementation of the Bernanke-Blanchard model provides a useful organising device to represent the contribution of sectoral shocks. ${ }^{[19]}$ The left panel of Chart 14 shows that shocks to energy and food prices, together with pandemic-related shortages, accounted for the largest part of the 20212022 inflation surges and the subsequent disinflation can largely be attributed to the fading of these shocks. In contrast, labour market tightness has played a comparatively minor role in inflation dynamics. The right panel of Chart 14 shows that the phase of above-target inflation has primarily been prolonged by the lagged adjustment of wages (and prices) to the initial inflation shocks. The aim of monetary tightening has been to contain this adjustment phase by making sure that the post-shock rounds of ---[PAGE_BREAK]--- wage and price adjustments were limited by dampened demand and underpinned by stable longer-term inflation expectations. # Chart 14 Sectoral shocks ## HICP inflation (year-on-year growth rate, pp contributions) ![img-13.jpeg](img-13.jpeg) ## Negotiated wage growth (year-on-year growth rate, pp contributions) ![img-14.jpeg](img-14.jpeg) Source: ECB calculations based on Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdón, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB. Notes: The figures show decompositions of the sources of seasonally adjusted annual wage growth and HICP inflation based on the solution of the full model and the implied impulse response functions. The out-sample projection is constructed by performing a conditional forecast starting in Q1 2020, conditional on realised variables between Q1 2020 and Q1 2024 and technical assumptions and inverted residuals between Q2 2024 and Q4 2026 such that HICP in the conditional projection is equal to the seasonally adjusted June 2024 Eurosystem staff projections. Assumptions from the June 2024 projections baseline correspond to energy and food price inflation and productivity growth. Labour market tightness is assumed to remain constant. The "shortages" (measured by the Global Supply Chain Pressure Index) are known up to Q2 2024 and projected according to an AR(3) process thereafter. The historical decomposition treats the projection as data and is carried out from Q1 2020 onwards to compute the contributions of the initial conditions and of the exogenous variables. According to this analytical framework, the bulk of disinflation could be expected to take place relatively quickly with the fading of the sectoral shocks, but full convergence back to the target would be slower due to the lagged nature of wage adjustments and the staggered pattern of economy-wide price adjustments to cost increases. In turn, these characteristics of the disinflation process (an initial rapid phase, followed by a slower convergence phase) have informed the calibration of monetary tightening. The nature of the disinflation process has been recognised in the Eurosystem staff projections. For instance, the December 2022 projections foresaw that inflation would decline from the quarterly peak of 10 per cent in Q4 2022 to 3.6 per cent in Q4 2023, 3.3 per cent in Q4 2024 and 2.0 per cent in Q4 ---[PAGE_BREAK]--- 2025. Disinflation turned out to be even more rapid during 2023, with Q4 inflation at 2.7 per cent. The June 2024 projections foresee inflation at 2.5 per cent in Q4 2024 and 2.0 per cent in Q4 2025. In summary, diagnosing the nature of inflation dynamics has been essential in calibrating monetary tightening. Conditional on inflation expectations remaining anchored, the fading out of the initial shocks that triggered the steep rise in inflation could be expected to deliver a two-phase disinflation process, with an initial steep decline followed by a slower convergence phase as wage-price and price-price staggered adjustment dynamics played out. ${ }^{[20]}$ The role of a demand-dampening monetary stance has been to make sure that inflation did not remain too far above the target for too long and to reinforce the commitment to a timely return to the inflation target, such that price and wage-setters could focus on "backward" adjustment dynamics - aimed at recovering lost purchasing power and re-establishing optimal relative prices - without worrying about the "forward" adjustment dynamics that would be generated by any de-anchoring of inflation expectations. # Sectoral balance sheets In calibrating the monetary stance, it is also essential to take into account that the impact of monetary policy depends on the condition of sectoral balance sheets. These encompass the balance sheets of firms, households, banks, the public sector and the rest of the world. ${ }^{[21]}$ ## Chart 15 Euro area net lending / net borrowing (as a percent of nominal GDP - four quarter sums) ![img-15.jpeg](img-15.jpeg) Sources: Eurostat and ECB. Note: The latest observations are for the first quarter of 2024. ---[PAGE_BREAK]--- # Chart 16 ## Sectoral leverage (percentages of nominal GDP - four-quarter sums) ![img-16.jpeg](img-16.jpeg) Sources: Eurostat, ECB and ECB calculations. Note: Leverage is defined as total non-equity liabilities divided by the four-quarter sum of nominal GDP. The latest observations are for the first quarter of 2024. ## Chart 17 Non-financial corporations' margins and saving ratio ![img-17.jpeg](img-17.jpeg) Sources: ECB and ECB calculations. Note: The latest observations are for the first quarter of 2024. ---[PAGE_BREAK]--- # Chart 18 Net worth of households (annual changes as percentages of nominal disposable income) ![img-18.jpeg](img-18.jpeg) Sources: Eurostat, ECB and ECB calculations. Note: Changes are mainly due to movements in real estate and share prices. The latest observations are for the first quarter of 2024. Chart 15 shows that households had exceptionally high savings rates in 2020 and 2021. While firms were net borrowers during the initial months of the pandemic in 2020, corporate debt was contained by significant fiscal transfers and de-risked through extensive public loan guarantees. Taking a longer-term perspective, Chart 16 shows that household leverage before the pandemic had declined relative to the 2010 peak but was still elevated compared to the initial years of the euro; although there had been some decline since 2016, the pre-pandemic level of corporate leverage was much higher than at the start of the euro. While the collapse of GDP meant that these leverage ratios jumped during 2020, both now stand well below their pre-pandemic levels, also due to the significant rise in nominal GDP. These balance sheet improvements have helped to cushion the financial impact of monetary policy tightening on households and firms. In addition, the trend shift towards fixed-rate mortgages also meant that fewer euro area households faced an immediate cash flow burden due to higher mortgage servicing costs. Moreover, in contrast to an inflation scenario in which the unwinding of a demand shock means that monetary tightening is accompanied by economic contraction, the improvement in supply capacity after the pandemic, the easing of bottlenecks and the 2023-2024 unwinding of the 2021-2022 energy shocks meant that there was underlying positive momentum in employment and output. This further contained credit risk premia, in contrast to tightening cycles triggered by excess demand episodes (often accompanied also by financial excess). One illustration is provided by Chart 17, which shows that corporate profitability was above the pre-pandemic level in 2021 and 2022, also boosted by prices adjusting more rapidly to the inflation surge than wages. While the monetary tightening and rising labour costs have seen a decline in corporate profitability, it only just returned to the pre-pandemic level in early 2024. ---[PAGE_BREAK]--- At the same time, the financial exposure to rising interest rates that was embedded in the holdings of non-bank financial intermediaries was ultimately held either by euro area households or the global investor community. Chart 18 shows that housing assets served as a partial inflation hedge during 2022 even if higher interests rates resulted in some reversal in valuations in 2023. At the same time, there were net capital losses on household financial portfolios during 2022. The sharp increase in inflation also eroded the real value of household deposits. The losses on financial portfolios are likely to have been disproportionately absorbed by higher-income households with relatively low marginal propensities to consume, with cushioning provided by the high share of this group in pandemic-era excess savings. ${ }^{[22]}$ In the aftermath of the 2008-2012 global and euro area crises, the resilience of the euro area banking system has been improved through a mix of higher regulatory requirements, more intensive bank supervision, the rolling-out of more extensive macroprudential regulations and greater managerial risk aversion. As an illustration, Chart 19 shows the marked improvement in capital ratios in the banking system between 2015 and 2019. Simultaneously, liquidity ratios improved significantly, further increasing the overall resilience of the banking sector. Pandemic-related excess savings by households, extensive fiscal transfers to households and firms, public loan guarantees, the reversal of the pandemic and energy shocks and low-cost funding from the ECB meant that banks did not suffer significant credit impairments during the 2020-2021 period. # Chart 19 Capital ratio of the banking system (percentages) ![img-19.jpeg](img-19.jpeg) Source: ECB supervisory reporting. Notes: The sample consists of significant institutions under the supervision of the ECB (changing composition). The latest observations are for the first quarter of 2024. ---[PAGE_BREAK]--- # Chart 20 Gross debt (percentage of euro area GDP) ![img-20.jpeg](img-20.jpeg) Source: June 2024 Eurosystem staff macroeconomic projections. Notes: Supranational EU debt (not reflected in the euro area aggregate) is the gross outstanding debt of the EU institutions, including Next Generation EU financing. Supranational EU debt is not an official statistic, but an internal estimate. ## Chart 21 Euro area net international investment position (percentage of GDP) ![img-21.jpeg](img-21.jpeg) Sources: ECB (balance of payments) and Eurostat (national accounts). Note: The latest observation is for the first quarter of 2024. The robust state of bank balance sheets meant that the transmission of rate hikes to banks could proceed in an orderly manner. In particular, the increases in risk-free rates were not amplified by an outsized increase in credit risk premia or a severe contraction in credit supply. Moreover, the capital losses on the bonds held by the banking sector were contained by the relatively low bond allocation in ---[PAGE_BREAK]--- the asset holdings of euro area banks. ${ }^{[23]}$ In a related manner, the high share of central bank reserves in the asset holdings of banks meant that the overall duration risk was relatively limited. Bank profitability improved substantially due to the shift to a higher interest rate environment and was further bolstered by the increase in interest paid on central bank reserves. ${ }^{[24]}$ In effect, the resilience of the banking sector, together with the highly-liquid composition of bank assets, has increased the feasible monetary policy space by muting concerns about the financial stability impact of rate hikes. ${ }^{[25]}$ The highly-liquid state of the asset side of bank balance sheets meant that losses from fixed rate mortgage assets were compensated by rising income from central bank reserve holdings. While the level of central bank excess reserves in the euro area remains high at around $€ 3.1$ trillion, these have declined by more than a third, or $€ 1.7$ trillion, since the peak reached in the second half of 2022. This has mostly been the result of the repayment of funding from targeted longer-term refinancing operations (TLTRO), which fell from $€ 2.2$ trillion in June 2022 to a mere $€ 76$ billion in July 2024 and will reach zero in December 2024. ${ }^{[26]}$ The reinvestment of the asset purchase programme (APP) portfolio stopped in June 2023, with the APP portfolio dropping from a peak of $€ 3.3$ trillion in June 2022 to $€ 2.8$ trillion in July 2024. The pandemic emergency purchase programme (PEPP) portfolio started to shrink in July, with the intention to discontinue reinvestments altogether at the end of this year. From a macroeconomic perspective, the transition from a high-reserves environment to a lowerreserves environment can trigger a shift in the risk-taking strategies of banks (vis-a-vis both lending and bond purchasing), in relation to a decline in the stock of reserves that might have been expected to remain in the banking system for an extended period as the funding counterparts to asset purchase programmes or long-term refinancing operations (sometimes described as "non-borrowed" reserves). [27][28][29] Directionally, this contraction in liquidity may have contributed to the relatively-strong decline in lending volumes in the euro area during this tightening episode. In particular, estimates by ECB staff suggest that banks with lower excess liquidity are more likely to reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is likely to be larger. This means that, as aggregate liquidity shrinks, the transmission of the restrictive monetary policy stance to bank lending may strengthen further. The counterpart to the insulation of household, bank and corporate balance sheets during the pandemic was an expansion in sovereign debt (see Chart 20). The surprise inflation, together with the output recovery, has partially offset the increase in debt-output ratios but these remain above their prepandemic levels. In addition, the considerable fiscal response to the energy shock in 2022 increased public debt levels, even if many of these temporary measures have now been reversed. Naturally, an integrated view of the consolidated public sector balance sheet should take into account the decline in the net equity position of central banks but any evaluation of the impact of monetary tightening via this channel will depend on the specification of the relevant counterfactual scenario. Despite some volatility episodes, the combination of higher policy rates, quantitative tightening and an increase in public debt levels has not triggered a substantial increase in sovereign risk premia in the euro area, while so far there has only been a limited increase in term premia. This likely reflects several ---[PAGE_BREAK]--- factors. First, as indicated by the anchoring of longer-term inflation expectations, this inflation episode has been interpreted throughout as a temporary phase, with a sufficient response from central banks to ensure that the initial inflation shocks do not mutate into permanent inflation. In turn, this has meant that longer-term bond yields rose by less than shorter-term interest rates Second, the 2020 launch of the Next Generation EU (NGEU) programme of joint debt and grants caused a reassessment of country-level risk premia by investors, in view of the solidarity demonstrated by EU Member States in the face of a severe tail risk. Third, the flexible design of the 2020 PEPP and 2022 announcement of the transmission protection instrument (TPI) provided reassurance to investors that unwarranted, disorderly dynamics in sovereign debt markets posing a serious threat to the transmission of monetary policy would not be tolerated, provided that countries comply with a set of established "prudent policy" criteria. Finally, it is important to take into account the external balance sheet of the euro area, in view of its role in the international transmission of domestic and foreign monetary tightening. In line with the impact of the severe decline in the terms of trade on import payments relative to export revenues, Chart 15 shows that the current account surplus of the euro area declined between the middle of 2021 and early 2023, which is also reflected in the decline in the net international investment position during this period, temporarily interrupting the rising trend observed since 2013, in Chart 21. Aside from the terms of trade channel, the global nature of the inflation shock and the similar monetary policy responses across countries meant that the composition of foreign assets and foreign liabilities played only a limited role in determining the international impact of monetary tightening. For instance, debt-related international investment income inflows and outflows increased by similar amounts between 2021 and 2024. Of course, taking a wider perspective, the global element of the inflation shock and the monetary policy response has shaped the disinflation process and the calibration of monetary policy. All else equal, the tightening moves by foreign central banks limited the required scale of domestic monetary tightening by slowing down global activity, containing globally-determined commodity prices and pushing up the common component in term premia. At the same time, if domestic monetary tightening had been too limited relative to foreign monetary tightening, exchange rate depreciation might have exerted a larger influence on the domestic disinflation process. # Conclusions At the time of writing (August 2024), my interim assessment of the effectiveness of ECB monetary policy in responding to the 2021-2022 inflation surges is that there has been good progress in delivering the overriding goal of making sure that inflation returns to target in a timely manner. Crucially, this disinflation process has been underpinned by the forceful transmission of monetary policy to the financial system, the level of demand and inflation expectations. This has required the ECB to appropriately calibrate its monetary policy stance to ensure that demand has been sufficiently dampened and the anchoring of medium-term inflation expectations sufficiently protected, while also containing the economic costs of a restrictive monetary stance. Among other factors, this calibration needed to take into account: the "re-anchoring from below" of medium-term inflation expectations and the associated pricing-out of low-for-long rate scenarios; the multiple ---[PAGE_BREAK]--- channels by which the unjustified Russian invasion of Ukraine directly served to moderate demand; the inflation-disinflation cycles generated by the pandemic and the energy shock; the interactions between monetary policy and sectoral balance sheets; and the global dimensions of the inflation shock and the international policy response. Of course, this assessment is necessarily interim: the return to target is not yet secure. In particular, the monetary stance will have to remain in restrictive territory for as long as is needed to shepherd the disinflation process towards a timely return to the target. Equally, the return to target needs to be sustainable: a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimising the side effects on output and employment. The data-dependent challenge for monetary policy will be to chart the sustainable and efficient path to the target. 1 . The views expressed in this contribution are my own and should not be interpreted as representing the collective view of the ECB's Governing Council. In the nature of a panel contribution, I will not try to provide a comprehensive account. For a more extensive discussion, see Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", speech at Stanford Graduate School of Business, 2 May. 2. It is beyond the scope of this contribution to review the origins of the inflation shock (including the relative contributions of cost-push shocks, sectoral demand-supply imbalances and aggregate demand dynamics at both domestic and global levels) and the optimal timing of the monetary policy response. Rather, I focus on the response of ECB monetary policy from December 2021 onwards. See also Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", The ECB Blog, ECB, 11 March (also published as Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", in English, B., Forbes, K. and Ubide, Á. (eds.), Monetary Policy Responses to the Post-Pandemic Inflation, Centre for Economic Policy Research, 13 February, pp. 65-95). 3. Our policy tightening has also been reflected in sovereign bond markets, which have coped well with the rapid increase in interest rates. It is plausible that the remarkably smooth transmission of the forceful tightening cycle to the sovereign bond market would not have been possible to the same extent without pandemic emergency purchase programme (PEPP) flexibility and the Transmission Protection Instrument (TPI). The EU-wide solidarity embodied in the Next Generation EU programme has also played a vital role in reducing risk premia. 4. Given the much shorter average duration of commercial credit in the euro area relative to the United States, the transmission of our policy rate hikes to the lending rates on loans to firms was much more ---[PAGE_BREAK]--- forceful than transmission in the United States, where the average maturity of firm loans is longer and loans are priced off the long-end Treasury curve that has been quick to invert in anticipation of lower inflation and future rate cuts. In other words, the borrowing conditions faced by our companies have evolved in much tighter sync with the ECB's policy intentions. 5. With some lag, also due to the initial conditions of negative interest rates, time deposit rates particularly those for firms - have closely followed policy rate hikes. However, the substantial central bank liquidity and low credit demand have reduced the pressure to raise deposit rates. There has been substantial variation in the response of deposit and lending rates across the member countries, driven in part by differences in competition within national banking systems. 6. This indicator is based on the responses to the euro area bank lending survey. See also Dimou, M., Ferrante, L., Köhler-Ulbrich, P. and Parle, C. (2023), "Happy anniversary. BLS - 20 years of the euro area bank lending survey", Economic Bulletin, Issue 7, ECB. 7. During the phase of policy rate hikes, the weakening in euro area monetary dynamics was primarily driven by the sharp adjustment in bank lending, while in the United States it reflected other sources of money creation (such as bank purchases of securities, external monetary flows and banks' wholesale funding, as well as quantitative tightening), with bank lending contributing only at a later stage. 8. One driver of the drop in credit was the significant adjustment seen in the real estate market, exacerbated by an initial condition of exuberance in some residential segments/countries and the structural fall in the demand for some commercial real estate after the pandemic. 9. Since there were extensive mobility restrictions in late 2021 and early 2022 due to concerns about the Omicron variant, the full pandemic reopening in Europe only took hold around March 2022 (by coincidence at the same time as the Russian invasion of Ukraine). The pandemic reopening was associated with strong demand-supply mismatches in contact-intensive services, as strong demand outpaced initially limited supply. The easing of supply chain bottlenecks and a strong backorder book allowed the manufacturing sector to grow during this period. 10. In terms of the sectoral impact, monetary policy has had a stronger direct impact on activity levels in interest-sensitive sectors such as construction, capital goods and consumer durables and a slower impact on activity levels in the services sector. Estimates suggest that the peak impact of policy tightening on activity levels is larger for manufacturing than for services, with the peak impact occurring ---[PAGE_BREAK]--- in the fourth quarter of 2023, and larger for business and housing investment than for private consumption, with the transmission to business investment strengthening further in the first quarter of 2024. 11 . Allayioti, A., Górnicka, L., Holton, S. and Martínez Hernandez, C. (2024), "Monetary policy passthrough to consumer prices: evidence from granular price data", Working Paper Series, ECB, forthcoming. 12. The accommodative policy stance since 2014 indicates that the Governing Council did not consider 1.7 per cent to be sufficiently close to two per cent to meet the goal of delivering inflation "below, but close to, two per cent". 13. This was also facilitated by the explicit commitment to a symmetric two per cent inflation target in the ECB's monetary policy strategy statement that was published in July 2021. 14. There was also a marked increase in the proportion of survey respondents that expected inflation to remain above target in the long-term: the evolution of the right-tail of the distribution has been closely monitored throughout the tightening campaign. 15. The right tail of the distribution of long-term inflation expectations in the SPF has diminished markedly compared with the peak inflation phase in late 2022. The inflation risk premium embedded in five-year-on-five-year inflation swaps has declined by about 40 basis points since last summer. ECB staff have also conducted a model-based exercise on the development of upside de-anchoring risks under the actual interest rate path during the hiking phase, as well as a counterfactual analysis where the rate is assumed to have remained on the path underlying the December 2021 staff projections (Christoffel, K. and Farkas, M. (2024), "Monetary policy and the risks of de-anchoring of inflation expectations", IMF Working Papers, International Monetary Fund, forthcoming). In the anchored regime, the perceived inflation target is in line with the actual two per cent target. In contrast, in the de-anchored regime, inflation expectations are driven by past and current inflation realisations, even though the central bank continues to pursue the unchanged two per cent target. Due to the tightening of monetary policy, the credibility of the central bank has been maintained by containing upside de-anchoring risks. If rates had been kept at the level of December 2021, the risks would have increased considerably. 16. Cavallo, A., Lippi, F. and Miyahara, K. (2024), "Large Shocks Travel Fast," American Economic Review: Insights, forthcoming; L'Huillier, J.-P. and Phelan, G. (2024), "Can Supply Shocks Be Inflationary with a ---[PAGE_BREAK]--- Flat Phillips Curve?", mimeo, Brandeis University. 17. Karadi, P., Nakov, A., Nuño, G., Pasten, E. and Thaler, D. (2024), "Strike while the iron is hot: optimal monetary policy with a nonlinear Phillips Curve", CEPR Discussion Papers, No 19339, Centre for Economic Policy Research. 18. The notable impact of sectoral shocks on the overall price level via cost channels and relative price rigidities meant that exclusion-type measures (such as core inflation) did not provide a good proxy for properly-measured underlying inflation dynamics. In order to capture the indirect impact of bottlenecks and energy inflation on measures of underlying inflation, ECB staff developed adjusted measures of underlying inflation that "partial out" these indirect influences. See Bańbura, M., Bobeica, E., Bodnár, K., Fagandini, B., Healy, P. and Paredes, J. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB; and Bańbura, M., Bobeica, E. and Martínez Hernández, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB. See also Lane, P.R. (2022), "Inflation Diagnostics", The ECB Blog, 22 November; and Lane, P.R. (2023), "Underlying inflation", lecture at Trinity College Dublin, 3 March. 19. Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdón, C. (2024), "What caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB. Important other contributions include Guerrieri, V., Marcussen, M., Reichlin, L. and Tenreyro, S. (2023), "The Art and Science of Patience: Relative Prices and Inflation", Geneva Reports on the World Economy, No 26; Di Giovanni, J., Kalemli-Özcan, Ṣ., Silva, A. and Yildirim, M.A. (2024), "Global supply chain pressures, international trade, and inflation", mimeo, Brown University; Dao, M., Gourinchas, P.-O., Leigh, D. and Mistra, P. (2024), "Understanding the International Rise and Fall of Inflation Since 2020", Journal of Monetary Economics, in press; Forbes, K., Ha, J. and Kose, M.A. (2024), "Demand versus supply: drivers of the post-pandemic inflation and interest rates", VOXEU, 9 August. 20. The array of fiscal subsidies that were introduced in late 2022 to contain the peak impact of the energy shock on households have been an additional factor in shaping the intensity and duration of the disinflation process in the euro area. Many of these temporary measures are expiring in the course of 2024, which is putting temporary upward pressure on the price level. This process will continue to play out during 2025. 21. On the role of bank balance sheets, see: Altavilla, C., Canova, F. and Ciccarelli, M. (2020), "Mending the broken link: heterogeneous bank lending rates and monetary policy pass-through", Journal of ---[PAGE_BREAK]--- Monetary Economics, Vol. 110, pp. 81-98; Bernanke, B. and Gertler, M. (1990), "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105, No 1, pp. 87-114; Bernanke, B. and Blinder A. (1988), "Credit, Money, and Aggregate Demand", American Economic Review, Vol. 78, No 2, pp. 435-439; Jiménez, G. et al. (2012), "Hazardous Times for monetary policy: what do twentythree million bank loans say about the effects of monetary policy on credit-risk taking?", Econometrica, Vol. 82, No 2, pp. 463-505; Kashyap, A. and Stein, J. (1995), "The impact of monetary policy on bank balance sheets", Carnegie-Rochester Conference Series on Public Policy, Vol. 42, pp. 151-195; Kashyap, A. and Stein, J. (2000), "What Do a Million Observations on Banks Say about the Transmission of Monetary Policy?", American Economic Review, Vol. 90, No 3, pp. 407-428; Kishan, R. and Opiela, T. (2000), "Bank Size, Bank Capital, and the Bank Lending Channel", Journal of Money, Credit and Banking, Vol. 32, No 1, pp. 121-141; Peek, J. and Rosengren, E. (1995), "Bank regulation and the credit crunch", Journal of Banking \& Finance, Vol. 19, No 3-4, pp. 679-692; Stein, J. (1998), "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy", The RAND Journal of Economics, Vol. 29, No 3, pp. 466-486; Van den Heuvel, S. (2002), "Does bank capital matter for monetary transmission?", Economic Policy Review, Vol. 8, No 1, pp. 259-265.On the role of household balance sheets, see: Auclert, A. (2019), "Monetary Policy and the Redistribution Channel", American Economic Review, Vol. 109, No 6, pp. 2333-2367; Carroll, C., Slacalek, J., Tokuoka, K. and White, M.N. (2017), "The distribution of wealth and the marginal propensity to consume", Quantitative Economics, Vol. 8, No 3, pp. 977-1020; Crawley, E. and Kuchler, A. (2023), "Consumption Heterogeneity: Micro Drivers and Macro Implications", American Economic Journal: Macroeconomics, Vol. 15, No 1, pp. 314-341; Jappelli, T. and Pistaferri, L. (2010), "The Consumption Response to Income Changes", Annual Review of Economics, Vol. 2, pp. 479-506; Slacalek, J., Tristani, O. and Violante, G.L. (2020), "Household balance sheet channels of monetary policy: a back of the envelope calculation for the euro area", Journal of Economic Dynamics and Control, Vol. 115, No 103879.On the role of firm balance sheets, see: Altavilla, C., Burlon, L., Giannetti, M. and Holton, S. (2022), "Is there a zero lower bound? The effects of negative policy rates on banks and firms", Journal of Financial Economics, Vol. 144, No 3, pp. 885-907; Altavilla, C., Gürkaynak, R.S. and Quaedvlieg, R. (2024), "Macro and micro of external finance premium and monetary policy transmission", Journal of Monetary Economics, forthcoming; Cloyne, J., Ferreira, C., Froemel, M. and Surico, P. (2023), "Monetary Policy, Corporate Finance, and Investment", Journal of the European Economic Association, Vol. 21, No 6, pp. 2586-2634; Caglio, C.R., Darst, R.M. and Kalemli-Özcan, Ş. (2021), "Collateral Heterogeneity and Monetary Policy Transmission: Evidence from Loans to SMEs and Large Firms", NBER Working Papers, No 28685, National Bureau of Economic Research; Ippolito, F., Ozdagli, A.K. and Perez-Orive, A. (2018), "The transmission of monetary policy through bank lending: the floating rate channel", Journal of Monetary Economics, Vol. 95, pp. 49-71; Jeenas, P. and Lagos, R. (2024), "Q-Monetary Transmission", Journal of Political Economy, Vol. 132, ---[PAGE_BREAK]--- No 3; Ottonello, P. and Winberry, T. (2020), "Financial Heterogeneity and the Investment Channel of Monetary Policy", Econometrica, Vol. 88, No 6, pp. 2473-2502. 22. There were significant differences across the member countries. See also Pallotti, F., Paz-Pardo, G., Slacalek, J., Tristani, O. and Violante, G.L. (2023), "Who bears the costs of inflation? Euro area households and the 2021-2022 shock," Working Paper Series, No 2877, ECB. 23. For example, in May 2022, credit to the general government constituted approximately 7 per cent of total bank assets. 24. In terms of bank lending, higher interest payments on central bank reserves exert both income and substitution effects. While the former might boost bank lending by relaxing capital constraints via higher profitability, the latter effect seems to dominate: bank lending in the euro area fell sharply, in part due to the reduced incentive for banks to lend when simply holding central bank reserves offers an increased payoff. 25. Akinci, O., Benigno, G., Del Negro, G., Queralto, A. (2023), "The Financial (In)Stability Real Interest Rate, r**", Staff Report, No 946, Federal Reserve Bank of New York, demonstrate via model simulations that more resilient banking sectors (proxied by higher asset quality and equity ratios) can withstand larger policy rate increases without triggering financial instability events. The transmission of monetary policy tightening is generally stronger for poorly capitalised banks (see for example Peek, J. and Rosengren, E. (1995) "Bank regulation and the credit crunch", Journal of Banking \& Finance, Vol. 19; Kishan, R. and Opiela, T. (2000) "Bank Size, Bank Capital, and the Bank Lending Channel." Journal of Money, Credit and Banking, Vol. 32; Van den Heuvel, S. (2002) "Does bank capital matter for monetary transmission?" Economic Policy Review, Vol. 8; Jiménez G. et al (2012) "Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit-risk taking?" Econometrica; Altavilla, C., Canova, F. and Ciccarelli, M. (2020) "Mending the broken link: Heterogeneous bank lending rates and monetary policy pass-through." Journal of Monetary Economics, Vol. 110) and illiquid banks (Stein, J. (1998) "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy", The RAND Journal of Economics, Vol. 29; Kashyap, A. and Stein, J. (2000) "What Do a Million Observations on Banks Say about the Transmission of Monetary Policy?", American Economic Review, Vol. 90; Bernanke, B. and Gertler, M. (1990) "Financial Fragility and Economic Performance", The Quarterly Journal of Economics, Vol. 105, Bernanke, B. and Blinder A. (1988) "Credit, Money and Aggregate Demand", The American Economic Review, Vol. 78). In this regard, the ample central bank reserves ---[PAGE_BREAK]--- play an important role in maintaining high bank liquidity buffers with lower sovereign-bank nexus, and contribute to decrease the financial vulnerability of the banking system to interest rate hikes (Greenwood, R., Hansen, S. and Stein, J. (2016), "The Federal Reserve's Balance Sheet as a Financial Stability Tool", Designing Resilient Monetary Policy Frameworks for the Future, Federal Reserve Bank of Kansas City; Altavilla, C., Rostagno, M., Schumacher, J. (2023), "Anchoring QT: Liquidity, credit and monetary policy implementation", Discussion Paper, No 18581, CEPR). 26. Whereas the decline in total Eurosystem assets since summer 2022 amounts to around €2.4 trillion, the decline in excess reserves is noticeably smaller than the sum of the decline in monetary policy assets due to partially offsetting changes in autonomous factors, notably the decline in government deposits held with the Eurosystem. 27. See Altavilla, C., Rostagno, M. and Schumacher, J., op. cit. See also Acharya, V. and Rajan, R. (2022), "Liquidity, liquidity everywhere, not a drop to use - Why flooding banks with central bank reserves may not expand liquidity", NBER Working Paper Series, No 29680, National Bureau of Economic Research; Acharya, V., Chauhan, R., Rajan, R. and Steffen, S. (2023), "Liquidity dependence and the waxing and waning of central bank balance sheets", NBER Working Paper Series, No 31050, National Bureau of Economic Research. 28. Of course, the counterpart to the high stock of central bank reserves at the start of the tightening cycle was the high stock of assets held by the central bank. For the ECB, the bond holdings associated with monetary policy peaked at €4.96 billion in June 2022, while the long-term refinancing loans to the banking system peaked at €2.22 billion in June 2021. The gap between the low yields on the purchased bonds and the high interest rate paid out on central bank reserves resulted in negative net income for the Eurosystem. Initially, there were also negative net income flows from the TLTRO programme, since the interest rate received on these loans had been set during the pandemic at a rate of DFR - 50 basis points for banks fulfilling the lending benchmarks. However, this interest rate was adjusted to equal the DFR by November 2022, such that the negative income flows from this programme were limited. Until the recalibration of its conditions that became effective on 23 November 2022, there were also negative net income flows from the TLTRO programme due to the pricing incentives put in place earlier on to support lending to the economy during the pandemic period. The decision to recalibrate TLTRO-III to align with the broader monetary policy normalisation process was made on 27 October 2022. It was determined that, starting from 23 November 2022, the interest rate on all remaining TLTRO-III operations would be indexed to the average of the applicable key ECB interest rates from that date onward. ---[PAGE_BREAK]--- 29. In relation to asset purchase programmes, the extent of the net fiscal impact depends on whether the maturity structure of government debt would have been different in the absence of a quantitative easing programme. More generally, an accurate assessment would also have taken into account the extent to which the level of GDP and thereby the overall level of tax revenue would have been different in the absence of a quantitative easing programme. See, for example, Del Negro, M. and Sims, C. A. (2015), "When Does a Central Bank's Balance Sheet Require Fiscal Support?" Journal of Monetary Economics, No 73, pp.1-19; Reis, R. (2015), "Different Types of Central Bank Insolvency and the Central Role of Seignorage", NBER Working Paper Series, No 21226; Belhocine, N., Bhatia, A. V. and Frie, J. (2023) "Raising Rates with a Large Balance Sheet: The Eurosystem's Net Income and its Fiscal Implications", IMF Working Paper Series, No 2023/145, Garcia-Escudero, E.E. and Romo Gonzalez, L.A. (2024), "Why a central bank's bottom line doesn't matter (that much)", Economic Bulletin, Banco de España, 2024Q2 and Gebauer, S., Pool, S. and Schumacher, J. (2024), "The Inflationary Consequences of Prioritising Central Bank Profits", ECB, mimeo.	Philip R Lane	Euro area	https://www.bis.org/review/r240828n.pdf	Jackson Hole, 24 August 2024 My aim in this contribution is to provide a euro area perspective on the effectiveness and transmission of monetary policy. In this contribution, I will report on the transmission of monetary policy, via financial markets and the banking system, to domestic demand and inflation expectations during this tightening episode. My interim conclusion is that monetary policy has been effective in underpinning the disinflation process, with the transmission of monetary tightening operating to restrict demand and stabilise inflation expectations. The effectiveness and efficiency of monetary policy has required a data-dependent approach to the calibration of the monetary stance. To this end, I will also discuss the importance for the calibration of monetary policy of fully recognising the asymmetric sectoral nature of the pandemic and energy shocks that triggered the initial inflation surges and the impact of sectoral balance sheets on macroeconomic dynamics. These considerations have shaped the monetary policy reaction function of the ECB during this episode, which has been guided by the incoming evidence on: (a) the unfolding inflation outlook; (b) the evolution of underlying inflation; and (c) the strength of monetary transmission (which, inter alia, depends on sectoral balance sheets). A striking feature of Chart 1 is that the inflation shock triggered a repricing of not only the near-term policy rate path but also the long-term policy rate path. At the end of 2021, the policy rate was expected to remain negative even in 2027 according to market pricing (and expert surveys). The re-pricing occurred in early 2022 and has persisted, with the 2027 (and longer-horizon) policy rate expected to settle in the neighbourhood of two per cent, which is consistent with market views of a near-zero equilibrium real rate and the successful delivery of the inflation target in the medium term. This has meant the inflation shock triggered a fundamental re-setting of the interest rate path, with no expectation of a return to the extraordinarily accommodative monetary stance that had been in place since 2014/2015. At the same time, Chart 2 shows the longer-term yields rose by much less than shortterm yields. The negative slope of the yield curve reflects the market assessment that inflation would normalise relatively quickly, such that the cumulative increase in policy rates also had a significant cyclical component that would be unwound. At the same time, this inversion of the yield curve also masked a marked increase in the term premium, including due to the significant decline in the bond market footprint of the Eurosystem: since December 2021, quantitative tightening is estimated to have raised the term premium in the overnight index swap (OIS) curve by about 55 basis points. Slope of the risk-free yield curve In the bank-based European financial system, the transmission of the restrictive monetary policy stance to bank lending conditions plays a central role. As shown in Chart 4, banks have faced higher funding costs (due to the combination of a rapid increase in bank bond yields and an increase (even if slower) in bank deposit rates) and bank lending rates to firms and households for new loans increased significantly (the prevalence of fixed-rate mortgages has meant that the lending rates facing existing household customers have increased far more slowly). Bank lending rates to firms and households, plus bank funding costs The latest observations are for the second quarter of 2024. Credit volumes to firms and households The decline in credit observed so far in the current cycle has been stronger than historical regularities, based on linear models, would have suggested. The particularly large and rapid increase in policy rates may have amplified the tightening impulse. Moreover, the perceived and abrupt end of the "low for long" era reduced the incentives to search for yield, further contributing to a pullback in risk taking by banks and customers. Large policy rate hikes (including a persistent component) increased the riskiness of borrowers, reducing the willingness to lend. The combination of the war impact and rapid rate hikes also signalled a less positive economic future, reducing the expected revenues and increasing the expected future funding costs of potential borrowers, leading them to reduce their demand for credit. Through the tightening of market-based and bank-based financing conditions, the restrictive policy stance has fed through to economic activity. Chart 7 shows that, the recovery in output over the period 2022-2024 has been much weaker than expected. Despite the impact of the war-related energy shock, the post-pandemic reopening did allow GDP to grow during the first nine months of 2022 (when monetary policy was not yet restrictive). Subsequently, economic activity stagnated between late 2022 and late 2023, with only a limited recovery during the first half of 2024. GDP at market prices. Private consumption. Government consumption. ■ Total investment ■ Changes in inventories The subdued economic performance is also clearly connected to the uncertainty shock and the energy price and terms of trade shocks triggered by the unjustified invasion of Ukraine by Russia. For instance, Chart 9 shows that, despite the post-pandemic output recovery and strong increase in employment, real disposable income stagnated during 2022 as inflation rose far more quickly than wages. The decline in real incomes would have been more severe in the absence of the countervailing fiscal measures that were widely introduced during 2022 and that boosted transfers to households and suppressed the most intense impact of rising energy prices on households. Indicators of consumer confidence fell at the onset of the war and, despite some gradual improvement, still remain below the pre-war level. Together with the contribution of the restrictive monetary stance, this helps to explain the still-limited response of consumption to the improvement in real disposable income that has been in train since the middle of 2023, due to the recovery in wages, the decline in inflation and the improvement in the terms of trade. Private consumption, real disposable income and consumer confidence Put differently, the adverse war-related 2022 shocks to household incomes, the terms of trade and confidence indicators for both households and firms served as countervailing influences on demand conditions and thereby reduced the extent of demand dampening that needed to be generated by monetary tightening. While employment growth also decelerated, it remained above the rate of output growth. Unemployment has remained broadly stable at a historically-low level, with employment growth accommodated by an increase in the labour force through a mix of rising participation and a recovery in immigration. This robust labour market performance (which has also mitigated the impact of rising interest rates on consumption) reflects the composition of activity, with services (including public services) more robust than manufacturing. It also reflects labour hoarding, with the anticipation of future recovery motivating firms to retain workers. In turn, labour hoarding was supported in 2022-2023 by strong profitability levels, the decline in real wages and the rise in interest rates (such that the relative price of labour versus capital declined). The moderation in the labour market in 2024 is consistent with a weakening of these forces, with profitability declining, real wages rising and a turn in the interest rate cycle. Monetary policy affects demand and prices through multiple channels: someone more direct (via intertemporal substitution) and others are more indirect (via growth and employment). This means that the full impact of changes in monetary policy on aggregate inflation occurs only with long and variable lags. As consumers rein in their spending in response to monetary policy tightening, they start by consuming fewer goods with a high intertemporal elasticity of substitution, such as durables and non- essential items. They also reduce spending on goods that are more interest-rate sensitive, such as durable goods purchased using credit, including housing. Analysis by ECB staff suggests that the peak price response of items most sensitive to monetary policy shocks, which tend to include durables and non-essential items, is around three times larger than for less sensitive items. The price reaction to monetary policy shocks of these more sensitive consumer items has been stronger in the recent tightening cycle than in past episodes of monetary restraint, reflecting the effectiveness of the steep and decisive hiking policy in dampening demand. In summary, monetary tightening has restricted domestic demand, especially since late 2022. A dampened-demand environment directly reduces the capacity of firms to raise prices and workers to obtain wage increases. It also contributes to the stabilisation of inflation expectations, to which we now turn. A primary task for monetary policy in the disinflation process has been to ensure that the large pandemic and sectoral shocks did not translate into an increase in the medium-term inflation trend by fostering an upward de-anchoring of inflation expectations that could persist even after the unwinding of the sectoral shocks. In particular, the very sharp rise in actual and projected inflation in the course of 2022 put a premium on guarding against the de-anchoring of inflation expectations and motivated an accelerated approach to monetary tightening between July 2022 and March 2023, with the policy rate hiked by 350 basis points over six meetings. In the post-crisis years before the pandemic, expectations had become de-anchored to the downside. The pre-pandemic distribution of long-term inflation expectations in the Survey of Professional Forecasters (SPF) was skewed to the left, as shown in Chart 10, and had a median expectation of 1.7 per cent. A similar pattern was evident in market-based indicators. This is in line with the behaviour of market interest rates shown in Chart 1: the re-anchoring of medium-term inflation expectations has removed the need for an open-ended accommodative underlying monetary stance. Reinforced by the target-consistent monetary policy decisions during this period, the stabilisation of medium-term inflation expectations has provided an important anchor in the disinflation process. The sheer magnitude of the inflation surge, the successive upward price shocks and the shifts in the short-term inflation outlook clearly could have generated upside de-anchoring risks. Instead, as shown in Chart 11, throughout this period the high-inflation phase has been expected to be relatively shortlived, supporting the timely return of inflation to the target. As shown in Charts 12 and 13, there has also been a decline in the medium-term inflation expectations reported by firms in the survey on the access to finance of enterprises (SAFE) and by households in the Consumer Expectations Survey (CES). Firms' expectations for euro area inflation at different horizons In turn, the anticipation of the monetary policy response helped to reduce the scale and duration of the inflation response to the large shocks. This anticipation effect was plausibly stronger during this episode, since the large shocks in 2021 and especially 2022 triggered an increase in the frequency of price adjustment. An increase in the frequency of price changes represents both an extra cost from high inflation (since there are economic costs including management costs - from adjusting prices more frequently) but also an opportunity: if price setters understand that the central bank is committed to returning inflation to the target in a timely manner through an aggressive interest rate response to the large shock, the phase of intense inflation will be shorter and the sacrifice ratio in terms of lost output will be lower since price setters only have to focus on adjusting prices to the cost shock rather than also having to incorporate an excessivelyprolonged aftershock phase of second round effects. In summary, the risk of an upside de-anchoring of inflation expectations has been contained. This has certainly been facilitated by the nature of the initial inflation shocks, with the relative price shifts triggered by the pandemic and the war-related energy shock reversing fairly quickly and disinflation being further supported by the innate demand-dampening characteristics of the war and the terms of trade deterioration. The historical evidence and model-based counterfactual analyses clearly indicate that an insufficiently -vigorous monetary policy response could have resulted in a persistent increase in the inflation trend. At the same time, the calibration of the monetary policy response also needed to contain the risk of returning to the downside-deanchored equilibrium that had prevailed in the euro area before the pandemic. During the disinflation process, the calibration of monetary policy needed to take into account the reversal in energy inflation, the easing of pipeline pressures and the relaxation of supply bottlenecks. The pandemic and the subsequent energy shock triggered by Russia's unjustified invasion of Ukraine had asymmetric and time-varying effects on different sectors. During 2020 and 2021, the impact of the pandemic on activity was most severe for contact-intensive services, while the goods sector was overwhelmed by the mismatch between a positive global demand shift and a decline in global supply capacity due to pandemic-related shutdowns and supply-chain interruptions. During 2022, the dislocations in the oil and gas sectors due to the Russia-Ukraine war were associated with an extraordinary surge in energy prices, which also constituted a severe terms of trade shock for the euro area as a net energy importer. In Europe, the full relaxation of pandemic-related lockdown measures also occurred only in spring 2022, after the subsidence of the Omicron variant. Accordingly, in 2022, the mis-match in the goods sector was succeeded by a mis-match in the services sector, with demand for contact-intensive services rising more quickly than supply capacity in the immediate aftermath of the full post-pandemic reopening that spring. Subsequently, the improvement in supply capacity and the unwinding of the adverse terms of trade shock has both supported economic activity and contributed to disinflation. In particular, the normalisation of demand and the expansion in supply capacity reduced these sectoral mismatches. After peaking in 2021, supply chain bottlenecks gradually eased during the course of 2022 and 2023, contributing to a decline in the relative price of goods. The decline in energy demand and the increase in energy supply capacity, together with the contribution from the various subsidy schemes that limited the impact of the shocks on retail energy prices, meant that energy prices fell by 14 per cent between their peak in October 2022 and July 2023. The easing of bottlenecks and the decline in the relative price of energy also helped to calm food inflation and, via lower cost pressures, services inflation. In addition, the reversal of the adverse supply shocks also boosted activity and employment, with the fading of the pandemic in particular supporting activity in 2021 and 2022, and falling energy prices and the receding impact of past bottlenecks boosting activity in 2023 and 2024. Compared to a purely demand-driven inflation episode, the nature of this inflation shock limited the extent to which disinflation would necessarily be accompanied by a severe economic contraction: rather, the aim of monetary policy was to make sure that demand grew more slowly than supply capacity during the disinflation phase. The euro area implementation of the Bernanke-Blanchard model provides a useful organising device to represent the contribution of sectoral shocks. The left panel of Chart 14 shows that shocks to energy and food prices, together with pandemic-related shortages, accounted for the largest part of the 20212022 inflation surges and the subsequent disinflation can largely be attributed to the fading of these shocks. In contrast, labour market tightness has played a comparatively minor role in inflation dynamics. The right panel of Chart 14 shows that the phase of above-target inflation has primarily been prolonged by the lagged adjustment of wages (and prices) to the initial inflation shocks. The aim of monetary tightening has been to contain this adjustment phase by making sure that the post-shock rounds of wage and price adjustments were limited by dampened demand and underpinned by stable longer-term inflation expectations. Sectoral shocks According to this analytical framework, the bulk of disinflation could be expected to take place relatively quickly with the fading of the sectoral shocks, but full convergence back to the target would be slower due to the lagged nature of wage adjustments and the staggered pattern of economy-wide price adjustments to cost increases. In turn, these characteristics of the disinflation process (an initial rapid phase, followed by a slower convergence phase) have informed the calibration of monetary tightening. The nature of the disinflation process has been recognised in the Eurosystem staff projections. For instance, the December 2022 projections foresaw that inflation would decline from the quarterly peak of 10 per cent in Q4 2022 to 3.6 per cent in Q4 2023, 3.3 per cent in Q4 2024 and 2.0 per cent in Q4 In summary, diagnosing the nature of inflation dynamics has been essential in calibrating monetary tightening. Conditional on inflation expectations remaining anchored, the fading out of the initial shocks that triggered the steep rise in inflation could be expected to deliver a two-phase disinflation process, with an initial steep decline followed by a slower convergence phase as wage-price and price-price staggered adjustment dynamics played out. The role of a demand-dampening monetary stance has been to make sure that inflation did not remain too far above the target for too long and to reinforce the commitment to a timely return to the inflation target, such that price and wage-setters could focus on "backward" adjustment dynamics - aimed at recovering lost purchasing power and re-establishing optimal relative prices - without worrying about the "forward" adjustment dynamics that would be generated by any de-anchoring of inflation expectations. In calibrating the monetary stance, it is also essential to take into account that the impact of monetary policy depends on the condition of sectoral balance sheets. These encompass the balance sheets of firms, households, banks, the public sector and the rest of the world. Euro area net lending / net borrowing The latest observations are for the first quarter of 2024. Net worth of households While the collapse of GDP meant that these leverage ratios jumped during 2020, both now stand well below their pre-pandemic levels, also due to the significant rise in nominal GDP. These balance sheet improvements have helped to cushion the financial impact of monetary policy tightening on households and firms. In addition, the trend shift towards fixed-rate mortgages also meant that fewer euro area households faced an immediate cash flow burden due to higher mortgage servicing costs. Moreover, in contrast to an inflation scenario in which the unwinding of a demand shock means that monetary tightening is accompanied by economic contraction, the improvement in supply capacity after the pandemic, the easing of bottlenecks and the 2023-2024 unwinding of the 2021-2022 energy shocks meant that there was underlying positive momentum in employment and output. This further contained credit risk premia, in contrast to tightening cycles triggered by excess demand episodes (often accompanied also by financial excess). One illustration is provided by Chart 17, which shows that corporate profitability was above the pre-pandemic level in 2021 and 2022, also boosted by prices adjusting more rapidly to the inflation surge than wages. While the monetary tightening and rising labour costs have seen a decline in corporate profitability, it only just returned to the pre-pandemic level in early 2024. At the same time, the financial exposure to rising interest rates that was embedded in the holdings of non-bank financial intermediaries was ultimately held either by euro area households or the global investor community. Chart 18 shows that housing assets served as a partial inflation hedge during 2022 even if higher interests rates resulted in some reversal in valuations in 2023. At the same time, there were net capital losses on household financial portfolios during 2022. The sharp increase in inflation also eroded the real value of household deposits. The losses on financial portfolios are likely to have been disproportionately absorbed by higher-income households with relatively low marginal propensities to consume, with cushioning provided by the high share of this group in pandemic-era excess savings. In the aftermath of the 2008-2012 global and euro area crises, the resilience of the euro area banking system has been improved through a mix of higher regulatory requirements, more intensive bank supervision, the rolling-out of more extensive macroprudential regulations and greater managerial risk aversion. As an illustration, Chart 19 shows the marked improvement in capital ratios in the banking system between 2015 and 2019. Simultaneously, liquidity ratios improved significantly, further increasing the overall resilience of the banking sector. Pandemic-related excess savings by households, extensive fiscal transfers to households and firms, public loan guarantees, the reversal of the pandemic and energy shocks and low-cost funding from the ECB meant that banks did not suffer significant credit impairments during the 2020-2021 period. Capital ratio of the banking system Gross debt Euro area net international investment position The robust state of bank balance sheets meant that the transmission of rate hikes to banks could proceed in an orderly manner. In particular, the increases in risk-free rates were not amplified by an outsized increase in credit risk premia or a severe contraction in credit supply. Moreover, the capital losses on the bonds held by the banking sector were contained by the relatively low bond allocation in the asset holdings of euro area banks. The highly-liquid state of the asset side of bank balance sheets meant that losses from fixed rate mortgage assets were compensated by rising income from central bank reserve holdings. While the level of central bank excess reserves in the euro area remains high at around $€ 3.1$ trillion, these have declined by more than a third, or $€ 1.7$ trillion, since the peak reached in the second half of 2022. This has mostly been the result of the repayment of funding from targeted longer-term refinancing operations (TLTRO), which fell from $€ 2.2$ trillion in June 2022 to a mere $€ 76$ billion in July 2024 and will reach zero in December 2024. The reinvestment of the asset purchase programme (APP) portfolio stopped in June 2023, with the APP portfolio dropping from a peak of $€ 3.3$ trillion in June 2022 to $€ 2.8$ trillion in July 2024. The pandemic emergency purchase programme (PEPP) portfolio started to shrink in July, with the intention to discontinue reinvestments altogether at the end of this year. From a macroeconomic perspective, the transition from a high-reserves environment to a lowerreserves environment can trigger a shift in the risk-taking strategies of banks (vis-a-vis both lending and bond purchasing), in relation to a decline in the stock of reserves that might have been expected to remain in the banking system for an extended period as the funding counterparts to asset purchase programmes or long-term refinancing operations (sometimes described as "non-borrowed" reserves). Directionally, this contraction in liquidity may have contributed to the relatively-strong decline in lending volumes in the euro area during this tightening episode. In particular, estimates by ECB staff suggest that banks with lower excess liquidity are more likely to reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is likely to be larger. This means that, as aggregate liquidity shrinks, the transmission of the restrictive monetary policy stance to bank lending may strengthen further. The counterpart to the insulation of household, bank and corporate balance sheets during the pandemic was an expansion in sovereign debt (see Chart 20). The surprise inflation, together with the output recovery, has partially offset the increase in debt-output ratios but these remain above their prepandemic levels. In addition, the considerable fiscal response to the energy shock in 2022 increased public debt levels, even if many of these temporary measures have now been reversed. Naturally, an integrated view of the consolidated public sector balance sheet should take into account the decline in the net equity position of central banks but any evaluation of the impact of monetary tightening via this channel will depend on the specification of the relevant counterfactual scenario. Despite some volatility episodes, the combination of higher policy rates, quantitative tightening and an increase in public debt levels has not triggered a substantial increase in sovereign risk premia in the euro area, while so far there has only been a limited increase in term premia. This likely reflects several factors. First, as indicated by the anchoring of longer-term inflation expectations, this inflation episode has been interpreted throughout as a temporary phase, with a sufficient response from central banks to ensure that the initial inflation shocks do not mutate into permanent inflation. In turn, this has meant that longer-term bond yields rose by less than shorter-term interest rates Second, the 2020 launch of the Next Generation EU (NGEU) programme of joint debt and grants caused a reassessment of country-level risk premia by investors, in view of the solidarity demonstrated by EU Member States in the face of a severe tail risk. Third, the flexible design of the 2020 PEPP and 2022 announcement of the transmission protection instrument (TPI) provided reassurance to investors that unwarranted, disorderly dynamics in sovereign debt markets posing a serious threat to the transmission of monetary policy would not be tolerated, provided that countries comply with a set of established "prudent policy" criteria. Finally, it is important to take into account the external balance sheet of the euro area, in view of its role in the international transmission of domestic and foreign monetary tightening. In line with the impact of the severe decline in the terms of trade on import payments relative to export revenues, Chart 15 shows that the current account surplus of the euro area declined between the middle of 2021 and early 2023, which is also reflected in the decline in the net international investment position during this period, temporarily interrupting the rising trend observed since 2013, in Chart 21. Aside from the terms of trade channel, the global nature of the inflation shock and the similar monetary policy responses across countries meant that the composition of foreign assets and foreign liabilities played only a limited role in determining the international impact of monetary tightening. For instance, debt-related international investment income inflows and outflows increased by similar amounts between 2021 and 2024. Of course, taking a wider perspective, the global element of the inflation shock and the monetary policy response has shaped the disinflation process and the calibration of monetary policy. All else equal, the tightening moves by foreign central banks limited the required scale of domestic monetary tightening by slowing down global activity, containing globally-determined commodity prices and pushing up the common component in term premia. At the same time, if domestic monetary tightening had been too limited relative to foreign monetary tightening, exchange rate depreciation might have exerted a larger influence on the domestic disinflation process. At the time of writing (August 2024), my interim assessment of the effectiveness of ECB monetary policy in responding to the 2021-2022 inflation surges is that there has been good progress in delivering the overriding goal of making sure that inflation returns to target in a timely manner. Crucially, this disinflation process has been underpinned by the forceful transmission of monetary policy to the financial system, the level of demand and inflation expectations. This has required the ECB to appropriately calibrate its monetary policy stance to ensure that demand has been sufficiently dampened and the anchoring of medium-term inflation expectations sufficiently protected, while also containing the economic costs of a restrictive monetary stance. Among other factors, this calibration needed to take into account: the "re-anchoring from below" of medium-term inflation expectations and the associated pricing-out of low-for-long rate scenarios; the multiple channels by which the unjustified Russian invasion of Ukraine directly served to moderate demand; the inflation-disinflation cycles generated by the pandemic and the energy shock; the interactions between monetary policy and sectoral balance sheets; and the global dimensions of the inflation shock and the international policy response. Of course, this assessment is necessarily interim: the return to target is not yet secure. In particular, the monetary stance will have to remain in restrictive territory for as long as is needed to shepherd the disinflation process towards a timely return to the target. Equally, the return to target needs to be sustainable: a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimising the side effects on output and employment. The data-dependent challenge for monetary policy will be to chart the sustainable and efficient path to the target. 1 . 11 . Flat Phillips Curve?", mimeo, Brandeis University. Whereas the decline in total Eurosystem assets since summer 2022 amounts to around €2.4 trillion, the decline in excess reserves is noticeably smaller than the sum of the decline in monetary policy assets due to partially offsetting changes in autonomous factors, notably the decline in government deposits held with the Eurosystem.
2024-08-28T00:00:00	Christopher J Waller: Interlinking fast payment systems	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Global Fintech Fest, Mumbai, 28 August 2024.	Christopher J Waller: Interlinking fast payment systems Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Global Fintech Fest, Mumbai, 28 August 2024. * * * Thank you to the conference organizers for the opportunity to speak this year at the 1 Global Fintech Fest-a place where there is so much payments innovation. The technology-driven payments revolution in India has been enabled by a public-private partnership to build the "technology stack" of digital platforms that has broadened 2 financial inclusion and done so at low costs. Building on the foundation established by the public sector, innovators in the private sector seized the opportunity to enhance payments through the introduction of new capabilities that alleviate frictions while remaining within regulatory guardrails. In today's remarks, I am going to touch on how interplay between the public and private sectors may be the key to advancing crossborder payments. Now that fast payment systems have been established around much of the globe-in over 70 countries and climbing-attention is turning to how these newer systems could potentially enhance global payments. Specifically, interlinking fast payment systems has been identified as a possible means to deliver enhanced cross-border payments for consumers and businesses. Interlinking arrangements would allow banks in different countries who are users of domestic fast payment systems to send payments to each other through technical connections between their respective domestic systems. As you all know, interlinking is one of the areas outlined in the G20 roadmap for further exploration as part of a holistic effort to enhance cross-border payments. The overarching G20 goal is to mitigate challenges with cross-border payments in a coordinated way at a global level, with input from key stakeholders including the private sector. The G20 roadmap addresses a new topic that payments industry stakeholders have been circling around for years-more cost-effective and timely cross-border payments for consumers and businesses. This policy goal has been advanced by the Federal Reserve over time in various payment system improvement initiatives, dating back to the late 1990s when the Federal Reserve began adapting the automated clearinghouse (ACH) service to support international payments, and more recently in 2015 when we 3 collaborated with industry to improve the payment system. Today's consumers and businesses can generally send a payment anywhere in the world, but they all seem to want faster and cheaper global payments, just like we always want faster flights and cheaper airfares. However, I am not entirely convinced that interlinking arrangements will necessarily deliver on those goals. Let me explain with some context. Faster and cheaper cross-border payments Not all frictions that slow payments down are bad. Certain frictions are purposely built into the global payment system for compliance and risk-management reasons. Slowing down the speed at which payments are cleared and settled helps banks prevent money laundering and counter the financing of terrorism, detect fraud, and recover fraudulent or misdirected cross-border payments. Granted, the practice today of sending payments through an often complex chain of correspondent banks contributes to slower payments that could benefit from efficiency enhancements. However, there is no silver bullet that increases speed and efficiency without tradeoffs. Unless new solutions are found, interlinking fast payment systems might increase the risk-management burden for banks that participate in them. That is, legal, compliance, and operational considerations are critical to the discussion of the promise and challenges of interlinking. Governance, oversight, and settlement arrangements also need to be thought through, along with considerations for data privacy. In addition, can we assume that all parties to a cross-border transaction want faster payments? The fundamental friction in any transaction is that the seller of an object-a can of soup, an hour of labor, or a good manufactured for export-wants to receive their money as fast as possible. However, the buyer of the object, or the buyer's intermediary, typically has an incentive to wait as long as they can to pay for something they have purchased. Under this logic, senders need to be properly incentivized to speed up cross-border payments. The one exception may be person-to-person remittances, where workers from other countries want to send money home, and recipients want access, as fast as possible. But remittances are only a small percentage of the value of cross-border payments, so we'd need to weigh the benefits against the costs of a potential public-sector intervention to shift incentives. So, I am still left with the larger question of whether we should be incentivizing faster cross-border payments. Suppose we do want to incentivize senders by lowering costs of faster payments-whose responsibility is it to do that? Should it be left to private-sector competition to drive down costs as is typically the case with other products? Or is there something unique about payments that requires central banks or payment system operators to step in to interlink their networks with the goal of bringing costs down? We have already seen examples of the private sector leveraging technology to innovate in the market for cross-border instant payments, both at the wholesale and retail level. For example, we have seen a real-time payment system built for wholesale clients that allows clearing and settlement between global clients in seconds, with necessary compliance performed upfront in less than 24 hours. Another example is the SWIFT Global Payments Innovation, which offers improved speed and transparency for the business customers of participating banks, and, by their account, has been adopted by 150 banks globally. In mentioning these examples, I am not intending to endorse certain private-sector services. Rather, these newer services are illustrative of how market forces and competition can meet consumer and business demands for more efficient cross-border payments. In the United States we have experience with offering low-cost international ACH payments. We provided direct ACH linkages from the United States to Europe and Canada, but after more than 20 years, the banks were not using it, and we stopped the service. It is possible that a fast payment interlinking arrangement adopted by Federal Reserve would be more effective for our bank customers than the former ACH service, but we would proceed cautiously to carefully consider the costs and benefits. Economic viability needs to be a cornerstone for any action we may take. We need to ask ourselves whether banks would find a central bank interlinking service more effective than their existing arrangements for cross-border payments, and if they would actually use it. Practical aspects of interlinking fast payment systems We know from basic economic theory that payment systems are similar to other networks in that greater participation is necessary for the network to grow and increase value to its users. This is true on a global scale, too, which in practical terms means that valuable global interlinked networks would have to be founded on underlying domestic networks with a breadth of senders and receivers. Domestic networks need to be developed first. If this condition is not in place, interlinked networks could end up being a road to nowhere. Building out domestic networks has been done in different ways. In some countries the central bank has authority to mandate participation, notably in Brazil with the successful Pix system. In other countries, notably India, united efforts by the government, central bank, and private sector established the digital public infrastructure that enabled broad adoption. In the United States, it's a different story, and the payments landscape is unique. With over 9,000 depository institutions and different authorities than other countries, the Federal Reserve determined that it needed to build a fast payment system accessible to all depository institutions to achieve our policy goals. At the time of our decision, there was only one private-sector instant payment system in the market, built by the largest banks. Based on our experience, we did not believe that this system would ultimately reach all depository institutions, nor would other private-sector systems emerge to compete with it and extend the scope of that service. Yet we knew from industry engagement that smaller banks across the country wanted a broadly accessible fast payment system, so we stepped in to address the clear coordination problem. This action is very much consistent with the Federal Reserve's role in the U.S. payment system historically. We have seen widespread adoption of the FedNow Service in just a little over a year since implementation, with close to 1,000 depository institutions on the network including many of the largest banks that will drive origination volume. Yet we are still at the beginning of a multiyear journey of establishing a ubiquitous network covering the majority of institutions in our country. Variation around the world in domestic fast payment network adoption means that the value of globally interlinked systems is not yet clear. From a technical perspective, the promise of interlinking, which is essentially interoperability between or among domestic fast payment systems, is that fast payment networks can just "connect"' with each other and move payments globally. It sounds simple. In practice, however, achieving interoperability is not simple. Technology is probably the easiest part. The legal, compliance, settlement, and governance challenges I mentioned earlier are more substantial. In addition, even when technological connections are in place, payments may not actually be instant as they traverse across systems because of domestic variations in ISO 20022 implementation, which is the global standard used by most fast payment systems. To send an ISO message seamlessly from one country to another across a technical link, operators need to coordinate and align on common practices. We should consider that new multilateral arrangements for interlinking could potentially address some of the challenges that I have outlined. Today, certain countries have established bilateral links between domestic fast payment systems primarily to support remittance payments. These arrangements demonstrate that linkages are technically possible and that legal and compliance issues can be addressed. Yet each link is unique and requires resource-intensive negotiation and alignment between parties. Establishing bilateral links across the globe simply will not scale. We know this to be true from our own bilateral ACH linkages, where each arrangement required bespoke agreements with correspondent banks and service providers. Multilateral arrangements might bring some efficiencies, yet they are no small undertaking. Conclusion To sum up, overall, I do see the value of a coordination role for the public sector to improve cross-border payments, an effort in which the Federal Reserve has been and will continue to be heavily engaged. We will continue our engagement with international fora to improve the speed and efficiency of cross-border payments and to investigate the issues critical to interlinking payment systems. Our chief focus in the near-to midterm, however, is continuing to build the FedNow network domestically and increasing participation in the service. We are also improving existing cross-border rails by considering expanded operating hours on our large-value, real-time gross settlement system, the Fedwire Funds Service, and by adopting ISO 20022, a globally accepted messaging standard. Looking out over the longer term, we will continue to conduct research and experimentation on emerging technologies to better understand the role these innovations could play in the payments landscape of the future. I expect the technical capabilities, legal infrastructure, and use cases for faster cross-border payments will evolve, and I look forward to following the private-sector innovation that will emerge from stakeholders represented at this event. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board. 2 The technology stack is a unified set of digital platforms that includes digital identity, payment rails, and data sharing policy. See Derryl D'Silva, Zuzana Filková, Frank Packer, and Siddharth Tiwari, "The design of digital financial infrastructure: lessons from India," (PDF) BIS Papers No 106 (Basel: Bank for International Settlements, December 2019). 3 See "Strategies for Improving the U.S. Payment System," (PDF) Federal Reserve System, last modified January 26, 2015 and "Strategies for Improving the U.S. Payment System: Federal Reserve Next Steps in the Payments Improvement Journey," (PDF) Federal Reserve System, last modified September 6, 2017.	---[PAGE_BREAK]--- # Christopher J Waller: Interlinking fast payment systems Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Global Fintech Fest, Mumbai, 28 August 2024. Thank you to the conference organizers for the opportunity to speak this year at the Global Fintech Fest-a place where there is so much payments innovation. ${ }^{1}$ The technology-driven payments revolution in India has been enabled by a public-private partnership to build the "technology stack" of digital platforms that has broadened financial inclusion and done so at low costs. ${ }^{2}$ Building on the foundation established by the public sector, innovators in the private sector seized the opportunity to enhance payments through the introduction of new capabilities that alleviate frictions while remaining within regulatory guardrails. In today's remarks, I am going to touch on how interplay between the public and private sectors may be the key to advancing crossborder payments. Now that fast payment systems have been established around much of the globe-in over 70 countries and climbing-attention is turning to how these newer systems could potentially enhance global payments. Specifically, interlinking fast payment systems has been identified as a possible means to deliver enhanced cross-border payments for consumers and businesses. Interlinking arrangements would allow banks in different countries who are users of domestic fast payment systems to send payments to each other through technical connections between their respective domestic systems. As you all know, interlinking is one of the areas outlined in the G20 roadmap for further exploration as part of a holistic effort to enhance cross-border payments. The overarching G20 goal is to mitigate challenges with cross-border payments in a coordinated way at a global level, with input from key stakeholders including the private sector. The G20 roadmap addresses a new topic that payments industry stakeholders have been circling around for years-more cost-effective and timely cross-border payments for consumers and businesses. This policy goal has been advanced by the Federal Reserve over time in various payment system improvement initiatives, dating back to the late 1990s when the Federal Reserve began adapting the automated clearinghouse (ACH) service to support international payments, and more recently in 2015 when we collaborated with industry to improve the payment system. ${ }^{3}$ Today's consumers and businesses can generally send a payment anywhere in the world, but they all seem to want faster and cheaper global payments, just like we always want faster flights and cheaper airfares. However, I am not entirely convinced that interlinking arrangements will necessarily deliver on those goals. Let me explain with some context. ## Faster and cheaper cross-border payments Not all frictions that slow payments down are bad. Certain frictions are purposely built into the global payment system for compliance and risk-management reasons. Slowing down the speed at which payments are cleared and settled helps banks prevent money laundering and counter the financing of terrorism, detect fraud, and recover fraudulent ---[PAGE_BREAK]--- or misdirected cross-border payments. Granted, the practice today of sending payments through an often complex chain of correspondent banks contributes to slower payments that could benefit from efficiency enhancements. However, there is no silver bullet that increases speed and efficiency without tradeoffs. Unless new solutions are found, interlinking fast payment systems might increase the risk-management burden for banks that participate in them. That is, legal, compliance, and operational considerations are critical to the discussion of the promise and challenges of interlinking. Governance, oversight, and settlement arrangements also need to be thought through, along with considerations for data privacy. In addition, can we assume that all parties to a cross-border transaction want faster payments? The fundamental friction in any transaction is that the seller of an object-a can of soup, an hour of labor, or a good manufactured for export-wants to receive their money as fast as possible. However, the buyer of the object, or the buyer's intermediary, typically has an incentive to wait as long as they can to pay for something they have purchased. Under this logic, senders need to be properly incentivized to speed up cross-border payments. The one exception may be person-to-person remittances, where workers from other countries want to send money home, and recipients want access, as fast as possible. But remittances are only a small percentage of the value of cross-border payments, so we'd need to weigh the benefits against the costs of a potential public-sector intervention to shift incentives. So, I am still left with the larger question of whether we should be incentivizing faster cross-border payments. Suppose we do want to incentivize senders by lowering costs of faster payments-whose responsibility is it to do that? Should it be left to private-sector competition to drive down costs as is typically the case with other products? Or is there something unique about payments that requires central banks or payment system operators to step in to interlink their networks with the goal of bringing costs down? We have already seen examples of the private sector leveraging technology to innovate in the market for cross-border instant payments, both at the wholesale and retail level. For example, we have seen a real-time payment system built for wholesale clients that allows clearing and settlement between global clients in seconds, with necessary compliance performed upfront in less than 24 hours. Another example is the SWIFT Global Payments Innovation, which offers improved speed and transparency for the business customers of participating banks, and, by their account, has been adopted by 150 banks globally. In mentioning these examples, I am not intending to endorse certain private-sector services. Rather, these newer services are illustrative of how market forces and competition can meet consumer and business demands for more efficient cross-border payments. In the United States we have experience with offering low-cost international ACH payments. We provided direct ACH linkages from the United States to Europe and Canada, but after more than 20 years, the banks were not using it, and we stopped the service. It is possible that a fast payment interlinking arrangement adopted by Federal Reserve would be more effective for our bank customers than the former ACH service, but we would proceed cautiously to carefully consider the costs and benefits. Economic viability needs to be a cornerstone for any action we may take. We need to ask ourselves whether banks would find a central bank interlinking service more effective than their existing arrangements for cross-border payments, and if they would actually use it. ---[PAGE_BREAK]--- # Practical aspects of interlinking fast payment systems We know from basic economic theory that payment systems are similar to other networks in that greater participation is necessary for the network to grow and increase value to its users. This is true on a global scale, too, which in practical terms means that valuable global interlinked networks would have to be founded on underlying domestic networks with a breadth of senders and receivers. Domestic networks need to be developed first. If this condition is not in place, interlinked networks could end up being a road to nowhere. Building out domestic networks has been done in different ways. In some countries the central bank has authority to mandate participation, notably in Brazil with the successful Pix system. In other countries, notably India, united efforts by the government, central bank, and private sector established the digital public infrastructure that enabled broad adoption. In the United States, it's a different story, and the payments landscape is unique. With over 9,000 depository institutions and different authorities than other countries, the Federal Reserve determined that it needed to build a fast payment system accessible to all depository institutions to achieve our policy goals. At the time of our decision, there was only one private-sector instant payment system in the market, built by the largest banks. Based on our experience, we did not believe that this system would ultimately reach all depository institutions, nor would other private-sector systems emerge to compete with it and extend the scope of that service. Yet we knew from industry engagement that smaller banks across the country wanted a broadly accessible fast payment system, so we stepped in to address the clear coordination problem. This action is very much consistent with the Federal Reserve's role in the U.S. payment system historically. We have seen widespread adoption of the FedNow Service in just a little over a year since implementation, with close to 1,000 depository institutions on the network including many of the largest banks that will drive origination volume. Yet we are still at the beginning of a multiyear journey of establishing a ubiquitous network covering the majority of institutions in our country. Variation around the world in domestic fast payment network adoption means that the value of globally interlinked systems is not yet clear. From a technical perspective, the promise of interlinking, which is essentially interoperability between or among domestic fast payment systems, is that fast payment networks can just "connect" with each other and move payments globally. It sounds simple. In practice, however, achieving interoperability is not simple. Technology is probably the easiest part. The legal, compliance, settlement, and governance challenges I mentioned earlier are more substantial. In addition, even when technological connections are in place, payments may not actually be instant as they traverse across systems because of domestic variations in ISO 20022 implementation, which is the global standard used by most fast payment systems. To send an ISO message seamlessly from one country to another across a technical link, operators need to coordinate and align on common practices. ---[PAGE_BREAK]--- We should consider that new multilateral arrangements for interlinking could potentially address some of the challenges that I have outlined. Today, certain countries have established bilateral links between domestic fast payment systems primarily to support remittance payments. These arrangements demonstrate that linkages are technically possible and that legal and compliance issues can be addressed. Yet each link is unique and requires resource-intensive negotiation and alignment between parties. Establishing bilateral links across the globe simply will not scale. We know this to be true from our own bilateral ACH linkages, where each arrangement required bespoke agreements with correspondent banks and service providers. Multilateral arrangements might bring some efficiencies, yet they are no small undertaking. # Conclusion To sum up, overall, I do see the value of a coordination role for the public sector to improve cross-border payments, an effort in which the Federal Reserve has been and will continue to be heavily engaged. We will continue our engagement with international fora to improve the speed and efficiency of cross-border payments and to investigate the issues critical to interlinking payment systems. Our chief focus in the near-to midterm, however, is continuing to build the FedNow network domestically and increasing participation in the service. We are also improving existing cross-border rails by considering expanded operating hours on our large-value, real-time gross settlement system, the Fedwire Funds Service, and by adopting ISO 20022, a globally accepted messaging standard. Looking out over the longer term, we will continue to conduct research and experimentation on emerging technologies to better understand the role these innovations could play in the payments landscape of the future. I expect the technical capabilities, legal infrastructure, and use cases for faster cross-border payments will evolve, and I look forward to following the private-sector innovation that will emerge from stakeholders represented at this event. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board. ${ }^{2}$ The technology stack is a unified set of digital platforms that includes digital identity, payment rails, and data sharing policy. See Derryl D'Silva, Zuzana Filková, Frank Packer, and Siddharth Tiwari, "The design of digital financial infrastructure: lessons from India," (PDF) BIS Papers No 106 (Basel: Bank for International Settlements, December 2019). ${ }^{3}$ See "Strategies for Improving the U.S. Payment System." (PDF) Federal Reserve System, last modified January 26, 2015 and "Strategies for Improving the U.S. Payment System: Federal Reserve Next Steps in the Payments Improvement Journey." (PDF) Federal Reserve System, last modified September 6, 2017.	Christopher J Waller	United States	https://www.bis.org/review/r240828a.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Global Fintech Fest, Mumbai, 28 August 2024. Thank you to the conference organizers for the opportunity to speak this year at the Global Fintech Fest-a place where there is so much payments innovation. Building on the foundation established by the public sector, innovators in the private sector seized the opportunity to enhance payments through the introduction of new capabilities that alleviate frictions while remaining within regulatory guardrails. In today's remarks, I am going to touch on how interplay between the public and private sectors may be the key to advancing crossborder payments. Now that fast payment systems have been established around much of the globe-in over 70 countries and climbing-attention is turning to how these newer systems could potentially enhance global payments. Specifically, interlinking fast payment systems has been identified as a possible means to deliver enhanced cross-border payments for consumers and businesses. Interlinking arrangements would allow banks in different countries who are users of domestic fast payment systems to send payments to each other through technical connections between their respective domestic systems. As you all know, interlinking is one of the areas outlined in the G20 roadmap for further exploration as part of a holistic effort to enhance cross-border payments. The overarching G20 goal is to mitigate challenges with cross-border payments in a coordinated way at a global level, with input from key stakeholders including the private sector. The G20 roadmap addresses a new topic that payments industry stakeholders have been circling around for years-more cost-effective and timely cross-border payments for consumers and businesses. This policy goal has been advanced by the Federal Reserve over time in various payment system improvement initiatives, dating back to the late 1990s when the Federal Reserve began adapting the automated clearinghouse (ACH) service to support international payments, and more recently in 2015 when we collaborated with industry to improve the payment system. Today's consumers and businesses can generally send a payment anywhere in the world, but they all seem to want faster and cheaper global payments, just like we always want faster flights and cheaper airfares. However, I am not entirely convinced that interlinking arrangements will necessarily deliver on those goals. Let me explain with some context. Not all frictions that slow payments down are bad. Certain frictions are purposely built into the global payment system for compliance and risk-management reasons. Slowing down the speed at which payments are cleared and settled helps banks prevent money laundering and counter the financing of terrorism, detect fraud, and recover fraudulent or misdirected cross-border payments. Granted, the practice today of sending payments through an often complex chain of correspondent banks contributes to slower payments that could benefit from efficiency enhancements. However, there is no silver bullet that increases speed and efficiency without tradeoffs. Unless new solutions are found, interlinking fast payment systems might increase the risk-management burden for banks that participate in them. That is, legal, compliance, and operational considerations are critical to the discussion of the promise and challenges of interlinking. Governance, oversight, and settlement arrangements also need to be thought through, along with considerations for data privacy. In addition, can we assume that all parties to a cross-border transaction want faster payments? The fundamental friction in any transaction is that the seller of an object-a can of soup, an hour of labor, or a good manufactured for export-wants to receive their money as fast as possible. However, the buyer of the object, or the buyer's intermediary, typically has an incentive to wait as long as they can to pay for something they have purchased. Under this logic, senders need to be properly incentivized to speed up cross-border payments. The one exception may be person-to-person remittances, where workers from other countries want to send money home, and recipients want access, as fast as possible. But remittances are only a small percentage of the value of cross-border payments, so we'd need to weigh the benefits against the costs of a potential public-sector intervention to shift incentives. So, I am still left with the larger question of whether we should be incentivizing faster cross-border payments. Suppose we do want to incentivize senders by lowering costs of faster payments-whose responsibility is it to do that? Should it be left to private-sector competition to drive down costs as is typically the case with other products? Or is there something unique about payments that requires central banks or payment system operators to step in to interlink their networks with the goal of bringing costs down? We have already seen examples of the private sector leveraging technology to innovate in the market for cross-border instant payments, both at the wholesale and retail level. For example, we have seen a real-time payment system built for wholesale clients that allows clearing and settlement between global clients in seconds, with necessary compliance performed upfront in less than 24 hours. Another example is the SWIFT Global Payments Innovation, which offers improved speed and transparency for the business customers of participating banks, and, by their account, has been adopted by 150 banks globally. In mentioning these examples, I am not intending to endorse certain private-sector services. Rather, these newer services are illustrative of how market forces and competition can meet consumer and business demands for more efficient cross-border payments. In the United States we have experience with offering low-cost international ACH payments. We provided direct ACH linkages from the United States to Europe and Canada, but after more than 20 years, the banks were not using it, and we stopped the service. It is possible that a fast payment interlinking arrangement adopted by Federal Reserve would be more effective for our bank customers than the former ACH service, but we would proceed cautiously to carefully consider the costs and benefits. Economic viability needs to be a cornerstone for any action we may take. We need to ask ourselves whether banks would find a central bank interlinking service more effective than their existing arrangements for cross-border payments, and if they would actually use it. We know from basic economic theory that payment systems are similar to other networks in that greater participation is necessary for the network to grow and increase value to its users. This is true on a global scale, too, which in practical terms means that valuable global interlinked networks would have to be founded on underlying domestic networks with a breadth of senders and receivers. Domestic networks need to be developed first. If this condition is not in place, interlinked networks could end up being a road to nowhere. Building out domestic networks has been done in different ways. In some countries the central bank has authority to mandate participation, notably in Brazil with the successful Pix system. In other countries, notably India, united efforts by the government, central bank, and private sector established the digital public infrastructure that enabled broad adoption. In the United States, it's a different story, and the payments landscape is unique. With over 9,000 depository institutions and different authorities than other countries, the Federal Reserve determined that it needed to build a fast payment system accessible to all depository institutions to achieve our policy goals. At the time of our decision, there was only one private-sector instant payment system in the market, built by the largest banks. Based on our experience, we did not believe that this system would ultimately reach all depository institutions, nor would other private-sector systems emerge to compete with it and extend the scope of that service. Yet we knew from industry engagement that smaller banks across the country wanted a broadly accessible fast payment system, so we stepped in to address the clear coordination problem. This action is very much consistent with the Federal Reserve's role in the U.S. payment system historically. We have seen widespread adoption of the FedNow Service in just a little over a year since implementation, with close to 1,000 depository institutions on the network including many of the largest banks that will drive origination volume. Yet we are still at the beginning of a multiyear journey of establishing a ubiquitous network covering the majority of institutions in our country. Variation around the world in domestic fast payment network adoption means that the value of globally interlinked systems is not yet clear. From a technical perspective, the promise of interlinking, which is essentially interoperability between or among domestic fast payment systems, is that fast payment networks can just "connect" with each other and move payments globally. It sounds simple. In practice, however, achieving interoperability is not simple. Technology is probably the easiest part. The legal, compliance, settlement, and governance challenges I mentioned earlier are more substantial. In addition, even when technological connections are in place, payments may not actually be instant as they traverse across systems because of domestic variations in ISO 20022 implementation, which is the global standard used by most fast payment systems. To send an ISO message seamlessly from one country to another across a technical link, operators need to coordinate and align on common practices. We should consider that new multilateral arrangements for interlinking could potentially address some of the challenges that I have outlined. Today, certain countries have established bilateral links between domestic fast payment systems primarily to support remittance payments. These arrangements demonstrate that linkages are technically possible and that legal and compliance issues can be addressed. Yet each link is unique and requires resource-intensive negotiation and alignment between parties. Establishing bilateral links across the globe simply will not scale. We know this to be true from our own bilateral ACH linkages, where each arrangement required bespoke agreements with correspondent banks and service providers. Multilateral arrangements might bring some efficiencies, yet they are no small undertaking. To sum up, overall, I do see the value of a coordination role for the public sector to improve cross-border payments, an effort in which the Federal Reserve has been and will continue to be heavily engaged. We will continue our engagement with international fora to improve the speed and efficiency of cross-border payments and to investigate the issues critical to interlinking payment systems. Our chief focus in the near-to midterm, however, is continuing to build the FedNow network domestically and increasing participation in the service. We are also improving existing cross-border rails by considering expanded operating hours on our large-value, real-time gross settlement system, the Fedwire Funds Service, and by adopting ISO 20022, a globally accepted messaging standard. Looking out over the longer term, we will continue to conduct research and experimentation on emerging technologies to better understand the role these innovations could play in the payments landscape of the future. I expect the technical capabilities, legal infrastructure, and use cases for faster cross-border payments will evolve, and I look forward to following the private-sector innovation that will emerge from stakeholders represented at this event.
2024-08-30T00:00:00	Isabel Schnabel: The euro area inflation outlook - a scenario analysis	Lecture by Ms Isabel Schnabel, Member of the Executive Board of the European Central Bank, at the Ragnar Nurkse Lecture Series, organised by Eesti Pank, Tallinn, 30 August 2024.	SPEECH The euro area inflation outlook: a scenario analysis Lecture by Isabel Schnabel, Member of the Executive Board of the ECB, at the Ragnar Nurkse Lecture Series organised by Eesti Pank in Tallinn, Estonia Tallinn, 30 August 2024 Disinflation in the euro area has proceeded rapidly. Headline inflation fell from a peak of 10.6% in October 2022 to 2.6% in July of this year. Data released yesterday suggest that in August inflation has declined further in parts of the euro area. These are welcome developments. They largely reflect an unwinding of the forces that over the past three years have led to strong increases in the prices of energy, food and goods, as well as the impact of our restrictive monetary policy. However, the current level of headline inflation understates the challenges monetary policy is still facing. In particular, domestic inflation remains high at 4.4%, largely reflecting persistent price pressures in the services sector, where disinflation has effectively stalled since last November. While goods inflation has fallen back to its pre-pandemic average at a fast pace, services inflation is still more than twice as high as its average between 1999 and 2019 (Slide 2, left-hand chart). As a result, services have accounted, on average, for 70% of headline inflation since the start of the year (Slide 2, right-hand chart). Within the services sector, price pressures are broad-based, with strong wage growth being just one factor keeping inflation at elevated levels (Slide 3, left-hand chart). Stubbornly high price pressures in the services sector are a global phenomenon. Across many advanced economies, services inflation remains high, even if there has been, on average, more progress towards pre-pandemic levels than in the euro area (Slide 3, right-hand chart). Continued high inflation momentum, defined as the annualised three-month-on-three-month change, suggests that services prices keep rising at an elevated pace of almost 5% (Slide 4, left-hand side). Medium-term price stability does not require services inflation to slow to 2%. Persistent relative price changes, often reflecting sectoral differences in productivity growth, are not unusual. In many advanced economies, the prices of services relative to those of goods have increased for a long time (Slide 4, right-hand side). But for price stability to be restored sustainably, services inflation needs to return to a level that is consistent with underlying inflation of 2% over the medium term. Uncertainty calls for policy robustness To assess whether the current monetary and financial conditions will secure a timely return of inflation to target, policymakers need to take a stand on the likely future evolution of the economy. Incoming data offer useful clues in this regard. But since monetary policy affects the economy with long and variable lags, there is a risk that policy might be adjusted too slowly if too much weight is given to backward-looking data. Therefore, economic projections remain a key input to our decision-making process. In the euro area, the latest Eurosystem staff projections are consistent with a return to price stability. They predict that inflation will fall to 2.2% in 2025 and to 1.9% in 2026, even if the last mile of disinflation is expected to be bumpy, with inflation likely to fall in the coming months before rising again towards the end of the year. Under strict inflation forecast targeting, policy should be adjusted to validate the financial conditions on which this outlook relies. However, inflation forecast targeting was already a challenge even in more tranquil times when shocks to inflation and its drivers were less pervasive.4] Since 2001, inflation projections from the forecasting community, including the ECB, have on average had little explanatory power for realised inflation over horizons beyond the very short term (Slide 5).41 In most cases, these forecasts almost mechanically converge to the 2% target, unless judgement is applied. Managing inflation is particularly challenging in an era of transformation. We are seeing fundamental changes in labour and energy markets and a reorganisation of global supply chains. At the same time, due to structural headwinds in some euro area economies, it is increasingly difficult to identify the impact of monetary policy on growth and inflation. These forces make it inherently more complex to produce accurate projections even over shorter horizons. While short-term forecast errors for inflation have generally come down since the start of the year, this masks differences within the Harmonised Index of Consumer Prices (HICP) basket. In particular, recent improved forecast accuracy for core inflation reflects offsetting forecast errors for goods and services. Since January, disinflation in services has consistently been slower than anticipated. In this environment, policy should be robust to contingencies causing the economy to evolve differently from what is implied by the modal outlook. Monetary policy that would be optimal under strict inflation forecast targeting can be suboptimal when knowledge is imperfect./4I Monetary policy to remain focused on bringing inflation down Scenario analysis is a powerful tool for making policy more robust while retaining a forward-looking perspective. Plausible alternative scenarios that scrutinise the key assumptions underlying the modal outlook highlight the large uncertainty surrounding the baseline scenario. If this uncertainty is communicated clearly and transparently, the distribution of future expected policy outcomes may better reflect the risks to the modal outlook. Inevitably, policy cannot be robust to all contingencies. A policy that is robust to downside risks is unlikely to be equally resilient against upside risks, and vice versa. Central banks thus need to weigh the risks and focus on those considered to be the most detrimental to the achievement of their mandate. In the current environment, monetary policy should remain focused on bringing inflation back to our target in a timely manner, for three main reasons. First, while risks to growth have increased, a soft landing still looks more likely than a recession. In recent weeks, financial markets have repriced more fundamentally the expected pace of central bank easing, also in the euro area. This reflects concerns that global growth is at risk of a rapid deterioration. While growth prospects warrant close scrutiny in the coming weeks, the market repricing reflects, by and large, spillovers from abroad that were amplified by technical factors, including reduced liquidity during the summer period and the unwinding of yen carry trades. It is therefore unclear to what extent the repricing reflects a change in macroeconomic fundamentals, also given the relative stability of growth forecasts for major economies by market analysts (Slide 6). At the ECB, too, growth projections for the euro area for 2024 and 2025 have remained broadly stable since September 2023. While monetary policy has to avoid unnecessary pain, it must also avoid overreacting to volatile financial market expectations. Central banks' actions should be guided by their evolving assessment of the inflation and growth outlook. Second, history shows that central banks were often unsuccessful in bringing inflation back to target after a long period of very high inflation.) In their new research, Christina and David Romer show that perseverance is critical for successfully restoring price stability after a large inflation shock. They demonstrate that strong perceived commitment to disinflation has often not been sufficient to reduce inflation through its impact on expected inflation. Rather, successful disinflation was typically the result of policymakers having persisted in their efforts to fully extinguish past inflationary shocks. Hence, central banks must not abandon disinflationary policies too early. In the euro area, as we gained confidence in the projected disinflation path, we decided to start dialling back the degree of policy restraint earlier than central banks in other advanced economies. But the earlier monetary policy shifts in response to forward-looking signals, the more cautious and gradual it can afford to be on the way back to (an unknown) neutral. Third, even if inflation is no longer a primary concern to financial markets, it is still very much on people's minds. Although headline inflation has come down quickly, inflation perceptions are proving more persistent, and untypically so from a historical perspective. Today, more than 40% of people still regard inflation as having risen "a lot" over the past 12 months (Slide 7, left-hand side). Elevated inflation perceptions raise inflation persistence and make inflation expectations more susceptible to new shocks, as memory cues make people recall past inflation experiences more rapidly.) In a new study, economists at the Federal Reserve Board quantify these risks.!2] They show that inflation persistence has increased measurably across advanced economies, including the euro area. As a result, if today the euro area were to be hit by a "normal" supply shock, as opposed to the unusually large shocks of the past few years, inflation would be higher by almost one percentage point next year compared with a scenario where inflation persistence is lower. This risk is also reflected in the right tail of the inflation expectations distribution remaining thicker than before the pandemic, even among professional forecasters (Slide 7, right-hand side). Incoming data broadly confirm the baseline scenario Making policy robust to these risks requires a thorough review of the main assumptions underlying the baseline scenario for policy to be adjusted. Such a broad-based review is carried out every three months when the projections are updated. In the euro area, the expected decline in headline inflation to the 2% target by the end of 2025 rests on three critical assumptions. One is that the current high growth in unit labour costs predominantly reflects the lagged effects of past price shocks related to the pandemic and Russia's invasion of Ukraine. As many wage contracts are only infrequently negotiated, the economy can take some time to return to equilibrium. The recent sharp decline in headline inflation should therefore progressively lead to lower wage growth, as also suggested by staff analysis (Slide 8, left-hand side). Unit labour cost growth is expected to slow further once the adverse impact of labour hoarding on productivity growth reverses as demand recovers. The second assumption is that firms are absorbing a large part of the current strong increases in unit labour costs in their profit margins, as the current level of interest rates is dampening the growth in aggregate demand. The third assumption is that price pressures outside the services sector will ease further or evolve in line with historical regularities. Over recent weeks, incoming data have lent support to these assumptions. Negotiated wage growth slowed visibly in the second quarter. Although part of this development is driven by volatile one-off payments, with wage growth expected to reaccelerate in the third quarter, surveys and private sector forecasts suggest that expected wage increases will moderate measurably in 2025 and beyond (Slide 8, right-hand side). Firms also expect that increases in their selling prices will decline as growth in input costs slows. According to the most recent Survey on Access to Finance of Enterprises (SAFE), selling prices are expected to increase by 3% on average over the next 12 months, down from 4.5% at the end of last year (Slide 9, left-hand chart). While firms in the services sector still expect a larger increase in their selling prices compared with other sectors, the size of intended price increases is declining there too. Firms have also started to use their margins to absorb the increases in labour costs. In the first quarter of this year, unit profits no longer contributed to inflation in a meaningful way (Slide 9, right-hand chart). This is a significant change from last year. Monetary policy is actively supporting this rebalancing process. By constraining growth in aggregate demand, it makes it more difficult for firms to pass on higher costs to consumers. Surveys suggest that the current level of interest rates is incentivising people to save more and spend less. Notably, savings intentions for the coming year have never been higher than they are today, with households actively shifting their savings into time deposits offering higher returns (Slide 10). As consumer confidence is recovering and households' unemployment expectations remain subdued, it is likely that the desire to save is not driven by precautionary motives only. Finally, energy and food inflation have recently surprised to the downside, while a stronger euro, coupled with the recent fall in oil prices, can ease headline inflation further, at least over the near term. All in all, recent data remain consistent with the baseline scenario that foresees that inflation will sustainably fall back to our 2% target by the end of 2025. Along with signs of a potential decline in economic momentum in other parts of the world, there is less risk that a further moderate and gradual dialling back of policy restraint could derail the path back to price stability. An alternative scenario: scrutinising the key assumptions It is conceivable, however, that the conditions on which the modal outlook rests do not materialise. Scenario analysis can reveal the reasoning behind these risks and evaluate their consequences for the inflation outlook. Unit labour cost growth could remain high for longer In the alternative scenario, growth in unit labour costs would not come down as quickly as projected. In the June Eurosystem staff projections, annual growth in unit labour costs is expected to fall to 2.5% in 2025, from 4.7% this year. This is a sharp decline, especially as unit labour costs were still growing at an annual rate of 5.3% in the first quarter, with momentum remaining high. By way of comparison, annual unit labour cost growth in the United States was only 0.9% in the second quarter. Growth in unit labour costs could disappoint expectations because of stronger wage growth. Although surveys suggest weaker wage growth ahead, the staggered nature of wage negotiations implies that workers may take longer than projected to recoup their purchasing power. While in some countries, such as Portugal and Spain, workers have, on average, recouped the losses incurred in their real wages since before the pandemic, there is still a considerable share of workers in Italy, Germany, Finland and other countries whose real wages remain well below pre-pandemic levels (Slide 11). This also reflects differences in the duration of collective wage agreements. Wages could also expand more strongly if labour market conditions remain tight. A protracted imbalance between labour supply and demand could more fundamentally challenge the assumption underlying the Eurosystem staff projections that wage growth merely reflects past price shocks and the resulting catch-up process. While labour demand is slowing, it remains high in an environment in which unemployment is historically low and where a significant share of firms, especially in the services sector, still regards labour as a factor limiting business (Slide 12). If a shortage of labour prevents firms from increasing production, rising demand results in higher inflation rather than higher output. Another reason why unit labour cost growth could remain higher than projected is a weaker recovery in productivity growth. In the Eurosystem projections, annual productivity growth is forecast to recover to 1% in 2025 and 1.1% in 2026, nearly double the historical average. The pick-up in productivity growth may be weaker if part of the current weakness is not cyclical but more persistent, reflecting the structural challenges facing the euro area economy." In fact, over the past year, the recovery in productivity growth has repeatedly been slower than expected. Increasing trade tensions, environmental policies or higher energy prices could all weigh on productivity growth over the coming years, reinforcing upward pressure on the growth of unit labour costs and thus inflation. Wage pass-through may be stronger In addition, under the alternative scenario, firms may decide to pass on a higher-than-expected share of rising labour costs to consumers. The Eurosystem staff projections expect unit profits to stagnate this year as firms use their margins to absorb strong growth in input costs. The buffer provided by profit margins is particularly important in the services sector, which is more labour-intensive and where inflation is still high. New evidence for the euro area suggests, however, that the pass-through of higher wages into producer prices is typically very strong in the services sector.'"4] After two and a half years, the estimated pass-through is 86%, twice as high as in the manufacturing sector (Slide 13).(21 In other words, if the pass-through in earlier stages of the pricing chain remains as in the past, there needs to be a strong decline in profit margins for the baseline to materialise. Softening demand for services as part of a rotation back to goods could be one such factor. So far, however, demand for services has remained relatively resilient, even if there are signs of a weakening (Slide 14). Looking ahead, it will be critical to observe how the interplay of rising real wages, a resilient labour market and the fading impact of monetary policy tightening will contribute to aggregate demand. In particular, the most recent bank lending survey suggests that the economy is starting to adapt to higher interest rates, as banks reported a first increase in loan demand by households in two years, while loan demand by firms is still contracting, but at a more moderate pace (Slide 15). Geopolitical uncertainty and protectionism pose risks to baseline Finally, price pressures outside the services sector may reappear. Goods inflation is a case in point. Under the baseline scenario, it is expected to remain close to current levels as the disinflationary effect of the easing in supply chain disruptions fades. At the same time, protectionism and geopolitical uncertainty are rising. According to the Peace Research Institute Oslo, the number of state-based conflicts is the highest since 1946 13] Geopolitical uncertainty is a key risk for the stability of global supply chains and commodity prices. Recently, for example, container freight rates have increased measurably, in part reflecting disruptions in the Suez Canal (Slide 16). A further escalation in the Middle East could disrupt energy markets and supply chains more fundamentally. Global trade measures are increasing in parallel, especially for critical raw materials - the production of which is often concentrated in just a few countries (Slide 17). Together with the growing impact of climate change on food prices, these are important forces that could challenge the assumptions underlying the baseline scenario. Conclusion I would like to conclude with three implications for monetary policy. First, incoming data have broadly confirmed the baseline outlook, bolstering our confidence that conditions remain in place for inflation to fall back to our 2% target by the end of 2025. Second, confidence is not knowledge. History will not judge our intentions but our success in delivering on our mandate. Given that the path back to price stability hinges on a set of critical assumptions, policy should proceed gradually and cautiously. In particular, the closer policy rates get to the upper band of estimates of the neutral rate of interest - that is, the less certain we are how restrictive our policy is -, the more cautious we should be to avoid that policy itself becomes a factor slowing down disinflation. In other words, the pace of policy easing cannot be mechanical. It needs to rest on data and analysis. Third, the world around us is changing rapidly. When the future is as uncertain as it is today, the modal outlook provides a false sense of comfort. Scenario analysis can protect us from falling victim to model uncertainty and overconfidence. Being transparent about what could go wrong, and factoring this into the decision-making process, can help make policy more robust to contingencies that threaten the achievement of our primary mandate. Thank you. Annexes 30 August 2024 Slides Schnabel, I. (2024), "The future of inflation (forecast) targeting", keynote speech at the thirteenth conference organised by the International Research Forum on Monetary Policy, "Monetary Policy Challenges during Uncertain Times", at the Federal Reserve Board, Washington, D.C., 17 April. 2. For a recent evaluation, see Conrad, C. and Enders, Z. (2024), "The limits of the ECB's inflation projections", SUERF Policy Brief, No 945, 1 August. 3. introductory speech at the opening reception of the ECB Forum on Central Banking, Sintra, 1 July. 4. See, for example, Orphanides, A. and Williams, J.C. (2007), "Robust monetary policy with imperfect knowledge", Journal of Monetary Economics, Vol. 54, Issue 5, pp. 1406-1435. 5. De Soyres, F. and Saijid, Z. (2024), "Lessons from Past Monetary Easing Cycles", FEDS Notes, 31 May. 6. Romer, C.D. and Romer, D.H. (2024), "Lessons from History for Successful Disinflation', NBER Working Paper, No 32666, July. 7. This is consistent with new research showing that determined action can change the public's perceptions of the central bank's commitment to price stability. See Bauer et al. (2024), "Changing Perceptions and Post-Pandemic Monetary Policy", paper presented at the Jackson Hole Economic Policy Symposium: Reassessing the Effectiveness and Transmission of Monetary Policy, 24 August. 8. Gennaioli, N. et al. (2024), "How Inflation Expectations De-Anchor: The Role of Selective Memory Cues", NBER Working Paper, No 32633, June. 9. De Michelis, A. et al. (2024), "Has the Inflation Process Become More Persistent? Evidence from the Major Advanced Economies", FEDS Notes, 19 July. 10. ECB (2024), "Alternative paths for euro area productivity developments and their impact on the economy", Eurosystem staff macroeconomic projections for the euro area, Box 3, June. 11. Ampudia, M. et al. (2024), "The wage-price pass-through across sectors: evidence from the euro area", Working Paper Series, No 2948, ECB, June. 12. The higher pass-through not only reflects a larger labour share but also a less competitive environment in the services sector. 13. Rustad, S.A. (2024), "Conflict Trends: A Global Overview, 1946-2023", PRIO Paper, Oslo. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # The euro area inflation outlook: a scenario analysis ## Lecture by Isabel Schnabel, Member of the Executive Board of the ECB, at the Ragnar Nurkse Lecture Series organised by Eesti Pank in Tallinn, Estonia Tallinn, 30 August 2024 Disinflation in the euro area has proceeded rapidly. Headline inflation fell from a peak of $10.6 \%$ in October 2022 to $2.6 \%$ in July of this year. Data released yesterday suggest that in August inflation has declined further in parts of the euro area. These are welcome developments. They largely reflect an unwinding of the forces that over the past three years have led to strong increases in the prices of energy, food and goods, as well as the impact of our restrictive monetary policy. However, the current level of headline inflation understates the challenges monetary policy is still facing. In particular, domestic inflation remains high at $4.4 \%$, largely reflecting persistent price pressures in the services sector, where disinflation has effectively stalled since last November. While goods inflation has fallen back to its pre-pandemic average at a fast pace, services inflation is still more than twice as high as its average between 1999 and 2019 (Slide 2, left-hand chart). As a result, services have accounted, on average, for $70 \%$ of headline inflation since the start of the year (Slide 2, right-hand chart). Within the services sector, price pressures are broad-based, with strong wage growth being just one factor keeping inflation at elevated levels (Slide 3, left-hand chart). Stubbornly high price pressures in the services sector are a global phenomenon. Across many advanced economies, services inflation remains high, even if there has been, on average, more progress towards pre-pandemic levels than in the euro area (Slide 3, right-hand chart). Continued high inflation momentum, defined as the annualised three-month-on-three-month change, suggests that services prices keep rising at an elevated pace of almost 5\% (Slide 4, left-hand side). Medium-term price stability does not require services inflation to slow to $2 \%$. Persistent relative price changes, often reflecting sectoral differences in productivity growth, are not unusual. In many advanced economies, the prices of services relative to those of goods have increased for a long time (Slide 4, right-hand side). But for price stability to be restored sustainably, services inflation needs to return to a level that is consistent with underlying inflation of $2 \%$ over the medium term. ## Uncertainty calls for policy robustness ---[PAGE_BREAK]--- To assess whether the current monetary and financial conditions will secure a timely return of inflation to target, policymakers need to take a stand on the likely future evolution of the economy. Incoming data offer useful clues in this regard. But since monetary policy affects the economy with long and variable lags, there is a risk that policy might be adjusted too slowly if too much weight is given to backward-looking data. Therefore, economic projections remain a key input to our decision-making process. In the euro area, the latest Eurosystem staff projections are consistent with a return to price stability. They predict that inflation will fall to $2.2 \%$ in 2025 and to $1.9 \%$ in 2026, even if the last mile of disinflation is expected to be bumpy, with inflation likely to fall in the coming months before rising again towards the end of the year. Under strict inflation forecast targeting, policy should be adjusted to validate the financial conditions on which this outlook relies. However, inflation forecast targeting was already a challenge even in more tranquil times when shocks to inflation and its drivers were less pervasive. ${ }^{[1]}$ Since 2001, inflation projections from the forecasting community, including the ECB, have on average had little explanatory power for realised inflation over horizons beyond the very short term (Slide 5). ${ }^{[2]}$ In most cases, these forecasts almost mechanically converge to the $2 \%$ target, unless judgement is applied. Managing inflation is particularly challenging in an era of transformation. ${ }^{[3]}$ We are seeing fundamental changes in labour and energy markets and a reorganisation of global supply chains. At the same time, due to structural headwinds in some euro area economies, it is increasingly difficult to identify the impact of monetary policy on growth and inflation. These forces make it inherently more complex to produce accurate projections even over shorter horizons. While short-term forecast errors for inflation have generally come down since the start of the year, this masks differences within the Harmonised Index of Consumer Prices (HICP) basket. In particular, recent improved forecast accuracy for core inflation reflects offsetting forecast errors for goods and services. Since January, disinflation in services has consistently been slower than anticipated. In this environment, policy should be robust to contingencies causing the economy to evolve differently from what is implied by the modal outlook. Monetary policy that would be optimal under strict inflation forecast targeting can be suboptimal when knowledge is imperfect. ${ }^{[4]}$ # Monetary policy to remain focused on bringing inflation down Scenario analysis is a powerful tool for making policy more robust while retaining a forward-looking perspective. Plausible alternative scenarios that scrutinise the key assumptions underlying the modal outlook highlight the large uncertainty surrounding the baseline scenario. If this uncertainty is communicated clearly and transparently, the distribution of future expected policy outcomes may better reflect the risks to the modal outlook. ---[PAGE_BREAK]--- Inevitably, policy cannot be robust to all contingencies. A policy that is robust to downside risks is unlikely to be equally resilient against upside risks, and vice versa. Central banks thus need to weigh the risks and focus on those considered to be the most detrimental to the achievement of their mandate. In the current environment, monetary policy should remain focused on bringing inflation back to our target in a timely manner, for three main reasons. First, while risks to growth have increased, a soft landing still looks more likely than a recession. In recent weeks, financial markets have repriced more fundamentally the expected pace of central bank easing, also in the euro area. This reflects concerns that global growth is at risk of a rapid deterioration. While growth prospects warrant close scrutiny in the coming weeks, the market repricing reflects, by and large, spillovers from abroad that were amplified by technical factors, including reduced liquidity during the summer period and the unwinding of yen carry trades. It is therefore unclear to what extent the repricing reflects a change in macroeconomic fundamentals, also given the relative stability of growth forecasts for major economies by market analysts (Slide 6). At the ECB, too, growth projections for the euro area for 2024 and 2025 have remained broadly stable since September 2023. While monetary policy has to avoid unnecessary pain, it must also avoid overreacting to volatile financial market expectations. Central banks' actions should be guided by their evolving assessment of the inflation and growth outlook. Second, history shows that central banks were often unsuccessful in bringing inflation back to target after a long period of very high inflation. ${ }^{[5]}$ In their new research, Christina and David Romer show that perseverance is critical for successfully restoring price stability after a large inflation shock. ${ }^{[6]}$ They demonstrate that strong perceived commitment to disinflation has often not been sufficient to reduce inflation through its impact on expected inflation. Rather, successful disinflation was typically the result of policymakers having persisted in their efforts to fully extinguish past inflationary shocks. ${ }^{[7]}$ Hence, central banks must not abandon disinflationary policies too early. In the euro area, as we gained confidence in the projected disinflation path, we decided to start dialling back the degree of policy restraint earlier than central banks in other advanced economies. But the earlier monetary policy shifts in response to forward-looking signals, the more cautious and gradual it can afford to be on the way back to (an unknown) neutral. Third, even if inflation is no longer a primary concern to financial markets, it is still very much on people's minds. Although headline inflation has come down quickly, inflation perceptions are proving more persistent, and untypically so from a historical perspective. Today, more than $40 \%$ of people still regard inflation as having risen "a lot" over the past 12 months (Slide 7, left-hand side). ---[PAGE_BREAK]--- Elevated inflation perceptions raise inflation persistence and make inflation expectations more susceptible to new shocks, as memory cues make people recall past inflation experiences more rapidly. ${ }^{[8]}$ In a new study, economists at the Federal Reserve Board quantify these risks. ${ }^{[9]}$ They show that inflation persistence has increased measurably across advanced economies, including the euro area. As a result, if today the euro area were to be hit by a "normal" supply shock, as opposed to the unusually large shocks of the past few years, inflation would be higher by almost one percentage point next year compared with a scenario where inflation persistence is lower. This risk is also reflected in the right tail of the inflation expectations distribution remaining thicker than before the pandemic, even among professional forecasters (Slide 7, right-hand side). # Incoming data broadly confirm the baseline scenario Making policy robust to these risks requires a thorough review of the main assumptions underlying the baseline scenario for policy to be adjusted. Such a broad-based review is carried out every three months when the projections are updated. In the euro area, the expected decline in headline inflation to the $2 \%$ target by the end of 2025 rests on three critical assumptions. One is that the current high growth in unit labour costs predominantly reflects the lagged effects of past price shocks related to the pandemic and Russia's invasion of Ukraine. As many wage contracts are only infrequently negotiated, the economy can take some time to return to equilibrium. The recent sharp decline in headline inflation should therefore progressively lead to lower wage growth, as also suggested by staff analysis (Slide 8, left-hand side). Unit labour cost growth is expected to slow further once the adverse impact of labour hoarding on productivity growth reverses as demand recovers. The second assumption is that firms are absorbing a large part of the current strong increases in unit labour costs in their profit margins, as the current level of interest rates is dampening the growth in aggregate demand. The third assumption is that price pressures outside the services sector will ease further or evolve in line with historical regularities. Over recent weeks, incoming data have lent support to these assumptions. Negotiated wage growth slowed visibly in the second quarter. Although part of this development is driven by volatile one-off payments, with wage growth expected to reaccelerate in the third quarter, surveys and private sector forecasts suggest that expected wage increases will moderate measurably in 2025 and beyond (Slide 8, right-hand side). Firms also expect that increases in their selling prices will decline as growth in input costs slows. According to the most recent Survey on Access to Finance of Enterprises (SAFE), selling prices are expected to increase by $3 \%$ on average over the next 12 months, down from $4.5 \%$ at the end of last ---[PAGE_BREAK]--- year (Slide 9, left-hand chart). While firms in the services sector still expect a larger increase in their selling prices compared with other sectors, the size of intended price increases is declining there too. Firms have also started to use their margins to absorb the increases in labour costs. In the first quarter of this year, unit profits no longer contributed to inflation in a meaningful way (Slide 9, right-hand chart). This is a significant change from last year. Monetary policy is actively supporting this rebalancing process. By constraining growth in aggregate demand, it makes it more difficult for firms to pass on higher costs to consumers. Surveys suggest that the current level of interest rates is incentivising people to save more and spend less. Notably, savings intentions for the coming year have never been higher than they are today, with households actively shifting their savings into time deposits offering higher returns (Slide 10). As consumer confidence is recovering and households' unemployment expectations remain subdued, it is likely that the desire to save is not driven by precautionary motives only. Finally, energy and food inflation have recently surprised to the downside, while a stronger euro, coupled with the recent fall in oil prices, can ease headline inflation further, at least over the near term. All in all, recent data remain consistent with the baseline scenario that foresees that inflation will sustainably fall back to our $2 \%$ target by the end of 2025. Along with signs of a potential decline in economic momentum in other parts of the world, there is less risk that a further moderate and gradual dialling back of policy restraint could derail the path back to price stability. # An alternative scenario: scrutinising the key assumptions It is conceivable, however, that the conditions on which the modal outlook rests do not materialise. Scenario analysis can reveal the reasoning behind these risks and evaluate their consequences for the inflation outlook. ## Unit labour cost growth could remain high for longer In the alternative scenario, growth in unit labour costs would not come down as quickly as projected. In the June Eurosystem staff projections, annual growth in unit labour costs is expected to fall to $2.5 \%$ in 2025, from $4.7 \%$ this year. This is a sharp decline, especially as unit labour costs were still growing at an annual rate of $5.3 \%$ in the first quarter, with momentum remaining high. By way of comparison, annual unit labour cost growth in the United States was only $0.9 \%$ in the second quarter. Growth in unit labour costs could disappoint expectations because of stronger wage growth. Although surveys suggest weaker wage growth ahead, the staggered nature of wage negotiations implies that workers may take longer than projected to recoup their purchasing power. While in some countries, such as Portugal and Spain, workers have, on average, recouped the losses incurred in their real wages since before the pandemic, there is still a considerable share of workers in Italy, Germany, Finland and other countries whose real wages remain well below pre-pandemic levels (Slide 11). This also reflects differences in the duration of collective wage agreements. Wages could also expand more strongly if labour market conditions remain tight. A protracted imbalance between labour supply and demand could more fundamentally challenge the assumption ---[PAGE_BREAK]--- underlying the Eurosystem staff projections that wage growth merely reflects past price shocks and the resulting catch-up process. While labour demand is slowing, it remains high in an environment in which unemployment is historically low and where a significant share of firms, especially in the services sector, still regards labour as a factor limiting business (Slide 12). If a shortage of labour prevents firms from increasing production, rising demand results in higher inflation rather than higher output. Another reason why unit labour cost growth could remain higher than projected is a weaker recovery in productivity growth. In the Eurosystem projections, annual productivity growth is forecast to recover to $1 \%$ in 2025 and $1.1 \%$ in 2026, nearly double the historical average. The pick-up in productivity growth may be weaker if part of the current weakness is not cyclical but more persistent, reflecting the structural challenges facing the euro area economy. ${ }^{[10]}$ In fact, over the past year, the recovery in productivity growth has repeatedly been slower than expected. Increasing trade tensions, environmental policies or higher energy prices could all weigh on productivity growth over the coming years, reinforcing upward pressure on the growth of unit labour costs and thus inflation. # Wage pass-through may be stronger In addition, under the alternative scenario, firms may decide to pass on a higher-than-expected share of rising labour costs to consumers. The Eurosystem staff projections expect unit profits to stagnate this year as firms use their margins to absorb strong growth in input costs. The buffer provided by profit margins is particularly important in the services sector, which is more labour-intensive and where inflation is still high. New evidence for the euro area suggests, however, that the pass-through of higher wages into producer prices is typically very strong in the services sector. ${ }^{[11]}$ After two and a half years, the estimated pass-through is $86 \%$, twice as high as in the manufacturing sector (Slide 13). ${ }^{[12]}$ In other words, if the pass-through in earlier stages of the pricing chain remains as in the past, there needs to be a strong decline in profit margins for the baseline to materialise. Softening demand for services as part of a rotation back to goods could be one such factor. So far, however, demand for services has remained relatively resilient, even if there are signs of a weakening (Slide 14). Looking ahead, it will be critical to observe how the interplay of rising real wages, a resilient labour market and the fading impact of monetary policy tightening will contribute to aggregate demand. In particular, the most recent bank lending survey suggests that the economy is starting to adapt to higher interest rates, as banks reported a first increase in loan demand by households in two years, while loan demand by firms is still contracting, but at a more moderate pace (Slide 15). ## Geopolitical uncertainty and protectionism pose risks to baseline Finally, price pressures outside the services sector may reappear. ---[PAGE_BREAK]--- Goods inflation is a case in point. Under the baseline scenario, it is expected to remain close to current levels as the disinflationary effect of the easing in supply chain disruptions fades. At the same time, protectionism and geopolitical uncertainty are rising. According to the Peace Research Institute Oslo, the number of state-based conflicts is the highest since 1946. ${ }^{[13]}$ Geopolitical uncertainty is a key risk for the stability of global supply chains and commodity prices. Recently, for example, container freight rates have increased measurably, in part reflecting disruptions in the Suez Canal (Slide 16). A further escalation in the Middle East could disrupt energy markets and supply chains more fundamentally. Global trade measures are increasing in parallel, especially for critical raw materials - the production of which is often concentrated in just a few countries (Slide 17). Together with the growing impact of climate change on food prices, these are important forces that could challenge the assumptions underlying the baseline scenario. # Conclusion I would like to conclude with three implications for monetary policy. First, incoming data have broadly confirmed the baseline outlook, bolstering our confidence that conditions remain in place for inflation to fall back to our $2 \%$ target by the end of 2025. Second, confidence is not knowledge. History will not judge our intentions but our success in delivering on our mandate. Given that the path back to price stability hinges on a set of critical assumptions, policy should proceed gradually and cautiously. In particular, the closer policy rates get to the upper band of estimates of the neutral rate of interest that is, the less certain we are how restrictive our policy is -, the more cautious we should be to avoid that policy itself becomes a factor slowing down disinflation. In other words, the pace of policy easing cannot be mechanical. It needs to rest on data and analysis. Third, the world around us is changing rapidly. When the future is as uncertain as it is today, the modal outlook provides a false sense of comfort. Scenario analysis can protect us from falling victim to model uncertainty and overconfidence. Being transparent about what could go wrong, and factoring this into the decision-making process, can help make policy more robust to contingencies that threaten the achievement of our primary mandate. Thank you. ## Annexes 30 August 2024 Slides ---[PAGE_BREAK]--- Schnabel, I. (2024), "The future of inflation (forecast) targeting", keynote speech at the thirteenth conference organised by the International Research Forum on Monetary Policy, "Monetary Policy Challenges during Uncertain Times", at the Federal Reserve Board, Washington, D.C., 17 April. 2. For a recent evaluation, see Conrad, C. and Enders, Z. (2024), "The limits of the ECB's inflation projections", SUERF Policy Brief, No 945, 1 August. 3. See Lagarde, C. (2024), "Monetary policy in an unusual cycle: the risks, the path and the costs", introductory speech at the opening reception of the ECB Forum on Central Banking, Sintra, 1 July. 4. See, for example, Orphanides, A. and Williams, J.C. (2007), "Robust monetary policy with imperfect knowledge", Journal of Monetary Economics, Vol. 54, Issue 5, pp. 1406-1435. 5. De Soyres, F. and Saijid, Z. (2024), "Lessons from Past Monetary Easing Cycles", FEDS Notes, 31 May. 6. Romer, C.D. and Romer, D.H. (2024), "Lessons from History for Successful Disinflation", NBER Working Paper, No 32666, July. 7. This is consistent with new research showing that determined action can change the public's perceptions of the central bank's commitment to price stability. See Bauer et al. (2024), "Changing Perceptions and Post-Pandemic Monetary Policy", paper presented at the Jackson Hole Economic Policy Symposium: Reassessing the Effectiveness and Transmission of Monetary Policy, 24 August. 8. Gennaioli, N. et al. (2024), "How Inflation Expectations De-Anchor: The Role of Selective Memory Cues", NBER Working Paper, No 32633, June. 9. De Michelis, A. et al. (2024), "Has the Inflation Process Become More Persistent? Evidence from the Major Advanced Economies", FEDS Notes, 19 July. 10. ECB (2024), "Alternative paths for euro area productivity developments and their impact on the economy", Eurosystem staff macroeconomic projections for the euro area, Box 3, June. 11. ---[PAGE_BREAK]--- Ampudia, M. et al. (2024), "The wage-Price pass-through across sectors: evidence from the euro area", Working Paper Series, No 2948, ECB, June. 12. The higher pass-through not only reflects a larger labour share but also a less competitive environment in the services sector. 13. Rustad, S. A. (2024), "Conflict Trends: A Global Overview, 1946-2023", PRIO Paper, Oslo.	Isabel Schnabel	Euro area	https://www.bis.org/review/r240902b.pdf	Tallinn, 30 August 2024 Disinflation in the euro area has proceeded rapidly. Headline inflation fell from a peak of $10.6 \%$ in October 2022 to $2.6 \%$ in July of this year. Data released yesterday suggest that in August inflation has declined further in parts of the euro area. These are welcome developments. They largely reflect an unwinding of the forces that over the past three years have led to strong increases in the prices of energy, food and goods, as well as the impact of our restrictive monetary policy. However, the current level of headline inflation understates the challenges monetary policy is still facing. In particular, domestic inflation remains high at $4.4 \%$, largely reflecting persistent price pressures in the services sector, where disinflation has effectively stalled since last November. While goods inflation has fallen back to its pre-pandemic average at a fast pace, services inflation is still more than twice as high as its average between 1999 and 2019 (Slide 2, left-hand chart). As a result, services have accounted, on average, for $70 \%$ of headline inflation since the start of the year (Slide 2, right-hand chart). Within the services sector, price pressures are broad-based, with strong wage growth being just one factor keeping inflation at elevated levels (Slide 3, left-hand chart). Stubbornly high price pressures in the services sector are a global phenomenon. Across many advanced economies, services inflation remains high, even if there has been, on average, more progress towards pre-pandemic levels than in the euro area (Slide 3, right-hand chart). Continued high inflation momentum, defined as the annualised three-month-on-three-month change, suggests that services prices keep rising at an elevated pace of almost 5\% (Slide 4, left-hand side). Medium-term price stability does not require services inflation to slow to $2 \%$. Persistent relative price changes, often reflecting sectoral differences in productivity growth, are not unusual. In many advanced economies, the prices of services relative to those of goods have increased for a long time (Slide 4, right-hand side). But for price stability to be restored sustainably, services inflation needs to return to a level that is consistent with underlying inflation of $2 \%$ over the medium term. To assess whether the current monetary and financial conditions will secure a timely return of inflation to target, policymakers need to take a stand on the likely future evolution of the economy. Incoming data offer useful clues in this regard. But since monetary policy affects the economy with long and variable lags, there is a risk that policy might be adjusted too slowly if too much weight is given to backward-looking data. Therefore, economic projections remain a key input to our decision-making process. In the euro area, the latest Eurosystem staff projections are consistent with a return to price stability. They predict that inflation will fall to $2.2 \%$ in 2025 and to $1.9 \%$ in 2026, even if the last mile of disinflation is expected to be bumpy, with inflation likely to fall in the coming months before rising again towards the end of the year. Under strict inflation forecast targeting, policy should be adjusted to validate the financial conditions on which this outlook relies. However, inflation forecast targeting was already a challenge even in more tranquil times when shocks to inflation and its drivers were less pervasive. Since 2001, inflation projections from the forecasting community, including the ECB, have on average had little explanatory power for realised inflation over horizons beyond the very short term (Slide 5). In most cases, these forecasts almost mechanically converge to the $2 \%$ target, unless judgement is applied. Managing inflation is particularly challenging in an era of transformation. We are seeing fundamental changes in labour and energy markets and a reorganisation of global supply chains. At the same time, due to structural headwinds in some euro area economies, it is increasingly difficult to identify the impact of monetary policy on growth and inflation. These forces make it inherently more complex to produce accurate projections even over shorter horizons. While short-term forecast errors for inflation have generally come down since the start of the year, this masks differences within the Harmonised Index of Consumer Prices (HICP) basket. In particular, recent improved forecast accuracy for core inflation reflects offsetting forecast errors for goods and services. Since January, disinflation in services has consistently been slower than anticipated. In this environment, policy should be robust to contingencies causing the economy to evolve differently from what is implied by the modal outlook. Monetary policy that would be optimal under strict inflation forecast targeting can be suboptimal when knowledge is imperfect. Scenario analysis is a powerful tool for making policy more robust while retaining a forward-looking perspective. Plausible alternative scenarios that scrutinise the key assumptions underlying the modal outlook highlight the large uncertainty surrounding the baseline scenario. If this uncertainty is communicated clearly and transparently, the distribution of future expected policy outcomes may better reflect the risks to the modal outlook. Inevitably, policy cannot be robust to all contingencies. A policy that is robust to downside risks is unlikely to be equally resilient against upside risks, and vice versa. Central banks thus need to weigh the risks and focus on those considered to be the most detrimental to the achievement of their mandate. In the current environment, monetary policy should remain focused on bringing inflation back to our target in a timely manner, for three main reasons. First, while risks to growth have increased, a soft landing still looks more likely than a recession. In recent weeks, financial markets have repriced more fundamentally the expected pace of central bank easing, also in the euro area. This reflects concerns that global growth is at risk of a rapid deterioration. While growth prospects warrant close scrutiny in the coming weeks, the market repricing reflects, by and large, spillovers from abroad that were amplified by technical factors, including reduced liquidity during the summer period and the unwinding of yen carry trades. It is therefore unclear to what extent the repricing reflects a change in macroeconomic fundamentals, also given the relative stability of growth forecasts for major economies by market analysts (Slide 6). At the ECB, too, growth projections for the euro area for 2024 and 2025 have remained broadly stable since September 2023. While monetary policy has to avoid unnecessary pain, it must also avoid overreacting to volatile financial market expectations. Central banks' actions should be guided by their evolving assessment of the inflation and growth outlook. Second, history shows that central banks were often unsuccessful in bringing inflation back to target after a long period of very high inflation. In their new research, Christina and David Romer show that perseverance is critical for successfully restoring price stability after a large inflation shock. They demonstrate that strong perceived commitment to disinflation has often not been sufficient to reduce inflation through its impact on expected inflation. Rather, successful disinflation was typically the result of policymakers having persisted in their efforts to fully extinguish past inflationary shocks. Hence, central banks must not abandon disinflationary policies too early. In the euro area, as we gained confidence in the projected disinflation path, we decided to start dialling back the degree of policy restraint earlier than central banks in other advanced economies. But the earlier monetary policy shifts in response to forward-looking signals, the more cautious and gradual it can afford to be on the way back to (an unknown) neutral. Third, even if inflation is no longer a primary concern to financial markets, it is still very much on people's minds. Although headline inflation has come down quickly, inflation perceptions are proving more persistent, and untypically so from a historical perspective. Today, more than $40 \%$ of people still regard inflation as having risen "a lot" over the past 12 months (Slide 7, left-hand side). Elevated inflation perceptions raise inflation persistence and make inflation expectations more susceptible to new shocks, as memory cues make people recall past inflation experiences more rapidly. In a new study, economists at the Federal Reserve Board quantify these risks. They show that inflation persistence has increased measurably across advanced economies, including the euro area. As a result, if today the euro area were to be hit by a "normal" supply shock, as opposed to the unusually large shocks of the past few years, inflation would be higher by almost one percentage point next year compared with a scenario where inflation persistence is lower. This risk is also reflected in the right tail of the inflation expectations distribution remaining thicker than before the pandemic, even among professional forecasters (Slide 7, right-hand side). Making policy robust to these risks requires a thorough review of the main assumptions underlying the baseline scenario for policy to be adjusted. Such a broad-based review is carried out every three months when the projections are updated. In the euro area, the expected decline in headline inflation to the $2 \%$ target by the end of 2025 rests on three critical assumptions. One is that the current high growth in unit labour costs predominantly reflects the lagged effects of past price shocks related to the pandemic and Russia's invasion of Ukraine. As many wage contracts are only infrequently negotiated, the economy can take some time to return to equilibrium. The recent sharp decline in headline inflation should therefore progressively lead to lower wage growth, as also suggested by staff analysis (Slide 8, left-hand side). Unit labour cost growth is expected to slow further once the adverse impact of labour hoarding on productivity growth reverses as demand recovers. The second assumption is that firms are absorbing a large part of the current strong increases in unit labour costs in their profit margins, as the current level of interest rates is dampening the growth in aggregate demand. The third assumption is that price pressures outside the services sector will ease further or evolve in line with historical regularities. Over recent weeks, incoming data have lent support to these assumptions. Negotiated wage growth slowed visibly in the second quarter. Although part of this development is driven by volatile one-off payments, with wage growth expected to reaccelerate in the third quarter, surveys and private sector forecasts suggest that expected wage increases will moderate measurably in 2025 and beyond (Slide 8, right-hand side). Firms also expect that increases in their selling prices will decline as growth in input costs slows. According to the most recent Survey on Access to Finance of Enterprises (SAFE), selling prices are expected to increase by $3 \%$ on average over the next 12 months, down from $4.5 \%$ at the end of last year (Slide 9, left-hand chart). While firms in the services sector still expect a larger increase in their selling prices compared with other sectors, the size of intended price increases is declining there too. Firms have also started to use their margins to absorb the increases in labour costs. In the first quarter of this year, unit profits no longer contributed to inflation in a meaningful way (Slide 9, right-hand chart). This is a significant change from last year. Monetary policy is actively supporting this rebalancing process. By constraining growth in aggregate demand, it makes it more difficult for firms to pass on higher costs to consumers. Surveys suggest that the current level of interest rates is incentivising people to save more and spend less. Notably, savings intentions for the coming year have never been higher than they are today, with households actively shifting their savings into time deposits offering higher returns (Slide 10). As consumer confidence is recovering and households' unemployment expectations remain subdued, it is likely that the desire to save is not driven by precautionary motives only. Finally, energy and food inflation have recently surprised to the downside, while a stronger euro, coupled with the recent fall in oil prices, can ease headline inflation further, at least over the near term. All in all, recent data remain consistent with the baseline scenario that foresees that inflation will sustainably fall back to our $2 \%$ target by the end of 2025. Along with signs of a potential decline in economic momentum in other parts of the world, there is less risk that a further moderate and gradual dialling back of policy restraint could derail the path back to price stability. It is conceivable, however, that the conditions on which the modal outlook rests do not materialise. Scenario analysis can reveal the reasoning behind these risks and evaluate their consequences for the inflation outlook. In the alternative scenario, growth in unit labour costs would not come down as quickly as projected. In the June Eurosystem staff projections, annual growth in unit labour costs is expected to fall to $2.5 \%$ in 2025, from $4.7 \%$ this year. This is a sharp decline, especially as unit labour costs were still growing at an annual rate of $5.3 \%$ in the first quarter, with momentum remaining high. By way of comparison, annual unit labour cost growth in the United States was only $0.9 \%$ in the second quarter. Growth in unit labour costs could disappoint expectations because of stronger wage growth. Although surveys suggest weaker wage growth ahead, the staggered nature of wage negotiations implies that workers may take longer than projected to recoup their purchasing power. While in some countries, such as Portugal and Spain, workers have, on average, recouped the losses incurred in their real wages since before the pandemic, there is still a considerable share of workers in Italy, Germany, Finland and other countries whose real wages remain well below pre-pandemic levels (Slide 11). This also reflects differences in the duration of collective wage agreements. Wages could also expand more strongly if labour market conditions remain tight. A protracted imbalance between labour supply and demand could more fundamentally challenge the assumption underlying the Eurosystem staff projections that wage growth merely reflects past price shocks and the resulting catch-up process. While labour demand is slowing, it remains high in an environment in which unemployment is historically low and where a significant share of firms, especially in the services sector, still regards labour as a factor limiting business (Slide 12). If a shortage of labour prevents firms from increasing production, rising demand results in higher inflation rather than higher output. Another reason why unit labour cost growth could remain higher than projected is a weaker recovery in productivity growth. In the Eurosystem projections, annual productivity growth is forecast to recover to $1 \%$ in 2025 and $1.1 \%$ in 2026, nearly double the historical average. The pick-up in productivity growth may be weaker if part of the current weakness is not cyclical but more persistent, reflecting the structural challenges facing the euro area economy. In fact, over the past year, the recovery in productivity growth has repeatedly been slower than expected. Increasing trade tensions, environmental policies or higher energy prices could all weigh on productivity growth over the coming years, reinforcing upward pressure on the growth of unit labour costs and thus inflation. In addition, under the alternative scenario, firms may decide to pass on a higher-than-expected share of rising labour costs to consumers. The Eurosystem staff projections expect unit profits to stagnate this year as firms use their margins to absorb strong growth in input costs. The buffer provided by profit margins is particularly important in the services sector, which is more labour-intensive and where inflation is still high. New evidence for the euro area suggests, however, that the pass-through of higher wages into producer prices is typically very strong in the services sector. In other words, if the pass-through in earlier stages of the pricing chain remains as in the past, there needs to be a strong decline in profit margins for the baseline to materialise. Softening demand for services as part of a rotation back to goods could be one such factor. So far, however, demand for services has remained relatively resilient, even if there are signs of a weakening (Slide 14). Looking ahead, it will be critical to observe how the interplay of rising real wages, a resilient labour market and the fading impact of monetary policy tightening will contribute to aggregate demand. In particular, the most recent bank lending survey suggests that the economy is starting to adapt to higher interest rates, as banks reported a first increase in loan demand by households in two years, while loan demand by firms is still contracting, but at a more moderate pace (Slide 15). Finally, price pressures outside the services sector may reappear. Goods inflation is a case in point. Under the baseline scenario, it is expected to remain close to current levels as the disinflationary effect of the easing in supply chain disruptions fades. At the same time, protectionism and geopolitical uncertainty are rising. According to the Peace Research Institute Oslo, the number of state-based conflicts is the highest since 1946. Geopolitical uncertainty is a key risk for the stability of global supply chains and commodity prices. Recently, for example, container freight rates have increased measurably, in part reflecting disruptions in the Suez Canal (Slide 16). A further escalation in the Middle East could disrupt energy markets and supply chains more fundamentally. Global trade measures are increasing in parallel, especially for critical raw materials - the production of which is often concentrated in just a few countries (Slide 17). Together with the growing impact of climate change on food prices, these are important forces that could challenge the assumptions underlying the baseline scenario. I would like to conclude with three implications for monetary policy. First, incoming data have broadly confirmed the baseline outlook, bolstering our confidence that conditions remain in place for inflation to fall back to our $2 \%$ target by the end of 2025. Second, confidence is not knowledge. History will not judge our intentions but our success in delivering on our mandate. Given that the path back to price stability hinges on a set of critical assumptions, policy should proceed gradually and cautiously. In particular, the closer policy rates get to the upper band of estimates of the neutral rate of interest that is, the less certain we are how restrictive our policy is -, the more cautious we should be to avoid that policy itself becomes a factor slowing down disinflation. In other words, the pace of policy easing cannot be mechanical. It needs to rest on data and analysis. Third, the world around us is changing rapidly. When the future is as uncertain as it is today, the modal outlook provides a false sense of comfort. Scenario analysis can protect us from falling victim to model uncertainty and overconfidence. Being transparent about what could go wrong, and factoring this into the decision-making process, can help make policy more robust to contingencies that threaten the achievement of our primary mandate. Thank you. Slides
2024-09-04T00:00:00	Frank Elderson: The art of bending without breaking - banking on operational resilience	Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the joint European Banking Authority and European Central Bank international conference "Addressing supervisory challenges through enhanced collaboration", Frankfurt am Main, 4 September 2024.	SPEECH The art of bending without breaking - banking on operational resilience Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the joint European Banking Authority and European Central Bank international conference on "Addressing supervisory challenges through enhanced collaboration" Frankfurt, 4 September 2024 I'm delighted to see supervisors from all around the globe here with us in Frankfurt to exchange views on some of the most pressing issues we face. The banks we supervise operate in an ever more complex risk environment, marked by heightened climate and nature-related risks, increasingly sophisticated cyberattacks and risks stemming from non-bank financial institutions - to name just a few for discussion today. The common denominator of all these risks is that they affect all of us: from Asia to the Americas, from Africa to Europe. To get a better grip on these risks enhanced international cooperation is essential - and this conference is a testament to that. In my remarks today, I will focus on a cornerstone of prudential supervisors' mission to keep banks sound: ensuring that banks build up and maintain adequate operational resilience. Let me start with a small detour into the world of botany. In an environment subject to more extreme weather conditions, certain tree species have proven particularly resilient to strong winds due to their distinct characteristics. The silver birch, for instance, is known for its flexible branches and widespread root system. These characteristics help it master the art of bending with the wind without breaking, even under hurricane-like conditions. The same resilience is needed in today's risk landscape, swept by heightened operational headwinds such as cyber incidents, technology disruptions and natural disasters: to master the art of bending without breaking under such headwinds, banks must develop distinct characteristics. Now, you might primarily associate a bank's resilience with its financial strength - particularly given the significant increases in capital and liquidity buffers following the post-crisis reforms. But I'll highlight why financial resilience alone is far from sufficient to weather the storms brewing over today's risk landscape. Consider the example of Amsterdam Trade Bank (ATB), which filed for bankruptcy although it had ample capital and liquidity. What went wrong? Imagine the bank's credit officers turning up at the office one Friday morning in April 2022, trying to access their documents - and all they see on the screen is that access is denied. Why? Owing to sanctions ATB had lost access to its IT systems, which were run by third-party providers. As a result, the bank couldn't provide banking services anymore. There weren't adequate contingency arrangements in place - because a scenario in which IT systems weren't operable had seemed too unrealistic -- and so the bank had to close shop. In 2023 when the New York arm of an investment bank was hit by a ransomware attack, it literally sent a runner with a USB stick across downtown Manhattan to help settle trades in the $25 trillion US treasury market. And most recently, the CrowdStrike incident caused the operating system of a major provider to crash, displaying the so-called blue screen of death, leading to significant disruptions across sectors - including at a few banks. 2] All these examples underscore a fundamental point: financial resilience alone is a necessary but not sufficient condition to weather operational headwinds. You can have ample capital and liquidity but still face major operational issues or even fail if you lack robust contingency planning for operational shocks that are impossible to avoid. In other words, some banks were missing an essential safeguard - operational resilience. Operational resilience goes beyond capital and liquidity While operational risk management aims to minimise the likelihood and impact of operational risks, operational resilience assumes that disruptions will inevitably occur. Hence banks must protect themselves from threats, and be able to respond to disruptive events, recover and learn from them in order to be able to "deliver critical operations through disruption". First the good news: regulators and supervisors have understood that merely scrutinising banks' balance sheets with an eagle eye is not sufficient to probe banks' resilience. As a result, operational resilience has made it to the top of the supervisory agenda around the globe.41 For instance, operational resilience has now been engraved in the marble of supervision: the Basel Core Principles. They now explicitly cover operational resilience, including enhanced requirements for aspects ranging from governance and business continuity planning to third-party dependency management. The revised Core Principles will help supervisors around the world to encourage banks to increase their resilience to operational threats. Such threats are unlikely to decline given heightened geopolitical, cyber, and climate and nature-related risks. Moreover, the Digital Operational Resilience Act (DORA), which will apply as of 17 January 2025 in the EU, will help to further boost operational resilience. Among other things, DORA provides a robust framework requiring banks to foster a culture of continuous IT and cyber risk management. In the banking union, we flagged addressing deficiencies in banks' operational resilience frameworks as one of the SSM supervisory priorities for 2024-2026. This means, for instance, conducting on-site inspections of banks' cybersecurity management or targeted analysis of banks' outsourcing arrangements with third-party providers, including potential concentrations of risk in certain providers. IT and cyber risks challenging banks' operational resilience One important factor challenging banks' operational resilience is IT and cyber risk. This can have a material financial, reputational and legal impact on banks. Cyberattacks can significantly disrupt banks' critical functions and services, such as providing credit or processing payments, and hence damage the trust in the banking system. According to the International Monetary Fund, cyberattacks have almost doubled since before the COVID-19 pandemic. This is reflected in the number of significant cyber incidents reported to the ECB too, which almost doubled from 2022 to 2023.1 Worryingly, the attacks have not only increased in number but also in sophistication. In order to help banks pinpoint their vulnerabilities to cyber risks, earlier this year we conducted a cyber resilience stress test. It wasn't a stress test in the traditional sense, with capital impact. Instead, it was a qualitative exercise aimed at encouraging banks to better understand how well they would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test showed that, although banks do have high-level response and recovery frameworks in place, there is room for improvement. Banks need to ensure that their recovery capabilities are sufficient to handle even worst-case scenarios, and that they can protect customers' assets and data, and in doing so maintain confidence in the banking system. We are therefore calling on banks to prioritise operational and cyber resilience and ensure that this resilience is integrated into their core business strategies. This will enable them to adapt and respond proactively to the fast-paced changes in the cyber threat landscape. Cloud outsourcing risk Let me now turn to another key challenge for banks' operational resilience that warrants closer attention - their use of cloud services. While there are undoubtedly benefits associated with banks steadily increasing their use of cloud services in recent years, there are also risks. This is why the Basel Committee stresses that "regulatory interventions are needed to address the risks arising from cloud adoption."2! But what exactly are these risks? We only have to look back to May this year to find a good example. A misconfiguration at a major cloud service provider erased the equivalent of €82 billion of clients' money from a pension fund, making the accounts of more than half a million customers inaccessible for a week." This incident shows that if an organisation can't easily replace outsourced services during a failure, its functioning may be severely affected. Hence if you outsource functions to a service provider you also need to ask whether the service provider has the same risk controls in place as if that service were provided in- house. To get a better insight into risk controls at cloud service providers, European banking supervision has started conducting on-site inspections of some of these providers. Another issue is concentration risk. The Bank of England has estimated that more than 70% of banks and 80% of insurers rely on just two cloud service providers." Ultimately, the failure of either of these providers could have a significant negative impact on markets and consumers, and on financial stability. This level of concentration implies that operational incidents may become more correlated among financial institutions that outsource critical functions to a common critical service provider. An emerging challenge in the digital financial landscape is the blurring of lines between policy areas. Prudential supervisors would be well advised to coordinate with other supervisory authorities, such as competition authorities, to understand the dynamic market forces at play. Coordination is crucial for ensuring that the drive towards digitalisation, which may result in an increase in market concentration, does not undermine financial stability. Concerning banks under ECB supervision, we found room for improvement in their cloud outsourcing strategies. We acted on this by publishing for public consultation a guide that sets out our supervisory expectations and provides recommendations on the outsourcing of cloud services. Importantly, the guide also outlines specific good practices that banks can use as a basis for tackling cloud outsourcing risk 12] Clearly, cloud outsourcing risk doesn't stop at national borders; it affects multiple jurisdictions. We've therefore teamed up with other prudential authorities to conduct a joint review into cloud outsourcing practices. This will enable us to better understand how banks are adopting cloud technology and the risks it may pose. For instance, we're collectively exploring banks' third-party risk management practices and their business continuity plans, as well as their exit strategies - including stressed exits. Bolstering operational resilience requires investment So how can banks strengthen their operational resilience? In contrast to financial resilience, operational resilience cannot be bolstered by accumulating additional basis points of Common Equity Tier 1. Rather, mastering the art of bending without breaking under operational headwinds requires multi-year investment in capability-building. We know that you should put your house in order in good times so that you are well prepared for bad times. Given the current uptick in banks' profitability, the time is right for banks to continue investing in building their operational resilience. This means, for instance, replacing legacy systems with state-of-the-art IT infrastructure, including in the areas of IT risk management and cyber hygiene, as well as ensuring that business continuity plans and third-party dependency management are implemented consistently. Importantly, operational resilience-building is not only a matter of systems and processes - it is also about people. Investment in human capital is therefore essential. Banks must ensure that employees at all levels of the organisation have the appropriate skillset, whether they are experts or managers. Soberingly, from our analysis of the effectiveness of banks' management bodies we can see that there are still boards that lack in-depth IT expertise, which may ultimately put into question the collective suitability of the board.""3] We expect all boards to have a sound understanding of IT and cyber risks so that they can assess the impact of these risks on banks' various business areas. Conclusion Let me conclude. The novelist Max Frisch once said: "Crisis is a productive state. You just have to take away the aftertaste of disaster'. Shocks stemming from cyber incidents or cloud outsourcing and IT risks are an opportunity for banks to further bolster their resilience - to nurture their capacity to bend without breaking. Financial resilience alone is far from sufficient to weather operational headwinds - you need operational resilience. And in order to bolster and maintain operational resilience banks must continue investing in future-proof systems, processes and people. This is not a steady state exercise. Operational resilience demands continuous attention and must keep pace with the changing risk environment. As I have highlighted, no jurisdiction is immune to operational shocks. All of us will be affected by them at some point. Let's therefore share good practices and use cases from our supervisory work. Let's reinforce policy and supervisory coordination across both jurisdictions and sectors. And let's strengthen communication channels to enable us to coordinate closely when shocks hit. Thank you for your attention. 1. Financial Times (2024), "Cyber attacks reveal fragility of financial markets", 16 January. 2. Financial Times (2024), "Global IT outage could take weeks to resolve, experts warn", 20 July; "Companies around the world hit by Microsoft outage", 19 July 3. The Basel Committee on Banking Supervision (BCBS) defines operational resilience as follows: "the ability of a bank to deliver critical operations through disruption. This ability enables a bank to identify and protect itself from threats and potential failures, respond and adapt to, as well as recover and learn from disruptive events in order to minimise their impact on the delivery of critical operations through disruption. In considering its operational resilience, a bank should assume that disruptions will occur, and take into account its overall risk appetite and tolerance for disruption." See paragraph 11 of the BCBS principles for operational resilience. 4. See the BCBS principles for operational resilience, the Bank of England web page on operational resilience, the Federal Reserve System web page on operational resilience, and Tuominen, A. (2024), "The Digital Operational Resilience Act: the next step in a connected digital world", contribution for Eurofi Magazine, 20 February. 5. In 2024 supervisors from around the world revised the Core Principles for Effective Banking Supervision, which were first published in 1997 and last updated in 2012. The Core Principles are one of the most important sets of global supervisory standards, establishing comprehensive requirements for both supervisors and banks. See also Elderson, F. (2024), "Updating the Magna Carta of ECB, 25 April. 6. International Monetary Fund (2024), "The Last Mile: Financial Vulnerabilities and Risks", Global Financial Stability Report, April. 7. Tuominen, A. (2024), Interview with I] Sole 24 Ore, 28 March. 8. See also Tuominen, A. (2024), "Enhancing banks' resilience against cyber threats - a key priority for the ECB", The Supervision Blog, ECB, 26 July. 9. Koh, T.Y. and Prenio, J. (2023), "Managing cloud risk - some considerations for the oversight of critical cloud service providers in the financial sector", FS/ Insights on policy implementation, No 53, Bank for International Settlements. 10. The Guardian (2024), "Google Cloud accidentally deletes UniSuper's online account due to 'unprecedented misconfiguration", 9 May. 11. Bank of England (2020), "How reliant are banks and insurers on cloud outsourcing?", Bank Overground, 17 January. 12. For instance, it is good practice to have multiple data centres in different geographical locations. Banks should also have exit strategies in place - with clearly defined roles, responsibilities and cost estimates - for all outsourced cloud services linked to critical functions. And banks should also assess concentration risks to a specific provider, geographical location and functionality. 13. For instance, 17% of banks do not have a management body member with more than five years of ICT experience. See Elderson, F. (2024), "Banks' governance and risk culture a decade on: progress and shortcomings", The Supervision Blog, 24 July. To ensure diversity of skills and collective suitability, for instance, we expect at least one non-executive member of the management body to have a minimum of five years of recent and specific knowledge and experience in the field of ICT and security risk management. See ECB Banking Supervision (2024), "New policy for more bank board expertise on ICT and security risks", Supervision Newsletter, ECB, 21 February.	---[PAGE_BREAK]--- # The art of bending without breaking - banking on operational resilience ## Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the joint European Banking Authority and European Central Bank international conference on "Addressing supervisory challenges through enhanced collaboration" Frankfurt, 4 September 2024 I'm delighted to see supervisors from all around the globe here with us in Frankfurt to exchange views on some of the most pressing issues we face. The banks we supervise operate in an ever more complex risk environment, marked by heightened climate and nature-related risks, increasingly sophisticated cyberattacks and risks stemming from non-bank financial institutions - to name just a few for discussion today. The common denominator of all these risks is that they affect all of us: from Asia to the Americas, from Africa to Europe. To get a better grip on these risks enhanced international cooperation is essential - and this conference is a testament to that. In my remarks today, I will focus on a cornerstone of prudential supervisors' mission to keep banks sound: ensuring that banks build up and maintain adequate operational resilience. Let me start with a small detour into the world of botany. In an environment subject to more extreme weather conditions, certain tree species have proven particularly resilient to strong winds due to their distinct characteristics. The silver birch, for instance, is known for its flexible branches and widespread root system. These characteristics help it master the art of bending with the wind without breaking, even under hurricane-like conditions. The same resilience is needed in today's risk landscape, swept by heightened operational headwinds such as cyber incidents, technology disruptions and natural disasters: to master the art of bending without breaking under such headwinds, banks must develop distinct characteristics. Now, you might primarily associate a bank's resilience with its financial strength - particularly given the significant increases in capital and liquidity buffers following the post-crisis reforms. But l'll highlight why financial resilience alone is far from sufficient to weather the storms brewing over today's risk landscape. Consider the example of Amsterdam Trade Bank (ATB), which filed for bankruptcy although it had ample capital and liquidity. What went wrong? Imagine the bank's credit officers turning up at the office one Friday morning in April 2022, trying to access their documents - and all they see on the screen is that access is denied. Why? Owing to sanctions ATB had lost access to its IT systems, which were run by third-party providers. As a result, the bank couldn't provide banking services anymore. There weren't adequate contingency ---[PAGE_BREAK]--- arrangements in place - because a scenario in which IT systems weren't operable had seemed too unrealistic - and so the bank had to close shop. In 2023 when the New York arm of an investment bank was hit by a ransomware attack, it literally sent a runner with a USB stick across downtown Manhattan to help settle trades in the $\$ 25$ trillion US treasury market. ${ }^{[1]}$ And most recently, the CrowdStrike incident caused the operating system of a major provider to crash, displaying the so-called blue screen of death, leading to significant disruptions across sectors including at a few banks. ${ }^{[2]}$ All these examples underscore a fundamental point: financial resilience alone is a necessary but not sufficient condition to weather operational headwinds. You can have ample capital and liquidity but still face major operational issues or even fail if you lack robust contingency planning for operational shocks that are impossible to avoid. In other words, some banks were missing an essential safeguard - operational resilience. # Operational resilience goes beyond capital and liquidity While operational risk management aims to minimise the likelihood and impact of operational risks, operational resilience assumes that disruptions will inevitably occur. Hence banks must protect themselves from threats, and be able to respond to disruptive events, recover and learn from them in order to be able to "deliver critical operations through disruption". ${ }^{[3]}$ First the good news: regulators and supervisors have understood that merely scrutinising banks' balance sheets with an eagle eye is not sufficient to probe banks' resilience. As a result, operational resilience has made it to the top of the supervisory agenda around the globe. ${ }^{[4]}$ For instance, operational resilience has now been engraved in the marble of supervision: the Basel Core Principles. They now explicitly cover operational resilience, including enhanced requirements for aspects ranging from governance and business continuity planning to third-party dependency management. ${ }^{[5]}$ The revised Core Principles will help supervisors around the world to encourage banks to increase their resilience to operational threats. Such threats are unlikely to decline given heightened geopolitical, cyber, and climate and nature-related risks. Moreover, the Digital Operational Resilience Act (DORA), which will apply as of 17 January 2025 in the EU, will help to further boost operational resilience. Among other things, DORA provides a robust framework requiring banks to foster a culture of continuous IT and cyber risk management. In the banking union, we flagged addressing deficiencies in banks' operational resilience frameworks as one of the SSM supervisory priorities for 2024-2026. This means, for instance, conducting on-site inspections of banks' cybersecurity management or targeted analysis of banks' outsourcing arrangements with third-party providers, including potential concentrations of risk in certain providers. ## IT and cyber risks challenging banks' operational resilience One important factor challenging banks' operational resilience is IT and cyber risk. This can have a material financial, reputational and legal impact on banks. Cyberattacks can significantly disrupt banks' ---[PAGE_BREAK]--- critical functions and services, such as providing credit or processing payments, and hence damage the trust in the banking system. According to the International Monetary Fund, cyberattacks have almost doubled since before the COVID-19 pandemic. ${ }^{[6]}$ This is reflected in the number of significant cyber incidents reported to the ECB too, which almost doubled from 2022 to 2023. ${ }^{[7]}$ Worryingly, the attacks have not only increased in number but also in sophistication. In order to help banks pinpoint their vulnerabilities to cyber risks, earlier this year we conducted a cyber resilience stress test. ${ }^{[8]}$ It wasn't a stress test in the traditional sense, with capital impact. Instead, it was a qualitative exercise aimed at encouraging banks to better understand how well they would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test showed that, although banks do have high-level response and recovery frameworks in place, there is room for improvement. Banks need to ensure that their recovery capabilities are sufficient to handle even worst-case scenarios, and that they can protect customers' assets and data, and in doing so maintain confidence in the banking system. We are therefore calling on banks to prioritise operational and cyber resilience and ensure that this resilience is integrated into their core business strategies. This will enable them to adapt and respond proactively to the fast-paced changes in the cyber threat landscape. # Cloud outsourcing risk Let me now turn to another key challenge for banks' operational resilience that warrants closer attention - their use of cloud services. While there are undoubtedly benefits associated with banks steadily increasing their use of cloud services in recent years, there are also risks. This is why the Basel Committee stresses that "regulatory interventions are needed to address the risks arising from cloud adoption." ${ }^{[9]}$ But what exactly are these risks? We only have to look back to May this year to find a good example. A misconfiguration at a major cloud service provider erased the equivalent of $€ 82$ billion of clients' money from a pension fund, making the accounts of more than half a million customers inaccessible for a week. ${ }^{[10]}$ This incident shows that if an organisation can't easily replace outsourced services during a failure, its functioning may be severely affected. Hence if you outsource functions to a service provider you also need to ask whether the service provider has the same risk controls in place as if that service were provided inhouse. To get a better insight into risk controls at cloud service providers, European banking supervision has started conducting on-site inspections of some of these providers. Another issue is concentration risk. The Bank of England has estimated that more than 70\% of banks and $80 \%$ of insurers rely on just two cloud service providers. ${ }^{[11]}$ Ultimately, the failure of either of these providers could have a significant negative impact on markets and consumers, and on financial ---[PAGE_BREAK]--- stability. This level of concentration implies that operational incidents may become more correlated among financial institutions that outsource critical functions to a common critical service provider. An emerging challenge in the digital financial landscape is the blurring of lines between policy areas. Prudential supervisors would be well advised to coordinate with other supervisory authorities, such as competition authorities, to understand the dynamic market forces at play. Coordination is crucial for ensuring that the drive towards digitalisation, which may result in an increase in market concentration, does not undermine financial stability. Concerning banks under ECB supervision, we found room for improvement in their cloud outsourcing strategies. We acted on this by publishing for public consultation a guide that sets out our supervisory expectations and provides recommendations on the outsourcing of cloud services. Importantly, the guide also outlines specific good practices that banks can use as a basis for tackling cloud outsourcing risk. ${ }^{[12]}$ Clearly, cloud outsourcing risk doesn't stop at national borders; it affects multiple jurisdictions. We've therefore teamed up with other prudential authorities to conduct a joint review into cloud outsourcing practices. This will enable us to better understand how banks are adopting cloud technology and the risks it may pose. For instance, we're collectively exploring banks' third-party risk management practices and their business continuity plans, as well as their exit strategies - including stressed exits. # Bolstering operational resilience requires investment So how can banks strengthen their operational resilience? In contrast to financial resilience, operational resilience cannot be bolstered by accumulating additional basis points of Common Equity Tier 1. Rather, mastering the art of bending without breaking under operational headwinds requires multi-year investment in capability-building. We know that you should put your house in order in good times so that you are well prepared for bad times. Given the current uptick in banks' profitability, the time is right for banks to continue investing in building their operational resilience. This means, for instance, replacing legacy systems with state-of-the-art IT infrastructure, including in the areas of IT risk management and cyber hygiene, as well as ensuring that business continuity plans and third-party dependency management are implemented consistently. Importantly, operational resilience-building is not only a matter of systems and processes - it is also about people. Investment in human capital is therefore essential. Banks must ensure that employees at all levels of the organisation have the appropriate skillset, whether they are experts or managers. Soberingly, from our analysis of the effectiveness of banks' management bodies we can see that there are still boards that lack in-depth IT expertise, which may ultimately put into question the collective suitability of the board. ${ }^{[13]}$ We expect all boards to have a sound understanding of IT and cyber risks so that they can assess the impact of these risks on banks' various business areas. ## Conclusion Let me conclude. The novelist Max Frisch once said: "Crisis is a productive state. You just have to take away the aftertaste of disaster". Shocks stemming from cyber incidents or cloud outsourcing and IT risks are an ---[PAGE_BREAK]--- opportunity for banks to further bolster their resilience - to nurture their capacity to bend without breaking. Financial resilience alone is far from sufficient to weather operational headwinds - you need operational resilience. And in order to bolster and maintain operational resilience banks must continue investing in future-proof systems, processes and people. This is not a steady state exercise. Operational resilience demands continuous attention and must keep pace with the changing risk environment. As I have highlighted, no jurisdiction is immune to operational shocks. All of us will be affected by them at some point. Let's therefore share good practices and use cases from our supervisory work. Let's reinforce policy and supervisory coordination across both jurisdictions and sectors. And let's strengthen communication channels to enable us to coordinate closely when shocks hit. Thank you for your attention. 1. Financial Times (2024), "Cyber attacks reveal fragility of financial markets", 16 January. 2. Financial Times (2024), "Global IT outage could take weeks to resolve, experts warn", 20 July; "Companies around the world hit by Microsoft outage", 19 July 3. The Basel Committee on Banking Supervision (BCBS) defines operational resilience as follows: "the ability of a bank to deliver critical operations through disruption. This ability enables a bank to identify and protect itself from threats and potential failures, respond and adapt to, as well as recover and learn from disruptive events in order to minimise their impact on the delivery of critical operations through disruption. In considering its operational resilience, a bank should assume that disruptions will occur, and take into account its overall risk appetite and tolerance for disruption." See paragraph 11 of the BCBS principles for operational resilience. 4. See the BCBS principles for operational resilience, the Bank of England web page on operational resilience, the Federal Reserve System web page on operational resilience, and Tuominen, A. (2024), "The Digital Operational Resilience Act: the next step in a connected digital world", contribution for Eurofi Magazine, 20 February. 5. In 2024 supervisors from around the world revised the Core Principles for Effective Banking Supervision, which were first published in 1997 and last updated in 2012. The Core Principles are one of the most important sets of global supervisory standards, establishing comprehensive requirements ---[PAGE_BREAK]--- for both supervisors and banks. See also Elderson, F. (2024), "Updating the Magna Carta of supervision: review of the Core Principles for Effective Banking Supervision", The Supervision Blog, ECB, 25 April. 6. International Monetary Fund (2024), "The Last Mile: Financial Vulnerabilities and Risks", Global Financial Stability Report, April. 7. Tuominen, A. (2024), Interview with II Sole 24 Ore, 28 March. 8. See also Tuominen, A. (2024), "Enhancing banks' resilience against cyber threats - a key priority for the ECB", The Supervision Blog, ECB, 26 July. 9. Koh, T.Y. and Prenio, J. (2023), "Managing cloud risk - some considerations for the oversight of critical cloud service providers in the financial sector", FSI Insights on policy implementation, No 53, Bank for International Settlements. 10. The Guardian (2024), "Google Cloud accidentally deletes UniSuper's online account due to 'unprecedented misconfiguration'", 9 May. 11. Bank of England (2020), "How reliant are banks and insurers on cloud outsourcing?", Bank Overground, 17 January. 12. For instance, it is good practice to have multiple data centres in different geographical locations. Banks should also have exit strategies in place - with clearly defined roles, responsibilities and cost estimates - for all outsourced cloud services linked to critical functions. And banks should also assess concentration risks to a specific provider, geographical location and functionality. 13. For instance, $17 \%$ of banks do not have a management body member with more than five years of ICT experience. See Elderson, F. (2024), "Banks' governance and risk culture a decade on: progress and shortcomings", The Supervision Blog, 24 July. To ensure diversity of skills and collective suitability, for instance, we expect at least one non-executive member of the management body to have a minimum of five years of recent and specific knowledge and experience in the field of ICT and security risk management. See ECB Banking Supervision (2024), "New policy for more bank board expertise on ICT and security risks", Supervision Newsletter, ECB, 21 February.	Frank Elderson	Euro area	https://www.bis.org/review/r240919c.pdf	Frankfurt, 4 September 2024 I'm delighted to see supervisors from all around the globe here with us in Frankfurt to exchange views on some of the most pressing issues we face. The banks we supervise operate in an ever more complex risk environment, marked by heightened climate and nature-related risks, increasingly sophisticated cyberattacks and risks stemming from non-bank financial institutions - to name just a few for discussion today. The common denominator of all these risks is that they affect all of us: from Asia to the Americas, from Africa to Europe. To get a better grip on these risks enhanced international cooperation is essential - and this conference is a testament to that. In my remarks today, I will focus on a cornerstone of prudential supervisors' mission to keep banks sound: ensuring that banks build up and maintain adequate operational resilience. Let me start with a small detour into the world of botany. In an environment subject to more extreme weather conditions, certain tree species have proven particularly resilient to strong winds due to their distinct characteristics. The silver birch, for instance, is known for its flexible branches and widespread root system. These characteristics help it master the art of bending with the wind without breaking, even under hurricane-like conditions. The same resilience is needed in today's risk landscape, swept by heightened operational headwinds such as cyber incidents, technology disruptions and natural disasters: to master the art of bending without breaking under such headwinds, banks must develop distinct characteristics. Now, you might primarily associate a bank's resilience with its financial strength - particularly given the significant increases in capital and liquidity buffers following the post-crisis reforms. But l'll highlight why financial resilience alone is far from sufficient to weather the storms brewing over today's risk landscape. Consider the example of Amsterdam Trade Bank (ATB), which filed for bankruptcy although it had ample capital and liquidity. What went wrong? Imagine the bank's credit officers turning up at the office one Friday morning in April 2022, trying to access their documents - and all they see on the screen is that access is denied. Why? Owing to sanctions ATB had lost access to its IT systems, which were run by third-party providers. As a result, the bank couldn't provide banking services anymore. There weren't adequate contingency arrangements in place - because a scenario in which IT systems weren't operable had seemed too unrealistic - and so the bank had to close shop. In 2023 when the New York arm of an investment bank was hit by a ransomware attack, it literally sent a runner with a USB stick across downtown Manhattan to help settle trades in the $\$ 25$ trillion US treasury market. And most recently, the CrowdStrike incident caused the operating system of a major provider to crash, displaying the so-called blue screen of death, leading to significant disruptions across sectors including at a few banks. All these examples underscore a fundamental point: financial resilience alone is a necessary but not sufficient condition to weather operational headwinds. You can have ample capital and liquidity but still face major operational issues or even fail if you lack robust contingency planning for operational shocks that are impossible to avoid. In other words, some banks were missing an essential safeguard - operational resilience. While operational risk management aims to minimise the likelihood and impact of operational risks, operational resilience assumes that disruptions will inevitably occur. Hence banks must protect themselves from threats, and be able to respond to disruptive events, recover and learn from them in order to be able to "deliver critical operations through disruption". First the good news: regulators and supervisors have understood that merely scrutinising banks' balance sheets with an eagle eye is not sufficient to probe banks' resilience. As a result, operational resilience has made it to the top of the supervisory agenda around the globe. For instance, operational resilience has now been engraved in the marble of supervision: the Basel Core Principles. They now explicitly cover operational resilience, including enhanced requirements for aspects ranging from governance and business continuity planning to third-party dependency management. The revised Core Principles will help supervisors around the world to encourage banks to increase their resilience to operational threats. Such threats are unlikely to decline given heightened geopolitical, cyber, and climate and nature-related risks. Moreover, the Digital Operational Resilience Act (DORA), which will apply as of 17 January 2025 in the EU, will help to further boost operational resilience. Among other things, DORA provides a robust framework requiring banks to foster a culture of continuous IT and cyber risk management. In the banking union, we flagged addressing deficiencies in banks' operational resilience frameworks as one of the SSM supervisory priorities for 2024-2026. This means, for instance, conducting on-site inspections of banks' cybersecurity management or targeted analysis of banks' outsourcing arrangements with third-party providers, including potential concentrations of risk in certain providers. One important factor challenging banks' operational resilience is IT and cyber risk. This can have a material financial, reputational and legal impact on banks. Cyberattacks can significantly disrupt banks' critical functions and services, such as providing credit or processing payments, and hence damage the trust in the banking system. According to the International Monetary Fund, cyberattacks have almost doubled since before the COVID-19 pandemic. Worryingly, the attacks have not only increased in number but also in sophistication. In order to help banks pinpoint their vulnerabilities to cyber risks, earlier this year we conducted a cyber resilience stress test. It wasn't a stress test in the traditional sense, with capital impact. Instead, it was a qualitative exercise aimed at encouraging banks to better understand how well they would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test showed that, although banks do have high-level response and recovery frameworks in place, there is room for improvement. Banks need to ensure that their recovery capabilities are sufficient to handle even worst-case scenarios, and that they can protect customers' assets and data, and in doing so maintain confidence in the banking system. We are therefore calling on banks to prioritise operational and cyber resilience and ensure that this resilience is integrated into their core business strategies. This will enable them to adapt and respond proactively to the fast-paced changes in the cyber threat landscape. Let me now turn to another key challenge for banks' operational resilience that warrants closer attention - their use of cloud services. While there are undoubtedly benefits associated with banks steadily increasing their use of cloud services in recent years, there are also risks. This is why the Basel Committee stresses that "regulatory interventions are needed to address the risks arising from cloud adoption." But what exactly are these risks? We only have to look back to May this year to find a good example. A misconfiguration at a major cloud service provider erased the equivalent of $€ 82$ billion of clients' money from a pension fund, making the accounts of more than half a million customers inaccessible for a week. This incident shows that if an organisation can't easily replace outsourced services during a failure, its functioning may be severely affected. Hence if you outsource functions to a service provider you also need to ask whether the service provider has the same risk controls in place as if that service were provided inhouse. To get a better insight into risk controls at cloud service providers, European banking supervision has started conducting on-site inspections of some of these providers. Another issue is concentration risk. The Bank of England has estimated that more than 70\% of banks and $80 \%$ of insurers rely on just two cloud service providers. Ultimately, the failure of either of these providers could have a significant negative impact on markets and consumers, and on financial stability. This level of concentration implies that operational incidents may become more correlated among financial institutions that outsource critical functions to a common critical service provider. An emerging challenge in the digital financial landscape is the blurring of lines between policy areas. Prudential supervisors would be well advised to coordinate with other supervisory authorities, such as competition authorities, to understand the dynamic market forces at play. Coordination is crucial for ensuring that the drive towards digitalisation, which may result in an increase in market concentration, does not undermine financial stability. Concerning banks under ECB supervision, we found room for improvement in their cloud outsourcing strategies. We acted on this by publishing for public consultation a guide that sets out our supervisory expectations and provides recommendations on the outsourcing of cloud services. Importantly, the guide also outlines specific good practices that banks can use as a basis for tackling cloud outsourcing risk. Clearly, cloud outsourcing risk doesn't stop at national borders; it affects multiple jurisdictions. We've therefore teamed up with other prudential authorities to conduct a joint review into cloud outsourcing practices. This will enable us to better understand how banks are adopting cloud technology and the risks it may pose. For instance, we're collectively exploring banks' third-party risk management practices and their business continuity plans, as well as their exit strategies - including stressed exits. So how can banks strengthen their operational resilience? In contrast to financial resilience, operational resilience cannot be bolstered by accumulating additional basis points of Common Equity Tier 1. Rather, mastering the art of bending without breaking under operational headwinds requires multi-year investment in capability-building. We know that you should put your house in order in good times so that you are well prepared for bad times. Given the current uptick in banks' profitability, the time is right for banks to continue investing in building their operational resilience. This means, for instance, replacing legacy systems with state-of-the-art IT infrastructure, including in the areas of IT risk management and cyber hygiene, as well as ensuring that business continuity plans and third-party dependency management are implemented consistently. Importantly, operational resilience-building is not only a matter of systems and processes - it is also about people. Investment in human capital is therefore essential. Banks must ensure that employees at all levels of the organisation have the appropriate skillset, whether they are experts or managers. Soberingly, from our analysis of the effectiveness of banks' management bodies we can see that there are still boards that lack in-depth IT expertise, which may ultimately put into question the collective suitability of the board. We expect all boards to have a sound understanding of IT and cyber risks so that they can assess the impact of these risks on banks' various business areas. Let me conclude. The novelist Max Frisch once said: "Crisis is a productive state. You just have to take away the aftertaste of disaster". Shocks stemming from cyber incidents or cloud outsourcing and IT risks are an opportunity for banks to further bolster their resilience - to nurture their capacity to bend without breaking. Financial resilience alone is far from sufficient to weather operational headwinds - you need operational resilience. And in order to bolster and maintain operational resilience banks must continue investing in future-proof systems, processes and people. This is not a steady state exercise. Operational resilience demands continuous attention and must keep pace with the changing risk environment. As I have highlighted, no jurisdiction is immune to operational shocks. All of us will be affected by them at some point. Let's therefore share good practices and use cases from our supervisory work. Let's reinforce policy and supervisory coordination across both jurisdictions and sectors. And let's strengthen communication channels to enable us to coordinate closely when shocks hit. Thank you for your attention. Overground, 17 January.
2024-09-06T00:00:00	Frank Elderson: Nature-related risk - legal implications for central banks, supervisors and financial institutions	Keynote speech by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the ESCB (Central banks of the European System) Legal Conference 2024, Frankfurt am Main, 6 September 2024.	SPEECH Nature-related risk: legal implications for central banks, supervisors and financial institutions Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the ESCB Legal Conference 2024 Frankfurt am Main, 6 September 2024 As a lawyer, I am always glad to discuss the novel legal issues affecting the work of central banks and supervisors. At last year's conference I spoke to you about climate-related litigation and its impact on the financial sector." This year I want to talk about the risks that nature degradation poses to the economy and the financial sector. As I have said before, assessing nature-related risk is not some kind of tree-hugging exercise. We are talking about material financial risks, which - like any other type of risk - must be assessed, analysed and managed.!2! Today, I want to focus on the legal implications of nature-related risk for our central banking and supervisory work. I will first outline the growing trend of nature-related litigation. Then I will look at how nature-related risk should be considered in the context of the mandates of central banks and supervisors. Nature degradation: risks for the economy and the financial sector Scientists worldwide agree that nature has been declining at an unprecedented rate over the past 50 years. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) already sounded the alarm back in 2019, shortly before the outbreak of the global pandemic. The IPBES report even warned us that nature degradation was exacerbating emerging infectious diseases in wildlife, domestic animals, plants and people.) The decline of nature is primarily caused by human activity and is being made worse by climate change. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths./4] This decline undermines the planet's ability to provide ecosystem services, which are the benefits we obtain from nature to support and sustain our society and economies. Examples of ecosystem services include food, drinking water, timber and minerals; protection against natural hazards, such as floods and landslides; or carbon uptake and storage by vegetation.5] The degradation of nature not only threatens these ecosystem services, but also increases the risk of us reaching ecosystem tipping points, i.e. non-linear, self-amplifying and irreversible changes in ecosystem states that can occur rapidly and on a large scale.[©] Through these tipping points, we are at risk of going beyond the Earth's safe operating space for sustaining life on the planet. From the perspective of central banks and supervisors, the degradation of nature makes our economies, our companies and our financial institutions increasingly vulnerable. We cannot ignore these vulnerabilities. Indeed, we need to deepen our understanding of how nature- related financial risk affects the economy and the financial system.] Work is progressing at the ECB: for example, our research has found that 72% of euro area companies are highly dependent on ecosystem services and would experience critical economic problems as a result of ecosystem degradation.!) Moreover, research by the European Commission has detailed that several sectors of the European economy - in particular agriculture, real estate and construction, and healthcare - are heavily dependent on nature and thus exposed to associated risks. [10] Work is also progressing at international level. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications of nature-related risks for the financial sector." In addition, the Network for Greening the Financial System (NGFS) - a network of 138 central banks and supervisors from around the world - had already acknowledged the relevance of nature-related risks for the mandates of central banks and supervisors back in March 2022.2] The NGFS has since developed a conceptual framework offering central banks and supervisors a common understanding of nature-related financial risks and a principle-based risk assessment approach.43] All these efforts are improving our ability to quantify the financial implications of nature degradation. And of course, there are also important legal implications that we need to start talking about. Nature-related litigation The first legal implication is the rise in nature-related litigation."4] Litigants are starting to understand the link between climate change and nature degradation and are using the legal system to drive policy change. Building on their successes in the field of climate litigation, litigants are taking court cases to address the biodiversity crisis, protect carbon sinks, limit deforestation and loss of ocean habitats, and prevent ecosystem degradation. In July of this year the NGFS published a report on this new trend to raise awareness among financial institutions, central banks and supervisors." The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. The report reiterated that litigation can affect financial institutions, not only where they are directly challenged, but also indirectly, when their counterparties, or the states in which they operate, are subject to such claims. 48] The report identified two key categories of nature-related litigation as well as two key drivers. Categories of nature-related litigation In terms of categories of litigation, most nature-related cases are being brought against states and public entities, using arguments based on fundamental rights." This is not surprising given how effective such arguments have been in climate litigation. Interestingly, however, corporates and banks, too, are already being directly targeted in nature-related litigation. This contrasts to the trends we saw under climate litigation, where cases against the private sector were much slower to start. First, this may be because climate litigation has offered a blueprint for action for litigants who are seeking innovative ways to protect nature. Second, it may be because nature-related litigation can identify a closer causal connection between the impact of economic activities on local ecosystems and people. It is often easier to pinpoint the damage and attribute responsibility to specific actors. Thanks to new legislation, it is also becoming easier to hold multinational companies liable for harm occurring in remote parts of their global supply chains. And we can even see that litigants are already challenging banks that are alleged to finance such companies. 2 Indeed, we can observe a close nexus between corporate litigation and legislation. Litigants are already relying on new corporate sustainability due diligence legislation,!24] on tort law, anti-money laundering laws!22] and shareholder rights to bring nature-related claims. The number of such cases is likely to grow as further legislation - such as the EU Directive on corporate sustainability due diligence and the EU Deforestation Regulation - enters into force. Drivers of nature-related litigation Looking now at the drivers behind the trend in nature-related litigation, the first is that scientists - and litigants - are developing a much better understanding of the climate-nature nexus. Protecting nature is crucial to mitigating climate change and vice versa. The climate crisis deepens the nature crisis, thus diminishing nature's ability to mitigate what the UN Secretary General has called "the era of global boiling".!23] The scientific consensus on this point may help litigants to strengthen their cases. [24] The second driver is that courts are taking, as a given, the findings of climate and environmental science, in the same manner as any other area of technical expertise. Court assessments and rulings are taking into account advanced scientific concepts and sources. We saw this quite clearly in the recent ruling of the European Court of Human Rights, in the case brought by a group of Swiss grandmothers.!25I There, the Court based its ruling on the IPCC reports, and took it as a matter of fact that climate change exists, that it poses a serious threat to human rights, and that states are aware and capable of doing something about it. Moreover, the Court held that states have a positive obligation to act, regardless of whether their individual contribution might be a "drop in the ocean" in terms of its ability to affect climate change.!24 Relevance of nature degradation for the mandates of central banks and supervisors This leads me to the next key legal implication of the nature crisis: how will it affect the mandates of central banks and supervisors? It goes without saying that addressing the nature crisis is primarily up to governments and legislators. However, as I mentioned at the outset, central banks and supervisors also need to consider the nature crisis as a source of risk to the economy, financial system and the individual banks they supervise. Nature-related risk and banking supervision Avery clear example of this is the way banking supervision is looking at nature-related risks. Back in 2020, the ECB's guide on supervisory expectations for the risk management of climate-related and environmentall24 (C&E) risks already highlighted the need for banks to identify, measure and - most importantly - manage nature-related risks, such as water stress and pollution.!28] We have been actively following up with banks regarding these supervisory expectations since then. (291 The first interim deadline fell due in March 2023, when banks were expected to have in place a sound and comprehensive materiality assessment of both climate and nature risks. Since then, we have issued binding supervisory decisions against 28 banks that failed to meet this first interim deadline - with the possibility of imposing periodic penalty payments in the 22 most relevant cases, if the banks don't remedy this shortcoming in time. Banks were also expected to meet a second interim deadline in December 2023, and by the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C&E risks. In that respect, nature degradation is already integrated in ECB supervisory work as a risk driver that banks are expected to manage. Rather than considering nature-related risk as a standalone category of risk, we see it as a driver for each traditional type of risk reflected in the Capital Requirements Directive, from credit risk, reputational and operational risk including legal risk, to market and liquidity risk. Nature-related risk and monetary policy We must also properly consider nature-related risk in the context of our monetary policy mandate. First, the nature crisis could have direct implications for price stability - the primary objective of the ECB. One of the papers presented at the annual ECB Forum on Central Banking in Sintra, Portugal, in July shows how loss of biodiversity can cause losses to economic output while at the same time decreasing the resilience of output to future biodiversity losses.!S2] As part of its Climate and Nature Plan 2024-2025, the ECB is conducting further work on the risk posed to the economy by nature loss and degradation.) This will inform our understanding of risks to price stability and financial stability. Second, it is clear from the Treaties that the ECB must take into account the EU's policies to address nature degradation when carrying out its mandate.!22] There are two key legal bases for this: the ECB's secondary objective in Article 127(1), second sentence, and the transversal Treaty provisions of Articles 11 and 7 of the Treaty on the Functioning of the European Union (TFEU). The ECB's secondary objective states that, without prejudice to price stability, the ECB shall support the general economic policies in the EU, with a view to contributing to the objectives of the EU. These objectives include "the sustainable development of Europe" and "a high level of protection and improvement of the quality of the environment". It is irrefutable that the EU's climate policy constitutes part of the general economic policies in the EU. As reiterated in the European Climate Law, the transition to net zero affects every aspect of economic life, in all sectors. Thus, to the extent that nature protection directly contributes to climate crisis mitigation and adaptation - which it often does - the ECB must support the EU's efforts in this field. In this context it is notable that the EU adopted the groundbreaking Nature Restoration Law earlier this year23) and signed up to the Kunming-Montreal Global Biodiversity Framework (the "Paris Agreement for nature") in 20221841 _ significant developments that could be invoked to argue that nature protection, just like climate policy, constitutes an independent general economic policy. As lawyers, we need to watch this space. Beyond the secondary objective, the ECB has to comply with two key transversal principles of the Treaties. Article 11 of the TFEU provides that the EU's environmental protection requirements must be "integrated into the definition and implementation of the Union's policies and activities".25] This imposes an obligation on the ECB to take into account the EU's policies to protect nature when shaping its own policies and performing its tasks. In addition, under Article 7 of the TFEU, the activities and policies of the ECB need to be consistent with EU law - including EU law on nature and biodiversity. This does not mean economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop means to transpose insights from nature science into variables of economic interest like growth, inflation and financial risks. In developing tools for policy analysis of nature-related risks, the growing availability of data from sustainability disclosures will make it easier for central banks to identify how they need to incorporate nature into their work. Recently adopted legislation, in particular the sustainable finance framework[25], creates an entire "ecosystem" of EU legislation that makes the link between nature degradation, the economy and the financial sector - and thus central banks and supervisors - clear and apparent. It leaves us in no doubt that we have the duty and the tools at our disposal to take nature-related risk into account when we exercise our mandate. Conclusion Let me conclude. The economy and the financial sector are vulnerable to nature-related risks. This vulnerability is all the more relevant given the importance of nature in mitigating and adapting to climate change. Time is running out to prepare for the materialisation of nature-related risks. We need to be ready for the impact of these risks, just like we are for climate-related risks - or indeed for any other risk driver. For that reason, we need to properly consider the legal implications of nature-related risks for the financial sector, and for the mandates of central banks and supervisors. Thank you for your attention. 1. Elderson, F. (2023), ""Come hell or high water": addressing the risks of climate and environment- related litigation for the banking sector", keynote speech at the ECB Legal Conference, 4 September. 2. Elderson, F. (2023), "Climate-related and environmental risks - a vital part of the ECB's supervisory agenda to keep banks safe and sound", introductory remarks at the panel on green finance policy and the role of Europe organised by the Federal Working Group Europe of the German Greens, 23 June. 3. summary for policymakers, IPBES secretariat, Bonn, Germany. 4. Lin, D., Hanscom, L., Murthy, A., Galli, A., Evans, M., Neill, E., Mancini, M.S., Martindill, J., Medouar, F.-Z., Huang, S. and Wackernagel, M. (2018), "Ecological Footprint Accounting for Countries: Updates and Results of the National Footprint Accounts, 2012-2018", Resources, Vol. 7, No 3, p.58. 5. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 6. Marsden, L. et al. (2024), "Ecosystem tipping points: Understanding risks to the economy and financial system", UCL Institute for Innovation and Public Purpose, Policy Report, April. 7. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 8. Elderson, F. (2023), "Ihe economy and banks need nature to survive", The ECB Blog, 8 June; Lagarde, C. (2024), "Central banks in a changing world: the role of the ECB in the face of climate and environmental risks", speech at the Maurice Allais Foundation, 7 June. 9. Boldrini, S. et al. (2023), "Living in a world of disappearing nature: physical risk and the implications for financial stability', Occasional Paper Series, No 333, ECB, Frankfurt am Main, November. 10. Cziesielski, M. et al. (2024), Study for a methodological framework and assessment of potential financial risks associated with biodiversity loss and ecosystem degradation - Final Report, European Commission, Brussels, March. These sectors are vulnerable to risks such as water scarcity, floods, storms, soil erosion, pests and invasive species, loss of pollinators and disease (including microbial resistance). 11. perspectives on financial risk, 18 July. 12. NGFS (2022), Statement on nature-related financial risks, 24 March. 13. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 14. The NGFS defines nature-related litigation as encompassing all strategic claims brought before judicial bodies, focusing on climate, biodiversity loss and ecosystem services degradation. 15. NGFS (2023), Climate-related litigation: recent trends and developments, September. 16. Setzer, J. and Higham, C. (2024), Global trends in climate change litigation: 2024 snapshot, London, June. 17. NGFS (2024), Nature-related litigation: emerging_trends and lessons learned from climate-related litigation, 2 July. 18. See also Solana, J. (2020), "Climate change litigation as financial risk", Green Finance, Vol. 2, Issue 4, p. 344. 19. Rodriguez-Garavito, C. and Boyd, D. (2023), "A Rights Turn in Biodiversity Litigation?" Transnational Environmental Law, Vol.12, No 3, p. 498. 20. See for example Comissao Pastoral da Terra and Notre Affaire a Tous v. BNP Paribas. This case is still pending. 21. For example, cases have been brought against corporates under the French "duty of vigilance" law, such as ClientEarth, Surfrider Foundation Europe, and Zero Waste France v. Danone and Envol Vert v. Casino. These cases are still pending. 22. For instance, a complaint has been brought against banks in France, citing financial support to companies implicated in alleged illegal deforestation in the Amazon. A different application has also been filed before the UK courts against an exchange operator, in connection with the trading of metals which are allegedly the proceeds of environmental crimes. 23. The Secretary-General noted: "The era of global warming has ended; the era of global boiling has arrived.", see Guterres, A. (2023), "Press conference by Secretary-General Antonio Guterres on climate", 27 July. 24. For instance, the Intergovernmental Panel on Climate Change (IPCC) has emphasised that safeguarding biodiversity and ecosystems is fundamental to climate resilient development, in the light of the threats posed by climate change to nature and its roles in adaptation and mitigation. Intergovernmental Panel on Climate Change (2022), "Summary for Policymakers", in IPCC, Climate Change 2022: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge University Press, Cambridge, pp. 3-33. 25. European Court of Human Rights (2024), "Judgment Verein KlimaSeniorinnen Schweiz and Others v. Switzerland - Violations of the European Convention for failing to implement sufficient measures to combat climate change", press release, 9 April. 26. See also Kotze, L. et al. (2024), "Courts, climate litigation and the evolution of earth system law", Global Policy, 15, 5-22. 27. Here, I use the terms "environmental" and "nature-related" risk interchangeably. 28. ECB (2020), Guide on climate-related and environmental risks - Supervisory expectations relating to risk management and disclosure, Frankfurt am Main, November. See also ECB (2022), Good practices for climate-related and environmental risk management - observations from the 2022 thematic review, Frankfurt am Main, November; ECB (2022), Walking the talk: Banks gearing_up to manage risks from climate change - results of the 2022 thematic review on climate-related and environmental risks, Frankfurt am Main, November. 29. Elderson, F. (2024), "You have to know your risks to manage them - banks' materiality assessments as_a crucial precondition for managing climate and environmental risks", ECB Blog, 8 May. For further background, see Elderson, F. (2021), "Mapping connected dots: how climate-related and environmental risk management is becoming _a reality", speech at a workshop organised by the International Monetary Fund's South Asia Regional Training and Technical Assistance Center and Monetary and Capital Markets Department, 10 December; Elderson, F. (2022), "Good, bad and hopeful news: the latest on the supervision of climate risks", speech at the 10th Annual Conference on Bank Steering & Bank Management at the Frankfurt School of Finance & Management, 22 June; Elderson, F. (2023), "'Running_up that hill" - how climate-related and environmental risks turned mainstream in banking supervision and next steps for banks' risk management practices", speech at the ECB Industry Outreach event on Climate-related and Environmental Risk, 3 February; Elderson, F. (2023), "Climate-related and environmental risks - a vital part of the ECB's supervisory agenda to keep banks safe and sound", speech at the panel on green finance policy and the role of Europe organised by the Federal Working Group Europe of the German Greens, 23 June; Elderson, F. (2024), "Making _banks resilient to climate and environmental risks - good practices to overcome the remaining stumbling blocks", speech at the 331st European Banking Federation Executive Committee meeting, 14 March; Elderson, F. (2024), "Know thyself - avoiding policy mistakes in light of the prevailing climate", speech at the Delphi Economic Forum IX, 12 April. 30. Kuchler, T. et al. (2024), The economics of biodiversity loss, ECB Forum on Central Banking, June. 31. ECB (2024), Climate and nature plan 2024-2025 at a glance. 32. O'Connell, M. (2024), "Birth of a naturalist? Nature-related risks and biodiversity loss: legal implications for the ECB", ECB Legal Working Paper Series, No 22, Frankfurt am Main, June. 33. restoration and amending Regulation (EU) 2022/869 (OJ L, 2024/1991, 29.7.2024). 34. Kunming-Montreal Global Biodiversity Framework (GBF) was agreed on 18 December 2022. 35. This "principle of integration" is also reflected in Article 37 of the Charter of Fundamental Rights. 36. In particular, the Taxonomy Regulation targets not only climate mitigation and adaptation, but also four further environmental objectives relevant to nature; the Sustainable Finance Disclosure Regulation (SFDR) defines "sustainable investments" with reference to the impact on biodiversity and nature; and substantial disclosure requirements related to nature. CONTACT	---[PAGE_BREAK]--- # Nature-related risk: legal implications for central banks, supervisors and financial institutions ## Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the ESCB Legal Conference 2024 Frankfurt am Main, 6 September 2024 As a lawyer, I am always glad to discuss the novel legal issues affecting the work of central banks and supervisors. At last year's conference I spoke to you about climate-related litigation and its impact on the financial sector. ${ }^{[1]}$ This year I want to talk about the risks that nature degradation poses to the economy and the financial sector. As I have said before, assessing nature-related risk is not some kind of tree-hugging exercise. We are talking about material financial risks, which - like any other type of risk - must be assessed, analysed and managed. ${ }^{[2]}$ Today, I want to focus on the legal implications of nature-related risk for our central banking and supervisory work. I will first outline the growing trend of nature-related litigation. Then I will look at how nature-related risk should be considered in the context of the mandates of central banks and supervisors. ## Nature degradation: risks for the economy and the financial sector Scientists worldwide agree that nature has been declining at an unprecedented rate over the past 50 years. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) already sounded the alarm back in 2019, shortly before the outbreak of the global pandemic. The IPBES report even warned us that nature degradation was exacerbating emerging infectious diseases in wildlife, domestic animals, plants and people. ${ }^{[3]}$ The decline of nature is primarily caused by human activity and is being made worse by climate change. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths. ${ }^{[4]}$ This decline undermines the planet's ability to provide ecosystem services, which are the benefits we obtain from nature to support and sustain our society and economies. Examples of ecosystem ---[PAGE_BREAK]--- services include food, drinking water, timber and minerals; protection against natural hazards, such as floods and landslides; or carbon uptake and storage by vegetation. 5 The degradation of nature not only threatens these ecosystem services, but also increases the risk of us reaching ecosystem tipping points, i.e. non-linear, self-amplifying and irreversible changes in ecosystem states that can occur rapidly and on a large scale. ${ }^{[6]}$ Through these tipping points, we are at risk of going beyond the Earth's safe operating space for sustaining life on the planet. ${ }^{[7]}$ From the perspective of central banks and supervisors, the degradation of nature makes our economies, our companies and our financial institutions increasingly vulnerable. We cannot ignore these vulnerabilities. Indeed, we need to deepen our understanding of how naturerelated financial risk affects the economy and the financial system. ${ }^{[8]}$ Work is progressing at the ECB: for example, our research has found that $72 \%$ of euro area companies are highly dependent on ecosystem services and would experience critical economic problems as a result of ecosystem degradation. ${ }^{[9]}$ Moreover, research by the European Commission has detailed that several sectors of the European economy - in particular agriculture, real estate and construction, and healthcare - are heavily dependent on nature and thus exposed to associated risks. 10 Work is also progressing at international level. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications of nature-related risks for the financial sector. ${ }^{[11]}$ In addition, the Network for Greening the Financial System (NGFS) - a network of 138 central banks and supervisors from around the world - had already acknowledged the relevance of nature-related risks for the mandates of central banks and supervisors back in March 2022. ${ }^{[12]}$ The NGFS has since developed a conceptual framework offering central banks and supervisors a common understanding of nature-related financial risks and a principle-based risk assessment approach. ${ }^{[13]}$ All these efforts are improving our ability to quantify the financial implications of nature degradation. And of course, there are also important legal implications that we need to start talking about. # Nature-related litigation The first legal implication is the rise in nature-related litigation. ${ }^{[14]}$ Litigants are starting to understand the link between climate change and nature degradation and are using the legal system to drive policy change. Building on their successes in the field of climate litigation, ${ }^{[15]}$ litigants are taking court cases to address the biodiversity crisis, protect carbon sinks, limit deforestation and loss of ocean habitats, and prevent ecosystem degradation. ${ }^{[16]}$ In July of this year the NGFS published a report on this new trend to raise awareness among financial institutions, central banks and supervisors. ${ }^{[17]}$ The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. ---[PAGE_BREAK]--- The report reiterated that litigation can affect financial institutions, not only where they are directly challenged, but also indirectly, when their counterparties, or the states in which they operate, are subject to such claims. ${ }^{[18]}$ The report identified two key categories of nature-related litigation as well as two key drivers. # Categories of nature-related litigation In terms of categories of litigation, most nature-related cases are being brought against states and public entities, using arguments based on fundamental rights. ${ }^{[19]}$ This is not surprising given how effective such arguments have been in climate litigation. Interestingly, however, corporates and banks, too, are already being directly targeted in nature-related litigation. This contrasts to the trends we saw under climate litigation, where cases against the private sector were much slower to start. First, this may be because climate litigation has offered a blueprint for action for litigants who are seeking innovative ways to protect nature. Second, it may be because nature-related litigation can identify a closer causal connection between the impact of economic activities on local ecosystems and people. It is often easier to pinpoint the damage and attribute responsibility to specific actors. Thanks to new legislation, it is also becoming easier to hold multinational companies liable for harm occurring in remote parts of their global supply chains. And we can even see that litigants are already challenging banks that are alleged to finance such companies. ${ }^{[20]}$ Indeed, we can observe a close nexus between corporate litigation and legislation. Litigants are already relying on new corporate sustainability due diligence legislation, ${ }^{[21]}$ on tort law, anti-money laundering laws ${ }^{[22]}$ and shareholder rights to bring nature-related claims. The number of such cases is likely to grow as further legislation - such as the EU Directive on corporate sustainability due diligence and the EU Deforestation Regulation - enters into force. ## Drivers of nature-related litigation Looking now at the drivers behind the trend in nature-related litigation, the first is that scientists - and litigants - are developing a much better understanding of the climate-nature nexus. Protecting nature is crucial to mitigating climate change and vice versa. The climate crisis deepens the nature crisis, thus diminishing nature's ability to mitigate what the UN Secretary General has called "the era of global boiling". ${ }^{[23]}$ The scientific consensus on this point may help litigants to strengthen their cases. ${ }^{[24]}$ The second driver is that courts are taking, as a given, the findings of climate and environmental science, in the same manner as any other area of technical expertise. Court assessments and rulings are taking into account advanced scientific concepts and sources. We saw this quite clearly in the recent ruling of the European Court of Human Rights, in the case brought by a group of Swiss grandmothers. ${ }^{[25]}$ There, the Court based its ruling on the IPCC reports, and took it as a matter of fact that climate change exists, that it poses a serious threat to human rights, and that states are aware and capable of doing something about it. Moreover, the Court held that states have a positive ---[PAGE_BREAK]--- obligation to act, regardless of whether their individual contribution might be a "drop in the ocean" in terms of its ability to affect climate change. ${ }^{[26]}$ # Relevance of nature degradation for the mandates of central banks and supervisors This leads me to the next key legal implication of the nature crisis: how will it affect the mandates of central banks and supervisors? It goes without saying that addressing the nature crisis is primarily up to governments and legislators. However, as I mentioned at the outset, central banks and supervisors also need to consider the nature crisis as a source of risk to the economy, financial system and the individual banks they supervise. ## Nature-related risk and banking supervision A very clear example of this is the way banking supervision is looking at nature-related risks. Back in 2020, the ECB's guide on supervisory expectations for the risk management of climate-related and environmental ${ }^{[27]}(\mathrm{C} \& \mathrm{E})$ risks already highlighted the need for banks to identify, measure and - most importantly - manage nature-related risks, such as water stress and pollution. ${ }^{[28]}$ We have been actively following up with banks regarding these supervisory expectations since then. ${ }^{[29]}$ The first interim deadline fell due in March 2023, when banks were expected to have in place a sound and comprehensive materiality assessment of both climate and nature risks. Since then, we have issued binding supervisory decisions against 28 banks that failed to meet this first interim deadline - with the possibility of imposing periodic penalty payments in the 22 most relevant cases, if the banks don't remedy this shortcoming in time. Banks were also expected to meet a second interim deadline in December 2023, and by the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C\&E risks. In that respect, nature degradation is already integrated in ECB supervisory work as a risk driver that banks are expected to manage. Rather than considering nature-related risk as a standalone category of risk, we see it as a driver for each traditional type of risk reflected in the Capital Requirements Directive, from credit risk, reputational and operational risk including legal risk, to market and liquidity risk. ## Nature-related risk and monetary policy We must also properly consider nature-related risk in the context of our monetary policy mandate. First, the nature crisis could have direct implications for price stability - the primary objective of the ECB. One of the papers presented at the annual ECB Forum on Central Banking in Sintra, Portugal, in July shows how loss of biodiversity can cause losses to economic output while at the same time decreasing the resilience of output to future biodiversity losses. ${ }^{[30]}$ As part of its Climate and Nature Plan 2024-2025, the ECB is conducting further work on the risk posed to the economy by nature loss and degradation. ${ }^{[31]}$ This will inform our understanding of risks to ---[PAGE_BREAK]--- price stability and financial stability. Second, it is clear from the Treaties that the ECB must take into account the EU's policies to address nature degradation when carrying out its mandate. ${ }^{[32]}$ There are two key legal bases for this: the ECB's secondary objective in Article 127(1), second sentence, and the transversal Treaty provisions of Articles 11 and 7 of the Treaty on the Functioning of the European Union (TFEU). The ECB's secondary objective states that, without prejudice to price stability, the ECB shall support the general economic policies in the EU, with a view to contributing to the objectives of the EU. These objectives include "the sustainable development of Europe" and "a high level of protection and improvement of the quality of the environment". It is irrefutable that the EU's climate policy constitutes part of the general economic policies in the EU. As reiterated in the European Climate Law, the transition to net zero affects every aspect of economic life, in all sectors. Thus, to the extent that nature protection directly contributes to climate crisis mitigation and adaptation - which it often does the ECB must support the EU's efforts in this field. In this context it is notable that the EU adopted the groundbreaking Nature Restoration Law earlier this year ${ }^{[33]}$ and signed up to the Kunming-Montreal Global Biodiversity Framework (the "Paris Agreement for nature") in 2022 ${ }^{[34]}$ - significant developments that could be invoked to argue that nature protection, just like climate policy, constitutes an independent general economic policy. As lawyers, we need to watch this space. Beyond the secondary objective, the ECB has to comply with two key transversal principles of the Treaties. Article 11 of the TFEU provides that the EU's environmental protection requirements must be "integrated into the definition and implementation of the Union's policies and activities". ${ }^{[35]}$ This imposes an obligation on the ECB to take into account the EU's policies to protect nature when shaping its own policies and performing its tasks. In addition, under Article 7 of the TFEU, the activities and policies of the ECB need to be consistent with EU law - including EU law on nature and biodiversity. This does not mean economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop means to transpose insights from nature science into variables of economic interest like growth, inflation and financial risks. In developing tools for policy analysis of nature-related risks, the growing availability of data from sustainability disclosures will make it easier for central banks to identify how they need to incorporate nature into their work. Recently adopted legislation, in particular the sustainable finance framework ${ }^{[36]}$, creates an entire "ecosystem" of EU legislation that makes the link between nature degradation, the economy and the financial sector - and thus central banks and supervisors - clear and apparent. It leaves us in no doubt that we have the duty and the tools at our disposal to take nature-related risk into account when we exercise our mandate. # Conclusion Let me conclude. The economy and the financial sector are vulnerable to nature-related risks. This vulnerability is all the more relevant given the importance of nature in mitigating and adapting to climate change. ---[PAGE_BREAK]--- Time is running out to prepare for the materialisation of nature-related risks. We need to be ready for the impact of these risks, just like we are for climate-related risks - or indeed for any other risk driver. For that reason, we need to properly consider the legal implications of nature-related risks for the financial sector, and for the mandates of central banks and supervisors. Thank you for your attention. 1. Elderson, F. (2023), "'Come hell or high water": addressing the risks of climate and environmentrelated litigation for the banking sector", keynote speech at the ECB Legal Conference, 4 September. 2. Elderson, F. (2023), "Climate-related and environmental risks - a vital part of the ECB's supervisory agenda to keep banks safe and sound", introductory remarks at the panel on green finance policy and the role of Europe organised by the Federal Working Group Europe of the German Greens, 23 June. 3. Díaz, S. et al. (eds.) (2019), The global assessment report on biodiversity and ecosystem services, summary for policymakers, IPBES secretariat, Bonn, Germany. 4. Lin, D., Hanscom, L., Murthy, A., Galli, A., Evans, M., Neill, E., Mancini, M.S., Martindill, J., Medouar, F.-Z., Huang, S. and Wackernagel, M. (2018), "Ecological Footprint Accounting for Countries: Updates and Results of the National Footprint Accounts, 2012-2018", Resources, Vol. 7, No 3, p. 58. 5. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 6. Marsden, L. et al. (2024), "Ecosystem tipping points: Understanding risks to the economy and financial system", UCL Institute for Innovation and Public Purpose, Policy Report, April. 7. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 8. Elderson, F. (2023), "The economy and banks need nature to survive", The ECB Blog, 8 June; Lagarde, C. (2024), "Central banks in a changing world: the role of the ECB in the face of climate and environmental risks", speech at the Maurice Allais Foundation, 7 June. 9. ---[PAGE_BREAK]--- Boldrini, S. et al. (2023), "Living in a world of disappearing nature: physical risk and the implications for financial stability", Occasional Paper Series, No 333, ECB, Frankfurt am Main, November. 10. Cziesielski, M. et al. (2024), Study for a methodological framework and assessment of potential financial risks associated with biodiversity loss and ecosystem degradation - Final Report, European Commission, Brussels, March. These sectors are vulnerable to risks such as water scarcity, floods, storms, soil erosion, pests and invasive species, loss of pollinators and disease (including microbial resistance). 11. FSB (2024), Stocktake on nature-related risks: Supervisory and regulatory approaches and perspectives on financial risk, 18 July. 12. NGFS (2022), Statement on nature-related financial risks, 24 March. 13. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 14. The NGFS defines nature-related litigation as encompassing all strategic claims brought before judicial bodies, focusing on climate, biodiversity loss and ecosystem services degradation. 15. NGFS (2023), Climate-related litigation: recent trends and developments, September. 16. Setzer, J. and Higham, C. (2024), Global trends in climate change litigation: 2024 snapshot, London, June. 17. NGFS (2024), Nature-related litigation: emerging trends and lessons learned from climate-related litigation, 2 July. 18. See also Solana, J. (2020), "Climate change litigation as financial risk", Green Finance, Vol. 2, Issue 4, p. 344. 19. Rodríguez-Garavito, C. and Boyd, D. (2023), "A Rights Turn in Biodiversity Litigation?" Transnational Environmental Law, Vol.12, No 3, p. 498. 20. ---[PAGE_BREAK]--- See for example Comissão Pastoral da Terra and Notre Affaire à Tous v. BNP Paribas. This case is still pending. 21. For example, cases have been brought against corporates under the French "duty of vigilance" law, such as ClientEarth, Surfrider Foundation Europe, and Zero Waste France v. Danone and Envol Vert v. Casino. These cases are still pending. 22. For instance, a complaint has been brought against banks in France, citing financial support to companies implicated in alleged illegal deforestation in the Amazon. A different application has also been filed before the UK courts against an exchange operator, in connection with the trading of metals which are allegedly the proceeds of environmental crimes. 23. The Secretary-General noted: "The era of global warming has ended; the era of global boiling has arrived.", see Guterres, A. (2023), "Press conference by Secretary-General António Guterres on climate", 27 July. 24. For instance, the Intergovernmental Panel on Climate Change (IPCC) has emphasised that safeguarding biodiversity and ecosystems is fundamental to climate resilient development, in the light of the threats posed by climate change to nature and its roles in adaptation and mitigation. Intergovernmental Panel on Climate Change (2022), "Summary for Policymakers", in IPCC, Climate Change 2022: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge University Press, Cambridge, pp. 3-33. 25. European Court of Human Rights (2024), "Judgment Verein KlimaSeniorinnen Schweiz and Others v. Switzerland - Violations of the European Convention for failing to implement sufficient measures to combat climate change", press release, 9 April. 26. See also Kotze, L. et al. (2024), "Courts, climate litigation and the evolution of earth system law", Global Policy, 15, 5-22. 27. Here, I use the terms "environmental" and "nature-related" risk interchangeably. 28. ---[PAGE_BREAK]--- ECB (2020), Guide on climate-related and environmental risks - Supervisory expectations relating to risk management and disclosure, Frankfurt am Main, November. See also ECB (2022), Good practices for climate-related and environmental risk management - observations from the 2022 thematic review, Frankfurt am Main, November; ECB (2022), Walking the talk: Banks gearing up to manage risks from climate change - results of the 2022 thematic review on climate-related and environmental risks, Frankfurt am Main, November. 29. Elderson, F. (2024), "You have to know your risks to manage them - banks' materiality assessments as a crucial precondition for managing climate and environmental risks", ECB Blog, 8 May. For further background, see Elderson, F. (2021), "Mapping connected dots: how climate-related and environmental risk management is becoming a reality", speech at a workshop organised by the International Monetary Fund's South Asia Regional Training and Technical Assistance Center and Monetary and Capital Markets Department, 10 December; Elderson, F. (2022), "Good .bad and hopeful news: the latest on the supervision of climate risks", speech at the 10th Annual Conference on Bank Steering \& Bank Management at the Frankfurt School of Finance \& Management, 22 June; Elderson, F. (2023), "Running up that hill" - how climate-related and environmental risks turned mainstream in banking supervision and next steps for banks' risk management practices", speech at the ECB Industry Outreach event on Climate-related and Environmental Risk, 3 February; Elderson, F. (2023), "Climate-related and environmental risks - a vital part of the ECB's supervisory agenda to keep banks safe and sound", speech at the panel on green finance policy and the role of Europe organised by the Federal Working Group Europe of the German Greens, 23 June; Elderson, F. (2024), "Making banks resilient to climate and environmental risks - good practices to overcome the remaining stumbling blocks", speech at the 331st European Banking Federation Executive Committee meeting, 14 March; Elderson, F. (2024), "Know thyself - avoiding policy mistakes in light of the prevailing climate", speech at the Delphi Economic Forum IX, 12 April. 30. Kuchler, T. et al. (2024), The economics of biodiversity loss, ECB Forum on Central Banking, June. 31. ECB (2024), Climate and nature plan 2024-2025 at a glance. 32. O'Connell, M. (2024), "Birth of a naturalist? Nature-related risks and biodiversity loss: legal implications for the ECB", ECB Legal Working Paper Series, No 22, Frankfurt am Main, June. 33. Regulation (EU) 2024/1991 of the European Parliament and of the Council of 24 June 2024 on nature restoration and amending Regulation (EU) 2022/869 (OJ L, 2024/1991, 29.7.2024). ---[PAGE_BREAK]--- 34. Kunming-Montreal Global Biodiversity Framework (GBF) was agreed on 18 December 2022. 35. This "principle of integration" is also reflected in Article 37 of the Charter of Fundamental Rights. 36. In particular, the Taxonomy Regulation targets not only climate mitigation and adaptation, but also four further environmental objectives relevant to nature; the Sustainable Finance Disclosure Regulation (SFDR) defines "sustainable investments" with reference to the impact on biodiversity and nature; and perhaps most importantly, the Corporate Sustainability Reporting Directive (CSRD) imposes substantial disclosure requirements related to nature.	Frank Elderson	Euro area	https://www.bis.org/review/r240919b.pdf	Frankfurt am Main, 6 September 2024 As a lawyer, I am always glad to discuss the novel legal issues affecting the work of central banks and supervisors. At last year's conference I spoke to you about climate-related litigation and its impact on the financial sector. This year I want to talk about the risks that nature degradation poses to the economy and the financial sector. As I have said before, assessing nature-related risk is not some kind of tree-hugging exercise. We are talking about material financial risks, which - like any other type of risk - must be assessed, analysed and managed. Today, I want to focus on the legal implications of nature-related risk for our central banking and supervisory work. I will first outline the growing trend of nature-related litigation. Then I will look at how nature-related risk should be considered in the context of the mandates of central banks and supervisors. Scientists worldwide agree that nature has been declining at an unprecedented rate over the past 50 years. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) already sounded the alarm back in 2019, shortly before the outbreak of the global pandemic. The IPBES report even warned us that nature degradation was exacerbating emerging infectious diseases in wildlife, domestic animals, plants and people. The decline of nature is primarily caused by human activity and is being made worse by climate change. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths. This decline undermines the planet's ability to provide ecosystem services, which are the benefits we obtain from nature to support and sustain our society and economies. Examples of ecosystem services include food, drinking water, timber and minerals; protection against natural hazards, such as floods and landslides; or carbon uptake and storage by vegetation. The degradation of nature not only threatens these ecosystem services, but also increases the risk of us reaching ecosystem tipping points, i.e. non-linear, self-amplifying and irreversible changes in ecosystem states that can occur rapidly and on a large scale. From the perspective of central banks and supervisors, the degradation of nature makes our economies, our companies and our financial institutions increasingly vulnerable. We cannot ignore these vulnerabilities. Indeed, we need to deepen our understanding of how naturerelated financial risk affects the economy and the financial system. Work is progressing at the ECB: for example, our research has found that $72 \%$ of euro area companies are highly dependent on ecosystem services and would experience critical economic problems as a result of ecosystem degradation. Moreover, research by the European Commission has detailed that several sectors of the European economy - in particular agriculture, real estate and construction, and healthcare - are heavily dependent on nature and thus exposed to associated risks. Work is also progressing at international level. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications of nature-related risks for the financial sector. All these efforts are improving our ability to quantify the financial implications of nature degradation. And of course, there are also important legal implications that we need to start talking about. The first legal implication is the rise in nature-related litigation. Litigants are starting to understand the link between climate change and nature degradation and are using the legal system to drive policy change. Building on their successes in the field of climate litigation, In July of this year the NGFS published a report on this new trend to raise awareness among financial institutions, central banks and supervisors. The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. The report reiterated that litigation can affect financial institutions, not only where they are directly challenged, but also indirectly, when their counterparties, or the states in which they operate, are subject to such claims. The report identified two key categories of nature-related litigation as well as two key drivers. In terms of categories of litigation, most nature-related cases are being brought against states and public entities, using arguments based on fundamental rights. This is not surprising given how effective such arguments have been in climate litigation. Interestingly, however, corporates and banks, too, are already being directly targeted in nature-related litigation. This contrasts to the trends we saw under climate litigation, where cases against the private sector were much slower to start. First, this may be because climate litigation has offered a blueprint for action for litigants who are seeking innovative ways to protect nature. Second, it may be because nature-related litigation can identify a closer causal connection between the impact of economic activities on local ecosystems and people. It is often easier to pinpoint the damage and attribute responsibility to specific actors. Thanks to new legislation, it is also becoming easier to hold multinational companies liable for harm occurring in remote parts of their global supply chains. And we can even see that litigants are already challenging banks that are alleged to finance such companies. Indeed, we can observe a close nexus between corporate litigation and legislation. Litigants are already relying on new corporate sustainability due diligence legislation, and shareholder rights to bring nature-related claims. The number of such cases is likely to grow as further legislation - such as the EU Directive on corporate sustainability due diligence and the EU Deforestation Regulation - enters into force. Looking now at the drivers behind the trend in nature-related litigation, the first is that scientists - and litigants - are developing a much better understanding of the climate-nature nexus. Protecting nature is crucial to mitigating climate change and vice versa. The climate crisis deepens the nature crisis, thus diminishing nature's ability to mitigate what the UN Secretary General has called "the era of global boiling". The second driver is that courts are taking, as a given, the findings of climate and environmental science, in the same manner as any other area of technical expertise. Court assessments and rulings are taking into account advanced scientific concepts and sources. We saw this quite clearly in the recent ruling of the European Court of Human Rights, in the case brought by a group of Swiss grandmothers. This leads me to the next key legal implication of the nature crisis: how will it affect the mandates of central banks and supervisors? It goes without saying that addressing the nature crisis is primarily up to governments and legislators. However, as I mentioned at the outset, central banks and supervisors also need to consider the nature crisis as a source of risk to the economy, financial system and the individual banks they supervise. A very clear example of this is the way banking supervision is looking at nature-related risks. Back in 2020, the ECB's guide on supervisory expectations for the risk management of climate-related and environmental We have been actively following up with banks regarding these supervisory expectations since then. The first interim deadline fell due in March 2023, when banks were expected to have in place a sound and comprehensive materiality assessment of both climate and nature risks. Since then, we have issued binding supervisory decisions against 28 banks that failed to meet this first interim deadline - with the possibility of imposing periodic penalty payments in the 22 most relevant cases, if the banks don't remedy this shortcoming in time. Banks were also expected to meet a second interim deadline in December 2023, and by the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C\&E risks. In that respect, nature degradation is already integrated in ECB supervisory work as a risk driver that banks are expected to manage. Rather than considering nature-related risk as a standalone category of risk, we see it as a driver for each traditional type of risk reflected in the Capital Requirements Directive, from credit risk, reputational and operational risk including legal risk, to market and liquidity risk. We must also properly consider nature-related risk in the context of our monetary policy mandate. First, the nature crisis could have direct implications for price stability - the primary objective of the ECB. One of the papers presented at the annual ECB Forum on Central Banking in Sintra, Portugal, in July shows how loss of biodiversity can cause losses to economic output while at the same time decreasing the resilience of output to future biodiversity losses. As part of its Climate and Nature Plan 2024-2025, the ECB is conducting further work on the risk posed to the economy by nature loss and degradation. This will inform our understanding of risks to price stability and financial stability. Second, it is clear from the Treaties that the ECB must take into account the EU's policies to address nature degradation when carrying out its mandate. There are two key legal bases for this: the ECB's secondary objective in Article 127(1), second sentence, and the transversal Treaty provisions of Articles 11 and 7 of the Treaty on the Functioning of the European Union (TFEU). The ECB's secondary objective states that, without prejudice to price stability, the ECB shall support the general economic policies in the EU, with a view to contributing to the objectives of the EU. These objectives include "the sustainable development of Europe" and "a high level of protection and improvement of the quality of the environment". It is irrefutable that the EU's climate policy constitutes part of the general economic policies in the EU. As reiterated in the European Climate Law, the transition to net zero affects every aspect of economic life, in all sectors. Thus, to the extent that nature protection directly contributes to climate crisis mitigation and adaptation - which it often does the ECB must support the EU's efforts in this field. In this context it is notable that the EU adopted the groundbreaking Nature Restoration Law earlier this year - significant developments that could be invoked to argue that nature protection, just like climate policy, constitutes an independent general economic policy. As lawyers, we need to watch this space. Beyond the secondary objective, the ECB has to comply with two key transversal principles of the Treaties. Article 11 of the TFEU provides that the EU's environmental protection requirements must be "integrated into the definition and implementation of the Union's policies and activities". This imposes an obligation on the ECB to take into account the EU's policies to protect nature when shaping its own policies and performing its tasks. In addition, under Article 7 of the TFEU, the activities and policies of the ECB need to be consistent with EU law - including EU law on nature and biodiversity. This does not mean economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop means to transpose insights from nature science into variables of economic interest like growth, inflation and financial risks. In developing tools for policy analysis of nature-related risks, the growing availability of data from sustainability disclosures will make it easier for central banks to identify how they need to incorporate nature into their work. Recently adopted legislation, in particular the sustainable finance framework , creates an entire "ecosystem" of EU legislation that makes the link between nature degradation, the economy and the financial sector - and thus central banks and supervisors - clear and apparent. It leaves us in no doubt that we have the duty and the tools at our disposal to take nature-related risk into account when we exercise our mandate. Let me conclude. The economy and the financial sector are vulnerable to nature-related risks. This vulnerability is all the more relevant given the importance of nature in mitigating and adapting to climate change. Time is running out to prepare for the materialisation of nature-related risks. We need to be ready for the impact of these risks, just like we are for climate-related risks - or indeed for any other risk driver. For that reason, we need to properly consider the legal implications of nature-related risks for the financial sector, and for the mandates of central banks and supervisors. Thank you for your attention.
2024-09-06T00:00:00	John C Williams: 'E' is for equipoise	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Council on Foreign Relations, New York City, 6 September 2024.	John C Williams: 'E' is for equipoise Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Council on Foreign Relations, New York City, 6 September 2024. * * * As prepared for delivery Introduction Good morning. I always appreciate the opportunity to speak before members of the Council on Foreign Relations.1 Before I get started, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Just as you'd expect, I'll be speaking today about the "e" word-by which, of course, I mean the economy. I'll talk about where it's headed, and the process of getting supply and demand in better balance and bringing inflation back down to the FOMC's 2 percent longer-run goal. I'll also discuss the progress made toward the Federal Reserve's dual mandate goals of maximum employment and price stability, as well as the path ahead for monetary policy. The Fed's Dual Mandate I'll start by discussing where the economy stands right now, broadly speaking. Since it's back-to-school season, I'll throw out another "e" word that you may find on a middle school vocabulary list. This word is a little less commonly used-at least in my own conversations. And that word is "equipoise." The definition, according to Merriam-Webster, is "a state of equilibrium." If I were asked to use it in a sentence, spelling bee-style, I'd say: "The significant progress we have seen toward our objectives of price stability and maximum employment means that the risks to the two sides of our dual mandate have moved into equipoise." This is because supply and demand imbalances have dissipated, labor market conditions have eased from being exceptionally tight, and inflation has come down significantly. Many factors have contributed to this favorable set of circumstances, including the Federal Reserve's strong actions to restore price stability. The Inflation Onion Is Back Now let me delve deeper into the two sides of our dual mandate that have moved into equipoise: inflation and the labor market. We'll go in alphabetical order, so let's start with inflation. I've been using the analogy of peeling an onion's layers to describe inflation-both how it 2 rose and how it has since moderated. In my "inflation onion," there are three layers. Each layer represents a major category of inflation: prices of globally traded commodities; prices of products or durable goods like appliances, furniture, and cars; and prices of core services. The sharp rise in inflation that we saw in 2021 and 2022 was in large part due to aftereffects of the pandemic, as well as Russia's war on Ukraine and consequent actions. Once those effects began to dissipate, the layers of the onion started to adjust in turn. While each inflation layer normalized at a different speed, they all moved in the right direction. This broad-based downward movement has brought the overall inflation rate back down closer to our 2 percent longer-run goal. This disinflation process shows up clearly in the data. The 12-month percent change in the personal consumption expenditures (PCE) price index has declined from its 40-year high of just above 7 percent in mid-2022 to 2.5 percent in July. Measures of underlying inflation, like core PCE inflation and the New York Fed's Multivariate Core Trend inflation, similarly show a sizable decline over the past two years to around 2-1/2 3 percent today. The decrease in inflation has benefited from a moderation in demand and improvements in supply that together have reduced supply-demand imbalances, both here in the U.S. and internationally. Equally reassuringly, inflation expectations remain well anchored. The New York Fed's Survey of Consumer Expectations (SCE) shows that inflation expectations have 4 remained in their pre-Covid ranges at all horizons in recent months. Other measures of inflation expectations, both survey- and market-based, give a similar signal. And the Atlanta Fed's measure of business inflation expectations, which reflects the thinking of businesses in setting prices, has similarly returned to levels near its average over the 2012-2019 period.5 The disinflation phenomenon is not unique to the United States. Canada, the United Kingdom, and most European economies experienced historically high inflation over the past few years and have similarly seen rapid declines. The global supply disruptions experienced following the pandemic and war in Ukraine amplified the rise in inflation, and the restoration of supply and demand balance has accelerated its decline. Labor Market Now let me turn to the labor market. Even as the economy has grown at a solid pace, a wide range of indicators have pointed to a continued normalization in the labor market following the red-hot period in 2021 and 2022. Today, most of these measures have moved from the tightest they've been in over two decades to levels more consistent with the good labor market that existed in the period before the pandemic. One measure that understandably gets a lot of attention is the unemployment rate, which has risen by nearly a percentage point from its very low reading in early 2023. Still, it remains relatively low by historical standards, and some of this increase reflects a cool-down in the labor market from an overheated state. In addition, the increase in unemployment has occurred in the context of a strong increase in labor supply, rather than from elevated layoffs. To get the full picture of the labor market and what it means for monetary policy, it's important to monitor a wide range of data in addition to the unemployment rate. For example, I take the temperature of the labor market by looking at surveys of both households and businesses; the rates of quits, hiring, and job vacancies; and the job-tojob transition rates and flows between unemployment and employment states. Taken together, these data indicate that the labor market is now roughly in balance and therefore unlikely to be a source of inflationary pressures going forward. Monetary Policy What does this mean for monetary policy? In its July statement, the FOMC said it "judges that the risks to achieving its employment and inflation goals continue to move into better balance", and that it is 6 "attentive to the risks to both sides of its dual mandate." Regarding the path of policy going forward, the Committee said it "will carefully assess incoming data, the evolving outlook, and the balance of risks" and that it "does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent." The accumulated evidence has increased my confidence that inflation is moving sustainably toward 2 percent. The current restrictive stance of monetary policy has been effective in restoring balance to the economy and bringing inflation down. With the economy now in equipoise and inflation on a path to 2 percent, it is now appropriate to dial down the degree of restrictiveness in the stance of policy by reducing the target range for the federal funds rate. This is the natural next step in executing our strategy to achieve our dual mandate goals. Looking ahead, with inflation moving toward the target and the economy in balance, the stance of monetary policy can be moved to a more a neutral setting over time depending on the evolution of the data, the outlook, and the risks to achieving our objectives. In terms of the Fed's balance sheet, the Committee began to slow the pace of decline of our securities holdings in June. That process is going smoothly and as planned, and the level of reserves remains well above ample. The Economic Outlook Before I close, I'll share my forecast for the other "e," the economy. I expect GDP growth this year to be around 2 to 2-1/2 percent. I expect the unemployment rate at the end of this year to be around 4-1/4 percent, and thereafter to move gradually down to my estimate of its longer-run level of 3-3/4 percent. With the labor market in balance, I expect the process of disinflation to continue. Specifically, I expect overall PCE inflation to moderate to around 2-1/4 percent this year and to be near 2 percent next year. That's my base case. But it's important to emphasize that the outlook remains uncertain, and I am attentive to signs of a shift in economic conditions. Three areas are particularly in focus. One is the possibility of a significant further weakening in the U.S. labor market. The second is a sharp slowdown in global growth that could spill over onto our shores. And third, the experience of the past year shows that the process of disinflation is not always smooth and can surprise both to the upside and downside. Conclusion We've come a long way from the unacceptably high inflation and overheated labor market that we experienced two years ago. Monetary policy has been unequivocally focused on returning inflation to our 2 percent longer-run target. The risks to our two goals are now in better balance, and policy needs to adjust to reflect that balance. Of course, one clear lesson of the past several years is that the future is highly uncertain. Therefore, our decisions will be data-dependent, with a keen eye on the achievement of our maximum employment and price stability goals. 1 These remarks were prepared based on data available as of September 5, 2024. 2 John C. Williams, A Bedrock Commitment to Price Stability , remarks at the 2022 U.S. Hispanic Chamber of Commerce National Conference, Phoenix, Arizona, October 3, 2022; John C. Williams, Peeling the Inflation Onion , remarks at the Economic Club of New York (delivered via videoconference), November 28, 2022; John C. Williams, " Peeling the Inflation Onion, Revisited," Federal Reserve Bank of New York, The Teller Window , September 29, 2023. 3 Federal Reserve Bank of New York, Multivariate Core Trend Inflation . 4 Federal Reserve Bank of New York, Survey of Consumer Expectations (July 2024 Survey). 5 Federal Reserve Bank of Atlanta, Business Inflation Expectations , August 2024. 6 Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, July 31, 2024.	---[PAGE_BREAK]--- # John C Williams: 'E' is for equipoise Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Council on Foreign Relations, New York City, 6 September 2024. As prepared for delivery ## Introduction Good morning. I always appreciate the opportunity to speak before members of the Council on Foreign Relations. ${ }^{1}$ Before I get started, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Just as you'd expect, I'll be speaking today about the "e" word-by which, of course, I mean the economy. I'll talk about where it's headed, and the process of getting supply and demand in better balance and bringing inflation back down to the FOMC's 2 percent longer-run goal. I'll also discuss the progress made toward the Federal Reserve's dual mandate goals of maximum employment and price stability, as well as the path ahead for monetary policy. ## The Fed's Dual Mandate I'll start by discussing where the economy stands right now, broadly speaking. Since it's back-to-school season, I'll throw out another "e" word that you may find on a middle school vocabulary list. This word is a little less commonly used-at least in my own conversations. And that word is "equipoise." The definition, according to Merriam-Webster, is "a state of equilibrium." If I were asked to use it in a sentence, spelling bee-style, I'd say: "The significant progress we have seen toward our objectives of price stability and maximum employment means that the risks to the two sides of our dual mandate have moved into equipoise." This is because supply and demand imbalances have dissipated, labor market conditions have eased from being exceptionally tight, and inflation has come down significantly. Many factors have contributed to this favorable set of circumstances, including the Federal Reserve's strong actions to restore price stability. ## The Inflation Onion Is Back Now let me delve deeper into the two sides of our dual mandate that have moved into equipoise: inflation and the labor market. ---[PAGE_BREAK]--- We'll go in alphabetical order, so let's start with inflation. I've been using the analogy of peeling an onion's layers to describe inflation-both how it rose and how it has since moderated. ${ }^{2}$ In my "inflation onion," there are three layers. Each layer represents a major category of inflation: prices of globally traded commodities; prices of products or durable goods like appliances, furniture, and cars; and prices of core services. The sharp rise in inflation that we saw in 2021 and 2022 was in large part due to aftereffects of the pandemic, as well as Russia's war on Ukraine and consequent actions. Once those effects began to dissipate, the layers of the onion started to adjust in turn. While each inflation layer normalized at a different speed, they all moved in the right direction. This broad-based downward movement has brought the overall inflation rate back down closer to our 2 percent longer-run goal. This disinflation process shows up clearly in the data. The 12-month percent change in the personal consumption expenditures (PCE) price index has declined from its 40-year high of just above 7 percent in mid-2022 to 2.5 percent in July. Measures of underlying inflation, like core PCE inflation and the New York Fed's Multivariate Core Trend inflation, similarly show a sizable decline over the past two years to around 2-1/2 percent today. ${ }^{3}$ The decrease in inflation has benefited from a moderation in demand and improvements in supply that together have reduced supply-demand imbalances, both here in the U.S. and internationally. Equally reassuringly, inflation expectations remain well anchored. The New York Fed's Survey of Consumer Expectations (SCE) shows that inflation expectations have remained in their pre-Covid ranges at all horizons in recent months. ${ }^{4}$ Other measures of inflation expectations, both survey- and market-based, give a similar signal. And the Atlanta Fed's measure of business inflation expectations, which reflects the thinking of businesses in setting prices, has similarly returned to levels near its average over the 2012-2019 period. ${ }^{5}$ The disinflation phenomenon is not unique to the United States. Canada, the United Kingdom, and most European economies experienced historically high inflation over the past few years and have similarly seen rapid declines. The global supply disruptions experienced following the pandemic and war in Ukraine amplified the rise in inflation, and the restoration of supply and demand balance has accelerated its decline. # Labor Market Now let me turn to the labor market. Even as the economy has grown at a solid pace, a wide range of indicators have pointed to a continued normalization in the labor market following the red-hot period in 2021 and 2022. Today, most of these measures have moved from the tightest they've been in over two decades to levels more consistent with the good labor market that existed in the period before the pandemic. One measure that understandably gets a lot of attention is the unemployment rate, which has risen by nearly a percentage point from its very low reading in early 2023. Still, it remains relatively low by historical standards, and some of this increase reflects ---[PAGE_BREAK]--- a cool-down in the labor market from an overheated state. In addition, the increase in unemployment has occurred in the context of a strong increase in labor supply, rather than from elevated layoffs. To get the full picture of the labor market and what it means for monetary policy, it's important to monitor a wide range of data in addition to the unemployment rate. For example, I take the temperature of the labor market by looking at surveys of both households and businesses; the rates of quits, hiring, and job vacancies; and the job-tojob transition rates and flows between unemployment and employment states. Taken together, these data indicate that the labor market is now roughly in balance and therefore unlikely to be a source of inflationary pressures going forward. # Monetary Policy What does this mean for monetary policy? In its July statement, the FOMC said it "judges that the risks to achieving its employment and inflation goals continue to move into better balance", and that it is "attentive to the risks to both sides of its dual mandate." Regarding the path of policy going forward, the Committee said it "will carefully assess incoming data, the evolving outlook, and the balance of risks" and that it "does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent." The accumulated evidence has increased my confidence that inflation is moving sustainably toward 2 percent. The current restrictive stance of monetary policy has been effective in restoring balance to the economy and bringing inflation down. With the economy now in equipoise and inflation on a path to 2 percent, it is now appropriate to dial down the degree of restrictiveness in the stance of policy by reducing the target range for the federal funds rate. This is the natural next step in executing our strategy to achieve our dual mandate goals. Looking ahead, with inflation moving toward the target and the economy in balance, the stance of monetary policy can be moved to a more a neutral setting over time depending on the evolution of the data, the outlook, and the risks to achieving our objectives. In terms of the Fed's balance sheet, the Committee began to slow the pace of decline of our securities holdings in June. That process is going smoothly and as planned, and the level of reserves remains well above ample. ## The Economic Outlook Before I close, I'll share my forecast for the other "e," the economy. I expect GDP growth this year to be around 2 to 2-1/2 percent. I expect the unemployment rate at the end of this year to be around 4-1/4 percent, and thereafter to move gradually down to my estimate of its longer-run level of 3-3/4 percent. With the labor market in balance, I expect the process of disinflation to continue. Specifically, I expect overall PCE inflation to moderate to around 2-1/4 percent this year and to be near 2 percent next year. ---[PAGE_BREAK]--- That's my base case. But it's important to emphasize that the outlook remains uncertain, and I am attentive to signs of a shift in economic conditions. Three areas are particularly in focus. One is the possibility of a significant further weakening in the U.S. labor market. The second is a sharp slowdown in global growth that could spill over onto our shores. And third, the experience of the past year shows that the process of disinflation is not always smooth and can surprise both to the upside and downside. # Conclusion We've come a long way from the unacceptably high inflation and overheated labor market that we experienced two years ago. Monetary policy has been unequivocally focused on returning inflation to our 2 percent longer-run target. The risks to our two goals are now in better balance, and policy needs to adjust to reflect that balance. Of course, one clear lesson of the past several years is that the future is highly uncertain. Therefore, our decisions will be data-dependent, with a keen eye on the achievement of our maximum employment and price stability goals. 1 These remarks were prepared based on data available as of September 5, 2024. ${ }^{2}$ John C. Williams, A Bedrock Commitment to Price Stability, remarks at the 2022 U.S. Hispanic Chamber of Commerce National Conference, Phoenix, Arizona, October 3, 2022; John C. Williams, Peeling the Inflation Onion, remarks at the Economic Club of New York (delivered via videoconference), November 28, 2022; John C. Williams, " Peeling the Inflation Onion, Revisited," Federal Reserve Bank of New York, The Teller Window, September 29, 2023. ${ }^{3}$ Federal Reserve Bank of New York, Multivariate Core Trend Inflation. ${ }^{4}$ Federal Reserve Bank of New York, Survey of Consumer Expectations (July 2024 Survey). ${ }^{5}$ Federal Reserve Bank of Atlanta, Business Inflation Expectations, August 2024. ${ }^{6}$ Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, July 31, 2024.	John C Williams	United States	https://www.bis.org/review/r240909b.pdf	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Council on Foreign Relations, New York City, 6 September 2024. As prepared for delivery Good morning. I always appreciate the opportunity to speak before members of the Council on Foreign Relations. Before I get started, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Just as you'd expect, I'll be speaking today about the "e" word-by which, of course, I mean the economy. I'll talk about where it's headed, and the process of getting supply and demand in better balance and bringing inflation back down to the FOMC's 2 percent longer-run goal. I'll also discuss the progress made toward the Federal Reserve's dual mandate goals of maximum employment and price stability, as well as the path ahead for monetary policy. I'll start by discussing where the economy stands right now, broadly speaking. Since it's back-to-school season, I'll throw out another "e" word that you may find on a middle school vocabulary list. This word is a little less commonly used-at least in my own conversations. And that word is "equipoise." The definition, according to Merriam-Webster, is "a state of equilibrium." If I were asked to use it in a sentence, spelling bee-style, I'd say: "The significant progress we have seen toward our objectives of price stability and maximum employment means that the risks to the two sides of our dual mandate have moved into equipoise." This is because supply and demand imbalances have dissipated, labor market conditions have eased from being exceptionally tight, and inflation has come down significantly. Many factors have contributed to this favorable set of circumstances, including the Federal Reserve's strong actions to restore price stability. Now let me delve deeper into the two sides of our dual mandate that have moved into equipoise: inflation and the labor market. We'll go in alphabetical order, so let's start with inflation. I've been using the analogy of peeling an onion's layers to describe inflation-both how it rose and how it has since moderated. In my "inflation onion," there are three layers. Each layer represents a major category of inflation: prices of globally traded commodities; prices of products or durable goods like appliances, furniture, and cars; and prices of core services. The sharp rise in inflation that we saw in 2021 and 2022 was in large part due to aftereffects of the pandemic, as well as Russia's war on Ukraine and consequent actions. Once those effects began to dissipate, the layers of the onion started to adjust in turn. While each inflation layer normalized at a different speed, they all moved in the right direction. This broad-based downward movement has brought the overall inflation rate back down closer to our 2 percent longer-run goal. This disinflation process shows up clearly in the data. The 12-month percent change in the personal consumption expenditures (PCE) price index has declined from its 40-year high of just above 7 percent in mid-2022 to 2.5 percent in July. Measures of underlying inflation, like core PCE inflation and the New York Fed's Multivariate Core Trend inflation, similarly show a sizable decline over the past two years to around 2-1/2 percent today. The decrease in inflation has benefited from a moderation in demand and improvements in supply that together have reduced supply-demand imbalances, both here in the U.S. and internationally. Equally reassuringly, inflation expectations remain well anchored. The New York Fed's Survey of Consumer Expectations (SCE) shows that inflation expectations have remained in their pre-Covid ranges at all horizons in recent months. The disinflation phenomenon is not unique to the United States. Canada, the United Kingdom, and most European economies experienced historically high inflation over the past few years and have similarly seen rapid declines. The global supply disruptions experienced following the pandemic and war in Ukraine amplified the rise in inflation, and the restoration of supply and demand balance has accelerated its decline. Now let me turn to the labor market. Even as the economy has grown at a solid pace, a wide range of indicators have pointed to a continued normalization in the labor market following the red-hot period in 2021 and 2022. Today, most of these measures have moved from the tightest they've been in over two decades to levels more consistent with the good labor market that existed in the period before the pandemic. One measure that understandably gets a lot of attention is the unemployment rate, which has risen by nearly a percentage point from its very low reading in early 2023. Still, it remains relatively low by historical standards, and some of this increase reflects a cool-down in the labor market from an overheated state. In addition, the increase in unemployment has occurred in the context of a strong increase in labor supply, rather than from elevated layoffs. To get the full picture of the labor market and what it means for monetary policy, it's important to monitor a wide range of data in addition to the unemployment rate. For example, I take the temperature of the labor market by looking at surveys of both households and businesses; the rates of quits, hiring, and job vacancies; and the job-tojob transition rates and flows between unemployment and employment states. Taken together, these data indicate that the labor market is now roughly in balance and therefore unlikely to be a source of inflationary pressures going forward. What does this mean for monetary policy? In its July statement, the FOMC said it "judges that the risks to achieving its employment and inflation goals continue to move into better balance", and that it is "attentive to the risks to both sides of its dual mandate." Regarding the path of policy going forward, the Committee said it "will carefully assess incoming data, the evolving outlook, and the balance of risks" and that it "does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent." The accumulated evidence has increased my confidence that inflation is moving sustainably toward 2 percent. The current restrictive stance of monetary policy has been effective in restoring balance to the economy and bringing inflation down. With the economy now in equipoise and inflation on a path to 2 percent, it is now appropriate to dial down the degree of restrictiveness in the stance of policy by reducing the target range for the federal funds rate. This is the natural next step in executing our strategy to achieve our dual mandate goals. Looking ahead, with inflation moving toward the target and the economy in balance, the stance of monetary policy can be moved to a more a neutral setting over time depending on the evolution of the data, the outlook, and the risks to achieving our objectives. In terms of the Fed's balance sheet, the Committee began to slow the pace of decline of our securities holdings in June. That process is going smoothly and as planned, and the level of reserves remains well above ample. Before I close, I'll share my forecast for the other "e," the economy. I expect GDP growth this year to be around 2 to 2-1/2 percent. I expect the unemployment rate at the end of this year to be around 4-1/4 percent, and thereafter to move gradually down to my estimate of its longer-run level of 3-3/4 percent. With the labor market in balance, I expect the process of disinflation to continue. Specifically, I expect overall PCE inflation to moderate to around 2-1/4 percent this year and to be near 2 percent next year. That's my base case. But it's important to emphasize that the outlook remains uncertain, and I am attentive to signs of a shift in economic conditions. Three areas are particularly in focus. One is the possibility of a significant further weakening in the U.S. labor market. The second is a sharp slowdown in global growth that could spill over onto our shores. And third, the experience of the past year shows that the process of disinflation is not always smooth and can surprise both to the upside and downside. We've come a long way from the unacceptably high inflation and overheated labor market that we experienced two years ago. Monetary policy has been unequivocally focused on returning inflation to our 2 percent longer-run target. The risks to our two goals are now in better balance, and policy needs to adjust to reflect that balance. Of course, one clear lesson of the past several years is that the future is highly uncertain. Therefore, our decisions will be data-dependent, with a keen eye on the achievement of our maximum employment and price stability goals.
2024-09-06T00:00:00	Christopher J Waller: The time has come	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the University of Notre Dame, Notre Dame, Indiana, 6 September 2024.	Christopher J Waller: The time has come Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the University of Notre Dame, Notre Dame, Indiana, 6 September 2024. * * * 1 Thank you, Eric, and thank you for the opportunity to speak to you today. My topic is the outlook for the U.S. economy and the implications for monetary policy, a set of judgements that have, of course, been influenced by this morning's jobs report. When I scheduled this speech several months ago, I knew it might be challenging to speak a few hours after the release of such an important piece of data. But we like to say that monetary policy must be nimble, so that means policymakers must be nimble also. Not Simone Biles nimble, but nimble. As you will hear, I believe the data we have received this week reinforces the view that there has been continued moderation in the labor market. In light of the considerable and ongoing progress toward the Federal Open Market Committee's 2 percent inflation goal, I believe that the balance of risks has shifted toward the employment side of our dual mandate, and that monetary policy needs to adjust accordingly. Looking back at the economic data over the first six months of 2024, it portrayed an economy slowly cooling and not showing signs of significant weakening. The labor market had been gradually moderating for the past year or so, and although inflation rose in the first quarter, it then retreated in the second, and there was a widespread view heading into the second half of the year that the FOMC was on track to achieve a much desired but unusual "soft landing." Then the July jobs report came in unexpectedly soft. Job creation slowed and the unemployment rate increased by two tenths of a percentage point to 4.3 percent, the highest since October 2021. There was speculation that weather-related issues might have distorted these results and, in fact, the unemployment rate ticked down in this morning's release. But, overall, the August report along with other recent labor data tend to confirm that there has been a continued moderation in the labor market. The ups and downs in the data over time highlight what I consider the right approach to meeting the FOMC's dual mandate goals-I believe we should be data dependent, but not overreact to any data point, including the latest data. When we faced a period of banking instability in the spring of 2023, there were calls from some to stop rate hikes despite inflation still running over 5 percent. But there were other tools in hand to deal with that stress, monetary policy did not overreact, and the FOMC continued tightening policy. When inflation fell unexpectedly in the second half of last year, we did not overreact and immediately cut the policy rate. Then when inflation accelerated in the first quarter, we did not overreact and raise rates despite some calls to do so. I will be looking at these last two employment reports in combination with all other data as we head into the September FOMC meeting to decide the best stance of policy. I believe our patience over the past 18 months has served us well. But the current batch of data no longer requires patience, it requires action. Today's jobs report continues the longer-term pattern of a softening of the labor market that is consistent with moderate growth in economic activity, the details of which I will get into in a moment. As I said at the outset, considering the progress we have made on getting inflation back to target, I believe that the balance of risks is now weighted more toward downside risks to the FOMC's maximum-employment mandate. While the labor market has clearly cooled, based on the evidence I see, I do not believe the economy is in a recession or necessarily headed for one soon. The collective set of economic data indicates to me that the labor market and the economy are performing in a solid manner and the prospects for continued growth and job creation are good, with inflation near 2 percent. I continue to believe that this can occur without substantial harm to the labor market. But I also believe that maintaining the economy's forward momentum means that, as Chair Powell said recently, the time has come to begin reducing the target range for the federal funds rate. In the rest of my remarks, I will lay out my reasons for believing that the economy and employment will likely keep growing as inflation moves toward 2 percent. The first of these is the large body of evidence that economic activity is continuing to grow at a solid pace. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of this year and recent data indicates that growth is continuing at around this pace in the third quarter. Retail sales were stronger than expected in July and showed that households continue to spend as their finances, in the aggregate, remain healthy. The increase was fairly broad based across goods categories. While many online retailers offered discounts last month, this was not a dominant factor in the solid results. Although manufacturing output fell in July and the August Institute for Supply Management manufacturing survey pointed to weak production and new orders, the similar survey for the larger, nonmanufacturing sector was consistent with a modest expansion of activity. As for the labor market, on balance, the data that we have received in the past three days indicates to me that the labor market is continuing to soften but not deteriorate, and this judgement is important to our upcoming decision on monetary policy. As I said earlier, Wednesday's report on job openings in July was consistent with a moderating labor market. Meanwhile, the four-week moving average of initial claims for unemployment insurance has risen gradually since January but has changed little on net in the past two months, with initial claims remaining fairly low. The jobs report for August, released this morning, supported the story of ongoing moderation in the labor market. After rising to 4.3 percent in July, the unemployment rate ticked down to 4.2 percent in August. Taking a longer perspective, the unemployment rate over the past 16 months has increased gradually but fairly steadily from 3.4 percent to 4.2 percent in today's release. Payrolls rose by 142,000 in August compared with 89,000 in July, leaving the three-month average payroll gain at 116,000, compared with the 267,000 average in the first quarter and 147,000 in the second. Accounting for revisions to the jobs numbers that we received in August, that level is a bit below what I see as the breakeven pace for job creation that absorbs new entrants to the workforce and keeps the unemployment rate constant.2 July marked the first time that the three-month average unemployment rate has increased by at least a half of a percentage point above its 12-month low, which was 3.6 percent in July 2023. This breached a threshold established by the Sahm rule, which observes that when this has occurred in the past, it has been a reliable indicator of the economy entering a recession. While this is a correlation that certainly bears attention, I want to make a few cautionary points about relying on such rules in deciding that a recession has begun. As we have seen in the recent past with other supposedly reliable recession rules, such as an inverted yield curve, there is more to forecasting economic outcomes than the relationships between a couple of variables. First, these rules are nothing more than a mechanical, statistical description of past economic outcomes-they do not seek to explain what economic forces drive the relationship between the data, nor are they based on the totality of economic data. All recessions rules do is pick up a correlation between movements in economic data and the dates of recessions or other outcomes. A second point is that, setting aside the unusual circumstances of the 1981-82 recession, recessions occur when a major 3 shock hits the economy. In the absence of a big negative shock, an inversion of the yield curve or a triggering of the Sahm rule doesn't necessarily mean we are entering a recession. Third, recession rules typically pick up demand-driven recessions. But this is not why unemployment is rising now. GDP forecasts for the current quarter all show solid growth, labor market data show lay off rates are stable, and consumer spending is growing at a healthy rate. These data suggest demand is fairly strong. Instead, most of the increase in the unemployment rate is from workers entering the labor force and not finding jobs right away. So, the recent rise in the unemployment rate appears to be more of a supply-side-driven phenomenon, not demand driven. And lastly, it should be clear to everyone that many pre-pandemic economic relationships have not proven to be good policy guides post-pandemic. Reliance on old lessons from inverted yield curves to predict a recession, a Phillips curve to predict inflation, or a flat Beveridge curve to predict the movement in the unemployment rate have all led to mistaken economic forecasts. While I don't see the recent data pointing to a recession, I do see some downside risk to employment that I will be watching closely. But at this point, I believe there is substantial evidence that the economy retains the strength and momentum to keep growing, supported by an appropriate loosening of monetary policy. Let me now turn to the outlook for inflation. With the labor market cooling, it doesn't surprise me that wage growth has slowed to a pace consistent with the FOMC's pricestability goal, and this is supporting ongoing progress toward that objective. The employment cost index grew at an annualized rate of 3.5 percent from March to June, and the 12-month change was 3.9 percent for private sector workers, the lowest since late 2021. three4 Average hourly earnings, reported in today's jobs report, rose at a month annualized pace of 3.8 percent in August, the same as the 12-month change. Inflation in July continued to show progress toward the FOMC's goal. The price index for personal consumption expenditures (PCE), the Committee's preferred inflation measure, increased at a monthly pace of 0.2 percent in July for both total and core PCE inflation. Core PCE inflation, which excludes volatile food and energy prices, is a good guide to underlying inflation, and it increased 2.7 percent over the past 12 months. Given the downward trajectory of monthly readings, I also look at the 6- and 3-month annualized rate. These stand at 2.6 percent and 1.7 percent, respectively. These numbers are good news and suggest that our restrictive policy stance has put us on the right path to attain our 2 percent inflation target. Looking across the components of inflation, one can see the breadth of the disinflation. Over 50 percent of categories in the total and core market baskets had annualized monthly inflation less than 2.5 percent in August. In fact, the index of core goods prices has reverted to its historical pattern of slight deflation, reflecting normalized supply after the disruptions of the pandemic as well as ongoing technological and productivity advances. Meanwhile, services price inflation has slowed as wage growth has slowed, since labor is a large input for much of the service sector. Overall, I see significant and ongoing progress toward the FOMC's inflation goal that I expect will continue over the remainder of this year. Now let me discuss the implications of this outlook for monetary policy. As I said at the outset, considering the achieved and continuing progress on inflation and moderation in the labor market, I believe the time has come to lower the target range for the federal funds rate at our upcoming meeting. Reducing the policy rate now is consistent with many versions of the Taylor rule, which suggest reducing the policy rate is appropriate given the data in hand. Furthermore, I do not expect this first cut to be the last. With inflation and employment near our longer-run goals and the labor market moderating, it is likely that a series of reductions will be appropriate. I believe there is sufficient room to cut the policy rate and still remain somewhat restrictive to ensure inflation continues on the path to our 2 percent target. Determining the appropriate pace at which to reduce policy restrictiveness will be challenging. Choosing a slower pace of rate cuts gives time to gradually assess whether the neutral rate has in fact risen, but at the risk of moving too slowly and putting the labor market at risk. Cutting the policy rate at a faster pace means a greater likelihood of achieving a soft landing but at the risk of overshooting on rate cuts if the neutral rate has in fact risen above its pre-pandemic level. This would cause an undesired loosening of monetary policy. Determining the pace of rate cuts and ultimately the total reduction in the policy rate are decisions that lie in the future. As of today, I believe it is important to start the rate cutting process at our next meeting. If subsequent data show a significant deterioration in the labor market, the FOMC can act quickly and forcefully to adjust monetary policy. I am open-minded about the size and pace of cuts, which will be based on what the data tell us about the evolution of the economy, and not on any pre-conceived notion of how and when the Committee should act. If the data supports cuts at consecutive meetings, then I believe it will be appropriate to cut at consecutive meetings. If the data suggests the need for larger cuts, then I will support that as well. I was a big advocate of front- loading rate hikes when inflation accelerated in 2022, and I will be an advocate of frontloading rate cuts if that is appropriate. Those decisions will be determined by new data and how it adds to the totality of the data and shapes my understanding of economic conditions. While I expect that these cuts will be done carefully as the economy and employment continue to grow, in the context of stable inflation, I stand ready to act promptly to support the economy as needed. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 The preliminary estimate of the annual benchmark revision to the establishment survey data, which was announced on August 21, suggests that payroll growth between April 2023 and March 2024 will likely be revised down early next year by about 68,000 per month on average. The implications for payroll growth beyond March are less clear. 3 The 1981-82 recession was triggered by tight monetary policy in an effort to fight mounting inflation. For more information about this recession, see Federal Reserve History . 4 The employment cost index is a valuable measure of compensation growth because it covers non-wage benefits and accounts for shifts in the shares of workers in different occupations and industries.	---[PAGE_BREAK]--- # Christopher J Waller: The time has come Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the University of Notre Dame, Notre Dame, Indiana, 6 September 2024. Thank you, Eric, and thank you for the opportunity to speak to you today. ${ }^{1}$ My topic is the outlook for the U.S. economy and the implications for monetary policy, a set of judgements that have, of course, been influenced by this morning's jobs report. When I scheduled this speech several months ago, I knew it might be challenging to speak a few hours after the release of such an important piece of data. But we like to say that monetary policy must be nimble, so that means policymakers must be nimble also. Not Simone Biles nimble, but nimble. As you will hear, I believe the data we have received this week reinforces the view that there has been continued moderation in the labor market. In light of the considerable and ongoing progress toward the Federal Open Market Committee's 2 percent inflation goal, I believe that the balance of risks has shifted toward the employment side of our dual mandate, and that monetary policy needs to adjust accordingly. Looking back at the economic data over the first six months of 2024, it portrayed an economy slowly cooling and not showing signs of significant weakening. The labor market had been gradually moderating for the past year or so, and although inflation rose in the first quarter, it then retreated in the second, and there was a widespread view heading into the second half of the year that the FOMC was on track to achieve a much desired but unusual "soft landing." Then the July jobs report came in unexpectedly soft. Job creation slowed and the unemployment rate increased by two tenths of a percentage point to 4.3 percent, the highest since October 2021. There was speculation that weather-related issues might have distorted these results and, in fact, the unemployment rate ticked down in this morning's release. But, overall, the August report along with other recent labor data tend to confirm that there has been a continued moderation in the labor market. The ups and downs in the data over time highlight what I consider the right approach to meeting the FOMC's dual mandate goals-I believe we should be data dependent, but not overreact to any data point, including the latest data. When we faced a period of banking instability in the spring of 2023, there were calls from some to stop rate hikes despite inflation still running over 5 percent. But there were other tools in hand to deal with that stress, monetary policy did not overreact, and the FOMC continued tightening policy. When inflation fell unexpectedly in the second half of last year, we did not overreact and immediately cut the policy rate. Then when inflation accelerated in the first quarter, we did not overreact and raise rates despite some calls to do so. I will be looking at these last two employment reports in combination with all other data as we head into the September FOMC meeting to decide the best stance of policy. I believe our patience over the past 18 months has served us well. But the current batch of data no longer requires patience, it requires action. ---[PAGE_BREAK]--- Today's jobs report continues the longer-term pattern of a softening of the labor market that is consistent with moderate growth in economic activity, the details of which I will get into in a moment. As I said at the outset, considering the progress we have made on getting inflation back to target, I believe that the balance of risks is now weighted more toward downside risks to the FOMC's maximum-employment mandate. While the labor market has clearly cooled, based on the evidence I see, I do not believe the economy is in a recession or necessarily headed for one soon. The collective set of economic data indicates to me that the labor market and the economy are performing in a solid manner and the prospects for continued growth and job creation are good, with inflation near 2 percent. I continue to believe that this can occur without substantial harm to the labor market. But I also believe that maintaining the economy's forward momentum means that, as Chair Powell said recently, the time has come to begin reducing the target range for the federal funds rate. In the rest of my remarks, I will lay out my reasons for believing that the economy and employment will likely keep growing as inflation moves toward 2 percent. The first of these is the large body of evidence that economic activity is continuing to grow at a solid pace. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of this year and recent data indicates that growth is continuing at around this pace in the third quarter. Retail sales were stronger than expected in July and showed that households continue to spend as their finances, in the aggregate, remain healthy. The increase was fairly broad based across goods categories. While many online retailers offered discounts last month, this was not a dominant factor in the solid results. Although manufacturing output fell in July and the August Institute for Supply Management manufacturing survey pointed to weak production and new orders, the similar survey for the larger, nonmanufacturing sector was consistent with a modest expansion of activity. As for the labor market, on balance, the data that we have received in the past three days indicates to me that the labor market is continuing to soften but not deteriorate, and this judgement is important to our upcoming decision on monetary policy. As I said earlier, Wednesday's report on job openings in July was consistent with a moderating labor market. Meanwhile, the four-week moving average of initial claims for unemployment insurance has risen gradually since January but has changed little on net in the past two months, with initial claims remaining fairly low. The jobs report for August, released this morning, supported the story of ongoing moderation in the labor market. After rising to 4.3 percent in July, the unemployment rate ticked down to 4.2 percent in August. Taking a longer perspective, the unemployment rate over the past 16 months has increased gradually but fairly steadily from 3.4 percent to 4.2 percent in today's release. Payrolls rose by 142,000 in August compared with 89,000 in July, leaving the three-month average payroll gain at 116,000, compared with the 267,000 average in the first quarter and 147,000 in the second. Accounting for revisions to the jobs numbers that we received in August, that level is a bit below what I see as the breakeven pace for job creation that absorbs new entrants to the workforce and keeps the unemployment rate constant. ${ }^{2}$ ---[PAGE_BREAK]--- July marked the first time that the three-month average unemployment rate has increased by at least a half of a percentage point above its 12-month low, which was 3.6 percent in July 2023. This breached a threshold established by the Sahm rule, which observes that when this has occurred in the past, it has been a reliable indicator of the economy entering a recession. While this is a correlation that certainly bears attention, I want to make a few cautionary points about relying on such rules in deciding that a recession has begun. As we have seen in the recent past with other supposedly reliable recession rules, such as an inverted yield curve, there is more to forecasting economic outcomes than the relationships between a couple of variables. First, these rules are nothing more than a mechanical, statistical description of past economic outcomes-they do not seek to explain what economic forces drive the relationship between the data, nor are they based on the totality of economic data. All recessions rules do is pick up a correlation between movements in economic data and the dates of recessions or other outcomes. A second point is that, setting aside the unusual circumstances of the 1981-82 recession, recessions occur when a major shock hits the economy. $\underline{3}$ In the absence of a big negative shock, an inversion of the yield curve or a triggering of the Sahm rule doesn't necessarily mean we are entering a recession. Third, recession rules typically pick up demand-driven recessions. But this is not why unemployment is rising now. GDP forecasts for the current quarter all show solid growth, labor market data show lay off rates are stable, and consumer spending is growing at a healthy rate. These data suggest demand is fairly strong. Instead, most of the increase in the unemployment rate is from workers entering the labor force and not finding jobs right away. So, the recent rise in the unemployment rate appears to be more of a supply-side-driven phenomenon, not demand driven. And lastly, it should be clear to everyone that many pre-pandemic economic relationships have not proven to be good policy guides post-pandemic. Reliance on old lessons from inverted yield curves to predict a recession, a Phillips curve to predict inflation, or a flat Beveridge curve to predict the movement in the unemployment rate have all led to mistaken economic forecasts. While I don't see the recent data pointing to a recession, I do see some downside risk to employment that I will be watching closely. But at this point, I believe there is substantial evidence that the economy retains the strength and momentum to keep growing, supported by an appropriate loosening of monetary policy. Let me now turn to the outlook for inflation. With the labor market cooling, it doesn't surprise me that wage growth has slowed to a pace consistent with the FOMC's pricestability goal, and this is supporting ongoing progress toward that objective. The employment cost index grew at an annualized rate of 3.5 percent from March to June, and the 12-month change was 3.9 percent for private sector workers, the lowest since late 2021. ${ }^{4}$ Average hourly earnings, reported in today's jobs report, rose at a threemonth annualized pace of 3.8 percent in August, the same as the 12-month change. ---[PAGE_BREAK]--- Inflation in July continued to show progress toward the FOMC's goal. The price index for personal consumption expenditures (PCE), the Committee's preferred inflation measure, increased at a monthly pace of 0.2 percent in July for both total and core PCE inflation. Core PCE inflation, which excludes volatile food and energy prices, is a good guide to underlying inflation, and it increased 2.7 percent over the past 12 months. Given the downward trajectory of monthly readings, I also look at the 6- and 3-month annualized rate. These stand at 2.6 percent and 1.7 percent, respectively. These numbers are good news and suggest that our restrictive policy stance has put us on the right path to attain our 2 percent inflation target. Looking across the components of inflation, one can see the breadth of the disinflation. Over 50 percent of categories in the total and core market baskets had annualized monthly inflation less than 2.5 percent in August. In fact, the index of core goods prices has reverted to its historical pattern of slight deflation, reflecting normalized supply after the disruptions of the pandemic as well as ongoing technological and productivity advances. Meanwhile, services price inflation has slowed as wage growth has slowed, since labor is a large input for much of the service sector. Overall, I see significant and ongoing progress toward the FOMC's inflation goal that I expect will continue over the remainder of this year. Now let me discuss the implications of this outlook for monetary policy. As I said at the outset, considering the achieved and continuing progress on inflation and moderation in the labor market, I believe the time has come to lower the target range for the federal funds rate at our upcoming meeting. Reducing the policy rate now is consistent with many versions of the Taylor rule, which suggest reducing the policy rate is appropriate given the data in hand. Furthermore, I do not expect this first cut to be the last. With inflation and employment near our longer-run goals and the labor market moderating, it is likely that a series of reductions will be appropriate. I believe there is sufficient room to cut the policy rate and still remain somewhat restrictive to ensure inflation continues on the path to our 2 percent target. Determining the appropriate pace at which to reduce policy restrictiveness will be challenging. Choosing a slower pace of rate cuts gives time to gradually assess whether the neutral rate has in fact risen, but at the risk of moving too slowly and putting the labor market at risk. Cutting the policy rate at a faster pace means a greater likelihood of achieving a soft landing but at the risk of overshooting on rate cuts if the neutral rate has in fact risen above its pre-pandemic level. This would cause an undesired loosening of monetary policy. Determining the pace of rate cuts and ultimately the total reduction in the policy rate are decisions that lie in the future. As of today, I believe it is important to start the rate cutting process at our next meeting. If subsequent data show a significant deterioration in the labor market, the FOMC can act quickly and forcefully to adjust monetary policy. I am open-minded about the size and pace of cuts, which will be based on what the data tell us about the evolution of the economy, and not on any pre-conceived notion of how and when the Committee should act. If the data supports cuts at consecutive meetings, then I believe it will be appropriate to cut at consecutive meetings. If the data suggests the need for larger cuts, then I will support that as well. I was a big advocate of front- ---[PAGE_BREAK]--- loading rate hikes when inflation accelerated in 2022, and I will be an advocate of frontloading rate cuts if that is appropriate. Those decisions will be determined by new data and how it adds to the totality of the data and shapes my understanding of economic conditions. While I expect that these cuts will be done carefully as the economy and employment continue to grow, in the context of stable inflation, I stand ready to act promptly to support the economy as needed. ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. $\underline{2}$ The preliminary estimate of the annual benchmark revision to the establishment survey data, which was announced on August 21, suggests that payroll growth between April 2023 and March 2024 will likely be revised down early next year by about 68,000 per month on average. The implications for payroll growth beyond March are less clear. $\underline{3}$ The 1981-82 recession was triggered by tight monetary policy in an effort to fight mounting inflation. For more information about this recession, see Federal Reserve History. ${ }^{4}$ The employment cost index is a valuable measure of compensation growth because it covers non-wage benefits and accounts for shifts in the shares of workers in different occupations and industries.	Christopher J Waller	United States	https://www.bis.org/review/r240909a.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the University of Notre Dame, Notre Dame, Indiana, 6 September 2024. Thank you, Eric, and thank you for the opportunity to speak to you today. My topic is the outlook for the U.S. economy and the implications for monetary policy, a set of judgements that have, of course, been influenced by this morning's jobs report. When I scheduled this speech several months ago, I knew it might be challenging to speak a few hours after the release of such an important piece of data. But we like to say that monetary policy must be nimble, so that means policymakers must be nimble also. Not Simone Biles nimble, but nimble. As you will hear, I believe the data we have received this week reinforces the view that there has been continued moderation in the labor market. In light of the considerable and ongoing progress toward the Federal Open Market Committee's 2 percent inflation goal, I believe that the balance of risks has shifted toward the employment side of our dual mandate, and that monetary policy needs to adjust accordingly. Looking back at the economic data over the first six months of 2024, it portrayed an economy slowly cooling and not showing signs of significant weakening. The labor market had been gradually moderating for the past year or so, and although inflation rose in the first quarter, it then retreated in the second, and there was a widespread view heading into the second half of the year that the FOMC was on track to achieve a much desired but unusual "soft landing." Then the July jobs report came in unexpectedly soft. Job creation slowed and the unemployment rate increased by two tenths of a percentage point to 4.3 percent, the highest since October 2021. There was speculation that weather-related issues might have distorted these results and, in fact, the unemployment rate ticked down in this morning's release. But, overall, the August report along with other recent labor data tend to confirm that there has been a continued moderation in the labor market. The ups and downs in the data over time highlight what I consider the right approach to meeting the FOMC's dual mandate goals-I believe we should be data dependent, but not overreact to any data point, including the latest data. When we faced a period of banking instability in the spring of 2023, there were calls from some to stop rate hikes despite inflation still running over 5 percent. But there were other tools in hand to deal with that stress, monetary policy did not overreact, and the FOMC continued tightening policy. When inflation fell unexpectedly in the second half of last year, we did not overreact and immediately cut the policy rate. Then when inflation accelerated in the first quarter, we did not overreact and raise rates despite some calls to do so. I will be looking at these last two employment reports in combination with all other data as we head into the September FOMC meeting to decide the best stance of policy. I believe our patience over the past 18 months has served us well. But the current batch of data no longer requires patience, it requires action. Today's jobs report continues the longer-term pattern of a softening of the labor market that is consistent with moderate growth in economic activity, the details of which I will get into in a moment. As I said at the outset, considering the progress we have made on getting inflation back to target, I believe that the balance of risks is now weighted more toward downside risks to the FOMC's maximum-employment mandate. While the labor market has clearly cooled, based on the evidence I see, I do not believe the economy is in a recession or necessarily headed for one soon. The collective set of economic data indicates to me that the labor market and the economy are performing in a solid manner and the prospects for continued growth and job creation are good, with inflation near 2 percent. I continue to believe that this can occur without substantial harm to the labor market. But I also believe that maintaining the economy's forward momentum means that, as Chair Powell said recently, the time has come to begin reducing the target range for the federal funds rate. In the rest of my remarks, I will lay out my reasons for believing that the economy and employment will likely keep growing as inflation moves toward 2 percent. The first of these is the large body of evidence that economic activity is continuing to grow at a solid pace. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of this year and recent data indicates that growth is continuing at around this pace in the third quarter. Retail sales were stronger than expected in July and showed that households continue to spend as their finances, in the aggregate, remain healthy. The increase was fairly broad based across goods categories. While many online retailers offered discounts last month, this was not a dominant factor in the solid results. Although manufacturing output fell in July and the August Institute for Supply Management manufacturing survey pointed to weak production and new orders, the similar survey for the larger, nonmanufacturing sector was consistent with a modest expansion of activity. As for the labor market, on balance, the data that we have received in the past three days indicates to me that the labor market is continuing to soften but not deteriorate, and this judgement is important to our upcoming decision on monetary policy. As I said earlier, Wednesday's report on job openings in July was consistent with a moderating labor market. Meanwhile, the four-week moving average of initial claims for unemployment insurance has risen gradually since January but has changed little on net in the past two months, with initial claims remaining fairly low. The jobs report for August, released this morning, supported the story of ongoing moderation in the labor market. After rising to 4.3 percent in July, the unemployment rate ticked down to 4.2 percent in August. Taking a longer perspective, the unemployment rate over the past 16 months has increased gradually but fairly steadily from 3.4 percent to 4.2 percent in today's release. Payrolls rose by 142,000 in August compared with 89,000 in July, leaving the three-month average payroll gain at 116,000, compared with the 267,000 average in the first quarter and 147,000 in the second. Accounting for revisions to the jobs numbers that we received in August, that level is a bit below what I see as the breakeven pace for job creation that absorbs new entrants to the workforce and keeps the unemployment rate constant. July marked the first time that the three-month average unemployment rate has increased by at least a half of a percentage point above its 12-month low, which was 3.6 percent in July 2023. This breached a threshold established by the Sahm rule, which observes that when this has occurred in the past, it has been a reliable indicator of the economy entering a recession. While this is a correlation that certainly bears attention, I want to make a few cautionary points about relying on such rules in deciding that a recession has begun. As we have seen in the recent past with other supposedly reliable recession rules, such as an inverted yield curve, there is more to forecasting economic outcomes than the relationships between a couple of variables. First, these rules are nothing more than a mechanical, statistical description of past economic outcomes-they do not seek to explain what economic forces drive the relationship between the data, nor are they based on the totality of economic data. All recessions rules do is pick up a correlation between movements in economic data and the dates of recessions or other outcomes. A second point is that, setting aside the unusual circumstances of the 1981-82 recession, recessions occur when a major shock hits the economy. In the absence of a big negative shock, an inversion of the yield curve or a triggering of the Sahm rule doesn't necessarily mean we are entering a recession. Third, recession rules typically pick up demand-driven recessions. But this is not why unemployment is rising now. GDP forecasts for the current quarter all show solid growth, labor market data show lay off rates are stable, and consumer spending is growing at a healthy rate. These data suggest demand is fairly strong. Instead, most of the increase in the unemployment rate is from workers entering the labor force and not finding jobs right away. So, the recent rise in the unemployment rate appears to be more of a supply-side-driven phenomenon, not demand driven. And lastly, it should be clear to everyone that many pre-pandemic economic relationships have not proven to be good policy guides post-pandemic. Reliance on old lessons from inverted yield curves to predict a recession, a Phillips curve to predict inflation, or a flat Beveridge curve to predict the movement in the unemployment rate have all led to mistaken economic forecasts. While I don't see the recent data pointing to a recession, I do see some downside risk to employment that I will be watching closely. But at this point, I believe there is substantial evidence that the economy retains the strength and momentum to keep growing, supported by an appropriate loosening of monetary policy. Let me now turn to the outlook for inflation. With the labor market cooling, it doesn't surprise me that wage growth has slowed to a pace consistent with the FOMC's pricestability goal, and this is supporting ongoing progress toward that objective. The employment cost index grew at an annualized rate of 3.5 percent from March to June, and the 12-month change was 3.9 percent for private sector workers, the lowest since late 2021. Average hourly earnings, reported in today's jobs report, rose at a threemonth annualized pace of 3.8 percent in August, the same as the 12-month change. Inflation in July continued to show progress toward the FOMC's goal. The price index for personal consumption expenditures (PCE), the Committee's preferred inflation measure, increased at a monthly pace of 0.2 percent in July for both total and core PCE inflation. Core PCE inflation, which excludes volatile food and energy prices, is a good guide to underlying inflation, and it increased 2.7 percent over the past 12 months. Given the downward trajectory of monthly readings, I also look at the 6- and 3-month annualized rate. These stand at 2.6 percent and 1.7 percent, respectively. These numbers are good news and suggest that our restrictive policy stance has put us on the right path to attain our 2 percent inflation target. Looking across the components of inflation, one can see the breadth of the disinflation. Over 50 percent of categories in the total and core market baskets had annualized monthly inflation less than 2.5 percent in August. In fact, the index of core goods prices has reverted to its historical pattern of slight deflation, reflecting normalized supply after the disruptions of the pandemic as well as ongoing technological and productivity advances. Meanwhile, services price inflation has slowed as wage growth has slowed, since labor is a large input for much of the service sector. Overall, I see significant and ongoing progress toward the FOMC's inflation goal that I expect will continue over the remainder of this year. Now let me discuss the implications of this outlook for monetary policy. As I said at the outset, considering the achieved and continuing progress on inflation and moderation in the labor market, I believe the time has come to lower the target range for the federal funds rate at our upcoming meeting. Reducing the policy rate now is consistent with many versions of the Taylor rule, which suggest reducing the policy rate is appropriate given the data in hand. Furthermore, I do not expect this first cut to be the last. With inflation and employment near our longer-run goals and the labor market moderating, it is likely that a series of reductions will be appropriate. I believe there is sufficient room to cut the policy rate and still remain somewhat restrictive to ensure inflation continues on the path to our 2 percent target. Determining the appropriate pace at which to reduce policy restrictiveness will be challenging. Choosing a slower pace of rate cuts gives time to gradually assess whether the neutral rate has in fact risen, but at the risk of moving too slowly and putting the labor market at risk. Cutting the policy rate at a faster pace means a greater likelihood of achieving a soft landing but at the risk of overshooting on rate cuts if the neutral rate has in fact risen above its pre-pandemic level. This would cause an undesired loosening of monetary policy. Determining the pace of rate cuts and ultimately the total reduction in the policy rate are decisions that lie in the future. As of today, I believe it is important to start the rate cutting process at our next meeting. If subsequent data show a significant deterioration in the labor market, the FOMC can act quickly and forcefully to adjust monetary policy. I am open-minded about the size and pace of cuts, which will be based on what the data tell us about the evolution of the economy, and not on any pre-conceived notion of how and when the Committee should act. If the data supports cuts at consecutive meetings, then I believe it will be appropriate to cut at consecutive meetings. If the data suggests the need for larger cuts, then I will support that as well. I was a big advocate of front- loading rate hikes when inflation accelerated in 2022, and I will be an advocate of frontloading rate cuts if that is appropriate. Those decisions will be determined by new data and how it adds to the totality of the data and shapes my understanding of economic conditions. While I expect that these cuts will be done carefully as the economy and employment continue to grow, in the context of stable inflation, I stand ready to act promptly to support the economy as needed.
2024-09-10T00:00:00	Michelle W Bowman: The future of stress testing and the stress capital buffer framework	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Executive Council of the Banking Law Section of the Federal Bar Association, Washington DC, 10 September 2024.	For release on delivery 12:15 p.m. EDT September 10, 2024 The Future of Stress Testing and the Stress Capital Buffer Framework Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Executive Council of the Banking Law Section of the Federal Bar Association Washington, D.C. September 10, 2024 Thank you for the invitation to join you.1 Given the recent conclusion of the Board's stress test, it seems timely to share my thoughts on the stress testing program. In the past, I have noted reservations about the stress testing process, so today I'd like to discuss in greater detail the benefits, challenges, and issues I would like to see resolved as the stress testing program evolves in the future.2 Earlier this summer, the Board announced the results of the supervisory stress tests. At a high level, all 31 banks subject to the test remained above their minimum common equity tier one (CET1) capital requirements from the hypothetical recession scenario.3 Under this scenario, banks would have absorbed projected hypothetical losses of nearly $685 billion, and would have experienced an aggregate CET1 capital decline of 2.8 percent.4 The hypothetical scenario included a 40 percent decline in commercial real estate prices, a substantial increase in office vacancies, a 36 percent decline in house prices, a spike in unemployment to a peak of 10 percent, and related declines in economic output.5 This year also saw the introduction of "exploratory" stress scenarios, which included two different funding stress scenarios, and for a subset of banks, 1 These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 Michelle W. Bowman, "Large Bank Supervision and Regulation" (remarks at the Institute of International Finance, Washington, D.C., September 30, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220930a.pdf; and Statement by Governor Michelle W. Bowman on the Basel III Endgame Proposal (July 27, 2023) https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230727.htm, ("Today's proposal is intended to improve risk capture, but in some circumstances, leaves in place and even introduces new regulatory redundancies, as with changes to the market risk capital rule, credit valuation adjustments, and operational risk that overlap with stress testing requirements and the stress capital buffer"). 3 Board of Governors of the Federal Reserve System, "Federal Reserve Board Annual Bank Stress Test Showed That While Large Banks Would Endure Greater Losses Than Last Year's Test, They Are Well Positioned to Weather a Severe Recession and Stay Above Minimum Capital Requirements," news release, June 26, 2024, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20240626a.htm. 4 Id. 5 Id. - 2 - included two trading book loss scenarios.6 The Board's press release announcing the results reported that large banks are well positioned to weather a severe recession and remain above minimum capital requirements.7 More recently, the Fed announced the final individual capital requirements for all large banks, effective on October 1, 2024.8 The firm-specific capital requirements are "informed by" the stress test results, and include a 4.5 percent minimum capital requirement, a stress capital buffer that is set at a minimum of 2.5 percent, and if applicable, a capital surcharge for the most complex banks that is based on each firm's systemic risk.9 The announcement of this year's results also noted the modification of the stress capital buffer for a single firm based on a reconsideration request. While firms subject to the stress test have long had the ability to request reconsideration-and many have done so in the past-this was notable as it was the first time that a reconsideration request was successful in producing a change to a firm's stress capital buffer. As we conclude this most recent cycle of stress testing-and as many firms begin to turn to the next round-I think it is helpful to pause and consider whether and how the process could be improved. My remarks today will address the value of stress testing on bank safety and soundness and on financial stability, my concerns about the current implementation of the stress test, and finally what I see as a potential path forward. I hope this discussion leads to a broader - 3 - consideration of stress testing, its role in the current prudential framework as a supervisory tool, and as a mechanism to set large bank capital standards through the stress capital buffer. The Value of Stress Testing Let me start by emphasizing that my remarks today should not be interpreted as a wholesale criticism of the stress testing process and framework. I firmly believe that stress testing is and will remain a valuable mechanism that provides insights that can inform supervision and can inform the public about how the largest and most complex banks would fare under a severe stress scenario. This exercise helps us gauge a bank's capital position and determine whether it has sufficient capital to absorb losses and continue lending during an economic stress event. In practice, stress testing provides a very granular assessment of a firm's risk, one that is more refined and risk-sensitive than capital standards alone. It relies on detailed balance sheet information-fixed at a particular date in the past-to do a deeper analysis of the firm's financial condition at that point in time. By subjecting this balance sheet to a hypothetical shock, we develop a better sense of not only the firm's risk, but also the firm's capacity to respond and adapt to changing economic conditions. This type of analysis would be impractical to conduct on a continuous basis, but it is a useful periodic supplement to ongoing capital requirements and can be used to support more robust supervisory practices. The Need for Reform While there are many virtues of stress testing, as currently implemented and executed there are several significant drawbacks. These drawbacks arguably make the process less fair, transparent, and useful than it could and should be. - 4 - I have long supported and argued in favor of fairness and transparency in the bank regulatory framework.10 The rules and supervisory practices that comprise this framework should be consistent among firms, and consistent over time. Banks should have a clear understanding of these rules to allow them to make informed business decisions that consider the impact of the regulatory framework. But we also know that the diversity and variability of bank business models can present a challenge to the clarity of the framework. Clarity is needed both to promote equitable treatment among banks with different business models, and to create rules that are fair over time. This allows firms to anticipate regulatory expectations as their business activities and balance sheets evolve in response to, among other things, changing economic conditions. Each bank is unique, and one need look no further than the balance sheets, business activities, and risk profiles of large banks to observe this variability. But the onus is on regulators to ensure that over time, regulations and supervisory practices are applied fairly and consistently, and that evolution in the framework is accompanied by appropriate transparency for regulated entities. The challenge of creating rules that are fair and transparent is nowhere more notable than in stress testing. Stress testing serves an important role in our regulatory framework, but one that requires evolution to ensure relevancy and effectiveness. To date, the evolution of stress testing has focused on refining the tests to be more robust over time and to provide more granular risk - 5 - information about these banks. While these incremental improvements have been helpful, the task of addressing identified problems is equally important. To be clear, these problems extend beyond model accuracy and consistency across firms. While by no means a comprehensive list, I would like to address four of my concerns in particular: (1) volatility in firm results from year to year, (2) the challenge of linking stress testing outcomes with capital through the stress capital buffer, (3) the broad lack of transparency, and (4) the overlap with other capital requirements like the overlap between the global market shock in stress testing and the market risk rule under the Basel III endgame proposal. Volatility One area of particular concern is the year-over-year volatility in stress testing results. Many of the stress test design features are intended to promote consistency across firms-the exercise uses a common scenario design, and subjects similarly situated firms to stress testing at the same frequency. This format allows for comparisons across firms and can provide important supervisory insights as regulators can look across firms to find common risk factors that could affect multiple firms-and lead to more significant and widespread economic impacts-in a stress event. But we have seen that stress test results for several firms vary considerably from year to year based on the interaction of the specific scenario being tested with a firm's business model, changes to the model, and each firm's balance sheet. This variability then flows through to the stress capital buffers that apply to the largest firms.11 - 6 - Some variability is to be expected as the risk factors and balance sheet composition of the tested firms both change over time. However, the test results observed year over year often produce results that are not predictable in advance-for example, some of the volatility we see is not based on fundamental changes to a tested bank's business model. The link between stress testing and capital also creates a practical timing issue for firms. The time frame for compliance with stress capital buffers compounds the issue of excessive year- over-year volatility. While many capital requirements give firms a runway to comply and adjust capital planning projections going forward, stress capital buffers allow a very brief window of time for firms to comply.12 As a real-time example, this year's preliminary stress capital buffer requirements were announced in late June, with required compliance by October 1st. This concern is experienced differently across firms-for example, some firms can likely predict that they will be subject to the stress capital buffer "floor," which perhaps can help with longer-term capital planning. But for those firms whose stress capital buffers exceed the floor, this short turnaround can pose significant planning challenges. Although banks historically have not been required to raise capital to meet higher stress capital buffer results, volatility is not a nonissue. As a matter of practice, banks maintain management buffers-additional capital in excess of capital and regulatory buffer requirements-to ensure that they operate at levels significantly above the "well-capitalized" threshold. Unexpectedly steep increases in stress capital buffers may force firms to recalibrate or reconsider their management buffer, perhaps operating at a higher level than would otherwise be necessary to account for known volatility in stress capital buffers over time. - 7 - This variability is not without cost. Firms engage in capital planning over a long-term planning horizon. Significant variability can disrupt these practices and require firms to hold more capital and higher capital management buffers than prudent business practices would indicate. The link between stress testing and capital-the stress capital buffer As currently implemented, the stress test exercise presents a single hypothetical shock to a firm's balance sheet, with the goal of better understanding firm performance and risks in the face of this stress. But the test is not intended to be-nor is it in practice-predictive of an actual stress event that the firm would experience. During the banking stress of 2023, the key risk factor was rapidly rising interest rates, and yet this type of economic stressor was not included in any past iteration of the test design. Why do we select one scenario and use that hypothetical to establish binding capital requirements for many firms regardless of their business model? What incentives does this system create as regulators design scenarios? Unquestionably, stress testing can provide valuable insights to inform supervision. Testing multiple stress scenarios could provide additional information that could be used to probe the unique risks and resilience of particular firms. And it could provide regulators and the public with a clearer understanding of financial stability risks across firms under different plausible future states of the world. But a more robust use of stress testing would require rationalizing the link between stress testing and capital to ensure that any change in overall calibration was driven by an intentional process that results in a reasonable policy outcome. As a practical matter, testing additional scenarios raises the question of what consequences should flow from a multi-scenario testing - 8 - regime. Would such an approach require across-the-board capital increases, as regulators calibrate stress capital buffers based on the most severe outcome of any tested scenario for each firm? Or should regulators pick a common scenario to calibrate stress capital buffers for all firms, even in a multi-scenario stress testing regime? Or should regulators take a different approach and sever the link between stress testing and capital requirements? The link between stress testing and capital raises important policy questions about the optimal level of capital, but ultimately should not dissuade us from using stress testing to better understand firm-specific and broader financial stability risks. At the same time, we need to pay careful attention to the design of all capital requirements-including not just the stress capital buffer, but also other risk-based capital requirements, leverage requirements, and long-term debt requirements-to ensure that the overall calibration of these requirements is proportionate to risk. In my view, an up-calibration of capital requirements through an expanded scenario-testing regime would not be supportable based on the underlying risks. Transparency One persistent issue with the stress tests is the lack of public transparency around the models. This opacity frustrates bank capital management and allocation. When a bank engages in an activity or prices a product or service, as a sound business practice, they must anticipate the financial consequences and the accompanying risks. Before making any decisions, a bank will often try to project the anticipated costs and revenues. In addition, the bank will want to evaluate the projected growth of the business or activity over time, determine whether the activity complements other existing products and services, and decide whether there will be sufficient customer demand to justify the cost based on the contemplated pricing levels and margins. One - 9 - important consideration in this exercise is the cost of capital. Banks often quantify the cost of capital and "allocate" those costs across various business lines. The capital requirements and supervisory risk assessment of activities are important inputs for bank decision-making. Banks benefit when they understand the regulatory perception of their activities. That feedback is often a critical part of the supervisory process. A regulatory perspective is embedded in stress testing, through the common parameters, assumptions, and conditions that will be used in the exercises. But much of this work remains hidden from public scrutiny and from the financial institutions subject to the stress tests. Providing access to this information-making clear the regulatory perspective-by improving the transparency of the process would enable banks to better manage their business and make more informed decisions. Of course, greater disclosure is not without its detractors. A common criticism of increased transparency is that disclosing the more granular parameters of particular calculations would lead to "gaming" of the test by large banks seeking to optimize their capital. The underlying premise of this concern seems to be that the stress tests are and must be static over time, and that if firms make changes to their activities that have no economic consequences-but instead are used only for "gaming" purposes to reduce stress losses-that regulators are limited in making further changes. I think this misinterprets the dynamism and review that should complement the stress testing process. Greater disclosure and transparency should be accompanied by a careful review of how firms incorporate and use any additional information, and to the extent that gaming activity is identified, further changes to the test design may be appropriate. Another criticism is that by disclosing test results, all firms-including in their internal stress testing practices-will "converge" on a common standard and that this standard will in some way increase risk. For example, if firms' stress testing practices are uniform, but include some flawed assumption or parameter, this could create a systemic weakness. Put differently, the model "monoculture" caused by greater transparency could miss important systemic risks. We should ask whether more granular disclosures would override the informed risk assessments of banks in managing their business-would all firms simply adopt whatever the regulators are doing in the supervisory stress test, undermining the utility of other practices like internal stress tests? However, we should not think about stress testing in isolation-supervision informed by stress testing, and ongoing improvements to supervisory stress testing can operate as a backstop to address risks that may accompany more transparency. I am concerned about changes that could undermine the utility of both regulatory and internal stress testing at large firms. Regulators should not seek to take risk-management decisions away from banks. But greater transparency, debate, and discussion of test parameters need not lead to a dilution of standards. These discussions could actually promote a cycle of continuous improvement and feedback. We have seen over time that the regulatory stress tests are not static. As regulators learn more, they adjust and adapt different elements of the exercise in light of lessons learned from the process. The issues of transparency around the stress tests extend beyond just disclosure. The reconsideration process itself could be improved by developing a more transparent process and clearer standards against which reconsideration requests will be evaluated. While this year saw a positive development with the Board for the first time changing a firm's stress capital buffer requirement in response to a request for reconsideration, the high failure rate of such requests over time shows the need for rethinking and revisiting the process. Overlap with other capital requirements Finally, as I have noted in the past, we must ensure that each element of the capital framework operates in a complementary and not contradictory way, and that requirements are calibrated proportionate to risks. Failing to appropriately calibrate capital and risk requirements creates risks-incentivizing banks to curtail activities that are assigned a punitive capital treatment and devoting more resources to activities that are assigned an inappropriately low capital risk weighting. Over time, these dynamics can have real-world market and economic consequences, resulting in negative outcomes for customers and economic activity. When we view capital requirements in their totality, one potential overlap can be found in the proposed changes to the market risk capital rules and operational risk rules with the "global market shock" and operational risk elements of the supervisory stress testing framework. We need to ensure that the risks captured and methodologies underpinning these distinct requirements do not lead to an over-calibration of capital requirements for activities that support the important role of U.S. capital markets in the global economy. The Path Forward As we look ahead to the future of stress testing, I think we need to carefully consider how the current framework can be improved. These issues-volatility, the link between stress testing results and capital and the short capital implementation compliance time frame, the lack of transparency, and the overlap between the global market shock in stress testing with the market risk test of Basel III-can all be addressed and should be prioritized in the ongoing evolution of the stress testing framework and stress capital buffer requirements. It is important that regulators consider the lessons learned from past tests and feedback from banks and other members of the public to ensure that stress testing is fair, transparent, and more useful going forward. First, we need to address the excessive year-over-year volatility, which flows through to the calculation of stress capital buffers. As I noted, capital planning for many firms is a long- term enterprise, and excessive volatility and unpredictability of stress capital buffer levels can increase costs and complicate capital allocation and management. Of course, the goal is not to eliminate variability over time-variability based on changing economic conditions and changing firm business activities and balance sheets-but rather to blunt the excessive volatility observed over the history of stress testing. There are many possible ways to limit excessive volatility while maintaining the value of the Board's stress tests. For example, one solution could be to average results over multiple years, so a firm's stress capital buffer would move in smaller increments through the averaging process. Another possibility is to constrain variability in annual stress test scenario design. Countercyclicality in the design of the regulatory stress tests-where the stress experienced by firms is more severe when economic conditions are better-acts as a counterweight to the inherent procyclicality of risk models. This approach "eases" capital requirements (through lower stress capital buffers) as economic conditions decline. But this countercyclicality is also a driver of volatility, and we should look more closely as to whether our attempts to adjust for countercyclicality are appropriate through the lens of stress test volatility. Second, I think there is a benefit to promoting greater transparency in stress testing, particularly as it relates to the disclosure of the underlying models. Stress testing need not be an exercise shrouded in secrecy, and the Federal Reserve has shown in the past that improvements are possible. For example, in 2019, the Board adopted new principles that guide the design of the stress tests, and promoted greater transparency.13 In addition to these principles, the Board moved to provide more information about its stress testing models, including ranges of loss rates for actual loans held, portfolios of hypothetical loans with loss rates estimated by the Board's models, and more detailed descriptions of the Board's models (including some granular information about certain equations and variables used in the models).14 While these were positive steps in promoting transparency, the announcement of design principles and enhanced disclosures did not go far enough in my view, and we have seen that even after several years, firms continue to struggle to understand and anticipate the results of supervisory stress tests and the accompanying stress capital buffer requirements. The simple solution here seems to be disclosure of more granular information about all of the models used in stress testing. In my view, disclosure of these models-and even subjecting the models to appropriate notice and comment processes and public feedback-would not undermine the goal of the stress tests of having a regulator-created model that is separate and distinct from the internal models used by firms. Regulators would still control the contours and content of the models but would have the benefit of public feedback. If we believe in the validity and reasonableness of our model design choices, we should not shy away from public feedback. Third, we should adjust the compliance framework for stress capital buffers. Firms should not be forced to comply with higher capital requirements after only a few months' notice but should have a reasonable time frame for compliance. I would note that a longer compliance runway is particularly important in a world in which testing is opaque and volatility continues to be excessive. To the extent that these more fundamental issues are addressed, this may mitigate the need for a shorter compliance window. Finally, as we move forward with Basel III implementation, we need to take a careful look at whether market risk and operational risk requirements are overlapping and redundant with the "global market shock" and operational risk elements of stress testing and think about the calibration of these requirements in the aggregate. Would these tests in tandem produce excessively calibrated capital requirements, and if so, what would the impact be on U.S. capital markets? In my view, there are strong indications that as currently formulated, the combination of these requirements would result in an excessive calibration of risk-weighted assets for market making and trading activities. And of course, we must think broadly about the optimal level of capital in the banking system, taking into account the full range of risk-based and leverage capital requirements and long-term debt requirements. There are many possible ways to move forward with stress testing, and the proposals I have offered above are merely a subset of possible changes that could improve the process and address many of the known deficiencies. But I believe there is a growing awareness of the need for a fundamental rethink and strategic reform of stress testing, and any such process must acknowledge and address these known issues within the framework.15 Closing Thoughts Thank you again for the invitation to join you today. The stress test is an important supervisory tool, and I think it is imperative that we work to continually improve it. I have laid out a number of my concerns about the current practice, and some potential areas to explore in terms of improvement. But I also think it is imperative to listen to a wide range of stakeholders about the path forward.	---[PAGE_BREAK]--- For release on delivery 12:15 p.m. EDT September 10, 2024 The Future of Stress Testing and the Stress Capital Buffer Framework Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Executive Council of the Banking Law Section of the Federal Bar Association Washington, D.C. September 10, 2024 ---[PAGE_BREAK]--- Thank you for the invitation to join you. ${ }^{1}$ Given the recent conclusion of the Board's stress test, it seems timely to share my thoughts on the stress testing program. In the past, I have noted reservations about the stress testing process, so today I'd like to discuss in greater detail the benefits, challenges, and issues I would like to see resolved as the stress testing program evolves in the future. ${ }^{2}$ Earlier this summer, the Board announced the results of the supervisory stress tests. At a high level, all 31 banks subject to the test remained above their minimum common equity tier one (CET1) capital requirements from the hypothetical recession scenario. ${ }^{3}$ Under this scenario, banks would have absorbed projected hypothetical losses of nearly $\$ 685$ billion, and would have experienced an aggregate CET1 capital decline of 2.8 percent. ${ }^{4}$ The hypothetical scenario included a 40 percent decline in commercial real estate prices, a substantial increase in office vacancies, a 36 percent decline in house prices, a spike in unemployment to a peak of 10 percent, and related declines in economic output. ${ }^{5}$ This year also saw the introduction of "exploratory" stress scenarios, which included two different funding stress scenarios, and for a subset of banks, [^0] [^0]: ${ }^{1}$ These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ Michelle W. Bowman, "Large Bank Supervision and Regulation" (remarks at the Institute of International Finance, Washington, D.C., September 30, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220930a.pdf; and Statement by Governor Michelle W. Bowman on the Basel III Endgame Proposal (July 27, 2023) https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230727.htm, ("Today's proposal is intended to improve risk capture, but in some circumstances, leaves in place and even introduces new regulatory redundancies, as with changes to the market risk capital rule, credit valuation adjustments, and operational risk that overlap with stress testing requirements and the stress capital buffer"). ${ }^{3}$ Board of Governors of the Federal Reserve System, "Federal Reserve Board Annual Bank Stress Test Showed That While Large Banks Would Endure Greater Losses Than Last Year's Test, They Are Well Positioned to Weather a Severe Recession and Stay Above Minimum Capital Requirements," news release, June 26, 2024, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20240626a.htm. ${ }^{4}$ Id. ${ }^{5} \mathrm{Id}$. ---[PAGE_BREAK]--- included two trading book loss scenarios. ${ }^{6}$ The Board's press release announcing the results reported that large banks are well positioned to weather a severe recession and remain above minimum capital requirements. ${ }^{7}$ More recently, the Fed announced the final individual capital requirements for all large banks, effective on October 1, 2024. ${ }^{8}$ The firm-specific capital requirements are "informed by" the stress test results, and include a 4.5 percent minimum capital requirement, a stress capital buffer that is set at a minimum of 2.5 percent, and if applicable, a capital surcharge for the most complex banks that is based on each firm's systemic risk. ${ }^{9}$ The announcement of this year's results also noted the modification of the stress capital buffer for a single firm based on a reconsideration request. While firms subject to the stress test have long had the ability to request reconsideration-and many have done so in the past-this was notable as it was the first time that a reconsideration request was successful in producing a change to a firm's stress capital buffer. As we conclude this most recent cycle of stress testing-and as many firms begin to turn to the next round-I think it is helpful to pause and consider whether and how the process could be improved. My remarks today will address the value of stress testing on bank safety and soundness and on financial stability, my concerns about the current implementation of the stress test, and finally what I see as a potential path forward. I hope this discussion leads to a broader [^0] [^0]: ${ }^{6}$ Id. ${ }^{7}$ Id. ${ }^{8}$ Board of Governors of the Federal Reserve System, "Federal Reserve Board Announces Final Individual Capital Requirements for All Large Banks, Effective on October 1," news release, August 28, 2024, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20240828a.htm. ${ }^{9}$ Id. ---[PAGE_BREAK]--- consideration of stress testing, its role in the current prudential framework as a supervisory tool, and as a mechanism to set large bank capital standards through the stress capital buffer. # The Value of Stress Testing Let me start by emphasizing that my remarks today should not be interpreted as a wholesale criticism of the stress testing process and framework. I firmly believe that stress testing is and will remain a valuable mechanism that provides insights that can inform supervision and can inform the public about how the largest and most complex banks would fare under a severe stress scenario. This exercise helps us gauge a bank's capital position and determine whether it has sufficient capital to absorb losses and continue lending during an economic stress event. In practice, stress testing provides a very granular assessment of a firm's risk, one that is more refined and risk-sensitive than capital standards alone. It relies on detailed balance sheet information—fixed at a particular date in the past-to do a deeper analysis of the firm's financial condition at that point in time. By subjecting this balance sheet to a hypothetical shock, we develop a better sense of not only the firm's risk, but also the firm's capacity to respond and adapt to changing economic conditions. This type of analysis would be impractical to conduct on a continuous basis, but it is a useful periodic supplement to ongoing capital requirements and can be used to support more robust supervisory practices. ## The Need for Reform While there are many virtues of stress testing, as currently implemented and executed there are several significant drawbacks. These drawbacks arguably make the process less fair, transparent, and useful than it could and should be. ---[PAGE_BREAK]--- I have long supported and argued in favor of fairness and transparency in the bank regulatory framework. ${ }^{10}$ The rules and supervisory practices that comprise this framework should be consistent among firms, and consistent over time. Banks should have a clear understanding of these rules to allow them to make informed business decisions that consider the impact of the regulatory framework. But we also know that the diversity and variability of bank business models can present a challenge to the clarity of the framework. Clarity is needed both to promote equitable treatment among banks with different business models, and to create rules that are fair over time. This allows firms to anticipate regulatory expectations as their business activities and balance sheets evolve in response to, among other things, changing economic conditions. Each bank is unique, and one need look no further than the balance sheets, business activities, and risk profiles of large banks to observe this variability. But the onus is on regulators to ensure that over time, regulations and supervisory practices are applied fairly and consistently, and that evolution in the framework is accompanied by appropriate transparency for regulated entities. The challenge of creating rules that are fair and transparent is nowhere more notable than in stress testing. Stress testing serves an important role in our regulatory framework, but one that requires evolution to ensure relevancy and effectiveness. To date, the evolution of stress testing has focused on refining the tests to be more robust over time and to provide more granular risk [^0] [^0]: ${ }^{10}$ See, e.g., Michelle W. Bowman, "My Perspective on Bank Regulation and Supervision," (remarks to the American Bankers Association Community Banking Conference, February 16, 2021), https://www.federalreserve.gov/newsevents/speech/files/bowman20210216a.pdf; Michelle W. Bowman, "Large Bank Supervision and Regulation," (remarks at the Institute of International Finance, Washington, D.C., September 30, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220930a.pdf; and Michelle W. Bowman, "Independence, Predictability, and Tailoring in Banking Regulation and Supervision," (remarks to the American Bankers Association Community Banking Conference, Orlando, FL, February 13, 2023), https://www.federalreserve.gov/newsevents/speech/files/bowman20230213a.pdf. ---[PAGE_BREAK]--- information about these banks. While these incremental improvements have been helpful, the task of addressing identified problems is equally important. To be clear, these problems extend beyond model accuracy and consistency across firms. While by no means a comprehensive list, I would like to address four of my concerns in particular: (1) volatility in firm results from year to year, (2) the challenge of linking stress testing outcomes with capital through the stress capital buffer, (3) the broad lack of transparency, and (4) the overlap with other capital requirements like the overlap between the global market shock in stress testing and the market risk rule under the Basel III endgame proposal. # Volatility One area of particular concern is the year-over-year volatility in stress testing results. Many of the stress test design features are intended to promote consistency across firms-the exercise uses a common scenario design, and subjects similarly situated firms to stress testing at the same frequency. This format allows for comparisons across firms and can provide important supervisory insights as regulators can look across firms to find common risk factors that could affect multiple firms-and lead to more significant and widespread economic impacts-in a stress event. But we have seen that stress test results for several firms vary considerably from year to year based on the interaction of the specific scenario being tested with a firm's business model, changes to the model, and each firm's balance sheet. This variability then flows through to the stress capital buffers that apply to the largest firms. ${ }^{11}$ [^0] [^0]: ${ }^{11}$ From 2000-2024, six firms were subject to the stress capital buffer "floor" of 2.5 percent, while other firms above the floor have seen significantly greater volatility. While the operation of the stress capital buffer floor has reduced volatility for these six firms and several others that have been subject to the floor at some point in time, this set of firms also has been subject to a higher stress capital buffer charge than would have been indicated by the results of the stress test. More than half of all firms subject to the stress test from 2000-2005 have experienced a change in their applicable stress capital buffer of at least 1 percent over time. See Board of Governors of the Federal Reserve System, "Annual Large Bank Capital Requirements," https://www.federalreserve.gov/supervisionreg/large-bank-capital-requirements.htm. ---[PAGE_BREAK]--- Some variability is to be expected as the risk factors and balance sheet composition of the tested firms both change over time. However, the test results observed year over year often produce results that are not predictable in advance-for example, some of the volatility we see is not based on fundamental changes to a tested bank's business model. The link between stress testing and capital also creates a practical timing issue for firms. The time frame for compliance with stress capital buffers compounds the issue of excessive year-over-year volatility. While many capital requirements give firms a runway to comply and adjust capital planning projections going forward, stress capital buffers allow a very brief window of time for firms to comply. ${ }^{12}$ As a real-time example, this year's preliminary stress capital buffer requirements were announced in late June, with required compliance by October 1st. This concern is experienced differently across firms-for example, some firms can likely predict that they will be subject to the stress capital buffer "floor," which perhaps can help with longer-term capital planning. But for those firms whose stress capital buffers exceed the floor, this short turnaround can pose significant planning challenges. Although banks historically have not been required to raise capital to meet higher stress capital buffer results, volatility is not a nonissue. As a matter of practice, banks maintain management buffers-additional capital in excess of capital and regulatory buffer requirements-to ensure that they operate at levels significantly above the "well-capitalized" threshold. Unexpectedly steep increases in stress capital buffers may force firms to recalibrate or reconsider their management buffer, perhaps operating at a higher level than would otherwise be necessary to account for known volatility in stress capital buffers over time. [^0] [^0]: 12 See 12 CFR § 225.8(h)(4); 12 CFR § 238.170(h)(4). ---[PAGE_BREAK]--- This variability is not without cost. Firms engage in capital planning over a long-term planning horizon. Significant variability can disrupt these practices and require firms to hold more capital and higher capital management buffers than prudent business practices would indicate. # The link between stress testing and capital-the stress capital buffer As currently implemented, the stress test exercise presents a single hypothetical shock to a firm's balance sheet, with the goal of better understanding firm performance and risks in the face of this stress. But the test is not intended to be-nor is it in practice-predictive of an actual stress event that the firm would experience. During the banking stress of 2023, the key risk factor was rapidly rising interest rates, and yet this type of economic stressor was not included in any past iteration of the test design. Why do we select one scenario and use that hypothetical to establish binding capital requirements for many firms regardless of their business model? What incentives does this system create as regulators design scenarios? Unquestionably, stress testing can provide valuable insights to inform supervision. Testing multiple stress scenarios could provide additional information that could be used to probe the unique risks and resilience of particular firms. And it could provide regulators and the public with a clearer understanding of financial stability risks across firms under different plausible future states of the world. But a more robust use of stress testing would require rationalizing the link between stress testing and capital to ensure that any change in overall calibration was driven by an intentional process that results in a reasonable policy outcome. As a practical matter, testing additional scenarios raises the question of what consequences should flow from a multi-scenario testing ---[PAGE_BREAK]--- regime. Would such an approach require across-the-board capital increases, as regulators calibrate stress capital buffers based on the most severe outcome of any tested scenario for each firm? Or should regulators pick a common scenario to calibrate stress capital buffers for all firms, even in a multi-scenario stress testing regime? Or should regulators take a different approach and sever the link between stress testing and capital requirements? The link between stress testing and capital raises important policy questions about the optimal level of capital, but ultimately should not dissuade us from using stress testing to better understand firm-specific and broader financial stability risks. At the same time, we need to pay careful attention to the design of all capital requirements-including not just the stress capital buffer, but also other risk-based capital requirements, leverage requirements, and long-term debt requirements-to ensure that the overall calibration of these requirements is proportionate to risk. In my view, an up-calibration of capital requirements through an expanded scenario-testing regime would not be supportable based on the underlying risks. # Transparency One persistent issue with the stress tests is the lack of public transparency around the models. This opacity frustrates bank capital management and allocation. When a bank engages in an activity or prices a product or service, as a sound business practice, they must anticipate the financial consequences and the accompanying risks. Before making any decisions, a bank will often try to project the anticipated costs and revenues. In addition, the bank will want to evaluate the projected growth of the business or activity over time, determine whether the activity complements other existing products and services, and decide whether there will be sufficient customer demand to justify the cost based on the contemplated pricing levels and margins. One ---[PAGE_BREAK]--- important consideration in this exercise is the cost of capital. Banks often quantify the cost of capital and "allocate" those costs across various business lines. The capital requirements and supervisory risk assessment of activities are important inputs for bank decision-making. Banks benefit when they understand the regulatory perception of their activities. That feedback is often a critical part of the supervisory process. A regulatory perspective is embedded in stress testing, through the common parameters, assumptions, and conditions that will be used in the exercises. But much of this work remains hidden from public scrutiny and from the financial institutions subject to the stress tests. Providing access to this information-making clear the regulatory perspective-by improving the transparency of the process would enable banks to better manage their business and make more informed decisions. Of course, greater disclosure is not without its detractors. A common criticism of increased transparency is that disclosing the more granular parameters of particular calculations would lead to "gaming" of the test by large banks seeking to optimize their capital. The underlying premise of this concern seems to be that the stress tests are and must be static over time, and that if firms make changes to their activities that have no economic consequences-but instead are used only for "gaming" purposes to reduce stress losses-that regulators are limited in making further changes. I think this misinterprets the dynamism and review that should complement the stress testing process. Greater disclosure and transparency should be accompanied by a careful review of how firms incorporate and use any additional information, and to the extent that gaming activity is identified, further changes to the test design may be appropriate. Another criticism is that by disclosing test results, all firms-including in their internal stress testing practices-will "converge" on a common standard and that this standard will in ---[PAGE_BREAK]--- some way increase risk. For example, if firms' stress testing practices are uniform, but include some flawed assumption or parameter, this could create a systemic weakness. Put differently, the model "monoculture" caused by greater transparency could miss important systemic risks. We should ask whether more granular disclosures would override the informed risk assessments of banks in managing their business-would all firms simply adopt whatever the regulators are doing in the supervisory stress test, undermining the utility of other practices like internal stress tests? However, we should not think about stress testing in isolation-supervision informed by stress testing, and ongoing improvements to supervisory stress testing can operate as a backstop to address risks that may accompany more transparency. I am concerned about changes that could undermine the utility of both regulatory and internal stress testing at large firms. Regulators should not seek to take risk-management decisions away from banks. But greater transparency, debate, and discussion of test parameters need not lead to a dilution of standards. These discussions could actually promote a cycle of continuous improvement and feedback. We have seen over time that the regulatory stress tests are not static. As regulators learn more, they adjust and adapt different elements of the exercise in light of lessons learned from the process. The issues of transparency around the stress tests extend beyond just disclosure. The reconsideration process itself could be improved by developing a more transparent process and clearer standards against which reconsideration requests will be evaluated. While this year saw a positive development with the Board for the first time changing a firm's stress capital buffer requirement in response to a request for reconsideration, the high failure rate of such requests over time shows the need for rethinking and revisiting the process. ---[PAGE_BREAK]--- # Overlap with other capital requirements Finally, as I have noted in the past, we must ensure that each element of the capital framework operates in a complementary and not contradictory way, and that requirements are calibrated proportionate to risks. Failing to appropriately calibrate capital and risk requirements creates risks-incentivizing banks to curtail activities that are assigned a punitive capital treatment and devoting more resources to activities that are assigned an inappropriately low capital risk weighting. Over time, these dynamics can have real-world market and economic consequences, resulting in negative outcomes for customers and economic activity. When we view capital requirements in their totality, one potential overlap can be found in the proposed changes to the market risk capital rules and operational risk rules with the "global market shock" and operational risk elements of the supervisory stress testing framework. We need to ensure that the risks captured and methodologies underpinning these distinct requirements do not lead to an over-calibration of capital requirements for activities that support the important role of U.S. capital markets in the global economy. ## The Path Forward As we look ahead to the future of stress testing, I think we need to carefully consider how the current framework can be improved. These issues-volatility, the link between stress testing results and capital and the short capital implementation compliance time frame, the lack of transparency, and the overlap between the global market shock in stress testing with the market risk test of Basel III-can all be addressed and should be prioritized in the ongoing evolution of the stress testing framework and stress capital buffer requirements. It is important that regulators consider the lessons learned from past tests and feedback from banks and other members of the public to ensure that stress testing is fair, transparent, and more useful going forward. ---[PAGE_BREAK]--- First, we need to address the excessive year-over-year volatility, which flows through to the calculation of stress capital buffers. As I noted, capital planning for many firms is a longterm enterprise, and excessive volatility and unpredictability of stress capital buffer levels can increase costs and complicate capital allocation and management. Of course, the goal is not to eliminate variability over time-variability based on changing economic conditions and changing firm business activities and balance sheets-but rather to blunt the excessive volatility observed over the history of stress testing. There are many possible ways to limit excessive volatility while maintaining the value of the Board's stress tests. For example, one solution could be to average results over multiple years, so a firm's stress capital buffer would move in smaller increments through the averaging process. Another possibility is to constrain variability in annual stress test scenario design. Countercyclicality in the design of the regulatory stress tests-where the stress experienced by firms is more severe when economic conditions are better-acts as a counterweight to the inherent procyclicality of risk models. This approach "eases" capital requirements (through lower stress capital buffers) as economic conditions decline. But this countercyclicality is also a driver of volatility, and we should look more closely as to whether our attempts to adjust for countercyclicality are appropriate through the lens of stress test volatility. Second, I think there is a benefit to promoting greater transparency in stress testing, particularly as it relates to the disclosure of the underlying models. Stress testing need not be an exercise shrouded in secrecy, and the Federal Reserve has shown in the past that improvements are possible. For example, in 2019, the Board adopted new principles that guide the design of ---[PAGE_BREAK]--- the stress tests, and promoted greater transparency. ${ }^{13}$ In addition to these principles, the Board moved to provide more information about its stress testing models, including ranges of loss rates for actual loans held, portfolios of hypothetical loans with loss rates estimated by the Board's models, and more detailed descriptions of the Board's models (including some granular information about certain equations and variables used in the models). ${ }^{14}$ While these were positive steps in promoting transparency, the announcement of design principles and enhanced disclosures did not go far enough in my view, and we have seen that even after several years, firms continue to struggle to understand and anticipate the results of supervisory stress tests and the accompanying stress capital buffer requirements. The simple solution here seems to be disclosure of more granular information about all of the models used in stress testing. In my view, disclosure of these models-and even subjecting the models to appropriate notice and comment processes and public feedback-would not undermine the goal of the stress tests of having a regulator-created model that is separate and distinct from the internal models used by firms. Regulators would still control the contours and content of the models but would have the benefit of public feedback. If we believe in the validity and reasonableness of our model design choices, we should not shy away from public feedback. Third, we should adjust the compliance framework for stress capital buffers. Firms should not be forced to comply with higher capital requirements after only a few months' notice but should have a reasonable time frame for compliance. I would note that a longer compliance [^0] [^0]: 13 "Stress Testing Policy Statement," 84 Fed. Reg. 6664 (February 28, 2019), https://www.govinfo.gov/content/pkg/FR-2019-02-28/pdf/2019-03503.pdf. ${ }^{14}$ Board of Governors of the Federal Reserve System, "Federal Reserve Board Finalizes Set of Changes That Will Increase the Transparency of Its Stress Testing Program for Nation's Largest and Most Complex Banks," news release, February 5, 2019, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20190205a.htm. ---[PAGE_BREAK]--- runway is particularly important in a world in which testing is opaque and volatility continues to be excessive. To the extent that these more fundamental issues are addressed, this may mitigate the need for a shorter compliance window. Finally, as we move forward with Basel III implementation, we need to take a careful look at whether market risk and operational risk requirements are overlapping and redundant with the "global market shock" and operational risk elements of stress testing and think about the calibration of these requirements in the aggregate. Would these tests in tandem produce excessively calibrated capital requirements, and if so, what would the impact be on U.S. capital markets? In my view, there are strong indications that as currently formulated, the combination of these requirements would result in an excessive calibration of risk-weighted assets for market making and trading activities. And of course, we must think broadly about the optimal level of capital in the banking system, taking into account the full range of risk-based and leverage capital requirements and long-term debt requirements. There are many possible ways to move forward with stress testing, and the proposals I have offered above are merely a subset of possible changes that could improve the process and address many of the known deficiencies. But I believe there is a growing awareness of the need for a fundamental rethink and strategic reform of stress testing, and any such process must acknowledge and address these known issues within the framework. ${ }^{15}$ # Closing Thoughts Thank you again for the invitation to join you today. The stress test is an important supervisory tool, and I think it is imperative that we work to continually improve it. I have laid [^0] [^0]: ${ }^{15}$ See Daniel K. Tarullo, "Reconsidering the Regulatory Uses of Stress Testing," Hutchins Center Working Paper \#92 (May 2024), https://www.brookings.edu/wp-content/uploads/2024/05/WP92_Tarullo-stress-testing.pdf. ---[PAGE_BREAK]--- out a number of my concerns about the current practice, and some potential areas to explore in terms of improvement. But I also think it is imperative to listen to a wide range of stakeholders about the path forward.	Michelle W Bowman	United States	https://www.bis.org/review/r240911b.pdf	For release on delivery 12:15 p.m. EDT September 10, 2024 The Future of Stress Testing and the Stress Capital Buffer Framework Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at Executive Council of the Banking Law Section of the Federal Bar Association Washington, D.C. September 10, 2024 Thank you for the invitation to join you. Earlier this summer, the Board announced the results of the supervisory stress tests. At a high level, all 31 banks subject to the test remained above their minimum common equity tier one (CET1) capital requirements from the hypothetical recession scenario. This year also saw the introduction of "exploratory" stress scenarios, which included two different funding stress scenarios, and for a subset of banks, ${ }^{5} \mathrm{Id}$. included two trading book loss scenarios. More recently, the Fed announced the final individual capital requirements for all large banks, effective on October 1, 2024. The announcement of this year's results also noted the modification of the stress capital buffer for a single firm based on a reconsideration request. While firms subject to the stress test have long had the ability to request reconsideration-and many have done so in the past-this was notable as it was the first time that a reconsideration request was successful in producing a change to a firm's stress capital buffer. As we conclude this most recent cycle of stress testing-and as many firms begin to turn to the next round-I think it is helpful to pause and consider whether and how the process could be improved. My remarks today will address the value of stress testing on bank safety and soundness and on financial stability, my concerns about the current implementation of the stress test, and finally what I see as a potential path forward. I hope this discussion leads to a broader consideration of stress testing, its role in the current prudential framework as a supervisory tool, and as a mechanism to set large bank capital standards through the stress capital buffer. Let me start by emphasizing that my remarks today should not be interpreted as a wholesale criticism of the stress testing process and framework. I firmly believe that stress testing is and will remain a valuable mechanism that provides insights that can inform supervision and can inform the public about how the largest and most complex banks would fare under a severe stress scenario. This exercise helps us gauge a bank's capital position and determine whether it has sufficient capital to absorb losses and continue lending during an economic stress event. In practice, stress testing provides a very granular assessment of a firm's risk, one that is more refined and risk-sensitive than capital standards alone. It relies on detailed balance sheet information—fixed at a particular date in the past-to do a deeper analysis of the firm's financial condition at that point in time. By subjecting this balance sheet to a hypothetical shock, we develop a better sense of not only the firm's risk, but also the firm's capacity to respond and adapt to changing economic conditions. This type of analysis would be impractical to conduct on a continuous basis, but it is a useful periodic supplement to ongoing capital requirements and can be used to support more robust supervisory practices. While there are many virtues of stress testing, as currently implemented and executed there are several significant drawbacks. These drawbacks arguably make the process less fair, transparent, and useful than it could and should be. I have long supported and argued in favor of fairness and transparency in the bank regulatory framework. The rules and supervisory practices that comprise this framework should be consistent among firms, and consistent over time. Banks should have a clear understanding of these rules to allow them to make informed business decisions that consider the impact of the regulatory framework. But we also know that the diversity and variability of bank business models can present a challenge to the clarity of the framework. Clarity is needed both to promote equitable treatment among banks with different business models, and to create rules that are fair over time. This allows firms to anticipate regulatory expectations as their business activities and balance sheets evolve in response to, among other things, changing economic conditions. Each bank is unique, and one need look no further than the balance sheets, business activities, and risk profiles of large banks to observe this variability. But the onus is on regulators to ensure that over time, regulations and supervisory practices are applied fairly and consistently, and that evolution in the framework is accompanied by appropriate transparency for regulated entities. The challenge of creating rules that are fair and transparent is nowhere more notable than in stress testing. Stress testing serves an important role in our regulatory framework, but one that requires evolution to ensure relevancy and effectiveness. To date, the evolution of stress testing has focused on refining the tests to be more robust over time and to provide more granular risk information about these banks. While these incremental improvements have been helpful, the task of addressing identified problems is equally important. To be clear, these problems extend beyond model accuracy and consistency across firms. While by no means a comprehensive list, I would like to address four of my concerns in particular: (1) volatility in firm results from year to year, (2) the challenge of linking stress testing outcomes with capital through the stress capital buffer, (3) the broad lack of transparency, and (4) the overlap with other capital requirements like the overlap between the global market shock in stress testing and the market risk rule under the Basel III endgame proposal. One area of particular concern is the year-over-year volatility in stress testing results. Many of the stress test design features are intended to promote consistency across firms-the exercise uses a common scenario design, and subjects similarly situated firms to stress testing at the same frequency. This format allows for comparisons across firms and can provide important supervisory insights as regulators can look across firms to find common risk factors that could affect multiple firms-and lead to more significant and widespread economic impacts-in a stress event. But we have seen that stress test results for several firms vary considerably from year to year based on the interaction of the specific scenario being tested with a firm's business model, changes to the model, and each firm's balance sheet. This variability then flows through to the stress capital buffers that apply to the largest firms. Some variability is to be expected as the risk factors and balance sheet composition of the tested firms both change over time. However, the test results observed year over year often produce results that are not predictable in advance-for example, some of the volatility we see is not based on fundamental changes to a tested bank's business model. The link between stress testing and capital also creates a practical timing issue for firms. The time frame for compliance with stress capital buffers compounds the issue of excessive year-over-year volatility. While many capital requirements give firms a runway to comply and adjust capital planning projections going forward, stress capital buffers allow a very brief window of time for firms to comply. As a real-time example, this year's preliminary stress capital buffer requirements were announced in late June, with required compliance by October 1st. This concern is experienced differently across firms-for example, some firms can likely predict that they will be subject to the stress capital buffer "floor," which perhaps can help with longer-term capital planning. But for those firms whose stress capital buffers exceed the floor, this short turnaround can pose significant planning challenges. Although banks historically have not been required to raise capital to meet higher stress capital buffer results, volatility is not a nonissue. As a matter of practice, banks maintain management buffers-additional capital in excess of capital and regulatory buffer requirements-to ensure that they operate at levels significantly above the "well-capitalized" threshold. Unexpectedly steep increases in stress capital buffers may force firms to recalibrate or reconsider their management buffer, perhaps operating at a higher level than would otherwise be necessary to account for known volatility in stress capital buffers over time. This variability is not without cost. Firms engage in capital planning over a long-term planning horizon. Significant variability can disrupt these practices and require firms to hold more capital and higher capital management buffers than prudent business practices would indicate. As currently implemented, the stress test exercise presents a single hypothetical shock to a firm's balance sheet, with the goal of better understanding firm performance and risks in the face of this stress. But the test is not intended to be-nor is it in practice-predictive of an actual stress event that the firm would experience. During the banking stress of 2023, the key risk factor was rapidly rising interest rates, and yet this type of economic stressor was not included in any past iteration of the test design. Why do we select one scenario and use that hypothetical to establish binding capital requirements for many firms regardless of their business model? What incentives does this system create as regulators design scenarios? Unquestionably, stress testing can provide valuable insights to inform supervision. Testing multiple stress scenarios could provide additional information that could be used to probe the unique risks and resilience of particular firms. And it could provide regulators and the public with a clearer understanding of financial stability risks across firms under different plausible future states of the world. But a more robust use of stress testing would require rationalizing the link between stress testing and capital to ensure that any change in overall calibration was driven by an intentional process that results in a reasonable policy outcome. As a practical matter, testing additional scenarios raises the question of what consequences should flow from a multi-scenario testing regime. Would such an approach require across-the-board capital increases, as regulators calibrate stress capital buffers based on the most severe outcome of any tested scenario for each firm? Or should regulators pick a common scenario to calibrate stress capital buffers for all firms, even in a multi-scenario stress testing regime? Or should regulators take a different approach and sever the link between stress testing and capital requirements? The link between stress testing and capital raises important policy questions about the optimal level of capital, but ultimately should not dissuade us from using stress testing to better understand firm-specific and broader financial stability risks. At the same time, we need to pay careful attention to the design of all capital requirements-including not just the stress capital buffer, but also other risk-based capital requirements, leverage requirements, and long-term debt requirements-to ensure that the overall calibration of these requirements is proportionate to risk. In my view, an up-calibration of capital requirements through an expanded scenario-testing regime would not be supportable based on the underlying risks. One persistent issue with the stress tests is the lack of public transparency around the models. This opacity frustrates bank capital management and allocation. When a bank engages in an activity or prices a product or service, as a sound business practice, they must anticipate the financial consequences and the accompanying risks. Before making any decisions, a bank will often try to project the anticipated costs and revenues. In addition, the bank will want to evaluate the projected growth of the business or activity over time, determine whether the activity complements other existing products and services, and decide whether there will be sufficient customer demand to justify the cost based on the contemplated pricing levels and margins. One important consideration in this exercise is the cost of capital. Banks often quantify the cost of capital and "allocate" those costs across various business lines. The capital requirements and supervisory risk assessment of activities are important inputs for bank decision-making. Banks benefit when they understand the regulatory perception of their activities. That feedback is often a critical part of the supervisory process. A regulatory perspective is embedded in stress testing, through the common parameters, assumptions, and conditions that will be used in the exercises. But much of this work remains hidden from public scrutiny and from the financial institutions subject to the stress tests. Providing access to this information-making clear the regulatory perspective-by improving the transparency of the process would enable banks to better manage their business and make more informed decisions. Of course, greater disclosure is not without its detractors. A common criticism of increased transparency is that disclosing the more granular parameters of particular calculations would lead to "gaming" of the test by large banks seeking to optimize their capital. The underlying premise of this concern seems to be that the stress tests are and must be static over time, and that if firms make changes to their activities that have no economic consequences-but instead are used only for "gaming" purposes to reduce stress losses-that regulators are limited in making further changes. I think this misinterprets the dynamism and review that should complement the stress testing process. Greater disclosure and transparency should be accompanied by a careful review of how firms incorporate and use any additional information, and to the extent that gaming activity is identified, further changes to the test design may be appropriate. Another criticism is that by disclosing test results, all firms-including in their internal stress testing practices-will "converge" on a common standard and that this standard will in some way increase risk. For example, if firms' stress testing practices are uniform, but include some flawed assumption or parameter, this could create a systemic weakness. Put differently, the model "monoculture" caused by greater transparency could miss important systemic risks. We should ask whether more granular disclosures would override the informed risk assessments of banks in managing their business-would all firms simply adopt whatever the regulators are doing in the supervisory stress test, undermining the utility of other practices like internal stress tests? However, we should not think about stress testing in isolation-supervision informed by stress testing, and ongoing improvements to supervisory stress testing can operate as a backstop to address risks that may accompany more transparency. I am concerned about changes that could undermine the utility of both regulatory and internal stress testing at large firms. Regulators should not seek to take risk-management decisions away from banks. But greater transparency, debate, and discussion of test parameters need not lead to a dilution of standards. These discussions could actually promote a cycle of continuous improvement and feedback. We have seen over time that the regulatory stress tests are not static. As regulators learn more, they adjust and adapt different elements of the exercise in light of lessons learned from the process. The issues of transparency around the stress tests extend beyond just disclosure. The reconsideration process itself could be improved by developing a more transparent process and clearer standards against which reconsideration requests will be evaluated. While this year saw a positive development with the Board for the first time changing a firm's stress capital buffer requirement in response to a request for reconsideration, the high failure rate of such requests over time shows the need for rethinking and revisiting the process. Finally, as I have noted in the past, we must ensure that each element of the capital framework operates in a complementary and not contradictory way, and that requirements are calibrated proportionate to risks. Failing to appropriately calibrate capital and risk requirements creates risks-incentivizing banks to curtail activities that are assigned a punitive capital treatment and devoting more resources to activities that are assigned an inappropriately low capital risk weighting. Over time, these dynamics can have real-world market and economic consequences, resulting in negative outcomes for customers and economic activity. When we view capital requirements in their totality, one potential overlap can be found in the proposed changes to the market risk capital rules and operational risk rules with the "global market shock" and operational risk elements of the supervisory stress testing framework. We need to ensure that the risks captured and methodologies underpinning these distinct requirements do not lead to an over-calibration of capital requirements for activities that support the important role of U.S. capital markets in the global economy. As we look ahead to the future of stress testing, I think we need to carefully consider how the current framework can be improved. These issues-volatility, the link between stress testing results and capital and the short capital implementation compliance time frame, the lack of transparency, and the overlap between the global market shock in stress testing with the market risk test of Basel III-can all be addressed and should be prioritized in the ongoing evolution of the stress testing framework and stress capital buffer requirements. It is important that regulators consider the lessons learned from past tests and feedback from banks and other members of the public to ensure that stress testing is fair, transparent, and more useful going forward. First, we need to address the excessive year-over-year volatility, which flows through to the calculation of stress capital buffers. As I noted, capital planning for many firms is a longterm enterprise, and excessive volatility and unpredictability of stress capital buffer levels can increase costs and complicate capital allocation and management. Of course, the goal is not to eliminate variability over time-variability based on changing economic conditions and changing firm business activities and balance sheets-but rather to blunt the excessive volatility observed over the history of stress testing. There are many possible ways to limit excessive volatility while maintaining the value of the Board's stress tests. For example, one solution could be to average results over multiple years, so a firm's stress capital buffer would move in smaller increments through the averaging process. Another possibility is to constrain variability in annual stress test scenario design. Countercyclicality in the design of the regulatory stress tests-where the stress experienced by firms is more severe when economic conditions are better-acts as a counterweight to the inherent procyclicality of risk models. This approach "eases" capital requirements (through lower stress capital buffers) as economic conditions decline. But this countercyclicality is also a driver of volatility, and we should look more closely as to whether our attempts to adjust for countercyclicality are appropriate through the lens of stress test volatility. Second, I think there is a benefit to promoting greater transparency in stress testing, particularly as it relates to the disclosure of the underlying models. Stress testing need not be an exercise shrouded in secrecy, and the Federal Reserve has shown in the past that improvements are possible. For example, in 2019, the Board adopted new principles that guide the design of the stress tests, and promoted greater transparency. While these were positive steps in promoting transparency, the announcement of design principles and enhanced disclosures did not go far enough in my view, and we have seen that even after several years, firms continue to struggle to understand and anticipate the results of supervisory stress tests and the accompanying stress capital buffer requirements. The simple solution here seems to be disclosure of more granular information about all of the models used in stress testing. In my view, disclosure of these models-and even subjecting the models to appropriate notice and comment processes and public feedback-would not undermine the goal of the stress tests of having a regulator-created model that is separate and distinct from the internal models used by firms. Regulators would still control the contours and content of the models but would have the benefit of public feedback. If we believe in the validity and reasonableness of our model design choices, we should not shy away from public feedback. Third, we should adjust the compliance framework for stress capital buffers. Firms should not be forced to comply with higher capital requirements after only a few months' notice but should have a reasonable time frame for compliance. I would note that a longer compliance runway is particularly important in a world in which testing is opaque and volatility continues to be excessive. To the extent that these more fundamental issues are addressed, this may mitigate the need for a shorter compliance window. Finally, as we move forward with Basel III implementation, we need to take a careful look at whether market risk and operational risk requirements are overlapping and redundant with the "global market shock" and operational risk elements of stress testing and think about the calibration of these requirements in the aggregate. Would these tests in tandem produce excessively calibrated capital requirements, and if so, what would the impact be on U.S. capital markets? In my view, there are strong indications that as currently formulated, the combination of these requirements would result in an excessive calibration of risk-weighted assets for market making and trading activities. And of course, we must think broadly about the optimal level of capital in the banking system, taking into account the full range of risk-based and leverage capital requirements and long-term debt requirements. There are many possible ways to move forward with stress testing, and the proposals I have offered above are merely a subset of possible changes that could improve the process and address many of the known deficiencies. But I believe there is a growing awareness of the need for a fundamental rethink and strategic reform of stress testing, and any such process must acknowledge and address these known issues within the framework. Thank you again for the invitation to join you today. The stress test is an important supervisory tool, and I think it is imperative that we work to continually improve it. I have laid out a number of my concerns about the current practice, and some potential areas to explore in terms of improvement. But I also think it is imperative to listen to a wide range of stakeholders about the path forward.
2024-09-10T00:00:00	Michael S Barr: The next steps on capital	Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the Brookings Institution, Washington DC, 10 September 2024.	Michael S Barr: The next steps on capital Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the Brookings Institution, Washington DC, 10 September 2024. * * * 1 Thank you for inviting me to speak today. Since I joined the Federal Reserve Board as Vice Chair for Supervision, I have spoken many times about the importance of bank 2 capital to the safety and soundness of banks and the stability of the financial system. It is critical that banks have the capacity to continue lending to households and businesses through times of stress. Bank capital is a key component of this resilience. And bank capital rules help to ensure that banks are holding capital commensurate with the risks of their activities and the risks that they pose to the U.S. financial system. But capital has costs too. As compared to debt, capital is a more expensive source of 3 funding to the bank. Thus, higher capital requirements can raise the cost of funding to a bank, and the bank can pass higher costs on to households, businesses, and clients engaged in a range of financial activities. These activities are critical to a wellfunctioning economy that works for everyone. That's why it is important to get the balance between resiliency and efficiency right. Today, I'll return to these themes in the context of two rules of great public interest: The Basel III endgame proposal and the proposal to adjust the capital surcharge for global systemically important banks (G-SIB).4 The path forward A little over a year ago, the Board sought comment on those two proposed rules, which would modify risk-based capital requirements for large banks. We received a great number of comments on the provisions in the proposal, as well as on the justifications and analysis that underlie those provisions. Since that time, we have been hard at work analyzing the comments and the data we collected to evaluate the combined impact of these proposals. We have spoken with a wide range of stakeholders, including banks, academics, public interest groups, consumers, businesses, other regulators, Congress, and others. As you would expect in a project as technical and consequential as this one, I have had many productive meetings with Board colleagues and our fellow federal bank regulatory agencies, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). This process has led us to conclude that broad and material changes to the proposals are warranted. As I said, there are benefits and costs to increasing capital requirements. The changes we intend to make will bring these two important objectives into better balance, in light of the feedback we have received. The changes to the endgame proposal have been a joint effort with my counterparts at the FDIC and the OCC. I intend to recommend that the Board re-propose the Basel endgame and G-SIB surcharge rules. This will provide the public the opportunity to fully review a number of key broad and material changes to the original proposals and provide comment. We will accept public comments on any aspect of the Basel endgame and G-SIB surcharge proposals. The changes in the endgame re-proposal will cover all major areas of the rule: credit risk; operational risk; and market risk. Banks with assets between $100 and $250 billion would no longer be subject to the endgame changes, other than the requirement to 5 recognize unrealized gains and losses of their securities in regulatory capital. These changes reflect the feedback we have received from the public, improve the tiering of the proposal, and better reflect risks. I will also recommend changes to the G-SIB surcharge proposal to better align the capital surcharge for a G-SIB with its systemic risk profile. Taken together, the re-proposals would increase aggregate common equity tier 1 capital requirements for the G-SIBs, which are the largest and most complex banks, by 9 percent. For other large banks that are not G-SIBs, the impact from the re-proposal would mainly result from the inclusion of unrealized gain and losses on their securities in regulatory capital, estimated to be equivalent to a 3 to 4 percent increase in capital requirements over the long run. The remainder of the re-proposal would increase capital requirements for non-GSIB firms still subject to the rule by 0.5 percent. While these proposed changes affect some of the most important aspects of the proposals, the agencies have not made final decisions on any aspect of the reproposals, including those that are not explicitly addressed in the re-proposal. The public should not view any omission of a potential change in these re-proposals as an indication that the agencies will finalize a provision as proposed. We continue to consider comments already received on the 2023 proposal, and we will consider those comments together with any comments submitted on the re-proposals as part of any final rulemakings. This is an interim step. Let me reiterate that we are open to comments on any aspect of the proposals. Now, I will turn to the changes. Credit risk I will begin with an overview of the changes I will recommend to the capital requirements for credit risk, which protect against the risk that a bank's loans will not be fully repaid. These changes include reducing the risk-weights for residential real estate and retail exposures, extending the scope of the reduced risk weight for certain low-risk corporate debt, and eliminating the minimum haircut for securities financing transactions. First, I intend to recommend that the Board lower the proposed risk-weighting for loans secured by residential real estate and loans to retail customers. The original proposal introduced more risk-sensitive approaches for residential real estate and retail exposures, but calibrated them to be higher than the Basel standard to promote domestic competitive equity. The agencies received significant comments on the proposed calibrations. Some commenters argued that the elevated risk weights would overstate the risk for these loans given their loss history. Others argued that the risk weighting would affect home affordability and homeownership opportunities, particularly for first-time homebuyers, minority communities, and low- and moderate-income borrowers, and could reduce the availability and affordability of retail credit. I will recommend that we reduce the calibration for residential real estate exposures so that it is in line with the calibration developed in the Basel process. With this change, allin capital requirements, including for operational and credit risk, will be lower on average than they are currently for mortgages up to 90 percent loan-to-value ratio, and about the same as they are now for mortgages up to 100 percent loan-to-value. With respect to loans to retail customers, I intend to recommend that we adopt the Basel standard, with two exceptions - first, we would lower the capital requirements for credit card exposures where the borrower uses only a small portion of the commitment line, and second, we would lower the capital requirement for charge cards with no pre-set credit limits. The second proposed change related to credit risk would extend the reduced risk weight for low-risk corporate exposures to certain regulated entities that a bank judges to be investment grade and that are not publicly traded. The original proposal provided this preferential treatment only to investment-grade corporates that were publicly traded because the financial disclosure requirements for these entities facilitate market participants' assessments of their financial condition, which in turn provide additional information for banking organizations to use when assessing these entities' credit risk. There were many comments that the preferential treatment should be extended further, including to regulated entities that are also subject to substantial regulatory discipline and substantial transparency requirements. Consistent with our objective of increasing risk sensitivity in capital requirements, I plan to recommend to the Board that we extend the reduced corporate risk weight to regulated entities - including regulated financial institutions that are not banks, such as pension funds, certain mutual funds, and foreign equivalents - that are investment-grade but not publicly traded. Third, I intend to recommend that the Board not adopt the capital treatment associated with minimum haircut floors for securities financing transactions. The proposal included heightened capital requirements for repo-style transactions and eligible margin loans that did not meet minimum margin requirements. While consistent with the Basel standard, several other major jurisdictions have not adopted this approach. Not adopting the minimum haircut floors will allow time to seek greater international consensus on this important topic before deciding on whether and how to implement such an approach in the United States. Equity Exposures Let me speak to the treatment of tax credit equity financing exposures. I plan to recommend that we significantly lower the risk weight for tax credit equity funding structures, given the lower inherent risk in these structures compared to many other equity investments. The revised lower risk weight for these exposures of 100 percent would reflect this lower risk and be consistent with the approach we take for other tax credit investments, such as the low-income housing tax credits. Operational risk Next, let me speak about three changes I intend to recommend for the proposed capital treatment of operational risk, which is the risk of losses from inadequate or failed processes, such as from fraud or cyberattacks. First, I plan to recommend that we no longer adjust a firm's operational risk charge based on its operational loss history. This change will reduce fluctuations in a bank's operational risk capital requirements over time. Second, I plan to recommend to the Board that we calculate fee income on a net basis in calculating its contribution to the operational risk capital requirement. The original proposal would have measured the contribution of fee-based activities based on gross revenues, instead of net income, which is revenues minus expenses. Moving to net income for fee-based activities-specifically, by netting noninterest income and expenses (except for operational losses)-would produce more consistency in how operational risk is measured across bank activities, as interest and trading income and expenses are already measured on a net basis under the proposal. This change would also produce more consistent operational risk capital requirements across banks because the approach is less sensitive to the differences in accounting practices across banks. Third, I plan to recommend to the Board that we reduce operational risk capital requirements for investment management activities to reflect the smaller historical operational losses for these activities relative to income. The agencies received comments suggesting that some fee-based business lines have incurred meaningfully lower operational losses than other business lines. We have found evidence that investment management has historically experienced noticeably low operational losses relative to income produced. Market risk and derivatives Now, I'll speak to the capital treatment for a bank's trading activities and its derivatives activities. The endgame proposal included a number of important improvements relative to the current market risk capital framework, including to incorporate lessons learned from the 2007-09 financial crisis that have not been sufficiently addressed in the current framework. It would permit firms to use internal models to capture the complex dynamics of most market risks but would put certain constraints on banks' models and provide fallbacks in areas where modeling practices are not adequate. We received numerous comments on ways to improve this part of the proposal. I plan to recommend that we make changes to facilitate banks' ability to use internal models for market risk. For example, the re-proposal will introduce a multiyear implementation period for the profit and loss attribution tests that are used to confirm that models are working as intended. This extended transition period would allow banks to gain experience with the tests and provide time to improve their systems and processes and address any potential gaps in data and model performance. In addition, the re-proposal would contain a few additional adjustments to improve incentives for a firm to model its exposures. Moreover, we will clarify that uniform mortgage-backed securities positions would be treated as having a single obligor, regardless of whether they were issued by Freddie Mac or Fannie Mae. This change will enable firms to recognize hedging across these securities. With respect to derivatives activities, I plan to recommend that the Board adjust the capital treatment for client-cleared derivatives activities by reducing the capital required for the client-facing leg of a client-cleared derivative. This change would better reflect the risks of these transactions, which are highly collateralized and subject to netting and daily margin requirements. This also would avoid disincentives to client clearing, which I'll return to later. Tiering Let me turn to tiering. The largest, most complex firms should be subject to the most stringent requirements, in light of the costs that their potential failure would impose on the broader financial system and thus on businesses and households. Under the reproposal, G-SIBs and other internationally active banks would be subject to the most stringent set of requirements, including the new credit risk and operational risk requirements, and the revised frameworks for market risk and CVA frameworks. Capital requirements for large banks that are not G-SIBs can be simpler while still supporting resilience. I am recommending a number of changes to better reflect this principle. For firms with assets between $250 and $700 billion that are not G-SIBs or internationally active, the re-proposal would apply the new credit risk and operational risk requirements; however, it would apply the frameworks for market risk and CVA frameworks only to firms that engage in significant trading activity. Further, the reproposal would revert to the simpler definition of capital - the numerator in the capital ratio - for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of accumulated other comprehensive income (AOCI). The re-proposal would maintain this element to better reflect interest rate risk in capital, a problem that played a major role in last March's bank failures. For large banks with assets between $100 and $250 billion, the re-proposal would not apply the credit risk and operational risk frameworks of the expanded risk-based approach to these banking organizations, maintaining a simpler capital framework for these less complex firms. For these firms, the re-proposal would also revert to the simpler definition of capital for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of AOCI. G-SIB surcharge proposal As I noted, last July, we sought comment on proposed revisions to the G-SIB surcharge, to better reflect the systemic risk of each G-SIB. In particular, the proposal would make adjustments to limit "window dressing" by requiring banks to report indicators as average values instead of on a point-in-time basis. It would also reduce "cliff effects" by calculating a G-SIB's capital surcharge in 0.1 percent increments instead of 0.5 percent increments. And the proposal would adjust how we measure some systemic indicators to better align them with risk.6 The goal of the 2023 proposal was to improve the risk sensitivity of the G-SIB surcharge. Commenters provided helpful feedback regarding the proposal's potential impact on certain types of activities, such as client clearing of derivatives. We are still considering these comments, but let me speak to areas where I will recommend making changes to the original proposal. First, I'll speak to the treatment of cleared derivatives. The proposal would have increased the extent to which client-cleared derivatives contribute to a bank's G-SIB surcharge, to promote consistency of the measure. However, commenters argued that the measure might result in higher costs and more volatility for derivative end users and might reduce incentives to provide clients' access to central clearing. While it is important for our capital rules to be risk-sensitive, it is also important that we consider the impact of our rules in the broader market context. Central clearing of derivatives is a critical tool that can help improve transparency and reduce systemic risk. To avoid disincentives for client clearing, I intend to recommend to the Board that we not adopt the proposed changes to capital requirements associated with client clearing. Second, let me speak to changes in the surcharge proposal that I will recommend to keep the measures we use up-to-date. The U.S. G-SIB surcharge was set nearly nine years ago, and the growth in the economy since 2015 has meant that G-SIBs' measures of systemic risk have increased, even for firms whose share of domestic or global economic activity has not increased. The Board noted the potential for this effect in the original 2015 G-SIB rule. While it did not provide a mechanism to automatically adjust for economic growth at that time, the Board stated that it would periodically reevaluate the framework. As part of the G-SIB re-proposal, I intend to recommend that we improve the calculation of the capital surcharges for G-SIBs by reflecting changes in the global banking system since the Board adopted the G-SIB surcharge in 2015. In addition, for the future, I intend to recommend that we account for effects from inflation and economic growth in the measurement of a G-SIB's systemic risk profile. As a result, a G-SIB's surcharge would not change based simply on growth in the economy.7 Conclusion The journey to improve capital requirements since the Global Financial Crisis has been a long one, and Basel III endgame is an important element of this effort. These reproposals bring us closer to completing the task. The broad and material changes to both proposals that I've outlined today would better balance the benefits and costs of capital in light of comments received, and result in a capital framework that appropriately reflects the risks of bank activities and is tiered to the banking sector. They also bring the proposals broadly in line with what other major jurisdictions are doing. And what does this all mean? A safer and fairer banking system. My goal, throughout my nearly 30 years in this field, has always been to help ensure that the banking system can support households and businesses of all types, during good times and bad. In addition to the re-proposals outlined today, we are looking carefully at how our stress test complements the risk-based capital rules to help ensure our overall framework supports a resilient and effective banking sector. We are attentive to the interactions across all components of our capital framework as well as the combined burden and benefits, and we take these issues seriously. In all of our work, we will continue to seek an approach that helps to ensure financial system resiliency and supports the flow of credit to households and businesses. It is most imperative that we get this right. Thank you. 1 The views I express here are my own, and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee. 2 See Michael S. Barr, "Why Bank Capital Matters" (speech at the American Enterprise Institute, Washington, DC, December 1, 2022), and Michael S. Barr, "Holistic Capital Review (PDF)" (speech at the Bipartisan Policy Center, Washington, DC, July 10, 2023). 3 Under standard corporate finance theory, a firm should be indifferent between debt and equity, but in practice, as compared to debt, equity is a more expensive source of funding to a bank given the structure of our laws and markets, the presence of deposit insurance and other government support, and other factors. See, e.g., Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," The American Economic Review 48 (June 1958): 261-297, and Ron J. Feldman, Gary H. Stern, and Paul A. Volcker, Too Big to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press, 2009). 4 The G-SIB surcharge is an additional layer of capital just for the G-SIBs, and it is measured on several factors of each G-SIB, specific to their individual risks. 5 To the extent that such a firm has large trading operations, it would also be subject to the revised market risk framework. 6 With regard to the adjustments to address window dressing and cliff effects, these will have a one-time impact on banks that carefully manage their operations to lower surcharge buckets, but should improve the efficiency and risk-sensitivity of the measure over time. 7 The re-proposal would update the method 2 coefficients to reflect changes from 2015 until the present using a methodology that is consistent with the Board's original calibration in 2015. Specifically, the supplemental proposal would update the method 2 coefficients for each of the systemic indicators for the size, interconnectedness, complexity, and cross-jurisdictional activity categories from 2015 until the present using the most recent available two-year average of aggregate global indicator amounts and the corresponding three-year average of euro/U.S. dollar exchange rates. Going forward, it would also include a mechanism to annually adjust the method 2 coefficients for each of the systemic indicators for the size, interconnectedness, complexity, and cross-jurisdictional activity categories based on U.S. inflation and real economic growth. This mechanism would use a three-year moving average of annual nominal U.S. gross domestic product (GDP) growth to adjust these coefficients on an annual basis.	---[PAGE_BREAK]--- # Michael S Barr: The next steps on capital Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the Brookings Institution, Washington DC, 10 September 2024. Thank you for inviting me to speak today. 1 Since I joined the Federal Reserve Board as Vice Chair for Supervision, I have spoken many times about the importance of bank capital to the safety and soundness of banks and the stability of the financial system. ${ }^{2}$ It is critical that banks have the capacity to continue lending to households and businesses through times of stress. Bank capital is a key component of this resilience. And bank capital rules help to ensure that banks are holding capital commensurate with the risks of their activities and the risks that they pose to the U.S. financial system. But capital has costs too. As compared to debt, capital is a more expensive source of funding to the bank. ${ }^{3}$ Thus, higher capital requirements can raise the cost of funding to a bank, and the bank can pass higher costs on to households, businesses, and clients engaged in a range of financial activities. These activities are critical to a wellfunctioning economy that works for everyone. That's why it is important to get the balance between resiliency and efficiency right. Today, l'll return to these themes in the context of two rules of great public interest: The Basel III endgame proposal and the proposal to adjust the capital surcharge for global systemically important banks (G-SIB). 4 ## The path forward A little over a year ago, the Board sought comment on those two proposed rules, which would modify risk-based capital requirements for large banks. We received a great number of comments on the provisions in the proposal, as well as on the justifications and analysis that underlie those provisions. Since that time, we have been hard at work analyzing the comments and the data we collected to evaluate the combined impact of these proposals. We have spoken with a wide range of stakeholders, including banks, academics, public interest groups, consumers, businesses, other regulators, Congress, and others. As you would expect in a project as technical and consequential as this one, I have had many productive meetings with Board colleagues and our fellow federal bank regulatory agencies, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). This process has led us to conclude that broad and material changes to the proposals are warranted. As I said, there are benefits and costs to increasing capital requirements. The changes we intend to make will bring these two important objectives into better balance, in light of the feedback we have received. The changes to the endgame proposal have been a joint effort with my counterparts at the FDIC and the OCC. ---[PAGE_BREAK]--- I intend to recommend that the Board re-propose the Basel endgame and G-SIB surcharge rules. This will provide the public the opportunity to fully review a number of key broad and material changes to the original proposals and provide comment. We will accept public comments on any aspect of the Basel endgame and G-SIB surcharge proposals. The changes in the endgame re-proposal will cover all major areas of the rule: credit risk; operational risk; and market risk. Banks with assets between $\$ 100$ and $\$ 250$ billion would no longer be subject to the endgame changes, other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital. ${ }^{5}$ These changes reflect the feedback we have received from the public, improve the tiering of the proposal, and better reflect risks. I will also recommend changes to the G-SIB surcharge proposal to better align the capital surcharge for a G-SIB with its systemic risk profile. Taken together, the re-proposals would increase aggregate common equity tier 1 capital requirements for the G-SIBs, which are the largest and most complex banks, by 9 percent. For other large banks that are not G-SIBs, the impact from the re-proposal would mainly result from the inclusion of unrealized gain and losses on their securities in regulatory capital, estimated to be equivalent to a 3 to 4 percent increase in capital requirements over the long run. The remainder of the re-proposal would increase capital requirements for non-GSIB firms still subject to the rule by 0.5 percent. While these proposed changes affect some of the most important aspects of the proposals, the agencies have not made final decisions on any aspect of the reproposals, including those that are not explicitly addressed in the re-proposal. The public should not view any omission of a potential change in these re-proposals as an indication that the agencies will finalize a provision as proposed. We continue to consider comments already received on the 2023 proposal, and we will consider those comments together with any comments submitted on the re-proposals as part of any final rulemakings. This is an interim step. Let me reiterate that we are open to comments on any aspect of the proposals. Now, I will turn to the changes. # Credit risk I will begin with an overview of the changes I will recommend to the capital requirements for credit risk, which protect against the risk that a bank's loans will not be fully repaid. These changes include reducing the risk-weights for residential real estate and retail exposures, extending the scope of the reduced risk weight for certain low-risk corporate debt, and eliminating the minimum haircut for securities financing transactions. First, I intend to recommend that the Board lower the proposed risk-weighting for loans secured by residential real estate and loans to retail customers. The original proposal introduced more risk-sensitive approaches for residential real estate and retail exposures, but calibrated them to be higher than the Basel standard to promote domestic competitive equity. The agencies received significant comments on the proposed calibrations. Some commenters argued that the elevated risk weights would overstate the risk for these loans given their loss history. Others argued that the risk weighting would affect home affordability and homeownership opportunities, particularly ---[PAGE_BREAK]--- for first-time homebuyers, minority communities, and low- and moderate-income borrowers, and could reduce the availability and affordability of retail credit. I will recommend that we reduce the calibration for residential real estate exposures so that it is in line with the calibration developed in the Basel process. With this change, allin capital requirements, including for operational and credit risk, will be lower on average than they are currently for mortgages up to 90 percent loan-to-value ratio, and about the same as they are now for mortgages up to 100 percent loan-to-value. With respect to loans to retail customers, I intend to recommend that we adopt the Basel standard, with two exceptions - first, we would lower the capital requirements for credit card exposures where the borrower uses only a small portion of the commitment line, and second, we would lower the capital requirement for charge cards with no pre-set credit limits. The second proposed change related to credit risk would extend the reduced risk weight for low-risk corporate exposures to certain regulated entities that a bank judges to be investment grade and that are not publicly traded. The original proposal provided this preferential treatment only to investment-grade corporates that were publicly traded because the financial disclosure requirements for these entities facilitate market participants' assessments of their financial condition, which in turn provide additional information for banking organizations to use when assessing these entities' credit risk. There were many comments that the preferential treatment should be extended further, including to regulated entities that are also subject to substantial regulatory discipline and substantial transparency requirements. Consistent with our objective of increasing risk sensitivity in capital requirements, I plan to recommend to the Board that we extend the reduced corporate risk weight to regulated entities - including regulated financial institutions that are not banks, such as pension funds, certain mutual funds, and foreign equivalents - that are investment-grade but not publicly traded. Third, I intend to recommend that the Board not adopt the capital treatment associated with minimum haircut floors for securities financing transactions. The proposal included heightened capital requirements for repo-style transactions and eligible margin loans that did not meet minimum margin requirements. While consistent with the Basel standard, several other major jurisdictions have not adopted this approach. Not adopting the minimum haircut floors will allow time to seek greater international consensus on this important topic before deciding on whether and how to implement such an approach in the United States. # Equity Exposures Let me speak to the treatment of tax credit equity financing exposures. I plan to recommend that we significantly lower the risk weight for tax credit equity funding structures, given the lower inherent risk in these structures compared to many other equity investments. The revised lower risk weight for these exposures of 100 percent would reflect this lower risk and be consistent with the approach we take for other tax credit investments, such as the low-income housing tax credits. ## Operational risk ---[PAGE_BREAK]--- Next, let me speak about three changes I intend to recommend for the proposed capital treatment of operational risk, which is the risk of losses from inadequate or failed processes, such as from fraud or cyberattacks. First, I plan to recommend that we no longer adjust a firm's operational risk charge based on its operational loss history. This change will reduce fluctuations in a bank's operational risk capital requirements over time. Second, I plan to recommend to the Board that we calculate fee income on a net basis in calculating its contribution to the operational risk capital requirement. The original proposal would have measured the contribution of fee-based activities based on gross revenues, instead of net income, which is revenues minus expenses. Moving to net income for fee-based activities-specifically, by netting noninterest income and expenses (except for operational losses)-would produce more consistency in how operational risk is measured across bank activities, as interest and trading income and expenses are already measured on a net basis under the proposal. This change would also produce more consistent operational risk capital requirements across banks because the approach is less sensitive to the differences in accounting practices across banks. Third, I plan to recommend to the Board that we reduce operational risk capital requirements for investment management activities to reflect the smaller historical operational losses for these activities relative to income. The agencies received comments suggesting that some fee-based business lines have incurred meaningfully lower operational losses than other business lines. We have found evidence that investment management has historically experienced noticeably low operational losses relative to income produced. # Market risk and derivatives Now, l'll speak to the capital treatment for a bank's trading activities and its derivatives activities. The endgame proposal included a number of important improvements relative to the current market risk capital framework, including to incorporate lessons learned from the 2007-09 financial crisis that have not been sufficiently addressed in the current framework. It would permit firms to use internal models to capture the complex dynamics of most market risks but would put certain constraints on banks' models and provide fallbacks in areas where modeling practices are not adequate. We received numerous comments on ways to improve this part of the proposal. I plan to recommend that we make changes to facilitate banks' ability to use internal models for market risk. For example, the re-proposal will introduce a multiyear implementation period for the profit and loss attribution tests that are used to confirm that models are working as intended. This extended transition period would allow banks to gain experience with the tests and provide time to improve their systems and processes and address any potential gaps in data and model performance. In addition, the re-proposal would contain a few additional adjustments to improve incentives for a firm to model its exposures. ---[PAGE_BREAK]--- Moreover, we will clarify that uniform mortgage-backed securities positions would be treated as having a single obligor, regardless of whether they were issued by Freddie Mac or Fannie Mae. This change will enable firms to recognize hedging across these securities. With respect to derivatives activities, I plan to recommend that the Board adjust the capital treatment for client-cleared derivatives activities by reducing the capital required for the client-facing leg of a client-cleared derivative. This change would better reflect the risks of these transactions, which are highly collateralized and subject to netting and daily margin requirements. This also would avoid disincentives to client clearing, which I'll return to later. # Tiering Let me turn to tiering. The largest, most complex firms should be subject to the most stringent requirements, in light of the costs that their potential failure would impose on the broader financial system and thus on businesses and households. Under the reproposal, G-SIBs and other internationally active banks would be subject to the most stringent set of requirements, including the new credit risk and operational risk requirements, and the revised frameworks for market risk and CVA frameworks. Capital requirements for large banks that are not G-SIBs can be simpler while still supporting resilience. I am recommending a number of changes to better reflect this principle. For firms with assets between $\$ 250$ and $\$ 700$ billion that are not G-SIBs or internationally active, the re-proposal would apply the new credit risk and operational risk requirements; however, it would apply the frameworks for market risk and CVA frameworks only to firms that engage in significant trading activity. Further, the reproposal would revert to the simpler definition of capital - the numerator in the capital ratio - for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of accumulated other comprehensive income (AOCI). The re-proposal would maintain this element to better reflect interest rate risk in capital, a problem that played a major role in last March's bank failures. For large banks with assets between $\$ 100$ and $\$ 250$ billion, the re-proposal would not apply the credit risk and operational risk frameworks of the expanded risk-based approach to these banking organizations, maintaining a simpler capital framework for these less complex firms. For these firms, the re-proposal would also revert to the simpler definition of capital for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of AOCI. ## G-SIB surcharge proposal As I noted, last July, we sought comment on proposed revisions to the G-SIB surcharge, to better reflect the systemic risk of each G-SIB. In particular, the proposal would make adjustments to limit "window dressing" by requiring banks to report indicators as average values instead of on a point-in-time basis. It would also reduce "cliff effects" by calculating a G-SIB's capital surcharge in 0.1 percent increments ---[PAGE_BREAK]--- instead of 0.5 percent increments. And the proposal would adjust how we measure some systemic indicators to better align them with risk. ${ }^{6}$ The goal of the 2023 proposal was to improve the risk sensitivity of the G-SIB surcharge. Commenters provided helpful feedback regarding the proposal's potential impact on certain types of activities, such as client clearing of derivatives. We are still considering these comments, but let me speak to areas where I will recommend making changes to the original proposal. First, l'll speak to the treatment of cleared derivatives. The proposal would have increased the extent to which client-cleared derivatives contribute to a bank's G-SIB surcharge, to promote consistency of the measure. However, commenters argued that the measure might result in higher costs and more volatility for derivative end users and might reduce incentives to provide clients' access to central clearing. While it is important for our capital rules to be risk-sensitive, it is also important that we consider the impact of our rules in the broader market context. Central clearing of derivatives is a critical tool that can help improve transparency and reduce systemic risk. To avoid disincentives for client clearing, I intend to recommend to the Board that we not adopt the proposed changes to capital requirements associated with client clearing. Second, let me speak to changes in the surcharge proposal that I will recommend to keep the measures we use up-to-date. The U.S. G-SIB surcharge was set nearly nine years ago, and the growth in the economy since 2015 has meant that G-SIBs' measures of systemic risk have increased, even for firms whose share of domestic or global economic activity has not increased. The Board noted the potential for this effect in the original 2015 G-SIB rule. While it did not provide a mechanism to automatically adjust for economic growth at that time, the Board stated that it would periodically reevaluate the framework. As part of the G-SIB re-proposal, I intend to recommend that we improve the calculation of the capital surcharges for G-SIBs by reflecting changes in the global banking system since the Board adopted the G-SIB surcharge in 2015. In addition, for the future, I intend to recommend that we account for effects from inflation and economic growth in the measurement of a G-SIB's systemic risk profile. As a result, a G-SIB's surcharge would not change based simply on growth in the economy. ${ }^{7}$ # Conclusion The journey to improve capital requirements since the Global Financial Crisis has been a long one, and Basel III endgame is an important element of this effort. These reproposals bring us closer to completing the task. The broad and material changes to both proposals that l've outlined today would better balance the benefits and costs of capital in light of comments received, and result in a capital framework that appropriately reflects the risks of bank activities and is tiered to the banking sector. They also bring the proposals broadly in line with what other major jurisdictions are doing. And what does this all mean? A safer and fairer banking system. My goal, throughout my nearly 30 years in this field, has always been to help ensure that the banking system can support households and businesses of all types, during good times and bad. ---[PAGE_BREAK]--- In addition to the re-proposals outlined today, we are looking carefully at how our stress test complements the risk-based capital rules to help ensure our overall framework supports a resilient and effective banking sector. We are attentive to the interactions across all components of our capital framework as well as the combined burden and benefits, and we take these issues seriously. In all of our work, we will continue to seek an approach that helps to ensure financial system resiliency and supports the flow of credit to households and businesses. It is most imperative that we get this right. Thank you. ${ }^{1}$ The views I express here are my own, and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee. ${ }^{2}$ See Michael S. Barr, "Why Bank Capital Matters" (speech at the American Enterprise Institute, Washington, DC, December 1, 2022), and Michael S. Barr, "Holistic Capital Review (PDF)" (speech at the Bipartisan Policy Center, Washington, DC, July 10, 2023). $\underline{3}$ Under standard corporate finance theory, a firm should be indifferent between debt and equity, but in practice, as compared to debt, equity is a more expensive source of funding to a bank given the structure of our laws and markets, the presence of deposit insurance and other government support, and other factors. See, e.g., Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," The American Economic Review 48 (June 1958): 261-297, and Ron J. Feldman, Gary H. Stern, and Paul A. Volcker, Too Big to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press, 2009). ${ }^{4}$ The G-SIB surcharge is an additional layer of capital just for the G-SIBs, and it is measured on several factors of each G-SIB, specific to their individual risks. ${ }^{5}$ To the extent that such a firm has large trading operations, it would also be subject to the revised market risk framework. ${ }^{6}$ With regard to the adjustments to address window dressing and cliff effects, these will have a one-time impact on banks that carefully manage their operations to lower surcharge buckets, but should improve the efficiency and risk-sensitivity of the measure over time. ${ }^{7}$ The re-proposal would update the method 2 coefficients to reflect changes from 2015 until the present using a methodology that is consistent with the Board's original calibration in 2015. Specifically, the supplemental proposal would update the method 2 coefficients for each of the systemic indicators for the size, interconnectedness, complexity, and cross-jurisdictional activity categories from 2015 until the present using the most recent available two-year average of aggregate global indicator amounts and the corresponding three-year average of euro/U.S. dollar exchange rates. Going forward, it would also include a mechanism to annually adjust the method 2 coefficients for each of the systemic indicators for the size, interconnectedness, complexity, and ---[PAGE_BREAK]--- cross-jurisdictional activity categories based on U.S. inflation and real economic growth. This mechanism would use a three-year moving average of annual nominal U.S. gross domestic product (GDP) growth to adjust these coefficients on an annual basis.	Michael S Barr	United States	https://www.bis.org/review/r240910b.pdf	Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the Brookings Institution, Washington DC, 10 September 2024. Thank you for inviting me to speak today. Since I joined the Federal Reserve Board as Vice Chair for Supervision, I have spoken many times about the importance of bank capital to the safety and soundness of banks and the stability of the financial system. Thus, higher capital requirements can raise the cost of funding to a bank, and the bank can pass higher costs on to households, businesses, and clients engaged in a range of financial activities. These activities are critical to a wellfunctioning economy that works for everyone. That's why it is important to get the balance between resiliency and efficiency right. Today, l'll return to these themes in the context of two rules of great public interest: The Basel III endgame proposal and the proposal to adjust the capital surcharge for global systemically important banks (G-SIB). A little over a year ago, the Board sought comment on those two proposed rules, which would modify risk-based capital requirements for large banks. We received a great number of comments on the provisions in the proposal, as well as on the justifications and analysis that underlie those provisions. Since that time, we have been hard at work analyzing the comments and the data we collected to evaluate the combined impact of these proposals. We have spoken with a wide range of stakeholders, including banks, academics, public interest groups, consumers, businesses, other regulators, Congress, and others. As you would expect in a project as technical and consequential as this one, I have had many productive meetings with Board colleagues and our fellow federal bank regulatory agencies, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). This process has led us to conclude that broad and material changes to the proposals are warranted. As I said, there are benefits and costs to increasing capital requirements. The changes we intend to make will bring these two important objectives into better balance, in light of the feedback we have received. The changes to the endgame proposal have been a joint effort with my counterparts at the FDIC and the OCC. I intend to recommend that the Board re-propose the Basel endgame and G-SIB surcharge rules. This will provide the public the opportunity to fully review a number of key broad and material changes to the original proposals and provide comment. We will accept public comments on any aspect of the Basel endgame and G-SIB surcharge proposals. The changes in the endgame re-proposal will cover all major areas of the rule: credit risk; operational risk; and market risk. Banks with assets between $\$ 100$ and $\$ 250$ billion would no longer be subject to the endgame changes, other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital. These changes reflect the feedback we have received from the public, improve the tiering of the proposal, and better reflect risks. I will also recommend changes to the G-SIB surcharge proposal to better align the capital surcharge for a G-SIB with its systemic risk profile. Taken together, the re-proposals would increase aggregate common equity tier 1 capital requirements for the G-SIBs, which are the largest and most complex banks, by 9 percent. For other large banks that are not G-SIBs, the impact from the re-proposal would mainly result from the inclusion of unrealized gain and losses on their securities in regulatory capital, estimated to be equivalent to a 3 to 4 percent increase in capital requirements over the long run. The remainder of the re-proposal would increase capital requirements for non-GSIB firms still subject to the rule by 0.5 percent. While these proposed changes affect some of the most important aspects of the proposals, the agencies have not made final decisions on any aspect of the reproposals, including those that are not explicitly addressed in the re-proposal. The public should not view any omission of a potential change in these re-proposals as an indication that the agencies will finalize a provision as proposed. We continue to consider comments already received on the 2023 proposal, and we will consider those comments together with any comments submitted on the re-proposals as part of any final rulemakings. This is an interim step. Let me reiterate that we are open to comments on any aspect of the proposals. Now, I will turn to the changes. I will begin with an overview of the changes I will recommend to the capital requirements for credit risk, which protect against the risk that a bank's loans will not be fully repaid. These changes include reducing the risk-weights for residential real estate and retail exposures, extending the scope of the reduced risk weight for certain low-risk corporate debt, and eliminating the minimum haircut for securities financing transactions. First, I intend to recommend that the Board lower the proposed risk-weighting for loans secured by residential real estate and loans to retail customers. The original proposal introduced more risk-sensitive approaches for residential real estate and retail exposures, but calibrated them to be higher than the Basel standard to promote domestic competitive equity. The agencies received significant comments on the proposed calibrations. Some commenters argued that the elevated risk weights would overstate the risk for these loans given their loss history. Others argued that the risk weighting would affect home affordability and homeownership opportunities, particularly for first-time homebuyers, minority communities, and low- and moderate-income borrowers, and could reduce the availability and affordability of retail credit. I will recommend that we reduce the calibration for residential real estate exposures so that it is in line with the calibration developed in the Basel process. With this change, allin capital requirements, including for operational and credit risk, will be lower on average than they are currently for mortgages up to 90 percent loan-to-value ratio, and about the same as they are now for mortgages up to 100 percent loan-to-value. With respect to loans to retail customers, I intend to recommend that we adopt the Basel standard, with two exceptions - first, we would lower the capital requirements for credit card exposures where the borrower uses only a small portion of the commitment line, and second, we would lower the capital requirement for charge cards with no pre-set credit limits. The second proposed change related to credit risk would extend the reduced risk weight for low-risk corporate exposures to certain regulated entities that a bank judges to be investment grade and that are not publicly traded. The original proposal provided this preferential treatment only to investment-grade corporates that were publicly traded because the financial disclosure requirements for these entities facilitate market participants' assessments of their financial condition, which in turn provide additional information for banking organizations to use when assessing these entities' credit risk. There were many comments that the preferential treatment should be extended further, including to regulated entities that are also subject to substantial regulatory discipline and substantial transparency requirements. Consistent with our objective of increasing risk sensitivity in capital requirements, I plan to recommend to the Board that we extend the reduced corporate risk weight to regulated entities - including regulated financial institutions that are not banks, such as pension funds, certain mutual funds, and foreign equivalents - that are investment-grade but not publicly traded. Third, I intend to recommend that the Board not adopt the capital treatment associated with minimum haircut floors for securities financing transactions. The proposal included heightened capital requirements for repo-style transactions and eligible margin loans that did not meet minimum margin requirements. While consistent with the Basel standard, several other major jurisdictions have not adopted this approach. Not adopting the minimum haircut floors will allow time to seek greater international consensus on this important topic before deciding on whether and how to implement such an approach in the United States. Let me speak to the treatment of tax credit equity financing exposures. I plan to recommend that we significantly lower the risk weight for tax credit equity funding structures, given the lower inherent risk in these structures compared to many other equity investments. The revised lower risk weight for these exposures of 100 percent would reflect this lower risk and be consistent with the approach we take for other tax credit investments, such as the low-income housing tax credits. Next, let me speak about three changes I intend to recommend for the proposed capital treatment of operational risk, which is the risk of losses from inadequate or failed processes, such as from fraud or cyberattacks. First, I plan to recommend that we no longer adjust a firm's operational risk charge based on its operational loss history. This change will reduce fluctuations in a bank's operational risk capital requirements over time. Second, I plan to recommend to the Board that we calculate fee income on a net basis in calculating its contribution to the operational risk capital requirement. The original proposal would have measured the contribution of fee-based activities based on gross revenues, instead of net income, which is revenues minus expenses. Moving to net income for fee-based activities-specifically, by netting noninterest income and expenses (except for operational losses)-would produce more consistency in how operational risk is measured across bank activities, as interest and trading income and expenses are already measured on a net basis under the proposal. This change would also produce more consistent operational risk capital requirements across banks because the approach is less sensitive to the differences in accounting practices across banks. Third, I plan to recommend to the Board that we reduce operational risk capital requirements for investment management activities to reflect the smaller historical operational losses for these activities relative to income. The agencies received comments suggesting that some fee-based business lines have incurred meaningfully lower operational losses than other business lines. We have found evidence that investment management has historically experienced noticeably low operational losses relative to income produced. Now, l'll speak to the capital treatment for a bank's trading activities and its derivatives activities. The endgame proposal included a number of important improvements relative to the current market risk capital framework, including to incorporate lessons learned from the 2007-09 financial crisis that have not been sufficiently addressed in the current framework. It would permit firms to use internal models to capture the complex dynamics of most market risks but would put certain constraints on banks' models and provide fallbacks in areas where modeling practices are not adequate. We received numerous comments on ways to improve this part of the proposal. I plan to recommend that we make changes to facilitate banks' ability to use internal models for market risk. For example, the re-proposal will introduce a multiyear implementation period for the profit and loss attribution tests that are used to confirm that models are working as intended. This extended transition period would allow banks to gain experience with the tests and provide time to improve their systems and processes and address any potential gaps in data and model performance. In addition, the re-proposal would contain a few additional adjustments to improve incentives for a firm to model its exposures. Moreover, we will clarify that uniform mortgage-backed securities positions would be treated as having a single obligor, regardless of whether they were issued by Freddie Mac or Fannie Mae. This change will enable firms to recognize hedging across these securities. With respect to derivatives activities, I plan to recommend that the Board adjust the capital treatment for client-cleared derivatives activities by reducing the capital required for the client-facing leg of a client-cleared derivative. This change would better reflect the risks of these transactions, which are highly collateralized and subject to netting and daily margin requirements. This also would avoid disincentives to client clearing, which I'll return to later. Let me turn to tiering. The largest, most complex firms should be subject to the most stringent requirements, in light of the costs that their potential failure would impose on the broader financial system and thus on businesses and households. Under the reproposal, G-SIBs and other internationally active banks would be subject to the most stringent set of requirements, including the new credit risk and operational risk requirements, and the revised frameworks for market risk and CVA frameworks. Capital requirements for large banks that are not G-SIBs can be simpler while still supporting resilience. I am recommending a number of changes to better reflect this principle. For firms with assets between $\$ 250$ and $\$ 700$ billion that are not G-SIBs or internationally active, the re-proposal would apply the new credit risk and operational risk requirements; however, it would apply the frameworks for market risk and CVA frameworks only to firms that engage in significant trading activity. Further, the reproposal would revert to the simpler definition of capital - the numerator in the capital ratio - for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of accumulated other comprehensive income (AOCI). The re-proposal would maintain this element to better reflect interest rate risk in capital, a problem that played a major role in last March's bank failures. For large banks with assets between $\$ 100$ and $\$ 250$ billion, the re-proposal would not apply the credit risk and operational risk frameworks of the expanded risk-based approach to these banking organizations, maintaining a simpler capital framework for these less complex firms. For these firms, the re-proposal would also revert to the simpler definition of capital for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of AOCI. As I noted, last July, we sought comment on proposed revisions to the G-SIB surcharge, to better reflect the systemic risk of each G-SIB. In particular, the proposal would make adjustments to limit "window dressing" by requiring banks to report indicators as average values instead of on a point-in-time basis. It would also reduce "cliff effects" by calculating a G-SIB's capital surcharge in 0.1 percent increments instead of 0.5 percent increments. And the proposal would adjust how we measure some systemic indicators to better align them with risk. The goal of the 2023 proposal was to improve the risk sensitivity of the G-SIB surcharge. Commenters provided helpful feedback regarding the proposal's potential impact on certain types of activities, such as client clearing of derivatives. We are still considering these comments, but let me speak to areas where I will recommend making changes to the original proposal. First, l'll speak to the treatment of cleared derivatives. The proposal would have increased the extent to which client-cleared derivatives contribute to a bank's G-SIB surcharge, to promote consistency of the measure. However, commenters argued that the measure might result in higher costs and more volatility for derivative end users and might reduce incentives to provide clients' access to central clearing. While it is important for our capital rules to be risk-sensitive, it is also important that we consider the impact of our rules in the broader market context. Central clearing of derivatives is a critical tool that can help improve transparency and reduce systemic risk. To avoid disincentives for client clearing, I intend to recommend to the Board that we not adopt the proposed changes to capital requirements associated with client clearing. Second, let me speak to changes in the surcharge proposal that I will recommend to keep the measures we use up-to-date. The U.S. G-SIB surcharge was set nearly nine years ago, and the growth in the economy since 2015 has meant that G-SIBs' measures of systemic risk have increased, even for firms whose share of domestic or global economic activity has not increased. The Board noted the potential for this effect in the original 2015 G-SIB rule. While it did not provide a mechanism to automatically adjust for economic growth at that time, the Board stated that it would periodically reevaluate the framework. As part of the G-SIB re-proposal, I intend to recommend that we improve the calculation of the capital surcharges for G-SIBs by reflecting changes in the global banking system since the Board adopted the G-SIB surcharge in 2015. In addition, for the future, I intend to recommend that we account for effects from inflation and economic growth in the measurement of a G-SIB's systemic risk profile. As a result, a G-SIB's surcharge would not change based simply on growth in the economy. The journey to improve capital requirements since the Global Financial Crisis has been a long one, and Basel III endgame is an important element of this effort. These reproposals bring us closer to completing the task. The broad and material changes to both proposals that l've outlined today would better balance the benefits and costs of capital in light of comments received, and result in a capital framework that appropriately reflects the risks of bank activities and is tiered to the banking sector. They also bring the proposals broadly in line with what other major jurisdictions are doing. And what does this all mean? A safer and fairer banking system. My goal, throughout my nearly 30 years in this field, has always been to help ensure that the banking system can support households and businesses of all types, during good times and bad. In addition to the re-proposals outlined today, we are looking carefully at how our stress test complements the risk-based capital rules to help ensure our overall framework supports a resilient and effective banking sector. We are attentive to the interactions across all components of our capital framework as well as the combined burden and benefits, and we take these issues seriously. In all of our work, we will continue to seek an approach that helps to ensure financial system resiliency and supports the flow of credit to households and businesses. It is most imperative that we get this right. Thank you.
2024-09-18T00:00:00	Elizabeth McCaul: The future of European banking supervision - connecting people and technology	Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the Supervision Innovators Conference 2024, Frankfurt am Main, 18 September 2024.	Elizabeth McCaul: The future of European banking supervision - connecting people and technology Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the Supervision Innovators Conference 2024, Frankfurt am Main, 18 September 2024. * * * Introduction I'm honoured to welcome you again to this conference, which is already being held for the fifth time. It's the fifth anniversary of this conference but we are also celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). Naturally, it is a moment of reflection about what the future holds and how European banking supervision should continue to evolve. And, right now, various societal, political, technological, environmental and economic mega trends are shaping the future of the financial industry. In the tech area, for example, we are in the midst of a fast-paced and unprecedented development which is changing every aspect of the economy. The ways of working are changing profoundly. My son is a computer programmer. This weekend while driving we spoke about the possibilities for his future and what sort of work he might do, given the rapid innovation taking place. He told me he uses AI now regularly to produce code for him that he then reviews. Very different from the work he was hired for just two years ago when he graduated! In the aviation field artificial intelligence (AI) is being used to enhance the safety and efficiency of air traffic control by analysing historical and real-time flight data to predict potential collisions. Predicting accidents before they occur: isn't that also a goal worthy of banking supervision? And in the health care field, common applications include diagnosing patients, end-to-end drug discovery and development, improving communication between physician and patient or transcribing medical documents such as prescriptions. All of this change in the industries around us are food for thought as we consider in a clear-eyed, realistic and vigilant way the risks and opportunities for us in banking supervision. Disruptive technologies like AI are playing a growing role in banks' day-to-day activities, and access to technology is becoming widespread. At the same time, banks are becoming ever more dependent on data, IT platforms and third-party providers. To keep the banking sector safe and sound in the face of these trends, we need to equip the supervisors of the future with the right tools and skills. And it is this principle that has guided our strategic work on the digital agenda. Since the inception of European banking supervision in 2014 we have built up and continuously improved a set of core IT systems, launched our suptech efforts and created multiple cutting-edge tools which are already up and running. And now it is time to shape a new common strategy covering both our core IT systems and our suptech tools, as well as, most importantly, their integration. SSM tech strategy for 2024-2028 The new SSM tech strategy for 2024-2028 builds on two main pillars: people and technology. The strategy not only addresses several critical business needs Any smart strategy developed for the future must have at its foundation the recognition that people and technology are increasingly, even inextricably intertwined. How have we incorporated that? We have done so by setting as our goal connecting people and technology so we can deliver "supervision at your fingertips", This way, human expertise and technological innovation go hand-in-hand. We are structuring our work to ensure efficient, effective and integrated supervision that keeps pace with the trends and structural changes in the banking sector which I touched upon earlier. We are working on several levels to make sure that supervisors can fully use the applications and data available to them and that technology is seamlessly integrated into their day-to-day work. And we aim to consolidate IT to further strengthen European banking supervision, allowing supervisors to work as a single team with shared technology across the ECB and national competent authorities (NCAs). But what does this mean more concretely for our banking supervisors of the future? What impact will this strategy have on their work? What tools will they use? To make this tangible, let's imagine a future supervisor called Pete. The name "Pete" symbolises the two key pillars of our strategy: "Pe" stands for people, and "te" for technology. So, how does our new strategy support Pete? People Let me start with the first pillar of our new strategy and the most important asset we have: our supervisors, people like Pete. Under this pillar, we plan to support Pete's work in the following three ways. Promoting a user-focused innovation culture First, we aim to instil a culture that supports the adoption of our suptech tools and embeds advanced technology into regular supervisory processes. We are convinced that having a clear user focus in all our technological activities and ensuring an enhanced user experience will encourage the take-up of our tools. One way of fostering the adoption of tools is our European banking supervision-wide suptech champions initiative. Under this initiative, Pete and other colleagues at the NCAs and in various business areas across ECB Banking Supervision can become trained experts in suptech tools. These suptech champions can then provide local and easy-to-access support to users. They also collect feedback and identify user needs in order to further develop the tool. In this way, suptech champions act as ambassadors, both promoting awareness and supporting the use and development of suptech tools. Already, 45 champions across 17 NCAs have reached over 1,000 supervisors through multiple channels, including workshops and providing guidance on the use of suptech tools. Future-proofing our organisation Second, we are continuing to make our organisation ready for the future by establishing a steady-state tech function that connects internal tech and supervision experts across business areas and NCAs. We want to cultivate a collaborative approach to shaping SSM technology and enhancing the adoption and use of available tools. In one of our flagship initiatives, NCAs can become suptech centres, which are at the forefront of developing technology for European banking supervision. They deliver tools that can subsequently be made available to the ECB and other NCAs. A case in point is that one NCA has developed a new use case for assessing the group structures of banks over time in our network analysis platform, Navi, which benefits European banking supervision as a whole. Deepening our global partnerships Third, we seek to tap into the global innovation networks with which we have established strong ties in recent years. For instance, we have been working closely with leading academic institutions to deliver state-of-the-art training to supervisors on machine learning, programming for data analytics, prompting and other topics. We are also working closely with industry leaders in other areas, such as generative AI, cloud technology and big data, as well as with start-ups to bring the latest and most advanced technologies to banking supervision. At the same time, we are partnering with other authorities across the world to experiment with new ways of solving common problems. Such partnerships mean that Pete has access to knowledge and state-of-the art technology that boost efficiency and improve supervisory outcomes, which brings me to the second pillar of our strategy, technology. Technology Through our SSM tech strategy, we want to connect people with technology. In other words, we need to equip Pete with the necessary tools and capabilities. Working as a single team with shared technology The first cluster in the technology pillar concerns our core IT systems. On the one hand we will continue to future-proof our core systems and data infrastructure by making them more modular, scalable and innovation-friendly while keeping them secure. We aim to optimise the IT landscape by integrating and consolidating systems across European banking supervision. On the other hand, we will decommission legacy systems to maximise the use and impact of existing applications. Working as a single team across the ECB and NCAs with access to shared technology will allow Pete to collaborate more intensively with European central banking colleagues. Olympus is a notable project in this regard. Through Olympus, we aim to proactively shape our IT landscape and make it ready for the upcoming challenges and opportunities offered by new technologies. This ambitious project reviews the full IT landscape and sets out a roadmap and action plan for the future of IT in European banking supervision. For this project, we have identified four high-level targets rooted in our supervisory needs that guide all activities. Our first target is to strengthen our data-driven work. Imagine having easy access to data and efficient processing within a few clicks. This will empower our teams to make informed decisions swiftly and effectively. The second target is to provide common and connected tools and systems. Using integrated systems to foster collaboration among all European banking supervisors, we will create a cohesive working environment that allows everyone to work together smoothly. The third target is to ensure seamless access and navigation. By unifying access and identity management, we will make it easier for our staff to find and use the resources they need, free from technical obstacles. Lastly, we will establish common IT standards and delivery. By adopting consistent IT standards, we will drive rapid and user-friendly digital innovation, ensuring our technology keeps pace with the latest advances. Under the Olympus project we have set out the concrete action needed to reach these targets. What does this mean for Pete, though? Let me give you an example. Pete will be able to use the SSM Cockpit to navigate through supervisory tasks. The SSM Cockpit will provide a user-centric platform integrated with core systems to facilitate access and navigation to various tools and systems. By design, it will be a flexible solution that meets the diverse information and reporting needs of different supervisory roles. The Cockpit will feature advanced, AI-powered capabilities to help supervisors efficiently carry out their core tasks. Generating new insights through supervisory analytics Supervisory analytics are the second cluster under the technology pillar. These seek to enhance risk assessment by augmenting analytical capabilities and combining structured and unstructured data. There is also a pressing business need to address emerging risks such as climate-related and environmental risks, as well as IT and cyber risks. To do so, we must explore new datasets and information sources, including social media. Supervisory analytics will give Pete and his colleagues new insights which will help them stay ahead of emerging risks and provide more robust and timely risk assessments. We have been working on a tool called Delphi which uses natural language processing to integrate market risk-based indicators and information from news items into a single web-based platform with a user-friendly interface. The insights afforded by combining such quantitative and qualitative information mean that supervisors like Pete can adequately assess the underlying risks and better understand the real-time risk development affecting individual banks. Automating processes by harnessing AI Our third and last cluster under the technology pillar concerns process automation and collaboration. Think about how the automotive industry is being transformed by smart manufacturing. In a smart factory, machines, devices and systems are interconnected and can communicate with one another, enabling real-time data collection, analysis and decision-making. What can we learn from other industries to become more effective and efficient in our supervision? We are committed to delivering additional breakthrough solutions that use AI - and more specifically generative AI - to simplify and automate workflows, while improving collaboration within European banking supervision. For a while now, we have been harnessing AI and making it available in some of our tools, such as Athena, which helps supervisors analyse extensive textual information in various formats and languages, and Virtual Lab, a platform for SSM-wide digital collaboration as well as code sharing, cloud computing and the development of generative AI (GenAI) capabilities. We are also planning to deploy AI in the AFM Medusa project which will support our supervisors in drafting, consistency-checking and benchmarking findings and measures. Our vision is for supervisors to be increasingly empowered by GenAI, while remaining engaged in the process since they will be the ones who continue to review and approve work and take the final decisions. This technology will provide suggestions, assist in drafting input and help with analysis. To this end, we have been collecting use cases and are determining where it makes sense to implement European banking supervision-wide solutions, where specialised applications with narrower scopes and user groups are appropriate, and where off-theshelf tools are sufficient. One of the solutions we have been working on is AthenaGPT, which complements Athena. Using AthenaGPT, supervisors like Pete are able to interact with several supervisory information sources at once. This boosts efficiency, as supervisors can then focus on the most relevant information. Searching for information in large supervisory repositories has never been easier. And in Agora, we are testing the ability for supervisors to query the data lake in English and use AI to translate into SQL, which is how the data can be accessed. This reminds me of how the work of my son is changing! Conclusion As you can see, we have ambitious plans for Pete and all our supervisors. Continuous investment in technology will remain key for ECB Banking Supervision to keep pace with changes in the banking landscape and address emerging supervisory risks. I am confident that we will be successful in this endeavour and that we will help Pete become a supervisor of the future: a strong SSM collaborator working in a single team with shared technology, an empowered data expert who bases decisions on advanced supervisory analytics and an agile supervisor making use of process automation and the latest technology. At the same time, I am incredibly proud of what we have already achieved. We have developed and fully implemented suptech tools that harness modern technologies such as AI across Europe. These tools have changed the way we do supervision. We have been surprised at how some of our tools have been received in our supervisory community. For example, we only expected to have around 200 users for Agora, the SSM single data lake. But we already have over 1,200 users, who have made over 1.6 million data queries using the tool. Our top innovation and collaboration tool, Virtual Lab, is being used by around 4,000 colleagues. And our network analytics tool, Navi, has now grown to cover almost a dozen major use cases. We have also trained almost 3,000 colleagues, including leaders, on topics related to innovation and digital transformation. This has helped broaden supervisors' skillsets and established a mindset within our organisation that embraces technological change. Last, but not least, we have won four global innovation awards in three consecutive years. While we can be proud of these achievements, I believe that much remains to be done. There is a famous quote by the American sociobiologist Edward O. Wilson that continues to occupy my thoughts of late: "The real problem of humanity is the following: We have Palaeolithic emotions, medieval institutions and godlike technology." You know that I spend a great deal of my waking hours thinking about the implications of the changing financial services environment we find ourselves in today. It's an increasingly complex landscape, where we are facing geopolitical, climate and operational resiliency risks emanating from third party dependencies and cyber-attacks. We are facing changes to business models incorporating partnerships and responding to competition from and new entrants BigTech and FinTech. And the exponential growth of the global markets since the Great Financial Crisis in the interconnectedness of entities categorized as non-bank financial institutions with banks, especially private credit and equity funds operating outside the regulatory perimeter, is concerning, even worrying as we think about the effects on supervision and financial stability. Successfully connecting our technology and people to empower them in this changing landscape is essential. I would say that if we want to truly equip Pete for the future, it's clear that our work has only just begun. Thank you very much for your attention. I hope you enjoy the rest of the conference.	---[PAGE_BREAK]--- # Elizabeth McCaul: The future of European banking supervision connecting people and technology Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the Supervision Innovators Conference 2024, Frankfurt am Main, 18 September 2024. ## Introduction I'm honoured to welcome you again to this conference, which is already being held for the fifth time. It's the fifth anniversary of this conference but we are also celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). Naturally, it is a moment of reflection about what the future holds and how European banking supervision should continue to evolve. And, right now, various societal, political, technological, environmental and economic mega trends are shaping the future of the financial industry. In the tech area, for example, we are in the midst of a fast-paced and unprecedented development which is changing every aspect of the economy. The ways of working are changing profoundly. My son is a computer programmer. This weekend while driving we spoke about the possibilities for his future and what sort of work he might do, given the rapid innovation taking place. He told me he uses AI now regularly to produce code for him that he then reviews. Very different from the work he was hired for just two years ago when he graduated! In the aviation field artificial intelligence (AI) is being used to enhance the safety and efficiency of air traffic control by analysing historical and real-time flight data to predict potential collisions. Predicting accidents before they occur: isn't that also a goal worthy of banking supervision? And in the health care field, common applications include diagnosing patients, end-to-end drug discovery and development, improving communication between physician and patient or transcribing medical documents such as prescriptions. All of this change in the industries around us are food for thought as we consider in a clear-eyed, realistic and vigilant way the risks and opportunities for us in banking supervision. Disruptive technologies like AI are playing a growing role in banks' day-to-day activities, and access to technology is becoming widespread. At the same time, banks are becoming ever more dependent on data, IT platforms and third-party providers. To keep the banking sector safe and sound in the face of these trends, we need to equip the supervisors of the future with the right tools and skills. And it is this principle that has guided our strategic work on the digital agenda. ---[PAGE_BREAK]--- Since the inception of European banking supervision in 2014 we have built up and continuously improved a set of core IT systems, launched our suptech efforts and created multiple cutting-edge tools which are already up and running. And now it is time to shape a new common strategy covering both our core IT systems and our suptech tools, as well as, most importantly, their integration. # SSM tech strategy for 2024-2028 The new SSM tech strategy for 2024-2028 builds on two main pillars: people and technology. The strategy not only addresses several critical business needs Any smart strategy developed for the future must have at its foundation the recognition that people and technology are increasingly, even inextricably intertwined. How have we incorporated that? We have done so by setting as our goal connecting people and technology so we can deliver "supervision at your fingertips", This way, human expertise and technological innovation go hand-in-hand. We are structuring our work to ensure efficient, effective and integrated supervision that keeps pace with the trends and structural changes in the banking sector which I touched upon earlier. We are working on several levels to make sure that supervisors can fully use the applications and data available to them and that technology is seamlessly integrated into their day-to-day work. And we aim to consolidate IT to further strengthen European banking supervision, allowing supervisors to work as a single team with shared technology across the ECB and national competent authorities (NCAs). But what does this mean more concretely for our banking supervisors of the future? What impact will this strategy have on their work? What tools will they use? To make this tangible, let's imagine a future supervisor called Pete. The name "Pete" symbolises the two key pillars of our strategy: "Pe" stands for people, and "te" for technology. So, how does our new strategy support Pete? ## People Let me start with the first pillar of our new strategy and the most important asset we have: our supervisors, people like Pete. Under this pillar, we plan to support Pete's work in the following three ways. ## Promoting a user-focused innovation culture First, we aim to instil a culture that supports the adoption of our suptech tools and embeds advanced technology into regular supervisory processes. We are convinced that having a clear user focus in all our technological activities and ensuring an enhanced user experience will encourage the take-up of our tools. ---[PAGE_BREAK]--- One way of fostering the adoption of tools is our European banking supervision-wide suptech champions initiative. Under this initiative, Pete and other colleagues at the NCAs and in various business areas across ECB Banking Supervision can become trained experts in suptech tools. These suptech champions can then provide local and easy-to-access support to users. They also collect feedback and identify user needs in order to further develop the tool. In this way, suptech champions act as ambassadors, both promoting awareness and supporting the use and development of suptech tools. Already, 45 champions across 17 NCAs have reached over 1,000 supervisors through multiple channels, including workshops and providing guidance on the use of suptech tools. # Future-proofing our organisation Second, we are continuing to make our organisation ready for the future by establishing a steady-state tech function that connects internal tech and supervision experts across business areas and NCAs. We want to cultivate a collaborative approach to shaping SSM technology and enhancing the adoption and use of available tools. In one of our flagship initiatives, NCAs can become suptech centres, which are at the forefront of developing technology for European banking supervision. They deliver tools that can subsequently be made available to the ECB and other NCAs. A case in point is that one NCA has developed a new use case for assessing the group structures of banks over time in our network analysis platform, Navi, which benefits European banking supervision as a whole. ## Deepening our global partnerships Third, we seek to tap into the global innovation networks with which we have established strong ties in recent years. For instance, we have been working closely with leading academic institutions to deliver state-of-the-art training to supervisors on machine learning, programming for data analytics, prompting and other topics. We are also working closely with industry leaders in other areas, such as generative AI, cloud technology and big data, as well as with start-ups to bring the latest and most advanced technologies to banking supervision. At the same time, we are partnering with other authorities across the world to experiment with new ways of solving common problems. Such partnerships mean that Pete has access to knowledge and state-of-the art technology that boost efficiency and improve supervisory outcomes, which brings me to the second pillar of our strategy, technology. ## Technology Through our SSM tech strategy, we want to connect people with technology. In other words, we need to equip Pete with the necessary tools and capabilities. ## Working as a single team with shared technology ---[PAGE_BREAK]--- The first cluster in the technology pillar concerns our core IT systems. On the one hand we will continue to future-proof our core systems and data infrastructure by making them more modular, scalable and innovation-friendly while keeping them secure. We aim to optimise the IT landscape by integrating and consolidating systems across European banking supervision. On the other hand, we will decommission legacy systems to maximise the use and impact of existing applications. Working as a single team across the ECB and NCAs with access to shared technology will allow Pete to collaborate more intensively with European central banking colleagues. Olympus is a notable project in this regard. Through Olympus, we aim to proactively shape our IT landscape and make it ready for the upcoming challenges and opportunities offered by new technologies. This ambitious project reviews the full IT landscape and sets out a roadmap and action plan for the future of IT in European banking supervision. For this project, we have identified four high-level targets rooted in our supervisory needs that guide all activities. Our first target is to strengthen our data-driven work. Imagine having easy access to data and efficient processing within a few clicks. This will empower our teams to make informed decisions swiftly and effectively. The second target is to provide common and connected tools and systems. Using integrated systems to foster collaboration among all European banking supervisors, we will create a cohesive working environment that allows everyone to work together smoothly. The third target is to ensure seamless access and navigation. By unifying access and identity management, we will make it easier for our staff to find and use the resources they need, free from technical obstacles. Lastly, we will establish common IT standards and delivery. By adopting consistent IT standards, we will drive rapid and user-friendly digital innovation, ensuring our technology keeps pace with the latest advances. Under the Olympus project we have set out the concrete action needed to reach these targets. What does this mean for Pete, though? Let me give you an example. Pete will be able to use the SSM Cockpit to navigate through supervisory tasks. The SSM Cockpit will provide a user-centric platform integrated with core systems to facilitate access and navigation to various tools and systems. By design, it will be a flexible solution that meets the diverse information and reporting needs of different supervisory roles. The Cockpit will feature advanced, Al-powered capabilities to help supervisors efficiently carry out their core tasks. # Generating new insights through supervisory analytics ---[PAGE_BREAK]--- Supervisory analytics are the second cluster under the technology pillar. These seek to enhance risk assessment by augmenting analytical capabilities and combining structured and unstructured data. There is also a pressing business need to address emerging risks such as climate-related and environmental risks, as well as IT and cyber risks. To do so, we must explore new datasets and information sources, including social media. Supervisory analytics will give Pete and his colleagues new insights which will help them stay ahead of emerging risks and provide more robust and timely risk assessments. We have been working on a tool called Delphi which uses natural language processing to integrate market risk-based indicators and information from news items into a single web-based platform with a user-friendly interface. The insights afforded by combining such quantitative and qualitative information mean that supervisors like Pete can adequately assess the underlying risks and better understand the real-time risk development affecting individual banks. # Automating processes by harnessing AI Our third and last cluster under the technology pillar concerns process automation and collaboration. Think about how the automotive industry is being transformed by smart manufacturing. In a smart factory, machines, devices and systems are interconnected and can communicate with one another, enabling real-time data collection, analysis and decision-making. What can we learn from other industries to become more effective and efficient in our supervision? We are committed to delivering additional breakthrough solutions that use AI - and more specifically generative AI - to simplify and automate workflows, while improving collaboration within European banking supervision. For a while now, we have been harnessing AI and making it available in some of our tools, such as Athena, which helps supervisors analyse extensive textual information in various formats and languages, and Virtual Lab, a platform for SSM-wide digital collaboration as well as code sharing, cloud computing and the development of generative AI (GenAI) capabilities. We are also planning to deploy AI in the AFM Medusa project which will support our supervisors in drafting, consistency-checking and benchmarking findings and measures. Our vision is for supervisors to be increasingly empowered by GenAI, while remaining engaged in the process since they will be the ones who continue to review and approve work and take the final decisions. This technology will provide suggestions, assist in drafting input and help with analysis. To this end, we have been collecting use cases and are determining where it makes sense to implement European banking supervision-wide solutions, where specialised applications with narrower scopes and user groups are appropriate, and where off-theshelf tools are sufficient. One of the solutions we have been working on is AthenaGPT, which complements Athena. Using AthenaGPT, supervisors like Pete are able to interact with several supervisory information sources at once. This boosts efficiency, as supervisors can then focus on the most relevant information. Searching for information in large supervisory repositories has never been easier. And in Agora, we are testing the ability for supervisors to query the data lake in English and use AI to translate into SQL, which is how the data can be accessed. This reminds me of how the work of my son is changing! ---[PAGE_BREAK]--- # Conclusion As you can see, we have ambitious plans for Pete and all our supervisors. Continuous investment in technology will remain key for ECB Banking Supervision to keep pace with changes in the banking landscape and address emerging supervisory risks. I am confident that we will be successful in this endeavour and that we will help Pete become a supervisor of the future: a strong SSM collaborator working in a single team with shared technology, an empowered data expert who bases decisions on advanced supervisory analytics and an agile supervisor making use of process automation and the latest technology. At the same time, I am incredibly proud of what we have already achieved. We have developed and fully implemented suptech tools that harness modern technologies such as AI across Europe. These tools have changed the way we do supervision. We have been surprised at how some of our tools have been received in our supervisory community. For example, we only expected to have around 200 users for Agora, the SSM single data lake. But we already have over 1,200 users, who have made over 1.6 million data queries using the tool. Our top innovation and collaboration tool, Virtual Lab, is being used by around 4,000 colleagues. And our network analytics tool, Navi, has now grown to cover almost a dozen major use cases. We have also trained almost 3,000 colleagues, including leaders, on topics related to innovation and digital transformation. This has helped broaden supervisors' skillsets and established a mindset within our organisation that embraces technological change. Last, but not least, we have won four global innovation awards in three consecutive years. While we can be proud of these achievements, I believe that much remains to be done. There is a famous quote by the American sociobiologist Edward O. Wilson that continues to occupy my thoughts of late: "The real problem of humanity is the following: We have Palaeolithic emotions, medieval institutions and godlike technology." You know that I spend a great deal of my waking hours thinking about the implications of the changing financial services environment we find ourselves in today. It's an increasingly complex landscape, where we are facing geopolitical, climate and operational resiliency risks emanating from third party dependencies and cyber-attacks. We are facing changes to business models incorporating partnerships and responding to competition from and new entrants BigTech and FinTech. And the exponential growth of the global markets since the Great Financial Crisis in the interconnectedness of entities categorized as non-bank financial institutions with banks, especially private credit and equity funds operating outside the regulatory perimeter, is concerning, even worrying as we think about the effects on supervision and financial stability. Successfully connecting our technology and people to empower them in this changing landscape is essential. I would say that if we want to truly equip Pete for the future, it's clear that our work has only just begun. Thank you very much for your attention. I hope you enjoy the rest of the conference.	Elizabeth McCaul	Euro area	https://www.bis.org/review/r240924i.pdf	Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the Supervision Innovators Conference 2024, Frankfurt am Main, 18 September 2024. I'm honoured to welcome you again to this conference, which is already being held for the fifth time. It's the fifth anniversary of this conference but we are also celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). Naturally, it is a moment of reflection about what the future holds and how European banking supervision should continue to evolve. And, right now, various societal, political, technological, environmental and economic mega trends are shaping the future of the financial industry. In the tech area, for example, we are in the midst of a fast-paced and unprecedented development which is changing every aspect of the economy. The ways of working are changing profoundly. My son is a computer programmer. This weekend while driving we spoke about the possibilities for his future and what sort of work he might do, given the rapid innovation taking place. He told me he uses AI now regularly to produce code for him that he then reviews. Very different from the work he was hired for just two years ago when he graduated! In the aviation field artificial intelligence (AI) is being used to enhance the safety and efficiency of air traffic control by analysing historical and real-time flight data to predict potential collisions. Predicting accidents before they occur: isn't that also a goal worthy of banking supervision? And in the health care field, common applications include diagnosing patients, end-to-end drug discovery and development, improving communication between physician and patient or transcribing medical documents such as prescriptions. All of this change in the industries around us are food for thought as we consider in a clear-eyed, realistic and vigilant way the risks and opportunities for us in banking supervision. Disruptive technologies like AI are playing a growing role in banks' day-to-day activities, and access to technology is becoming widespread. At the same time, banks are becoming ever more dependent on data, IT platforms and third-party providers. To keep the banking sector safe and sound in the face of these trends, we need to equip the supervisors of the future with the right tools and skills. And it is this principle that has guided our strategic work on the digital agenda. Since the inception of European banking supervision in 2014 we have built up and continuously improved a set of core IT systems, launched our suptech efforts and created multiple cutting-edge tools which are already up and running. And now it is time to shape a new common strategy covering both our core IT systems and our suptech tools, as well as, most importantly, their integration. The new SSM tech strategy for 2024-2028 builds on two main pillars: people and technology. The strategy not only addresses several critical business needs Any smart strategy developed for the future must have at its foundation the recognition that people and technology are increasingly, even inextricably intertwined. How have we incorporated that? We have done so by setting as our goal connecting people and technology so we can deliver "supervision at your fingertips", This way, human expertise and technological innovation go hand-in-hand. We are structuring our work to ensure efficient, effective and integrated supervision that keeps pace with the trends and structural changes in the banking sector which I touched upon earlier. We are working on several levels to make sure that supervisors can fully use the applications and data available to them and that technology is seamlessly integrated into their day-to-day work. And we aim to consolidate IT to further strengthen European banking supervision, allowing supervisors to work as a single team with shared technology across the ECB and national competent authorities (NCAs). But what does this mean more concretely for our banking supervisors of the future? What impact will this strategy have on their work? What tools will they use? To make this tangible, let's imagine a future supervisor called Pete. The name "Pete" symbolises the two key pillars of our strategy: "Pe" stands for people, and "te" for technology. So, how does our new strategy support Pete? Let me start with the first pillar of our new strategy and the most important asset we have: our supervisors, people like Pete. Under this pillar, we plan to support Pete's work in the following three ways. First, we aim to instil a culture that supports the adoption of our suptech tools and embeds advanced technology into regular supervisory processes. We are convinced that having a clear user focus in all our technological activities and ensuring an enhanced user experience will encourage the take-up of our tools. One way of fostering the adoption of tools is our European banking supervision-wide suptech champions initiative. Under this initiative, Pete and other colleagues at the NCAs and in various business areas across ECB Banking Supervision can become trained experts in suptech tools. These suptech champions can then provide local and easy-to-access support to users. They also collect feedback and identify user needs in order to further develop the tool. In this way, suptech champions act as ambassadors, both promoting awareness and supporting the use and development of suptech tools. Already, 45 champions across 17 NCAs have reached over 1,000 supervisors through multiple channels, including workshops and providing guidance on the use of suptech tools. Second, we are continuing to make our organisation ready for the future by establishing a steady-state tech function that connects internal tech and supervision experts across business areas and NCAs. We want to cultivate a collaborative approach to shaping SSM technology and enhancing the adoption and use of available tools. In one of our flagship initiatives, NCAs can become suptech centres, which are at the forefront of developing technology for European banking supervision. They deliver tools that can subsequently be made available to the ECB and other NCAs. A case in point is that one NCA has developed a new use case for assessing the group structures of banks over time in our network analysis platform, Navi, which benefits European banking supervision as a whole. Third, we seek to tap into the global innovation networks with which we have established strong ties in recent years. For instance, we have been working closely with leading academic institutions to deliver state-of-the-art training to supervisors on machine learning, programming for data analytics, prompting and other topics. We are also working closely with industry leaders in other areas, such as generative AI, cloud technology and big data, as well as with start-ups to bring the latest and most advanced technologies to banking supervision. At the same time, we are partnering with other authorities across the world to experiment with new ways of solving common problems. Such partnerships mean that Pete has access to knowledge and state-of-the art technology that boost efficiency and improve supervisory outcomes, which brings me to the second pillar of our strategy, technology. Through our SSM tech strategy, we want to connect people with technology. In other words, we need to equip Pete with the necessary tools and capabilities. The first cluster in the technology pillar concerns our core IT systems. On the one hand we will continue to future-proof our core systems and data infrastructure by making them more modular, scalable and innovation-friendly while keeping them secure. We aim to optimise the IT landscape by integrating and consolidating systems across European banking supervision. On the other hand, we will decommission legacy systems to maximise the use and impact of existing applications. Working as a single team across the ECB and NCAs with access to shared technology will allow Pete to collaborate more intensively with European central banking colleagues. Olympus is a notable project in this regard. Through Olympus, we aim to proactively shape our IT landscape and make it ready for the upcoming challenges and opportunities offered by new technologies. This ambitious project reviews the full IT landscape and sets out a roadmap and action plan for the future of IT in European banking supervision. For this project, we have identified four high-level targets rooted in our supervisory needs that guide all activities. Our first target is to strengthen our data-driven work. Imagine having easy access to data and efficient processing within a few clicks. This will empower our teams to make informed decisions swiftly and effectively. The second target is to provide common and connected tools and systems. Using integrated systems to foster collaboration among all European banking supervisors, we will create a cohesive working environment that allows everyone to work together smoothly. The third target is to ensure seamless access and navigation. By unifying access and identity management, we will make it easier for our staff to find and use the resources they need, free from technical obstacles. Lastly, we will establish common IT standards and delivery. By adopting consistent IT standards, we will drive rapid and user-friendly digital innovation, ensuring our technology keeps pace with the latest advances. Under the Olympus project we have set out the concrete action needed to reach these targets. What does this mean for Pete, though? Let me give you an example. Pete will be able to use the SSM Cockpit to navigate through supervisory tasks. The SSM Cockpit will provide a user-centric platform integrated with core systems to facilitate access and navigation to various tools and systems. By design, it will be a flexible solution that meets the diverse information and reporting needs of different supervisory roles. The Cockpit will feature advanced, Al-powered capabilities to help supervisors efficiently carry out their core tasks. Supervisory analytics are the second cluster under the technology pillar. These seek to enhance risk assessment by augmenting analytical capabilities and combining structured and unstructured data. There is also a pressing business need to address emerging risks such as climate-related and environmental risks, as well as IT and cyber risks. To do so, we must explore new datasets and information sources, including social media. Supervisory analytics will give Pete and his colleagues new insights which will help them stay ahead of emerging risks and provide more robust and timely risk assessments. We have been working on a tool called Delphi which uses natural language processing to integrate market risk-based indicators and information from news items into a single web-based platform with a user-friendly interface. The insights afforded by combining such quantitative and qualitative information mean that supervisors like Pete can adequately assess the underlying risks and better understand the real-time risk development affecting individual banks. Our third and last cluster under the technology pillar concerns process automation and collaboration. Think about how the automotive industry is being transformed by smart manufacturing. In a smart factory, machines, devices and systems are interconnected and can communicate with one another, enabling real-time data collection, analysis and decision-making. What can we learn from other industries to become more effective and efficient in our supervision? We are committed to delivering additional breakthrough solutions that use AI - and more specifically generative AI - to simplify and automate workflows, while improving collaboration within European banking supervision. For a while now, we have been harnessing AI and making it available in some of our tools, such as Athena, which helps supervisors analyse extensive textual information in various formats and languages, and Virtual Lab, a platform for SSM-wide digital collaboration as well as code sharing, cloud computing and the development of generative AI (GenAI) capabilities. We are also planning to deploy AI in the AFM Medusa project which will support our supervisors in drafting, consistency-checking and benchmarking findings and measures. Our vision is for supervisors to be increasingly empowered by GenAI, while remaining engaged in the process since they will be the ones who continue to review and approve work and take the final decisions. This technology will provide suggestions, assist in drafting input and help with analysis. To this end, we have been collecting use cases and are determining where it makes sense to implement European banking supervision-wide solutions, where specialised applications with narrower scopes and user groups are appropriate, and where off-theshelf tools are sufficient. One of the solutions we have been working on is AthenaGPT, which complements Athena. Using AthenaGPT, supervisors like Pete are able to interact with several supervisory information sources at once. This boosts efficiency, as supervisors can then focus on the most relevant information. Searching for information in large supervisory repositories has never been easier. And in Agora, we are testing the ability for supervisors to query the data lake in English and use AI to translate into SQL, which is how the data can be accessed. This reminds me of how the work of my son is changing! As you can see, we have ambitious plans for Pete and all our supervisors. Continuous investment in technology will remain key for ECB Banking Supervision to keep pace with changes in the banking landscape and address emerging supervisory risks. I am confident that we will be successful in this endeavour and that we will help Pete become a supervisor of the future: a strong SSM collaborator working in a single team with shared technology, an empowered data expert who bases decisions on advanced supervisory analytics and an agile supervisor making use of process automation and the latest technology. At the same time, I am incredibly proud of what we have already achieved. We have developed and fully implemented suptech tools that harness modern technologies such as AI across Europe. These tools have changed the way we do supervision. We have been surprised at how some of our tools have been received in our supervisory community. For example, we only expected to have around 200 users for Agora, the SSM single data lake. But we already have over 1,200 users, who have made over 1.6 million data queries using the tool. Our top innovation and collaboration tool, Virtual Lab, is being used by around 4,000 colleagues. And our network analytics tool, Navi, has now grown to cover almost a dozen major use cases. We have also trained almost 3,000 colleagues, including leaders, on topics related to innovation and digital transformation. This has helped broaden supervisors' skillsets and established a mindset within our organisation that embraces technological change. Last, but not least, we have won four global innovation awards in three consecutive years. While we can be proud of these achievements, I believe that much remains to be done. There is a famous quote by the American sociobiologist Edward O. Wilson that continues to occupy my thoughts of late: "The real problem of humanity is the following: We have Palaeolithic emotions, medieval institutions and godlike technology." You know that I spend a great deal of my waking hours thinking about the implications of the changing financial services environment we find ourselves in today. It's an increasingly complex landscape, where we are facing geopolitical, climate and operational resiliency risks emanating from third party dependencies and cyber-attacks. We are facing changes to business models incorporating partnerships and responding to competition from and new entrants BigTech and FinTech. And the exponential growth of the global markets since the Great Financial Crisis in the interconnectedness of entities categorized as non-bank financial institutions with banks, especially private credit and equity funds operating outside the regulatory perimeter, is concerning, even worrying as we think about the effects on supervision and financial stability. Successfully connecting our technology and people to empower them in this changing landscape is essential. I would say that if we want to truly equip Pete for the future, it's clear that our work has only just begun. Thank you very much for your attention. I hope you enjoy the rest of the conference.
2024-09-23T00:00:00	Frank Elderson: Energy performance data - a must-have for managing climate-related credit risk	Welcome address by Frank Elderson, Member of the Executive Board of the ECB, and Vice-Chair of the Supervisory Board of the ECB, at the European Central Bank conference on real estate climate data industry good practices, Frankfurt am Main, 23 September 2024.	Frank Elderson: Energy performance data - a must-have for managing climate-related credit risk Welcome address by Frank Elderson, Member of the Executive Board of the ECB , and Vice-Chair of the Supervisory Board of the ECB, at the European Central Bank conference on real estate climate data industry good practices, Frankfurt am Main, 23 September 2024. * * * Good morning and a very warm welcome to all of you. It is a pleasure to see so many of you - bank representatives, journalists and supervisors - here in Frankfurt to discuss good practices for collecting and assessing climate-related data for the real estate sector. We have come a long way since 2019 when we first started to talk about climate-related and environmental risk management with you - the banks we supervise. Thanks to the tireless work of many dedicated climate risk experts in banks across Europe, jointly we have built up considerable expertise and made encouraging progress. Real estate lending represents a significant share of supervised banks' banking books. The real estate sector is also a concrete example of how physical and transition risks affect traditional prudential risk categories, in this case credit risk. And just as we do for any other material risk, we expect banks to identify, measure and - most importantly - manage these risks. Good data are crucial for sound risk management In short, to manage your risks you need to know them. And to know your risks you need to have good data. The same holds true when integrating climate-related risk drivers into credit risk management. To manage credit risk in the real estate sector, we need data on buildings' energy efficiency. This is crucial for collateral valuations or determining borrowers' ability to pay back their loan, for example. With this in mind, back in 2021 ECB Banking Supervision started looking at energy performance data for the commercial and residential real estate sectors by conducting targeted reviews for a sample of banks that were most exposed to these sectors. Supervisors collected data from these banks and engaged with them on their practices. As expectations were not yet set on this specific topic, we let banks explain how they obtained energy performance data. We looked at new lending as well as existing loan stocks. Overall, our targeted review showed that more progress had been made for new lending, for which most data were based on real data from energy performance certificates. As a concrete outcome of our targeted review, we asked all banks in the sample to collect real energy performance data at loan origination. Our supervisory recommendation was well received by banks that were not yet doing it, showing banks' willingness to integrate energy performance data into their credit risk management policies. This is good news. However, as supervisors, we are also concerned about the existing stock of loans. Most of the data on this are based on proxies, which makes it difficult for both banks and supervisors to design and implement proper risk management measures. Obtaining real data is admittedly challenging, yet many of the banks represented here today have made notable strides. You have found a way to collect energy performance data and use them effectively. And we invite all banks that have not yet advanced on collecting such data to learn from the good practices of those banks that have made critical leaps forward. Legislative changes will improve the availability of energy performance data Integrating climate-related data is also vitally important in view of impending legislative 1 changes. The revised Energy Performance of Buildings Directive , which includes common requirements for setting up national databases on the energy performance of buildings, is an important development that should help narrow the data gap. In the spirit of the Directive, further work is needed to ensure adequate data management and increase the reliability and consistency of climate-related real estate data across the European Union. Establishing a comprehensive European database of all buildings in the EU will take time. So banks cannot just sit back and wait. As supervisors we expect banks to manage all material risks. And this requirement is not conditional on the attainability of harmonised data. We therefore strongly encourage all efforts to improve data availability and welcome the successful strategies that some banks have implemented to address data gaps. Today's agenda will focus on the collection of energy performance data for the commercial and residential real estate sectors. But this will not be the only topic. Properties in areas prone to hazard events such as floods, rising sea levels or wildfires are increasingly vulnerable and could see a decrease in their collateral value. Last week's devastating floods in Austria, Czechia, Hungary, Italy, Poland, Romania and Slovakia were a stark reminder of that. Therefore, later in today's programme we will discuss the challenges and potential solutions for monitoring physical risk. In the coming weeks, the ECB will publish an analytical paper focusing on whether residential mortgage rates in high climate risk areas are influenced by this risk. The paper finds evidence that climate-related risk is already priced into mortgages. In other words, we see that an average bank took climate-related risks into account as loans secured by real estate in high climate risk areas were more expensive than loans with the same characteristics but in safer regions. However, the effect we find is economically small, so it seems that the climate-related risk is still underpriced by the average bank. Let me conclude. Good, reliable data are a cornerstone of sound risk management. This also holds true for managing the risks stemming from climate change. Thanks to the ongoing dialogue between supervisors and banks, some major stumbling blocks have already been overcome. The good practices observed for collecting real data on energy performance show that, while the task is challenging, it is far from impossible. Sharing your practices with peers will help more banks to improve the availability of energy performance data. So we are all looking forward to hearing about your experiences and learning from what worked well. The ongoing climate and nature crises will inevitably render our economy more susceptible to shocks. From a risk-based perspective, let me reassure you that ECB Banking Supervision will continue to play our part in spurring on banks to prepare for these risks. To succeed in our common goal of making banks resilient to climate and nature-related risks, it is vital that we keep up this dialogue with you - the industry - and encourage the exchange of good practices in the years to come. I would like to thank you for coming to Frankfurt today to share your experiences. 1 See European Commission (2024), Energy Performance of Buildings Directive.	---[PAGE_BREAK]--- # Frank Elderson: Energy performance data - a must-have for managing climate-related credit risk Welcome address by Frank Elderson, Member of the Executive Board of the ECB, and Vice-Chair of the Supervisory Board of the ECB, at the European Central Bank conference on real estate climate data industry good practices, Frankfurt am Main, 23 September 2024. Good morning and a very warm welcome to all of you. It is a pleasure to see so many of you - bank representatives, journalists and supervisors - here in Frankfurt to discuss good practices for collecting and assessing climate-related data for the real estate sector. We have come a long way since 2019 when we first started to talk about climate-related and environmental risk management with you - the banks we supervise. Thanks to the tireless work of many dedicated climate risk experts in banks across Europe, jointly we have built up considerable expertise and made encouraging progress. Real estate lending represents a significant share of supervised banks' banking books. The real estate sector is also a concrete example of how physical and transition risks affect traditional prudential risk categories, in this case credit risk. And just as we do for any other material risk, we expect banks to identify, measure and - most importantly manage these risks. ## Good data are crucial for sound risk management In short, to manage your risks you need to know them. And to know your risks you need to have good data. The same holds true when integrating climate-related risk drivers into credit risk management. To manage credit risk in the real estate sector, we need data on buildings' energy efficiency. This is crucial for collateral valuations or determining borrowers' ability to pay back their loan, for example. With this in mind, back in 2021 ECB Banking Supervision started looking at energy performance data for the commercial and residential real estate sectors by conducting targeted reviews for a sample of banks that were most exposed to these sectors. Supervisors collected data from these banks and engaged with them on their practices. As expectations were not yet set on this specific topic, we let banks explain how they obtained energy performance data. We looked at new lending as well as existing loan stocks. Overall, our targeted review showed that more progress had been made for new lending, for which most data were based on real data from energy performance certificates. As a concrete outcome of our targeted review, we asked all banks in the sample to collect real energy performance data at loan origination. Our supervisory recommendation was well received by banks that were not yet doing it, showing banks' ---[PAGE_BREAK]--- willingness to integrate energy performance data into their credit risk management policies. This is good news. However, as supervisors, we are also concerned about the existing stock of loans. Most of the data on this are based on proxies, which makes it difficult for both banks and supervisors to design and implement proper risk management measures. Obtaining real data is admittedly challenging, yet many of the banks represented here today have made notable strides. You have found a way to collect energy performance data and use them effectively. And we invite all banks that have not yet advanced on collecting such data to learn from the good practices of those banks that have made critical leaps forward. # Legislative changes will improve the availability of energy performance data Integrating climate-related data is also vitally important in view of impending legislative changes. The revised Energy Performance of Buildings Directive ${ }^{1}$, which includes common requirements for setting up national databases on the energy performance of buildings, is an important development that should help narrow the data gap. In the spirit of the Directive, further work is needed to ensure adequate data management and increase the reliability and consistency of climate-related real estate data across the European Union. Establishing a comprehensive European database of all buildings in the EU will take time. So banks cannot just sit back and wait. As supervisors we expect banks to manage all material risks. And this requirement is not conditional on the attainability of harmonised data. We therefore strongly encourage all efforts to improve data availability and welcome the successful strategies that some banks have implemented to address data gaps. Today's agenda will focus on the collection of energy performance data for the commercial and residential real estate sectors. But this will not be the only topic. Properties in areas prone to hazard events such as floods, rising sea levels or wildfires are increasingly vulnerable and could see a decrease in their collateral value. Last week's devastating floods in Austria, Czechia, Hungary, Italy, Poland, Romania and Slovakia were a stark reminder of that. Therefore, later in today's programme we will discuss the challenges and potential solutions for monitoring physical risk. In the coming weeks, the ECB will publish an analytical paper focusing on whether residential mortgage rates in high climate risk areas are influenced by this risk. The paper finds evidence that climate-related risk is already priced into mortgages. In other words, we see that an average bank took climate-related risks into account as loans secured by real estate in high climate risk areas were more expensive than loans with the same characteristics but in safer regions. However, the effect we find is economically small, so it seems that the climate-related risk is still underpriced by the average bank. Let me conclude. Good, reliable data are a cornerstone of sound risk management. This also holds true for managing the risks stemming from climate change. Thanks to the ongoing dialogue between supervisors and banks, some major stumbling blocks have already been overcome. The good practices observed for collecting real data on energy performance ---[PAGE_BREAK]--- show that, while the task is challenging, it is far from impossible. Sharing your practices with peers will help more banks to improve the availability of energy performance data. So we are all looking forward to hearing about your experiences and learning from what worked well. The ongoing climate and nature crises will inevitably render our economy more susceptible to shocks. From a risk-based perspective, let me reassure you that ECB Banking Supervision will continue to play our part in spurring on banks to prepare for these risks. To succeed in our common goal of making banks resilient to climate and nature-related risks, it is vital that we keep up this dialogue with you - the industry and encourage the exchange of good practices in the years to come. I would like to thank you for coming to Frankfurt today to share your experiences. ${ }^{1}$ See European Commission (2024), Energy Performance of Buildings Directive.	Frank Elderson	Euro area	https://www.bis.org/review/r240924r.pdf	Welcome address by Frank Elderson, Member of the Executive Board of the ECB, and Vice-Chair of the Supervisory Board of the ECB, at the European Central Bank conference on real estate climate data industry good practices, Frankfurt am Main, 23 September 2024. Good morning and a very warm welcome to all of you. It is a pleasure to see so many of you - bank representatives, journalists and supervisors - here in Frankfurt to discuss good practices for collecting and assessing climate-related data for the real estate sector. We have come a long way since 2019 when we first started to talk about climate-related and environmental risk management with you - the banks we supervise. Thanks to the tireless work of many dedicated climate risk experts in banks across Europe, jointly we have built up considerable expertise and made encouraging progress. Real estate lending represents a significant share of supervised banks' banking books. The real estate sector is also a concrete example of how physical and transition risks affect traditional prudential risk categories, in this case credit risk. And just as we do for any other material risk, we expect banks to identify, measure and - most importantly manage these risks. In short, to manage your risks you need to know them. And to know your risks you need to have good data. The same holds true when integrating climate-related risk drivers into credit risk management. To manage credit risk in the real estate sector, we need data on buildings' energy efficiency. This is crucial for collateral valuations or determining borrowers' ability to pay back their loan, for example. With this in mind, back in 2021 ECB Banking Supervision started looking at energy performance data for the commercial and residential real estate sectors by conducting targeted reviews for a sample of banks that were most exposed to these sectors. Supervisors collected data from these banks and engaged with them on their practices. As expectations were not yet set on this specific topic, we let banks explain how they obtained energy performance data. We looked at new lending as well as existing loan stocks. Overall, our targeted review showed that more progress had been made for new lending, for which most data were based on real data from energy performance certificates. As a concrete outcome of our targeted review, we asked all banks in the sample to collect real energy performance data at loan origination. Our supervisory recommendation was well received by banks that were not yet doing it, showing banks' willingness to integrate energy performance data into their credit risk management policies. This is good news. However, as supervisors, we are also concerned about the existing stock of loans. Most of the data on this are based on proxies, which makes it difficult for both banks and supervisors to design and implement proper risk management measures. Obtaining real data is admittedly challenging, yet many of the banks represented here today have made notable strides. You have found a way to collect energy performance data and use them effectively. And we invite all banks that have not yet advanced on collecting such data to learn from the good practices of those banks that have made critical leaps forward. Integrating climate-related data is also vitally important in view of impending legislative changes. The revised Energy Performance of Buildings Directive , which includes common requirements for setting up national databases on the energy performance of buildings, is an important development that should help narrow the data gap. In the spirit of the Directive, further work is needed to ensure adequate data management and increase the reliability and consistency of climate-related real estate data across the European Union. Establishing a comprehensive European database of all buildings in the EU will take time. So banks cannot just sit back and wait. As supervisors we expect banks to manage all material risks. And this requirement is not conditional on the attainability of harmonised data. We therefore strongly encourage all efforts to improve data availability and welcome the successful strategies that some banks have implemented to address data gaps. Today's agenda will focus on the collection of energy performance data for the commercial and residential real estate sectors. But this will not be the only topic. Properties in areas prone to hazard events such as floods, rising sea levels or wildfires are increasingly vulnerable and could see a decrease in their collateral value. Last week's devastating floods in Austria, Czechia, Hungary, Italy, Poland, Romania and Slovakia were a stark reminder of that. Therefore, later in today's programme we will discuss the challenges and potential solutions for monitoring physical risk. In the coming weeks, the ECB will publish an analytical paper focusing on whether residential mortgage rates in high climate risk areas are influenced by this risk. The paper finds evidence that climate-related risk is already priced into mortgages. In other words, we see that an average bank took climate-related risks into account as loans secured by real estate in high climate risk areas were more expensive than loans with the same characteristics but in safer regions. However, the effect we find is economically small, so it seems that the climate-related risk is still underpriced by the average bank. Let me conclude. Good, reliable data are a cornerstone of sound risk management. This also holds true for managing the risks stemming from climate change. Thanks to the ongoing dialogue between supervisors and banks, some major stumbling blocks have already been overcome. The good practices observed for collecting real data on energy performance show that, while the task is challenging, it is far from impossible. Sharing your practices with peers will help more banks to improve the availability of energy performance data. So we are all looking forward to hearing about your experiences and learning from what worked well. The ongoing climate and nature crises will inevitably render our economy more susceptible to shocks. From a risk-based perspective, let me reassure you that ECB Banking Supervision will continue to play our part in spurring on banks to prepare for these risks. To succeed in our common goal of making banks resilient to climate and nature-related risks, it is vital that we keep up this dialogue with you - the industry and encourage the exchange of good practices in the years to come. I would like to thank you for coming to Frankfurt today to share your experiences.
2024-09-24T00:00:00	Michelle W Bowman: Recent views on monetary policy and the economic outlook	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 Kentucky Bankers Association Annual Convention, Hot Springs, Virginia, 24 September 2024.	Michelle W Bowman: Recent views on monetary policy and the economic outlook Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 Kentucky Bankers Association Annual Convention, Hot Springs, Virginia, 24 September 2024. * * * Good morning. I would like to thank the Kentucky Bankers Association for the invitation 1 to join you today for your annual convention. I appreciate the opportunity to share my views on the U.S. economy and monetary policy before we engage on community banking issues and other matters affecting the banking industry. In light of last week's Federal Open Market Committee (FOMC) meeting, I will begin my remarks by providing some perspective on my vote and will then share my current views on the economy and monetary policy. Update on the Most Recent FOMC Meeting In order to address high inflation, for more than two years, the FOMC increased and held the federal funds rate at a restrictive level. At our September meeting, the FOMC voted to lower the target range for the federal funds rate by 1/2 percentage point to 4-3 /4 to 5 percent and to continue reducing the Federal Reserve's securities holdings. As the post-meeting statement noted, I dissented from the FOMC's decision, preferring instead to lower the target range for the federal funds rate by 1/4 percentage point to 5 to 5-1/4 percent. Last Friday, once our FOMC participant communications blackout period concluded, the Board of Governors released my statement explaining the decision to depart from the majority of the voting members. I agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by recalibrating the level of the federal funds rate and begin the process of moving toward a more neutral stance of policy. As my statement notes, I preferred a smaller initial cut in the policy rate while the U.S. economy remains strong and inflation remains a concern, despite recent progress. Economic Conditions and Outlook In recent months, we have seen some further progress on slowing the pace of inflation, with monthly readings lower than the elevated pace seen in the first three months of the year. The 12-month measure of core personal consumption expenditures (PCE) inflation, which provides a broader perspective than the more volatile higher-frequency readings, has moved down since April, although it came in at 2.6 percent in July, again remaining well above our 2 percent goal. In addition, the latest consumer and producer price index reports suggest that 12-month core PCE inflation in August was likely a touch above the July reading. The persistently high core inflation largely reflects pressures on housing prices, perhaps due in part to low inventories of affordable housing. The progress in lowering inflation since April is a welcome development, but core inflation is still uncomfortably above the Committee's 2 percent goal. Prices remain much higher than before the pandemic, which continues to weigh on consumer sentiment. Higher prices have an outsized effect on lower- and moderateincome households, as these households devote a significantly larger share of income to food, energy, and housing. Prices for these spending categories have far outpaced overall inflation over the past few years. Economic growth moderated earlier this year after coming in stronger last year. Private domestic final purchases (PDFP) growth has been solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories including net exports, suggesting that underlying economic growth was stronger than GDP indicated. PDFP has continued to increase at a solid pace so far in the third quarter, despite some further weakening in housing activity, as retail sales have shown further robust gains in July and August. Although personal consumption has remained resilient, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have extra savings to support this type of spending, and we have seen loan delinquency rates normalize from historically low levels during the pandemic. The most recent labor market report shows that payroll employment gains have slowed appreciably to a pace moderately above 100,000 per month over the three months ending in August. The unemployment rate edged down to 4.2 percent in August from 4.3 percent in July. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has declined further to a touch below the historically elevated pre-pandemic level-a sign that the number of available workers and the number of available jobs have come into better balance. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength despite the reported data. Although wage growth has slowed further in recent months, it remains indicative of a tight labor market. At just under 4 percent, as measured by both the employment cost index and average hourly earnings, wage gains are still above the pace consistent with our inflation goal given trend productivity growth. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, there are other factors likely contributing the increased unemployment. A mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. It is also likely that some temporary factors contributed to the recent rise in the unemployment rate, as unemployment among working age teenagers sharply increased in August. Preference for a More Measured Recalibration of Policy The U.S. economy remains strong and core inflation remains uncomfortably above our 2 percent target. In light of these economic conditions, a few further considerations supported the case for a more measured approach in beginning the process to recalibrate our policy stance to remove restriction and move toward a more neutral setting. First, I was concerned that reducing the target range for the federal funds rate by 1/2 percentage point could be interpreted as a signal that the Committee sees some fragility or greater downside risks to the economy. In the current economic environment, with no clear signs of material weakening or fragility, in my view, beginning the ratecutting cycle with a 1/4 percentage point move would have better reinforced the strength in economic conditions, while also confidently recognizing progress toward our goals. In my mind, a more measured approach would have avoided the risk of unintentionally signaling concerns about underlying economic conditions. Second, I was also concerned that reducing the policy rate by 1/2 percentage point could have led market participants to expect that the Committee would lower the target range by that same pace at future meetings until the policy rate approaches a neutral level. If this expectation had materialized, we could have seen an unwarranted decline in longer-term interest rates and broader financial conditions could become overly accommodative. This outcome could work against the Committee's goal of returning inflation to our 2 percent target. I am pleased that Chair Powell directly addressed both of these concerns during the press conference following last week's FOMC meeting. Third, there continues to be a considerable amount of pent-up demand and cash on the sidelines ready to be deployed as the path of interest rates moves down. Bringing the policy rate down too quickly carries the risk of unleashing that pent-up demand. A more measured approach would also avoid unnecessarily stoking demand and potentially reigniting inflationary pressures. Finally, in dialing back our restrictive stance of policy, we also need to be mindful of what the end point is likely to be. My estimate of the neutral rate is much higher than it was before the pandemic. Therefore, I think we are much closer to neutral than would have been the case under pre-pandemic conditions, and I did not see the peak stance of policy as restrictive to the same extent that my colleagues may have. With a higher estimate of neutral, for any given pace of rate reductions, we would arrive at our destination sooner. Ongoing Risks to the Outlook Turning to the risks to achieving our dual mandate, I continue to see greater risks to price stability, especially while the labor market continues to be near estimates of full employment. Although the labor market data have been showing signs of cooling in recent months, still-elevated wage growth, solid consumer spending, and resilient GDP growth are not consistent with a material economic weakening or fragility. My contacts also continue to mention that they are not planning layoffs and continue to have difficulty hiring. Therefore, I am taking less signal from the recent labor market data until there are clear trends indicating that both spending growth and the labor market have materially weakened. I suspect the recent immigration flows have and will continue to affect labor markets in ways that we do not yet fully understand and cannot yet accurately measure. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. In my view, the upside risks to inflation remain prominent. Global supply chains continue to be susceptible to labor strikes and increased geopolitical tensions, which could result in inflationary effects on food, energy, and other commodity markets. Expansionary fiscal spending could also lead to inflationary risks, as could an increased demand for housing given the long-standing limited supply, especially of affordable housing. While it has not been my baseline outlook, I cannot rule out the risk that progress on inflation could continue to stall. Although it is important to recognize that there has been meaningful progress on lowering inflation, while core inflation remains around or above 2.5 percent, I see the risk that the Committee's larger policy action could be interpreted as a premature declaration of victory on our price-stability mandate. Accomplishing our mission of returning to low and stable inflation at our 2 percent goal is necessary to foster a strong labor market and an economy that works for everyone in the longer term. In light of these considerations, I believe that, by moving at a measured pace toward a more neutral policy stance, we will be better positioned to achieve further progress in bringing inflation down to our 2 percent target, while closely watching the evolution of labor market conditions. The Path Forward Despite my dissent at the recent FOMC meeting, I respect and appreciate that my FOMC colleagues preferred to begin the reduction in the federal funds rate with a larger initial cut in the target range for the policy rate. I remain committed to working together with my colleagues to ensure that monetary policy is appropriately positioned to achieve our goals of attaining maximum employment and returning inflation to our 2 percent target. I will continue to monitor the incoming data and information as I assess the appropriate path of monetary policy, and I will remain cautious in my approach to adjusting the stance of policy going forward. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook guided by the Fed's dual-mandate goals of maximum employment and stable prices. We need to ensure that the public understands clearly how current and expected deviations of inflation and employment from our mandated goals inform our policy decisions. By the time of our next meeting in November, we will have received updated reports on inflation, employment, and economic activity. We may also have a better understanding of how developments in longer-term interest rates and broader financial conditions might influence the economic outlook. During the intermeeting period, I will continue to visit with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as a concern. In light of the upside risks that I just described, it remains necessary to pay close attention to the pricestability side of our mandate while being attentive to the risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. However, should the data evolve in a way that points to a material weakening in the labor market, I would support taking action and adjust monetary policy as needed while taking into account our inflation mandate. Closing Thoughts In closing, thank you again for welcoming me here today. It is a pleasure to join you and to have the opportunity to discuss my views on the economy and monetary policy. And given the recent FOMC meeting decision and my dissent, I appreciate being able to provide a more detailed explanation of the reasoning that led me to dissent in favor of a smaller reduction in the policy rate at last week's FOMC meeting. I look forward to answering your questions and to engaging with your members on bank regulatory and supervisory matters. 1 The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors.	---[PAGE_BREAK]--- # Michelle W Bowman: Recent views on monetary policy and the economic outlook Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 Kentucky Bankers Association Annual Convention, Hot Springs, Virginia, 24 September 2024. Good morning. I would like to thank the Kentucky Bankers Association for the invitation to join you today for your annual convention. I appreciate the opportunity to share my views on the U.S. economy and monetary policy before we engage on community banking issues and other matters affecting the banking industry. In light of last week's Federal Open Market Committee (FOMC) meeting, I will begin my remarks by providing some perspective on my vote and will then share my current views on the economy and monetary policy. ## Update on the Most Recent FOMC Meeting In order to address high inflation, for more than two years, the FOMC increased and held the federal funds rate at a restrictive level. At our September meeting, the FOMC voted to lower the target range for the federal funds rate by $1 / 2$ percentage point to $4-3$ /4 to 5 percent and to continue reducing the Federal Reserve's securities holdings. As the post-meeting statement noted, I dissented from the FOMC's decision, preferring instead to lower the target range for the federal funds rate by $1 / 4$ percentage point to 5 to 5-1/4 percent. Last Friday, once our FOMC participant communications blackout period concluded, the Board of Governors released my statement explaining the decision to depart from the majority of the voting members. I agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by recalibrating the level of the federal funds rate and begin the process of moving toward a more neutral stance of policy. As my statement notes, I preferred a smaller initial cut in the policy rate while the U.S. economy remains strong and inflation remains a concern, despite recent progress. ## Economic Conditions and Outlook In recent months, we have seen some further progress on slowing the pace of inflation, with monthly readings lower than the elevated pace seen in the first three months of the year. The 12-month measure of core personal consumption expenditures (PCE) inflation, which provides a broader perspective than the more volatile higher-frequency readings, has moved down since April, although it came in at 2.6 percent in July, again remaining well above our 2 percent goal. In addition, the latest consumer and producer price index reports suggest that 12-month core PCE inflation in August was likely a touch above the July reading. The persistently high core inflation largely reflects ---[PAGE_BREAK]--- pressures on housing prices, perhaps due in part to low inventories of affordable housing. The progress in lowering inflation since April is a welcome development, but core inflation is still uncomfortably above the Committee's 2 percent goal. Prices remain much higher than before the pandemic, which continues to weigh on consumer sentiment. Higher prices have an outsized effect on lower- and moderateincome households, as these households devote a significantly larger share of income to food, energy, and housing. Prices for these spending categories have far outpaced overall inflation over the past few years. Economic growth moderated earlier this year after coming in stronger last year. Private domestic final purchases (PDFP) growth has been solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories including net exports, suggesting that underlying economic growth was stronger than GDP indicated. PDFP has continued to increase at a solid pace so far in the third quarter, despite some further weakening in housing activity, as retail sales have shown further robust gains in July and August. Although personal consumption has remained resilient, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have extra savings to support this type of spending, and we have seen loan delinquency rates normalize from historically low levels during the pandemic. The most recent labor market report shows that payroll employment gains have slowed appreciably to a pace moderately above 100,000 per month over the three months ending in August. The unemployment rate edged down to 4.2 percent in August from 4.3 percent in July. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has declined further to a touch below the historically elevated pre-pandemic level-a sign that the number of available workers and the number of available jobs have come into better balance. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength despite the reported data. Although wage growth has slowed further in recent months, it remains indicative of a tight labor market. At just under 4 percent, as measured by both the employment cost index and average hourly earnings, wage gains are still above the pace consistent with our inflation goal given trend productivity growth. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, there are other factors likely contributing the increased unemployment. A mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. It is ---[PAGE_BREAK]--- also likely that some temporary factors contributed to the recent rise in the unemployment rate, as unemployment among working age teenagers sharply increased in August. # Preference for a More Measured Recalibration of Policy The U.S. economy remains strong and core inflation remains uncomfortably above our 2 percent target. In light of these economic conditions, a few further considerations supported the case for a more measured approach in beginning the process to recalibrate our policy stance to remove restriction and move toward a more neutral setting. First, I was concerned that reducing the target range for the federal funds rate by $1 / 2$ percentage point could be interpreted as a signal that the Committee sees some fragility or greater downside risks to the economy. In the current economic environment, with no clear signs of material weakening or fragility, in my view, beginning the ratecutting cycle with a $1 / 4$ percentage point move would have better reinforced the strength in economic conditions, while also confidently recognizing progress toward our goals. In my mind, a more measured approach would have avoided the risk of unintentionally signaling concerns about underlying economic conditions. Second, I was also concerned that reducing the policy rate by $1 / 2$ percentage point could have led market participants to expect that the Committee would lower the target range by that same pace at future meetings until the policy rate approaches a neutral level. If this expectation had materialized, we could have seen an unwarranted decline in longer-term interest rates and broader financial conditions could become overly accommodative. This outcome could work against the Committee's goal of returning inflation to our 2 percent target. I am pleased that Chair Powell directly addressed both of these concerns during the press conference following last week's FOMC meeting. Third, there continues to be a considerable amount of pent-up demand and cash on the sidelines ready to be deployed as the path of interest rates moves down. Bringing the policy rate down too quickly carries the risk of unleashing that pent-up demand. A more measured approach would also avoid unnecessarily stoking demand and potentially reigniting inflationary pressures. Finally, in dialing back our restrictive stance of policy, we also need to be mindful of what the end point is likely to be. My estimate of the neutral rate is much higher than it was before the pandemic. Therefore, I think we are much closer to neutral than would have been the case under pre-pandemic conditions, and I did not see the peak stance of policy as restrictive to the same extent that my colleagues may have. With a higher estimate of neutral, for any given pace of rate reductions, we would arrive at our destination sooner. ## Ongoing Risks to the Outlook Turning to the risks to achieving our dual mandate, I continue to see greater risks to price stability, especially while the labor market continues to be near estimates of full ---[PAGE_BREAK]--- employment. Although the labor market data have been showing signs of cooling in recent months, still-elevated wage growth, solid consumer spending, and resilient GDP growth are not consistent with a material economic weakening or fragility. My contacts also continue to mention that they are not planning layoffs and continue to have difficulty hiring. Therefore, I am taking less signal from the recent labor market data until there are clear trends indicating that both spending growth and the labor market have materially weakened. I suspect the recent immigration flows have and will continue to affect labor markets in ways that we do not yet fully understand and cannot yet accurately measure. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. In my view, the upside risks to inflation remain prominent. Global supply chains continue to be susceptible to labor strikes and increased geopolitical tensions, which could result in inflationary effects on food, energy, and other commodity markets. Expansionary fiscal spending could also lead to inflationary risks, as could an increased demand for housing given the long-standing limited supply, especially of affordable housing. While it has not been my baseline outlook, I cannot rule out the risk that progress on inflation could continue to stall. Although it is important to recognize that there has been meaningful progress on lowering inflation, while core inflation remains around or above 2.5 percent, I see the risk that the Committee's larger policy action could be interpreted as a premature declaration of victory on our price-stability mandate. Accomplishing our mission of returning to low and stable inflation at our 2 percent goal is necessary to foster a strong labor market and an economy that works for everyone in the longer term. In light of these considerations, I believe that, by moving at a measured pace toward a more neutral policy stance, we will be better positioned to achieve further progress in bringing inflation down to our 2 percent target, while closely watching the evolution of labor market conditions. # The Path Forward Despite my dissent at the recent FOMC meeting, I respect and appreciate that my FOMC colleagues preferred to begin the reduction in the federal funds rate with a larger initial cut in the target range for the policy rate. I remain committed to working together with my colleagues to ensure that monetary policy is appropriately positioned to achieve our goals of attaining maximum employment and returning inflation to our 2 percent target. I will continue to monitor the incoming data and information as I assess the appropriate path of monetary policy, and I will remain cautious in my approach to adjusting the stance of policy going forward. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook guided by the Fed's dual-mandate goals of maximum employment and stable prices. We need to ensure that the public understands clearly how current and expected deviations of inflation and employment from our mandated goals inform our policy decisions. ---[PAGE_BREAK]--- By the time of our next meeting in November, we will have received updated reports on inflation, employment, and economic activity. We may also have a better understanding of how developments in longer-term interest rates and broader financial conditions might influence the economic outlook. During the intermeeting period, I will continue to visit with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as a concern. In light of the upside risks that I just described, it remains necessary to pay close attention to the pricestability side of our mandate while being attentive to the risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. However, should the data evolve in a way that points to a material weakening in the labor market, I would support taking action and adjust monetary policy as needed while taking into account our inflation mandate. # Closing Thoughts In closing, thank you again for welcoming me here today. It is a pleasure to join you and to have the opportunity to discuss my views on the economy and monetary policy. And given the recent FOMC meeting decision and my dissent, I appreciate being able to provide a more detailed explanation of the reasoning that led me to dissent in favor of a smaller reduction in the policy rate at last week's FOMC meeting. I look forward to answering your questions and to engaging with your members on bank regulatory and supervisory matters. ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors.	Michelle W Bowman	United States	https://www.bis.org/review/r240924n.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 Kentucky Bankers Association Annual Convention, Hot Springs, Virginia, 24 September 2024. Good morning. I would like to thank the Kentucky Bankers Association for the invitation to join you today for your annual convention. I appreciate the opportunity to share my views on the U.S. economy and monetary policy before we engage on community banking issues and other matters affecting the banking industry. In light of last week's Federal Open Market Committee (FOMC) meeting, I will begin my remarks by providing some perspective on my vote and will then share my current views on the economy and monetary policy. In order to address high inflation, for more than two years, the FOMC increased and held the federal funds rate at a restrictive level. At our September meeting, the FOMC voted to lower the target range for the federal funds rate by $1 / 2$ percentage point to $4-3$ /4 to 5 percent and to continue reducing the Federal Reserve's securities holdings. As the post-meeting statement noted, I dissented from the FOMC's decision, preferring instead to lower the target range for the federal funds rate by $1 / 4$ percentage point to 5 to 5-1/4 percent. Last Friday, once our FOMC participant communications blackout period concluded, the Board of Governors released my statement explaining the decision to depart from the majority of the voting members. I agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by recalibrating the level of the federal funds rate and begin the process of moving toward a more neutral stance of policy. As my statement notes, I preferred a smaller initial cut in the policy rate while the U.S. economy remains strong and inflation remains a concern, despite recent progress. In recent months, we have seen some further progress on slowing the pace of inflation, with monthly readings lower than the elevated pace seen in the first three months of the year. The 12-month measure of core personal consumption expenditures (PCE) inflation, which provides a broader perspective than the more volatile higher-frequency readings, has moved down since April, although it came in at 2.6 percent in July, again remaining well above our 2 percent goal. In addition, the latest consumer and producer price index reports suggest that 12-month core PCE inflation in August was likely a touch above the July reading. The persistently high core inflation largely reflects pressures on housing prices, perhaps due in part to low inventories of affordable housing. The progress in lowering inflation since April is a welcome development, but core inflation is still uncomfortably above the Committee's 2 percent goal. Prices remain much higher than before the pandemic, which continues to weigh on consumer sentiment. Higher prices have an outsized effect on lower- and moderateincome households, as these households devote a significantly larger share of income to food, energy, and housing. Prices for these spending categories have far outpaced overall inflation over the past few years. Economic growth moderated earlier this year after coming in stronger last year. Private domestic final purchases (PDFP) growth has been solid and slowed much less than gross domestic product (GDP), as the slowdown in GDP growth was partly driven by volatile categories including net exports, suggesting that underlying economic growth was stronger than GDP indicated. PDFP has continued to increase at a solid pace so far in the third quarter, despite some further weakening in housing activity, as retail sales have shown further robust gains in July and August. Although personal consumption has remained resilient, consumers appear to be pulling back on discretionary items and expenses, as evidenced in part by a decline in restaurant spending since late last year. Low- and moderate-income consumers no longer have extra savings to support this type of spending, and we have seen loan delinquency rates normalize from historically low levels during the pandemic. The most recent labor market report shows that payroll employment gains have slowed appreciably to a pace moderately above 100,000 per month over the three months ending in August. The unemployment rate edged down to 4.2 percent in August from 4.3 percent in July. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has declined further to a touch below the historically elevated pre-pandemic level-a sign that the number of available workers and the number of available jobs have come into better balance. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength despite the reported data. Although wage growth has slowed further in recent months, it remains indicative of a tight labor market. At just under 4 percent, as measured by both the employment cost index and average hourly earnings, wage gains are still above the pace consistent with our inflation goal given trend productivity growth. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, there are other factors likely contributing the increased unemployment. A mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. It is also likely that some temporary factors contributed to the recent rise in the unemployment rate, as unemployment among working age teenagers sharply increased in August. The U.S. economy remains strong and core inflation remains uncomfortably above our 2 percent target. In light of these economic conditions, a few further considerations supported the case for a more measured approach in beginning the process to recalibrate our policy stance to remove restriction and move toward a more neutral setting. First, I was concerned that reducing the target range for the federal funds rate by $1 / 2$ percentage point could be interpreted as a signal that the Committee sees some fragility or greater downside risks to the economy. In the current economic environment, with no clear signs of material weakening or fragility, in my view, beginning the ratecutting cycle with a $1 / 4$ percentage point move would have better reinforced the strength in economic conditions, while also confidently recognizing progress toward our goals. In my mind, a more measured approach would have avoided the risk of unintentionally signaling concerns about underlying economic conditions. Second, I was also concerned that reducing the policy rate by $1 / 2$ percentage point could have led market participants to expect that the Committee would lower the target range by that same pace at future meetings until the policy rate approaches a neutral level. If this expectation had materialized, we could have seen an unwarranted decline in longer-term interest rates and broader financial conditions could become overly accommodative. This outcome could work against the Committee's goal of returning inflation to our 2 percent target. I am pleased that Chair Powell directly addressed both of these concerns during the press conference following last week's FOMC meeting. Third, there continues to be a considerable amount of pent-up demand and cash on the sidelines ready to be deployed as the path of interest rates moves down. Bringing the policy rate down too quickly carries the risk of unleashing that pent-up demand. A more measured approach would also avoid unnecessarily stoking demand and potentially reigniting inflationary pressures. Finally, in dialing back our restrictive stance of policy, we also need to be mindful of what the end point is likely to be. My estimate of the neutral rate is much higher than it was before the pandemic. Therefore, I think we are much closer to neutral than would have been the case under pre-pandemic conditions, and I did not see the peak stance of policy as restrictive to the same extent that my colleagues may have. With a higher estimate of neutral, for any given pace of rate reductions, we would arrive at our destination sooner. Turning to the risks to achieving our dual mandate, I continue to see greater risks to price stability, especially while the labor market continues to be near estimates of full employment. Although the labor market data have been showing signs of cooling in recent months, still-elevated wage growth, solid consumer spending, and resilient GDP growth are not consistent with a material economic weakening or fragility. My contacts also continue to mention that they are not planning layoffs and continue to have difficulty hiring. Therefore, I am taking less signal from the recent labor market data until there are clear trends indicating that both spending growth and the labor market have materially weakened. I suspect the recent immigration flows have and will continue to affect labor markets in ways that we do not yet fully understand and cannot yet accurately measure. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. In my view, the upside risks to inflation remain prominent. Global supply chains continue to be susceptible to labor strikes and increased geopolitical tensions, which could result in inflationary effects on food, energy, and other commodity markets. Expansionary fiscal spending could also lead to inflationary risks, as could an increased demand for housing given the long-standing limited supply, especially of affordable housing. While it has not been my baseline outlook, I cannot rule out the risk that progress on inflation could continue to stall. Although it is important to recognize that there has been meaningful progress on lowering inflation, while core inflation remains around or above 2.5 percent, I see the risk that the Committee's larger policy action could be interpreted as a premature declaration of victory on our price-stability mandate. Accomplishing our mission of returning to low and stable inflation at our 2 percent goal is necessary to foster a strong labor market and an economy that works for everyone in the longer term. In light of these considerations, I believe that, by moving at a measured pace toward a more neutral policy stance, we will be better positioned to achieve further progress in bringing inflation down to our 2 percent target, while closely watching the evolution of labor market conditions. Despite my dissent at the recent FOMC meeting, I respect and appreciate that my FOMC colleagues preferred to begin the reduction in the federal funds rate with a larger initial cut in the target range for the policy rate. I remain committed to working together with my colleagues to ensure that monetary policy is appropriately positioned to achieve our goals of attaining maximum employment and returning inflation to our 2 percent target. I will continue to monitor the incoming data and information as I assess the appropriate path of monetary policy, and I will remain cautious in my approach to adjusting the stance of policy going forward. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each FOMC meeting based on the incoming data and the implications for and risks to the outlook guided by the Fed's dual-mandate goals of maximum employment and stable prices. We need to ensure that the public understands clearly how current and expected deviations of inflation and employment from our mandated goals inform our policy decisions. By the time of our next meeting in November, we will have received updated reports on inflation, employment, and economic activity. We may also have a better understanding of how developments in longer-term interest rates and broader financial conditions might influence the economic outlook. During the intermeeting period, I will continue to visit with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. As I noted earlier, I continue to view inflation as a concern. In light of the upside risks that I just described, it remains necessary to pay close attention to the pricestability side of our mandate while being attentive to the risks of a material weakening in the labor market. My view continues to be that restoring price stability is essential for achieving maximum employment over the longer run. However, should the data evolve in a way that points to a material weakening in the labor market, I would support taking action and adjust monetary policy as needed while taking into account our inflation mandate. In closing, thank you again for welcoming me here today. It is a pleasure to join you and to have the opportunity to discuss my views on the economy and monetary policy. And given the recent FOMC meeting decision and my dissent, I appreciate being able to provide a more detailed explanation of the reasoning that led me to dissent in favor of a smaller reduction in the policy rate at last week's FOMC meeting. I look forward to answering your questions and to engaging with your members on bank regulatory and supervisory matters.
2024-09-25T00:00:00	Adriana D Kugler: How we got here - a perspective on inflation and the labor market	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Mossavar-Rahmani Center for Business and Government, Harvard Kennedy School, Cambridge, Massachusetts, 25 September 2024.	For release on delivery 4:00 p.m. EDT September 25, 2024 How We Got Here: A Perspective on Inflation and the Labor Market Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Mossavar-Rahmani Center for Business and Government Harvard Kennedy School Cambridge, Massachusetts September 25, 2024 Thank you, John, and thank you for the opportunity to speak here today.1 It is good to be back at the Kennedy School and in particular at the Mossavar-Rahmani Center, which has a long tradition of engaging on important policy issues. In my remarks today, I will provide my outlook for the U.S. economy and the implications for monetary policy. The combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision last week by the Federal Open Market Committee (FOMC) to cut the federal funds rate by 50 basis points. While future actions by the FOMC will depend on data we receive on inflation, employment, and economic activity, if conditions continue to evolve in the direction traveled thus far, then additional cuts will be appropriate. I will begin by summarizing where we stand on inflation, including details on how the different components of inflation have changed over time, since these facts form the basis for my judgment on where inflation is headed. I will then talk about the recent cooling in the labor market and the forces driving it as well as how shifts on this other side of our mandate fit into the overall economic outlook for the rest of this year. I will conclude with the implications of all this for appropriate monetary policy and our focus on our dual mandate. Inflation based on personal consumption expenditures (PCE) has come down from a peak of 7.1 percent on a year-on-year basis to 2.5 percent in July. Core PCE inflation, which excludes energy and food prices and tends to be less volatile, has come down from a peak of 5.6 percent to now 2.6 percent. Based on consumer and producer - 2 - price indexes, I estimate headline PCE and core PCE inflation to be at about 2.2 and 2.7 percent, respectively, in August, consistent with ongoing progress toward the FOMC's 2 percent target. The progress on inflation is good news, but it is important to remember that households and businesses are still dealing with prices for many goods and services that are significantly higher than a couple of years ago. Prices for groceries, for example, are about 20 percent higher than before inflation started rising in 2021, and while earnings have been rising faster than inflation, it may take some time for it to feel as though prices are back to normal.2 Inflation data are produced by the Labor Department, and when I served as chief economist at Labor, I delved into the differential effects of inflation on various demographic groups. When inflation was at its peak in 2022, it was more than 1 percentage point higher for lower-income households, for those without a college degree, and for those aged 18 to 29-all groups that spend a higher share of income on necessities and have less wealth to draw from.3 Fortunately, research by staff at the Fed shows that disinflation helps close that gap as well, something that only adds to the urgency I feel about returning inflation to the FOMC's 2 percent goal. Research on the causes of inflation and the subsequent disinflation show that both supply and demand forces have played an important role. In the past two years, specifically, improvements in supply, along with moderation in demand in part due to - 3 - tighter monetary policy, have both played a role in the disinflationary process.4 Supply chain bottlenecks as well as the drastic drop in the labor force due to excess retirements and the withdrawal of prime-age workers contributed to the initial rise in inflation, but the resolution of these disruptions and the return of workers to the labor force have also helped rein in inflation. Early on, consumers shifted spending from services to goods, a development that goods producers struggled to accommodate, putting upward pressure on prices. But as the demand shock to goods unwound and consumer spending shifted back to services, goods inflation fell and has been running below zero in recent months. Also, the increased demand due to the fiscal response to COVID-19 in 2020 and 2021 has more recently been roughly neutral on growth, as shown by the Hutchins Center on Fiscal and Monetary Policy in their measure of fiscal impact. And, of course, as I will discuss in a moment, tight monetary policy has been and continues to be a moderating force on demand, primarily by raising costs for interest-sensitive goods and services. As I think about where inflation is headed, I find it helpful to consider how it has evolved over the past several years and in particular how the major components of inflation have behaved, so I want to take a few minutes to walk through those details. 4 Different approaches allow a parsing of the relative contributions of supply and demand, top-down approaches by Bernanke and Blanchard (forthcoming) and Benigno and Eggertson (2023) and bottom-up approaches by Braun, Flaaen, and Hoke (2024) and Shapiro (2022); see Ben Bernanke and Olivier Blanchard (forthcoming), "What Caused the U.S. Pandemic-Era Inflation?" American Economic Journal: Macroeconomics; Pierpaolo Benigno and Gauti B. Eggertsson (2023), "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve," NBER Working Paper Series 31197 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w31197; Robin Braun, Aaron Flaaen, and Sinem Hacioglu Hoke (2024), "Supply vs Demand Factors Influencing Prices of Manufactured Goods," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, February 23), https://www.federalreserve.gov/econres/notes/feds-notes/supply-vs-demand-factorsinfluencing-prices-of-manufactured-goods-20240223.html; and Adam Hale Shapiro (2022), "How Much Do Supply and Demand Drive Inflation?" FRBSF Economic Letter 2022-15 (San Francisco: Federal Reserve Bank of San Francisco, June 21), https://www.frbsf.org/research-andinsights/publications/economic-letter/2022/06/how-much-do-supply-and-demand-drive-inflation. All of these studies agree that both supply and demand shocks contributed to the surge in inflation as well as its fall. - 4 - As I have indicated, the big picture is that goods inflation surged early on in 2020 and 2021, followed by prices for services excluding housing, and then housing, with some overlap in those steps. Disinflation has followed that course in reverse. Core goods inflation rose, after almost a year of social distancing shifted spending from services and after production and delivery of goods was disrupted by the pandemic. This was a big change because over the long expansion leading to the pandemic, core goods prices actually fell, slightly but consistently.5 On a 12-month basis, core PCE goods inflation rose above zero in December 2020, reached a peak of 7.6 percent in February 2022, and fell again below zero at the end of 2023. In July of this year, it was negative 0.5 percent. This recent disinflation offset still-rising prices for services and helped reduce overall inflation. Goods inflation has reverted to its longer-term pattern as demand has moderated and supply chain problems have abated. This is reflected by various indexes of supply chain bottlenecks that showed the supply-side disruptions that contributed early on to surging inflation have now retreated to pre-pandemic levels.6 Other data show that computer chip supply, which fell far short of demand early in the pandemic, is back to normal conditions as well. Food and energy prices, always subject to larger ups and downs than other parts of inflation, rose also early on. Food inflation increased in 2020 as shoppers began stockpiling groceries and as warehouses and production facilities had difficulty staffing due to COVID. After Russia's invasion of Ukraine, energy price inflation reached a peak - 5 - 12-month rate of nearly 45 percent and food inflation reached a peak of 12 percent in mid-2022, highlighting the importance of petroleum and agricultural commodities from that part of the world. Food and energy inflation has moderated over the past two years and are now both running at 12-month rates of 1.4 percent and 1.9 percent, respectively, as supply chain issues have resolved and production in the U.S. and elsewhere has increased. Food and energy expenses represent a sizable share of consumer spending, but the frequent purchase of these goods means that they are highly salient in the public's views on inflation. Research by Francesco D'Acunto and coauthors has shown that the weights that consumers assign to price changes in forming their inflation expectations are not based on the actual share of their expenditures but instead on the frequency of purchases, which happen to be highest for food and energy goods.7 Thus, the fall in food and energy prices is important because it may feed back into lower inflation in other categories by moderating overall inflation expectations and also real wage expectations in wage bargaining. Housing services price increases were the last component of inflation to escalate, rising to a peak 12-month rate of 8.3 percent in April 2023 and moderating to a 5.3 percent pace in July. It took time for housing prices to escalate and has taken longer for them to moderate because of both the nature of the rental market and the data collection method from the Bureau of Labor Statistics, as I have discussed at length in other speeches.8 However, new rent increases, which better capture rental price changes in real - 6 - time, are falling and are the main reason why I expect housing services costs to moderate further. The final component of inflation is services excluding housing, which accounts for 50 percent of PCE inflation and is heavily influenced by labor markets. On a 12- month basis, this component of inflation rose to a peak of 5.3 percent in December 2021, stayed persistently high until February 2023, and has moderated since then to 3.3 percent in July of this year. Its escalation was driven both by the rise in labor costs and by the transition of demand from goods to services following the pandemic. Labor costs are a substantial share of the total costs for services. For example, labor accounts for between 60 percent to 80 percent of costs in construction, education, and health services. Among the initial forces driving the escalation in wages were the increase in food and energy prices, as wage demands tend to track closely with the prices of these frequently purchased goods. Data on wage demands from the New York Fed's Survey of Consumer Expectations indeed show a sudden increase early on during the pandemic right after the first bout of food inflation.9 Importantly, worker shortages likely allowed those higher wage demands to be realized, contributing to the rise in wages. Later, as demand for services quickly rose and employers were creating a large number of jobs in several service sectors, workers were able to be more selective, and the ensuing "Great Resignation" took hold, allowing people to choose different careers. The relatively high - 7 - demand relative to the supply of workers in some service sectors encouraged workers to move from job to job for higher wages, benefits, and other improvements in working conditions. Evidence from the Atlanta Fed's Wage Growth Tracker suggests that during this period, wages for job switchers grew more than 2 percentage points faster than wages for people staying in the same job, though this wage premium for job switchers disappeared by the second half of last year. But now inflation for services excluding housing is declining, after a temporary escalation in the first quarter of this year that was likely partly due to residual seasonality. There had been fears that wage increases would drive a wage-price spiral, as the U.S. experienced in the 1970s, but this did not occur. To sum up, inflation has broadly moderated as the supply of goods and services has improved, and as producers and consumers have adjusted to the effects of higher prices. Demand has moderated, in part due to tighter monetary policy. And, as I just noted, changes in the pace of wage growth have also played an important role in the ups and downs of inflation, which points me toward a discussion of labor markets, which has recently become a greater focus of monetary policy. As I have noted, there has been a significant moderation in the labor market recently, but I want to start by pointing to what really has been a remarkable performance of the labor market over the past four years. After the unprecedented job losses early in the pandemic, and even accounting for the quick recovery of a large share of those losses, the recovery of the labor market that followed was historically swift. Unemployment was 7.8 percent in September 2020 and 4.7 percent only 12 months later, and it fell to under 4 percent 3 months after that. That is a more rapid recovery than the U.S. has experienced - 8 - since the 1960's. What started, at that point, was 30 straight months of unemployment at or below 4 percent, which had not happened during the pre-pandemic period, the boom of the 1990s, or anytime during the 1980s, and it was only exceeded by the strong labor market of the latter half of the 1960s. Something that I think was just as remarkable has been the narrowing of the typical gap between labor market outcomes for less-advantaged groups. For example, there has been a reduction in the unemployment rate between Black and Latino workers, on the one hand, and white workers, on the other hand. There has also been a narrowing of the prime-age labor force participation rate among these groups, and, perhaps most notable of all, wage inequality among them has narrowed, which is not typical during economic expansions, according to research by David Autor and several coauthors.10 They found that one benefit of the unusually tight labor market of the past few years was that the heightened competition for scarce workers produced more rapid wage gains for workers at the bottom of the wage distribution. The real wage gains for those in the lower quartiles of the distribution and with higher propensities to consume, in turn, likely spurred consumption and helped sustain growth after the pandemic. After a couple of years in which labor demand exceeded supply, the labor market has come into balance, reflecting an economy that has moderated in part due to tighter monetary policy. On the labor supply side, two forces have contributed to this rebalancing of the labor market. Labor force participation suffered due to the disruptions - 9 - in work during the pandemic but rebounded strongly in 2022 and 2023 as the labor market tightened and wages rose sharply. The labor force participation rate for prime-age women reached historic highs over the past year and reached yet another historic record high in August. The overall increase in participation among workers aged 25 to 54, in the prime of their working lives, helped offset the loss of many workers aged 55 and over who experienced excess retirements during the pandemic. The second force boosting labor supply has been the large increase in immigration. The Congressional Budget Office estimates that net immigration boosted the U.S. population by close to 6 million people in 2022 and 2023, the majority of them of working age, and, by most accounts, rates of immigration have remained high in 2024. As a result of improved supply and easing of demand for workers, the labor market has rebalanced. After running at very low levels, unemployment has edged up this year to 4.2 percent in August, still quite low by historical standards. The slowdown in labor demand is most evident in payroll numbers. Job creation averaged 267,000 a month in the first quarter of the year and now stands at an average of 116,000 in the three months ending in August, which is still a healthy pace of job creation. Yet, given recent revisions in the payroll numbers, it is important to continue monitoring additional labor market indicators. In addition, the fall in diffusion indexes suggests that job creation cooling has been broad based, complementing the payroll data in showing rebalances in demand and supply across sectors. Beyond payroll data, voluntary quits, which tend to reflect the rate at which people find a better job, are now back around where they were before the pandemic. The ratio of job vacancies to the number of people looking for work, the V/U ratio, has also fallen close to its pre-pandemic ratio.11 In summary, after a period of demand exceeding supply, the labor market appears to have rebalanced. In tandem with the cooling in the labor market, economic activity has slowed but is still expanding at a solid pace. After adjusting for inflation, gross domestic product (GDP) grew 2.5 percent in 2023 and at around a 2 percent annual rate in the first half of 2024. Personal spending, which accounts for the majority of economic activity, has been solid this year, supported by a resilient labor market so far and high levels of household wealth relative to income. But given a rise in credit card and auto delinquencies, a rise in credit card balances, and a cooling labor market, I expect spending to grow at a somewhat more moderate pace moving forward. Certainly, tight monetary policy has contributed to cool off aggregate demand and slow the economy. It has done so in large part by slowing spending on interest-sensitive expenditures, such as housing, as well as autos and other durable goods. Other spending typically financed with credit, such as business equipment, has also been slower. Another effect of tight monetary policy is to keep expectations of future inflation in check. And, to the extent that expectations affect decisions by businesses to set prices and by workers to negotiate wages, this has helped put downward pressure on inflation. Survey- and market-based measures of future inflation did increase when inflation surged, but only modestly, and they have moved down in tandem with inflation and have largely returned to their 2019 levels. In conclusion, I would say that recent economic developments, against the backdrop of the experience of the past four years, have validated the Federal Reserve's focus on reducing inflation and set the stage for the shift in monetary policy that occurred last week. The progress in bringing down inflation thus far, coupled with the softening in the labor market that I have described, means that while our focus should remain on continuing to bring inflation to 2 percent, we should now also shift attention to the maximum-employment side of the FOMC's dual mandate. The labor market remains resilient, but the FOMC now needs to balance its focus so we can continue making progress on disinflation while avoiding unnecessary pain and weakness in the economy as disinflation continues in the right trajectory. I strongly supported last week's decision and, if progress on inflation continues as I expect, I will support additional cuts in the federal funds rate going forward. Thank you.	---[PAGE_BREAK]--- For release on delivery 4:00 p.m. EDT September 25, 2024 How We Got Here: A Perspective on Inflation and the Labor Market Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Mossavar-Rahmani Center for Business and Government Harvard Kennedy School Cambridge, Massachusetts September 25, 2024 ---[PAGE_BREAK]--- Thank you, John, and thank you for the opportunity to speak here today. ${ }^{1}$ It is good to be back at the Kennedy School and in particular at the Mossavar-Rahmani Center, which has a long tradition of engaging on important policy issues. In my remarks today, I will provide my outlook for the U.S. economy and the implications for monetary policy. The combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision last week by the Federal Open Market Committee (FOMC) to cut the federal funds rate by 50 basis points. While future actions by the FOMC will depend on data we receive on inflation, employment, and economic activity, if conditions continue to evolve in the direction traveled thus far, then additional cuts will be appropriate. I will begin by summarizing where we stand on inflation, including details on how the different components of inflation have changed over time, since these facts form the basis for my judgment on where inflation is headed. I will then talk about the recent cooling in the labor market and the forces driving it as well as how shifts on this other side of our mandate fit into the overall economic outlook for the rest of this year. I will conclude with the implications of all this for appropriate monetary policy and our focus on our dual mandate. Inflation based on personal consumption expenditures (PCE) has come down from a peak of 7.1 percent on a year-on-year basis to 2.5 percent in July. Core PCE inflation, which excludes energy and food prices and tends to be less volatile, has come down from a peak of 5.6 percent to now 2.6 percent. Based on consumer and producer [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- price indexes, I estimate headline PCE and core PCE inflation to be at about 2.2 and 2.7 percent, respectively, in August, consistent with ongoing progress toward the FOMC's 2 percent target. The progress on inflation is good news, but it is important to remember that households and businesses are still dealing with prices for many goods and services that are significantly higher than a couple of years ago. Prices for groceries, for example, are about 20 percent higher than before inflation started rising in 2021, and while earnings have been rising faster than inflation, it may take some time for it to feel as though prices are back to normal. ${ }^{2}$ Inflation data are produced by the Labor Department, and when I served as chief economist at Labor, I delved into the differential effects of inflation on various demographic groups. When inflation was at its peak in 2022, it was more than 1 percentage point higher for lower-income households, for those without a college degree, and for those aged 18 to 29 - all groups that spend a higher share of income on necessities and have less wealth to draw from. ${ }^{3}$ Fortunately, research by staff at the Fed shows that disinflation helps close that gap as well, something that only adds to the urgency I feel about returning inflation to the FOMC's 2 percent goal. Research on the causes of inflation and the subsequent disinflation show that both supply and demand forces have played an important role. In the past two years, specifically, improvements in supply, along with moderation in demand in part due to [^0] [^0]: ${ }^{2}$ Unlike in previous recoveries, those in the lower half of the distribution have benefited more from the real earnings increases during the post-pandemic period. The 12-month change in average hourly earnings and the employment cost index have been rising faster than consumer price index inflation for those in the first and second quartiles since 2019 and since 2022, respectively, and for everyone across the distribution for roughly a year. ${ }^{3}$ See Xavier Jaravel (2021), "Inflation Inequality: Measurement, Causes, and Policy Implications," Annual Review of Economics, vol. 13, pp. 599-629. ---[PAGE_BREAK]--- tighter monetary policy, have both played a role in the disinflationary process. ${ }^{4}$ Supply chain bottlenecks as well as the drastic drop in the labor force due to excess retirements and the withdrawal of prime-age workers contributed to the initial rise in inflation, but the resolution of these disruptions and the return of workers to the labor force have also helped rein in inflation. Early on, consumers shifted spending from services to goods, a development that goods producers struggled to accommodate, putting upward pressure on prices. But as the demand shock to goods unwound and consumer spending shifted back to services, goods inflation fell and has been running below zero in recent months. Also, the increased demand due to the fiscal response to COVID-19 in 2020 and 2021 has more recently been roughly neutral on growth, as shown by the Hutchins Center on Fiscal and Monetary Policy in their measure of fiscal impact. And, of course, as I will discuss in a moment, tight monetary policy has been and continues to be a moderating force on demand, primarily by raising costs for interest-sensitive goods and services. As I think about where inflation is headed, I find it helpful to consider how it has evolved over the past several years and in particular how the major components of inflation have behaved, so I want to take a few minutes to walk through those details. [^0] [^0]: ${ }^{4}$ Different approaches allow a parsing of the relative contributions of supply and demand, top-down approaches by Bernanke and Blanchard (forthcoming) and Benigno and Eggertson (2023) and bottom-up approaches by Braun, Flaaen, and Hoke (2024) and Shapiro (2022); see Ben Bernanke and Olivier Blanchard (forthcoming), "What Caused the U.S. Pandemic-Era Inflation?" American Economic Journal: Macroeconomics; Pierpaolo Benigno and Gauti B. Eggertsson (2023), "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve," NBER Working Paper Series 31197 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w31197; Robin Braun, Aaron Flaaen, and Sinem Hacioglu Hoke (2024), "Supply vs Demand Factors Influencing Prices of Manufactured Goods," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, February 23), https://www.federalreserve.gov/econres/notes/feds-notes/supply-vs-demand-factors-influencing-prices-of-manufactured-goods-20240223.html; and Adam Hale Shapiro (2022), "How Much Do Supply and Demand Drive Inflation?" FRBSF Economic Letter 2022-15 (San Francisco: Federal Reserve Bank of San Francisco, June 21), https://www.frbsf.org/research-and-insights/publications/economic-letter/2022/06/how-much-do-supply-and-demand-drive-inflation. All of these studies agree that both supply and demand shocks contributed to the surge in inflation as well as its fall. ---[PAGE_BREAK]--- As I have indicated, the big picture is that goods inflation surged early on in 2020 and 2021, followed by prices for services excluding housing, and then housing, with some overlap in those steps. Disinflation has followed that course in reverse. Core goods inflation rose, after almost a year of social distancing shifted spending from services and after production and delivery of goods was disrupted by the pandemic. This was a big change because over the long expansion leading to the pandemic, core goods prices actually fell, slightly but consistently. ${ }^{5}$ On a 12-month basis, core PCE goods inflation rose above zero in December 2020, reached a peak of 7.6 percent in February 2022, and fell again below zero at the end of 2023. In July of this year, it was negative 0.5 percent. This recent disinflation offset still-rising prices for services and helped reduce overall inflation. Goods inflation has reverted to its longer-term pattern as demand has moderated and supply chain problems have abated. This is reflected by various indexes of supply chain bottlenecks that showed the supply-side disruptions that contributed early on to surging inflation have now retreated to pre-pandemic levels. ${ }^{6}$ Other data show that computer chip supply, which fell far short of demand early in the pandemic, is back to normal conditions as well. Food and energy prices, always subject to larger ups and downs than other parts of inflation, rose also early on. Food inflation increased in 2020 as shoppers began stockpiling groceries and as warehouses and production facilities had difficulty staffing due to COVID. After Russia's invasion of Ukraine, energy price inflation reached a peak [^0] [^0]: ${ }^{5}$ The causes most often cited by economists are competition from globalized trade and productivity gains, including from technological advances. ${ }^{6}$ The most commonly used indicators of supply chain bottlenecks are the Global Supply Chain Pressure Index produced by the Federal Reserve Bank of New York, the Supplier Deliveries Index from the Institute for Supply Management, and the percent of answers to the question of why production is not at capacity in the Quarterly Survey of Plant Capacity Utilization fielded by the Census Bureau and funded by the Federal Reserve Board. ---[PAGE_BREAK]--- 12-month rate of nearly 45 percent and food inflation reached a peak of 12 percent in mid-2022, highlighting the importance of petroleum and agricultural commodities from that part of the world. Food and energy inflation has moderated over the past two years and are now both running at 12-month rates of 1.4 percent and 1.9 percent, respectively, as supply chain issues have resolved and production in the U.S. and elsewhere has increased. Food and energy expenses represent a sizable share of consumer spending, but the frequent purchase of these goods means that they are highly salient in the public's views on inflation. Research by Francesco D'Acunto and coauthors has shown that the weights that consumers assign to price changes in forming their inflation expectations are not based on the actual share of their expenditures but instead on the frequency of purchases, which happen to be highest for food and energy goods. ${ }^{7}$ Thus, the fall in food and energy prices is important because it may feed back into lower inflation in other categories by moderating overall inflation expectations and also real wage expectations in wage bargaining. Housing services price increases were the last component of inflation to escalate, rising to a peak 12-month rate of 8.3 percent in April 2023 and moderating to a 5.3 percent pace in July. It took time for housing prices to escalate and has taken longer for them to moderate because of both the nature of the rental market and the data collection method from the Bureau of Labor Statistics, as I have discussed at length in other speeches. ${ }^{8}$ However, new rent increases, which better capture rental price changes in real [^0] [^0]: ${ }^{7}$ See Francesco D'Acunto, Ulrike Malmendier, Juan Ospina, and Michael Weber (2021), "Exposure to Grocery Prices and Inflation Expectations," Journal of Political Economy, vol. 129 (May), 1615-39. ${ }^{8}$ Rental prices are the basis for all estimates of housing service costs. Prices tend to change only when rented homes change tenants, which happens relatively infrequently. Prices tend to change more when there are new tenants, while the majority of lease renewals tend to keep the same price-generating ---[PAGE_BREAK]--- time, are falling and are the main reason why I expect housing services costs to moderate further. The final component of inflation is services excluding housing, which accounts for 50 percent of PCE inflation and is heavily influenced by labor markets. On a 12month basis, this component of inflation rose to a peak of 5.3 percent in December 2021, stayed persistently high until February 2023, and has moderated since then to 3.3 percent in July of this year. Its escalation was driven both by the rise in labor costs and by the transition of demand from goods to services following the pandemic. Labor costs are a substantial share of the total costs for services. For example, labor accounts for between 60 percent to 80 percent of costs in construction, education, and health services. Among the initial forces driving the escalation in wages were the increase in food and energy prices, as wage demands tend to track closely with the prices of these frequently purchased goods. Data on wage demands from the New York Fed's Survey of Consumer Expectations indeed show a sudden increase early on during the pandemic right after the first bout of food inflation. ${ }^{9}$ Importantly, worker shortages likely allowed those higher wage demands to be realized, contributing to the rise in wages. Later, as demand for services quickly rose and employers were creating a large number of jobs in several service sectors, workers were able to be more selective, and the ensuing "Great Resignation" took hold, allowing people to choose different careers. The relatively high [^0] [^0]: persistence. In addition, the Bureau of Economic Analysis samples rents only every six months. As a result, substantial lags are built into the official statistics. See Adriana D. Kugler (2024), "The Outlook for the Economy and Monetary Policy," speech delivered at the Brookings Institution, Washington, D.C., February 7, https://www.federalreserve.gov/newsevents/speech/kugler20240207a.htm; Adriana D. Kugler (2024), "Some Reasons for Optimism about Inflation," speech delivered at the Peterson Institute for International Economics, Washington, D.C., June 18, https://www.federalreserve.gov/newsevents/speech/kugler20240618a.htm. ${ }^{9}$ The Survey of Consumer Expectations from the New York Fed collects data on "reservation wages," which are what workers report as being the minimum wage that they would require to accept a job. ---[PAGE_BREAK]--- demand relative to the supply of workers in some service sectors encouraged workers to move from job to job for higher wages, benefits, and other improvements in working conditions. Evidence from the Atlanta Fed's Wage Growth Tracker suggests that during this period, wages for job switchers grew more than 2 percentage points faster than wages for people staying in the same job, though this wage premium for job switchers disappeared by the second half of last year. But now inflation for services excluding housing is declining, after a temporary escalation in the first quarter of this year that was likely partly due to residual seasonality. There had been fears that wage increases would drive a wage-price spiral, as the U.S. experienced in the 1970s, but this did not occur. To sum up, inflation has broadly moderated as the supply of goods and services has improved, and as producers and consumers have adjusted to the effects of higher prices. Demand has moderated, in part due to tighter monetary policy. And, as I just noted, changes in the pace of wage growth have also played an important role in the ups and downs of inflation, which points me toward a discussion of labor markets, which has recently become a greater focus of monetary policy. As I have noted, there has been a significant moderation in the labor market recently, but I want to start by pointing to what really has been a remarkable performance of the labor market over the past four years. After the unprecedented job losses early in the pandemic, and even accounting for the quick recovery of a large share of those losses, the recovery of the labor market that followed was historically swift. Unemployment was 7.8 percent in September 2020 and 4.7 percent only 12 months later, and it fell to under 4 percent 3 months after that. That is a more rapid recovery than the U.S. has experienced ---[PAGE_BREAK]--- since the 1960's. What started, at that point, was 30 straight months of unemployment at or below 4 percent, which had not happened during the pre-pandemic period, the boom of the 1990s, or anytime during the 1980s, and it was only exceeded by the strong labor market of the latter half of the 1960s. Something that I think was just as remarkable has been the narrowing of the typical gap between labor market outcomes for less-advantaged groups. For example, there has been a reduction in the unemployment rate between Black and Latino workers, on the one hand, and white workers, on the other hand. There has also been a narrowing of the prime-age labor force participation rate among these groups, and, perhaps most notable of all, wage inequality among them has narrowed, which is not typical during economic expansions, according to research by David Autor and several coauthors. ${ }^{10}$ They found that one benefit of the unusually tight labor market of the past few years was that the heightened competition for scarce workers produced more rapid wage gains for workers at the bottom of the wage distribution. The real wage gains for those in the lower quartiles of the distribution and with higher propensities to consume, in turn, likely spurred consumption and helped sustain growth after the pandemic. After a couple of years in which labor demand exceeded supply, the labor market has come into balance, reflecting an economy that has moderated in part due to tighter monetary policy. On the labor supply side, two forces have contributed to this rebalancing of the labor market. Labor force participation suffered due to the disruptions [^0] [^0]: ${ }^{10}$ See David Autor, Arindrajit Dube, and Annie McGrew (2024), "The Unexpected Compression: Competition at Work in the Low Wage Labor Market," NBER Working Paper Series 31010 (Cambridge, Mass.: National Bureau of Economic Research, March; revised May 2024), http://www.nber.org/papers/w31010. Using Current Population Survey microdata, they show that increased labor market competition for scarce workers produced more rapid real wage gains at the bottom of the wage distribution, reducing wage inequality. ---[PAGE_BREAK]--- in work during the pandemic but rebounded strongly in 2022 and 2023 as the labor market tightened and wages rose sharply. The labor force participation rate for prime-age women reached historic highs over the past year and reached yet another historic record high in August. The overall increase in participation among workers aged 25 to 54, in the prime of their working lives, helped offset the loss of many workers aged 55 and over who experienced excess retirements during the pandemic. The second force boosting labor supply has been the large increase in immigration. The Congressional Budget Office estimates that net immigration boosted the U.S. population by close to 6 million people in 2022 and 2023, the majority of them of working age, and, by most accounts, rates of immigration have remained high in 2024. As a result of improved supply and easing of demand for workers, the labor market has rebalanced. After running at very low levels, unemployment has edged up this year to 4.2 percent in August, still quite low by historical standards. The slowdown in labor demand is most evident in payroll numbers. Job creation averaged 267,000 a month in the first quarter of the year and now stands at an average of 116,000 in the three months ending in August, which is still a healthy pace of job creation. Yet, given recent revisions in the payroll numbers, it is important to continue monitoring additional labor market indicators. In addition, the fall in diffusion indexes suggests that job creation cooling has been broad based, complementing the payroll data in showing rebalances in demand and supply across sectors. Beyond payroll data, voluntary quits, which tend to reflect the rate at which people find a better job, are now back around where they were before the pandemic. The ratio of job vacancies to the number of people looking for ---[PAGE_BREAK]--- work, the V/U ratio, has also fallen close to its pre-pandemic ratio. ${ }^{11}$ In summary, after a period of demand exceeding supply, the labor market appears to have rebalanced. In tandem with the cooling in the labor market, economic activity has slowed but is still expanding at a solid pace. After adjusting for inflation, gross domestic product (GDP) grew 2.5 percent in 2023 and at around a 2 percent annual rate in the first half of 2024. Personal spending, which accounts for the majority of economic activity, has been solid this year, supported by a resilient labor market so far and high levels of household wealth relative to income. But given a rise in credit card and auto delinquencies, a rise in credit card balances, and a cooling labor market, I expect spending to grow at a somewhat more moderate pace moving forward. Certainly, tight monetary policy has contributed to cool off aggregate demand and slow the economy. It has done so in large part by slowing spending on interest-sensitive expenditures, such as housing, as well as autos and other durable goods. Other spending typically financed with credit, such as business equipment, has also been slower. Another effect of tight monetary policy is to keep expectations of future inflation in check. And, to the extent that expectations affect decisions by businesses to set prices and by workers to negotiate wages, this has helped put downward pressure on inflation. Survey- and market-based measures of future inflation did increase when inflation surged, but only modestly, and they have moved down in tandem with inflation and have largely returned to their 2019 levels. [^0] [^0]: ${ }^{11}$ I consider here a V/U ratio in which the numerator is the ratio of the vacancy rate for the total nonfarm sector computed as job openings over the labor force. Job openings data are from the Job Openings and Labor Turnover Survey fielded by the Bureau of Labor Statistics. The denominator is the unemployment rate. The last data point available for job openings is July 2024, while the last data point for the unemployment rate is August. ---[PAGE_BREAK]--- In conclusion, I would say that recent economic developments, against the backdrop of the experience of the past four years, have validated the Federal Reserve's focus on reducing inflation and set the stage for the shift in monetary policy that occurred last week. The progress in bringing down inflation thus far, coupled with the softening in the labor market that I have described, means that while our focus should remain on continuing to bring inflation to 2 percent, we should now also shift attention to the maximum-employment side of the FOMC's dual mandate. The labor market remains resilient, but the FOMC now needs to balance its focus so we can continue making progress on disinflation while avoiding unnecessary pain and weakness in the economy as disinflation continues in the right trajectory. I strongly supported last week's decision and, if progress on inflation continues as I expect, I will support additional cuts in the federal funds rate going forward. Thank you.	Adriana D Kugler	United States	https://www.bis.org/review/r240926b.pdf	For release on delivery 4:00 p.m. EDT September 25, 2024 How We Got Here: A Perspective on Inflation and the Labor Market Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Mossavar-Rahmani Center for Business and Government Harvard Kennedy School Cambridge, Massachusetts September 25, 2024 Thank you, John, and thank you for the opportunity to speak here today. It is good to be back at the Kennedy School and in particular at the Mossavar-Rahmani Center, which has a long tradition of engaging on important policy issues. In my remarks today, I will provide my outlook for the U.S. economy and the implications for monetary policy. The combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision last week by the Federal Open Market Committee (FOMC) to cut the federal funds rate by 50 basis points. While future actions by the FOMC will depend on data we receive on inflation, employment, and economic activity, if conditions continue to evolve in the direction traveled thus far, then additional cuts will be appropriate. I will begin by summarizing where we stand on inflation, including details on how the different components of inflation have changed over time, since these facts form the basis for my judgment on where inflation is headed. I will then talk about the recent cooling in the labor market and the forces driving it as well as how shifts on this other side of our mandate fit into the overall economic outlook for the rest of this year. I will conclude with the implications of all this for appropriate monetary policy and our focus on our dual mandate. Inflation based on personal consumption expenditures (PCE) has come down from a peak of 7.1 percent on a year-on-year basis to 2.5 percent in July. Core PCE inflation, which excludes energy and food prices and tends to be less volatile, has come down from a peak of 5.6 percent to now 2.6 percent. Based on consumer and producer price indexes, I estimate headline PCE and core PCE inflation to be at about 2.2 and 2.7 percent, respectively, in August, consistent with ongoing progress toward the FOMC's 2 percent target. The progress on inflation is good news, but it is important to remember that households and businesses are still dealing with prices for many goods and services that are significantly higher than a couple of years ago. Prices for groceries, for example, are about 20 percent higher than before inflation started rising in 2021, and while earnings have been rising faster than inflation, it may take some time for it to feel as though prices are back to normal. Inflation data are produced by the Labor Department, and when I served as chief economist at Labor, I delved into the differential effects of inflation on various demographic groups. When inflation was at its peak in 2022, it was more than 1 percentage point higher for lower-income households, for those without a college degree, and for those aged 18 to 29 - all groups that spend a higher share of income on necessities and have less wealth to draw from. Fortunately, research by staff at the Fed shows that disinflation helps close that gap as well, something that only adds to the urgency I feel about returning inflation to the FOMC's 2 percent goal. Research on the causes of inflation and the subsequent disinflation show that both supply and demand forces have played an important role. In the past two years, specifically, improvements in supply, along with moderation in demand in part due to tighter monetary policy, have both played a role in the disinflationary process. Supply chain bottlenecks as well as the drastic drop in the labor force due to excess retirements and the withdrawal of prime-age workers contributed to the initial rise in inflation, but the resolution of these disruptions and the return of workers to the labor force have also helped rein in inflation. Early on, consumers shifted spending from services to goods, a development that goods producers struggled to accommodate, putting upward pressure on prices. But as the demand shock to goods unwound and consumer spending shifted back to services, goods inflation fell and has been running below zero in recent months. Also, the increased demand due to the fiscal response to COVID-19 in 2020 and 2021 has more recently been roughly neutral on growth, as shown by the Hutchins Center on Fiscal and Monetary Policy in their measure of fiscal impact. And, of course, as I will discuss in a moment, tight monetary policy has been and continues to be a moderating force on demand, primarily by raising costs for interest-sensitive goods and services. As I think about where inflation is headed, I find it helpful to consider how it has evolved over the past several years and in particular how the major components of inflation have behaved, so I want to take a few minutes to walk through those details. As I have indicated, the big picture is that goods inflation surged early on in 2020 and 2021, followed by prices for services excluding housing, and then housing, with some overlap in those steps. Disinflation has followed that course in reverse. Core goods inflation rose, after almost a year of social distancing shifted spending from services and after production and delivery of goods was disrupted by the pandemic. This was a big change because over the long expansion leading to the pandemic, core goods prices actually fell, slightly but consistently. Other data show that computer chip supply, which fell far short of demand early in the pandemic, is back to normal conditions as well. Food and energy prices, always subject to larger ups and downs than other parts of inflation, rose also early on. Food inflation increased in 2020 as shoppers began stockpiling groceries and as warehouses and production facilities had difficulty staffing due to COVID. After Russia's invasion of Ukraine, energy price inflation reached a peak 12-month rate of nearly 45 percent and food inflation reached a peak of 12 percent in mid-2022, highlighting the importance of petroleum and agricultural commodities from that part of the world. Food and energy inflation has moderated over the past two years and are now both running at 12-month rates of 1.4 percent and 1.9 percent, respectively, as supply chain issues have resolved and production in the U.S. and elsewhere has increased. Food and energy expenses represent a sizable share of consumer spending, but the frequent purchase of these goods means that they are highly salient in the public's views on inflation. Research by Francesco D'Acunto and coauthors has shown that the weights that consumers assign to price changes in forming their inflation expectations are not based on the actual share of their expenditures but instead on the frequency of purchases, which happen to be highest for food and energy goods. Thus, the fall in food and energy prices is important because it may feed back into lower inflation in other categories by moderating overall inflation expectations and also real wage expectations in wage bargaining. Housing services price increases were the last component of inflation to escalate, rising to a peak 12-month rate of 8.3 percent in April 2023 and moderating to a 5.3 percent pace in July. It took time for housing prices to escalate and has taken longer for them to moderate because of both the nature of the rental market and the data collection method from the Bureau of Labor Statistics, as I have discussed at length in other speeches. However, new rent increases, which better capture rental price changes in real The final component of inflation is services excluding housing, which accounts for 50 percent of PCE inflation and is heavily influenced by labor markets. On a 12month basis, this component of inflation rose to a peak of 5.3 percent in December 2021, stayed persistently high until February 2023, and has moderated since then to 3.3 percent in July of this year. Its escalation was driven both by the rise in labor costs and by the transition of demand from goods to services following the pandemic. Labor costs are a substantial share of the total costs for services. For example, labor accounts for between 60 percent to 80 percent of costs in construction, education, and health services. Among the initial forces driving the escalation in wages were the increase in food and energy prices, as wage demands tend to track closely with the prices of these frequently purchased goods. Data on wage demands from the New York Fed's Survey of Consumer Expectations indeed show a sudden increase early on during the pandemic right after the first bout of food inflation. Importantly, worker shortages likely allowed those higher wage demands to be realized, contributing to the rise in wages. Later, as demand for services quickly rose and employers were creating a large number of jobs in several service sectors, workers were able to be more selective, and the ensuing "Great Resignation" took hold, allowing people to choose different careers. The relatively high demand relative to the supply of workers in some service sectors encouraged workers to move from job to job for higher wages, benefits, and other improvements in working conditions. Evidence from the Atlanta Fed's Wage Growth Tracker suggests that during this period, wages for job switchers grew more than 2 percentage points faster than wages for people staying in the same job, though this wage premium for job switchers disappeared by the second half of last year. But now inflation for services excluding housing is declining, after a temporary escalation in the first quarter of this year that was likely partly due to residual seasonality. There had been fears that wage increases would drive a wage-price spiral, as the U.S. experienced in the 1970s, but this did not occur. To sum up, inflation has broadly moderated as the supply of goods and services has improved, and as producers and consumers have adjusted to the effects of higher prices. Demand has moderated, in part due to tighter monetary policy. And, as I just noted, changes in the pace of wage growth have also played an important role in the ups and downs of inflation, which points me toward a discussion of labor markets, which has recently become a greater focus of monetary policy. As I have noted, there has been a significant moderation in the labor market recently, but I want to start by pointing to what really has been a remarkable performance of the labor market over the past four years. After the unprecedented job losses early in the pandemic, and even accounting for the quick recovery of a large share of those losses, the recovery of the labor market that followed was historically swift. Unemployment was 7.8 percent in September 2020 and 4.7 percent only 12 months later, and it fell to under 4 percent 3 months after that. That is a more rapid recovery than the U.S. has experienced since the 1960's. What started, at that point, was 30 straight months of unemployment at or below 4 percent, which had not happened during the pre-pandemic period, the boom of the 1990s, or anytime during the 1980s, and it was only exceeded by the strong labor market of the latter half of the 1960s. Something that I think was just as remarkable has been the narrowing of the typical gap between labor market outcomes for less-advantaged groups. For example, there has been a reduction in the unemployment rate between Black and Latino workers, on the one hand, and white workers, on the other hand. There has also been a narrowing of the prime-age labor force participation rate among these groups, and, perhaps most notable of all, wage inequality among them has narrowed, which is not typical during economic expansions, according to research by David Autor and several coauthors. They found that one benefit of the unusually tight labor market of the past few years was that the heightened competition for scarce workers produced more rapid wage gains for workers at the bottom of the wage distribution. The real wage gains for those in the lower quartiles of the distribution and with higher propensities to consume, in turn, likely spurred consumption and helped sustain growth after the pandemic. After a couple of years in which labor demand exceeded supply, the labor market has come into balance, reflecting an economy that has moderated in part due to tighter monetary policy. On the labor supply side, two forces have contributed to this rebalancing of the labor market. Labor force participation suffered due to the disruptions in work during the pandemic but rebounded strongly in 2022 and 2023 as the labor market tightened and wages rose sharply. The labor force participation rate for prime-age women reached historic highs over the past year and reached yet another historic record high in August. The overall increase in participation among workers aged 25 to 54, in the prime of their working lives, helped offset the loss of many workers aged 55 and over who experienced excess retirements during the pandemic. The second force boosting labor supply has been the large increase in immigration. The Congressional Budget Office estimates that net immigration boosted the U.S. population by close to 6 million people in 2022 and 2023, the majority of them of working age, and, by most accounts, rates of immigration have remained high in 2024. As a result of improved supply and easing of demand for workers, the labor market has rebalanced. After running at very low levels, unemployment has edged up this year to 4.2 percent in August, still quite low by historical standards. The slowdown in labor demand is most evident in payroll numbers. Job creation averaged 267,000 a month in the first quarter of the year and now stands at an average of 116,000 in the three months ending in August, which is still a healthy pace of job creation. Yet, given recent revisions in the payroll numbers, it is important to continue monitoring additional labor market indicators. In addition, the fall in diffusion indexes suggests that job creation cooling has been broad based, complementing the payroll data in showing rebalances in demand and supply across sectors. Beyond payroll data, voluntary quits, which tend to reflect the rate at which people find a better job, are now back around where they were before the pandemic. The ratio of job vacancies to the number of people looking for work, the V/U ratio, has also fallen close to its pre-pandemic ratio. In summary, after a period of demand exceeding supply, the labor market appears to have rebalanced. In tandem with the cooling in the labor market, economic activity has slowed but is still expanding at a solid pace. After adjusting for inflation, gross domestic product (GDP) grew 2.5 percent in 2023 and at around a 2 percent annual rate in the first half of 2024. Personal spending, which accounts for the majority of economic activity, has been solid this year, supported by a resilient labor market so far and high levels of household wealth relative to income. But given a rise in credit card and auto delinquencies, a rise in credit card balances, and a cooling labor market, I expect spending to grow at a somewhat more moderate pace moving forward. Certainly, tight monetary policy has contributed to cool off aggregate demand and slow the economy. It has done so in large part by slowing spending on interest-sensitive expenditures, such as housing, as well as autos and other durable goods. Other spending typically financed with credit, such as business equipment, has also been slower. Another effect of tight monetary policy is to keep expectations of future inflation in check. And, to the extent that expectations affect decisions by businesses to set prices and by workers to negotiate wages, this has helped put downward pressure on inflation. Survey- and market-based measures of future inflation did increase when inflation surged, but only modestly, and they have moved down in tandem with inflation and have largely returned to their 2019 levels. In conclusion, I would say that recent economic developments, against the backdrop of the experience of the past four years, have validated the Federal Reserve's focus on reducing inflation and set the stage for the shift in monetary policy that occurred last week. The progress in bringing down inflation thus far, coupled with the softening in the labor market that I have described, means that while our focus should remain on continuing to bring inflation to 2 percent, we should now also shift attention to the maximum-employment side of the FOMC's dual mandate. The labor market remains resilient, but the FOMC now needs to balance its focus so we can continue making progress on disinflation while avoiding unnecessary pain and weakness in the economy as disinflation continues in the right trajectory. I strongly supported last week's decision and, if progress on inflation continues as I expect, I will support additional cuts in the federal funds rate going forward. Thank you.
2024-09-26T00:00:00	Michael S Barr: Supporting market resilience and financial stability	Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024.	Michael S Barr: Supporting market resilience and financial stability Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. * * * Thank you, and thank you for the opportunity to speak to you today.1 It is great to be here again, particularly because this year marks the 10th annual conference on the Treasury market, a milestone that is worth celebrating. I want to acknowledge the Federal Reserve Bank of New York for its leadership in this area, including the dedication and excellence it has brought to hosting this conference over the past decade, in collaboration with the Inter-Agency Working Group on Treasury Market Surveillance, led by the Treasury Department. The Treasury market is the means by which our government meets its financing needs in service to the American people, and it is also the bedrock of the financial system. Promoting the resilience of the Treasury market and ensuring it can continue to fulfill these roles requires the collaboration of agencies and individuals across the government along with the private sector. As others have pointed out today, we have made important progress since last year's conference. The Securities and Exchange Commission has finalized a rule on central clearing of Treasury transactions, the Treasury Department has instituted a program for buying back less-liquid Treasury securities, and the Office of Financial Research is preparing for its permanent collection of data on non-centrally-cleared bilateral repurchase agreement (repo) transactions, which will support our understanding of this market segment as it evolves. I will share some thoughts with you on how I see the work of the Federal Reserve in supporting Treasury market resilience. Our capital and liquidity regulations, our supervision of the firms over which we have authority, and our liquidity facilities play important roles in supporting market resilience and financial stability. Earlier this month, I gave a speech where I reiterated the crucial role of capital in serving these objectives, and the need to balance resilience and efficiency in designing our rules. In that speech, I also outlined the elements of a capital re-proposal that I believe will have broad consensus at the Federal Reserve Board. The adjustments are in response to a robust public comment process, and some of them are designed to address interactions and market functioning concerns raised by commentators. In terms of rulemaking, today I will focus on some additional aspects of our regulatory framework-namely, enhancements to our liquidity regulations. I will share some perspective on how our liquidity regulations work together and are supportive of market functioning and the smooth implementation of monetary policy. The Intersection of Monetary Policy Tools and Supervision and Regulation We consider how all of the Fed's tools work together to support our objectives. In previous speeches, I have talked about the role of the discount window and the standing repo facility (SRF) in supporting both monetary policy implementation and financial stability, noting how important it is that eligible institutions be ready to use 2 these facilities. Today I want to dig into this topic a bit more, including how these tools support monetary policy implementation through appropriate incorporation into liquidity regulations and supervisory practices. After the banking stress in March 2023, we saw a substantial improvement among banks of all sizes in their level of readiness to tap the discount window both in taking the necessary steps for set-up and in their pledging of collateral. Since that time, over $1 trillion in additional collateral has been pledged to the discount window, and additional banks have established access to the SRF. Both of these facilities are potential venues for monetizing assets and raising liquidity to address volatility in private funding market rates or gaps in the availability of private-market funding. We had been hearing that some were confused about how banks could incorporate ready access to the discount window and the SRF into their contingency funding plans and internal liquidity stress tests. Supervisors have a role in assessing the viability of large banks' plans to meet stressed outflows in their stress scenarios, and we have been asked whether the discount window, the SRF, and also Federal Home Loan Bank advances can play a role in those scenarios. The answer to this question is "yes." We provided clarity to the public in August on permissible assumptions for how firms can incorporate the discount window and the SRF into their internal liquidity stress-test scenarios. There are a couple of principles that underlie our response in the frequently 3 asked questions we posted on the Board's website. One principle is that our tools are readily available to firms. This means that we see it as acceptable and beneficial for firms to incorporate our facilities to meet liquidity needs in both planning and practice. If firms plan to use our facilities, we expect them to demonstrate ex ante that they are fully capable of doing so, including through test transactions. An additional principle underlying our approach is that, while firms should be ready to use a range of funding sources, firms need to hold sufficient highly liquid assets to meet their potential liquidity needs. That is, they need to self-insure against their own liquidity risks. A third principle is that firms should be ready and able to use private channels to turn these assets into cash, in addition to any public channels they may plan to use. I want to dig a bit deeper into the benefits to both individual firms and the financial system when firms incorporate Fed facilities into their stress preparedness planning. Again, a design feature of our liquidity regulations is that large banks must self-insure against major liquidity risks. Our regulations also provide flexibility in terms of the portfolio composition such banks use to do so. This flexibility allows them to adjust their portfolios based on market conditions and firm needs. A key component of this flexibility is that reserves and certain high-quality liquid assets (HQLA), such as Treasury securities, are equivalent in terms of being treated as the highest quality of liquid assets. This feature is important because, while it allows firms to manage their liquidity buffers more flexibly, it also allows for greater flexibility in our monetary policy implementation and it supports market functioning. We have heard over the years, however, that the degree of substitutability among these assets has been limited by concerns about capacity in stress for the market to turn securities into reserves immediately; these concerns are valid. This constraint can be addressed in part by the appropriate incorporation of Federal Reserve facilities into monetization plans in firms' internal liquidity stress tests. When firms understand that they will not be fully constrained by the capacity of private markets or their individual credit lines to monetize HQLA immediately in stress, they can reduce their demand for reserves in favor of Treasury securities, all else being equal, for their stress planning purposes. This dynamic improves the substitutability of holding reserves and holding Treasury securities either outright or through repo transactions. When banks exhibit a high degree of substitutability of demand for these assets, money market functioning improves. Let me explain with an example. If a bank sees holding reserves and investing in Treasury repo as near substitutes in its liquidity portfolio, it should lend into Treasury repo markets when repo rates rise above the interest rate earned on reserves. When banks can nimbly adjust portfolios in response to price incentives, the efficiency of reserves redistribution through the system improves, and market functioning is enhanced. In aggregate, this activity can prevent rates from rising further, all else being equal. The point at which banks, in aggregate, have a relatively immutable demand for reserves, and are unwilling to lend them out, is evident when a small decrease in the supply of reserves results in a sharp increase in the cost to borrow them. Our monetary policy tools are well positioned to help us avoid this outcome. But, of course, greater willingness of banks to reallocate across close substitutes should help avoid the emergence of sudden pressures in money markets by reducing money market frictions. In 2021, the Federal Reserve launched the SRF, which, along with the discount window, should help cap upward pressure in repo markets that could spill over into the federal funds market. Use of these facilities also increases the supply of reserves in the system. The enhanced clarity for firms that Fed facilities are a fully acceptable venue to get same-day liquidity for their HQLA should help reassure firms about holding reserves and their close substitutes, such as Treasury securities, in their liquidity portfolios. Of course, as I stated earlier, for the largest banks, there is a requirement that they hold highly liquid assets to address their own liquidity risks. They must also be ready to use private markets to monetize these assets. It is also critical that banks recognize and manage the interest rate and liquidity risk of their securities portfolios to ensure those securities held for liquidity purposes can be monetized in stress without creating other adverse effects on a firm's safety and soundness. In 2022 and 2023, certain large banks did not effectively manage the risks of rising rates, and suffered significant fair value losses on their securities holdings, including those in held-to-maturity (HTM) portfolios. These losses affected their ability to respond to liquidity stress, as monetizing the assets could result in realizing losses. When the banking stress hit in March 2023, these securities could not be sold to meet stressed outflows because large unrealized losses inhibited their sale without significant capital implications. This is further complicated in the case of HTM securities, which cannot be sold without risking revaluing a firm's entire HTM portfolio. Selling HTM securities to generate liquidity would therefore have had a particularly large effect on these firms' capital levels, likely increasing the stress on these firms. Further, some firms were unable to rely on private channels such as repo markets for monetization because they were not prepared, they were not regular participants in the market, and market participants were unwilling to lend because of counterparty credit concerns. This combination of factors meant that HTM securities that had been identified by banks as available to serve as a liquidity buffer of assets in stress could not effectively serve that function. Improvements to Our Liquidity Regulations As I have mentioned in previous speeches, to address the lessons about liquidity learned in the spring of 2023, we are exploring targeted adjustments to our current 4 liquidity framework. Many firms have taken steps to improve their liquidity resilience, and the regulatory adjustments we are considering would ensure that large banks maintain better liquidity risk-management practices going forward. Improvements to our liquidity regulations will also complement the other components of our supervisory and regulatory regime by improving banks' ability to respond to funding shocks. Specifically, we are exploring a requirement that larger banks maintain a minimum amount of readily available liquidity with a pool of reserves and pre-positioned collateral at the discount window, based on a fraction of their uninsured deposits. Community banks would not be covered, and we would take a tiered approach to the requirements. The collateral pre-positioned at the window could include both Treasury securities and the full range of assets eligible for pledging at the discount window. It is vital that uninsured depositors have confidence that their funds will be readily available for withdrawal, if needed, and this confidence would be enhanced by a requirement that larger banks have readily available liquidity to meet requests for withdrawal of these deposits. This requirement would be a complement to existing liquidity regulations such as those that require the internal liquidity stress tests (ILST) I described earlier as well as meeting the liquidity coverage ratio (LCR).5 Incorporating the discount window into a readiness requirement would also reemphasize that supervisors and examiners view use of the discount window as appropriate under both normal and stressed market conditions. In addition, as I have discussed previously, we identified significant gaps in interest rate risk management in the March 2023 banking stress, including in portfolios of highly liquid securities. Relatedly, we saw that banks faced constraints in monetizing HTM assets with large unrealized losses in private markets because they were unable to repo these securities or sell these securities without realizing significant losses. To address these gaps, we are considering a partial limit on the extent of reliance on HTM assets in larger banks' liquidity buffers, such as those held under the LCR and ILST requirements. These adjustments would address the known challenges of banks being able to use these assets in stress conditions. Finally, we are reviewing the treatment of a handful of types of deposits in the current liquidity framework. Observed behavior of different deposit types during times of stress suggests the need to recalibrate deposit outflow assumptions in our rules for certain types of depositors. We are also revisiting the scope of application of our current liquidity framework for large banks. These enhancements to our liquidity regulations will help bolster firms' ability to manage liquidity shocks, and they will also be well integrated with our monetary policy tools and framework. Modernizing Our Tools to Meet Current and Future Needs Turning back to the discount window, I also want to note that the discount window has served its role well in recent years, and that we are also engaging in ongoing work to improve its operations. Given the crucial role of the discount window in providing ready access to liquidity in a wide variety of market conditions, we continuously work to assess and improve its functionality while engaging with current and potential users of the window. Among the steps we have taken recently include that we now have an online portal, Discount Window Direct, that allows firms to request and prepay discount window loans in a more streamlined manner than was previously possible. We also recently published a request for information on discount window operations and daylight credit asking about key components of these functions. Feedback from the public will help us prioritize areas for improvement, so I strongly encourage anyone with an interest in this topic to weigh in during the comment period. Your feedback will help us ensure that the discount window continues to improve in its role of providing ready access to funding under a variety of market conditions. Thank you. 1 The views I express here are my own and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee. 2 See Michael S. Barr (2023), "The 2023 U.S. Treasury Market Conference," speech delivered at the Federal Reserve Bank of New York, New York, November 16. 3 See "Subparts D and O-Enhanced Prudential Standards" in Board of Governors of the Federal Reserve System (2024), "Frequently Asked Questions about Regulation YY," webpage. 4 See Michael S. Barr (2024), "On Building a Resilient Regulatory Framework," speech delivered at Central Banking in the Post-Pandemic Financial System, 28th Annual Financial Markets Conference, the Federal Reserve Bank of Atlanta, Fernandina Beach, Fla., May 20. 5 The LCR and ILST are two separate, but complementary, liquidity requirements. The LCR is a standardized liquidity measure across banks, meaning the outflow assumptions are the same for each bank. The ILST is a nonstandardized liquidity measure across banks, meaning each bank determines its own outflow assumptions, subject to supervisory input.	---[PAGE_BREAK]--- # Michael S Barr: Supporting market resilience and financial stability Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. Thank you, and thank you for the opportunity to speak to you today. ${ }^{1}$ It is great to be here again, particularly because this year marks the 10th annual conference on the Treasury market, a milestone that is worth celebrating. I want to acknowledge the Federal Reserve Bank of New York for its leadership in this area, including the dedication and excellence it has brought to hosting this conference over the past decade, in collaboration with the Inter-Agency Working Group on Treasury Market Surveillance, led by the Treasury Department. The Treasury market is the means by which our government meets its financing needs in service to the American people, and it is also the bedrock of the financial system. Promoting the resilience of the Treasury market and ensuring it can continue to fulfill these roles requires the collaboration of agencies and individuals across the government along with the private sector. As others have pointed out today, we have made important progress since last year's conference. The Securities and Exchange Commission has finalized a rule on central clearing of Treasury transactions, the Treasury Department has instituted a program for buying back less-liquid Treasury securities, and the Office of Financial Research is preparing for its permanent collection of data on non-centrally-cleared bilateral repurchase agreement (repo) transactions, which will support our understanding of this market segment as it evolves. I will share some thoughts with you on how I see the work of the Federal Reserve in supporting Treasury market resilience. Our capital and liquidity regulations, our supervision of the firms over which we have authority, and our liquidity facilities play important roles in supporting market resilience and financial stability. Earlier this month, I gave a speech where I reiterated the crucial role of capital in serving these objectives, and the need to balance resilience and efficiency in designing our rules. In that speech, I also outlined the elements of a capital re-proposal that I believe will have broad consensus at the Federal Reserve Board. The adjustments are in response to a robust public comment process, and some of them are designed to address interactions and market functioning concerns raised by commentators. In terms of rulemaking, today I will focus on some additional aspects of our regulatory framework-namely, enhancements to our liquidity regulations. I will share some perspective on how our liquidity regulations work together and are supportive of market functioning and the smooth implementation of monetary policy. ## The Intersection of Monetary Policy Tools and Supervision and Regulation ---[PAGE_BREAK]--- We consider how all of the Fed's tools work together to support our objectives. In previous speeches, I have talked about the role of the discount window and the standing repo facility (SRF) in supporting both monetary policy implementation and financial stability, noting how important it is that eligible institutions be ready to use these facilities. ${ }^{2}$ Today I want to dig into this topic a bit more, including how these tools support monetary policy implementation through appropriate incorporation into liquidity regulations and supervisory practices. After the banking stress in March 2023, we saw a substantial improvement among banks of all sizes in their level of readiness to tap the discount window both in taking the necessary steps for set-up and in their pledging of collateral. Since that time, over $\$ 1$ trillion in additional collateral has been pledged to the discount window, and additional banks have established access to the SRF. Both of these facilities are potential venues for monetizing assets and raising liquidity to address volatility in private funding market rates or gaps in the availability of private-market funding. We had been hearing that some were confused about how banks could incorporate ready access to the discount window and the SRF into their contingency funding plans and internal liquidity stress tests. Supervisors have a role in assessing the viability of large banks' plans to meet stressed outflows in their stress scenarios, and we have been asked whether the discount window, the SRF, and also Federal Home Loan Bank advances can play a role in those scenarios. The answer to this question is "yes." We provided clarity to the public in August on permissible assumptions for how firms can incorporate the discount window and the SRF into their internal liquidity stress-test scenarios. There are a couple of principles that underlie our response in the frequently asked questions we posted on the Board's website. ${ }^{3}$ One principle is that our tools are readily available to firms. This means that we see it as acceptable and beneficial for firms to incorporate our facilities to meet liquidity needs in both planning and practice. If firms plan to use our facilities, we expect them to demonstrate ex ante that they are fully capable of doing so, including through test transactions. An additional principle underlying our approach is that, while firms should be ready to use a range of funding sources, firms need to hold sufficient highly liquid assets to meet their potential liquidity needs. That is, they need to self-insure against their own liquidity risks. A third principle is that firms should be ready and able to use private channels to turn these assets into cash, in addition to any public channels they may plan to use. I want to dig a bit deeper into the benefits to both individual firms and the financial system when firms incorporate Fed facilities into their stress preparedness planning. Again, a design feature of our liquidity regulations is that large banks must self-insure against major liquidity risks. Our regulations also provide flexibility in terms of the portfolio composition such banks use to do so. This flexibility allows them to adjust their portfolios based on market conditions and firm needs. A key component of this flexibility is that reserves and certain high-quality liquid assets (HQLA), such as Treasury securities, are equivalent in terms of being treated as the highest quality of liquid assets. This feature is important because, while it allows firms to manage their liquidity buffers more flexibly, it also allows for greater flexibility in our monetary policy implementation and it supports market functioning. We have heard over the years, however, that the degree of substitutability among these assets has been limited by concerns about capacity in stress for the market to turn securities into reserves ---[PAGE_BREAK]--- immediately; these concerns are valid. This constraint can be addressed in part by the appropriate incorporation of Federal Reserve facilities into monetization plans in firms' internal liquidity stress tests. When firms understand that they will not be fully constrained by the capacity of private markets or their individual credit lines to monetize HQLA immediately in stress, they can reduce their demand for reserves in favor of Treasury securities, all else being equal, for their stress planning purposes. This dynamic improves the substitutability of holding reserves and holding Treasury securities either outright or through repo transactions. When banks exhibit a high degree of substitutability of demand for these assets, money market functioning improves. Let me explain with an example. If a bank sees holding reserves and investing in Treasury repo as near substitutes in its liquidity portfolio, it should lend into Treasury repo markets when repo rates rise above the interest rate earned on reserves. When banks can nimbly adjust portfolios in response to price incentives, the efficiency of reserves redistribution through the system improves, and market functioning is enhanced. In aggregate, this activity can prevent rates from rising further, all else being equal. The point at which banks, in aggregate, have a relatively immutable demand for reserves, and are unwilling to lend them out, is evident when a small decrease in the supply of reserves results in a sharp increase in the cost to borrow them. Our monetary policy tools are well positioned to help us avoid this outcome. But, of course, greater willingness of banks to reallocate across close substitutes should help avoid the emergence of sudden pressures in money markets by reducing money market frictions. In 2021, the Federal Reserve launched the SRF, which, along with the discount window, should help cap upward pressure in repo markets that could spill over into the federal funds market. Use of these facilities also increases the supply of reserves in the system. The enhanced clarity for firms that Fed facilities are a fully acceptable venue to get same-day liquidity for their HQLA should help reassure firms about holding reserves and their close substitutes, such as Treasury securities, in their liquidity portfolios. Of course, as I stated earlier, for the largest banks, there is a requirement that they hold highly liquid assets to address their own liquidity risks. They must also be ready to use private markets to monetize these assets. It is also critical that banks recognize and manage the interest rate and liquidity risk of their securities portfolios to ensure those securities held for liquidity purposes can be monetized in stress without creating other adverse effects on a firm's safety and soundness. In 2022 and 2023, certain large banks did not effectively manage the risks of rising rates, and suffered significant fair value losses on their securities holdings, including those in held-to-maturity (HTM) portfolios. These losses affected their ability to respond to liquidity stress, as monetizing the assets could result in realizing losses. When the banking stress hit in March 2023, these securities could not be sold to meet stressed outflows because large unrealized losses inhibited their sale without significant capital implications. This is further complicated in the case of HTM securities, which cannot be sold without risking revaluing a firm's entire HTM portfolio. Selling HTM securities to generate liquidity would therefore have had a particularly large effect on these firms' capital levels, likely increasing the stress on these firms. Further, some firms were unable to rely on private channels such as repo markets for monetization because they were not prepared, they ---[PAGE_BREAK]--- were not regular participants in the market, and market participants were unwilling to lend because of counterparty credit concerns. This combination of factors meant that HTM securities that had been identified by banks as available to serve as a liquidity buffer of assets in stress could not effectively serve that function. # Improvements to Our Liquidity Regulations As I have mentioned in previous speeches, to address the lessons about liquidity learned in the spring of 2023, we are exploring targeted adjustments to our current liquidity framework. ${ }^{4}$ Many firms have taken steps to improve their liquidity resilience, and the regulatory adjustments we are considering would ensure that large banks maintain better liquidity risk-management practices going forward. Improvements to our liquidity regulations will also complement the other components of our supervisory and regulatory regime by improving banks' ability to respond to funding shocks. Specifically, we are exploring a requirement that larger banks maintain a minimum amount of readily available liquidity with a pool of reserves and pre-positioned collateral at the discount window, based on a fraction of their uninsured deposits. Community banks would not be covered, and we would take a tiered approach to the requirements. The collateral pre-positioned at the window could include both Treasury securities and the full range of assets eligible for pledging at the discount window. It is vital that uninsured depositors have confidence that their funds will be readily available for withdrawal, if needed, and this confidence would be enhanced by a requirement that larger banks have readily available liquidity to meet requests for withdrawal of these deposits. This requirement would be a complement to existing liquidity regulations such as those that require the internal liquidity stress tests (ILST) I described earlier as well as meeting the liquidity coverage ratio (LCR). $\underline{5}$ Incorporating the discount window into a readiness requirement would also reemphasize that supervisors and examiners view use of the discount window as appropriate under both normal and stressed market conditions. In addition, as I have discussed previously, we identified significant gaps in interest rate risk management in the March 2023 banking stress, including in portfolios of highly liquid securities. Relatedly, we saw that banks faced constraints in monetizing HTM assets with large unrealized losses in private markets because they were unable to repo these securities or sell these securities without realizing significant losses. To address these gaps, we are considering a partial limit on the extent of reliance on HTM assets in larger banks' liquidity buffers, such as those held under the LCR and ILST requirements. These adjustments would address the known challenges of banks being able to use these assets in stress conditions. Finally, we are reviewing the treatment of a handful of types of deposits in the current liquidity framework. Observed behavior of different deposit types during times of stress suggests the need to recalibrate deposit outflow assumptions in our rules for certain types of depositors. We are also revisiting the scope of application of our current liquidity framework for large banks. ---[PAGE_BREAK]--- These enhancements to our liquidity regulations will help bolster firms' ability to manage liquidity shocks, and they will also be well integrated with our monetary policy tools and framework. # Modernizing Our Tools to Meet Current and Future Needs Turning back to the discount window, I also want to note that the discount window has served its role well in recent years, and that we are also engaging in ongoing work to improve its operations. Given the crucial role of the discount window in providing ready access to liquidity in a wide variety of market conditions, we continuously work to assess and improve its functionality while engaging with current and potential users of the window. Among the steps we have taken recently include that we now have an online portal, Discount Window Direct, that allows firms to request and prepay discount window loans in a more streamlined manner than was previously possible. We also recently published a request for information on discount window operations and daylight credit asking about key components of these functions. Feedback from the public will help us prioritize areas for improvement, so I strongly encourage anyone with an interest in this topic to weigh in during the comment period. Your feedback will help us ensure that the discount window continues to improve in its role of providing ready access to funding under a variety of market conditions. Thank you. ${ }^{1}$ The views I express here are my own and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee. ${ }^{2}$ See Michael S. Barr (2023), "The 2023 U.S. Treasury Market Conference," speech delivered at the Federal Reserve Bank of New York, New York, November 16. ${ }^{3}$ See "Subparts D and O-Enhanced Prudential Standards" in Board of Governors of the Federal Reserve System (2024), "Frequently Asked Questions about Regulation YY," webpage. ${ }^{4}$ See Michael S. Barr (2024), "On Building a Resilient Regulatory Framework," speech delivered at Central Banking in the Post-Pandemic Financial System, 28th Annual Financial Markets Conference, the Federal Reserve Bank of Atlanta, Fernandina Beach, Fla., May 20. ${ }^{5}$ The LCR and ILST are two separate, but complementary, liquidity requirements. The LCR is a standardized liquidity measure across banks, meaning the outflow assumptions are the same for each bank. The ILST is a nonstandardized liquidity measure across banks, meaning each bank determines its own outflow assumptions, subject to supervisory input.	Michael S Barr	United States	https://www.bis.org/review/r241001b.pdf	Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. Thank you, and thank you for the opportunity to speak to you today. It is great to be here again, particularly because this year marks the 10th annual conference on the Treasury market, a milestone that is worth celebrating. I want to acknowledge the Federal Reserve Bank of New York for its leadership in this area, including the dedication and excellence it has brought to hosting this conference over the past decade, in collaboration with the Inter-Agency Working Group on Treasury Market Surveillance, led by the Treasury Department. The Treasury market is the means by which our government meets its financing needs in service to the American people, and it is also the bedrock of the financial system. Promoting the resilience of the Treasury market and ensuring it can continue to fulfill these roles requires the collaboration of agencies and individuals across the government along with the private sector. As others have pointed out today, we have made important progress since last year's conference. The Securities and Exchange Commission has finalized a rule on central clearing of Treasury transactions, the Treasury Department has instituted a program for buying back less-liquid Treasury securities, and the Office of Financial Research is preparing for its permanent collection of data on non-centrally-cleared bilateral repurchase agreement (repo) transactions, which will support our understanding of this market segment as it evolves. I will share some thoughts with you on how I see the work of the Federal Reserve in supporting Treasury market resilience. Our capital and liquidity regulations, our supervision of the firms over which we have authority, and our liquidity facilities play important roles in supporting market resilience and financial stability. Earlier this month, I gave a speech where I reiterated the crucial role of capital in serving these objectives, and the need to balance resilience and efficiency in designing our rules. In that speech, I also outlined the elements of a capital re-proposal that I believe will have broad consensus at the Federal Reserve Board. The adjustments are in response to a robust public comment process, and some of them are designed to address interactions and market functioning concerns raised by commentators. In terms of rulemaking, today I will focus on some additional aspects of our regulatory framework-namely, enhancements to our liquidity regulations. I will share some perspective on how our liquidity regulations work together and are supportive of market functioning and the smooth implementation of monetary policy. We consider how all of the Fed's tools work together to support our objectives. In previous speeches, I have talked about the role of the discount window and the standing repo facility (SRF) in supporting both monetary policy implementation and financial stability, noting how important it is that eligible institutions be ready to use these facilities. Today I want to dig into this topic a bit more, including how these tools support monetary policy implementation through appropriate incorporation into liquidity regulations and supervisory practices. After the banking stress in March 2023, we saw a substantial improvement among banks of all sizes in their level of readiness to tap the discount window both in taking the necessary steps for set-up and in their pledging of collateral. Since that time, over $\$ 1$ trillion in additional collateral has been pledged to the discount window, and additional banks have established access to the SRF. Both of these facilities are potential venues for monetizing assets and raising liquidity to address volatility in private funding market rates or gaps in the availability of private-market funding. We had been hearing that some were confused about how banks could incorporate ready access to the discount window and the SRF into their contingency funding plans and internal liquidity stress tests. Supervisors have a role in assessing the viability of large banks' plans to meet stressed outflows in their stress scenarios, and we have been asked whether the discount window, the SRF, and also Federal Home Loan Bank advances can play a role in those scenarios. The answer to this question is "yes." We provided clarity to the public in August on permissible assumptions for how firms can incorporate the discount window and the SRF into their internal liquidity stress-test scenarios. There are a couple of principles that underlie our response in the frequently asked questions we posted on the Board's website. One principle is that our tools are readily available to firms. This means that we see it as acceptable and beneficial for firms to incorporate our facilities to meet liquidity needs in both planning and practice. If firms plan to use our facilities, we expect them to demonstrate ex ante that they are fully capable of doing so, including through test transactions. An additional principle underlying our approach is that, while firms should be ready to use a range of funding sources, firms need to hold sufficient highly liquid assets to meet their potential liquidity needs. That is, they need to self-insure against their own liquidity risks. A third principle is that firms should be ready and able to use private channels to turn these assets into cash, in addition to any public channels they may plan to use. I want to dig a bit deeper into the benefits to both individual firms and the financial system when firms incorporate Fed facilities into their stress preparedness planning. Again, a design feature of our liquidity regulations is that large banks must self-insure against major liquidity risks. Our regulations also provide flexibility in terms of the portfolio composition such banks use to do so. This flexibility allows them to adjust their portfolios based on market conditions and firm needs. A key component of this flexibility is that reserves and certain high-quality liquid assets (HQLA), such as Treasury securities, are equivalent in terms of being treated as the highest quality of liquid assets. This feature is important because, while it allows firms to manage their liquidity buffers more flexibly, it also allows for greater flexibility in our monetary policy implementation and it supports market functioning. We have heard over the years, however, that the degree of substitutability among these assets has been limited by concerns about capacity in stress for the market to turn securities into reserves immediately; these concerns are valid. This constraint can be addressed in part by the appropriate incorporation of Federal Reserve facilities into monetization plans in firms' internal liquidity stress tests. When firms understand that they will not be fully constrained by the capacity of private markets or their individual credit lines to monetize HQLA immediately in stress, they can reduce their demand for reserves in favor of Treasury securities, all else being equal, for their stress planning purposes. This dynamic improves the substitutability of holding reserves and holding Treasury securities either outright or through repo transactions. When banks exhibit a high degree of substitutability of demand for these assets, money market functioning improves. Let me explain with an example. If a bank sees holding reserves and investing in Treasury repo as near substitutes in its liquidity portfolio, it should lend into Treasury repo markets when repo rates rise above the interest rate earned on reserves. When banks can nimbly adjust portfolios in response to price incentives, the efficiency of reserves redistribution through the system improves, and market functioning is enhanced. In aggregate, this activity can prevent rates from rising further, all else being equal. The point at which banks, in aggregate, have a relatively immutable demand for reserves, and are unwilling to lend them out, is evident when a small decrease in the supply of reserves results in a sharp increase in the cost to borrow them. Our monetary policy tools are well positioned to help us avoid this outcome. But, of course, greater willingness of banks to reallocate across close substitutes should help avoid the emergence of sudden pressures in money markets by reducing money market frictions. In 2021, the Federal Reserve launched the SRF, which, along with the discount window, should help cap upward pressure in repo markets that could spill over into the federal funds market. Use of these facilities also increases the supply of reserves in the system. The enhanced clarity for firms that Fed facilities are a fully acceptable venue to get same-day liquidity for their HQLA should help reassure firms about holding reserves and their close substitutes, such as Treasury securities, in their liquidity portfolios. Of course, as I stated earlier, for the largest banks, there is a requirement that they hold highly liquid assets to address their own liquidity risks. They must also be ready to use private markets to monetize these assets. It is also critical that banks recognize and manage the interest rate and liquidity risk of their securities portfolios to ensure those securities held for liquidity purposes can be monetized in stress without creating other adverse effects on a firm's safety and soundness. In 2022 and 2023, certain large banks did not effectively manage the risks of rising rates, and suffered significant fair value losses on their securities holdings, including those in held-to-maturity (HTM) portfolios. These losses affected their ability to respond to liquidity stress, as monetizing the assets could result in realizing losses. When the banking stress hit in March 2023, these securities could not be sold to meet stressed outflows because large unrealized losses inhibited their sale without significant capital implications. This is further complicated in the case of HTM securities, which cannot be sold without risking revaluing a firm's entire HTM portfolio. Selling HTM securities to generate liquidity would therefore have had a particularly large effect on these firms' capital levels, likely increasing the stress on these firms. Further, some firms were unable to rely on private channels such as repo markets for monetization because they were not prepared, they were not regular participants in the market, and market participants were unwilling to lend because of counterparty credit concerns. This combination of factors meant that HTM securities that had been identified by banks as available to serve as a liquidity buffer of assets in stress could not effectively serve that function. As I have mentioned in previous speeches, to address the lessons about liquidity learned in the spring of 2023, we are exploring targeted adjustments to our current liquidity framework. Many firms have taken steps to improve their liquidity resilience, and the regulatory adjustments we are considering would ensure that large banks maintain better liquidity risk-management practices going forward. Improvements to our liquidity regulations will also complement the other components of our supervisory and regulatory regime by improving banks' ability to respond to funding shocks. Specifically, we are exploring a requirement that larger banks maintain a minimum amount of readily available liquidity with a pool of reserves and pre-positioned collateral at the discount window, based on a fraction of their uninsured deposits. Community banks would not be covered, and we would take a tiered approach to the requirements. The collateral pre-positioned at the window could include both Treasury securities and the full range of assets eligible for pledging at the discount window. It is vital that uninsured depositors have confidence that their funds will be readily available for withdrawal, if needed, and this confidence would be enhanced by a requirement that larger banks have readily available liquidity to meet requests for withdrawal of these deposits. This requirement would be a complement to existing liquidity regulations such as those that require the internal liquidity stress tests (ILST) I described earlier as well as meeting the liquidity coverage ratio (LCR). Incorporating the discount window into a readiness requirement would also reemphasize that supervisors and examiners view use of the discount window as appropriate under both normal and stressed market conditions. In addition, as I have discussed previously, we identified significant gaps in interest rate risk management in the March 2023 banking stress, including in portfolios of highly liquid securities. Relatedly, we saw that banks faced constraints in monetizing HTM assets with large unrealized losses in private markets because they were unable to repo these securities or sell these securities without realizing significant losses. To address these gaps, we are considering a partial limit on the extent of reliance on HTM assets in larger banks' liquidity buffers, such as those held under the LCR and ILST requirements. These adjustments would address the known challenges of banks being able to use these assets in stress conditions. Finally, we are reviewing the treatment of a handful of types of deposits in the current liquidity framework. Observed behavior of different deposit types during times of stress suggests the need to recalibrate deposit outflow assumptions in our rules for certain types of depositors. We are also revisiting the scope of application of our current liquidity framework for large banks. These enhancements to our liquidity regulations will help bolster firms' ability to manage liquidity shocks, and they will also be well integrated with our monetary policy tools and framework. Turning back to the discount window, I also want to note that the discount window has served its role well in recent years, and that we are also engaging in ongoing work to improve its operations. Given the crucial role of the discount window in providing ready access to liquidity in a wide variety of market conditions, we continuously work to assess and improve its functionality while engaging with current and potential users of the window. Among the steps we have taken recently include that we now have an online portal, Discount Window Direct, that allows firms to request and prepay discount window loans in a more streamlined manner than was previously possible. We also recently published a request for information on discount window operations and daylight credit asking about key components of these functions. Feedback from the public will help us prioritize areas for improvement, so I strongly encourage anyone with an interest in this topic to weigh in during the comment period. Your feedback will help us ensure that the discount window continues to improve in its role of providing ready access to funding under a variety of market conditions. Thank you.
2024-09-26T00:00:00	Lisa D Cook: What will artificial intelligence mean for America's workers?	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the Ohio State University, Columbus, Ohio, 26 September 2024.	Lisa D Cook: What will artificial intelligence mean for America's workers? Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the Ohio State University, Columbus, Ohio, 26 September 2024. * * * I am grateful for the educational opportunities this university has afforded my family over the years, including my uncle Samuel DuBois Cook who received his M.A. and Ph. D. here in 1950 and 1953. I am delighted to be here! Today, I would like to discuss the implications of artificial intelligence (AI) for workers and the labor market, more 1 generally. I will discuss AI's potential to boost productivity, offer a framework to consider which jobs will be most affected by AI, and consider AI's effect on aggregate employment. I hope this discussion will be informative for many of you in the audience, especially those of you who will be entering the job market in the next few years. However, before discussing AI, I think it will be helpful to first set the stage by reviewing how the labor market has evolved in recent years and where it is today. View of the Labor Market On the eve of the pandemic, the labor market was quite strong. The unemployment rate was flirting with historical lows, having fallen to 3.5 percent in the fall of 2019 from an average of 4.7 percent between 2014 and 2019. Jobs were relatively plentiful, with 12 openings for every 10 unemployed job seekers. Then, the labor market changed dramatically in the first few months of the pandemic when economies around the world shut down. By April 2020, nearly one out of every seven U.S. workers was unemployed. The U.S. labor market lost more than 20 million jobs in just two months. To put that into perspective, that is nearly four times the total number of jobs in Ohio. U.S. workers and employers, with the support of timely and extraordinary policy action, proved to be resilient and innovative. As we know from the National Bureau of Economic Research's Business Cycle Dating Committee, the pandemic recession was the shortest on record, even though it was the deepest since the Great Depression. By mid-2020, the economy was growing again. And grow it did. The labor market roared back, gaining 25 million jobs in the three years from its low point in April 2020. Demand for labor outpaced supply such that by mid2022 there were 20 job openings for every 10 unemployed job seekers. By early 2023, the unemployment rate fell to 3.4 percent, its lowest level in 60 years. In the last year and a half, labor demand has moderated, as restrictive monetary policy helped bring aggregate demand in line with supply and eased inflationary pressure. At the same time, labor supply grew rapidly, and now labor demand and supply are more balanced. While the overall labor market remains solid, it has cooled noticeably this year and is now less tight than it was on the eve of the pandemic. In August, the unemployment rate stood at 4.2 percent, having risen by almost a 1/2 percentage point over the past 12 months. And, in recent months, the number of job openings relative to unemployed job seekers has fallen to just below its pre-pandemic range. As labor demand and supply are now more evenly balanced, it may become more difficult for some individuals to find employment. For example, younger workers could experience more hurdles as they look for that first job that will launch them on a longer career path. Over the past 12 months, the share of 16- to 24-year-olds in the labor force who are unemployed has risen over 1 percentage point, notably larger than the overall increase. Such data are consistent with a report in the most recent Beige Book, a compilation of anecdotal information from around the country shared with Fed officials before our meetings, indicating some recent graduates are facing unexpected 2 difficulties finding suitable jobs. It is also the case that less-educated and minority workers could face greater hurdles, as they tend to benefit more from tighter labor markets and suffer more from weakening economic conditions. The slowing of the solid labor market has come alongside a significant easing in inflationary pressure. Inflation was 2.5 percent over the 12 months ending in July, notably closer to our 2 percent target than a year earlier-when inflation was 3.3 percentand far below its peak of 7 percent in mid-2022. In recent months, the upside risks to inflation have diminished, and the downside risks to employment have increased. In response to these changing conditions, I whole heartedly supported the decision at last week's Federal Open Market Committee (FOMC) meeting to lower our policy interest rate by 1/2 percentage point. The FOMC, of which I am a member, is the Federal Reserve's primary monetary policymaking body. That decision reflected growing confidence that, with an appropriate recalibration of our policy stance, the solid labor market can be maintained in a context of moderate economic growth and inflation continuing to move sustainably down to our target. In thinking about the path of policy moving forward, I will be looking carefully at incoming data, the evolving outlook, and the balance of risks. The return to balance in the labor market between supply and demand, as well as the ongoing return toward our inflation target, reflects the normalization of the economy after the dislocations of the pandemic. This normalization, particularly of inflation, is quite welcome, as a balance between supply and demand is essential for sustaining a prolonged period of labor-market strength. Of course, there will always be new developments and changes that will reshape the labor market. Recent advances in AI technology are perhaps the most talked about and debated of such developments today. I anticipate that these advances may have a significant effect on workers, the labor market, and the economy in coming years. Artificial Intelligence and Productivity From the outset, I, like most of my economist colleagues studying the economics of innovation and AI closely, acknowledge that the implications of AI are highly uncertain. We still do not know what the ultimate magnitude or intensity of this effect will be, which workers and firms will be most affected, or even the time period over which these effects will be realized. But today, I will highlight how economic theory and some recent studies can shed initial light on these critical questions. The key reason why many expect AI will have a substantial effect on the economy is, because AI has the potential to provide a large and sustained boost to labor-productivity growth-which is simply how much output of an individual worker grows over time. Ultimately, growth in output per person, workers' real earnings, and households' real purchasing power can all be tied back to growth in labor productivity. Like many of the most significant technological innovations of the past 200 or so years-such as the steam engine, electricity, computers, and the internet-AI has the potential to affect labor productivity in a plethora of economic activities across many industries and occupations. For instance, over the past few years we have seen dramatic advances in generative AI technologies, which synthesize massive quantities of data to create models that can produce high-quality text, images, and video. Building upon these recent advances, a wide variety of new AI assistants have been deployed to help workers in a broad range of jobs. Although the degree to which these new assistants will improve labor productivity is likely to be quite idiosyncratic, some early studies suggest the effects could be large. One recent study examined the effect of an AI assistant for customer support agents and found that agents using the AI assistant resolved 14 percent more customer issues per hour-with this improvement being most pronounced for workers with comparatively less experience and less formal training.3 But perhaps even more promising is AI's potential for improving our ability to generate new ideas. AI is being used in drug discovery to identify novel chemical compounds; in energy research to extend the duration of a fusion reaction; and in engineering to better understand the aerodynamics of automobiles, airplanes, and ships. If AI can improve our ability to generate new ideas, then it could provide a long-term boost to labor productivity growth, as each newly discovered idea will itself provide an incremental boost to labor productivity. Judging the Effect of Artificial Intelligence on Occupations Because of their effects on labor productivity, past technological innovations have resulted in dramatic positive and negative shocks to the demand for specific occupations or tasks. We should expect AI to do the same: eliminating some jobs but, crucially, also creating new ones. As a society, we will need to consider how to retrain and support workers who may be displaced from their jobs, even as many others benefit from AI adoption. As I think about AI's implications for employment in any given job or task, I tend to focus on three questions. How much exposure? First, how exposed is a particular job to AI? It is helpful to think about a job as a set of tasks that the worker must perform. Economist David Autor pioneered this task-based framework for jobs. He used it to demonstrate that the shift in labor demand, which began in the 1970s, away from jobs that involved a large degree of routine tasks can be explained by these jobs' greater 4 exposure to the rapid adoption of computerization and automation technologies. We can take a similar task-based approach to determine a job's exposure to AI. Start by considering what share of a job's tasks can be performed by AI. For example, we might expect AI to be able to perform a larger share of a software programmer's tasks versus those of a plumber. Next, for those tasks that can be performed by AI, consider how well AI performs them relative to a typical worker. For instance, generative AI is used in a medical setting to summarize patient interviews-a task that it performs quite well relative to a human doctor. Based on that interview, AI could diagnose a patient and develop a treatment plan, but these are tasks that doctors still tend to perform better than AI. Finally, for those tasks that can be performed by AI, think about the quality threshold required for that job task. Coming back to the example of a doctor and AI, while there may be some tolerance for incorrectly summarizing a patient interview, there is little tolerance for misdiagnosing a patient or developing a bad treatment plan. I would also note that we may have higher quality thresholds for AI than we do for human workerswith driverless cars being an example where AI drivers may be held to a higher standard than human drivers. Thus, a job will be more exposed to AI, if AI can perform a large share of the job's tasks sufficiently well relative to a human worker and a set of quality thresholds. Importantly, we can expect that a job's exposure to AI will change over time, because advances in AI technology will both expand the set of tasks that AI can perform and improve the quality of AI's performance of those tasks. Which brings me to my second question for AI's implications for any given job. Complement or substitute? Will AI be a complement to or a substitute for the job, given its set of tasks? AI is more likely to serve as a complement to jobs that have less exposure to AI but use the services or products that are produced by jobs with a high degree of AI exposure. For instance, a job as a litigator may have little direct exposure to AI but will benefit from AI's ability to assist with legal research.5 Even for some jobs with a high degree of exposure to AI, it is possible for AI to serve as a complement. Let's return to the example of the doctor, who may now see more patients or spend more time on diagnoses, because AI has taken over writing summaries of patient interviews. More broadly, jobs with a high degree of exposure to AI will likely be complemented by AI, if workers are able to offload time-intensive, but low value-added, tasks to AI and focus their time on the highest value-added tasks. However, we can expect that there will be some jobs that have a high degree of exposure to AI and for which AI can perform some especially high-valued tasks. Thus, AI may be more of a substitute for human labor in these jobs. But even for these jobs, the employment implications are ambiguous and will depend on the third question. What is the elasticity of demand? What is the price elasticity of demand for the output of these jobs that are highly affected by AI? To understand what I mean, it is helpful to consider a concrete example. I want to come back to the software programmer jobs that I mentioned before as having a high degree of exposure to AI. Recent advances in generative AI have resulted in the development of new AI-powered coding assistants that help automate some aspects of writing software code. Some early studies have found that these AI coding assistants can provide a significant boost to programmers' productivity. One randomized controlled trial found that these AI coding assistants cut in half the amount of time it took to finish a 6 small programming project. Another study found that programmers who were randomly assigned to use an AI coding assistant submitted 20 percent more requests each week 7 asking to add code they had written to a software project. And I emphasize that these tools are still in their infancy, which suggests that the productivity gains for softwareprogramming jobs may be even larger. These productivity enhancements will allow software programming projects to be delivered in less time and at a lower cost. As we know from economic theory, as the costs and delivery times for software projects fall, demand for such projects should increase. The number of software-programming jobs will depend on whether the demand for software projects increases more than one for one with the decrease in cost. In other words, is the price elasticity of demand for software projects greater than one? If it is, then the reduction in software programmers' hours devoted to programming tasks that can now be performed by AI will be more than offset by the increase in their hours from the greater demand for AI-enhanced software programming. I find these questions helpful for framing how to think about AI's implications for any job or set of tasks. While I mentioned that there will likely be benefits for certain workers, it is important to recognize a universal lesson from past technological innovationsnamely, that the employment and earnings of some workers are likely to be negatively affected by these innovations. The magnitude and extent of these negative effects will depend on a variety of factors. For instance, consider if AI is able to perform job tasks that previously required a high degree of training or specialization. Affected workers in these jobs could experience larger declines in their earning power, if AI depreciates the value of their accumulated human capital. The degree to which AI could negatively affect some workers' earnings and employment will also be influenced by the pace of AI adoption. It is possible that if AI adoption is rapid, we could see the effects on some workers come quickly and be more concentrated, depending on which sectors are early adopters. Implications of Artificial Intelligence for Aggregate Employment In addition to considering AI's effects on individual workers, economists also evaluate AI's implications for aggregate employment. As I discussed, it remains unclear whether AI will be a boon for or a drag on net employment for those jobs that are most directly affected by AI. For workers who are not directly exposed to AI but, rather, are users of the output from AI-exposed jobs, the aggregate employment implications are more likely to be positive. Generally, these downstream jobs will benefit from the lower input costs that result from greater productivity realized by AI-exposed jobs. An exception might be jobs where the cheaper inputs are a substitute for labor in the downstream job. Moreover, I anticipate that inventors and innovators will continue to discover new products and services that are enabled by AI. The companies that are then formed to deliver these new products and services can be expected to raise aggregate employment. In light of the uncertainty regarding AI's implications for the labor market, I want to highlight the important role that decisions by firms and, to a lesser extent, workers can have for determining how AI will affect the labor market. If incumbent firms are able to adjust their processes to capture productivity benefits from AI, then these firms could help mitigate some of AI's potential for job displacement by internally reallocating affected workers to new roles and providing necessary training. If some job tasks can be replaced with AI-especially those that are mundane and repetitive-workers may be freed up to focus on other tasks or new activities they find more rewarding. Individual workers play a limited role in determining how AI will affect their earnings and employment. Workers in jobs that will be complemented by AI might benefit from familiarizing themselves with how to effectively use AI. Workers in jobs where AI will be able to perform a substantial share of their tasks will face greater challenges. Some of these workers may seek to develop expertise in the aspects of their jobs for which AI is particularly ill-suited. Yet, many of these more-exposed workers may need to invest in training in alternative occupations that are less exposed to AI, similar to some of the skill-retraining efforts for manufacturing workers over the past 50 years. Conclusion In closing, I suspect that the tremendous uncertainty I highlighted related to AI's implications for the labor market will be some combination of disconcerting and exciting for many in the audience, especially those who will be graduating and launching their careers in the coming years. My recommendation to you is to take the time to experiment with AI, familiarizing yourself with its capabilities and limitations. Doing so will make you well placed to help your future employers - and that could include yourselves - transform their business processes to effectively use AI. And for the smaller subset of you who are purely excited about the opportunity presented by AI, I look forward to seeing the innovative new products and services you create and disseminate throughout the economy to raise the living standards for all Americans. Thank you for having me at The Ohio State University. I look forward to your questions. 1 The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. 2 The August 2024 Beige Book is available on the Board's website at https://www. federalreserve.gov/monetarypolicy/files/BeigeBook_20240904.pdf . 3 See Erik Brynjolfsson, Danielle Li, and Lindsey R. Raymond (2023), "Generative AI at Work," NBER Working Paper Series 31161 (Cambridge, Mass.: National Bureau of Economic Research, April; revised November). 4 See David H. Autor, Frank Levy, and Richard J. Murnane (2003), "The Skill Content of Recent Technological Change: An Empirical Exploration," Quarterly Journal of Economics, vol. 118 (November), pp. 1279-1333. 5 See Bloomberg Industrial Group (2024), "How Is AI Changing the Legal Profession?" Bloomberg Law, May 23. 6 See Sida Peng, Eirini Kalliamvakou, Peter Cihon, and Mert Demirer (2023), "The Impact of AI on Developer Productivity: Evidence from GitHub Copilot," working paper, February. 7 See Kevin Zheyuan Cui, Mert Demirer, Sonia Jaffe, Leon Musolff, Sida Peng, and Tobia Salz (2024), "The Productivity Effects of Generative AI: Evidence from a Field Experiment with GitHub Copilot," An MIT Exploration of Generative AI (Cambridge, Mass.: Massachusetts Institute of Technology, March).	---[PAGE_BREAK]--- # Lisa D Cook: What will artificial intelligence mean for America's workers? Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the Ohio State University, Columbus, Ohio, 26 September 2024. I am grateful for the educational opportunities this university has afforded my family over the years, including my uncle Samuel DuBois Cook who received his M.A. and Ph. D. here in 1950 and 1953. I am delighted to be here! Today, I would like to discuss the implications of artificial intelligence (AI) for workers and the labor market, more generally. ${ }^{1}$ I will discuss AI's potential to boost productivity, offer a framework to consider which jobs will be most affected by AI, and consider AI's effect on aggregate employment. I hope this discussion will be informative for many of you in the audience, especially those of you who will be entering the job market in the next few years. However, before discussing AI, I think it will be helpful to first set the stage by reviewing how the labor market has evolved in recent years and where it is today. ## View of the Labor Market On the eve of the pandemic, the labor market was quite strong. The unemployment rate was flirting with historical lows, having fallen to 3.5 percent in the fall of 2019 from an average of 4.7 percent between 2014 and 2019. Jobs were relatively plentiful, with 12 openings for every 10 unemployed job seekers. Then, the labor market changed dramatically in the first few months of the pandemic when economies around the world shut down. By April 2020, nearly one out of every seven U.S. workers was unemployed. The U.S. labor market lost more than 20 million jobs in just two months. To put that into perspective, that is nearly four times the total number of jobs in Ohio. U.S. workers and employers, with the support of timely and extraordinary policy action, proved to be resilient and innovative. As we know from the National Bureau of Economic Research's Business Cycle Dating Committee, the pandemic recession was the shortest on record, even though it was the deepest since the Great Depression. By mid-2020, the economy was growing again. And grow it did. The labor market roared back, gaining 25 million jobs in the three years from its low point in April 2020. Demand for labor outpaced supply such that by mid2022 there were 20 job openings for every 10 unemployed job seekers. By early 2023, the unemployment rate fell to 3.4 percent, its lowest level in 60 years. In the last year and a half, labor demand has moderated, as restrictive monetary policy helped bring aggregate demand in line with supply and eased inflationary pressure. At the same time, labor supply grew rapidly, and now labor demand and supply are more balanced. While the overall labor market remains solid, it has cooled noticeably this year and is now less tight than it was on the eve of the pandemic. In August, the unemployment rate stood at 4.2 percent, having risen by almost a $1 / 2$ percentage point over the past 12 months. And, in recent months, the number of job openings relative to unemployed job seekers has fallen to just below its pre-pandemic range. ---[PAGE_BREAK]--- As labor demand and supply are now more evenly balanced, it may become more difficult for some individuals to find employment. For example, younger workers could experience more hurdles as they look for that first job that will launch them on a longer career path. Over the past 12 months, the share of 16 - to 24 -year-olds in the labor force who are unemployed has risen over 1 percentage point, notably larger than the overall increase. Such data are consistent with a report in the most recent Beige Book, a compilation of anecdotal information from around the country shared with Fed officials before our meetings, indicating some recent graduates are facing unexpected difficulties finding suitable jobs. ${ }^{2}$ It is also the case that less-educated and minority workers could face greater hurdles, as they tend to benefit more from tighter labor markets and suffer more from weakening economic conditions. The slowing of the solid labor market has come alongside a significant easing in inflationary pressure. Inflation was 2.5 percent over the 12 months ending in July, notably closer to our 2 percent target than a year earlier-when inflation was 3.3 percentand far below its peak of 7 percent in mid-2022. In recent months, the upside risks to inflation have diminished, and the downside risks to employment have increased. In response to these changing conditions, I whole heartedly supported the decision at last week's Federal Open Market Committee (FOMC) meeting to lower our policy interest rate by $1 / 2$ percentage point. The FOMC, of which I am a member, is the Federal Reserve's primary monetary policymaking body. That decision reflected growing confidence that, with an appropriate recalibration of our policy stance, the solid labor market can be maintained in a context of moderate economic growth and inflation continuing to move sustainably down to our target. In thinking about the path of policy moving forward, I will be looking carefully at incoming data, the evolving outlook, and the balance of risks. The return to balance in the labor market between supply and demand, as well as the ongoing return toward our inflation target, reflects the normalization of the economy after the dislocations of the pandemic. This normalization, particularly of inflation, is quite welcome, as a balance between supply and demand is essential for sustaining a prolonged period of labor-market strength. Of course, there will always be new developments and changes that will reshape the labor market. Recent advances in AI technology are perhaps the most talked about and debated of such developments today. I anticipate that these advances may have a significant effect on workers, the labor market, and the economy in coming years. # Artificial Intelligence and Productivity From the outset, I, like most of my economist colleagues studying the economics of innovation and AI closely, acknowledge that the implications of AI are highly uncertain. We still do not know what the ultimate magnitude or intensity of this effect will be, which workers and firms will be most affected, or even the time period over which these effects will be realized. But today, I will highlight how economic theory and some recent studies can shed initial light on these critical questions. The key reason why many expect AI will have a substantial effect on the economy is, because AI has the potential to provide a large and sustained boost to labor-productivity growth-which is simply how much output of an individual worker grows over time. ---[PAGE_BREAK]--- Ultimately, growth in output per person, workers' real earnings, and households' real purchasing power can all be tied back to growth in labor productivity. Like many of the most significant technological innovations of the past 200 or so years-such as the steam engine, electricity, computers, and the internet-AI has the potential to affect labor productivity in a plethora of economic activities across many industries and occupations. For instance, over the past few years we have seen dramatic advances in generative AI technologies, which synthesize massive quantities of data to create models that can produce high-quality text, images, and video. Building upon these recent advances, a wide variety of new Al assistants have been deployed to help workers in a broad range of jobs. Although the degree to which these new assistants will improve labor productivity is likely to be quite idiosyncratic, some early studies suggest the effects could be large. One recent study examined the effect of an Al assistant for customer support agents and found that agents using the Al assistant resolved 14 percent more customer issues per hour-with this improvement being most pronounced for workers with comparatively less experience and less formal training. $\underline{3}$ But perhaps even more promising is AI's potential for improving our ability to generate new ideas. Al is being used in drug discovery to identify novel chemical compounds; in energy research to extend the duration of a fusion reaction; and in engineering to better understand the aerodynamics of automobiles, airplanes, and ships. If AI can improve our ability to generate new ideas, then it could provide a long-term boost to labor productivity growth, as each newly discovered idea will itself provide an incremental boost to labor productivity. # Judging the Effect of Artificial Intelligence on Occupations Because of their effects on labor productivity, past technological innovations have resulted in dramatic positive and negative shocks to the demand for specific occupations or tasks. We should expect AI to do the same: eliminating some jobs but, crucially, also creating new ones. As a society, we will need to consider how to retrain and support workers who may be displaced from their jobs, even as many others benefit from AI adoption. As I think about AI's implications for employment in any given job or task, I tend to focus on three questions. ## How much exposure? First, how exposed is a particular job to AI? It is helpful to think about a job as a set of tasks that the worker must perform. Economist David Autor pioneered this task-based framework for jobs. He used it to demonstrate that the shift in labor demand, which began in the 1970s, away from jobs that involved a large degree of routine tasks can be explained by these jobs' greater exposure to the rapid adoption of computerization and automation technologies. ${ }^{4}$ We can take a similar task-based approach to determine a job's exposure to AI. Start by considering what share of a job's tasks can be performed by AI. For example, we might expect AI to be able to perform a larger share of a software programmer's tasks versus those of a plumber. ---[PAGE_BREAK]--- Next, for those tasks that can be performed by AI, consider how well Al performs them relative to a typical worker. For instance, generative AI is used in a medical setting to summarize patient interviews-a task that it performs quite well relative to a human doctor. Based on that interview, Al could diagnose a patient and develop a treatment plan, but these are tasks that doctors still tend to perform better than Al. Finally, for those tasks that can be performed by AI, think about the quality threshold required for that job task. Coming back to the example of a doctor and AI, while there may be some tolerance for incorrectly summarizing a patient interview, there is little tolerance for misdiagnosing a patient or developing a bad treatment plan. I would also note that we may have higher quality thresholds for Al than we do for human workerswith driverless cars being an example where Al drivers may be held to a higher standard than human drivers. Thus, a job will be more exposed to AI, if AI can perform a large share of the job's tasks sufficiently well relative to a human worker and a set of quality thresholds. Importantly, we can expect that a job's exposure to Al will change over time, because advances in AI technology will both expand the set of tasks that AI can perform and improve the quality of AI's performance of those tasks. Which brings me to my second question for AI's implications for any given job. # Complement or substitute? Will Al be a complement to or a substitute for the job, given its set of tasks? Al is more likely to serve as a complement to jobs that have less exposure to Al but use the services or products that are produced by jobs with a high degree of Al exposure. For instance, a job as a litigator may have little direct exposure to Al but will benefit from AI's ability to assist with legal research. ${ }^{5}$ Even for some jobs with a high degree of exposure to Al , it is possible for Al to serve as a complement. Let's return to the example of the doctor, who may now see more patients or spend more time on diagnoses, because AI has taken over writing summaries of patient interviews. More broadly, jobs with a high degree of exposure to Al will likely be complemented by Al, if workers are able to offload time-intensive, but low value-added, tasks to AI and focus their time on the highest value-added tasks. However, we can expect that there will be some jobs that have a high degree of exposure to AI and for which AI can perform some especially high-valued tasks. Thus, Al may be more of a substitute for human labor in these jobs. But even for these jobs, the employment implications are ambiguous and will depend on the third question. ## What is the elasticity of demand? What is the price elasticity of demand for the output of these jobs that are highly affected by Al? To understand what I mean, it is helpful to consider a concrete example. I want to come back to the software programmer jobs that I mentioned before as having a high degree of exposure to Al. Recent advances in generative AI have resulted in the development of new Al-powered coding assistants that help automate some aspects of writing software code. Some early studies have found that these Al coding assistants can ---[PAGE_BREAK]--- provide a significant boost to programmers' productivity. One randomized controlled trial found that these Al coding assistants cut in half the amount of time it took to finish a small programming project. ${ }^{6}$ Another study found that programmers who were randomly assigned to use an AI coding assistant submitted 20 percent more requests each week asking to add code they had written to a software project. ${ }^{7}$ And I emphasize that these tools are still in their infancy, which suggests that the productivity gains for softwareprogramming jobs may be even larger. These productivity enhancements will allow software programming projects to be delivered in less time and at a lower cost. As we know from economic theory, as the costs and delivery times for software projects fall, demand for such projects should increase. The number of software-programming jobs will depend on whether the demand for software projects increases more than one for one with the decrease in cost. In other words, is the price elasticity of demand for software projects greater than one? If it is, then the reduction in software programmers' hours devoted to programming tasks that can now be performed by AI will be more than offset by the increase in their hours from the greater demand for AI-enhanced software programming. I find these questions helpful for framing how to think about AI's implications for any job or set of tasks. While I mentioned that there will likely be benefits for certain workers, it is important to recognize a universal lesson from past technological innovationsnamely, that the employment and earnings of some workers are likely to be negatively affected by these innovations. The magnitude and extent of these negative effects will depend on a variety of factors. For instance, consider if AI is able to perform job tasks that previously required a high degree of training or specialization. Affected workers in these jobs could experience larger declines in their earning power, if AI depreciates the value of their accumulated human capital. The degree to which AI could negatively affect some workers' earnings and employment will also be influenced by the pace of AI adoption. It is possible that if AI adoption is rapid, we could see the effects on some workers come quickly and be more concentrated, depending on which sectors are early adopters. # Implications of Artificial Intelligence for Aggregate Employment In addition to considering AI's effects on individual workers, economists also evaluate AI's implications for aggregate employment. As I discussed, it remains unclear whether AI will be a boon for or a drag on net employment for those jobs that are most directly affected by AI. For workers who are not directly exposed to Al but, rather, are users of the output from Al-exposed jobs, the aggregate employment implications are more likely to be positive. Generally, these downstream jobs will benefit from the lower input costs that result from greater productivity realized by AI-exposed jobs. An exception might be jobs where the cheaper inputs are a substitute for labor in the downstream job. Moreover, I anticipate that inventors and innovators will continue to discover new products and services that are enabled by AI. The companies that are then formed to deliver these new products and services can be expected to raise aggregate employment. ---[PAGE_BREAK]--- In light of the uncertainty regarding AI's implications for the labor market, I want to highlight the important role that decisions by firms and, to a lesser extent, workers can have for determining how AI will affect the labor market. If incumbent firms are able to adjust their processes to capture productivity benefits from AI, then these firms could help mitigate some of AI's potential for job displacement by internally reallocating affected workers to new roles and providing necessary training. If some job tasks can be replaced with AI-especially those that are mundane and repetitive-workers may be freed up to focus on other tasks or new activities they find more rewarding. Individual workers play a limited role in determining how AI will affect their earnings and employment. Workers in jobs that will be complemented by AI might benefit from familiarizing themselves with how to effectively use AI. Workers in jobs where AI will be able to perform a substantial share of their tasks will face greater challenges. Some of these workers may seek to develop expertise in the aspects of their jobs for which AI is particularly ill-suited. Yet, many of these more-exposed workers may need to invest in training in alternative occupations that are less exposed to AI, similar to some of the skill-retraining efforts for manufacturing workers over the past 50 years. # Conclusion In closing, I suspect that the tremendous uncertainty I highlighted related to AI's implications for the labor market will be some combination of disconcerting and exciting for many in the audience, especially those who will be graduating and launching their careers in the coming years. My recommendation to you is to take the time to experiment with AI, familiarizing yourself with its capabilities and limitations. Doing so will make you well placed to help your future employers - and that could include yourselves - transform their business processes to effectively use AI. And for the smaller subset of you who are purely excited about the opportunity presented by AI, I look forward to seeing the innovative new products and services you create and disseminate throughout the economy to raise the living standards for all Americans. Thank you for having me at The Ohio State University. I look forward to your questions. 1 The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. 2 The August 2024 Beige Book is available on the Board's website at https://www. federalreserve.gov/monetarypolicy/files/BeigeBook_20240904.pdf. 3 See Erik Brynjolfsson, Danielle Li, and Lindsey R. Raymond (2023), "Generative AI at Work." NBER Working Paper Series 31161 (Cambridge, Mass.: National Bureau of Economic Research, April; revised November). ---[PAGE_BREAK]--- 4 See David H. Autor, Frank Levy, and Richard J. Murnane (2003), "The Skill Content of Recent Technological Change: An Empirical Exploration," Quarterly Journal of Economics, vol. 118 (November), pp. 1279-1333. 5 See Bloomberg Industrial Group (2024), "How Is AI Changing the Legal Profession?" Bloomberg Law, May 23. 6 See Sida Peng, Eirini Kalliamvakou, Peter Cihon, and Mert Demirer (2023), "The Impact of AI on Developer Productivity: Evidence from GitHub Copilot," working paper, February. 7 See Kevin Zheyuan Cui, Mert Demirer, Sonia Jaffe, Leon Musolff, Sida Peng, and Tobia Salz (2024), "The Productivity Effects of Generative AI: Evidence from a Field Experiment with GitHub Copilot," An MIT Exploration of Generative AI (Cambridge, Mass.: Massachusetts Institute of Technology, March).	Lisa D Cook	United States	https://www.bis.org/review/r241001c.pdf	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the Ohio State University, Columbus, Ohio, 26 September 2024. I am grateful for the educational opportunities this university has afforded my family over the years, including my uncle Samuel DuBois Cook who received his M.A. and Ph. D. here in 1950 and 1953. I am delighted to be here! Today, I would like to discuss the implications of artificial intelligence (AI) for workers and the labor market, more generally. I will discuss AI's potential to boost productivity, offer a framework to consider which jobs will be most affected by AI, and consider AI's effect on aggregate employment. I hope this discussion will be informative for many of you in the audience, especially those of you who will be entering the job market in the next few years. However, before discussing AI, I think it will be helpful to first set the stage by reviewing how the labor market has evolved in recent years and where it is today. On the eve of the pandemic, the labor market was quite strong. The unemployment rate was flirting with historical lows, having fallen to 3.5 percent in the fall of 2019 from an average of 4.7 percent between 2014 and 2019. Jobs were relatively plentiful, with 12 openings for every 10 unemployed job seekers. Then, the labor market changed dramatically in the first few months of the pandemic when economies around the world shut down. By April 2020, nearly one out of every seven U.S. workers was unemployed. The U.S. labor market lost more than 20 million jobs in just two months. To put that into perspective, that is nearly four times the total number of jobs in Ohio. U.S. workers and employers, with the support of timely and extraordinary policy action, proved to be resilient and innovative. As we know from the National Bureau of Economic Research's Business Cycle Dating Committee, the pandemic recession was the shortest on record, even though it was the deepest since the Great Depression. By mid-2020, the economy was growing again. And grow it did. The labor market roared back, gaining 25 million jobs in the three years from its low point in April 2020. Demand for labor outpaced supply such that by mid2022 there were 20 job openings for every 10 unemployed job seekers. By early 2023, the unemployment rate fell to 3.4 percent, its lowest level in 60 years. In the last year and a half, labor demand has moderated, as restrictive monetary policy helped bring aggregate demand in line with supply and eased inflationary pressure. At the same time, labor supply grew rapidly, and now labor demand and supply are more balanced. While the overall labor market remains solid, it has cooled noticeably this year and is now less tight than it was on the eve of the pandemic. In August, the unemployment rate stood at 4.2 percent, having risen by almost a $1 / 2$ percentage point over the past 12 months. And, in recent months, the number of job openings relative to unemployed job seekers has fallen to just below its pre-pandemic range. As labor demand and supply are now more evenly balanced, it may become more difficult for some individuals to find employment. For example, younger workers could experience more hurdles as they look for that first job that will launch them on a longer career path. Over the past 12 months, the share of 16 - to 24 -year-olds in the labor force who are unemployed has risen over 1 percentage point, notably larger than the overall increase. Such data are consistent with a report in the most recent Beige Book, a compilation of anecdotal information from around the country shared with Fed officials before our meetings, indicating some recent graduates are facing unexpected difficulties finding suitable jobs. It is also the case that less-educated and minority workers could face greater hurdles, as they tend to benefit more from tighter labor markets and suffer more from weakening economic conditions. The slowing of the solid labor market has come alongside a significant easing in inflationary pressure. Inflation was 2.5 percent over the 12 months ending in July, notably closer to our 2 percent target than a year earlier-when inflation was 3.3 percentand far below its peak of 7 percent in mid-2022. In recent months, the upside risks to inflation have diminished, and the downside risks to employment have increased. In response to these changing conditions, I whole heartedly supported the decision at last week's Federal Open Market Committee (FOMC) meeting to lower our policy interest rate by $1 / 2$ percentage point. The FOMC, of which I am a member, is the Federal Reserve's primary monetary policymaking body. That decision reflected growing confidence that, with an appropriate recalibration of our policy stance, the solid labor market can be maintained in a context of moderate economic growth and inflation continuing to move sustainably down to our target. In thinking about the path of policy moving forward, I will be looking carefully at incoming data, the evolving outlook, and the balance of risks. The return to balance in the labor market between supply and demand, as well as the ongoing return toward our inflation target, reflects the normalization of the economy after the dislocations of the pandemic. This normalization, particularly of inflation, is quite welcome, as a balance between supply and demand is essential for sustaining a prolonged period of labor-market strength. Of course, there will always be new developments and changes that will reshape the labor market. Recent advances in AI technology are perhaps the most talked about and debated of such developments today. I anticipate that these advances may have a significant effect on workers, the labor market, and the economy in coming years. From the outset, I, like most of my economist colleagues studying the economics of innovation and AI closely, acknowledge that the implications of AI are highly uncertain. We still do not know what the ultimate magnitude or intensity of this effect will be, which workers and firms will be most affected, or even the time period over which these effects will be realized. But today, I will highlight how economic theory and some recent studies can shed initial light on these critical questions. The key reason why many expect AI will have a substantial effect on the economy is, because AI has the potential to provide a large and sustained boost to labor-productivity growth-which is simply how much output of an individual worker grows over time. Ultimately, growth in output per person, workers' real earnings, and households' real purchasing power can all be tied back to growth in labor productivity. Like many of the most significant technological innovations of the past 200 or so years-such as the steam engine, electricity, computers, and the internet-AI has the potential to affect labor productivity in a plethora of economic activities across many industries and occupations. For instance, over the past few years we have seen dramatic advances in generative AI technologies, which synthesize massive quantities of data to create models that can produce high-quality text, images, and video. Building upon these recent advances, a wide variety of new Al assistants have been deployed to help workers in a broad range of jobs. Although the degree to which these new assistants will improve labor productivity is likely to be quite idiosyncratic, some early studies suggest the effects could be large. One recent study examined the effect of an Al assistant for customer support agents and found that agents using the Al assistant resolved 14 percent more customer issues per hour-with this improvement being most pronounced for workers with comparatively less experience and less formal training. But perhaps even more promising is AI's potential for improving our ability to generate new ideas. Al is being used in drug discovery to identify novel chemical compounds; in energy research to extend the duration of a fusion reaction; and in engineering to better understand the aerodynamics of automobiles, airplanes, and ships. If AI can improve our ability to generate new ideas, then it could provide a long-term boost to labor productivity growth, as each newly discovered idea will itself provide an incremental boost to labor productivity. Because of their effects on labor productivity, past technological innovations have resulted in dramatic positive and negative shocks to the demand for specific occupations or tasks. We should expect AI to do the same: eliminating some jobs but, crucially, also creating new ones. As a society, we will need to consider how to retrain and support workers who may be displaced from their jobs, even as many others benefit from AI adoption. As I think about AI's implications for employment in any given job or task, I tend to focus on three questions. First, how exposed is a particular job to AI? It is helpful to think about a job as a set of tasks that the worker must perform. Economist David Autor pioneered this task-based framework for jobs. He used it to demonstrate that the shift in labor demand, which began in the 1970s, away from jobs that involved a large degree of routine tasks can be explained by these jobs' greater exposure to the rapid adoption of computerization and automation technologies. We can take a similar task-based approach to determine a job's exposure to AI. Start by considering what share of a job's tasks can be performed by AI. For example, we might expect AI to be able to perform a larger share of a software programmer's tasks versus those of a plumber. Next, for those tasks that can be performed by AI, consider how well Al performs them relative to a typical worker. For instance, generative AI is used in a medical setting to summarize patient interviews-a task that it performs quite well relative to a human doctor. Based on that interview, Al could diagnose a patient and develop a treatment plan, but these are tasks that doctors still tend to perform better than Al. Finally, for those tasks that can be performed by AI, think about the quality threshold required for that job task. Coming back to the example of a doctor and AI, while there may be some tolerance for incorrectly summarizing a patient interview, there is little tolerance for misdiagnosing a patient or developing a bad treatment plan. I would also note that we may have higher quality thresholds for Al than we do for human workerswith driverless cars being an example where Al drivers may be held to a higher standard than human drivers. Thus, a job will be more exposed to AI, if AI can perform a large share of the job's tasks sufficiently well relative to a human worker and a set of quality thresholds. Importantly, we can expect that a job's exposure to Al will change over time, because advances in AI technology will both expand the set of tasks that AI can perform and improve the quality of AI's performance of those tasks. Which brings me to my second question for AI's implications for any given job. Will Al be a complement to or a substitute for the job, given its set of tasks? Al is more likely to serve as a complement to jobs that have less exposure to Al but use the services or products that are produced by jobs with a high degree of Al exposure. For instance, a job as a litigator may have little direct exposure to Al but will benefit from AI's ability to assist with legal research. Even for some jobs with a high degree of exposure to Al , it is possible for Al to serve as a complement. Let's return to the example of the doctor, who may now see more patients or spend more time on diagnoses, because AI has taken over writing summaries of patient interviews. More broadly, jobs with a high degree of exposure to Al will likely be complemented by Al, if workers are able to offload time-intensive, but low value-added, tasks to AI and focus their time on the highest value-added tasks. However, we can expect that there will be some jobs that have a high degree of exposure to AI and for which AI can perform some especially high-valued tasks. Thus, Al may be more of a substitute for human labor in these jobs. But even for these jobs, the employment implications are ambiguous and will depend on the third question. What is the price elasticity of demand for the output of these jobs that are highly affected by Al? To understand what I mean, it is helpful to consider a concrete example. I want to come back to the software programmer jobs that I mentioned before as having a high degree of exposure to Al. Recent advances in generative AI have resulted in the development of new Al-powered coding assistants that help automate some aspects of writing software code. Some early studies have found that these Al coding assistants can provide a significant boost to programmers' productivity. One randomized controlled trial found that these Al coding assistants cut in half the amount of time it took to finish a small programming project. And I emphasize that these tools are still in their infancy, which suggests that the productivity gains for softwareprogramming jobs may be even larger. These productivity enhancements will allow software programming projects to be delivered in less time and at a lower cost. As we know from economic theory, as the costs and delivery times for software projects fall, demand for such projects should increase. The number of software-programming jobs will depend on whether the demand for software projects increases more than one for one with the decrease in cost. In other words, is the price elasticity of demand for software projects greater than one? If it is, then the reduction in software programmers' hours devoted to programming tasks that can now be performed by AI will be more than offset by the increase in their hours from the greater demand for AI-enhanced software programming. I find these questions helpful for framing how to think about AI's implications for any job or set of tasks. While I mentioned that there will likely be benefits for certain workers, it is important to recognize a universal lesson from past technological innovationsnamely, that the employment and earnings of some workers are likely to be negatively affected by these innovations. The magnitude and extent of these negative effects will depend on a variety of factors. For instance, consider if AI is able to perform job tasks that previously required a high degree of training or specialization. Affected workers in these jobs could experience larger declines in their earning power, if AI depreciates the value of their accumulated human capital. The degree to which AI could negatively affect some workers' earnings and employment will also be influenced by the pace of AI adoption. It is possible that if AI adoption is rapid, we could see the effects on some workers come quickly and be more concentrated, depending on which sectors are early adopters. In addition to considering AI's effects on individual workers, economists also evaluate AI's implications for aggregate employment. As I discussed, it remains unclear whether AI will be a boon for or a drag on net employment for those jobs that are most directly affected by AI. For workers who are not directly exposed to Al but, rather, are users of the output from Al-exposed jobs, the aggregate employment implications are more likely to be positive. Generally, these downstream jobs will benefit from the lower input costs that result from greater productivity realized by AI-exposed jobs. An exception might be jobs where the cheaper inputs are a substitute for labor in the downstream job. Moreover, I anticipate that inventors and innovators will continue to discover new products and services that are enabled by AI. The companies that are then formed to deliver these new products and services can be expected to raise aggregate employment. In light of the uncertainty regarding AI's implications for the labor market, I want to highlight the important role that decisions by firms and, to a lesser extent, workers can have for determining how AI will affect the labor market. If incumbent firms are able to adjust their processes to capture productivity benefits from AI, then these firms could help mitigate some of AI's potential for job displacement by internally reallocating affected workers to new roles and providing necessary training. If some job tasks can be replaced with AI-especially those that are mundane and repetitive-workers may be freed up to focus on other tasks or new activities they find more rewarding. Individual workers play a limited role in determining how AI will affect their earnings and employment. Workers in jobs that will be complemented by AI might benefit from familiarizing themselves with how to effectively use AI. Workers in jobs where AI will be able to perform a substantial share of their tasks will face greater challenges. Some of these workers may seek to develop expertise in the aspects of their jobs for which AI is particularly ill-suited. Yet, many of these more-exposed workers may need to invest in training in alternative occupations that are less exposed to AI, similar to some of the skill-retraining efforts for manufacturing workers over the past 50 years. In closing, I suspect that the tremendous uncertainty I highlighted related to AI's implications for the labor market will be some combination of disconcerting and exciting for many in the audience, especially those who will be graduating and launching their careers in the coming years. My recommendation to you is to take the time to experiment with AI, familiarizing yourself with its capabilities and limitations. Doing so will make you well placed to help your future employers - and that could include yourselves - transform their business processes to effectively use AI. And for the smaller subset of you who are purely excited about the opportunity presented by AI, I look forward to seeing the innovative new products and services you create and disseminate throughout the economy to raise the living standards for all Americans. Thank you for having me at The Ohio State University. I look forward to your questions.
2024-09-26T00:00:00	John C Williams: Ten years gone	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024.	John C Williams: Ten years gone Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. * * * As prepared for delivery Introduction Welcome, everyone. Thank you for joining us. And a special thank you to those who make today's event so powerful: the distinguished speakers, panelists, and event organizers. We have a packed agenda on a variety of important topics, and I look forward to hearing about the progress we've made and priorities for the future. Ten Years Gone Today marks our tenth annual U.S. Treasury Market Conference, and a decade of partnership between our agencies. These conferences have proven to be a valuable forum to share insights and perspectives on the evolution of the Treasury market, identify challenges and risks to smooth market functioning, and, most importantly, discuss ways to enhance its resilience and effectiveness in both good times and bad times. The New York Fed is proud to host this conference each year. It leverages -sorry, I realize that leverage is not a popular word in this crowd-it draws upon our strength as a convener of market participants, academics, policymakers, and central bankers. Today, I'll take a look at how our interagency collaboration has strengthened our understanding of Treasury market resiliency and that of adjacent markets. And I'll talk about the importance of continuing this work over the next decade and beyond. I will also share some news about our ongoing commitment to ensuring that our financial system continues to stand on a strong foundation of sound reference rates. Now, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Stairway to the Annual Conference Let's think back to the middle of October 2014, when U.S. Treasury yields plunged and then quickly rebounded, an episode later named the "flash rally." This episode was an impetus for the drafting of a joint staff report that ultimately led to 1 the inaugural U.S. Treasury Market Conference in 2015. That conference first brought together what is now known as the "Joint Member Agencies" to discuss the evolving structure of the Treasury market. That meeting focused on potential operational risks, 2 regulatory requirements, and repo market considerations. It drew about 300 people-an impressive figure for the first year. I know that some who participated in that conference are here again today. The organizers recognized that it would be important to have a regular forum to address developments in the Treasury market and adjacent markets, in order to continue to study structural issues and explore ongoing developments as a way to prevent disruptions to the system. To be clear, attention on the function of the Treasury market didn't start in 2015. In fact, if you read Fed history-a genre of literature that I particularly enjoy-it's clear that the importance of Treasury market functioning was central to the Federal Reserve and the New York Fed for a long time. But what became apparent in more recent times was that as the markets evolved, the need for formal joint-agency collaboration and engagement with the private sector became more pressing. When the Levee Breaks What drives all of our efforts-from staff reports, to conferences, to actions, and all the communication in between- is that liquid, well-functioning markets for Treasury and related securities are absolutely essential for credit to flow and the economy to prosper.3 It's not an overstatement that a well-functioning U.S. Treasury market is critical to our economy, and, in fact, to the entire world.4 The Song Remains the Same What are some of the themes that we've discussed at these conferences, and what's been the impact on our financial system? Let's take a look back at that first joint staff report. It made the case on two notable fronts. First, it highlighted that principal trading firms played a much larger role in the electronic trading market than was previously understood. Second, it highlighted the need for improved transparency and increased availability of Treasury market data. Ten years gone, the song remains the same. Those themes are still at the forefront of our conversations. For example, while principal trading firms still continue to be a big presence in the Treasury market, hedge funds now also play an important role. The work monitoring the changing investor base and participant types continues through this forum and the work of the Inter-Agency Working Group on Treasury Market Surveillance and the Financial Stability Oversight Council. On the data side, we've made tremendous progress toward increased data transparency with the Trade Reporting and Compliance Engine (TRACE) data initiative. And we've seen efforts to further increase the transparency of this data to the public. In March of this year, TRACE began publishing daily transaction data on on-the-run securities at the end of the day. In fact, at this very podium last year, I said that we must continue to prioritize transparency and clarity in financial data, especially in the age of AI, when the sources of data are harder to ascertain.5 I'd be remiss if I did not mention expanded central clearing as another key theme that has emerged over the years. This is a major shift that is an outgrowth of our work. We'll hear more about that in a panel discussion later today, and I look forward to the continued progress the market will make on this front as we move toward the implementation deadlines of the SEC's clearing rule. What Is and What Should Never Be Before I cede the stage, I will end on a topic that is at the core of the financial system and closely connected to the Treasury market: reference rates. Thankfully, we have said good riddance to LIBOR, and our financial system is now resting on a safe and solid foundation. I know I promised not to bring up LIBOR again at this conference. But the LIBOR saga taught us all two important lessons. First, enormous systemic risk can build in the global financial system gradually over time, and second, it took a complex, expensive, decadelong effort to fix that problem. We must not repeat that experience. To that end, I am pleased to announce that today, the Federal Reserve Bank of New York is launching the Reference Rate Use Committee, or RRUC. It will convene private market participants to support integrity, efficiency, and resiliency in the use of interest rate benchmarks-or reference rates-across financial markets, including the rates published by the New York Fed. Its first meeting will occur in October. The RRUC will focus on key issues regarding reference rates, including how their use is evolving and how the markets underpinning them may be changing too. It will promote best practices related to the use of reference rates, including the recommendations set out by the Alternative Reference Rates Committee (ARRC) during the transition away 6 from LIBOR. In this way, the RRUC will serve as an essential partnership that builds upon the work and accomplishments of the ARRC, by helping to preserve a robust system of reference rates. This work will complement international efforts at the Bank for International Settlements and the Financial Stability Board to monitor developments in the use of interest rate benchmarks and ensure that we never have to face a problem like LIBOR again.7 Bring It On Home I will now bring it on home. We are now at the bridge to the next 10 years of the U.S. Treasury Market Conference. Although there has been significant progress, the growth and evolution of this market remind us of the importance of staying focused on this work and continuing to make progress in the years ahead. In an era of heightened uncertainty and volatility, it is essential that the U.S. Treasury market remain liquid and resilient, so that all financial markets can operate effectively. If you were ever in doubt of how important this is, the experience of the past several years should convince you otherwise. Thank you, and I look forward to today's conference, and to another decade of partnership and success. U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U. S. Commodity Futures Trading Commission, Joint Staff Report: The U.S. Treasury Market on October 15, 2014 , July 13, 2015. 2 Conference Summary, " The Evolving Structure of the U.S. Treasury Market ," held at the Federal Reserve Bank of New York, October 20-21, 2015. 3 John C. Williams, A Solution to Every Puzzle , Remarks at the 2020 U.S. Treasury Market Conference, Federal Reserve Bank of New York, September 29, 2020. 4 John C. Williams, A Jack of All Trades Is a Master of None , Remarks at the 2022 U.S. Treasury Market Conference, Federal Reserve Bank of New York, November 16, 2022. 5 John C. Williams, Elementary, Dear Data , Remarks at the 2023 U.S. Treasury Market Conference, Federal Reserve Bank of New York, November 16, 2023. 6 Federal Reserve Board, Federal Reserve Bank of New York: Alternative Reference Rates Committee 7 Financial Stability Board, Final Reflections on the LIBOR Transition, July 28, 2023.	---[PAGE_BREAK]--- # John C Williams: Ten years gone Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. As prepared for delivery ## Introduction Welcome, everyone. Thank you for joining us. And a special thank you to those who make today's event so powerful: the distinguished speakers, panelists, and event organizers. We have a packed agenda on a variety of important topics, and I look forward to hearing about the progress we've made and priorities for the future. ## Ten Years Gone Today marks our tenth annual U.S. Treasury Market Conference, and a decade of partnership between our agencies. These conferences have proven to be a valuable forum to share insights and perspectives on the evolution of the Treasury market, identify challenges and risks to smooth market functioning, and, most importantly, discuss ways to enhance its resilience and effectiveness in both good times and bad times. The New York Fed is proud to host this conference each year. It leverages-sorry, I realize that leverage is not a popular word in this crowd-it draws upon our strength as a convener of market participants, academics, policymakers, and central bankers. Today, I'll take a look at how our interagency collaboration has strengthened our understanding of Treasury market resiliency and that of adjacent markets. And I'll talk about the importance of continuing this work over the next decade and beyond. I will also share some news about our ongoing commitment to ensuring that our financial system continues to stand on a strong foundation of sound reference rates. Now, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. ## Stairway to the Annual Conference Let's think back to the middle of October 2014, when U.S. Treasury yields plunged and then quickly rebounded, an episode later named the "flash rally." This episode was an impetus for the drafting of a joint staff report that ultimately led to the inaugural U.S. Treasury Market Conference in 2015. ${ }^{1}$ That conference first brought together what is now known as the "Joint Member Agencies" to discuss the evolving structure of the Treasury market. That meeting focused on potential operational risks, regulatory requirements, and repo market considerations. $\underline{2}$ It drew about 300 people-an ---[PAGE_BREAK]--- impressive figure for the first year. I know that some who participated in that conference are here again today. The organizers recognized that it would be important to have a regular forum to address developments in the Treasury market and adjacent markets, in order to continue to study structural issues and explore ongoing developments as a way to prevent disruptions to the system. To be clear, attention on the function of the Treasury market didn't start in 2015. In fact, if you read Fed history-a genre of literature that I particularly enjoy-it's clear that the importance of Treasury market functioning was central to the Federal Reserve and the New York Fed for a long time. But what became apparent in more recent times was that as the markets evolved, the need for formal joint-agency collaboration and engagement with the private sector became more pressing. # When the Levee Breaks What drives all of our efforts-from staff reports, to conferences, to actions, and all the communication in between- is that liquid, well-functioning markets for Treasury and related securities are absolutely essential for credit to flow and the economy to prosper. ${ }^{3}$ It's not an overstatement that a well-functioning U.S. Treasury market is critical to our economy, and, in fact, to the entire world. ${ }^{4}$ ## The Song Remains the Same What are some of the themes that we've discussed at these conferences, and what's been the impact on our financial system? Let's take a look back at that first joint staff report. It made the case on two notable fronts. First, it highlighted that principal trading firms played a much larger role in the electronic trading market than was previously understood. Second, it highlighted the need for improved transparency and increased availability of Treasury market data. Ten years gone, the song remains the same. Those themes are still at the forefront of our conversations. For example, while principal trading firms still continue to be a big presence in the Treasury market, hedge funds now also play an important role. The work monitoring the changing investor base and participant types continues through this forum and the work of the Inter-Agency Working Group on Treasury Market Surveillance and the Financial Stability Oversight Council. On the data side, we've made tremendous progress toward increased data transparency with the Trade Reporting and Compliance Engine (TRACE) data initiative. And we've seen efforts to further increase the transparency of this data to the public. In March of this year, TRACE began publishing daily transaction data on on-the-run securities at the end of the day. In fact, at this very podium last year, I said that we must continue to prioritize transparency and clarity in financial data, especially in the age of AI, when the sources of data are harder to ascertain. ${ }^{5}$ ---[PAGE_BREAK]--- I'd be remiss if I did not mention expanded central clearing as another key theme that has emerged over the years. This is a major shift that is an outgrowth of our work. We'll hear more about that in a panel discussion later today, and I look forward to the continued progress the market will make on this front as we move toward the implementation deadlines of the SEC's clearing rule. # What Is and What Should Never Be Before I cede the stage, I will end on a topic that is at the core of the financial system and closely connected to the Treasury market: reference rates. Thankfully, we have said good riddance to LIBOR, and our financial system is now resting on a safe and solid foundation. I know I promised not to bring up LIBOR again at this conference. But the LIBOR saga taught us all two important lessons. First, enormous systemic risk can build in the global financial system gradually over time, and second, it took a complex, expensive, decadelong effort to fix that problem. We must not repeat that experience. To that end, I am pleased to announce that today, the Federal Reserve Bank of New York is launching the Reference Rate Use Committee, or RRUC. It will convene private market participants to support integrity, efficiency, and resiliency in the use of interest rate benchmarks-or reference rates-across financial markets, including the rates published by the New York Fed. Its first meeting will occur in October. The RRUC will focus on key issues regarding reference rates, including how their use is evolving and how the markets underpinning them may be changing too. It will promote best practices related to the use of reference rates, including the recommendations set out by the Alternative Reference Rates Committee (ARRC) during the transition away from LIBOR. $\underline{6}$ In this way, the RRUC will serve as an essential partnership that builds upon the work and accomplishments of the ARRC, by helping to preserve a robust system of reference rates. This work will complement international efforts at the Bank for International Settlements and the Financial Stability Board to monitor developments in the use of interest rate benchmarks and ensure that we never have to face a problem like LIBOR again. $\underline{7}$ ## Bring It On Home I will now bring it on home. We are now at the bridge to the next 10 years of the U.S. Treasury Market Conference. Although there has been significant progress, the growth and evolution of this market remind us of the importance of staying focused on this work and continuing to make progress in the years ahead. In an era of heightened uncertainty and volatility, it is essential that the U.S. Treasury market remain liquid and resilient, so that all financial markets can operate effectively. If you were ever in doubt of how important this is, the experience of the past several years should convince you otherwise. Thank you, and I look forward to today's conference, and to another decade of partnership and success. ---[PAGE_BREAK]--- ${ }^{1}$ U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U. S. Commodity Futures Trading Commission, Joint Staff Report: The U.S. Treasury Market on October 15, 2014, July 13, 2015. ${ }^{2}$ Conference Summary, "The Evolving Structure of the U.S. Treasury Market," held at the Federal Reserve Bank of New York, October 20-21, 2015. ${ }^{3}$ John C. Williams, A Solution to Every Puzzle, Remarks at the 2020 U.S. Treasury Market Conference, Federal Reserve Bank of New York, September 29, 2020. ${ }^{4}$ John C. Williams, A Jack of All Trades Is a Master of None, Remarks at the 2022 U.S. Treasury Market Conference, Federal Reserve Bank of New York, November 16, 2022. ${ }^{5}$ John C. Williams, Elementary, Dear Data, Remarks at the 2023 U.S. Treasury Market Conference, Federal Reserve Bank of New York, November 16, 2023. ${ }^{6}$ Federal Reserve Board, Federal Reserve Bank of New York: Alternative Reference Rates Committee ${ }^{7}$ Financial Stability Board, Final Reflections on the LIBOR Transition, July 28, 2023.	John C Williams	United States	https://www.bis.org/review/r241001a.pdf	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. As prepared for delivery Welcome, everyone. Thank you for joining us. And a special thank you to those who make today's event so powerful: the distinguished speakers, panelists, and event organizers. We have a packed agenda on a variety of important topics, and I look forward to hearing about the progress we've made and priorities for the future. Today marks our tenth annual U.S. Treasury Market Conference, and a decade of partnership between our agencies. These conferences have proven to be a valuable forum to share insights and perspectives on the evolution of the Treasury market, identify challenges and risks to smooth market functioning, and, most importantly, discuss ways to enhance its resilience and effectiveness in both good times and bad times. The New York Fed is proud to host this conference each year. It leverages-sorry, I realize that leverage is not a popular word in this crowd-it draws upon our strength as a convener of market participants, academics, policymakers, and central bankers. Today, I'll take a look at how our interagency collaboration has strengthened our understanding of Treasury market resiliency and that of adjacent markets. And I'll talk about the importance of continuing this work over the next decade and beyond. I will also share some news about our ongoing commitment to ensuring that our financial system continues to stand on a strong foundation of sound reference rates. Now, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Let's think back to the middle of October 2014, when U.S. Treasury yields plunged and then quickly rebounded, an episode later named the "flash rally." This episode was an impetus for the drafting of a joint staff report that ultimately led to the inaugural U.S. Treasury Market Conference in 2015. It drew about 300 people-an impressive figure for the first year. I know that some who participated in that conference are here again today. The organizers recognized that it would be important to have a regular forum to address developments in the Treasury market and adjacent markets, in order to continue to study structural issues and explore ongoing developments as a way to prevent disruptions to the system. To be clear, attention on the function of the Treasury market didn't start in 2015. In fact, if you read Fed history-a genre of literature that I particularly enjoy-it's clear that the importance of Treasury market functioning was central to the Federal Reserve and the New York Fed for a long time. But what became apparent in more recent times was that as the markets evolved, the need for formal joint-agency collaboration and engagement with the private sector became more pressing. What drives all of our efforts-from staff reports, to conferences, to actions, and all the communication in between- is that liquid, well-functioning markets for Treasury and related securities are absolutely essential for credit to flow and the economy to prosper. What are some of the themes that we've discussed at these conferences, and what's been the impact on our financial system? Let's take a look back at that first joint staff report. It made the case on two notable fronts. First, it highlighted that principal trading firms played a much larger role in the electronic trading market than was previously understood. Second, it highlighted the need for improved transparency and increased availability of Treasury market data. Ten years gone, the song remains the same. Those themes are still at the forefront of our conversations. For example, while principal trading firms still continue to be a big presence in the Treasury market, hedge funds now also play an important role. The work monitoring the changing investor base and participant types continues through this forum and the work of the Inter-Agency Working Group on Treasury Market Surveillance and the Financial Stability Oversight Council. On the data side, we've made tremendous progress toward increased data transparency with the Trade Reporting and Compliance Engine (TRACE) data initiative. And we've seen efforts to further increase the transparency of this data to the public. In March of this year, TRACE began publishing daily transaction data on on-the-run securities at the end of the day. In fact, at this very podium last year, I said that we must continue to prioritize transparency and clarity in financial data, especially in the age of AI, when the sources of data are harder to ascertain. I'd be remiss if I did not mention expanded central clearing as another key theme that has emerged over the years. This is a major shift that is an outgrowth of our work. We'll hear more about that in a panel discussion later today, and I look forward to the continued progress the market will make on this front as we move toward the implementation deadlines of the SEC's clearing rule. Before I cede the stage, I will end on a topic that is at the core of the financial system and closely connected to the Treasury market: reference rates. Thankfully, we have said good riddance to LIBOR, and our financial system is now resting on a safe and solid foundation. I know I promised not to bring up LIBOR again at this conference. But the LIBOR saga taught us all two important lessons. First, enormous systemic risk can build in the global financial system gradually over time, and second, it took a complex, expensive, decadelong effort to fix that problem. We must not repeat that experience. To that end, I am pleased to announce that today, the Federal Reserve Bank of New York is launching the Reference Rate Use Committee, or RRUC. It will convene private market participants to support integrity, efficiency, and resiliency in the use of interest rate benchmarks-or reference rates-across financial markets, including the rates published by the New York Fed. Its first meeting will occur in October. The RRUC will focus on key issues regarding reference rates, including how their use is evolving and how the markets underpinning them may be changing too. It will promote best practices related to the use of reference rates, including the recommendations set out by the Alternative Reference Rates Committee (ARRC) during the transition away from LIBOR. I will now bring it on home. We are now at the bridge to the next 10 years of the U.S. Treasury Market Conference. Although there has been significant progress, the growth and evolution of this market remind us of the importance of staying focused on this work and continuing to make progress in the years ahead. In an era of heightened uncertainty and volatility, it is essential that the U.S. Treasury market remain liquid and resilient, so that all financial markets can operate effectively. If you were ever in doubt of how important this is, the experience of the past several years should convince you otherwise. Thank you, and I look forward to today's conference, and to another decade of partnership and success.
2024-09-26T00:00:00	Jerome H Powell: Opening remarks - 2024 US Treasury Market Conference	Opening remarks (via prerecorded video) by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024.	Jerome H Powell: Opening remarks - 2024 US Treasury Market Conference Opening remarks (via prerecorded video) by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. * * * Hello, everyone, and welcome to the 10th Annual U.S. Treasury Market Conference. "Tenth annual" is a phrase that generates a bit of surprise, and much pride. It is surprising because it does not seem like the first of these gatherings, which I was honored to play a role in organizing, was all that long ago. But we can also take pride because the conference has proven useful and important for a full decade, as I expect it will do for many more years to come. Much has changed in the economy since we first gathered in 2015-but the importance of the U.S. Treasury market has not. As you all know, this market is the deepest and most liquid in the world. In addition to meeting the financing needs of the federal government, it plays a critical role in the implementation of monetary policy. It is no exaggeration to say that the Treasury market is part of the bedrock of our economy and indeed of the world economy. The October '14 flash crash and the subsequent publication of the Interagency Working Group report on that event are what brought us together for the first annual conference.1 October 2014 was a wakeup call because there had never been such a large swing in Treasury prices in such a short period of time. The Interagency Working Group report shed light on how much the structure of the Treasury market had changed and how large a role high-speed, electronic trading firms were playing in it. It also showed the value of cooperation and communication between the five agencies in the working group, something that proved again to be vital during the disruptions caused by the COVID-19 pandemic. I am pleased to see that all working group members are represented here today. You will be hearing directly from many senior leaders, including your host, President Williams; Vice Chair Barr; and Secretary Yellen, who, of course, was Fed chair at the time of the first conference. It is essential that our Treasury markets are able to efficiently transform Treasury securities into cash, even at times of elevated stress. As I noted at this event in 2015, "these markets need to keep functioning at a high level, and we all have a stake in making sure that they do." I remain wholly dedicated to that goal.2 I wish you a productive and educational conference. Thank you. 1 Joint Staff Report: See Interagency Working Group on Treasury Market Surveillance, The U.S. Treasury Market on October 15, 2014 (PDF)(Washington: Interagency Working Group, July 2015). See Jerome H. Powell, "Opening Remarks" (speech at the 2015 Roundtable on Treasury Markets and Debt Management: Evolution of Treasury Market and Its Implications, New York, NY, November 20, 2015). i. Note: On September 26, 2024, the text of the speech was updated to reflect the delivered remarks in the video version of this speech.	---[PAGE_BREAK]--- # Jerome H Powell: Opening remarks - 2024 US Treasury Market Conference Opening remarks (via prerecorded video) by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. Hello, everyone, and welcome to the 10th Annual U.S. Treasury Market Conference. "Tenth annual" is a phrase that generates a bit of surprise, and much pride. It is surprising because it does not seem like the first of these gatherings, which I was honored to play a role in organizing, was all that long ago. But we can also take pride because the conference has proven useful and important for a full decade, as I expect it will do for many more years to come. Much has changed in the economy since we first gathered in 2015-but the importance of the U.S. Treasury market has not. As you all know, this market is the deepest and most liquid in the world. In addition to meeting the financing needs of the federal government, it plays a critical role in the implementation of monetary policy. It is no exaggeration to say that the Treasury market is part of the bedrock of our economy and indeed of the world economy. The October '14 flash crash and the subsequent publication of the Interagency Working Group report on that event are what brought us together for the first annual conference. $\underline{1}$ October 2014 was a wakeup call because there had never been such a large swing in Treasury prices in such a short period of time. The Interagency Working Group report shed light on how much the structure of the Treasury market had changed and how large a role high-speed, electronic trading firms were playing in it. It also showed the value of cooperation and communication between the five agencies in the working group, something that proved again to be vital during the disruptions caused by the COVID-19 pandemic. I am pleased to see that all working group members are represented here today. You will be hearing directly from many senior leaders, including your host, President Williams; Vice Chair Barr; and Secretary Yellen, who, of course, was Fed chair at the time of the first conference. It is essential that our Treasury markets are able to efficiently transform Treasury securities into cash, even at times of elevated stress. As I noted at this event in 2015, "these markets need to keep functioning at a high level, and we all have a stake in making sure that they do." I remain wholly dedicated to that goal. ${ }^{2}$ I wish you a productive and educational conference. Thank you. [^0] [^0]: ${ }^{1}$ See Interagency Working Group on Treasury Market Surveillance, Joint Staff Report: The U.S. Treasury Market on October 15, 2014 (PDF) (Washington: Interagency Working Group, July 2015). ---[PAGE_BREAK]--- ${ }^{2}$ See Jerome H. Powell, "Opening Remarks" (speech at the 2015 Roundtable on Treasury Markets and Debt Management: Evolution of Treasury Market and Its Implications, New York, NY, November 20, 2015). i. Note: On September 26, 2024, the text of the speech was updated to reflect the delivered remarks in the video version of this speech.	Jerome H Powell	United States	https://www.bis.org/review/r240930d.pdf	Opening remarks (via prerecorded video) by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the 10th Annual US Treasury Market Conference, Federal Reserve Bank of New York, New York City, 26 September 2024. Hello, everyone, and welcome to the 10th Annual U.S. Treasury Market Conference. "Tenth annual" is a phrase that generates a bit of surprise, and much pride. It is surprising because it does not seem like the first of these gatherings, which I was honored to play a role in organizing, was all that long ago. But we can also take pride because the conference has proven useful and important for a full decade, as I expect it will do for many more years to come. Much has changed in the economy since we first gathered in 2015-but the importance of the U.S. Treasury market has not. As you all know, this market is the deepest and most liquid in the world. In addition to meeting the financing needs of the federal government, it plays a critical role in the implementation of monetary policy. It is no exaggeration to say that the Treasury market is part of the bedrock of our economy and indeed of the world economy. The October '14 flash crash and the subsequent publication of the Interagency Working Group report on that event are what brought us together for the first annual conference. October 2014 was a wakeup call because there had never been such a large swing in Treasury prices in such a short period of time. The Interagency Working Group report shed light on how much the structure of the Treasury market had changed and how large a role high-speed, electronic trading firms were playing in it. It also showed the value of cooperation and communication between the five agencies in the working group, something that proved again to be vital during the disruptions caused by the COVID-19 pandemic. I am pleased to see that all working group members are represented here today. You will be hearing directly from many senior leaders, including your host, President Williams; Vice Chair Barr; and Secretary Yellen, who, of course, was Fed chair at the time of the first conference. It is essential that our Treasury markets are able to efficiently transform Treasury securities into cash, even at times of elevated stress. As I noted at this event in 2015, "these markets need to keep functioning at a high level, and we all have a stake in making sure that they do." I remain wholly dedicated to that goal. I wish you a productive and educational conference. Thank you. i. Note: On September 26, 2024, the text of the speech was updated to reflect the delivered remarks in the video version of this speech.
2024-09-27T00:00:00	Piero Cipollone: Monetary sovereignty in the digital age - the case for a digital euro	Keynote speech by Mr Piero Cipollone, Member of the Executive Board of the European Central Bank, at the Economics of Payments XIII Conference, organised by the Oesterreichische Nationalbank, the Austrian central bank, Vienna, 27 September 2024.	SPEECH Monetary sovereignty in the digital age: the case for a digital euro Keynote speech by Piero Cipollone, Member of the Executive Board of the ECB, at the Economics of Payments XIll Conference organised by the Oesterreichische Nationalbank Vienna, 27 September 2024 Money plays a fundamental role in society, driving economic activity and enabling daily transactions.) Money in physical form, cash, remains the most frequently used means of payment in stores, especially for lower value transactions. But more and more people are using money in digital form. An average of 379 million retail transactions are made digitally in the euro area every day.!2] Given money's importance for our material and social well-being, the regulation of money has long been considered a cornerstone of state sovereignty. As the influential French jurist and political philosopher Jean Bodin observed in the 16th century, "only he who has the power to make law can regulate the coinage."!] Today, legislators continue to regulate the use of money and they have entrusted central banks with issuing public money and maintaining confidence in the monetary system. At the European Central Bank (ECB), we issue money that can be used to settle wholesale and retail transactions throughout the euro area, thereby guaranteeing the singleness of money across the monetary union. And we ensure that the euro remains a safe, stable and effective medium of exchange and store of value. This provides an essential anchor for the economy and the financial system. The Eurosystem has made significant progress in integrating wholesale transactions, largely thanks to the robust payment infrastructure it provides. The Eurosystem's real-time gross settlement system T2, for instance, processes a value close to the entire euro area GDP on a weekly basis, and it has established itself as a leading global payment system. In parallel, euro banknotes are accepted for retail payments across the euro area. They have become a symbol of European integration and freedom"), uniting us and strengthening our collective identity as Europeans. But while central banks have long offered digital settlement in central bank money for wholesale transactions, we do not yet have a digital form of cash. This is becoming increasingly problematic because the use and acceptance of cash are declining. In the euro area, cash transactions have fallen below card transactions in value.[5] And the share of companies reporting that they do not accept cash has tripled in the last three years to 12%.!§] The European Commission has therefore put forward a legislative proposal to ensure the acceptance of cash!] and the ECB is committed to keeping euro cash widely available and accessible. still, the trend towards less use of banknotes for daily transactions is likely to continue, reflecting the digitalisation of economic activity and mirroring patterns observed in many advanced economies. Moreover, digital payments in the euro area remain fragmented, both along national lines and in terms of use cases. Current European digital payment solutions mainly cater to national markets and specific use cases. To pay across European countries, consumers have to rely on a few non-European providers, which now dominate most of these transactions. And even those providers' payment solutions are not accepted everywhere and do not cover all key use cases (payments in shops, from person to person and online). So a key objective of central bank money - to offer the public a means of payment backed by the sovereign authority that can be used for retail transactions across the jurisdiction - is not being fulfilled in the euro area's digital space. This is all the more awkward given that some euro area countries have made it mandatory to accept digital means of payment, for instance in a bid to combat tax evasion. In addition, European payments have become a prime example of the situation that Enrico Letta and Mario Draghi have described in their recent reports. The fragmentation of the market, the lack of European payment solutions available on a European scale and the difficulty faced by European payment service providers in keeping pace with technological advances! means that Europe is not competitive within its own market, let alone on a global scale. Moreover, in an unstable geopolitical environment, we are being left to rely on companies based in other countries. Today's dependency on US companies could in future develop into reliance on companies from countries other than the United States. Platforms like Ant Group's Alipay have demonstrated their ability to bridge geographical gaps: during major events like UEFA EURO 2024 they were able to boost their payment app usage among customers in Europe.) We must move swiftly to address the risks stemming from Europe's current inability to secure the integration and autonomy of its retail payment system. This is a key motivation behind the digital euro project: bringing central bank money into the digital age would provide a digital equivalent to banknotes and strengthen our monetary sovereignty. Today, I will outline the policy challenges we face as digitalisation reinforces the two-sided nature of the payments market. I will then discuss how the introduction of a digital euro could make a significant difference. By designing the digital euro to meet the diverse needs of consumers, merchants and payment service providers, we can ensure its widespread adoption. This, in turn, will empower us to pursue strategic goals such as innovation, integration and independence, ultimately enhancing our economic efficiency, resilience and sovereignty. The retail payments market: a two-sided marketplace To fully appreciate why we have been failing to overcome fragmentation and why the digital euro would be a game changer, we must first understand the structure of the retail payments market as a two-sided marketplace. Retail payment systems act as vital intermediaries connecting two key participants - merchants and consumers - whose transactions are facilitated by payment service providers."4] The defining feature of this marketplace is that interactions between participants generate network effects, where the value for each group increases as more participants join the other side. Consider the telephone system: its utility grows with each new user. However, on the downside, this also creates a challenging chicken- and-egg dilemma. Platforms need a critical mass of users to attract additional participants, but they struggle to achieve scale without that initial user base. That is why platforms with existing large user bases have an advantage in entering such markets. Indeed, the strength of network effects is amplified when platforms expand their range of activities, thereby broadening their user base. Technological innovation and the rise of digital platforms managed by major tech companies are expected to further exacerbate these dynamics. Big techs conduct business in finance in a unique way, drawing on three mutually reinforcing components: data analytics, network effects and interconnected activities."3] Network effects help big techs gather more data, which enhances their analytics. Better analytics improve services and attract more users, allowing them to offer more services and gather even more data. As aresult, payment apps provided by big techs have become especially popular in emerging markets and developing economies.!"4] Take China, for example. Its financial system has largely disintermediated banks from payment transactions. Instead, big techs have leveraged the widespread use of mobile apps, integrating social interactions and shopping experiences to offer users seamless digital payment methods.!"5] what is even more problematic is that these companies operate closed- loop payment systems, in contrast to international card schemes' open-loop systems. In a closed-loop system, consumers load money onto their Alipay account, for example, and pay by scanning the merchant's Alipay QR code. As a result, funds are transferred directly from the consumer to the merchant, bypassing the traditional system of banks and network processors. Only the owner of the closed-loop system has access to the payment data. This challenges the traditional banking model, which relies on customer data and relationships to function effectively, and also has an impact on how credit is extended to the economy." There is a risk that the closed-loop systems developed by successful online platforms and big tech companies could, in future, create a parallel economy with their own currencies and distinct units of account. At global level, big techs such as PayPal and Apple have developed highly successful ecosystems based on the closed-loop financial services model. By encouraging people to use their payment apps, these ecosystems effectively oblige them to use their payment rails. In parallel, payment platforms have tried to become more integrated in social media giants like WhatsApp and Meta]. Platforms like X (formerly Twitter) are considering offering payment functions.""8] And Amazon is now venturing into the credit card and payment app business too. These examples illustrate how these firms can exploit customer networks to create cross-subsidised links between various services. However, while network effects can foster a virtuous cycle of economic growth, they also pose significant risks. In particular, walled gardens or lack of interoperability between various solutions can result in market fragmentation. Technology can be used to exclude competitors - for example, by preferencing a platform's own products or restricting competing services - and so can skew the competitive landscape in favour of a dominant player. And these dynamics could further raise the barriers to enter and grow in the two-sided payments market, stifling competition and making it even more difficult for European payment solutions to emerge on a pan-European scale. There is thus a risk that the current dynamics, where big tech companies seek to exploit the power of their platforms to expand in payments, could exacerbate the challenges facing the European retail payments market in terms of integration and the ability of European solutions to compete and innovate at scale. Addressing market failures through European policy actions Since the creation of the monetary union, European policymakers have taken significant steps to foster the development of private European payment initiatives that span the euro area. The hope was that these initiatives could enhance competition within the European payments landscape, providing consumers and businesses with more choice and better services. From the launch of the Single Euro Payments Area to the recent adoption of the Instant Payments Regulation, the European Commission and ECB24] have worked with the private sector to support integration, innovation and the creation of a pan-European retail payment solution. Yet, despite these efforts, more than 30 years since the inception of the Single Market and 25 years since the launch of the single currency, most European retail payment solutions remain national in scope, addressing only limited use cases. Moreover, 13 out of 20 euro area countries rely entirely on non-European solutions in the absence of their own domestic payment scheme. As a result, people who live, work, travel or shop online in other euro area countries find themselves effectively dependent on two international card schemes, which enjoy strong market power. This situation discourages small businesses from expanding across borders or even into their national online markets, ultimately hindering the deepening of the Single Market.!22] And paradoxically, the benefits from the efforts we make to lower the barriers to trade in European product markets may not fully reach consumers, as they are absorbed in the form of higher profits by the few international players that currently enable payments in stores and online across Europe. Rather than joining forces and sharing resources to develop successful pan-European solutions, national communities have often preferred to preserve the legacy of investments made in the past./25] This reluctance has allowed a few major global players not only to dominate cross-border European payment transactions, but also to steadily capture an even larger share of domestic transactions. The result is that international payment schemes operated by non-European operators today facilitate 64% of all electronically initiated transactions with cards issued in the euro area, 24] Merchants - and consumers, to whom costs are eventually passed on - are left to deal with the consequences of the international card schemes' market dominance. For instance, the average net merchant service charges in the EU nearly doubled from 0.27% in 2018 to 0.44% in 2022.!25] This increase occurred despite regulatory efforts to contain it!25], as international card schemes exploited their strong negotiating position to raise the non-regulated components of the merchant service charge, such as scheme fees.!24] As a result, every year, European merchants collectively transfer large amounts to international card networks.!2& The cost falls disproportionately on smaller retailers, who face charges that are three to four times higher than those paid by their larger counterparts. 291 This situation has raised concerns among European businesses of all sizes.29 while the EU competition authorities can take effective action, they usually do so after dominance has been established. Moreover, they have to deal with the complexities of regulating payment networks. 34) This trend highlights broader competitiveness issues that have emerged across various markets. In Canada, class action lawsuits alleging collusion to set higher interchange fees have been filed against certain banks as well as Visa and Mastercard.!22! In the United Kingdom, the Payment Systems Regulator has provisionally concluded that there is insufficient competition in the card payments market. This lack of competition allows the two largest schemes to raise fees.!24] Similarly, the United States Justice Department filed a civil antitrust lawsuit earlier this week against Visa, claiming that Visa's exclusionary and anticompetitive conduct undermines choice and innovation in payments and imposes enormous costs on consumers, merchants and the American economy.{4! It emphasised that Visa extracts fees that far exceed what it could charge in a competitive market and amount to a hidden toll adding up to billions of dollars imposed annually on American consumers and businesses. And because merchants and banks pass on those costs to consumers, Visa's conduct affects not just the price of one thing, but the price of nearly everything. 25] The fact that these issues are not unique to Europe offers little comfort, particularly when considering that, unlike in the United States, this situation poses a risk to our monetary sovereignty. The excessive dependence on foreign entities in the European payments sector threatens the autonomy and resilience of European payment services. Without decisive public action, this dependence is likely to worsen. New foreign players - including from China", Brazil!®4 and Indial®8) - are seeking to enter, or increase their footprint in, the European market. While foreign competition is welcome, we cannot be satisfied that Europeans do not have their own digital payments solution allowing them to pay throughout the euro area. And we need to be careful that foreign central bank digital currencies (CBDCs) do not end up eroding the international role of the euro, especially as some jurisdictions are thinking about allowing their CBDCs to be used abroad. 22 European policymakers - and particularly the ECB - have recognised this challenge. In response, we have initiated the digital euro project, which is currently in the preparation phase, (40 Digital euro: addressing fragmentation and delivering tangible benefits The digital euro project is a crucial step towards enhancing Europe's payments landscape and safeguarding our monetary sovereignty. By ensuring everyone across the euro area would have access to central bank money in digital form, the project aims to provide tangible benefits to consumers, merchants and payment service providers alike. Benefits for consumers and merchants Complementing banknotes, the digital euro would offer all European citizens and firms the freedom to make and receive digital payments seamlessly. During my recent hearing before the European Parliament!*4), I extensively discussed the benefits of the digital euro for consumers, particularly in terms of the convenience it would offer. The digital euro would provide a single, easy, secure and universally accepted public solution for digital payments in stores, online and from person to person. It would be available both online and offline. And it would be free for basic use. At the hearing, I also highlighted how the digital euro would provide merchants with seamless access to Europe's consumer base. Moreover, it would offer an alternative that would increase competition, thereby lowering transaction costs in a more direct way than regulations and competition authorities can, 42] Fostering competition and innovation in a unified payments ecosystem The digital euro would also generate broader benefits for the euro area economy by fostering competition and innovation. European payment service providers are finding it increasingly difficult to compete with international card schemes and e-payment solutions. For example, Apple Pay has significantly expanded its reach in Europe, capturing a portion of interchange fees, which represents a "significant expense"! for issuing banks. As a result, banks risk missing out on not only interchange fees but also client relationships and user data. By contrast, the digital euro would ensure that distribution would remain with payment service providers, allowing them to maintain customer relationships and be compensated for their services, as is currently the case./"4I It would also offer an alternative to co-branding with international card schemes for cross-border payments in - and potentially beyond - the euro area, thus promoting competition. The digital euro would also expand opportunities for payment service providers while reducing the cost of rolling out solutions on a European scale. In addition, it would cultivate an environment conducive to the widespread adoption of payment innovations throughout Europe. Currently, several innovations aimed at simplifying payments are emerging within specific national markets or across a few countries, driven by European payment service providers. Although these innovations are highly commendable and would enhance people's lives, existing structural barriers mean they would encounter considerable obstacles in trying to achieve pan-European scale. This fragmentation along national lines further impedes private participants' ability to achieve the scale required in a two-sided market like the payments market. What is the end result? By failing to implement large-scale innovations accessible to everyone in the euro area, these companies are unable to achieve the optimal scale needed for continuous investment in new technology. This limits their ability to compete effectively with the large international players who can fully leverage economies of scale, even on a global level. According to the European Commission's legislative proposal!"4I, the digital euro's legal tender status - which would require merchants to accept the digital euro for electronic payments - and mandatory distribution would help overcome the challenges of achieving sufficient scale in a two-sided marketplace by ensuring widespread accessibility and acceptance across the euro area. This legal tender status, combined with the digital euro rulebook, would establish common standards, which are not in place today. Let me use an example to explain this in simpler terms. At the moment, in-store payment terminals often use technology known as the "kernel"/46], provided by Mastercard and Visa, to enable contactless (near field communication) transactions. Although domestic card schemes can currently access this technology for free, multi-country European card schemes cannot. Moreover, this free-of- charge policy could change at any time. In the future, all stores would be required to accept the digital euro, meaning payment terminals would need to support its standard. According to the draft regulation, the standard would have to be made available for reuse by private parties, who could use it to develop their services. This would mean that all payment terminals in Europe that support digital euro transactions would be equipped with a scheme-agnostic kernel. This open system would be accessible to both regional and domestic European payment schemes, thereby allowing customers to make contactless payments throughout the euro area. This would advance a more integrated European payments market. As private providers expand their geographical footprint and diversify their product portfolios, they will benefit from cost efficiencies and be better positioned to compete internationally. In essence, the network effects generated by a digital euro would function as a public good, benefiting both public and private initiatives. This approach is akin to creating a unified European railway network or European energy grid, where various companies could competitively operate their own services and deliver added value to customers. Instead of requiring significant investment to expand existing services across the euro area, the open digital euro standards would facilitate cost-effective standardisation, making it possible for private retail payment solution providers to launch new products and functionalities on a broader scale. Ultimately, whether through the digital euro or private solutions, this standardised framework would unlock innovation, create new business opportunities and improve consumer access to a diverse range of goods and services. Making this vision a shared reality The design of the digital euro, as well as the key provision in the Regulation proposed by the European Commission, contains all the key elements required to make this vision a reality. Over the past years, we have extensively engaged with a multitude of market stakeholders, including through the Rulebook Development Group"4 and the Euro Retail Payments Board, to shape the digital euro value proposition and prepare its implementation. We have collected and discussed the input of the payments ecosystem at large, including from representatives of consumers, merchants, banks and other payment service providers. In the coming months we will expand our cooperation with the private sector, focusing on three main themes: how to create a more competitive environment to encourage innovation and offer consumers more choice, how to best identify and leverage synergies to enhance efficiency and create mutually beneficial opportunities across the payments ecosystem, and how to strengthen the business models of all stakeholders, ensuring they can adapt and thrive in a rapidly evolving landscape. Each of these value drivers will be discussed in depth, taking into account the different roles in the payment chain, including those of issuing banks and third-party providers. By adopting this inclusive approach, we can ensure that everyone's needs and perspectives are addressed, paving the way for a more robust and dynamic payments system. Conclusion Let me conclude. Money is key to sovereignty, a reality that resonates more than ever in the digital age. Some 63 countries are now operating, piloting, developing or exploring retail CBDCs./48] Meanwhile, major private payment solutions are expanding globally and some nations may even seek to leverage crypto-assets, with figures such as US presidential candidate Donald Trump promising to make the United States a "Bitcoin superpower"./42] In this fast-moving environment, Europe cannot stand still. And the role of the ECB in issuing money that is accepted throughout the euro area is particularly crucial in a monetary union where payments markets remain fragmented along national lines. We are committed to ensuring that people in Europe can continue to use cash.2] However, we cannot stand by and watch as individuals are unable to use central bank money for their daily digital transactions. Bringing central bank money into a digitalised world through the digital euro would safeguard our monetary sovereignty in the digital age. It would overcome fragmentation by offering money that can be used for any digital payments in the euro area, foster competition and innovation by facilitating the development of pan-European payments services and strengthen our autonomy and resilience by helping us avoid becoming over-reliant on foreign payment solutions. Thank you for your attention. I would like to thank Alessandro Giovannini, Jean-Francois Jamet and Cyril Max Neumann for their help in preparing this speech, as well as Henk Esselink, Patrick Papsdorf, Benjamin Sahel, Doris Schneeberger, Erik Tak and Evelien Witlox for their comments. 2. Source: ECB Payments Statistics. The data are for non-cash payment transactions in 2023. This excludes cash withdrawals and includes credit transfers, direct debits, card payments with cards issued by resident payment service providers, e-money payment transactions with e-money issued by resident payment service providers, cheques, money remittances and other payment services. 3. Six Books of the Commonwealth (originally published in French in 1576 as Les Six livres de la République). 4. Most Europeans want to have the option to pay in cash and many view it as essential to their freedom: cash is easy to obtain, inclusive, universally accepted across the euro area and offers the highest level of privacy. See Cipollone, P. (2024), "Maintaining the freedom to choose how we pay", The ECB Blog, 25 June. 5. In terms of value of payments, cards (46%) accounted for a higher share of transactions than cash payments (42%) in 2022. This contrasts with 2016 and 2019, when the share of cash transactions in value (54% in 2016 and 47% in 2019) was higher than the share of card transactions. See ECB (2022), "Study on the payment attitudes of consumers in the euro area", 22 December. 6. The share of companies not accepting cash has increased from 4% in 2021 to 12% in 2024 in the euro area. See ECB (2024), "Use of cash by companies in the euro area in 2024", 18 September. 7. In June 2023, the European Commission tabled a legislative proposal on the legal tender of euro cash to safeguard the role of cash and ensure it is widely accepted as a means of payment and remains easily accessible for people and businesses across the euro area. See European Commission (2023), a digital euro", press release, 28 June. 8. The Eurosystem cash strategy aims to ensure that euro cash remains widely available, accessible and accepted as both a means of payment and a store of value. 9. Letta, E. (2024), Much more than a market, April; Draghi, M (2024), The future of European competitiveness, September. 10. For instance, according to Capgemini Financial Services, only 13% of European banks can claim a strong technology foundation for instant payments. See Capgemini (2024), "Velocity, meet value", World Report Series 2025, September. 11. Alipay saw a 67% increase in transactions in Germany during the opening week of UEFA EURO 2024, with a 40% increase in merchants accepting these payments. 12. See Rochet, J-C. and Tirole, J. (2023), "Platform competition in two sided markets", Journal of the European Economic Association, June, pp. 990-1029; Rochet, J-C. and Tirole, J. (2002), "Cooperation among competitors: the economics of payment card associations", RAND Journal of Economics, Vol. 33, No 4, pp. 1-22; Rysman, M. (2009), "The economics of two-sided markets", Journal of Economic Perspectives, Vol. 23, No 3, pp.125-43. 13. Bank for International Settlements (2019), "Big tech in finance: opportunities and risks", BIS Annual Economic Report, 23 June. 14. Doerr, S., Frost, J., Gambacorta, L. and Shreeti, V. (2023), "Big techs in finance", BIS Working Papers, No WP1129, October. 15. Alipay running through Alibaba (China's version of Amazon) and WeChat Pay running through Tencent (China's version of Facebook). 16. financial inclusion", BIS Working Papers, No 1011, 4 May. 17. WhatsApp Pay is an in-app payment feature that allows businesses to receive payments directly through WhatsApp. Launched in India in November 2020, it now operates also in the United States (using Novi, a digital wallet from Meta) and Brazil (operating via Facebook Pay, also known as Meta Pay). 18. Finextra (2024), "X working_on 'payments' button", 7 August. 19. August. 20. European Commission (2020), Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions on a Retail Payments Strategy for the EU, 24 September. 21. Cipollone, P. (2024), "Innovation, integration and independence: taking the Single Euro Payments Area to the next level", speech at the ECB conference on "An innovative and integrated European retail payments market", 24 April. 22. Letta, E., op. cit. 23. The Eurosystem supports market-led initiatives to develop privately operated, European-governed, pan-European payment solutions at the point of interaction. The European Payments Initiative, which is backed by 16 European banks and financial services companies, aims to develop a payment solution for consumers and merchants across Europe, based on a digital wallet. In parallel, new initiatives based on the principle of interoperability have been announced. However, these initiatives do not yet cover the entire area. 24. This is the volume share of international card schemes in total electronically initiated card payments with cards issued in the euro area and transactions acquired worldwide for the first half of 2023. It is based on data collected under Regulation (EU) No 1409/2013 of the European Central Bank on payments statistics (ECB/2013/43). 25. European Commission (2024), Study on new developments in card-based payment markets, including as regards relevant aspects of the application of the Interchange Fee Regulation - Final Report, February. 26. In recent years, legislators have taken several initiatives to promote higher competition in the retail payments landscape, such as the Interchange Fee Regulation (IFR), Commitments on interregional card transactions, Payment Services Directive and Regulation (PSD2/PSR) and Instant Payments Regulation (IPR). 27. landscape - a call for urgent action", Position paper - Payments, 8 July. 28. See Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", Introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament, 23 September. 29. EHI, Zahlungssysteme im Einzelhandel 2023; European Commission (2024), op. cit. 30. EuroCommerce (2024), op. cit. 31. European Commission (2024), op. cit. 32. See apnews's article on Canadian credit card class actions entitled "Visa, Mastercard settle long- running_anti-trust suit over swipe fees with merchants", 26 March 2024. 33. Payment Systems Regulator (2024), "PSR provisionally finds that the card schemes do not face effective competition in the supply of scheme and processing services to acquirers", 21 May. 34. US Department of Justice (2024), "Justice Department Sues Visa for Monopolizing Debit Markets", 24 September. 35. See "Attorney General Merrick B. Garland Delivers Remarks on the Justice Department's Lawsuit Against Visa for Monopolizing Debit Markets", 24 September. 36. As of June 2024, over 400,000 European merchants accept mobile payments through Alipay+ from 14 international e-wallets and banking apps. Additionally, users of more than 370 banks in Germany and Austria can pay digitally through a partnership between Alipay+ and Bluecode. In France, Alipay+ has teamed up with Crédit Mutuel to enable acceptance at various retailers, hotels and restaurants. In Spain, Alipay+ is available at the Boqueria Market in Barcelona and department store El Corte Ingles, offering special discounts. In Italy, Alipay+ expanded its partnership with Worldline Italia to upgrade all Android POS terminals, benefiting Asian tourists across thousands of locations. Business Wire (2024), "Alipay+ Expands Global Merchants Coverage for Partner E-Wallets in UEFA EURO 2024tm Summer Craze", 12 June. 37. It was recently announced that Wipay, a Spanish payment technology company, has partnered with PagBrasil to introduce Brazil's Pix Instant Payment System to Europe. PagBrasil also announced plans to test the instant payment system Pix at various points of sale in Spain, Portugal and the Netherlands. 38. As of February 2024, tickets for the Eiffel Tower can be purchased via the Indian payment solution UPI. France was the first European country to accept UPI after the National Payments Corporation of India (NPCI) partnered with Lyra, a French e-commerce and proximity company. See Lyra (2024), 39. Panetta F. (2022), "'Hic sunt leones' - open research questions on the international dimension of central bank digital currencies", speech at the ECB-CEBRA conference on international aspects of digital currencies and fintech, 19 October. 40. The preparation phase follows the investigation phase of the project, which discussed key design and distribution choices for the digital euro. ECB (2024), Progress on the preparation phase of a digital euro, 24 June. 41. See Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", Introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament, 23 September. 42. Usher, A., Reshidi, E., Rivadeneyra, F. and Hendry, S. (2021), "The Positive Case for a CBDC", Staff Discussion Paper, Bank of Canada, 20 July; and Liu, Y., Reshidi, E. and Rivadeneyra, F. (2023), "CBDC and Payment Platform Competition", Bank of Canada, 17 May. 43. 44. The draft legislation envisages a compensation model with fair economic incentives for all involved (e.g. consumers, merchants and banks) in line with the following principles: i) as a public good, a digital euro would be free of charge for basic use; ii) payment service providers would charge merchants fees for providing digital euro-related services to offset the operational costs of distributing a digital euro, as is the case today for other digital means of payment. Payment service providers would also be able to develop additional digital euro services for their customers, on top of those required for basic use; iii) the fees that merchants pay payment service providers for digital euro services would be subject to a cap to provide adequate safeguards against excessive charges, as outlined by the European Commission in its legislative proposal on a digital euro; iv) as for the production of banknotes, the Eurosystem would bear the issuance costs. 45. See European Commission (2023), op. cit.. 46. A kernel is a core piece of software embedded in payment terminals that handles the processing of payment transactions. It ensures that the terminal can read and authenticate card or digital wallet data and communicate with the bank or payment network to approve or decline the transaction. Essentially, it manages the steps required to complete a secure payment. 47. See European Central Bank (2024), "Update on the work of the digital euro scheme's Rulebook Development Group", 5 September. 48. According to the Atlantic Council CBDC tracker, three countries have launched a retail CBDC, 35 are running pilots, 13 are in the development phase and 12 are conducting research. 49. See New York Times (2024), "Trump, Appealing to Bitcoin Fans, Vows U.S. Will Be 'Crypto Capital of the Planet", 27 July. 50. The Eurosystem cash strategy aims to ensure that cash remains widely available and accepted as both a means of payment and a store of value. See also ECB (2023), "ECB selects "European culture" and "Rivers and birds" as possible themes for future euro banknotes", press release, 30 November. CONTACT European Central Bank Directorate General Communications > Sonnemannstrasse 20 > 60314 Frankfurt am Main, Germany > +49 69 1344 7455 > [email protected] Reproduction is permitted provided that the source is acknowledged. Media contacts Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # SPEECH ## Monetary sovereignty in the digital age: the case for a digital euro ## Keynote speech by Piero Cipollone, Member of the Executive Board of the ECB, at the Economics of Payments XIII Conference organised by the Oesterreichische Nationalbank Vienna, 27 September 2024 Money plays a fundamental role in society, driving economic activity and enabling daily transactions. ${ }^{[1]}$ Money in physical form, cash, remains the most frequently used means of payment in stores, especially for lower value transactions. But more and more people are using money in digital form. An average of 379 million retail transactions are made digitally in the euro area every day. ${ }^{[2]}$ Given money's importance for our material and social well-being, the regulation of money has long been considered a cornerstone of state sovereignty. As the influential French jurist and political philosopher Jean Bodin observed in the 16th century, "only he who has the power to make law can regulate the coinage." ${ }^{[3]}$ Today, legislators continue to regulate the use of money and they have entrusted central banks with issuing public money and maintaining confidence in the monetary system. At the European Central Bank (ECB), we issue money that can be used to settle wholesale and retail transactions throughout the euro area, thereby guaranteeing the singleness of money across the monetary union. And we ensure that the euro remains a safe, stable and effective medium of exchange and store of value. This provides an essential anchor for the economy and the financial system. The Eurosystem has made significant progress in integrating wholesale transactions, largely thanks to the robust payment infrastructure it provides. The Eurosystem's real-time gross settlement system T2, for instance, processes a value close to the entire euro area GDP on a weekly basis, and it has established itself as a leading global payment system. In parallel, euro banknotes are accepted for retail payments across the euro area. They have become a symbol of European integration and freedom ${ }^{[4]}$, uniting us and strengthening our collective identity as Europeans. But while central banks have long offered digital settlement in central bank money for wholesale transactions, we do not yet have a digital form of cash. This is becoming increasingly problematic because the use and acceptance of cash are declining. In the euro area, cash transactions have fallen below card transactions in value. ${ }^{[5]}$ And the share of companies reporting that they do not accept cash has tripled in the last three years to $12 \%$. ${ }^{[6]}$ The ---[PAGE_BREAK]--- European Commission has therefore put forward a legislative proposal to ensure the acceptance of cash ${ }^{[7]}$ and the ECB is committed to keeping euro cash widely available and accessible. ${ }^{[8]}$ Still, the trend towards less use of banknotes for daily transactions is likely to continue, reflecting the digitalisation of economic activity and mirroring patterns observed in many advanced economies. Moreover, digital payments in the euro area remain fragmented, both along national lines and in terms of use cases. Current European digital payment solutions mainly cater to national markets and specific use cases. To pay across European countries, consumers have to rely on a few non-European providers, which now dominate most of these transactions. And even those providers' payment solutions are not accepted everywhere and do not cover all key use cases (payments in shops, from person to person and online). So a key objective of central bank money - to offer the public a means of payment backed by the sovereign authority that can be used for retail transactions across the jurisdiction - is not being fulfilled in the euro area's digital space. This is all the more awkward given that some euro area countries have made it mandatory to accept digital means of payment, for instance in a bid to combat tax evasion. In addition, European payments have become a prime example of the situation that Enrico Letta and Mario Draghi have described in their recent reports. ${ }^{[9]}$ The fragmentation of the market, the lack of European payment solutions available on a European scale and the difficulty faced by European payment service providers in keeping pace with technological advances ${ }^{[10]}$ means that Europe is not competitive within its own market, let alone on a global scale. Moreover, in an unstable geopolitical environment, we are being left to rely on companies based in other countries. Today's dependency on US companies could in future develop into reliance on companies from countries other than the United States. Platforms like Ant Group's Alipay have demonstrated their ability to bridge geographical gaps: during major events like UEFA EURO 2024 they were able to boost their payment app usage among customers in Europe. ${ }^{[11]}$ We must move swiftly to address the risks stemming from Europe's current inability to secure the integration and autonomy of its retail payment system. This is a key motivation behind the digital euro project: bringing central bank money into the digital age would provide a digital equivalent to banknotes and strengthen our monetary sovereignty. Today, I will outline the policy challenges we face as digitalisation reinforces the two-sided nature of the payments market. I will then discuss how the introduction of a digital euro could make a significant difference. By designing the digital euro to meet the diverse needs of consumers, merchants and payment service providers, we can ensure its widespread adoption. This, in turn, will empower us to pursue strategic goals such as innovation, integration and independence, ultimately enhancing our economic efficiency, resilience and sovereignty. # The retail payments market: a two-sided marketplace To fully appreciate why we have been failing to overcome fragmentation and why the digital euro would be a game changer, we must first understand the structure of the retail payments market as a two-sided marketplace. ---[PAGE_BREAK]--- Retail payment systems act as vital intermediaries connecting two key participants - merchants and consumers - whose transactions are facilitated by payment service providers. ${ }^{[12]}$ The defining feature of this marketplace is that interactions between participants generate network effects, where the value for each group increases as more participants join the other side. Consider the telephone system: its utility grows with each new user. However, on the downside, this also creates a challenging chicken-and-egg dilemma. Platforms need a critical mass of users to attract additional participants, but they struggle to achieve scale without that initial user base. That is why platforms with existing large user bases have an advantage in entering such markets. Indeed, the strength of network effects is amplified when platforms expand their range of activities, thereby broadening their user base. Technological innovation and the rise of digital platforms managed by major tech companies are expected to further exacerbate these dynamics. Big techs conduct business in finance in a unique way, drawing on three mutually reinforcing components: data analytics, network effects and interconnected activities. ${ }^{[13]}$ Network effects help big techs gather more data, which enhances their analytics. Better analytics improve services and attract more users, allowing them to offer more services and gather even more data. As a result, payment apps provided by big techs have become especially popular in emerging markets and developing economies. ${ }^{[14]}$ Take China, for example. Its financial system has largely disintermediated banks from payment transactions. Instead, big techs have leveraged the widespread use of mobile apps, integrating social interactions and shopping experiences to offer users seamless digital payment methods. ${ }^{[15]}$ What is even more problematic is that these companies operate closedloop payment systems, in contrast to international card schemes' open-loop systems. In a closed-loop system, consumers load money onto their Alipay account, for example, and pay by scanning the merchant's Alipay QR code. As a result, funds are transferred directly from the consumer to the merchant, bypassing the traditional system of banks and network processors. Only the owner of the closed-loop system has access to the payment data. This challenges the traditional banking model, which relies on customer data and relationships to function effectively, and also has an impact on how credit is extended to the economy. ${ }^{[16]}$ There is a risk that the closed-loop systems developed by successful online platforms and big tech companies could, in future, create a parallel economy with their own currencies and distinct units of account. At global level, big techs such as PayPal and Apple have developed highly successful ecosystems based on the closed-loop financial services model. By encouraging people to use their payment apps, these ecosystems effectively oblige them to use their payment rails. In parallel, payment platforms have tried to become more integrated in social media giants like WhatsApp and Meta ${ }^{[17]}$. Platforms like X (formerly Twitter) are considering offering payment functions. ${ }^{[18]}$ And Amazon is now venturing into the credit card and payment app business too. These examples illustrate how these firms can exploit customer networks to create cross-subsidised links between various services. ${ }^{[19]}$ However, while network effects can foster a virtuous cycle of economic growth, they also pose significant risks. ---[PAGE_BREAK]--- In particular, walled gardens or lack of interoperability between various solutions can result in market fragmentation. Technology can be used to exclude competitors - for example, by preferencing a platform's own products or restricting competing services - and so can skew the competitive landscape in favour of a dominant player. And these dynamics could further raise the barriers to enter and grow in the two-sided payments market, stifling competition and making it even more difficult for European payment solutions to emerge on a pan-European scale. There is thus a risk that the current dynamics, where big tech companies seek to exploit the power of their platforms to expand in payments, could exacerbate the challenges facing the European retail payments market in terms of integration and the ability of European solutions to compete and innovate at scale. # Addressing market failures through European policy actions Since the creation of the monetary union, European policymakers have taken significant steps to foster the development of private European payment initiatives that span the euro area. The hope was that these initiatives could enhance competition within the European payments landscape, providing consumers and businesses with more choice and better services. From the launch of the Single Euro Payments Area to the recent adoption of the Instant Payments Regulation, the European Commission ${ }^{[20]}$ and ECB ${ }^{[21]}$ have worked with the private sector to support integration, innovation and the creation of a pan-European retail payment solution. Yet, despite these efforts, more than 30 years since the inception of the Single Market and 25 years since the launch of the single currency, most European retail payment solutions remain national in scope, addressing only limited use cases. Moreover, 13 out of 20 euro area countries rely entirely on non-European solutions in the absence of their own domestic payment scheme. As a result, people who live, work, travel or shop online in other euro area countries find themselves effectively dependent on two international card schemes, which enjoy strong market power. This situation discourages small businesses from expanding across borders or even into their national online markets, ultimately hindering the deepening of the Single Market. ${ }^{[22]}$ And paradoxically, the benefits from the efforts we make to lower the barriers to trade in European product markets may not fully reach consumers, as they are absorbed in the form of higher profits by the few international players that currently enable payments in stores and online across Europe. Rather than joining forces and sharing resources to develop successful pan-European solutions, national communities have often preferred to preserve the legacy of investments made in the past. ${ }^{[23]}$ This reluctance has allowed a few major global players not only to dominate cross-border European payment transactions, but also to steadily capture an even larger share of domestic transactions. The result is that international payment schemes operated by non-European operators today facilitate 64\% of all electronically initiated transactions with cards issued in the euro area. ${ }^{[24]}$ Merchants - and consumers, to whom costs are eventually passed on - are left to deal with the consequences of the international card schemes' market dominance. ---[PAGE_BREAK]--- For instance, the average net merchant service charges in the EU nearly doubled from $0.27 \%$ in 2018 to $0.44 \%$ in $2022 .{ }^{[25]}$ This increase occurred despite regulatory efforts to contain it ${ }^{[26]}$, as international card schemes exploited their strong negotiating position to raise the non-regulated components of the merchant service charge, such as scheme fees. ${ }^{[27]}$ As a result, every year, European merchants collectively transfer large amounts to international card networks. ${ }^{[28]}$ The cost falls disproportionately on smaller retailers, who face charges that are three to four times higher than those paid by their larger counterparts. ${ }^{[29]}$ This situation has raised concerns among European businesses of all sizes. ${ }^{[30]}$ While the EU competition authorities can take effective action, they usually do so after dominance has been established. Moreover, they have to deal with the complexities of regulating payment networks. ${ }^{[31]}$ This trend highlights broader competitiveness issues that have emerged across various markets. In Canada, class action lawsuits alleging collusion to set higher interchange fees have been filed against certain banks as well as Visa and Mastercard. ${ }^{[32]}$ In the United Kingdom, the Payment Systems Regulator has provisionally concluded that there is insufficient competition in the card payments market. This lack of competition allows the two largest schemes to raise fees. ${ }^{[33]}$ Similarly, the United States Justice Department filed a civil antitrust lawsuit earlier this week against Visa, claiming that Visa's exclusionary and anticompetitive conduct undermines choice and innovation in payments and imposes enormous costs on consumers, merchants and the American economy. ${ }^{[34]}$ It emphasised that Visa extracts fees that far exceed what it could charge in a competitive market and amount to a hidden toll adding up to billions of dollars imposed annually on American consumers and businesses. And because merchants and banks pass on those costs to consumers, Visa's conduct affects not just the price of one thing, but the price of nearly everything. ${ }^{[35]}$ The fact that these issues are not unique to Europe offers little comfort, particularly when considering that, unlike in the United States, this situation poses a risk to our monetary sovereignty. The excessive dependence on foreign entities in the European payments sector threatens the autonomy and resilience of European payment services. Without decisive public action, this dependence is likely to worsen. New foreign players - including from China ${ }^{[36]}$, Brazil ${ }^{[37]}$ and India ${ }^{[38]}$ - are seeking to enter, or increase their footprint in, the European market. While foreign competition is welcome, we cannot be satisfied that Europeans do not have their own digital payments solution allowing them to pay throughout the euro area. And we need to be careful that foreign central bank digital currencies (CBDCs) do not end up eroding the international role of the euro, especially as some jurisdictions are thinking about allowing their CBDCs to be used abroad. ${ }^{[39]}$ European policymakers - and particularly the ECB - have recognised this challenge. In response, we have initiated the digital euro project, which is currently in the preparation phase. ${ }^{[40]}$ # Digital euro: addressing fragmentation and delivering tangible benefits ---[PAGE_BREAK]--- The digital euro project is a crucial step towards enhancing Europe's payments landscape and safeguarding our monetary sovereignty. By ensuring everyone across the euro area would have access to central bank money in digital form, the project aims to provide tangible benefits to consumers, merchants and payment service providers alike. # Benefits for consumers and merchants Complementing banknotes, the digital euro would offer all European citizens and firms the freedom to make and receive digital payments seamlessly. During my recent hearing before the European Parliament ${ }^{[41]}$, I extensively discussed the benefits of the digital euro for consumers, particularly in terms of the convenience it would offer. The digital euro would provide a single, easy, secure and universally accepted public solution for digital payments in stores, online and from person to person. It would be available both online and offline. And it would be free for basic use. At the hearing, I also highlighted how the digital euro would provide merchants with seamless access to Europe's consumer base. Moreover, it would offer an alternative that would increase competition, thereby lowering transaction costs in a more direct way than regulations and competition authorities can. ${ }^{[42]}$ ## Fostering competition and innovation in a unified payments ecosystem The digital euro would also generate broader benefits for the euro area economy by fostering competition and innovation. European payment service providers are finding it increasingly difficult to compete with international card schemes and e-payment solutions. For example, Apple Pay has significantly expanded its reach in Europe, capturing a portion of interchange fees, which represents a "significant expense"[43] for issuing banks. As a result, banks risk missing out on not only interchange fees but also client relationships and user data. By contrast, the digital euro would ensure that distribution would remain with payment service providers, allowing them to maintain customer relationships and be compensated for their services, as is currently the case. ${ }^{[44]}$ It would also offer an alternative to co-branding with international card schemes for cross-border payments in - and potentially beyond - the euro area, thus promoting competition. The digital euro would also expand opportunities for payment service providers while reducing the cost of rolling out solutions on a European scale. In addition, it would cultivate an environment conducive to the widespread adoption of payment innovations throughout Europe. Currently, several innovations aimed at simplifying payments are emerging within specific national markets or across a few countries, driven by European payment service providers. Although these innovations are highly commendable and would enhance people's lives, existing structural barriers mean they would encounter considerable obstacles in trying to achieve pan-European scale. This ---[PAGE_BREAK]--- fragmentation along national lines further impedes private participants' ability to achieve the scale required in a two-sided market like the payments market. What is the end result? By failing to implement large-scale innovations accessible to everyone in the euro area, these companies are unable to achieve the optimal scale needed for continuous investment in new technology. This limits their ability to compete effectively with the large international players who can fully leverage economies of scale, even on a global level. According to the European Commission's legislative proposal[45], the digital euro's legal tender status - which would require merchants to accept the digital euro for electronic payments - and mandatory distribution would help overcome the challenges of achieving sufficient scale in a two-sided marketplace by ensuring widespread accessibility and acceptance across the euro area. This legal tender status, combined with the digital euro rulebook, would establish common standards, which are not in place today. Let me use an example to explain this in simpler terms. At the moment, in-store payment terminals often use technology known as the "kernel"[46], provided by Mastercard and Visa, to enable contactless (near field communication) transactions. Although domestic card schemes can currently access this technology for free, multi-country European card schemes cannot. Moreover, this free-ofcharge policy could change at any time. In the future, all stores would be required to accept the digital euro, meaning payment terminals would need to support its standard. According to the draft regulation, the standard would have to be made available for reuse by private parties, who could use it to develop their services. This would mean that all payment terminals in Europe that support digital euro transactions would be equipped with a scheme-agnostic kernel. This open system would be accessible to both regional and domestic European payment schemes, thereby allowing customers to make contactless payments throughout the euro area. This would advance a more integrated European payments market. As private providers expand their geographical footprint and diversify their product portfolios, they will benefit from cost efficiencies and be better positioned to compete internationally. In essence, the network effects generated by a digital euro would function as a public good, benefiting both public and private initiatives. This approach is akin to creating a unified European railway network or European energy grid, where various companies could competitively operate their own services and deliver added value to customers. Instead of requiring significant investment to expand existing services across the euro area, the open digital euro standards would facilitate cost-effective standardisation, making it possible for private retail payment solution providers to launch new products and functionalities on a broader scale. Ultimately, whether through the digital euro or private solutions, this standardised framework would unlock innovation, create new business opportunities and improve consumer access to a diverse range of goods and services. # Making this vision a shared reality ---[PAGE_BREAK]--- The design of the digital euro, as well as the key provision in the Regulation proposed by the European Commission, contains all the key elements required to make this vision a reality. Over the past years, we have extensively engaged with a multitude of market stakeholders, including through the Rulebook Development Group ${ }^{[47]}$ and the Euro Retail Payments Board, to shape the digital euro value proposition and prepare its implementation. We have collected and discussed the input of the payments ecosystem at large, including from representatives of consumers, merchants, banks and other payment service providers. In the coming months we will expand our cooperation with the private sector, focusing on three main themes: how to create a more competitive environment to encourage innovation and offer consumers more choice, how to best identify and leverage synergies to enhance efficiency and create mutually beneficial opportunities across the payments ecosystem, and how to strengthen the business models of all stakeholders, ensuring they can adapt and thrive in a rapidly evolving landscape. Each of these value drivers will be discussed in depth, taking into account the different roles in the payment chain, including those of issuing banks and third-party providers. By adopting this inclusive approach, we can ensure that everyone's needs and perspectives are addressed, paving the way for a more robust and dynamic payments system. # Conclusion Let me conclude. Money is key to sovereignty, a reality that resonates more than ever in the digital age. Some 63 countries are now operating, piloting, developing or exploring retail CBDCs. ${ }^{[48]}$ Meanwhile, major private payment solutions are expanding globally and some nations may even seek to leverage crypto-assets, with figures such as US presidential candidate Donald Trump promising to make the United States a "Bitcoin superpower". ${ }^{[49]}$ In this fast-moving environment, Europe cannot stand still. And the role of the ECB in issuing money that is accepted throughout the euro area is particularly crucial in a monetary union where payments markets remain fragmented along national lines. We are committed to ensuring that people in Europe can continue to use cash. ${ }^{[50]}$ However, we cannot stand by and watch as individuals are unable to use central bank money for their daily digital transactions. Bringing central bank money into a digitalised world through the digital euro would safeguard our monetary sovereignty in the digital age. It would overcome fragmentation by offering money that can be used for any digital payments in the euro area, foster competition and innovation by facilitating the development of pan-European payments services and strengthen our autonomy and resilience by helping us avoid becoming over-reliant on foreign payment solutions. Thank you for your attention. ---[PAGE_BREAK]--- I would like to thank Alessandro Giovannini, Jean-Francois Jamet and Cyril Max Neumann for their help in preparing this speech, as well as Henk Esselink, Patrick Papsdorf, Benjamin Sahel, Doris Schneeberger, Erik Tak and Evelien Witlox for their comments. 2. Source: ECB Payments Statistics. The data are for non-cash payment transactions in 2023. This excludes cash withdrawals and includes credit transfers, direct debits, card payments with cards issued by resident payment service providers, e-money payment transactions with e-money issued by resident payment service providers, cheques, money remittances and other payment services. 3. Six Books of the Commonwealth (originally published in French in 1576 as Les Six livres de la République). 4. Most Europeans want to have the option to pay in cash and many view it as essential to their freedom: cash is easy to obtain, inclusive, universally accepted across the euro area and offers the highest level of privacy. See Cipollone, P. (2024), "Maintaining the freedom to choose how we pay", The ECB Blog, 25 June. 5. In terms of value of payments, cards (46\%) accounted for a higher share of transactions than cash payments (42\%) in 2022. This contrasts with 2016 and 2019, when the share of cash transactions in value ( $54 \%$ in 2016 and $47 \%$ in 2019) was higher than the share of card transactions. See ECB (2022), "Study on the payment attitudes of consumers in the euro area", 22 December. 6. The share of companies not accepting cash has increased from 4\% in 2021 to 12\% in 2024 in the euro area. See ECB (2024), "Use of cash by companies in the euro area in 2024", 18 September. 7. In June 2023, the European Commission tabled a legislative proposal on the legal tender of euro cash to safeguard the role of cash and ensure it is widely accepted as a means of payment and remains easily accessible for people and businesses across the euro area. See European Commission (2023), "Single Currency Package: new proposals to support the use of cash and to propose a framework for a digital euro", press release, 28 June. 8. The Eurosystem cash strategy aims to ensure that euro cash remains widely available, accessible and accepted as both a means of payment and a store of value. 9. ---[PAGE_BREAK]--- Letta, E. (2024), Much more than a market, April; Draghi, M (2024), The future of European comoetitiveness, September. 10 . For instance, according to Capgemini Financial Services, only 13\% of European banks can claim a strong technology foundation for instant payments. See Capgemini (2024), "Velocity, meet value", World Report Series 2025, September. 11. Alipay saw a 67\% increase in transactions in Germany during the opening week of UEFA EURO 2024, with a $40 \%$ increase in merchants accepting these payments. 12. See Rochet, J-C. and Tirole, J. (2023), "Platform competition in two sided markets", Journal of the European Economic Association, June, pp. 990-1029; Rochet, J-C. and Tirole, J. (2002), "Cooperation among competitors: the economics of payment card associations", RAND Journal of Economics, Vol. 33, No 4, pp. 1-22; Rysman, M. (2009), "The economics of two-sided markets", Journal of Economic Perspectives, Vol. 23, No 3, pp.125-43. 13. Bank for International Settlements (2019), "Big tech in finance: opportunities and risks", BIS Annual Economic Report, 23 June. 14. Doerr, S., Frost, J., Gambacorta, L. and Shreeti, V. (2023), "Big techs in finance", BIS Working Papers, No WP1129, October. 15. Alipay running through Alibaba (China's version of Amazon) and WeChat Pay running through Tencent (China's version of Facebook). 16. Beck, T., Gambacorta, L., Huang, Y., Li, Z. and Qiu, H. (2022), "Big techs, QR code payments and financial inclusion", BIS Working Papers, No 1011, 4 May. 17. WhatsApp Pay is an in-app payment feature that allows businesses to receive payments directly through WhatsApp. Launched in India in November 2020, it now operates also in the United States (using Novi, a digital wallet from Meta) and Brazil (operating via Facebook Pay, also known as Meta Pay). 18. Finextra (2024), "X working on 'payments' button", 7 August. ---[PAGE_BREAK]--- 19. TechCrunch (2024), "Amazon considers moving Amazon Pay into a standalone app in India", 19 August. 20. European Commission (2020), Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions on a Retail Payments Strategy for the EU, 24 September. 21. Cipollone, P. (2024), "Innovation, integration and independence: taking the Single Euro Payments Area to the next level", speech at the ECB conference on "An innovative and integrated European retail payments market", 24 April. 22. Letta, E., op. cit. 23. The Eurosystem supports market-led initiatives to develop privately operated, European-governed, pan-European payment solutions at the point of interaction. The European Payments Initiative, which is backed by 16 European banks and financial services companies, aims to develop a payment solution for consumers and merchants across Europe, based on a digital wallet. In parallel, new initiatives based on the principle of interoperability have been announced. However, these initiatives do not yet cover the entire area. 24. This is the volume share of international card schemes in total electronically initiated card payments with cards issued in the euro area and transactions acquired worldwide for the first half of 2023. It is based on data collected under Regulation (EU) No 1409/2013 of the European Central Bank on payments statistics (ECB/2013/43). 25. European Commission (2024), Study on new developments in card-based payment markets, including as regards relevant aspects of the application of the Interchange Fee Regulation - Final Report, February. 26. In recent years, legislators have taken several initiatives to promote higher competition in the retail payments landscape, such as the Interchange Fee Regulation (IFR), Commitments on interregional card transactions, Payment Services Directive and Regulation (PSD2/PSR) and Instant Payments Regulation (IPR). ---[PAGE_BREAK]--- 27. EuroCommerce (2024), "EU businesses' competitiveness impacted by current cards payments landscape - a call for urgent action", Position paper - Payments, 8 July. 28. See Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", Introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament, 23 September. 29. EHI, Zahlungssysteme im Einzelhandel 2023; European Commission (2024), op. cit. 30. EuroCommerce (2024), op. cit. 31. European Commission (2024), op. cit. 32. See apnews's article on Canadian credit card class actions entitled "Visa, Mastercard settle longrunning anti-trust suit over swipe fees with merchants", 26 March 2024. 33. Payment Systems Regulator (2024), "PSR provisionally finds that the card schemes do not face effective competition in the supply of scheme and processing services to acquirers", 21 May. 34. US Department of Justice (2024), "Justice Department Sues Visa for Monopolizing Debit Markets", 24 September. 35. See "Attorney General Merrick B. Garland Delivers Remarks on the Justice Department's Lawsuit Against Visa for Monopolizing Debit Markets", 24 September. 36. As of June 2024, over 400,000 European merchants accept mobile payments through Alipay+ from 14 international e-wallets and banking apps. Additionally, users of more than 370 banks in Germany and Austria can pay digitally through a partnership between Alipay+ and Bluecode. In France, Alipay+ has teamed up with Crédit Mutuel to enable acceptance at various retailers, hotels and restaurants. In Spain, Alipay+ is available at the Boqueria Market in Barcelona and department store El Corte Ingles, offering special discounts. In Italy, Alipay+ expanded its partnership with Worldline Italia to upgrade all Android POS terminals, benefiting Asian tourists across thousands of locations. Business Wire (2024), ---[PAGE_BREAK]--- "Alipay+ Expands Global Merchants Coverage for Partner E-Wallets in UEFA EURO 2024TM Summer Craze", 12 June. 37. It was recently announced that Wipay, a Spanish payment technology company, has partnered with PagBrasil to introduce Brazil's Pix Instant Payment System to Europe. PagBrasil also announced plans to test the instant payment system Pix at various points of sale in Spain, Portugal and the Netherlands. 38. As of February 2024, tickets for the Eiffel Tower can be purchased via the Indian payment solution UPI. France was the first European country to accept UPI after the National Payments Corporation of India (NPCI) partnered with Lyra, a French e-commerce and proximity company. See Lyra (2024), "Lyra Network revolutionizes global payments with UPI transactions in France", 2 February. 39. Panetta F. (2022), "'Hic sunt leones' - open research questions on the international dimension of central bank digital currencies", speech at the ECB-CEBRA conference on international aspects of digital currencies and fintech, 19 October. 40. The preparation phase follows the investigation phase of the project, which discussed key design and distribution choices for the digital euro. ECB (2024), Progress on the preparation phase of a digital euro, 24 June. 41. See Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", Introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament, 23 September. 42. Usher, A., Reshidi, E., Rivadeneyra, F. and Hendry, S. (2021), "The Positive Case for a CBDC", Staff Discussion Paper, Bank of Canada, 20 July; and Liu, Y., Reshidi, E. and Rivadeneyra, F. (2023), "CBDC and Payment Platform Competition", Bank of Canada, 17 May. 43. See Payments Dive (2024), "DOJ calls Apple card fees 'significant expense' for banks", 26 March. 44. The draft legislation envisages a compensation model with fair economic incentives for all involved (e.g. consumers, merchants and banks) in line with the following principles: i) as a public good, a digital euro would be free of charge for basic use; ii) payment service providers would charge ---[PAGE_BREAK]--- merchants fees for providing digital euro-related services to offset the operational costs of distributing a digital euro, as is the case today for other digital means of payment. Payment service providers would also be able to develop additional digital euro services for their customers, on top of those required for basic use; iii) the fees that merchants pay payment service providers for digital euro services would be subject to a cap to provide adequate safeguards against excessive charges, as outlined by the European Commission in its legislative proposal on a digital euro; iv) as for the production of banknotes, the Eurosystem would bear the issuance costs. 45. See European Commission (2023), op. cit.. 46. A kernel is a core piece of software embedded in payment terminals that handles the processing of payment transactions. It ensures that the terminal can read and authenticate card or digital wallet data and communicate with the bank or payment network to approve or decline the transaction. Essentially, it manages the steps required to complete a secure payment. 47. See European Central Bank (2024), "Update on the work of the digital euro scheme's Rulebook Development Group", 5 September. 48. According to the Atlantic Council CBDC tracker, three countries have launched a retail CBDC, 35 are running pilots, 13 are in the development phase and 12 are conducting research. 49. See New York Times (2024), "Trump. Appealing to Bitcoin Fans. Vows U.S. Will Be 'Crypto Capital of the Planet'", 27 July. 50. The Eurosystem cash strategy aims to ensure that cash remains widely available and accepted as both a means of payment and a store of value. See also ECB (2023), "ECB selects "European culture" and "Rivers and birds" as possible themes for future euro banknotes", press release, 30 November. ---[PAGE_BREAK]--- # Directorate General Communications $>\quad$ Sonnemannstrasse 20 $>\quad 60314$ Frankfurt am Main, Germany $>\quad+496913447455$ $>\quad$ [email protected] Reproduction is permitted provided that the source is acknowledged. ## Media contacts Copyright 2024, European Central Bank	Piero Cipollone	Euro area	https://www.bis.org/review/r241014e.pdf	Vienna, 27 September 2024 Money plays a fundamental role in society, driving economic activity and enabling daily transactions. Given money's importance for our material and social well-being, the regulation of money has long been considered a cornerstone of state sovereignty. As the influential French jurist and political philosopher Jean Bodin observed in the 16th century, "only he who has the power to make law can regulate the coinage." Today, legislators continue to regulate the use of money and they have entrusted central banks with issuing public money and maintaining confidence in the monetary system. At the European Central Bank (ECB), we issue money that can be used to settle wholesale and retail transactions throughout the euro area, thereby guaranteeing the singleness of money across the monetary union. And we ensure that the euro remains a safe, stable and effective medium of exchange and store of value. This provides an essential anchor for the economy and the financial system. The Eurosystem has made significant progress in integrating wholesale transactions, largely thanks to the robust payment infrastructure it provides. The Eurosystem's real-time gross settlement system T2, for instance, processes a value close to the entire euro area GDP on a weekly basis, and it has established itself as a leading global payment system. In parallel, euro banknotes are accepted for retail payments across the euro area. They have become a symbol of European integration and freedom , uniting us and strengthening our collective identity as Europeans. But while central banks have long offered digital settlement in central bank money for wholesale transactions, we do not yet have a digital form of cash. This is becoming increasingly problematic because the use and acceptance of cash are declining. In the euro area, cash transactions have fallen below card transactions in value. The European Commission has therefore put forward a legislative proposal to ensure the acceptance of cash Still, the trend towards less use of banknotes for daily transactions is likely to continue, reflecting the digitalisation of economic activity and mirroring patterns observed in many advanced economies. Moreover, digital payments in the euro area remain fragmented, both along national lines and in terms of use cases. Current European digital payment solutions mainly cater to national markets and specific use cases. To pay across European countries, consumers have to rely on a few non-European providers, which now dominate most of these transactions. And even those providers' payment solutions are not accepted everywhere and do not cover all key use cases (payments in shops, from person to person and online). So a key objective of central bank money - to offer the public a means of payment backed by the sovereign authority that can be used for retail transactions across the jurisdiction - is not being fulfilled in the euro area's digital space. This is all the more awkward given that some euro area countries have made it mandatory to accept digital means of payment, for instance in a bid to combat tax evasion. In addition, European payments have become a prime example of the situation that Enrico Letta and Mario Draghi have described in their recent reports. means that Europe is not competitive within its own market, let alone on a global scale. Moreover, in an unstable geopolitical environment, we are being left to rely on companies based in other countries. Today's dependency on US companies could in future develop into reliance on companies from countries other than the United States. Platforms like Ant Group's Alipay have demonstrated their ability to bridge geographical gaps: during major events like UEFA EURO 2024 they were able to boost their payment app usage among customers in Europe. We must move swiftly to address the risks stemming from Europe's current inability to secure the integration and autonomy of its retail payment system. This is a key motivation behind the digital euro project: bringing central bank money into the digital age would provide a digital equivalent to banknotes and strengthen our monetary sovereignty. Today, I will outline the policy challenges we face as digitalisation reinforces the two-sided nature of the payments market. I will then discuss how the introduction of a digital euro could make a significant difference. By designing the digital euro to meet the diverse needs of consumers, merchants and payment service providers, we can ensure its widespread adoption. This, in turn, will empower us to pursue strategic goals such as innovation, integration and independence, ultimately enhancing our economic efficiency, resilience and sovereignty. To fully appreciate why we have been failing to overcome fragmentation and why the digital euro would be a game changer, we must first understand the structure of the retail payments market as a two-sided marketplace. Retail payment systems act as vital intermediaries connecting two key participants - merchants and consumers - whose transactions are facilitated by payment service providers. The defining feature of this marketplace is that interactions between participants generate network effects, where the value for each group increases as more participants join the other side. Consider the telephone system: its utility grows with each new user. However, on the downside, this also creates a challenging chicken-and-egg dilemma. Platforms need a critical mass of users to attract additional participants, but they struggle to achieve scale without that initial user base. That is why platforms with existing large user bases have an advantage in entering such markets. Indeed, the strength of network effects is amplified when platforms expand their range of activities, thereby broadening their user base. Technological innovation and the rise of digital platforms managed by major tech companies are expected to further exacerbate these dynamics. Big techs conduct business in finance in a unique way, drawing on three mutually reinforcing components: data analytics, network effects and interconnected activities. Network effects help big techs gather more data, which enhances their analytics. Better analytics improve services and attract more users, allowing them to offer more services and gather even more data. As a result, payment apps provided by big techs have become especially popular in emerging markets and developing economies. There is a risk that the closed-loop systems developed by successful online platforms and big tech companies could, in future, create a parallel economy with their own currencies and distinct units of account. At global level, big techs such as PayPal and Apple have developed highly successful ecosystems based on the closed-loop financial services model. By encouraging people to use their payment apps, these ecosystems effectively oblige them to use their payment rails. In parallel, payment platforms have tried to become more integrated in social media giants like WhatsApp and Meta However, while network effects can foster a virtuous cycle of economic growth, they also pose significant risks. In particular, walled gardens or lack of interoperability between various solutions can result in market fragmentation. Technology can be used to exclude competitors - for example, by preferencing a platform's own products or restricting competing services - and so can skew the competitive landscape in favour of a dominant player. And these dynamics could further raise the barriers to enter and grow in the two-sided payments market, stifling competition and making it even more difficult for European payment solutions to emerge on a pan-European scale. There is thus a risk that the current dynamics, where big tech companies seek to exploit the power of their platforms to expand in payments, could exacerbate the challenges facing the European retail payments market in terms of integration and the ability of European solutions to compete and innovate at scale. Since the creation of the monetary union, European policymakers have taken significant steps to foster the development of private European payment initiatives that span the euro area. The hope was that these initiatives could enhance competition within the European payments landscape, providing consumers and businesses with more choice and better services. From the launch of the Single Euro Payments Area to the recent adoption of the Instant Payments Regulation, the European Commission have worked with the private sector to support integration, innovation and the creation of a pan-European retail payment solution. Yet, despite these efforts, more than 30 years since the inception of the Single Market and 25 years since the launch of the single currency, most European retail payment solutions remain national in scope, addressing only limited use cases. Moreover, 13 out of 20 euro area countries rely entirely on non-European solutions in the absence of their own domestic payment scheme. As a result, people who live, work, travel or shop online in other euro area countries find themselves effectively dependent on two international card schemes, which enjoy strong market power. This situation discourages small businesses from expanding across borders or even into their national online markets, ultimately hindering the deepening of the Single Market. And paradoxically, the benefits from the efforts we make to lower the barriers to trade in European product markets may not fully reach consumers, as they are absorbed in the form of higher profits by the few international players that currently enable payments in stores and online across Europe. Rather than joining forces and sharing resources to develop successful pan-European solutions, national communities have often preferred to preserve the legacy of investments made in the past. Merchants - and consumers, to whom costs are eventually passed on - are left to deal with the consequences of the international card schemes' market dominance. For instance, the average net merchant service charges in the EU nearly doubled from $0.27 \%$ in 2018 to $0.44 \%$ in $2022 .{ }^{}$ This increase occurred despite regulatory efforts to contain it This situation has raised concerns among European businesses of all sizes. The fact that these issues are not unique to Europe offers little comfort, particularly when considering that, unlike in the United States, this situation poses a risk to our monetary sovereignty. The excessive dependence on foreign entities in the European payments sector threatens the autonomy and resilience of European payment services. Without decisive public action, this dependence is likely to worsen. New foreign players - including from China - are seeking to enter, or increase their footprint in, the European market. While foreign competition is welcome, we cannot be satisfied that Europeans do not have their own digital payments solution allowing them to pay throughout the euro area. And we need to be careful that foreign central bank digital currencies (CBDCs) do not end up eroding the international role of the euro, especially as some jurisdictions are thinking about allowing their CBDCs to be used abroad. The digital euro project is a crucial step towards enhancing Europe's payments landscape and safeguarding our monetary sovereignty. By ensuring everyone across the euro area would have access to central bank money in digital form, the project aims to provide tangible benefits to consumers, merchants and payment service providers alike. Complementing banknotes, the digital euro would offer all European citizens and firms the freedom to make and receive digital payments seamlessly. During my recent hearing before the European Parliament , I extensively discussed the benefits of the digital euro for consumers, particularly in terms of the convenience it would offer. The digital euro would provide a single, easy, secure and universally accepted public solution for digital payments in stores, online and from person to person. It would be available both online and offline. And it would be free for basic use. At the hearing, I also highlighted how the digital euro would provide merchants with seamless access to Europe's consumer base. Moreover, it would offer an alternative that would increase competition, thereby lowering transaction costs in a more direct way than regulations and competition authorities can. The digital euro would also generate broader benefits for the euro area economy by fostering competition and innovation. European payment service providers are finding it increasingly difficult to compete with international card schemes and e-payment solutions. For example, Apple Pay has significantly expanded its reach in Europe, capturing a portion of interchange fees, which represents a "significant expense" for issuing banks. As a result, banks risk missing out on not only interchange fees but also client relationships and user data. By contrast, the digital euro would ensure that distribution would remain with payment service providers, allowing them to maintain customer relationships and be compensated for their services, as is currently the case. It would also offer an alternative to co-branding with international card schemes for cross-border payments in - and potentially beyond - the euro area, thus promoting competition. The digital euro would also expand opportunities for payment service providers while reducing the cost of rolling out solutions on a European scale. In addition, it would cultivate an environment conducive to the widespread adoption of payment innovations throughout Europe. Currently, several innovations aimed at simplifying payments are emerging within specific national markets or across a few countries, driven by European payment service providers. Although these innovations are highly commendable and would enhance people's lives, existing structural barriers mean they would encounter considerable obstacles in trying to achieve pan-European scale. This fragmentation along national lines further impedes private participants' ability to achieve the scale required in a two-sided market like the payments market. What is the end result? By failing to implement large-scale innovations accessible to everyone in the euro area, these companies are unable to achieve the optimal scale needed for continuous investment in new technology. This limits their ability to compete effectively with the large international players who can fully leverage economies of scale, even on a global level. According to the European Commission's legislative proposal, the digital euro's legal tender status - which would require merchants to accept the digital euro for electronic payments - and mandatory distribution would help overcome the challenges of achieving sufficient scale in a two-sided marketplace by ensuring widespread accessibility and acceptance across the euro area. This legal tender status, combined with the digital euro rulebook, would establish common standards, which are not in place today. Let me use an example to explain this in simpler terms. At the moment, in-store payment terminals often use technology known as the "kernel", provided by Mastercard and Visa, to enable contactless (near field communication) transactions. Although domestic card schemes can currently access this technology for free, multi-country European card schemes cannot. Moreover, this free-ofcharge policy could change at any time. In the future, all stores would be required to accept the digital euro, meaning payment terminals would need to support its standard. According to the draft regulation, the standard would have to be made available for reuse by private parties, who could use it to develop their services. This would mean that all payment terminals in Europe that support digital euro transactions would be equipped with a scheme-agnostic kernel. This open system would be accessible to both regional and domestic European payment schemes, thereby allowing customers to make contactless payments throughout the euro area. This would advance a more integrated European payments market. As private providers expand their geographical footprint and diversify their product portfolios, they will benefit from cost efficiencies and be better positioned to compete internationally. In essence, the network effects generated by a digital euro would function as a public good, benefiting both public and private initiatives. This approach is akin to creating a unified European railway network or European energy grid, where various companies could competitively operate their own services and deliver added value to customers. Instead of requiring significant investment to expand existing services across the euro area, the open digital euro standards would facilitate cost-effective standardisation, making it possible for private retail payment solution providers to launch new products and functionalities on a broader scale. Ultimately, whether through the digital euro or private solutions, this standardised framework would unlock innovation, create new business opportunities and improve consumer access to a diverse range of goods and services. The design of the digital euro, as well as the key provision in the Regulation proposed by the European Commission, contains all the key elements required to make this vision a reality. Over the past years, we have extensively engaged with a multitude of market stakeholders, including through the Rulebook Development Group and the Euro Retail Payments Board, to shape the digital euro value proposition and prepare its implementation. We have collected and discussed the input of the payments ecosystem at large, including from representatives of consumers, merchants, banks and other payment service providers. In the coming months we will expand our cooperation with the private sector, focusing on three main themes: how to create a more competitive environment to encourage innovation and offer consumers more choice, how to best identify and leverage synergies to enhance efficiency and create mutually beneficial opportunities across the payments ecosystem, and how to strengthen the business models of all stakeholders, ensuring they can adapt and thrive in a rapidly evolving landscape. Each of these value drivers will be discussed in depth, taking into account the different roles in the payment chain, including those of issuing banks and third-party providers. By adopting this inclusive approach, we can ensure that everyone's needs and perspectives are addressed, paving the way for a more robust and dynamic payments system. Let me conclude. Money is key to sovereignty, a reality that resonates more than ever in the digital age. Some 63 countries are now operating, piloting, developing or exploring retail CBDCs. In this fast-moving environment, Europe cannot stand still. And the role of the ECB in issuing money that is accepted throughout the euro area is particularly crucial in a monetary union where payments markets remain fragmented along national lines. We are committed to ensuring that people in Europe can continue to use cash. However, we cannot stand by and watch as individuals are unable to use central bank money for their daily digital transactions. Bringing central bank money into a digitalised world through the digital euro would safeguard our monetary sovereignty in the digital age. It would overcome fragmentation by offering money that can be used for any digital payments in the euro area, foster competition and innovation by facilitating the development of pan-European payments services and strengthen our autonomy and resilience by helping us avoid becoming over-reliant on foreign payment solutions. Thank you for your attention. I would like to thank Alessandro Giovannini, Jean-Francois Jamet and Cyril Max Neumann for their help in preparing this speech, as well as Henk Esselink, Patrick Papsdorf, Benjamin Sahel, Doris Schneeberger, Erik Tak and Evelien Witlox for their comments. 2. 10 . "Alipay+ Expands Global Merchants Coverage for Partner E-Wallets in UEFA EURO 2024TM Summer Craze", 12 June. The draft legislation envisages a compensation model with fair economic incentives for all involved (e.g. consumers, merchants and banks) in line with the following principles: i) as a public good, a digital euro would be free of charge for basic use; ii) payment service providers would charge merchants fees for providing digital euro-related services to offset the operational costs of distributing a digital euro, as is the case today for other digital means of payment. Payment service providers would also be able to develop additional digital euro services for their customers, on top of those required for basic use; iii) the fees that merchants pay payment service providers for digital euro services would be subject to a cap to provide adequate safeguards against excessive charges, as outlined by the European Commission in its legislative proposal on a digital euro; iv) as for the production of banknotes, the Eurosystem would bear the issuance costs. $>\quad+496913447455$ $>\quad$ [email protected] Reproduction is permitted provided that the source is acknowledged. Copyright 2024, European Central Bank
2024-09-30T00:00:00	Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 30 September 2024.	Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 30 September 2024. * * * Charts accompanying the speech Transcript of the hearing It is a great pleasure to return to this Committee for the first time since the European elections. I very much look forward to my exchanges with all of you, new and not-sonew members, over the course of this parliamentary term. First, let me congratulate each of you on your election to this Parliament. Europe faces significant challenges, and critical decisions will need to be taken over the next five years. Your work will be crucial in guiding us forward. As Members of the European Parliament, you play an essential role in channelling citizens' questions and concerns about the ECB's policies. I am committed to maintaining an open dialogue with you, building on the positive and constructive relationship between our two institutions. By working together, we can fulfil our joint accountability obligations under the Treaty and build trust in the ECB. In my remarks today, I will start by providing an update on the euro area's economic outlook and the ECB's monetary policy stance, the first topic you have selected for today's hearing. I will then discuss the need to advance the capital markets union - the second topic you have chosen. The outlook for the euro area economy Economic activity has recovered slowly since the end of the pandemic. The postpandemic reopening allowed the euro area economy to grow during the first nine months of 2022, but economic activity broadly stagnated thereafter. This was due, among other factors, to the energy price shock following Russia's invasion of Ukraine and the increased geopolitical uncertainty, but also to the tightening of our monetary policy. Growth resumed in early 2024. The euro area economy grew by 0.2% in the second quarter, after 0.3% in the first quarter. However, growth in the second quarter stemmed mainly from exports and government consumption. Domestic demand remained weak as households consumed less, firms cut business investment and housing investment dropped. The services sector is holding up, with signs of deceleration, while activity in the manufacturing and construction sectors remains subdued. Looking ahead, the suppressed level of some survey indicators suggests that the recovery is facing headwinds. We expect the recovery to strengthen over time, as rising real incomes should allow households to consume more. The latest ECB staff projections foresee the economy growing by 0.8% in 2024, 1.3% in 2025 and 1.5% in 2026. The labour market remains resilient, with the unemployment rate standing at 6.4% in July - broadly unchanged over the past year. At the same time, employment growth slowed to just 0.2% in the second quarter, and recent indicators point to a further deceleration in the coming quarters. According to ECB staff, the unemployment rate is projected to remain around its current low level. Turning to price developments, disinflation has been accelerating over the last two months. Headline inflation fell to 2.2% in August 2024 and is expected to drop further in September, mainly on account of falling energy costs. Core inflation - excluding energy and food - edged down to 2.8% in August driven by a decline in goods inflation that outweighed an increase in services inflation. The indicator of domestic inflation, which only includes items with a low import intensity, remained high in August as wages continued to grow at an elevated pace. At the same time, the overall growth in labour costs has been moderating in recent quarters, and profits have been buffering the impact of higher wages on inflation. Looking ahead, inflation might temporarily increase in the fourth quarter of this year as previous sharp falls in energy prices drop out of the annual rates, but the latest developments strengthen our confidence that inflation will return to target in a timely manner. We will take that into account in our next monetary policy meeting in October. The ECB staff projections from September foresee inflation to average 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. The ECB's monetary policy stance Let me now turn to our monetary policy stance - the first topic chosen for today's hearing. We have come a long way in the fight against inflation. In October 2022 inflation peaked at 10.6%. By September 2023, the last time we raised interest rates, it had dropped by more than half, to 5.2%. The decline in inflation and the anchoring of longer-term inflation expectations showed that our strong response was bearing fruit. Then, after nine months of holding rates steady, we saw inflation halve again to 2.6% in June when we started lowering interest rates. The new data available at the time of the September Governing Council meeting reinforced our confidence in the timely return of inflation to our 2% target. We therefore lowered the rate on the deposit facility, which is the rate through which we steer the monetary policy stance, by another 25 basis points to 3.5%. We are determined to ensure that inflation returns to our 2% medium-term target in a timely manner. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction, focusing on the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. Policy rates will be kept sufficiently restrictive for as long as necessary to achieve our aim. We are not pre-committing to a particular rate path. Moreover, as we announced on 13 March 2024, some changes to the operational 1 framework for implementing monetary policy took effect from 18 September. In particular, the spread between the interest rate on the main refinancing operations and the deposit facility rate was set at 15 basis points. The aim is to steer short-term money market rates more closely in line with monetary policy decisions. In parallel to our policy deliberations, we have also launched an assessment of our monetary policy strategy. This assessment will be more limited in scope than our last review, which we completed in July 2021, and will include two work streams. One work stream will focus on the changed inflation environment and the other on the implications for our monetary policy strategy, including what we can learn from the periods of both low and high inflation. We expect to conclude the assessment in the second half of 2025 and I intend to keep you informed in our regular hearings and interactions. Advancing capital markets union Let me now turn to the second topic of this hearing - the capital markets union. The ECB has long emphasised the need for progress in this area to integrate our fragmented markets and thus foster risk diversification and shock absorption across the EU. Doing so would support financial stability and facilitate the transmission of monetary policy. But a deep and integrated single market for capital is also essential for achieving some of the EU's other key goals, from financing the green and digital transitions to enabling savers to earn higher returns. Additionally, young and innovative firms need to grow and become more productive, which will ultimately benefit all Europeans. For the time being, however, a lack of access to equity financing is a key factor holding these firms back. Advancing the capital markets union must therefore be a cornerstone of the EU's competitiveness strategy. Significant efforts have been made over the past decade to move forwards, and I want to pay tribute to the role the European Parliament has played in promoting an ambitious, European approach. But vested interests and competing national priorities have hampered progress. Now, at the beginning of a new legislative term, we are at a crossroads. The current political momentum needs to be converted into a concrete agenda with clear priorities. And this agenda must be swiftly followed up with genuine actions. The ECB's Governing Council laid out its priorities for European capital markets in a 2 statement in March. Let me highlight three key areas where progress is essential. First, we must improve the way we save in Europe. In 2022, European household 3 savings exceeded EUR 1.1 trillion. However, around a third of these savings are held 4 in deposits - significantly more than in the United States. Mobilizing even a small portion of these funds and investing them in European capital markets could greatly contribute to the more than EUR 700 billion needed annually to achieve the EU's key strategic objectives. This is also likely to provide better long-term returns for our citizens while improving European companies' access to equity finance. Second, we need a single regulatory and supervisory ecosystem that promotes market integration. And third, for EU capital markets to be more attractive to investors and issuers, they need to achieve greater scale and depth. This can only happen through integration - especially in our trading and post-trading infrastructure. Conclusion To conclude - the world is changing rapidly, and Europe is falling behind. The diagnosis and the remedy are clear - the EU must come together and address its structural challenges to increase its competitiveness. Advancing the capital markets union is an important part of this agenda, but not the only one. Significant efforts to boost Europe's economic resilience and decarbonise the economy will also be needed. This will require substantial investment in the coming years, which needs to come from both private and public sources. Progress in these areas will not only enhance Europe's ability to withstand future economic shocks, but also help the ECB to maintain price stability. As Jacques Chirac once observed, "The construction of Europe is an art. It is the art of the possible." This Parliament has found ways to push Europe forwards before, and I trust you will do so again. The future of Europe is in your hands. Thank you for your attention - I look forward to your questions and to engaging with you throughout what will be a decisive period for Europe. 1 ECB (2024), "Changes to the operational framework for implementing monetary policy ", ECB, press release , 13 March. 2 ECB (2024), "Statement by the ECB Governing Council on advancing the Capital Markets Union", 7 March. Eurostat and European Commission (2024), "The future of European competitiveness: A competitiveness strategy for Europe ". 4 Approximation based on Eurostat, ECB, and OECD data.	---[PAGE_BREAK]--- # Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 30 September 2024. Charts accompanying the speech Transcript of the hearing It is a great pleasure to return to this Committee for the first time since the European elections. I very much look forward to my exchanges with all of you, new and not-sonew members, over the course of this parliamentary term. First, let me congratulate each of you on your election to this Parliament. Europe faces significant challenges, and critical decisions will need to be taken over the next five years. Your work will be crucial in guiding us forward. As Members of the European Parliament, you play an essential role in channelling citizens' questions and concerns about the ECB's policies. I am committed to maintaining an open dialogue with you, building on the positive and constructive relationship between our two institutions. By working together, we can fulfil our joint accountability obligations under the Treaty and build trust in the ECB. In my remarks today, I will start by providing an update on the euro area's economic outlook and the ECB's monetary policy stance, the first topic you have selected for today's hearing. I will then discuss the need to advance the capital markets union - the second topic you have chosen. ## The outlook for the euro area economy Economic activity has recovered slowly since the end of the pandemic. The postpandemic reopening allowed the euro area economy to grow during the first nine months of 2022, but economic activity broadly stagnated thereafter. This was due, among other factors, to the energy price shock following Russia's invasion of Ukraine and the increased geopolitical uncertainty, but also to the tightening of our monetary policy. Growth resumed in early 2024. The euro area economy grew by $0.2 \%$ in the second quarter, after $0.3 \%$ in the first quarter. However, growth in the second quarter stemmed mainly from exports and government consumption. Domestic demand remained weak as households consumed less, firms cut business investment and housing investment dropped. The services sector is holding up, with signs of deceleration, while activity in the manufacturing and construction sectors remains subdued. ---[PAGE_BREAK]--- Looking ahead, the suppressed level of some survey indicators suggests that the recovery is facing headwinds. We expect the recovery to strengthen over time, as rising real incomes should allow households to consume more. The latest ECB staff projections foresee the economy growing by $0.8 \%$ in 2024, $1.3 \%$ in 2025 and $1.5 \%$ in 2026. The labour market remains resilient, with the unemployment rate standing at $6.4 \%$ in July - broadly unchanged over the past year. At the same time, employment growth slowed to just $0.2 \%$ in the second quarter, and recent indicators point to a further deceleration in the coming quarters. According to ECB staff, the unemployment rate is projected to remain around its current low level. Turning to price developments, disinflation has been accelerating over the last two months. Headline inflation fell to $2.2 \%$ in August 2024 and is expected to drop further in September, mainly on account of falling energy costs. Core inflation - excluding energy and food - edged down to $2.8 \%$ in August driven by a decline in goods inflation that outweighed an increase in services inflation. The indicator of domestic inflation, which only includes items with a low import intensity, remained high in August as wages continued to grow at an elevated pace. At the same time, the overall growth in labour costs has been moderating in recent quarters, and profits have been buffering the impact of higher wages on inflation. Looking ahead, inflation might temporarily increase in the fourth quarter of this year as previous sharp falls in energy prices drop out of the annual rates, but the latest developments strengthen our confidence that inflation will return to target in a timely manner. We will take that into account in our next monetary policy meeting in October. The ECB staff projections from September foresee inflation to average 2.5\% in 2024, $2.2 \%$ in 2025 and $1.9 \%$ in 2026. # The ECB's monetary policy stance Let me now turn to our monetary policy stance - the first topic chosen for today's hearing. We have come a long way in the fight against inflation. In October 2022 inflation peaked at $10.6 \%$. By September 2023, the last time we raised interest rates, it had dropped by more than half, to $5.2 \%$. The decline in inflation and the anchoring of longer-term inflation expectations showed that our strong response was bearing fruit. Then, after nine months of holding rates steady, we saw inflation halve again to $2.6 \%$ in June when we started lowering interest rates. The new data available at the time of the September Governing Council meeting reinforced our confidence in the timely return of inflation to our $2 \%$ target. We therefore lowered the rate on the deposit facility, which is the rate through which we steer the monetary policy stance, by another 25 basis points to $3.5 \%$. We are determined to ensure that inflation returns to our $2 \%$ medium-term target in a timely manner. We will continue to follow a data-dependent approach to determining the ---[PAGE_BREAK]--- appropriate level and duration of restriction, focusing on the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. Policy rates will be kept sufficiently restrictive for as long as necessary to achieve our aim. We are not pre-committing to a particular rate path. Moreover, as we announced on 13 March 2024, some changes to the operational framework for implementing monetary policy took effect from 18 September. ${ }^{1}$ In particular, the spread between the interest rate on the main refinancing operations and the deposit facility rate was set at 15 basis points. The aim is to steer short-term money market rates more closely in line with monetary policy decisions. In parallel to our policy deliberations, we have also launched an assessment of our monetary policy strategy. This assessment will be more limited in scope than our last review, which we completed in July 2021, and will include two work streams. One work stream will focus on the changed inflation environment and the other on the implications for our monetary policy strategy, including what we can learn from the periods of both low and high inflation. We expect to conclude the assessment in the second half of 2025 and I intend to keep you informed in our regular hearings and interactions. # Advancing capital markets union Let me now turn to the second topic of this hearing - the capital markets union. The ECB has long emphasised the need for progress in this area to integrate our fragmented markets and thus foster risk diversification and shock absorption across the EU. Doing so would support financial stability and facilitate the transmission of monetary policy. But a deep and integrated single market for capital is also essential for achieving some of the EU's other key goals, from financing the green and digital transitions to enabling savers to earn higher returns. Additionally, young and innovative firms need to grow and become more productive, which will ultimately benefit all Europeans. For the time being, however, a lack of access to equity financing is a key factor holding these firms back. Advancing the capital markets union must therefore be a cornerstone of the EU's competitiveness strategy. Significant efforts have been made over the past decade to move forwards, and I want to pay tribute to the role the European Parliament has played in promoting an ambitious, European approach. But vested interests and competing national priorities have hampered progress. Now, at the beginning of a new legislative term, we are at a crossroads. The current political momentum needs to be converted into a concrete agenda with clear priorities. And this agenda must be swiftly followed up with genuine actions. ---[PAGE_BREAK]--- The ECB's Governing Council laid out its priorities for European capital markets in a statement in March. ${ }^{2}$ Let me highlight three key areas where progress is essential. First, we must improve the way we save in Europe. In 2022, European household savings exceeded EUR 1.1 trillion. ${ }^{3}$ However, around a third of these savings are held in deposits ${ }^{4}$ - significantly more than in the United States. Mobilizing even a small portion of these funds and investing them in European capital markets could greatly contribute to the more than EUR 700 billion needed annually to achieve the EU's key strategic objectives. This is also likely to provide better long-term returns for our citizens while improving European companies' access to equity finance. Second, we need a single regulatory and supervisory ecosystem that promotes market integration. And third, for EU capital markets to be more attractive to investors and issuers, they need to achieve greater scale and depth. This can only happen through integration especially in our trading and post-trading infrastructure. # Conclusion To conclude - the world is changing rapidly, and Europe is falling behind. The diagnosis and the remedy are clear - the EU must come together and address its structural challenges to increase its competitiveness. Advancing the capital markets union is an important part of this agenda, but not the only one. Significant efforts to boost Europe's economic resilience and decarbonise the economy will also be needed. This will require substantial investment in the coming years, which needs to come from both private and public sources. Progress in these areas will not only enhance Europe's ability to withstand future economic shocks, but also help the ECB to maintain price stability. As Jacques Chirac once observed, "The construction of Europe is an art. It is the art of the possible." This Parliament has found ways to push Europe forwards before, and I trust you will do so again. The future of Europe is in your hands. Thank you for your attention - I look forward to your questions and to engaging with you throughout what will be a decisive period for Europe. [^0] [^0]: ${ }^{1}$ ECB (2024), "Changes to the operational framework for implementing monetary policy ", ECB, press release, 13 March. ${ }^{2}$ ECB (2024), "Statement by the ECB Governing Council on advancing the Capital Markets Union", 7 March. ---[PAGE_BREAK]--- ${ }^{3}$ Eurostat and European Commission (2024), "The future of European competitiveness: A competitiveness strategy for Europe". ${ }^{4}$ Approximation based on Eurostat, ECB, and OECD data.	Christine Lagarde	Euro area	https://www.bis.org/review/r241014c.pdf	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 30 September 2024. Charts accompanying the speech Transcript of the hearing It is a great pleasure to return to this Committee for the first time since the European elections. I very much look forward to my exchanges with all of you, new and not-sonew members, over the course of this parliamentary term. First, let me congratulate each of you on your election to this Parliament. Europe faces significant challenges, and critical decisions will need to be taken over the next five years. Your work will be crucial in guiding us forward. As Members of the European Parliament, you play an essential role in channelling citizens' questions and concerns about the ECB's policies. I am committed to maintaining an open dialogue with you, building on the positive and constructive relationship between our two institutions. By working together, we can fulfil our joint accountability obligations under the Treaty and build trust in the ECB. In my remarks today, I will start by providing an update on the euro area's economic outlook and the ECB's monetary policy stance, the first topic you have selected for today's hearing. I will then discuss the need to advance the capital markets union - the second topic you have chosen. Economic activity has recovered slowly since the end of the pandemic. The postpandemic reopening allowed the euro area economy to grow during the first nine months of 2022, but economic activity broadly stagnated thereafter. This was due, among other factors, to the energy price shock following Russia's invasion of Ukraine and the increased geopolitical uncertainty, but also to the tightening of our monetary policy. Growth resumed in early 2024. The euro area economy grew by $0.2 \%$ in the second quarter, after $0.3 \%$ in the first quarter. However, growth in the second quarter stemmed mainly from exports and government consumption. Domestic demand remained weak as households consumed less, firms cut business investment and housing investment dropped. The services sector is holding up, with signs of deceleration, while activity in the manufacturing and construction sectors remains subdued. Looking ahead, the suppressed level of some survey indicators suggests that the recovery is facing headwinds. We expect the recovery to strengthen over time, as rising real incomes should allow households to consume more. The latest ECB staff projections foresee the economy growing by $0.8 \%$ in 2024, $1.3 \%$ in 2025 and $1.5 \%$ in 2026. The labour market remains resilient, with the unemployment rate standing at $6.4 \%$ in July - broadly unchanged over the past year. At the same time, employment growth slowed to just $0.2 \%$ in the second quarter, and recent indicators point to a further deceleration in the coming quarters. According to ECB staff, the unemployment rate is projected to remain around its current low level. Turning to price developments, disinflation has been accelerating over the last two months. Headline inflation fell to $2.2 \%$ in August 2024 and is expected to drop further in September, mainly on account of falling energy costs. Core inflation - excluding energy and food - edged down to $2.8 \%$ in August driven by a decline in goods inflation that outweighed an increase in services inflation. The indicator of domestic inflation, which only includes items with a low import intensity, remained high in August as wages continued to grow at an elevated pace. At the same time, the overall growth in labour costs has been moderating in recent quarters, and profits have been buffering the impact of higher wages on inflation. Looking ahead, inflation might temporarily increase in the fourth quarter of this year as previous sharp falls in energy prices drop out of the annual rates, but the latest developments strengthen our confidence that inflation will return to target in a timely manner. We will take that into account in our next monetary policy meeting in October. The ECB staff projections from September foresee inflation to average 2.5\% in 2024, $2.2 \%$ in 2025 and $1.9 \%$ in 2026. Let me now turn to our monetary policy stance - the first topic chosen for today's hearing. We have come a long way in the fight against inflation. In October 2022 inflation peaked at $10.6 \%$. By September 2023, the last time we raised interest rates, it had dropped by more than half, to $5.2 \%$. The decline in inflation and the anchoring of longer-term inflation expectations showed that our strong response was bearing fruit. Then, after nine months of holding rates steady, we saw inflation halve again to $2.6 \%$ in June when we started lowering interest rates. The new data available at the time of the September Governing Council meeting reinforced our confidence in the timely return of inflation to our $2 \%$ target. We therefore lowered the rate on the deposit facility, which is the rate through which we steer the monetary policy stance, by another 25 basis points to $3.5 \%$. We are determined to ensure that inflation returns to our $2 \%$ medium-term target in a timely manner. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction, focusing on the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. Policy rates will be kept sufficiently restrictive for as long as necessary to achieve our aim. We are not pre-committing to a particular rate path. Moreover, as we announced on 13 March 2024, some changes to the operational framework for implementing monetary policy took effect from 18 September. In particular, the spread between the interest rate on the main refinancing operations and the deposit facility rate was set at 15 basis points. The aim is to steer short-term money market rates more closely in line with monetary policy decisions. In parallel to our policy deliberations, we have also launched an assessment of our monetary policy strategy. This assessment will be more limited in scope than our last review, which we completed in July 2021, and will include two work streams. One work stream will focus on the changed inflation environment and the other on the implications for our monetary policy strategy, including what we can learn from the periods of both low and high inflation. We expect to conclude the assessment in the second half of 2025 and I intend to keep you informed in our regular hearings and interactions. Let me now turn to the second topic of this hearing - the capital markets union. The ECB has long emphasised the need for progress in this area to integrate our fragmented markets and thus foster risk diversification and shock absorption across the EU. Doing so would support financial stability and facilitate the transmission of monetary policy. But a deep and integrated single market for capital is also essential for achieving some of the EU's other key goals, from financing the green and digital transitions to enabling savers to earn higher returns. Additionally, young and innovative firms need to grow and become more productive, which will ultimately benefit all Europeans. For the time being, however, a lack of access to equity financing is a key factor holding these firms back. Advancing the capital markets union must therefore be a cornerstone of the EU's competitiveness strategy. Significant efforts have been made over the past decade to move forwards, and I want to pay tribute to the role the European Parliament has played in promoting an ambitious, European approach. But vested interests and competing national priorities have hampered progress. Now, at the beginning of a new legislative term, we are at a crossroads. The current political momentum needs to be converted into a concrete agenda with clear priorities. And this agenda must be swiftly followed up with genuine actions. The ECB's Governing Council laid out its priorities for European capital markets in a statement in March. Let me highlight three key areas where progress is essential. First, we must improve the way we save in Europe. In 2022, European household savings exceeded EUR 1.1 trillion. - significantly more than in the United States. Mobilizing even a small portion of these funds and investing them in European capital markets could greatly contribute to the more than EUR 700 billion needed annually to achieve the EU's key strategic objectives. This is also likely to provide better long-term returns for our citizens while improving European companies' access to equity finance. Second, we need a single regulatory and supervisory ecosystem that promotes market integration. And third, for EU capital markets to be more attractive to investors and issuers, they need to achieve greater scale and depth. This can only happen through integration especially in our trading and post-trading infrastructure. To conclude - the world is changing rapidly, and Europe is falling behind. The diagnosis and the remedy are clear - the EU must come together and address its structural challenges to increase its competitiveness. Advancing the capital markets union is an important part of this agenda, but not the only one. Significant efforts to boost Europe's economic resilience and decarbonise the economy will also be needed. This will require substantial investment in the coming years, which needs to come from both private and public sources. Progress in these areas will not only enhance Europe's ability to withstand future economic shocks, but also help the ECB to maintain price stability. As Jacques Chirac once observed, "The construction of Europe is an art. It is the art of the possible." This Parliament has found ways to push Europe forwards before, and I trust you will do so again. The future of Europe is in your hands. Thank you for your attention - I look forward to your questions and to engaging with you throughout what will be a decisive period for Europe.
2024-09-30T00:00:00	Jerome H Powell: Economic outlook	Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the National Association for Business Economics Annual Meeting, Nashville, Tennessee, 30 September 2024.	Jerome H Powell: Economic outlook Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the National Association for Business Economics Annual Meeting, Nashville, Tennessee, 30 September 2024. * * * I have some brief comments on the economy and monetary policy and look forward to our discussion. Our economy is strong overall and has made significant progress over the past two years toward achieving our dual-mandate goals of maximum employment and stable prices. Labor market conditions are solid, having cooled from their previously overheated state. Inflation has eased, and my Federal Open Market Committee colleagues and I have greater confidence that it is on a sustainable path to 2 percent. At our meeting earlier this month, we reduced the level of policy restraint by lowering the target range of the federal funds rate by 1/2 percentage point. That decision reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in an environment of moderate economic growth and inflation moving sustainably down to our objective. Recent Economic Data The labor market Many indicators show the labor market is solid. To mention just a few, the unemployment rate is well within the range of estimates of its natural rate. Layoffs are low. The labor force participation rate of individuals aged 25 to 54 (so-called prime age) is near its historic high, and the prime-age women's participation rate has continued to reach new all-time highs. Real wages are increasing at a solid pace, broadly in line with gains in productivity. The ratio of job openings to unemployed workers has moved down steadily but remains just above 1-so that there are still more open positions than there are people seeking work. Prior to 2019, that was rarely the case. Still, labor market conditions have clearly cooled over the past year. Workers now view jobs as somewhat less available than they were in 2019. The moderation in job growth and the increase in labor supply have led the unemployment rate to increase to 4.2 percent, still low by historical standards. We do not believe that we need to see further cooling in labor market conditions to achieve 2 percent inflation. Inflation Over the most recent 12 months, headline and core inflation were 2.2 percent and 2.7 percent, respectively. Disinflation has been broad based, and recent data indicate further progress toward a sustained return to 2 percent. Core goods prices have fallen 0.5 percent over the past year, close to their pre-pandemic pace, as supply bottlenecks have eased. Outside of housing, core services inflation is also close to its pre-pandemic pace. Housing services inflation continues to decline, but sluggishly. The growth rate in rents charged to new tenants remains low. As long as that remains the case, housing services inflation will continue to decline. Broader economic conditions also set the table for further disinflation. The labor market is now roughly in balance. Longer-run inflation expectations remain well anchored. Monetary Policy Over the past year, we have continued to see solid growth and healthy gains in the labor force and productivity. Our goal all along has been to restore price stability without the kind of painful rise in unemployment that has frequently accompanied efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. For much of the past three years, inflation ran well above our goal, and the labor market was extremely tight. Appropriately, our focus was on bringing down inflation. By keeping monetary policy restrictive, we helped restore the balance between overall supply and demand in the economy. That patient approach has paid dividends: Inflation is now much closer to our 2 percent objective. Today, we see the risks to achieving our employment and inflation goals as roughly in balance. Our policy rate had been at a two-decade high since the July 2023 meeting. At the time of that meeting, core inflation was above 4 percent, well above our target, and unemployment was 3.5 percent, near a 50-year low. In the 14 months since, inflation has moved down, and unemployment has moved up, in both cases significantly. It was time for a recalibration of our policy stance to reflect progress toward our goals as well as the changed balance of risks. As I mentioned, our decision to reduce our policy rate by 50 basis points reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in a context of moderate economic growth and inflation moving sustainably down to 2 percent. Looking forward, if the economy evolves broadly as expected, policy will move over time toward a more neutral stance. But we are not on any preset course. The risks are two-sided, and we will continue to make our decisions meeting by meeting. As we consider additional policy adjustments, we will carefully assess incoming data, the evolving outlook, and the balance of risks. Overall, the economy is in solid shape; we intend to use our tools to keep it there. We remain resolute in our commitment to our maximum-employment and price-stability mandates. Everything we do is in service to our public mission. Thank you. I look forward to our conversation.	---[PAGE_BREAK]--- # Jerome H Powell: Economic outlook Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the National Association for Business Economics Annual Meeting, Nashville, Tennessee, 30 September 2024. I have some brief comments on the economy and monetary policy and look forward to our discussion. Our economy is strong overall and has made significant progress over the past two years toward achieving our dual-mandate goals of maximum employment and stable prices. Labor market conditions are solid, having cooled from their previously overheated state. Inflation has eased, and my Federal Open Market Committee colleagues and I have greater confidence that it is on a sustainable path to 2 percent. At our meeting earlier this month, we reduced the level of policy restraint by lowering the target range of the federal funds rate by $1 / 2$ percentage point. That decision reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in an environment of moderate economic growth and inflation moving sustainably down to our objective. ## Recent Economic Data ## The labor market Many indicators show the labor market is solid. To mention just a few, the unemployment rate is well within the range of estimates of its natural rate. Layoffs are low. The labor force participation rate of individuals aged 25 to 54 (so-called prime age) is near its historic high, and the prime-age women's participation rate has continued to reach new all-time highs. Real wages are increasing at a solid pace, broadly in line with gains in productivity. The ratio of job openings to unemployed workers has moved down steadily but remains just above 1 -so that there are still more open positions than there are people seeking work. Prior to 2019, that was rarely the case. Still, labor market conditions have clearly cooled over the past year. Workers now view jobs as somewhat less available than they were in 2019. The moderation in job growth and the increase in labor supply have led the unemployment rate to increase to 4.2 percent, still low by historical standards. We do not believe that we need to see further cooling in labor market conditions to achieve 2 percent inflation. ## Inflation Over the most recent 12 months, headline and core inflation were 2.2 percent and 2.7 percent, respectively. Disinflation has been broad based, and recent data indicate further progress toward a sustained return to 2 percent. Core goods prices have fallen 0.5 percent over the past year, close to their pre-pandemic pace, as supply bottlenecks have eased. Outside of housing, core services inflation is also close to its pre-pandemic pace. Housing services inflation continues to decline, but sluggishly. The growth rate in rents charged to new tenants remains low. As long as that remains the case, housing services inflation will continue to decline. ---[PAGE_BREAK]--- Broader economic conditions also set the table for further disinflation. The labor market is now roughly in balance. Longer-run inflation expectations remain well anchored. # Monetary Policy Over the past year, we have continued to see solid growth and healthy gains in the labor force and productivity. Our goal all along has been to restore price stability without the kind of painful rise in unemployment that has frequently accompanied efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. For much of the past three years, inflation ran well above our goal, and the labor market was extremely tight. Appropriately, our focus was on bringing down inflation. By keeping monetary policy restrictive, we helped restore the balance between overall supply and demand in the economy. That patient approach has paid dividends: Inflation is now much closer to our 2 percent objective. Today, we see the risks to achieving our employment and inflation goals as roughly in balance. Our policy rate had been at a two-decade high since the July 2023 meeting. At the time of that meeting, core inflation was above 4 percent, well above our target, and unemployment was 3.5 percent, near a 50-year low. In the 14 months since, inflation has moved down, and unemployment has moved up, in both cases significantly. It was time for a recalibration of our policy stance to reflect progress toward our goals as well as the changed balance of risks. As I mentioned, our decision to reduce our policy rate by 50 basis points reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in a context of moderate economic growth and inflation moving sustainably down to 2 percent. Looking forward, if the economy evolves broadly as expected, policy will move over time toward a more neutral stance. But we are not on any preset course. The risks are two-sided, and we will continue to make our decisions meeting by meeting. As we consider additional policy adjustments, we will carefully assess incoming data, the evolving outlook, and the balance of risks. Overall, the economy is in solid shape; we intend to use our tools to keep it there. We remain resolute in our commitment to our maximum-employment and price-stability mandates. Everything we do is in service to our public mission. Thank you. I look forward to our conversation.	Jerome H Powell	United States	https://www.bis.org/review/r241001d.pdf	Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the National Association for Business Economics Annual Meeting, Nashville, Tennessee, 30 September 2024. I have some brief comments on the economy and monetary policy and look forward to our discussion. Our economy is strong overall and has made significant progress over the past two years toward achieving our dual-mandate goals of maximum employment and stable prices. Labor market conditions are solid, having cooled from their previously overheated state. Inflation has eased, and my Federal Open Market Committee colleagues and I have greater confidence that it is on a sustainable path to 2 percent. At our meeting earlier this month, we reduced the level of policy restraint by lowering the target range of the federal funds rate by $1 / 2$ percentage point. That decision reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in an environment of moderate economic growth and inflation moving sustainably down to our objective. Many indicators show the labor market is solid. To mention just a few, the unemployment rate is well within the range of estimates of its natural rate. Layoffs are low. The labor force participation rate of individuals aged 25 to 54 (so-called prime age) is near its historic high, and the prime-age women's participation rate has continued to reach new all-time highs. Real wages are increasing at a solid pace, broadly in line with gains in productivity. The ratio of job openings to unemployed workers has moved down steadily but remains just above 1 -so that there are still more open positions than there are people seeking work. Prior to 2019, that was rarely the case. Still, labor market conditions have clearly cooled over the past year. Workers now view jobs as somewhat less available than they were in 2019. The moderation in job growth and the increase in labor supply have led the unemployment rate to increase to 4.2 percent, still low by historical standards. We do not believe that we need to see further cooling in labor market conditions to achieve 2 percent inflation. Over the most recent 12 months, headline and core inflation were 2.2 percent and 2.7 percent, respectively. Disinflation has been broad based, and recent data indicate further progress toward a sustained return to 2 percent. Core goods prices have fallen 0.5 percent over the past year, close to their pre-pandemic pace, as supply bottlenecks have eased. Outside of housing, core services inflation is also close to its pre-pandemic pace. Housing services inflation continues to decline, but sluggishly. The growth rate in rents charged to new tenants remains low. As long as that remains the case, housing services inflation will continue to decline. Broader economic conditions also set the table for further disinflation. The labor market is now roughly in balance. Longer-run inflation expectations remain well anchored. Over the past year, we have continued to see solid growth and healthy gains in the labor force and productivity. Our goal all along has been to restore price stability without the kind of painful rise in unemployment that has frequently accompanied efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. For much of the past three years, inflation ran well above our goal, and the labor market was extremely tight. Appropriately, our focus was on bringing down inflation. By keeping monetary policy restrictive, we helped restore the balance between overall supply and demand in the economy. That patient approach has paid dividends: Inflation is now much closer to our 2 percent objective. Today, we see the risks to achieving our employment and inflation goals as roughly in balance. Our policy rate had been at a two-decade high since the July 2023 meeting. At the time of that meeting, core inflation was above 4 percent, well above our target, and unemployment was 3.5 percent, near a 50-year low. In the 14 months since, inflation has moved down, and unemployment has moved up, in both cases significantly. It was time for a recalibration of our policy stance to reflect progress toward our goals as well as the changed balance of risks. As I mentioned, our decision to reduce our policy rate by 50 basis points reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in a context of moderate economic growth and inflation moving sustainably down to 2 percent. Looking forward, if the economy evolves broadly as expected, policy will move over time toward a more neutral stance. But we are not on any preset course. The risks are two-sided, and we will continue to make our decisions meeting by meeting. As we consider additional policy adjustments, we will carefully assess incoming data, the evolving outlook, and the balance of risks. Overall, the economy is in solid shape; we intend to use our tools to keep it there. We remain resolute in our commitment to our maximum-employment and price-stability mandates. Everything we do is in service to our public mission. Thank you. I look forward to our conversation.
2024-10-01T00:00:00	Lisa D Cook: Artificial intelligence, big data, and the path ahead for productivity	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work" conference, organised by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, Georgia, 1 October 2024.	For release on delivery 11:10 a.m. EDT October 1, 2024 Artificial Intelligence, Big Data, and the Path Ahead for Productivity Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond Atlanta, Georgia October 1, 2024 Thank you, President Bostic. Let me start by saying my thoughts are with all the people of Florida, Georgia, North Carolina, South Carolina, Tennessee and the other communities who have felt the force of Helene's impact. I am saddened by the tragic loss of life and widespread disruption in these regions served by the Federal Reserve Banks of Atlanta and Richmond. As Chair Powell said yesterday, we at the Fed are encouraging banks to work with customers in affected areas and we are working to support the Reserve Banks to ensure there are ample cash supplies, which can be especially important during times of power outages. I am always happy to be in Atlanta, in Georgia, and at the Federal Reserve Bank of Atlanta. I grew up in Georgia, and I am a proud graduate of Spelman College. Atlanta is an appropriate place to speak about today's topic, artificial intelligence (AI), as it is in the midst of large corporations and startups developing uses for AI and near so many impressive schools, including Georgia Tech, a top AI research university and where I took courses to prepare for a Ph.D. in economics. Our tech entrepreneurship and AI roundtable with Chair Powell, held at Spelman last year, is a testament to Atlanta being such a locus of activity. Today, I will speak to you about AI, big data, and the path ahead for productivity.1 My comments today will build upon what I offered a year ago at the NBER AI meeting in Toronto, when I emphasized the importance of business decision- 1 The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. - 2 - making in our progress along that path.2 Technology alone will not determine the outcome. Futurists have dreamed of an autonomous, thinking machine throughout the modern era. Benjamin Franklin once lost a game of chess to such a machine, the "Mechanical Turk"; of course, there was a human chess master hidden inside. Nowadays, chess engines that beat the top players can run on your phone. exactly makes these machines merit the label of "artificial intelligence"? So, what Information systems with AI exploit complex patterns recognized in vast unstructured data sets to mimic human creativity, problem solving, and critical thinking. Some forms of AI-prediction of customer tastes with machine learning, for example-are already employed in the business sector. Others are still emerging, especially generative AI- programs that create new text and images in response to prompts. Applications in software creation, customer service, and marketing are already with us. But the full scope of generative AI's application will be revealed slowly as firms experiment and innovate. This subject bears careful research and understanding in my role as a monetary policymaker. The Federal Reserve's dual mandate is to promote maximum employment and stable prices. As I discussed in a recent speech at the Ohio State University, the spread of AI and other technologies could have an effect on both.3 2 See Lisa D. Cook (2023), "Generative AI, Productivity, the Labor Market, and Choice Behavior," speech delivered at the National Bureau of Economic Research Economics of Artificial Intelligence Conference, Fall 2023, Toronto, September 22, https://www.federalreserve.gov/newsevents/speech/cook20230922a.htm. 3 See Lisa D. Cook (2024), "What Will Artificial Intelligence Mean for America's Workers?" speech delivered at the Ohio State University, Columbus, Ohio, September 26, https://www.federalreserve.gov/newsevents/speech/cook20240926a.htm. - 3 - Artificial Intelligence Adoption on the Rise Let me say from the outset that there is tremendous uncertainty about AI's implications. We still do not know what the magnitude or intensity of these effects will be, which workers and firms will be most affected, how big the increase in productivity might be, or even the period over which these effects will be realized. While much is still to be learned, I see growing evidence that AI is poised to have a substantial effect on U.S. and global labor markets. As firms deploy these technologies and workers discover ways to make use of them, such developments can create the conditions for greater productivity and thus higher wage growth consistent with stable prices. And adjustments in the labor market that follow as the economy adapts to technical change can affect maximum employment. My view is that AI, and generative AI in particular, is likely to become a general- purpose technology-one that spreads throughout the economy, sparks downstream innovation, and continues to improve over time. Since my speech last year, further evidence in favor of a cautiously optimistic view has accumulated. The list of tasks for which AI performance is at least equivalent to that of a skilled human continues to grow. Remarkably, one AI model reached silver-medal performance at the International Mathematical Olympiad this year.4 Survey results from the Census Bureau show that AI adoption has risen, with AI in regular use across many sectors of the economy, but is still 4 See Nestor Maslej, Loredana Fattorini, Raymond Perrault, Vanessa Parli, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, and Jack Clark (2024), Artificial Intelligence Index Report 2024 (Stanford, Calif.: Stanford University, Institute for Human-Centered AI, AI Index Steering Committee, April), https://aiindex.stanford.edu/wp-content/uploads/2024/04/HAI_2024_AI-Index-Report.pdf; and Manon Bischoff (2024), "AI Reaches Silver-Medal Level at This Year's Math Olympiad," Scientific American, August 6. - 4 - used in only a small share of firms.5 Other surveys find wider adoption. For example, a study from the Federal Reserve Bank of St. Louis found generative AI is being adopted at a faster rate than the internet and personal computers were at a comparable point after those technologies were widely introduced.6 In a sign that the prospect of more widespread use of AI is on the horizon, U.S. data center construction spending and semiconductor imports have soared in the past two years. Examining Productivity Since the high-tech boom ended in the early 2000s, smoothing through recession- driven swings, growth in output per hour worked has been relatively modest, roughly 1.5 percent per year, on average, though it has picked up some over the past two years. In fact, the latest estimate for productivity would not have looked out of place in the high- tech boom: it grew 2.7 percent over the year ending in the second quarter. The emergence of generative AI has raised hopes for a technology-fueled revival of strong growth in labor productivity, which could support rising real earnings for workers and purchasing power for households. Like many of the most significant innovations of the past few centuries-such as the steam engine, electricity, computers, and the internet- 5 semiweekly Of the firms sampled in the U.S. Census Bureau's Business Trends and Outlook Survey, 5.5 percent indicated they had used AI in the two weeks preceding the August 25, 2024, survey- 1.5 percentage points higher than a year earlier. Other estimates based on convenience samples report higher shares. For example, McKinsey & Company estimates that 72 percent of firms used AI in at least one business function in August 2024, up from 55 percent the year before. For a comparison of the Census and McKinsey measures, see Kathryn Bonney, Cory Breaux, Cathy Buffington, Emin Dinlersoz, Lucia S. Foster, Nathan Goldschlag, John C. Haltiwanger, Zachary Kroff, and Keith Savage (2024), "Tracking Firm Use of AI in Real Time: A Snapshot from the Business Trends and Outlook Survey," NBER Working Paper Series 32319 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w32319. 6 See Alexander Bick, Adam Blandin, and David Deming (2024), "The Rapid Adoption of Generative AI," Federal Reserve Bank of St. Louis, On the Economy (blog), September 23, https://www.stlouisfed.org/onthe-economy/2024/sep/rapid-adoption-generativeai?utm_source=twitter&utm_medium=SM&utm_content=stlouisfed&utm_campaign=dc2f59ec-5fde-491c98fa-f0161b783bd1 - 5 - AI has the potential to affect labor productivity in a wide swath of economic activities across many industries and occupations. Although I share the view that AI could lift productivity out of this period of low growth, it bears emphasis that recent productivity gains have been modest despite rather impressive changes in information technology. For example, we live much of our lives on our smartphones, devices that almost no one used 20 years ago. Moreover, the generative AI models that have captured our attention since 2022 were preceded by other forms of AI that have already been integrated into e-commerce and other business operations. In other words, the modest productivity growth seen of late already incorporates gains from some types of AI. Whether generative AI delivers a similar, incremental contribution to productivity growth or something larger remains to be seen. The degree to which AI leads to productivity improvement bears careful watching, because, if it does meaningfully lift productivity, it could help constrain unit labor costs and inflation in the long run. And, of course, measuring productivity in real time is challenging. Famously, Chairman Alan Greenspan spied productivity gains from information technology in the 1990s long before they appeared in the data. The challenge for macroeconomic forecasters is that productivity does not follow immediately from invention and innovation. The translation of technology into productivity depends on the choices made by firms, workers, and policymakers. Time- consuming work at the adopting firm is often needed to tailor the technology to its specific needs.7 For example, a case study by researchers at Harvard Business School 7 See Timothy Bresnahan, Shane Greenstein, David Brownstone, and Kenneth Flamm (1996), "Technical Progress and Co-invention in Computing and in the Uses of Computers," Brookings Papers on Economic Activity: Microeconomics 1996, pp. 1-83, https://www.brookings.edu/articles/technical-progress-and-coinvention-in-computing-and-in-the-uses-of-computers. - 6 - revealed that when GitHub built Copilot, a code-completion tool, on top of generative AI technology adopted from OpenAI, it went through a process of experimentation, false starts, management challenges, and substantial expense.8 Moreover, while productivity growth follows from translation of clever new ideas into concrete business practices, this full effect is realized only when capital and labor are reallocated to the firms that are most adept at doing so. This "business dynamism" contribution to productivity dwindled in the years before the pandemic.9 The recent surge in new business creation provides some hope that dynamism may be rebounding. Variation between Firms The push to use AI algorithms to make more decisions will entail some degree of adjustment at AI-using firms to the jobs of their employees, as well. Understandably, the prospect of those adjustments has many knowledge workers concerned about job security.10 Importantly, when one considers the wide array of tasks involved in performing most jobs-some of the ones we take for granted are quite difficult to automate-it becomes harder to imagine entire positions becoming redundant.11 For example, an advertising firm might allow AI to produce suggested copy and images reflecting the identity of a client, but only after providing the AI system with notes based 8 See Frank Nagle, Shane Greenstein, Maria P. Roche, Nataliya Langburd Wright, and Sarah Mehta (2023), "Copilot(s): Generative AI at Microsoft and GitHub," Harvard Business School case study, Harvard Business Review, November 16. 9 See Ryan A. Decker, John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2020), "Changing Business Dynamism and Productivity: Shocks versus Responsiveness," American Economic Review, vol. 110 (December), pp. 3952-90. 10 The 2024 Work Trend Index Annual Report, published by Microsoft and LinkedIn, reports that 45 percent of knowledge workers are afraid AI will replace them. See Microsoft Corp. and LinkedIn (2024), 2024 Work Trend Index Annual Report: AI at Work Is Here. Now Comes the Hard Part (Redmond, Wash.: Microsoft Corp. and LinkedIn, May), https://www.microsoft.com/en-us/worklab/work-trendindex/ai-at-work-is-here-now-comes-the-hard-part. 11 See David H. Autor, Frank Levy, and Richard J. Murnane (2002), "Upstairs, Downstairs: Computers and Skills on Two Floors of a Large Bank," Industrial and Labor Relations Review, vol. 55 (April), pp. 432-47. - 7 - on meetings, observation, and experience. And the proposed advertisement could be further reviewed and revised, presented to the client, and evaluated for success by human beings. This makes it likely that the bundle of tasks involved in many jobs will change, as of the worker's time spent on each task. AI may field routine customer will the share service requests and leave unusual or especially important requests to human representatives. Indeed, work by Erik Brynjolfsson, Danielle Li, and Lindsey Raymond shows that AI may accelerate the acquisition of skills for new workers by offering suggested responses based on the history of previous interactions on a given subject.12 This adjustment process entails both modifying the mix of tasks handled by retained workers and hiring new talent from outside the firm. A recent survey conducted by the Federal Reserve Bank of New York found that very few AI-adopting firms had laid off workers as part of that process in the previous six months, and many firms have plans to retrain their workers to use AI.13 Adapting an incumbent business to fully exploit AI can be a daunting task: the business may need to substantially reorganize its operations to reap the full benefit of AI.14 Given access to information from throughout the firm, AI may offer insights into business process efficiency, but the data landscape may be Balkanized, with differing 12 See Erik Brynjolfsson, Danielle Li, and Lindsey R. Raymond (2023), "Generative AI at Work," NBER Working Paper Series 31161 (Cambridge, Mass.: National Bureau of Economic Research, November), https://www.nber.org/papers/w31161. 13 See Jaison R. Abel, Richard Deitz, Natalia Emanuel, and Benjamin Hyman (2024), "AI and the Labor Market: Will Firms Hire, Fire, or Retrain?" Federal Reserve Bank of New York, Liberty Street Economics (blog), September 4, https://libertystreeteconomics.newyorkfed.org/2024/09/ai-and-the-labor-market-willfirms-hire-fire-or-retrain. The survey covered firms in the New York-Northern New Jersey region. A June survey of Texas firms yielded similar results. 14 See Marco Iansiti and Karim R. Lakhani (2020), Competing in the Age of AI: Strategy and Leadership When Algorithms and Networks Run the World (Boston: Harvard Business Review Press). - 8 - standards and restrictive permissions. Reports are that one prominent technology firm addressed this problem by requiring that employees provide widespread access to all data sets within the company and service interfaces to make the access seamless.15 Not all firms will find it feasible or desirable to take such sweeping measures. New entrants may have an advantage in this landscape in that they have fewer entrenched practices. In a development that one may speculate is connected to AI, Ryan Decker and John Haltiwanger found that a large share of the surge in new business entry seen in the past three years has been in high tech industries.16 Importantly, even in this moment of abundant startups, we may be missing the potential contributions of some groups. In my own work before joining the Federal Reserve Board, I found that investors underrate the prospects of Black-founded, or simply outsider-founded, startups in early funding stages.17 Addressing better assessment in the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute. Nonetheless, incumbent firms may be better positioned to fund the gargantuan sums required to train AI models. Leading-edge models, adaptable for a wide range of tasks, cost tens of millions of dollars to train.18 Big data processing techniques- distributed computing, scalability, in-memory processing-play an important role in that training, which uses terabytes of unstructured data. 15 See Iansiti and Lakhani, Competing in the Age of AI, in note 14. 16 See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era, FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. 17 See Lisa D. Cook, Matt Marx, and Emmanuel Yimfor (2022), "Funding Black High-Growth Startups," NBER Working Paper Series 30682 (Cambridge, Mass.: National Bureau of Economic Research, November), https://www.nber.org/papers/w30682. 18 See Ben Cottier, Robi Rahman, Loredana Fattorini, Nestor Maslej, and David Owen (2024), "The Rising Costs of Training Frontier AI Models," arXiv preprint, arXiv:2405.21015 (Ithaca, N.Y.: Cornell University, May), https://doi.org/10.48550/arXiv.2405.21015. - 9 - And those firms have the accumulated data from their business operations with which to train AI. Some observers have noted that the finite supply of high-quality data is beginning to constrain model improvement.19 Apparently, central bankers are not the only ones always looking for "more good data"! Future gains are expected to be driven by the adaptation of AI to specific contexts using proprietary data available only within the confines of individual firms. Conclusion In closing, looking ahead, I anticipate an acceleration in productivity grounded in the impressive advances in AI, but substantial uncertainty attends that forecast. Such uncertainty arises from the nature of invention, innovation, diffusion, and adaptation of new technologies, as well as from policy decisions that will govern this process. Fostering the global innovation ecosystem remains desirable through research and development, advanced education, worker training and retraining, and legal protections for intellectual property. Moreover, a consensus needs to be forged on the benefits and costs of regulation of the use of AI in the areas of privacy, compensation for training data, perpetuation and amplification of bias, and fraud. Additionally, the ultimate outcomes could benefit from broader inclusion across demographic groups in the startup and research communities and attention to the potential effects on competition of the advantages of incumbent firms. In short, AI will be translated into productivity improvements with "long and as variable lags," we monetary policymakers like to say. The changes we see in the macroeconomy-aggregate output, employment, and income-are the collective effect of 19 See Tammy Xu (2022), "We Could Run Out of Data to Train AI Language Programs," MIT Technology Review, November 24. - 10 - millions of firms, households, and government policymakers thinking through what AI means for them. You might say that, like the Mechanical Turk, ultimately the human inside the machine is still in charge. My hope is that rising productivity gains will serve as a counterweight to inflation going forward. We will monitor these developments closely. Thank you for having me here today. I look forward to your questions.	---[PAGE_BREAK]--- For release on delivery 11:10 a.m. EDT October 1, 2024 Artificial Intelligence, Big Data, and the Path Ahead for Productivity Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond Atlanta, Georgia October 1, 2024 ---[PAGE_BREAK]--- Thank you, President Bostic. Let me start by saying my thoughts are with all the people of Florida, Georgia, North Carolina, South Carolina, Tennessee and the other communities who have felt the force of Helene's impact. I am saddened by the tragic loss of life and widespread disruption in these regions served by the Federal Reserve Banks of Atlanta and Richmond. As Chair Powell said yesterday, we at the Fed are encouraging banks to work with customers in affected areas and we are working to support the Reserve Banks to ensure there are ample cash supplies, which can be especially important during times of power outages. I am always happy to be in Atlanta, in Georgia, and at the Federal Reserve Bank of Atlanta. I grew up in Georgia, and I am a proud graduate of Spelman College. Atlanta is an appropriate place to speak about today's topic, artificial intelligence (AI), as it is in the midst of large corporations and startups developing uses for AI and near so many impressive schools, including Georgia Tech, a top AI research university and where I took courses to prepare for a Ph.D. in economics. Our tech entrepreneurship and AI roundtable with Chair Powell, held at Spelman last year, is a testament to Atlanta being such a locus of activity. Today, I will speak to you about AI, big data, and the path ahead for productivity. ${ }^{1}$ My comments today will build upon what I offered a year ago at the NBER AI meeting in Toronto, when I emphasized the importance of business decision- [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. ---[PAGE_BREAK]--- making in our progress along that path. ${ }^{2}$ Technology alone will not determine the outcome. Futurists have dreamed of an autonomous, thinking machine throughout the modern era. Benjamin Franklin once lost a game of chess to such a machine, the "Mechanical Turk"; of course, there was a human chess master hidden inside. Nowadays, chess engines that beat the top players can run on your phone. So, what exactly makes these machines merit the label of "artificial intelligence"? Information systems with AI exploit complex patterns recognized in vast unstructured data sets to mimic human creativity, problem solving, and critical thinking. Some forms of AI—prediction of customer tastes with machine learning, for example—are already employed in the business sector. Others are still emerging, especially generative AI— programs that create new text and images in response to prompts. Applications in software creation, customer service, and marketing are already with us. But the full scope of generative AI's application will be revealed slowly as firms experiment and innovate. This subject bears careful research and understanding in my role as a monetary policymaker. The Federal Reserve's dual mandate is to promote maximum employment and stable prices. As I discussed in a recent speech at the Ohio State University, the spread of AI and other technologies could have an effect on both. ${ }^{3}$ [^0] [^0]: ${ }^{2}$ See Lisa D. Cook (2023), "Generative AI, Productivity, the Labor Market, and Choice Behavior," speech delivered at the National Bureau of Economic Research Economics of Artificial Intelligence Conference, Fall 2023, Toronto, September 22, https://www.federalreserve.gov/newsevents/speech/cook20230922a.htm. ${ }^{3}$ See Lisa D. Cook (2024), "What Will Artificial Intelligence Mean for America’s Workers?" speech delivered at the Ohio State University, Columbus, Ohio, September 26, https://www.federalreserve.gov/newsevents/speech/cook20240926a.htm. ---[PAGE_BREAK]--- # Artificial Intelligence Adoption on the Rise Let me say from the outset that there is tremendous uncertainty about AI's implications. We still do not know what the magnitude or intensity of these effects will be, which workers and firms will be most affected, how big the increase in productivity might be, or even the period over which these effects will be realized. While much is still to be learned, I see growing evidence that AI is poised to have a substantial effect on U.S. and global labor markets. As firms deploy these technologies and workers discover ways to make use of them, such developments can create the conditions for greater productivity and thus higher wage growth consistent with stable prices. And adjustments in the labor market that follow as the economy adapts to technical change can affect maximum employment. My view is that AI, and generative AI in particular, is likely to become a general-purpose technology—one that spreads throughout the economy, sparks downstream innovation, and continues to improve over time. Since my speech last year, further evidence in favor of a cautiously optimistic view has accumulated. The list of tasks for which AI performance is at least equivalent to that of a skilled human continues to grow. Remarkably, one AI model reached silver-medal performance at the International Mathematical Olympiad this year. ${ }^{4}$ Survey results from the Census Bureau show that AI adoption has risen, with AI in regular use across many sectors of the economy, but is still [^0] [^0]: ${ }^{4}$ See Nestor Maslej, Loredana Fattorini, Raymond Perrault, Vanessa Parli, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, and Jack Clark (2024), Artificial Intelligence Index Report 2024 (Stanford, Calif.: Stanford University, Institute for Human-Centered AI, AI Index Steering Committee, April), https://aiindex.stanford.edu/wp-content/uploads/2024/04/HAI_2024_AI-Index-Report.pdf; and Manon Bischoff (2024), "AI Reaches Silver-Medal Level at This Year's Math Olympiad," Scientific American, August 6. ---[PAGE_BREAK]--- used in only a small share of firms. ${ }^{5}$ Other surveys find wider adoption. For example, a study from the Federal Reserve Bank of St. Louis found generative AI is being adopted at a faster rate than the internet and personal computers were at a comparable point after those technologies were widely introduced. ${ }^{6}$ In a sign that the prospect of more widespread use of AI is on the horizon, U.S. data center construction spending and semiconductor imports have soared in the past two years. # Examining Productivity Since the high-tech boom ended in the early 2000s, smoothing through recessiondriven swings, growth in output per hour worked has been relatively modest, roughly 1.5 percent per year, on average, though it has picked up some over the past two years. In fact, the latest estimate for productivity would not have looked out of place in the hightech boom: it grew 2.7 percent over the year ending in the second quarter. The emergence of generative AI has raised hopes for a technology-fueled revival of strong growth in labor productivity, which could support rising real earnings for workers and purchasing power for households. Like many of the most significant innovations of the past few centuries-such as the steam engine, electricity, computers, and the internet- [^0] [^0]: ${ }^{5}$ Of the firms sampled in the U.S. Census Bureau's semiweekly Business Trends and Outlook Survey, 5.5 percent indicated they had used AI in the two weeks preceding the August 25, 2024, survey1.5 percentage points higher than a year earlier. Other estimates based on convenience samples report higher shares. For example, McKinsey \& Company estimates that 72 percent of firms used AI in at least one business function in August 2024, up from 55 percent the year before. For a comparison of the Census and McKinsey measures, see Kathryn Bonney, Cory Breaux, Cathy Buffington, Emin Dinlersoz, Lucia S. Foster, Nathan Goldschlag, John C. Haltiwanger, Zachary Kroff, and Keith Savage (2024), "Tracking Firm Use of AI in Real Time: A Snapshot from the Business Trends and Outlook Survey," NBER Working Paper Series 32319 (Cambridge, Mass.: National Bureau of Economic Research, April), https://www.nber.org/papers/w32319. ${ }^{6}$ See Alexander Bick, Adam Blandin, and David Deming (2024), "The Rapid Adoption of Generative AI," Federal Reserve Bank of St. Louis, On the Economy (blog), September 23, https://www.stlouisfed.org/onthe-economy/2024/sep/rapid-adoption-generativeai?utm_source=twitter\&utm_medium=SM\&utm_content=stlouisfed\&utm_campaign=dc2f59ec-5fde-491c98fa-f0161b783bd1 ---[PAGE_BREAK]--- AI has the potential to affect labor productivity in a wide swath of economic activities across many industries and occupations. Although I share the view that AI could lift productivity out of this period of low growth, it bears emphasis that recent productivity gains have been modest despite rather impressive changes in information technology. For example, we live much of our lives on our smartphones, devices that almost no one used 20 years ago. Moreover, the generative AI models that have captured our attention since 2022 were preceded by other forms of AI that have already been integrated into e-commerce and other business operations. In other words, the modest productivity growth seen of late already incorporates gains from some types of AI. Whether generative AI delivers a similar, incremental contribution to productivity growth or something larger remains to be seen. The degree to which AI leads to productivity improvement bears careful watching, because, if it does meaningfully lift productivity, it could help constrain unit labor costs and inflation in the long run. And, of course, measuring productivity in real time is challenging. Famously, Chairman Alan Greenspan spied productivity gains from information technology in the 1990s long before they appeared in the data. The challenge for macroeconomic forecasters is that productivity does not follow immediately from invention and innovation. The translation of technology into productivity depends on the choices made by firms, workers, and policymakers. Timeconsuming work at the adopting firm is often needed to tailor the technology to its specific needs. ${ }^{7}$ For example, a case study by researchers at Harvard Business School [^0] [^0]: ${ }^{7}$ See Timothy Bresnahan, Shane Greenstein, David Brownstone, and Kenneth Flamm (1996), "Technical Progress and Co-invention in Computing and in the Uses of Computers,"Brookings Papers on Economic Activity: Microeconomics 1996, pp. 1-83, https://www.brookings.edu/articles/technical-progress-and-co-invention-in-computing-and-in-the-uses-of-computers. ---[PAGE_BREAK]--- revealed that when GitHub built Copilot, a code-completion tool, on top of generative AI technology adopted from OpenAI, it went through a process of experimentation, false starts, management challenges, and substantial expense. ${ }^{8}$ Moreover, while productivity growth follows from translation of clever new ideas into concrete business practices, this full effect is realized only when capital and labor are reallocated to the firms that are most adept at doing so. This "business dynamism" contribution to productivity dwindled in the years before the pandemic. ${ }^{9}$ The recent surge in new business creation provides some hope that dynamism may be rebounding. # Variation between Firms The push to use AI algorithms to make more decisions will entail some degree of adjustment at AI-using firms to the jobs of their employees, as well. Understandably, the prospect of those adjustments has many knowledge workers concerned about job security. ${ }^{10}$ Importantly, when one considers the wide array of tasks involved in performing most jobs-some of the ones we take for granted are quite difficult to automate-it becomes harder to imagine entire positions becoming redundant. ${ }^{11}$ For example, an advertising firm might allow AI to produce suggested copy and images reflecting the identity of a client, but only after providing the AI system with notes based [^0] [^0]: ${ }^{8}$ See Frank Nagle, Shane Greenstein, Maria P. Roche, Nataliya Langburd Wright, and Sarah Mehta (2023), "Copilot(s): Generative AI at Microsoft and GitHub," Harvard Business School case study, Harvard Business Review, November 16. ${ }^{9}$ See Ryan A. Decker, John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2020), "Changing Business Dynamism and Productivity: Shocks versus Responsiveness," American Economic Review, vol. 110 (December), pp. 3952-90. ${ }^{10}$ The 2024 Work Trend Index Annual Report, published by Microsoft and LinkedIn, reports that 45 percent of knowledge workers are afraid AI will replace them. See Microsoft Corp. and LinkedIn (2024), 2024 Work Trend Index Annual Report: AI at Work Is Here. Now Comes the Hard Part (Redmond, Wash.: Microsoft Corp. and LinkedIn, May), https://www.microsoft.com/en-us/worklab/work-trend-index/ai-at-work-is-here-now-comes-the-hard-part. ${ }^{11}$ See David H. Autor, Frank Levy, and Richard J. Murnane (2002), "Upstairs, Downstairs: Computers and Skills on Two Floors of a Large Bank," Industrial and Labor Relations Review, vol. 55 (April), pp. 432-47. ---[PAGE_BREAK]--- on meetings, observation, and experience. And the proposed advertisement could be further reviewed and revised, presented to the client, and evaluated for success by human beings. This makes it likely that the bundle of tasks involved in many jobs will change, as will the share of the worker's time spent on each task. AI may field routine customer service requests and leave unusual or especially important requests to human representatives. Indeed, work by Erik Brynjolfsson, Danielle Li, and Lindsey Raymond shows that AI may accelerate the acquisition of skills for new workers by offering suggested responses based on the history of previous interactions on a given subject. ${ }^{12}$ This adjustment process entails both modifying the mix of tasks handled by retained workers and hiring new talent from outside the firm. A recent survey conducted by the Federal Reserve Bank of New York found that very few AI-adopting firms had laid off workers as part of that process in the previous six months, and many firms have plans to retrain their workers to use $\mathrm{AI}^{13}$ Adapting an incumbent business to fully exploit AI can be a daunting task: the business may need to substantially reorganize its operations to reap the full benefit of AI. ${ }^{14}$ Given access to information from throughout the firm, AI may offer insights into business process efficiency, but the data landscape may be Balkanized, with differing [^0] [^0]: ${ }^{12}$ See Erik Brynjolfsson, Danielle Li, and Lindsey R. Raymond (2023), "Generative AI at Work," NBER Working Paper Series 31161 (Cambridge, Mass.: National Bureau of Economic Research, November), https://www.nber.org/papers/w31161. ${ }^{13}$ See Jaison R. Abel, Richard Deitz, Natalia Emanuel, and Benjamin Hyman (2024), "AI and the Labor Market: Will Firms Hire, Fire, or Retrain?" Federal Reserve Bank of New York, Liberty Street Economics (blog), September 4, https://libertystreeteconomics.newyorkfed.org/2024/09/ai-and-the-labor-market-will-firms-hire-fire-or-retrain. The survey covered firms in the New York-Northern New Jersey region. A June survey of Texas firms yielded similar results. ${ }^{14}$ See Marco Iansiti and Karim R. Lakhani (2020), Competing in the Age of AI: Strategy and Leadership When Algorithms and Networks Run the World (Boston: Harvard Business Review Press). ---[PAGE_BREAK]--- standards and restrictive permissions. Reports are that one prominent technology firm addressed this problem by requiring that employees provide widespread access to all data sets within the company and service interfaces to make the access seamless. ${ }^{15}$ Not all firms will find it feasible or desirable to take such sweeping measures. New entrants may have an advantage in this landscape in that they have fewer entrenched practices. In a development that one may speculate is connected to AI, Ryan Decker and John Haltiwanger found that a large share of the surge in new business entry seen in the past three years has been in high tech industries. ${ }^{16}$ Importantly, even in this moment of abundant startups, we may be missing the potential contributions of some groups. In my own work before joining the Federal Reserve Board, I found that investors underrate the prospects of Black-founded, or simply outsider-founded, startups in early funding stages. ${ }^{17}$ Addressing better assessment in the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute. Nonetheless, incumbent firms may be better positioned to fund the gargantuan sums required to train AI models. Leading-edge models, adaptable for a wide range of tasks, cost tens of millions of dollars to train. ${ }^{18}$ Big data processing techniquesdistributed computing, scalability, in-memory processing-play an important role in that training, which uses terabytes of unstructured data. [^0] [^0]: ${ }^{15}$ See Iansiti and Lakhani, Competing in the Age of AI, in note 14. ${ }^{16}$ See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era, FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. ${ }^{17}$ See Lisa D. Cook, Matt Marx, and Emmanuel Yimfor (2022), "Funding Black High-Growth Startups," NBER Working Paper Series 30682 (Cambridge, Mass.: National Bureau of Economic Research, November), https://www.nber.org/papers/w30682. ${ }^{18}$ See Ben Cottier, Robi Rahman, Loredana Fattorini, Nestor Maslej, and David Owen (2024), "The Rising Costs of Training Frontier AI Models," arXiv preprint, arXiv:2405.21015 (Ithaca, N.Y.: Cornell University, May), https://doi.org/10.48550/arXiv.2405.21015. ---[PAGE_BREAK]--- And those firms have the accumulated data from their business operations with which to train AI. Some observers have noted that the finite supply of high-quality data is beginning to constrain model improvement. ${ }^{19}$ Apparently, central bankers are not the only ones always looking for "more good data"! Future gains are expected to be driven by the adaptation of AI to specific contexts using proprietary data available only within the confines of individual firms. # Conclusion In closing, looking ahead, I anticipate an acceleration in productivity grounded in the impressive advances in AI, but substantial uncertainty attends that forecast. Such uncertainty arises from the nature of invention, innovation, diffusion, and adaptation of new technologies, as well as from policy decisions that will govern this process. Fostering the global innovation ecosystem remains desirable through research and development, advanced education, worker training and retraining, and legal protections for intellectual property. Moreover, a consensus needs to be forged on the benefits and costs of regulation of the use of AI in the areas of privacy, compensation for training data, perpetuation and amplification of bias, and fraud. Additionally, the ultimate outcomes could benefit from broader inclusion across demographic groups in the startup and research communities and attention to the potential effects on competition of the advantages of incumbent firms. In short, AI will be translated into productivity improvements with "long and variable lags," as we monetary policymakers like to say. The changes we see in the macroeconomy—aggregate output, employment, and income—are the collective effect of [^0] [^0]: ${ }^{19}$ See Tammy Xu (2022), "We Could Run Out of Data to Train AI Language Programs," MIT Technology Review, November 24. ---[PAGE_BREAK]--- millions of firms, households, and government policymakers thinking through what AI means for them. You might say that, like the Mechanical Turk, ultimately the human inside the machine is still in charge. My hope is that rising productivity gains will serve as a counterweight to inflation going forward. We will monitor these developments closely. Thank you for having me here today. I look forward to your questions.	Lisa D Cook	United States	https://www.bis.org/review/r241002c.pdf	For release on delivery 11:10 a.m. EDT October 1, 2024 Artificial Intelligence, Big Data, and the Path Ahead for Productivity Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond Atlanta, Georgia October 1, 2024 Thank you, President Bostic. Let me start by saying my thoughts are with all the people of Florida, Georgia, North Carolina, South Carolina, Tennessee and the other communities who have felt the force of Helene's impact. I am saddened by the tragic loss of life and widespread disruption in these regions served by the Federal Reserve Banks of Atlanta and Richmond. As Chair Powell said yesterday, we at the Fed are encouraging banks to work with customers in affected areas and we are working to support the Reserve Banks to ensure there are ample cash supplies, which can be especially important during times of power outages. I am always happy to be in Atlanta, in Georgia, and at the Federal Reserve Bank of Atlanta. I grew up in Georgia, and I am a proud graduate of Spelman College. Atlanta is an appropriate place to speak about today's topic, artificial intelligence (AI), as it is in the midst of large corporations and startups developing uses for AI and near so many impressive schools, including Georgia Tech, a top AI research university and where I took courses to prepare for a Ph.D. in economics. Our tech entrepreneurship and AI roundtable with Chair Powell, held at Spelman last year, is a testament to Atlanta being such a locus of activity. Today, I will speak to you about AI, big data, and the path ahead for productivity. My comments today will build upon what I offered a year ago at the NBER AI meeting in Toronto, when I emphasized the importance of business decision- making in our progress along that path. Technology alone will not determine the outcome. Futurists have dreamed of an autonomous, thinking machine throughout the modern era. Benjamin Franklin once lost a game of chess to such a machine, the "Mechanical Turk"; of course, there was a human chess master hidden inside. Nowadays, chess engines that beat the top players can run on your phone. So, what exactly makes these machines merit the label of "artificial intelligence"? Information systems with AI exploit complex patterns recognized in vast unstructured data sets to mimic human creativity, problem solving, and critical thinking. Some forms of AI—prediction of customer tastes with machine learning, for example—are already employed in the business sector. Others are still emerging, especially generative AI— programs that create new text and images in response to prompts. Applications in software creation, customer service, and marketing are already with us. But the full scope of generative AI's application will be revealed slowly as firms experiment and innovate. This subject bears careful research and understanding in my role as a monetary policymaker. The Federal Reserve's dual mandate is to promote maximum employment and stable prices. As I discussed in a recent speech at the Ohio State University, the spread of AI and other technologies could have an effect on both. Let me say from the outset that there is tremendous uncertainty about AI's implications. We still do not know what the magnitude or intensity of these effects will be, which workers and firms will be most affected, how big the increase in productivity might be, or even the period over which these effects will be realized. While much is still to be learned, I see growing evidence that AI is poised to have a substantial effect on U.S. and global labor markets. As firms deploy these technologies and workers discover ways to make use of them, such developments can create the conditions for greater productivity and thus higher wage growth consistent with stable prices. And adjustments in the labor market that follow as the economy adapts to technical change can affect maximum employment. My view is that AI, and generative AI in particular, is likely to become a general-purpose technology—one that spreads throughout the economy, sparks downstream innovation, and continues to improve over time. Since my speech last year, further evidence in favor of a cautiously optimistic view has accumulated. The list of tasks for which AI performance is at least equivalent to that of a skilled human continues to grow. Remarkably, one AI model reached silver-medal performance at the International Mathematical Olympiad this year. Survey results from the Census Bureau show that AI adoption has risen, with AI in regular use across many sectors of the economy, but is still used in only a small share of firms. In a sign that the prospect of more widespread use of AI is on the horizon, U.S. data center construction spending and semiconductor imports have soared in the past two years. Since the high-tech boom ended in the early 2000s, smoothing through recessiondriven swings, growth in output per hour worked has been relatively modest, roughly 1.5 percent per year, on average, though it has picked up some over the past two years. In fact, the latest estimate for productivity would not have looked out of place in the hightech boom: it grew 2.7 percent over the year ending in the second quarter. The emergence of generative AI has raised hopes for a technology-fueled revival of strong growth in labor productivity, which could support rising real earnings for workers and purchasing power for households. Like many of the most significant innovations of the past few centuries-such as the steam engine, electricity, computers, and the internet- AI has the potential to affect labor productivity in a wide swath of economic activities across many industries and occupations. Although I share the view that AI could lift productivity out of this period of low growth, it bears emphasis that recent productivity gains have been modest despite rather impressive changes in information technology. For example, we live much of our lives on our smartphones, devices that almost no one used 20 years ago. Moreover, the generative AI models that have captured our attention since 2022 were preceded by other forms of AI that have already been integrated into e-commerce and other business operations. In other words, the modest productivity growth seen of late already incorporates gains from some types of AI. Whether generative AI delivers a similar, incremental contribution to productivity growth or something larger remains to be seen. The degree to which AI leads to productivity improvement bears careful watching, because, if it does meaningfully lift productivity, it could help constrain unit labor costs and inflation in the long run. And, of course, measuring productivity in real time is challenging. Famously, Chairman Alan Greenspan spied productivity gains from information technology in the 1990s long before they appeared in the data. The challenge for macroeconomic forecasters is that productivity does not follow immediately from invention and innovation. The translation of technology into productivity depends on the choices made by firms, workers, and policymakers. Timeconsuming work at the adopting firm is often needed to tailor the technology to its specific needs. For example, a case study by researchers at Harvard Business School revealed that when GitHub built Copilot, a code-completion tool, on top of generative AI technology adopted from OpenAI, it went through a process of experimentation, false starts, management challenges, and substantial expense. Moreover, while productivity growth follows from translation of clever new ideas into concrete business practices, this full effect is realized only when capital and labor are reallocated to the firms that are most adept at doing so. This "business dynamism" contribution to productivity dwindled in the years before the pandemic. The recent surge in new business creation provides some hope that dynamism may be rebounding. The push to use AI algorithms to make more decisions will entail some degree of adjustment at AI-using firms to the jobs of their employees, as well. Understandably, the prospect of those adjustments has many knowledge workers concerned about job security. For example, an advertising firm might allow AI to produce suggested copy and images reflecting the identity of a client, but only after providing the AI system with notes based on meetings, observation, and experience. And the proposed advertisement could be further reviewed and revised, presented to the client, and evaluated for success by human beings. This makes it likely that the bundle of tasks involved in many jobs will change, as will the share of the worker's time spent on each task. AI may field routine customer service requests and leave unusual or especially important requests to human representatives. Indeed, work by Erik Brynjolfsson, Danielle Li, and Lindsey Raymond shows that AI may accelerate the acquisition of skills for new workers by offering suggested responses based on the history of previous interactions on a given subject. This adjustment process entails both modifying the mix of tasks handled by retained workers and hiring new talent from outside the firm. A recent survey conducted by the Federal Reserve Bank of New York found that very few AI-adopting firms had laid off workers as part of that process in the previous six months, and many firms have plans to retrain their workers to use $\mathrm{AI}^{13}$ Adapting an incumbent business to fully exploit AI can be a daunting task: the business may need to substantially reorganize its operations to reap the full benefit of AI. Given access to information from throughout the firm, AI may offer insights into business process efficiency, but the data landscape may be Balkanized, with differing standards and restrictive permissions. Reports are that one prominent technology firm addressed this problem by requiring that employees provide widespread access to all data sets within the company and service interfaces to make the access seamless. Not all firms will find it feasible or desirable to take such sweeping measures. New entrants may have an advantage in this landscape in that they have fewer entrenched practices. In a development that one may speculate is connected to AI, Ryan Decker and John Haltiwanger found that a large share of the surge in new business entry seen in the past three years has been in high tech industries. Addressing better assessment in the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute. Nonetheless, incumbent firms may be better positioned to fund the gargantuan sums required to train AI models. Leading-edge models, adaptable for a wide range of tasks, cost tens of millions of dollars to train. Big data processing techniquesdistributed computing, scalability, in-memory processing-play an important role in that training, which uses terabytes of unstructured data. And those firms have the accumulated data from their business operations with which to train AI. Some observers have noted that the finite supply of high-quality data is beginning to constrain model improvement. Apparently, central bankers are not the only ones always looking for "more good data"! Future gains are expected to be driven by the adaptation of AI to specific contexts using proprietary data available only within the confines of individual firms. In closing, looking ahead, I anticipate an acceleration in productivity grounded in the impressive advances in AI, but substantial uncertainty attends that forecast. Such uncertainty arises from the nature of invention, innovation, diffusion, and adaptation of new technologies, as well as from policy decisions that will govern this process. Fostering the global innovation ecosystem remains desirable through research and development, advanced education, worker training and retraining, and legal protections for intellectual property. Moreover, a consensus needs to be forged on the benefits and costs of regulation of the use of AI in the areas of privacy, compensation for training data, perpetuation and amplification of bias, and fraud. Additionally, the ultimate outcomes could benefit from broader inclusion across demographic groups in the startup and research communities and attention to the potential effects on competition of the advantages of incumbent firms. In short, AI will be translated into productivity improvements with "long and variable lags," as we monetary policymakers like to say. The changes we see in the macroeconomy—aggregate output, employment, and income—are the collective effect of millions of firms, households, and government policymakers thinking through what AI means for them. You might say that, like the Mechanical Turk, ultimately the human inside the machine is still in charge. My hope is that rising productivity gains will serve as a counterweight to inflation going forward. We will monitor these developments closely. Thank you for having me here today. I look forward to your questions.
2024-10-01T00:00:00	Luis de Guindos: Expectations surveys, central banks and the economy	Welcome address by Mr Luis de Guindos, Vice-President of the European Central Bank, at the 5th joint European Central Bank, Bank of Canada and Federal Reserve Bank of New York Conference on expectations surveys, central banks and the economy, Frankfurt am Main, 1 October 2024.	SPEECH Expectations surveys, central banks and the economy Welcome address by Luis de Guindos, Vice-President of the ECB, at the 5th joint ECB, Bank of Canada and Federal Reserve Bank of New York Conference on expectations surveys, central banks and the economy Frankfurt am Main, 1 October 2024 It is my pleasure to welcome you to this fifth joint conference on expectations surveys organised by the European Central Bank, the Bank of Canada and the Federal Reserve Bank of New York. In my remarks today, I will delve into the fascinating world of expectations surveys and their relevance to central banks. I will review how useful expectations surveys have proven to be for central banks over the period since 2019, the year we held our first conference in this series. In addition, I will touch on the challenges facing central banks in using surveys. The fact that central banks generally operate under great uncertainty has come to the fore over the past five years. Today, too, we are facing huge uncertainty - not least in view of the many prevailing economic, financial and geopolitical risks. Yet, it is precisely in this unpredictable and highly complex landscape that surveys have come into their own. The return of survey expectations Over the past decade, central banks and other policymaking institutions have invested significantly in expectations surveys and have drawn increasingly on survey data for their policy analysis and research. These surveys cover consumers, firms, financial market participants and other experts, including professional forecasters. At the ECB, we can fortunately look to a wide array of such surveys covering diverse topics such as consumer expectations, household finance and consumption, access to finance of enterprises, the payment attitudes of consumers and bank lending. Since 2013, the ECB has also conducted a survey of wholesale market participants on credit terms and conditions, and it recently developed a new survey of monetary analysts to collect expert expectations about key monetary policy parameters and concepts. Finally, the ECB's Survey of Professional Forecasters was launched back in 1999 at the start of Economic and Monetary Union. Its structured collection of data has supported a rich research programme investigating economic forecasts and expert expectations. 4] All ECB surveys can provide insights into how different economic agents form and update their expectations. They can reveal the potential biases in these expectations and the extent to which expectations feed into economic decisions. Surveys were indeed quite central to the economic debate in the 1950s and the 1960s but their role became more marginal when rational expectations were incorporated into economic modelling in the 1970s. Over the past ten years, however, economists have seen survey expectations clearly returning to the mainstream.!2] One could describe the recent growth in survey-based research as a "counter-revolution" following the earlier "revolution" centred on rational expectations. Today, while models based on rational expectations still form a useful reference point in our analysis and research, they are no longer thought to provide a solid basis for understanding business cycles, for gauging the risks of financial crises or for designing effective economic policies. The central insight gained from this new line of survey-based research is that many economic agents may systematically form expectations by using partial sets of information or by following subjective narratives about how the economy functions - for example by applying simple rules of thumb.) It is important to understand such subjective expectations, because these beliefs often underlie the economic choices and financial decisions that drive the economy. Surveys have repeatedly proven their usefulness over the past five years. During the COVID-19 pandemic, they were especially useful in helping to track financial conditions for firms and households, as well as in estimating the labour market response to the pandemic shock. Online surveys were of great benefit during the pandemic as in-person survey interviews were hampered by lockdown restrictions. For example, the ECB's Consumer Expectations Survey - an online survey which was fortuitously launched in early 2020 - helped us understand the severity of the pandemic-induced collapse in consumption and gauge the overall effectiveness of the major policy interventions by governments and other authorities at the time. Insights from surveys during the recent period of high inflation More recently, the data collected in surveys strongly supported the analysis of the recent inflationary episode in the euro area. During the early phase of the inflation surge in 2022, survey data helped to inform the central discussion on the likely persistence of the shock. For example, the observed increase in consumers' medium-term expectations may have interacted with an increase in firms' pricing power to make the original supply shocks more persistent than they would otherwise have been. Forces that would gradually help bring inflation back down to our target were also visible in more recent survey data. For example, we could see how the rise in inflation and inflation expectations was acting as a major constraint on demand and consumer spending owing to its impact on real incomes. In August 2023 respondents to the ECB's Consumer Expectations Survey were asked what actions they were planning to take in light of their expectations about future inflation. The results clearly showed that a much higher share of consumers planned to reduce their spending in response to the expectations of higher prices.!2 In addition, consumers indicated that they would start to shop around more and buy cheaper varieties of goods and services than they normally would. In a context where the ECB was taking decisive monetary policy action aimed at restoring price stability, these behavioural responses to higher inflation expectations also contributed to the gradual unwinding of the inflationary pressures across the euro area economy. Insights for financial stability analysis In addition to monetary policy, expectations surveys are now increasingly being used for other central bank tasks as well. This includes financial stability analysis. Here, surveys can help identify potential sources of financial risk not only in financial markets and the banking system, but also in the household and non-financial corporate sectors.!2! Even when there is no discernible financial stress at the aggregate level, the disaggregated or individual-level data typically provided by surveys can help us to identify emerging risks across particular sectors or socio-demographic groups. In financial stability analysis, the topic of financial literacy is receiving increased attention. In the first keynote lecture of the conference, Professor Annamaria Lusardi from Stanford University will talk about why financial literacy is relevant for central banks. One consideration for financial stability analysis is that less financially literate households may be less prepared to cope with adverse economic and financial shocks. Yet, these households tend to be the most exposed to such shocks and more heavily affected when they occur. Policies seeking to boost financial literacy may help borrowers to source loans that are cheaper to service, thus promoting more efficient and more sustainable debt management. These issues may be particularly relevant for real estate markets and housing, which will be the focus of the second keynote lecture of the conference, given by Professor Tarun Ramadorai from Imperial College London. Professor Ramadorai will discuss the importance of non-rational beliefs in the housing market and how household surveys can help inform policies that can address these frictions. Sustaining the quality and representativeness of surveys Our experiences with survey data also highlight the challenges that policymakers face when using these data. Survey data can be volatile and there is evidence of overreaction in both household and firm surveys of expectations. For this reason, surveys may provide a noisy signal for policymaking in practice, which complicates how these data should feed into the policy reaction function. In this respect, I hope the research presented at today's conference can also help policymakers distinguish the signal from the noise that is always embedded in expectations data. These considerations underline the importance of the quality of the survey design, including the sampling and data collection methods. It is crucial that questions are designed to avoid the framing of responses and that the complexity of the questionnaires is managed appropriately to avoid survey fatigue, which may negatively affect data quality. As central banks are making increasing use of survey data, they need to continuously and carefully monitor these data to ensure responses remain representative of the underlying population's beliefs and behaviour. Conclusion Let me conclude. Today, expectations surveys are an important part of the toolkit available to central banks for their policy analysis. These surveys reveal insights about the economy that would otherwise remain hidden from view. As a result, they can contribute to more robust policy decisions and better policy assessments. I would like to finish by thanking the presenters and participants in advance for their contributions and the conference organisers for putting together such an impressive programme. I wish you all a productive and successful two days of lively debate and discussion. I am confident that the insights that will emerge from sharing our experiences of different surveys across many countries and institutions will ultimately enhance the way in which we use expectations surveys to help guide policy decisions. 1. See ECB surveys. 2. See Coibion, O., Gorodnichenko, Y. and Kamdar, R. (2018), "The Formation of Expectations, Inflation, and the Phillips curve", Journal of Economic Literature, Vol. 56, No 4, pp. 1447-1491; D'Acunto, F., Charalambakis, E., Georgarakos, D., Kenny, G., Meyer, J. and Weber, M. (2024), "Household inflation expectations: An overview of recent insights for monetary policy", Discussion Paper Series, No 24, ECB; Shleifer, A., (2019), "The return of survey expectations", NBER Reporter, No 1, pp. 14-17. 3. See Andre, P., Pizzinelli, C., Roth, C. and Wohlfart, J. (2022), "Subjective models of the macroeconomy: Evidence from experts and representative samples", The Review of Economic Studies, Vol. 89, No 6, pp. 2958-2991; Weber, M., Candia, B., Afrouzi, H., Ropele, T., Lluberas, R., Frache, S., Meyer, B.H., Kumar, S., Gorodnichenko, Y., Georgarakos, D., Coibion, O. and Kenny, G. (2024), "Tell me something I don't already know: learning in low and high-inflation settings", Working Paper Series, No 2914, ECB, March, shows that the attention of both consumers and firms to inflation depends on the level of inflation. In particular, consumers and firms don't pay much attention to official news about inflation when inflation is low, but they are much more attentive and informed about inflation developments when inflation is high. 4. See Manski, C.F. (2004), "Measuring expectations", Econometrica, Vol. 72, No 5, pp. 1329-1376; Manski, C.F. (2018), "Survey measurement of probabilistic macroeconomic expectations: progress and promise", NBER Macroeconomics Annual, Vol. 32, No 1, pp. 411-471. 5. See, for example, Christelis, D., Georgarakos, D., Jappelli T. and Kenny, G. (2020), "The Covid-19 crisis and consumption: survey evidence from six EU countries", Working Paper Series, No 2507, ECB, December and Georgarakos, D. and Kenny, G. (2022), "Household spending and fiscal support during the COVID-19 pandemic: Insights from a new consumer survey", Journal of Monetary Economics, Vol. 129, pp. S1-S14. 6. For a recent review of the insights for monetary policy from research using household inflation expectations see D'Acunto, F. et al. (2024), op. cit. 7. See Acharya, V.V., Crosignani, M., Eisert, T. and Eufinger, C. (2023), "How do supply shocks to inflation generalize? Evidence from the pandemic era in Europe", NBER Working Paper, No 31790, as well as the discussion in D'Acunto, F. et al. (2024); Baumann, U., Ferrando, A., Georgarakos, D., Gorodnichenko, Y. and Reinelt, T. (2024), "SAFE to update inflation expectations? New survey evidence on euro area firms", Working Paper Series, No 2949, ECB, uses the ECB's Survey on Access to Finance of Enterprises and demonstrates a causal effect of changes in inflation expectations on firms' price-setting decisions with a 1.0 percentage point increase in inflation expectations leading firms to plan an increase of 0.3% in their selling prices. 8. See also D'Acunto, F. et al. (2024), op. cit. 9. K6rdel and Molitor (2023) discuss how SESFOD has contributed to the determination of market participants' risk appetite. Dieckelmann and Metzler (2022) use the HFCS to analyse how household inequality is central to the assessment of financial stability risks. See K6rdel, S. and Molitor, P. (2023), "SESFOD@10 - credit terms and conditions in euro-denominated securities financing_and over-the- counter derivatives markets since 2013", Economic Bulletin, Issue 6 and Dieckelmann, D. and Metzler, J. (2022), "Household inequality and financial stability risks: exploring the impact of changes in consumer prices and interest rates", Financial Stability Review, ECB, November. CONTACT	---[PAGE_BREAK]--- # Expectations surveys, central banks and the economy ## Welcome address by Luis de Guindos, Vice-President of the ECB, at the 5th joint ECB, Bank of Canada and Federal Reserve Bank of New York Conference on expectations surveys, central banks and the economy Frankfurt am Main, 1 October 2024 It is my pleasure to welcome you to this fifth joint conference on expectations surveys organised by the European Central Bank, the Bank of Canada and the Federal Reserve Bank of New York. In my remarks today, I will delve into the fascinating world of expectations surveys and their relevance to central banks. I will review how useful expectations surveys have proven to be for central banks over the period since 2019, the year we held our first conference in this series. In addition, I will touch on the challenges facing central banks in using surveys. The fact that central banks generally operate under great uncertainty has come to the fore over the past five years. Today, too, we are facing huge uncertainty - not least in view of the many prevailing economic, financial and geopolitical risks. Yet, it is precisely in this unpredictable and highly complex landscape that surveys have come into their own. ## The return of survey expectations Over the past decade, central banks and other policymaking institutions have invested significantly in expectations surveys and have drawn increasingly on survey data for their policy analysis and research. These surveys cover consumers, firms, financial market participants and other experts, including professional forecasters. At the ECB, we can fortunately look to a wide array of such surveys covering diverse topics such as consumer expectations, household finance and consumption, access to finance of enterprises, the payment attitudes of consumers and bank lending. Since 2013, the ECB has also conducted a survey of wholesale market participants on credit terms and conditions, and it recently developed a new survey of monetary analysts to collect expert expectations about key monetary policy parameters and concepts. Finally, the ECB's Survey of Professional Forecasters was launched back in 1999 at the start of Economic and Monetary Union. Its structured collection of data has supported a rich research programme investigating economic forecasts and expert expectations. [1] All ECB surveys can provide insights into how different economic agents form and update their expectations. They can reveal the potential biases in these expectations and the extent to which expectations feed into economic decisions. Surveys were indeed quite central to the economic debate in the 1950s and the 1960s but their role became more marginal when rational expectations were incorporated into economic modelling in the 1970s. Over the past ten years, however, economists ---[PAGE_BREAK]--- have seen survey expectations clearly returning to the mainstream. ${ }^{[2]}$ One could describe the recent growth in survey-based research as a "counter-revolution" following the earlier "revolution" centred on rational expectations. Today, while models based on rational expectations still form a useful reference point in our analysis and research, they are no longer thought to provide a solid basis for understanding business cycles, for gauging the risks of financial crises or for designing effective economic policies. The central insight gained from this new line of survey-based research is that many economic agents may systematically form expectations by using partial sets of information or by following subjective narratives about how the economy functions - for example by applying simple rules of thumb. ${ }^{[3]}$ It is important to understand such subjective expectations, because these beliefs often underlie the economic choices and financial decisions that drive the economy. ${ }^{[4]}$ Surveys have repeatedly proven their usefulness over the past five years. During the COVID-19 pandemic, they were especially useful in helping to track financial conditions for firms and households, as well as in estimating the labour market response to the pandemic shock. Online surveys were of great benefit during the pandemic as in-person survey interviews were hampered by lockdown restrictions. For example, the ECB's Consumer Expectations Survey - an online survey which was fortuitously launched in early 2020 - helped us understand the severity of the pandemic-induced collapse in consumption and gauge the overall effectiveness of the major policy interventions by governments and other authorities at the time. ${ }^{[5]}$ # Insights from surveys during the recent period of high inflation More recently, the data collected in surveys strongly supported the analysis of the recent inflationary episode in the euro area. ${ }^{[6]}$ During the early phase of the inflation surge in 2022, survey data helped to inform the central discussion on the likely persistence of the shock. For example, the observed increase in consumers' medium-term expectations may have interacted with an increase in firms' pricing power to make the original supply shocks more persistent than they would otherwise have been. ${ }^{[7]}$ Forces that would gradually help bring inflation back down to our target were also visible in more recent survey data. For example, we could see how the rise in inflation and inflation expectations was acting as a major constraint on demand and consumer spending owing to its impact on real incomes. In August 2023 respondents to the ECB's Consumer Expectations Survey were asked what actions they were planning to take in light of their expectations about future inflation. The results clearly showed that a much higher share of consumers planned to reduce their spending in response to the expectations of higher prices. ${ }^{[8]}$ In addition, consumers indicated that they would start to shop around more and buy cheaper varieties of goods and services than they normally would. In a context where the ECB was taking decisive monetary policy action aimed at restoring price stability, these behavioural responses to higher inflation expectations also contributed to the gradual unwinding of the inflationary pressures across the euro area economy. ## Insights for financial stability analysis ---[PAGE_BREAK]--- In addition to monetary policy, expectations surveys are now increasingly being used for other central bank tasks as well. This includes financial stability analysis. Here, surveys can help identify potential sources of financial risk not only in financial markets and the banking system, but also in the household and non-financial corporate sectors. ${ }^{[9]}$ Even when there is no discernible financial stress at the aggregate level, the disaggregated or individual-level data typically provided by surveys can help us to identify emerging risks across particular sectors or socio-demographic groups. In financial stability analysis, the topic of financial literacy is receiving increased attention. In the first keynote lecture of the conference, Professor Annamaria Lusardi from Stanford University will talk about why financial literacy is relevant for central banks. One consideration for financial stability analysis is that less financially literate households may be less prepared to cope with adverse economic and financial shocks. Yet, these households tend to be the most exposed to such shocks and more heavily affected when they occur. Policies seeking to boost financial literacy may help borrowers to source loans that are cheaper to service, thus promoting more efficient and more sustainable debt management. These issues may be particularly relevant for real estate markets and housing, which will be the focus of the second keynote lecture of the conference, given by Professor Tarun Ramadorai from Imperial College London. Professor Ramadorai will discuss the importance of non-rational beliefs in the housing market and how household surveys can help inform policies that can address these frictions. # Sustaining the quality and representativeness of surveys Our experiences with survey data also highlight the challenges that policymakers face when using these data. Survey data can be volatile and there is evidence of overreaction in both household and firm surveys of expectations. For this reason, surveys may provide a noisy signal for policymaking in practice, which complicates how these data should feed into the policy reaction function. In this respect, I hope the research presented at today's conference can also help policymakers distinguish the signal from the noise that is always embedded in expectations data. These considerations underline the importance of the quality of the survey design, including the sampling and data collection methods. It is crucial that questions are designed to avoid the framing of responses and that the complexity of the questionnaires is managed appropriately to avoid survey fatigue, which may negatively affect data quality. As central banks are making increasing use of survey data, they need to continuously and carefully monitor these data to ensure responses remain representative of the underlying population's beliefs and behaviour. ## Conclusion Let me conclude. Today, expectations surveys are an important part of the toolkit available to central banks for their policy analysis. These surveys reveal insights about the economy that would otherwise remain hidden from view. As a result, they can contribute to more robust policy decisions and better policy assessments. I would like to finish by thanking the presenters and participants in advance for their contributions and the conference organisers for putting together such an impressive programme. I wish you all a productive and successful two days of lively debate and discussion. I am confident that the insights ---[PAGE_BREAK]--- that will emerge from sharing our experiences of different surveys across many countries and institutions will ultimately enhance the way in which we use expectations surveys to help guide policy decisions. 1. See ECB surveys. 2. See Coibion, O., Gorodnichenko, Y. and Kamdar, R. (2018), "The Formation of Expectations, Inflation, and the Phillips curve", Journal of Economic Literature, Vol. 56, No 4, pp. 1447-1491; D'Acunto, F., Charalambakis, E., Georgarakos, D., Kenny, G., Meyer, J. and Weber, M. (2024), "Household inflation expectations: An overview of recent insights for monetary policy", Discussion Paper Series, No 24, ECB; Shleifer, A., (2019), "The return of survey expectations", NBER Reporter, No 1, pp. 14-17. 3. See Andre, P., Pizzinelli, C., Roth, C. and Wohlfart, J. (2022), "Subjective models of the macroeconomy: Evidence from experts and representative samples", The Review of Economic Studies, Vol. 89, No 6, pp. 2958-2991; Weber, M., Candia, B., Afrouzi, H., Ropele, T., Lluberas, R., Frache, S., Meyer, B.H., Kumar, S., Gorodnichenko, Y., Georgarakos, D., Coibion, O. and Kenny, G. (2024), "Tell me something I don't already know: learning in low and high-inflation settings", Working Paper Series, No 2914, ECB, March, shows that the attention of both consumers and firms to inflation depends on the level of inflation. In particular, consumers and firms don't pay much attention to official news about inflation when inflation is low, but they are much more attentive and informed about inflation developments when inflation is high. 4. See Manski, C.F. (2004), "Measuring expectations", Econometrica, Vol. 72, No 5, pp. 1329-1376; Manski, C.F. (2018), "Survey measurement of probabilistic macroeconomic expectations: progress and promise", NBER Macroeconomics Annual, Vol. 32, No 1, pp. 411-471. 5. See, for example, Christelis, D., Georgarakos, D., Jappelli T. and Kenny, G. (2020), "The Covid-19 crisis and consumption: survey evidence from six EU countries", Working Paper Series, No 2507, ECB, December and Georgarakos, D. and Kenny, G. (2022), "Household spending and fiscal support during the COVID-19 pandemic: Insights from a new consumer survey", Journal of Monetary Economics, Vol. 129, pp. S1-S14. 6. For a recent review of the insights for monetary policy from research using household inflation expectations see D'Acunto, F. et al. (2024), op. cit. ---[PAGE_BREAK]--- 7. See Acharya, V.V., Crosignani, M., Eisert, T. and Eufinger, C. (2023), "How do supply shocks to inflation generalize? Evidence from the pandemic era in Europe", NBER Working Paper, No 31790, as well as the discussion in D'Acunto, F. et al. (2024); Baumann, U., Ferrando, A., Georgarakos, D., Gorodnichenko, Y. and Reinelt, T. (2024), "SAFE to update inflation expectations? New survey evidence on euro area firms", Working Paper Series, No 2949, ECB, uses the ECB's Survey on Access to Finance of Enterprises and demonstrates a causal effect of changes in inflation expectations on firms' price-setting decisions with a 1.0 percentage point increase in inflation expectations leading firms to plan an increase of $0.3 \%$ in their selling prices. 8. See also D'Acunto, F. et al. (2024), op. cit. 9. Kördel and Molitor (2023) discuss how SESFOD has contributed to the determination of market participants' risk appetite. Dieckelmann and Metzler (2022) use the HFCS to analyse how household inequality is central to the assessment of financial stability risks. See Kördel, S. and Molitor, P. (2023), "SESFOD@10 - credit terms and conditions in euro-denominated securities financing and over-thecounter derivatives markets since 2013", Economic Bulletin, Issue 6 and Dieckelmann, D. and Metzler, J. (2022), "Household inequality and financial stability risks: exploring the impact of changes in consumer prices and interest rates", Financial Stability Review, ECB, November.	Luis de Guindos	Euro area	https://www.bis.org/review/r241014d.pdf	Frankfurt am Main, 1 October 2024 It is my pleasure to welcome you to this fifth joint conference on expectations surveys organised by the European Central Bank, the Bank of Canada and the Federal Reserve Bank of New York. In my remarks today, I will delve into the fascinating world of expectations surveys and their relevance to central banks. I will review how useful expectations surveys have proven to be for central banks over the period since 2019, the year we held our first conference in this series. In addition, I will touch on the challenges facing central banks in using surveys. The fact that central banks generally operate under great uncertainty has come to the fore over the past five years. Today, too, we are facing huge uncertainty - not least in view of the many prevailing economic, financial and geopolitical risks. Yet, it is precisely in this unpredictable and highly complex landscape that surveys have come into their own. Over the past decade, central banks and other policymaking institutions have invested significantly in expectations surveys and have drawn increasingly on survey data for their policy analysis and research. These surveys cover consumers, firms, financial market participants and other experts, including professional forecasters. At the ECB, we can fortunately look to a wide array of such surveys covering diverse topics such as consumer expectations, household finance and consumption, access to finance of enterprises, the payment attitudes of consumers and bank lending. Since 2013, the ECB has also conducted a survey of wholesale market participants on credit terms and conditions, and it recently developed a new survey of monetary analysts to collect expert expectations about key monetary policy parameters and concepts. Finally, the ECB's Survey of Professional Forecasters was launched back in 1999 at the start of Economic and Monetary Union. Its structured collection of data has supported a rich research programme investigating economic forecasts and expert expectations. All ECB surveys can provide insights into how different economic agents form and update their expectations. They can reveal the potential biases in these expectations and the extent to which expectations feed into economic decisions. Surveys were indeed quite central to the economic debate in the 1950s and the 1960s but their role became more marginal when rational expectations were incorporated into economic modelling in the 1970s. Over the past ten years, however, economists have seen survey expectations clearly returning to the mainstream. Surveys have repeatedly proven their usefulness over the past five years. During the COVID-19 pandemic, they were especially useful in helping to track financial conditions for firms and households, as well as in estimating the labour market response to the pandemic shock. Online surveys were of great benefit during the pandemic as in-person survey interviews were hampered by lockdown restrictions. For example, the ECB's Consumer Expectations Survey - an online survey which was fortuitously launched in early 2020 - helped us understand the severity of the pandemic-induced collapse in consumption and gauge the overall effectiveness of the major policy interventions by governments and other authorities at the time. More recently, the data collected in surveys strongly supported the analysis of the recent inflationary episode in the euro area. Forces that would gradually help bring inflation back down to our target were also visible in more recent survey data. For example, we could see how the rise in inflation and inflation expectations was acting as a major constraint on demand and consumer spending owing to its impact on real incomes. In August 2023 respondents to the ECB's Consumer Expectations Survey were asked what actions they were planning to take in light of their expectations about future inflation. The results clearly showed that a much higher share of consumers planned to reduce their spending in response to the expectations of higher prices. In addition, consumers indicated that they would start to shop around more and buy cheaper varieties of goods and services than they normally would. In a context where the ECB was taking decisive monetary policy action aimed at restoring price stability, these behavioural responses to higher inflation expectations also contributed to the gradual unwinding of the inflationary pressures across the euro area economy. In addition to monetary policy, expectations surveys are now increasingly being used for other central bank tasks as well. This includes financial stability analysis. Here, surveys can help identify potential sources of financial risk not only in financial markets and the banking system, but also in the household and non-financial corporate sectors. Even when there is no discernible financial stress at the aggregate level, the disaggregated or individual-level data typically provided by surveys can help us to identify emerging risks across particular sectors or socio-demographic groups. In financial stability analysis, the topic of financial literacy is receiving increased attention. In the first keynote lecture of the conference, Professor Annamaria Lusardi from Stanford University will talk about why financial literacy is relevant for central banks. One consideration for financial stability analysis is that less financially literate households may be less prepared to cope with adverse economic and financial shocks. Yet, these households tend to be the most exposed to such shocks and more heavily affected when they occur. Policies seeking to boost financial literacy may help borrowers to source loans that are cheaper to service, thus promoting more efficient and more sustainable debt management. These issues may be particularly relevant for real estate markets and housing, which will be the focus of the second keynote lecture of the conference, given by Professor Tarun Ramadorai from Imperial College London. Professor Ramadorai will discuss the importance of non-rational beliefs in the housing market and how household surveys can help inform policies that can address these frictions. Our experiences with survey data also highlight the challenges that policymakers face when using these data. Survey data can be volatile and there is evidence of overreaction in both household and firm surveys of expectations. For this reason, surveys may provide a noisy signal for policymaking in practice, which complicates how these data should feed into the policy reaction function. In this respect, I hope the research presented at today's conference can also help policymakers distinguish the signal from the noise that is always embedded in expectations data. These considerations underline the importance of the quality of the survey design, including the sampling and data collection methods. It is crucial that questions are designed to avoid the framing of responses and that the complexity of the questionnaires is managed appropriately to avoid survey fatigue, which may negatively affect data quality. As central banks are making increasing use of survey data, they need to continuously and carefully monitor these data to ensure responses remain representative of the underlying population's beliefs and behaviour. Let me conclude. Today, expectations surveys are an important part of the toolkit available to central banks for their policy analysis. These surveys reveal insights about the economy that would otherwise remain hidden from view. As a result, they can contribute to more robust policy decisions and better policy assessments. I would like to finish by thanking the presenters and participants in advance for their contributions and the conference organisers for putting together such an impressive programme. I wish you all a productive and successful two days of lively debate and discussion. I am confident that the insights that will emerge from sharing our experiences of different surveys across many countries and institutions will ultimately enhance the way in which we use expectations surveys to help guide policy decisions.
2024-10-02T00:00:00	Luis de Guindos: Bridging the gap - reviving the euro area's productivity growth through innovation, investment and integration	Keynote speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Bank of Latvia and SUERF Economic Conference 2024, Riga, 2 October 2024.	SPEECH Bridging the gap: reviving the euro area's productivity growth through innovation, investment and integration Keynote speech by Luis de Guindos, Vice-President of the ECB, at the Latvijas Banka and SUERF Economic Conference 2024 Riga, 2 October 2024 It is a pleasure to talk to you today about reviving productivity growth in the euro area - a critical challenge that demands urgent attention and collective action. The euro area's economic recovery I would like to start by outlining recent economic developments. After more than a year of stagnation, economic activity in the euro area recovered mildly in the first half of 2024, with considerable variation across countries and sectors. Growth, however, was weaker than expected in the second quarter of the year. The euro area growth outlook was revised down in September, compared with the June Eurosystem staff projections, with risks to growth remaining tilted to the downside. Looking ahead, we expect the recovery to strengthen over time, as rising real incomes and the gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should also continue contributing to the recovery as global demand picks up. The recovery should be underpinned by an expected recovery in productivity growth, which has been particularly weak since the onset of the pandemic. Weak labour productivity can be partly attributed to cyclical factors, especially given the relative rigidity of the euro area labour market, where employers do not fully adjust their workforce at times of low growth, resulting in labour hoarding." Cyclical factors that incentivise labour hoarding are expected to gradually diminish, leading to a recovery in productivity. However, productivity growth has not only been dampened through cyclical channels. It has been decelerating for decades in the euro area, mirroring a broader global trend. This structural weakness has been a significant drag on economic activity and continues to constrain medium-term growth prospects in the euro area, particularly in light of demographic developments. The population is shrinking and our societies are ageing, so sustaining the workforce will rely on higher participation rates, especially among women and older people, alongside well-designed immigration policies to address labour shortages and support long-term growth. But allow me to delve deeper into the core drivers of this sluggish productivity growth, particularly when compared with the United States. The productivity gap and how to address it Over the past 30 years, the productivity gap between the euro area and the United States has widened considerably. This divergence has been driven by relatively weak total factor productivity growth in the euro area and, since the global financial crisis, insufficient capital deepening. To understand this productivity gap, we must look at the structural challenges we face. As Mario Draghi highlighted in his recent report on European competitiveness, one key issue is that Europe largely missed out on the digital revolution.!2! While the United States capitalised on its high- tech sector, many of the euro area's most productive "frontier" firms are concentrated in mid-tech sectors with limited potential for productivity growth. This divergence is not due to the level of public R&D expenditure or the quality of our research, but rather to sectoral specialisation and the lack of coordination in investment and innovation policies across Member States.) Total investment ratios, both private and public, as a percentage of GDP are also lower in the euro area than in the United States.) Despite an increase in public investment since 2020, driven by the Next Generation EU initiative, there is still a substantial gap in private investment, particularly in the areas of R&D, digital innovation and digital uptake. The decline in total factor productivity growth among high-tech frontier firms in the euro area partly reflects their age, as older firms are typically less productive. Moreover, a secular decline in business entry rates and the winner-takes-all dynamics of new technologies have reduced competition, limiting the process of creative destruction needed for productivity growth. In the services sector, a widening total factor productivity growth gap between leading and lagging firms suggests that the adoption of new technologies by non-frontier firms, particularly small and medium-sized enterprises, remains sluggish. The European ecosystem of small and ageing firms struggles to compete globally. If we do not act quickly, their comparative disadvantages will only grow in this era of rapid technological progress. Our firms face scaling-up challenges, skill shortages, and framework conditions that are not conducive to radical innovation, but instead favour marginal improvements in mature technologies. Business dynamism is stifled by intricate regulations and overlapping governmental institutions and tax systems. This restricts the creation of innovative firms and the reallocation of resources to the most productive, undermining productivity growth and competitiveness. These complexities are amplified across national borders, further limiting the ability of European businesses to scale up. Ensuring a Single Market that's fit for purpose Europe's productivity would be higher if more innovative firms had a better environment in which to become established, grow, innovate and thrive. Since its inception, the Single Market has made significant progress in fostering growth and convergence across Europe, but the environment for innovative firms still leaves much to be desired. Enrico Letta's recent report offers a comprehensive perspective on the Single Market, highlighting the as yet untapped potential. His proposals to streamline the regulatory burdens, favour regulations instead of directives for greater harmonisation, improve administrative capacity and introduce a European business code as a 28th regime merit particular attention. Advancing the capital markets union A larger and more integrated Single Market would call for a single, deep capital market to finance the EU's competitive firms. Greater economic integration in the EU will bring greater financial integration. Numerous proposals have been made to develop the capital markets union, and the ECB's Governing Council issued a statement on the topic in March 2024 [8 Let me first focus on the proposals aimed at fostering the growth of competitive European firms. As companies progress from developing an idea to becoming large and successful enterprises, they require diverse sources of financing and need to be connected to stakeholders who can best support them through their growth phases. However, Europe's financial system is predominantly reliant on bank lending, which is not ideally suited for financing young high-risk firms. During the scaling-up phase in particular, innovative companies need access to risk capital and investors with the networks, experience and risk tolerance to allow them to experiment and potentially fail. Venture capital funds are particularly well-suited for this purpose. However, the venture capital market segment in Europe is underdeveloped. As a percentage of GDP, venture capital financing in Europe is a third of that in the United States. In addition, individual EU venture capital funds are smaller owing to a fragmented market. This has direct consequences for firms: not many EU venture capital funds are large enough or have deep enough pockets to meet firms' financing needs or cope with the high failure rate of start-ups or young high-risk firms. It is not uncommon to see failure rates of 80% for risky frontier-tech investments, for example.) If firms need to seek funding in countries outside the EU, such as the United States, their activities can end up being relocated abroad, affecting Europe's economy. Companies that source foreign funding in the later stages of their scaling-up may then be listed on foreign exchanges, further depriving Europe's equity markets of large and innovative firms that contribute to the markets' depth and liquidity. The recent listing gap between the United States and Europe is due, at least in part, to the greater attractiveness of US stock markets for foreign firms. The percentage of foreign companies among all companies listed in the United States rose from around 18% in 2017 to 24% in 2022. By contrast, foreign listings in European markets have shown a slight downward trend over the same period. Europe lacks a single, sufficiently deep and liquid equity market where firms listing in the EU could aim for similarly high valuations as those they can currently aspire to in the United States. The average market capitalisation of US companies has historically been much higher than that of European companies, with the gap having widened significantly since 2010. In 2022, US companies achieved, on average, a market capitalisation that was 3.3 times higher than that of EU companies.!12] Overall, Europe's underdeveloped venture capital environment, fragmented equity markets and heterogenous national markets are leading to higher financing costs and inefficiencies in the allocation of capital when compared with the United States. To overcome Europe's private investment gap and give European firms access to the financing they need, especially in terms of equity, we need a more ambitious agenda for both developing and integrating EU capital markets. First, household savings should be directed towards capital markets. A retail savings product that offers tax incentives and could be sold across the EU would be a step forward. The same goes for lowering the entry barriers for retail investors to participate in equity and bond markets. Increasing the share of equity investments in funded pension systems would also have mutually reinforcing benefits. It would give institutional investors, such as pension funds, a greater role in providing a large investor base for equity markets, similar to the role they now play in the United States."5] Ensuring the portability of pensions across borders, as envisaged when launching the Pan-European Personal Pension Product, will also be fundamental in supporting the single labour market by enhancing mobility for workers in Europe. Second, regulatory action can encourage investment in equity by addressing the debt-equity bias in taxation. Simplifying regulation can attract investors, promote risk-taking by Europe's companies and boost cross-border market developments. For instance, streamlining eligibility requirements in the uciTs"4] and European Venture Capital Fund! directives could incentivise investment in venture capital funds and make the most of the "passport" system that facilitates the distribution of funds throughout the EU. Third, to develop the equity market, we need to make listings in Europe more attractive and efficient. To this end, we should aim to create a single pool of liquidity for public equity markets that would provide sufficient market depth to issuers and investors, including asset managers, pension funds and other large EU-based investors."9] This requires (i) deeper integration in the trading and post-trading landscape; (ii) further harmonisation in difficult areas like insolvency regimes, accounting, and securities law; and (iii) more centralised supervision for systemic cross-border entities, including stock exchanges and market infrastructures. Where political agreement on harmonisation is not yet reachable, intermediate solutions mentioned before, such as a 28th regime, or enhanced cooperation, should be considered. Away of deepening the securitisation market would be to set up a European securitisation platform. Besides fostering standardisation, this would support the development of green and other strategic segments while maintaining a sound prudential framework. Finally, public-private partnerships will be critical in future for stepping up investment in innovative firms and the green and digital transitions. Mobilising EU-level financing for the provision of European public goods The complementarity between public and private investment leads me to my final point on the need to mobilise fiscal resources at EU level. The EU needs a massive amount of financing to close the productivity gap and support the digital and green transition." Europe has to reflect on how it can use targeted public investment to help meet these financing needs. The EU and Member States should explore a reorientation of the EU budget as well as options for jointly funding investment in specific projects. The Recovery and Resilience Facility (RRF) was a step in the right direction. Joint European action can successfully bring about key investments as well as growth-enhancing structural reforms, while fostering national ownership, mitigating fragmentation risks, enhancing economic resilience and improving risk sharing. But the RRF is a temporary tool, and once it elapses in 2026, the EU budget will shrink significantly owing to the cliff effect.18] We should be determined to permanently enhance the EU's fiscal capacity, also to support cross- border and pan-European projects. These could include the provision of European public goods such as energy infrastructure, innovative technologies and common defence, further strengthening risk sharing by ensuring that key investments take place even in adverse macroeconomic conditions.12] Besides common spending initiatives, essential elements for supporting innovative projects are well- targeted subsidies and a cohesive European industrial policy.!2! A level playing field needs to be restored, fully phasing out the State Aid Temporary Framework adopted during the pandemic. Conclusion Let me conclude. Broadly speaking, the problems we are discussing today derive from the incompleteness of the Economic and Monetary Union: greater integration in the markets for goods and services, as well as in the capital and labour factors of production, are essential for the success of the European project. The recent high-level reports from Enrico Letta and Mario Draghi correctly emphasise that the key to Europe's success is to leverage on all aspects of EU collaboration and coordination, including the completion of the Single Market. This would boost EU productivity and competitiveness for the benefit of our economies and citizens. Regarding the topic of today's conference, advancing on the agenda for the capital markets union will require efforts to dismantle the barriers to enlarging segments of the capital markets and provide the financing needed by innovative firms to develop throughout their lifecycle. But the capital markets union alone will not deliver those benefits if economic integration is still in the starting blocks, the Single Market remains fragmented, the banking union is not yet complete, and EU industrial competition and trade policies are not part of an overall EU strategy. This calls for an ambitious and comprehensive agenda with a more focused Europe. To reignite European productivity and competitiveness, ensure sustainable growth and rising living standards for all European citizens, the EU response must be determined and cohesive. 1. Arce, O. and Sondermann, D. (2024), "Low for long? Reasons for the recent decline in productivity", The ECB Blog, ECB, 6 May. 2. European Commission (2024), EU competitiveness: looking ahead. 3. See Bergeaud, A. (2024), "The past, present and future of European productivity", ECB Forum on Central Banking 1-3 July 2024; Fuest, C., Gros, D., Mengel, P.-L., Presidente, G. and Tirole, J. (2024), "EU Innovation Policy: How to Escape the Middle Technology Trap", EconPol Policy Report, April. 4. Private investment refers to real gross fixed capital formation of the private sector (excluding dwellings) over real GDP. 5. See Raudla, R. and Spendzharova, A. (2022), "Challenges to the European single market at thirty: renationalisation, resilience, or renewed integration?" Journal of European Integration, Vol. 44, No 1, pp. 1-17. See also Ebeke, C.H., Frie, J.-M. and Rabier, L. (2019), "Deepening the EU's single market for services" Working Paper Series, No 2019/269, IMF. 6. Lehtimaki, J. and Sondermann, D. (2022), "Baldwin versus Cecchini revisited: the growth impact of the European Single Market', Empirical Economics, Vol. 63, pp. 603-635 finds that the Single Market boosted real GDP per capita by around 12-22% for the group of members as a whole. 7. See Letta, E. (2024), "Much More Than a Market-Speed, Security, Solidarity: Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens', April. 8. ECB (2024), Statement by the ECB Governing Council on advancing the Capital Markets Union, 7 March. 9. Innovation in Europe", Working Paper Series, No 2024/146, IMF. 10. See Coatanlem, Y. (2024), "Why Europe is a laggard in tech", Opinion - Technology sector, Financial Times, 26 February. 11. See Gati, Z., Lambert, C., Ranucci, D., Rouveyrol, C. and Schdlermann, H. (2024), "Examining the causes and consequences of the recent listing gap between the United States and Europe", Financial Integration and Structure in the Euro Area, May. 12. ibid. 13. The equity share of private pension investment is particularly low in countries with large pay-as-you-go systems. By contrast, countries with large funded pension systems, and, therefore, large aggregate private retirement savings, typically have the most developed capital markets. See, for example, Scharfstein, D. (2018), "Presidential address: Pension policy and the financial system", Journal of Finance, Vol. 73, No 4, pp. 1463-1512. 14. The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive 2009/65 is an EU directive that allows collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one Member State. 15. The European Venture Capital Fund (EuVECA) Regulation 345/2013 offers a voluntary EU-wide marketing passport to smaller fund managers, sparing them the costs associated with authorisation and compliance with the general regulation for alternative investment fund managers. 16. See European Investment Bank (2024), "The scale-up gap: Financial market constraints holding back innovative firms in the European Union", EIB Thematic Studies. 17. See Bouabdallah, O., Dorrucci, E., Hoendervangers L. and Nerlich C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them" The ECB Blog, ECB, 27 June. 18. For reference, the final RRF envelope amounts to €648 billion, equivalent to around 33.7% of the EU budget for the period 2021-27. 19. Schang, C. and Vinci, F. (2024), "Marrying fiscal rules & investment: a central fiscal capacity for Europe", Working Paper Series, No 2962, ECB, July proposes a central fiscal capacity (CFC) design focused on euro area-wide investment in European public goods (EPGs), assuming that these underpin productivity across the entire bloc and advance strategic European goals. The EPG-focused CFC reallocates their cost across regions over the business cycle, in effect resulting in stabilisation, while ensuring common investment needs are met. 20. See Borota, T., Defever F., Impullitti, G. and Spencer, A. (2022), "Innovation Union: Costs and Benefits of Innovation Policy Cooperation", CEPR Discussion Paper, No 17549. CONTACT	---[PAGE_BREAK]--- # Bridging the gap: reviving the euro area's productivity growth through innovation, investment and integration ## Keynote speech by Luis de Guindos, Vice-President of the ECB, at the Latvijas Banka and SUERF Economic Conference 2024 Riga, 2 October 2024 It is a pleasure to talk to you today about reviving productivity growth in the euro area - a critical challenge that demands urgent attention and collective action. ## The euro area's economic recovery I would like to start by outlining recent economic developments. After more than a year of stagnation, economic activity in the euro area recovered mildly in the first half of 2024, with considerable variation across countries and sectors. Growth, however, was weaker than expected in the second quarter of the year. The euro area growth outlook was revised down in September, compared with the June Eurosystem staff projections, with risks to growth remaining tilted to the downside. Looking ahead, we expect the recovery to strengthen over time, as rising real incomes and the gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should also continue contributing to the recovery as global demand picks up. The recovery should be underpinned by an expected recovery in productivity growth, which has been particularly weak since the onset of the pandemic. Weak labour productivity can be partly attributed to cyclical factors, especially given the relative rigidity of the euro area labour market, where employers do not fully adjust their workforce at times of low growth, resulting in labour hoarding. ${ }^{[1]}$ Cyclical factors that incentivise labour hoarding are expected to gradually diminish, leading to a recovery in productivity. However, productivity growth has not only been dampened through cyclical channels. It has been decelerating for decades in the euro area, mirroring a broader global trend. This structural weakness has been a significant drag on economic activity and continues to constrain medium-term growth prospects in the euro area, particularly in light of demographic developments. The population is shrinking and our societies are ageing, so sustaining the workforce will rely on higher participation rates, especially among women and older people, alongside well-designed immigration policies to address labour shortages and support long-term growth. But allow me to delve deeper into the core drivers of this sluggish productivity growth, particularly when compared with the United States. ## The productivity gap and how to address it ---[PAGE_BREAK]--- Over the past 30 years, the productivity gap between the euro area and the United States has widened considerably. This divergence has been driven by relatively weak total factor productivity growth in the euro area and, since the global financial crisis, insufficient capital deepening. To understand this productivity gap, we must look at the structural challenges we face. As Mario Draghi highlighted in his recent report on European competitiveness, one key issue is that Europe largely missed out on the digital revolution. ${ }^{[2]}$ While the United States capitalised on its hightech sector, many of the euro area's most productive "frontier" firms are concentrated in mid-tech sectors with limited potential for productivity growth. This divergence is not due to the level of public R\&D expenditure or the quality of our research, but rather to sectoral specialisation and the lack of coordination in investment and innovation policies across Member States. ${ }^{[3]}$ Total investment ratios, both private and public, as a percentage of GDP are also lower in the euro area than in the United States. ${ }^{[4]}$ Despite an increase in public investment since 2020, driven by the Next Generation EU initiative, there is still a substantial gap in private investment, particularly in the areas of R\&D, digital innovation and digital uptake. The decline in total factor productivity growth among high-tech frontier firms in the euro area partly reflects their age, as older firms are typically less productive. Moreover, a secular decline in business entry rates and the winner-takes-all dynamics of new technologies have reduced competition, limiting the process of creative destruction needed for productivity growth. In the services sector, a widening total factor productivity growth gap between leading and lagging firms suggests that the adoption of new technologies by non-frontier firms, particularly small and medium-sized enterprises, remains sluggish. The European ecosystem of small and ageing firms struggles to compete globally. If we do not act quickly, their comparative disadvantages will only grow in this era of rapid technological progress. Our firms face scaling-up challenges, skill shortages, and framework conditions that are not conducive to radical innovation, but instead favour marginal improvements in mature technologies. Business dynamism is stifled by intricate regulations and overlapping governmental institutions and tax systems. This restricts the creation of innovative firms and the reallocation of resources to the most productive, undermining productivity growth and competitiveness. These complexities are amplified across national borders, further limiting the ability of European businesses to scale up. ${ }^{[5]}$ # Ensuring a Single Market that's fit for purpose Europe's productivity would be higher if more innovative firms had a better environment in which to become established, grow, innovate and thrive. Since its inception, the Single Market has made significant progress in fostering growth and convergence across Europe, but the environment for innovative firms still leaves much to be desired. ${ }^{[6]}$ Enrico Letta's recent report offers a comprehensive perspective on the Single Market, highlighting the as yet untapped potential. ${ }^{[7]}$ His proposals to streamline the regulatory burdens, favour regulations instead of directives for greater harmonisation, improve administrative capacity and introduce a European business code as a 28th regime merit particular attention. ---[PAGE_BREAK]--- # Advancing the capital markets union A larger and more integrated Single Market would call for a single, deep capital market to finance the EU's competitive firms. Greater economic integration in the EU will bring greater financial integration. Numerous proposals have been made to develop the capital markets union, and the ECB's Governing Council issued a statement on the topic in March 2024. $\underline{[5]}$ Let me first focus on the proposals aimed at fostering the growth of competitive European firms. As companies progress from developing an idea to becoming large and successful enterprises, they require diverse sources of financing and need to be connected to stakeholders who can best support them through their growth phases. However, Europe's financial system is predominantly reliant on bank lending, which is not ideally suited for financing young high-risk firms. During the scaling-up phase in particular, innovative companies need access to risk capital and investors with the networks, experience and risk tolerance to allow them to experiment and potentially fail. Venture capital funds are particularly well-suited for this purpose. However, the venture capital market segment in Europe is underdeveloped. As a percentage of GDP, venture capital financing in Europe is a third of that in the United States. $\underline{[6]}$ In addition, individual EU venture capital funds are smaller owing to a fragmented market. This has direct consequences for firms: not many EU venture capital funds are large enough or have deep enough pockets to meet firms' financing needs or cope with the high failure rate of start-ups or young high-risk firms. It is not uncommon to see failure rates of $80 \%$ for risky frontier-tech investments, for example. $\underline{[10]}$ If firms need to seek funding in countries outside the EU, such as the United States, their activities can end up being relocated abroad, affecting Europe's economy. Companies that source foreign funding in the later stages of their scaling-up may then be listed on foreign exchanges, further depriving Europe's equity markets of large and innovative firms that contribute to the markets' depth and liquidity. The recent listing gap between the United States and Europe is due, at least in part, to the greater attractiveness of US stock markets for foreign firms. The percentage of foreign companies among all companies listed in the United States rose from around 18\% in 2017 to 24\% in 2022. By contrast, foreign listings in European markets have shown a slight downward trend over the same period. $\underline{[11]}$ Europe lacks a single, sufficiently deep and liquid equity market where firms listing in the EU could aim for similarly high valuations as those they can currently aspire to in the United States. The average market capitalisation of US companies has historically been much higher than that of European companies, with the gap having widened significantly since 2010. In 2022, US companies achieved, on average, a market capitalisation that was 3.3 times higher than that of EU companies. $\underline{[12]}$ Overall, Europe's underdeveloped venture capital environment, fragmented equity markets and heterogenous national markets are leading to higher financing costs and inefficiencies in the allocation of capital when compared with the United States. To overcome Europe's private investment gap and give European firms access to the financing they need, especially in terms of equity, we need a more ambitious agenda for both developing and integrating EU capital markets. First, household savings should be directed towards capital markets. A retail savings product that offers tax incentives and could be sold across the EU would be a step forward. The same goes for ---[PAGE_BREAK]--- lowering the entry barriers for retail investors to participate in equity and bond markets. Increasing the share of equity investments in funded pension systems would also have mutually reinforcing benefits. It would give institutional investors, such as pension funds, a greater role in providing a large investor base for equity markets, similar to the role they now play in the United States. ${ }^{[13]}$ Ensuring the portability of pensions across borders, as envisaged when launching the Pan-European Personal Pension Product, will also be fundamental in supporting the single labour market by enhancing mobility for workers in Europe. Second, regulatory action can encourage investment in equity by addressing the debt-equity bias in taxation. Simplifying regulation can attract investors, promote risk-taking by Europe's companies and boost cross-border market developments. For instance, streamlining eligibility requirements in the UCITS ${ }^{[14]}$ and European Venture Capital Fund ${ }^{[15]}$ directives could incentivise investment in venture capital funds and make the most of the "passport" system that facilitates the distribution of funds throughout the EU. Third, to develop the equity market, we need to make listings in Europe more attractive and efficient. To this end, we should aim to create a single pool of liquidity for public equity markets that would provide sufficient market depth to issuers and investors, including asset managers, pension funds and other large EU-based investors. ${ }^{[16]}$ This requires (i) deeper integration in the trading and post-trading landscape; (ii) further harmonisation in difficult areas like insolvency regimes, accounting, and securities law; and (iii) more centralised supervision for systemic cross-border entities, including stock exchanges and market infrastructures. Where political agreement on harmonisation is not yet reachable, intermediate solutions mentioned before, such as a 28th regime, or enhanced cooperation, should be considered. A way of deepening the securitisation market would be to set up a European securitisation platform. Besides fostering standardisation, this would support the development of green and other strategic segments while maintaining a sound prudential framework. Finally, public-private partnerships will be critical in future for stepping up investment in innovative firms and the green and digital transitions. # Mobilising EU-level financing for the provision of European public goods The complementarity between public and private investment leads me to my final point on the need to mobilise fiscal resources at EU level. The EU needs a massive amount of financing to close the productivity gap and support the digital and green transition. ${ }^{[17]}$ Europe has to reflect on how it can use targeted public investment to help meet these financing needs. The EU and Member States should explore a reorientation of the EU budget as well as options for jointly funding investment in specific projects. The Recovery and Resilience Facility (RRF) was a step in the right direction. Joint European action can successfully bring about key investments as well as growth-enhancing structural reforms, while fostering national ownership, mitigating fragmentation risks, enhancing economic resilience and ---[PAGE_BREAK]--- improving risk sharing. But the RRF is a temporary tool, and once it elapses in 2026, the EU budget will shrink significantly owing to the cliff effect. ${ }^{[18]}$ We should be determined to permanently enhance the EU's fiscal capacity, also to support crossborder and pan-European projects. These could include the provision of European public goods such as energy infrastructure, innovative technologies and common defence, further strengthening risk sharing by ensuring that key investments take place even in adverse macroeconomic conditions. ${ }^{[19]}$ Besides common spending initiatives, essential elements for supporting innovative projects are welltargeted subsidies and a cohesive European industrial policy. ${ }^{[20]}$ A level playing field needs to be restored, fully phasing out the State Aid Temporary Framework adopted during the pandemic. # Conclusion Let me conclude. Broadly speaking, the problems we are discussing today derive from the incompleteness of the Economic and Monetary Union: greater integration in the markets for goods and services, as well as in the capital and labour factors of production, are essential for the success of the European project. The recent high-level reports from Enrico Letta and Mario Draghi correctly emphasise that the key to Europe's success is to leverage on all aspects of EU collaboration and coordination, including the completion of the Single Market. This would boost EU productivity and competitiveness for the benefit of our economies and citizens. Regarding the topic of today's conference, advancing on the agenda for the capital markets union will require efforts to dismantle the barriers to enlarging segments of the capital markets and provide the financing needed by innovative firms to develop throughout their lifecycle. But the capital markets union alone will not deliver those benefits if economic integration is still in the starting blocks, the Single Market remains fragmented, the banking union is not yet complete, and EU industrial competition and trade policies are not part of an overall EU strategy. This calls for an ambitious and comprehensive agenda with a more focused Europe. To reignite European productivity and competitiveness, ensure sustainable growth and rising living standards for all European citizens, the EU response must be determined and cohesive. 1. Arce, O. and Sondermann, D. (2024), "Low for long? Reasons for the recent decline in productivity", The ECB Blog, ECB, 6 May. 2. European Commission (2024), EU competitiveness: looking ahead. 3. See Bergeaud, A. (2024), "The past, present and future of European productivity", ECB Forum on Central Banking 1-3 July 2024; Fuest, C., Gros, D., Mengel, P.-L., Presidente, G. and Tirole, J. (2024), "EU Innovation Policy: How to Escape the Middle Technology Trap", EconPol Policy Report, April. ---[PAGE_BREAK]--- 4. Private investment refers to real gross fixed capital formation of the private sector (excluding dwellings) over real GDP. 5. See Raudla, R. and Spendzharova, A. (2022), "Challenges to the European single market at thirty: renationalisation, resilience, or renewed integration?" Journal of European Integration, Vol. 44, No 1, pp. 1-17. See also Ebeke, C.H., Frie, J.-M. and Rabier, L. (2019), "Deepening the EU's single market for services" Working Paper Series, No 2019/269, IMF. 6. Lehtimäki, J. and Sondermann, D. (2022), "Baldwin versus Cecchini revisited: the growth impact of the European Single Market", Empirical Economics, Vol. 63, pp. 603-635 finds that the Single Market boosted real GDP per capita by around 12-22\% for the group of members as a whole. 7. See Letta, E. (2024), "Much More Than a Market-Speed. Security. Solidarity: Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens", April. 8. ECB (2024), Statement by the ECB Governing Council on advancing the Capital Markets Union, 7 March. 9. See Arnold, N.G., Claveres, G. and Frie, J. (2024), "Stepping Up Venture Capital to Finance Innovation in Europe", Working Paper Series, No 2024/146, IMF. 10. See Coatanlem, Y. (2024), "Why Europe is a laggard in tech", Opinion - Technology sector, Financial Times, 26 February. 11. See Gati, Z., Lambert, C., Ranucci, D., Rouveyrol, C. and Schölermann, H. (2024), "Examining the causes and consequences of the recent listing gap between the United States and Europe", Financial Integration and Structure in the Euro Area, May. 12. ibid. 13. The equity share of private pension investment is particularly low in countries with large pay-as-you-go systems. By contrast, countries with large funded pension systems, and, therefore, large aggregate private retirement savings, typically have the most developed capital markets. See, for example, ---[PAGE_BREAK]--- Scharfstein, D. (2018), "Presidential address: Pension policy and the financial system", Journal of Finance, Vol. 73, No 4, pp. 1463-1512. 14. The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive 2009/65 is an EU directive that allows collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one Member State. 15. The European Venture Capital Fund (EuVECA) Regulation 345/2013 offers a voluntary EU-wide marketing passport to smaller fund managers, sparing them the costs associated with authorisation and compliance with the general regulation for alternative investment fund managers. 16. See European Investment Bank (2024), "The scale-up gap: Financial market constraints holding back innovative firms in the European Union", EIB Thematic Studies. 17. See Bouabdallah, O., Dorrucci, E., Hoendervangers L. and Nerlich C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them" The ECB Blog, ECB, 27 June. 18. For reference, the final RRF envelope amounts to $€ 648$ billion, equivalent to around $33.7 \%$ of the EU budget for the period 2021-27. 19. Schang, C. and Vinci, F. (2024), "Marrying fiscal rules \& investment: a central fiscal capacity for Europe", Working Paper Series, No 2962, ECB, July proposes a central fiscal capacity (CFC) design focused on euro area-wide investment in European public goods (EPGs), assuming that these underpin productivity across the entire bloc and advance strategic European goals. The EPG-focused CFC reallocates their cost across regions over the business cycle, in effect resulting in stabilisation, while ensuring common investment needs are met. 20. See Borota, T., Defever F., Impullitti, G. and Spencer, A. (2022), "Innovation Union: Costs and Benefits of Innovation Policy Cooperation", CEPR Discussion Paper, No 17549.	Luis de Guindos	Euro area	https://www.bis.org/review/r241015d.pdf	Riga, 2 October 2024 It is a pleasure to talk to you today about reviving productivity growth in the euro area - a critical challenge that demands urgent attention and collective action. I would like to start by outlining recent economic developments. After more than a year of stagnation, economic activity in the euro area recovered mildly in the first half of 2024, with considerable variation across countries and sectors. Growth, however, was weaker than expected in the second quarter of the year. The euro area growth outlook was revised down in September, compared with the June Eurosystem staff projections, with risks to growth remaining tilted to the downside. Looking ahead, we expect the recovery to strengthen over time, as rising real incomes and the gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should also continue contributing to the recovery as global demand picks up. The recovery should be underpinned by an expected recovery in productivity growth, which has been particularly weak since the onset of the pandemic. Weak labour productivity can be partly attributed to cyclical factors, especially given the relative rigidity of the euro area labour market, where employers do not fully adjust their workforce at times of low growth, resulting in labour hoarding. Cyclical factors that incentivise labour hoarding are expected to gradually diminish, leading to a recovery in productivity. However, productivity growth has not only been dampened through cyclical channels. It has been decelerating for decades in the euro area, mirroring a broader global trend. This structural weakness has been a significant drag on economic activity and continues to constrain medium-term growth prospects in the euro area, particularly in light of demographic developments. The population is shrinking and our societies are ageing, so sustaining the workforce will rely on higher participation rates, especially among women and older people, alongside well-designed immigration policies to address labour shortages and support long-term growth. But allow me to delve deeper into the core drivers of this sluggish productivity growth, particularly when compared with the United States. Over the past 30 years, the productivity gap between the euro area and the United States has widened considerably. This divergence has been driven by relatively weak total factor productivity growth in the euro area and, since the global financial crisis, insufficient capital deepening. To understand this productivity gap, we must look at the structural challenges we face. As Mario Draghi highlighted in his recent report on European competitiveness, one key issue is that Europe largely missed out on the digital revolution. Total investment ratios, both private and public, as a percentage of GDP are also lower in the euro area than in the United States. Despite an increase in public investment since 2020, driven by the Next Generation EU initiative, there is still a substantial gap in private investment, particularly in the areas of R\&D, digital innovation and digital uptake. The decline in total factor productivity growth among high-tech frontier firms in the euro area partly reflects their age, as older firms are typically less productive. Moreover, a secular decline in business entry rates and the winner-takes-all dynamics of new technologies have reduced competition, limiting the process of creative destruction needed for productivity growth. In the services sector, a widening total factor productivity growth gap between leading and lagging firms suggests that the adoption of new technologies by non-frontier firms, particularly small and medium-sized enterprises, remains sluggish. The European ecosystem of small and ageing firms struggles to compete globally. If we do not act quickly, their comparative disadvantages will only grow in this era of rapid technological progress. Our firms face scaling-up challenges, skill shortages, and framework conditions that are not conducive to radical innovation, but instead favour marginal improvements in mature technologies. Business dynamism is stifled by intricate regulations and overlapping governmental institutions and tax systems. This restricts the creation of innovative firms and the reallocation of resources to the most productive, undermining productivity growth and competitiveness. These complexities are amplified across national borders, further limiting the ability of European businesses to scale up. Europe's productivity would be higher if more innovative firms had a better environment in which to become established, grow, innovate and thrive. Since its inception, the Single Market has made significant progress in fostering growth and convergence across Europe, but the environment for innovative firms still leaves much to be desired. Enrico Letta's recent report offers a comprehensive perspective on the Single Market, highlighting the as yet untapped potential. His proposals to streamline the regulatory burdens, favour regulations instead of directives for greater harmonisation, improve administrative capacity and introduce a European business code as a 28th regime merit particular attention. A larger and more integrated Single Market would call for a single, deep capital market to finance the EU's competitive firms. Greater economic integration in the EU will bring greater financial integration. Numerous proposals have been made to develop the capital markets union, and the ECB's Governing Council issued a statement on the topic in March 2024. Let me first focus on the proposals aimed at fostering the growth of competitive European firms. As companies progress from developing an idea to becoming large and successful enterprises, they require diverse sources of financing and need to be connected to stakeholders who can best support them through their growth phases. However, Europe's financial system is predominantly reliant on bank lending, which is not ideally suited for financing young high-risk firms. During the scaling-up phase in particular, innovative companies need access to risk capital and investors with the networks, experience and risk tolerance to allow them to experiment and potentially fail. Venture capital funds are particularly well-suited for this purpose. However, the venture capital market segment in Europe is underdeveloped. As a percentage of GDP, venture capital financing in Europe is a third of that in the United States. If firms need to seek funding in countries outside the EU, such as the United States, their activities can end up being relocated abroad, affecting Europe's economy. Companies that source foreign funding in the later stages of their scaling-up may then be listed on foreign exchanges, further depriving Europe's equity markets of large and innovative firms that contribute to the markets' depth and liquidity. The recent listing gap between the United States and Europe is due, at least in part, to the greater attractiveness of US stock markets for foreign firms. The percentage of foreign companies among all companies listed in the United States rose from around 18\% in 2017 to 24\% in 2022. By contrast, foreign listings in European markets have shown a slight downward trend over the same period. Overall, Europe's underdeveloped venture capital environment, fragmented equity markets and heterogenous national markets are leading to higher financing costs and inefficiencies in the allocation of capital when compared with the United States. To overcome Europe's private investment gap and give European firms access to the financing they need, especially in terms of equity, we need a more ambitious agenda for both developing and integrating EU capital markets. First, household savings should be directed towards capital markets. A retail savings product that offers tax incentives and could be sold across the EU would be a step forward. The same goes for lowering the entry barriers for retail investors to participate in equity and bond markets. Increasing the share of equity investments in funded pension systems would also have mutually reinforcing benefits. It would give institutional investors, such as pension funds, a greater role in providing a large investor base for equity markets, similar to the role they now play in the United States. Ensuring the portability of pensions across borders, as envisaged when launching the Pan-European Personal Pension Product, will also be fundamental in supporting the single labour market by enhancing mobility for workers in Europe. Second, regulatory action can encourage investment in equity by addressing the debt-equity bias in taxation. Simplifying regulation can attract investors, promote risk-taking by Europe's companies and boost cross-border market developments. For instance, streamlining eligibility requirements in the UCITS directives could incentivise investment in venture capital funds and make the most of the "passport" system that facilitates the distribution of funds throughout the EU. Third, to develop the equity market, we need to make listings in Europe more attractive and efficient. To this end, we should aim to create a single pool of liquidity for public equity markets that would provide sufficient market depth to issuers and investors, including asset managers, pension funds and other large EU-based investors. This requires (i) deeper integration in the trading and post-trading landscape; (ii) further harmonisation in difficult areas like insolvency regimes, accounting, and securities law; and (iii) more centralised supervision for systemic cross-border entities, including stock exchanges and market infrastructures. Where political agreement on harmonisation is not yet reachable, intermediate solutions mentioned before, such as a 28th regime, or enhanced cooperation, should be considered. A way of deepening the securitisation market would be to set up a European securitisation platform. Besides fostering standardisation, this would support the development of green and other strategic segments while maintaining a sound prudential framework. Finally, public-private partnerships will be critical in future for stepping up investment in innovative firms and the green and digital transitions. The complementarity between public and private investment leads me to my final point on the need to mobilise fiscal resources at EU level. The EU needs a massive amount of financing to close the productivity gap and support the digital and green transition. Europe has to reflect on how it can use targeted public investment to help meet these financing needs. The EU and Member States should explore a reorientation of the EU budget as well as options for jointly funding investment in specific projects. The Recovery and Resilience Facility (RRF) was a step in the right direction. Joint European action can successfully bring about key investments as well as growth-enhancing structural reforms, while fostering national ownership, mitigating fragmentation risks, enhancing economic resilience and improving risk sharing. But the RRF is a temporary tool, and once it elapses in 2026, the EU budget will shrink significantly owing to the cliff effect. We should be determined to permanently enhance the EU's fiscal capacity, also to support crossborder and pan-European projects. These could include the provision of European public goods such as energy infrastructure, innovative technologies and common defence, further strengthening risk sharing by ensuring that key investments take place even in adverse macroeconomic conditions. A level playing field needs to be restored, fully phasing out the State Aid Temporary Framework adopted during the pandemic. Let me conclude. Broadly speaking, the problems we are discussing today derive from the incompleteness of the Economic and Monetary Union: greater integration in the markets for goods and services, as well as in the capital and labour factors of production, are essential for the success of the European project. The recent high-level reports from Enrico Letta and Mario Draghi correctly emphasise that the key to Europe's success is to leverage on all aspects of EU collaboration and coordination, including the completion of the Single Market. This would boost EU productivity and competitiveness for the benefit of our economies and citizens. Regarding the topic of today's conference, advancing on the agenda for the capital markets union will require efforts to dismantle the barriers to enlarging segments of the capital markets and provide the financing needed by innovative firms to develop throughout their lifecycle. But the capital markets union alone will not deliver those benefits if economic integration is still in the starting blocks, the Single Market remains fragmented, the banking union is not yet complete, and EU industrial competition and trade policies are not part of an overall EU strategy. This calls for an ambitious and comprehensive agenda with a more focused Europe. To reignite European productivity and competitiveness, ensure sustainable growth and rising living standards for all European citizens, the EU response must be determined and cohesive. 12. ibid.
2024-10-02T00:00:00	Isabel Schnabel: Escaping stagnation - towards a stronger euro area	Speech by Ms Isabel Schnabel, Member of the Executive Board of the European Central Bank, at the 19th Walter Eucken Lecture, Freiburg, 2 October 2024.	SPEECH Escaping stagnation: towards a stronger euro area Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at a lecture in memory of Walter Eucken Freiburg, 2 October 2024 The euro area economy is stagnating. Over the past two years, real GDP has expanded, on average, by only 0.1% per quarter. Surveys among firms indicate that growth is likely to remain subdued during the second half of this year. Weak growth reflects, to a large extent, the exceptional shocks that hit the euro area economy in recent years, most notably the pandemic and Russia's invasion of Ukraine. Another reason is the tightening of monetary policy. From late 2021 to the end of 2023, bank lending rates for house purchases by households increased from 1.3% to 4%, and those for corporate loans from 1.4% to 5.3%. Such levels had not been seen in more than a decade. Dampening growth in aggregate demand was needed to restore price stability. In 2021, when the euro area economy reopened in the pandemic and the economy's supply capacity was still severely constrained, real private consumption rose by more than 8% in just two quarters. When we began to raise our key policy rates in July 2022, households and firms started to spend less and save more, thereby bringing supply and demand closer into balance. Yet, although the peak impact of monetary tightening is likely to be behind us and real incomes are rising as inflation falls and wages increase, growth remains shallow. Over the past 18 months, the recovery has repeatedly been weaker than anticipated. Aggregate growth figures mask, however, significant heterogeneity across euro area economies. Since interest rates started to rise, growth has become increasingly uneven (Slide 2). In some Member States, such as Malta, Spain and Portugal, output has expanded measurably. In Malta, for example, annual real GDP growth has averaged 6% since 2022. In Spain and Portugal, real activity has grown by nearly 4% annually. In fact, much of the euro area's dismal growth performance since we started raising our key policy rates can be attributed to a small group of countries, including Germany, Finland and Estonia. If one were to plot growth in the euro area excluding Germany, for example, activity in the currency area would have been remarkably resilient in the face of the sharpest monetary policy tightening in decades and a war raging at the EU's doorstep. Only a few advanced economies, most notably the United States, have expanded at a faster pace during this period (Slide 3). Monetary policy unlikely to be the key driver of heterogeneity Monetary policy has probably been one factor contributing to heterogeneity in the euro area. An economy such as Germany's, which is centred around a strong manufacturing base, is likely to be more sensitive to changes in interest rates than more service-oriented economies. Three observations suggest, however, that monetary policy is unlikely to be the key driver of heterogeneity. First, output in Germany had started to stagnate well before the rise in interest rates. At the end of 2021, real GDP was only 1% above its level four years earlier, against increases of 4.9% for the euro area excluding Germany and even 10% in the United States over the same period. In other words, the growth gap was widening already well before we started tightening monetary policy. Second, we observe significant heterogeneity even in parts of economic activity that are more sensitive to changes in interest rates. In Germany, industrial production (excluding construction) is 10% lower today than it was before market interest rates started to rise in late 2021 - a considerably larger loss than that seen in most other economies (Slide 4, left-hand side). This contrast becomes even starker when one considers the production of capital goods, which tend to be the most interest-rate sensitive. Over the past two and a half years, the slowdown in the production of capital goods started earlier and was more pronounced in Germany than in other major euro area economies. Today, capital goods production in Germany is 3% lower than at the end of 2021. By contrast, it remained nearly 17% higher in the Netherlands over the same period (Slide 4, right-hand side). Third, German households have, on aggregate, so far benefited from the rise in interest rates. Since the end of 2021, their net interest income has increased sharply, as they shifted their savings into time deposits offering higher returns, while interest rates on long-running, fixed-rate mortgages remained low (Slide 5). By contrast, the widespread prevalence of flexible-rate mortgages in Spain has led to a notable increase in interest payments that has more than offset the rise in income gained from higher interest rates on savings. That is, the transmission of monetary policy through some channels, such as the mortgage channel, is likely to have been weaker, not stronger, in Germany than in other countries. Resilient growth in the south of the euro area To understand the main drivers behind the heterogeneity, it is necessary to look at both the countries that have grown faster than what might have been expected considering tight policy and those that have been underperforming. Let me focus first on the more dynamic regions of the euro area. In many cases, trade played an important role. In Spain, for example, net exports contributed, on average, around 0.4 percentage points to growth every quarter over the past two and a half years. This is a notable increase from the period preceding the pandemic (Slide 6, left-hand side). The same broad pattern can be observed in Italy and Portugal. A strong recovery in tourism after the pandemic has been a key factor supporting the rise in exports in these economies. But trade is not the whole story. Labour market developments played an equally important role. Greece is the most remarkable case. Unemployment fell from 13.7% in early 2022 to 9.9% in July this year, a level not seen since the global financial crisis (Slide 6, right-hand side). We observe similar improvements in labour markets across the south of the euro area. In Italy, for example, the number of people in employment has expanded by more than one million since 2022, measurably supporting private consumption and confidence. Finally, in some countries fiscal policy remained more accommodative than in others. In Italy, the government deficit last year was 7.2%, compared with 2.6% in Germany. Funds allocated under the Next Generation EU programme provided further impetus to growth and employment. In 2022 and 2023, 37% of the funds were allocated to the five fastest-growing countries although their share in the euro area's economy accounted for only 13%. All in all, in large parts of the single currency area, the impact of tighter monetary policy was weakened by a combination of looser fiscal policy and a shift in consumption towards services. In addition, some of these economies have gone some way towards becoming more resilient through structural reforms after the sovereign debt crisis, which helps explain their overperformance. While some countries will need to adjust government spending to be in line with the new European fiscal rules, the gradual dialling back of monetary policy restraint since June, together with the continued rise in real incomes, is likely to support growth further over the medium term. Structural headwinds in export-oriented countries The gradual moderation in the degree of monetary policy restriction will also support growth in those parts of the euro area that have stagnated in recent years. Construction activity, for example, has contracted by 12% since 2022 in Finland and by nearly 7% in Germany. While rising costs for equipment and raw materials contributed measurably to the drag in construction, the recent decline in mortgage rates is already translating into rising demand for housing. Aless restrictive policy stance may help reduce risks of negative growth spillovers from the core to the periphery. However, monetary policy is no panacea. Germany, in particular, is currently facing strong headwinds that will not be resolved by lower interest rates alone. Its business model is built on export-driven growth, focusing on the high-end segment of traditional manufacturing industries. From 2000 to 2015, Germany's current account turned from a deficit of 1.8% of GDP to a surplus of 8.6% - an unparalleled surge among advanced economies (Slide 7, left-hand side). As a result, net exports accounted for almost one-third of growth over this period. But on average since 2016, net exports have no longer been contributing to growth, with Germany losing export market shares at a concerning pace (Slide 7, right-hand side). And with domestic demand not stepping up, the German economy has been growing by just 1% on average per year over this period. Of course, this needs to be seen in the context of the series of shocks in recent years. Germany's growth outcomes were better than feared considering the sheer size of the energy shock. The swift reduction in gas consumption and the rapid switch to alternative energy sources in response to the sudden loss of access to Russian gas have demonstrated the adaptability of the German economy.!2] And yet, Germany is facing deep-seated challenges. In fact, the perils of relying on exports as a primary source of growth have long been known. In the two decades up to the pandemic, euro area exporters - and German firms in particular - benefited from exceptionally strong growth in some key markets, especially in China, where a real estate boom fuelled demand for goods exports from the euro area, particularly for capital goods.) ECB staff analysis shows that euro area firms would have lost export market shares at a much faster pace if it had not been for such geographical and sectoral effects, which largely offset parallel losses in price competitiveness related to higher energy and labour costs as well as weaker productivity growth (Slide 8, panel a). But since the pandemic, competitiveness effects have started to dominate as the special factors boosting euro area exports have slowed, explaining the sizeable drop in export market shares (Slide 8, panel b).!4] Export-led growth model may need adjustment Part of the weakness in exports is likely to be cyclical, reflecting the lagged effects of global monetary policy tightening and the weakness in China. But there is a risk that the pre-pandemic export-oriented growth model will face more permanent headwinds and require adjustment, for three main reasons. First, the nature of globalisation is changing. Geoeconomic fragmentation is intensifying, with global trade measures increasing sharply, especially for critical raw materials - the production of which is often concentrated in just a few countries. As such, the times when globalisation was boosting trade and growth may be behind us. There is evidence that geopolitics is increasingly hampering trade and that firms progressively seek to diversify their supply of strategic goods by sourcing them from producers in geopolitically aligned countries.!5] Given that euro area firms are more deeply integrated into global value chains than many of their competitors, fragmentation could hurt the euro area economy more than others. Second, the energy shock was a major driver behind the decline in euro area market shares. Unlike past oil price shocks, which affected firms across the globe, Russia's invasion of Ukraine and the resulting sharp spike in gas prices, was a massive competitiveness shock for the euro area, as the input costs of domestic exporters rose sharply relative to those of their competitors. As a result, the exports of energy-intensive sectors decreased strongly, accounting for almost the entire decline in total exports in 2023 (Slide 9, left-hand side). ECB staff analysis shows that, at the peak of the European gas crisis, the average impact on euro area export market shares was a decline of 7%, with energy-intensive industries experiencing losses of more than 15% in export market shares (Slide 9, right-hand side). Although energy costs have fallen from their peak, they remain almost four times as high as in the United States (Slide 10, left-hand side). Energy will therefore likely remain a drag on euro area price competitiveness. Third, competition is changing. Two decades ago, Chinese firms specialised mainly in the production of low-value goods, such as clothing, footwear or plastic. Today, China is increasingly building up large production capacities in high-value-added industries, such as the automotive and specialised machinery sectors. China moving up in the value chain is not only directly dampening demand for euro area goods - it is also turning China into a fierce competitor in third markets. This is particularly visible in Germany and Italy, which over the past two decades have seen a steady increase in the number of sectors in which these economies and China have a revealed comparative advantage - meaning they export more in these sectors than the global average (Slide 10, right-hand side). With Chinese and euro area firms increasingly competing in similar export markets, China's significant gains in price competitiveness vis-a-vis the euro area are weighing on euro area exports. Since 2021, China has accounted for the entire appreciation in real effective exchange rate of the euro based on producer prices (Slide 11, left-hand side). While euro area producer prices have increased significantly, Chinese producer prices have remained remarkably stable over the past four years (Slide 11, right-hand side). On the one hand, this is the result of generous state subsidies that are significantly higher than in most other advanced and major emerging market economies (Slide 12, left-hand side).!& On the other hand, rising overcapacities are weighing on Chinese export prices.!2] The automotive sector is a case in point. China is making significant upfront investments in production and transport to boost its export capacity. Orders for new shipping vessels are projected to raise the number of electric vehicles available for exports by 1.7 million annually by 2026 (Slide 12, right-hand side). To put this in perspective, the total number of electric vehicles sold across the EU in 2023 was 2.5 million. Need for a reform agenda putting innovation and entrepreneurship first Europe, and Germany in particular, needs to adapt to this new environment. At a time when global economic relationships are becoming more uncertain, Europe needs to regain its competitiveness to protect its standard of living and social values. Past efforts to regain competitiveness were not without shortcomings. Policies aimed at reducing wage costs, for example, often came with significant economic hardship and social costs. Today, the focus needs to be a different one. Europe should put innovation and entrepreneurship at the heart of its agenda. In his recent report, Mario Draghi presents a candid and unsparing diagnosis of the state of the euro area economy and makes many useful proposals. Some of those proposals are unlikely to find broad support among political leaders. But it would be wrong to reduce the report to a call for more joint borrowing, which in any case should only be discussed after evaluating the experience with the Recovery and Resilience Facility. In fact, many reforms that can foster European competitiveness do not need significant upfront investment, nor do they require changes to the EU Treaty. Let me highlight three areas that I consider most promising. Creating a European Silicon Valley First, Europe needs to facilitate the birth and growth of innovative start-ups. Since 2000, productivity per hour worked has increased by just 0.8% per year on average - only half the growth seen in the United States (Slide 13). European firms' failure to reap the efficiency gains brought about by information and communication technologies is one of the root causes.) Europe is not short on innovation potential. But its regulatory framework and the lack of deep capital markets make it difficult for young firms to thrive. Over the past decade, European start-ups have raised funds equivalent to just 0.3% of GDP from venture capital investments, less than a third of the figure for the United States."2] Banks do not have the risk-bearing capacity to fill this void, and this would not change even if we managed to revive securitisation in the euro area. Today, many promising start-ups shift their operations overseas because of a lack of risk capital. In 2022, 58 founders of "unicorns" in the United States - start-ups that went on to be valued over USD 1 billion - had been born in the euro area. If Europe wants to retain such potential, it needs to make private equity investments more attractive, including by removing the "debt bias" in national tax systems. Better mobilisation of capital is one way to foster innovation. Strengthening the Single Market, fostering competition and cutting red tape is another. The European economy remains segmented along national borders, torn between different rules and legal systems. This makes it difficult for young firms to grow into sufficient size and form innovation clusters, so that new ideas and technologies can spread faster and allow them to compete in an environment where "the winner takes most". The Single Market is Europe's most effective tool to mobilise economies of scale and to enable the creation of a European Silicon Valley. However, the level of European integration remains disappointingly low - especially in services, which amount to around 67% of the EU's GDP. Intra-EU trade in services accounts for only about 15% of GDP, compared with close to 50% for goods. To a significant extent, this reflects regulatory and administrative barriers to doing business in the euro area that hold back competition and thus innovation. Green innovation as an engine of growth Second, Europe needs to leverage the green transition. Making the European economies more sustainable is not a choice. Weather-related disasters are becoming more frequent and more severe, which requires urgent action to reduce carbon emissions and adapt to the growing impact of climate change. Embracing the green transition comes with costs for society. Relative price changes are often most painful for those who can least afford it. But the green transition also offers the potential to unlock economic opportunities, especially for those moving first. This is the spirit of the Porter hypothesis - the view that environmental measures can be an important driver of innovation. Although controversial, there is ample evidence in favour of the Porter hypothesis. Consider the automotive industry. Euro area car producers have lost export market share over the past few years (Slide 14, left-hand side). But these losses were largely confined to the combustion engine segment - in the electric car industry, euro area firms made considerable gains, also by developing hybrid technologies early. These gains were made possible by significant investments in research and development. According to the most recent data, automotive companies in the euro area still boasted the world's largest investments in research and development in 2022, about twice as much as the United States and China. The green industry, including low-emission car production, is the only innovative sector where the EU is currently leading in terms of the number of patents (Slide 14, right-hand side). Technological leadership also allowed euro area firms to raise their export prices on motor vehicles more than others, benefiting from a relatively price-inelastic demand (Slide 15, left-hand side).4] Asa result, gross value added was typically more resilient than industrial production, as firms moved into higher-margin activities (Slide 15, right-hand side). In other words, Europe has invested more than other countries in being a frontrunner in the green transition. Now is not the time to backtrack. Europe needs to continue investing in green technologies and innovations to turn the green transition into an engine of growth. The sooner Europe decarbonises its energy consumption, the faster it will reduce its dependency on foreign suppliers and regain price competitiveness, because the marginal cost of renewable energies is practically zero. This is all the more important in times of the artificial intelligence revolution, which will significantly increase the demand for energy. At the same time, the adoption of new energy sources, such as hydrogen, may require a transition phase during which not all hydrogen can be generated from renewable energies. Managing the green transition requires both private and public investments. To foster this process, a mission-oriented industrial policy may be needed that strategically focuses on achieving the green transition through coordinated efforts and thus reduces uncertainty." For example, last year France introduced new criteria for granting subsidies to purchase electric vehicles, which privilege supply chains that are entirely green. As China's electric vehicle industry relies heavily on coal-generated electricity, these criteria implicitly favour European production." Significant private and public investments are also needed to upgrade Europe's electricity grid and to build new infrastructure, such as pipelines or networks of fuel stations for hydrogen, and these investments need to happen soon if Europe wants to be a leader in new technologies. The scale of these investments may require new financing ideas. Their costs, and the uncertainty about future payoffs, are often so large that they may not break even over conventional investment horizons. So, in some cases the resulting risks cannot be borne by entrepreneurs alone, making public-private partnerships a viable option to internalise the externalities arising from climate change. In some cases, this could include exploring options of granting state guarantees as a way for governments to incentivise private firms to invest in green infrastructure and technologies. Higher labour participation and immigration are indispensable to address labour scarcity Third, Europe needs to address labour scarcity. Longer life expectancy and declining fertility will lead to a sharp drop in the euro area's working-age population and a significant increase in the old-age dependency ratio. These developments are most concerning in Italy, where the share in the total population of those aged between 15 and 64 is projected to fall from about 63% today to 55% by 2050 (Slide 16, left-hand side). Over the past ten years, these strains have partly been cushioned by immigration. But as the baby boomer generation is retiring and migration is expected to moderate, the drag on growth coming from an ageing population is likely to be significant. New research suggests that, over the next two decades, demographic change may lower annual per capita output growth by more than one percentage point in Italy and by 0.8 percentage points in Germany. This comes at a time when a considerable share of firms across the euro area are already reporting acute shortages of labour limiting their business (Slide 16, right-hand side). Despite declining somewhat recently, this share has never been higher than in recent years. Labour scarcity cuts across society. In many countries, thousands of teacher vacancies are not filled, especially for STEM subjects. There are chronic staff shortages in hospitals and nursing homes. And all countries are facing a lack of skilled workers in specialised industries. These shortages are likely to dramatically increase as demographic change proceeds and cannot be offset by rising productivity alone. Europe should therefore do four things to address labour scarcity. First, it should further increase labour force participation. Significant progress has been made in recent decades, especially by bringing more women and older workers into the labour force. But participation rates remain below those in some other advanced economies. Second, resources need to be allocated more efficiently. The public sector has played an important role in explaining total employment growth over the past few years.!/£] The health crisis in particular has made some of these developments necessary. But the larger the public sector becomes, the less human capital is available for private firms to expand their productive businesses. Third, Europe needs to strengthen education. In many euro area countries, a significant share of adults - in some cases more than a third - have not completed upper secondary school. Supporting education will not only unlock the benefits of new technologies. It will also work against demographic headwinds, as higher levels of education tend to lead to higher labour market participation.12] Last, Europe needs to attract foreign workers. Solutions are needed for how to make immigration socially acceptable and how to promote the flow of workers across the single currency area. Conclusion Let me conclude. In recent years, growth in the euro area has become increasingly uneven. While monetary policy may have contributed to rising heterogeneity, it is not the main driver. Rather, structural headwinds are holding back growth in some countries more than in others. We cannot ignore the headwinds to growth. With signs of softening labour demand and further progress in disinflation, a sustainable fall of inflation back to our 2% target in a timely manner is becoming more likely, despite still elevated services inflation and strong wage growth. At the same time, monetary policy cannot resolve structural issues. European governments have a historic responsibility to turn the current challenges into opportunities. Europe has demonstrated in the past that it can adjust and rebound when faced with adversity. Escaping stagnation requires forceful action at both national and European level. It requires putting innovation and entrepreneurship first by promoting competition and business dynamism. This means strengthening the Single Market, improving access to private equity capital and reducing burdensome bureaucracy. It means leveraging the green transition to advance innovation and regain price competitiveness. And it means putting in place policies that incentivise labour participation and preserve a skilled workforce through immigration and education. In all these ways, we can make the euro area stronger. Thank you. Annexes 2 October 2024 Slides 1. See European Central Bank (2023), "Global value chains and the pandemic: the impact of supply bottlenecks", Economic Bulletin, lssue 2; Emter, L. et al. (2024), "The energy shock, price competitiveness and euro area export performance", Economic Bulletin, issue 3; De Santis, R.A. (2024), "Supply Chain Disruption and Energy Supply Shocks: Impact on Euro Area Output and Prices', International Journal of Central Banking, 20 (2): 193-236. 2. See also Bachmann et al. (2024), "What if? The Economic Effects for Germany of a Stop of Energy Imports from Russia", Economica, Vol. 91, Issue 364, pp. 1157-1200. 3. See also Fidora, M. and Gunnella, V. (2024), "Past and future challenges for the external competitiveness of the euro area", Economic Bulletin, Ilssue 6, ECB. 4. See, for example, IMF (2022), "Global Trade and Value Chains during the Pandemic" World Economic Outlook, Chapter 4, April; and Huang, F. (2020), "Winning Export Market Share despite the COVID-19 Crisis", Allianz Research, October. 5. 6. See Attinasi, M. et al. (2023), "Friend-shoring global value chains: a model-based assessment", Economic Bulletin, Ilssue 2, ECB. 7. For the effects of high energy costs on production, see European Central Bank (2023), "How have higher energy prices affected industrial production and imports?", Economic Bulletin, Ilssue 1. 8. The experience with the solar panel industry in the early 2000s is a testament to the cost advantages that can be achieved with high levels of subsidies. At the time, China began to heavily subsidise its solar panel industry, leading to sharp increases in export market shares and crowding out of European and US manufacturers. 9. Significant state-owned fixed investments, together with subdued domestic demand, have resulted in excess capacity in China. For example, inventories are rising notably across sectors as output is expanding faster than sales. See Al-Haschimi, A. and Spital, T. (2024), "The evolution of China's growth model: challenges and long-term growth prospects", Economic Bulletin, Issue 5, ECB. Recent survey evidence points in a similar direction. According to the European Chamber of Commerce in China, over one-third of respondents observed overcapacity in their industry and cited overinvestment as the main reason for this. See European Union Chamber of Commerce in China (2024), Business Confidence Survey, 10 May. 10. Draghi, M. (2024), The future of European competitiveness, September. 11. Schnabel, I. (2024), "From laggard to leader? Closing the euro area's technology gap", inaugural lecture of the EMU Lab at the European University Institute, Florence, 16 February. 12. Arnold, N.G. et al. (2024), "Stepping Up Venture Capital to Finance Innovation in Europe", /MF Working Paper, No 2024/146. 13. See Porter, M. E. (1991), "America's Green Strategy", Scientific American, No 264(4), p. 168; Porter, M. and van der Linde, C. (1995), "Toward a New Conception of the Environment-Competitiveness Relationship", Journal of Economic Perspectives, Vol. 9 (4), pp. 97-118; Rubashkina, Y. et al. (2015), "Environmental regulation and competitiveness: Empirical evidence on the Porter Hypothesis from European manufacturing sectors", Energy Policy, Vol. 83, pp. 288-300; and van Leeuwen, G. and Mohnen, P. (2017), "Revisiting the Porter hypothesis: an empirical analysis of Green innovation for the Netherlands", Economics of Innovation and New Technology, Vol. 26:1-2, pp. 63-77. 14. ECB analyses suggest that units exported from the euro area are less sensitive to changes in car prices compared with the exported units from other main global producers (Japan, United States and Korea) and significantly less sensitive than those from China. 15. See also Mazzucato, M. (2018), "Mission-oriented innovation policies: challenges and opportunities", Industrial and Corporate Change, Vol. 27, Issue 5, pp. 803-815. 16. See ACEA (2022), EU ETS: Auto manufacturers welcome inclusion of road transport to grant fair competition, 22 June. Similarly, public support for investments in the manufacturing of strategic equipment is having tangible effects. Germany is expected to become self-reliant in the production of mega car batteries by 2025, producing 12% of the global supply from less than 2% two years ago. See International Energy Agency (2023), Global EV Outlook 2023. 17. Cooley, T.F. et al. (2024), "Demographic obstacles to European growth", European Economic Review, Vol. 169. 18. See also Consolo, A. and Dias da Silva, A. (2022), "The role of public employment during the COVID- 19 crisis", Economic Bulletin, Issue 6, ECB. 19. Around 80% of people with an undergraduate degree or higher are active in the labour market, compared with less than 50% among those who have not finished a secondary school degree or similar. See Berson, C. and Botelho, V. (2023), "Record labour participation: workforce gets older, better educated and more female", The ECB Blog, 8 November. CONTACT European Central Bank Directorate General Communications > Sonnemannstrasse 20 > 60314 Frankfurt am Main, Germany > +49 69 1344 7455 > [email protected] Reproduction is permitted provided that the source is acknowledged. Media contacts Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # Escaping stagnation: towards a stronger euro area ## Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at a lecture in memory of Walter Eucken Freiburg, 2 October 2024 The euro area economy is stagnating. Over the past two years, real GDP has expanded, on average, by only $0.1 \%$ per quarter. Surveys among firms indicate that growth is likely to remain subdued during the second half of this year. Weak growth reflects, to a large extent, the exceptional shocks that hit the euro area economy in recent years, most notably the pandemic and Russia's invasion of Ukraine. ${ }^{[1]}$ Another reason is the tightening of monetary policy. From late 2021 to the end of 2023, bank lending rates for house purchases by households increased from $1.3 \%$ to $4 \%$, and those for corporate loans from $1.4 \%$ to $5.3 \%$. Such levels had not been seen in more than a decade. Dampening growth in aggregate demand was needed to restore price stability. In 2021, when the euro area economy reopened in the pandemic and the economy's supply capacity was still severely constrained, real private consumption rose by more than $8 \%$ in just two quarters. When we began to raise our key policy rates in July 2022, households and firms started to spend less and save more, thereby bringing supply and demand closer into balance. Yet, although the peak impact of monetary tightening is likely to be behind us and real incomes are rising as inflation falls and wages increase, growth remains shallow. Over the past 18 months, the recovery has repeatedly been weaker than anticipated. Aggregate growth figures mask, however, significant heterogeneity across euro area economies. Since interest rates started to rise, growth has become increasingly uneven (Slide 2). In some Member States, such as Malta, Spain and Portugal, output has expanded measurably. In Malta, for example, annual real GDP growth has averaged 6\% since 2022. In Spain and Portugal, real activity has grown by nearly $4 \%$ annually. In fact, much of the euro area's dismal growth performance since we started raising our key policy rates can be attributed to a small group of countries, including Germany, Finland and Estonia. If one were to plot growth in the euro area excluding Germany, for example, activity in the currency area would have been remarkably resilient in the face of the sharpest monetary policy tightening in decades and a war raging at the EU's doorstep. Only a few advanced economies, most notably the United States, have expanded at a faster pace during this period (Slide 3). ## Monetary policy unlikely to be the key driver of heterogeneity ---[PAGE_BREAK]--- Monetary policy has probably been one factor contributing to heterogeneity in the euro area. An economy such as Germany's, which is centred around a strong manufacturing base, is likely to be more sensitive to changes in interest rates than more service-oriented economies. Three observations suggest, however, that monetary policy is unlikely to be the key driver of heterogeneity. First, output in Germany had started to stagnate well before the rise in interest rates. At the end of 2021, real GDP was only $1 \%$ above its level four years earlier, against increases of $4.9 \%$ for the euro area excluding Germany and even 10\% in the United States over the same period. In other words, the growth gap was widening already well before we started tightening monetary policy. Second, we observe significant heterogeneity even in parts of economic activity that are more sensitive to changes in interest rates. In Germany, industrial production (excluding construction) is 10\% lower today than it was before market interest rates started to rise in late 2021 - a considerably larger loss than that seen in most other economies (Slide 4, left-hand side). This contrast becomes even starker when one considers the production of capital goods, which tend to be the most interest-rate sensitive. Over the past two and a half years, the slowdown in the production of capital goods started earlier and was more pronounced in Germany than in other major euro area economies. Today, capital goods production in Germany is 3\% lower than at the end of 2021. By contrast, it remained nearly 17\% higher in the Netherlands over the same period (Slide 4, right-hand side). Third, German households have, on aggregate, so far benefited from the rise in interest rates. Since the end of 2021, their net interest income has increased sharply, as they shifted their savings into time deposits offering higher returns, while interest rates on long-running, fixed-rate mortgages remained low (Slide 5). By contrast, the widespread prevalence of flexible-rate mortgages in Spain has led to a notable increase in interest payments that has more than offset the rise in income gained from higher interest rates on savings. That is, the transmission of monetary policy through some channels, such as the mortgage channel, is likely to have been weaker, not stronger, in Germany than in other countries. # Resilient growth in the south of the euro area To understand the main drivers behind the heterogeneity, it is necessary to look at both the countries that have grown faster than what might have been expected considering tight policy and those that have been underperforming. Let me focus first on the more dynamic regions of the euro area. In many cases, trade played an important role. In Spain, for example, net exports contributed, on average, around 0.4 percentage points to growth every quarter over the past two and a half years. This is a notable increase from the period preceding the pandemic (Slide 6, left-hand side). The same broad pattern can be observed in Italy and Portugal. ---[PAGE_BREAK]--- A strong recovery in tourism after the pandemic has been a key factor supporting the rise in exports in these economies. But trade is not the whole story. Labour market developments played an equally important role. Greece is the most remarkable case. Unemployment fell from 13.7\% in early 2022 to 9.9\% in July this year, a level not seen since the global financial crisis (Slide 6, right-hand side). We observe similar improvements in labour markets across the south of the euro area. In Italy, for example, the number of people in employment has expanded by more than one million since 2022, measurably supporting private consumption and confidence. Finally, in some countries fiscal policy remained more accommodative than in others. In Italy, the government deficit last year was $7.2 \%$, compared with $2.6 \%$ in Germany. Funds allocated under the Next Generation EU programme provided further impetus to growth and employment. In 2022 and 2023, 37\% of the funds were allocated to the five fastest-growing countries although their share in the euro area's economy accounted for only $13 \%$. All in all, in large parts of the single currency area, the impact of tighter monetary policy was weakened by a combination of looser fiscal policy and a shift in consumption towards services. In addition, some of these economies have gone some way towards becoming more resilient through structural reforms after the sovereign debt crisis, which helps explain their overperformance. While some countries will need to adjust government spending to be in line with the new European fiscal rules, the gradual dialling back of monetary policy restraint since June, together with the continued rise in real incomes, is likely to support growth further over the medium term. # Structural headwinds in export-oriented countries The gradual moderation in the degree of monetary policy restriction will also support growth in those parts of the euro area that have stagnated in recent years. Construction activity, for example, has contracted by $12 \%$ since 2022 in Finland and by nearly $7 \%$ in Germany. While rising costs for equipment and raw materials contributed measurably to the drag in construction, the recent decline in mortgage rates is already translating into rising demand for housing. A less restrictive policy stance may help reduce risks of negative growth spillovers from the core to the periphery. However, monetary policy is no panacea. Germany, in particular, is currently facing strong headwinds that will not be resolved by lower interest rates alone. Its business model is built on export-driven growth, focusing on the high-end segment of traditional manufacturing industries. From 2000 to 2015, Germany's current account turned from a deficit of 1.8\% of GDP to a surplus of $8.6 \%$ - an unparalleled surge among advanced economies (Slide 7, left-hand side). As a result, net exports accounted for almost one-third of growth over this period. But on average since 2016, net exports have no longer been contributing to growth, with Germany losing export market shares at a concerning pace (Slide 7, right-hand side). And with domestic demand not stepping up, the German economy has been growing by just $1 \%$ on average per year over this period. ---[PAGE_BREAK]--- Of course, this needs to be seen in the context of the series of shocks in recent years. Germany's growth outcomes were better than feared considering the sheer size of the energy shock. The swift reduction in gas consumption and the rapid switch to alternative energy sources in response to the sudden loss of access to Russian gas have demonstrated the adaptability of the German economy. ${ }^{[2]}$ And yet, Germany is facing deep-seated challenges. In fact, the perils of relying on exports as a primary source of growth have long been known. In the two decades up to the pandemic, euro area exporters - and German firms in particular benefited from exceptionally strong growth in some key markets, especially in China, where a real estate boom fuelled demand for goods exports from the euro area, particularly for capital goods. ${ }^{[3]}$ ECB staff analysis shows that euro area firms would have lost export market shares at a much faster pace if it had not been for such geographical and sectoral effects, which largely offset parallel losses in price competitiveness related to higher energy and labour costs as well as weaker productivity growth (Slide 8, panel a). But since the pandemic, competitiveness effects have started to dominate as the special factors boosting euro area exports have slowed, explaining the sizeable drop in export market shares (Slide 8, panel b). ${ }^{[4]}$ # Export-led growth model may need adjustment Part of the weakness in exports is likely to be cyclical, reflecting the lagged effects of global monetary policy tightening and the weakness in China. But there is a risk that the pre-pandemic export-oriented growth model will face more permanent headwinds and require adjustment, for three main reasons. First, the nature of globalisation is changing. Geoeconomic fragmentation is intensifying, with global trade measures increasing sharply, especially for critical raw materials - the production of which is often concentrated in just a few countries. As such, the times when globalisation was boosting trade and growth may be behind us. There is evidence that geopolitics is increasingly hampering trade and that firms progressively seek to diversify their supply of strategic goods by sourcing them from producers in geopolitically aligned countries. ${ }^{[5]}$ Given that euro area firms are more deeply integrated into global value chains than many of their competitors, fragmentation could hurt the euro area economy more than others. ${ }^{[6]}$ Second, the energy shock was a major driver behind the decline in euro area market shares. Unlike past oil price shocks, which affected firms across the globe, Russia's invasion of Ukraine and the resulting sharp spike in gas prices, was a massive competitiveness shock for the euro area, as the input costs of domestic exporters rose sharply relative to those of their competitors. As a result, the exports of energy-intensive sectors decreased strongly, accounting for almost the entire decline in total exports in 2023 (Slide 9, left-hand side). ${ }^{[7]}$ ---[PAGE_BREAK]--- ECB staff analysis shows that, at the peak of the European gas crisis, the average impact on euro area export market shares was a decline of $7 \%$, with energy-intensive industries experiencing losses of more than $15 \%$ in export market shares (Slide 9, right-hand side). Although energy costs have fallen from their peak, they remain almost four times as high as in the United States (Slide 10, left-hand side). Energy will therefore likely remain a drag on euro area price competitiveness. Third, competition is changing. Two decades ago, Chinese firms specialised mainly in the production of low-value goods, such as clothing, footwear or plastic. Today, China is increasingly building up large production capacities in high-value-added industries, such as the automotive and specialised machinery sectors. China moving up in the value chain is not only directly dampening demand for euro area goods - it is also turning China into a fierce competitor in third markets. This is particularly visible in Germany and Italy, which over the past two decades have seen a steady increase in the number of sectors in which these economies and China have a revealed comparative advantage - meaning they export more in these sectors than the global average (Slide 10, right-hand side). With Chinese and euro area firms increasingly competing in similar export markets, China's significant gains in price competitiveness vis-à-vis the euro area are weighing on euro area exports. Since 2021, China has accounted for the entire appreciation in real effective exchange rate of the euro based on producer prices (Slide 11, left-hand side). While euro area producer prices have increased significantly, Chinese producer prices have remained remarkably stable over the past four years (Slide 11, right-hand side). On the one hand, this is the result of generous state subsidies that are significantly higher than in most other advanced and major emerging market economies (Slide 12, left-hand side). ${ }^{[5]}$ On the other hand, rising overcapacities are weighing on Chinese export prices. ${ }^{[3]}$ The automotive sector is a case in point. China is making significant upfront investments in production and transport to boost its export capacity. Orders for new shipping vessels are projected to raise the number of electric vehicles available for exports by 1.7 million annually by 2026 (Slide 12, right-hand side). To put this in perspective, the total number of electric vehicles sold across the EU in 2023 was 2.5 million. # Need for a reform agenda putting innovation and entrepreneurship first Europe, and Germany in particular, needs to adapt to this new environment. At a time when global economic relationships are becoming more uncertain, Europe needs to regain its competitiveness to protect its standard of living and social values. Past efforts to regain competitiveness were not without shortcomings. Policies aimed at reducing wage costs, for example, often came with significant economic hardship and social costs. ---[PAGE_BREAK]--- Today, the focus needs to be a different one. Europe should put innovation and entrepreneurship at the heart of its agenda. In his recent report, Mario Draghi presents a candid and unsparing diagnosis of the state of the euro area economy and makes many useful proposals. ${ }^{[10]}$ Some of those proposals are unlikely to find broad support among political leaders. But it would be wrong to reduce the report to a call for more joint borrowing, which in any case should only be discussed after evaluating the experience with the Recovery and Resilience Facility. In fact, many reforms that can foster European competitiveness do not need significant upfront investment, nor do they require changes to the EU Treaty. Let me highlight three areas that I consider most promising. # Creating a European Silicon Valley First, Europe needs to facilitate the birth and growth of innovative start-ups. Since 2000, productivity per hour worked has increased by just $0.8 \%$ per year on average - only half the growth seen in the United States (Slide 13). European firms' failure to reap the efficiency gains brought about by information and communication technologies is one of the root causes. ${ }^{[11]}$ Europe is not short on innovation potential. But its regulatory framework and the lack of deep capital markets make it difficult for young firms to thrive. Over the past decade, European start-ups have raised funds equivalent to just $0.3 \%$ of GDP from venture capital investments, less than a third of the figure for the United States. ${ }^{[12]}$ Banks do not have the risk-bearing capacity to fill this void, and this would not change even if we managed to revive securitisation in the euro area. Today, many promising start-ups shift their operations overseas because of a lack of risk capital. In 2022, 58 founders of "unicorns" in the United States - start-ups that went on to be valued over USD 1 billion - had been born in the euro area. If Europe wants to retain such potential, it needs to make private equity investments more attractive, including by removing the "debt bias" in national tax systems. Better mobilisation of capital is one way to foster innovation. Strengthening the Single Market, fostering competition and cutting red tape is another. The European economy remains segmented along national borders, torn between different rules and legal systems. This makes it difficult for young firms to grow into sufficient size and form innovation clusters, so that new ideas and technologies can spread faster and allow them to compete in an environment where "the winner takes most". The Single Market is Europe's most effective tool to mobilise economies of scale and to enable the creation of a European Silicon Valley. However, the level of European integration remains disappointingly low - especially in services, which amount to around $67 \%$ of the EU's GDP. Intra-EU trade in services accounts for only about $15 \%$ of GDP, compared with close to $50 \%$ for goods. ---[PAGE_BREAK]--- To a significant extent, this reflects regulatory and administrative barriers to doing business in the euro area that hold back competition and thus innovation. # Green innovation as an engine of growth Second, Europe needs to leverage the green transition. Making the European economies more sustainable is not a choice. Weather-related disasters are becoming more frequent and more severe, which requires urgent action to reduce carbon emissions and adapt to the growing impact of climate change. Embracing the green transition comes with costs for society. Relative price changes are often most painful for those who can least afford it. But the green transition also offers the potential to unlock economic opportunities, especially for those moving first. This is the spirit of the Porter hypothesis - the view that environmental measures can be an important driver of innovation. ${ }^{[13]}$ Although controversial, there is ample evidence in favour of the Porter hypothesis. Consider the automotive industry. Euro area car producers have lost export market share over the past few years (Slide 14, left-hand side). But these losses were largely confined to the combustion engine segment - in the electric car industry, euro area firms made considerable gains, also by developing hybrid technologies early. These gains were made possible by significant investments in research and development. According to the most recent data, automotive companies in the euro area still boasted the world's largest investments in research and development in 2022, about twice as much as the United States and China. The green industry, including low-emission car production, is the only innovative sector where the EU is currently leading in terms of the number of patents (Slide 14, right-hand side). Technological leadership also allowed euro area firms to raise their export prices on motor vehicles more than others, benefiting from a relatively price-inelastic demand (Slide 15, left-hand side). ${ }^{[14]}$ As a result, gross value added was typically more resilient than industrial production, as firms moved into higher-margin activities (Slide 15, right-hand side). In other words, Europe has invested more than other countries in being a frontrunner in the green transition. Now is not the time to backtrack. Europe needs to continue investing in green technologies and innovations to turn the green transition into an engine of growth. The sooner Europe decarbonises its energy consumption, the faster it will reduce its dependency on foreign suppliers and regain price competitiveness, because the marginal cost of renewable energies is practically zero. This is all the more important in times of the artificial intelligence revolution, which will significantly increase the demand for energy. At the same time, the adoption of new energy sources, such as hydrogen, may require a transition phase during which not all hydrogen can be generated from renewable energies. ---[PAGE_BREAK]--- Managing the green transition requires both private and public investments. To foster this process, a mission-oriented industrial policy may be needed that strategically focuses on achieving the green transition through coordinated efforts and thus reduces uncertainty. ${ }^{[15]}$ For example, last year France introduced new criteria for granting subsidies to purchase electric vehicles, which privilege supply chains that are entirely green. As China's electric vehicle industry relies heavily on coal-generated electricity, these criteria implicitly favour European production. ${ }^{[16]}$ Significant private and public investments are also needed to upgrade Europe's electricity grid and to build new infrastructure, such as pipelines or networks of fuel stations for hydrogen, and these investments need to happen soon if Europe wants to be a leader in new technologies. The scale of these investments may require new financing ideas. Their costs, and the uncertainty about future payoffs, are often so large that they may not break even over conventional investment horizons. So, in some cases the resulting risks cannot be borne by entrepreneurs alone, making public-private partnerships a viable option to internalise the externalities arising from climate change. In some cases, this could include exploring options of granting state guarantees as a way for governments to incentivise private firms to invest in green infrastructure and technologies. # Higher labour participation and immigration are indispensable to address labour scarcity Third, Europe needs to address labour scarcity. Longer life expectancy and declining fertility will lead to a sharp drop in the euro area's working-age population and a significant increase in the old-age dependency ratio. These developments are most concerning in Italy, where the share in the total population of those aged between 15 and 64 is projected to fall from about $63 \%$ today to $55 \%$ by 2050 (Slide 16, left-hand side). Over the past ten years, these strains have partly been cushioned by immigration. But as the baby boomer generation is retiring and migration is expected to moderate, the drag on growth coming from an ageing population is likely to be significant. New research suggests that, over the next two decades, demographic change may lower annual per capita output growth by more than one percentage point in Italy and by 0.8 percentage points in Germany. ${ }^{[17]}$ This comes at a time when a considerable share of firms across the euro area are already reporting acute shortages of labour limiting their business (Slide 16, right-hand side). Despite declining somewhat recently, this share has never been higher than in recent years. Labour scarcity cuts across society. In many countries, thousands of teacher vacancies are not filled, especially for STEM subjects. There are chronic staff shortages in hospitals and nursing homes. And all countries are facing a lack of skilled workers in specialised industries. These shortages are likely to dramatically increase as demographic change proceeds and cannot be offset by rising productivity alone. ---[PAGE_BREAK]--- Europe should therefore do four things to address labour scarcity. First, it should further increase labour force participation. Significant progress has been made in recent decades, especially by bringing more women and older workers into the labour force. But participation rates remain below those in some other advanced economies. Second, resources need to be allocated more efficiently. The public sector has played an important role in explaining total employment growth over the past few years. ${ }^{[18]}$ The health crisis in particular has made some of these developments necessary. But the larger the public sector becomes, the less human capital is available for private firms to expand their productive businesses. Third, Europe needs to strengthen education. In many euro area countries, a significant share of adults - in some cases more than a third - have not completed upper secondary school. Supporting education will not only unlock the benefits of new technologies. It will also work against demographic headwinds, as higher levels of education tend to lead to higher labour market participation. ${ }^{[19]}$ Last, Europe needs to attract foreign workers. Solutions are needed for how to make immigration socially acceptable and how to promote the flow of workers across the single currency area. # Conclusion Let me conclude. In recent years, growth in the euro area has become increasingly uneven. While monetary policy may have contributed to rising heterogeneity, it is not the main driver. Rather, structural headwinds are holding back growth in some countries more than in others. We cannot ignore the headwinds to growth. With signs of softening labour demand and further progress in disinflation, a sustainable fall of inflation back to our 2\% target in a timely manner is becoming more likely, despite still elevated services inflation and strong wage growth. At the same time, monetary policy cannot resolve structural issues. European governments have a historic responsibility to turn the current challenges into opportunities. Europe has demonstrated in the past that it can adjust and rebound when faced with adversity. Escaping stagnation requires forceful action at both national and European level. It requires putting innovation and entrepreneurship first by promoting competition and business dynamism. This means strengthening the Single Market, improving access to private equity capital and reducing burdensome bureaucracy. It means leveraging the green transition to advance innovation and regain price competitiveness. And it means putting in place policies that incentivise labour participation and preserve a skilled workforce through immigration and education. In all these ways, we can make the euro area stronger. Thank you. ## Annexes 2 October 2024 Slides ---[PAGE_BREAK]--- 1. See European Central Bank (2023), "Global value chains and the pandemic: the impact of supply bottlenecks", Economic Bulletin, Issue 2; Emter, L. et al. (2024), "The energy shock. price competitiveness and euro area export performance", Economic Bulletin, Issue 3; De Santis, R.A. (2024), "Supply Chain Disruption and Energy Supply Shocks: Impact on Euro Area Output and Prices", International Journal of Central Banking, 20 (2): 193-236. 2. See also Bachmann et al. (2024), "What if? The Economic Effects for Germany of a Stop of Energy Imports from Russia", Economica, Vol. 91, Issue 364, pp. 1157-1200. 3. See also Fidora, M. and Gunnella, V. (2024), "Past and future challenges for the external competitiveness of the euro area", Economic Bulletin, Issue 6, ECB. 4. See, for example, IMF (2022), "Global Trade and Value Chains during the Pandemic" World Economic Outlook, Chapter 4, April; and Huang, F. (2020), "Winning Export Market Share despite the COVID-19 Crisis", Allianz Research, October. 5. See European Central Bank (2024), "How geopolitics is changing trade", Economic Bulletin, Issue 2. 6. See Attinasi, M. et al. (2023), "Friend-shoring global value chains: a model-based assessment", Economic Bulletin, Issue 2, ECB. 7. For the effects of high energy costs on production, see European Central Bank (2023), "How have higher energy prices affected industrial production and imports?", Economic Bulletin, Issue 1. 8. The experience with the solar panel industry in the early 2000s is a testament to the cost advantages that can be achieved with high levels of subsidies. At the time, China began to heavily subsidise its solar panel industry, leading to sharp increases in export market shares and crowding out of European and US manufacturers. 9. Significant state-owned fixed investments, together with subdued domestic demand, have resulted in excess capacity in China. For example, inventories are rising notably across sectors as output is expanding faster than sales. See Al-Haschimi, A. and Spital, T. (2024), "The evolution of China's ---[PAGE_BREAK]--- growth model: challenges and long-term growth prospects", Economic Bulletin, Issue 5, ECB. Recent survey evidence points in a similar direction. According to the European Chamber of Commerce in China, over one-third of respondents observed overcapacity in their industry and cited overinvestment as the main reason for this. See European Union Chamber of Commerce in China (2024), Business Confidence Survey, 10 May. 10. Draghi, M. (2024), The future of European competitiveness, September. 11. Schnabel, I. (2024), "From laggard to leader? Closing the euro area's technology gap", inaugural lecture of the EMU Lab at the European University Institute, Florence, 16 February. 12. Arnold, N.G. et al. (2024), "Stepping Up Venture Capital to Finance Innovation in Europe", IMF Working Paper, No 2024/146. 13. See Porter, M. E. (1991), "America's Green Strategy", Scientific American, No 264(4), p. 168; Porter, M. and van der Linde, C. (1995), "Toward a New Conception of the Environment-Competitiveness Relationship", Journal of Economic Perspectives, Vol. 9 (4), pp. 97-118; Rubashkina, Y. et al. (2015), "Environmental regulation and competitiveness: Empirical evidence on the Porter Hypothesis from European manufacturing sectors", Energy Policy, Vol. 83, pp. 288-300; and van Leeuwen, G. and Mohnen, P. (2017), "Revisiting the Porter hypothesis: an empirical analysis of Green innovation for the Netherlands", Economics of Innovation and New Technology, Vol. 26:1-2, pp. 63-77. 14. ECB analyses suggest that units exported from the euro area are less sensitive to changes in car prices compared with the exported units from other main global producers (Japan, United States and Korea) and significantly less sensitive than those from China. 15. See also Mazzucato, M. (2018), "Mission-oriented innovation policies: challenges and opportunities", Industrial and Corporate Change, Vol. 27, Issue 5, pp. 803-815. 16. See ACEA (2022), EU ETS: Auto manufacturers welcome inclusion of road transport to grant fair competition, 22 June. Similarly, public support for investments in the manufacturing of strategic equipment is having tangible effects. Germany is expected to become self-reliant in the production of mega car batteries by 2025, producing 12\% of the global supply from less than 2\% two years ago. See International Energy Agency (2023), Global EV Outlook 2023. ---[PAGE_BREAK]--- 17. Cooley, T.F. et al. (2024), "Demographic obstacles to European growth", European Economic Review, Vol. 169. 18. See also Consolo, A. and Dias da Silva, A. (2022), "The role of public employment during the COVID19 crisis", Economic Bulletin, Issue 6, ECB. 19. Around $80 \%$ of people with an undergraduate degree or higher are active in the labour market, compared with less than $50 \%$ among those who have not finished a secondary school degree or similar. See Berson, C. and Botelho, V. (2023), "Record labour participation: workforce gets older, better educated and more female", The ECB Blog, 8 November. # CONTACT <br> European Central Bank <br> Directorate General Communications $>\quad$ Sonnemannstrasse 20 $>\quad 60314$ Frankfurt am Main, Germany $>\quad+496913447455$ $>\quad$ [email protected] Reproduction is permitted provided that the source is acknowledged. ## Media contacts Copyright 2024, European Central Bank	Isabel Schnabel	Euro area	https://www.bis.org/review/r241015i.pdf	Freiburg, 2 October 2024 The euro area economy is stagnating. Over the past two years, real GDP has expanded, on average, by only $0.1 \%$ per quarter. Surveys among firms indicate that growth is likely to remain subdued during the second half of this year. Weak growth reflects, to a large extent, the exceptional shocks that hit the euro area economy in recent years, most notably the pandemic and Russia's invasion of Ukraine. Another reason is the tightening of monetary policy. From late 2021 to the end of 2023, bank lending rates for house purchases by households increased from $1.3 \%$ to $4 \%$, and those for corporate loans from $1.4 \%$ to $5.3 \%$. Such levels had not been seen in more than a decade. Dampening growth in aggregate demand was needed to restore price stability. In 2021, when the euro area economy reopened in the pandemic and the economy's supply capacity was still severely constrained, real private consumption rose by more than $8 \%$ in just two quarters. When we began to raise our key policy rates in July 2022, households and firms started to spend less and save more, thereby bringing supply and demand closer into balance. Yet, although the peak impact of monetary tightening is likely to be behind us and real incomes are rising as inflation falls and wages increase, growth remains shallow. Over the past 18 months, the recovery has repeatedly been weaker than anticipated. Aggregate growth figures mask, however, significant heterogeneity across euro area economies. Since interest rates started to rise, growth has become increasingly uneven (Slide 2). In some Member States, such as Malta, Spain and Portugal, output has expanded measurably. In Malta, for example, annual real GDP growth has averaged 6\% since 2022. In Spain and Portugal, real activity has grown by nearly $4 \%$ annually. In fact, much of the euro area's dismal growth performance since we started raising our key policy rates can be attributed to a small group of countries, including Germany, Finland and Estonia. If one were to plot growth in the euro area excluding Germany, for example, activity in the currency area would have been remarkably resilient in the face of the sharpest monetary policy tightening in decades and a war raging at the EU's doorstep. Only a few advanced economies, most notably the United States, have expanded at a faster pace during this period (Slide 3). Monetary policy has probably been one factor contributing to heterogeneity in the euro area. An economy such as Germany's, which is centred around a strong manufacturing base, is likely to be more sensitive to changes in interest rates than more service-oriented economies. Three observations suggest, however, that monetary policy is unlikely to be the key driver of heterogeneity. First, output in Germany had started to stagnate well before the rise in interest rates. At the end of 2021, real GDP was only $1 \%$ above its level four years earlier, against increases of $4.9 \%$ for the euro area excluding Germany and even 10\% in the United States over the same period. In other words, the growth gap was widening already well before we started tightening monetary policy. Second, we observe significant heterogeneity even in parts of economic activity that are more sensitive to changes in interest rates. In Germany, industrial production (excluding construction) is 10\% lower today than it was before market interest rates started to rise in late 2021 - a considerably larger loss than that seen in most other economies (Slide 4, left-hand side). This contrast becomes even starker when one considers the production of capital goods, which tend to be the most interest-rate sensitive. Over the past two and a half years, the slowdown in the production of capital goods started earlier and was more pronounced in Germany than in other major euro area economies. Today, capital goods production in Germany is 3\% lower than at the end of 2021. By contrast, it remained nearly 17\% higher in the Netherlands over the same period (Slide 4, right-hand side). Third, German households have, on aggregate, so far benefited from the rise in interest rates. Since the end of 2021, their net interest income has increased sharply, as they shifted their savings into time deposits offering higher returns, while interest rates on long-running, fixed-rate mortgages remained low (Slide 5). By contrast, the widespread prevalence of flexible-rate mortgages in Spain has led to a notable increase in interest payments that has more than offset the rise in income gained from higher interest rates on savings. That is, the transmission of monetary policy through some channels, such as the mortgage channel, is likely to have been weaker, not stronger, in Germany than in other countries. To understand the main drivers behind the heterogeneity, it is necessary to look at both the countries that have grown faster than what might have been expected considering tight policy and those that have been underperforming. Let me focus first on the more dynamic regions of the euro area. In many cases, trade played an important role. In Spain, for example, net exports contributed, on average, around 0.4 percentage points to growth every quarter over the past two and a half years. This is a notable increase from the period preceding the pandemic (Slide 6, left-hand side). The same broad pattern can be observed in Italy and Portugal. A strong recovery in tourism after the pandemic has been a key factor supporting the rise in exports in these economies. But trade is not the whole story. Labour market developments played an equally important role. Greece is the most remarkable case. Unemployment fell from 13.7\% in early 2022 to 9.9\% in July this year, a level not seen since the global financial crisis (Slide 6, right-hand side). We observe similar improvements in labour markets across the south of the euro area. In Italy, for example, the number of people in employment has expanded by more than one million since 2022, measurably supporting private consumption and confidence. Finally, in some countries fiscal policy remained more accommodative than in others. In Italy, the government deficit last year was $7.2 \%$, compared with $2.6 \%$ in Germany. Funds allocated under the Next Generation EU programme provided further impetus to growth and employment. In 2022 and 2023, 37\% of the funds were allocated to the five fastest-growing countries although their share in the euro area's economy accounted for only $13 \%$. All in all, in large parts of the single currency area, the impact of tighter monetary policy was weakened by a combination of looser fiscal policy and a shift in consumption towards services. In addition, some of these economies have gone some way towards becoming more resilient through structural reforms after the sovereign debt crisis, which helps explain their overperformance. While some countries will need to adjust government spending to be in line with the new European fiscal rules, the gradual dialling back of monetary policy restraint since June, together with the continued rise in real incomes, is likely to support growth further over the medium term. The gradual moderation in the degree of monetary policy restriction will also support growth in those parts of the euro area that have stagnated in recent years. Construction activity, for example, has contracted by $12 \%$ since 2022 in Finland and by nearly $7 \%$ in Germany. While rising costs for equipment and raw materials contributed measurably to the drag in construction, the recent decline in mortgage rates is already translating into rising demand for housing. A less restrictive policy stance may help reduce risks of negative growth spillovers from the core to the periphery. However, monetary policy is no panacea. Germany, in particular, is currently facing strong headwinds that will not be resolved by lower interest rates alone. Its business model is built on export-driven growth, focusing on the high-end segment of traditional manufacturing industries. From 2000 to 2015, Germany's current account turned from a deficit of 1.8\% of GDP to a surplus of $8.6 \%$ - an unparalleled surge among advanced economies (Slide 7, left-hand side). As a result, net exports accounted for almost one-third of growth over this period. But on average since 2016, net exports have no longer been contributing to growth, with Germany losing export market shares at a concerning pace (Slide 7, right-hand side). And with domestic demand not stepping up, the German economy has been growing by just $1 \%$ on average per year over this period. Of course, this needs to be seen in the context of the series of shocks in recent years. Germany's growth outcomes were better than feared considering the sheer size of the energy shock. The swift reduction in gas consumption and the rapid switch to alternative energy sources in response to the sudden loss of access to Russian gas have demonstrated the adaptability of the German economy. And yet, Germany is facing deep-seated challenges. In fact, the perils of relying on exports as a primary source of growth have long been known. In the two decades up to the pandemic, euro area exporters - and German firms in particular benefited from exceptionally strong growth in some key markets, especially in China, where a real estate boom fuelled demand for goods exports from the euro area, particularly for capital goods. ECB staff analysis shows that euro area firms would have lost export market shares at a much faster pace if it had not been for such geographical and sectoral effects, which largely offset parallel losses in price competitiveness related to higher energy and labour costs as well as weaker productivity growth (Slide 8, panel a). But since the pandemic, competitiveness effects have started to dominate as the special factors boosting euro area exports have slowed, explaining the sizeable drop in export market shares (Slide 8, panel b). Part of the weakness in exports is likely to be cyclical, reflecting the lagged effects of global monetary policy tightening and the weakness in China. But there is a risk that the pre-pandemic export-oriented growth model will face more permanent headwinds and require adjustment, for three main reasons. First, the nature of globalisation is changing. Geoeconomic fragmentation is intensifying, with global trade measures increasing sharply, especially for critical raw materials - the production of which is often concentrated in just a few countries. As such, the times when globalisation was boosting trade and growth may be behind us. There is evidence that geopolitics is increasingly hampering trade and that firms progressively seek to diversify their supply of strategic goods by sourcing them from producers in geopolitically aligned countries. Second, the energy shock was a major driver behind the decline in euro area market shares. Unlike past oil price shocks, which affected firms across the globe, Russia's invasion of Ukraine and the resulting sharp spike in gas prices, was a massive competitiveness shock for the euro area, as the input costs of domestic exporters rose sharply relative to those of their competitors. As a result, the exports of energy-intensive sectors decreased strongly, accounting for almost the entire decline in total exports in 2023 (Slide 9, left-hand side). ECB staff analysis shows that, at the peak of the European gas crisis, the average impact on euro area export market shares was a decline of $7 \%$, with energy-intensive industries experiencing losses of more than $15 \%$ in export market shares (Slide 9, right-hand side). Although energy costs have fallen from their peak, they remain almost four times as high as in the United States (Slide 10, left-hand side). Energy will therefore likely remain a drag on euro area price competitiveness. Third, competition is changing. Two decades ago, Chinese firms specialised mainly in the production of low-value goods, such as clothing, footwear or plastic. Today, China is increasingly building up large production capacities in high-value-added industries, such as the automotive and specialised machinery sectors. China moving up in the value chain is not only directly dampening demand for euro area goods - it is also turning China into a fierce competitor in third markets. This is particularly visible in Germany and Italy, which over the past two decades have seen a steady increase in the number of sectors in which these economies and China have a revealed comparative advantage - meaning they export more in these sectors than the global average (Slide 10, right-hand side). With Chinese and euro area firms increasingly competing in similar export markets, China's significant gains in price competitiveness vis-à-vis the euro area are weighing on euro area exports. Since 2021, China has accounted for the entire appreciation in real effective exchange rate of the euro based on producer prices (Slide 11, left-hand side). While euro area producer prices have increased significantly, Chinese producer prices have remained remarkably stable over the past four years (Slide 11, right-hand side). On the one hand, this is the result of generous state subsidies that are significantly higher than in most other advanced and major emerging market economies (Slide 12, left-hand side). On the other hand, rising overcapacities are weighing on Chinese export prices. The automotive sector is a case in point. China is making significant upfront investments in production and transport to boost its export capacity. Orders for new shipping vessels are projected to raise the number of electric vehicles available for exports by 1.7 million annually by 2026 (Slide 12, right-hand side). To put this in perspective, the total number of electric vehicles sold across the EU in 2023 was 2.5 million. Europe, and Germany in particular, needs to adapt to this new environment. At a time when global economic relationships are becoming more uncertain, Europe needs to regain its competitiveness to protect its standard of living and social values. Past efforts to regain competitiveness were not without shortcomings. Policies aimed at reducing wage costs, for example, often came with significant economic hardship and social costs. Today, the focus needs to be a different one. Europe should put innovation and entrepreneurship at the heart of its agenda. In his recent report, Mario Draghi presents a candid and unsparing diagnosis of the state of the euro area economy and makes many useful proposals. Some of those proposals are unlikely to find broad support among political leaders. But it would be wrong to reduce the report to a call for more joint borrowing, which in any case should only be discussed after evaluating the experience with the Recovery and Resilience Facility. In fact, many reforms that can foster European competitiveness do not need significant upfront investment, nor do they require changes to the EU Treaty. Let me highlight three areas that I consider most promising. First, Europe needs to facilitate the birth and growth of innovative start-ups. Since 2000, productivity per hour worked has increased by just $0.8 \%$ per year on average - only half the growth seen in the United States (Slide 13). European firms' failure to reap the efficiency gains brought about by information and communication technologies is one of the root causes. Europe is not short on innovation potential. But its regulatory framework and the lack of deep capital markets make it difficult for young firms to thrive. Over the past decade, European start-ups have raised funds equivalent to just $0.3 \%$ of GDP from venture capital investments, less than a third of the figure for the United States. Banks do not have the risk-bearing capacity to fill this void, and this would not change even if we managed to revive securitisation in the euro area. Today, many promising start-ups shift their operations overseas because of a lack of risk capital. In 2022, 58 founders of "unicorns" in the United States - start-ups that went on to be valued over USD 1 billion - had been born in the euro area. If Europe wants to retain such potential, it needs to make private equity investments more attractive, including by removing the "debt bias" in national tax systems. Better mobilisation of capital is one way to foster innovation. Strengthening the Single Market, fostering competition and cutting red tape is another. The European economy remains segmented along national borders, torn between different rules and legal systems. This makes it difficult for young firms to grow into sufficient size and form innovation clusters, so that new ideas and technologies can spread faster and allow them to compete in an environment where "the winner takes most". The Single Market is Europe's most effective tool to mobilise economies of scale and to enable the creation of a European Silicon Valley. However, the level of European integration remains disappointingly low - especially in services, which amount to around $67 \%$ of the EU's GDP. Intra-EU trade in services accounts for only about $15 \%$ of GDP, compared with close to $50 \%$ for goods. To a significant extent, this reflects regulatory and administrative barriers to doing business in the euro area that hold back competition and thus innovation. Second, Europe needs to leverage the green transition. Making the European economies more sustainable is not a choice. Weather-related disasters are becoming more frequent and more severe, which requires urgent action to reduce carbon emissions and adapt to the growing impact of climate change. Embracing the green transition comes with costs for society. Relative price changes are often most painful for those who can least afford it. But the green transition also offers the potential to unlock economic opportunities, especially for those moving first. This is the spirit of the Porter hypothesis - the view that environmental measures can be an important driver of innovation. Although controversial, there is ample evidence in favour of the Porter hypothesis. Consider the automotive industry. Euro area car producers have lost export market share over the past few years (Slide 14, left-hand side). But these losses were largely confined to the combustion engine segment - in the electric car industry, euro area firms made considerable gains, also by developing hybrid technologies early. These gains were made possible by significant investments in research and development. According to the most recent data, automotive companies in the euro area still boasted the world's largest investments in research and development in 2022, about twice as much as the United States and China. The green industry, including low-emission car production, is the only innovative sector where the EU is currently leading in terms of the number of patents (Slide 14, right-hand side). Technological leadership also allowed euro area firms to raise their export prices on motor vehicles more than others, benefiting from a relatively price-inelastic demand (Slide 15, left-hand side). As a result, gross value added was typically more resilient than industrial production, as firms moved into higher-margin activities (Slide 15, right-hand side). In other words, Europe has invested more than other countries in being a frontrunner in the green transition. Now is not the time to backtrack. Europe needs to continue investing in green technologies and innovations to turn the green transition into an engine of growth. The sooner Europe decarbonises its energy consumption, the faster it will reduce its dependency on foreign suppliers and regain price competitiveness, because the marginal cost of renewable energies is practically zero. This is all the more important in times of the artificial intelligence revolution, which will significantly increase the demand for energy. At the same time, the adoption of new energy sources, such as hydrogen, may require a transition phase during which not all hydrogen can be generated from renewable energies. Managing the green transition requires both private and public investments. To foster this process, a mission-oriented industrial policy may be needed that strategically focuses on achieving the green transition through coordinated efforts and thus reduces uncertainty. For example, last year France introduced new criteria for granting subsidies to purchase electric vehicles, which privilege supply chains that are entirely green. As China's electric vehicle industry relies heavily on coal-generated electricity, these criteria implicitly favour European production. Significant private and public investments are also needed to upgrade Europe's electricity grid and to build new infrastructure, such as pipelines or networks of fuel stations for hydrogen, and these investments need to happen soon if Europe wants to be a leader in new technologies. The scale of these investments may require new financing ideas. Their costs, and the uncertainty about future payoffs, are often so large that they may not break even over conventional investment horizons. So, in some cases the resulting risks cannot be borne by entrepreneurs alone, making public-private partnerships a viable option to internalise the externalities arising from climate change. In some cases, this could include exploring options of granting state guarantees as a way for governments to incentivise private firms to invest in green infrastructure and technologies. Third, Europe needs to address labour scarcity. Longer life expectancy and declining fertility will lead to a sharp drop in the euro area's working-age population and a significant increase in the old-age dependency ratio. These developments are most concerning in Italy, where the share in the total population of those aged between 15 and 64 is projected to fall from about $63 \%$ today to $55 \%$ by 2050 (Slide 16, left-hand side). Over the past ten years, these strains have partly been cushioned by immigration. But as the baby boomer generation is retiring and migration is expected to moderate, the drag on growth coming from an ageing population is likely to be significant. New research suggests that, over the next two decades, demographic change may lower annual per capita output growth by more than one percentage point in Italy and by 0.8 percentage points in Germany. This comes at a time when a considerable share of firms across the euro area are already reporting acute shortages of labour limiting their business (Slide 16, right-hand side). Despite declining somewhat recently, this share has never been higher than in recent years. Labour scarcity cuts across society. In many countries, thousands of teacher vacancies are not filled, especially for STEM subjects. There are chronic staff shortages in hospitals and nursing homes. And all countries are facing a lack of skilled workers in specialised industries. These shortages are likely to dramatically increase as demographic change proceeds and cannot be offset by rising productivity alone. Europe should therefore do four things to address labour scarcity. First, it should further increase labour force participation. Significant progress has been made in recent decades, especially by bringing more women and older workers into the labour force. But participation rates remain below those in some other advanced economies. Second, resources need to be allocated more efficiently. The public sector has played an important role in explaining total employment growth over the past few years. The health crisis in particular has made some of these developments necessary. But the larger the public sector becomes, the less human capital is available for private firms to expand their productive businesses. Third, Europe needs to strengthen education. In many euro area countries, a significant share of adults - in some cases more than a third - have not completed upper secondary school. Supporting education will not only unlock the benefits of new technologies. It will also work against demographic headwinds, as higher levels of education tend to lead to higher labour market participation. Last, Europe needs to attract foreign workers. Solutions are needed for how to make immigration socially acceptable and how to promote the flow of workers across the single currency area. Let me conclude. In recent years, growth in the euro area has become increasingly uneven. While monetary policy may have contributed to rising heterogeneity, it is not the main driver. Rather, structural headwinds are holding back growth in some countries more than in others. We cannot ignore the headwinds to growth. With signs of softening labour demand and further progress in disinflation, a sustainable fall of inflation back to our 2\% target in a timely manner is becoming more likely, despite still elevated services inflation and strong wage growth. At the same time, monetary policy cannot resolve structural issues. European governments have a historic responsibility to turn the current challenges into opportunities. Europe has demonstrated in the past that it can adjust and rebound when faced with adversity. Escaping stagnation requires forceful action at both national and European level. It requires putting innovation and entrepreneurship first by promoting competition and business dynamism. This means strengthening the Single Market, improving access to private equity capital and reducing burdensome bureaucracy. It means leveraging the green transition to advance innovation and regain price competitiveness. And it means putting in place policies that incentivise labour participation and preserve a skilled workforce through immigration and education. In all these ways, we can make the euro area stronger. Thank you. Slides $>\quad+496913447455$ $>\quad$ [email protected] Reproduction is permitted provided that the source is acknowledged. Copyright 2024, European Central Bank
2024-10-02T00:00:00	Michelle W Bowman: Building a community banking framework for the future	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 2024 Community Banking Research Conference, sponsored by the Federal Reserve System, the Conference of State Bank Supervisors, and the Federal Deposit Insurance Corporation, St. Louis, Missouri, 2 October 2024.	For release on delivery 11:00 a.m. EDT (10:00 a.m. local time) October 2, 2024 Building a Community Banking Framework for the Future Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 2024 Community Banking Research Conference Sponsored by the Federal Reserve System, the Conference of State Bank Supervisors, and the Federal Deposit Insurance Corporation St. Louis, Missouri October 2, 2024 It is an honor to return to St. Louis for the 12th year of the Community Banking Research Conference.1 This conference is a model of effective partnership between the Federal Reserve and the Conference of State Bank Supervisors, and more recently, the Federal Deposit Insurance Corporation (FDIC). It is an opportunity for us all to dig deeper into the community banking model and the important role of community banks now and into the future. Together, regulators work to ensure that the approach to supervision and regulation is fit for purpose, and that each element of both supervision and regulation acts in a complementary manner. Policy disagreements are a healthy part of the process, but we must also strive to build consensus where we can. At a minimum, we must understand and respect our counterparts' and colleagues' viewpoints. Ultimately, we all share the same goal of promoting a safe and sound banking system. The strength of the U.S. banking system relies upon the diversity of its institutions, and facilitating an environment that allows each category of bank to thrive is essential to fostering a healthy financial system. For community banks, this includes building a framework that better supports the unique characteristics of these institutions. Today, my remarks will consider three foundational questions as we contemplate revising the community banking framework: (1) Given the continued evolution of the banking system, how should a community bank be defined? (2) Are we pursuing the most appropriate approach to supervision and regulation of community banks, and finally, (3) How can we build a policy framework that better supports and anticipates this evolution of the banking system now and into the future? - 2 - How to Define a Community Bank By necessity, regulators divide banks into more manageable categories. The Federal and four "categories" of Reserve has distinct portfolios that oversee "community," "regional," larger banks.2 The Federal Reserve and federal banking agencies further subdivide these portfolios based on additional factors. They may also depart from this framework altogether to group banks across portfolios or based on other common features. This approach to separating bank supervisory portfolios can enable us to more clearly articulate the tailoring applied to specific requirements of supervision and regulation.3 This approach has its virtues, including allowing examiners to better organize supervisory activities and training in different portfolios to focus on issues that are most relevant for the institutions being examined. When appropriately executed, it can lead to better and more risk-focused supervision, which ultimately promotes a safer and more sound banking system. Of course, there are limits to this framework. And we should continue to ask if the metrics and thresholds established through regulation, and more often recently through supervisory policy decisions, are appropriate over time as conditions change. Locking regulatory standards into a fixed asset-size threshold has its costs. Over time, these fixed thresholds fail to take into account growth attributable to broader economic growth 2 Larger banks are defined using tests that look primarily at asset size but may include other metrics like crossjurisdictional activity, nonbank assets, short-term wholesale funding, or off-balance sheet exposures. 3 For example, the "tailoring" rule in 2019 included a helpful visual that laid out the various standards and thresholds at which such standards applied across Category I-IV firms, and firms with more than $50 billion in Board of Governors of the Federal Reserve System, Tailoring Rule Visual, "Requirements for Domestic assets. See and Foreign Banking Organizations" (October 10, 2019), https://www.federalreserve.gov/aboutthefed/boardmeetings/files/tailoring-rule-visual-20191010.pdf. We use a variety of asset-size thresholds to help define our current portfolios and establish thresholds for supervisory and regulatory expectations. These thresholds apply for banks with assets of $10 billion, $50 billion, $100 billion, $250 billion, and $750 billion. Some regulatory standards implement lower thresholds under the current $10 billion 228.12 (defining a "small bank" and "intermediate bank" for community bank asset threshold. See, e.g., 12 C.F.R. purposes of the regulations implementing the Community Reinvestment Act); 13 C.F.R. 121.201 (SBA regulations defining small business entities, including commercial banks with less than $850 million in assets). - 3 - in a particular bank's activities or risk and inflation. They are also not reflective of any changes profile. As a result, many firms that are stable in their growth, business model, and risk profile end up unintentionally crossing regulatory thresholds. As they approach, and certainly once they cross over these asset-size lines, they must comply with additional regulatory and supervisory requirements that were specifically designed and implemented for larger and more complex firms. While the fixed-threshold approach benefits from simplicity, it is necessary to periodically revisit the policy effect of these bright-line thresholds. There are certainly cases in which a bank with assets less than $10 billion faces risks that are disproportionate to its asset size, warranting greater supervisory scrutiny. For these firms, asset size may vastly understate their risk profile. Often, they do not operate like traditional community banks, relying instead on nontraditional services and engaging in complex activities. Therefore, it may be appropriate for a community bank to be subject to additional oversight. This is particularly relevant when a bank has un-remediated, long-standing supervisory issues that require more supervisory monitoring and oversight. In such cases, a community bank supervisory approach is likely not sufficient or appropriate. At the same time, many banks with assets over $10 billion do operate like community banks, with a relationship-based straightforward business model, yet they are not regulated or supervised as such. Over time, the mismatch in supervisory expectations around this and other asset thresholds becomes more pronounced as economic growth and inflation effectively lower them. This results in potentially overly complex supervisory constructs for banks with a limited traditional community bank risk profile. - 4 - Is it appropriate to impose more restrictive requirements on firms when those heightened requirements are not a deliberate policy choice based on the level of risk? Is it appropriate to treat each bank below a regulatory threshold as a traditional community bank? Historically, regulators have been willing to push more complex requirements and expectations down to smaller banks-essentially bumping them into a higher risk tier-than moving larger firms into a lower risk tier when that treatment may be more appropriate. One important aspect of this definitional question involves the natural evolution of as it relates to innovation. The "push down" of regulatory and supervisory banking, specifically standards often applies when a bank pursues activities that fit under the broad umbrella of "innovation." Innovation can be defined expansively to include engaging in bank-fintech partnerships, using (or considering using) digital ledger technology, or even providing traditional banking services to entities that touch the crypto-asset ecosystem. Innovation can present a the "cost" challenging problem for both regulators and banks. If of adopting innovation results in a bank's inclusion in a higher compliance tier, it may be difficult to encourage greater investment in innovation for smaller banks. Establishing appropriate regulatory thresholds does not force regulators to eliminate or purge innovation from the banking system, especially among community banks.4 When considering building a framework to support community banks, the definition is key-which banks will be in scope? The answer lies in the bank's business model, activities, and risk profile. - 5 - Where we have established fixed-dollar asset thresholds, we must commit to revisit and adjust them as needed. In my view, this is a principle that extends beyond the lines defining community banks to all regulatory and supervisory thresholds. While there is need for flexibility in both directions, it is apparent that over time economic growth and inflation will result in thresholds that are inappropriately low. The Supervision and Regulation of Community Banks Establishing a definition for community banks leaves open the fundamental question of regulatory and supervisory approach. Before turning to that discussion, we need to take stock of supervision and regulation today. What areas of the framework require review and attention? The Tradeoffs of Regulation Regulation can be a powerful and effective tool to promote bank safety and soundness, and U.S. financial stability. The special privileges that are granted with a banking charter- including deposit insurance and access to the discount window-all come with the responsibility and obligation to comply with the bank regulatory framework. A robust presence of community banks, especially those that are remote and rural, enables access to credit, banking, and payment services in underserved markets and communities. These banks support local economies by serving consumers and small- and medium-sized businesses, building an economic foundation to drive business development and growth. But community banks, like any business, face the economic reality that accompanies running a successful business. Each must manage its costs-including personnel, funding, and regulatory compliance-in light of its revenues to achieve a reasonable return on equity. - 6 - a bank's When costs increase, there is, by necessity, a need to make changes if the bank hopes to maintain profitability and ultimately its survival. This usually involves either cutting costs or raising prices on banking services. How do the realities of operating a business inform our current approach to regulation? The question becomes acutely relevant when regulators consider imposing new or revised regulations. Regulators should always ask (1) what problem does this new regulation solve, (2) what are costs of this approach, and (3) are there alternative approaches? Before discussing the path forward, I would like to note an example that highlights this concern. The final Community Reinvestment Act (CRA) regulations issued in 2023 established new regulatory thresholds defining "small," "intermediate" and "large" banks, with the last category-large banks-including every bank with more than $2 billion in assets.5 In my view, this rulemaking represented a missed opportunity to rationalize the requirements of the CRA among community banks, and ignored the fundamental differences among banks with different balance sheets and business models.6 An approach that applies the same evaluation standards to a bank with $2 billion in assets as it does to a bank with $2 trillion in assets arguably represents a shortcoming in considering the fundamental differences among firms, and the disproportionate costs these standards may impose on the smallest banks. The Hidden Cost of Supervision and Guidance While regulation carries with it the obligation to comply with public notice and comment procedures under the Administrative Procedure Act, regulators have far more discretion in the - 7 - "guidance" that is technically supervisory process, and in issuing non-binding but often operates as a de facto requirement. The development and implementation of new supervisory approaches and of guidance largely escape rigorous scrutiny due to the lack of formal procedural requirements for its development. This is true even though the expectations created by guidance can be equally or more impactful to banks than rules. For example, the examination process often produces supervisory findings over- emphasizing non-core and non-financial risks, highlighting issues like IT and operational risk, management, risk management, and internal controls.7 These issues have filtered down from examinations and findings at the largest banks to the smallest, raising the question of appropriateness of application for smaller firms. In the supervisory process, we should guard against being distracted by less relevant issues. The prevalence of supervisory findings related to nonfinancial metrics is in part driven by the time it may take to remediate certain issues. However, we should also scrutinize whether this trend is indicative of our supervisory focus-beyond financial risk and toward non-financial risks and internal processes-and whether that shift is appropriate. We should also be aware that due to the vast diversity in business models, size, and geographic footprint among banks, we should not expect every firm to follow the same standards and must be careful to prevent forcing "grading on a uniformity through curve." This risk can be exacerbated through any type of horizontal-like reviews. The supervisory findings made during the examination process inform bank ratings, which can have follow-on effects like limiting options for mergers and acquisitions - 8 - (M&A) activity; raising the cost of liquidity; or diverting resources away from other, more important bank management priorities. Guidance can also impose costs on banks that are not always obvious or quantified. The purpose of guidance is to provide clarity to banks and reduce implementation uncertainty and risk. To serve this purpose, however, guidance must be clear, actionable, and account for the needs of the targeted firms, especially for community banks. In 2023, the federal banking agencies published supervisory guidance addressing third- party risk management, guidance expressly applicable to community banks. As I noted at the time this guidance was issued, it included shortcomings that were known and identified, but not addressed in advance.8 While I am pleased that the community bank implementation guide was eventually published, this recent example demonstrates that we need to ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the same time we publish the guidance. Guidance can help clarify uncertainty about the application of legal requirements or suggest how regulators may view particular activities in the supervisory process. But when guidance is unclear or ambiguous about supervisory views and expectations, it can hinder ability community banks' to clearly understand and meet them. Community bankers feel a strong obligation to review the voluminous body of guidance published by regulators, knowing - 9 - that even where it does not apply to them on its face, it may be pushed down to these banks as a best practice in the future.9 Bank Mergers, Acquisitions, and De Novo Formations What does a healthy banking system look like? While we often espouse the virtues of a "diverse" banking system-one with many different sizes of institutions and the flexibility to shift in size over time-a healthy banking system includes opportunities for entry and exit- from de novo bank formation through merger and acquisition activity. De novo bank formation promotes competition and greater availability of banking services. As banks consolidate or wind down operations, new banks fill gaps in the banking system. But the significant decline in the number of de novo banks raises questions about whether this pipeline can continue to be effective, even while there is existing and unmet demand for new charters.10 While factors other than the regulatory climate for applications may influence bank formation, the application process itself can be a significant roadblock, one that can limit the healthy formation of new community banks. For example, the M&A approval process can because the "screens" used to evaluate the have a disproportionate impact on community banks competitive effects of a proposed merger often result in a finding that a rural market M&A is 9 applicability "threshold" may effectively As I have noted in the past, even guidance with an establish new expectations even for much smaller banks. Michelle W. Bowman, "Tailoring, Fidelity to the Rule of Law, and Unintended Consequences" (speech at the Harvard Law School Faculty Club, Cambridge, Massachusetts, March 5, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240305a.pdf ("[w]hen guidance notes that 'all financial institutions, regardless of size, may have material exposures to climate-related financial risks...,' my intuition is that banks will take little comfort from the nominal carveout [of banks with less than $100 billion in assets] in light of this language...."). 10 See Michelle W. Bowman, "Bank Mergers and Acquisitions, and De Novo Bank Formation: Implications for the Future of the Banking System" (speech at A Workshop on the Future of Banking, Hosted by the Federal Reserve Bank of Kansas City, Kansas City, Missouri, April 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240402a.pdf. "anticompetitive."11 Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects, which isolates deposits as the proxy for the bundle of banking services, results in many delays for M&A transactions involving community banks or requiring additional review and analysis. Some recent policy changes at the FDIC have signaled a growing awareness of the need to better recognize a broader range of competition. But I am concerned that fully pivoting to a segment-by-segment analysis of competitive effects could, in practice, result in greater opportunities for regulatory objection to transactions, rather than as a mechanism to better reflect the competitive pressures for community banks. Replacing the deposit-based threshold to analyze competition with a completely open-ended approach-without standards for what products will be reviewed, what standards to apply for different products, and how to approach a transaction where the competitive impacts vary by product type-seems likely to promote inconsistency in the analysis among firms, and even longer delays in processing times. This is especially concerning when accompanied by changes that may result in even greater barriers to M&A regulatory approval.12 Fostering an environment that enables bank formation and merger transactions is vital to ensuring a future for community banking. Without viable formation and merger options for all create a "barbell" in the banking banks, but especially for community banks, we will system. If this continues, it will eventually result in a handful of very large banks, and an ever-shrinking number of community banks, with nothing left in the middle. Over time, these trends will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. Building a Framework to Better Support Community Banks After acknowledging the importance of community banks and effectively defining these firms, the next step is identifying principles for how these firms should be regulated and supervised. The guiding principles are relatively straightforward: the approach must be tailored to risk, transparent, and consistent across similar institutions. Together, these elements can create an opportunity to construct an enduring community bank regulatory and supervisory framework for the future. This conference provides an ideal venue to facilitate conversations that can help spur the development of blue-sky ideas to preserve community banking well into the future. While it would be impossible to lay out a comprehensive blueprint for a community banking reform agenda in this speech, I see several opportunities that are promising and essential. The Value of Experience Building this framework for the future starts with personnel, the people making decisions over the long term. How do we approach our responsibilities? We should highlight examples that have been successful but also reflect on the significant work that remains to be done. Congress reserved one seat on the Federal Reserve Board for someone with demonstrated primary experience working in or supervising community banks.13 While Congress did not enumerate any specific additional responsibilities for this particular seat on the Board, the creation of this role itself is an implicit acknowledgement of the value that this experience can bring across the Board's functions, especially regarding bank regulation and supervision. This experience, of having worked as a banker or as a state regulator, is uncommon within the Federal regulatory agencies. For example, of the current members of the Federal Reserve Board, I am the only member with experience as a banker or state regulator. In my view, we should ask how someone with this experience in the community banking system can best serve on the Board. This experience and perspective is critical. As a former community banker at a state- chartered bank and as the State Bank Commissioner of Kansas, I have seen and directly experienced the practical effect of supervision and regulation from "both sides" of the banker's desk. With this background, one understands and appreciates the importance of a respectful and healthy partnership between state and federal regulators and the need for setting high standards and applying strong oversight to banks of all sizes, including community banks. This background also provides perspective on how overregulation can impose disproportionate burden on a community bank, over time leading to the erosion of the viability of the community banking model. The requirement for community banking experience does not equate to advocacy on behalf of community banks. Instead, this role provides much-needed perspective on-and calls attention to-bank regulatory and supervisory matters that affect community banks. When I arrived at the Board, I was designated to serve as the chair of the Subcommittee on Smaller Regional and Community Banking. One of my first priorities was to make clear to examination staff the importance of their work in supervising community banks. After the 2008 financial crisis, although many community banks failed, much of the supervisory attention shifted to the very largest firms. The focus of this role provided the platform and opportunity to prioritize small regional and community banking issues, which led to a number of important successes, including: • the creation of the Small Bank Supervision Working Group to focus on the unique issues facing small banks with Reserve Bank staff from across the system; • the development and implementation of tools to assist community banks in complying Current Expected Credit Losses ("CECL") reporting change; with the • as interest rates were rising, encouraged supervisory focus to develop examination guidance to assess the risks associated with a changing interest rate environment and low tangible common equity, well before the spring 2023 banking failures; • improved frequency and content of communication with community banks; and • during the COVID-19 response, worked together with agency partners to implement approaches that encouraged banks to work with their borrowers, suspend exam timelines, and extend reporting deadlines for affected banks. During that time, staff also developed guidance for examiners as we emerged from the pandemic. These accomplishments highlight how prioritizing community banking issues at the highest level can improve the outcomes and experiences for community banks. We need a balanced approach to regulation and supervision of community banks. This approach should prioritize the key risks facing the banking system, acknowledge the costs of regulation and supervision, and consider alternatives that may be more efficient than simply adding additional requirements and expectations for smaller institutions. While I am proud of these accomplishments and our work together, a more formal structure for this seat's responsibilities-one that includes dedicated responsibility over the supervision and regulation of community banks, and to play an active role in interagency coordinating bodies like the Federal Financial Institutions Examination Council (FFIEC)- would go a long way toward building and preserving an enduring framework that supports community banks in the future. State Coordination One priority that would enhance our current approach to supervision would be to more effectively engage and coordinate with state banking regulators. What does coordination look like in practice? As a baseline, it should include communication during the consideration of regulatory proposals. But let's begin with the examination process. One of the concerning trends in 2023 were reports-including reports from state banking regulators-that some federal supervisory actions were excessive considering the risks posed by some smaller institutions.14 Historically, such disagreements have been uncommon because the examination process for state-chartered banks is joint between the state and federal counterparts at the Fed or the FDIC. We share responsibility for oversight of state banks, and jointly participate in examinations, so it is unsurprising that we often reach similar conclusions. When there are disagreements, supervisory divergence can also signal material changes in approach or standards, a shift that fails to accomplish the goal of effective supervisory judgment and consistency in the supervision of banks of all types. There are other opportunities to expand coordination with states, both through formal coordination bodies and when engaged in rule making efforts that are intended to impact state- chartered institutions. These coordination bodies include (1) the FFIEC-which is tasked with prescribing uniform principles, standards, and reporting forms for the federal examination of financial institutions, and making recommendations to promote consistency in the supervision of financial institutions-and (2) the Financial and Banking Information Infrastructure Committee-which is tasked with promoting information sharing and enhancing incident response planning, in addition to identifying cybersecurity best practices. Coordination is only effective if we are committed to work in an open, collaborative, and balanced way with other agencies and policymakers. There are unmet opportunities on this front. For example, the FFIEC is the venue in which regulators coordinate on examination standards and discuss and agree on reporting requirements that apply to smaller banks. With a growing divergence in the approach of state and federal regulators to the examination process, we need to ask how the FFIEC can better accomplish its goals. We also need to ask whether the other important work of the FFIEC, like establishing reporting requirements, is being conducted in an appropriate way. The opportunities for input, review, and oversight of this important work are very limited, with only the Board representative on the FFIEC participating. Notwithstanding these structural impediments, I have prioritized rationalizing the Call Report, an effort that I revived when I joined the Board. These types of overly broad requirements pose their own risks to community banks, and we should remember to focus on the unglamorous work of making sure we are not collecting more data than is necessary and appropriate for supervisory purposes, and that we are efficient in the collection of that data, for example, by leveraging data previously collected instead of requiring further collection of the same data. Regulators also tend to be very proprietary about the development of regulatory and supervisory proposals. Often, policies are far along in the development process before they are published for public comment in the rulemaking process, and state banking regulators rarely provide feedback on proposals before or after they are put out for comment. While regulators tasked with implementing regulations, supervision, and guidance bear the ultimate responsibility for those policy choices, this process can greatly benefit from more interaction among federal regulators and our state bank regulatory counterparts. More extensive dialogue with state regulators can improve proposals in the formulation stage by sharing practical, real-world perspectives, including observations on the impacts of intended and unintended consequences. While it is challenging to anticipate the unintended consequences of reforms, casting a wide net for views can lead to better, less disruptive, and better-informed policy choices. The importance of enhancing coordination between state regulators and the Federal Reserve cannot be overstated. At a recent meeting of the Board's Subcommittee on Smaller Regional and Community Banking, my colleagues and I were delighted to welcome representatives of the Conference of State Bank Supervisors and four of their State Bank Commissioner members. We learned firsthand about the successes, frustrations, concerns, and areas for improvement in the coordination between state and federal regulators. There is simply no substitute for these direct conversations and building upon and improving these important intergovernmental relationships. Collaborative Approach to Reform Historically, one of the many virtues of the Federal Reserve Board is the structural incentive to work together to achieve compromise. Governors serve extended, staggered terms intended to insulate them from political considerations. The Board consists of seven independent governors who often bring their unique voices to a range of policy matters. While instances of dissent tend to attract the most attention, the Fed has a long history and tradition of engaging in thoughtful debate, exchange of views, and reaching more durable compromises on rulemaking matters. The history of consensus on bank regulatory matters is not surprising because we work toward common goals of safety and soundness and financial stability. Consensus is a powerful tool. When there is broad policy agreement, there tends to be moderation in approach, acting as a check on wild swings of the regulatory pendulum and providing banks and holding companies with an important degree of stability in their regulatory and supervisory expectations. While it is important for regulators to adapt to changing conditions, and to evolve in the face of new and emerging risks, this incremental approach tends to produce better policy and better outcomes in the banking system. The antithesis of this policymaking approach is one that involves the close guarding of information, limiting the airing of competing views, and failing to engage in meaningful discussion and debate about policy. When contrasting these two ends of the policymaking spectrum, the virtues of consensus-building are even more apparent. Regulatory reform should not be a "shock" to the banking system, and meaningful discussion and consensus act as a check on dramatic swings of the regulatory pendulum. Collaborative reform is more effective when we have both a widespread sharing of information, analysis, and policy perspectives, and when a range of views is brought to bear on important regulatory questions. One way that we can accomplish this goal is through representation of those with banking or state regulatory experience representing the Federal Reserve in bodies that are influential in the shaping of policy approaches, like the FFIEC, and by embracing a culture of freely sharing information among policymakers both within and across regulatory agencies. Assessing the Costs and Benefits of Existing Approaches and Reform Too often when regulators impose requirements on banks, the temptation is to overestimate the benefits and underestimate the costs. Requiring banks to report additional data allows us to better understand the operations of banks. Limiting the fees that may be charged to consumers may result in a short-run reduction in consumer costs. But in the long run, regulation carries with it many costs, ranging from the direct costs of compliance and capital to indirect costs like the reduction in product offerings or increased prices for consumers. Regulators must anticipate, assess, and balance these costs in the rulemaking process and accept that, at times, the right policy is not to impose additional regulations but rather to take actions to reduce the burden of existing regulatory requirements. One of the key challenges to pursuing this balancing is how to effectively complete the analysis. The incremental burden of any single regulatory reform may be challenging to measure-its costs may seem minor when weighed against the benefits. But this approach cumulative ignores the additional cost of burdens, a concern that is particularly acute among community banks faced with an onslaught of changes. If we ignore cumulative burdens, we risk more rapid and pronounced swings in the regulatory pendulum. These swings in approach risk not only our ability to effectively supervise ability banks, but banks' to effectively manage their business.15 When faced with regulatory change, how does bank management review and provide meaningful comment on voluminous concurrent regulatory proposals that may build upon proposed, but not finalized regulations? When new rules are adopted, how can a bank ensure it has appropriate staffing and resources to ensure compliance? The cumulative burden of regulation is rarely acknowledged in the rulemaking process. While we assess burden with respect to discrete rule changes, there is no obligation to "refresh" that analysis due to changes in underlying conditions or new information about impact absent a further rule change. And the analysis of a rule focuses on the incremental impact of the specific regulation, ignoring the likely aggregate effect of requirements. While the minimum legal process required under the Administrative Procedure Act should be the "floor" for rulemaking, in my view it is insufficient. Likewise, while policymakers have even greater discretion in pursuing changes to supervision, we need not do so in a vacuum without opportunities for-and a receptiveness to-feedback. We can and should expand the lens through which we consider proposals, in a way that considers the cumulative effects of regulation and supervision on banks and their ultimate customers, in a way that identifies redundancies and excessive burdens, and in a way that considers multiple alternatives and the tradeoffs of different approaches. Tailoring Finally, I would be remiss to discuss the future of community banking without noting one of the critical mechanisms to build a sensible framework for the future-tailoring. Tailoring helps us calibrate regulation and supervision to the activities and risks at every tier within our oversight framework, but it is particularly important when we think about the application of prudential tools to community banks. Tailoring our approach helps with the allocation of finite resources-among both banks and regulators. It enables us to right-size the approach to regulation and supervision to the complexity of banks, acknowledging that community banks that pose manageable risks in the event of their failure, and no real risk to financial stability, simply do not warrant the same treatment as larger, more complex, and more systemically interconnected banking institutions. While in some cases, policymakers have made efforts to promote appropriate tailoring, often the end result has been lacking. As I noted earlier, in my view the 2023 CRA reforms represent a missed opportunity to rationalize and right-size CRA requirements for community banks. Instead, the rule applied the same essential framework to all institutions above $2 billion in assets, scoping in community banks with the very largest global systemically important banks. Even where supervisory approaches take into account the needs of community banks, the end result requires reviewing and incorporating ever-increasing guidance into their risk management activities. This was certainly the case with regulatory guidance on third-party risk management. To be clear, tailoring is not only an efficient way to allocate resources, but the lack of tailoring poses a longer-term threat to the viability of community and smaller banks. As the banking system evolves, with new opportunities and new risks, the temptation is to simply increase the body of regulatory requirements, without doing the necessary work of "maintenance," to ensure that the set of requirements that applies to banking activities is appropriate.16 Often, our guidance has a "cumulative" or "compounding" effect-a bank cannot go to a single source or compendium to understand supervisory expectations or requirements for a particular activity. Instead, a banker must parse through multiple regulations and guidance before understanding how regulators expect an activity to be conducted. A community banking regulatory framework that enables small banks to thrive must prioritize tailoring. Closing Thoughts Thank you for your commitment to community banking, and conducting the important research that can inform the regulatory policy agenda. Community banks may be small but their contributions to local communities are mighty. The importance of their role in providing credit to a broad range of customers and businesses that in their absence would have far fewer banking options cannot be overstated. There simply is no alternative or replacement for community banks and the relationship banking model. If regulators believe in a dynamic banking system, if we support financial inclusion and extending the availability of banking access, we must acknowledge the importance of community banks and ensure that our regulatory framework preserves their role for the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance. The discussions we will have over the next two days will include steps to further preserve and enhance the future of community banking. The presentations will enhance our understanding of the dynamics and pressures that shape the banking system, identify issues and concerns that may threaten different bank business models and activities, and develop policy approaches that consider the tradeoffs in our regulatory and supervisory approach.	---[PAGE_BREAK]--- For release on delivery 11:00 a.m. EDT (10:00 a.m. local time) October 2, 2024 Building a Community Banking Framework for the Future Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 2024 Community Banking Research Conference Sponsored by the Federal Reserve System, the Conference of State Bank Supervisors, and the Federal Deposit Insurance Corporation St. Louis, Missouri October 2, 2024 ---[PAGE_BREAK]--- It is an honor to return to St. Louis for the 12th year of the Community Banking Research Conference. ${ }^{1}$ This conference is a model of effective partnership between the Federal Reserve and the Conference of State Bank Supervisors, and more recently, the Federal Deposit Insurance Corporation (FDIC). It is an opportunity for us all to dig deeper into the community banking model and the important role of community banks now and into the future. Together, regulators work to ensure that the approach to supervision and regulation is fit for purpose, and that each element of both supervision and regulation acts in a complementary manner. Policy disagreements are a healthy part of the process, but we must also strive to build consensus where we can. At a minimum, we must understand and respect our counterparts' and colleagues' viewpoints. Ultimately, we all share the same goal of promoting a safe and sound banking system. The strength of the U.S. banking system relies upon the diversity of its institutions, and facilitating an environment that allows each category of bank to thrive is essential to fostering a healthy financial system. For community banks, this includes building a framework that better supports the unique characteristics of these institutions. Today, my remarks will consider three foundational questions as we contemplate revising the community banking framework: (1) Given the continued evolution of the banking system, how should a community bank be defined? (2) Are we pursuing the most appropriate approach to supervision and regulation of community banks, and finally, (3) How can we build a policy framework that better supports and anticipates this evolution of the banking system now and into the future? [^0] [^0]: ${ }^{1}$ These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- # How to Define a Community Bank By necessity, regulators divide banks into more manageable categories. The Federal Reserve has distinct portfolios that oversee "community," "regional," and four "categories" of larger banks. ${ }^{2}$ The Federal Reserve and federal banking agencies further subdivide these portfolios based on additional factors. They may also depart from this framework altogether to group banks across portfolios or based on other common features. This approach to separating bank supervisory portfolios can enable us to more clearly articulate the tailoring applied to specific requirements of supervision and regulation. ${ }^{3}$ This approach has its virtues, including allowing examiners to better organize supervisory activities and training in different portfolios to focus on issues that are most relevant for the institutions being examined. When appropriately executed, it can lead to better and more risk-focused supervision, which ultimately promotes a safer and more sound banking system. Of course, there are limits to this framework. And we should continue to ask if the metrics and thresholds established through regulation, and more often recently through supervisory policy decisions, are appropriate over time as conditions change. Locking regulatory standards into a fixed asset-size threshold has its costs. Over time, these fixed thresholds fail to take into account growth attributable to broader economic growth [^0] [^0]: ${ }^{2}$ Larger banks are defined using tests that look primarily at asset size but may include other metrics like crossjurisdictional activity, nonbank assets, short-term wholesale funding, or off-balance sheet exposures. ${ }^{3}$ For example, the "tailoring" rule in 2019 included a helpful visual that laid out the various standards and thresholds at which such standards applied across Category I-IV firms, and firms with more than $\$ 50$ billion in assets. See Board of Governors of the Federal Reserve System, Tailoring Rule Visual, "Requirements for Domestic and Foreign Banking Organizations" (October 10, 2019), https://www.federalreserve.gov/aboutthefed/boardmeetings/files/tailoring-rule-visual-20191010.pdf. We use a variety of asset-size thresholds to help define our current portfolios and establish thresholds for supervisory and regulatory expectations. These thresholds apply for banks with assets of $\$ 10$ billion, $\$ 50$ billion, $\$ 100$ billion, $\$ 250$ billion, and $\$ 750$ billion. Some regulatory standards implement lower thresholds under the current $\$ 10$ billion community bank asset threshold. See, e.g., 12 C.F.R. 228.12 (defining a "small bank" and "intermediate bank" for purposes of the regulations implementing the Community Reinvestment Act); 13 C.F.R. 121.201 (SBA regulations defining small business entities, including commercial banks with less than $\$ 850$ million in assets). ---[PAGE_BREAK]--- and inflation. They are also not reflective of any changes in a particular bank's activities or risk profile. As a result, many firms that are stable in their growth, business model, and risk profile end up unintentionally crossing regulatory thresholds. As they approach, and certainly once they cross over these asset-size lines, they must comply with additional regulatory and supervisory requirements that were specifically designed and implemented for larger and more complex firms. While the fixed-threshold approach benefits from simplicity, it is necessary to periodically revisit the policy effect of these bright-line thresholds. There are certainly cases in which a bank with assets less than $\$ 10$ billion faces risks that are disproportionate to its asset size, warranting greater supervisory scrutiny. For these firms, asset size may vastly understate their risk profile. Often, they do not operate like traditional community banks, relying instead on nontraditional services and engaging in complex activities. Therefore, it may be appropriate for a community bank to be subject to additional oversight. This is particularly relevant when a bank has un-remediated, long-standing supervisory issues that require more supervisory monitoring and oversight. In such cases, a community bank supervisory approach is likely not sufficient or appropriate. At the same time, many banks with assets over $\$ 10$ billion do operate like community banks, with a relationship-based straightforward business model, yet they are not regulated or supervised as such. Over time, the mismatch in supervisory expectations around this and other asset thresholds becomes more pronounced as economic growth and inflation effectively lower them. This results in potentially overly complex supervisory constructs for banks with a limited traditional community bank risk profile. ---[PAGE_BREAK]--- Is it appropriate to impose more restrictive requirements on firms when those heightened requirements are not a deliberate policy choice based on the level of risk? Is it appropriate to treat each bank below a regulatory threshold as a traditional community bank? Historically, regulators have been willing to push more complex requirements and expectations down to smaller banks-essentially bumping them into a higher risk tier-than moving larger firms into a lower risk tier when that treatment may be more appropriate. One important aspect of this definitional question involves the natural evolution of banking, specifically as it relates to innovation. The "push down" of regulatory and supervisory standards often applies when a bank pursues activities that fit under the broad umbrella of "innovation." Innovation can be defined expansively to include engaging in bank-fintech partnerships, using (or considering using) digital ledger technology, or even providing traditional banking services to entities that touch the crypto-asset ecosystem. Innovation can present a challenging problem for both regulators and banks. If the "cost" of adopting innovation results in a bank's inclusion in a higher compliance tier, it may be difficult to encourage greater investment in innovation for smaller banks. Establishing appropriate regulatory thresholds does not force regulators to eliminate or purge innovation from the banking system, especially among community banks. ${ }^{4}$ When considering building a framework to support community banks, the definition is key-which banks will be in scope? The answer lies in the bank's business model, activities, and risk profile. [^0] [^0]: ${ }^{4}$ Michelle W. Bowman, "Innovation and the Evolving Financial Landscape" (speech at The Digital Chamber DC Blockchain Summit 2024, Washington, D.C., May 15, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240515a.pdf; Michelle W. Bowman, "Innovation in the Financial System" (speech at The Salzburg Global Seminar on Financial Technology Innovation, Social Impact, and Regulation, Salzburg, Austria, June 17, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240617a.pdf. ---[PAGE_BREAK]--- Where we have established fixed-dollar asset thresholds, we must commit to revisit and adjust them as needed. In my view, this is a principle that extends beyond the lines defining community banks to all regulatory and supervisory thresholds. While there is need for flexibility in both directions, it is apparent that over time economic growth and inflation will result in thresholds that are inappropriately low. # The Supervision and Regulation of Community Banks Establishing a definition for community banks leaves open the fundamental question of regulatory and supervisory approach. Before turning to that discussion, we need to take stock of supervision and regulation today. What areas of the framework require review and attention? ## The Tradeoffs of Regulation Regulation can be a powerful and effective tool to promote bank safety and soundness, and U.S. financial stability. The special privileges that are granted with a banking charterincluding deposit insurance and access to the discount window-all come with the responsibility and obligation to comply with the bank regulatory framework. A robust presence of community banks, especially those that are remote and rural, enables access to credit, banking, and payment services in underserved markets and communities. These banks support local economies by serving consumers and small- and medium-sized businesses, building an economic foundation to drive business development and growth. But community banks, like any business, face the economic reality that accompanies running a successful business. Each must manage its costs-including personnel, funding, and regulatory compliance-in light of its revenues to achieve a reasonable return on equity. ---[PAGE_BREAK]--- When a bank's costs increase, there is, by necessity, a need to make changes if the bank hopes to maintain profitability and ultimately its survival. This usually involves either cutting costs or raising prices on banking services. How do the realities of operating a business inform our current approach to regulation? The question becomes acutely relevant when regulators consider imposing new or revised regulations. Regulators should always ask (1) what problem does this new regulation solve, (2) what are costs of this approach, and (3) are there alternative approaches? Before discussing the path forward, I would like to note an example that highlights this concern. The final Community Reinvestment Act (CRA) regulations issued in 2023 established new regulatory thresholds defining "small," "intermediate" and "large" banks, with the last category—large banks—including every bank with more than $\$ 2$ billion in assets. ${ }^{5}$ In my view, this rulemaking represented a missed opportunity to rationalize the requirements of the CRA among community banks, and ignored the fundamental differences among banks with different balance sheets and business models. ${ }^{6}$ An approach that applies the same evaluation standards to a bank with $\$ 2$ billion in assets as it does to a bank with $\$ 2$ trillion in assets arguably represents a shortcoming in considering the fundamental differences among firms, and the disproportionate costs these standards may impose on the smallest banks. # The Hidden Cost of Supervision and Guidance While regulation carries with it the obligation to comply with public notice and comment procedures under the Administrative Procedure Act, regulators have far more discretion in the [^0] [^0]: ${ }^{5}$ Community Reinvestment Act, 89 Fed. Reg. 6574 (February 1, 2024), https://www.govinfo.gov/content/pkg/FR-2024-02-01/pdf/2023-25797.pdf. ${ }^{6}$ See dissenting statement, "Statement on the Community Reinvestment Act Final Rule by Governor Michelle W. Bowman," news release, October 24, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20231024.htm. ---[PAGE_BREAK]--- supervisory process, and in issuing "guidance" that is technically non-binding but often operates as a de facto requirement. The development and implementation of new supervisory approaches and of guidance largely escape rigorous scrutiny due to the lack of formal procedural requirements for its development. This is true even though the expectations created by guidance can be equally or more impactful to banks than rules. For example, the examination process often produces supervisory findings overemphasizing non-core and non-financial risks, highlighting issues like IT and operational risk, management, risk management, and internal controls. ${ }^{7}$ These issues have filtered down from examinations and findings at the largest banks to the smallest, raising the question of appropriateness of application for smaller firms. In the supervisory process, we should guard against being distracted by less relevant issues. The prevalence of supervisory findings related to nonfinancial metrics is in part driven by the time it may take to remediate certain issues. However, we should also scrutinize whether this trend is indicative of our supervisory focus-beyond financial risk and toward non-financial risks and internal processes-and whether that shift is appropriate. We should also be aware that due to the vast diversity in business models, size, and geographic footprint among banks, we should not expect every firm to follow the same standards and must be careful to prevent forcing uniformity through "grading on a curve." This risk can be exacerbated through any type of horizontal-like reviews. The supervisory findings made during the examination process inform bank ratings, which can have follow-on effects like limiting options for mergers and acquisitions [^0] [^0]: ${ }^{7}$ As noted in the Board's most recent Supervision and Regulation Report, nearly half of the 1,340 supervisory findings for community banks were cited in these categories, more frequently than credit risk as of the fourth quarter of 2023. See Board of Governors of the Federal Reserve System, Supervision and Regulation Report, (Washington: Board of Governors, May 2024) 22, figure 16, https://www.federalreserve.gov/publications/files/202405supervision-and-regulation-report.pdf. ---[PAGE_BREAK]--- (M\&A) activity; raising the cost of liquidity; or diverting resources away from other, more important bank management priorities. Guidance can also impose costs on banks that are not always obvious or quantified. The purpose of guidance is to provide clarity to banks and reduce implementation uncertainty and risk. To serve this purpose, however, guidance must be clear, actionable, and account for the needs of the targeted firms, especially for community banks. In 2023, the federal banking agencies published supervisory guidance addressing thirdparty risk management, guidance expressly applicable to community banks. As I noted at the time this guidance was issued, it included shortcomings that were known and identified, but not addressed in advance. ${ }^{8}$ While I am pleased that the community bank implementation guide was eventually published, this recent example demonstrates that we need to ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the same time we publish the guidance. Guidance can help clarify uncertainty about the application of legal requirements or suggest how regulators may view particular activities in the supervisory process. But when guidance is unclear or ambiguous about supervisory views and expectations, it can hinder community banks' ability to clearly understand and meet them. Community bankers feel a strong obligation to review the voluminous body of guidance published by regulators, knowing [^0] [^0]: ${ }^{8}$ Michelle W. Bowman, "Defining a Bank" (Speech to the American Bankers Association 2024 Conference for Community Bankers, San Antonio, Texas, February 12, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240212a.pdf; Statement on Third Party Risk Management Guidance by Governor Michelle W. Bowman (June 6, 2023), https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230606.htm ("... Federal Reserve regional bank supervisors have indicated that we should provide additional resources for community banks upon implementation to provide appropriate expectations and ensure that small banks understand and can effectively use the guidance to inform their third-party risk management processes.... I am disappointed that the agencies failed to make the upfront investment to reduce unnecessary confusion and burden on community banks"). ---[PAGE_BREAK]--- that even where it does not apply to them on its face, it may be pushed down to these banks as a best practice in the future. ${ }^{9}$ # Bank Mergers, Acquisitions, and De Novo Formations What does a healthy banking system look like? While we often espouse the virtues of a "diverse" banking system-one with many different sizes of institutions and the flexibility to shift in size over time-a healthy banking system includes opportunities for entry and exitfrom de novo bank formation through merger and acquisition activity. De novo bank formation promotes competition and greater availability of banking services. As banks consolidate or wind down operations, new banks fill gaps in the banking system. But the significant decline in the number of de novo banks raises questions about whether this pipeline can continue to be effective, even while there is existing and unmet demand for new charters. ${ }^{10}$ While factors other than the regulatory climate for applications may influence bank formation, the application process itself can be a significant roadblock, one that can limit the healthy formation of new community banks. For example, the M\&A approval process can have a disproportionate impact on community banks because the "screens" used to evaluate the competitive effects of a proposed merger often result in a finding that a rural market M\&A is [^0] [^0]: ${ }^{9}$ As I have noted in the past, even guidance with an applicability "threshold" may effectively establish new expectations even for much smaller banks. Michelle W. Bowman, "Tailoring, Fidelity to the Rule of Law, and Unintended Consequences" (speech at the Harvard Law School Faculty Club, Cambridge, Massachusetts, March 5, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240305a.pdf ("[w]hen guidance notes that 'all financial institutions, regardless of size, may have material exposures to climate-related financial risks...,' my intuition is that banks will take little comfort from the nominal carveout [of banks with less than $\$ 100$ billion in assets] in light of this language...."). ${ }^{10}$ See Michelle W. Bowman, "Bank Mergers and Acquisitions, and De Novo Bank Formation: Implications for the Future of the Banking System" (speech at A Workshop on the Future of Banking, Hosted by the Federal Reserve Bank of Kansas City, Kansas City, Missouri, April 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240402a.pdf. ---[PAGE_BREAK]--- "anticompetitive." ${ }^{11}$ Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects, which isolates deposits as the proxy for the bundle of banking services, results in many delays for M\&A transactions involving community banks or requiring additional review and analysis. Some recent policy changes at the FDIC have signaled a growing awareness of the need to better recognize a broader range of competition. But I am concerned that fully pivoting to a segment-by-segment analysis of competitive effects could, in practice, result in greater opportunities for regulatory objection to transactions, rather than as a mechanism to better reflect the competitive pressures for community banks. Replacing the deposit-based threshold to analyze competition with a completely open-ended approach-without standards for what products will be reviewed, what standards to apply for different products, and how to approach a transaction where the competitive impacts vary by product type-seems likely to promote inconsistency in the analysis among firms, and even longer delays in processing times. This is especially concerning when accompanied by changes that may result in even greater barriers to M\&A regulatory approval. ${ }^{12}$ Fostering an environment that enables bank formation and merger transactions is vital to ensuring a future for community banking. Without viable formation and merger options for all banks, but especially for community banks, we will create a "barbell" in the banking system. If this continues, it will eventually result in a handful of very large banks, and an ever-shrinking [^0] [^0]: ${ }^{11}$ Michelle W. Bowman, "The Role of Research, Data, and Analysis in Banking Reforms" (speech at the 2023 Community Banking Research Conference, St. Louis, Missouri, October 4, 2023), https://www.federalreserve.gov/newsevents/speech/files/bowman20231004a.pdf; Michelle W. Bowman, "The New Landscape for Banking Competition," (speech at the 2022 Community Banking Research Conference, St. Louis, Missouri, September 28, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220928a.pdf. ${ }^{12}$ FDIC, "Final Statement of Policy on Bank Merger Transactions," (September 17, 2024), https://www.fdic.gov/system/files/2024-09/final-statement-of-policy-on-bank-merger-transactions.pdf. ---[PAGE_BREAK]--- number of community banks, with nothing left in the middle. Over time, these trends will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. # Building a Framework to Better Support Community Banks After acknowledging the importance of community banks and effectively defining these firms, the next step is identifying principles for how these firms should be regulated and supervised. The guiding principles are relatively straightforward: the approach must be tailored to risk, transparent, and consistent across similar institutions. Together, these elements can create an opportunity to construct an enduring community bank regulatory and supervisory framework for the future. This conference provides an ideal venue to facilitate conversations that can help spur the development of blue-sky ideas to preserve community banking well into the future. While it would be impossible to lay out a comprehensive blueprint for a community banking reform agenda in this speech, I see several opportunities that are promising and essential. ## The Value of Experience Building this framework for the future starts with personnel, the people making decisions over the long term. How do we approach our responsibilities? We should highlight examples that have been successful but also reflect on the significant work that remains to be done. Congress reserved one seat on the Federal Reserve Board for someone with demonstrated primary experience working in or supervising community banks. ${ }^{13}$ While Congress did not enumerate any specific additional responsibilities for this particular seat on the Board, the [^0] [^0]: ${ }^{13} 12$ U.S.C. § 241 ---[PAGE_BREAK]--- creation of this role itself is an implicit acknowledgement of the value that this experience can bring across the Board's functions, especially regarding bank regulation and supervision. This experience, of having worked as a banker or as a state regulator, is uncommon within the Federal regulatory agencies. For example, of the current members of the Federal Reserve Board, I am the only member with experience as a banker or state regulator. In my view, we should ask how someone with this experience in the community banking system can best serve on the Board. This experience and perspective is critical. As a former community banker at a statechartered bank and as the State Bank Commissioner of Kansas, I have seen and directly experienced the practical effect of supervision and regulation from "both sides" of the banker's desk. With this background, one understands and appreciates the importance of a respectful and healthy partnership between state and federal regulators and the need for setting high standards and applying strong oversight to banks of all sizes, including community banks. This background also provides perspective on how overregulation can impose disproportionate burden on a community bank, over time leading to the erosion of the viability of the community banking model. The requirement for community banking experience does not equate to advocacy on behalf of community banks. Instead, this role provides much-needed perspective on-and calls attention to—bank regulatory and supervisory matters that affect community banks. When I arrived at the Board, I was designated to serve as the chair of the Subcommittee on Smaller Regional and Community Banking. One of my first priorities was to make clear to examination staff the importance of their work in supervising community banks. After the 2008 financial crisis, although many community banks failed, much of the supervisory attention ---[PAGE_BREAK]--- shifted to the very largest firms. The focus of this role provided the platform and opportunity to prioritize small regional and community banking issues, which led to a number of important successes, including: - the creation of the Small Bank Supervision Working Group to focus on the unique issues facing small banks with Reserve Bank staff from across the system; - the development and implementation of tools to assist community banks in complying with the Current Expected Credit Losses ("CECL") reporting change; - as interest rates were rising, encouraged supervisory focus to develop examination guidance to assess the risks associated with a changing interest rate environment and low tangible common equity, well before the spring 2023 banking failures; - improved frequency and content of communication with community banks; and - during the COVID-19 response, worked together with agency partners to implement approaches that encouraged banks to work with their borrowers, suspend exam timelines, and extend reporting deadlines for affected banks. During that time, staff also developed guidance for examiners as we emerged from the pandemic. These accomplishments highlight how prioritizing community banking issues at the highest level can improve the outcomes and experiences for community banks. We need a balanced approach to regulation and supervision of community banks. This approach should prioritize the key risks facing the banking system, acknowledge the costs of regulation and supervision, and consider alternatives that may be more efficient than simply adding additional requirements and expectations for smaller institutions. While I am proud of these accomplishments and our work together, a more formal structure for this seat's responsibilities-one that includes dedicated responsibility over the ---[PAGE_BREAK]--- supervision and regulation of community banks, and to play an active role in interagency coordinating bodies like the Federal Financial Institutions Examination Council (FFIEC)— would go a long way toward building and preserving an enduring framework that supports community banks in the future. # State Coordination One priority that would enhance our current approach to supervision would be to more effectively engage and coordinate with state banking regulators. What does coordination look like in practice? As a baseline, it should include communication during the consideration of regulatory proposals. But let's begin with the examination process. One of the concerning trends in 2023 were reports-including reports from state banking regulators-that some federal supervisory actions were excessive considering the risks posed by some smaller institutions. ${ }^{14}$ Historically, such disagreements have been uncommon because the examination process for state-chartered banks is joint between the state and federal counterparts at the Fed or the FDIC. We share responsibility for oversight of state banks, and jointly participate in examinations, so it is unsurprising that we often reach similar conclusions. When there are disagreements, supervisory divergence can also signal material changes in approach or standards, a shift that fails to accomplish the goal of effective supervisory judgment and consistency in the supervision of banks of all types. There are other opportunities to expand coordination with states, both through formal coordination bodies and when engaged in rule making efforts that are intended to impact state- [^0] [^0]: ${ }^{14}$ Michelle W. Bowman, "Defining a Bank," (speech at the American Bankers Association 2024 Conference for Community Bankers, San Antonio, Texas, February 12, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240212a.pdf; Michelle W. Bowman, "New Year's Resolutions for Bank Regulatory Policymakers," (speech at the South Carolina Bankers Association 2024 Community Bankers Conference, Columbia, South Carolina, January 8, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240108a.pdf. ---[PAGE_BREAK]--- chartered institutions. These coordination bodies include (1) the FFIEC-which is tasked with prescribing uniform principles, standards, and reporting forms for the federal examination of financial institutions, and making recommendations to promote consistency in the supervision of financial institutions-and (2) the Financial and Banking Information Infrastructure Committee-which is tasked with promoting information sharing and enhancing incident response planning, in addition to identifying cybersecurity best practices. Coordination is only effective if we are committed to work in an open, collaborative, and balanced way with other agencies and policymakers. There are unmet opportunities on this front. For example, the FFIEC is the venue in which regulators coordinate on examination standards and discuss and agree on reporting requirements that apply to smaller banks. With a growing divergence in the approach of state and federal regulators to the examination process, we need to ask how the FFIEC can better accomplish its goals. We also need to ask whether the other important work of the FFIEC, like establishing reporting requirements, is being conducted in an appropriate way. The opportunities for input, review, and oversight of this important work are very limited, with only the Board representative on the FFIEC participating. Notwithstanding these structural impediments, I have prioritized rationalizing the Call Report, an effort that I revived when I joined the Board. These types of overly broad requirements pose their own risks to community banks, and we should remember to focus on the unglamorous work of making sure we are not collecting more data than is necessary and appropriate for supervisory purposes, and that we are efficient in the collection of that data, for example, by leveraging data previously collected instead of requiring further collection of the same data. ---[PAGE_BREAK]--- Regulators also tend to be very proprietary about the development of regulatory and supervisory proposals. Often, policies are far along in the development process before they are published for public comment in the rulemaking process, and state banking regulators rarely provide feedback on proposals before or after they are put out for comment. While regulators tasked with implementing regulations, supervision, and guidance bear the ultimate responsibility for those policy choices, this process can greatly benefit from more interaction among federal regulators and our state bank regulatory counterparts. More extensive dialogue with state regulators can improve proposals in the formulation stage by sharing practical, real-world perspectives, including observations on the impacts of intended and unintended consequences. While it is challenging to anticipate the unintended consequences of reforms, casting a wide net for views can lead to better, less disruptive, and better-informed policy choices. The importance of enhancing coordination between state regulators and the Federal Reserve cannot be overstated. At a recent meeting of the Board's Subcommittee on Smaller Regional and Community Banking, my colleagues and I were delighted to welcome representatives of the Conference of State Bank Supervisors and four of their State Bank Commissioner members. We learned firsthand about the successes, frustrations, concerns, and areas for improvement in the coordination between state and federal regulators. There is simply no substitute for these direct conversations and building upon and improving these important intergovernmental relationships. # Collaborative Approach to Reform Historically, one of the many virtues of the Federal Reserve Board is the structural incentive to work together to achieve compromise. Governors serve extended, staggered terms ---[PAGE_BREAK]--- intended to insulate them from political considerations. The Board consists of seven independent governors who often bring their unique voices to a range of policy matters. While instances of dissent tend to attract the most attention, the Fed has a long history and tradition of engaging in thoughtful debate, exchange of views, and reaching more durable compromises on rulemaking matters. The history of consensus on bank regulatory matters is not surprising because we work toward common goals of safety and soundness and financial stability. Consensus is a powerful tool. When there is broad policy agreement, there tends to be moderation in approach, acting as a check on wild swings of the regulatory pendulum and providing banks and holding companies with an important degree of stability in their regulatory and supervisory expectations. While it is important for regulators to adapt to changing conditions, and to evolve in the face of new and emerging risks, this incremental approach tends to produce better policy and better outcomes in the banking system. The antithesis of this policymaking approach is one that involves the close guarding of information, limiting the airing of competing views, and failing to engage in meaningful discussion and debate about policy. When contrasting these two ends of the policymaking spectrum, the virtues of consensus-building are even more apparent. Regulatory reform should not be a "shock" to the banking system, and meaningful discussion and consensus act as a check on dramatic swings of the regulatory pendulum. Collaborative reform is more effective when we have both a widespread sharing of information, analysis, and policy perspectives, and when a range of views is brought to bear on important regulatory questions. One way that we can accomplish this goal is through representation of those with banking or state regulatory experience representing the Federal Reserve in bodies that are influential in the shaping of policy approaches, like the FFIEC, and by ---[PAGE_BREAK]--- embracing a culture of freely sharing information among policymakers both within and across regulatory agencies. # Assessing the Costs and Benefits of Existing Approaches and Reform Too often when regulators impose requirements on banks, the temptation is to overestimate the benefits and underestimate the costs. Requiring banks to report additional data allows us to better understand the operations of banks. Limiting the fees that may be charged to consumers may result in a short-run reduction in consumer costs. But in the long run, regulation carries with it many costs, ranging from the direct costs of compliance and capital to indirect costs like the reduction in product offerings or increased prices for consumers. Regulators must anticipate, assess, and balance these costs in the rulemaking process and accept that, at times, the right policy is not to impose additional regulations but rather to take actions to reduce the burden of existing regulatory requirements. One of the key challenges to pursuing this balancing is how to effectively complete the analysis. The incremental burden of any single regulatory reform may be challenging to measure-its costs may seem minor when weighed against the benefits. But this approach ignores the additional cost of cumulative burdens, a concern that is particularly acute among community banks faced with an onslaught of changes. If we ignore cumulative burdens, we risk more rapid and pronounced swings in the regulatory pendulum. These swings in approach risk not only our ability to effectively supervise banks, but banks' ability to effectively manage their business. ${ }^{15}$ When faced with regulatory change, how does bank management review and provide meaningful comment on voluminous [^0] [^0]: ${ }^{15}$ Michelle W. Bowman, "Bank Mergers and Acquisition, and De Novo Bank Formation: Implications for the Future of the Banking System," (speech at a Workshop on the Future of Banking hosted by the Federal Reserve Bank of Kansas City, Kansas City, Missouri, April 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240402a.pdf. ---[PAGE_BREAK]--- concurrent regulatory proposals that may build upon proposed, but not finalized regulations? When new rules are adopted, how can a bank ensure it has appropriate staffing and resources to ensure compliance? The cumulative burden of regulation is rarely acknowledged in the rulemaking process. While we assess burden with respect to discrete rule changes, there is no obligation to "refresh" that analysis due to changes in underlying conditions or new information about impact absent a further rule change. And the analysis of a rule focuses on the incremental impact of the specific regulation, ignoring the likely aggregate effect of requirements. While the minimum legal process required under the Administrative Procedure Act should be the "floor" for rulemaking, in my view it is insufficient. Likewise, while policymakers have even greater discretion in pursuing changes to supervision, we need not do so in a vacuum without opportunities for-and a receptiveness to-feedback. We can and should expand the lens through which we consider proposals, in a way that considers the cumulative effects of regulation and supervision on banks and their ultimate customers, in a way that identifies redundancies and excessive burdens, and in a way that considers multiple alternatives and the tradeoffs of different approaches. # Tailoring Finally, I would be remiss to discuss the future of community banking without noting one of the critical mechanisms to build a sensible framework for the future-tailoring. Tailoring helps us calibrate regulation and supervision to the activities and risks at every tier within our oversight framework, but it is particularly important when we think about the application of prudential tools to community banks. Tailoring our approach helps with the allocation of finite resources-among both banks and regulators. It enables us to right-size the approach to ---[PAGE_BREAK]--- regulation and supervision to the complexity of banks, acknowledging that community banks that pose manageable risks in the event of their failure, and no real risk to financial stability, simply do not warrant the same treatment as larger, more complex, and more systemically interconnected banking institutions. While in some cases, policymakers have made efforts to promote appropriate tailoring, often the end result has been lacking. As I noted earlier, in my view the 2023 CRA reforms represent a missed opportunity to rationalize and right-size CRA requirements for community banks. Instead, the rule applied the same essential framework to all institutions above $\$ 2$ billion in assets, scoping in community banks with the very largest global systemically important banks. Even where supervisory approaches take into account the needs of community banks, the end result requires reviewing and incorporating ever-increasing guidance into their risk management activities. This was certainly the case with regulatory guidance on third-party risk management. To be clear, tailoring is not only an efficient way to allocate resources, but the lack of tailoring poses a longer-term threat to the viability of community and smaller banks. As the banking system evolves, with new opportunities and new risks, the temptation is to simply increase the body of regulatory requirements, without doing the necessary work of "maintenance," to ensure that the set of requirements that applies to banking activities is appropriate. ${ }^{16}$ Often, our guidance has a "cumulative" or "compounding" effect-a bank cannot go to a single source or compendium to understand supervisory expectations or requirements for a particular activity. Instead, a banker must parse through multiple regulations and guidance [^0] [^0]: ${ }^{16}$ The banking agencies have an obligation under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 to review their regulations every 10 years to identify, with input from the public, outdated, unnecessary, or unduly burdensome regulation and to consider how to reduce regulatory burden. See 12 U.S.C. § 3311. ---[PAGE_BREAK]--- before understanding how regulators expect an activity to be conducted. A community banking regulatory framework that enables small banks to thrive must prioritize tailoring. # Closing Thoughts Thank you for your commitment to community banking, and conducting the important research that can inform the regulatory policy agenda. Community banks may be small but their contributions to local communities are mighty. The importance of their role in providing credit to a broad range of customers and businesses that in their absence would have far fewer banking options cannot be overstated. There simply is no alternative or replacement for community banks and the relationship banking model. If regulators believe in a dynamic banking system, if we support financial inclusion and extending the availability of banking access, we must acknowledge the importance of community banks and ensure that our regulatory framework preserves their role for the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance. The discussions we will have over the next two days will include steps to further preserve and enhance the future of community banking. The presentations will enhance our understanding of the dynamics and pressures that shape the banking system, identify issues and concerns that may threaten different bank business models and activities, and develop policy approaches that consider the tradeoffs in our regulatory and supervisory approach.	Michelle W Bowman	United States	https://www.bis.org/review/r241003a.pdf	For release on delivery 11:00 a.m. EDT (10:00 a.m. local time) October 2, 2024 Building a Community Banking Framework for the Future Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 2024 Community Banking Research Conference Sponsored by the Federal Reserve System, the Conference of State Bank Supervisors, and the Federal Deposit Insurance Corporation St. Louis, Missouri October 2, 2024 It is an honor to return to St. Louis for the 12th year of the Community Banking Research Conference. This conference is a model of effective partnership between the Federal Reserve and the Conference of State Bank Supervisors, and more recently, the Federal Deposit Insurance Corporation (FDIC). It is an opportunity for us all to dig deeper into the community banking model and the important role of community banks now and into the future. Together, regulators work to ensure that the approach to supervision and regulation is fit for purpose, and that each element of both supervision and regulation acts in a complementary manner. Policy disagreements are a healthy part of the process, but we must also strive to build consensus where we can. At a minimum, we must understand and respect our counterparts' and colleagues' viewpoints. Ultimately, we all share the same goal of promoting a safe and sound banking system. The strength of the U.S. banking system relies upon the diversity of its institutions, and facilitating an environment that allows each category of bank to thrive is essential to fostering a healthy financial system. For community banks, this includes building a framework that better supports the unique characteristics of these institutions. Today, my remarks will consider three foundational questions as we contemplate revising the community banking framework: (1) Given the continued evolution of the banking system, how should a community bank be defined? (2) Are we pursuing the most appropriate approach to supervision and regulation of community banks, and finally, (3) How can we build a policy framework that better supports and anticipates this evolution of the banking system now and into the future? By necessity, regulators divide banks into more manageable categories. The Federal Reserve has distinct portfolios that oversee "community," "regional," and four "categories" of larger banks. The Federal Reserve and federal banking agencies further subdivide these portfolios based on additional factors. They may also depart from this framework altogether to group banks across portfolios or based on other common features. This approach to separating bank supervisory portfolios can enable us to more clearly articulate the tailoring applied to specific requirements of supervision and regulation. This approach has its virtues, including allowing examiners to better organize supervisory activities and training in different portfolios to focus on issues that are most relevant for the institutions being examined. When appropriately executed, it can lead to better and more risk-focused supervision, which ultimately promotes a safer and more sound banking system. Of course, there are limits to this framework. And we should continue to ask if the metrics and thresholds established through regulation, and more often recently through supervisory policy decisions, are appropriate over time as conditions change. Locking regulatory standards into a fixed asset-size threshold has its costs. Over time, these fixed thresholds fail to take into account growth attributable to broader economic growth and inflation. They are also not reflective of any changes in a particular bank's activities or risk profile. As a result, many firms that are stable in their growth, business model, and risk profile end up unintentionally crossing regulatory thresholds. As they approach, and certainly once they cross over these asset-size lines, they must comply with additional regulatory and supervisory requirements that were specifically designed and implemented for larger and more complex firms. While the fixed-threshold approach benefits from simplicity, it is necessary to periodically revisit the policy effect of these bright-line thresholds. There are certainly cases in which a bank with assets less than $\$ 10$ billion faces risks that are disproportionate to its asset size, warranting greater supervisory scrutiny. For these firms, asset size may vastly understate their risk profile. Often, they do not operate like traditional community banks, relying instead on nontraditional services and engaging in complex activities. Therefore, it may be appropriate for a community bank to be subject to additional oversight. This is particularly relevant when a bank has un-remediated, long-standing supervisory issues that require more supervisory monitoring and oversight. In such cases, a community bank supervisory approach is likely not sufficient or appropriate. At the same time, many banks with assets over $\$ 10$ billion do operate like community banks, with a relationship-based straightforward business model, yet they are not regulated or supervised as such. Over time, the mismatch in supervisory expectations around this and other asset thresholds becomes more pronounced as economic growth and inflation effectively lower them. This results in potentially overly complex supervisory constructs for banks with a limited traditional community bank risk profile. Is it appropriate to impose more restrictive requirements on firms when those heightened requirements are not a deliberate policy choice based on the level of risk? Is it appropriate to treat each bank below a regulatory threshold as a traditional community bank? Historically, regulators have been willing to push more complex requirements and expectations down to smaller banks-essentially bumping them into a higher risk tier-than moving larger firms into a lower risk tier when that treatment may be more appropriate. One important aspect of this definitional question involves the natural evolution of banking, specifically as it relates to innovation. The "push down" of regulatory and supervisory standards often applies when a bank pursues activities that fit under the broad umbrella of "innovation." Innovation can be defined expansively to include engaging in bank-fintech partnerships, using (or considering using) digital ledger technology, or even providing traditional banking services to entities that touch the crypto-asset ecosystem. Innovation can present a challenging problem for both regulators and banks. If the "cost" of adopting innovation results in a bank's inclusion in a higher compliance tier, it may be difficult to encourage greater investment in innovation for smaller banks. Establishing appropriate regulatory thresholds does not force regulators to eliminate or purge innovation from the banking system, especially among community banks. When considering building a framework to support community banks, the definition is key-which banks will be in scope? The answer lies in the bank's business model, activities, and risk profile. "Innovation in the Financial System" (speech at The Salzburg Global Seminar on Financial Technology Innovation, Social Impact, and Regulation, Salzburg, Austria, June 17, 2024), Where we have established fixed-dollar asset thresholds, we must commit to revisit and adjust them as needed. In my view, this is a principle that extends beyond the lines defining community banks to all regulatory and supervisory thresholds. While there is need for flexibility in both directions, it is apparent that over time economic growth and inflation will result in thresholds that are inappropriately low. Establishing a definition for community banks leaves open the fundamental question of regulatory and supervisory approach. Before turning to that discussion, we need to take stock of supervision and regulation today. What areas of the framework require review and attention? Regulation can be a powerful and effective tool to promote bank safety and soundness, and U.S. financial stability. The special privileges that are granted with a banking charterincluding deposit insurance and access to the discount window-all come with the responsibility and obligation to comply with the bank regulatory framework. A robust presence of community banks, especially those that are remote and rural, enables access to credit, banking, and payment services in underserved markets and communities. These banks support local economies by serving consumers and small- and medium-sized businesses, building an economic foundation to drive business development and growth. But community banks, like any business, face the economic reality that accompanies running a successful business. Each must manage its costs-including personnel, funding, and regulatory compliance-in light of its revenues to achieve a reasonable return on equity. When a bank's costs increase, there is, by necessity, a need to make changes if the bank hopes to maintain profitability and ultimately its survival. This usually involves either cutting costs or raising prices on banking services. How do the realities of operating a business inform our current approach to regulation? The question becomes acutely relevant when regulators consider imposing new or revised regulations. Regulators should always ask (1) what problem does this new regulation solve, (2) what are costs of this approach, and (3) are there alternative approaches? Before discussing the path forward, I would like to note an example that highlights this concern. The final Community Reinvestment Act (CRA) regulations issued in 2023 established new regulatory thresholds defining "small," "intermediate" and "large" banks, with the last category—large banks—including every bank with more than $\$ 2$ billion in assets. An approach that applies the same evaluation standards to a bank with $\$ 2$ billion in assets as it does to a bank with $\$ 2$ trillion in assets arguably represents a shortcoming in considering the fundamental differences among firms, and the disproportionate costs these standards may impose on the smallest banks. While regulation carries with it the obligation to comply with public notice and comment procedures under the Administrative Procedure Act, regulators have far more discretion in the supervisory process, and in issuing "guidance" that is technically non-binding but often operates as a de facto requirement. The development and implementation of new supervisory approaches and of guidance largely escape rigorous scrutiny due to the lack of formal procedural requirements for its development. This is true even though the expectations created by guidance can be equally or more impactful to banks than rules. For example, the examination process often produces supervisory findings overemphasizing non-core and non-financial risks, highlighting issues like IT and operational risk, management, risk management, and internal controls. These issues have filtered down from examinations and findings at the largest banks to the smallest, raising the question of appropriateness of application for smaller firms. In the supervisory process, we should guard against being distracted by less relevant issues. The prevalence of supervisory findings related to nonfinancial metrics is in part driven by the time it may take to remediate certain issues. However, we should also scrutinize whether this trend is indicative of our supervisory focus-beyond financial risk and toward non-financial risks and internal processes-and whether that shift is appropriate. We should also be aware that due to the vast diversity in business models, size, and geographic footprint among banks, we should not expect every firm to follow the same standards and must be careful to prevent forcing uniformity through "grading on a curve." This risk can be exacerbated through any type of horizontal-like reviews. The supervisory findings made during the examination process inform bank ratings, which can have follow-on effects like limiting options for mergers and acquisitions (M\&A) activity; raising the cost of liquidity; or diverting resources away from other, more important bank management priorities. Guidance can also impose costs on banks that are not always obvious or quantified. The purpose of guidance is to provide clarity to banks and reduce implementation uncertainty and risk. To serve this purpose, however, guidance must be clear, actionable, and account for the needs of the targeted firms, especially for community banks. In 2023, the federal banking agencies published supervisory guidance addressing thirdparty risk management, guidance expressly applicable to community banks. As I noted at the time this guidance was issued, it included shortcomings that were known and identified, but not addressed in advance. While I am pleased that the community bank implementation guide was eventually published, this recent example demonstrates that we need to ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the same time we publish the guidance. Guidance can help clarify uncertainty about the application of legal requirements or suggest how regulators may view particular activities in the supervisory process. But when guidance is unclear or ambiguous about supervisory views and expectations, it can hinder community banks' ability to clearly understand and meet them. Community bankers feel a strong obligation to review the voluminous body of guidance published by regulators, knowing that even where it does not apply to them on its face, it may be pushed down to these banks as a best practice in the future. What does a healthy banking system look like? While we often espouse the virtues of a "diverse" banking system-one with many different sizes of institutions and the flexibility to shift in size over time-a healthy banking system includes opportunities for entry and exitfrom de novo bank formation through merger and acquisition activity. De novo bank formation promotes competition and greater availability of banking services. As banks consolidate or wind down operations, new banks fill gaps in the banking system. But the significant decline in the number of de novo banks raises questions about whether this pipeline can continue to be effective, even while there is existing and unmet demand for new charters. While factors other than the regulatory climate for applications may influence bank formation, the application process itself can be a significant roadblock, one that can limit the healthy formation of new community banks. For example, the M\&A approval process can have a disproportionate impact on community banks because the "screens" used to evaluate the competitive effects of a proposed merger often result in a finding that a rural market M\&A is "anticompetitive." Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects, which isolates deposits as the proxy for the bundle of banking services, results in many delays for M\&A transactions involving community banks or requiring additional review and analysis. Some recent policy changes at the FDIC have signaled a growing awareness of the need to better recognize a broader range of competition. But I am concerned that fully pivoting to a segment-by-segment analysis of competitive effects could, in practice, result in greater opportunities for regulatory objection to transactions, rather than as a mechanism to better reflect the competitive pressures for community banks. Replacing the deposit-based threshold to analyze competition with a completely open-ended approach-without standards for what products will be reviewed, what standards to apply for different products, and how to approach a transaction where the competitive impacts vary by product type-seems likely to promote inconsistency in the analysis among firms, and even longer delays in processing times. This is especially concerning when accompanied by changes that may result in even greater barriers to M\&A regulatory approval. Fostering an environment that enables bank formation and merger transactions is vital to ensuring a future for community banking. Without viable formation and merger options for all banks, but especially for community banks, we will create a "barbell" in the banking system. If this continues, it will eventually result in a handful of very large banks, and an ever-shrinking number of community banks, with nothing left in the middle. Over time, these trends will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. After acknowledging the importance of community banks and effectively defining these firms, the next step is identifying principles for how these firms should be regulated and supervised. The guiding principles are relatively straightforward: the approach must be tailored to risk, transparent, and consistent across similar institutions. Together, these elements can create an opportunity to construct an enduring community bank regulatory and supervisory framework for the future. This conference provides an ideal venue to facilitate conversations that can help spur the development of blue-sky ideas to preserve community banking well into the future. While it would be impossible to lay out a comprehensive blueprint for a community banking reform agenda in this speech, I see several opportunities that are promising and essential. Building this framework for the future starts with personnel, the people making decisions over the long term. How do we approach our responsibilities? We should highlight examples that have been successful but also reflect on the significant work that remains to be done. Congress reserved one seat on the Federal Reserve Board for someone with demonstrated primary experience working in or supervising community banks. While Congress did not enumerate any specific additional responsibilities for this particular seat on the Board, the creation of this role itself is an implicit acknowledgement of the value that this experience can bring across the Board's functions, especially regarding bank regulation and supervision. This experience, of having worked as a banker or as a state regulator, is uncommon within the Federal regulatory agencies. For example, of the current members of the Federal Reserve Board, I am the only member with experience as a banker or state regulator. In my view, we should ask how someone with this experience in the community banking system can best serve on the Board. This experience and perspective is critical. As a former community banker at a statechartered bank and as the State Bank Commissioner of Kansas, I have seen and directly experienced the practical effect of supervision and regulation from "both sides" of the banker's desk. With this background, one understands and appreciates the importance of a respectful and healthy partnership between state and federal regulators and the need for setting high standards and applying strong oversight to banks of all sizes, including community banks. This background also provides perspective on how overregulation can impose disproportionate burden on a community bank, over time leading to the erosion of the viability of the community banking model. The requirement for community banking experience does not equate to advocacy on behalf of community banks. Instead, this role provides much-needed perspective on-and calls attention to—bank regulatory and supervisory matters that affect community banks. When I arrived at the Board, I was designated to serve as the chair of the Subcommittee on Smaller Regional and Community Banking. One of my first priorities was to make clear to examination staff the importance of their work in supervising community banks. After the 2008 financial crisis, although many community banks failed, much of the supervisory attention shifted to the very largest firms. The focus of this role provided the platform and opportunity to prioritize small regional and community banking issues, which led to a number of important successes, including: the creation of the Small Bank Supervision Working Group to focus on the unique issues facing small banks with Reserve Bank staff from across the system;. the development and implementation of tools to assist community banks in complying with the Current Expected Credit Losses ("CECL") reporting change;. as interest rates were rising, encouraged supervisory focus to develop examination guidance to assess the risks associated with a changing interest rate environment and low tangible common equity, well before the spring 2023 banking failures;. improved frequency and content of communication with community banks; and. during the COVID-19 response, worked together with agency partners to implement approaches that encouraged banks to work with their borrowers, suspend exam timelines, and extend reporting deadlines for affected banks. During that time, staff also developed guidance for examiners as we emerged from the pandemic. These accomplishments highlight how prioritizing community banking issues at the highest level can improve the outcomes and experiences for community banks. We need a balanced approach to regulation and supervision of community banks. This approach should prioritize the key risks facing the banking system, acknowledge the costs of regulation and supervision, and consider alternatives that may be more efficient than simply adding additional requirements and expectations for smaller institutions. While I am proud of these accomplishments and our work together, a more formal structure for this seat's responsibilities-one that includes dedicated responsibility over the supervision and regulation of community banks, and to play an active role in interagency coordinating bodies like the Federal Financial Institutions Examination Council (FFIEC)— would go a long way toward building and preserving an enduring framework that supports community banks in the future. One priority that would enhance our current approach to supervision would be to more effectively engage and coordinate with state banking regulators. What does coordination look like in practice? As a baseline, it should include communication during the consideration of regulatory proposals. But let's begin with the examination process. One of the concerning trends in 2023 were reports-including reports from state banking regulators-that some federal supervisory actions were excessive considering the risks posed by some smaller institutions. Historically, such disagreements have been uncommon because the examination process for state-chartered banks is joint between the state and federal counterparts at the Fed or the FDIC. We share responsibility for oversight of state banks, and jointly participate in examinations, so it is unsurprising that we often reach similar conclusions. When there are disagreements, supervisory divergence can also signal material changes in approach or standards, a shift that fails to accomplish the goal of effective supervisory judgment and consistency in the supervision of banks of all types. There are other opportunities to expand coordination with states, both through formal coordination bodies and when engaged in rule making efforts that are intended to impact state- chartered institutions. These coordination bodies include (1) the FFIEC-which is tasked with prescribing uniform principles, standards, and reporting forms for the federal examination of financial institutions, and making recommendations to promote consistency in the supervision of financial institutions-and (2) the Financial and Banking Information Infrastructure Committee-which is tasked with promoting information sharing and enhancing incident response planning, in addition to identifying cybersecurity best practices. Coordination is only effective if we are committed to work in an open, collaborative, and balanced way with other agencies and policymakers. There are unmet opportunities on this front. For example, the FFIEC is the venue in which regulators coordinate on examination standards and discuss and agree on reporting requirements that apply to smaller banks. With a growing divergence in the approach of state and federal regulators to the examination process, we need to ask how the FFIEC can better accomplish its goals. We also need to ask whether the other important work of the FFIEC, like establishing reporting requirements, is being conducted in an appropriate way. The opportunities for input, review, and oversight of this important work are very limited, with only the Board representative on the FFIEC participating. Notwithstanding these structural impediments, I have prioritized rationalizing the Call Report, an effort that I revived when I joined the Board. These types of overly broad requirements pose their own risks to community banks, and we should remember to focus on the unglamorous work of making sure we are not collecting more data than is necessary and appropriate for supervisory purposes, and that we are efficient in the collection of that data, for example, by leveraging data previously collected instead of requiring further collection of the same data. Regulators also tend to be very proprietary about the development of regulatory and supervisory proposals. Often, policies are far along in the development process before they are published for public comment in the rulemaking process, and state banking regulators rarely provide feedback on proposals before or after they are put out for comment. While regulators tasked with implementing regulations, supervision, and guidance bear the ultimate responsibility for those policy choices, this process can greatly benefit from more interaction among federal regulators and our state bank regulatory counterparts. More extensive dialogue with state regulators can improve proposals in the formulation stage by sharing practical, real-world perspectives, including observations on the impacts of intended and unintended consequences. While it is challenging to anticipate the unintended consequences of reforms, casting a wide net for views can lead to better, less disruptive, and better-informed policy choices. The importance of enhancing coordination between state regulators and the Federal Reserve cannot be overstated. At a recent meeting of the Board's Subcommittee on Smaller Regional and Community Banking, my colleagues and I were delighted to welcome representatives of the Conference of State Bank Supervisors and four of their State Bank Commissioner members. We learned firsthand about the successes, frustrations, concerns, and areas for improvement in the coordination between state and federal regulators. There is simply no substitute for these direct conversations and building upon and improving these important intergovernmental relationships. Historically, one of the many virtues of the Federal Reserve Board is the structural incentive to work together to achieve compromise. Governors serve extended, staggered terms intended to insulate them from political considerations. The Board consists of seven independent governors who often bring their unique voices to a range of policy matters. While instances of dissent tend to attract the most attention, the Fed has a long history and tradition of engaging in thoughtful debate, exchange of views, and reaching more durable compromises on rulemaking matters. The history of consensus on bank regulatory matters is not surprising because we work toward common goals of safety and soundness and financial stability. Consensus is a powerful tool. When there is broad policy agreement, there tends to be moderation in approach, acting as a check on wild swings of the regulatory pendulum and providing banks and holding companies with an important degree of stability in their regulatory and supervisory expectations. While it is important for regulators to adapt to changing conditions, and to evolve in the face of new and emerging risks, this incremental approach tends to produce better policy and better outcomes in the banking system. The antithesis of this policymaking approach is one that involves the close guarding of information, limiting the airing of competing views, and failing to engage in meaningful discussion and debate about policy. When contrasting these two ends of the policymaking spectrum, the virtues of consensus-building are even more apparent. Regulatory reform should not be a "shock" to the banking system, and meaningful discussion and consensus act as a check on dramatic swings of the regulatory pendulum. Collaborative reform is more effective when we have both a widespread sharing of information, analysis, and policy perspectives, and when a range of views is brought to bear on important regulatory questions. One way that we can accomplish this goal is through representation of those with banking or state regulatory experience representing the Federal Reserve in bodies that are influential in the shaping of policy approaches, like the FFIEC, and by embracing a culture of freely sharing information among policymakers both within and across regulatory agencies. Too often when regulators impose requirements on banks, the temptation is to overestimate the benefits and underestimate the costs. Requiring banks to report additional data allows us to better understand the operations of banks. Limiting the fees that may be charged to consumers may result in a short-run reduction in consumer costs. But in the long run, regulation carries with it many costs, ranging from the direct costs of compliance and capital to indirect costs like the reduction in product offerings or increased prices for consumers. Regulators must anticipate, assess, and balance these costs in the rulemaking process and accept that, at times, the right policy is not to impose additional regulations but rather to take actions to reduce the burden of existing regulatory requirements. One of the key challenges to pursuing this balancing is how to effectively complete the analysis. The incremental burden of any single regulatory reform may be challenging to measure-its costs may seem minor when weighed against the benefits. But this approach ignores the additional cost of cumulative burdens, a concern that is particularly acute among community banks faced with an onslaught of changes. If we ignore cumulative burdens, we risk more rapid and pronounced swings in the regulatory pendulum. These swings in approach risk not only our ability to effectively supervise banks, but banks' ability to effectively manage their business. When faced with regulatory change, how does bank management review and provide meaningful comment on voluminous concurrent regulatory proposals that may build upon proposed, but not finalized regulations? When new rules are adopted, how can a bank ensure it has appropriate staffing and resources to ensure compliance? The cumulative burden of regulation is rarely acknowledged in the rulemaking process. While we assess burden with respect to discrete rule changes, there is no obligation to "refresh" that analysis due to changes in underlying conditions or new information about impact absent a further rule change. And the analysis of a rule focuses on the incremental impact of the specific regulation, ignoring the likely aggregate effect of requirements. While the minimum legal process required under the Administrative Procedure Act should be the "floor" for rulemaking, in my view it is insufficient. Likewise, while policymakers have even greater discretion in pursuing changes to supervision, we need not do so in a vacuum without opportunities for-and a receptiveness to-feedback. We can and should expand the lens through which we consider proposals, in a way that considers the cumulative effects of regulation and supervision on banks and their ultimate customers, in a way that identifies redundancies and excessive burdens, and in a way that considers multiple alternatives and the tradeoffs of different approaches. Finally, I would be remiss to discuss the future of community banking without noting one of the critical mechanisms to build a sensible framework for the future-tailoring. Tailoring helps us calibrate regulation and supervision to the activities and risks at every tier within our oversight framework, but it is particularly important when we think about the application of prudential tools to community banks. Tailoring our approach helps with the allocation of finite resources-among both banks and regulators. It enables us to right-size the approach to regulation and supervision to the complexity of banks, acknowledging that community banks that pose manageable risks in the event of their failure, and no real risk to financial stability, simply do not warrant the same treatment as larger, more complex, and more systemically interconnected banking institutions. While in some cases, policymakers have made efforts to promote appropriate tailoring, often the end result has been lacking. As I noted earlier, in my view the 2023 CRA reforms represent a missed opportunity to rationalize and right-size CRA requirements for community banks. Instead, the rule applied the same essential framework to all institutions above $\$ 2$ billion in assets, scoping in community banks with the very largest global systemically important banks. Even where supervisory approaches take into account the needs of community banks, the end result requires reviewing and incorporating ever-increasing guidance into their risk management activities. This was certainly the case with regulatory guidance on third-party risk management. To be clear, tailoring is not only an efficient way to allocate resources, but the lack of tailoring poses a longer-term threat to the viability of community and smaller banks. As the banking system evolves, with new opportunities and new risks, the temptation is to simply increase the body of regulatory requirements, without doing the necessary work of "maintenance," to ensure that the set of requirements that applies to banking activities is appropriate. Often, our guidance has a "cumulative" or "compounding" effect-a bank cannot go to a single source or compendium to understand supervisory expectations or requirements for a particular activity. Instead, a banker must parse through multiple regulations and guidance before understanding how regulators expect an activity to be conducted. A community banking regulatory framework that enables small banks to thrive must prioritize tailoring. Thank you for your commitment to community banking, and conducting the important research that can inform the regulatory policy agenda. Community banks may be small but their contributions to local communities are mighty. The importance of their role in providing credit to a broad range of customers and businesses that in their absence would have far fewer banking options cannot be overstated. There simply is no alternative or replacement for community banks and the relationship banking model. If regulators believe in a dynamic banking system, if we support financial inclusion and extending the availability of banking access, we must acknowledge the importance of community banks and ensure that our regulatory framework preserves their role for the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance. The discussions we will have over the next two days will include steps to further preserve and enhance the future of community banking. The presentations will enhance our understanding of the dynamics and pressures that shape the banking system, identify issues and concerns that may threaten different bank business models and activities, and develop policy approaches that consider the tradeoffs in our regulatory and supervisory approach.
2024-10-04T00:00:00	John C Williams: New York City is alive	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the "Future of New York City: Focus on Jobs" conference, organised by the Federal Reserve Bank of New York, New York City, 4 October 2024.	John C Williams: New York City is alive Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the "Future of New York City: Focus on Jobs" conference, organised by the Federal Reserve Bank of New York, New York City, 4 October 2024. * * * As prepared for delivery Good morning. Let me welcome you to the Federal Reserve Bank of New York and to our second Future of New York City conference. And thank you to the speakers, participants, and organizers who make this such a valuable forum. This year we are celebrating the centennial of this landmark building here at 33 Liberty Street. We are proud of our history as a downtown anchor institution and look forward to the next 100 years. Before I go further, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. It was not too long ago-a little over four years back-when some predicted that the future of New York City was quite bleak. Others even went as far to declare that New York City is dead forever. Well, that forecast didn't age well. I imagine those of you sitting right here in this auditorium would agree with me. Just to get here this morning, you likely had to catch a ride on a crowded subway, train, bus, or ferry. Or maybe you were brave enough to drive over a bridge or through a tunnel and then search for parking. Perhaps you stood in a long line waiting for coffee or a pastry, or dodged tourists taking a photo right in the middle of the sidewalk. I won't even mention the e-scooters and bikes. And it's only 9:00 a.m. That's because New York City is again one of the most alive cities on Earth. In truth, that 2020 forecast was based on the reality during that moment in time, at least economically speaking. New York City was the epicenter of the pandemic in the U.S., and our region was hit especially hard. According to New York Fed business surveys, business activity plunged to historic lows in April 2020, as fear of contagion kept many people at home and efforts to stop the spread of the virus shutdown large parts of the 1 regional economy. About 60 percent of service-based businesses and more than half of manufacturers reported at least a partial shutdown of their operations early on in the pandemic. Layoffs were widespread. The initial job loss of more than 20 percent in New 2 York City exceeded the national decline of 15 percent. You'll hear more about how the employment situation has evolved over the past four years from my colleague Jaison Abel in a few minutes. I lived and worked here in Lower Manhattan, so I remember just what that drastic change felt like. The city went from being packed at all hours of the day to being almost unrecognizable. Here at the New York Fed and in offices just like ours across the city, only essential workers came to work in person. And neighborhood businesses and services-and the employees that supported them-suffered as a result. But after that chapter came a remarkable rebound. To be clear, things are not exactly the same as they were prior to the pandemic. The city had to adapt to changes in office attendance and commute patterns, and the fallout is still lingering. But we are back on our feet, and the current reality is far different from the onset of pandemic and the period that followed. One indication that's important for our conversation today is that we've recovered the jobs lost during the pandemic and then some. Now, shows and venues are packed. It's hard to get restaurant reservations at certain places. Apartment vacancies are low. And office workers are back, even if in some cases it's only a few days a week. When we first hosted this conference in 2022, the discussion focused on remote work and the city's infrastructure, with a particular focus on an equitable recovery. The overarching question that shaped our conversations in that moment was, "What is the future of New York City?" Now, that question has shifted. There's no doubt that New York City has a great future. kind of future do we want to build for New York City?" So today, we're asking, "What The future will build and expand on what has worked so well for the city in the past. The foundational aspects that have made New York so successful for so long are still present. The excitement and enthusiasm that draw people to live and work here have not changed. At the same time, many of the challenges have not changed either. For example, the high cost of living and housing availability are still predominant concerns, among others. The entertainment, arts, businesses, culture, and landmarks that we have here in New York cannot be replicated elsewhere. But those experiences can only be had if there are jobs and a healthy economy to support it all. It's important that we invest in the study of the challenges and opportunities for employment in this city, so that we can build the future. Our conference today will do just that. In our sessions this morning, we'll talk about how employment was and continues to be impacted by shifts in the city. And we'll discuss similarities and distinctions across industries and occupations, initiatives that will attract and retain a robust workforce, and more. Thanks again to our speakers and panelists for the knowledge and insight they bring to this event, and to all of you for attending and demonstrating your commitment to shaping the future of this great city. Jaison R. Abel, Jason Bram, and Richard Deitz, "New York Fed Surveys: Business Activity in the Region Sees Historic Plunge in April," Federal Reserve Bank of New York Liberty Street Economics , April 16, 2020. 2 Jaison R. Abel, Jason Bram, Richard Deitz, and Jonathan Hastings, "The Region Is Struggling to Recover from the Pandemic Recession," Federal Reserve Bank of New York Liberty Street Economics, December 17, 2021.	---[PAGE_BREAK]--- # John C Williams: New York City is alive Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the "Future of New York City: Focus on Jobs" conference, organised by the Federal Reserve Bank of New York, New York City, 4 October 2024. ## As prepared for delivery Good morning. Let me welcome you to the Federal Reserve Bank of New York and to our second Future of New York City conference. And thank you to the speakers, participants, and organizers who make this such a valuable forum. This year we are celebrating the centennial of this landmark building here at 33 Liberty Street. We are proud of our history as a downtown anchor institution and look forward to the next 100 years. Before I go further, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. It was not too long ago-a little over four years back-when some predicted that the future of New York City was quite bleak. Others even went as far to declare that New York City is dead forever. Well, that forecast didn't age well. I imagine those of you sitting right here in this auditorium would agree with me. Just to get here this morning, you likely had to catch a ride on a crowded subway, train, bus, or ferry. Or maybe you were brave enough to drive over a bridge or through a tunnel and then search for parking. Perhaps you stood in a long line waiting for coffee or a pastry, or dodged tourists taking a photo right in the middle of the sidewalk. I won't even mention the e-scooters and bikes. And it's only 9:00 a.m. That's because New York City is again one of the most alive cities on Earth. In truth, that 2020 forecast was based on the reality during that moment in time, at least economically speaking. New York City was the epicenter of the pandemic in the U.S., and our region was hit especially hard. According to New York Fed business surveys, business activity plunged to historic lows in April 2020, as fear of contagion kept many people at home and efforts to stop the spread of the virus shutdown large parts of the regional economy. ${ }^{1}$ About 60 percent of service-based businesses and more than half of manufacturers reported at least a partial shutdown of their operations early on in the pandemic. Layoffs were widespread. The initial job loss of more than 20 percent in New York City exceeded the national decline of 15 percent. ${ }^{2}$ You'll hear more about how the employment situation has evolved over the past four years from my colleague Jaison Abel in a few minutes. ---[PAGE_BREAK]--- I lived and worked here in Lower Manhattan, so I remember just what that drastic change felt like. The city went from being packed at all hours of the day to being almost unrecognizable. Here at the New York Fed and in offices just like ours across the city, only essential workers came to work in person. And neighborhood businesses and services-and the employees that supported them-suffered as a result. But after that chapter came a remarkable rebound. To be clear, things are not exactly the same as they were prior to the pandemic. The city had to adapt to changes in office attendance and commute patterns, and the fallout is still lingering. But we are back on our feet, and the current reality is far different from the onset of pandemic and the period that followed. One indication that's important for our conversation today is that we've recovered the jobs lost during the pandemic and then some. Now, shows and venues are packed. It's hard to get restaurant reservations at certain places. Apartment vacancies are low. And office workers are back, even if in some cases it's only a few days a week. When we first hosted this conference in 2022, the discussion focused on remote work and the city's infrastructure, with a particular focus on an equitable recovery. The overarching question that shaped our conversations in that moment was, "What is the future of New York City?" Now, that question has shifted. There's no doubt that New York City has a great future. So today, we're asking, "What kind of future do we want to build for New York City?" The future will build and expand on what has worked so well for the city in the past. The foundational aspects that have made New York so successful for so long are still present. The excitement and enthusiasm that draw people to live and work here have not changed. At the same time, many of the challenges have not changed either. For example, the high cost of living and housing availability are still predominant concerns, among others. The entertainment, arts, businesses, culture, and landmarks that we have here in New York cannot be replicated elsewhere. But those experiences can only be had if there are jobs and a healthy economy to support it all. It's important that we invest in the study of the challenges and opportunities for employment in this city, so that we can build the future. Our conference today will do just that. In our sessions this morning, we'll talk about how employment was and continues to be impacted by shifts in the city. And we'll discuss similarities and distinctions across industries and occupations, initiatives that will attract and retain a robust workforce, and more. Thanks again to our speakers and panelists for the knowledge and insight they bring to this event, and to all of you for attending and demonstrating your commitment to shaping the future of this great city. ---[PAGE_BREAK]--- 1 Jaison R. Abel, Jason Bram, and Richard Deitz, "New York Fed Surveys: Business Activity in the Region Sees Historic Plunge in April," Federal Reserve Bank of New York Liberty Street Economics, April 16, 2020. ${ }^{2}$ Jaison R. Abel, Jason Bram, Richard Deitz, and Jonathan Hastings, "The Region Is Struggling to Recover from the Pandemic Recession," Federal Reserve Bank of New York Liberty Street Economics, December 17, 2021.	John C Williams	United States	https://www.bis.org/review/r241007b.pdf	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the "Future of New York City: Focus on Jobs" conference, organised by the Federal Reserve Bank of New York, New York City, 4 October 2024. Good morning. Let me welcome you to the Federal Reserve Bank of New York and to our second Future of New York City conference. And thank you to the speakers, participants, and organizers who make this such a valuable forum. This year we are celebrating the centennial of this landmark building here at 33 Liberty Street. We are proud of our history as a downtown anchor institution and look forward to the next 100 years. Before I go further, let me give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. It was not too long ago-a little over four years back-when some predicted that the future of New York City was quite bleak. Others even went as far to declare that New York City is dead forever. Well, that forecast didn't age well. I imagine those of you sitting right here in this auditorium would agree with me. Just to get here this morning, you likely had to catch a ride on a crowded subway, train, bus, or ferry. Or maybe you were brave enough to drive over a bridge or through a tunnel and then search for parking. Perhaps you stood in a long line waiting for coffee or a pastry, or dodged tourists taking a photo right in the middle of the sidewalk. I won't even mention the e-scooters and bikes. And it's only 9:00 a.m. That's because New York City is again one of the most alive cities on Earth. In truth, that 2020 forecast was based on the reality during that moment in time, at least economically speaking. New York City was the epicenter of the pandemic in the U.S., and our region was hit especially hard. According to New York Fed business surveys, business activity plunged to historic lows in April 2020, as fear of contagion kept many people at home and efforts to stop the spread of the virus shutdown large parts of the regional economy. You'll hear more about how the employment situation has evolved over the past four years from my colleague Jaison Abel in a few minutes. I lived and worked here in Lower Manhattan, so I remember just what that drastic change felt like. The city went from being packed at all hours of the day to being almost unrecognizable. Here at the New York Fed and in offices just like ours across the city, only essential workers came to work in person. And neighborhood businesses and services-and the employees that supported them-suffered as a result. But after that chapter came a remarkable rebound. To be clear, things are not exactly the same as they were prior to the pandemic. The city had to adapt to changes in office attendance and commute patterns, and the fallout is still lingering. But we are back on our feet, and the current reality is far different from the onset of pandemic and the period that followed. One indication that's important for our conversation today is that we've recovered the jobs lost during the pandemic and then some. Now, shows and venues are packed. It's hard to get restaurant reservations at certain places. Apartment vacancies are low. And office workers are back, even if in some cases it's only a few days a week. When we first hosted this conference in 2022, the discussion focused on remote work and the city's infrastructure, with a particular focus on an equitable recovery. The overarching question that shaped our conversations in that moment was, "What is the future of New York City?" Now, that question has shifted. There's no doubt that New York City has a great future. So today, we're asking, "What kind of future do we want to build for New York City?" The future will build and expand on what has worked so well for the city in the past. The foundational aspects that have made New York so successful for so long are still present. The excitement and enthusiasm that draw people to live and work here have not changed. At the same time, many of the challenges have not changed either. For example, the high cost of living and housing availability are still predominant concerns, among others. The entertainment, arts, businesses, culture, and landmarks that we have here in New York cannot be replicated elsewhere. But those experiences can only be had if there are jobs and a healthy economy to support it all. It's important that we invest in the study of the challenges and opportunities for employment in this city, so that we can build the future. Our conference today will do just that. In our sessions this morning, we'll talk about how employment was and continues to be impacted by shifts in the city. And we'll discuss similarities and distinctions across industries and occupations, initiatives that will attract and retain a robust workforce, and more. Thanks again to our speakers and panelists for the knowledge and insight they bring to this event, and to all of you for attending and demonstrating your commitment to shaping the future of this great city.
2024-10-04T00:00:00	Frank Elderson: Sustainable finance - from "eureka!" to action	Keynote speech by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the Sustainable Finance Lab Symposium on Finance in Transition, Amsterdam, 4 October 2024.	SPEECH Sustainable finance: from "eureka!" to action Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the Sustainable Finance Lab Symposium on Finance in Transition Amsterdam, 4 October 2024 Many great discoveries have been made outside well-controlled laboratory environments. Alexander Fleming discovered penicillin when he returned from holiday and found mould growing on a Petri dish containing bacteria he was studying. Henri Becquerel discovered radioactivity by accident after he put the equipment he used to study the relationship between x-rays and sunlight in a drawer on an overcast day. And Archimedes famously had his "eureka" moment while sitting in a bathtub. Not all "eureka" moments happen in well-controlled laboratory experiments, but laboratories nevertheless provide an ideal controlled environment to make major discoveries. To develop ideas, test theories and move from scientific findings to practical solutions for real-world problems. Laboratories provide the bridge from theory to practice, from discovery to application and from insight to action. Eureka! Back in 2017 a small group of central banks and supervisors from around the world shared an insight that was relatively novel to them and their peers: climate and nature-related risks are a source of financial risk." And this insight was as consequential as it was straightforward. If climate and nature- related risks are a source of financial risk, they fall squarely within the respective mandates of central banks and supervisors - to preserve price stability and ensure the safety and soundness of banks. In fact, if central banks and supervisors were to disregard climate and nature-related risks, they would run the risk of failing to deliver on their mandates. This was a "eureka" moment for central banks and supervisors. That small group of central banks and supervisors recognised that action was needed if they were to continue delivering on their mandates as the climate and nature crises increasingly affected the economy and the financial system. And so the Central Banks and Supervisors Network for Greening the Financial System (NGFS) was founded in 2017, providing a much needed laboratory environment for central banks and supervisors working on climate and nature.!2! The NGFS was created as a platform to share, develop and advance practices to incorporate climate and nature-related considerations into the tasks and responsibilities of central banks and supervisors. And, importantly, to work closely with academics and stakeholder groups who were already considering the macro- financial consequences of global heating and nature degradation. Sharing the "eureka!" moment From that "eureka" moment, it quickly became the globally accepted consensus that climate and nature-related risks fall squarely within the mandates of central banks and supervisors. The NGFS has grown from eight members in 2017 to 142 members today. All of these central banks and supervisors - from all over the world - subscribe to the NGFS's stance on the relevance of climate and nature- related risks and use the network as a platform to share experiences and best practices. In addition, and to a large extent as a direct result of the NGFS's pioneering work, climate-related risks now feature prominently in the work programmes of major international standard-setting bodies such as the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures and the Financial Stability Board. Unfortunately, the same cannot yet be said for nature-related risks, though a recent stocktake on nature-related risks by the Financial Stability Board showed that a growing number of authorities have been considering the potential implications of nature-related risks for financial stability./2] In Europe, the relevance of climate and nature-related risks for the economy and the financial system has also been explicitly acknowledged by the legislator. The revised Capital Requirements Directive, which provides the regulatory and supervisory framework for banks in Europe, contains a clear reference to climate and nature-related risks. And the European Union's climate objectives are explicitly recognised as part of its general economic policies. Moreover, there is an ever-growing body of evidence showing the macro-financial relevance of climate and nature-related risks. Even if a successful and timely transition requires vast investment flows, analysis consistently confirms that the economic benefits of a transition far outweigh the costs. This conclusion holds especially when considered against the alternative scenarios of doing nothing or doing too little too late.!4] Moreover, if global heating and nature degradation are left unchecked, they will lead to increased macroeconomic volatility as climate and nature events become more severe and more frequent and have a greater impact on the economy - something we are already witnessing today, Regrettably, the prevailing consensus in climate science tells us that the goal of limiting global heating to 2 degrees Celsius, as set out in the Paris Agreement, is not currently being met. And it is not even close to being met. Last year the UN Emissions Gap Report concluded that the world is on track for an average increase of 2.9 degrees. And even that will only be achieved if all government commitments to mitigation measures are implemented in full and on time. This means that, besides the investment needs for the transition, policymakers also have to be increasingly mindful of the investment needs for adaption to increased damages from global heating and nature degradation! To sum up, there is no doubt that the ongoing climate and nature crises go to the heart of central banking and banking supervision. And that is why the ECB, moving in lockstep with the work being done by the NGFS, international standard-setting bodies and academia, has been taking action to incorporate climate and nature-related considerations into its monetary policy and supervisory tasks. From "eureka!" to action: in monetary policy... Let me start with the steps we have taken in the area of monetary policy. When the ECB concluded its strategy review in the summer of 2021 - the first review since 2003 - the new strategy explicitly acknowledged the profound implications of climate change for the economy and its relevance for monetary policy. And this new strategy came with a concrete climate action plan. In the three years since then, we have made significant progress in improving our ability to take climate considerations into account in the macroeconomic analyses that inform our policy discussions. We are now much better able to assess the economic consequences of the green transition in the euro area using a set of macroeconomic models. Moreover, we are identifying physical risks that are already posing risks to price stability. We found, for instance, that increases in food prices following extreme heatwaves were an upside risk to price stability.!2] This risk has featured explicitly in our monetary policy assessment and communication in recent quarters. With respect to our monetary policy instruments, in October 2022 we started tilting our reinvestments of corporate bonds towards issuers with a better climate performance. This enables us to avoid undue exposures to climate-related risks that are detrimental to price stability and to align the way we conduct our monetary policy more closely with the EU's general economic policies. As of July 2023 we suspended bond purchases under our asset purchase programme, including corporate bonds, to help bring inflation back to our 2% target. We are still applying the tilting strategy in the partial reinvestments of maturing bonds in the context of our pandemic emergency purchase programme, until these reinvestments are also discontinued as intended at the end of 2024.! If any corporate bond purchases were needed for monetary policy purposes in the future, the established direction of the tilt would set the minimum benchmark. In addition to our bond holdings, we are also looking at the collateral framework that we apply in relation to banks' participation in our lending operations. As an early outcome of this work, in 2021 we started to accept sustainability-linked bonds as collateral, provided that they meet the eligibility criteria. We have also decided that only assets that comply with the EU Corporate Sustainability Reporting Directive will remain eligible once this Directive enters into force. And we are continuing to explore options to further incorporate climate considerations into our collateral framework. To this end, we are working with relevant authorities, such as the European Securities and Markets Authority and the European Banking Authority, to encourage better disclosures from collateral issuers and in turn facilitate a better assessment of climate-related risks. Our current actions aim to support a high degree of confidence in the alignment of our activities with the goals set by the Paris Agreement within our mandate. However, the decarbonisation path for our monetary policy assets remains dependent on actions that are not fully under our control, including the decarbonisation efforts made by the issuers of bonds that we hold. This is one of the main reasons why we have committed to regularly reviewing all our measures to assess their impact. If necessary, we will adapt them to ensure they continue to fulfil their monetary policy objectives and support the decarbonisation path to reach the goals set by the Paris Agreement and the EU's climate neutrality objectives. Within our mandate, we will also look into addressing additional nature-related challenges. This process will be fully guided by our monetary policy strategy. Specifically, wnenever we have a choice between two instruments - or calibrations of instruments - that are equally conducive to maintaining price stability, we are legally obliged to choose the one that best supports the general economic policies in the EU. This implies that whenever we adjust the calibration of our instruments, we must choose the option that supports our decarbonisation path, unless our proportionality assessment shows that there are other, less intrusive ways of achieving price stability. Looking ahead, besides the adjustments that we are already implementing, this strategic commitment may require us to consider two further avenues.2] The first concerns our public sector bond holdings. Here our reasoning is very similar to that applied to our corporate bond holdings. Presently, most of our monetary policy assets are bonds issued by governments of EU Member States. However, the climate and nature-related risk intensity of these bonds is not obvious as there is currently no clear and reliable framework to assess their compatibility with the Paris Agreement. At the same time, since the pandemic, the universe of supranational bonds issued by EU institutions has increased significantly, with green bonds now making up a relatively large share.!"4] In my view, when there is no clear monetary policy rationale for preferring domestic sovereign bonds, we should contemplate increasing the share of EU supranational bonds in our total bond holdings to minimise potential climate and nature-related risks and to better align our balance sheet with the general economic policies in the EU. This would be relevant if we had to consider new bond purchases in the future. But it is also relevant for the composition of the structural bond portfolio that will be part of our new operational framework, as announced earlier this year.!12] Second, if there is a monetary policy need to reconsider targeted longer-term refinancing operations (TLTROs) for banks in the future, there are compelling reasons to seriously consider greening these TLTROs. After all, the ECB has in the past adopted a similar approach by incorporating financial stability considerations into the design of its instruments. As of the third series, which was launched in 2019, the TLTROs featured a lending target that excluded housing loans to limit the risk of real estate bubbles forming.43] Similar targeting strategies can be considered to support green lending or exclude non-green lending in the future, provided an efficient validation process can be found. ...and banking supervision Let me move to the steps we are taking in banking supervision. Since the ECB published a guide setting out our supervisory expectations for banks' risk management practices in 2020, we have consistently taken climate and nature-related risks"4] into account in our supervision."5] Our guide outlines the ECB's understanding of the safe and prudent management of climate and nature-related risks under the current prudential framework. We have now carried out a number of supervisory exercises to assess banks' approaches to managing these risks against our expectations. Following these horizontal exercises, we have repeatedly urged banks to ensure the sound management of climate and nature-related risks, using our expectations as a starting point. In other words, we expect banks to manage climate and nature-related risks just like any other material risk they are exposed to. Considering the requirements clearly set out in the Capital Requirements Directive as implemented into national law and the need for banks to implement a regular process for identifying all material risks, banks must ensure that practices are in place for the sound management of climate and nature-related risks. They must do so by the end of 2024, and we have also set interim deadlines for banks to remediate certain shortcomings related to the management of these risks. These deadlines were informed by what the banks themselves considered reasonable when we first started discussing climate and nature-related risk management with them. However, our first two interim deadlines have now passed and a number of banks did not deliver. As a basic starting point for managing any type of risk, we asked banks to perform an adequate materiality assessment of the impact of climate and nature-related risks across their portfolio by March 2023. Almost a year ago - just over six months after that deadline expired - we announced that a number of banks had not yet satisfactorily delivered on this. Consequently, 28 banks received binding supervisory decisions. Out of those, 22 were told that if they didn't remedy their shortcomings by a certain date, they would incur a periodic penalty payment for every day the bank remains in breach of the requirement. Encouragingly, most banks have now submitted a meaningful materiality assessment, which shows that our supervisory efforts have been effective in almost all cases. For the banks where this is not the case, the process is ongoing to determine whether penalties will be charged. For the second interim deadline, we asked banks to clearly include climate- and nature-related risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, most banks have made progress and frameworks for climate and nature-related risks are now broadly in place. This notwithstanding, weaknesses in banks' practices remain and have been communicated in further feedback letters. In a small group of outliers, foundational elements for the adequate management of climate and nature-related risks are still missing. These banks are now receiving binding supervisory decisions outlining the potential of periodic penalty payments if they fail to timely deliver on the requirements. To avoid any doubt, we will proceed in exactly the same way with respect to the third and final deadline at the end of this year. By then we want to see that banks' risk management practices ensure the sound management of climate and nature-related risks across all areas of our supervisory expectations. Thereafter, banks will have to keep updating their practices in accordance with advances in data availability, methodologies and legislative and regulatory requirements. Banks need to ensure that their risk management practices are and continue to be commensurate with the magnitude of the climate and nature-related risks that they face. As supervisors it is our job to make sure they do. To achieve this, we will use - obviously always in a proportionate way - all supervisory instruments that we have at our disposal. Conclusion The impact of the climate and nature crises on the world and therefore also on the economy will become increasingly profound. While we should continue to push for an orderly and full transition, it is becoming increasingly likely that we will ultimately see a combination of disorderly transition and further increasing physical damages due to the climate and nature crises. It implies that the world in which we live and in which central banks and supervisors pursue their mandate will see a further increase in uncertainty. The perhaps most renowned laboratory scientist in human history Marie Sktodowska-Curie once remarked that "nothing in life is to be feared; it is only to be understood." She went on to say that "now is the time to understand more, so that we may fear less." In light of the ongoing climate and nature crises I would add that now is the time to understand more, so that we can act. NGOs and academic think tanks play a critical role in advancing the frontier of our understanding and in pushing for action. In the pursuit of their mandates, central banks and supervisors are forward-looking and science-based institutions. We have understood - eureka! - that the climate and nature crises require us to look further than ever before beyond our familiar horizon. We are learning to update our models and analytical tools with insights from academic areas beyond economics and finance. We are adapting our instruments to incorporate climate and nature-related considerations. It is our task. It is our commitment. Because it is our mandate. Thank you for your attention. 1. The initial acknowledgement by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) focused on climate-related risks as a source of financial risk, yet its early reports also made explicit reference to broader environmental risks as a source of financial risk. The NGFS formally acknowledged that nature-related risks are a source of financial risk in a statement in March 2022. See NGFS (2022), Statement on Nature-Related Financial Risks, 24 March. 2. The eight founding members of the NGFS were the Banco de Mexico, the Bank of England, the Banque de France and Autorité de contréle prudentiel et de résolution, De Nederlandsche Bank, the Deutsche Bundesbank, Finansinspektionen, the Monetary Authority of Singapore and the People's Bank of China. 3. Financial Stability Board (2024), Stocktake on Nature-related Risks - supervisory and regulatory approaches and perspectives on financial risk, 18 July. 4. Emambakhsh, T. et al. (2023), "The Road to Paris: stress testing the transition towards a net-zero economy", Occasional Paper Series, No 328, ECB. 5. The frequency and severity of extreme weather events resulting from rising temperatures have already increased markedly. In the NGFS 2023 membership survey, around three-quarters of central banks surveyed indicated that their economies had already experienced damages from such acute climate events over the last decade. Annual global damages from weather-related hazards have more than doubled in real terms in the past 20 years, reaching USD 275 billion in 2022. See NGFS (2024), "NGES publishes report on acute physical impacts from climate change and monetary policy", press release, 29 August. 6. Elderson, F. (2024), ""Know thyself' - avoiding policy mistakes in light of the prevailing climate science", keynote speech at the Delphi Economic Forum, 12 April. 7. Brand, C., Coenen, G., Hutchinson, J. and Saint Guilhem, A. (2023), "The macroeconomic implications of the transition to a low-carbon economy", Economic Bulletin, Ilssue 5, ECB. 8. Kotz, M. et al. (2023), "The impact of global warming on inflation: averages, seasonality and extremes", Working Paper Series, No 2821, ECB. 9. On 6 June 2024 the Governing Council announced that it intends to discontinue all reinvestments under the pandemic emergency purchase programme at the end of 2024. 10. oe Elderson, F. (2023), "Monetary policy in the climate and nature crises: preserving a "Stabilitatskultur"", speech at the Bertelsmann Stiftung, 22 November. 11. Schnabel, I. (2023), "Monetary policy tightening and the green transition", speech at the International Symposium on Central Bank Independence organised by Sveriges Riksbank, 10 January. 12. ECB (2024), "Changes to the operational framework for implementing monetary policy", 13 March. 13. ECB (2021), "The role of financial stability considerations in monetary policy and the interaction with macroprudential policy in the euro area", Occasional Paper Series, No 272, Frankfurt am Main, September. 14. In our banking supervision we have typically referred to these risks as climate-related and environmental risks, or C&E risks. For the purpose of this speech I will consider environmental and nature-related risks interchangeable and only refer to the latter. 15. ECB (2020), Guide on climate-related and environmental risks, November.	---[PAGE_BREAK]--- # Sustainable finance: from "eureka!" to action ## Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the Sustainable Finance Lab Symposium on Finance in Transition Amsterdam, 4 October 2024 Many great discoveries have been made outside well-controlled laboratory environments. Alexander Fleming discovered penicillin when he returned from holiday and found mould growing on a Petri dish containing bacteria he was studying. Henri Becquerel discovered radioactivity by accident after he put the equipment he used to study the relationship between x-rays and sunlight in a drawer on an overcast day. And Archimedes famously had his "eureka" moment while sitting in a bathtub. Not all "eureka" moments happen in well-controlled laboratory experiments, but laboratories nevertheless provide an ideal controlled environment to make major discoveries. To develop ideas, test theories and move from scientific findings to practical solutions for real-world problems. Laboratories provide the bridge from theory to practice, from discovery to application and from insight to action. ## Eureka! Back in 2017 a small group of central banks and supervisors from around the world shared an insight that was relatively novel to them and their peers: climate and nature-related risks are a source of financial risk. ${ }^{[1]}$ And this insight was as consequential as it was straightforward. If climate and naturerelated risks are a source of financial risk, they fall squarely within the respective mandates of central banks and supervisors - to preserve price stability and ensure the safety and soundness of banks. In fact, if central banks and supervisors were to disregard climate and nature-related risks, they would run the risk of failing to deliver on their mandates. This was a "eureka" moment for central banks and supervisors. That small group of central banks and supervisors recognised that action was needed if they were to continue delivering on their mandates as the climate and nature crises increasingly affected the economy and the financial system. And so the Central Banks and Supervisors Network for Greening the Financial System (NGFS) was founded in 2017, providing a much needed laboratory environment for central banks and supervisors working on climate and nature. ${ }^{[2]}$ The NGFS was created as a platform to share, develop and advance practices to incorporate climate and nature-related considerations into the tasks and responsibilities of central banks and supervisors. And, importantly, to work closely with academics and stakeholder groups who were already considering the macrofinancial consequences of global heating and nature degradation. ## Sharing the "eureka!" moment ---[PAGE_BREAK]--- From that "eureka" moment, it quickly became the globally accepted consensus that climate and nature-related risks fall squarely within the mandates of central banks and supervisors. The NGFS has grown from eight members in 2017 to 142 members today. All of these central banks and supervisors - from all over the world - subscribe to the NGFS's stance on the relevance of climate and naturerelated risks and use the network as a platform to share experiences and best practices. In addition, and to a large extent as a direct result of the NGFS's pioneering work, climate-related risks now feature prominently in the work programmes of major international standard-setting bodies such as the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures and the Financial Stability Board. Unfortunately, the same cannot yet be said for nature-related risks, though a recent stocktake on nature-related risks by the Financial Stability Board showed that a growing number of authorities have been considering the potential implications of nature-related risks for financial stability. $\underline{[3]}$ In Europe, the relevance of climate and nature-related risks for the economy and the financial system has also been explicitly acknowledged by the legislator. The revised Capital Requirements Directive, which provides the regulatory and supervisory framework for banks in Europe, contains a clear reference to climate and nature-related risks. And the European Union's climate objectives are explicitly recognised as part of its general economic policies. Moreover, there is an ever-growing body of evidence showing the macro-financial relevance of climate and nature-related risks. Even if a successful and timely transition requires vast investment flows, analysis consistently confirms that the economic benefits of a transition far outweigh the costs. This conclusion holds especially when considered against the alternative scenarios of doing nothing or doing too little too late. $\underline{[4]}$ Moreover, if global heating and nature degradation are left unchecked, they will lead to increased macroeconomic volatility as climate and nature events become more severe and more frequent and have a greater impact on the economy - something we are already witnessing today. $\underline{[5]}$ Regrettably, the prevailing consensus in climate science tells us that the goal of limiting global heating to 2 degrees Celsius, as set out in the Paris Agreement, is not currently being met. And it is not even close to being met. Last year the UN Emissions Gap Report concluded that the world is on track for an average increase of 2.9 degrees. And even that will only be achieved if all government commitments to mitigation measures are implemented in full and on time. This means that, besides the investment needs for the transition, policymakers also have to be increasingly mindful of the investment needs for adaption to increased damages from global heating and nature degradation. $\underline{[6]}$ To sum up, there is no doubt that the ongoing climate and nature crises go to the heart of central banking and banking supervision. And that is why the ECB, moving in lockstep with the work being done by the NGFS, international standard-setting bodies and academia, has been taking action to incorporate climate and nature-related considerations into its monetary policy and supervisory tasks. # From "eureka!" to action: in monetary policy... Let me start with the steps we have taken in the area of monetary policy. ---[PAGE_BREAK]--- When the ECB concluded its strategy review in the summer of 2021 - the first review since 2003 - the new strategy explicitly acknowledged the profound implications of climate change for the economy and its relevance for monetary policy. And this new strategy came with a concrete climate action plan. In the three years since then, we have made significant progress in improving our ability to take climate considerations into account in the macroeconomic analyses that inform our policy discussions. We are now much better able to assess the economic consequences of the green transition in the euro area using a set of macroeconomic models. $\frac{7}{}$ Moreover, we are identifying physical risks that are already posing risks to price stability. We found, for instance, that increases in food prices following extreme heatwaves were an upside risk to price stability. $\frac{8}{}$ This risk has featured explicitly in our monetary policy assessment and communication in recent quarters. With respect to our monetary policy instruments, in October 2022 we started tilting our reinvestments of corporate bonds towards issuers with a better climate performance. This enables us to avoid undue exposures to climate-related risks that are detrimental to price stability and to align the way we conduct our monetary policy more closely with the EU's general economic policies. As of July 2023 we suspended bond purchases under our asset purchase programme, including corporate bonds, to help bring inflation back to our $2 \%$ target. We are still applying the tilting strategy in the partial reinvestments of maturing bonds in the context of our pandemic emergency purchase programme, until these reinvestments are also discontinued as intended at the end of 2024. $\frac{9}{}$ If any corporate bond purchases were needed for monetary policy purposes in the future, the established direction of the tilt would set the minimum benchmark. In addition to our bond holdings, we are also looking at the collateral framework that we apply in relation to banks' participation in our lending operations. As an early outcome of this work, in 2021 we started to accept sustainability-linked bonds as collateral, provided that they meet the eligibility criteria. We have also decided that only assets that comply with the EU Corporate Sustainability Reporting Directive will remain eligible once this Directive enters into force. And we are continuing to explore options to further incorporate climate considerations into our collateral framework. To this end, we are working with relevant authorities, such as the European Securities and Markets Authority and the European Banking Authority, to encourage better disclosures from collateral issuers and in turn facilitate a better assessment of climate-related risks. Our current actions aim to support a high degree of confidence in the alignment of our activities with the goals set by the Paris Agreement within our mandate. However, the decarbonisation path for our monetary policy assets remains dependent on actions that are not fully under our control, including the decarbonisation efforts made by the issuers of bonds that we hold. This is one of the main reasons why we have committed to regularly reviewing all our measures to assess their impact. If necessary, we will adapt them to ensure they continue to fulfil their monetary policy objectives and support the decarbonisation path to reach the goals set by the Paris Agreement and the EU's climate neutrality objectives. Within our mandate, we will also look into addressing additional nature-related challenges. This process will be fully guided by our monetary policy strategy. Specifically, whenever we have a choice between two instruments - or calibrations of instruments - that are equally conducive to ---[PAGE_BREAK]--- maintaining price stability, we are legally obliged to choose the one that best supports the general economic policies in the EU. This implies that whenever we adjust the calibration of our instruments, we must choose the option that supports our decarbonisation path, unless our proportionality assessment shows that there are other, less intrusive ways of achieving price stability. Looking ahead, besides the adjustments that we are already implementing, this strategic commitment may require us to consider two further avenues. ${ }^{[10]}$ The first concerns our public sector bond holdings. Here our reasoning is very similar to that applied to our corporate bond holdings. Presently, most of our monetary policy assets are bonds issued by governments of EU Member States. However, the climate and nature-related risk intensity of these bonds is not obvious as there is currently no clear and reliable framework to assess their compatibility with the Paris Agreement. At the same time, since the pandemic, the universe of supranational bonds issued by EU institutions has increased significantly, with green bonds now making up a relatively large share. ${ }^{[11]}$ In my view, when there is no clear monetary policy rationale for preferring domestic sovereign bonds, we should contemplate increasing the share of EU supranational bonds in our total bond holdings to minimise potential climate and nature-related risks and to better align our balance sheet with the general economic policies in the EU. This would be relevant if we had to consider new bond purchases in the future. But it is also relevant for the composition of the structural bond portfolio that will be part of our new operational framework, as announced earlier this year. ${ }^{[12]}$ Second, if there is a monetary policy need to reconsider targeted longer-term refinancing operations (TLTROs) for banks in the future, there are compelling reasons to seriously consider greening these TLTROs. After all, the ECB has in the past adopted a similar approach by incorporating financial stability considerations into the design of its instruments. As of the third series, which was launched in 2019, the TLTROs featured a lending target that excluded housing loans to limit the risk of real estate bubbles forming. ${ }^{[13]}$ Similar targeting strategies can be considered to support green lending or exclude non-green lending in the future, provided an efficient validation process can be found. # ...and banking supervision Let me move to the steps we are taking in banking supervision. Since the ECB published a guide setting out our supervisory expectations for banks' risk management practices in 2020, we have consistently taken climate and nature-related risks ${ }^{[14]}$ into account in our supervision. ${ }^{[15]}$ Our guide outlines the ECB's understanding of the safe and prudent management of climate and nature-related risks under the current prudential framework. We have now carried out a number of supervisory exercises to assess banks' approaches to managing these risks against our expectations. Following these horizontal exercises, we have repeatedly urged banks to ensure the sound management of climate and nature-related risks, using our expectations as a starting point. In other words, we expect banks to manage climate and nature-related risks just like any other material risk they are exposed to. Considering the requirements clearly set out in the Capital Requirements Directive as implemented into national law and the need for banks to implement a regular process for identifying all material risks, banks must ensure that practices are in place for the sound management ---[PAGE_BREAK]--- of climate and nature-related risks. They must do so by the end of 2024, and we have also set interim deadlines for banks to remediate certain shortcomings related to the management of these risks. These deadlines were informed by what the banks themselves considered reasonable when we first started discussing climate and nature-related risk management with them. However, our first two interim deadlines have now passed and a number of banks did not deliver. As a basic starting point for managing any type of risk, we asked banks to perform an adequate materiality assessment of the impact of climate and nature-related risks across their portfolio by March 2023. Almost a year ago - just over six months after that deadline expired - we announced that a number of banks had not yet satisfactorily delivered on this. Consequently, 28 banks received binding supervisory decisions. Out of those, 22 were told that if they didn't remedy their shortcomings by a certain date, they would incur a periodic penalty payment for every day the bank remains in breach of the requirement. Encouragingly, most banks have now submitted a meaningful materiality assessment, which shows that our supervisory efforts have been effective in almost all cases. For the banks where this is not the case, the process is ongoing to determine whether penalties will be charged. For the second interim deadline, we asked banks to clearly include climate- and nature-related risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, most banks have made progress and frameworks for climate and nature-related risks are now broadly in place. This notwithstanding, weaknesses in banks' practices remain and have been communicated in further feedback letters. In a small group of outliers, foundational elements for the adequate management of climate and nature-related risks are still missing. These banks are now receiving binding supervisory decisions outlining the potential of periodic penalty payments if they fail to timely deliver on the requirements. To avoid any doubt, we will proceed in exactly the same way with respect to the third and final deadline at the end of this year. By then we want to see that banks' risk management practices ensure the sound management of climate and nature-related risks across all areas of our supervisory expectations. Thereafter, banks will have to keep updating their practices in accordance with advances in data availability, methodologies and legislative and regulatory requirements. Banks need to ensure that their risk management practices are and continue to be commensurate with the magnitude of the climate and nature-related risks that they face. As supervisors it is our job to make sure they do. To achieve this, we will use - obviously always in a proportionate way - all supervisory instruments that we have at our disposal. # Conclusion The impact of the climate and nature crises on the world and therefore also on the economy will become increasingly profound. While we should continue to push for an orderly and full transition, it is becoming increasingly likely that we will ultimately see a combination of disorderly transition and further increasing physical damages due to the climate and nature crises. It implies that the world in which we live and in which central banks and supervisors pursue their mandate will see a further increase in uncertainty. ---[PAGE_BREAK]--- The perhaps most renowned laboratory scientist in human history Marie Skłodowska-Curie once remarked that "nothing in life is to be feared; it is only to be understood." She went on to say that "now is the time to understand more, so that we may fear less." In light of the ongoing climate and nature crises I would add that now is the time to understand more, so that we can act. NGOs and academic think tanks play a critical role in advancing the frontier of our understanding and in pushing for action. In the pursuit of their mandates, central banks and supervisors are forward-looking and science-based institutions. We have understood - eureka! - that the climate and nature crises require us to look further than ever before beyond our familiar horizon. We are learning to update our models and analytical tools with insights from academic areas beyond economics and finance. We are adapting our instruments to incorporate climate and nature-related considerations. It is our task. It is our commitment. Because it is our mandate. Thank you for your attention. 1 . The initial acknowledgement by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) focused on climate-related risks as a source of financial risk, yet its early reports also made explicit reference to broader environmental risks as a source of financial risk. The NGFS formally acknowledged that nature-related risks are a source of financial risk in a statement in March 2022. See NGFS (2022), Statement on Nature-Related Financial Risks, 24 March. 2. The eight founding members of the NGFS were the Banco de México, the Bank of England, the Banque de France and Autorité de contrôle prudentiel et de résolution, De Nederlandsche Bank, the Deutsche Bundesbank, Finansinspektionen, the Monetary Authority of Singapore and the People's Bank of China. 3. Financial Stability Board (2024), Stocktake on Nature-related Risks - supervisory and regulatory approaches and perspectives on financial risk, 18 July. 4. Emambakhsh, T. et al. (2023), "The Road to Paris: stress testing the transition towards a net-zero economy", Occasional Paper Series, No 328, ECB. 5. The frequency and severity of extreme weather events resulting from rising temperatures have already increased markedly. In the NGFS 2023 membership survey, around three-quarters of central banks surveyed indicated that their economies had already experienced damages from such acute climate events over the last decade. Annual global damages from weather-related hazards have more than doubled in real terms in the past 20 years, reaching USD 275 billion in 2022. See NGFS (2024), ---[PAGE_BREAK]--- "NGFS publishes report on acute physical impacts from climate change and monetary policy", press release, 29 August. 6. Elderson, F. (2024), "'Know thyself" - avoiding policy mistakes in light of the prevailing climate science", keynote speech at the Delphi Economic Forum, 12 April. 7. Brand, C., Coenen, G., Hutchinson, J. and Saint Guilhem, A. (2023), "The macroeconomic implications of the transition to a low-carbon economy", Economic Bulletin, Issue 5, ECB. 8. Kotz, M. et al. (2023), "The impact of global warming on inflation: averages, seasonality and extremes", Working Paper Series, No 2821, ECB. 9. On 6 June 2024 the Governing Council announced that it intends to discontinue all reinvestments under the pandemic emergency purchase programme at the end of 2024. 10. Elderson, F. (2023), "Monetary policy in the climate and nature crises: preserving a "Stabilitätskultur"", speech at the Bertelsmann Stiftung, 22 November. 11. Schnabel, I. (2023), "Monetary policy tightening and the green transition", speech at the International Symposium on Central Bank Independence organised by Sveriges Riksbank, 10 January. 12. ECB (2024), "Changes to the operational framework for imolementing monetary policy", 13 March. 13. ECB (2021), "The role of financial stability considerations in monetary policy and the interaction with macroprudential policy in the euro area", Occasional Paper Series, No 272, Frankfurt am Main, September. 14. In our banking supervision we have typically referred to these risks as climate-related and environmental risks, or C\&E risks. For the purpose of this speech I will consider environmental and nature-related risks interchangeable and only refer to the latter. 15. ECB (2020), Guide on climate-related and environmental risks, November.	Frank Elderson	Euro area	https://www.bis.org/review/r241007d.pdf	Amsterdam, 4 October 2024 Many great discoveries have been made outside well-controlled laboratory environments. Alexander Fleming discovered penicillin when he returned from holiday and found mould growing on a Petri dish containing bacteria he was studying. Henri Becquerel discovered radioactivity by accident after he put the equipment he used to study the relationship between x-rays and sunlight in a drawer on an overcast day. And Archimedes famously had his "eureka" moment while sitting in a bathtub. Not all "eureka" moments happen in well-controlled laboratory experiments, but laboratories nevertheless provide an ideal controlled environment to make major discoveries. To develop ideas, test theories and move from scientific findings to practical solutions for real-world problems. Laboratories provide the bridge from theory to practice, from discovery to application and from insight to action. Back in 2017 a small group of central banks and supervisors from around the world shared an insight that was relatively novel to them and their peers: climate and nature-related risks are a source of financial risk. And this insight was as consequential as it was straightforward. If climate and naturerelated risks are a source of financial risk, they fall squarely within the respective mandates of central banks and supervisors - to preserve price stability and ensure the safety and soundness of banks. In fact, if central banks and supervisors were to disregard climate and nature-related risks, they would run the risk of failing to deliver on their mandates. This was a "eureka" moment for central banks and supervisors. That small group of central banks and supervisors recognised that action was needed if they were to continue delivering on their mandates as the climate and nature crises increasingly affected the economy and the financial system. And so the Central Banks and Supervisors Network for Greening the Financial System (NGFS) was founded in 2017, providing a much needed laboratory environment for central banks and supervisors working on climate and nature. The NGFS was created as a platform to share, develop and advance practices to incorporate climate and nature-related considerations into the tasks and responsibilities of central banks and supervisors. And, importantly, to work closely with academics and stakeholder groups who were already considering the macrofinancial consequences of global heating and nature degradation. From that "eureka" moment, it quickly became the globally accepted consensus that climate and nature-related risks fall squarely within the mandates of central banks and supervisors. The NGFS has grown from eight members in 2017 to 142 members today. All of these central banks and supervisors - from all over the world - subscribe to the NGFS's stance on the relevance of climate and naturerelated risks and use the network as a platform to share experiences and best practices. In addition, and to a large extent as a direct result of the NGFS's pioneering work, climate-related risks now feature prominently in the work programmes of major international standard-setting bodies such as the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures and the Financial Stability Board. Unfortunately, the same cannot yet be said for nature-related risks, though a recent stocktake on nature-related risks by the Financial Stability Board showed that a growing number of authorities have been considering the potential implications of nature-related risks for financial stability. In Europe, the relevance of climate and nature-related risks for the economy and the financial system has also been explicitly acknowledged by the legislator. The revised Capital Requirements Directive, which provides the regulatory and supervisory framework for banks in Europe, contains a clear reference to climate and nature-related risks. And the European Union's climate objectives are explicitly recognised as part of its general economic policies. Moreover, there is an ever-growing body of evidence showing the macro-financial relevance of climate and nature-related risks. Even if a successful and timely transition requires vast investment flows, analysis consistently confirms that the economic benefits of a transition far outweigh the costs. This conclusion holds especially when considered against the alternative scenarios of doing nothing or doing too little too late. Regrettably, the prevailing consensus in climate science tells us that the goal of limiting global heating to 2 degrees Celsius, as set out in the Paris Agreement, is not currently being met. And it is not even close to being met. Last year the UN Emissions Gap Report concluded that the world is on track for an average increase of 2.9 degrees. And even that will only be achieved if all government commitments to mitigation measures are implemented in full and on time. This means that, besides the investment needs for the transition, policymakers also have to be increasingly mindful of the investment needs for adaption to increased damages from global heating and nature degradation. To sum up, there is no doubt that the ongoing climate and nature crises go to the heart of central banking and banking supervision. And that is why the ECB, moving in lockstep with the work being done by the NGFS, international standard-setting bodies and academia, has been taking action to incorporate climate and nature-related considerations into its monetary policy and supervisory tasks. Let me start with the steps we have taken in the area of monetary policy. When the ECB concluded its strategy review in the summer of 2021 - the first review since 2003 - the new strategy explicitly acknowledged the profound implications of climate change for the economy and its relevance for monetary policy. And this new strategy came with a concrete climate action plan. In the three years since then, we have made significant progress in improving our ability to take climate considerations into account in the macroeconomic analyses that inform our policy discussions. We are now much better able to assess the economic consequences of the green transition in the euro area using a set of macroeconomic models. $\frac{7}{}$ Moreover, we are identifying physical risks that are already posing risks to price stability. We found, for instance, that increases in food prices following extreme heatwaves were an upside risk to price stability. $\frac{8}{}$ This risk has featured explicitly in our monetary policy assessment and communication in recent quarters. With respect to our monetary policy instruments, in October 2022 we started tilting our reinvestments of corporate bonds towards issuers with a better climate performance. This enables us to avoid undue exposures to climate-related risks that are detrimental to price stability and to align the way we conduct our monetary policy more closely with the EU's general economic policies. As of July 2023 we suspended bond purchases under our asset purchase programme, including corporate bonds, to help bring inflation back to our $2 \%$ target. We are still applying the tilting strategy in the partial reinvestments of maturing bonds in the context of our pandemic emergency purchase programme, until these reinvestments are also discontinued as intended at the end of 2024. $\frac{9}{}$ If any corporate bond purchases were needed for monetary policy purposes in the future, the established direction of the tilt would set the minimum benchmark. In addition to our bond holdings, we are also looking at the collateral framework that we apply in relation to banks' participation in our lending operations. As an early outcome of this work, in 2021 we started to accept sustainability-linked bonds as collateral, provided that they meet the eligibility criteria. We have also decided that only assets that comply with the EU Corporate Sustainability Reporting Directive will remain eligible once this Directive enters into force. And we are continuing to explore options to further incorporate climate considerations into our collateral framework. To this end, we are working with relevant authorities, such as the European Securities and Markets Authority and the European Banking Authority, to encourage better disclosures from collateral issuers and in turn facilitate a better assessment of climate-related risks. Our current actions aim to support a high degree of confidence in the alignment of our activities with the goals set by the Paris Agreement within our mandate. However, the decarbonisation path for our monetary policy assets remains dependent on actions that are not fully under our control, including the decarbonisation efforts made by the issuers of bonds that we hold. This is one of the main reasons why we have committed to regularly reviewing all our measures to assess their impact. If necessary, we will adapt them to ensure they continue to fulfil their monetary policy objectives and support the decarbonisation path to reach the goals set by the Paris Agreement and the EU's climate neutrality objectives. Within our mandate, we will also look into addressing additional nature-related challenges. This process will be fully guided by our monetary policy strategy. Specifically, whenever we have a choice between two instruments - or calibrations of instruments - that are equally conducive to maintaining price stability, we are legally obliged to choose the one that best supports the general economic policies in the EU. This implies that whenever we adjust the calibration of our instruments, we must choose the option that supports our decarbonisation path, unless our proportionality assessment shows that there are other, less intrusive ways of achieving price stability. Looking ahead, besides the adjustments that we are already implementing, this strategic commitment may require us to consider two further avenues. The first concerns our public sector bond holdings. Here our reasoning is very similar to that applied to our corporate bond holdings. Presently, most of our monetary policy assets are bonds issued by governments of EU Member States. However, the climate and nature-related risk intensity of these bonds is not obvious as there is currently no clear and reliable framework to assess their compatibility with the Paris Agreement. At the same time, since the pandemic, the universe of supranational bonds issued by EU institutions has increased significantly, with green bonds now making up a relatively large share. Second, if there is a monetary policy need to reconsider targeted longer-term refinancing operations (TLTROs) for banks in the future, there are compelling reasons to seriously consider greening these TLTROs. After all, the ECB has in the past adopted a similar approach by incorporating financial stability considerations into the design of its instruments. As of the third series, which was launched in 2019, the TLTROs featured a lending target that excluded housing loans to limit the risk of real estate bubbles forming. Similar targeting strategies can be considered to support green lending or exclude non-green lending in the future, provided an efficient validation process can be found. Let me move to the steps we are taking in banking supervision. Since the ECB published a guide setting out our supervisory expectations for banks' risk management practices in 2020, we have consistently taken climate and nature-related risks Our guide outlines the ECB's understanding of the safe and prudent management of climate and nature-related risks under the current prudential framework. We have now carried out a number of supervisory exercises to assess banks' approaches to managing these risks against our expectations. Following these horizontal exercises, we have repeatedly urged banks to ensure the sound management of climate and nature-related risks, using our expectations as a starting point. In other words, we expect banks to manage climate and nature-related risks just like any other material risk they are exposed to. Considering the requirements clearly set out in the Capital Requirements Directive as implemented into national law and the need for banks to implement a regular process for identifying all material risks, banks must ensure that practices are in place for the sound management of climate and nature-related risks. They must do so by the end of 2024, and we have also set interim deadlines for banks to remediate certain shortcomings related to the management of these risks. These deadlines were informed by what the banks themselves considered reasonable when we first started discussing climate and nature-related risk management with them. However, our first two interim deadlines have now passed and a number of banks did not deliver. As a basic starting point for managing any type of risk, we asked banks to perform an adequate materiality assessment of the impact of climate and nature-related risks across their portfolio by March 2023. Almost a year ago - just over six months after that deadline expired - we announced that a number of banks had not yet satisfactorily delivered on this. Consequently, 28 banks received binding supervisory decisions. Out of those, 22 were told that if they didn't remedy their shortcomings by a certain date, they would incur a periodic penalty payment for every day the bank remains in breach of the requirement. Encouragingly, most banks have now submitted a meaningful materiality assessment, which shows that our supervisory efforts have been effective in almost all cases. For the banks where this is not the case, the process is ongoing to determine whether penalties will be charged. For the second interim deadline, we asked banks to clearly include climate- and nature-related risks in their governance, strategy and risk management by December 2023. As with the first interim deadline, most banks have made progress and frameworks for climate and nature-related risks are now broadly in place. This notwithstanding, weaknesses in banks' practices remain and have been communicated in further feedback letters. In a small group of outliers, foundational elements for the adequate management of climate and nature-related risks are still missing. These banks are now receiving binding supervisory decisions outlining the potential of periodic penalty payments if they fail to timely deliver on the requirements. To avoid any doubt, we will proceed in exactly the same way with respect to the third and final deadline at the end of this year. By then we want to see that banks' risk management practices ensure the sound management of climate and nature-related risks across all areas of our supervisory expectations. Thereafter, banks will have to keep updating their practices in accordance with advances in data availability, methodologies and legislative and regulatory requirements. Banks need to ensure that their risk management practices are and continue to be commensurate with the magnitude of the climate and nature-related risks that they face. As supervisors it is our job to make sure they do. To achieve this, we will use - obviously always in a proportionate way - all supervisory instruments that we have at our disposal. The impact of the climate and nature crises on the world and therefore also on the economy will become increasingly profound. While we should continue to push for an orderly and full transition, it is becoming increasingly likely that we will ultimately see a combination of disorderly transition and further increasing physical damages due to the climate and nature crises. It implies that the world in which we live and in which central banks and supervisors pursue their mandate will see a further increase in uncertainty. The perhaps most renowned laboratory scientist in human history Marie Skłodowska-Curie once remarked that "nothing in life is to be feared; it is only to be understood." She went on to say that "now is the time to understand more, so that we may fear less." In light of the ongoing climate and nature crises I would add that now is the time to understand more, so that we can act. NGOs and academic think tanks play a critical role in advancing the frontier of our understanding and in pushing for action. In the pursuit of their mandates, central banks and supervisors are forward-looking and science-based institutions. We have understood - eureka! - that the climate and nature crises require us to look further than ever before beyond our familiar horizon. We are learning to update our models and analytical tools with insights from academic areas beyond economics and finance. We are adapting our instruments to incorporate climate and nature-related considerations. It is our task. It is our commitment. Because it is our mandate. Thank you for your attention. 1 . "NGFS publishes report on acute physical impacts from climate change and monetary policy", press release, 29 August.
2024-10-07T00:00:00	Piero Cipollone: Towards a digital capital markets union	Keynote speech by Mr Piero Cipollone, Member of the Executive Board of the European Central Bank, at the Bundesbank Symposium on the Future of Payments, Frankfurt am Main, 7 October 2024.	SPEECH Towards a digital capital markets union Keynote speech by Piero Cipollone, Member of the Executive Board of the ECB, at the Bundesbank Symposium on the Future of Payments Frankfurt am Main, 7 October 2024 The foundations of the financial system as we know it today can be traced back to 14th-century Italy, when double-entry bookkeeping!2! was introduced, along with nostro and vostro accounts" to facilitate the settlement of foreign trades across separate, independent ledgers], Although today's financial markets are highly complex and sophisticated, the fundamental practice of bookkeeping across ledgers has remained largely unchanged and continues to exert a significant influence on existing market structures. For example, at each stage of the securities life cycle, banks, brokers, information providers and other market participants play an essential role in intermediation. This complexity comes at a cost: research shows that on the whole, financial intermediation costs in advanced economies have increased since the late 1960s. In Europe, this complexity is compounded by regulatory fragmentation across the continent, resulting in the ongoing fragmentation of capital markets. For example, there are 35 different exchanges for listings and 41 exchanges for trading.!©] Some effort has been made towards integration in the post- trade sector, including through the creation of the TARGET2-Securities (T2S) platform, which can be used to transfer securities and cash between investors across Europe, and through common platforms used by central securities depositories (CSDs). But the lack of harmonisation in the legislative and regulatory framework regarding custody, asset servicing and tax-related processes, for example, prevents the sector from reaping the benefits and synergies that an integrated European market could bring. The European Union (EU) has taken steps to address the regulatory barriers that exist in order to create deeper and more integrated capital markets.!2! But many obstacles still remain, such as insufficient regulatory harmonisation, the absence of unified supervision" or the lack of a permanent safe asset and integrated banking system. This has led to multiple calls for renewed efforts, including from euro area finance ministers"2, EU institutions"®] and Enrico Letta and Mario Draghi in their recent reports!"4], But there is one crucial dimension that has often been overlooked, and that is technology. My aim today is not to discuss how to create a capital markets union for traditional assets, but to discuss how to create one for digital assets from the outset. Although technology has undeniably helped facilitate the provision of financial services through electronic bookkeeping, for example, digital technology has so far failed to deliver financial integration in Europe. In fact, non-interoperable technological ecosystems in each country - shaped by diverging national regulatory regimes - have created siloed pools of asset liquidity, further entrenching fragmentation. However, recent advancements in digital technology offer an opportunity to create an integrated European capital market for digital assets - in other words, a digital capital markets union. Financial institutions are increasingly exploring the potential of tokenisation, which is the process of using new technologies, such as distributed ledger technology (DLT), to issue or represent assets in digital form, known as tokens. Unlike conventional assets, these tokens are not recorded on a centralised ledger but using DLT. Imagine a future where money and securities no longer sit in electronic, book-entry accounts but "live" on distributed ledgers held across a network of traders, each with a synchronised copy. If public authorities fail to act, this could lead to fragmentation. But if they seize the opportunity, then the benefits of this new approach could reach far beyond tackling technological inefficiencies, eventually resulting in a move away from the centuries-old structure of intermediation to a unified, distributed ledger or a constellation of fully interoperable ledgers. This transition could help us deal with the current fragmentation of financial infrastructures, reduce barriers to entry and serve as a driver of capital market integration in Europe. As a central bank, we recognise that our role in this transformative journey is to maintain trust and confidence in the value of money and the financial system. To fulfil this mandate, we have to adapt to the evolving technological landscape that is reshaping how money is exchanged and financial transactions are settled in an increasingly digital world. Understanding these innovations, preparing for them and - when they materialise - supporting their safe adoption are central to our mission. In addition, central bank money has a key role to play in facilitating the interoperability and integration of decentralised systems. Today, I want to explore how we can build an integrated European capital market for digital assets from the outset. At the same time, while the potential benefits of advances tokenisation and DLT are significant, we must also consider the risks to the financial market structure and the provision of central bank money. I will discuss how central banks can effectively support this technological transition. The transformative potential of tokenisation and DLT in capital markets: balancing innovation with risk In recent years, there has been a notable increase in the adoption of financial technology, including the use of tokens and DLT. This transformation is not just theoretical: it is happening now. In the banking sector alone, over 60% of EU banks surveyed are actively exploring, experimenting with or using DLT solutions, while 22% have already started using DLT applications." However, the use of DLT is not yet widespread. Currently, it is mainly used for primary issuance, although further applications and use cases are increasingly being looked at. But there is strong interest in exploring the potential of DLT, and leading global financial market infrastructures such as DTCC, Clearstream and Euroclear are aiming to set standards to facilitate the adoption of tokenisation across the financial sector. The public sector is also contributing to this movement. Since having a solution for settling transactions in central bank money makes DLT-based solutions more attractive and less risky, there is strong demand from market participants to be able to use central bank money to settle digital asset transactions. As a result, the Eurosystem is conducting exploratory work to test DLT for the settlement of wholesale transactions in central bank money.) Similarly, the Bank for International Settlements' Innovation Hub has launched several projects exploring this theme.(48] The promise of tokenisation and DLT lies in the creation of a transparent ledger which would make it possible to perform the three key functions of asset trading, namely negotiation, settlement and custody, on the same platform. This is expected to reduce transaction costs by reducing the need for reconciliation, matching and other data processing steps, which would foster resilience and make it possible to operate on a 24/7, 365 days a year basis. DLT also supports the native issuance of digital assets, enabling direct transactions between a wide range of investors. This could lower barriers to entry and create opportunities for small issuers, such as small and medium-sized enterprises, to access capital markets. DLT would also enhance efficiency by significantly reducing settlement times and using the self-executing, programmable functions in smart contracts. This could potentially bring substantial savings. According to some estimates, automation and smart contracts could reduce annual infrastructure operational costs by approximately USD 15-20 billion in global capital markets.!22] In addition to these savings, the possibility of extensive implementation of tokenisation and DLT offers opportunities to overhaul market structures. This could prove instrumental in tackling the technological obstacles hindering the establishment of a capital markets union in Europe. The new ecosystem could be designed from scratch in a more integrated and harmonised manner by providing a "common set of rails" - a shared ledger or an ecosystem of fully interoperable ledgers - that would ensure reachability, open access and compatibility across participants' services. CSDs, banks, investment managers and other market stakeholders would provide their services directly on a shared infrastructure, while each would be able to maintain a level of control and customisation over the functionalities. This would also allow a more flexible approach to the role of each participant in the ecosystem. From a technical perspective, it would also be possible to bring together all assets, functionalities and market players on one centralised platform. But it is precisely the combination of a shared infrastructure with customised control that could encourage different stakeholders to agree on "common rails" instead of relying on their own infrastructures, as they often do today. However, the early development stages of DLT present significant coordination challenges and risks to the financial system. There are therefore three primary risks that we must address. The first is the potential for an uncoordinated proliferation of DLT platforms, which could result in a fragmented landscape. In this nascent stage of development, established financial institutions are apprehensive about DLT but are nevertheless keen to take advantage of its potential. Several new DLT platforms could emerge as a result, as market participants develop their own solutions without fully considering the broader economic implications. This could exacerbate the existing fragmentation among CSDs and other proprietary ledgers, leading to a lack of standardisation. This, in turn, would pose new coordination challenges and jeopardise our objective of establishing a digital capital markets union for Europe. /24) The second risk is that central bank money could lose its status as the safest and most liquid settlement asset. If end users - in this case firms and investors - demand an "on-chain" means of payment to seamlessly support automated transactions via DLT, the lack of a solution for settling transactions in central bank money could encourage banks or stablecoin issuers to offer private money alternatives. A permanent shift from central bank money to commercial bank money or stablecoins could disrupt the existing two-tier monetary system and threaten financial stability by undermining central bank money's role as a risk-free settlement asset. This would contradict the principles agreed at international level.!22] Lastly, public authorities still have more work to do to understand and assess the inherent risks and vulnerabilities stemming from DLT-based tokenisation.!25] Tokenisation does not remove the vulnerabilities we know of from traditional finance, although these vulnerabilities may play out differently depending on design choices, adoption and scale. The key issue will be the choice of settlement assets, which could amplify liquidity risk or other vulnerabilities, but other risks could also emerge if new entities fall outside the scope of regulation or there are operational weaknesses. To deal with these risks, central banks and regulators must act early and work with market participants from the outset. If we drag our feet while other jurisdictions move faster and produce better solutions, we could see financial activities migrating elsewhere and private entities from outside the EU assuming a dominant position in European capital markets. Moreover, European market participants may then adopt uncoordinated approaches and invest in their own infrastructures. They could then resist any efforts by central banks to introduce enhanced settlement solutions, particularly if these threatened the viability of their new business models. If we don't act soon, it may be impossible to achieve a genuine digital capital markets union with efficient wholesale payment and settlement services using risk-free central bank money. A European vision for the future of digital capital markets Given the early stage of market development and the strategic approaches being adopted by industry players, it is paramount that central banks provide clear direction. By offering clear and consistent guidance, the ECB serves as a crucial coordination mechanism for the European financial industry. This helps market participants align their efforts and innovate within a common framework, fostering interoperability. Central banks should play a proactive role in this transformation for two main reasons. First, it is vitally important to maintain, if not increase, the use of central bank money as the settlement asset in wholesale markets. Central bank money plays a pivotal role as the anchor of our two-tier monetary system, serving as a cornerstone of financial stability. The second reason is to promote robust, stable and integrated European capital markets. Therefore, our aim is to facilitate the provision of central bank money settlement for wholesale transactions of DLT assets, thereby using the financial industry's adoption of DLT to address existing shortcomings associated with the fragmentation of European capital markets. One way to achieve this would be to move towards a European ledger, which would be a single- platform solution where assets and cash would coexist on one chain. Many market participants believe this is a must if we want to fully reap the benefits of DLT. This ledger would address the technological complexities, inefficiencies and fragmentation that are currently preventing the integration of European capital markets for traditional assets. A European ledger could bring together token versions of central bank money, commercial bank money and other digital assets on a shared, programmable platform. In essence, this would see T2S evolving into a DLT-based, single financial market infrastructure for Europe. While central banks would provide the platform, or the "rails" so to speak, market participants would supply the content, or the "trains". However, further consideration would have to be given to the specifics of this platform, including the scope of services, governance structure, operational procedures and the potential implications for existing infrastructure and assets. One risk of the unified ledger is that it entails choosing one technological solution over all others. As all market players will use it, they will be less inclined to explore and promote alternative innovative technical solutions to provide the same services. Another option would therefore be to allow the coordinated development of an ecosystem of fully interoperable technical solutions. This flexibility would be beneficial, as it would better serve specific use cases and the coexistence of legacy and new solutions. We need to reflect on this trade-off. Research is continuing in the market, but in the meantime, there is a pressing need for solutions that would make it possible to settle DLT transactions in central bank money. This provides an opportunity to build on the interoperability solutions we have been trialling as part of the Eurosystem's exploratory work. This trial, in which the Eurosystem offers interoperability between its central bank money settlement services and external DLT platforms for both real and mock transactions, was successfully launched in May 2024 and will run until November. Some 60 industry participants are involved, in addition to central banks. Offering such solutions could allow the Eurosystem and market participants to experiment and develop DLT-based solutions further, unlocking investment in the industry. To this end, we have started to look at how we can build on our ongoing exploration. We will also examine the eligibility of DLT-based assets for use as collateral in Eurosystem credit operations. However, there is a risk that relying on existing interoperability solutions over the long term could perpetuate inefficiencies in the post-trade environment given the ongoing lack of full harmonisation and standardisation. Such interim solutions are thus a stopgap measure to smooth the transition towards our long-term vision. These efforts must align with EU legislators and regulators who have a window of opportunity to create a comprehensive, European regulatory and supervisory framework that will support financial integration for digital assets while protecting market participants and preserving the underlying infrastructures. The limited progress in advancing a capital markets union for traditional assets shows that harmonising new activities from the outset is much easier than ironing out any differences at a late stage. Building on the EU's DLT pilot regime, this new framework should aim to establish the harmonised regulation and integrated supervision of digital assets. Conclusion Let me conclude. In the current era of rapid technological change, "whosoever desires constant success must change his conduct with the times".!24] These insights mirror the European financial sector's current exploration of tokenisation and DLT. These technologies do not just have the potential to enhance efficiency. They could also fundamentally reshape the very structure of financial intermediation - a system that has remained largely unchanged for centuries. Many financial market participants have already started to delve into these technologies, recognising their transformative potential. As prudent central bankers, we must also adapt to these new technologies if we are to fulfil our mandate of preserving trust and confidence in money and the financial system. Our primary objective in this evolving landscape is to ensure that central bank money - the safest and most liquid settlement asset - remains a cornerstone of stability, even in a capital market based on tokens and DLT. Or to quote Tancredi in Lampedusa's The Leopard!24], "For things to stay the same, everything must change". However, the current nascent stage of market development does not just pose challenges. It also offers a unique opportunity. By establishing a clear vision of a digital capital markets union - an integrated European digital ecosystem where assets and cash coexist on one or more fully interoperable chains - these emerging technologies could help to address the existing shortcomings of European capital markets. In embracing this technological shift, we are not merely reacting to change, but actively participating in shaping a more efficient, innovative and resilient financial future for Europe. Thank you for your attention. 1. I would like to thank Cyril Max Neumann and Jean-Francois Jamet for their help in preparing this speech, as well as Ulrich Bindseil, Alexandra Born, Johanne Evrard, Daniel Kapp, Mirjam Plooij and Anton Van der Kraaij for their comments. 2. Sangster, A. (2024), "The emergence of double entry bookkeeping", The Economic History Review, pp. 1-30, May. 3. A nostro/vostro account is a bank account where one bank has another bank's money on deposit, typically on behalf of a foreign bank in relation to international trade or other financial transactions. The terms "nostro" and "vostro" are used to indicate which bank has money on deposit. 4. Yamey, B. S. (2011), "Two-currency, nostro and vostro accounts: historical notes, 1400-1800", Accounting Historians Journal, Vol. 38, No 2, pp. 125-143, December. 5. Bazot, G. (2018), "Financial Consumption and the Cost of Finance: Measuring Financial Efficiency in Europe (1950-2007)', Journal of the European Economic Association, Vol. 16, Issue 1, pp. 123-160, February. The study provides evidence that the ratio of domestic financial intermediaries' income to GDP increases continuously in Germany, France, the United Kingdom and Europe more broadly over the period from 1950 to 2007, even during the 1990s and the 2000s. When including property income and capital gains, this ratio stood at 6-7% in Germany, France and the UK, and around 9% in the United States at the end of the period. The study then measures the unit cost of financial intermediation based on the ratio of financial income to financial assets intermediated. It finds that the European unit cost appears to have increased since the late 1960s but by a smaller proportion than in the United States. See also Philippon, T. (2015), "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation", American Economic Review, Vol. 105, No 4, pp. 1408-1438, April. This paper finds that the unit cost of intermediation does not seem to have decreased significantly with advances in information technology and changes in how the finance industry is organised. Philippon finds that the annual cost of intermediation is 1.5-2% of intermediated assets, while Bizot finds that the European unit cost of financial intermediation falls within a similar range. 6. Wright, W. and Hamre, E.F. (2021), "The problem with European stock markets", New Financial LLP, March. There are also a large number of central counterparties (CCPs) and central securities depositories (CSDs). However, a large part of EU CCP and CSD activity is concentrated in a few CSDs and CCPs within large corporate groups. For instance, the three largest groups represent 96% of European CSD settlement activity and 93% of assets under custody. See also Euroclear (2024), "Unlocking scale and competitiveness in Europe's markets - Enablers for an integrated and digitised post-trade architecture", Whitepaper, September. 7. T2S provides a common platform on which securities and cash can be transferred between investors across Europe, using harmonised rules and practices. Banks pay for securities on the platform using the account they have with their central bank, so the money used to settle transactions is central bank money. As a result, transaction risk is greatly reduced. T2S lays the foundations for a single market for securities settlement and thus contributes to achieving greater integration of Europe's financial market. 8. For an example, see Born, A., Heymann, D. S., Chaves, M. and Lambert, C. (2024), "Frictions in debt issuance procedures and home bias in the euro area", Financial Integration and Structure in the Euro Area, ECB, April. 9. European Council and Council of the European Union (2024), What the EU is doing to deepen its capital markets and McGuinness, M. (2024), "Vested interests must not block the EU's capital markets union", Financial Times, 19 March. 10. Lagarde, C. (2023), "A Kantian shift for the capital markets union", speech at the European Banking Congress, 17 November and Véron, N. (2024), "Capital Markets Union: Ten Years Later", European Parliament, March. 11. Panetta, F. (2023), "Europe needs to think bigger to build its capital markets union", The ECB Blog, 30 August. 12. Eurogroup (2024), Statement of the Eurogroup in inclusive format on the future of the Capital Markets Union, 11 March. 13. ECB (2024), Statement by the ECB Governing_Council on advancing the Capital Markets Union, 7 March; European Council (2024), Special meeting of the European Council - Conclusions, 18 April 2024; and European Commission (2024), Mission Letter from Ursula von der Leyen to Henna Virkunnen, 17 September. 14. Letta, E. (2024), Much more than a market - Speed, Security, Solidarity. Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens, April; Draghi, M. (2024), The future of European competitiveness - A competitiveness strategy for Europe, September. 15. Cipollone, P. (2024), "Modernising finance: the role of central bank money", keynote speech at the 30th Annual Congress of Financial Market Professionals organised by Assiom Forex, 9 February. 16. European Banking Authority (2024), Uses of DLT in the EU banking_and payments sector: EBA innovation monitoring and convergence work, April. 17. European Central Bank (2024), "Second group of participants chosen to test DLT for settlement in central bank money", MIP News, 21 June. 18. Bank for International Settlements (2023), "Blueprint for the future monetary system: improving the old, enabling the new", Annual Economic Report, Chapter III, 20 June. 19. These three functions are currently performed by three different entities (exchange, settlement infrastructure and CSD). 20. Global Financial Markets Association (2023), /mpact of Distributed Ledger Technology in Global Capital Markets, 17 May. 21. See also ECB (2024), Statement by the ECB Governing Council on advancing the Capital Markets Union, 7 March. 22. See Bank for International Settlements, (2012), Principles for financial market infrastructures, April. 23. The Financial Stability Board is assessing the potential financial stability implications of tokenisation in an upcoming report. 24. Machiavelli, N. (1513), Discourses on the First Ten Books of Titus Livius, Third Book, Chapter IX. 25. Lampedusa, G.T. di (1958), The Leopard. CONTACT European Central Bank	---[PAGE_BREAK]--- # Towards a digital capital markets union ## Keynote speech by Piero Cipollone, Member of the Executive Board of the ECB, at the Bundesbank Symposium on the Future of Payments Frankfurt am Main, 7 October 2024 The foundations of the financial system as we know it today can be traced back to 14th-century Italy, ${ }^{[1]}$ when double-entry bookkeeping ${ }^{[2]}$ was introduced, along with nostro and vostro accounts ${ }^{[3]}$ to facilitate the settlement of foreign trades across separate, independent ledgers ${ }^{[4]}$. Although today's financial markets are highly complex and sophisticated, the fundamental practice of bookkeeping across ledgers has remained largely unchanged and continues to exert a significant influence on existing market structures. For example, at each stage of the securities life cycle, banks, brokers, information providers and other market participants play an essential role in intermediation. This complexity comes at a cost: research shows that on the whole, financial intermediation costs in advanced economies have increased since the late 1960s. ${ }^{[5]}$ In Europe, this complexity is compounded by regulatory fragmentation across the continent, resulting in the ongoing fragmentation of capital markets. For example, there are 35 different exchanges for listings and 41 exchanges for trading. ${ }^{[6]}$ Some effort has been made towards integration in the posttrade sector, including through the creation of the TARGET2-Securities (T2S) platform, which can be used to transfer securities and cash between investors across Europe ${ }^{[7]}$, and through common platforms used by central securities depositories (CSDs). But the lack of harmonisation in the legislative and regulatory framework regarding custody, asset servicing and tax-related processes, for example, prevents the sector from reaping the benefits and synergies that an integrated European market could bring. ${ }^{[8]}$ The European Union (EU) has taken steps to address the regulatory barriers that exist in order to create deeper and more integrated capital markets. ${ }^{[9]}$ But many obstacles still remain, such as insufficient regulatory harmonisation, the absence of unified supervision ${ }^{[10]}$ or the lack of a permanent safe asset and integrated banking system ${ }^{[11]}$. This has led to multiple calls for renewed efforts, including from euro area finance ministers ${ }^{[12]}$, EU institutions ${ }^{[13]}$ and Enrico Letta and Mario Draghi in their recent reports ${ }^{[14]}$. But there is one crucial dimension that has often been overlooked, and that is technology. My aim today is not to discuss how to create a capital markets union for traditional assets, but to discuss how to create one for digital assets from the outset. ---[PAGE_BREAK]--- Although technology has undeniably helped facilitate the provision of financial services through electronic bookkeeping, for example, digital technology has so far failed to deliver financial integration in Europe. In fact, non-interoperable technological ecosystems in each country - shaped by diverging national regulatory regimes - have created siloed pools of asset liquidity, further entrenching fragmentation. However, recent advancements in digital technology offer an opportunity to create an integrated European capital market for digital assets - in other words, a digital capital markets union. Financial institutions are increasingly exploring the potential of tokenisation, which is the process of using new technologies, such as distributed ledger technology (DLT), to issue or represent assets in digital form, known as tokens. Unlike conventional assets, these tokens are not recorded on a centralised ledger but using DLT. Imagine a future where money and securities no longer sit in electronic, book-entry accounts but "live" on distributed ledgers held across a network of traders, each with a synchronised copy. If public authorities fail to act, this could lead to fragmentation. But if they seize the opportunity, then the benefits of this new approach could reach far beyond tackling technological inefficiencies, eventually resulting in a move away from the centuries-old structure of intermediation to a unified, distributed ledger or a constellation of fully interoperable ledgers. This transition could help us deal with the current fragmentation of financial infrastructures, reduce barriers to entry and serve as a driver of capital market integration in Europe. As a central bank, we recognise that our role in this transformative journey is to maintain trust and confidence in the value of money and the financial system. To fulfil this mandate, we have to adapt to the evolving technological landscape that is reshaping how money is exchanged and financial transactions are settled in an increasingly digital world. Understanding these innovations, preparing for them and - when they materialise - supporting their safe adoption are central to our mission. In addition, central bank money has a key role to play in facilitating the interoperability and integration of decentralised systems. ${ }^{[15]}$ Today, I want to explore how we can build an integrated European capital market for digital assets from the outset. At the same time, while the potential benefits of advances tokenisation and DLT are significant, we must also consider the risks to the financial market structure and the provision of central bank money. I will discuss how central banks can effectively support this technological transition. # The transformative potential of tokenisation and DLT in capital markets: balancing innovation with risk In recent years, there has been a notable increase in the adoption of financial technology, including the use of tokens and DLT. This transformation is not just theoretical: it is happening now. In the banking sector alone, over 60\% of EU banks surveyed are actively exploring, experimenting with or using DLT solutions, while $22 \%$ have already started using DLT applications. ${ }^{[16]}$ However, the use of DLT is not yet widespread. Currently, it is mainly used for primary issuance, although further applications and use cases are increasingly being looked at. But there is strong interest in exploring ---[PAGE_BREAK]--- the potential of DLT, and leading global financial market infrastructures such as DTCC, Clearstream and Euroclear are aiming to set standards to facilitate the adoption of tokenisation across the financial sector. The public sector is also contributing to this movement. Since having a solution for settling transactions in central bank money makes DLT-based solutions more attractive and less risky, there is strong demand from market participants to be able to use central bank money to settle digital asset transactions. As a result, the Eurosystem is conducting exploratory work to test DLT for the settlement of wholesale transactions in central bank money. ${ }^{[17]}$ Similarly, the Bank for International Settlements' Innovation Hub has launched several projects exploring this theme. ${ }^{[18]}$ The promise of tokenisation and DLT lies in the creation of a transparent ledger which would make it possible to perform the three key functions of asset trading, namely negotiation, settlement and custody, on the same platform. ${ }^{[19]}$ This is expected to reduce transaction costs by reducing the need for reconciliation, matching and other data processing steps, which would foster resilience and make it possible to operate on a 24/7, 365 days a year basis. DLT also supports the native issuance of digital assets, enabling direct transactions between a wide range of investors. This could lower barriers to entry and create opportunities for small issuers, such as small and medium-sized enterprises, to access capital markets. DLT would also enhance efficiency by significantly reducing settlement times and using the self-executing, programmable functions in smart contracts. This could potentially bring substantial savings. According to some estimates, automation and smart contracts could reduce annual infrastructure operational costs by approximately USD 15-20 billion in global capital markets. ${ }^{[20]}$ In addition to these savings, the possibility of extensive implementation of tokenisation and DLT offers opportunities to overhaul market structures. This could prove instrumental in tackling the technological obstacles hindering the establishment of a capital markets union in Europe. The new ecosystem could be designed from scratch in a more integrated and harmonised manner by providing a "common set of rails" - a shared ledger or an ecosystem of fully interoperable ledgers - that would ensure reachability, open access and compatibility across participants' services. CSDs, banks, investment managers and other market stakeholders would provide their services directly on a shared infrastructure, while each would be able to maintain a level of control and customisation over the functionalities. This would also allow a more flexible approach to the role of each participant in the ecosystem. From a technical perspective, it would also be possible to bring together all assets, functionalities and market players on one centralised platform. But it is precisely the combination of a shared infrastructure with customised control that could encourage different stakeholders to agree on "common rails" instead of relying on their own infrastructures, as they often do today. However, the early development stages of DLT present significant coordination challenges and risks to the financial system. There are therefore three primary risks that we must address. The first is the potential for an uncoordinated proliferation of DLT platforms, which could result in a fragmented landscape. In this nascent stage of development, established financial institutions are ---[PAGE_BREAK]--- apprehensive about DLT but are nevertheless keen to take advantage of its potential. Several new DLT platforms could emerge as a result, as market participants develop their own solutions without fully considering the broader economic implications. This could exacerbate the existing fragmentation among CSDs and other proprietary ledgers, leading to a lack of standardisation. This, in turn, would pose new coordination challenges and jeopardise our objective of establishing a digital capital markets union for Europe. ${ }^{[21]}$ The second risk is that central bank money could lose its status as the safest and most liquid settlement asset. If end users - in this case firms and investors - demand an "on-chain" means of payment to seamlessly support automated transactions via DLT, the lack of a solution for settling transactions in central bank money could encourage banks or stablecoin issuers to offer private money alternatives. A permanent shift from central bank money to commercial bank money or stablecoins could disrupt the existing two-tier monetary system and threaten financial stability by undermining central bank money's role as a risk-free settlement asset. This would contradict the principles agreed at international level. ${ }^{[22]}$ Lastly, public authorities still have more work to do to understand and assess the inherent risks and vulnerabilities stemming from DLT-based tokenisation. ${ }^{[23]}$ Tokenisation does not remove the vulnerabilities we know of from traditional finance, although these vulnerabilities may play out differently depending on design choices, adoption and scale. The key issue will be the choice of settlement assets, which could amplify liquidity risk or other vulnerabilities, but other risks could also emerge if new entities fall outside the scope of regulation or there are operational weaknesses. To deal with these risks, central banks and regulators must act early and work with market participants from the outset. If we drag our feet while other jurisdictions move faster and produce better solutions, we could see financial activities migrating elsewhere and private entities from outside the EU assuming a dominant position in European capital markets. Moreover, European market participants may then adopt uncoordinated approaches and invest in their own infrastructures. They could then resist any efforts by central banks to introduce enhanced settlement solutions, particularly if these threatened the viability of their new business models. If we don't act soon, it may be impossible to achieve a genuine digital capital markets union with efficient wholesale payment and settlement services using risk-free central bank money. # A European vision for the future of digital capital markets Given the early stage of market development and the strategic approaches being adopted by industry players, it is paramount that central banks provide clear direction. By offering clear and consistent guidance, the ECB serves as a crucial coordination mechanism for the European financial industry. This helps market participants align their efforts and innovate within a common framework, fostering interoperability. Central banks should play a proactive role in this transformation for two main reasons. First, it is vitally important to maintain, if not increase, the use of central bank money as the settlement asset in wholesale markets. Central bank money plays a pivotal role as the anchor of our two-tier monetary system, serving as a cornerstone of financial stability. ---[PAGE_BREAK]--- The second reason is to promote robust, stable and integrated European capital markets. Therefore, our aim is to facilitate the provision of central bank money settlement for wholesale transactions of DLT assets, thereby using the financial industry's adoption of DLT to address existing shortcomings associated with the fragmentation of European capital markets. One way to achieve this would be to move towards a European ledger, which would be a singleplatform solution where assets and cash would coexist on one chain. Many market participants believe this is a must if we want to fully reap the benefits of DLT. This ledger would address the technological complexities, inefficiencies and fragmentation that are currently preventing the integration of European capital markets for traditional assets. A European ledger could bring together token versions of central bank money, commercial bank money and other digital assets on a shared, programmable platform. In essence, this would see T2S evolving into a DLT-based, single financial market infrastructure for Europe. While central banks would provide the platform, or the "rails" so to speak, market participants would supply the content, or the "trains". However, further consideration would have to be given to the specifics of this platform, including the scope of services, governance structure, operational procedures and the potential implications for existing infrastructure and assets. One risk of the unified ledger is that it entails choosing one technological solution over all others. As all market players will use it, they will be less inclined to explore and promote alternative innovative technical solutions to provide the same services. Another option would therefore be to allow the coordinated development of an ecosystem of fully interoperable technical solutions. This flexibility would be beneficial, as it would better serve specific use cases and the coexistence of legacy and new solutions. We need to reflect on this trade-off. Research is continuing in the market, but in the meantime, there is a pressing need for solutions that would make it possible to settle DLT transactions in central bank money. This provides an opportunity to build on the interoperability solutions we have been trialling as part of the Eurosystem's exploratory work. This trial, in which the Eurosystem offers interoperability between its central bank money settlement services and external DLT platforms for both real and mock transactions, was successfully launched in May 2024 and will run until November. Some 60 industry participants are involved, in addition to central banks. Offering such solutions could allow the Eurosystem and market participants to experiment and develop DLT-based solutions further, unlocking investment in the industry. To this end, we have started to look at how we can build on our ongoing exploration. We will also examine the eligibility of DLT-based assets for use as collateral in Eurosystem credit operations. However, there is a risk that relying on existing interoperability solutions over the long term could perpetuate inefficiencies in the post-trade environment given the ongoing lack of full harmonisation and standardisation. Such interim solutions are thus a stopgap measure to smooth the transition towards our long-term vision. These efforts must align with EU legislators and regulators who have a window of opportunity to create a comprehensive, European regulatory and supervisory framework that will support financial ---[PAGE_BREAK]--- integration for digital assets while protecting market participants and preserving the underlying infrastructures. The limited progress in advancing a capital markets union for traditional assets shows that harmonising new activities from the outset is much easier than ironing out any differences at a late stage. Building on the EU's DLT pilot regime, this new framework should aim to establish the harmonised regulation and integrated supervision of digital assets. # Conclusion Let me conclude. In the current era of rapid technological change, "whosoever desires constant success must change his conduct with the times". ${ }^{[24]}$ These insights mirror the European financial sector's current exploration of tokenisation and DLT. These technologies do not just have the potential to enhance efficiency. They could also fundamentally reshape the very structure of financial intermediation - a system that has remained largely unchanged for centuries. Many financial market participants have already started to delve into these technologies, recognising their transformative potential. As prudent central bankers, we must also adapt to these new technologies if we are to fulfil our mandate of preserving trust and confidence in money and the financial system. Our primary objective in this evolving landscape is to ensure that central bank money - the safest and most liquid settlement asset - remains a cornerstone of stability, even in a capital market based on tokens and DLT. Or to quote Tancredi in Lampedusa's The Leopard ${ }^{[25]}$, "For things to stay the same, everything must change". However, the current nascent stage of market development does not just pose challenges. It also offers a unique opportunity. By establishing a clear vision of a digital capital markets union - an integrated European digital ecosystem where assets and cash coexist on one or more fully interoperable chains - these emerging technologies could help to address the existing shortcomings of European capital markets. In embracing this technological shift, we are not merely reacting to change, but actively participating in shaping a more efficient, innovative and resilient financial future for Europe. Thank you for your attention. 1. I would like to thank Cyril Max Neumann and Jean-Francois Jamet for their help in preparing this speech, as well as Ulrich Bindseil, Alexandra Born, Johanne Evrard, Daniel Kapp, Mirjam Plooij and Anton Van der Kraaij for their comments. 2. Sangster, A. (2024), "The emergence of double entry bookkeeping", The Economic History Review, pp. 1-30, May. 3. ---[PAGE_BREAK]--- A nostro/vostro account is a bank account where one bank has another bank's money on deposit, typically on behalf of a foreign bank in relation to international trade or other financial transactions. The terms "nostro" and "vostro" are used to indicate which bank has money on deposit. 4. Yamey, B. S. (2011), "Two-currency, nostro and vostro accounts: historical notes. 1400-1800", Accounting Historians Journal, Vol. 38, No 2, pp. 125-143, December. 5. Bazot, G. (2018), "Financial Consumption and the Cost of Finance: Measuring Financial Efficiency in Europe (1950-2007)", Journal of the European Economic Association, Vol. 16, Issue 1, pp. 123-160, February. The study provides evidence that the ratio of domestic financial intermediaries' income to GDP increases continuously in Germany, France, the United Kingdom and Europe more broadly over the period from 1950 to 2007, even during the 1990s and the 2000s. When including property income and capital gains, this ratio stood at 6-7\% in Germany, France and the UK, and around 9\% in the United States at the end of the period. The study then measures the unit cost of financial intermediation based on the ratio of financial income to financial assets intermediated. It finds that the European unit cost appears to have increased since the late 1960s but by a smaller proportion than in the United States. See also Philippon, T. (2015), "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation", American Economic Review, Vol. 105, No 4, pp. 1408-1438, April. This paper finds that the unit cost of intermediation does not seem to have decreased significantly with advances in information technology and changes in how the finance industry is organised. Philippon finds that the annual cost of intermediation is 1.5-2\% of intermediated assets, while Bizot finds that the European unit cost of financial intermediation falls within a similar range. 6. Wright, W. and Hamre, E.F. (2021), "The problem with European stock markets", New Financial LLP, March. There are also a large number of central counterparties (CCPs) and central securities depositories (CSDs). However, a large part of EU CCP and CSD activity is concentrated in a few CSDs and CCPs within large corporate groups. For instance, the three largest groups represent 96\% of European CSD settlement activity and 93\% of assets under custody. See also Euroclear (2024), "Unlocking scale and competitiveness in Europe's markets - Enablers for an integrated and digitised post-trade architecture", Whitepaper, September. 7. T2S provides a common platform on which securities and cash can be transferred between investors across Europe, using harmonised rules and practices. Banks pay for securities on the platform using the account they have with their central bank, so the money used to settle transactions is central bank ---[PAGE_BREAK]--- money. As a result, transaction risk is greatly reduced. T2S lays the foundations for a single market for securities settlement and thus contributes to achieving greater integration of Europe's financial market. 8. For an example, see Born, A., Heymann, D. S., Chaves, M. and Lambert, C. (2024), "Frictions in debt issuance procedures and home bias in the euro area", Financial Integration and Structure in the Euro Area, ECB, April. 9. European Council and Council of the European Union (2024), What the EU is doing to deepen its capital markets and McGuinness, M. (2024), "Vested interests must not block the EU's capital markets union", Financial Times, 19 March. 10. Lagarde, C. (2023), "A Kantian shift for the capital markets union", speech at the European Banking Congress, 17 November and Véron, N. (2024), "Capital Markets Union: Ten Years Later", European Parliament, March. 11. Panetta, F. (2023), "Europe needs to think bigger to build its capital markets union", The ECB Blog, 30 August. 12. Eurogroup (2024), Statement of the Eurogroup in inclusive format on the future of the Capital Markets Union, 11 March. 13. ECB (2024), Statement by the ECB Governing Council on advancing the Capital Markets Union, 7 March; European Council (2024), Special meeting of the European Council - Conclusions, 18 April 2024; and European Commission (2024), Mission Letter from Ursula von der Leyen to Henna Virkunnen, 17 September. 14. Letta, E. (2024), Much more than a market - Speed. Security. Solidarity. Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens, April; Draghi, M. (2024), The future of European competitiveness - A competitiveness strategy for Europe, September. 15. Cipollone, P. (2024), "Modernising finance: the role of central bank money", keynote speech at the 30th Annual Congress of Financial Market Professionals organised by Assiom Forex, 9 February. ---[PAGE_BREAK]--- European Banking Authority (2024), Uses of DLT in the EU banking and payments sector: EBA innovation monitoring and convergence work, April. 17. European Central Bank (2024), "Second group of participants chosen to test DLT for settlement in central bank money", MIP News, 21 June. 18. Bank for International Settlements (2023), "Blueprint for the future monetary system: improving the old, enabling the new", Annual Economic Report, Chapter III, 20 June. 19. These three functions are currently performed by three different entities (exchange, settlement infrastructure and CSD). 20. Global Financial Markets Association (2023), Impact of Distributed Ledger Technology in Global Capital Markets, 17 May. 21. See also ECB (2024), Statement by the ECB Governing Council on advancing the Capital Markets Union, 7 March. 22. See Bank for International Settlements, (2012), Principles for financial market infrastructures, April. 23. The Financial Stability Board is assessing the potential financial stability implications of tokenisation in an upcoming report. 24. Machiavelli, N. (1513), Discourses on the First Ten Books of Titus Livius, Third Book, Chapter IX. 25. Lampedusa, G.T. di (1958), The Leopard. # CONTACT <br> European Central Bank	Piero Cipollone	Euro area	https://www.bis.org/review/r241015f.pdf	Frankfurt am Main, 7 October 2024 The foundations of the financial system as we know it today can be traced back to 14th-century Italy, . Although today's financial markets are highly complex and sophisticated, the fundamental practice of bookkeeping across ledgers has remained largely unchanged and continues to exert a significant influence on existing market structures. For example, at each stage of the securities life cycle, banks, brokers, information providers and other market participants play an essential role in intermediation. This complexity comes at a cost: research shows that on the whole, financial intermediation costs in advanced economies have increased since the late 1960s. In Europe, this complexity is compounded by regulatory fragmentation across the continent, resulting in the ongoing fragmentation of capital markets. For example, there are 35 different exchanges for listings and 41 exchanges for trading. The European Union (EU) has taken steps to address the regulatory barriers that exist in order to create deeper and more integrated capital markets. . But there is one crucial dimension that has often been overlooked, and that is technology. My aim today is not to discuss how to create a capital markets union for traditional assets, but to discuss how to create one for digital assets from the outset. Although technology has undeniably helped facilitate the provision of financial services through electronic bookkeeping, for example, digital technology has so far failed to deliver financial integration in Europe. In fact, non-interoperable technological ecosystems in each country - shaped by diverging national regulatory regimes - have created siloed pools of asset liquidity, further entrenching fragmentation. However, recent advancements in digital technology offer an opportunity to create an integrated European capital market for digital assets - in other words, a digital capital markets union. Financial institutions are increasingly exploring the potential of tokenisation, which is the process of using new technologies, such as distributed ledger technology (DLT), to issue or represent assets in digital form, known as tokens. Unlike conventional assets, these tokens are not recorded on a centralised ledger but using DLT. Imagine a future where money and securities no longer sit in electronic, book-entry accounts but "live" on distributed ledgers held across a network of traders, each with a synchronised copy. If public authorities fail to act, this could lead to fragmentation. But if they seize the opportunity, then the benefits of this new approach could reach far beyond tackling technological inefficiencies, eventually resulting in a move away from the centuries-old structure of intermediation to a unified, distributed ledger or a constellation of fully interoperable ledgers. This transition could help us deal with the current fragmentation of financial infrastructures, reduce barriers to entry and serve as a driver of capital market integration in Europe. As a central bank, we recognise that our role in this transformative journey is to maintain trust and confidence in the value of money and the financial system. To fulfil this mandate, we have to adapt to the evolving technological landscape that is reshaping how money is exchanged and financial transactions are settled in an increasingly digital world. Understanding these innovations, preparing for them and - when they materialise - supporting their safe adoption are central to our mission. In addition, central bank money has a key role to play in facilitating the interoperability and integration of decentralised systems. Today, I want to explore how we can build an integrated European capital market for digital assets from the outset. At the same time, while the potential benefits of advances tokenisation and DLT are significant, we must also consider the risks to the financial market structure and the provision of central bank money. I will discuss how central banks can effectively support this technological transition. In recent years, there has been a notable increase in the adoption of financial technology, including the use of tokens and DLT. This transformation is not just theoretical: it is happening now. In the banking sector alone, over 60\% of EU banks surveyed are actively exploring, experimenting with or using DLT solutions, while $22 \%$ have already started using DLT applications. However, the use of DLT is not yet widespread. Currently, it is mainly used for primary issuance, although further applications and use cases are increasingly being looked at. But there is strong interest in exploring the potential of DLT, and leading global financial market infrastructures such as DTCC, Clearstream and Euroclear are aiming to set standards to facilitate the adoption of tokenisation across the financial sector. The public sector is also contributing to this movement. Since having a solution for settling transactions in central bank money makes DLT-based solutions more attractive and less risky, there is strong demand from market participants to be able to use central bank money to settle digital asset transactions. As a result, the Eurosystem is conducting exploratory work to test DLT for the settlement of wholesale transactions in central bank money. The promise of tokenisation and DLT lies in the creation of a transparent ledger which would make it possible to perform the three key functions of asset trading, namely negotiation, settlement and custody, on the same platform. This is expected to reduce transaction costs by reducing the need for reconciliation, matching and other data processing steps, which would foster resilience and make it possible to operate on a 24/7, 365 days a year basis. DLT also supports the native issuance of digital assets, enabling direct transactions between a wide range of investors. This could lower barriers to entry and create opportunities for small issuers, such as small and medium-sized enterprises, to access capital markets. DLT would also enhance efficiency by significantly reducing settlement times and using the self-executing, programmable functions in smart contracts. This could potentially bring substantial savings. According to some estimates, automation and smart contracts could reduce annual infrastructure operational costs by approximately USD 15-20 billion in global capital markets. In addition to these savings, the possibility of extensive implementation of tokenisation and DLT offers opportunities to overhaul market structures. This could prove instrumental in tackling the technological obstacles hindering the establishment of a capital markets union in Europe. The new ecosystem could be designed from scratch in a more integrated and harmonised manner by providing a "common set of rails" - a shared ledger or an ecosystem of fully interoperable ledgers - that would ensure reachability, open access and compatibility across participants' services. CSDs, banks, investment managers and other market stakeholders would provide their services directly on a shared infrastructure, while each would be able to maintain a level of control and customisation over the functionalities. This would also allow a more flexible approach to the role of each participant in the ecosystem. From a technical perspective, it would also be possible to bring together all assets, functionalities and market players on one centralised platform. But it is precisely the combination of a shared infrastructure with customised control that could encourage different stakeholders to agree on "common rails" instead of relying on their own infrastructures, as they often do today. However, the early development stages of DLT present significant coordination challenges and risks to the financial system. There are therefore three primary risks that we must address. The first is the potential for an uncoordinated proliferation of DLT platforms, which could result in a fragmented landscape. In this nascent stage of development, established financial institutions are apprehensive about DLT but are nevertheless keen to take advantage of its potential. Several new DLT platforms could emerge as a result, as market participants develop their own solutions without fully considering the broader economic implications. This could exacerbate the existing fragmentation among CSDs and other proprietary ledgers, leading to a lack of standardisation. This, in turn, would pose new coordination challenges and jeopardise our objective of establishing a digital capital markets union for Europe. The second risk is that central bank money could lose its status as the safest and most liquid settlement asset. If end users - in this case firms and investors - demand an "on-chain" means of payment to seamlessly support automated transactions via DLT, the lack of a solution for settling transactions in central bank money could encourage banks or stablecoin issuers to offer private money alternatives. A permanent shift from central bank money to commercial bank money or stablecoins could disrupt the existing two-tier monetary system and threaten financial stability by undermining central bank money's role as a risk-free settlement asset. This would contradict the principles agreed at international level. Lastly, public authorities still have more work to do to understand and assess the inherent risks and vulnerabilities stemming from DLT-based tokenisation. Tokenisation does not remove the vulnerabilities we know of from traditional finance, although these vulnerabilities may play out differently depending on design choices, adoption and scale. The key issue will be the choice of settlement assets, which could amplify liquidity risk or other vulnerabilities, but other risks could also emerge if new entities fall outside the scope of regulation or there are operational weaknesses. To deal with these risks, central banks and regulators must act early and work with market participants from the outset. If we drag our feet while other jurisdictions move faster and produce better solutions, we could see financial activities migrating elsewhere and private entities from outside the EU assuming a dominant position in European capital markets. Moreover, European market participants may then adopt uncoordinated approaches and invest in their own infrastructures. They could then resist any efforts by central banks to introduce enhanced settlement solutions, particularly if these threatened the viability of their new business models. If we don't act soon, it may be impossible to achieve a genuine digital capital markets union with efficient wholesale payment and settlement services using risk-free central bank money. Given the early stage of market development and the strategic approaches being adopted by industry players, it is paramount that central banks provide clear direction. By offering clear and consistent guidance, the ECB serves as a crucial coordination mechanism for the European financial industry. This helps market participants align their efforts and innovate within a common framework, fostering interoperability. Central banks should play a proactive role in this transformation for two main reasons. First, it is vitally important to maintain, if not increase, the use of central bank money as the settlement asset in wholesale markets. Central bank money plays a pivotal role as the anchor of our two-tier monetary system, serving as a cornerstone of financial stability. The second reason is to promote robust, stable and integrated European capital markets. Therefore, our aim is to facilitate the provision of central bank money settlement for wholesale transactions of DLT assets, thereby using the financial industry's adoption of DLT to address existing shortcomings associated with the fragmentation of European capital markets. One way to achieve this would be to move towards a European ledger, which would be a singleplatform solution where assets and cash would coexist on one chain. Many market participants believe this is a must if we want to fully reap the benefits of DLT. This ledger would address the technological complexities, inefficiencies and fragmentation that are currently preventing the integration of European capital markets for traditional assets. A European ledger could bring together token versions of central bank money, commercial bank money and other digital assets on a shared, programmable platform. In essence, this would see T2S evolving into a DLT-based, single financial market infrastructure for Europe. While central banks would provide the platform, or the "rails" so to speak, market participants would supply the content, or the "trains". However, further consideration would have to be given to the specifics of this platform, including the scope of services, governance structure, operational procedures and the potential implications for existing infrastructure and assets. One risk of the unified ledger is that it entails choosing one technological solution over all others. As all market players will use it, they will be less inclined to explore and promote alternative innovative technical solutions to provide the same services. Another option would therefore be to allow the coordinated development of an ecosystem of fully interoperable technical solutions. This flexibility would be beneficial, as it would better serve specific use cases and the coexistence of legacy and new solutions. We need to reflect on this trade-off. Research is continuing in the market, but in the meantime, there is a pressing need for solutions that would make it possible to settle DLT transactions in central bank money. This provides an opportunity to build on the interoperability solutions we have been trialling as part of the Eurosystem's exploratory work. This trial, in which the Eurosystem offers interoperability between its central bank money settlement services and external DLT platforms for both real and mock transactions, was successfully launched in May 2024 and will run until November. Some 60 industry participants are involved, in addition to central banks. Offering such solutions could allow the Eurosystem and market participants to experiment and develop DLT-based solutions further, unlocking investment in the industry. To this end, we have started to look at how we can build on our ongoing exploration. We will also examine the eligibility of DLT-based assets for use as collateral in Eurosystem credit operations. However, there is a risk that relying on existing interoperability solutions over the long term could perpetuate inefficiencies in the post-trade environment given the ongoing lack of full harmonisation and standardisation. Such interim solutions are thus a stopgap measure to smooth the transition towards our long-term vision. These efforts must align with EU legislators and regulators who have a window of opportunity to create a comprehensive, European regulatory and supervisory framework that will support financial integration for digital assets while protecting market participants and preserving the underlying infrastructures. The limited progress in advancing a capital markets union for traditional assets shows that harmonising new activities from the outset is much easier than ironing out any differences at a late stage. Building on the EU's DLT pilot regime, this new framework should aim to establish the harmonised regulation and integrated supervision of digital assets. Let me conclude. In the current era of rapid technological change, "whosoever desires constant success must change his conduct with the times". These insights mirror the European financial sector's current exploration of tokenisation and DLT. These technologies do not just have the potential to enhance efficiency. They could also fundamentally reshape the very structure of financial intermediation - a system that has remained largely unchanged for centuries. Many financial market participants have already started to delve into these technologies, recognising their transformative potential. As prudent central bankers, we must also adapt to these new technologies if we are to fulfil our mandate of preserving trust and confidence in money and the financial system. Our primary objective in this evolving landscape is to ensure that central bank money - the safest and most liquid settlement asset - remains a cornerstone of stability, even in a capital market based on tokens and DLT. Or to quote Tancredi in Lampedusa's The Leopard , "For things to stay the same, everything must change". However, the current nascent stage of market development does not just pose challenges. It also offers a unique opportunity. By establishing a clear vision of a digital capital markets union - an integrated European digital ecosystem where assets and cash coexist on one or more fully interoperable chains - these emerging technologies could help to address the existing shortcomings of European capital markets. In embracing this technological shift, we are not merely reacting to change, but actively participating in shaping a more efficient, innovative and resilient financial future for Europe. Thank you for your attention.
2024-10-08T00:00:00	Philip N Jefferson: A history of the Fed's discount window - 1913-2000	Speech by Mr Philip N Jefferson, Vice Chair of the Board of Governors of the Federal Reserve System, at the Davidson College, Davidson, North Carolina, 8 October 2024.	For release on delivery 7:30 p.m. EDT October 8, 2024 A History of the Fed's Discount Window: 1913-2000 Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at Davidson College Davidson, North Carolina October 8, 2024 Thank you, President Hicks and Tara Boehmler, for the kind introduction.1 Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected, including those in the Davidson College family. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. I am happy to be back at Davidson College. This is a special community. I am bound to it by a shared experience defined not by its length, but by its intensity. As I visited with you today, and as I look around this hall, I see the faces of colleagues who became dear friends during the COVID-19 pandemic. Back then, we spoke often about the unprecedented uncertainty we faced. Amidst that uncertainty, however, we supported each other on this campus. Now, looking back, we can attest that this mutual support was vital. I am grateful to have been amongst you during that unprecedented time. Today, I am proud to see that Davidson is stronger than ever. I am excited to be here with you this evening and to talk to you about the history of the Federal Reserve's discount window.2 The discount window is one of the tools the Fed uses to support the liquidity and stability of the banking system, and to implement - 2 - monetary policy effectively. It was created in 1913 when the Fed was established. Today, more than 110 years later, this tool continues to play an important role. At the Fed, we always look for ways to improve our tools, including our discount window operations. Recently, the Fed published a request for information document to receive feedback from the public regarding operational aspects of the discount window and intraday credit.3 Today, I will do three things. First, I will discuss briefly my outlook for the U.S. economy. Second, I will offer my historical perspective on the discount window, starting in 1913 and ending in 2000. Finally, I will provide a few details about the request for information the Fed recently published. Tomorrow, I will say more about the discount window when I speak at the Charlotte Economics Club. Economic Outlook and Considerations for Monetary Policy Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. As you can see in slide 3, personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of - 3 - households, businesses, and forecasters as well as measures from financial markets. Inflation is now much closer to the Federal Open Market Committee's (FOMC) 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. A shown in slide 4, the unemployment rate now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by 1/2 percentage point, as shown in slide 5. Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy - 4 - evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. Discount Window History 1913: The Fed was established Now, I will turn to my perspective on the history of the discount window. Understanding this history is important as we consider ways to ensure the discount window continues to serve effectively in its critical role of providing liquidity to the banking system as the economy and financial system evolve. Before the Federal Reserve was founded, the U.S. experienced frequent financial panics. One example is illustrated in slide 6 with a newspaper clipping from the Rocky Mountain Times printed on July 19, 1893. It depicts panic swirling against banks at a time when bank runs swept through midwestern and western cities such as Chicago, Denver, and Los Angeles. The illustration shows how waves of panic hit public confidence, the rocks in the picture, and how banks have a fortress mentality. They stand strong against the panic, but they are not lending, and they are isolated. Back then, the supply of money to the economy was inelastic in the short term, in part because the monetary system in the U.S. was based on the gold standard. Demand for cash, however, varied over the course of the year and was particularly strong during harvest season, when crops were brought to the market. The surge in demand for cash, combined with the inelastic supply of money in the short term, caused financial conditions to tighten seasonally. The banking system was fairly good at moving money to where it needed to go, but it had little scope to expand the total amount of money available in response to the U.S. economy's needs. So if a shock hit the economy when - 5 - financial conditions were already tight, then the banking system struggled to provide the extra liquidity needed. Banks would seek to preserve liquidity by reducing their investments and denying loan requests, for example. Depositors, fearful that they might not be able to access their funds when they needed them, would rush to withdraw their money. Of course, that caused the banks to conserve further on liquidity. In some cases, they simply closed their doors until the storm passed. When banks closed their doors, economic activity would contract.4 Activity would recover when the banks reopened, but the economic suffering in the meantime was meaningful. In addition to the supply of money in the economy being inelastic in the short term, two prominent frictions, asymmetric information and externalities, made banks and private markets vulnerable to systemic crises. Here, asymmetric information refers to the fact that customers do not have access to all the information they need to evaluate whether a bank is insolvent, illiquid, or both.5 Therefore, customers rely on imperfect signals, such as news reports about another bank failing, to decide whether to withdraw their money from their own bank. Then there are externalities, in the sense that an individual bank may not consider how an innocent bystander may be negatively impacted by its actions. When a financial 4 See, for example, Goodhart (1988). 5 Illiquidity is a short-term cash flow problem. An illiquid bank cannot pay its current obligations, such as deposit withdrawals, even though the value of the bank's assets exceeds the value of its liabilities. In other words, illiquidity means the bank does not currently have the resources to meet its current obligations. With a short-term loan, an illiquid bank would be able to pay its obligations. Insolvency is a long-term balance sheet problem. Total obligations of an insolvent bank are larger than its total assets. A short-term loan would not help an insolvent bank. Of course, evaluating the quality of a bank's loan book in real time to determine whether a bank is solvent can be extremely challenging during a crisis. In addition, in some cases, illiquidity caused by large deposit withdrawals can lead banks to sell assets at fire-sale prices that then impairs their solvency. Conversely, concerns about insolvency, even if unfounded, can lead to liquidity problems. In the bank run literature, the connections between liquidity and solvency are a key factor that gives rise to runs. - 6 - institution fails, that may lead depositors to withdraw money from other unrelated banks, which may in turn cause those banks to fail. Contagion can transform a single bank failure into a systemic crisis, where many banks fail, credit evaporates, the stock market collapses, the economy enters a recession, and the unemployment rate increases dramatically. The severe financial panic of 1907 stands out as an example of market failure due to these two prominent frictions. The panic was triggered by a series of bad banking decisions that led to a frenzy of withdrawals caused by asymmetric information and public distrust in the liquidity of the banking system.6 Banks in many large cities, including financial centers such as New York and Chicago, simply stopped sending payments outside of their communities. The resulting disruption in the payment system and to the flow of liquidity through the banking system led to a severe, though short- lived, economic contraction. This experience led Congress to pass the Federal Reserve Act in 1913.7 This act created the Federal Reserve System, composed of the Federal Reserve Board in Washington, D.C., and 12 Federal Reserve Banks across the country.8 In 1913, the main monetary policy tool at the Fed's disposal was the discount window. At that time, the Fed did not use open market operations-the buying and 6 The panic of 1907 started in October 1907 when three brothers-F. Augustus Heinze, Otto Heinze, and Arthur P. Heinze-as well as Charles W. Morse attempted to manipulate the price of United Copper stock by purchasing a large number of shares of the company. Their plan failed, and the stock price of United Copper collapsed. The collapse led to depositor runs on banks and trust companies associated with the Heinzes and Morse. This included a run on the Knickerbocker Trust Company, whose president was connected to Morse. The Knickerbocker Trust Company failed, and the New York Stock Exchange fell nearly 50 percent from its peak of the previous year in the wake of the failure. See Terrell (2021). 7 To aid its thinking on reforming the monetary system, Congress established the National Monetary Commission. The landmark 24 volume report from the commission provides a rich review of the operations of central banks in other countries, a history of financial crises in the U.S., and an appraisal of the state of the contemporary banking system in the U.S. at the time. 8 See "History and Purpose of the Federal Reserve" on the St. Louis Fed's website at https://www.stlouisfed.org/in-plain-english/history-and-purpose-of-the-fed. - 7 - selling of government securities in the open market-to conduct monetary policy. Instead, the Fed adjusted the money supply by lending directly to banks that needed funds through the discount window. The Fed's ability to provide funds to banks as needed made the money supply of the U.S. more elastic and considerably reduced the seasonal volatility in interest rates.9 This ability also enabled the Fed to provide stability in times of stress, helping banks that experienced rapid withdrawals to satisfy their customers' demand for liquidity and thereby potentially preventing banking panics. 1920s: The Fed began to discourage strongly use of the discount window In fact, many researchers have argued that the existence of the Fed's discount window prevented a financial crisis in the early 1920s, when the banking sector came under pressure as the U.S. economy transitioned to a peacetime economy following the end of World War I.10 There had been an agricultural boom during the war and a significant accumulation of debt within that sector. Farmers came under pressure as the prices of agricultural goods dropped from wartime highs. The banks sought to support their customers, and the Fed sought to support the banks. There were serious concerns about the condition of several banks in parts of the country. The Fed's discount window lending provided critical support that saved many banks but also resulted in habitual use of the discount window by some banks during the 1920s.11 Slide 7 shows that as of August 1925, 593 member banks, 6 percent of the total, had been borrowing for a year or more from Federal Reserve Banks. Moreover, there were real solvency problems, and several banks failed with discount window loans - 8 - outstanding. These challenges resulted in the Fed strongly discouraging banks from continuous borrowing from the discount window and the adoption of a policy of encouraging a "reluctance to borrow."12 By 1926, the Fed was explicit that borrowing at the discount window was meant to be short term. As I emphasize in slide 8, the Federal Reserve's annual report for 1926 stated that while continuous borrowing by a member bank may be necessary, depending on local economic conditions, "the funds of the Federal reserve banks are primarily intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal reserve act."13 The late 1920s also highlighted Fed concerns about the purpose of the borrowing. The Fed sought to distinguish between "speculative security loans" and loans for "legitimate business."14 A staff reappraisal of the discount mechanism stated that "[t]he controversy over direct pressure intensified in the latter part of the 1920s as an increasing flow of bank credit went into the stock market."15 In short, the Fed observed that some banks were becoming habitual borrowers from the discount window. It was concerned 12 See Shull (1971, pp. 33-34). 13 See Board of Governors (1927, p. 4). In 1926, approximately one-third of all banks in the U.S. were member banks, holding about 60 percent of the total loans and investments for all banks; see Board of Governors (1926). Banks receiving charters from the federal government were required to become members of the Federal Reserve System while banks receiving charters from state governments had the option to become members. Discount window borrowing was originally limited to Federal Reserve System member banks. The Monetary Control Act of 1980 opened the window to all depository institutions. 14 See Gorton and Metrick (2013). 15 See Anderson (1971, p. 137). In the statement, "direct pressure" refers to the Fed policy of pressuring banks not to borrow from the window. Congress may have shared some of those concerns, as the Federal Reserve Act was amended in 1933 to include a passage in section 4 requiring Reserve Banks to be careful about speculative uses of the Federal Reserve credit. - 9 - that an overreliance on discount window borrowings would weaken banks and make them more prone to failure. In the late 1920s, the Fed switched to open market operations as its primary tool for conducting monetary policy.16 That allowed the Fed to determine the aggregate amount of liquidity in the system and to rely on private financial markets to distribute it efficiently. The discount window would thus serve as a safety valve if there was a shock that caused conditions to tighten unexpectedly or if individual banks experienced idiosyncratic shocks or somehow lost access to interbank markets. The intention of this set-up was for banks to use the discount window to borrow from the Fed only occasionally. Ordinarily and predominantly, financial institutions were supposed to rely on private markets for their funding. This set-up was designed to limit moral hazard-the possibility that institutions take unnecessary risks when there is no market discipline. This is the key balancing act. The Fed needs to be a reliable backstop to prevent financial crises, but it also needs to minimize moral hazard that comes from always standing ready to provide support. 1930s-1940s: The Great Depression and WWII During the Great Depression in the 1930s, the banking system experienced severe stress, including many bank runs. There are many reasons why the discount window was insufficient to address the problems in the banking system in the 1930s. I will highlight only two. First, many banks were insolvent rather than illiquid. Central bank lending is not a fundamental solution in those circumstances. When banks are insolvent, it is important to manage the closure in as orderly a manner as possible. The establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 gave bank regulators increased ability to do that. Relatedly, the challenging experiences of lending to troubled banks in the 1920s likely made the Fed more reluctant to lend in circumstances in which solvency concerns were material. Second, the types of collateral that the Fed was initially able to accept when lending to banks were quite limited. In response, in the early 1930s Congress expanded the range of banking assets that could serve as collateral for discount window loans and added a variety of new Fed emergency lending authorities.17 These new lending authorities were used in the 1930s to help alleviate distress. Some were also used in the early 1940s as the Fed helped support the World War II mobilization effort. The period following the war was relatively calm. The role of the discount window shifted from addressing distress in the banking system to acting as a safety valve to manage tightness in money markets and support monetary policy operations. 1950-2000: Measures to discourage discount window borrowing In March 1951, the U.S. Treasury and the Fed reached an agreement to separate government debt management from the conduct of monetary policy, thereby laying the foundation for the modern Fed.18 In the 1950s, the Fed set the interest rate on discount window loans above market rates. Thus, it served as an effective ceiling on the federal funds rate. The Fed continued to discourage extensive use of the discount window, but the relatively high interest rate also made its sustained use less attractive. In the 1960s, the Fed placed greater emphasis on open market operations to set its monetary policy stance. Concurrently, the Fed shifted to a policy of setting the interest rate on discount window loans below the market rates. Because the interest rate no longer deterred use of the window, the Fed turned increasingly to other measures, such as administrative pressures and moral suasion, to limit the frequency with which banks requested loans from the discount window. Indeed, between the late 1920s and the 1980s, the Fed adopted and amended numerous restrictions on discount window borrowing. Whenever discount window usage increased too much, the Fed tightened the restrictions to suppress borrowing. For example, in the 1950s, the Fed defined appropriate and inappropriate discount window borrowing. In particular, the Board's regulations in 1955 stated that "[u]nder ordinary conditions, the continuous use of Federal Reserve credit by a member bank over a considerable period of time is not regarded as appropriate" and provided more details on how Reserve Banks should evaluate the "purpose" of a credit request.19 By 1973, the Board had made additional changes to its regulations on discount window use and defined three distinct discount window programs: adjustment credit, intended to help depository institutions meet short-term liquidity needs; seasonal credit, intended to help small depository institutions manage liquidity needs that arise from seasonal swings in loans and deposits; and extended credit, intended to help depository institutions that have somewhat longer-term liquidity needs resulting from exceptional circumstances.20 Over time, the Board added provisions in its regulations requiring banks to exhaust other sources of funding before using discount window credit.21 In addition, in the early 1980s, the Fed levied a surcharge on frequent borrowings by large banks to augment the administrative restrictions.22 Despite these policies to discourage use of the discount window, slide 9 shows that discount window borrowing, adjusted for the size of the Federal Reserve's balance sheet, was notable in the 1970s and 1980s, suggesting that the discount window was an important marginal source of funding for banks during that period. That changed in the 1980s and early 1990s, when there were notable solvency problems in the banking industry. During this period, the discount window provided support to troubled institutions, while the FDIC sought to find merger partners or otherwise manage the failure of these institutions in an orderly manner. The discount window activity that took place while FDIC resolutions proceeded increased the association between use of the discount window and being a troubled institution.23 As a result, banks became more reluctant to borrow from the discount window. The greater 20 See Board of Governors of the Federal Reserve System, Extensions of Credit by Federal Reserve Banks, 38 Fed. Reg. 9065, 9076-9077 (April 10, 1973). 21 By 1980, the Board's regulations stated that adjustment credit "generally is available only after reasonable alternative sources of funds, including credit from special industry lenders, such as Federal Home Loan Banks, the National Credit Union Administration's Central Liquidity Facility, and corporate central credit unions have been fully used"; seasonal credit was "available only if similar assistance is not available from other special industry lenders"; and other extended credit was available only "where similar assistance is not reasonably available from other sources, including special industry lenders"; see Board of Governors of the Federal Reserve System, Extensions of Credit by Federal Reserve Banks, 45 Fed. Reg. 54009, 54009-54011 (Aug. 14, 1980). See also Clouse (1994). 22 See Meulendyke (1992). 23 A congressional inquiry found that this lending likely increased losses to the deposit insurance funds at the time and led to limitations on the ability of the Federal Reserve to provide loans to troubled depository institutions as part of the Federal Deposit Insurance Corporation Improvement Act of 1991. reluctance to borrow from the discount window made it less effective, both as a monetary policy tool and as a crisis-fighting tool. That resulted in a series of efforts by the Fed in the early 2000s to change how the discount window operates. Tomorrow, I will discuss those efforts when I speak at the Charlotte Economics Club. A request for information Before closing, I'd like to return to where I began. Understanding the history of the discount window is important as we consider ways to ensure it continues to serve effectively in its critical role in providing liquidity to the banking system as the economy and financial system evolve. One way to ensure it continues to serve effectively is to collect feedback from the public. Slide 10 provides some touch points on the Board's request for information document. The request for information seeks feedback from the public on a range of operational practices for the discount window and intraday credit, including the collection of legal documents; the process for pledging and withdrawing collateral; the process for requesting, receiving and repaying discount window advances; the extension of intraday credit; and Reserve Bank communications practices. My colleagues and I are looking forward to this feedback to inform potential future enhancements to discount window operations. The period for responding to our request for information ends on December 9, 2024. Thank you to the event organizers and to the Davidson College community for the opportunity to discuss this important topic with you. It has been such a pleasure to be back on campus. References Anderson, Clay (1971). "Evolution of the Role and the Functioning of the Discount Mechanism," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1. Washington: Board of Governors of the Federal Reserve System, pp. 133-65, https://fraser.stlouisfed.org/title/reappraisal-federal-reserve-discount-mechanism1206?browse=1970s#3578. Board of Governors of the Federal Reserve System (1922). 8th Annual Report, 1921. Washington: Government Printing Office, https://fraser.stlouisfed.org/title/annual-report-board-governors-federal-reservesystem-117/1921-2479. --- (1926). Federal Reserve Bulletin, vol. 12 (July), https://fraser.stlouisfed.org/title/federal-reserve-bulletin-62/july-1926-20655. --- (1927). 13th Annual Report, 1926. Washington: Government Printing Office, https://fraser.stlouisfed.org/title/annual-report-board-governors-federal-reservesystem-117/1926-2484. Carlson, Mark (forthcoming). The Young Fed: The Banking Crises of the 1920s and the Making of a Lender of Last Resort. Chicago: University of Chicago Press. Clouse, James (1994). "Recent Developments in Discount Window Policy," Federal Reserve Bulletin, vol. 80 (November), pp. 965-77, https://www.federalreserve.gov/monetarypolicy/1194lead.pdf. Goodhart, Charles A.E. (1988). The Evolution of Central Banks. Cambridge, Mass.: MIT Press. Gorton, Gary (1988). "Banking Panics and Business Cycles," Oxford Economic Papers, vol. 40 (December), pp. 751-81. Gorton, Gary, and Andrew Metrick (2013). "The Federal Reserve and Financial Regulation: The First Hundred Years," NBER Working Paper Series 19292. Cambridge, Mass.: National Bureau of Economic Research, August, https://www.nber.org/papers/w19292. Meltzer, Allan (2003). A History of the Federal Reserve, Volume 1: 1913-1951. Chicago: University of Chicago Press. Miron, Jeffrey A. (1986). "Financial Panics, the Seasonality of the Nominal Interest Rate, and the Founding of the Fed," American Economic Review, vol. 76 (March), pp. 125-40. Meulendyke, Ann-Marie (1992). "Reserve Requirements and the Discount Window in Recent Decades," Federal Reserve Bank of New York, Quarterly Review, vol. 17 (Autumn), pp. 25-43, https://www.newyorkfed.org/medialibrary/media/research/quarterly_review/1992 v17/v17n3article3.pdf. Shull, Bernard (1971). "Report on Research Undertaken in Connection with a System Study," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1. Washington: Board of Governors of the Federal Reserve System, pp. 27-77, https://fraser.stlouisfed.org/title/reappraisal-federal-reserve-discount-mechanism1206?browse=1970s. Terrell, Ellen (2021). "United Copper, Wall Street, and the Panic of 1907," Library of Congress, Inside Adams: Science, Technology & Business (blog), March 9, https://blogs.loc.gov/inside_adams/2021/03/united-copper-panic-of-1907. Willis, Henry Parker (1923). The Federal Reserve System: Legislation, Organization and Operation. New York: The Ronald Press Company. A History of the Fed's Discount Window: 1913-2000 Philip N. Jefferson Vice Chair, Federal Reserve Board Davidson College, Oct. 8, 2024 Disclaimer: The views I will express today are my own and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve System. Roadmap of Talk • Economic Outlook • Historical Perspective on Discount Window • Request for Information Figure 4. Newspaper Illustration from 1893 • Panic swirling against banks • Public confidence is stopping the waves • Banks have a fortress mentality, not lending, isolated Table 1. Member Banks Borrowing Continuously for a Year or More from Reserve Banks As of Number August 31, 1925 593 December 31, 1925 517 December 31, 1926 457 December 31, 1927 303 Source: Bernard Shull (1971), "Report on Research Undertaken in Connection with a System Study," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1 (Washington: Board of Governors of the Federal Reserve System), table 1, p. 34. In 1926 the Fed Encourages a Reluctance to Borrow from Discount Window funds of the Federal Reserve banks are primarily "the intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal Reserve Act." 1926 Federal Reserve Annual Report, page 4. Request for Information (RFI) • RFI published in the Federal Register on September 10, 2024 • You can find the RFI at https://www.federalregister.gov • Comment period is open until December 9, 2024	---[PAGE_BREAK]--- For release on delivery 7:30 p.m. EDT October 8, 2024 A History of the Fed's Discount Window: 1913-2000 Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at Davidson College Davidson, North Carolina October 8, 2024 ---[PAGE_BREAK]--- Thank you, President Hicks and Tara Boehmler, for the kind introduction. ${ }^{1}$ Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected, including those in the Davidson College family. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. I am happy to be back at Davidson College. This is a special community. I am bound to it by a shared experience defined not by its length, but by its intensity. As I visited with you today, and as I look around this hall, I see the faces of colleagues who became dear friends during the COVID-19 pandemic. Back then, we spoke often about the unprecedented uncertainty we faced. Amidst that uncertainty, however, we supported each other on this campus. Now, looking back, we can attest that this mutual support was vital. I am grateful to have been amongst you during that unprecedented time. Today, I am proud to see that Davidson is stronger than ever. I am excited to be here with you this evening and to talk to you about the history of the Federal Reserve's discount window. ${ }^{2}$ The discount window is one of the tools the Fed uses to support the liquidity and stability of the banking system, and to implement [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ The discount window is a monetary policy facility where depository institutions can request to borrow money against collateral from the Fed. The term "window" originates with the now obsolete practice of sending a bank representative to a Reserve Bank physical teller window when a bank needed to borrow money. The term "discount" refers to how depository institutions borrow money on a discount basisinterest amount for the entire loan period (plus other charges, if any) is deducted from the principal at the time a loan is disbursed. ---[PAGE_BREAK]--- monetary policy effectively. It was created in 1913 when the Fed was established. Today, more than 110 years later, this tool continues to play an important role. At the Fed, we always look for ways to improve our tools, including our discount window operations. Recently, the Fed published a request for information document to receive feedback from the public regarding operational aspects of the discount window and intraday credit. ${ }^{3}$ Today, I will do three things. First, I will discuss briefly my outlook for the U.S. economy. Second, I will offer my historical perspective on the discount window, starting in 1913 and ending in 2000. Finally, I will provide a few details about the request for information the Fed recently published. Tomorrow, I will say more about the discount window when I speak at the Charlotte Economics Club. # Economic Outlook and Considerations for Monetary Policy Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. As you can see in slide 3, personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of [^0] [^0]: ${ }^{3}$ The Federal Reserve provides intraday credit to depository institutions to foster a safe and efficient payment system. For more information on intraday credit and the Board's Payment System Risk policy, see "Payment System Risk" on the Board's website at https://www.federalreserve.gov/paymentsystems/psr_about.htm. ---[PAGE_BREAK]--- households, businesses, and forecasters as well as measures from financial markets. Inflation is now much closer to the Federal Open Market Committee's (FOMC) 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. A shown in slide 4, the unemployment rate now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by $1 / 2$ percentage point, as shown in slide 5 . Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy ---[PAGE_BREAK]--- evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. # Discount Window History 1913: The Fed was established Now, I will turn to my perspective on the history of the discount window. Understanding this history is important as we consider ways to ensure the discount window continues to serve effectively in its critical role of providing liquidity to the banking system as the economy and financial system evolve. Before the Federal Reserve was founded, the U.S. experienced frequent financial panics. One example is illustrated in slide 6 with a newspaper clipping from the Rocky Mountain Times printed on July 19, 1893. It depicts panic swirling against banks at a time when bank runs swept through midwestern and western cities such as Chicago, Denver, and Los Angeles. The illustration shows how waves of panic hit public confidence, the rocks in the picture, and how banks have a fortress mentality. They stand strong against the panic, but they are not lending, and they are isolated. Back then, the supply of money to the economy was inelastic in the short term, in part because the monetary system in the U.S. was based on the gold standard. Demand for cash, however, varied over the course of the year and was particularly strong during harvest season, when crops were brought to the market. The surge in demand for cash, combined with the inelastic supply of money in the short term, caused financial conditions to tighten seasonally. The banking system was fairly good at moving money to where it needed to go, but it had little scope to expand the total amount of money available in response to the U.S. economy's needs. So if a shock hit the economy when ---[PAGE_BREAK]--- financial conditions were already tight, then the banking system struggled to provide the extra liquidity needed. Banks would seek to preserve liquidity by reducing their investments and denying loan requests, for example. Depositors, fearful that they might not be able to access their funds when they needed them, would rush to withdraw their money. Of course, that caused the banks to conserve further on liquidity. In some cases, they simply closed their doors until the storm passed. When banks closed their doors, economic activity would contract. ${ }^{4}$ Activity would recover when the banks reopened, but the economic suffering in the meantime was meaningful. In addition to the supply of money in the economy being inelastic in the short term, two prominent frictions, asymmetric information and externalities, made banks and private markets vulnerable to systemic crises. Here, asymmetric information refers to the fact that customers do not have access to all the information they need to evaluate whether a bank is insolvent, illiquid, or both. ${ }^{5}$ Therefore, customers rely on imperfect signals, such as news reports about another bank failing, to decide whether to withdraw their money from their own bank. Then there are externalities, in the sense that an individual bank may not consider how an innocent bystander may be negatively impacted by its actions. When a financial [^0] [^0]: ${ }^{4}$ See, for example, Goodhart (1988). ${ }^{5}$ Illiquidity is a short-term cash flow problem. An illiquid bank cannot pay its current obligations, such as deposit withdrawals, even though the value of the bank's assets exceeds the value of its liabilities. In other words, illiquidity means the bank does not currently have the resources to meet its current obligations. With a short-term loan, an illiquid bank would be able to pay its obligations. Insolvency is a long-term balance sheet problem. Total obligations of an insolvent bank are larger than its total assets. A short-term loan would not help an insolvent bank. Of course, evaluating the quality of a bank's loan book in real time to determine whether a bank is solvent can be extremely challenging during a crisis. In addition, in some cases, illiquidity caused by large deposit withdrawals can lead banks to sell assets at fire-sale prices that then impairs their solvency. Conversely, concerns about insolvency, even if unfounded, can lead to liquidity problems. In the bank run literature, the connections between liquidity and solvency are a key factor that gives rise to runs. ---[PAGE_BREAK]--- institution fails, that may lead depositors to withdraw money from other unrelated banks, which may in turn cause those banks to fail. Contagion can transform a single bank failure into a systemic crisis, where many banks fail, credit evaporates, the stock market collapses, the economy enters a recession, and the unemployment rate increases dramatically. The severe financial panic of 1907 stands out as an example of market failure due to these two prominent frictions. The panic was triggered by a series of bad banking decisions that led to a frenzy of withdrawals caused by asymmetric information and public distrust in the liquidity of the banking system. ${ }^{6}$ Banks in many large cities, including financial centers such as New York and Chicago, simply stopped sending payments outside of their communities. The resulting disruption in the payment system and to the flow of liquidity through the banking system led to a severe, though shortlived, economic contraction. This experience led Congress to pass the Federal Reserve Act in 1913. ${ }^{7}$ This act created the Federal Reserve System, composed of the Federal Reserve Board in Washington, D.C., and 12 Federal Reserve Banks across the country. ${ }^{8}$ In 1913, the main monetary policy tool at the Fed's disposal was the discount window. At that time, the Fed did not use open market operations-the buying and [^0] [^0]: ${ }^{6}$ The panic of 1907 started in October 1907 when three brothers-F. Augustus Heinze, Otto Heinze, and Arthur P. Heinze-as well as Charles W. Morse attempted to manipulate the price of United Copper stock by purchasing a large number of shares of the company. Their plan failed, and the stock price of United Copper collapsed. The collapse led to depositor runs on banks and trust companies associated with the Heinzes and Morse. This included a run on the Knickerbocker Trust Company, whose president was connected to Morse. The Knickerbocker Trust Company failed, and the New York Stock Exchange fell nearly 50 percent from its peak of the previous year in the wake of the failure. See Terrell (2021). ${ }^{7}$ To aid its thinking on reforming the monetary system, Congress established the National Monetary Commission. The landmark 24 volume report from the commission provides a rich review of the operations of central banks in other countries, a history of financial crises in the U.S., and an appraisal of the state of the contemporary banking system in the U.S. at the time. ${ }^{8}$ See "History and Purpose of the Federal Reserve" on the St. Louis Fed's website at https://www.stlouisfed.org/in-plain-english/history-and-purpose-of-the-fed. ---[PAGE_BREAK]--- selling of government securities in the open market-to conduct monetary policy. Instead, the Fed adjusted the money supply by lending directly to banks that needed funds through the discount window. The Fed's ability to provide funds to banks as needed made the money supply of the U.S. more elastic and considerably reduced the seasonal volatility in interest rates. ${ }^{9}$ This ability also enabled the Fed to provide stability in times of stress, helping banks that experienced rapid withdrawals to satisfy their customers' demand for liquidity and thereby potentially preventing banking panics. 1920s: The Fed began to discourage strongly use of the discount window In fact, many researchers have argued that the existence of the Fed's discount window prevented a financial crisis in the early 1920s, when the banking sector came under pressure as the U.S. economy transitioned to a peacetime economy following the end of World War I. ${ }^{10}$ There had been an agricultural boom during the war and a significant accumulation of debt within that sector. Farmers came under pressure as the prices of agricultural goods dropped from wartime highs. The banks sought to support their customers, and the Fed sought to support the banks. There were serious concerns about the condition of several banks in parts of the country. The Fed's discount window lending provided critical support that saved many banks but also resulted in habitual use of the discount window by some banks during the 1920s. ${ }^{11}$ Slide 7 shows that as of August 1925, 593 member banks, 6 percent of the total, had been borrowing for a year or more from Federal Reserve Banks. Moreover, there were real solvency problems, and several banks failed with discount window loans [^0] [^0]: ${ }^{9}$ See Miron (1986). ${ }^{10}$ See, for example, Gorton (1988). Willis (1923) and Board of Governors (1922) also suggest that the Fed prevented a crisis from happening in 1920. ${ }^{11}$ See Carlson (forthcoming). ---[PAGE_BREAK]--- outstanding. These challenges resulted in the Fed strongly discouraging banks from continuous borrowing from the discount window and the adoption of a policy of encouraging a "reluctance to borrow." 12 By 1926, the Fed was explicit that borrowing at the discount window was meant to be short term. As I emphasize in slide 8, the Federal Reserve's annual report for 1926 stated that while continuous borrowing by a member bank may be necessary, depending on local economic conditions, "the funds of the Federal reserve banks are primarily intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal reserve act." ${ }^{13}$ The late 1920s also highlighted Fed concerns about the purpose of the borrowing. The Fed sought to distinguish between "speculative security loans" and loans for "legitimate business." ${ }^{14}$ A staff reappraisal of the discount mechanism stated that " $[t]$ he controversy over direct pressure intensified in the latter part of the 1920s as an increasing flow of bank credit went into the stock market." ${ }^{15}$ In short, the Fed observed that some banks were becoming habitual borrowers from the discount window. It was concerned [^0] [^0]: ${ }^{12}$ See Shull (1971, pp. 33-34). ${ }^{13}$ See Board of Governors (1927, p. 4). In 1926, approximately one-third of all banks in the U.S. were member banks, holding about 60 percent of the total loans and investments for all banks; see Board of Governors (1926). Banks receiving charters from the federal government were required to become members of the Federal Reserve System while banks receiving charters from state governments had the option to become members. Discount window borrowing was originally limited to Federal Reserve System member banks. The Monetary Control Act of 1980 opened the window to all depository institutions. ${ }^{14}$ See Gorton and Metrick (2013). ${ }^{15}$ See Anderson (1971, p. 137). In the statement, "direct pressure" refers to the Fed policy of pressuring banks not to borrow from the window. Congress may have shared some of those concerns, as the Federal Reserve Act was amended in 1933 to include a passage in section 4 requiring Reserve Banks to be careful about speculative uses of the Federal Reserve credit. ---[PAGE_BREAK]--- that an overreliance on discount window borrowings would weaken banks and make them more prone to failure. In the late 1920s, the Fed switched to open market operations as its primary tool for conducting monetary policy. ${ }^{16}$ That allowed the Fed to determine the aggregate amount of liquidity in the system and to rely on private financial markets to distribute it efficiently. The discount window would thus serve as a safety valve if there was a shock that caused conditions to tighten unexpectedly or if individual banks experienced idiosyncratic shocks or somehow lost access to interbank markets. The intention of this set-up was for banks to use the discount window to borrow from the Fed only occasionally. Ordinarily and predominantly, financial institutions were supposed to rely on private markets for their funding. This set-up was designed to limit moral hazard-the possibility that institutions take unnecessary risks when there is no market discipline. This is the key balancing act. The Fed needs to be a reliable backstop to prevent financial crises, but it also needs to minimize moral hazard that comes from always standing ready to provide support. # 1930s-1940s: The Great Depression and WWII During the Great Depression in the 1930s, the banking system experienced severe stress, including many bank runs. There are many reasons why the discount window was insufficient to address the problems in the banking system in the 1930s. I will highlight only two. First, many banks were insolvent rather than illiquid. Central bank lending is not a fundamental solution in those circumstances. When banks are insolvent, it is [^0] [^0]: ${ }^{16}$ Open market operations are the purchase or sale of securities (for example, U.S. Treasury bonds) in the open market by the Fed. In modern times, the short-term objective for open market operations is specified by the FOMC. For more information, please refer to "Open Market Operations" on the Board's website at https://www.federalreserve.gov/monetarypolicy/openmarket.htm. ---[PAGE_BREAK]--- important to manage the closure in as orderly a manner as possible. The establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 gave bank regulators increased ability to do that. Relatedly, the challenging experiences of lending to troubled banks in the 1920s likely made the Fed more reluctant to lend in circumstances in which solvency concerns were material. Second, the types of collateral that the Fed was initially able to accept when lending to banks were quite limited. In response, in the early 1930s Congress expanded the range of banking assets that could serve as collateral for discount window loans and added a variety of new Fed emergency lending authorities. ${ }^{17}$ These new lending authorities were used in the 1930s to help alleviate distress. Some were also used in the early 1940s as the Fed helped support the World War II mobilization effort. The period following the war was relatively calm. The role of the discount window shifted from addressing distress in the banking system to acting as a safety valve to manage tightness in money markets and support monetary policy operations. # 1950-2000: Measures to discourage discount window borrowing In March 1951, the U.S. Treasury and the Fed reached an agreement to separate government debt management from the conduct of monetary policy, thereby laying the foundation for the modern Fed. ${ }^{18}$ [^0] [^0]: ${ }^{17}$ There are several banking acts that do this, but especially the Banking Act of 1932, the Emergency Relief and Construction Act of 1932, and the Banking Act of 1935. Yet one more reason why the discount window was insufficient to address the problems of the banking system in the 1930s is that, during this period, nonmember banks did not have access to the discount window. These banks suffered the most during the Great Depression. The ability of nonmember banks to access the window only changed in 1980 with the Monetary Control Act. ${ }^{18}$ After the U.S. entered World War II, the Federal Reserve supported efforts by the Treasury to hold down the cost of financing the war by establishing caps on interest rates on Treasury securities (see, for instance, Meltzer, 2003, Chapter 7). The cap pertaining to longer-term interest rates continued to be in place until the 1951 agreement. ---[PAGE_BREAK]--- In the 1950s, the Fed set the interest rate on discount window loans above market rates. Thus, it served as an effective ceiling on the federal funds rate. The Fed continued to discourage extensive use of the discount window, but the relatively high interest rate also made its sustained use less attractive. In the 1960s, the Fed placed greater emphasis on open market operations to set its monetary policy stance. Concurrently, the Fed shifted to a policy of setting the interest rate on discount window loans below the market rates. Because the interest rate no longer deterred use of the window, the Fed turned increasingly to other measures, such as administrative pressures and moral suasion, to limit the frequency with which banks requested loans from the discount window. Indeed, between the late 1920s and the 1980s, the Fed adopted and amended numerous restrictions on discount window borrowing. Whenever discount window usage increased too much, the Fed tightened the restrictions to suppress borrowing. For example, in the 1950s, the Fed defined appropriate and inappropriate discount window borrowing. In particular, the Board's regulations in 1955 stated that "[u]nder ordinary conditions, the continuous use of Federal Reserve credit by a member bank over a considerable period of time is not regarded as appropriate" and provided more details on how Reserve Banks should evaluate the "purpose" of a credit request. ${ }^{19}$ By 1973, the Board had made additional changes to its regulations on discount window use and defined three distinct discount window programs: adjustment credit, intended to help depository institutions meet short-term liquidity needs; seasonal credit, intended to help small depository institutions manage liquidity needs that arise from seasonal swings in [^0] [^0]: ${ }^{19}$ See Board of Governors of the Federal Reserve System, Advances and Discounts by Federal Reserve Banks, 20 Fed. Reg. 261, 263 (Jan. 12, 1955). ---[PAGE_BREAK]--- loans and deposits; and extended credit, intended to help depository institutions that have somewhat longer-term liquidity needs resulting from exceptional circumstances. ${ }^{20}$ Over time, the Board added provisions in its regulations requiring banks to exhaust other sources of funding before using discount window credit. ${ }^{21}$ In addition, in the early 1980s, the Fed levied a surcharge on frequent borrowings by large banks to augment the administrative restrictions. ${ }^{22}$ Despite these policies to discourage use of the discount window, slide 9 shows that discount window borrowing, adjusted for the size of the Federal Reserve's balance sheet, was notable in the 1970s and 1980s, suggesting that the discount window was an important marginal source of funding for banks during that period. That changed in the 1980s and early 1990s, when there were notable solvency problems in the banking industry. During this period, the discount window provided support to troubled institutions, while the FDIC sought to find merger partners or otherwise manage the failure of these institutions in an orderly manner. The discount window activity that took place while FDIC resolutions proceeded increased the association between use of the discount window and being a troubled institution. ${ }^{23}$ As a result, banks became more reluctant to borrow from the discount window. The greater [^0] [^0]: ${ }^{20}$ See Board of Governors of the Federal Reserve System, Extensions of Credit by Federal Reserve Banks, 38 Fed. Reg. 9065, 9076-9077 (April 10, 1973). ${ }^{21}$ By 1980, the Board's regulations stated that adjustment credit "generally is available only after reasonable alternative sources of funds, including credit from special industry lenders, such as Federal Home Loan Banks, the National Credit Union Administration's Central Liquidity Facility, and corporate central credit unions have been fully used"; seasonal credit was "available only if similar assistance is not available from other special industry lenders"; and other extended credit was available only "where similar assistance is not reasonably available from other sources, including special industry lenders"; see Board of Governors of the Federal Reserve System, Extensions of Credit by Federal Reserve Banks, 45 Fed. Reg. 54009, 54009-54011 (Aug. 14, 1980). See also Clouse (1994). ${ }^{22}$ See Meulendyke (1992). ${ }^{23}$ A congressional inquiry found that this lending likely increased losses to the deposit insurance funds at the time and led to limitations on the ability of the Federal Reserve to provide loans to troubled depository institutions as part of the Federal Deposit Insurance Corporation Improvement Act of 1991. ---[PAGE_BREAK]--- reluctance to borrow from the discount window made it less effective, both as a monetary policy tool and as a crisis-fighting tool. That resulted in a series of efforts by the Fed in the early 2000s to change how the discount window operates. Tomorrow, I will discuss those efforts when I speak at the Charlotte Economics Club. # A request for information Before closing, I'd like to return to where I began. Understanding the history of the discount window is important as we consider ways to ensure it continues to serve effectively in its critical role in providing liquidity to the banking system as the economy and financial system evolve. One way to ensure it continues to serve effectively is to collect feedback from the public. Slide 10 provides some touch points on the Board's request for information document. The request for information seeks feedback from the public on a range of operational practices for the discount window and intraday credit, including the collection of legal documents; the process for pledging and withdrawing collateral; the process for requesting, receiving and repaying discount window advances; the extension of intraday credit; and Reserve Bank communications practices. My colleagues and I are looking forward to this feedback to inform potential future enhancements to discount window operations. The period for responding to our request for information ends on December 9, 2024. Thank you to the event organizers and to the Davidson College community for the opportunity to discuss this important topic with you. It has been such a pleasure to be back on campus. ---[PAGE_BREAK]--- # References Anderson, Clay (1971). "Evolution of the Role and the Functioning of the Discount Mechanism," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1. Washington: Board of Governors of the Federal Reserve System, pp. 133-65, https://fraser.stlouisfed.org/title/reappraisal-federal-reserve-discount-mechanism1206?browse $=1970 \mathrm{~s} \# 3578$. Board of Governors of the Federal Reserve System (1922). 8th Annual Report, 1921. Washington: Government Printing Office, https://fraser.stlouisfed.org/title/annual-report-board-governors-federal-reserve-system-117/1921-2479. (1926). Federal Reserve Bulletin, vol. 12 (July), https://fraser.stlouisfed.org/title/federal-reserve-bulletin-62/july-1926-20655. (1927). 13th Annual Report, 1926. Washington: Government Printing Office, https://fraser.stlouisfed.org/title/annual-report-board-governors-federal-reserve-system-117/1926-2484. Carlson, Mark (forthcoming). The Young Fed: The Banking Crises of the 1920s and the Making of a Lender of Last Resort. Chicago: University of Chicago Press. Clouse, James (1994). "Recent Developments in Discount Window Policy," Federal Reserve Bulletin, vol. 80 (November), pp. 965-77, https://www.federalreserve.gov/monetarypolicy/1194lead.pdf. Goodhart, Charles A.E. (1988). The Evolution of Central Banks. Cambridge, Mass.: MIT Press. Gorton, Gary (1988). "Banking Panics and Business Cycles," Oxford Economic Papers, vol. 40 (December), pp. 751-81. Gorton, Gary, and Andrew Metrick (2013). "The Federal Reserve and Financial Regulation: The First Hundred Years," NBER Working Paper Series 19292. Cambridge, Mass.: National Bureau of Economic Research, August, https://www.nber.org/papers/w19292. Meltzer, Allan (2003). A History of the Federal Reserve, Volume 1: 1913-1951. Chicago: University of Chicago Press. Miron, Jeffrey A. (1986). "Financial Panics, the Seasonality of the Nominal Interest Rate, and the Founding of the Fed," American Economic Review, vol. 76 (March), pp. 125-40. ---[PAGE_BREAK]--- Meulendyke, Ann-Marie (1992). "Reserve Requirements and the Discount Window in Recent Decades," Federal Reserve Bank of New York, Quarterly Review, vol. 17 (Autumn), pp. 25-43, https://www.newyorkfed.org/medialibrary/media/research/quarterly_review/1992 v17/v17n3article3.pdf. Shull, Bernard (1971). "Report on Research Undertaken in Connection with a System Study," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1. Washington: Board of Governors of the Federal Reserve System, pp. 27-77, https://fraser.stlouisfed.org/title/reappraisal-federal-reserve-discount-mechanism1206?browse $=1970 \mathrm{~s}$. Terrell, Ellen (2021). "United Copper, Wall Street, and the Panic of 1907," Library of Congress, Inside Adams: Science, Technology \& Business (blog), March 9, https://blogs.loc.gov/inside_adams/2021/03/united-copper-panic-of-1907. Willis, Henry Parker (1923). The Federal Reserve System: Legislation, Organization and Operation. New York: The Ronald Press Company. ---[PAGE_BREAK]--- ![img-0.jpeg](img-0.jpeg) # A History of the Fed's Discount Window: 1913-2000 Philip N. Jefferson Vice Chair, Federal Reserve Board Davidson College, Oct. 8, 2024 Disclaimer: The views I will express today are my own and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve System. ---[PAGE_BREAK]--- # Roadmap of Talk - Economic Outlook - Historical Perspective on Discount Window - Request for Information ---[PAGE_BREAK]--- Figure 1: PCE and Core PCE Inflation ![img-1.jpeg](img-1.jpeg) Note: Percent change in the personal consumption expenditures (PCE) price index from 12 months ago. Core refers to the price index excluding food and energy. The gray shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research. The shaded recession period extends from February 2020 through April 2020. Source: Bureau of Economic Analysis, Personal Consumption Expenditures Price Index. ---[PAGE_BREAK]--- Figure 2: Unemployment Rate ![img-2.jpeg](img-2.jpeg) Note: The unemployment rate represents the number of unemployed persons as a percentage of the labor force. The gray shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research. The shaded recession period extends from February 2020 through April 2020. Source: U.S. Bureau of Labor Statistics, Employment Situation report. ---[PAGE_BREAK]--- Figure 3: Effective Federal Funds Rate ![img-3.jpeg](img-3.jpeg) Note: Average daily effective federal funds rate. Source: Board of Governors of the Federal Reserve System. ---[PAGE_BREAK]--- Figure 4. Newspaper Illustration from 1893 ![img-4.jpeg](img-4.jpeg) - Panic swirling against banks - Public confidence is stopping the waves - Banks have a fortress mentality, not lending, isolated Rocky Mountain Times, July 19, 1893 ---[PAGE_BREAK]--- # Table 1. Member Banks Borrowing Continuously for a Year or More from Reserve Banks \| As of \| Number \| \| :-- \| :-- \| \| August 31, 1925 \| 593 \| \| December 31, 1925 \| 517 \| \| December 31, 1926 \| 457 \| \| December 31, 1927 \| 303 \| Source: Bernard Shull (1971), "Report on Research Undertaken in Connection with a System Study," in Reappraisal of the Federal Reserve Discount Mechanism, vol. 1 (Washington: Board of Governors of the Federal Reserve System), table 1, p. 34. ---[PAGE_BREAK]--- # In 1926 the Fed Encourages a Reluctance to Borrow from Discount Window "the funds of the Federal Reserve banks are primarily intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal Reserve Act." 1926 Federal Reserve Annual Report, page 4. ---[PAGE_BREAK]--- Figure 5: Discount Window Borrowing ![img-5.jpeg](img-5.jpeg) Note: Discount window borrowing as a percent of total assets computed using Federal Reserve of St. Louis FRED weekly total bills discounted (RABDTBD) divided by total assets (TOTRA) times one hundred, and averaged over the month. Source: The Center for Financial Stability; The Federal Reserve System's Weekly Balance Sheet Since 1914; accessed via Federal Reserve Bank of St. Louis FRED. ---[PAGE_BREAK]--- # Request for Information (RFI) - RFI published in the Federal Register on September 10, 2024 - You can find the RFI at https://www.federalregister.gov - Comment period is open until December 9, 2024	Philip N Jefferson	United States	https://www.bis.org/review/r241009a.pdf	For release on delivery 7:30 p.m. EDT October 8, 2024 A History of the Fed's Discount Window: 1913-2000 Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at Davidson College Davidson, North Carolina October 8, 2024 Thank you, President Hicks and Tara Boehmler, for the kind introduction. Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected, including those in the Davidson College family. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. I am happy to be back at Davidson College. This is a special community. I am bound to it by a shared experience defined not by its length, but by its intensity. As I visited with you today, and as I look around this hall, I see the faces of colleagues who became dear friends during the COVID-19 pandemic. Back then, we spoke often about the unprecedented uncertainty we faced. Amidst that uncertainty, however, we supported each other on this campus. Now, looking back, we can attest that this mutual support was vital. I am grateful to have been amongst you during that unprecedented time. Today, I am proud to see that Davidson is stronger than ever. I am excited to be here with you this evening and to talk to you about the history of the Federal Reserve's discount window. The discount window is one of the tools the Fed uses to support the liquidity and stability of the banking system, and to implement monetary policy effectively. It was created in 1913 when the Fed was established. Today, more than 110 years later, this tool continues to play an important role. At the Fed, we always look for ways to improve our tools, including our discount window operations. Recently, the Fed published a request for information document to receive feedback from the public regarding operational aspects of the discount window and intraday credit. Today, I will do three things. First, I will discuss briefly my outlook for the U.S. economy. Second, I will offer my historical perspective on the discount window, starting in 1913 and ending in 2000. Finally, I will provide a few details about the request for information the Fed recently published. Tomorrow, I will say more about the discount window when I speak at the Charlotte Economics Club. Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. As you can see in slide 3, personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of households, businesses, and forecasters as well as measures from financial markets. Inflation is now much closer to the Federal Open Market Committee's (FOMC) 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. A shown in slide 4, the unemployment rate now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by $1 / 2$ percentage point, as shown in slide 5 . Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. 1913: The Fed was established Now, I will turn to my perspective on the history of the discount window. Understanding this history is important as we consider ways to ensure the discount window continues to serve effectively in its critical role of providing liquidity to the banking system as the economy and financial system evolve. Before the Federal Reserve was founded, the U.S. experienced frequent financial panics. One example is illustrated in slide 6 with a newspaper clipping from the Rocky Mountain Times printed on July 19, 1893. It depicts panic swirling against banks at a time when bank runs swept through midwestern and western cities such as Chicago, Denver, and Los Angeles. The illustration shows how waves of panic hit public confidence, the rocks in the picture, and how banks have a fortress mentality. They stand strong against the panic, but they are not lending, and they are isolated. Back then, the supply of money to the economy was inelastic in the short term, in part because the monetary system in the U.S. was based on the gold standard. Demand for cash, however, varied over the course of the year and was particularly strong during harvest season, when crops were brought to the market. The surge in demand for cash, combined with the inelastic supply of money in the short term, caused financial conditions to tighten seasonally. The banking system was fairly good at moving money to where it needed to go, but it had little scope to expand the total amount of money available in response to the U.S. economy's needs. So if a shock hit the economy when financial conditions were already tight, then the banking system struggled to provide the extra liquidity needed. Banks would seek to preserve liquidity by reducing their investments and denying loan requests, for example. Depositors, fearful that they might not be able to access their funds when they needed them, would rush to withdraw their money. Of course, that caused the banks to conserve further on liquidity. In some cases, they simply closed their doors until the storm passed. When banks closed their doors, economic activity would contract. Activity would recover when the banks reopened, but the economic suffering in the meantime was meaningful. In addition to the supply of money in the economy being inelastic in the short term, two prominent frictions, asymmetric information and externalities, made banks and private markets vulnerable to systemic crises. Here, asymmetric information refers to the fact that customers do not have access to all the information they need to evaluate whether a bank is insolvent, illiquid, or both. Therefore, customers rely on imperfect signals, such as news reports about another bank failing, to decide whether to withdraw their money from their own bank. Then there are externalities, in the sense that an individual bank may not consider how an innocent bystander may be negatively impacted by its actions. When a financial institution fails, that may lead depositors to withdraw money from other unrelated banks, which may in turn cause those banks to fail. Contagion can transform a single bank failure into a systemic crisis, where many banks fail, credit evaporates, the stock market collapses, the economy enters a recession, and the unemployment rate increases dramatically. The severe financial panic of 1907 stands out as an example of market failure due to these two prominent frictions. The panic was triggered by a series of bad banking decisions that led to a frenzy of withdrawals caused by asymmetric information and public distrust in the liquidity of the banking system. Banks in many large cities, including financial centers such as New York and Chicago, simply stopped sending payments outside of their communities. The resulting disruption in the payment system and to the flow of liquidity through the banking system led to a severe, though shortlived, economic contraction. This experience led Congress to pass the Federal Reserve Act in 1913. In 1913, the main monetary policy tool at the Fed's disposal was the discount window. At that time, the Fed did not use open market operations-the buying and selling of government securities in the open market-to conduct monetary policy. Instead, the Fed adjusted the money supply by lending directly to banks that needed funds through the discount window. The Fed's ability to provide funds to banks as needed made the money supply of the U.S. more elastic and considerably reduced the seasonal volatility in interest rates. This ability also enabled the Fed to provide stability in times of stress, helping banks that experienced rapid withdrawals to satisfy their customers' demand for liquidity and thereby potentially preventing banking panics. 1920s: The Fed began to discourage strongly use of the discount window In fact, many researchers have argued that the existence of the Fed's discount window prevented a financial crisis in the early 1920s, when the banking sector came under pressure as the U.S. economy transitioned to a peacetime economy following the end of World War I. Slide 7 shows that as of August 1925, 593 member banks, 6 percent of the total, had been borrowing for a year or more from Federal Reserve Banks. Moreover, there were real solvency problems, and several banks failed with discount window loans outstanding. These challenges resulted in the Fed strongly discouraging banks from continuous borrowing from the discount window and the adoption of a policy of encouraging a "reluctance to borrow." 12 By 1926, the Fed was explicit that borrowing at the discount window was meant to be short term. As I emphasize in slide 8, the Federal Reserve's annual report for 1926 stated that while continuous borrowing by a member bank may be necessary, depending on local economic conditions, "the funds of the Federal reserve banks are primarily intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal reserve act." The late 1920s also highlighted Fed concerns about the purpose of the borrowing. The Fed sought to distinguish between "speculative security loans" and loans for "legitimate business." In short, the Fed observed that some banks were becoming habitual borrowers from the discount window. It was concerned that an overreliance on discount window borrowings would weaken banks and make them more prone to failure. In the late 1920s, the Fed switched to open market operations as its primary tool for conducting monetary policy. That allowed the Fed to determine the aggregate amount of liquidity in the system and to rely on private financial markets to distribute it efficiently. The discount window would thus serve as a safety valve if there was a shock that caused conditions to tighten unexpectedly or if individual banks experienced idiosyncratic shocks or somehow lost access to interbank markets. The intention of this set-up was for banks to use the discount window to borrow from the Fed only occasionally. Ordinarily and predominantly, financial institutions were supposed to rely on private markets for their funding. This set-up was designed to limit moral hazard-the possibility that institutions take unnecessary risks when there is no market discipline. This is the key balancing act. The Fed needs to be a reliable backstop to prevent financial crises, but it also needs to minimize moral hazard that comes from always standing ready to provide support. During the Great Depression in the 1930s, the banking system experienced severe stress, including many bank runs. There are many reasons why the discount window was insufficient to address the problems in the banking system in the 1930s. I will highlight only two. First, many banks were insolvent rather than illiquid. Central bank lending is not a fundamental solution in those circumstances. When banks are insolvent, it is important to manage the closure in as orderly a manner as possible. The establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 gave bank regulators increased ability to do that. Relatedly, the challenging experiences of lending to troubled banks in the 1920s likely made the Fed more reluctant to lend in circumstances in which solvency concerns were material. Second, the types of collateral that the Fed was initially able to accept when lending to banks were quite limited. In response, in the early 1930s Congress expanded the range of banking assets that could serve as collateral for discount window loans and added a variety of new Fed emergency lending authorities. These new lending authorities were used in the 1930s to help alleviate distress. Some were also used in the early 1940s as the Fed helped support the World War II mobilization effort. The period following the war was relatively calm. The role of the discount window shifted from addressing distress in the banking system to acting as a safety valve to manage tightness in money markets and support monetary policy operations. In March 1951, the U.S. Treasury and the Fed reached an agreement to separate government debt management from the conduct of monetary policy, thereby laying the foundation for the modern Fed. In the 1950s, the Fed set the interest rate on discount window loans above market rates. Thus, it served as an effective ceiling on the federal funds rate. The Fed continued to discourage extensive use of the discount window, but the relatively high interest rate also made its sustained use less attractive. In the 1960s, the Fed placed greater emphasis on open market operations to set its monetary policy stance. Concurrently, the Fed shifted to a policy of setting the interest rate on discount window loans below the market rates. Because the interest rate no longer deterred use of the window, the Fed turned increasingly to other measures, such as administrative pressures and moral suasion, to limit the frequency with which banks requested loans from the discount window. Indeed, between the late 1920s and the 1980s, the Fed adopted and amended numerous restrictions on discount window borrowing. Whenever discount window usage increased too much, the Fed tightened the restrictions to suppress borrowing. For example, in the 1950s, the Fed defined appropriate and inappropriate discount window borrowing. In particular, the Board's regulations in 1955 stated that "nder ordinary conditions, the continuous use of Federal Reserve credit by a member bank over a considerable period of time is not regarded as appropriate" and provided more details on how Reserve Banks should evaluate the "purpose" of a credit request. By 1973, the Board had made additional changes to its regulations on discount window use and defined three distinct discount window programs: adjustment credit, intended to help depository institutions meet short-term liquidity needs; seasonal credit, intended to help small depository institutions manage liquidity needs that arise from seasonal swings in loans and deposits; and extended credit, intended to help depository institutions that have somewhat longer-term liquidity needs resulting from exceptional circumstances. Over time, the Board added provisions in its regulations requiring banks to exhaust other sources of funding before using discount window credit. Despite these policies to discourage use of the discount window, slide 9 shows that discount window borrowing, adjusted for the size of the Federal Reserve's balance sheet, was notable in the 1970s and 1980s, suggesting that the discount window was an important marginal source of funding for banks during that period. That changed in the 1980s and early 1990s, when there were notable solvency problems in the banking industry. During this period, the discount window provided support to troubled institutions, while the FDIC sought to find merger partners or otherwise manage the failure of these institutions in an orderly manner. The discount window activity that took place while FDIC resolutions proceeded increased the association between use of the discount window and being a troubled institution. As a result, banks became more reluctant to borrow from the discount window. The greater reluctance to borrow from the discount window made it less effective, both as a monetary policy tool and as a crisis-fighting tool. That resulted in a series of efforts by the Fed in the early 2000s to change how the discount window operates. Tomorrow, I will discuss those efforts when I speak at the Charlotte Economics Club. Before closing, I'd like to return to where I began. Understanding the history of the discount window is important as we consider ways to ensure it continues to serve effectively in its critical role in providing liquidity to the banking system as the economy and financial system evolve. One way to ensure it continues to serve effectively is to collect feedback from the public. Slide 10 provides some touch points on the Board's request for information document. The request for information seeks feedback from the public on a range of operational practices for the discount window and intraday credit, including the collection of legal documents; the process for pledging and withdrawing collateral; the process for requesting, receiving and repaying discount window advances; the extension of intraday credit; and Reserve Bank communications practices. My colleagues and I are looking forward to this feedback to inform potential future enhancements to discount window operations. The period for responding to our request for information ends on December 9, 2024. Thank you to the event organizers and to the Davidson College community for the opportunity to discuss this important topic with you. It has been such a pleasure to be back on campus. Carlson, Mark (forthcoming). The Young Fed: The Banking Crises of the 1920s and the Making of a Lender of Last Resort. Chicago: University of Chicago Press. Philip N. Jefferson Vice Chair, Federal Reserve Board Davidson College, Oct. 8, 2024 Disclaimer: The views I will express today are my own and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve System. Economic Outlook. Historical Perspective on Discount Window. Request for Information. Panic swirling against banks. Public confidence is stopping the waves. Banks have a fortress mentality, not lending, isolated. Rocky Mountain Times, July 19, 1893 "the funds of the Federal Reserve banks are primarily intended to be used in meeting the seasonal and temporary requirements of members, and continuous borrowing by a member bank as a general practice would not be consistent with the intent of the Federal Reserve Act." RFI published in the Federal Register on September 10, 2024. You can find the RFI at https://www.federalregister.gov. Comment period is open until December 9, 2024.
2024-10-08T00:00:00	Adriana D Kugler: The global fight against inflation	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Conference on Monetary Policy 2024 "Bridging Science and Practice, European Central Bank", Frankfurt am Main, Germany, 8 October 2024.	For release on delivery 3:00 a.m. EDT (9:00 a.m. local time) October 8, 2024 The Global Fight Against Inflation Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany October 8, 2024 Thank you, Isabel, and thank you for the opportunity to speak here at the ECB today.1 I am particularly pleased to be part of this year's conference because the theme you have chosen has, for some time now, also been a theme of my career as an academic and public servant. Every day, of course, central bankers must bridge science and practice, drawing on the insights that research provides, specifically, because the economy and the world are continuously subject to new circumstances. We must do so, and put those insights into practice, because everyone in the United States, and in Europe, and around the world, depends on a healthy and growing economy, and depends on policymakers making the right decisions to help keep it that way. But well before I came to the Federal Reserve, I was also bridging science and practice. First, as a labor economist, when, for example, I was exploring how employment, productivity, and earnings are influenced not only by educational attainment and experience, but also by policies. Later, as chief economist at the Department of Labor, I brought science to bear in carrying out its mission of supporting workers. As the U.S. representative at the World Bank, economic science was likewise crucial in deciding how to best direct the institution's resources to where they were needed the most. In each of these roles, I have learned a bit more about the need to balance rigorous scientific understanding of the problems that people face with the real- world experiences of those people, which sometimes do not fit so neatly into an economic theorem or principle. Most recently, my colleagues and I on the Federal Open Market Committee (FOMC) have been focused on the very practical task of reducing inflation while keeping - 2 - employment at its maximum level. To understand the recent experience of high inflation in the United States, it is helpful to consider how inflation behaved around the world after the advent of the COVID-19 pandemic. In the remainder of my remarks, I will discuss the global dimensions of the recent bout of high inflation in different economies, both comparing similarities and contrasting differences, with a special emphasis on the factors that enabled the United States to achieve disinflation while having stronger economic activity relative to its peers. I will then conclude with some comments on the U.S. economic outlook and the implications for monetary policy. Starting with the similarities in our inflationary experiences, in early 2020, a worldwide pandemic disrupted the global economy and ultimately caused a surge of inflation around the world. Global goods production was hobbled, transportation and other aspects of supply chains became entangled, and there were significant labor shortages, all combining to cause a severe imbalance between supply and demand in much of the world. Sharp increases in commodity prices were exacerbated by Russia's invasion of Ukraine. The result was a global escalation of inflation. As you can see by the black line on slide 2, a measure of world headline inflation in 26 economies accounting for 60 percent of global gross domestic product (GDP) rose to a degree that had not been experienced since the early 1980s. This worldwide increase of inflation was synchronized and widespread across advanced and emerging economies. To measure the synchronization and breadth of this inflationary period, Federal Reserve Board researchers have employed a dynamic factor - 3 - model to estimate a common component of inflation across these 26 economies.2 As you can see by the blue line on slide 2, the estimated global component accounts for a large share of the variation of headline inflation among these economies after inflation began rising sharply in 2021. This evidence is consistent with the familiar story of widespread lockdowns, shutdowns of manufacturing plants in different parts of the world, disrupted logistic networks, increases in shipping costs, and longer delivery times. In the recovery, we also saw globally higher demand for commodities, intermediate inputs, and final goods and services, with demand exceeding a still-constrained supply. Indeed, one important contributor to the recent co-movement in inflation across the world has been food and energy prices. As you know, most of the time variations in inflation are heavily influenced by food and energy prices, which tend to be more volatile than the prices for other goods and services. Because many food and energy commodities are traded internationally, retail prices paid by consumers also tend to have some degree of global synchronization. Thus, as you would expect, the black line in the left chart on slide 3 shows that food and energy inflation faced by consumers around the world-here called noncore inflation-rose substantially in the recent inflationary episode. Moreover, world noncore inflation is largely accounted for by its global component in yellow, thus also showing a high degree of global synchronization. Another thing we can say about the recent worldwide escalation of inflation is how widely diffused it was across different price categories. Core inflation excludes food - 4 - and energy prices, and it includes many categories more exposed to domestic conditions such as housing and medical services. Yet, as shown by the black and red lines in the right chart on slide 3, the recent rise in core inflation showed a high degree of global synchronization, with the global component accounting for a large share of the post- pandemic inflation. Looking back in history, this is the first time since the 1970s that we saw a rise in core inflation so widespread across such a large number of countries. Moreover, underlying this rise in core inflation in the United States and other advanced economies, research carried out by Federal Reserve Board economists shows that there was a widespread rise in prices across the whole range of categories within the core basket.3 Academics and policymakers have debated about the possible reasons explaining the recent co-movement of inflation around the world. The COVID-19 pandemic was a global phenomenon and had effects on supply and demand that were similar in many countries. On the supply side, businesses closed, affecting goods production and the provision of services. There were labor shortages due to illness, social distancing, early retirements, and declines in immigration, with all of these factors making it harder to produce goods and services.4 Production disruptions and labor shortages propagated 3 I refer to updated estimates from the following works: Hie Joo Ahn and Matteo Luciani (2020), "Common and Idiosyncratic Inflation," Finance and Economics Discussion Series 2020-024 (Washington: Board of Governors of the Federal Reserve System, March; revised August 2024), https://doi.org/10.17016/FEDS.2020.024r1; and Eli Nir, Flora Haberkorn, and Danilo Cascaldi-Garcia (2021), "International Measures of Common Inflation," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, November 5), https://www.federalreserve.gov/econres/notes/fedsnotes/international-measures-of-common-inflation-20211105.html. 4 See Danilo Cascaldi-Garcia, Musa Orak, and Zina Saijid (2023), "Drivers of Post-Pandemic Inflation in Selected Advanced Economies and Implications for the Outlook," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, January 13), https://www.federalreserve.gov/econres/notes/fedsnotes/drivers-of-post-pandemic-inflation-in-selected-advanced-economies-and-implications-for-theoutlook-20230113.html. - 5 - around the world due to long and intricate supply chains forged over several decades of growing globalization in trade. The imbalance between supply and demand widened as consumers switched their spending from services to goods, straining transportation capacity that further disrupted supply chains.5 This re-allocation of demand from services to goods also strained the ability of firms to produce, as they struggled to find qualified workers due to the needed re-allocation of workers across sectors.6 This demand was also likely fueled by the fiscal response to COVID-19 in 2020 and 2021. All of these factors drove up costs, and there were others. Russia's war on Ukraine intensified the increases in energy and food commodity prices during the recovery from the pandemic. And the interaction of these different forces also likely played a role.7 For example, as Asia increased production to meet higher demand for goods in the U.S., this may have driven up wages and other input costs in Asia, increasing demand for imports from other places and, in turn, raising costs there, and so on. My assessment is that both supply and demand contributed to the recent global inflationary episode, including in the United States, with international trade of goods, including commodities, and services playing an important role in disseminating these forces around the world. One salient aspect of past inflationary episodes is the observation that core inflation typically falls more slowly than it increases. As we can see by the red lines on slide 4, world core inflation rose more quickly than it decreased in the three most recent - 6 - episodes of significant inflation and disinflation-from a trough in 1972 to a new trough in 1978; from 1978 to a trough in 1986; and then the recent episode, from the end of 2020 through the first quarter of 2024. In these episodes, the escalation of four-quarter core inflation increased by an average of 7/10 percentage point per quarter to its peak, while it decreased by an average of only 3/10 percentage point per quarter to the trough.8 Still, it is important that central bankers not only compare similarities across economies in the recent inflation fight, but also contrast the differences. Notably, another important feature of the last three inflation and disinflation periods is that though the share of core inflation explained by the common component increases when inflation rises, this share decreases when inflation falls, as can be seen by the black shaded areas of the three panels on slide 4. This suggests that while the reasons underlying the co- movement of inflation across the world-such as global supply disruptions and commodity price shocks-may have been important when prices were increasing, they have been less important when prices have decreased. This evidence indicates that factors that vary from economy to economy become more relevant in the disinflationary period. Economic researchers have raised several possible explanations for the different inflation trajectories experienced by different economies during this post-pandemic period. For example, some point to differences in the magnitudes of the demand and supply imbalances driven by the shutdown and reopening of each economy, with this - 7 - imbalance possibly playing a larger role on inflation in the euro area relative to the United States.9 While noting that differences in the size of fiscal stimulus in different countries were likely important, the targeting of that stimulus also differed, in some cases with a greater emphasis on addressing supply disruptions.10 Global factors also affect various economies differently, with studies showing that the exposures to fluctuations in commodity prices are an important issue.11 For instance, Europe was heavily affected by natural gas shortages related to Russia's war on Ukraine, while gas supplies in the United States were more plentiful during this period. Also, supply chains were untangled at different speeds in different parts of the world, with, for instance, low water levels in the Panama Canal and attacks in the Red Sea by Houthi rebels affecting different shipping routes differently around the world. And, last but not least, differences in labor market tightness very likely played a role, with evidence pointing to its importance in the United States in driving up nominal wage growth, a factor that likely helped keep employment and economic activity at healthy levels.12 9 See Domenico Giannone and Giorgio Primiceri (2024), "The Drivers of Post-Pandemic Inflation," NBER Working Paper Series 32859 (Cambridge, Mass.: National Bureau of Economic Research, August), https://www.nber.org/papers/w32859. 10 For the economic effects on the size of fiscal stimuli, see Oscar Jorda and Fernanda Nechio (2023), "Inflation and Wage Growth since the Pandemic," European Economic Review, vol. 156, 104474. 11 See Christiane Baumeister, Gert Peersman, and Ine Van Robays (2010), "The Economic Consequences of Oil Shocks: Differences across Countries and Time," in Renee Fry, Callum Jones, and Christopher Kent, eds., Inflation in an Era of Relative Price Shocks (Sydney: Reserve Bank of Australia), pp. 91-128, https://www.rba.gov.au/publications/confs/2009/pdf/conf-vol-2009.pdf; and Andrea De Michelis, Thiago Ferreira, and Matteo Iacoviello (2020), "Oil Prices and Consumption across Countries and U.S. States," International Journal of Central Banking, vol. 16 (March), pp. 3-43. 12 For the effects of labor market tightness on price and wage inflation, see Olivier J. Blanchard and Ben S. Bernanke (2022), "What Caused the U.S. Pandemic-Era Inflation?" NBER Working Paper Series 31417 (Cambridge, Mass.: National Bureau of Economic Research, June), https://www.nber.org/papers/w31417; Olivier J. Blanchard and Ben S. Bernanke (2024), "An Analysis of Pandemic-Era Inflation in 11 Economies," NBER Working Paper Series 32532 (Cambridge, Mass.: National Bureau of Economic Research, May), https://www.nber.org/papers/w32532. - 8 - Researchers at the Board of Governors also find that differences in the pace of disinflation across countries have been largely driven by different trajectories of services price inflation.13 As shown on slide 5, they find that the dispersion of inflation across countries peaked in 2023 and has been declining since then for headline and core goods, but not so much for core services inflation, with housing developments helping to account for the differences in services inflation. Other cross-country research suggests that wage developments help explain services inflation dynamics.14 Indeed, services inflation from both the United States and the euro area have been elevated. Still, while U.S. housing services inflation has been running higher than the wage-driven nonhousing component, the reverse is true in the euro area. While the cross-country differences during the recent bout of high inflation have emerged more prominently during the disinflationary period, economic growth has been very heterogenous since the onset of the COVID-19 pandemic. Generally speaking, the U.S. has experienced a significantly stronger recovery than other advanced economies. As we can see in the left panel on slide 6, real GDP has grown substantially more in the United States since 2021. This is also the case with respect to the larger components of GDP, such as consumption and investment, shown in the right two panels. In explaining why the U.S. has managed to bring down inflation and experience strong economic activity, I believe that the combination of restrictive monetary policy - 9 - together with convex supply curves can help explain these developments.15 In addition, there are three supply-related factors that have also made significant contributions to the combination of rapid disinflation together with continued and resilient growth. First, there are important factors that have affected total factor productivity differently across countries. For instance, the U.S. has seen greater business dynamism, as reflected in a higher rate of new business formation, shown in the left panel on slide 7. This is important because while most new firms fail, a small share of those that survive grow rapidly and make significant contributions to aggregate productivity.16 Moreover, the pandemic-era business creation surge has been particularly strong in high-tech sectors, such as computer systems design as well as research and development services.17 In fact, we have also seen greater growth in total factor productivity in the U.S. relative to other advanced economies, as shown in the right figure on slide 7. In addition, while the artificial intelligence (AI) technology is still in its nascency, U.S. businesses across different sectors of the economy are investing in and adopting AI. According to the Business Trends and Outlook Survey of the Census, more than 20 percent of companies in 15 sectors have adopted AI.18 It may be too early to tell, but additional productivity 15 See Adriana D. Kugler (2024), "Disinflation without a Rise in Unemployment? What Is Different This Time Around," speech delivered at the 2024 Stanford Institute for Economic Policy Research Economic Summit, Stanford University, Stanford, Calif., March 1, https://www.federalreserve.gov/newsevents/speech/kugler20240301a.htm. 16 See Titan Alon, David Berger, Robert Dent, and Benjamin Pugsley (2018), "Older and Slower: The Startup Deficit's Lasting Effects on Aggregate Productivity Growth," Journal of Monetary Economics, vol. 93 (January), pp. 68-85; and Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in U.S. Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. 17 See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. 18 In data released September 23, 2024, the share of firms reporting the use of AI to perform tasks previously done by employees in producing goods or services was 27 percent. gains may be coming from tasks that are enhanced by AI through process improvements.19 Second, we have seen a stronger rate of labor productivity growth in the United States as shown in the left panel on slide 8.20 The economic policy response to the pandemic in the U.S. was robust, but it was different from the response in many other advanced economies. In other economies, the emphasis was on maintaining employment, and specifically keeping workers employed in their existing firms when the pandemic arrived. This was the case, for example, in the euro area, and the middle panel indeed shows that the unemployment rate peaked several times higher in the United States. This approach minimized euro-area job losses, but it may have limited the flow of workers to more-productive sectors of the economy, which is supported by Federal Reserve Board research showing substantially more sectoral re-allocation of workers in the United States compared to the euro area, as seen in the right figure on slide 8.21 Third, the U.S. labor supply has grown in the post-pandemic period. The labor force participation rate increased solidly, especially from the beginning of 2021 through the middle of 2023, and the U.S. population increased strongly because of high levels of immigration. While recent immigration flows into some European countries have been comparable in proportion to those into the U.S., as seen in the left figure on slide 9, new 19 See Lisa D. Cook (2024), "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. 20 See Francois de Soyres, Joaquin Garcia-Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why Is the U.S. GDP Recovering Faster than Other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://www.federalreserve.gov/econres/notes/feds-notes/why-is-the-u-s-gdp-recovering-faster-than-otheradvanced-economies-20240517.html. 21 See Joaquin García-Cabo, Anna Lipińska, and Gaston Navarro (2023), "Sectoral Shocks, Reallocation, and Labor Market Policies," European Economic Review, vol. 156 (July), 104494. immigrants may have contributed relatively more to U.S. growth because they often integrate more quickly into the labor force, as seen in the right figure.22 Finally, and turning our focus to monetary policy, this stronger economic performance, with falling inflation, has allowed the FOMC to be patient about the timing in reducing our policy rate. This performance gave us time to strongly focus on the inflation side of our mandate. And this, together with the bump in inflation early this year, helps explain why we began to ease monetary policy to less-restrictive levels only after other central banks of advanced economies had done so. But now, the combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision by the FOMC in our September meeting to cut the federal funds rate by 50 basis points. Looking ahead, while I believe the focus should remain on continuing to bring inflation to 2 percent, I support shifting attention to the maximum-employment side of the FOMC's dual mandate as well. The labor market remains resilient, but I support a balanced approach to the FOMC's dual mandate so we can continue making progress on inflation while avoiding an undesirable slowdown in employment growth and economic expansion. If progress on inflation continues as I expect, I will support additional cuts in the federal funds rate to move toward a more neutral policy stance over time. Still, my approach to any policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is evolving. For instance, I am closely monitoring the economic effects from Hurricane Helene and from geopolitical events in the Middle East, since these could affect the U.S. economic outlook. If downside risks to employment escalate, it may be appropriate to move policy more quickly to a neutral stance. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to slow normalization in the policy rate. As I have described, the escalation of inflation unleashed by the pandemic was global in scope, and the fight to reduce inflation has also been global. Each of our economies faces its own unique mixture of challenges, but by comparing our similarities and contrasting our differences, I believe we can learn from each other's experiences. In conclusion, let me thank those of you in this room who contribute to bridging science and practice. For those working on the policy side, thank you for the hard work you do each day to analyze the economic data that allows not only policymakers like me, but also consumers and businesses to gain a better understanding of ongoing developments in the global economy. On the academic side, thank you for your creativity and ingenuity in asking policy-relevant questions and pushing the boundaries of our understanding of an ever-changing economic landscape. The Global Fight Against Inflation Adriana D. Kugler Member Board of Governors of the Federal Reserve System at Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany October 8, 2024 Slide 1 Global Components of World Inflation Global Components of World Inflation World Core Inflation in Inflationary Periods Share of Global vs Idiosyncratic Components Dispersion in Inflation Across Countries Price categories Slide 5 Overview of Economic Indicators since 2005 Entrepreneurship and TFP Labor Market: Productivity and Developments Demographic Factors	---[PAGE_BREAK]--- For release on delivery 3:00 a.m. EDT (9:00 a.m. local time) October 8, 2024 The Global Fight Against Inflation Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany October 8, 2024 ---[PAGE_BREAK]--- Thank you, Isabel, and thank you for the opportunity to speak here at the ECB today. ${ }^{1}$ I am particularly pleased to be part of this year's conference because the theme you have chosen has, for some time now, also been a theme of my career as an academic and public servant. Every day, of course, central bankers must bridge science and practice, drawing on the insights that research provides, specifically, because the economy and the world are continuously subject to new circumstances. We must do so, and put those insights into practice, because everyone in the United States, and in Europe, and around the world, depends on a healthy and growing economy, and depends on policymakers making the right decisions to help keep it that way. But well before I came to the Federal Reserve, I was also bridging science and practice. First, as a labor economist, when, for example, I was exploring how employment, productivity, and earnings are influenced not only by educational attainment and experience, but also by policies. Later, as chief economist at the Department of Labor, I brought science to bear in carrying out its mission of supporting workers. As the U.S. representative at the World Bank, economic science was likewise crucial in deciding how to best direct the institution's resources to where they were needed the most. In each of these roles, I have learned a bit more about the need to balance rigorous scientific understanding of the problems that people face with the realworld experiences of those people, which sometimes do not fit so neatly into an economic theorem or principle. Most recently, my colleagues and I on the Federal Open Market Committee (FOMC) have been focused on the very practical task of reducing inflation while keeping [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- employment at its maximum level. To understand the recent experience of high inflation in the United States, it is helpful to consider how inflation behaved around the world after the advent of the COVID-19 pandemic. In the remainder of my remarks, I will discuss the global dimensions of the recent bout of high inflation in different economies, both comparing similarities and contrasting differences, with a special emphasis on the factors that enabled the United States to achieve disinflation while having stronger economic activity relative to its peers. I will then conclude with some comments on the U.S. economic outlook and the implications for monetary policy. Starting with the similarities in our inflationary experiences, in early 2020, a worldwide pandemic disrupted the global economy and ultimately caused a surge of inflation around the world. Global goods production was hobbled, transportation and other aspects of supply chains became entangled, and there were significant labor shortages, all combining to cause a severe imbalance between supply and demand in much of the world. Sharp increases in commodity prices were exacerbated by Russia's invasion of Ukraine. The result was a global escalation of inflation. As you can see by the black line on slide 2, a measure of world headline inflation in 26 economies accounting for 60 percent of global gross domestic product (GDP) rose to a degree that had not been experienced since the early 1980s. This worldwide increase of inflation was synchronized and widespread across advanced and emerging economies. To measure the synchronization and breadth of this inflationary period, Federal Reserve Board researchers have employed a dynamic factor ---[PAGE_BREAK]--- model to estimate a common component of inflation across these 26 economies. ${ }^{2}$ As you can see by the blue line on slide 2, the estimated global component accounts for a large share of the variation of headline inflation among these economies after inflation began rising sharply in 2021. This evidence is consistent with the familiar story of widespread lockdowns, shutdowns of manufacturing plants in different parts of the world, disrupted logistic networks, increases in shipping costs, and longer delivery times. In the recovery, we also saw globally higher demand for commodities, intermediate inputs, and final goods and services, with demand exceeding a still-constrained supply. Indeed, one important contributor to the recent co-movement in inflation across the world has been food and energy prices. As you know, most of the time variations in inflation are heavily influenced by food and energy prices, which tend to be more volatile than the prices for other goods and services. Because many food and energy commodities are traded internationally, retail prices paid by consumers also tend to have some degree of global synchronization. Thus, as you would expect, the black line in the left chart on slide 3 shows that food and energy inflation faced by consumers around the world—here called noncore inflation—rose substantially in the recent inflationary episode. Moreover, world noncore inflation is largely accounted for by its global component in yellow, thus also showing a high degree of global synchronization. Another thing we can say about the recent worldwide escalation of inflation is how widely diffused it was across different price categories. Core inflation excludes food [^0] [^0]: ${ }^{2}$ See Danilo Cascaldi-Garcia, Luca Guerrieri, Matteo Iacoviello, and Michele Modugno (2024), "Lessons from the Co-Movement of Inflation around the World," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, June 28), https://www.federalreserve.gov/econres/notes/feds-notes/lessons-from-the-co-movement-of-inflation-around-the-world-20240628.html. ---[PAGE_BREAK]--- and energy prices, and it includes many categories more exposed to domestic conditions such as housing and medical services. Yet, as shown by the black and red lines in the right chart on slide 3, the recent rise in core inflation showed a high degree of global synchronization, with the global component accounting for a large share of the postpandemic inflation. Looking back in history, this is the first time since the 1970s that we saw a rise in core inflation so widespread across such a large number of countries. Moreover, underlying this rise in core inflation in the United States and other advanced economies, research carried out by Federal Reserve Board economists shows that there was a widespread rise in prices across the whole range of categories within the core basket. ${ }^{3}$ Academics and policymakers have debated about the possible reasons explaining the recent co-movement of inflation around the world. The COVID-19 pandemic was a global phenomenon and had effects on supply and demand that were similar in many countries. On the supply side, businesses closed, affecting goods production and the provision of services. There were labor shortages due to illness, social distancing, early retirements, and declines in immigration, with all of these factors making it harder to produce goods and services. ${ }^{4}$ Production disruptions and labor shortages propagated [^0] [^0]: ${ }^{3}$ I refer to updated estimates from the following works: Hie Joo Ahn and Matteo Luciani (2020), "Common and Idiosyncratic Inflation," Finance and Economics Discussion Series 2020-024 (Washington: Board of Governors of the Federal Reserve System, March; revised August 2024), https://doi.org/10.17016/FEDS.2020.024r1; and Eli Nir, Flora Haberkorn, and Danilo Cascaldi-Garcia (2021), "International Measures of Common Inflation," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, November 5), https://www.federalreserve.gov/econres/notes/fedsnotes/international-measures-of-common-inflation-20211105.html. ${ }^{4}$ See Danilo Cascaldi-Garcia, Musa Orak, and Zina Saijid (2023), "Drivers of Post-Pandemic Inflation in Selected Advanced Economies and Implications for the Outlook," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, January 13), https://www.federalreserve.gov/econres/notes/fedsnotes/drivers-of-post-pandemic-inflation-in-selected-advanced-economies-and-implications-for-the-outlook-20230113.html. ---[PAGE_BREAK]--- around the world due to long and intricate supply chains forged over several decades of growing globalization in trade. The imbalance between supply and demand widened as consumers switched their spending from services to goods, straining transportation capacity that further disrupted supply chains. ${ }^{5}$ This re-allocation of demand from services to goods also strained the ability of firms to produce, as they struggled to find qualified workers due to the needed re-allocation of workers across sectors. ${ }^{6}$ This demand was also likely fueled by the fiscal response to COVID-19 in 2020 and 2021. All of these factors drove up costs, and there were others. Russia's war on Ukraine intensified the increases in energy and food commodity prices during the recovery from the pandemic. And the interaction of these different forces also likely played a role. ${ }^{7}$ For example, as Asia increased production to meet higher demand for goods in the U.S., this may have driven up wages and other input costs in Asia, increasing demand for imports from other places and, in turn, raising costs there, and so on. My assessment is that both supply and demand contributed to the recent global inflationary episode, including in the United States, with international trade of goods, including commodities, and services playing an important role in disseminating these forces around the world. One salient aspect of past inflationary episodes is the observation that core inflation typically falls more slowly than it increases. As we can see by the red lines on slide 4 , world core inflation rose more quickly than it decreased in the three most recent [^0] [^0]: ${ }^{5}$ See Gianluca Benigno, Julian di Giovanni, Jan J.J. Groen, and Adam I. Noble (2022), "The GSCPI: A New Barometer of Global Supply Chain Pressures," Staff Reports 1017 (New York: Federal Reserve Bank of New York, May), https://www.newyorkfed.org/research/staff_reports/sr1017.html. ${ }^{6}$ See Francesco Ferrante, Sebastian Graves, and Matteo Iacoviello (2023), "The Inflationary Effects of Sectoral Reallocation," Journal of Monetary Economics, vol. 140, supplement (November), pp. S64-S81. ${ }^{7}$ See Paul Ho, Pierre-Daniel Sarte, and Felipe Schwartzman (2022), "Multilateral Comovement in a New Keynesian World: A Little Trade Goes a Long Way," Working Paper Series 22-10 (Richmond: Federal Reserve Bank of Richmond, November), https://www.richmondfed.org/1media/RichmondFedOrg/publications/research/working_papers/2022/wp22-10.pdf. ---[PAGE_BREAK]--- episodes of significant inflation and disinflation—from a trough in 1972 to a new trough in 1978; from 1978 to a trough in 1986; and then the recent episode, from the end of 2020 through the first quarter of 2024. In these episodes, the escalation of four-quarter core inflation increased by an average of $7 / 10$ percentage point per quarter to its peak, while it decreased by an average of only $3 / 10$ percentage point per quarter to the trough. ${ }^{8}$ Still, it is important that central bankers not only compare similarities across economies in the recent inflation fight, but also contrast the differences. Notably, another important feature of the last three inflation and disinflation periods is that though the share of core inflation explained by the common component increases when inflation rises, this share decreases when inflation falls, as can be seen by the black shaded areas of the three panels on slide 4 . This suggests that while the reasons underlying the comovement of inflation across the world—such as global supply disruptions and commodity price shocks-may have been important when prices were increasing, they have been less important when prices have decreased. This evidence indicates that factors that vary from economy to economy become more relevant in the disinflationary period. Economic researchers have raised several possible explanations for the different inflation trajectories experienced by different economies during this post-pandemic period. For example, some point to differences in the magnitudes of the demand and supply imbalances driven by the shutdown and reopening of each economy, with this [^0] [^0]: ${ }^{8}$ For the 1972-78 period, we define the inflation ascent path as 1972:Q3 to 1974:Q4, while its descent path is 1975:Q1 to 1978:Q2. For the 1978-86 period, we define the inflation ascent path as 1978:Q3 to 1980:Q2, while its descent path is 1980:Q3 to 1986:Q2. For the 2020-24 period, we define the inflation ascent path as 2021:Q1 to 2022:Q4, while its descent path is 2023:Q1 to 2024:Q1 because it is the latest available data. ---[PAGE_BREAK]--- imbalance possibly playing a larger role on inflation in the euro area relative to the United States. ${ }^{9}$ While noting that differences in the size of fiscal stimulus in different countries were likely important, the targeting of that stimulus also differed, in some cases with a greater emphasis on addressing supply disruptions. ${ }^{10}$ Global factors also affect various economies differently, with studies showing that the exposures to fluctuations in commodity prices are an important issue. ${ }^{11}$ For instance, Europe was heavily affected by natural gas shortages related to Russia's war on Ukraine, while gas supplies in the United States were more plentiful during this period. Also, supply chains were untangled at different speeds in different parts of the world, with, for instance, low water levels in the Panama Canal and attacks in the Red Sea by Houthi rebels affecting different shipping routes differently around the world. And, last but not least, differences in labor market tightness very likely played a role, with evidence pointing to its importance in the United States in driving up nominal wage growth, a factor that likely helped keep employment and economic activity at healthy levels. ${ }^{12}$ [^0] [^0]: ${ }^{9}$ See Domenico Giannone and Giorgio Primiceri (2024), "The Drivers of Post-Pandemic Inflation," NBER Working Paper Series 32859 (Cambridge, Mass.: National Bureau of Economic Research, August), https://www.nber.org/papers/w32859. ${ }^{10}$ For the economic effects on the size of fiscal stimuli, see Oscar Jorda and Fernanda Nechio (2023), "Inflation and Wage Growth since the Pandemic," European Economic Review, vol. 156, 104474. ${ }^{11}$ See Christiane Baumeister, Gert Peersman, and Ine Van Robays (2010), "The Economic Consequences of Oil Shocks: Differences across Countries and Time," in Renee Fry, Callum Jones, and Christopher Kent, eds., Inflation in an Era of Relative Price Shocks (Sydney: Reserve Bank of Australia), pp. 91-128, https://www.rba.gov.au/publications/confs/2009/pdf/conf-vol-2009.pdf; and Andrea De Michelis, Thiago Ferreira, and Matteo Iacoviello (2020), "Oil Prices and Consumption across Countries and U.S. States," International Journal of Central Banking, vol. 16 (March), pp. 3-43. ${ }^{12}$ For the effects of labor market tightness on price and wage inflation, see Olivier J. Blanchard and Ben S. Bernanke (2022), "What Caused the U.S. Pandemic-Era Inflation?" NBER Working Paper Series 31417 (Cambridge, Mass.: National Bureau of Economic Research, June), https://www.nber.org/papers/w31417; Olivier J. Blanchard and Ben S. Bernanke (2024), "An Analysis of Pandemic-Era Inflation in 11 Economies," NBER Working Paper Series 32532 (Cambridge, Mass.: National Bureau of Economic Research, May), https://www.nber.org/papers/w32532. ---[PAGE_BREAK]--- Researchers at the Board of Governors also find that differences in the pace of disinflation across countries have been largely driven by different trajectories of services price inflation. ${ }^{13}$ As shown on slide 5, they find that the dispersion of inflation across countries peaked in 2023 and has been declining since then for headline and core goods, but not so much for core services inflation, with housing developments helping to account for the differences in services inflation. Other cross-country research suggests that wage developments help explain services inflation dynamics. ${ }^{14}$ Indeed, services inflation from both the United States and the euro area have been elevated. Still, while U.S. housing services inflation has been running higher than the wage-driven nonhousing component, the reverse is true in the euro area. While the cross-country differences during the recent bout of high inflation have emerged more prominently during the disinflationary period, economic growth has been very heterogenous since the onset of the COVID-19 pandemic. Generally speaking, the U.S. has experienced a significantly stronger recovery than other advanced economies. As we can see in the left panel on slide 6, real GDP has grown substantially more in the United States since 2021. This is also the case with respect to the larger components of GDP, such as consumption and investment, shown in the right two panels. In explaining why the U.S. has managed to bring down inflation and experience strong economic activity, I believe that the combination of restrictive monetary policy [^0] [^0]: ${ }^{13}$ See Maria Aristizabal-Ramirez, Dylan Moore, and Eva Van Leemput (forthcoming), "What Goes Up Together Must Not Come Down Together: An Analysis of Services Disinflation," Forthcoming as an International Finance Discussion Paper (Washington: Board of Governors of the Federal Reserve System). ${ }^{14}$ See Pongpitch Amatyakul, Deniz Igan, and Marco Jacopo Lombardi (2024), "Sectoral Price Dynamics in the Last Mile of Post-COVID-19 Disinflation," BIS Quarterly Review, March, pp. 45-57. ---[PAGE_BREAK]--- together with convex supply curves can help explain these developments. ${ }^{15}$ In addition, there are three supply-related factors that have also made significant contributions to the combination of rapid disinflation together with continued and resilient growth. First, there are important factors that have affected total factor productivity differently across countries. For instance, the U.S. has seen greater business dynamism, as reflected in a higher rate of new business formation, shown in the left panel on slide 7 . This is important because while most new firms fail, a small share of those that survive grow rapidly and make significant contributions to aggregate productivity. ${ }^{16}$ Moreover, the pandemic-era business creation surge has been particularly strong in high-tech sectors, such as computer systems design as well as research and development services. ${ }^{17}$ In fact, we have also seen greater growth in total factor productivity in the U.S. relative to other advanced economies, as shown in the right figure on slide 7. In addition, while the artificial intelligence (AI) technology is still in its nascency, U.S. businesses across different sectors of the economy are investing in and adopting AI. According to the Business Trends and Outlook Survey of the Census, more than 20 percent of companies in 15 sectors have adopted AI. ${ }^{18}$ It may be too early to tell, but additional productivity [^0] [^0]: ${ }^{15}$ See Adriana D. Kugler (2024), "Disinflation without a Rise in Unemployment? What Is Different This Time Around," speech delivered at the 2024 Stanford Institute for Economic Policy Research Economic Summit, Stanford University, Stanford, Calif., March 1, https://www.federalreserve.gov/newsevents/speech/kugler20240301a.htm. ${ }^{16}$ See Titan Alon, David Berger, Robert Dent, and Benjamin Pugsley (2018), "Older and Slower: The Startup Deficit's Lasting Effects on Aggregate Productivity Growth," Journal of Monetary Economics, vol. 93 (January), pp. 68-85; and Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in U.S. Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. ${ }^{17}$ See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. ${ }^{18}$ In data released September 23, 2024, the share of firms reporting the use of AI to perform tasks previously done by employees in producing goods or services was 27 percent. ---[PAGE_BREAK]--- gains may be coming from tasks that are enhanced by AI through process improvements. ${ }^{19}$ Second, we have seen a stronger rate of labor productivity growth in the United States as shown in the left panel on slide $8 .{ }^{20}$ The economic policy response to the pandemic in the U.S. was robust, but it was different from the response in many other advanced economies. In other economies, the emphasis was on maintaining employment, and specifically keeping workers employed in their existing firms when the pandemic arrived. This was the case, for example, in the euro area, and the middle panel indeed shows that the unemployment rate peaked several times higher in the United States. This approach minimized euro-area job losses, but it may have limited the flow of workers to more-productive sectors of the economy, which is supported by Federal Reserve Board research showing substantially more sectoral re-allocation of workers in the United States compared to the euro area, as seen in the right figure on slide $8 .{ }^{21}$ Third, the U.S. labor supply has grown in the post-pandemic period. The labor force participation rate increased solidly, especially from the beginning of 2021 through the middle of 2023, and the U.S. population increased strongly because of high levels of immigration. While recent immigration flows into some European countries have been comparable in proportion to those into the U.S., as seen in the left figure on slide 9 , new [^0] [^0]: ${ }^{19}$ See Lisa D. Cook (2024), "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. ${ }^{20}$ See Francois de Soyres, Joaquin Garcia-Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why Is the U.S. GDP Recovering Faster than Other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://www.federalreserve.gov/econres/notes/feds-notes/why-is-the-u-s-gdp-recovering-faster-than-other-advanced-economies-20240517.html. ${ }^{21}$ See Joaquin Garcia-Cabo, Anna Lipińska, and Gaston Navarro (2023), "Sectoral Shocks, Reallocation, and Labor Market Policies," European Economic Review, vol. 156 (July), 104494. ---[PAGE_BREAK]--- immigrants may have contributed relatively more to U.S. growth because they often integrate more quickly into the labor force, as seen in the right figure. ${ }^{22}$ Finally, and turning our focus to monetary policy, this stronger economic performance, with falling inflation, has allowed the FOMC to be patient about the timing in reducing our policy rate. This performance gave us time to strongly focus on the inflation side of our mandate. And this, together with the bump in inflation early this year, helps explain why we began to ease monetary policy to less-restrictive levels only after other central banks of advanced economies had done so. But now, the combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision by the FOMC in our September meeting to cut the federal funds rate by 50 basis points. Looking ahead, while I believe the focus should remain on continuing to bring inflation to 2 percent, I support shifting attention to the maximum-employment side of the FOMC's dual mandate as well. The labor market remains resilient, but I support a balanced approach to the FOMC's dual mandate so we can continue making progress on inflation while avoiding an undesirable slowdown in employment growth and economic expansion. If progress on inflation continues as I expect, I will support additional cuts in the federal funds rate to move toward a more neutral policy stance over time. Still, my approach to any policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is [^0] [^0]: ${ }^{22}$ See Courtney Brell, Christian Dustmann, and Ian Preston (2020), "The Labor Market Integration of Refugee Migrants in High-Income Countries," Journal of Economic Perspectives, vol. 34 (Winter), pp. 94121 . ---[PAGE_BREAK]--- evolving. For instance, I am closely monitoring the economic effects from Hurricane Helene and from geopolitical events in the Middle East, since these could affect the U.S. economic outlook. If downside risks to employment escalate, it may be appropriate to move policy more quickly to a neutral stance. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to slow normalization in the policy rate. As I have described, the escalation of inflation unleashed by the pandemic was global in scope, and the fight to reduce inflation has also been global. Each of our economies faces its own unique mixture of challenges, but by comparing our similarities and contrasting our differences, I believe we can learn from each other's experiences. In conclusion, let me thank those of you in this room who contribute to bridging science and practice. For those working on the policy side, thank you for the hard work you do each day to analyze the economic data that allows not only policymakers like me, but also consumers and businesses to gain a better understanding of ongoing developments in the global economy. On the academic side, thank you for your creativity and ingenuity in asking policy-relevant questions and pushing the boundaries of our understanding of an ever-changing economic landscape. ---[PAGE_BREAK]--- ![img-0.jpeg](img-0.jpeg) # The Global Fight Against Inflation Adriana D. Kugler<br>Member<br>Board of Governors of the Federal Reserve System at Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany October 8, 2024 ---[PAGE_BREAK]--- # Global Components of World Inflation ## Headline Inflation ![img-1.jpeg](img-1.jpeg) Note: World headline inflation is the gross domestic product (GDP)-weighted, 4-quarter percent change of consumer price indexes for selected economies. Global component is the GDP-weighted aggregate of each economy's common component. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Global Components of World Inflation ## Noncore Inflation ![img-2.jpeg](img-2.jpeg) Note: World noncore inflation is the gross domestic product (GDP)-weighted, 4-quarter percent change of noncore consumer price indexes for selected economies. Global component is the GDP-weighted aggregate of each economy's common component. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ## Core Inflation ![img-3.jpeg](img-3.jpeg) Note: World core inflation is the gross domestic product (GDP)-weighted, 4-quarter percent change of core consumer price indexes for selected economies. Global component is the GDP-weighted aggregate of each economy's common component. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # World Core Inflation in Inflationary Periods ## Share of Global vs Idiosyncratic Components ![img-4.jpeg](img-4.jpeg) Note: World core inflation is the gross domestic product (GDP)-weighted, 4-quarter percent change of core consumer price indexes for selected economies. Global component is the GDP-weighted aggregate of each economy's common component. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. - Core World Inflation (left scale) Share Explained by Global Component (right scale) Share Explained by Idiosyncratic Component (right scale) ---[PAGE_BREAK]--- # Dispersion in Inflation Across Countries ## Price categories ![img-5.jpeg](img-5.jpeg) Note: Dispersion is measured as the standard deviation across countries of standardized inflation using the pre-COVID (2017-19) mean and standard deviation per country. A value of 1 means the dispersion across countries in the level of inflation is identical to the pre-COVID level. Higher values imply there are more differences across countries compared with the pre-COVID trend. Source: Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Overview of Economic Indicators since 2005 ## Real GDP ![img-6.jpeg](img-6.jpeg) ## Final Consumption ![img-7.jpeg](img-7.jpeg) ## Investment ![img-8.jpeg](img-8.jpeg) ---[PAGE_BREAK]--- # Entrepreneurship and TFP ## New Business Registrations ![img-9.jpeg](img-9.jpeg) Note: Data extend through 2024:Q3 for the U.S. and 2024:Q2 for the euro area. Euro area series is business registrations. U.S. series is applications for employer identification numbers. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. ## TFP Cumulative Growth 2019-22 ![img-10.jpeg](img-10.jpeg) Note: TFP is total factor productivity. Source: Long-Term Productivity Database; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Labor Market: Productivity and Developments ![img-11.jpeg](img-11.jpeg) Note: Output per hour is gross domestic product (GDP) divided by total hours worked. Employment is all employed persons in the euro area and U.S., those aged 15 or older in Canada, and those aged 16 or older in the U.K. Hours per employee is the total number of hours worked divided by employment. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. Civilian Unemployment Rate ![img-12.jpeg](img-12.jpeg) Note: Latest values are September for the U.S. and August for Canada and the euro area; the U.K. is a 3-month moving average with July as the end point. Source: National sources via Haver Analytics; Federal Reserve Board staff calculations. Sectoral Reallocation Index ![img-13.jpeg](img-13.jpeg) Note: The reallocation index is calculated using year-over-year growth rates of employment from Standard Industrial Classification system. Source: Statistical Office of European Communities; Bureau of Labor Statistics via Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Demographic Factors ## Net Migration over 2022 and 2023 ![img-14.jpeg](img-14.jpeg) Source: National sources via Haver Analytics; Congressional Budget Office; Federal Reserve Board staff calculations. ## Employment Rate of Refugees ![img-15.jpeg](img-15.jpeg) Source: Brell, Dustmann, and Preston (2020).	Adriana D Kugler	United States	https://www.bis.org/review/r241008b.pdf	For release on delivery 3:00 a.m. EDT (9:00 a.m. local time) October 8, 2024 The Global Fight Against Inflation Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany October 8, 2024 Thank you, Isabel, and thank you for the opportunity to speak here at the ECB today. I am particularly pleased to be part of this year's conference because the theme you have chosen has, for some time now, also been a theme of my career as an academic and public servant. Every day, of course, central bankers must bridge science and practice, drawing on the insights that research provides, specifically, because the economy and the world are continuously subject to new circumstances. We must do so, and put those insights into practice, because everyone in the United States, and in Europe, and around the world, depends on a healthy and growing economy, and depends on policymakers making the right decisions to help keep it that way. But well before I came to the Federal Reserve, I was also bridging science and practice. First, as a labor economist, when, for example, I was exploring how employment, productivity, and earnings are influenced not only by educational attainment and experience, but also by policies. Later, as chief economist at the Department of Labor, I brought science to bear in carrying out its mission of supporting workers. As the U.S. representative at the World Bank, economic science was likewise crucial in deciding how to best direct the institution's resources to where they were needed the most. In each of these roles, I have learned a bit more about the need to balance rigorous scientific understanding of the problems that people face with the realworld experiences of those people, which sometimes do not fit so neatly into an economic theorem or principle. Most recently, my colleagues and I on the Federal Open Market Committee (FOMC) have been focused on the very practical task of reducing inflation while keeping employment at its maximum level. To understand the recent experience of high inflation in the United States, it is helpful to consider how inflation behaved around the world after the advent of the COVID-19 pandemic. In the remainder of my remarks, I will discuss the global dimensions of the recent bout of high inflation in different economies, both comparing similarities and contrasting differences, with a special emphasis on the factors that enabled the United States to achieve disinflation while having stronger economic activity relative to its peers. I will then conclude with some comments on the U.S. economic outlook and the implications for monetary policy. Starting with the similarities in our inflationary experiences, in early 2020, a worldwide pandemic disrupted the global economy and ultimately caused a surge of inflation around the world. Global goods production was hobbled, transportation and other aspects of supply chains became entangled, and there were significant labor shortages, all combining to cause a severe imbalance between supply and demand in much of the world. Sharp increases in commodity prices were exacerbated by Russia's invasion of Ukraine. The result was a global escalation of inflation. As you can see by the black line on slide 2, a measure of world headline inflation in 26 economies accounting for 60 percent of global gross domestic product (GDP) rose to a degree that had not been experienced since the early 1980s. This worldwide increase of inflation was synchronized and widespread across advanced and emerging economies. To measure the synchronization and breadth of this inflationary period, Federal Reserve Board researchers have employed a dynamic factor model to estimate a common component of inflation across these 26 economies. As you can see by the blue line on slide 2, the estimated global component accounts for a large share of the variation of headline inflation among these economies after inflation began rising sharply in 2021. This evidence is consistent with the familiar story of widespread lockdowns, shutdowns of manufacturing plants in different parts of the world, disrupted logistic networks, increases in shipping costs, and longer delivery times. In the recovery, we also saw globally higher demand for commodities, intermediate inputs, and final goods and services, with demand exceeding a still-constrained supply. Indeed, one important contributor to the recent co-movement in inflation across the world has been food and energy prices. As you know, most of the time variations in inflation are heavily influenced by food and energy prices, which tend to be more volatile than the prices for other goods and services. Because many food and energy commodities are traded internationally, retail prices paid by consumers also tend to have some degree of global synchronization. Thus, as you would expect, the black line in the left chart on slide 3 shows that food and energy inflation faced by consumers around the world—here called noncore inflation—rose substantially in the recent inflationary episode. Moreover, world noncore inflation is largely accounted for by its global component in yellow, thus also showing a high degree of global synchronization. Another thing we can say about the recent worldwide escalation of inflation is how widely diffused it was across different price categories. Core inflation excludes food and energy prices, and it includes many categories more exposed to domestic conditions such as housing and medical services. Yet, as shown by the black and red lines in the right chart on slide 3, the recent rise in core inflation showed a high degree of global synchronization, with the global component accounting for a large share of the postpandemic inflation. Looking back in history, this is the first time since the 1970s that we saw a rise in core inflation so widespread across such a large number of countries. Moreover, underlying this rise in core inflation in the United States and other advanced economies, research carried out by Federal Reserve Board economists shows that there was a widespread rise in prices across the whole range of categories within the core basket. Academics and policymakers have debated about the possible reasons explaining the recent co-movement of inflation around the world. The COVID-19 pandemic was a global phenomenon and had effects on supply and demand that were similar in many countries. On the supply side, businesses closed, affecting goods production and the provision of services. There were labor shortages due to illness, social distancing, early retirements, and declines in immigration, with all of these factors making it harder to produce goods and services. Production disruptions and labor shortages propagated around the world due to long and intricate supply chains forged over several decades of growing globalization in trade. The imbalance between supply and demand widened as consumers switched their spending from services to goods, straining transportation capacity that further disrupted supply chains. For example, as Asia increased production to meet higher demand for goods in the U.S., this may have driven up wages and other input costs in Asia, increasing demand for imports from other places and, in turn, raising costs there, and so on. My assessment is that both supply and demand contributed to the recent global inflationary episode, including in the United States, with international trade of goods, including commodities, and services playing an important role in disseminating these forces around the world. One salient aspect of past inflationary episodes is the observation that core inflation typically falls more slowly than it increases. As we can see by the red lines on slide 4 , world core inflation rose more quickly than it decreased in the three most recent episodes of significant inflation and disinflation—from a trough in 1972 to a new trough in 1978; from 1978 to a trough in 1986; and then the recent episode, from the end of 2020 through the first quarter of 2024. In these episodes, the escalation of four-quarter core inflation increased by an average of $7 / 10$ percentage point per quarter to its peak, while it decreased by an average of only $3 / 10$ percentage point per quarter to the trough. Still, it is important that central bankers not only compare similarities across economies in the recent inflation fight, but also contrast the differences. Notably, another important feature of the last three inflation and disinflation periods is that though the share of core inflation explained by the common component increases when inflation rises, this share decreases when inflation falls, as can be seen by the black shaded areas of the three panels on slide 4 . This suggests that while the reasons underlying the comovement of inflation across the world—such as global supply disruptions and commodity price shocks-may have been important when prices were increasing, they have been less important when prices have decreased. This evidence indicates that factors that vary from economy to economy become more relevant in the disinflationary period. Economic researchers have raised several possible explanations for the different inflation trajectories experienced by different economies during this post-pandemic period. For example, some point to differences in the magnitudes of the demand and supply imbalances driven by the shutdown and reopening of each economy, with this imbalance possibly playing a larger role on inflation in the euro area relative to the United States. Researchers at the Board of Governors also find that differences in the pace of disinflation across countries have been largely driven by different trajectories of services price inflation. Indeed, services inflation from both the United States and the euro area have been elevated. Still, while U.S. housing services inflation has been running higher than the wage-driven nonhousing component, the reverse is true in the euro area. While the cross-country differences during the recent bout of high inflation have emerged more prominently during the disinflationary period, economic growth has been very heterogenous since the onset of the COVID-19 pandemic. Generally speaking, the U.S. has experienced a significantly stronger recovery than other advanced economies. As we can see in the left panel on slide 6, real GDP has grown substantially more in the United States since 2021. This is also the case with respect to the larger components of GDP, such as consumption and investment, shown in the right two panels. In explaining why the U.S. has managed to bring down inflation and experience strong economic activity, I believe that the combination of restrictive monetary policy together with convex supply curves can help explain these developments. In addition, there are three supply-related factors that have also made significant contributions to the combination of rapid disinflation together with continued and resilient growth. First, there are important factors that have affected total factor productivity differently across countries. For instance, the U.S. has seen greater business dynamism, as reflected in a higher rate of new business formation, shown in the left panel on slide 7 . This is important because while most new firms fail, a small share of those that survive grow rapidly and make significant contributions to aggregate productivity. It may be too early to tell, but additional productivity gains may be coming from tasks that are enhanced by AI through process improvements. Second, we have seen a stronger rate of labor productivity growth in the United States as shown in the left panel on slide $8 .{ }^{20}$ The economic policy response to the pandemic in the U.S. was robust, but it was different from the response in many other advanced economies. In other economies, the emphasis was on maintaining employment, and specifically keeping workers employed in their existing firms when the pandemic arrived. This was the case, for example, in the euro area, and the middle panel indeed shows that the unemployment rate peaked several times higher in the United States. This approach minimized euro-area job losses, but it may have limited the flow of workers to more-productive sectors of the economy, which is supported by Federal Reserve Board research showing substantially more sectoral re-allocation of workers in the United States compared to the euro area, as seen in the right figure on slide $8 .{ }^{21}$ Third, the U.S. labor supply has grown in the post-pandemic period. The labor force participation rate increased solidly, especially from the beginning of 2021 through the middle of 2023, and the U.S. population increased strongly because of high levels of immigration. While recent immigration flows into some European countries have been comparable in proportion to those into the U.S., as seen in the left figure on slide 9 , new immigrants may have contributed relatively more to U.S. growth because they often integrate more quickly into the labor force, as seen in the right figure. Finally, and turning our focus to monetary policy, this stronger economic performance, with falling inflation, has allowed the FOMC to be patient about the timing in reducing our policy rate. This performance gave us time to strongly focus on the inflation side of our mandate. And this, together with the bump in inflation early this year, helps explain why we began to ease monetary policy to less-restrictive levels only after other central banks of advanced economies had done so. But now, the combination of significant ongoing progress in reducing inflation and a cooling in the labor market means that the time has come to begin easing monetary policy, and I strongly supported the decision by the FOMC in our September meeting to cut the federal funds rate by 50 basis points. Looking ahead, while I believe the focus should remain on continuing to bring inflation to 2 percent, I support shifting attention to the maximum-employment side of the FOMC's dual mandate as well. The labor market remains resilient, but I support a balanced approach to the FOMC's dual mandate so we can continue making progress on inflation while avoiding an undesirable slowdown in employment growth and economic expansion. If progress on inflation continues as I expect, I will support additional cuts in the federal funds rate to move toward a more neutral policy stance over time. Still, my approach to any policy decision will continue to be data dependent and to rely on multiple and diverse sources of data to form my view of how the economy is evolving. For instance, I am closely monitoring the economic effects from Hurricane Helene and from geopolitical events in the Middle East, since these could affect the U.S. economic outlook. If downside risks to employment escalate, it may be appropriate to move policy more quickly to a neutral stance. Alternatively, if incoming data do not provide confidence that inflation is moving sustainably toward 2 percent, it may be appropriate to slow normalization in the policy rate. As I have described, the escalation of inflation unleashed by the pandemic was global in scope, and the fight to reduce inflation has also been global. Each of our economies faces its own unique mixture of challenges, but by comparing our similarities and contrasting our differences, I believe we can learn from each other's experiences. Adriana D. Kugler<br>Member<br>Board of Governors of the Federal Reserve System at Conference on Monetary Policy 2024: Bridging Science and Practice European Central Bank Frankfurt, Germany
2024-10-08T00:00:00	Elizabeth McCaul: Beyond the spotlight - using peripheral vision for better supervision	Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the S&P European Financial Institutions Conference, Frankfurt am Main, 8 October 2024.	Elizabeth McCaul: Beyond the spotlight - using peripheral vision for better supervision Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the S&P European Financial Institutions Conference, Frankfurt am Main, 8 October 2024. * * * Introduction Thank you very much for inviting me to today's conference, it is a pleasure to be here. The former German Chancellor Helmut Schmidt used to say "People with visions should go to the doctor". This sounds concerning to a supervisor. After all, the word "supervision" is made up of the prefix "super", which means "over" or "above", and "vision". But what exactly is vision? To find out, I followed Helmut Schmidt's advice and went to the doctor. What I learnt is that eye doctors distinguish between central vision, fringe vision and peripheral vision. Central vision is the very centre of the visual field. It delivers sharp, detailed pictures, allowing us to focus on objects straight ahead. In the banking world, these are the issues directly in front of us: capital, asset quality, profitability and key risk categories including climate-and environmental risks or cyber risk etc. Fringe vision refers to the area right outside the central vision, around 30 to 60 degrees of the visual field, where visual clarity and detail recognition start to decrease. Fringe vision helps us to absorb information faster when we read as our brains anticipate the next words and letters, making the process faster and smoother. Translating this to banking, this would be like noticing changes in the macroeconomic environment, rising geopolitical tensions, and their impact on banks' business models and risk profiles. Finally, peripheral vision is everything that occurs outside the very centre of our gaze, beyond 60 degrees. It encompasses everything that can be seen to the sides, providing spatial awareness which helps with navigation and balance. Improving peripheral vision is crucial for athletes as it increases reaction speed, improves anticipation and reduces the risk of injury. In banking, beyond the centre of our gaze are the structural transformations of our societies and economies: the acceleration of technological progress, including the rise of generative artificial intelligence or the impact of social media on depositor behaviour; the reconfiguration of the financial value chain; new entrants in the competitive landscape or the growing share of non-bank financial institutions. Good supervision and good risk management in banks require central, fringe and peripheral vision. Good peripheral vision sets apart decent athletes from great ones, allowing them to anticipate movements and respond swiftly to changes on the field. And the same holds true for banking supervisors: while central vision and fringe vision are crucial in focusing on immediate risks, it is the ability to maintain a broad, strategic view - our "peripheral vision" - that ensures truly effective supervision. This broader perspective enables us to detect emerging risks in the wider financial system, anticipate potential disruptions and respond proactively. In my remarks today, I will share our assessment of the current risk landscape, describing what we see in our central, fringe and peripheral vision. Central vision Let me start with the central vision of the state of the European banking system. In recent years, Europe's banking sector has shown resilience in the face of unforeseen challenges: the pandemic, the energy supply shock following Russia's invasion of Ukraine and a period of high inflation. This resilience is reflected in the numbers: in 2015, the average ratio of non-performing loans (NPLs) for significant banks in the banking union was 7.5%, at a time when some banking systems had ratios close to 50%. At the end of the second quarter of this year, this ratio had decreased to 2.3%, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from 12.7% in 2015 to 15.8% today. Bank profitability has considerably increased in recent quarters, benefiting from higher interest rates, and return on equity now stands at 10.1%. On the one hand, this resilience is a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis and the related improvements in banks' risk management. On the other hand, looking particularly at recent years, banks have also benefited from policy support which has helped shield the real economy from adverse shocks. For example, during the pandemic, comprehensive fiscal support measures contained corporate insolvencies and the associated loan losses. While bank profitability and valuations have recently improved due to higher interest rates, the effects of this supporting factor are gradually diminishing. Turning to liquidity, banks continue to show strong positions despite an ongoing reduction in excess liquidity. Access to both retail and wholesale funding remains robust, and the higher-than-expected stickiness of deposits has contributed to a stable funding environment. Nevertheless, banks should remain cautious and ensure that their liquidity and funding strategies are resilient to potential market disruptions. They need to maintain robust asset and liability management frameworks to enhance their resilience to both liquidity and funding risks as well as interest rate risk in the banking book. I will return to this topic later again. Finally, our supervisory priorities also include banks' capabilities to manage climate- and environmental risks and cyber risk. Climate change can no longer be regarded only as a long-term or emerging risk, which is why banks need to address the challenges and grasp the opportunities of climate transition and adaptation. With regard to cyber risk, we have recently concluded a cyber resilience stress test to assess how banks would respond to and recover from a severe but plausible cybersecurity incident. While cyber risk has become a key risk for the banking sector, geopolitical tensions have further increased the threat of cyber-attacks. So, we may ask: how much of this resilience is structural, how much is cyclical? To get a more accurate picture of the current risk landscape, we need to slightly widen our gaze. Fringe vision This brings me to the fringe vision, looking at the broader macroeconomic environment. While the macro-financial environment has recently been improving as inflation decreases, near-term growth remains weak and subject to high uncertainty. Recent data indicate a gradual recovery in real GDP growth, primarily driven by the services sector, while industrial activity continues to face headwinds. Credit risk has only partially materialised so far, supported by strong fundamentals of households and corporates. Still, NPLs are slowly increasing, particularly in the commercial real estate (CRE) and small and medium-sized enterprise (SME) sectors. While the macroeconomic outlook signals a lower immediate risk of recession, asset quality in riskier segments is slowly deteriorating as the higher interest rate environment experienced over the last two years after a decade of 'low for long' weighs and may affect the debt servicing capacity of borrowers. In this context, we are conducting targeted reviews on banks' portfolios that demonstrate more sensitivity to the current macro-financial environment. This includes targeted reviews of SME portfolios and following up on the findings from residential real estate and CRE portfolio reviews as well as from deep dives on forbearance and unlikely-to-pay policies. Banks also need to remediate persistent shortcomings in their IFRS 9 frameworks and maintain an adequate level of provisions. In this context, we are continuing IFRS 9 targeted reviews focusing on, among other things, the use of overlays and coverage of novel risks. The current market risk environment is characterised by high risk appetite and benign risk pricing, which has prevailed in financial markets over the past year. This environment is susceptible to sudden shifts in market sentiment and episodes of high volatility, as seen in the recent global financial market sell-off. Although markets showed substantial resilience during the spike in volatility in August, banks should be ready for and able to cope with further episodes of sharp repricing and high volatility. The implementation of the recently postponed market risk part of the Basel III reform, the Fundamental Review of the Trading Book, will strengthen capital requirements for banks and help boost their resilience. Rising geopolitical tensions Also within the broader macro-environment, the evolving geopolitical risk landscape has been on our radar for some time, considering the events of the past two and a half years, namely Russia's war in Ukraine and the conflict in the Middle East. While the direct impact of recent geopolitical events on the banking sector has been contained so far and the immediate threats are limited, we need to remain attentive and systematically assess the possible ramifications for banks. Geopolitical shocks are cross-cutting and could have direct and indirect effects on banks' financial and nonfinancial risks. For example, geopolitical shocks can exacerbate governance, operational and business model risks they lead to more sanctions or increased cyberattacks. We have seen a clear increase in the number of significant cyber incidents in 2023 and 2024, driven by attacks on service providers (typically ransomware) and by distributed denial-of-service attacks on banks. There can also be material consequences for banks' credit, market, liquidity, funding and profitability risks, especially in cases where banks have largescale direct or indirect balance sheet exposures to the countries, sectors, supply chains or firms and households that may be adversely affected by a geopolitical shock. Moreover, geopolitical events can also have wider second-round effects that could have negative knock-on consequences for the banking sector. For instance, downside risks to growth from slower economic activity or worsened sentiment as well as upward pressure on inflation related to supply or price shocks in energy or broader commodity markets can disrupt banks' operating environment. Escalating geopolitical tensions might also result in heightened financial market volatility, triggering further episodes of asset price corrections. The recent increase in geopolitical tensions calls for heightened scrutiny and robust risk management frameworks in banks, so that supervisors and banks can properly assess potential risks in the evolving geopolitical environment and proactively mitigate them. As 1 Supervisory Board Chair Claudia Buch said recently , strengthening resilience to geopolitical shocks is a key priority for ECB Banking Supervision, and we will focus on a range of risk factors, from governance and risk management to capital planning, credit risk and operational resilience. Peripheral vision And now, let us exercise our athletic capabilities, and use our peripheral vision to look at the wider risk landscape. Structural trends, such as the reconfiguration of the financial value chain, the impact of digitalisation and social media on liquidity, and the rise of non-bank financial institutions, are reshaping the environment in which banks operate. Reconfiguration of the financial value chain The emergence of big tech companies and other non-banking firms offering financial services is leading to a major restructuring in the market, changing the risk landscape, blurring traditional industry lines and challenging conventional regulatory boundaries. Companies whose primary business is technology are entering the financial sector through e-commerce and payment platforms and subsequently expanding into retail credit, mortgage lending or crypto services. These firms may explore alternative, less regulated lending forms like crypto lending using peer-to-peer platforms, ultimately mimicking the economic functions of banks without being subject to the same comprehensive oversight. We need to expand our tools and surveillance to prevent gaps in oversight and ensure they are robust and versatile enough to oversee disintermediated, increasingly interconnected and possibly distributed-ledger-based business models. We must adapt the regulation and oversight of such firms, especially for entities that are mainly active in non-financial services, to gain a thorough understanding of the financial activities of large non-bank groups across jurisdictions and sectors. Let me underscore that we should avoid a regulatory "race to the bottom" driven by a narrow mission of prioritising innovation and attracting large firms, which may not contribute to the good of society. Liquidity risk supervision post-March 2023 Earlier, I asked how much of banks' resilience is structural and how much is cyclical. Let us look at the banking turmoil of March 2023 to better understand how banks weathered this crisis and identify what lessons we have learnt with regard to liquidity and funding. First, the events were a reminder to banks of the changing and increasingly volatile nature of depositor behaviour. Social media can play a pivotal role in encouraging large numbers of customers to withdraw deposits. In the case of Silicon Valley Bank, this behaviour was exacerbated by a highly networked and concentrated depositor base. Moreover, the advent of online banking, digitalisation, and the influence of non-bank competitors may also have a significant impact on depositor behaviour, affecting the stability of liquidity and funding sources. Therefore, banks must adapt their approaches so that they can monitor these risks more closely and understand the channels through which deposits are collected. We recently conducted a targeted review on the diversification of funding sources and the adequacy of funding plans. Our findings indicate a concerning heterogeneity in the adverse scenarios considered by significant banks. Often, these scenarios are only described at a high level, are not conservative, or only "stress" individual balance sheet items. The absence of comprehensive and credible underlying assumptions in these adverse scenarios reduces the reliability of funding plans and increases execution risk. The events of March 2023 also underscored the importance of banks' readiness to swiftly implement contingency and recovery measures. Another recent targeted review focused on collateral mobilisation. It found that banks have the operational capacity to tap central bank liquidity facilities. However, banks' assumptions about the time needed to monetise the assets appear rather optimistic in some cases, especially under stressed conditions. This optimism could hinder banks' ability to cover any unexpected outflows in a timely and sufficient manner. Furthermore, banks need to adopt a more holistic and comprehensive cross-risk analysis of potential vulnerabilities. The turmoil demonstrated how quickly deficiencies in business models and shortcomings in the management of interest rate risk in the banking book (IRRBB) can escalate into liquidity issues. It is essential to assess spillover effects and understand how shortcomings in one area can amplify risks in another. From a regulatory perspective, the events of spring 2023, along with past crises, have shown that compliance with the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) may not provide sufficient assurance about a bank's liquidity and funding situation. For instance, an LCR above 100% might still hide significant cliff risks just beyond the 30-day horizon. Two banks with identical LCRs might have vastly different liquidity profiles owing to concentration risks not captured by the ratio. However, it is important to remember that the LCR and the NSFR do not - and are not intended to - prevent all liquidity crises. They are not designed to address every residual risk, which should be managed on a case-by-case basis under Pillar 2. So while we support a review of specific aspects of the current calibration of these metrics, we are cautious about drastic changes. Instead, I would focus on the supervisory follow-up. And I can draw four main lessons with regard to the supervision of liquidity risk. First, supervisors, like banks, need to carry out holistic cross-risk analysis. Instead of looking at risks in isolation, we need to broaden our gaze and also focus on the interplay between IRRBB, liquidity risk management and governance arrangements. Second, we need increased supervisory scrutiny of banks' modelling of non-maturity deposits, as these models are sometimes not based on proper economic evidence. Third, it is essential that supervisors consider supplementary liquidity and funding risk indicators, such as survival period or concentration metrics, to capture residual risks not addressed by the LCR or the NSFR. In European banking supervision we have successfully used maturity ladder reporting to calculate survival periods, which provides a more comprehensive analysis beyond the fixed calibration of the LCR and the NSFR. Finally, the March 2023 turmoil demonstrated the need for timely and up-to-date information on liquidity and funding. We therefore introduced weekly data collections for liquidity risks in September 2023. This has been instrumental in identifying changes and detecting structural shifts across the banking system. Growth of non-bank financial institutions Another issue we detect in our peripheral vision is the staggering growth of the nonbank financial institution (NBFI) sector. In the euro area, the sector has more than doubled in size, from €15 trillion in 2008 to €32 trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from €87 trillion in 2008 to €200 trillion in 2022. The private credit market is of particular concern. It accounts for €1.6 trillion of the global market and has also seen significant growth recently. The European private credit market has grown by 29% in the last three years but is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We have recently completed a deep dive on the topic and found that banks are not able to properly identify the detailed nature and levels of their full exposure to private credit funds. Therefore, concentration risk could be significant. We know that risk from the NBFI sector can materialise through various channels. One of them is through the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque and more visible within even our fringe and central line of sight, we should further harmonise, enhance and expand reporting requirements. We need to make information sharing between authorities easier at global level to provide the visibility we need to play with more agility on the field. Conclusion Earlier, I asked how much of the banking system's resilience is cyclical and how much is structural. I think it is safe to say that the European banking system is in better shape today than it was ten years ago. This won't surprise anyone in this room. Stronger capital and liquidity positions and healthier balance sheets are objective factors contributing to the resilience of the system. Still, I am a supervisor, so I am paid to worry. If my career has taught me anything, it's that accidents are more likely to happen when people get complacent. This is why I am calling on you to use your full vision - not only your central and fringe vision, but your peripheral vision too. Crises often emerge from the shadows, and it's the overlooked risks that pose the greatest danger. Let me conclude with another lesson that I have learnt during my career. It's a quote from Mark Twain: "There is no education in the second kick of a mule". We have seen too many crises caused by hidden risks lurking beneath the surface - the ones we fail to see until it's too late - which is precisely why we must get ahead of these risks this time around. Thank you very much for your attention. 1 Buch, C. (2024), "Global rifts and financial shifts: supervising banks in an era of geopolitical instability", keynote speech at the eighth European Systemic Risk Board (ESRB) annual conference on "New Frontiers in Macroprudential Policy", 26 September.	---[PAGE_BREAK]--- # Elizabeth McCaul: Beyond the spotlight - using peripheral vision for better supervision Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the S\&P European Financial Institutions Conference, Frankfurt am Main, 8 October 2024. ## Introduction Thank you very much for inviting me to today's conference, it is a pleasure to be here. The former German Chancellor Helmut Schmidt used to say "People with visions should go to the doctor". This sounds concerning to a supervisor. After all, the word "supervision" is made up of the prefix "super", which means "over" or "above", and "vision". But what exactly is vision? To find out, I followed Helmut Schmidt's advice and went to the doctor. What I learnt is that eye doctors distinguish between central vision, fringe vision and peripheral vision. Central vision is the very centre of the visual field. It delivers sharp, detailed pictures, allowing us to focus on objects straight ahead. In the banking world, these are the issues directly in front of us: capital, asset quality, profitability and key risk categories including climate-and environmental risks or cyber risk etc. Fringe vision refers to the area right outside the central vision, around 30 to 60 degrees of the visual field, where visual clarity and detail recognition start to decrease. Fringe vision helps us to absorb information faster when we read as our brains anticipate the next words and letters, making the process faster and smoother. Translating this to banking, this would be like noticing changes in the macroeconomic environment, rising geopolitical tensions, and their impact on banks' business models and risk profiles. Finally, peripheral vision is everything that occurs outside the very centre of our gaze, beyond 60 degrees. It encompasses everything that can be seen to the sides, providing spatial awareness which helps with navigation and balance. Improving peripheral vision is crucial for athletes as it increases reaction speed, improves anticipation and reduces the risk of injury. In banking, beyond the centre of our gaze are the structural transformations of our societies and economies: the acceleration of technological progress, including the rise of generative artificial intelligence or the impact of social media on depositor behaviour; the reconfiguration of the financial value chain; new entrants in the competitive landscape or the growing share of non-bank financial institutions. Good supervision and good risk management in banks require central, fringe and peripheral vision. Good peripheral vision sets apart decent athletes from great ones, allowing them to anticipate movements and respond swiftly to changes on the field. And the same holds true for banking supervisors: while central vision and fringe vision are ---[PAGE_BREAK]--- crucial in focusing on immediate risks, it is the ability to maintain a broad, strategic view - our "peripheral vision" - that ensures truly effective supervision. This broader perspective enables us to detect emerging risks in the wider financial system, anticipate potential disruptions and respond proactively. In my remarks today, I will share our assessment of the current risk landscape, describing what we see in our central, fringe and peripheral vision. # Central vision Let me start with the central vision of the state of the European banking system. In recent years, Europe's banking sector has shown resilience in the face of unforeseen challenges: the pandemic, the energy supply shock following Russia's invasion of Ukraine and a period of high inflation. This resilience is reflected in the numbers: in 2015, the average ratio of non-performing loans (NPLs) for significant banks in the banking union was $7.5 \%$, at a time when some banking systems had ratios close to $50 \%$. At the end of the second quarter of this year, this ratio had decreased to $2.3 \%$, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from $12.7 \%$ in 2015 to $15.8 \%$ today. Bank profitability has considerably increased in recent quarters, benefiting from higher interest rates, and return on equity now stands at $10.1 \%$. On the one hand, this resilience is a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis and the related improvements in banks' risk management. On the other hand, looking particularly at recent years, banks have also benefited from policy support which has helped shield the real economy from adverse shocks. For example, during the pandemic, comprehensive fiscal support measures contained corporate insolvencies and the associated loan losses. While bank profitability and valuations have recently improved due to higher interest rates, the effects of this supporting factor are gradually diminishing. Turning to liquidity, banks continue to show strong positions despite an ongoing reduction in excess liquidity. Access to both retail and wholesale funding remains robust, and the higher-than-expected stickiness of deposits has contributed to a stable funding environment. Nevertheless, banks should remain cautious and ensure that their liquidity and funding strategies are resilient to potential market disruptions. They need to maintain robust asset and liability management frameworks to enhance their resilience to both liquidity and funding risks as well as interest rate risk in the banking book. I will return to this topic later again. Finally, our supervisory priorities also include banks' capabilities to manage climateand environmental risks and cyber risk. Climate change can no longer be regarded only as a long-term or emerging risk, which is why banks need to address the challenges and grasp the opportunities of climate transition and adaptation. With regard to cyber risk, we have recently concluded a cyber resilience stress test to assess how banks would respond to and recover from a severe but plausible cybersecurity incident. While ---[PAGE_BREAK]--- cyber risk has become a key risk for the banking sector, geopolitical tensions have further increased the threat of cyber-attacks. So, we may ask: how much of this resilience is structural, how much is cyclical? To get a more accurate picture of the current risk landscape, we need to slightly widen our gaze. # Fringe vision This brings me to the fringe vision, looking at the broader macroeconomic environment. While the macro-financial environment has recently been improving as inflation decreases, near-term growth remains weak and subject to high uncertainty. Recent data indicate a gradual recovery in real GDP growth, primarily driven by the services sector, while industrial activity continues to face headwinds. Credit risk has only partially materialised so far, supported by strong fundamentals of households and corporates. Still, NPLs are slowly increasing, particularly in the commercial real estate (CRE) and small and medium-sized enterprise (SME) sectors. While the macroeconomic outlook signals a lower immediate risk of recession, asset quality in riskier segments is slowly deteriorating as the higher interest rate environment experienced over the last two years after a decade of 'low for long' weighs and may affect the debt servicing capacity of borrowers. In this context, we are conducting targeted reviews on banks' portfolios that demonstrate more sensitivity to the current macro-financial environment. This includes targeted reviews of SME portfolios and following up on the findings from residential real estate and CRE portfolio reviews as well as from deep dives on forbearance and unlikely-to-pay policies. Banks also need to remediate persistent shortcomings in their IFRS 9 frameworks and maintain an adequate level of provisions. In this context, we are continuing IFRS 9 targeted reviews focusing on, among other things, the use of overlays and coverage of novel risks. The current market risk environment is characterised by high risk appetite and benign risk pricing, which has prevailed in financial markets over the past year. This environment is susceptible to sudden shifts in market sentiment and episodes of high volatility, as seen in the recent global financial market sell-off. Although markets showed substantial resilience during the spike in volatility in August, banks should be ready for and able to cope with further episodes of sharp repricing and high volatility. The implementation of the recently postponed market risk part of the Basel III reform, the Fundamental Review of the Trading Book, will strengthen capital requirements for banks and help boost their resilience. ## Rising geopolitical tensions Also within the broader macro-environment, the evolving geopolitical risk landscape has been on our radar for some time, considering the events of the past two and a half years, namely Russia's war in Ukraine and the conflict in the Middle East. While the direct impact of recent geopolitical events on the banking sector has been contained so far and the immediate threats are limited, we need to remain attentive and systematically assess the possible ramifications for banks. Geopolitical shocks are ---[PAGE_BREAK]--- cross-cutting and could have direct and indirect effects on banks' financial and nonfinancial risks. For example, geopolitical shocks can exacerbate governance, operational and business model risks they lead to more sanctions or increased cyberattacks. We have seen a clear increase in the number of significant cyber incidents in 2023 and 2024, driven by attacks on service providers (typically ransomware) and by distributed denial-of-service attacks on banks. There can also be material consequences for banks' credit, market, liquidity, funding and profitability risks, especially in cases where banks have largescale direct or indirect balance sheet exposures to the countries, sectors, supply chains or firms and households that may be adversely affected by a geopolitical shock. Moreover, geopolitical events can also have wider second-round effects that could have negative knock-on consequences for the banking sector. For instance, downside risks to growth from slower economic activity or worsened sentiment as well as upward pressure on inflation related to supply or price shocks in energy or broader commodity markets can disrupt banks' operating environment. Escalating geopolitical tensions might also result in heightened financial market volatility, triggering further episodes of asset price corrections. The recent increase in geopolitical tensions calls for heightened scrutiny and robust risk management frameworks in banks, so that supervisors and banks can properly assess potential risks in the evolving geopolitical environment and proactively mitigate them. As Supervisory Board Chair Claudia Buch said recently ${ }^{1}$, strengthening resilience to geopolitical shocks is a key priority for ECB Banking Supervision, and we will focus on a range of risk factors, from governance and risk management to capital planning, credit risk and operational resilience. # Peripheral vision And now, let us exercise our athletic capabilities, and use our peripheral vision to look at the wider risk landscape. Structural trends, such as the reconfiguration of the financial value chain, the impact of digitalisation and social media on liquidity, and the rise of non-bank financial institutions, are reshaping the environment in which banks operate. ## Reconfiguration of the financial value chain The emergence of big tech companies and other non-banking firms offering financial services is leading to a major restructuring in the market, changing the risk landscape, blurring traditional industry lines and challenging conventional regulatory boundaries. Companies whose primary business is technology are entering the financial sector through e-commerce and payment platforms and subsequently expanding into retail credit, mortgage lending or crypto services. These firms may explore alternative, less regulated lending forms like crypto lending using peer-to-peer platforms, ultimately mimicking the economic functions of banks without being subject to the same comprehensive oversight. ---[PAGE_BREAK]--- We need to expand our tools and surveillance to prevent gaps in oversight and ensure they are robust and versatile enough to oversee disintermediated, increasingly interconnected and possibly distributed-ledger-based business models. We must adapt the regulation and oversight of such firms, especially for entities that are mainly active in non-financial services, to gain a thorough understanding of the financial activities of large non-bank groups across jurisdictions and sectors. Let me underscore that we should avoid a regulatory "race to the bottom" driven by a narrow mission of prioritising innovation and attracting large firms, which may not contribute to the good of society. # Liquidity risk supervision post-March 2023 Earlier, I asked how much of banks' resilience is structural and how much is cyclical. Let us look at the banking turmoil of March 2023 to better understand how banks weathered this crisis and identify what lessons we have learnt with regard to liquidity and funding. First, the events were a reminder to banks of the changing and increasingly volatile nature of depositor behaviour. Social media can play a pivotal role in encouraging large numbers of customers to withdraw deposits. In the case of Silicon Valley Bank, this behaviour was exacerbated by a highly networked and concentrated depositor base. Moreover, the advent of online banking, digitalisation, and the influence of non-bank competitors may also have a significant impact on depositor behaviour, affecting the stability of liquidity and funding sources. Therefore, banks must adapt their approaches so that they can monitor these risks more closely and understand the channels through which deposits are collected. We recently conducted a targeted review on the diversification of funding sources and the adequacy of funding plans. Our findings indicate a concerning heterogeneity in the adverse scenarios considered by significant banks. Often, these scenarios are only described at a high level, are not conservative, or only "stress" individual balance sheet items. The absence of comprehensive and credible underlying assumptions in these adverse scenarios reduces the reliability of funding plans and increases execution risk. The events of March 2023 also underscored the importance of banks' readiness to swiftly implement contingency and recovery measures. Another recent targeted review focused on collateral mobilisation. It found that banks have the operational capacity to tap central bank liquidity facilities. However, banks' assumptions about the time needed to monetise the assets appear rather optimistic in some cases, especially under stressed conditions. This optimism could hinder banks' ability to cover any unexpected outflows in a timely and sufficient manner. Furthermore, banks need to adopt a more holistic and comprehensive cross-risk analysis of potential vulnerabilities. The turmoil demonstrated how quickly deficiencies in business models and shortcomings in the management of interest rate risk in the banking book (IRRBB) can escalate into liquidity issues. It is essential to assess spillover effects and understand how shortcomings in one area can amplify risks in another. From a regulatory perspective, the events of spring 2023, along with past crises, have shown that compliance with the liquidity coverage ratio (LCR) and the net stable funding ---[PAGE_BREAK]--- ratio (NSFR) may not provide sufficient assurance about a bank's liquidity and funding situation. For instance, an LCR above 100\% might still hide significant cliff risks just beyond the 30-day horizon. Two banks with identical LCRs might have vastly different liquidity profiles owing to concentration risks not captured by the ratio. However, it is important to remember that the LCR and the NSFR do not - and are not intended to - prevent all liquidity crises. They are not designed to address every residual risk, which should be managed on a case-by-case basis under Pillar 2. So while we support a review of specific aspects of the current calibration of these metrics, we are cautious about drastic changes. Instead, I would focus on the supervisory follow-up. And I can draw four main lessons with regard to the supervision of liquidity risk. First, supervisors, like banks, need to carry out holistic cross-risk analysis. Instead of looking at risks in isolation, we need to broaden our gaze and also focus on the interplay between IRRBB, liquidity risk management and governance arrangements. Second, we need increased supervisory scrutiny of banks' modelling of non-maturity deposits, as these models are sometimes not based on proper economic evidence. Third, it is essential that supervisors consider supplementary liquidity and funding risk indicators, such as survival period or concentration metrics, to capture residual risks not addressed by the LCR or the NSFR. In European banking supervision we have successfully used maturity ladder reporting to calculate survival periods, which provides a more comprehensive analysis beyond the fixed calibration of the LCR and the NSFR. Finally, the March 2023 turmoil demonstrated the need for timely and up-to-date information on liquidity and funding. We therefore introduced weekly data collections for liquidity risks in September 2023. This has been instrumental in identifying changes and detecting structural shifts across the banking system. # Growth of non-bank financial institutions Another issue we detect in our peripheral vision is the staggering growth of the nonbank financial institution (NBFI) sector. In the euro area, the sector has more than doubled in size, from $€ 15$ trillion in 2008 to $€ 32$ trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from $€ 87$ trillion in 2008 to $€ 200$ trillion in 2022. The private credit market is of particular concern. It accounts for $€ 1.6$ trillion of the global market and has also seen significant growth recently. The European private credit market has grown by $29 \%$ in the last three years but is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We have recently completed a deep dive on the topic and found that banks are not able to properly identify the detailed nature and levels of their full exposure to private credit funds. Therefore, concentration risk could be significant. ---[PAGE_BREAK]--- We know that risk from the NBFI sector can materialise through various channels. One of them is through the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque and more visible within even our fringe and central line of sight, we should further harmonise, enhance and expand reporting requirements. We need to make information sharing between authorities easier at global level to provide the visibility we need to play with more agility on the field. # Conclusion Earlier, I asked how much of the banking system's resilience is cyclical and how much is structural. I think it is safe to say that the European banking system is in better shape today than it was ten years ago. This won't surprise anyone in this room. Stronger capital and liquidity positions and healthier balance sheets are objective factors contributing to the resilience of the system. Still, I am a supervisor, so I am paid to worry. If my career has taught me anything, it's that accidents are more likely to happen when people get complacent. This is why I am calling on you to use your full vision - not only your central and fringe vision, but your peripheral vision too. Crises often emerge from the shadows, and it's the overlooked risks that pose the greatest danger. Let me conclude with another lesson that I have learnt during my career. It's a quote from Mark Twain: "There is no education in the second kick of a mule". We have seen too many crises caused by hidden risks lurking beneath the surface - the ones we fail to see until it's too late - which is precisely why we must get ahead of these risks this time around. Thank you very much for your attention. [^0] [^0]: ${ }^{1}$ Buch, C. (2024), "Global rifts and financial shifts: supervising banks in an era of geopolitical instability", keynote speech at the eighth European Systemic Risk Board (ESRB) annual conference on "New Frontiers in Macroprudential Policy", 26 September.	Elizabeth McCaul	Euro area	https://www.bis.org/review/r241008f.pdf	Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the S\&P European Financial Institutions Conference, Frankfurt am Main, 8 October 2024. Thank you very much for inviting me to today's conference, it is a pleasure to be here. The former German Chancellor Helmut Schmidt used to say "People with visions should go to the doctor". This sounds concerning to a supervisor. After all, the word "supervision" is made up of the prefix "super", which means "over" or "above", and "vision". But what exactly is vision? To find out, I followed Helmut Schmidt's advice and went to the doctor. What I learnt is that eye doctors distinguish between central vision, fringe vision and peripheral vision. Central vision is the very centre of the visual field. It delivers sharp, detailed pictures, allowing us to focus on objects straight ahead. In the banking world, these are the issues directly in front of us: capital, asset quality, profitability and key risk categories including climate-and environmental risks or cyber risk etc. Fringe vision refers to the area right outside the central vision, around 30 to 60 degrees of the visual field, where visual clarity and detail recognition start to decrease. Fringe vision helps us to absorb information faster when we read as our brains anticipate the next words and letters, making the process faster and smoother. Translating this to banking, this would be like noticing changes in the macroeconomic environment, rising geopolitical tensions, and their impact on banks' business models and risk profiles. Finally, peripheral vision is everything that occurs outside the very centre of our gaze, beyond 60 degrees. It encompasses everything that can be seen to the sides, providing spatial awareness which helps with navigation and balance. Improving peripheral vision is crucial for athletes as it increases reaction speed, improves anticipation and reduces the risk of injury. In banking, beyond the centre of our gaze are the structural transformations of our societies and economies: the acceleration of technological progress, including the rise of generative artificial intelligence or the impact of social media on depositor behaviour; the reconfiguration of the financial value chain; new entrants in the competitive landscape or the growing share of non-bank financial institutions. Good supervision and good risk management in banks require central, fringe and peripheral vision. Good peripheral vision sets apart decent athletes from great ones, allowing them to anticipate movements and respond swiftly to changes on the field. And the same holds true for banking supervisors: while central vision and fringe vision are crucial in focusing on immediate risks, it is the ability to maintain a broad, strategic view - our "peripheral vision" - that ensures truly effective supervision. This broader perspective enables us to detect emerging risks in the wider financial system, anticipate potential disruptions and respond proactively. In my remarks today, I will share our assessment of the current risk landscape, describing what we see in our central, fringe and peripheral vision. Let me start with the central vision of the state of the European banking system. In recent years, Europe's banking sector has shown resilience in the face of unforeseen challenges: the pandemic, the energy supply shock following Russia's invasion of Ukraine and a period of high inflation. This resilience is reflected in the numbers: in 2015, the average ratio of non-performing loans (NPLs) for significant banks in the banking union was $7.5 \%$, at a time when some banking systems had ratios close to $50 \%$. At the end of the second quarter of this year, this ratio had decreased to $2.3 \%$, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from $12.7 \%$ in 2015 to $15.8 \%$ today. Bank profitability has considerably increased in recent quarters, benefiting from higher interest rates, and return on equity now stands at $10.1 \%$. On the one hand, this resilience is a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis and the related improvements in banks' risk management. On the other hand, looking particularly at recent years, banks have also benefited from policy support which has helped shield the real economy from adverse shocks. For example, during the pandemic, comprehensive fiscal support measures contained corporate insolvencies and the associated loan losses. While bank profitability and valuations have recently improved due to higher interest rates, the effects of this supporting factor are gradually diminishing. Turning to liquidity, banks continue to show strong positions despite an ongoing reduction in excess liquidity. Access to both retail and wholesale funding remains robust, and the higher-than-expected stickiness of deposits has contributed to a stable funding environment. Nevertheless, banks should remain cautious and ensure that their liquidity and funding strategies are resilient to potential market disruptions. They need to maintain robust asset and liability management frameworks to enhance their resilience to both liquidity and funding risks as well as interest rate risk in the banking book. I will return to this topic later again. Finally, our supervisory priorities also include banks' capabilities to manage climateand environmental risks and cyber risk. Climate change can no longer be regarded only as a long-term or emerging risk, which is why banks need to address the challenges and grasp the opportunities of climate transition and adaptation. With regard to cyber risk, we have recently concluded a cyber resilience stress test to assess how banks would respond to and recover from a severe but plausible cybersecurity incident. While cyber risk has become a key risk for the banking sector, geopolitical tensions have further increased the threat of cyber-attacks. So, we may ask: how much of this resilience is structural, how much is cyclical? To get a more accurate picture of the current risk landscape, we need to slightly widen our gaze. This brings me to the fringe vision, looking at the broader macroeconomic environment. While the macro-financial environment has recently been improving as inflation decreases, near-term growth remains weak and subject to high uncertainty. Recent data indicate a gradual recovery in real GDP growth, primarily driven by the services sector, while industrial activity continues to face headwinds. Credit risk has only partially materialised so far, supported by strong fundamentals of households and corporates. Still, NPLs are slowly increasing, particularly in the commercial real estate (CRE) and small and medium-sized enterprise (SME) sectors. While the macroeconomic outlook signals a lower immediate risk of recession, asset quality in riskier segments is slowly deteriorating as the higher interest rate environment experienced over the last two years after a decade of 'low for long' weighs and may affect the debt servicing capacity of borrowers. In this context, we are conducting targeted reviews on banks' portfolios that demonstrate more sensitivity to the current macro-financial environment. This includes targeted reviews of SME portfolios and following up on the findings from residential real estate and CRE portfolio reviews as well as from deep dives on forbearance and unlikely-to-pay policies. Banks also need to remediate persistent shortcomings in their IFRS 9 frameworks and maintain an adequate level of provisions. In this context, we are continuing IFRS 9 targeted reviews focusing on, among other things, the use of overlays and coverage of novel risks. The current market risk environment is characterised by high risk appetite and benign risk pricing, which has prevailed in financial markets over the past year. This environment is susceptible to sudden shifts in market sentiment and episodes of high volatility, as seen in the recent global financial market sell-off. Although markets showed substantial resilience during the spike in volatility in August, banks should be ready for and able to cope with further episodes of sharp repricing and high volatility. The implementation of the recently postponed market risk part of the Basel III reform, the Fundamental Review of the Trading Book, will strengthen capital requirements for banks and help boost their resilience. Also within the broader macro-environment, the evolving geopolitical risk landscape has been on our radar for some time, considering the events of the past two and a half years, namely Russia's war in Ukraine and the conflict in the Middle East. While the direct impact of recent geopolitical events on the banking sector has been contained so far and the immediate threats are limited, we need to remain attentive and systematically assess the possible ramifications for banks. Geopolitical shocks are cross-cutting and could have direct and indirect effects on banks' financial and nonfinancial risks. For example, geopolitical shocks can exacerbate governance, operational and business model risks they lead to more sanctions or increased cyberattacks. We have seen a clear increase in the number of significant cyber incidents in 2023 and 2024, driven by attacks on service providers (typically ransomware) and by distributed denial-of-service attacks on banks. There can also be material consequences for banks' credit, market, liquidity, funding and profitability risks, especially in cases where banks have largescale direct or indirect balance sheet exposures to the countries, sectors, supply chains or firms and households that may be adversely affected by a geopolitical shock. Moreover, geopolitical events can also have wider second-round effects that could have negative knock-on consequences for the banking sector. For instance, downside risks to growth from slower economic activity or worsened sentiment as well as upward pressure on inflation related to supply or price shocks in energy or broader commodity markets can disrupt banks' operating environment. Escalating geopolitical tensions might also result in heightened financial market volatility, triggering further episodes of asset price corrections. The recent increase in geopolitical tensions calls for heightened scrutiny and robust risk management frameworks in banks, so that supervisors and banks can properly assess potential risks in the evolving geopolitical environment and proactively mitigate them. As Supervisory Board Chair Claudia Buch said recently , strengthening resilience to geopolitical shocks is a key priority for ECB Banking Supervision, and we will focus on a range of risk factors, from governance and risk management to capital planning, credit risk and operational resilience. And now, let us exercise our athletic capabilities, and use our peripheral vision to look at the wider risk landscape. Structural trends, such as the reconfiguration of the financial value chain, the impact of digitalisation and social media on liquidity, and the rise of non-bank financial institutions, are reshaping the environment in which banks operate. The emergence of big tech companies and other non-banking firms offering financial services is leading to a major restructuring in the market, changing the risk landscape, blurring traditional industry lines and challenging conventional regulatory boundaries. Companies whose primary business is technology are entering the financial sector through e-commerce and payment platforms and subsequently expanding into retail credit, mortgage lending or crypto services. These firms may explore alternative, less regulated lending forms like crypto lending using peer-to-peer platforms, ultimately mimicking the economic functions of banks without being subject to the same comprehensive oversight. We need to expand our tools and surveillance to prevent gaps in oversight and ensure they are robust and versatile enough to oversee disintermediated, increasingly interconnected and possibly distributed-ledger-based business models. We must adapt the regulation and oversight of such firms, especially for entities that are mainly active in non-financial services, to gain a thorough understanding of the financial activities of large non-bank groups across jurisdictions and sectors. Let me underscore that we should avoid a regulatory "race to the bottom" driven by a narrow mission of prioritising innovation and attracting large firms, which may not contribute to the good of society. Earlier, I asked how much of banks' resilience is structural and how much is cyclical. Let us look at the banking turmoil of March 2023 to better understand how banks weathered this crisis and identify what lessons we have learnt with regard to liquidity and funding. First, the events were a reminder to banks of the changing and increasingly volatile nature of depositor behaviour. Social media can play a pivotal role in encouraging large numbers of customers to withdraw deposits. In the case of Silicon Valley Bank, this behaviour was exacerbated by a highly networked and concentrated depositor base. Moreover, the advent of online banking, digitalisation, and the influence of non-bank competitors may also have a significant impact on depositor behaviour, affecting the stability of liquidity and funding sources. Therefore, banks must adapt their approaches so that they can monitor these risks more closely and understand the channels through which deposits are collected. We recently conducted a targeted review on the diversification of funding sources and the adequacy of funding plans. Our findings indicate a concerning heterogeneity in the adverse scenarios considered by significant banks. Often, these scenarios are only described at a high level, are not conservative, or only "stress" individual balance sheet items. The absence of comprehensive and credible underlying assumptions in these adverse scenarios reduces the reliability of funding plans and increases execution risk. The events of March 2023 also underscored the importance of banks' readiness to swiftly implement contingency and recovery measures. Another recent targeted review focused on collateral mobilisation. It found that banks have the operational capacity to tap central bank liquidity facilities. However, banks' assumptions about the time needed to monetise the assets appear rather optimistic in some cases, especially under stressed conditions. This optimism could hinder banks' ability to cover any unexpected outflows in a timely and sufficient manner. Furthermore, banks need to adopt a more holistic and comprehensive cross-risk analysis of potential vulnerabilities. The turmoil demonstrated how quickly deficiencies in business models and shortcomings in the management of interest rate risk in the banking book (IRRBB) can escalate into liquidity issues. It is essential to assess spillover effects and understand how shortcomings in one area can amplify risks in another. From a regulatory perspective, the events of spring 2023, along with past crises, have shown that compliance with the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) may not provide sufficient assurance about a bank's liquidity and funding situation. For instance, an LCR above 100\% might still hide significant cliff risks just beyond the 30-day horizon. Two banks with identical LCRs might have vastly different liquidity profiles owing to concentration risks not captured by the ratio. However, it is important to remember that the LCR and the NSFR do not - and are not intended to - prevent all liquidity crises. They are not designed to address every residual risk, which should be managed on a case-by-case basis under Pillar 2. So while we support a review of specific aspects of the current calibration of these metrics, we are cautious about drastic changes. Instead, I would focus on the supervisory follow-up. And I can draw four main lessons with regard to the supervision of liquidity risk. First, supervisors, like banks, need to carry out holistic cross-risk analysis. Instead of looking at risks in isolation, we need to broaden our gaze and also focus on the interplay between IRRBB, liquidity risk management and governance arrangements. Second, we need increased supervisory scrutiny of banks' modelling of non-maturity deposits, as these models are sometimes not based on proper economic evidence. Third, it is essential that supervisors consider supplementary liquidity and funding risk indicators, such as survival period or concentration metrics, to capture residual risks not addressed by the LCR or the NSFR. In European banking supervision we have successfully used maturity ladder reporting to calculate survival periods, which provides a more comprehensive analysis beyond the fixed calibration of the LCR and the NSFR. Finally, the March 2023 turmoil demonstrated the need for timely and up-to-date information on liquidity and funding. We therefore introduced weekly data collections for liquidity risks in September 2023. This has been instrumental in identifying changes and detecting structural shifts across the banking system. Another issue we detect in our peripheral vision is the staggering growth of the nonbank financial institution (NBFI) sector. In the euro area, the sector has more than doubled in size, from $€ 15$ trillion in 2008 to $€ 32$ trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from $€ 87$ trillion in 2008 to $€ 200$ trillion in 2022. The private credit market is of particular concern. It accounts for $€ 1.6$ trillion of the global market and has also seen significant growth recently. The European private credit market has grown by $29 \%$ in the last three years but is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We have recently completed a deep dive on the topic and found that banks are not able to properly identify the detailed nature and levels of their full exposure to private credit funds. Therefore, concentration risk could be significant. We know that risk from the NBFI sector can materialise through various channels. One of them is through the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque and more visible within even our fringe and central line of sight, we should further harmonise, enhance and expand reporting requirements. We need to make information sharing between authorities easier at global level to provide the visibility we need to play with more agility on the field. Earlier, I asked how much of the banking system's resilience is cyclical and how much is structural. I think it is safe to say that the European banking system is in better shape today than it was ten years ago. This won't surprise anyone in this room. Stronger capital and liquidity positions and healthier balance sheets are objective factors contributing to the resilience of the system. Still, I am a supervisor, so I am paid to worry. If my career has taught me anything, it's that accidents are more likely to happen when people get complacent. This is why I am calling on you to use your full vision - not only your central and fringe vision, but your peripheral vision too. Crises often emerge from the shadows, and it's the overlooked risks that pose the greatest danger. Let me conclude with another lesson that I have learnt during my career. It's a quote from Mark Twain: "There is no education in the second kick of a mule". We have seen too many crises caused by hidden risks lurking beneath the surface - the ones we fail to see until it's too late - which is precisely why we must get ahead of these risks this time around. Thank you very much for your attention.
2024-10-09T00:00:00	Philip N Jefferson: The Fed's discount window - 1990 to the present	Speech by Mr Philip N Jefferson, Vice Chair of the Board of Governors of the Federal Reserve System, at the Charlotte Economics Club, Charlotte, North Carolina, 9 October 2024.	For release on delivery 12:30 p.m. EDT October 9, 2024 The Fed's Discount Window: 1990 to the Present Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at the Charlotte Economics Club Charlotte, North Carolina October 9, 2024 Thank you, Steve, for that kind introduction and for the opportunity to talk to this group today. ! Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. Yesterday I shared my historical perspective on the discount window at Davidson College." In 1913, when the Federal Reserve was established, the discount window was the main tool it used to provide the nation with a safer, more flexible, and more stable monetary and financial system. More than 110 years later, the discount window continues to play an important role in supporting the liquidity and stability of the banking system, and the effective implementation of monetary policy. Today I would like to discuss with you how the discount window has evolved in the 21st century, including recent steps the Federal Reserve Board has taken to solicit feedback from the public on discount window operations. Before I address our most recent efforts, however, I will review some important episodes in discount window history that brought us to where we are today. First, I will recount briefly events in the 1980s and early 1990s that provide important context for the reappraisal of the discount window in the early 2000s. Second, ' The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ? See Jefferson (2024). -2- I will summarize revisions to the discount window that the Fed made in 2003 and some additional changes made since then. Third, I will describe efforts that the Fed has taken to ensure that the discount window remains effective today, including the request for information that the Board recently issued on operational aspects of the discount window and intraday credit. After completing my discussion of the discount window, I will conclude with my outlook for the U.S. economy. Events before the 2003 Discount Window Revisions I would like to pick up today where I left off yesterday in my speech at Davidson College: the 1980s and early 1990s. This was a period of widespread problems in the commercial banking sector. Troubled institutions borrowed from the discount window for extended periods of time as the Federal Deposit Insurance Corporation (FDIC) sought to find merger partners or otherwise manage the closure of these institutions. As a result, the discount window became associated strongly with lending to troubled institutions. Healthy banks' reluctance to borrow from the discount window increased. The greater reluctance to borrow from the discount window made it less effective both as a monetary policy tool and as a crisis-fighting tool.* This led to a reassessment of the discount window in the early 2000s and to eventual revisions implemented in 2003. 3 For more details about this period, see Clouse (1994). In response to the wave of depository institution failures, Congress placed legal limitations on Federal Reserve lending to troubled institutions. Specifically, section 142 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) amended section 10B of the Federal Reserve Act to place restraints on discount window lending to undercapitalized and critically undercapitalized insured depository institutions. FDICIA also imposed liability on the Board of Governors for excess losses incurred by the FDIC that are attributable to lending beyond those limits. The provisions of FDICIA were intended to reduce moral hazard in the banking system and limit taxpayer losses. -3- A Reassessment of the Discount Window in the Early 2000s The key challenge in the reassessment of the discount window was to establish a lending program that would not only operate effectively and support monetary policy implementation, but also mitigate moral hazard and provide sufficient controls to minimize risk to Reserve Banks and, ultimately, to American taxpayers. After the reassessment, the Fed implemented several changes aimed to achieve the right balance. The Board replaced the adjustment credit program, which was extended at a below-market rate, with a new type of discount window credit called primary credit. This new type of discount window credit became effective in 2003. It is available as a backup source of liquidity to depository institutions in generally sound financial condition at an above-market rate. Making the discount rate a penalty rate is more consistent with the long-standing practice of other major central banks. This feature was intended to reduce the need for administrative pressures based on Reserve Bank staff judgment of inappropriate usage when the discount rate was below market rates. Although those measures effectively limited usage that was deemed inappropriate at the time, they also presented communication challenges regarding when it was appropriate to use the discount window and perpetuated the perception that the Fed discouraged its use. Primary credit is a "no questions asked" facility in which eligible depository institutions are no longer required to have exhausted other sources of funding or be subject to restrictions on the use of the borrowed funds. The Fed initially set the primary credit rate 100 basis points above the target federal funds rate.> Since March 2020, the 4 For more details, see the October 31, 2002, Federal Reserve press release (Board of Governors, 2002b) and the final rule implementing the changes (Board of Governors, 2002a). 5 In 2003, when primary credit was implemented, there was a single federal funds target rate. The Federal Open Market Committee adopted a federal funds target range on December 16, 2008. 4. Fed has set the primary credit rate at a level equal to the top of the target range for the federal funds rate.° At the same time primary credit was established, another new program, called secondary credit, replaced the extended credit program. Secondary credit is available to depository institutions that are not eligible for primary credit. It was initially available at an interest rate 50 basis points higher than the primary credit rate, which is the spread in effect today. In contrast to primary credit, extensions under secondary credit are subject to higher collateral discounts and may involve ongoing oversight on the use of funds obtained under the program, reflecting the less-sound condition of secondary credit borrowers. Typically, Reserve Banks review a depository institution's plan to repay the loan and return to market sources of funding. This two-tiered structure of providing the no-questions-asked primary credit program for healthy depository institutions and the secondary credit program for less- than-healthy depository institutions was designed primarily to instill public confidence in the health of institutions borrowing from the primary credit program and to reduce the reluctance of healthy depository institutions to borrow.' In addition, having two separate facilities would reinforce the notion that healthy and troubled depository institutions alike should regard borrowing from the Fed as an option in the event of a need for additional funds. 6 For details on the change to the rate spread announced in March 2020, see the press release (Board of Governors, 2020). As will be discussed in greater detail later, before 2020, the spread between the primary credit rate and the target federal funds rate (or top of the target range) had changed a few times to address economic conditions during the 2007-09 financial crisis and the subsequent recovery. 7 This design feature also would help Reserve Banks manage risk more easily by establishing a standardized approach and risk controls when lending through a facility reserved for troubled depository institutions. Loans to troubled depository institutions entail more risk to the lending Reserve Bank, and depository institutions that are undercapitalized or critically undercapitalized are subject to lending limitations under FDICIA. -5- In the early years of the switch to the new facilities, there were signs that healthy depository institutions became more willing to borrow from the discount window. For example, some research found that after the 2003 discount window revisions, banks borrowed more from the discount window when the federal funds rate spiked than they had previously.* This finding suggests that the redesign of the discount window was effective in reducing banks' reluctance to borrow. As a result, the discount window may have been more effective in placing a ceiling on short-term funding rates, aiding the implementation of monetary policy, and serving as a liquidity tool when needed. Nevertheless, it is important to acknowledge that it is difficult to measure reluctance to borrow from the discount window. When the interest rate on primary credit is above the target federal funds rate and the federal funds rate is close to its target, the aggregate volume of primary credit is expected to be low. In other words, a low average level of discount window borrowing does not necessarily mean that there is a reluctance to borrow; instead, it could simply reflect a situation in which depository institutions do not currently need to borrow. In addition, when there is an abundance of liquidity in the banking system, as is the case in the current ample-reserves monetary policy regime, depository institutions may have less need to obtain additional liquidity via the discount window. Again, this does not necessarily mean that there is a reluctance to borrow. Conversely, the presence of discount window borrowing does not necessarily reflect the absence of a reluctance to borrow. It could be the case that, although aggregate usage increases, there are still some depository institutions that are willing to pay well above the primary credit rate even when they could have borrowed readily from the discount 8 See Artu¢ and Demiralp (2010). -6- window. For these reasons, it is important that we complement data with market outreach information to assess the effectiveness of the discount window. Changes and Challenges since the Introduction of Primary and Secondary Credit Primary and secondary credit exist today, but some changes have been made to primary credit since its inception. For example, although the discount window was used extensively and played an important role in the emergency measures taken during the financial crisis of 2007-09, some depository institutions during this period still were willing to borrow funds from the market at rates above the discount rate." This suggested that there was a reluctance to borrow before the crisis, and that reluctance appeared to grow over the course of the crisis. To promote the restoration of orderly conditions in financial markets and provide depository institutions with greater assurance about the cost and availability of funding, the Board approved temporary changes to its primary credit discount window facility during the crisis.!° In addition, in late 2007, the Board established the Term Auction Facility (TAF).!! Concerns about lending to troubled depository institutions reemerged after the 2007-09 financial crisis. In the Dodd-Frank Wall Street Reform and Consumer ° See Bernanke (2009a) and Madigan (2009) for a retrospective that elaborates on some of the emergency measures taken during the 2007-09 financial crisis and the reasoning for discount window rate changes during the financial crisis. '0 Throughout this crisis, the Board approved numerous reductions in the primary credit rate and narrowed the spread between the primary credit rate and the target federal funds rate twice. With the narrowing of the spread in August 2007 from 100 basis points to 50 basis points and in March 2008 to 25 basis points, the Board announced that the maximum term for primary credit loans would be extended, first to 30 days and then to 90 days, respectively. As economic conditions improved, in 2010, the Board increased the spread between the primary credit rate and the target federal funds rate to 50 basis points and shortened the maximum term for primary credit loans to overnight. "I The TAF provided fixed quantities of term credit to depository institutions through an auction mechanism and seemed to have largely addressed banks' concern that borrowing from the Federal Reserve would imply weakness. According to Bernanke (2009b, paragraph 7), this was "partly because the sizable number of borrowers provides a greater assurance of anonymity, and possibly also because the three-day period between the auction and auction settlement suggests that the facility's users are not using it to meet acute funding needs on a particular day." -7- Protection Act, which was enacted in 2010, Congress required the Fed to publish detailed individual institution borrowing data with a two-year lag.!* This action was intended to enhance the transparency and accountability of Federal Reserve lending while still preserving a measure of confidentiality to avoid discouraging depository institutions from borrowing. More recently, in March 2020, the Fed announced changes to the provision of primary credit that were intended to encourage depository institutions to use the discount window to meet demands for credit from households and businesses in connection with the COVID-19 pandemic. These changes included setting the primary credit rate at a level equal to the top of the federal funds target range-a step that enhanced the ability of the discount window to support trading within the Federal Open Market Committee's (FOMC) target range for the federal funds rate-and communicating the terms of borrowing as 90 days, prepayable and renewable on a daily basis. To further encourage depository institutions to use the discount window, the Fed also made changes to its reporting of Reserve Bank-level aggregate weekly discount window borrowing. It consolidated amounts previously reported as "loans," which include discount window borrowing, into a broader category of assets.'? The changes made in 2020 remain in effect. 2 See section 1103 of the Dodd-Frank Act, which amended section 11 of the Federal Reserve Act. '3 The Board's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," is published weekly (https://www.federalreserve.gov/releases/h41). It presents a balance sheet for each Federal Reserve Bank, a consolidated balance sheet for all 12 Reserve Banks, an associated statement that lists the factors affecting reserve balances of depository institutions, and several other tables presenting information on the assets, liabilities, and commitments of the Federal Reserve Banks. For additional details on the consolidation of "loans" into a broader category of assets, see the March 19, 2020, H.4.1 announcement, available on the Board's website at https://www.federalreserve.gov/releases/h4 1/202003 19. -8- During and after the spring 2023 stress events, the discount window again played an important role in supporting both monetary policy and financial stability. Depository institutions that came under severe stress turned to the discount window. The discount window also served an important role in providing ready access to funding, especially for depository institutions experiencing spillovers from the bank failures. To further ensure that depository institutions had the ability to meet the needs of all their depositors, the Board announced the creation of a new emergency program, the Bank Term Funding Program (BTFP). Although the BTFP was established pursuant to the Board's emergency lending authority in section 13(3) of the Federal Reserve Act, the BTFP used the discount window infrastructure to lend to eligible depository institution borrowers. '4 By relying on the existing discount window infrastructure, the BTFP was able to begin operating right away. The program ceased extending new loans on March 11, 2024, as scheduled. Today the discount window continues to be an effective tool, but it is important to acknowledge that economic and banking conditions continue to evolve. Since the 2003 discount window reassessment, we have seen an increased focus on liquidity in banking regulation, including the advent of quantitative liquidity requirements for large banking organizations; technological changes in the banking system; a general trend toward faster and 24-7-365 payment systems; changes in the composition and posture of Federal Home '4 As with the discount window, an eligible institution participated in the BTFP through its local Reserve Bank. The legal agreements and process for pledging securities in the BTFP also relied on those used in discount window lending. Nevertheless, the BTFP differed from the discount window in various ways, including the term of lending, scope of eligible collateral, collateral valuation, and interest rate. For more information on the differences between the BTFP and the discount window, see the response to question A.3 in Board of Governors (2024a, p. 3). For additional details on the BTFP, see the March 12, 2023, press release (Board of Governors, 2023). -9- Loan Bank lending; and the move to an ample-reserves monetary policy implementation regime. In light of these developments, the Federal Reserve System has taken important steps to ensure that the discount window performs its functions successfully in the 21st- century economy. For example, last year the Board, along with the other federal banking agencies and the National Credit Union Administration, issued guidance on contingency funding plans that encouraged depository institutions to be ready to borrow from the discount window.'> This includes taking steps to establish borrowing relationships with the Federal Reserve, such as providing certain legal documentation and ensuring that collateral to secure loans is ready to pledge. In connection with interagency initiatives, Reserve Banks have conducted outreach to depository institutions and made efforts to guide them in using the discount window. Data suggest that this encouragement is working. By the end of 2023, 3,900 banks, or roughly 80 percent of all banks, had completed the legal documentation required to borrow from the discount window.'® Of those, nearly 2,000 banks had pledged collateral, with an aggregate lendable value of over $2.6 trillion after applying appropriate discounts. These figures are notably above their levels at the end of 2021 and 2022. Although I am pleased to see the improvements in discount window readiness statistics, continued outreach is still important. To that effect, this summer, Federal Reserve Banks hosted an Ask the Fed® session to discuss the purpose of the discount 'S See Board of Governors and others (2023). '6 The statistics in this paragraph are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/discount-window-readiness.htm. -10- window, its facilities, and recommendations for depository institutions on how to prepare to borrow from the Fed.!7 Additionally, the Federal Reserve System has made important investments to enhance the technology that supports discount window activities. Earlier this year, the System launched Discount Window Direct, which is an online portal for depository institutions to request and prepay loans as well as securely message their local Reserve Bank.!® Discount Window Direct generally is accessible 24 hours a day. We are actively encouraging the use of Discount Window Direct. Seeking Feedback on the Discount Window To complement our efforts to enhance discount window operations, the Federal Reserve Board recently announced that it is collecting feedback from the public on operational frictions associated with the discount window and intraday credit through the issuance of a request for information. As some of you may know, a request for information is a formal document through which a government agency solicits feedback. Members of the public can submit comments in response to the request for information until December 9, 2024.!9 The Board requests input on various discount window and intraday credit operational practices, such as the process for requesting, receiving, and repaying discount window loans as well as Reserve Bank discount window and intraday credit communications practices. Through the request for information, the Board hopes to gain '7 More information on Ask the Fed is available on the Federal Reserve Bank of St. Louis's website at https://bsr.stlouisfed.org/askthefed/Auth/Logon. '8 Additional details on Discount Window Direct can be found on the Federal Reserve Bank Services website at https://www. frbservices.org/central-bank/lending-central. '9 See the information on discount window operations in section II.A of Board of Governors (2024b). -ll- further insight into the operational aspects that are the most costly or burdensome for depository institutions. This will help the Fed consider further improvements to promote efficiency and reduce burden on depository institutions. Ultimately, the Fed's goal is to build on the current discount window operations and processes so that the discount window will continue to provide ready access to funding against a wide range of collateral in the future. I encourage members of the public to submit comments on the request for information, and I look forward to considering the feedback that we receive. Economic Outlook Before concluding, let me share with you a summary of my outlook for the U.S. economy, as I did yesterday with the audience at Davidson. Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. Personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of households, businesses, and forecasters, as well as measures from financial markets. Inflation is now much closer to the FOMC's 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. The unemployment rate -12- now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by 1/2 percentage point. Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. Thank you. -13- References Artug, Erhan, and Selva Demiralp (2010). "Provision of Liquidity through the Primary Credit Facility during the Financial Crisis: A Structural Analysis," Federal Reserve Bank of New York, Economic Policy Review, vol. 16 (August), p. 43-53. Bernanke, Ben S. (2009a). "The Federal Reserve's Balance Sheet," speech delivered at the Federal Reserve Bank of Richmond 2009 Credit Markets Symposium, Charlotte, N.C., April 3, https://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm. (2009b). "The Federal Reserve's Balance Sheet: An Update," speech delivered at the Federal Reserve Board Conference on Key Developments in Monetary Policy, Washington, October 8, https://www.federalreserve.gov/newsevents/speech/bernanke2009 1008a.htm. Board of Governors of the Federal Reserve System (2002a). "Extensions of Credit by Federal Reserve Banks; Reserve Requirements of Depository Institutions," final tule, technical amendment (Docket Nos. R-1123 and R-1134), Federal Register, vol. 67 (November 7), pp. 67777-87, https://www. federalregister.gov/documents/2002/1 1/07/02-28 1 15/extensions-of- credit-by-federal-reserve-banks-reserve-requirements-of-depository-institutions. (2002b). "Publication of Final Rule Amending Regulation A (Extensions of Credit by Federal Reserve Banks)," press release, October 31, https://www.federalreserve. gov/boarddocs/press/bcreg/2002/200210312. (2020). "Federal Reserve Actions to Support the Flow of Credit to Households and Businesses," press release, March 15, https://www.federalreserve.gov/newsevents/pressreleases/monetary202003 15b.htm. (2023). "Federal Reserve Board Announces It Will Make Available Additional Funding to Eligible Depository Institutions to Help Assure Banks Have the Ability to Meet the Needs of All Their Depositors," press release, March 12, https://www.federalreserve.gov/newsevents/pressreleases/monetary202303 12a.htm. --- (2024a). "Bank Term Funding Program: Frequently Asked Questions," updated January 24, https://www.federalreserve.gov/financial-stability/files/bank-term- funding-program-faqs. pdf. - (2024b). "Request for Information and Comment on Operational Aspects of Federal Reserve Bank Extensions of Discount Window and Intraday Credit," request for information and comment (Docket No. OP-1838), Federal Register, vol. 89 (September 10), pp. 73415-18, https://www. federalregister.gov/documents/2024/09/10/2024-204 I 8/request-for- information-and-comment-on-operational-aspects-of-federal-reserve-bank- extensions-of#:~:text=A.- -14- ,Discount%20Window%20Operations, institution"%20must%20take%20several%2 Osteps. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency (2023). "Agencies Update Guidance on Liquidity Risks and Contingency Planning," joint press release, July 28, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230728a.htm. Clouse, James A. (1994). "Recent Developments in Discount Window Policy," Federal Reserve Bulletin, vol. 80 (November), pp. 965-77, https://www.federalreserve.gov/monetarypolicy/1194lead.pdf. Jefferson, Philip N. (2024). "A History of the Fed's Discount Window: 1913-2000," speech delivered at Davidson College, Davidson, N.C., October 8, https://www.federalreserve.gov/newsevents/speech/jefferson20241008a.htm. Madigan, Brian F. (2009). "Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis," speech delivered at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyo., August 21, https://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm.	---[PAGE_BREAK]--- For release on delivery 12:30 p.m. EDT October 9, 2024 The Fed's Discount Window: 1990 to the Present Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at the Charlotte Economics Club Charlotte, North Carolina October 9, 2024 ---[PAGE_BREAK]--- Thank you, Steve, for that kind introduction and for the opportunity to talk to this group today. ${ }^{1}$ Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. Yesterday I shared my historical perspective on the discount window at Davidson College. ${ }^{2}$ In 1913, when the Federal Reserve was established, the discount window was the main tool it used to provide the nation with a safer, more flexible, and more stable monetary and financial system. More than 110 years later, the discount window continues to play an important role in supporting the liquidity and stability of the banking system, and the effective implementation of monetary policy. Today I would like to discuss with you how the discount window has evolved in the 21 st century, including recent steps the Federal Reserve Board has taken to solicit feedback from the public on discount window operations. Before I address our most recent efforts, however, I will review some important episodes in discount window history that brought us to where we are today. First, I will recount briefly events in the 1980s and early 1990s that provide important context for the reappraisal of the discount window in the early 2000s. Second, [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See Jefferson (2024). ---[PAGE_BREAK]--- I will summarize revisions to the discount window that the Fed made in 2003 and some additional changes made since then. Third, I will describe efforts that the Fed has taken to ensure that the discount window remains effective today, including the request for information that the Board recently issued on operational aspects of the discount window and intraday credit. After completing my discussion of the discount window, I will conclude with my outlook for the U.S. economy. # Events before the 2003 Discount Window Revisions I would like to pick up today where I left off yesterday in my speech at Davidson College: the 1980s and early 1990s. This was a period of widespread problems in the commercial banking sector. Troubled institutions borrowed from the discount window for extended periods of time as the Federal Deposit Insurance Corporation (FDIC) sought to find merger partners or otherwise manage the closure of these institutions. As a result, the discount window became associated strongly with lending to troubled institutions. Healthy banks' reluctance to borrow from the discount window increased. The greater reluctance to borrow from the discount window made it less effective both as a monetary policy tool and as a crisis-fighting tool. ${ }^{3}$ This led to a reassessment of the discount window in the early 2000s and to eventual revisions implemented in 2003. [^0] [^0]: ${ }^{3}$ For more details about this period, see Clouse (1994). In response to the wave of depository institution failures, Congress placed legal limitations on Federal Reserve lending to troubled institutions. Specifically, section 142 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) amended section 10B of the Federal Reserve Act to place restraints on discount window lending to undercapitalized and critically undercapitalized insured depository institutions. FDICIA also imposed liability on the Board of Governors for excess losses incurred by the FDIC that are attributable to lending beyond those limits. The provisions of FDICIA were intended to reduce moral hazard in the banking system and limit taxpayer losses. ---[PAGE_BREAK]--- # A Reassessment of the Discount Window in the Early 2000s The key challenge in the reassessment of the discount window was to establish a lending program that would not only operate effectively and support monetary policy implementation, but also mitigate moral hazard and provide sufficient controls to minimize risk to Reserve Banks and, ultimately, to American taxpayers. After the reassessment, the Fed implemented several changes aimed to achieve the right balance. The Board replaced the adjustment credit program, which was extended at a below-market rate, with a new type of discount window credit called primary credit. This new type of discount window credit became effective in 2003. ${ }^{4}$ It is available as a backup source of liquidity to depository institutions in generally sound financial condition at an above-market rate. Making the discount rate a penalty rate is more consistent with the long-standing practice of other major central banks. This feature was intended to reduce the need for administrative pressures based on Reserve Bank staff judgment of inappropriate usage when the discount rate was below market rates. Although those measures effectively limited usage that was deemed inappropriate at the time, they also presented communication challenges regarding when it was appropriate to use the discount window and perpetuated the perception that the Fed discouraged its use. Primary credit is a "no questions asked" facility in which eligible depository institutions are no longer required to have exhausted other sources of funding or be subject to restrictions on the use of the borrowed funds. The Fed initially set the primary credit rate 100 basis points above the target federal funds rate. ${ }^{5}$ Since March 2020, the [^0] [^0]: ${ }^{4}$ For more details, see the October 31, 2002, Federal Reserve press release (Board of Governors, 2002b) and the final rule implementing the changes (Board of Governors, 2002a). ${ }^{5}$ In 2003, when primary credit was implemented, there was a single federal funds target rate. The Federal Open Market Committee adopted a federal funds target range on December 16, 2008. ---[PAGE_BREAK]--- Fed has set the primary credit rate at a level equal to the top of the target range for the federal funds rate. ${ }^{6}$ At the same time primary credit was established, another new program, called secondary credit, replaced the extended credit program. Secondary credit is available to depository institutions that are not eligible for primary credit. It was initially available at an interest rate 50 basis points higher than the primary credit rate, which is the spread in effect today. In contrast to primary credit, extensions under secondary credit are subject to higher collateral discounts and may involve ongoing oversight on the use of funds obtained under the program, reflecting the less-sound condition of secondary credit borrowers. Typically, Reserve Banks review a depository institution's plan to repay the loan and return to market sources of funding. This two-tiered structure of providing the no-questions-asked primary credit program for healthy depository institutions and the secondary credit program for less-than-healthy depository institutions was designed primarily to instill public confidence in the health of institutions borrowing from the primary credit program and to reduce the reluctance of healthy depository institutions to borrow. ${ }^{7}$ In addition, having two separate facilities would reinforce the notion that healthy and troubled depository institutions alike should regard borrowing from the Fed as an option in the event of a need for additional funds. [^0] [^0]: ${ }^{6}$ For details on the change to the rate spread announced in March 2020, see the press release (Board of Governors, 2020). As will be discussed in greater detail later, before 2020, the spread between the primary credit rate and the target federal funds rate (or top of the target range) had changed a few times to address economic conditions during the 2007-09 financial crisis and the subsequent recovery. ${ }^{7}$ This design feature also would help Reserve Banks manage risk more easily by establishing a standardized approach and risk controls when lending through a facility reserved for troubled depository institutions. Loans to troubled depository institutions entail more risk to the lending Reserve Bank, and depository institutions that are undercapitalized or critically undercapitalized are subject to lending limitations under FDICIA. ---[PAGE_BREAK]--- In the early years of the switch to the new facilities, there were signs that healthy depository institutions became more willing to borrow from the discount window. For example, some research found that after the 2003 discount window revisions, banks borrowed more from the discount window when the federal funds rate spiked than they had previously. ${ }^{8}$ This finding suggests that the redesign of the discount window was effective in reducing banks' reluctance to borrow. As a result, the discount window may have been more effective in placing a ceiling on short-term funding rates, aiding the implementation of monetary policy, and serving as a liquidity tool when needed. Nevertheless, it is important to acknowledge that it is difficult to measure reluctance to borrow from the discount window. When the interest rate on primary credit is above the target federal funds rate and the federal funds rate is close to its target, the aggregate volume of primary credit is expected to be low. In other words, a low average level of discount window borrowing does not necessarily mean that there is a reluctance to borrow; instead, it could simply reflect a situation in which depository institutions do not currently need to borrow. In addition, when there is an abundance of liquidity in the banking system, as is the case in the current ample-reserves monetary policy regime, depository institutions may have less need to obtain additional liquidity via the discount window. Again, this does not necessarily mean that there is a reluctance to borrow. Conversely, the presence of discount window borrowing does not necessarily reflect the absence of a reluctance to borrow. It could be the case that, although aggregate usage increases, there are still some depository institutions that are willing to pay well above the primary credit rate even when they could have borrowed readily from the discount [^0] [^0]: ${ }^{8}$ See Artuç and Demiralp (2010). ---[PAGE_BREAK]--- window. For these reasons, it is important that we complement data with market outreach information to assess the effectiveness of the discount window. # Changes and Challenges since the Introduction of Primary and Secondary Credit Primary and secondary credit exist today, but some changes have been made to primary credit since its inception. For example, although the discount window was used extensively and played an important role in the emergency measures taken during the financial crisis of 2007-09, some depository institutions during this period still were willing to borrow funds from the market at rates above the discount rate. ${ }^{9}$ This suggested that there was a reluctance to borrow before the crisis, and that reluctance appeared to grow over the course of the crisis. To promote the restoration of orderly conditions in financial markets and provide depository institutions with greater assurance about the cost and availability of funding, the Board approved temporary changes to its primary credit discount window facility during the crisis. ${ }^{10}$ In addition, in late 2007, the Board established the Term Auction Facility (TAF). ${ }^{11}$ Concerns about lending to troubled depository institutions reemerged after the 2007-09 financial crisis. In the Dodd-Frank Wall Street Reform and Consumer [^0] [^0]: ${ }^{9}$ See Bernanke (2009a) and Madigan (2009) for a retrospective that elaborates on some of the emergency measures taken during the 2007-09 financial crisis and the reasoning for discount window rate changes during the financial crisis. ${ }^{10}$ Throughout this crisis, the Board approved numerous reductions in the primary credit rate and narrowed the spread between the primary credit rate and the target federal funds rate twice. With the narrowing of the spread in August 2007 from 100 basis points to 50 basis points and in March 2008 to 25 basis points, the Board announced that the maximum term for primary credit loans would be extended, first to 30 days and then to 90 days, respectively. As economic conditions improved, in 2010, the Board increased the spread between the primary credit rate and the target federal funds rate to 50 basis points and shortened the maximum term for primary credit loans to overnight. ${ }^{11}$ The TAF provided fixed quantities of term credit to depository institutions through an auction mechanism and seemed to have largely addressed banks' concern that borrowing from the Federal Reserve would imply weakness. According to Bernanke (2009b, paragraph 7), this was "partly because the sizable number of borrowers provides a greater assurance of anonymity, and possibly also because the three-day period between the auction and auction settlement suggests that the facility's users are not using it to meet acute funding needs on a particular day." ---[PAGE_BREAK]--- Protection Act, which was enacted in 2010, Congress required the Fed to publish detailed individual institution borrowing data with a two-year lag. ${ }^{12}$ This action was intended to enhance the transparency and accountability of Federal Reserve lending while still preserving a measure of confidentiality to avoid discouraging depository institutions from borrowing. More recently, in March 2020, the Fed announced changes to the provision of primary credit that were intended to encourage depository institutions to use the discount window to meet demands for credit from households and businesses in connection with the COVID-19 pandemic. These changes included setting the primary credit rate at a level equal to the top of the federal funds target range-a step that enhanced the ability of the discount window to support trading within the Federal Open Market Committee's (FOMC) target range for the federal funds rate-and communicating the terms of borrowing as 90 days, prepayable and renewable on a daily basis. To further encourage depository institutions to use the discount window, the Fed also made changes to its reporting of Reserve Bank-level aggregate weekly discount window borrowing. It consolidated amounts previously reported as "loans," which include discount window borrowing, into a broader category of assets. ${ }^{13}$ The changes made in 2020 remain in effect. [^0] [^0]: ${ }^{12}$ See section 1103 of the Dodd-Frank Act, which amended section 11 of the Federal Reserve Act. ${ }^{13}$ The Board's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," is published weekly (https://www.federalreserve.gov/releases/h41). It presents a balance sheet for each Federal Reserve Bank, a consolidated balance sheet for all 12 Reserve Banks, an associated statement that lists the factors affecting reserve balances of depository institutions, and several other tables presenting information on the assets, liabilities, and commitments of the Federal Reserve Banks. For additional details on the consolidation of "loans" into a broader category of assets, see the March 19, 2020, H.4.1 announcement, available on the Board's website at https://www.federalreserve.gov/releases/h41/20200319. ---[PAGE_BREAK]--- During and after the spring 2023 stress events, the discount window again played an important role in supporting both monetary policy and financial stability. Depository institutions that came under severe stress turned to the discount window. The discount window also served an important role in providing ready access to funding, especially for depository institutions experiencing spillovers from the bank failures. To further ensure that depository institutions had the ability to meet the needs of all their depositors, the Board announced the creation of a new emergency program, the Bank Term Funding Program (BTFP). Although the BTFP was established pursuant to the Board's emergency lending authority in section 13(3) of the Federal Reserve Act, the BTFP used the discount window infrastructure to lend to eligible depository institution borrowers. ${ }^{14}$ By relying on the existing discount window infrastructure, the BTFP was able to begin operating right away. The program ceased extending new loans on March 11, 2024, as scheduled. Today the discount window continues to be an effective tool, but it is important to acknowledge that economic and banking conditions continue to evolve. Since the 2003 discount window reassessment, we have seen an increased focus on liquidity in banking regulation, including the advent of quantitative liquidity requirements for large banking organizations; technological changes in the banking system; a general trend toward faster and 24-7-365 payment systems; changes in the composition and posture of Federal Home [^0] [^0]: ${ }^{14}$ As with the discount window, an eligible institution participated in the BTFP through its local Reserve Bank. The legal agreements and process for pledging securities in the BTFP also relied on those used in discount window lending. Nevertheless, the BTFP differed from the discount window in various ways, including the term of lending, scope of eligible collateral, collateral valuation, and interest rate. For more information on the differences between the BTFP and the discount window, see the response to question A. 3 in Board of Governors (2024a, p. 3). For additional details on the BTFP, see the March 12, 2023, press release (Board of Governors, 2023). ---[PAGE_BREAK]--- Loan Bank lending; and the move to an ample-reserves monetary policy implementation regime. In light of these developments, the Federal Reserve System has taken important steps to ensure that the discount window performs its functions successfully in the 21stcentury economy. For example, last year the Board, along with the other federal banking agencies and the National Credit Union Administration, issued guidance on contingency funding plans that encouraged depository institutions to be ready to borrow from the discount window. ${ }^{15}$ This includes taking steps to establish borrowing relationships with the Federal Reserve, such as providing certain legal documentation and ensuring that collateral to secure loans is ready to pledge. In connection with interagency initiatives, Reserve Banks have conducted outreach to depository institutions and made efforts to guide them in using the discount window. Data suggest that this encouragement is working. By the end of 2023, 3,900 banks, or roughly 80 percent of all banks, had completed the legal documentation required to borrow from the discount window. ${ }^{16}$ Of those, nearly 2,000 banks had pledged collateral, with an aggregate lendable value of over $\$ 2.6$ trillion after applying appropriate discounts. These figures are notably above their levels at the end of 2021 and 2022. Although I am pleased to see the improvements in discount window readiness statistics, continued outreach is still important. To that effect, this summer, Federal Reserve Banks hosted an Ask the Fed ${ }^{\circledR}$ session to discuss the purpose of the discount [^0] [^0]: ${ }^{15}$ See Board of Governors and others (2023). ${ }^{16}$ The statistics in this paragraph are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/discount-window-readiness.htm. ---[PAGE_BREAK]--- window, its facilities, and recommendations for depository institutions on how to prepare to borrow from the Fed. ${ }^{17}$ Additionally, the Federal Reserve System has made important investments to enhance the technology that supports discount window activities. Earlier this year, the System launched Discount Window Direct, which is an online portal for depository institutions to request and prepay loans as well as securely message their local Reserve Bank. ${ }^{18}$ Discount Window Direct generally is accessible 24 hours a day. We are actively encouraging the use of Discount Window Direct. # Seeking Feedback on the Discount Window To complement our efforts to enhance discount window operations, the Federal Reserve Board recently announced that it is collecting feedback from the public on operational frictions associated with the discount window and intraday credit through the issuance of a request for information. As some of you may know, a request for information is a formal document through which a government agency solicits feedback. Members of the public can submit comments in response to the request for information until December 9, 2024. ${ }^{19}$ The Board requests input on various discount window and intraday credit operational practices, such as the process for requesting, receiving, and repaying discount window loans as well as Reserve Bank discount window and intraday credit communications practices. Through the request for information, the Board hopes to gain [^0] [^0]: ${ }^{17}$ More information on Ask the Fed is available on the Federal Reserve Bank of St. Louis's website at https://bsr.stlouisfed.org/askthefed/Auth/Logon. ${ }^{18}$ Additional details on Discount Window Direct can be found on the Federal Reserve Bank Services website at https://www.frbservices.org/central-bank/lending-central. ${ }^{19}$ See the information on discount window operations in section II.A of Board of Governors (2024b). ---[PAGE_BREAK]--- further insight into the operational aspects that are the most costly or burdensome for depository institutions. This will help the Fed consider further improvements to promote efficiency and reduce burden on depository institutions. Ultimately, the Fed's goal is to build on the current discount window operations and processes so that the discount window will continue to provide ready access to funding against a wide range of collateral in the future. I encourage members of the public to submit comments on the request for information, and I look forward to considering the feedback that we receive. # Economic Outlook Before concluding, let me share with you a summary of my outlook for the U.S. economy, as I did yesterday with the audience at Davidson. Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. Personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of households, businesses, and forecasters, as well as measures from financial markets. Inflation is now much closer to the FOMC's 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. The unemployment rate ---[PAGE_BREAK]--- now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by $1 / 2$ percentage point. Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. Thank you. ---[PAGE_BREAK]--- # References Artuç, Erhan, and Selva Demiralp (2010). "Provision of Liquidity through the Primary Credit Facility during the Financial Crisis: A Structural Analysis," Federal Reserve Bank of New York, Economic Policy Review, vol. 16 (August), p. 43-53. Bernanke, Ben S. (2009a). "The Federal Reserve's Balance Sheet," speech delivered at the Federal Reserve Bank of Richmond 2009 Credit Markets Symposium, Charlotte, N.C., April 3, https://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm. (2009b). "The Federal Reserve's Balance Sheet: An Update," speech delivered at the Federal Reserve Board Conference on Key Developments in Monetary Policy, Washington, October 8, https://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm. Board of Governors of the Federal Reserve System (2002a). "Extensions of Credit by Federal Reserve Banks; Reserve Requirements of Depository Institutions," final rule, technical amendment (Docket Nos. R-1123 and R-1134), Federal Register, vol. 67 (November 7), pp. 67777-87, https://www.federalregister.gov/documents/2002/11/07/02-28115/extensions-of-credit-by-federal-reserve-banks-reserve-requirements-of-depository-institutions. (2002b). "Publication of Final Rule Amending Regulation A (Extensions of Credit by Federal Reserve Banks)," press release, October 31, https://www.federalreserve.gov/boarddocs/press/bcreg/2002/200210312. (2020). "Federal Reserve Actions to Support the Flow of Credit to Households and Businesses," press release, March 15, https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm. (2023). "Federal Reserve Board Announces It Will Make Available Additional Funding to Eligible Depository Institutions to Help Assure Banks Have the Ability to Meet the Needs of All Their Depositors," press release, March 12, https://www.federalreserve.gov/newsevents/pressreleases/monetary20230312a.htm. (2024a). "Bank Term Funding Program: Frequently Asked Questions," updated January 24, https://www.federalreserve.gov/financial-stability/files/bank-term-funding-program-faqs.pdf. (2024b). "Request for Information and Comment on Operational Aspects of Federal Reserve Bank Extensions of Discount Window and Intraday Credit," request for information and comment (Docket No. OP-1838), Federal Register, vol. 89 (September 10), pp. 73415-18, https://www.federalregister.gov/documents/2024/09/10/2024-20418/request-for-information-and-comment-on-operational-aspects-of-federal-reserve-bank-extensions-of\#: :text=A.- ---[PAGE_BREAK]--- ,Discount\%20Window\%20Operations,institution\%20must\%20take\%20several\%2 0steps. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency (2023). "Agencies Update Guidance on Liquidity Risks and Contingency Planning," joint press release, July 28, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230728a.htm. Clouse, James A. (1994). "Recent Developments in Discount Window Policy," Federal Reserve Bulletin, vol. 80 (November), pp. 965-77, https://www.federalreserve.gov/monetarypolicy/1194lead.pdf. Jefferson, Philip N. (2024). "A History of the Fed's Discount Window: 1913-2000," speech delivered at Davidson College, Davidson, N.C., October 8, https://www.federalreserve.gov/newsevents/speech/jefferson20241008a.htm. Madigan, Brian F. (2009). "Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis," speech delivered at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyo., August 21, https://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm.	Philip N Jefferson	United States	https://www.bis.org/review/r241010a.pdf	For release on delivery 12:30 p.m. EDT October 9, 2024 The Fed's Discount Window: 1990 to the Present Remarks by Philip N. Jefferson Vice Chair Board of Governors of the Federal Reserve System at the Charlotte Economics Club Charlotte, North Carolina October 9, 2024 Thank you, Steve, for that kind introduction and for the opportunity to talk to this group today. Let me start by saying that I am saddened by the tragic loss of life, destruction, and damage resulting from Hurricane Helene in North Carolina, and throughout this region. My thoughts are with the people and communities affected. For our part, the Federal Reserve and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area to help make sure they can continue to meet the financial services needs of their communities. Yesterday I shared my historical perspective on the discount window at Davidson College. In 1913, when the Federal Reserve was established, the discount window was the main tool it used to provide the nation with a safer, more flexible, and more stable monetary and financial system. More than 110 years later, the discount window continues to play an important role in supporting the liquidity and stability of the banking system, and the effective implementation of monetary policy. Today I would like to discuss with you how the discount window has evolved in the 21 st century, including recent steps the Federal Reserve Board has taken to solicit feedback from the public on discount window operations. Before I address our most recent efforts, however, I will review some important episodes in discount window history that brought us to where we are today. First, I will recount briefly events in the 1980s and early 1990s that provide important context for the reappraisal of the discount window in the early 2000s. Second, I will summarize revisions to the discount window that the Fed made in 2003 and some additional changes made since then. Third, I will describe efforts that the Fed has taken to ensure that the discount window remains effective today, including the request for information that the Board recently issued on operational aspects of the discount window and intraday credit. After completing my discussion of the discount window, I will conclude with my outlook for the U.S. economy. I would like to pick up today where I left off yesterday in my speech at Davidson College: the 1980s and early 1990s. This was a period of widespread problems in the commercial banking sector. Troubled institutions borrowed from the discount window for extended periods of time as the Federal Deposit Insurance Corporation (FDIC) sought to find merger partners or otherwise manage the closure of these institutions. As a result, the discount window became associated strongly with lending to troubled institutions. Healthy banks' reluctance to borrow from the discount window increased. The greater reluctance to borrow from the discount window made it less effective both as a monetary policy tool and as a crisis-fighting tool. This led to a reassessment of the discount window in the early 2000s and to eventual revisions implemented in 2003. The key challenge in the reassessment of the discount window was to establish a lending program that would not only operate effectively and support monetary policy implementation, but also mitigate moral hazard and provide sufficient controls to minimize risk to Reserve Banks and, ultimately, to American taxpayers. After the reassessment, the Fed implemented several changes aimed to achieve the right balance. The Board replaced the adjustment credit program, which was extended at a below-market rate, with a new type of discount window credit called primary credit. This new type of discount window credit became effective in 2003. It is available as a backup source of liquidity to depository institutions in generally sound financial condition at an above-market rate. Making the discount rate a penalty rate is more consistent with the long-standing practice of other major central banks. This feature was intended to reduce the need for administrative pressures based on Reserve Bank staff judgment of inappropriate usage when the discount rate was below market rates. Although those measures effectively limited usage that was deemed inappropriate at the time, they also presented communication challenges regarding when it was appropriate to use the discount window and perpetuated the perception that the Fed discouraged its use. Primary credit is a "no questions asked" facility in which eligible depository institutions are no longer required to have exhausted other sources of funding or be subject to restrictions on the use of the borrowed funds. The Fed initially set the primary credit rate 100 basis points above the target federal funds rate. Since March 2020, the Fed has set the primary credit rate at a level equal to the top of the target range for the federal funds rate. At the same time primary credit was established, another new program, called secondary credit, replaced the extended credit program. Secondary credit is available to depository institutions that are not eligible for primary credit. It was initially available at an interest rate 50 basis points higher than the primary credit rate, which is the spread in effect today. In contrast to primary credit, extensions under secondary credit are subject to higher collateral discounts and may involve ongoing oversight on the use of funds obtained under the program, reflecting the less-sound condition of secondary credit borrowers. Typically, Reserve Banks review a depository institution's plan to repay the loan and return to market sources of funding. This two-tiered structure of providing the no-questions-asked primary credit program for healthy depository institutions and the secondary credit program for less-than-healthy depository institutions was designed primarily to instill public confidence in the health of institutions borrowing from the primary credit program and to reduce the reluctance of healthy depository institutions to borrow. In addition, having two separate facilities would reinforce the notion that healthy and troubled depository institutions alike should regard borrowing from the Fed as an option in the event of a need for additional funds. In the early years of the switch to the new facilities, there were signs that healthy depository institutions became more willing to borrow from the discount window. For example, some research found that after the 2003 discount window revisions, banks borrowed more from the discount window when the federal funds rate spiked than they had previously. This finding suggests that the redesign of the discount window was effective in reducing banks' reluctance to borrow. As a result, the discount window may have been more effective in placing a ceiling on short-term funding rates, aiding the implementation of monetary policy, and serving as a liquidity tool when needed. Nevertheless, it is important to acknowledge that it is difficult to measure reluctance to borrow from the discount window. When the interest rate on primary credit is above the target federal funds rate and the federal funds rate is close to its target, the aggregate volume of primary credit is expected to be low. In other words, a low average level of discount window borrowing does not necessarily mean that there is a reluctance to borrow; instead, it could simply reflect a situation in which depository institutions do not currently need to borrow. In addition, when there is an abundance of liquidity in the banking system, as is the case in the current ample-reserves monetary policy regime, depository institutions may have less need to obtain additional liquidity via the discount window. Again, this does not necessarily mean that there is a reluctance to borrow. Conversely, the presence of discount window borrowing does not necessarily reflect the absence of a reluctance to borrow. It could be the case that, although aggregate usage increases, there are still some depository institutions that are willing to pay well above the primary credit rate even when they could have borrowed readily from the discount window. For these reasons, it is important that we complement data with market outreach information to assess the effectiveness of the discount window. Primary and secondary credit exist today, but some changes have been made to primary credit since its inception. For example, although the discount window was used extensively and played an important role in the emergency measures taken during the financial crisis of 2007-09, some depository institutions during this period still were willing to borrow funds from the market at rates above the discount rate. Concerns about lending to troubled depository institutions reemerged after the 2007-09 financial crisis. In the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in 2010, Congress required the Fed to publish detailed individual institution borrowing data with a two-year lag. This action was intended to enhance the transparency and accountability of Federal Reserve lending while still preserving a measure of confidentiality to avoid discouraging depository institutions from borrowing. More recently, in March 2020, the Fed announced changes to the provision of primary credit that were intended to encourage depository institutions to use the discount window to meet demands for credit from households and businesses in connection with the COVID-19 pandemic. These changes included setting the primary credit rate at a level equal to the top of the federal funds target range-a step that enhanced the ability of the discount window to support trading within the Federal Open Market Committee's (FOMC) target range for the federal funds rate-and communicating the terms of borrowing as 90 days, prepayable and renewable on a daily basis. To further encourage depository institutions to use the discount window, the Fed also made changes to its reporting of Reserve Bank-level aggregate weekly discount window borrowing. It consolidated amounts previously reported as "loans," which include discount window borrowing, into a broader category of assets. The changes made in 2020 remain in effect. During and after the spring 2023 stress events, the discount window again played an important role in supporting both monetary policy and financial stability. Depository institutions that came under severe stress turned to the discount window. The discount window also served an important role in providing ready access to funding, especially for depository institutions experiencing spillovers from the bank failures. To further ensure that depository institutions had the ability to meet the needs of all their depositors, the Board announced the creation of a new emergency program, the Bank Term Funding Program (BTFP). Although the BTFP was established pursuant to the Board's emergency lending authority in section 13(3) of the Federal Reserve Act, the BTFP used the discount window infrastructure to lend to eligible depository institution borrowers. By relying on the existing discount window infrastructure, the BTFP was able to begin operating right away. The program ceased extending new loans on March 11, 2024, as scheduled. Today the discount window continues to be an effective tool, but it is important to acknowledge that economic and banking conditions continue to evolve. Since the 2003 discount window reassessment, we have seen an increased focus on liquidity in banking regulation, including the advent of quantitative liquidity requirements for large banking organizations; technological changes in the banking system; a general trend toward faster and 24-7-365 payment systems; changes in the composition and posture of Federal Home Loan Bank lending; and the move to an ample-reserves monetary policy implementation regime. In light of these developments, the Federal Reserve System has taken important steps to ensure that the discount window performs its functions successfully in the 21stcentury economy. For example, last year the Board, along with the other federal banking agencies and the National Credit Union Administration, issued guidance on contingency funding plans that encouraged depository institutions to be ready to borrow from the discount window. This includes taking steps to establish borrowing relationships with the Federal Reserve, such as providing certain legal documentation and ensuring that collateral to secure loans is ready to pledge. In connection with interagency initiatives, Reserve Banks have conducted outreach to depository institutions and made efforts to guide them in using the discount window. Data suggest that this encouragement is working. By the end of 2023, 3,900 banks, or roughly 80 percent of all banks, had completed the legal documentation required to borrow from the discount window. session to discuss the purpose of the discount window, its facilities, and recommendations for depository institutions on how to prepare to borrow from the Fed. Additionally, the Federal Reserve System has made important investments to enhance the technology that supports discount window activities. Earlier this year, the System launched Discount Window Direct, which is an online portal for depository institutions to request and prepay loans as well as securely message their local Reserve Bank. Discount Window Direct generally is accessible 24 hours a day. We are actively encouraging the use of Discount Window Direct. To complement our efforts to enhance discount window operations, the Federal Reserve Board recently announced that it is collecting feedback from the public on operational frictions associated with the discount window and intraday credit through the issuance of a request for information. As some of you may know, a request for information is a formal document through which a government agency solicits feedback. Members of the public can submit comments in response to the request for information until December 9, 2024. The Board requests input on various discount window and intraday credit operational practices, such as the process for requesting, receiving, and repaying discount window loans as well as Reserve Bank discount window and intraday credit communications practices. Through the request for information, the Board hopes to gain further insight into the operational aspects that are the most costly or burdensome for depository institutions. This will help the Fed consider further improvements to promote efficiency and reduce burden on depository institutions. Ultimately, the Fed's goal is to build on the current discount window operations and processes so that the discount window will continue to provide ready access to funding against a wide range of collateral in the future. I encourage members of the public to submit comments on the request for information, and I look forward to considering the feedback that we receive. Before concluding, let me share with you a summary of my outlook for the U.S. economy, as I did yesterday with the audience at Davidson. Economic activity continues to grow at a solid pace. Inflation has eased substantially. The labor market has cooled from its formerly overheated state. Personal consumption expenditures (PCE) prices rose 2.2 percent over the 12 months ending in August, well down from 6.5 percent two years earlier. Excluding the volatile food and energy categories, core PCE prices rose 2.7 percent, compared with 5.2 percent two years earlier. Our restrictive monetary policy stance played a role in restraining demand and in keeping longer-term inflation expectations well anchored, as reflected in a broad range of inflation surveys of households, businesses, and forecasters, as well as measures from financial markets. Inflation is now much closer to the FOMC's 2 percent objective. I expect that we will continue to make progress toward that goal. While, overall, the economy continues to grow at a solid pace, the labor market has modestly cooled. Employers added an average of 186,000 jobs per month during July through September, a slower pace than seen early this year. The unemployment rate now stands at 4.1 percent, up from 3.8 percent in September 2023. Meanwhile, job openings declined by about 4 million since their peak in March 2022. The good news is that the rise in unemployment has been limited and gradual, and the level of unemployment remains historically low. Even so, the cooling in the labor market is noticeable. Congress mandated the Fed to pursue maximum employment and price stability. The balance of risks to our two mandates has changed-as risks to inflation have diminished and risks to employment have risen, these risks have been brought roughly into balance. The FOMC has gained greater confidence that inflation is moving sustainably toward our 2 percent goal. To maintain the strength of the labor market, my FOMC colleagues and I recalibrated our policy stance last month, lowering our policy interest rate by $1 / 2$ percentage point. Looking ahead, I will carefully watch incoming data, the evolving outlook, and the balance of risks when considering additional adjustments to the federal funds target range, our primary tool for adjusting the stance of monetary policy. My approach to monetary policymaking is to make decisions meeting by meeting. As the economy evolves, I will continue to update my thinking about policy to best promote maximum employment and price stability. Thank you. Bernanke, Ben S. (2009a). "The Federal Reserve's Balance Sheet," speech delivered at the Federal Reserve Bank of Richmond 2009 Credit Markets Symposium, Charlotte, N.C., April 3, https://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm. (2009b). "The Federal Reserve's Balance Sheet: An Update," speech delivered at the Federal Reserve Board Conference on Key Developments in Monetary Policy, Washington, October 8, https://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm. Board of Governors of the Federal Reserve System (2002a). "Extensions of Credit by Federal Reserve Banks; Reserve Requirements of Depository Institutions," final rule, technical amendment (Docket Nos. R-1123 and R-1134), Federal Register, vol. 67 (November 7), pp. 67777-87, https://www.federalregister.gov/documents/2002/11/07/02-28115/extensions-of-credit-by-federal-reserve-banks-reserve-requirements-of-depository-institutions. (2002b). "Publication of Final Rule Amending Regulation A (Extensions of Credit by Federal Reserve Banks)," press release, October 31, https://www.federalreserve.gov/boarddocs/press/bcreg/2002/200210312. (2024a). "Bank Term Funding Program: Frequently Asked Questions," updated January 24, https://www.federalreserve.gov/financial-stability/files/bank-term-funding-program-faqs.pdf. (2024b). "Request for Information and Comment on Operational Aspects of Federal Reserve Bank Extensions of Discount Window and Intraday Credit," request for information and comment (Docket No. OP-1838), Federal Register, vol. 89 (September 10), pp. 73415-18, https://www.federalregister.gov/documents/2024/09/10/2024-20418/request-for-information-and-comment-on-operational-aspects-of-federal-reserve-bank-extensions-of\#: :text=A.- ,Discount\%20Window\%20Operations,institution\%20must\%20take\%20several\%2 0steps.
2024-10-10T00:00:00	John C Williams: All about data	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Binghamton University, Binghamton, New York, 10 October 2024.	John C Williams: All about data Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Binghamton University, Binghamton, New York, 10 October 2024. * * * As prepared for delivery Introduction Good morning. I'm so pleased to be here at Binghamton University, a true gem of the SUNY system. Meeting with students, educators, and business and community leaders is a valuable and enjoyable part of my job. The New York Fed represents the Federal Reserve System's Second District, which includes New York State, northern New Jersey, western Connecticut, Puerto Rico, and the U.S. Virgin Islands. This is a diverse region made up of many smaller local economies. Therefore, it's important for me and my colleagues at the New York Fed to collect data and learn about the challenges and opportunities facing all of the communities we serve. That said, monetary policy affects everyone, and the Federal Reserve is committed to using its tools to achieve its dual mandate of maximum employment and price stability. Today, I will talk about monetary policy and how the Fed is working to fulfill this dual mandate. I'll also give you my outlook on the U.S. economy. Before I do, I will give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Obsessing Over Data As I've traveled around the Southern Tier region, I've enjoyed seeing the emergence of the colors of autumn. Tracking fall foliage is a hobby for many. What I like is that it's all about data. "Leaf peepers" submit field reports on changing color conditions, and experts pore over the information. One forecast predicts we will hit peak foliage in four days.1 At the Fed, we're equally obsessed with data. In our case, we study data about the economy-whether here in the district, across the country, or around the world. So, I'll highlight some of the data that help my understanding of how the economy is performing relative to our dual mandate goals, as well as what policy actions we can take to achieve these goals. When inflation became unacceptably high and the labor market exceptionally tight, the FOMC acted with resolve to bring inflation back down to our 2 percent longer-run target. The Committee's strong actions have helped bring the economy much closer to our goals. Imbalances between supply and demand in the economy have mostly dissipated, even as the economy and employment have continued to grow. And inflation, as measured by the personal consumption expenditures (PCE) price index, has declined from over 7 percent in June of 2022 to just 2-1/4 percent in the latest reading. There's still some distance to go to reach our goal of 2 percent, but we're definitely moving in the right direction. The data paint a picture of an economy that has returned to balance, or in a word that the English majors in the room may appreciate, "equipoise." In light of the progress we have seen in reducing inflation and restoring balance to the economy, the FOMC decided at its most recent meeting to lower the interest rate that it sets. Simply put, this action will help maintain the strength of the economy and labor market while inflation moves back to 2 percent on a sustainable basis. Moving to Price Stability I'll go further into our policy decision and what it means for the economic outlook in a minute. But first, I'll give more details about each side of our dual mandate, starting with inflation. I'll use an onion analogy that I have found useful over the past two years to demonstrate how inflation's three distinct layers are normalizing at different rates.2 The onion's outer layer represents globally traded commodities. As the economy started to rebound from pandemic shutdowns and demand began to soar, inflation surged, then rose further when Russia invaded Ukraine. Since then, supply and demand have come into balance, and these prices have generally been flat or falling. The middle onion layer is made up of core goods, excluding commodities. Demand for goods rose sharply as the economy emerged from the pandemic downturn-just as global pandemic-related supply-chain disruptions significantly hampered supply. But, as seen in the New York Fed's Global Supply Chain Pressure Index, those supply pressures have eased, and core goods inflation has returned to pre-pandemic norms.3 The inner onion layer comprises core services. Although this category is taking the longest to normalize, the disinflationary process is well underway here too. For example, measures of underlying inflation that tend to be heavily influenced by core services inflation today average around 2-1/2 percent.4 One positive piece of data that reinforces my confidence that inflation is on course to reach our 2 percent goal is that inflation expectations remain well anchored across all forecast horizons. This is seen in the New York Fed's Survey of Consumer Expectations as well as other surveys and market-based measures.5 A Labor Market in Balance Now I'll turn to the employment side of our mandate. And no surprise, I'll point to data. A wide range of metrics-including the unemployment rate; measures of job openings, hiring, quits, and employment flows; and perceptions of job and worker availabilityindicate that the very tight labor market of the past few years has now returned to more normal conditions and is unlikely to be a source of inflationary pressures going forward. Recent analysis by researchers at the New York Fed provides a useful way to gauge 6 whether the labor market is tight or loose. They find that you can effectively summarize the state of the overall labor market in terms of its effect on compensation growth by using just two indicators: the rate at which employees quit their jobs and the ratio of job openings to job seekers. In fact, once you take these two measures into account, other labor market metrics that get a lot of attention-such as the unemployment rate and the vacancy-to-unemployment ratio-don't provide additional useful information. Combining these two measures into an index of labor market tightness provides two key insights. First, data as of the second quarter of this year indicate that the labor market is about where it was in early 2018-a period of solid labor market conditions and low inflation. Second, compensation growth should soon return to levels that prevailed prior to the pandemic. Seasons of Change So, the labor market is solid. The economy is in a good place. And inflation is closing in on our 2 percent longer-run goal. With the risks to achieving our goals now in balance, the FOMC decided to lower the target range for the federal funds rate by half a percentage point, to 4-3/4 to 5 percent. In addition, the Committee continued to normalize the holdings of securities on the Fed's balance sheet.7 Looking ahead, based on my current forecast for the economy, I expect that it will be appropriate to continue the process of moving the stance of monetary policy to a more neutral setting over time. The timing and pace of future adjustments to interest rates will be based on the evolution of the data, the economic outlook, and the risks to achieving our goals. We will continue to be data-dependent and attuned to the evolution of economic conditions in making our decisions. With monetary policy moving to a more neutral setting over time, I expect real GDP to grow between 2-1/4 and 2-1/2 percent this year and to average about 2-1/4 percent over the next two years. I anticipate the unemployment rate to edge up from its current level of about 4 percent to around 4-1/4 percent at the end of this year and stay around that level next year. With the economy in balance and inflation expectations well anchored, I expect overall PCE inflation to be around 2-1/4 percent this year, and to be close to 2 percent next year. Conclusion The economy has been on a remarkable journey. In two years, the red-hot labor market has normalized, and inflation has come within striking distance of our 2 percent longerrun goal-all while employment and the economy continue to grow. We instituted and maintained a very restrictive monetary policy stance until the data gave us confidence that inflation is sustainably on course to 2 percent. With this progress toward achieving price stability, moving toward a more neutral monetary policy stance will help maintain the strength of the economy and labor market. Although the outlook remains uncertain, we are well positioned to achieve our dual mandate goals. See https://smokymountains.com/fall-foliage-map for the forecast of foliage in this area as well as across the nation. 2 John C. Williams, A Bedrock Commitment to Price Stability , remarks at the 2022 U.S. Hispanic Chamber of Commerce National Conference, Phoenix, Arizona, October 3, 2022; John C. Williams, Peeling the Inflation Onion , remarks at the Economic Club of New York (delivered via videoconference), November 28, 2022; John C. Williams, " Peeling the Inflation Onion, Revisited," Federal Reserve Bank of New York, The Teller Window , September 29, 2023. 3 Federal Reserve Bank of New York, Global Supply Chain Pressure Index (September 2024). 4 In particular, the Federal Reserve Bank of New York Multivariate Core Trend Inflation measure was 2.6% in August (August 2024 report), while the 6-month change in the Dallas Fed trimmed mean measure was 2.3% at an annual rate. 5 Federal Reserve Bank of New York, Survey of Consumer Expectations (August 2024). 6 Sebastian Heise, Jeremy Pearce, and Jacob P. Weber, "A New Indicator of Labor Market Tightness for Predicting Wage Inflation," Federal Reserve Bank of New York Liberty Street Economics, October 9, 2024; and Sebastian Heise, Jeremy Pearce, and Jacob P. Weber, " Wage Growth and Labor Market Tightness ," Federal Reserve Bank of New York Staff Report Number 1128, October 2024. 7 Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, September 18, 2024.	---[PAGE_BREAK]--- # John C Williams: All about data Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Binghamton University, Binghamton, New York, 10 October 2024. ## As prepared for delivery ## Introduction Good morning. I'm so pleased to be here at Binghamton University, a true gem of the SUNY system. Meeting with students, educators, and business and community leaders is a valuable and enjoyable part of my job. The New York Fed represents the Federal Reserve System's Second District, which includes New York State, northern New Jersey, western Connecticut, Puerto Rico, and the U.S. Virgin Islands. This is a diverse region made up of many smaller local economies. Therefore, it's important for me and my colleagues at the New York Fed to collect data and learn about the challenges and opportunities facing all of the communities we serve. That said, monetary policy affects everyone, and the Federal Reserve is committed to using its tools to achieve its dual mandate of maximum employment and price stability. Today, I will talk about monetary policy and how the Fed is working to fulfill this dual mandate. I'll also give you my outlook on the U.S. economy. Before I do, I will give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. ## Obsessing Over Data As I've traveled around the Southern Tier region, I've enjoyed seeing the emergence of the colors of autumn. Tracking fall foliage is a hobby for many. What I like is that it's all about data. "Leaf peepers" submit field reports on changing color conditions, and experts pore over the information. One forecast predicts we will hit peak foliage in four days. ${ }^{1}$ At the Fed, we're equally obsessed with data. In our case, we study data about the economy-whether here in the district, across the country, or around the world. So, I'll highlight some of the data that help my understanding of how the economy is performing relative to our dual mandate goals, as well as what policy actions we can take to achieve these goals. When inflation became unacceptably high and the labor market exceptionally tight, the FOMC acted with resolve to bring inflation back down to our 2 percent longer-run target. The Committee's strong actions have helped bring the economy much closer to our ---[PAGE_BREAK]--- goals. Imbalances between supply and demand in the economy have mostly dissipated, even as the economy and employment have continued to grow. And inflation, as measured by the personal consumption expenditures (PCE) price index, has declined from over 7 percent in June of 2022 to just 2-1/4 percent in the latest reading. There's still some distance to go to reach our goal of 2 percent, but we're definitely moving in the right direction. The data paint a picture of an economy that has returned to balance, or in a word that the English majors in the room may appreciate, "equipoise." In light of the progress we have seen in reducing inflation and restoring balance to the economy, the FOMC decided at its most recent meeting to lower the interest rate that it sets. Simply put, this action will help maintain the strength of the economy and labor market while inflation moves back to 2 percent on a sustainable basis. # Moving to Price Stability I'll go further into our policy decision and what it means for the economic outlook in a minute. But first, I'll give more details about each side of our dual mandate, starting with inflation. I'll use an onion analogy that I have found useful over the past two years to demonstrate how inflation's three distinct layers are normalizing at different rates. $\underline{2}$ The onion's outer layer represents globally traded commodities. As the economy started to rebound from pandemic shutdowns and demand began to soar, inflation surged, then rose further when Russia invaded Ukraine. Since then, supply and demand have come into balance, and these prices have generally been flat or falling. The middle onion layer is made up of core goods, excluding commodities. Demand for goods rose sharply as the economy emerged from the pandemic downturn-just as global pandemic-related supply-chain disruptions significantly hampered supply. But, as seen in the New York Fed's Global Supply Chain Pressure Index, those supply pressures have eased, and core goods inflation has returned to pre-pandemic norms. $\underline{3}$ The inner onion layer comprises core services. Although this category is taking the longest to normalize, the disinflationary process is well underway here too. For example, measures of underlying inflation that tend to be heavily influenced by core services inflation today average around 2-1/2 percent. $\underline{4}$ One positive piece of data that reinforces my confidence that inflation is on course to reach our 2 percent goal is that inflation expectations remain well anchored across all forecast horizons. This is seen in the New York Fed's Survey of Consumer Expectations as well as other surveys and market-based measures. ${ }^{5}$ ## A Labor Market in Balance Now I'll turn to the employment side of our mandate. And no surprise, I'll point to data. A wide range of metrics-including the unemployment rate; measures of job openings, hiring, quits, and employment flows; and perceptions of job and worker availabilityindicate that the very tight labor market of the past few years has now returned to more normal conditions and is unlikely to be a source of inflationary pressures going forward. ---[PAGE_BREAK]--- Recent analysis by researchers at the New York Fed provides a useful way to gauge whether the labor market is tight or loose. ${ }^{6}$ They find that you can effectively summarize the state of the overall labor market in terms of its effect on compensation growth by using just two indicators: the rate at which employees quit their jobs and the ratio of job openings to job seekers. In fact, once you take these two measures into account, other labor market metrics that get a lot of attention-such as the unemployment rate and the vacancy-to-unemployment ratio-don't provide additional useful information. Combining these two measures into an index of labor market tightness provides two key insights. First, data as of the second quarter of this year indicate that the labor market is about where it was in early 2018-a period of solid labor market conditions and low inflation. Second, compensation growth should soon return to levels that prevailed prior to the pandemic. # Seasons of Change So, the labor market is solid. The economy is in a good place. And inflation is closing in on our 2 percent longer-run goal. With the risks to achieving our goals now in balance, the FOMC decided to lower the target range for the federal funds rate by half a percentage point, to $4-3 / 4$ to 5 percent. In addition, the Committee continued to normalize the holdings of securities on the Fed's balance sheet. ${ }^{7}$ Looking ahead, based on my current forecast for the economy, I expect that it will be appropriate to continue the process of moving the stance of monetary policy to a more neutral setting over time. The timing and pace of future adjustments to interest rates will be based on the evolution of the data, the economic outlook, and the risks to achieving our goals. We will continue to be data-dependent and attuned to the evolution of economic conditions in making our decisions. With monetary policy moving to a more neutral setting over time, I expect real GDP to grow between 2-1/4 and 2-1/2 percent this year and to average about 2-1/4 percent over the next two years. I anticipate the unemployment rate to edge up from its current level of about 4 percent to around $4-1 / 4$ percent at the end of this year and stay around that level next year. With the economy in balance and inflation expectations well anchored, I expect overall PCE inflation to be around 2-1/4 percent this year, and to be close to 2 percent next year. ## Conclusion The economy has been on a remarkable journey. In two years, the red-hot labor market has normalized, and inflation has come within striking distance of our 2 percent longerrun goal-all while employment and the economy continue to grow. We instituted and maintained a very restrictive monetary policy stance until the data gave us confidence that inflation is sustainably on course to 2 percent. With this progress toward achieving price stability, moving toward a more neutral monetary policy stance will help maintain the strength of the economy and labor market. Although the outlook remains uncertain, we are well positioned to achieve our dual mandate goals. ---[PAGE_BREAK]--- ${ }^{1}$ See https://smokymountains.com/fall-foliage-map for the forecast of foliage in this area as well as across the nation. ${ }^{2}$ John C. Williams, A Bedrock Commitment to Price Stability, remarks at the 2022 U.S. Hispanic Chamber of Commerce National Conference, Phoenix, Arizona, October 3, 2022; John C. Williams, Peeling the Inflation Onion, remarks at the Economic Club of New York (delivered via videoconference), November 28, 2022; John C. Williams, " Peeling the Inflation Onion, Revisited," Federal Reserve Bank of New York, The Teller Window, September 29, 2023. ${ }^{3}$ Federal Reserve Bank of New York, Global Supply Chain Pressure Index (September 2024). ${ }^{4}$ In particular, the Federal Reserve Bank of New York Multivariate Core Trend Inflation measure was $2.6 \%$ in August (August 2024 report), while the 6-month change in the Dallas Fed trimmed mean measure was $2.3 \%$ at an annual rate. ${ }^{5}$ Federal Reserve Bank of New York, Survey of Consumer Expectations (August 2024). ${ }^{6}$ Sebastian Heise, Jeremy Pearce, and Jacob P. Weber, "A New Indicator of Labor Market Tightness for Predicting Wage Inflation," Federal Reserve Bank of New York Liberty Street Economics, October 9, 2024; and Sebastian Heise, Jeremy Pearce, and Jacob P. Weber, "Wage Growth and Labor Market Tightness," Federal Reserve Bank of New York Staff Report Number 1128, October 2024. ${ }^{7}$ Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, September 18, 2024.	John C Williams	United States	https://www.bis.org/review/r241014n.pdf	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Binghamton University, Binghamton, New York, 10 October 2024. Good morning. I'm so pleased to be here at Binghamton University, a true gem of the SUNY system. Meeting with students, educators, and business and community leaders is a valuable and enjoyable part of my job. The New York Fed represents the Federal Reserve System's Second District, which includes New York State, northern New Jersey, western Connecticut, Puerto Rico, and the U.S. Virgin Islands. This is a diverse region made up of many smaller local economies. Therefore, it's important for me and my colleagues at the New York Fed to collect data and learn about the challenges and opportunities facing all of the communities we serve. That said, monetary policy affects everyone, and the Federal Reserve is committed to using its tools to achieve its dual mandate of maximum employment and price stability. Today, I will talk about monetary policy and how the Fed is working to fulfill this dual mandate. I'll also give you my outlook on the U.S. economy. Before I do, I will give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. As I've traveled around the Southern Tier region, I've enjoyed seeing the emergence of the colors of autumn. Tracking fall foliage is a hobby for many. What I like is that it's all about data. "Leaf peepers" submit field reports on changing color conditions, and experts pore over the information. One forecast predicts we will hit peak foliage in four days. At the Fed, we're equally obsessed with data. In our case, we study data about the economy-whether here in the district, across the country, or around the world. So, I'll highlight some of the data that help my understanding of how the economy is performing relative to our dual mandate goals, as well as what policy actions we can take to achieve these goals. When inflation became unacceptably high and the labor market exceptionally tight, the FOMC acted with resolve to bring inflation back down to our 2 percent longer-run target. The Committee's strong actions have helped bring the economy much closer to our goals. Imbalances between supply and demand in the economy have mostly dissipated, even as the economy and employment have continued to grow. And inflation, as measured by the personal consumption expenditures (PCE) price index, has declined from over 7 percent in June of 2022 to just 2-1/4 percent in the latest reading. There's still some distance to go to reach our goal of 2 percent, but we're definitely moving in the right direction. The data paint a picture of an economy that has returned to balance, or in a word that the English majors in the room may appreciate, "equipoise." In light of the progress we have seen in reducing inflation and restoring balance to the economy, the FOMC decided at its most recent meeting to lower the interest rate that it sets. Simply put, this action will help maintain the strength of the economy and labor market while inflation moves back to 2 percent on a sustainable basis. I'll go further into our policy decision and what it means for the economic outlook in a minute. But first, I'll give more details about each side of our dual mandate, starting with inflation. I'll use an onion analogy that I have found useful over the past two years to demonstrate how inflation's three distinct layers are normalizing at different rates. The onion's outer layer represents globally traded commodities. As the economy started to rebound from pandemic shutdowns and demand began to soar, inflation surged, then rose further when Russia invaded Ukraine. Since then, supply and demand have come into balance, and these prices have generally been flat or falling. The middle onion layer is made up of core goods, excluding commodities. Demand for goods rose sharply as the economy emerged from the pandemic downturn-just as global pandemic-related supply-chain disruptions significantly hampered supply. But, as seen in the New York Fed's Global Supply Chain Pressure Index, those supply pressures have eased, and core goods inflation has returned to pre-pandemic norms. The inner onion layer comprises core services. Although this category is taking the longest to normalize, the disinflationary process is well underway here too. For example, measures of underlying inflation that tend to be heavily influenced by core services inflation today average around 2-1/2 percent. One positive piece of data that reinforces my confidence that inflation is on course to reach our 2 percent goal is that inflation expectations remain well anchored across all forecast horizons. This is seen in the New York Fed's Survey of Consumer Expectations as well as other surveys and market-based measures. Now I'll turn to the employment side of our mandate. And no surprise, I'll point to data. A wide range of metrics-including the unemployment rate; measures of job openings, hiring, quits, and employment flows; and perceptions of job and worker availabilityindicate that the very tight labor market of the past few years has now returned to more normal conditions and is unlikely to be a source of inflationary pressures going forward. Recent analysis by researchers at the New York Fed provides a useful way to gauge whether the labor market is tight or loose. They find that you can effectively summarize the state of the overall labor market in terms of its effect on compensation growth by using just two indicators: the rate at which employees quit their jobs and the ratio of job openings to job seekers. In fact, once you take these two measures into account, other labor market metrics that get a lot of attention-such as the unemployment rate and the vacancy-to-unemployment ratio-don't provide additional useful information. Combining these two measures into an index of labor market tightness provides two key insights. First, data as of the second quarter of this year indicate that the labor market is about where it was in early 2018-a period of solid labor market conditions and low inflation. Second, compensation growth should soon return to levels that prevailed prior to the pandemic. So, the labor market is solid. The economy is in a good place. And inflation is closing in on our 2 percent longer-run goal. With the risks to achieving our goals now in balance, the FOMC decided to lower the target range for the federal funds rate by half a percentage point, to $4-3 / 4$ to 5 percent. In addition, the Committee continued to normalize the holdings of securities on the Fed's balance sheet. Looking ahead, based on my current forecast for the economy, I expect that it will be appropriate to continue the process of moving the stance of monetary policy to a more neutral setting over time. The timing and pace of future adjustments to interest rates will be based on the evolution of the data, the economic outlook, and the risks to achieving our goals. We will continue to be data-dependent and attuned to the evolution of economic conditions in making our decisions. With monetary policy moving to a more neutral setting over time, I expect real GDP to grow between 2-1/4 and 2-1/2 percent this year and to average about 2-1/4 percent over the next two years. I anticipate the unemployment rate to edge up from its current level of about 4 percent to around $4-1 / 4$ percent at the end of this year and stay around that level next year. With the economy in balance and inflation expectations well anchored, I expect overall PCE inflation to be around 2-1/4 percent this year, and to be close to 2 percent next year. The economy has been on a remarkable journey. In two years, the red-hot labor market has normalized, and inflation has come within striking distance of our 2 percent longerrun goal-all while employment and the economy continue to grow. We instituted and maintained a very restrictive monetary policy stance until the data gave us confidence that inflation is sustainably on course to 2 percent. With this progress toward achieving price stability, moving toward a more neutral monetary policy stance will help maintain the strength of the economy and labor market. Although the outlook remains uncertain, we are well positioned to achieve our dual mandate goals.
2024-10-10T00:00:00	Lisa D Cook: Entrepreneurs, innovation, and participation	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the 2024 Women for Women Summit, Charleston, South Carolina, 10 October 2024.	For release on delivery 9:15 a.m. EDT October 10, 2024 Entrepreneurs, Innovation, and Participation Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the 2024 Women for Women Summit Charleston, South Carolina October 10, 2024 Thank you for the kind introduction, Jennet.1 Let me start by saying my thoughts are with all the people in Florida, Georgia, North Carolina, South Carolina, Tennessee and Virginia who have felt the force of Helene's and Milton's impact. I am saddened by the tragic loss of life and widespread disruption in this region. The Federal Reserve Board and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area. As we normally do in these unfortunate situations, we are encouraging institutions operating in the affected areas to meet the needs of their communities.2 It is an honor to stand before you and speak to this group of audacious, innovative women. I am also very happy to be back in Charleston. I grew up in Milledgeville, Georgia, just about 250 miles down the road. Some of my fondest childhood memories of traveling in the South, especially as a Girl Scout, include South Carolina. Today I would like to talk with you about the important role startups, new businesses, and entrepreneurship play in our economy from the perspective of a Federal Reserve policymaker. I also want to share a bit of my story. Just like many of you- including those who have started a business or those who dream of doing that someday- I have faced and overcome hurdles along a winding path. - 2 - My Story I was born and raised in Milledgeville, where my mother, Professor Mary Murray Cook, was a faculty member in the Nursing Department of Georgia College and State University. She was the first tenured African American faculty member at that university. My father, Rev. Payton B. Cook, was a chaplain and then in senior leadership at the hospital there. My family lived through the events that brought Milledgeville out of a deeply segregated South. My sisters and I were among the first African American students to desegregate the schools we attended. I drew strength from the example set by my family, others in the Civil Rights Movement, and the village that raised me and from their conviction in the hope and promise of a world that could and would continually improve. While I had an interest in economics even before I entered high school, that was not the initial field of study I pursued. I entered Spelman College in Atlanta as a physics and philosophy major. After graduation, I had the honor of studying at the University of Oxford as a Marshall Scholar. After Oxford, I continued my education at the University of Dakar in Senegal in West Africa. However, at the end of my year in Africa, it was the chance to climb Mount Kilimanjaro in Tanzania in East Africa where I discovered my love of economics. I hiked alongside a British economist, and, by the end of the trek, he convinced me that studying economics would provide me with the tools to address some big and important questions I had pondered for a long time. I went on to earn my Ph.D. in economics from the University of California, Berkeley. Entering the economics profession came with its usual challenges, and, for - 3 - women, a few more challenges existed. To this day, women are still underrepresented in economics. Women earned just 34 percent of bachelor's degrees in economics and 36 percent of Ph.D.'s in economics in 2022, the most recent available data from the U.S. Department of Education. The share of women earning those degrees rose only modestly from 1999, when women earned about 32 percent of economics bachelor's degrees and 27 percent of Ph.D.'s. The data stand in sharp contrast to all science and engineering degrees, including in social science fields, where women earned roughly half of degrees granted in 2022.3 Education was paramount in my family and was construed as a means of realizing the promise of the Civil Rights Movement and continual improvement of our society and economy. Of course, economics, like physics, is a field where math skills are vitally important. Between my mother, my aunts, and my extended family, I had essentially understood STEM (science, technology, engineering, and mathematics)-related jobs to be women's work. I was grateful to have these role models in my orbit to give me the confidence to undertake study in a STEM field. Access and encouragement for girls to pursue study in math and science are a significant concern. Economist Dania V. Francis's research shows that Black girls are disproportionately under-recommended for Advanced Placement calculus.4 The course is - 4 - often a gateway for economics, for STEM classes, and for college preparation, in general.5 My mentors and role models encouraged careful study, teaching, and scholarship and helped me block out the voices saying I did not belong at each juncture. They encouraged my work and have been champions for me. As a result, I have been committed to serving as a mentor, as well. For several years, I was the director of and taught in the American Economic Association's Summer Program, an important training ground for disadvantaged students considering economics careers. Each year, the share of students who are women oscillated between 41 percent and 67 percent, much higher than the enrollment in undergraduate economics courses nationally.6 I told those students-and continue to tell them as they make their way through graduate programs in economics and through the economics profession-"You belong here. Your insights are unique, and the profession will benefit from them." In my career as an economist, I studied, researched, and taught in roles at universities and worked in the private sector and in government before I was nominated by the President and confirmed by the Senate to become a member of the Board of Governors of the Federal Reserve System in 2022. I am honored and humbled to serve in this role and proud to be the first African American woman and first woman of color to serve on the Board of Governors. As Fed policymakers, we make decisions affecting the - 5 - entire economy and the well-being of every American by focusing on the dual mandate given to us by Congress: maximum employment and stable prices. Entrepreneurs' Vital Role in the Economy In my years of conducting research and while at the Board, I have met many inventors, innovators, and entrepreneurs who made important contributions to the economy. Many of them happened to be women who were very knowledgeable, creative, and inspiring. So I want to discuss the vital role entrepreneurship and new business creation play in our economy. You might ask what interest I have in this subject, as a monetary policymaker focused closely on the dual mandate of maximum employment and stable prices. Well, this topic has interested me for a long time, and I conducted a fair amount of research on entrepreneurship and innovation before joining the Board. But the topic is also important precisely because of our dual mandate. To convince you of this, I will explain a few of the ways in which economists think about entrepreneurship, and how they relate to the dual mandate. The first is the most basic: For many people-many millions, in fact- entrepreneurship or self-employment is a career choice.7 It is their preferred way of 7 There is no single way to measure the number of self-employed individuals and related businesses, but it certainly numbers in the millions. The latest Bureau of Labor Statistics Current Population Survey indicates there are roughly 10 million unincorporated and 7 million incorporated self-employed individuals. Separate data on businesses from the U.S. Census Bureau indicate that, as of 2021, there were about 25 million nonemployer and 800,000 employer sole proprietorships (Nonemployer Statistics; Statistics of U.S. Businesses), https://www.census.gov/programs-surveys/nonemployer-statistics.html, https://www.census.gov/programs-surveys/susb.html. For analysis of inconsistencies between self-employment data sources, see Katharine G. Abraham, John C. Haltiwanger, Claire Hou, Kristin Sandusky, and James R. Spletzer (2021), "Reconciling Survey and Administrative Measures of Self-Employment," Journal of Labor Economics, vol. 39 (October), pp. 825- 60. - 6 - participating in the labor market and obtaining income for themselves and their families. They prefer to be their own bosses, with all the benefits and risks that entails.8 But whether they end up hiring others or not, self-employed individuals support the labor market by providing a job for themselves. A second way economists think about entrepreneurship is a little broader: New business creation is a large contributor to overall job growth. In fact, new businesses punch above their weight. For example, during the handful of years before the pandemic, in a typical year only about 8 percent of all employer firms were new entrants, but these new entrants accounted for about 15 percent of annual gross job creation.9 And research has found that this job creation effect is long lasting. Even though many new firms do not survive, those that do survive tend to grow rapidly over 5 to 10 years, largely offsetting the job losses from those firms that shut down.10 A third way economists think about entrepreneurship, which I have explored in my own research, is that a small but critical subset of new firms are innovators-they introduce new products or business processes that change how we consume or produce.11 8 See Erik Hurst and Benjamin Wild Pugsley (2011), "What Do Small Businesses Do?" Brookings Papers on Economic Activity, Fall, pp. 73-142, https://www.brookings.edu/wpcontent/uploads/2011/09/2011b_bpea_hurst.pdf; and Erik G. Hurst and Benjamin W. Pugsley (2017), "Wealth, Tastes, and Entrepreneurial Choice," in John Haltiwanger, Erik Hurst, Javier Miranda, and Antoinette Schoar, eds., Measuring Entrepreneurial Businesses: Current Knowledge and Challenges (Chicago: University of Chicago Press). 9 Gross job creation refers to all jobs created by entering and expanding establishments. Data are from the Census Bureau Business Dynamics Statistics, averaged for 2015-19. New firms' share of net job creation is much higher, but this is partly an artifact of measurement practices: Firms with an age less than one measured in annual data cannot contribute negatively to net job creation. 10 See John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2013), "Who Creates Jobs? Small versus Large versus Young," Review of Economics and Statistics, vol. 95 (May), pp. 347-61; and Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in US Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. 11 For evidence on the importance of innovating young and small firms, see Daron Acemoglu, Ufuk Akcigit, Harun Alp, Nicholas Bloom, and William Kerr (2018), "Innovation, Reallocation, and Growth," American Economic Review, vol. 108 (November), pp. 3450-91. For recent trends in technology diffusion of relevance to business entry, see Ufuk Akcigit and Sina T. Ates (2023), "What Happened to US Business Dynamism?" Journal of Political Economy, vol. 131 (August), pp. 2059-2124. - 7 - As such, they make large contributions to overall productivity growth over time. That is, innovative entrepreneurs help enable us to do more with less-and even more so if access to innovation participation is equitable.12 It is important that everyone, including women, historically underrepresented groups, people from certain geographic regions, and other diverse representative groups, can participate in the entrepreneurship and innovation economy. In my research, I have found that investors underrate the prospects of Black- founded, or simply outsider-founded, startups in early funding stages. Better assessment of the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute to their local communities and the broader economy. Consider the Dual Mandate So let's return to the dual mandate. You can now understand that self- employment and entrepreneurial job creation are relevant for our employment mandate. Indeed, one could argue that entrepreneurs are critical to Fed policymakers' efforts to promote maximum employment. And the productivity gains we reap from entrepreneurship are like productivity growth from any other source. When the pace of productivity growth increases, it allows for economic activity and wage growth to be robust while also being consistent with price stability. The importance of business startups to our dual mandate objectives is why I have watched closely as various measures of new business formation have surged since the onset of the COVID-19 pandemic. - 8 - Applications for new businesses jumped to a record pace shortly after the pandemic struck the U.S.13 The pace of applications has remained elevated above pre- pandemic norms all the way from the summer of 2020 to the most recent data, even though the pace appears to be cooling some this year.14 At first, it might have seemed like these business applications were mainly being submitted by people who lost their jobs, or perhaps by an increase in "gig economy" work. There was doubtless some of that going on, but research and data since then have painted a more optimistic picture. When researchers look across areas of the country, the pandemic business applications had only a weak connection with layoffs. The surge in applications persisted long after overall layoffs fell to the subdued pace we have seen since early 2021. The applications did have a strong relationship with workers voluntarily leaving their jobs. Some quitting workers may have chosen to join these new businesses as founders or early employees. And surging business applications were soon followed by new businesses hiring workers and expanding. Over the last two years of available data, new firms created 1.9 million jobs per year, a pace not seen since the eve of the Global Financial Crisis.15 13 "Business applications" refers to applications for new Employer Identification Numbers submitted to the Internal Revenue Service. These are reported by the U.S. Census Bureau in the Business Formation Statistics. An application does not necessarily mean an actual firm with employees, revenue, or both will result. 14 Unless otherwise noted, the facts described in this section are documented in Ryan A. Decker and John Haltiwanger (2024), "Surging Business Formation in the Pandemic: A Brief Update," working paper, September; and Ryan A. Decker and John Haltiwanger (2023), "Surging Business Formation in the Pandemic: Causes and Consequences?" Brookings Papers on Economic Activity, Fall, pp. 249-302, https://www.brookings.edu/wp-content/uploads/2023/09/Decker-Haltiwanger_16820-BPEAFA23_WEB.pdf. 15 Data from the Bureau of Labor Statistics Business Employment Dynamics (BED) report new firm job creation of 1.9 million, on average, in 2022 and 2023, the highest pace since 2007. Alternative data on firm births from the Census Bureau Business Dynamics Statistics, which lag the BED by one year, report 2.5 million jobs created by new firms in 2022, also the highest pace since 2007. - 9 - The industry patterns of this surge reflect shifts in consumer and business needs resulting from the pandemic and its aftermath. For example, in large metro areas, new business creation shifted from city centers to the suburbs, perhaps because of the increase in remote work. Suddenly, people wanted to eat lunch or go to the gym closer to their home, rather than close to their downtown office. Likewise, consumer and business tastes for more online purchases, with the shipping requirements that entails, are evident in the surge of business entry in the online retail and transportation sectors. But this is not only about moving restaurants closer to workers or changing patterns of goods consumption. There was also a particularly strong entry into high-tech industries, such as data processing and hosting, as well as research and development services.16 That may have more to do with developments like artificial intelligence than with the pandemic specifically, as I discussed in a speech in Atlanta last week.17 Economists will spend years debating the various causes of the surge in business creation during and soon after the pandemic. Perhaps strong monetary and fiscal policy backstopping aggregate demand played some role, or pandemic social safety net policies, or simply the accommodative financial conditions of 2020 and 2021.18 Indeed, more research is needed and will be the subject of many dissertations in the near future. 16 See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. 17 See Lisa D. Cook (2024), "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. 18 For a potential role of fiscal policy, see Catherine E. Fazio, Jorge Guzman, Yupeng Liu, and Scott Stern (2021), "How Is COVID Changing the Geography of Entrepreneurship? Evidence from the Startup Cartography Project," NBER Working Paper Series 28787 (Cambridge, Mass.: National Bureau of Economic Research, May), https://www.nber.org/papers/w28787. For safety net programs (specifically expanded unemployment insurance), see Joonkyu Choi, Samuel Messer, Michael Navarrete, and Veronika I do think a large part of the story is ultimately a case of resourceful and determined American entrepreneurs, perhaps including some of you, responding to the tumultuous shocks of the pandemic. They, like some of you, stepped in to meet the rapidly changing needs of households and businesses. This points to a fourth way economists like to think about entrepreneurship, which is that entrepreneurship plays a big role in helping the economy adapt to change. Research suggests that entrepreneurs and the businesses they create are highly responsive to big economic shocks, and the COVID-19 pandemic was certainly a seismic shock.19 To be sure, the future is uncertain. It is unclear what the productivity effects of the pandemic surge of new businesses, particularly in high tech, will be.20 And whether that surge will continue is an open question; after all, the pre-pandemic period was a period of declining rates of new business creation, and the pandemic surge itself does appear to be cooling off recently.21 Penciakova (2024), "Unemployment Benefits Expansion and Business Formation," working paper, April. For the importance of financial conditions for entrepreneurship in past business cycles, see Michael Siemer (2019), "Employment Effects of Financial Constraints during the Great Recession," Review of Economics and Statistics, vol. 101 (March), pp. 16-29; and Teresa C. Fort, John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2013), "How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size," IMF Economic Review, vol. 61 (3), pp. 520-59. 19 Examples of research finding a large role for business entry in responding to aggregate shocks include Manuel Adelino, Song Ma, and David Robinson (2017), "Firm Age, Investment Opportunities, and Job Creation," Journal of Finance, vol. 72 (June), pp. 999-1038; Ryan A. Decker, Meagan McCollum, and Gregory B. Upton, Jr. (2024), "Boom Town Business Dynamics," Journal of Human Resources, vol. 59 (March), pp. 627-51; and Fatih Karahan, Benjamin Pugsley, and Ayşegűl Şahin (2024), "Demographic Origins of the Startup Deficit," American Economic Review, vol. 114 (July), pp. 1986-2023. 20 The last period of robust productivity growth in the U.S., the late 1990s and early 2000s, was preceded by several years by strong business creation in high-tech industries; see Lucia Foster, Cheryl Grim, John C. Haltiwanger, and Zoltan Wolf (2021), "Innovation, Productivity Dispersion, and Productivity Growth," in Carol Corrado, Jonathan Haskel, Javier Miranda, and Daniel Sichel, eds., Measuring and Accounting for Innovation in the Twenty-First Century (Chicago: University of Chicago Press). 21 The number of annual new firms as a share of all firms declined from around 12 percent in the 1980s, on average, to around 9 percent in the period of 2010-19. New firms' share of gross job creation declined from nearly 20 percent to less than 15 percent over the same period. Data are from Census Bureau Business Dynamics Statistics. The pre-pandemic trend decline in entry rates was documented by Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in US Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. Conclusion For now, let me say that I am grateful that entrepreneurs continue to give us a hand in meeting our employment mandate, and whatever productivity gains we may reap in coming years as a result may help ease tradeoffs with inflation as well. Finally, I will share one last story about why South Carolina will always hold a special place in my and my sisters' hearts. Every summer and at Thanksgiving, we would travel through the Palmetto State to our grandparents' house in Winston-Salem. Sitting in the back seat of the station wagon, we were entranced by the many colorful signs along Interstate 95 advertising what I, as a child, viewed as South Carolina's number one attraction: the South of the Border roadside amusement park. We begged our parents to stop every time. It was an epic struggle that went on for more than a decade. Once or twice they did relent, a sweet childhood victory! And here is the funny thing about travels-paths can cross. The timing is such that my sisters and I may have even been helped by a waiter named Ben, a young man from Dillon, South Carolina, who 22 would go on to be Federal Reserve Chairman Ben Bernanke! Perhaps it was the world's way of foreshadowing. Thank you for having me here in Charleston. It is inspiring to meet this group of bold, entrepreneurial women in South Carolina, and I look forward to continuing our conversation.	---[PAGE_BREAK]--- For release on delivery 9:15 a.m. EDT October 10, 2024 Entrepreneurs, Innovation, and Participation Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the 2024 Women for Women Summit Charleston, South Carolina October 10, 2024 ---[PAGE_BREAK]--- Thank you for the kind introduction, Jennet. ${ }^{1}$ Let me start by saying my thoughts are with all the people in Florida, Georgia, North Carolina, South Carolina, Tennessee and Virginia who have felt the force of Helene's and Milton's impact. I am saddened by the tragic loss of life and widespread disruption in this region. The Federal Reserve Board and other federal and state financial regulatory agencies are working with banks and credit unions in the affected area. As we normally do in these unfortunate situations, we are encouraging institutions operating in the affected areas to meet the needs of their communities. ${ }^{2}$ It is an honor to stand before you and speak to this group of audacious, innovative women. I am also very happy to be back in Charleston. I grew up in Milledgeville, Georgia, just about 250 miles down the road. Some of my fondest childhood memories of traveling in the South, especially as a Girl Scout, include South Carolina. Today I would like to talk with you about the important role startups, new businesses, and entrepreneurship play in our economy from the perspective of a Federal Reserve policymaker. I also want to share a bit of my story. Just like many of youincluding those who have started a business or those who dream of doing that somedayI have faced and overcome hurdles along a winding path. [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. ${ }^{2}$ See Federal Deposit Insurance Corporation, Federal Reserve Board, National Credit Union Administration, Office of the Comptroller of the Currency, and State Financial Regulators (2024), "Federal and State Financial Regulatory Agencies Issue Interagency Statement on Supervisory Practices regarding Financial Institutions Affected by Hurricane Helene," joint press release, October 2, https://www.federalreserve.gov/newsevents/pressreleases/other20241002a.htm. ---[PAGE_BREAK]--- # My Story I was born and raised in Milledgeville, where my mother, Professor Mary Murray Cook, was a faculty member in the Nursing Department of Georgia College and State University. She was the first tenured African American faculty member at that university. My father, Rev. Payton B. Cook, was a chaplain and then in senior leadership at the hospital there. My family lived through the events that brought Milledgeville out of a deeply segregated South. My sisters and I were among the first African American students to desegregate the schools we attended. I drew strength from the example set by my family, others in the Civil Rights Movement, and the village that raised me and from their conviction in the hope and promise of a world that could and would continually improve. While I had an interest in economics even before I entered high school, that was not the initial field of study I pursued. I entered Spelman College in Atlanta as a physics and philosophy major. After graduation, I had the honor of studying at the University of Oxford as a Marshall Scholar. After Oxford, I continued my education at the University of Dakar in Senegal in West Africa. However, at the end of my year in Africa, it was the chance to climb Mount Kilimanjaro in Tanzania in East Africa where I discovered my love of economics. I hiked alongside a British economist, and, by the end of the trek, he convinced me that studying economics would provide me with the tools to address some big and important questions I had pondered for a long time. I went on to earn my Ph.D. in economics from the University of California, Berkeley. Entering the economics profession came with its usual challenges, and, for ---[PAGE_BREAK]--- women, a few more challenges existed. To this day, women are still underrepresented in economics. Women earned just 34 percent of bachelor's degrees in economics and 36 percent of Ph.D.'s in economics in 2022, the most recent available data from the U.S. Department of Education. The share of women earning those degrees rose only modestly from 1999, when women earned about 32 percent of economics bachelor's degrees and 27 percent of Ph.D.'s. The data stand in sharp contrast to all science and engineering degrees, including in social science fields, where women earned roughly half of degrees granted in 2022. ${ }^{3}$ Education was paramount in my family and was construed as a means of realizing the promise of the Civil Rights Movement and continual improvement of our society and economy. Of course, economics, like physics, is a field where math skills are vitally important. Between my mother, my aunts, and my extended family, I had essentially understood STEM (science, technology, engineering, and mathematics)-related jobs to be women's work. I was grateful to have these role models in my orbit to give me the confidence to undertake study in a STEM field. Access and encouragement for girls to pursue study in math and science are a significant concern. Economist Dania V. Francis's research shows that Black girls are disproportionately under-recommended for Advanced Placement calculus. ${ }^{4}$ The course is [^0] [^0]: ${ }^{3}$ See U.S. Department of Education, National Center for Education Statistics (NCES), Integrated Postsecondary Education Data System, Completions Survey, available on the NCES website at https://nces.ed.gov/ipeds/survey-components/7. ${ }^{4}$ See Dania V. Francis, Angela C.M. de Oliveira, and Carey Dimmitt (2019), "Do School Counselors Exhibit Bias in Recommending Students for Advanced Coursework?" B.E. Journal of Economic Analysis \& Policy, vol. 19 (July), pp. 1-17. ---[PAGE_BREAK]--- often a gateway for economics, for STEM classes, and for college preparation, in general. ${ }^{5}$ My mentors and role models encouraged careful study, teaching, and scholarship and helped me block out the voices saying I did not belong at each juncture. They encouraged my work and have been champions for me. As a result, I have been committed to serving as a mentor, as well. For several years, I was the director of and taught in the American Economic Association's Summer Program, an important training ground for disadvantaged students considering economics careers. Each year, the share of students who are women oscillated between 41 percent and 67 percent, much higher than the enrollment in undergraduate economics courses nationally. ${ }^{6}$ I told those students - and continue to tell them as they make their way through graduate programs in economics and through the economics profession-"You belong here. Your insights are unique, and the profession will benefit from them." In my career as an economist, I studied, researched, and taught in roles at universities and worked in the private sector and in government before I was nominated by the President and confirmed by the Senate to become a member of the Board of Governors of the Federal Reserve System in 2022. I am honored and humbled to serve in this role and proud to be the first African American woman and first woman of color to serve on the Board of Governors. As Fed policymakers, we make decisions affecting the [^0] [^0]: ${ }^{5}$ See Lisa D. Cook and Anna Gifty Opoku-Agyeman (2019), "'It Was a Mistake for Me to Choose This Field,' " New York Times, September 30. ${ }^{6}$ See Lisa D. Cook and Christine Moser (2024), "Lessons for Expanding the Share of Disadvantaged Students in Economics from the AEA Summer Program at Michigan State University," Journal of Economic Perspectives, vol. 38 (Summer), pp. 191-208. ---[PAGE_BREAK]--- entire economy and the well-being of every American by focusing on the dual mandate given to us by Congress: maximum employment and stable prices. # Entrepreneurs' Vital Role in the Economy In my years of conducting research and while at the Board, I have met many inventors, innovators, and entrepreneurs who made important contributions to the economy. Many of them happened to be women who were very knowledgeable, creative, and inspiring. So I want to discuss the vital role entrepreneurship and new business creation play in our economy. You might ask what interest I have in this subject, as a monetary policymaker focused closely on the dual mandate of maximum employment and stable prices. Well, this topic has interested me for a long time, and I conducted a fair amount of research on entrepreneurship and innovation before joining the Board. But the topic is also important precisely because of our dual mandate. To convince you of this, I will explain a few of the ways in which economists think about entrepreneurship, and how they relate to the dual mandate. The first is the most basic: For many people-many millions, in factentrepreneurship or self-employment is a career choice. ${ }^{7}$ It is their preferred way of [^0] [^0]: ${ }^{7}$ There is no single way to measure the number of self-employed individuals and related businesses, but it certainly numbers in the millions. The latest Bureau of Labor Statistics Current Population Survey indicates there are roughly 10 million unincorporated and 7 million incorporated self-employed individuals. Separate data on businesses from the U.S. Census Bureau indicate that, as of 2021, there were about 25 million nonemployer and 800,000 employer sole proprietorships (Nonemployer Statistics; Statistics of U.S. Businesses), https://www.census.gov/programs-surveys/nonemployer-statistics.html, https://www.census.gov/programs-surveys/susb.html. For analysis of inconsistencies between self-employment data sources, see Katharine G. Abraham, John C. Haltiwanger, Claire Hou, Kristin Sandusky, and James R. Spletzer (2021), "Reconciling Survey and Administrative Measures of Self-Employment," Journal of Labor Economics, vol. 39 (October), pp. 82560 . ---[PAGE_BREAK]--- participating in the labor market and obtaining income for themselves and their families. They prefer to be their own bosses, with all the benefits and risks that entails. ${ }^{8}$ But whether they end up hiring others or not, self-employed individuals support the labor market by providing a job for themselves. A second way economists think about entrepreneurship is a little broader: New business creation is a large contributor to overall job growth. In fact, new businesses punch above their weight. For example, during the handful of years before the pandemic, in a typical year only about 8 percent of all employer firms were new entrants, but these new entrants accounted for about 15 percent of annual gross job creation. ${ }^{9}$ And research has found that this job creation effect is long lasting. Even though many new firms do not survive, those that do survive tend to grow rapidly over 5 to 10 years, largely offsetting the job losses from those firms that shut down. ${ }^{10}$ A third way economists think about entrepreneurship, which I have explored in my own research, is that a small but critical subset of new firms are innovators-they introduce new products or business processes that change how we consume or produce. ${ }^{11}$ [^0] [^0]: ${ }^{8}$ See Erik Hurst and Benjamin Wild Pugsley (2011), "What Do Small Businesses Do?" Brookings Papers on Economic Activity, Fall, pp. 73-142, https://www.brookings.edu/wp-content/uploads/2011/09/2011b_hpea_hurst.pdf; and Erik G. Hurst and Benjamin W. Pugsley (2017), "Wealth, Tastes, and Entrepreneurial Choice," in John Haltiwanger, Erik Hurst, Javier Miranda, and Antoinette Schoar, eds., Measuring Entrepreneurial Businesses: Current Knowledge and Challenges (Chicago: University of Chicago Press). ${ }^{9}$ Gross job creation refers to all jobs created by entering and expanding establishments. Data are from the Census Bureau Business Dynamics Statistics, averaged for 2015-19. New firms' share of net job creation is much higher, but this is partly an artifact of measurement practices: Firms with an age less than one measured in annual data cannot contribute negatively to net job creation. ${ }^{10}$ See John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2013), "Who Creates Jobs? Small versus Large versus Young," Review of Economics and Statistics, vol. 95 (May), pp. 347-61; and Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in US Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. ${ }^{11}$ For evidence on the importance of innovating young and small firms, see Daron Acemoglu, Ufuk Akcigit, Harun Alp, Nicholas Bloom, and William Kerr (2018), "Innovation, Reallocation, and Growth," American Economic Review, vol. 108 (November), pp. 3450-91. For recent trends in technology diffusion of relevance to business entry, see Ufuk Akcigit and Sina T. Ates (2023), "What Happened to US Business Dynamism?" Journal of Political Economy, vol. 131 (August), pp. 2059-2124. ---[PAGE_BREAK]--- As such, they make large contributions to overall productivity growth over time. That is, innovative entrepreneurs help enable us to do more with less-and even more so if access to innovation participation is equitable. ${ }^{12}$ It is important that everyone, including women, historically underrepresented groups, people from certain geographic regions, and other diverse representative groups, can participate in the entrepreneurship and innovation economy. In my research, I have found that investors underrate the prospects of Blackfounded, or simply outsider-founded, startups in early funding stages. Better assessment of the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute to their local communities and the broader economy. # Consider the Dual Mandate So let's return to the dual mandate. You can now understand that selfemployment and entrepreneurial job creation are relevant for our employment mandate. Indeed, one could argue that entrepreneurs are critical to Fed policymakers' efforts to promote maximum employment. And the productivity gains we reap from entrepreneurship are like productivity growth from any other source. When the pace of productivity growth increases, it allows for economic activity and wage growth to be robust while also being consistent with price stability. The importance of business startups to our dual mandate objectives is why I have watched closely as various measures of new business formation have surged since the onset of the COVID-19 pandemic. [^0] [^0]: ${ }^{12}$ See Lisa D. Cook (2011), "Inventing Social Capital: Evidence from African American Inventors, 18431930," Explorations in Economic History, vol. 48 (December), pp. 507-18; Lisa D. Cook (2014), "Violence and Economic Activity: Evidence from African American Patents, 1870-1940," Journal of Economic Growth, vol. 19 (June), pp. 221-57; and Lisa D. Cook (2020), "Policies to Broaden Participation in the Innovation Process," Hamilton Project Policy Proposal 2020-11 (Washington: Brookings Institution, August), https://www.hamiltonproject.org/assets/files/Cook_PP_LO_8.13.pdf. ---[PAGE_BREAK]--- Applications for new businesses jumped to a record pace shortly after the pandemic struck the U.S. ${ }^{13}$ The pace of applications has remained elevated above pre- pandemic norms all the way from the summer of 2020 to the most recent data, even though the pace appears to be cooling some this year. ${ }^{14}$ At first, it might have seemed like these business applications were mainly being submitted by people who lost their jobs, or perhaps by an increase in "gig economy" work. There was doubtless some of that going on, but research and data since then have painted a more optimistic picture. When researchers look across areas of the country, the pandemic business applications had only a weak connection with layoffs. The surge in applications persisted long after overall layoffs fell to the subdued pace we have seen since early 2021. The applications did have a strong relationship with workers voluntarily leaving their jobs. Some quitting workers may have chosen to join these new businesses as founders or early employees. And surging business applications were soon followed by new businesses hiring workers and expanding. Over the last two years of available data, new firms created 1.9 million jobs per year, a pace not seen since the eve of the Global Financial Crisis. ${ }^{15}$ [^0] [^0]: ${ }^{13}$ "Business applications" refers to applications for new Employer Identification Numbers submitted to the Internal Revenue Service. These are reported by the U.S. Census Bureau in the Business Formation Statistics. An application does not necessarily mean an actual firm with employees, revenue, or both will result. ${ }^{14}$ Unless otherwise noted, the facts described in this section are documented in Ryan A. Decker and John Haltiwanger (2024), "Surging Business Formation in the Pandemic: A Brief Update," working paper, September; and Ryan A. Decker and John Haltiwanger (2023), "Surging Business Formation in the Pandemic: Causes and Consequences?" Brookings Papers on Economic Activity, Fall, pp. 249-302, https://www.brookings.edu/wp-content/uploads/2023/09/Decker-Haltiwanger_16820-BPEAFA23_WEB.pdf. ${ }^{15}$ Data from the Bureau of Labor Statistics Business Employment Dynamics (BED) report new firm job creation of 1.9 million, on average, in 2022 and 2023, the highest pace since 2007. Alternative data on firm births from the Census Bureau Business Dynamics Statistics, which lag the BED by one year, report 2.5 million jobs created by new firms in 2022, also the highest pace since 2007. ---[PAGE_BREAK]--- The industry patterns of this surge reflect shifts in consumer and business needs resulting from the pandemic and its aftermath. For example, in large metro areas, new business creation shifted from city centers to the suburbs, perhaps because of the increase in remote work. Suddenly, people wanted to eat lunch or go to the gym closer to their home, rather than close to their downtown office. Likewise, consumer and business tastes for more online purchases, with the shipping requirements that entails, are evident in the surge of business entry in the online retail and transportation sectors. But this is not only about moving restaurants closer to workers or changing patterns of goods consumption. There was also a particularly strong entry into high-tech industries, such as data processing and hosting, as well as research and development services. ${ }^{16}$ That may have more to do with developments like artificial intelligence than with the pandemic specifically, as I discussed in a speech in Atlanta last week. ${ }^{17}$ Economists will spend years debating the various causes of the surge in business creation during and soon after the pandemic. Perhaps strong monetary and fiscal policy backstopping aggregate demand played some role, or pandemic social safety net policies, or simply the accommodative financial conditions of 2020 and $2021 .{ }^{18}$ Indeed, more research is needed and will be the subject of many dissertations in the near future. [^0] [^0]: ${ }^{16}$ See Ryan Decker and John Haltiwanger (2024), "High Tech Business Entry in the Pandemic Era," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 19), https://www.federalreserve.gov/econres/notes/feds-notes/high-tech-business-entry-in-the-pandemic-era20240419.html. ${ }^{17}$ See Lisa D. Cook (2024), "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. ${ }^{18}$ For a potential role of fiscal policy, see Catherine E. Fazio, Jorge Guzman, Yupeng Liu, and Scott Stern (2021), "How Is COVID Changing the Geography of Entrepreneurship? Evidence from the Startup Cartography Project," NBER Working Paper Series 28787 (Cambridge, Mass.: National Bureau of Economic Research, May), https://www.nber.org/papers/w28787. For safety net programs (specifically expanded unemployment insurance), see Joonkyu Choi, Samuel Messer, Michael Navarrete, and Veronika ---[PAGE_BREAK]--- I do think a large part of the story is ultimately a case of resourceful and determined American entrepreneurs, perhaps including some of you, responding to the tumultuous shocks of the pandemic. They, like some of you, stepped in to meet the rapidly changing needs of households and businesses. This points to a fourth way economists like to think about entrepreneurship, which is that entrepreneurship plays a big role in helping the economy adapt to change. Research suggests that entrepreneurs and the businesses they create are highly responsive to big economic shocks, and the COVID-19 pandemic was certainly a seismic shock. ${ }^{19}$ To be sure, the future is uncertain. It is unclear what the productivity effects of the pandemic surge of new businesses, particularly in high tech, will be. ${ }^{20}$ And whether that surge will continue is an open question; after all, the pre-pandemic period was a period of declining rates of new business creation, and the pandemic surge itself does appear to be cooling off recently. ${ }^{21}$ [^0] [^0]: Penciakova (2024), "Unemployment Benefits Expansion and Business Formation," working paper, April. For the importance of financial conditions for entrepreneurship in past business cycles, see Michael Siemer (2019), "Employment Effects of Financial Constraints during the Great Recession," Review of Economics and Statistics, vol. 101 (March), pp. 16-29; and Teresa C. Fort, John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2013), "How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size," IMF Economic Review, vol. 61 (3), pp. 520-59. ${ }^{19}$ Examples of research finding a large role for business entry in responding to aggregate shocks include Manuel Adelino, Song Ma, and David Robinson (2017), "Firm Age, Investment Opportunities, and Job Creation," Journal of Finance, vol. 72 (June), pp. 999-1038; Ryan A. Decker, Meagan McCollum, and Gregory B. Upton, Jr. (2024), "Boom Town Business Dynamics," Journal of Human Resources, vol. 59 (March), pp. 627-51; and Fatih Karahan, Benjamin Pugsley, and Ayşegül Şahin (2024), "Demographic Origins of the Startup Deficit," American Economic Review, vol. 114 (July), pp. 1986-2023. ${ }^{20}$ The last period of robust productivity growth in the U.S., the late 1990s and early 2000s, was preceded by several years by strong business creation in high-tech industries; see Lucia Foster, Cheryl Grim, John C. Haltiwanger, and Zoltan Wolf (2021), "Innovation, Productivity Dispersion, and Productivity Growth," in Carol Corrado, Jonathan Haskel, Javier Miranda, and Daniel Sichel, eds., Measuring and Accounting for Innovation in the Twenty-First Century (Chicago: University of Chicago Press). ${ }^{21}$ The number of annual new firms as a share of all firms declined from around 12 percent in the 1980s, on average, to around 9 percent in the period of 2010-19. New firms' share of gross job creation declined from nearly 20 percent to less than 15 percent over the same period. Data are from Census Bureau Business Dynamics Statistics. The pre-pandemic trend decline in entry rates was documented by Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of Entrepreneurship in US Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24. ---[PAGE_BREAK]--- # Conclusion For now, let me say that I am grateful that entrepreneurs continue to give us a hand in meeting our employment mandate, and whatever productivity gains we may reap in coming years as a result may help ease tradeoffs with inflation as well. Finally, I will share one last story about why South Carolina will always hold a special place in my and my sisters' hearts. Every summer and at Thanksgiving, we would travel through the Palmetto State to our grandparents' house in Winston-Salem. Sitting in the back seat of the station wagon, we were entranced by the many colorful signs along Interstate 95 advertising what I, as a child, viewed as South Carolina's number one attraction: the South of the Border roadside amusement park. We begged our parents to stop every time. It was an epic struggle that went on for more than a decade. Once or twice they did relent, a sweet childhood victory! And here is the funny thing about travels-paths can cross. The timing is such that my sisters and I may have even been helped by a waiter named Ben, a young man from Dillon, South Carolina, who would go on to be Federal Reserve Chairman Ben Bernanke! ${ }^{22}$ Perhaps it was the world's way of foreshadowing. Thank you for having me here in Charleston. It is inspiring to meet this group of bold, entrepreneurial women in South Carolina, and I look forward to continuing our conversation. [^0] [^0]: ${ }^{22}$ See Ben S. Bernanke (2009), "Brief Remarks," speech delivered at the Interstate Interchange Dedication Ceremony, Dillon, S.C., March 7, https://www.federalreserve.gov/newsevents/speech/bernanke20090307a.htm.	Lisa D Cook	United States	https://www.bis.org/review/r241014g.pdf	For release on delivery 9:15 a.m. EDT October 10, 2024 Entrepreneurs, Innovation, and Participation Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the Charleston, South Carolina October 10, 2024 Thank you for the kind introduction, Jennet. It is an honor to stand before you and speak to this group of audacious, innovative women. I am also very happy to be back in Charleston. I grew up in Milledgeville, Georgia, just about 250 miles down the road. Some of my fondest childhood memories of traveling in the South, especially as a Girl Scout, include South Carolina. Today I would like to talk with you about the important role startups, new businesses, and entrepreneurship play in our economy from the perspective of a Federal Reserve policymaker. I also want to share a bit of my story. Just like many of youincluding those who have started a business or those who dream of doing that somedayI have faced and overcome hurdles along a winding path. I was born and raised in Milledgeville, where my mother, Professor Mary Murray Cook, was a faculty member in the Nursing Department of Georgia College and State University. She was the first tenured African American faculty member at that university. My father, Rev. Payton B. Cook, was a chaplain and then in senior leadership at the hospital there. My family lived through the events that brought Milledgeville out of a deeply segregated South. My sisters and I were among the first African American students to desegregate the schools we attended. I drew strength from the example set by my family, others in the Civil Rights Movement, and the village that raised me and from their conviction in the hope and promise of a world that could and would continually improve. While I had an interest in economics even before I entered high school, that was not the initial field of study I pursued. I entered Spelman College in Atlanta as a physics and philosophy major. After graduation, I had the honor of studying at the University of Oxford as a Marshall Scholar. After Oxford, I continued my education at the University of Dakar in Senegal in West Africa. However, at the end of my year in Africa, it was the chance to climb Mount Kilimanjaro in Tanzania in East Africa where I discovered my love of economics. I hiked alongside a British economist, and, by the end of the trek, he convinced me that studying economics would provide me with the tools to address some big and important questions I had pondered for a long time. I went on to earn my Ph.D. in economics from the University of California, Berkeley. Entering the economics profession came with its usual challenges, and, for women, a few more challenges existed. To this day, women are still underrepresented in economics. Women earned just 34 percent of bachelor's degrees in economics and 36 percent of Ph.D.'s in economics in 2022, the most recent available data from the U.S. Department of Education. The share of women earning those degrees rose only modestly from 1999, when women earned about 32 percent of economics bachelor's degrees and 27 percent of Ph.D.'s. The data stand in sharp contrast to all science and engineering degrees, including in social science fields, where women earned roughly half of degrees granted in 2022. Education was paramount in my family and was construed as a means of realizing the promise of the Civil Rights Movement and continual improvement of our society and economy. Of course, economics, like physics, is a field where math skills are vitally important. Between my mother, my aunts, and my extended family, I had essentially understood STEM (science, technology, engineering, and mathematics)-related jobs to be women's work. I was grateful to have these role models in my orbit to give me the confidence to undertake study in a STEM field. Access and encouragement for girls to pursue study in math and science are a significant concern. Economist Dania V. Francis's research shows that Black girls are disproportionately under-recommended for Advanced Placement calculus. The course is often a gateway for economics, for STEM classes, and for college preparation, in general. My mentors and role models encouraged careful study, teaching, and scholarship and helped me block out the voices saying I did not belong at each juncture. They encouraged my work and have been champions for me. As a result, I have been committed to serving as a mentor, as well. For several years, I was the director of and taught in the American Economic Association's Summer Program, an important training ground for disadvantaged students considering economics careers. Each year, the share of students who are women oscillated between 41 percent and 67 percent, much higher than the enrollment in undergraduate economics courses nationally. I told those students - and continue to tell them as they make their way through graduate programs in economics and through the economics profession-"You belong here. Your insights are unique, and the profession will benefit from them." In my career as an economist, I studied, researched, and taught in roles at universities and worked in the private sector and in government before I was nominated by the President and confirmed by the Senate to become a member of the Board of Governors of the Federal Reserve System in 2022. I am honored and humbled to serve in this role and proud to be the first African American woman and first woman of color to serve on the Board of Governors. As Fed policymakers, we make decisions affecting the entire economy and the well-being of every American by focusing on the dual mandate given to us by Congress: maximum employment and stable prices. In my years of conducting research and while at the Board, I have met many inventors, innovators, and entrepreneurs who made important contributions to the economy. Many of them happened to be women who were very knowledgeable, creative, and inspiring. So I want to discuss the vital role entrepreneurship and new business creation play in our economy. You might ask what interest I have in this subject, as a monetary policymaker focused closely on the dual mandate of maximum employment and stable prices. Well, this topic has interested me for a long time, and I conducted a fair amount of research on entrepreneurship and innovation before joining the Board. But the topic is also important precisely because of our dual mandate. To convince you of this, I will explain a few of the ways in which economists think about entrepreneurship, and how they relate to the dual mandate. The first is the most basic: For many people-many millions, in factentrepreneurship or self-employment is a career choice. It is their preferred way of participating in the labor market and obtaining income for themselves and their families. They prefer to be their own bosses, with all the benefits and risks that entails. But whether they end up hiring others or not, self-employed individuals support the labor market by providing a job for themselves. A second way economists think about entrepreneurship is a little broader: New business creation is a large contributor to overall job growth. In fact, new businesses punch above their weight. For example, during the handful of years before the pandemic, in a typical year only about 8 percent of all employer firms were new entrants, but these new entrants accounted for about 15 percent of annual gross job creation. A third way economists think about entrepreneurship, which I have explored in my own research, is that a small but critical subset of new firms are innovators-they introduce new products or business processes that change how we consume or produce. As such, they make large contributions to overall productivity growth over time. That is, innovative entrepreneurs help enable us to do more with less-and even more so if access to innovation participation is equitable. It is important that everyone, including women, historically underrepresented groups, people from certain geographic regions, and other diverse representative groups, can participate in the entrepreneurship and innovation economy. In my research, I have found that investors underrate the prospects of Blackfounded, or simply outsider-founded, startups in early funding stages. Better assessment of the early stages of invention and innovation could broaden the range of new entrants and the ideas they contribute to their local communities and the broader economy. So let's return to the dual mandate. You can now understand that selfemployment and entrepreneurial job creation are relevant for our employment mandate. Indeed, one could argue that entrepreneurs are critical to Fed policymakers' efforts to promote maximum employment. And the productivity gains we reap from entrepreneurship are like productivity growth from any other source. When the pace of productivity growth increases, it allows for economic activity and wage growth to be robust while also being consistent with price stability. The importance of business startups to our dual mandate objectives is why I have watched closely as various measures of new business formation have surged since the onset of the COVID-19 pandemic. Applications for new businesses jumped to a record pace shortly after the pandemic struck the U.S. The pace of applications has remained elevated above pre- pandemic norms all the way from the summer of 2020 to the most recent data, even though the pace appears to be cooling some this year. At first, it might have seemed like these business applications were mainly being submitted by people who lost their jobs, or perhaps by an increase in "gig economy" work. There was doubtless some of that going on, but research and data since then have painted a more optimistic picture. When researchers look across areas of the country, the pandemic business applications had only a weak connection with layoffs. The surge in applications persisted long after overall layoffs fell to the subdued pace we have seen since early 2021. The applications did have a strong relationship with workers voluntarily leaving their jobs. Some quitting workers may have chosen to join these new businesses as founders or early employees. And surging business applications were soon followed by new businesses hiring workers and expanding. Over the last two years of available data, new firms created 1.9 million jobs per year, a pace not seen since the eve of the Global Financial Crisis. The industry patterns of this surge reflect shifts in consumer and business needs resulting from the pandemic and its aftermath. For example, in large metro areas, new business creation shifted from city centers to the suburbs, perhaps because of the increase in remote work. Suddenly, people wanted to eat lunch or go to the gym closer to their home, rather than close to their downtown office. Likewise, consumer and business tastes for more online purchases, with the shipping requirements that entails, are evident in the surge of business entry in the online retail and transportation sectors. But this is not only about moving restaurants closer to workers or changing patterns of goods consumption. There was also a particularly strong entry into high-tech industries, such as data processing and hosting, as well as research and development services. Economists will spend years debating the various causes of the surge in business creation during and soon after the pandemic. Perhaps strong monetary and fiscal policy backstopping aggregate demand played some role, or pandemic social safety net policies, or simply the accommodative financial conditions of 2020 and $2021 .{ }^{18}$ Indeed, more research is needed and will be the subject of many dissertations in the near future. I do think a large part of the story is ultimately a case of resourceful and determined American entrepreneurs, perhaps including some of you, responding to the tumultuous shocks of the pandemic. They, like some of you, stepped in to meet the rapidly changing needs of households and businesses. This points to a fourth way economists like to think about entrepreneurship, which is that entrepreneurship plays a big role in helping the economy adapt to change. Research suggests that entrepreneurs and the businesses they create are highly responsive to big economic shocks, and the COVID-19 pandemic was certainly a seismic shock. For now, let me say that I am grateful that entrepreneurs continue to give us a hand in meeting our employment mandate, and whatever productivity gains we may reap in coming years as a result may help ease tradeoffs with inflation as well. Finally, I will share one last story about why South Carolina will always hold a special place in my and my sisters' hearts. Every summer and at Thanksgiving, we would travel through the Palmetto State to our grandparents' house in Winston-Salem. Sitting in the back seat of the station wagon, we were entranced by the many colorful signs along Interstate 95 advertising what I, as a child, viewed as South Carolina's number one attraction: the South of the Border roadside amusement park. We begged our parents to stop every time. It was an epic struggle that went on for more than a decade. Once or twice they did relent, a sweet childhood victory! And here is the funny thing about travels-paths can cross. The timing is such that my sisters and I may have even been helped by a waiter named Ben, a young man from Dillon, South Carolina, who would go on to be Federal Reserve Chairman Ben Bernanke! Perhaps it was the world's way of foreshadowing. Thank you for having me here in Charleston. It is inspiring to meet this group of bold, entrepreneurial women in South Carolina, and I look forward to continuing our conversation.
2024-10-11T00:00:00	Michelle W Bowman: Challenges to the community banking model	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the 18th Annual Community Bankers Symposium "Community Banking: Navigating a Changing Landscape", Chicago, Illinois, 11 October 2024.	For release on delivery 1:10 p.m. EDT (12:10 p.m. local time) October 11, 2024 Challenges to the Community Banking Model Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 18th Annual Community Bankers Symposium Community Banking: Navigating a Changing Landscape Chicago, Illinois October 11, 2024 Good afternoon, I'd like to begin by thanking the event organizers, including our staff at the Chicago Federal Reserve Bank, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, and the Conference of State Bank Supervisors for inviting me to share my thoughts with you at the 18th Annual Community Bankers Symposium. ! I always enjoy the opportunity to speak to bankers across the country and share perspectives on the issues facing the banking and financial system, especially when it's related to community banks. Banks are a critical component of the U.S. economy." Their work often extends well beyond the provision of credit- providing services and volunteer and financial support within their community. Among many things, banks offer financial education, sponsorships and funding for community programs and events. Without question, community banks are important and integral to the local economy. But community banks also face challenges that require proactive risk management, effective and efficient prioritization of compliance resources, and the need to innovate. Today, I would like to briefly highlight some of the issues banks are facing and discuss ways that community banks and regulators can more effectively work together in the future. The Challenges Facing Community Banks As this audience knows well, community banks face a number of challenges. They often rely on third-party service providers to offer products and services to their customers. It may be more difficult for them to hire and retain qualified staff or plan for future leadership with ' These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 See Michelle W. Bowman, "Building a Community Banking Framework for the Future" (speech at the Federal Reserve Bank of St. Louis Community Banking Research Conference, St. Louis, MO, October 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20241002a.pdf. -2- management succession planning. Given limited staffing, they may be overwhelmed by the recent onslaught of new regulations and guidance. And in light of all of this, it may be challenging to prioritize resources in order to appropriately focus on the most important risks facing their businesses. While the headwinds may seem overwhelming, community banks are always resilient in the face of change. Often, one of the greatest challenges facing a community bank is not about managing any particular risk but rather how to address all of the risks they face-and how to prioritize the approach to address each of those risks. Regulators have, at times, exacerbated these challenges through policy choices. The risk of mis-prioritization is not limited to community banks. In my mind, this was most recently evident in the events and supervision leading to the failure of Silicon Valley Bank. Management failed to address growing interest rate risk and funding risks, and supervisors failed to prioritize and escalate these issues. Our goal should be to identify, understand, and learn from these past mistakes, and to avoid repeating them. Both regulators and banks should be working toward a common goal-a banking system that supports economic activity throughout the country, in which banks operate in a safe and sound manner and in compliance with consumer laws and regulations. In considering the challenges facing community banks, both regulators and banks have an important role to play. Competition Community banks face competitive pressures from many sources. These pressures may result from local or regional economic conditions, the needs of retail and business customers, and the products and services available in the market. Competitors can take the form of traditional banks, internet banks, and non-banks like fin-techs and mortgage companies. While fin-tech partnerships can be beneficial to both the customer and the bank, if the relationship is not -3- managed according to safe and sound banking principles, serious problems can result. When deposits are accepted through fin-tech relationships but not handled appropriately, deposit insurance can be jeopardized and the ability to access deposited funds may be impacted.* Competition can also come from other local competitors like credit unions, large banks with a broader operational footprint, payday lenders, or other nonbank credit sources. As bank customers grow increasingly comfortable and familiar with new mechanisms for doing business, the use of online banking has continued to expand. This has tended to increase the footprint of non-local banks or lenders, enabling them to effectively compete for business outside of their geographic area. Even against this backdrop, research shows that community banks have maintained an important role in many banking markets, including in small- and medium-sized business lending.* The regulatory framework establishes expectations for how community banks can compete, and often creates an unlevel playing field with many of these competitors. This includes whether they are subject to the same regulation as banks that engage in the same activities and how competition is evaluated. A core concept in financial regulation is to impose the same regulation-and I suggest we expand this to include the same regulation, guidance, and supervisory expectations-on entities that are engaged in the same activities. Banks compete against many non-bank providers, including financial technology firms, credit unions, and other non-bank lenders. In some of 3 See, e.g., Board of Governors of the Federal Reserve System, Arkansas State Bank Department, "In the Matter of Evolve Bancorp, Inc. and Evolve Bank & Trust, Cease and Desist Order," news release, June 11, 2024, https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240614al .pdf. 4 Allen N. Berger, Nathan H. Miller, Mitchell A. Petersen, Raghuram G. Rajan, and Jeremy C. Stein, "Does Function Follow Organizational Form? Evidence from the Lending Practices of Large and Small Banks," National Bureau of Economic Research, Working Paper 8752 (Cambridge, MA: National Bureau of Economic Research, February 2002), https://www.nber.org/system/files/working papers/w8752/w8752.pdf. -4. these head-to-head competitions, community banks face distinct disadvantages that can pose challenges when competing for the same banking opportunities. For example, banks are subject to taxes and additional regulatory requirements (including the Community Reinvestment Act). They are also subject to a broader range of restrictions imposed by regulatory requirements or the "soft" power of supervision. In all of these cases, the disparity in the legal framework can have a distortive effect on competition. In short, where the financial regulatory framework can provide for parity of treatment, it should do so. The regulatory framework should not knowingly distort competition, or effectively impose a regulatory allocation of credit. The framework also plays an important role in assessing competition among banks. The mergers and acquisitions (M&A) approval process can have a disproportionate impact on community banks because the "screens" that are used to evaluate the competitive effects of a proposed merger often result in a finding that M&A transactions in rural markets can have an adverse effect on competition and should therefore be disallowed.° Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects-which is grounded in the effect of proposed transactions on the control of deposits within individual banking markets-often requires additional review or analysis, and can lead to delays in the regulatory approval process. Cybersecurity Community banks often note cybersecurity and third-party risk management as areas that raise significant concerns. Cyber-related events, including ransomware attacks and business 5 Michelle W. Bowman, "The Role of Research, Data, and Analysis in Banking Reforms" (speech at the 2023 Community Banking Research Conference, St. Louis, MO, October 4, 2023), https://www.federalreserve.gov/newsevents/speech/files/bowman20231004a.pdf; Michelle W. Bowman, "The New Landscape for Banking Competition," (speech at the 2022 Community Banking Research Conference, St. Louis, MO, September 28, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220928a.pdf. -5- email compromises, are costly and time-consuming experiences, and they pose unique challenges for community banks. For example, the maintenance of and the technology resources required to support a successful cybersecurity program are often difficult for smaller banks. Regulators can promote cybersecurity, and stronger cyber-incident "resilience" and response capabilities by identifying resources and opportunities for banks to develop "muscle memory" in cyber incident response. Recent incidents, like the Crowdstrike-related outage, have highlighted the heavy dependence many banks have on technology, third-party providers, and the broader supply chain. In the current risk environment, it is important for banks of all sizes to implement sound operational resilience, cybersecurity, and third-party risk-management practices. One important resource for community banks is the Federal Financial Institutions Examination Council (FFIEC) website, which includes the FFIEC Cybersecurity Resource Guide and links to other external cybersecurity resources. The Federal Reserve plays an important role in supervising banks and supporting risk management practices. For example, the Federal Reserve hosts the Midwest Cyber Workshop, with the Federal Reserve Banks of Chicago, Kansas City, and St. Louis.° Over the past two years, this workshop has provided a forum to further cyber risk discussions among community bankers, regulators, law enforcement, and other industry stakeholders. Today's Symposium also includes an interactive cyber workshop, during which participants will participate in a cyber ® See Federal Reserve Bank of Chicago, Federal Reserve Bank of St. Louis, and Federal Reserve Bank of Kansas City, Midwest Cyber Workshop 2024 (June 25-26, 2024), https://www.chicagofed.org/events/2024/midwest-cyber- workshop. -6- exercise, working through the various decisions that would be required in responding to a hypothetical cyberattack.' We know well that cyber threats pose real risks to the banking system. We also recognize that community banks may have unique needs in preventing, remediating, and responding to cyber threats. Therefore, regulators should ensure that a range of resources are available to support community banks and seek further opportunities to help build community bank resilience against these threats. Third-Party Risk Management Third-party risk management can pose an additional challenge for community banks. Due to their size and scale, community banks often leverage centralized resources-technical experts who have greater expertise than the bank could fully maintain on staff-to advise and assist on a range of issues. Often these third-party service providers are significantly larger, and their bank clients-including smaller banks-may lack leverage in conducting due diligence and negotiating the terms of the relationship. In 2023, the federal banking agencies published supervisory guidance addressing third- party risk management, which was expressly applicable to community banks. As I noted at the time it was issued, the guidance included shortcomings that were known and identified but not addressed in advance.* 7 Federal Reserve Bank of Chicago, Community Bankers Symposium (October 11, 2024), https://www.chicagofed.org/events/2024/annual-community-bankers-symposium-18th 8 Michelle W. Bowman, "Defining a Bank" (Speech to the American Bankers Association 2024 Conference for Community Bankers, San Antonio, TX, February 12, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240212a.pdf; Statement by Governor Michelle W. Bowman, "Third-Party Risk-Management Guidance," news release, June 6, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230606.htm ("...Federal Reserve regional bank supervisors have indicated that we should provide additional resources for community banks upon implementation to provide appropriate expectations and ensure that small banks understand and can effectively use -7- What many of you may not know is that after nearly a year from the original publication, the regulators published a guide to assist community banks interpret and apply the guidance to their third-party risk management activities. The guide was intended to provide additional context for the guidance-including step-by-step examples of how to address third-party risk management-making the guidance more useful. While I am pleased that the community bank implementation guide was eventually published, the delays in its publication suggest a shortcoming in our regulatory approach. We must ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the time the guidance is published. Consumer Compliance Like third-party risk management, consumer compliance can be another area that may present challenges to community banks given their size and scale. An effective and well-run consumer compliance program balances consumer protection with the complexity and cost to establish a robust compliance management program. One challenge for community banks is the difficulty in retaining qualified consumer compliance experts. Notwithstanding these challenges, community banks devote significant time and resources to their consumer compliance risk management programs. Compliance with consumer protection laws and regulations, including fair lending laws, is essential to ensuring that the banking system provides fair and broad access to credit and financial services. Community banks take these responsibilities seriously, and the overwhelming majority of banks that we supervise invest in strong compliance management systems to prevent violations the guidance to inform their third-party risk management processes... am disappointed that the agencies failed to make the upfront investment to reduce unnecessary confusion and burden on community banks"). -8- and detect problems before they occur. When consumer compliance concerns arise, banks address them by making their customers whole and adopting the necessary changes to ensure that issues do not persist or reoccur. In a very small subset of cases, banks fall short of their obligations, and we hold those institutions accountable through enforcement actions or other supervisory actions. The Federal Reserve's consumer compliance supervision program is risk-focused and tailored to a bank's compliance risk, focused on the activities that present the greatest risk. One example related to third-party risk management is our recent system supervisory focus on consumer compliance risks associated with fin-tech relationships. As a result of this work, our supervisors seek to identify the parties to relationships that pose the greatest risk of consumer harm. This effort promotes our understanding of higher risk fin-tech partners across the Federal Reserve System, and helps supervisors proactively identify relationships that pose greater risk of consumer harm. Other Core Risks There are a number of "core" risks that are essential for bank management to address. These "core" risks-including funding, liquidity and credit risk-should already be integrated into management priorities, since they pose the greatest threats to a bank's operations. Focusing on core risks is second nature for community banks. In contrast, supervision can be susceptible to diversion from core to non-core risks leading supervisors to neglect the build-up of traditional risk. Diverting resources to non-core risks can often leave a bank vulnerable, especially when regulators direct banks to allocate resources in other ways, whether by regulation, guidance, or through supervisory expectations. Mitigating Risks to Community Banks The design of regulation, guidance, and supervisory approach regulators rely upon for community banks-and the intentional policy choices that underpin this framework-are important for ensuring their effectiveness in supporting the safety and soundness of the banking system. These design choices can enable community banks to operate successfully while mitigating risks, leveraging tailoring, transparency, and consistency across institutions.' I have spoken at length about these themes in the past, but I would like to reiterate just a few of the critical elements of a regulatory agenda that will allow community banks to thrive in the future: e First, we need to revisit size thresholds over time as inflation and economic growth slowly erode our regulatory categories. The bank regulatory framework is built largely upon asset-based size thresholds, and these thresholds should reflect a deliberate policy choice. But, over time, these fixed thresholds effectively result in more firms being "scoped in" to higher compliance tiers over time, even when there has been no change in a bank's underlying risk profile.' e We need to have a regulatory system in which M&A transactions and de novo bank formations are possible for banks, not one in which regulatory approval requirements are used to impose additional (and extra-regulatory) requirements on firms.!! Viable formation and merger options for banks of all sizes are necessary to avoid creating a ° See Michelle W. Bowman, "Building a Community Banking Framework for the Future" (speech at the Federal Reserve Bank of St. Louis Community Banking Research Conference, St. Louis, Missouri, October 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20241002a.pdf. '0 See, e.g., Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity," 88 Fed. Reg. 64,028, 64,095 (September 18, 2023) ("[t]o reflect inflation since 1996 and growth in the capital markets, the agencies are proposing to increase the trading activity dollar threshold [applicable to the market risk rule] from $1 billion to $5 billion."). 'l FDIC, "Final Statement of Policy on Bank Merger Transactions," (September 17, 2024), https://www.fdic.gov/system/files/2024-09/final-statement-of-policy-on-bank-merger-transactions.pdf. -10- "barbell" of the very largest and very smallest banks in the banking system, with the number of community banks continuing to erode over time. Left unchecked, an applications process that imposes additional costs and delays on healthy and appropriate banking transactions will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. We should prioritize direct experience in our regulatory efforts, giving greater voice and opportunities for input from policymakers with banking or state supervisory experience currently at the Federal banking agencies, and by soliciting and accepting feedback from our state banking counterparts. Greater coordination and participation by a wider set of policymakers in regulatory reform efforts would bring several benefits. For example, discussion of competing ideas and compromise in the drafting of regulatory proposals often results in a more moderate approach, reducing dramatic swings of the regulatory pendulum. And in many instances, we can better anticipate the unintended consequences of reform proposals if policymakers engage in good faith discussions and coordination of these efforts. While regulatory reform brings many benefits, we should also shift our mindset to focus on the tradeoffs of regulation, guidance, and supervision. Changes to the regulatory framework often yield benefits in terms of greater visibility into the workings of the banking system, additional capital that can absorb losses and promote financial resiliency, and more conservative risk-management standards for interest rate risk and funding risk. But we need to evaluate not only the benefits of proposals but also the costs and unintended consequences. How will banks adjust their activities in response? Will they raise prices on lending activities or for other banking products or services? Will -ll- they exit certain low-margin businesses, resulting in greater concentration and increased financial stability risk? By considering the cumulative burden, we can better address and acknowledge these concerns. e And finally, we must incorporate "tailoring"-calibrating the regulatory framework based on the size and complexity of banks' activities-as a required input for regulatory consideration. Tailoring helps us to better allocate finite resources both in banks and among regulators and helps us avoid threatening the long-term viability of community banks by simply adding to the mass of existing regulations, guidance, and other supervisory material. We simply cannot ignore the "cumulative" or "compounding" effect of increasing the complexity of the regulatory framework and we must make room in our reform agenda for the unglamorous work of "maintenance" in promoting an efficient framework. By no means is this proposal for regulatory reform exhaustive, but these critical components must be integrated into our future approach to ensure a diverse banking system for the future. Closing Thoughts Thank you for the opportunity to speak to you today, and for your commitment to community banking. You serve a critical role within the banking system, and in support of the U.S. economy. Your work to leverage the power of the community banking model enables you to serve your customers, promote financial inclusion and expand access to banking services. But policymakers have an important responsibility to make sure that the community banking model remains viable into the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial -12- institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance.	---[PAGE_BREAK]--- For release on delivery 1:10 p.m. EDT (12:10 p.m. local time) October 11, 2024 Challenges to the Community Banking Model Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 18th Annual Community Bankers Symposium Community Banking: Navigating a Changing Landscape Chicago, Illinois October 11, 2024 ---[PAGE_BREAK]--- Good afternoon, I'd like to begin by thanking the event organizers, including our staff at the Chicago Federal Reserve Bank, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, and the Conference of State Bank Supervisors for inviting me to share my thoughts with you at the 18th Annual Community Bankers Symposium. ${ }^{1}$ I always enjoy the opportunity to speak to bankers across the country and share perspectives on the issues facing the banking and financial system, especially when it's related to community banks. Banks are a critical component of the U.S. economy. ${ }^{2}$ Their work often extends well beyond the provision of credit— providing services and volunteer and financial support within their community. Among many things, banks offer financial education, sponsorships and funding for community programs and events. Without question, community banks are important and integral to the local economy. But community banks also face challenges that require proactive risk management, effective and efficient prioritization of compliance resources, and the need to innovate. Today, I would like to briefly highlight some of the issues banks are facing and discuss ways that community banks and regulators can more effectively work together in the future. # The Challenges Facing Community Banks As this audience knows well, community banks face a number of challenges. They often rely on third-party service providers to offer products and services to their customers. It may be more difficult for them to hire and retain qualified staff or plan for future leadership with [^0] [^0]: ${ }^{1}$ These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See Michelle W. Bowman, "Building a Community Banking Framework for the Future" (speech at the Federal Reserve Bank of St. Louis Community Banking Research Conference, St. Louis, MO, October 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20241002a.pdf. ---[PAGE_BREAK]--- management succession planning. Given limited staffing, they may be overwhelmed by the recent onslaught of new regulations and guidance. And in light of all of this, it may be challenging to prioritize resources in order to appropriately focus on the most important risks facing their businesses. While the headwinds may seem overwhelming, community banks are always resilient in the face of change. Often, one of the greatest challenges facing a community bank is not about managing any particular risk but rather how to address all of the risks they face-and how to prioritize the approach to address each of those risks. Regulators have, at times, exacerbated these challenges through policy choices. The risk of mis-prioritization is not limited to community banks. In my mind, this was most recently evident in the events and supervision leading to the failure of Silicon Valley Bank. Management failed to address growing interest rate risk and funding risks, and supervisors failed to prioritize and escalate these issues. Our goal should be to identify, understand, and learn from these past mistakes, and to avoid repeating them. Both regulators and banks should be working toward a common goal-a banking system that supports economic activity throughout the country, in which banks operate in a safe and sound manner and in compliance with consumer laws and regulations. In considering the challenges facing community banks, both regulators and banks have an important role to play. # Competition Community banks face competitive pressures from many sources. These pressures may result from local or regional economic conditions, the needs of retail and business customers, and the products and services available in the market. Competitors can take the form of traditional banks, internet banks, and non-banks like fin-techs and mortgage companies. While fin-tech partnerships can be beneficial to both the customer and the bank, if the relationship is not ---[PAGE_BREAK]--- managed according to safe and sound banking principles, serious problems can result. When deposits are accepted through fin-tech relationships but not handled appropriately, deposit insurance can be jeopardized and the ability to access deposited funds may be impacted. ${ }^{3}$ Competition can also come from other local competitors like credit unions, large banks with a broader operational footprint, payday lenders, or other nonbank credit sources. As bank customers grow increasingly comfortable and familiar with new mechanisms for doing business, the use of online banking has continued to expand. This has tended to increase the footprint of non-local banks or lenders, enabling them to effectively compete for business outside of their geographic area. Even against this backdrop, research shows that community banks have maintained an important role in many banking markets, including in small- and medium-sized business lending. ${ }^{4}$ The regulatory framework establishes expectations for how community banks can compete, and often creates an unlevel playing field with many of these competitors. This includes whether they are subject to the same regulation as banks that engage in the same activities and how competition is evaluated. A core concept in financial regulation is to impose the same regulation-and I suggest we expand this to include the same regulation, guidance, and supervisory expectations-on entities that are engaged in the same activities. Banks compete against many non-bank providers, including financial technology firms, credit unions, and other non-bank lenders. In some of [^0] [^0]: ${ }^{3}$ See, e.g., Board of Governors of the Federal Reserve System, Arkansas State Bank Department, "In the Matter of Evolve Bancorp, Inc. and Evolve Bank \& Trust, Cease and Desist Order," news release, June 11, 2024, https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240614a1.pdf. ${ }^{4}$ Allen N. Berger, Nathan H. Miller, Mitchell A. Petersen, Raghuram G. Rajan, and Jeremy C. Stein, "Does Function Follow Organizational Form? Evidence from the Lending Practices of Large and Small Banks," National Bureau of Economic Research, Working Paper 8752 (Cambridge, MA: National Bureau of Economic Research, February 2002), https://www.nber.org/system/files/working_papers/w8752/w8752.pdf. ---[PAGE_BREAK]--- these head-to-head competitions, community banks face distinct disadvantages that can pose challenges when competing for the same banking opportunities. For example, banks are subject to taxes and additional regulatory requirements (including the Community Reinvestment Act). They are also subject to a broader range of restrictions imposed by regulatory requirements or the "soft" power of supervision. In all of these cases, the disparity in the legal framework can have a distortive effect on competition. In short, where the financial regulatory framework can provide for parity of treatment, it should do so. The regulatory framework should not knowingly distort competition, or effectively impose a regulatory allocation of credit. The framework also plays an important role in assessing competition among banks. The mergers and acquisitions (M\&A) approval process can have a disproportionate impact on community banks because the "screens" that are used to evaluate the competitive effects of a proposed merger often result in a finding that M\&A transactions in rural markets can have an adverse effect on competition and should therefore be disallowed. ${ }^{5}$ Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects-which is grounded in the effect of proposed transactions on the control of deposits within individual banking markets-often requires additional review or analysis, and can lead to delays in the regulatory approval process. # Cybersecurity Community banks often note cybersecurity and third-party risk management as areas that raise significant concerns. Cyber-related events, including ransomware attacks and business [^0] [^0]: ${ }^{5}$ Michelle W. Bowman, "The Role of Research, Data, and Analysis in Banking Reforms" (speech at the 2023 Community Banking Research Conference, St. Louis, MO, October 4, 2023), https://www.federalreserve.gov/newsevents/speech/files/bowman20231004a.pdf; Michelle W. Bowman, "The New Landscape for Banking Competition," (speech at the 2022 Community Banking Research Conference, St. Louis, MO, September 28, 2022), https://www.federalreserve.gov/newsevents/speech/files/bowman20220928a.pdf. ---[PAGE_BREAK]--- email compromises, are costly and time-consuming experiences, and they pose unique challenges for community banks. For example, the maintenance of and the technology resources required to support a successful cybersecurity program are often difficult for smaller banks. Regulators can promote cybersecurity, and stronger cyber-incident "resilience" and response capabilities by identifying resources and opportunities for banks to develop "muscle memory" in cyber incident response. Recent incidents, like the Crowdstrike-related outage, have highlighted the heavy dependence many banks have on technology, third-party providers, and the broader supply chain. In the current risk environment, it is important for banks of all sizes to implement sound operational resilience, cybersecurity, and third-party risk-management practices. One important resource for community banks is the Federal Financial Institutions Examination Council (FFIEC) website, which includes the FFIEC Cybersecurity Resource Guide and links to other external cybersecurity resources. The Federal Reserve plays an important role in supervising banks and supporting risk management practices. For example, the Federal Reserve hosts the Midwest Cyber Workshop, with the Federal Reserve Banks of Chicago, Kansas City, and St. Louis. ${ }^{6}$ Over the past two years, this workshop has provided a forum to further cyber risk discussions among community bankers, regulators, law enforcement, and other industry stakeholders. Today's Symposium also includes an interactive cyber workshop, during which participants will participate in a cyber [^0] [^0]: ${ }^{6}$ See Federal Reserve Bank of Chicago, Federal Reserve Bank of St. Louis, and Federal Reserve Bank of Kansas City, Midwest Cyber Workshop 2024 (June 25-26, 2024), https://www.chicagofed.org/events/2024/midwest-cyberworkshop. ---[PAGE_BREAK]--- exercise, working through the various decisions that would be required in responding to a hypothetical cyberattack. ${ }^{7}$ We know well that cyber threats pose real risks to the banking system. We also recognize that community banks may have unique needs in preventing, remediating, and responding to cyber threats. Therefore, regulators should ensure that a range of resources are available to support community banks and seek further opportunities to help build community bank resilience against these threats. # Third-Party Risk Management Third-party risk management can pose an additional challenge for community banks. Due to their size and scale, community banks often leverage centralized resources-technical experts who have greater expertise than the bank could fully maintain on staff-to advise and assist on a range of issues. Often these third-party service providers are significantly larger, and their bank clients—including smaller banks—may lack leverage in conducting due diligence and negotiating the terms of the relationship. In 2023, the federal banking agencies published supervisory guidance addressing thirdparty risk management, which was expressly applicable to community banks. As I noted at the time it was issued, the guidance included shortcomings that were known and identified but not addressed in advance. ${ }^{8}$ [^0] [^0]: ${ }^{7}$ Federal Reserve Bank of Chicago, Community Bankers Symposium (October 11, 2024), https://www.chicagofed.org/events/2024/annual-community-bankers-symposium-18th ${ }^{8}$ Michelle W. Bowman, "Defining a Bank" (Speech to the American Bankers Association 2024 Conference for Community Bankers, San Antonio, TX, February 12, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20240212a.pdf; Statement by Governor Michelle W. Bowman, "Third-Party Risk-Management Guidance," news release, June 6, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230606.htm ("...Federal Reserve regional bank supervisors have indicated that we should provide additional resources for community banks upon implementation to provide appropriate expectations and ensure that small banks understand and can effectively use ---[PAGE_BREAK]--- What many of you may not know is that after nearly a year from the original publication, the regulators published a guide to assist community banks interpret and apply the guidance to their third-party risk management activities. The guide was intended to provide additional context for the guidance-including step-by-step examples of how to address third-party risk management—making the guidance more useful. While I am pleased that the community bank implementation guide was eventually published, the delays in its publication suggest a shortcoming in our regulatory approach. We must ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the time the guidance is published. # Consumer Compliance Like third-party risk management, consumer compliance can be another area that may present challenges to community banks given their size and scale. An effective and well-run consumer compliance program balances consumer protection with the complexity and cost to establish a robust compliance management program. One challenge for community banks is the difficulty in retaining qualified consumer compliance experts. Notwithstanding these challenges, community banks devote significant time and resources to their consumer compliance risk management programs. Compliance with consumer protection laws and regulations, including fair lending laws, is essential to ensuring that the banking system provides fair and broad access to credit and financial services. Community banks take these responsibilities seriously, and the overwhelming majority of banks that we supervise invest in strong compliance management systems to prevent violations the guidance to inform their third-party risk management processes...I am disappointed that the agencies failed to make the upfront investment to reduce unnecessary confusion and burden on community banks"). ---[PAGE_BREAK]--- and detect problems before they occur. When consumer compliance concerns arise, banks address them by making their customers whole and adopting the necessary changes to ensure that issues do not persist or reoccur. In a very small subset of cases, banks fall short of their obligations, and we hold those institutions accountable through enforcement actions or other supervisory actions. The Federal Reserve's consumer compliance supervision program is risk-focused and tailored to a bank's compliance risk, focused on the activities that present the greatest risk. One example related to third-party risk management is our recent system supervisory focus on consumer compliance risks associated with fin-tech relationships. As a result of this work, our supervisors seek to identify the parties to relationships that pose the greatest risk of consumer harm. This effort promotes our understanding of higher risk fin-tech partners across the Federal Reserve System, and helps supervisors proactively identify relationships that pose greater risk of consumer harm. # Other Core Risks There are a number of "core" risks that are essential for bank management to address. These "core" risks-including funding, liquidity and credit risk—should already be integrated into management priorities, since they pose the greatest threats to a bank's operations. Focusing on core risks is second nature for community banks. In contrast, supervision can be susceptible to diversion from core to non-core risks leading supervisors to neglect the build-up of traditional risk. Diverting resources to non-core risks can often leave a bank vulnerable, especially when regulators direct banks to allocate resources in other ways, whether by regulation, guidance, or through supervisory expectations. ---[PAGE_BREAK]--- # Mitigating Risks to Community Banks The design of regulation, guidance, and supervisory approach regulators rely upon for community banks-and the intentional policy choices that underpin this framework-are important for ensuring their effectiveness in supporting the safety and soundness of the banking system. These design choices can enable community banks to operate successfully while mitigating risks, leveraging tailoring, transparency, and consistency across institutions. ${ }^{9}$ I have spoken at length about these themes in the past, but I would like to reiterate just a few of the critical elements of a regulatory agenda that will allow community banks to thrive in the future: - First, we need to revisit size thresholds over time as inflation and economic growth slowly erode our regulatory categories. The bank regulatory framework is built largely upon asset-based size thresholds, and these thresholds should reflect a deliberate policy choice. But, over time, these fixed thresholds effectively result in more firms being "scoped in" to higher compliance tiers over time, even when there has been no change in a bank's underlying risk profile. ${ }^{10}$ - We need to have a regulatory system in which M\&A transactions and de novo bank formations are possible for banks, not one in which regulatory approval requirements are used to impose additional (and extra-regulatory) requirements on firms. ${ }^{11}$ Viable formation and merger options for banks of all sizes are necessary to avoid creating a [^0] [^0]: ${ }^{9}$ See Michelle W. Bowman, "Building a Community Banking Framework for the Future" (speech at the Federal Reserve Bank of St. Louis Community Banking Research Conference, St. Louis, Missouri, October 2, 2024), https://www.federalreserve.gov/newsevents/speech/files/bowman20241002a.pdf. ${ }^{10}$ See, e.g., Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, "Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity," 88 Fed. Reg. 64,028, 64,095 (September 18, 2023) ("[t]o reflect inflation since 1996 and growth in the capital markets, the agencies are proposing to increase the trading activity dollar threshold [applicable to the market risk rule] from $\$ 1$ billion to $\$ 5$ billion."). ${ }^{11}$ FDIC, "Final Statement of Policy on Bank Merger Transactions," (September 17, 2024), https://www.fdic.gov/system/files/2024-09/final-statement-of-policy-on-bank-merger-transactions.pdf. ---[PAGE_BREAK]--- "barbell" of the very largest and very smallest banks in the banking system, with the number of community banks continuing to erode over time. Left unchecked, an applications process that imposes additional costs and delays on healthy and appropriate banking transactions will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. - We should prioritize direct experience in our regulatory efforts, giving greater voice and opportunities for input from policymakers with banking or state supervisory experience currently at the Federal banking agencies, and by soliciting and accepting feedback from our state banking counterparts. Greater coordination and participation by a wider set of policymakers in regulatory reform efforts would bring several benefits. For example, discussion of competing ideas and compromise in the drafting of regulatory proposals often results in a more moderate approach, reducing dramatic swings of the regulatory pendulum. And in many instances, we can better anticipate the unintended consequences of reform proposals if policymakers engage in good faith discussions and coordination of these efforts. - While regulatory reform brings many benefits, we should also shift our mindset to focus on the tradeoffs of regulation, guidance, and supervision. Changes to the regulatory framework often yield benefits in terms of greater visibility into the workings of the banking system, additional capital that can absorb losses and promote financial resiliency, and more conservative risk-management standards for interest rate risk and funding risk. But we need to evaluate not only the benefits of proposals but also the costs and unintended consequences. How will banks adjust their activities in response? Will they raise prices on lending activities or for other banking products or services? Will ---[PAGE_BREAK]--- they exit certain low-margin businesses, resulting in greater concentration and increased financial stability risk? By considering the cumulative burden, we can better address and acknowledge these concerns. - And finally, we must incorporate "tailoring"-calibrating the regulatory framework based on the size and complexity of banks' activities-as a required input for regulatory consideration. Tailoring helps us to better allocate finite resources both in banks and among regulators and helps us avoid threatening the long-term viability of community banks by simply adding to the mass of existing regulations, guidance, and other supervisory material. We simply cannot ignore the "cumulative" or "compounding" effect of increasing the complexity of the regulatory framework and we must make room in our reform agenda for the unglamorous work of "maintenance" in promoting an efficient framework. By no means is this proposal for regulatory reform exhaustive, but these critical components must be integrated into our future approach to ensure a diverse banking system for the future. # Closing Thoughts Thank you for the opportunity to speak to you today, and for your commitment to community banking. You serve a critical role within the banking system, and in support of the U.S. economy. Your work to leverage the power of the community banking model enables you to serve your customers, promote financial inclusion and expand access to banking services. But policymakers have an important responsibility to make sure that the community banking model remains viable into the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial ---[PAGE_BREAK]--- institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance.	Michelle W Bowman	United States	https://www.bis.org/review/r241014a.pdf	For release on delivery 1:10 p.m. EDT (12:10 p.m. local time) October 11, 2024 Challenges to the Community Banking Model Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The 18th Annual Community Bankers Symposium Community Banking: Navigating a Changing Landscape Chicago, Illinois October 11, 2024 Good afternoon, I'd like to begin by thanking the event organizers, including our staff at the Chicago Federal Reserve Bank, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, and the Conference of State Bank Supervisors for inviting me to share my thoughts with you at the 18th Annual Community Bankers Symposium. I always enjoy the opportunity to speak to bankers across the country and share perspectives on the issues facing the banking and financial system, especially when it's related to community banks. Banks are a critical component of the U.S. economy. Their work often extends well beyond the provision of credit— providing services and volunteer and financial support within their community. Among many things, banks offer financial education, sponsorships and funding for community programs and events. Without question, community banks are important and integral to the local economy. But community banks also face challenges that require proactive risk management, effective and efficient prioritization of compliance resources, and the need to innovate. Today, I would like to briefly highlight some of the issues banks are facing and discuss ways that community banks and regulators can more effectively work together in the future. As this audience knows well, community banks face a number of challenges. They often rely on third-party service providers to offer products and services to their customers. It may be more difficult for them to hire and retain qualified staff or plan for future leadership with management succession planning. Given limited staffing, they may be overwhelmed by the recent onslaught of new regulations and guidance. And in light of all of this, it may be challenging to prioritize resources in order to appropriately focus on the most important risks facing their businesses. While the headwinds may seem overwhelming, community banks are always resilient in the face of change. Often, one of the greatest challenges facing a community bank is not about managing any particular risk but rather how to address all of the risks they face-and how to prioritize the approach to address each of those risks. Regulators have, at times, exacerbated these challenges through policy choices. The risk of mis-prioritization is not limited to community banks. In my mind, this was most recently evident in the events and supervision leading to the failure of Silicon Valley Bank. Management failed to address growing interest rate risk and funding risks, and supervisors failed to prioritize and escalate these issues. Our goal should be to identify, understand, and learn from these past mistakes, and to avoid repeating them. Both regulators and banks should be working toward a common goal-a banking system that supports economic activity throughout the country, in which banks operate in a safe and sound manner and in compliance with consumer laws and regulations. In considering the challenges facing community banks, both regulators and banks have an important role to play. Community banks face competitive pressures from many sources. These pressures may result from local or regional economic conditions, the needs of retail and business customers, and the products and services available in the market. Competitors can take the form of traditional banks, internet banks, and non-banks like fin-techs and mortgage companies. While fin-tech partnerships can be beneficial to both the customer and the bank, if the relationship is not managed according to safe and sound banking principles, serious problems can result. When deposits are accepted through fin-tech relationships but not handled appropriately, deposit insurance can be jeopardized and the ability to access deposited funds may be impacted. Competition can also come from other local competitors like credit unions, large banks with a broader operational footprint, payday lenders, or other nonbank credit sources. As bank customers grow increasingly comfortable and familiar with new mechanisms for doing business, the use of online banking has continued to expand. This has tended to increase the footprint of non-local banks or lenders, enabling them to effectively compete for business outside of their geographic area. Even against this backdrop, research shows that community banks have maintained an important role in many banking markets, including in small- and medium-sized business lending. The regulatory framework establishes expectations for how community banks can compete, and often creates an unlevel playing field with many of these competitors. This includes whether they are subject to the same regulation as banks that engage in the same activities and how competition is evaluated. A core concept in financial regulation is to impose the same regulation-and I suggest we expand this to include the same regulation, guidance, and supervisory expectations-on entities that are engaged in the same activities. Banks compete against many non-bank providers, including financial technology firms, credit unions, and other non-bank lenders. In some of these head-to-head competitions, community banks face distinct disadvantages that can pose challenges when competing for the same banking opportunities. For example, banks are subject to taxes and additional regulatory requirements (including the Community Reinvestment Act). They are also subject to a broader range of restrictions imposed by regulatory requirements or the "soft" power of supervision. In all of these cases, the disparity in the legal framework can have a distortive effect on competition. In short, where the financial regulatory framework can provide for parity of treatment, it should do so. The regulatory framework should not knowingly distort competition, or effectively impose a regulatory allocation of credit. The framework also plays an important role in assessing competition among banks. The mergers and acquisitions (M\&A) approval process can have a disproportionate impact on community banks because the "screens" that are used to evaluate the competitive effects of a proposed merger often result in a finding that M\&A transactions in rural markets can have an adverse effect on competition and should therefore be disallowed. Even when these transactions are eventually approved, the mechanical approach to analyzing competitive effects-which is grounded in the effect of proposed transactions on the control of deposits within individual banking markets-often requires additional review or analysis, and can lead to delays in the regulatory approval process. Community banks often note cybersecurity and third-party risk management as areas that raise significant concerns. Cyber-related events, including ransomware attacks and business email compromises, are costly and time-consuming experiences, and they pose unique challenges for community banks. For example, the maintenance of and the technology resources required to support a successful cybersecurity program are often difficult for smaller banks. Regulators can promote cybersecurity, and stronger cyber-incident "resilience" and response capabilities by identifying resources and opportunities for banks to develop "muscle memory" in cyber incident response. Recent incidents, like the Crowdstrike-related outage, have highlighted the heavy dependence many banks have on technology, third-party providers, and the broader supply chain. In the current risk environment, it is important for banks of all sizes to implement sound operational resilience, cybersecurity, and third-party risk-management practices. One important resource for community banks is the Federal Financial Institutions Examination Council (FFIEC) website, which includes the FFIEC Cybersecurity Resource Guide and links to other external cybersecurity resources. The Federal Reserve plays an important role in supervising banks and supporting risk management practices. For example, the Federal Reserve hosts the Midwest Cyber Workshop, with the Federal Reserve Banks of Chicago, Kansas City, and St. Louis. Over the past two years, this workshop has provided a forum to further cyber risk discussions among community bankers, regulators, law enforcement, and other industry stakeholders. Today's Symposium also includes an interactive cyber workshop, during which participants will participate in a cyber exercise, working through the various decisions that would be required in responding to a hypothetical cyberattack. We know well that cyber threats pose real risks to the banking system. We also recognize that community banks may have unique needs in preventing, remediating, and responding to cyber threats. Therefore, regulators should ensure that a range of resources are available to support community banks and seek further opportunities to help build community bank resilience against these threats. Third-party risk management can pose an additional challenge for community banks. Due to their size and scale, community banks often leverage centralized resources-technical experts who have greater expertise than the bank could fully maintain on staff-to advise and assist on a range of issues. Often these third-party service providers are significantly larger, and their bank clients—including smaller banks—may lack leverage in conducting due diligence and negotiating the terms of the relationship. In 2023, the federal banking agencies published supervisory guidance addressing thirdparty risk management, which was expressly applicable to community banks. As I noted at the time it was issued, the guidance included shortcomings that were known and identified but not addressed in advance. What many of you may not know is that after nearly a year from the original publication, the regulators published a guide to assist community banks interpret and apply the guidance to their third-party risk management activities. The guide was intended to provide additional context for the guidance-including step-by-step examples of how to address third-party risk management—making the guidance more useful. While I am pleased that the community bank implementation guide was eventually published, the delays in its publication suggest a shortcoming in our regulatory approach. We must ensure new guidance provides clarity to regulated firms on its own, or that we provide additional resources at the time the guidance is published. Like third-party risk management, consumer compliance can be another area that may present challenges to community banks given their size and scale. An effective and well-run consumer compliance program balances consumer protection with the complexity and cost to establish a robust compliance management program. One challenge for community banks is the difficulty in retaining qualified consumer compliance experts. Notwithstanding these challenges, community banks devote significant time and resources to their consumer compliance risk management programs. Compliance with consumer protection laws and regulations, including fair lending laws, is essential to ensuring that the banking system provides fair and broad access to credit and financial services. Community banks take these responsibilities seriously, and the overwhelming majority of banks that we supervise invest in strong compliance management systems to prevent violations the guidance to inform their third-party risk management processes.I am disappointed that the agencies failed to make the upfront investment to reduce unnecessary confusion and burden on community banks"). and detect problems before they occur. When consumer compliance concerns arise, banks address them by making their customers whole and adopting the necessary changes to ensure that issues do not persist or reoccur. In a very small subset of cases, banks fall short of their obligations, and we hold those institutions accountable through enforcement actions or other supervisory actions. The Federal Reserve's consumer compliance supervision program is risk-focused and tailored to a bank's compliance risk, focused on the activities that present the greatest risk. One example related to third-party risk management is our recent system supervisory focus on consumer compliance risks associated with fin-tech relationships. As a result of this work, our supervisors seek to identify the parties to relationships that pose the greatest risk of consumer harm. This effort promotes our understanding of higher risk fin-tech partners across the Federal Reserve System, and helps supervisors proactively identify relationships that pose greater risk of consumer harm. There are a number of "core" risks that are essential for bank management to address. These "core" risks-including funding, liquidity and credit risk—should already be integrated into management priorities, since they pose the greatest threats to a bank's operations. Focusing on core risks is second nature for community banks. In contrast, supervision can be susceptible to diversion from core to non-core risks leading supervisors to neglect the build-up of traditional risk. Diverting resources to non-core risks can often leave a bank vulnerable, especially when regulators direct banks to allocate resources in other ways, whether by regulation, guidance, or through supervisory expectations. The design of regulation, guidance, and supervisory approach regulators rely upon for community banks-and the intentional policy choices that underpin this framework-are important for ensuring their effectiveness in supporting the safety and soundness of the banking system. These design choices can enable community banks to operate successfully while mitigating risks, leveraging tailoring, transparency, and consistency across institutions. I have spoken at length about these themes in the past, but I would like to reiterate just a few of the critical elements of a regulatory agenda that will allow community banks to thrive in the future: First, we need to revisit size thresholds over time as inflation and economic growth slowly erode our regulatory categories. The bank regulatory framework is built largely upon asset-based size thresholds, and these thresholds should reflect a deliberate policy choice. But, over time, these fixed thresholds effectively result in more firms being "scoped in" to higher compliance tiers over time, even when there has been no change in a bank's underlying risk profile. . We need to have a regulatory system in which M\&A transactions and de novo bank formations are possible for banks, not one in which regulatory approval requirements are used to impose additional (and extra-regulatory) requirements on firms. Viable formation and merger options for banks of all sizes are necessary to avoid creating a. "barbell" of the very largest and very smallest banks in the banking system, with the number of community banks continuing to erode over time. Left unchecked, an applications process that imposes additional costs and delays on healthy and appropriate banking transactions will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm. We should prioritize direct experience in our regulatory efforts, giving greater voice and opportunities for input from policymakers with banking or state supervisory experience currently at the Federal banking agencies, and by soliciting and accepting feedback from our state banking counterparts. Greater coordination and participation by a wider set of policymakers in regulatory reform efforts would bring several benefits. For example, discussion of competing ideas and compromise in the drafting of regulatory proposals often results in a more moderate approach, reducing dramatic swings of the regulatory pendulum. And in many instances, we can better anticipate the unintended consequences of reform proposals if policymakers engage in good faith discussions and coordination of these efforts. While regulatory reform brings many benefits, we should also shift our mindset to focus on the tradeoffs of regulation, guidance, and supervision. Changes to the regulatory framework often yield benefits in terms of greater visibility into the workings of the banking system, additional capital that can absorb losses and promote financial resiliency, and more conservative risk-management standards for interest rate risk and funding risk. But we need to evaluate not only the benefits of proposals but also the costs and unintended consequences. How will banks adjust their activities in response? Will they raise prices on lending activities or for other banking products or services? Will they exit certain low-margin businesses, resulting in greater concentration and increased financial stability risk? By considering the cumulative burden, we can better address and acknowledge these concerns. And finally, we must incorporate "tailoring"-calibrating the regulatory framework based on the size and complexity of banks' activities-as a required input for regulatory consideration. Tailoring helps us to better allocate finite resources both in banks and among regulators and helps us avoid threatening the long-term viability of community banks by simply adding to the mass of existing regulations, guidance, and other supervisory material. We simply cannot ignore the "cumulative" or "compounding" effect of increasing the complexity of the regulatory framework and we must make room in our reform agenda for the unglamorous work of "maintenance" in promoting an efficient framework. By no means is this proposal for regulatory reform exhaustive, but these critical components must be integrated into our future approach to ensure a diverse banking system for the future. Thank you for the opportunity to speak to you today, and for your commitment to community banking. You serve a critical role within the banking system, and in support of the U.S. economy. Your work to leverage the power of the community banking model enables you to serve your customers, promote financial inclusion and expand access to banking services. But policymakers have an important responsibility to make sure that the community banking model remains viable into the future. To function effectively, the banking system requires the presence of banks of all sizes-larger, regional, and community banks. This diversity of our financial institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance.
2024-10-14T00:00:00	Christopher J Waller: Thoughts on the economy and policy rules at the Federal Open Market Committee	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at "A 50 Year Retrospective on the Shadow Open Market Committee and Its Role in Monetary Policy" conference, sponsored by the Hoover Institution, Stanford University, Stanford, California, 14 October 2024.	Christopher J Waller: Thoughts on the economy and policy rules at the Federal Open Market Committee Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at "A 50 Year Retrospective on the Shadow Open Market Committee and Its Role in Monetary Policy" conference, sponsored by the Hoover Institution, Stanford University, Stanford, California, 14 October 2024. * * * Thank you, Athanasios, and thank you for the opportunity to be part of this very worthy 1 celebration. In support of the theme of this conference, I do have some thoughts on the Shadow Open Market Committee's contributions to the policy debate, in particular its advocacy for policy rules. But before I get to that, I am going to exercise the keynote speaker's freedom to talk about whatever I want. To that end, I want to take a few minutes to offer my views on the economic outlook and its implications for monetary policy. So let me start there, and afterward I will discuss the role that policy rules play in my decision making and in the deliberations of the Federal Open Market Committee (FOMC). In the three weeks or so since the most recent FOMC meeting, data we have received has been uneven, as it sometimes has been over the past year. I continue to judge that the U.S. economy is on a solid footing, with employment near the FOMC's maximum employment objective and inflation in the vicinity of our target, even though the latest inflation data was disappointing. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of 2024, and I expect it to grow a bit faster in the third quarter. The Blue Chip consensus of private sector forecasters predicts 2.3 percent, while the Atlanta Fed's GDPNow model, based on up-to-the moment data, is predicting real growth of 3.2 percent. Earlier, there were concerns that GDP in the first half of this year was overstating the strength of the economy, since gross domestic income (GDI) was estimated to have grown a mere 1.3 percent in the first half of this year, suggesting a big downward revision to GDP was coming. But revisions received after our most recent FOMC meeting showed the opposite-GDI growth was revised up substantially to 3.2 percent. This change in turn led to an upward revision in the personal saving rate of about 2 percentage points in the second quarter, leaving it at 5.2 percent in June. This revision suggests that household resources for future consumption are actually in good shape, although data and anecdotal evidence suggests lower-income groups are struggling. These revisions suggest that the economy is much stronger than previously thought, with little indication of a major slowdown in economic activity. That outlook is supported by consumer spending that has been and continues to be strong. Though the growth in personal consumption expenditures (PCE) has moderated since the second half of 2023, it has continued at an average pace of close to 2.5 percent so far this year. Also, my business contacts believe that there is considerable pent-up demand for durable goods, home improvements, and other big-ticket items, demand that built up due to high interest rates for credit cards and home equity loans. Now that rates have started to come down and are expected to come down more, consumers will be eager to make those purchases. For business spending, purchasing managers for manufacturers describe ongoing weakness in that sector, but those for the large majority of businesses outside of manufacturing continue to report a solid expansion of activity. Now let's talk about the labor market. Only a couple months ago, it appeared that the labor market was cooling too quickly. Low numbers for job creation and a jump in the unemployment rate from 4.1 percent in June to 4.3 percent in July raised risks that the labor market was deteriorating. To remind you of how bad the markets viewed the July data, some Fed watchers were calling for an emergency FOMC meeting to discuss a rate cut. While the unemployment rate ticked down in August, job growth was once again well below expectations. Many were arguing that the labor market was on the verge of a serious deterioration and that the Fed was behind the curve even after a 50 basis point cut in the policy rate at the September FOMC meeting. Then we got the September employment report. Job creation in September was unexpectedly strong at 254,000 and the unemployment rate fell back down to 4.1 percent, which is where it was in June. The report also showed big upward revisions to payroll gains for the previous two months. Together, the message was loud and clear: While job creation has moderated and the unemployment rate has risen over the past year, the labor market remains quite healthy. Along with other new data on the labor market, the evidence is that labor supply and demand have come into balance. The number of job vacancies, a sign of strength in the labor market, has fallen gradually since the beginning of the year. The ratio of vacancies to unemployed is at 1.2, about the level in 2019, which was a pretty strong labor market. To put this number into perspective, recent research has shown that this 2 ratio has been above 1 only three times since 1960. The quits rate, another sign of labor market strength, has fallen lower than it was in 2019, a decrease which partly reflects that the hiring rate has fallen as labor supply and demand have come into better balance. In sum, based on payrolls, the unemployment rate and job revisions, there has been a very gradual moderation in labor demand relative to supply, but not a deterioration. The stability of the labor market, as reflected in these two measures as well as the other metrics I mentioned, bolsters my confidence that we can achieve further progress toward the FOMC's inflation goal while supporting a healthy labor market that adds jobs and boosts wages and living standards for workers. I will be looking for more evidence to support this outlook in the weeks and months to come. But, unfortunately, it won't be easy to interpret the October jobs report to be released just before the next FOMC meeting. This report will most likely show a significant but temporary loss of jobs from the two recent hurricanes and the strike at Boeing. I expect these factors may reduce employment growth by more than 100,000 this month, and there may be a small effect on the unemployment rate, but I'm not sure it will be that visible. Since the jobs report will come during the usual blackout period for policymakers commenting on the economy, you won't have any of us trying to put this low reading into perspective, though I hope others will. Looking ahead, I expect payroll gains to moderate from their current pace but continue at a solid rate. The unemployment rate may drift a bit higher but is likely to remain quite low in historical terms. While I believe the labor market is on a solid footing, I will continue to watch the full range of data for signs of weakness. Meanwhile, inflation, after showing considerable progress for several months toward the FOMC's 2 percent target, likely moved up in September. The consumer price index grew 0.2 percent over the past month, 2.1 percent over the past three months, 1.6 percent over six months and 2.4 percent in the past year. Oil prices fell over most of the summer but then more recently have surged. Excluding energy and also food prices that likewise tend to be volatile, and just as it did in August, core CPI inflation printed at 0.3 percent in September and 3.3 percent over the past year. Private-sector forecasts are predicting that PCE inflation, the FOMC's preferred measure, will also move up in September. Core PCE prices are expected to have risen around 0.25 percent last month. While not a welcome development, if the monthly core PCE inflation number comes in around this level, over the last 5 months it is still running very close to 2 percent on an annualized basis. We have made a lot of progress on inflation over the course of the last year and half, but that progress has clearly been uneven-at times it feels like being on a rollercoaster. Whether or not this month's inflation reading is just noise or if it signals ongoing increases, is yet to be seen. I will be watching the data carefully to see how persistent this recent uptick is. The FOMC's inflation goal is an average of 2 percent over the longer run and there are some good reasons to think that price increases will be modest going forward. I am hearing reports from firms that their pricing power seems to have waned as consumers have become more sensitive to price changes. There has also been a steady slowing in the growth of labor compensation. It is true that average hourly earnings growth in September ticked up to 4 percent over the past year. And though it might seem like wage increases of 4 percent a year would put upward pressure on inflation that is near 2 percent, that might not be true if one considers productivity, which has grown at an average annual rate of 2.9 percent for the past five quarters. Some of this strength was making up for productivity that shrank due to the pandemic, but the longer it continuesup 2.5 percent for the second quarter-the better productivity supports wage growth of 4 percent, or even higher, without driving up inflation. All that said, I will be watching all the data related to inflation closely. With the labor market in rough balance, employment near its maximum level, and inflation generally running close to our target over the past several months, I want to do what I can as a policymaker to keep the economy on this path. For me, the central question is how much and how fast to reduce the target for the federal funds rate, which I believe is currently set at a restrictive level. To help answer questions like this, I often look at various monetary policy rules to assess the appropriate setting of policy. Policy rules have long been of serious interest to the Shadow Open Market Committee. So before I turn to my views on the future path of policy, I thought I would talk about monetary policy rules versus discretion and begin with some background about the use of rules at the FOMC. For a brief overview of the history of the advent of rules at the Board, I have been directed to the second chapter of The Taylor Rule and the Transformation of Monetary Policy written by George Kahn, and I have also consulted the memories of longtime 3 members of the Board staff. Rules came along in the 1990s as the Fed was moving away from monetary targeting, focusing more on interest-rate policy, and taking its first major steps toward increased transparency. There was immediate interest in 4 Taylortype rules among Fed staff, and even some contributions of research. There was a presentation to the FOMC on rules in 1995, and that was the same year that John Taylor's Bay Area colleague, Janet Yellen, was apparently the first policymaker to mention the Taylor rule at an FOMC meeting. While FOMC decisions mimicked a Taylor rule much of the time under Chairman Alan Greenspan, he was famously an advocate of "constructive ambiguity" in communication, and he and other central bankers since have resisted the suggestion that decisions could be handed over to strict rules. Today, of course, a number of rules-based analyses are included in the material submitted to policymakers ahead of every FOMC meeting, and we publish the policy prescriptions of different rules as part of the Board's semi-annual Monetary Policy Report . Rules have become part of the furniture in modern policymaking. As everyone here knows, but for the benefit of other listeners, Taylor rules relate the level of the policy interest rate to a limited number of other economic variables, most often including the deviation of inflation from a target value and a measure of resource 5 use in the economy relative to some long-run trend. There are numerous forms of the Taylor rule, but they generally fall into two categories. The first of these, an inertial rule, has the property that the policy rate changes only slowly over time. I tend to think of it as an approach that captures the reaction function of a policymaker in a stable economy where the forces that would tend to change the economy and policy build over time. When change does occur, a gradual response may give policymakers time to assess the true state of the economy and the possible effects of their decision. One example I can use is the steadfastness of policymakers in the latter part of 2023, when inflation fell more rapidly than was widely expected, and again in early 2024, when it briefly escalated. The FOMC did not change course either time, an approach validated by inertial rules. A non-inertial rule, on the other hand, allows and in fact calls for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events. One saw these non-inertial rules prescribe a sharper rise in the policy rate above the effective lower bound starting in 2021 as inflation began climbing above the FOMC's 2 percent target. Non-inertial rules are also more useful in the face of major shocks to the economy such as the 2008 financial crisis and the start of the pandemic. The great promise of rules is that they provide a simple and reliable guide to policy, but what should one do when different rules recommend different policy actions given the same economic conditions? Right now, inertial rules tell us to move slowly in reducing policy rates toward a neutral stance that neither restricts nor stimulates the economy. On the other hand, non-inertial rules tell us to cut the policy rate more aggressively, subject to the caveat that one is certain of the values of all the 'star' variables: U, Y and r*. I think the answer is that while rules are valuable in helping analyze policy options, they have limitations. Among these are the limits of the data considered, which is typically narrower than the range of data that policymakers use to make decisions, and also the fact that simple policy rules do not take into account risk management, which is often a critical consideration in policy decisions. So, while policy rules serve as a good check on discretionary policy, there are times when discretion is needed. As a result, I prefer to think of them as "policy rules of thumb". Turning to my view for the path for policy, let me discuss three scenarios that I have had in mind to manage the risks of upcoming decisions in the medium term. The first scenario is one where the overall strong economic developments that I have described today continue, with inflation nearing the FOMC's target and the unemployment rate moving up only slightly. This scenario implies to me that we can proceed with moving policy toward a neutral stance at a deliberate pace. This path would be based on the judgment that the risks to both sides of our dual mandate are balanced. In this circumstance, our job is to keep inflation near 2 percent and not slow the economy unnecessarily. Another scenario, less likely in light of recent data, is that inflation falls materially below 2 percent for some time, and/or the labor market significantly deteriorates. The message here is that demand is falling, the FOMC may suddenly be behind the curve, and that message would argue for moving to neutral more quickly by front-loading cuts to the policy rate. The third scenario applies if inflation unexpectedly escalates either because of strongerthan-expected consumer demand or wage pressure, or because of some shock to supply that pushes up inflation. As we learned in the recovery from the pandemic recession, when demand was stronger and supply weaker than initially expected, such surprises do occur. In this circumstance, as long as the labor market isn't deteriorating, we can pause rate cuts until progress resumes and uncertainty diminishes. Most recently, we have seen upward revisions to GDI, an increase in job vacancies, high GDP growth forecasts, a strong jobs report and a hotter than expected CPI report. This data is signaling that the economy may not be slowing as much as desired. While we do not want to overreact to this data or look through it, I view the totality of the data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting. I will be watching to see whether data, due out before our next meeting, on inflation, the labor market and economic activity confirms or undercuts my inclination to be more cautious about loosening monetary policy. Whatever happens in the near term, my baseline still calls for reducing the policy rate gradually over the next year. The median rate for FOMC participants at the end of 2025 is 3.4 percent, so most of my colleagues likewise expect to reduce policy over the next year. There is less certainty about the final destination. The median estimated longerrun level of the federal funds rate in the Committee's Summary of Economic Projections (SEP) is 2.9 percent, but with quite a wide dispersion, ranging from 2.4 percent to 3.8 percent. While much attention is given to the size of cuts over the next meeting or two, I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually. Thank you again, for the opportunity to be part of today's conference, and for allowing me to share some thoughts, relevant to monetary policy rules and my day job back in Washington. The Shadow Committee has elevated the public debate about monetary policy. May you continue to play that role for many years to come. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Open Market Committee. 2 See Pierpaolo Benigno and Gauti B. Eggertsson (2024), "Revisiting the Phillips and Beveridge Curves: Insights from the 2020s Inflation Surge (PDF)," paper presented at "Reassessing the Effectiveness and Transmission of Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 23. 3 See Evan F. Koenig, Robert Leeson, and George A. Kahn, eds. (2012), The Taylor Rule and the Transformation of Monetary Policy (Stanford, Calif.: Hoover Institution Press). I was assisted in this brief history by Board economists James Clouse and Edward Nelson. 4 See Dale W. Henderson and Warwick J. McKibbin (1993), "A Comparison of Some Basic Monetary Policy Regimes for Open Economies: Implications of Different Degrees of Instrument Adjustment and Wage Persistence," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 221-317). This paper was also published in the International Finance Discussion Papers series and is available on the Board's website at https://www.federalreserve.gov/pubs/ifdp/1993/458/ifdp458.pdf . 5 Monetary Policy For a variety of Taylor rules and their implication for policy, see the Report, available on the Board's website at https://www.federalreserve.gov /monetarypolicy/publications/mpr_default.htm . i. Note: On October 14, 2024, a sentence on page 10 was corrected to say "restrictiveness": "I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually."	---[PAGE_BREAK]--- # Christopher J Waller: Thoughts on the economy and policy rules at the Federal Open Market Committee Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at "A 50 Year Retrospective on the Shadow Open Market Committee and Its Role in Monetary Policy" conference, sponsored by the Hoover Institution, Stanford University, Stanford, California, 14 October 2024. Thank you, Athanasios, and thank you for the opportunity to be part of this very worthy celebration. ${ }^{1}$ In support of the theme of this conference, I do have some thoughts on the Shadow Open Market Committee's contributions to the policy debate, in particular its advocacy for policy rules. But before I get to that, I am going to exercise the keynote speaker's freedom to talk about whatever I want. To that end, I want to take a few minutes to offer my views on the economic outlook and its implications for monetary policy. So let me start there, and afterward I will discuss the role that policy rules play in my decision making and in the deliberations of the Federal Open Market Committee (FOMC). In the three weeks or so since the most recent FOMC meeting, data we have received has been uneven, as it sometimes has been over the past year. I continue to judge that the U.S. economy is on a solid footing, with employment near the FOMC's maximum employment objective and inflation in the vicinity of our target, even though the latest inflation data was disappointing. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of 2024, and I expect it to grow a bit faster in the third quarter. The Blue Chip consensus of private sector forecasters predicts 2.3 percent, while the Atlanta Fed's GDPNow model, based on up-to-the moment data, is predicting real growth of 3.2 percent. Earlier, there were concerns that GDP in the first half of this year was overstating the strength of the economy, since gross domestic income (GDI) was estimated to have grown a mere 1.3 percent in the first half of this year, suggesting a big downward revision to GDP was coming. But revisions received after our most recent FOMC meeting showed the opposite-GDI growth was revised up substantially to 3.2 percent. This change in turn led to an upward revision in the personal saving rate of about 2 percentage points in the second quarter, leaving it at 5.2 percent in June. This revision suggests that household resources for future consumption are actually in good shape, although data and anecdotal evidence suggests lower-income groups are struggling. These revisions suggest that the economy is much stronger than previously thought, with little indication of a major slowdown in economic activity. That outlook is supported by consumer spending that has been and continues to be strong. Though the growth in personal consumption expenditures (PCE) has moderated since the second half of 2023, it has continued at an average pace of close to 2.5 percent so far this year. Also, my business contacts believe that there is considerable pent-up demand for durable goods, home improvements, and other big-ticket items, demand that built up due to high interest rates for credit cards and home equity loans. ---[PAGE_BREAK]--- Now that rates have started to come down and are expected to come down more, consumers will be eager to make those purchases. For business spending, purchasing managers for manufacturers describe ongoing weakness in that sector, but those for the large majority of businesses outside of manufacturing continue to report a solid expansion of activity. Now let's talk about the labor market. Only a couple months ago, it appeared that the labor market was cooling too quickly. Low numbers for job creation and a jump in the unemployment rate from 4.1 percent in June to 4.3 percent in July raised risks that the labor market was deteriorating. To remind you of how bad the markets viewed the July data, some Fed watchers were calling for an emergency FOMC meeting to discuss a rate cut. While the unemployment rate ticked down in August, job growth was once again well below expectations. Many were arguing that the labor market was on the verge of a serious deterioration and that the Fed was behind the curve even after a 50 basis point cut in the policy rate at the September FOMC meeting. Then we got the September employment report. Job creation in September was unexpectedly strong at 254,000 and the unemployment rate fell back down to 4.1 percent, which is where it was in June. The report also showed big upward revisions to payroll gains for the previous two months. Together, the message was loud and clear: While job creation has moderated and the unemployment rate has risen over the past year, the labor market remains quite healthy. Along with other new data on the labor market, the evidence is that labor supply and demand have come into balance. The number of job vacancies, a sign of strength in the labor market, has fallen gradually since the beginning of the year. The ratio of vacancies to unemployed is at 1.2, about the level in 2019, which was a pretty strong labor market. To put this number into perspective, recent research has shown that this ratio has been above 1 only three times since 1960. ${ }^{2}$ The quits rate, another sign of labor market strength, has fallen lower than it was in 2019, a decrease which partly reflects that the hiring rate has fallen as labor supply and demand have come into better balance. In sum, based on payrolls, the unemployment rate and job revisions, there has been a very gradual moderation in labor demand relative to supply, but not a deterioration. The stability of the labor market, as reflected in these two measures as well as the other metrics I mentioned, bolsters my confidence that we can achieve further progress toward the FOMC's inflation goal while supporting a healthy labor market that adds jobs and boosts wages and living standards for workers. I will be looking for more evidence to support this outlook in the weeks and months to come. But, unfortunately, it won't be easy to interpret the October jobs report to be released just before the next FOMC meeting. This report will most likely show a significant but temporary loss of jobs from the two recent hurricanes and the strike at Boeing. I expect these factors may reduce employment growth by more than 100,000 this month, and there may be a small effect on the unemployment rate, but I'm not sure it will be that visible. Since the jobs report will come during the usual blackout period for policymakers commenting on the economy, you won't have any of us trying to put this low reading into perspective, though I hope others will. ---[PAGE_BREAK]--- Looking ahead, I expect payroll gains to moderate from their current pace but continue at a solid rate. The unemployment rate may drift a bit higher but is likely to remain quite low in historical terms. While I believe the labor market is on a solid footing, I will continue to watch the full range of data for signs of weakness. Meanwhile, inflation, after showing considerable progress for several months toward the FOMC's 2 percent target, likely moved up in September. The consumer price index grew 0.2 percent over the past month, 2.1 percent over the past three months, 1.6 percent over six months and 2.4 percent in the past year. Oil prices fell over most of the summer but then more recently have surged. Excluding energy and also food prices that likewise tend to be volatile, and just as it did in August, core CPI inflation printed at 0.3 percent in September and 3.3 percent over the past year. Private-sector forecasts are predicting that PCE inflation, the FOMC's preferred measure, will also move up in September. Core PCE prices are expected to have risen around 0.25 percent last month. While not a welcome development, if the monthly core PCE inflation number comes in around this level, over the last 5 months it is still running very close to 2 percent on an annualized basis. We have made a lot of progress on inflation over the course of the last year and half, but that progress has clearly been uneven-at times it feels like being on a rollercoaster. Whether or not this month's inflation reading is just noise or if it signals ongoing increases, is yet to be seen. I will be watching the data carefully to see how persistent this recent uptick is. The FOMC's inflation goal is an average of 2 percent over the longer run and there are some good reasons to think that price increases will be modest going forward. I am hearing reports from firms that their pricing power seems to have waned as consumers have become more sensitive to price changes. There has also been a steady slowing in the growth of labor compensation. It is true that average hourly earnings growth in September ticked up to 4 percent over the past year. And though it might seem like wage increases of 4 percent a year would put upward pressure on inflation that is near 2 percent, that might not be true if one considers productivity, which has grown at an average annual rate of 2.9 percent for the past five quarters. Some of this strength was making up for productivity that shrank due to the pandemic, but the longer it continuesup 2.5 percent for the second quarter-the better productivity supports wage growth of 4 percent, or even higher, without driving up inflation. All that said, I will be watching all the data related to inflation closely. With the labor market in rough balance, employment near its maximum level, and inflation generally running close to our target over the past several months, I want to do what I can as a policymaker to keep the economy on this path. For me, the central question is how much and how fast to reduce the target for the federal funds rate, which I believe is currently set at a restrictive level. To help answer questions like this, I often look at various monetary policy rules to assess the appropriate setting of policy. Policy rules have long been of serious interest to the Shadow Open Market Committee. So before I turn to my views on the future path of policy, I thought I would talk about monetary policy rules versus discretion and begin with some background about the use of rules at the FOMC. For a brief overview of the history of the advent of rules at the Board, I have been directed to the second chapter of The Taylor Rule and the Transformation of Monetary ---[PAGE_BREAK]--- Policy written by George Kahn, and I have also consulted the memories of longtime members of the Board staff. $\underline{3}$ Rules came along in the 1990s as the Fed was moving away from monetary targeting, focusing more on interest-rate policy, and taking its first major steps toward increased transparency. There was immediate interest in Taylortype rules among Fed staff, and even some contributions of research. $\underline{4}$ There was a presentation to the FOMC on rules in 1995, and that was the same year that John Taylor's Bay Area colleague, Janet Yellen, was apparently the first policymaker to mention the Taylor rule at an FOMC meeting. While FOMC decisions mimicked a Taylor rule much of the time under Chairman Alan Greenspan, he was famously an advocate of "constructive ambiguity" in communication, and he and other central bankers since have resisted the suggestion that decisions could be handed over to strict rules. Today, of course, a number of rules-based analyses are included in the material submitted to policymakers ahead of every FOMC meeting, and we publish the policy prescriptions of different rules as part of the Board's semi-annual Monetary Policy Report. Rules have become part of the furniture in modern policymaking. As everyone here knows, but for the benefit of other listeners, Taylor rules relate the level of the policy interest rate to a limited number of other economic variables, most often including the deviation of inflation from a target value and a measure of resource use in the economy relative to some long-run trend. $\underline{5}$ There are numerous forms of the Taylor rule, but they generally fall into two categories. The first of these, an inertial rule, has the property that the policy rate changes only slowly over time. I tend to think of it as an approach that captures the reaction function of a policymaker in a stable economy where the forces that would tend to change the economy and policy build over time. When change does occur, a gradual response may give policymakers time to assess the true state of the economy and the possible effects of their decision. One example I can use is the steadfastness of policymakers in the latter part of 2023, when inflation fell more rapidly than was widely expected, and again in early 2024, when it briefly escalated. The FOMC did not change course either time, an approach validated by inertial rules. A non-inertial rule, on the other hand, allows and in fact calls for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events. One saw these non-inertial rules prescribe a sharper rise in the policy rate above the effective lower bound starting in 2021 as inflation began climbing above the FOMC's 2 percent target. Non-inertial rules are also more useful in the face of major shocks to the economy such as the 2008 financial crisis and the start of the pandemic. The great promise of rules is that they provide a simple and reliable guide to policy, but what should one do when different rules recommend different policy actions given the same economic conditions? Right now, inertial rules tell us to move slowly in reducing policy rates toward a neutral stance that neither restricts nor stimulates the economy. On the other hand, non-inertial rules tell us to cut the policy rate more aggressively, subject to the caveat that one is certain of the values of all the 'star' variables: $U^{}, Y^{}$ and $r^{*}$. I think the answer is that while rules are valuable in helping analyze policy options, they have limitations. Among these are the limits of the data considered, which is typically narrower than the range of data that policymakers use to make decisions, ---[PAGE_BREAK]--- and also the fact that simple policy rules do not take into account risk management, which is often a critical consideration in policy decisions. So, while policy rules serve as a good check on discretionary policy, there are times when discretion is needed. As a result, I prefer to think of them as "policy rules of thumb". Turning to my view for the path for policy, let me discuss three scenarios that I have had in mind to manage the risks of upcoming decisions in the medium term. The first scenario is one where the overall strong economic developments that I have described today continue, with inflation nearing the FOMC's target and the unemployment rate moving up only slightly. This scenario implies to me that we can proceed with moving policy toward a neutral stance at a deliberate pace. This path would be based on the judgment that the risks to both sides of our dual mandate are balanced. In this circumstance, our job is to keep inflation near 2 percent and not slow the economy unnecessarily. Another scenario, less likely in light of recent data, is that inflation falls materially below 2 percent for some time, and/or the labor market significantly deteriorates. The message here is that demand is falling, the FOMC may suddenly be behind the curve, and that message would argue for moving to neutral more quickly by front-loading cuts to the policy rate. The third scenario applies if inflation unexpectedly escalates either because of stronger-than-expected consumer demand or wage pressure, or because of some shock to supply that pushes up inflation. As we learned in the recovery from the pandemic recession, when demand was stronger and supply weaker than initially expected, such surprises do occur. In this circumstance, as long as the labor market isn't deteriorating, we can pause rate cuts until progress resumes and uncertainty diminishes. Most recently, we have seen upward revisions to GDI, an increase in job vacancies, high GDP growth forecasts, a strong jobs report and a hotter than expected CPI report. This data is signaling that the economy may not be slowing as much as desired. While we do not want to overreact to this data or look through it, I view the totality of the data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting. I will be watching to see whether data, due out before our next meeting, on inflation, the labor market and economic activity confirms or undercuts my inclination to be more cautious about loosening monetary policy. Whatever happens in the near term, my baseline still calls for reducing the policy rate gradually over the next year. The median rate for FOMC participants at the end of 2025 is 3.4 percent, so most of my colleagues likewise expect to reduce policy over the next year. There is less certainty about the final destination. The median estimated longerrun level of the federal funds rate in the Committee's Summary of Economic Projections (SEP) is 2.9 percent, but with quite a wide dispersion, ranging from 2.4 percent to 3.8 percent. While much attention is given to the size of cuts over the next meeting or two, I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually. ---[PAGE_BREAK]--- Thank you again, for the opportunity to be part of today's conference, and for allowing me to share some thoughts, relevant to monetary policy rules and my day job back in Washington. The Shadow Committee has elevated the public debate about monetary policy. May you continue to play that role for many years to come. ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Open Market Committee. ${ }^{2}$ See Pierpaolo Benigno and Gauti B. Eggertsson (2024), "Revisiting the Phillips and Beveridge Curves: Insights from the 2020s Inflation Surge (PDF)," paper presented at "Reassessing the Effectiveness and Transmission of Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 23. ${ }^{3}$ See Evan F. Koenig, Robert Leeson, and George A. Kahn, eds. (2012), The Taylor Rule and the Transformation of Monetary Policy (Stanford, Calif.: Hoover Institution Press). I was assisted in this brief history by Board economists James Clouse and Edward Nelson. ${ }^{4}$ See Dale W. Henderson and Warwick J. McKibbin (1993), "A Comparison of Some Basic Monetary Policy Regimes for Open Economies: Implications of Different Degrees of Instrument Adjustment and Wage Persistence," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 221-317). This paper was also published in the International Finance Discussion Papers series and is available on the Board's website at https://www.federalreserve.gov/pubs/ifdp/1993/458/ifdp458.pdf. ${ }^{5}$ For a variety of Taylor rules and their implication for policy, see the Monetary Policy Report, available on the Board's website at https://www.federalreserve.gov /monetarypolicy/publications/mpr_default.htm. i. Note: On October 14, 2024, a sentence on page 10 was corrected to say "restrictiveness": "I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually."	Christopher J Waller	United States	https://www.bis.org/review/r241015e.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at "A 50 Year Retrospective on the Shadow Open Market Committee and Its Role in Monetary Policy" conference, sponsored by the Hoover Institution, Stanford University, Stanford, California, 14 October 2024. Thank you, Athanasios, and thank you for the opportunity to be part of this very worthy celebration. In support of the theme of this conference, I do have some thoughts on the Shadow Open Market Committee's contributions to the policy debate, in particular its advocacy for policy rules. But before I get to that, I am going to exercise the keynote speaker's freedom to talk about whatever I want. To that end, I want to take a few minutes to offer my views on the economic outlook and its implications for monetary policy. So let me start there, and afterward I will discuss the role that policy rules play in my decision making and in the deliberations of the Federal Open Market Committee (FOMC). In the three weeks or so since the most recent FOMC meeting, data we have received has been uneven, as it sometimes has been over the past year. I continue to judge that the U.S. economy is on a solid footing, with employment near the FOMC's maximum employment objective and inflation in the vicinity of our target, even though the latest inflation data was disappointing. Real gross domestic product (GDP) grew at a 2.2 percent annual rate in the first half of 2024, and I expect it to grow a bit faster in the third quarter. The Blue Chip consensus of private sector forecasters predicts 2.3 percent, while the Atlanta Fed's GDPNow model, based on up-to-the moment data, is predicting real growth of 3.2 percent. Earlier, there were concerns that GDP in the first half of this year was overstating the strength of the economy, since gross domestic income (GDI) was estimated to have grown a mere 1.3 percent in the first half of this year, suggesting a big downward revision to GDP was coming. But revisions received after our most recent FOMC meeting showed the opposite-GDI growth was revised up substantially to 3.2 percent. This change in turn led to an upward revision in the personal saving rate of about 2 percentage points in the second quarter, leaving it at 5.2 percent in June. This revision suggests that household resources for future consumption are actually in good shape, although data and anecdotal evidence suggests lower-income groups are struggling. These revisions suggest that the economy is much stronger than previously thought, with little indication of a major slowdown in economic activity. That outlook is supported by consumer spending that has been and continues to be strong. Though the growth in personal consumption expenditures (PCE) has moderated since the second half of 2023, it has continued at an average pace of close to 2.5 percent so far this year. Also, my business contacts believe that there is considerable pent-up demand for durable goods, home improvements, and other big-ticket items, demand that built up due to high interest rates for credit cards and home equity loans. Now that rates have started to come down and are expected to come down more, consumers will be eager to make those purchases. For business spending, purchasing managers for manufacturers describe ongoing weakness in that sector, but those for the large majority of businesses outside of manufacturing continue to report a solid expansion of activity. Now let's talk about the labor market. Only a couple months ago, it appeared that the labor market was cooling too quickly. Low numbers for job creation and a jump in the unemployment rate from 4.1 percent in June to 4.3 percent in July raised risks that the labor market was deteriorating. To remind you of how bad the markets viewed the July data, some Fed watchers were calling for an emergency FOMC meeting to discuss a rate cut. While the unemployment rate ticked down in August, job growth was once again well below expectations. Many were arguing that the labor market was on the verge of a serious deterioration and that the Fed was behind the curve even after a 50 basis point cut in the policy rate at the September FOMC meeting. Then we got the September employment report. Job creation in September was unexpectedly strong at 254,000 and the unemployment rate fell back down to 4.1 percent, which is where it was in June. The report also showed big upward revisions to payroll gains for the previous two months. Together, the message was loud and clear: While job creation has moderated and the unemployment rate has risen over the past year, the labor market remains quite healthy. Along with other new data on the labor market, the evidence is that labor supply and demand have come into balance. The number of job vacancies, a sign of strength in the labor market, has fallen gradually since the beginning of the year. The ratio of vacancies to unemployed is at 1.2, about the level in 2019, which was a pretty strong labor market. To put this number into perspective, recent research has shown that this ratio has been above 1 only three times since 1960. The quits rate, another sign of labor market strength, has fallen lower than it was in 2019, a decrease which partly reflects that the hiring rate has fallen as labor supply and demand have come into better balance. In sum, based on payrolls, the unemployment rate and job revisions, there has been a very gradual moderation in labor demand relative to supply, but not a deterioration. The stability of the labor market, as reflected in these two measures as well as the other metrics I mentioned, bolsters my confidence that we can achieve further progress toward the FOMC's inflation goal while supporting a healthy labor market that adds jobs and boosts wages and living standards for workers. I will be looking for more evidence to support this outlook in the weeks and months to come. But, unfortunately, it won't be easy to interpret the October jobs report to be released just before the next FOMC meeting. This report will most likely show a significant but temporary loss of jobs from the two recent hurricanes and the strike at Boeing. I expect these factors may reduce employment growth by more than 100,000 this month, and there may be a small effect on the unemployment rate, but I'm not sure it will be that visible. Since the jobs report will come during the usual blackout period for policymakers commenting on the economy, you won't have any of us trying to put this low reading into perspective, though I hope others will. Looking ahead, I expect payroll gains to moderate from their current pace but continue at a solid rate. The unemployment rate may drift a bit higher but is likely to remain quite low in historical terms. While I believe the labor market is on a solid footing, I will continue to watch the full range of data for signs of weakness. Meanwhile, inflation, after showing considerable progress for several months toward the FOMC's 2 percent target, likely moved up in September. The consumer price index grew 0.2 percent over the past month, 2.1 percent over the past three months, 1.6 percent over six months and 2.4 percent in the past year. Oil prices fell over most of the summer but then more recently have surged. Excluding energy and also food prices that likewise tend to be volatile, and just as it did in August, core CPI inflation printed at 0.3 percent in September and 3.3 percent over the past year. Private-sector forecasts are predicting that PCE inflation, the FOMC's preferred measure, will also move up in September. Core PCE prices are expected to have risen around 0.25 percent last month. While not a welcome development, if the monthly core PCE inflation number comes in around this level, over the last 5 months it is still running very close to 2 percent on an annualized basis. We have made a lot of progress on inflation over the course of the last year and half, but that progress has clearly been uneven-at times it feels like being on a rollercoaster. Whether or not this month's inflation reading is just noise or if it signals ongoing increases, is yet to be seen. I will be watching the data carefully to see how persistent this recent uptick is. The FOMC's inflation goal is an average of 2 percent over the longer run and there are some good reasons to think that price increases will be modest going forward. I am hearing reports from firms that their pricing power seems to have waned as consumers have become more sensitive to price changes. There has also been a steady slowing in the growth of labor compensation. It is true that average hourly earnings growth in September ticked up to 4 percent over the past year. And though it might seem like wage increases of 4 percent a year would put upward pressure on inflation that is near 2 percent, that might not be true if one considers productivity, which has grown at an average annual rate of 2.9 percent for the past five quarters. Some of this strength was making up for productivity that shrank due to the pandemic, but the longer it continuesup 2.5 percent for the second quarter-the better productivity supports wage growth of 4 percent, or even higher, without driving up inflation. All that said, I will be watching all the data related to inflation closely. With the labor market in rough balance, employment near its maximum level, and inflation generally running close to our target over the past several months, I want to do what I can as a policymaker to keep the economy on this path. For me, the central question is how much and how fast to reduce the target for the federal funds rate, which I believe is currently set at a restrictive level. To help answer questions like this, I often look at various monetary policy rules to assess the appropriate setting of policy. Policy rules have long been of serious interest to the Shadow Open Market Committee. So before I turn to my views on the future path of policy, I thought I would talk about monetary policy rules versus discretion and begin with some background about the use of rules at the FOMC. For a brief overview of the history of the advent of rules at the Board, I have been directed to the second chapter of The Taylor Rule and the Transformation of Monetary Policy written by George Kahn, and I have also consulted the memories of longtime members of the Board staff. There was a presentation to the FOMC on rules in 1995, and that was the same year that John Taylor's Bay Area colleague, Janet Yellen, was apparently the first policymaker to mention the Taylor rule at an FOMC meeting. While FOMC decisions mimicked a Taylor rule much of the time under Chairman Alan Greenspan, he was famously an advocate of "constructive ambiguity" in communication, and he and other central bankers since have resisted the suggestion that decisions could be handed over to strict rules. Today, of course, a number of rules-based analyses are included in the material submitted to policymakers ahead of every FOMC meeting, and we publish the policy prescriptions of different rules as part of the Board's semi-annual Monetary Policy Report. Rules have become part of the furniture in modern policymaking. As everyone here knows, but for the benefit of other listeners, Taylor rules relate the level of the policy interest rate to a limited number of other economic variables, most often including the deviation of inflation from a target value and a measure of resource use in the economy relative to some long-run trend. There are numerous forms of the Taylor rule, but they generally fall into two categories. The first of these, an inertial rule, has the property that the policy rate changes only slowly over time. I tend to think of it as an approach that captures the reaction function of a policymaker in a stable economy where the forces that would tend to change the economy and policy build over time. When change does occur, a gradual response may give policymakers time to assess the true state of the economy and the possible effects of their decision. One example I can use is the steadfastness of policymakers in the latter part of 2023, when inflation fell more rapidly than was widely expected, and again in early 2024, when it briefly escalated. The FOMC did not change course either time, an approach validated by inertial rules. A non-inertial rule, on the other hand, allows and in fact calls for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events. One saw these non-inertial rules prescribe a sharper rise in the policy rate above the effective lower bound starting in 2021 as inflation began climbing above the FOMC's 2 percent target. Non-inertial rules are also more useful in the face of major shocks to the economy such as the 2008 financial crisis and the start of the pandemic. The great promise of rules is that they provide a simple and reliable guide to policy, but what should one do when different rules recommend different policy actions given the same economic conditions? Right now, inertial rules tell us to move slowly in reducing policy rates toward a neutral stance that neither restricts nor stimulates the economy. On the other hand, non-inertial rules tell us to cut the policy rate more aggressively, subject to the caveat that one is certain of the values of all the 'star' variables: $U^{}, Y^{}$ and $r^{*}$. I think the answer is that while rules are valuable in helping analyze policy options, they have limitations. Among these are the limits of the data considered, which is typically narrower than the range of data that policymakers use to make decisions, and also the fact that simple policy rules do not take into account risk management, which is often a critical consideration in policy decisions. So, while policy rules serve as a good check on discretionary policy, there are times when discretion is needed. As a result, I prefer to think of them as "policy rules of thumb". Turning to my view for the path for policy, let me discuss three scenarios that I have had in mind to manage the risks of upcoming decisions in the medium term. The first scenario is one where the overall strong economic developments that I have described today continue, with inflation nearing the FOMC's target and the unemployment rate moving up only slightly. This scenario implies to me that we can proceed with moving policy toward a neutral stance at a deliberate pace. This path would be based on the judgment that the risks to both sides of our dual mandate are balanced. In this circumstance, our job is to keep inflation near 2 percent and not slow the economy unnecessarily. Another scenario, less likely in light of recent data, is that inflation falls materially below 2 percent for some time, and/or the labor market significantly deteriorates. The message here is that demand is falling, the FOMC may suddenly be behind the curve, and that message would argue for moving to neutral more quickly by front-loading cuts to the policy rate. The third scenario applies if inflation unexpectedly escalates either because of stronger-than-expected consumer demand or wage pressure, or because of some shock to supply that pushes up inflation. As we learned in the recovery from the pandemic recession, when demand was stronger and supply weaker than initially expected, such surprises do occur. In this circumstance, as long as the labor market isn't deteriorating, we can pause rate cuts until progress resumes and uncertainty diminishes. Most recently, we have seen upward revisions to GDI, an increase in job vacancies, high GDP growth forecasts, a strong jobs report and a hotter than expected CPI report. This data is signaling that the economy may not be slowing as much as desired. While we do not want to overreact to this data or look through it, I view the totality of the data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting. I will be watching to see whether data, due out before our next meeting, on inflation, the labor market and economic activity confirms or undercuts my inclination to be more cautious about loosening monetary policy. Whatever happens in the near term, my baseline still calls for reducing the policy rate gradually over the next year. The median rate for FOMC participants at the end of 2025 is 3.4 percent, so most of my colleagues likewise expect to reduce policy over the next year. There is less certainty about the final destination. The median estimated longerrun level of the federal funds rate in the Committee's Summary of Economic Projections (SEP) is 2.9 percent, but with quite a wide dispersion, ranging from 2.4 percent to 3.8 percent. While much attention is given to the size of cuts over the next meeting or two, I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually. Thank you again, for the opportunity to be part of today's conference, and for allowing me to share some thoughts, relevant to monetary policy rules and my day job back in Washington. The Shadow Committee has elevated the public debate about monetary policy. May you continue to play that role for many years to come. i. Note: On October 14, 2024, a sentence on page 10 was corrected to say "restrictiveness": "I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually."
2024-10-16T00:00:00	Christine Lagarde: Lessons from Ljubljana in uncertain times	Speech by Ms Christine Lagarde, President of the European Central Bank, at the official dinner of Bank of Slovenia, Ljubljana, 16 October 2024.	Christine Lagarde: Lessons from Ljubljana in uncertain times Speech by Ms Christine Lagarde, President of the European Central Bank, at the official dinner of Bank of Slovenia, Ljubljana, 16 October 2024. * * * It is a pleasure to be here this evening. Not far from here, tucked away in the National and University Library, lie copies of the Abecedarium and the Catechism . These two texts, written by the religious reformer Primož Trubar in 1550, were the first ever books to be printed in Slovenian.1 At a time when German was the language of the ruling classes, Trubar's pioneering act was fundamental in helping to establish the national identity of Slovenians.2 Today, his portrait graces the €1 coin in Slovenia, framed by the famous words found in 3 the Catechism , " Stati inu Obstati " - "to stand and withstand". It is telling that both books - one a primer for the Slovenian language, the other guidelines for religious observance - were designed to teach, for there is much that Europe can learn from Slovenia in the uncertain world we now face. The global order we knew is fading. Open trade is being replaced with fragmented trade, multilateral rules with state-sponsored competition and stable geopolitics with conflict. Europe had invested considerably in the old order, so this transition is challenging for us. As the most open of the major economies, we are more exposed than others. So, in this new landscape, we too must learn "to stand and withstand". And we can do so by drawing on two valuable lessons from Ljubljana. Opportunity in times of uncertainty The first lesson is that uncertainty can create opportunity. While many in Europe are anxious about the future, Slovenians are no strangers to uncertainty. Within a single generation, Slovenia made a success of the extraordinarily difficult transition from a planned economy to a market economy. Policymakers defied the odds by implementing tough structural reforms to first join the EU and, later, the euro area. Today, Slovenia is a success story. It is a developed, stable and high-income economy, with the highest GDP per capita at purchasing power parity of central and eastern European countries (CEECs). The nation's success owes much to the creativity and vigour of its people and their innate ability to seize economic turning points and transform them into opportunities. For example, when Slovenia joined the EU, it was exposed to greater levels of competition from other Member States in the economic bloc. But Slovenia quickly capitalised on its skilled workforce to develop a new business model based on deep integration in the Single Market. Today, every single car produced in Europe has at least one component that is made in Slovenia.4 For Europe, the changes in the global economy today represent a similar turning point. But if we approach it with the right spirit, I believe it can be an opportunity for renewal. A less favourable global economy can push us to complete our domestic market. Fiercer foreign competition can encourage us to develop new technologies. More volatile geopolitics can drive us to become more energy secure and self-sufficient in our supply chains. For Slovenia, the transformation of the automotive supply chain will be a particular challenge. But the economy is already adapting. For example, in July this year Slovenia secured a major investment in domestic electric vehicle production.5 For many Slovenians, striding into an unpredictable future may seem like second nature. One of your most famous paintings, "The Sower", hangs on display here at the National Gallery. Depicting an agricultural labourer at the crack of dawn hard at work sowing seeds in a field, the painting represents Slovenians' resolute determination in the face of uncertainty. The rest of us in Europe will need to draw on this example in the uncertain times ahead. If we do so, we can also turn uncertainty into opportunity. The importance of sharing the benefits of change The second lesson from Slovenia is that the benefits of change can - and should - be more widely shared. The path of renewal for Europe is inescapably linked with new technology, especially digitalisation. But new technologies can sometimes lead to uneven labour market outcomes. Slovenia has undergone remarkable technological change over the past 20 years. Today, the country's level of digital development is 7% above the CEEC average and it can compete with some of the most digitally developed EU countries in certain areas.6 Yet Slovenia's Gini coefficient - a measure of income inequality - is the second lowest 7 in the OECD. The country also benefits from high levels of gender equality. Female labour force participation is higher than the EU average and nearly equal to that of men. 8 Many in Europe are worried about the challenges ahead, such as the effects of artificial intelligence on social inclusion. But we should let Slovenia's example inspire us. With the right approach, we can move forward and become more technologically advanced while ensuring everyone can benefit from the gains. And when everyone benefits, Europe benefits too. Over three-quarters of citizens in Slovenia feel attached to Europe, and almost two-thirds identify as both Slovenian and European - levels that are well above their respective EU averages.9 Conclusion Let me conclude. In today's uncertain world, Europe must learn "to stand and withstand". And it can do so by looking to Slovenia as an example of how to overcome challenges that come its way. First, we must work hard to sow the seeds of success. And then, as the folk singer Vlado Kreslin sings, " vse se da" - "everything is possible". Thank you. 1Charney, N. (2017), Slovenology: living and traveling in the world's best country , Beletrina, p. 40. 2 As argued in Jakac-Bizjak, V. (2003), "National Library of Slovenia", in Drake, M.A. (editor), Encyclopedia of library and information science , CRC Press, p. 2080. 3 See the ECB's web page on " Slovenia ". 4 Slovenia Business Development Agency, "Automotive industry - a trusted partner in the European value chain ". 5 Republic of Slovenia (2024), "Slovenia establishes itself as an electric vehicle manufacturer with the production of electric Renault Twingo ", 24 July. 6 European Commission (2024), " Slovenia: a snapshot of digital skills ", 30 July. 7 See the OECD's web page on " Income inequality ". 8 OECD (2024), " Economic Surveys: Slovenia 2024". European Commission (2024), " Standard Eurobarometer 101 - Spring 2024".	---[PAGE_BREAK]--- # Christine Lagarde: Lessons from Ljubljana in uncertain times Speech by Ms Christine Lagarde, President of the European Central Bank, at the official dinner of Bank of Slovenia, Ljubljana, 16 October 2024. It is a pleasure to be here this evening. Not far from here, tucked away in the National and University Library, lie copies of the A becedarium and the Catechism. These two texts, written by the religious reformer Primož Trubar in 1550, were the first ever books to be printed in Slovenian. ${ }^{1}$ At a time when German was the language of the ruling classes, Trubar's pioneering act was fundamental in helping to establish the national identity of Slovenians. ${ }^{2}$ Today, his portrait graces the $€ 1$ coin in Slovenia, framed by the famous words found in the Catechism, ".Stati inu Obstati" - "to stand and withstand". ${ }^{3}$ It is telling that both books - one a primer for the Slovenian language, the other guidelines for religious observance - were designed to teach, for there is much that Europe can learn from Slovenia in the uncertain world we now face. The global order we knew is fading. Open trade is being replaced with fragmented trade, multilateral rules with state-sponsored competition and stable geopolitics with conflict. Europe had invested considerably in the old order, so this transition is challenging for us. As the most open of the major economies, we are more exposed than others. So, in this new landscape, we too must learn "to stand and withstand". And we can do so by drawing on two valuable lessons from Ljubljana. ## Opportunity in times of uncertainty The first lesson is that uncertainty can create opportunity. While many in Europe are anxious about the future, Slovenians are no strangers to uncertainty. Within a single generation, Slovenia made a success of the extraordinarily difficult transition from a planned economy to a market economy. Policymakers defied the odds by implementing tough structural reforms to first join the EU and, later, the euro area. Today, Slovenia is a success story. It is a developed, stable and high-income economy, with the highest GDP per capita at purchasing power parity of central and eastern European countries (CEECs). ---[PAGE_BREAK]--- The nation's success owes much to the creativity and vigour of its people and their innate ability to seize economic turning points and transform them into opportunities. For example, when Slovenia joined the EU, it was exposed to greater levels of competition from other Member States in the economic bloc. But Slovenia quickly capitalised on its skilled workforce to develop a new business model based on deep integration in the Single Market. Today, every single car produced in Europe has at least one component that is made in Slovenia. $\underline{4}$ For Europe, the changes in the global economy today represent a similar turning point. But if we approach it with the right spirit, I believe it can be an opportunity for renewal. A less favourable global economy can push us to complete our domestic market. Fiercer foreign competition can encourage us to develop new technologies. More volatile geopolitics can drive us to become more energy secure and self-sufficient in our supply chains. For Slovenia, the transformation of the automotive supply chain will be a particular challenge. But the economy is already adapting. For example, in July this year Slovenia secured a major investment in domestic electric vehicle production. $\underline{5}$ For many Slovenians, striding into an unpredictable future may seem like second nature. One of your most famous paintings, "The Sower", hangs on display here at the National Gallery. Depicting an agricultural labourer at the crack of dawn hard at work sowing seeds in a field, the painting represents Slovenians' resolute determination in the face of uncertainty. The rest of us in Europe will need to draw on this example in the uncertain times ahead. If we do so, we can also turn uncertainty into opportunity. # The importance of sharing the benefits of change The second lesson from Slovenia is that the benefits of change can - and should - be more widely shared. The path of renewal for Europe is inescapably linked with new technology, especially digitalisation. But new technologies can sometimes lead to uneven labour market outcomes. Slovenia has undergone remarkable technological change over the past 20 years. Today, the country's level of digital development is $7 \%$ above the CEEC average and it can compete with some of the most digitally developed EU countries in certain areas. $\underline{6}$ ---[PAGE_BREAK]--- Yet Slovenia's Gini coefficient - a measure of income inequality - is the second lowest in the OECD. ${ }^{7}$ The country also benefits from high levels of gender equality. Female labour force participation is higher than the EU average and nearly equal to that of men. $\underline{8}$ Many in Europe are worried about the challenges ahead, such as the effects of artificial intelligence on social inclusion. But we should let Slovenia's example inspire us. With the right approach, we can move forward and become more technologically advanced while ensuring everyone can benefit from the gains. And when everyone benefits, Europe benefits too. Over three-quarters of citizens in Slovenia feel attached to Europe, and almost two-thirds identify as both Slovenian and European - levels that are well above their respective EU averages. ${ }^{9}$ # Conclusion Let me conclude. In today's uncertain world, Europe must learn "to stand and withstand". And it can do so by looking to Slovenia as an example of how to overcome challenges that come its way. First, we must work hard to sow the seeds of success. And then, as the folk singer Vlado Kreslin sings, " vse se dd" - "everything is possible". Thank you. ${ }^{1}$ Charney, N. (2017), Slovenology: living and traveling in the world's best country, Beletrina, p. 40. ${ }^{2}$ As argued in Jakac-Bizjak, V. (2003), "National Library of Slovenia", in Drake, M.A. (editor), Encyclopedia of library and information science, CRC Press, p. 2080. ${ }^{3}$ See the ECB's web page on "Slovenia". ${ }^{4}$ Slovenia Business Development Agency, "Automotive industry - a trusted partner in the European value chain". ${ }^{5}$ Republic of Slovenia (2024), "Slovenia establishes itself as an electric vehicle manufacturer with the production of electric Renault Twingo", 24 July. ${ }^{6}$ European Commission (2024), "Slovenia: a snapshot of digital skills", 30 July. ${ }^{7}$ See the OECD's web page on "Income inequality". ${ }^{8}$ OECD (2024), "Economic Surveys: Slovenia 2024". ---[PAGE_BREAK]--- ${ }^{9}$ European Commission (2024), "Standard Eurobarometer 101 - Spring 2024".	Christine Lagarde	Euro area	https://www.bis.org/review/r241021f.pdf	Speech by Ms Christine Lagarde, President of the European Central Bank, at the official dinner of Bank of Slovenia, Ljubljana, 16 October 2024. It is a pleasure to be here this evening. Not far from here, tucked away in the National and University Library, lie copies of the A becedarium and the Catechism. These two texts, written by the religious reformer Primož Trubar in 1550, were the first ever books to be printed in Slovenian. At a time when German was the language of the ruling classes, Trubar's pioneering act was fundamental in helping to establish the national identity of Slovenians. Today, his portrait graces the $€ 1$ coin in Slovenia, framed by the famous words found in the Catechism, ".Stati inu Obstati" - "to stand and withstand". It is telling that both books - one a primer for the Slovenian language, the other guidelines for religious observance - were designed to teach, for there is much that Europe can learn from Slovenia in the uncertain world we now face. The global order we knew is fading. Open trade is being replaced with fragmented trade, multilateral rules with state-sponsored competition and stable geopolitics with conflict. Europe had invested considerably in the old order, so this transition is challenging for us. As the most open of the major economies, we are more exposed than others. So, in this new landscape, we too must learn "to stand and withstand". And we can do so by drawing on two valuable lessons from Ljubljana. The first lesson is that uncertainty can create opportunity. While many in Europe are anxious about the future, Slovenians are no strangers to uncertainty. Within a single generation, Slovenia made a success of the extraordinarily difficult transition from a planned economy to a market economy. Policymakers defied the odds by implementing tough structural reforms to first join the EU and, later, the euro area. Today, Slovenia is a success story. It is a developed, stable and high-income economy, with the highest GDP per capita at purchasing power parity of central and eastern European countries (CEECs). The nation's success owes much to the creativity and vigour of its people and their innate ability to seize economic turning points and transform them into opportunities. For example, when Slovenia joined the EU, it was exposed to greater levels of competition from other Member States in the economic bloc. But Slovenia quickly capitalised on its skilled workforce to develop a new business model based on deep integration in the Single Market. Today, every single car produced in Europe has at least one component that is made in Slovenia. For Europe, the changes in the global economy today represent a similar turning point. But if we approach it with the right spirit, I believe it can be an opportunity for renewal. A less favourable global economy can push us to complete our domestic market. Fiercer foreign competition can encourage us to develop new technologies. More volatile geopolitics can drive us to become more energy secure and self-sufficient in our supply chains. For Slovenia, the transformation of the automotive supply chain will be a particular challenge. But the economy is already adapting. For example, in July this year Slovenia secured a major investment in domestic electric vehicle production. For many Slovenians, striding into an unpredictable future may seem like second nature. One of your most famous paintings, "The Sower", hangs on display here at the National Gallery. Depicting an agricultural labourer at the crack of dawn hard at work sowing seeds in a field, the painting represents Slovenians' resolute determination in the face of uncertainty. The rest of us in Europe will need to draw on this example in the uncertain times ahead. If we do so, we can also turn uncertainty into opportunity. The second lesson from Slovenia is that the benefits of change can - and should - be more widely shared. The path of renewal for Europe is inescapably linked with new technology, especially digitalisation. But new technologies can sometimes lead to uneven labour market outcomes. Slovenia has undergone remarkable technological change over the past 20 years. Today, the country's level of digital development is $7 \%$ above the CEEC average and it can compete with some of the most digitally developed EU countries in certain areas. Yet Slovenia's Gini coefficient - a measure of income inequality - is the second lowest in the OECD. Many in Europe are worried about the challenges ahead, such as the effects of artificial intelligence on social inclusion. But we should let Slovenia's example inspire us. With the right approach, we can move forward and become more technologically advanced while ensuring everyone can benefit from the gains. And when everyone benefits, Europe benefits too. Over three-quarters of citizens in Slovenia feel attached to Europe, and almost two-thirds identify as both Slovenian and European - levels that are well above their respective EU averages. Let me conclude. In today's uncertain world, Europe must learn "to stand and withstand". And it can do so by looking to Slovenia as an example of how to overcome challenges that come its way. First, we must work hard to sow the seeds of success. And then, as the folk singer Vlado Kreslin sings, " vse se dd" - "everything is possible". Thank you.
2024-10-17T00:00:00	Elizabeth McCaul: Supervisory expectations on cloud outsourcing	Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the KPMG Cloud Conference 2024, Frankfurt am Main, 17 October 2024.	Elizabeth McCaul: Supervisory expectations on cloud outsourcing Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the KPMG Cloud Conference 2024, Frankfurt am Main, 17 October 2024. * * * Introduction It is my great pleasure to speak today at the KPMG Cloud Conference 2024. It is a pity that I cannot be with you in person, but I am sure that you are having a wonderful conference. There is no doubt that cloud outsourcing offers opportunities to scale operations efficiently, reduce costs and enhance flexibility by leveraging cloud providers' advanced infrastructure and services. Indeed, using the cloud can be a viable strategy for banks to reduce the complexity of their IT operations, which would be a welcome development. But it also introduces new risks and new challenges, including preparing IT systems for use in a cloud environment. In particular, it presents risks related to IT and data security and vendor lock-in which, if not properly managed, could lead to operational vulnerabilities and business disruptions. I would like to make three main points in my speech today. First, cloud outsourcing is rapidly transforming the banking sector, with a significant rise in adoption and expenditure. But it also increases banks' risk exposure, which demands heightened responsibility and robust governance frameworks. Second, when adopting cloud strategies, banks should retain full accountability for outsourced services, ensuring clear roles, rigorous risk management and appropriate IT security measures. Third, our supervisory expectations should not be seen as regulatory hurdles, but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. Relevance of the cloud Cloud services are transforming the economic landscape and reshaping traditional business models. According to a report by Gartner, worldwide end-user spending on 1 public cloud services is forecast to grow by 20.4% to total USD 675.4 billion in 2024 , driven largely by sectors like banking. In our own stocktake, we have found that essentially all significant institutions under our supervision use cloud services. Cloud services account for approximately 15% of all outsourcing contracts, with half of these contracts covering the outsourcing of critical or important functions. Moreover, cloud expenses are among the fastest-rising outsourcing costs. But with this growth comes increased responsibility. Third-party risk management, including cloud outsourcing, is high on the list of the ECB's supervisory priorities for 2024-26 and we expect banks to establish robust outsourcing risk arrangements to proactively tackle any risks that might lead to disruption of critical activities or services. The ECB's supervisory expectations We published our draft Guide on cloud outsourcing for public consultation in June this year. The public consultation was open until mid-July and we are now assessing all of the comments. In total, we received 698 comments from 26 respondents, and there was a strong focus on governance aspects. The main respondents were banking associations, although cloud service providers, individual banks and other industry associations also contributed to the consultation. Before I tell you more about the comments, let me first explain what the Guide is all about. The Guide is consistent with existing regulation such as the Digital Operational Resilience Act (DORA) and aims to promote a level playing field for the supervisory treatment of cloud outsourcing by clarifying our supervisory expectations. The Guide draws on risks and best practices observed by Joint Supervisory Teams in the context of ongoing supervision and dedicated on-site inspections. At the heart of the Guide is the clear expectation for banks to retain full responsibility for their outsourced services. It is not merely a matter of compliance, but accountability. The management body in each institution should ensure that the roles and responsibilities related to cloud outsourcing are clearly defined, well understood and embedded in both internal policies and contractual agreements with cloud service providers (CSPs). In line with the requirements under DORA, banks should conduct a thorough preoutsourcing analysis. This involves a detailed risk assessment that considers the complexities of sub-outsourcing chains, data security risks and potential vendor lock-in scenarios. It is important that banks align their cloud strategy with their overall business strategy, ensuring consistency across governance frameworks. The Capital Requirements Directive states that banks must have contingency and business continuity plans that ensure they are able to continue operating and limit losses in the event of severe disruption to their business. In doing so, banks should adopt a holistic approach to business continuity, particularly for critical functions. Those measures may include multi-region data centres, hybrid cloud architectures, or even multiple CSPs to enhance resilience. This layered approach is crucial in mitigating the risk of service disruption and ensuring that banks can continue to operate smoothly, even in worst-case scenarios such as a failure of the CSP. We also place significant emphasis on IT security and data confidentiality. This includes implementing stringent data security measures such as encryption and associated cryptographic key management to protect sensitive information. It is vital that these measures are regularly reviewed and updated in response to evolving threats. Additionally, we consider it good practice for banks to maintain a clear policy on data location, ensuring that data storage and processing comply with both regulatory requirements and the institution's own risk management policies. Moreover, we advise banks to subject all cloud services to rigorous testing, including disaster recovery plans. In particular, we say that banks should not solely rely on certifications provided by CSPs but also conduct their own independent checks to validate these critical processes. Indeed, I would highlight that the external certifications provided by CSPs may not always be tested as robustly as banks would hope. Banks should be careful not to be too trusting, like the financial sector was before 2008 when it trusted the credit rating agencies. Regular audits and continuous monitoring of CSPs are essential to verify compliance with agreed standards and to promptly identify any emerging risks. Robust exit strategies are another important element in the area of cloud outsourcing. Comprehensive exit plans ensure seamless transitions and minimise any potential disruptions. These plans should include clear roles and responsibilities, effective data portability solutions and provisions for business continuity. Regular testing of disaster recovery strategies is crucial, ensuring that both the bank and its CSPs are prepared for various scenarios, including abrupt service discontinuation. I encourage all of you to view these guidelines not as mere regulatory hurdles, but as strategic enablers. Robust governance and risk management frameworks are not just about meeting supervisory expectations - they are about safeguarding the integrity of banks and the trust that depositors put in them. Let me now turn to some of the comments we have received. Many of them concern the legal nature of the Guide and how it relates to existing regulation. Again, let me be very clear here: the Guide does not establish any new regulatory requirements. It simply sets out our supervisory expectations and provides examples of good practices. Some of the other comments relate to more specific issues, such as the need for backups in separate locations, cloud resilience measures and the definition of concentration risks. We very much welcome this detailed feedback and will adjust the Guide as necessary to clarify our expectations. We plan to have the final version ready by the end of the year. Conclusion Let me conclude. Cloud outsourcing can provide significant opportunities for banks but it also increases their risk exposure. This demands robust governance, comprehensive risk assessments and thorough pre-outsourcing analyses. Our supervisory expectations should not be seen as regulatory hurdles in this regard but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. I wish you a wonderful rest of the conference today. Gartner (2024), "Gartner Forecasts Worldwide Public Cloud End-User Spending to Surpass $675 Billion in 2024 ", press release, 20 May.	---[PAGE_BREAK]--- # Elizabeth McCaul: Supervisory expectations on cloud outsourcing Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the KPMG Cloud Conference 2024, Frankfurt am Main, 17 October 2024. ## Introduction It is my great pleasure to speak today at the KPMG Cloud Conference 2024. It is a pity that I cannot be with you in person, but I am sure that you are having a wonderful conference. There is no doubt that cloud outsourcing offers opportunities to scale operations efficiently, reduce costs and enhance flexibility by leveraging cloud providers' advanced infrastructure and services. Indeed, using the cloud can be a viable strategy for banks to reduce the complexity of their IT operations, which would be a welcome development. But it also introduces new risks and new challenges, including preparing IT systems for use in a cloud environment. In particular, it presents risks related to IT and data security and vendor lock-in which, if not properly managed, could lead to operational vulnerabilities and business disruptions. I would like to make three main points in my speech today. First, cloud outsourcing is rapidly transforming the banking sector, with a significant rise in adoption and expenditure. But it also increases banks' risk exposure, which demands heightened responsibility and robust governance frameworks. Second, when adopting cloud strategies, banks should retain full accountability for outsourced services, ensuring clear roles, rigorous risk management and appropriate IT security measures. Third, our supervisory expectations should not be seen as regulatory hurdles, but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. ## Relevance of the cloud Cloud services are transforming the economic landscape and reshaping traditional business models. According to a report by Gartner, worldwide end-user spending on public cloud services is forecast to grow by $20.4 \%$ to total USD 675.4 billion in 2024. ${ }^{1}$, driven largely by sectors like banking. In our own stocktake, we have found that essentially all significant institutions under our supervision use cloud services. Cloud services account for approximately $15 \%$ of all outsourcing contracts, with half of these contracts covering the outsourcing of critical or important functions. Moreover, cloud expenses are among the fastest-rising outsourcing costs. But with this growth comes increased responsibility. ---[PAGE_BREAK]--- Third-party risk management, including cloud outsourcing, is high on the list of the ECB's supervisory priorities for 2024-26 and we expect banks to establish robust outsourcing risk arrangements to proactively tackle any risks that might lead to disruption of critical activities or services. # The ECB's supervisory expectations We published our draft Guide on cloud outsourcing for public consultation in June this year. The public consultation was open until mid-July and we are now assessing all of the comments. In total, we received 698 comments from 26 respondents, and there was a strong focus on governance aspects. The main respondents were banking associations, although cloud service providers, individual banks and other industry associations also contributed to the consultation. Before I tell you more about the comments, let me first explain what the Guide is all about. The Guide is consistent with existing regulation such as the Digital Operational Resilience Act (DORA) and aims to promote a level playing field for the supervisory treatment of cloud outsourcing by clarifying our supervisory expectations. The Guide draws on risks and best practices observed by Joint Supervisory Teams in the context of ongoing supervision and dedicated on-site inspections. At the heart of the Guide is the clear expectation for banks to retain full responsibility for their outsourced services. It is not merely a matter of compliance, but accountability. The management body in each institution should ensure that the roles and responsibilities related to cloud outsourcing are clearly defined, well understood and embedded in both internal policies and contractual agreements with cloud service providers (CSPs). In line with the requirements under DORA, banks should conduct a thorough preoutsourcing analysis. This involves a detailed risk assessment that considers the complexities of sub-outsourcing chains, data security risks and potential vendor lock-in scenarios. It is important that banks align their cloud strategy with their overall business strategy, ensuring consistency across governance frameworks. The Capital Requirements Directive states that banks must have contingency and business continuity plans that ensure they are able to continue operating and limit losses in the event of severe disruption to their business. In doing so, banks should adopt a holistic approach to business continuity, particularly for critical functions. Those measures may include multi-region data centres, hybrid cloud architectures, or even multiple CSPs to enhance resilience. This layered approach is crucial in mitigating the risk of service disruption and ensuring that banks can continue to operate smoothly, even in worst-case scenarios such as a failure of the CSP. We also place significant emphasis on IT security and data confidentiality. This includes implementing stringent data security measures such as encryption and associated cryptographic key management to protect sensitive information. It is vital that these ---[PAGE_BREAK]--- measures are regularly reviewed and updated in response to evolving threats. Additionally, we consider it good practice for banks to maintain a clear policy on data location, ensuring that data storage and processing comply with both regulatory requirements and the institution's own risk management policies. Moreover, we advise banks to subject all cloud services to rigorous testing, including disaster recovery plans. In particular, we say that banks should not solely rely on certifications provided by CSPs but also conduct their own independent checks to validate these critical processes. Indeed, I would highlight that the external certifications provided by CSPs may not always be tested as robustly as banks would hope. Banks should be careful not to be too trusting, like the financial sector was before 2008 when it trusted the credit rating agencies. Regular audits and continuous monitoring of CSPs are essential to verify compliance with agreed standards and to promptly identify any emerging risks. Robust exit strategies are another important element in the area of cloud outsourcing. Comprehensive exit plans ensure seamless transitions and minimise any potential disruptions. These plans should include clear roles and responsibilities, effective data portability solutions and provisions for business continuity. Regular testing of disaster recovery strategies is crucial, ensuring that both the bank and its CSPs are prepared for various scenarios, including abrupt service discontinuation. I encourage all of you to view these guidelines not as mere regulatory hurdles, but as strategic enablers. Robust governance and risk management frameworks are not just about meeting supervisory expectations - they are about safeguarding the integrity of banks and the trust that depositors put in them. Let me now turn to some of the comments we have received. Many of them concern the legal nature of the Guide and how it relates to existing regulation. Again, let me be very clear here: the Guide does not establish any new regulatory requirements. It simply sets out our supervisory expectations and provides examples of good practices. Some of the other comments relate to more specific issues, such as the need for backups in separate locations, cloud resilience measures and the definition of concentration risks. We very much welcome this detailed feedback and will adjust the Guide as necessary to clarify our expectations. We plan to have the final version ready by the end of the year. # Conclusion Let me conclude. Cloud outsourcing can provide significant opportunities for banks but it also increases their risk exposure. This demands robust governance, comprehensive risk assessments and thorough pre-outsourcing analyses. Our supervisory expectations should not be seen as regulatory hurdles in this regard but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. I wish you a wonderful rest of the conference today. ---[PAGE_BREAK]--- Gartner (2024), "Gartner Forecasts Worldwide Public Cloud End-User Spending to Surpass $\$ 675$ Billion in 2024", press release, 20 May.	Elizabeth McCaul	Euro area	https://www.bis.org/review/r241028r.pdf	Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the KPMG Cloud Conference 2024, Frankfurt am Main, 17 October 2024. It is my great pleasure to speak today at the KPMG Cloud Conference 2024. It is a pity that I cannot be with you in person, but I am sure that you are having a wonderful conference. There is no doubt that cloud outsourcing offers opportunities to scale operations efficiently, reduce costs and enhance flexibility by leveraging cloud providers' advanced infrastructure and services. Indeed, using the cloud can be a viable strategy for banks to reduce the complexity of their IT operations, which would be a welcome development. But it also introduces new risks and new challenges, including preparing IT systems for use in a cloud environment. In particular, it presents risks related to IT and data security and vendor lock-in which, if not properly managed, could lead to operational vulnerabilities and business disruptions. I would like to make three main points in my speech today. First, cloud outsourcing is rapidly transforming the banking sector, with a significant rise in adoption and expenditure. But it also increases banks' risk exposure, which demands heightened responsibility and robust governance frameworks. Second, when adopting cloud strategies, banks should retain full accountability for outsourced services, ensuring clear roles, rigorous risk management and appropriate IT security measures. Third, our supervisory expectations should not be seen as regulatory hurdles, but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. Cloud services are transforming the economic landscape and reshaping traditional business models. According to a report by Gartner, worldwide end-user spending on public cloud services is forecast to grow by $20.4 \%$ to total USD 675.4 billion in 2024. , driven largely by sectors like banking. In our own stocktake, we have found that essentially all significant institutions under our supervision use cloud services. Cloud services account for approximately $15 \%$ of all outsourcing contracts, with half of these contracts covering the outsourcing of critical or important functions. Moreover, cloud expenses are among the fastest-rising outsourcing costs. But with this growth comes increased responsibility. Third-party risk management, including cloud outsourcing, is high on the list of the ECB's supervisory priorities for 2024-26 and we expect banks to establish robust outsourcing risk arrangements to proactively tackle any risks that might lead to disruption of critical activities or services. We published our draft Guide on cloud outsourcing for public consultation in June this year. The public consultation was open until mid-July and we are now assessing all of the comments. In total, we received 698 comments from 26 respondents, and there was a strong focus on governance aspects. The main respondents were banking associations, although cloud service providers, individual banks and other industry associations also contributed to the consultation. Before I tell you more about the comments, let me first explain what the Guide is all about. The Guide is consistent with existing regulation such as the Digital Operational Resilience Act (DORA) and aims to promote a level playing field for the supervisory treatment of cloud outsourcing by clarifying our supervisory expectations. The Guide draws on risks and best practices observed by Joint Supervisory Teams in the context of ongoing supervision and dedicated on-site inspections. At the heart of the Guide is the clear expectation for banks to retain full responsibility for their outsourced services. It is not merely a matter of compliance, but accountability. The management body in each institution should ensure that the roles and responsibilities related to cloud outsourcing are clearly defined, well understood and embedded in both internal policies and contractual agreements with cloud service providers (CSPs). In line with the requirements under DORA, banks should conduct a thorough preoutsourcing analysis. This involves a detailed risk assessment that considers the complexities of sub-outsourcing chains, data security risks and potential vendor lock-in scenarios. It is important that banks align their cloud strategy with their overall business strategy, ensuring consistency across governance frameworks. The Capital Requirements Directive states that banks must have contingency and business continuity plans that ensure they are able to continue operating and limit losses in the event of severe disruption to their business. In doing so, banks should adopt a holistic approach to business continuity, particularly for critical functions. Those measures may include multi-region data centres, hybrid cloud architectures, or even multiple CSPs to enhance resilience. This layered approach is crucial in mitigating the risk of service disruption and ensuring that banks can continue to operate smoothly, even in worst-case scenarios such as a failure of the CSP. We also place significant emphasis on IT security and data confidentiality. This includes implementing stringent data security measures such as encryption and associated cryptographic key management to protect sensitive information. It is vital that these measures are regularly reviewed and updated in response to evolving threats. Additionally, we consider it good practice for banks to maintain a clear policy on data location, ensuring that data storage and processing comply with both regulatory requirements and the institution's own risk management policies. Moreover, we advise banks to subject all cloud services to rigorous testing, including disaster recovery plans. In particular, we say that banks should not solely rely on certifications provided by CSPs but also conduct their own independent checks to validate these critical processes. Indeed, I would highlight that the external certifications provided by CSPs may not always be tested as robustly as banks would hope. Banks should be careful not to be too trusting, like the financial sector was before 2008 when it trusted the credit rating agencies. Regular audits and continuous monitoring of CSPs are essential to verify compliance with agreed standards and to promptly identify any emerging risks. Robust exit strategies are another important element in the area of cloud outsourcing. Comprehensive exit plans ensure seamless transitions and minimise any potential disruptions. These plans should include clear roles and responsibilities, effective data portability solutions and provisions for business continuity. Regular testing of disaster recovery strategies is crucial, ensuring that both the bank and its CSPs are prepared for various scenarios, including abrupt service discontinuation. I encourage all of you to view these guidelines not as mere regulatory hurdles, but as strategic enablers. Robust governance and risk management frameworks are not just about meeting supervisory expectations - they are about safeguarding the integrity of banks and the trust that depositors put in them. Let me now turn to some of the comments we have received. Many of them concern the legal nature of the Guide and how it relates to existing regulation. Again, let me be very clear here: the Guide does not establish any new regulatory requirements. It simply sets out our supervisory expectations and provides examples of good practices. Some of the other comments relate to more specific issues, such as the need for backups in separate locations, cloud resilience measures and the definition of concentration risks. We very much welcome this detailed feedback and will adjust the Guide as necessary to clarify our expectations. We plan to have the final version ready by the end of the year. Let me conclude. Cloud outsourcing can provide significant opportunities for banks but it also increases their risk exposure. This demands robust governance, comprehensive risk assessments and thorough pre-outsourcing analyses. Our supervisory expectations should not be seen as regulatory hurdles in this regard but as strategic enablers to enhance resilience, operational continuity and data protection in banks' cloud strategies. I wish you a wonderful rest of the conference today.
2024-10-18T00:00:00	Christopher J Waller: Centralized and decentralized finance - substitutes or complements?	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Vienna Macroeconomics Workshop, organised by the Institute of Advanced Studies, Vienna, Austria, 18 October 2024.	Christopher J Waller: Centralized and decentralized finance - substitutes or complements? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Vienna Macroeconomics Workshop, organised by the Institute of Advanced Studies, Vienna, Austria, 18 October 2024. * * * 1 Thank you for inviting me to speak today. I have participated in this conference for nearly 20 years and have often presented my research on monetary theory, banking, and payments. So, I believe this is the right audience to speak to regarding the role of centralized finance and the emergence of decentralized finance, or defi for short. Over the past few years, there has been a lot of attention and work on defi, which will be a major focus of my remarks. Many argue that defi will replace traditional centralized finance while others argue that it merely extends traditional finance methods and trading activities onto new platforms. It is in this sense that I want to address the question of whether centralized finance and defi are substitutes or complements to each other. Advances associated with defi have the potential to profoundly affect financial market trading. While I believe these advances could lead to efficiency gains, I recognize the significant value that has been delivered for centuries by financial intermediaries and through centralized financial markets. Before I share my views on the promise of these new technologies, let me tell you where I'm coming from on these issues. I am an economist, and so my first inclination is to think about the underlying economics driving an issue. But to understand the value proposition of defi, it is useful to first recall why centralized financial market trading arose in the first place. Centralized finance clearly provides benefits to people, but obviously also comes with some costs. I am going to take a few minutes to discuss those benefits and costs before turning to the question at hand. Let's start with the economics of trading. Most financial trades are "pairwise" in that the seller of an object needs to find a buyer of that exact object. The problem is that it is often complicated, costly, and time-consuming to search for a buyer. This gives rise to the need for someone to step in and help buyers and sellers match in a faster and less costly manner. In short, there is a profit opportunity for someone to intermediate the trade. Another name for intermediaries is middlemen. Why would we pay a middleman? In their paper from nearly 40 years ago, Ariel Rubenstein and Asher Wolinsky described it eloquently: "What makes the middlemen's activity possible is the time-consuming nature of the trade, which enables middlemen to extract surplus in return for shortening the time period that sellers and buyers have to wait for a transaction."2 Let me contextualize the value of middlemen with an example I used for years when teaching money and banking. Suppose you had some extra income from saving and wanted to lend it out to earn interest. How would you do that? First, you would have to advertise that you had funds to lend. Then, you would have to wait for the right person who needed that exact amount of funds, which could be a long time. Once you met the right person, you would have to negotiate when repayment would occur. Next, you would need to know a lot of information about the person receiving your funds and the likelihood you would get repaid. This is needed to assess the risk of the transaction and the compensation you would need to give up your funds. You would also need a lot of legal advice to draw up a contract and stipulate how the contract would be enforced under a range of conditions. Finally, since you are the sole source of funding, you will bear the entire cost of a default. It should be clear that this would be a daunting exercise for most people and explains why they would turn to a middleman who specializes in this type of activity to do all this on their behalf. It is for these reasons that banks arose as early as in ancient Mesopotamia to carry out 3 some of these functions. Similar issues arise when it comes to other ways of transferring resources from one person to another, as occurs from non-bank debt, equities and insurance contracts. Many point to trades of shares in the Dutch East India Trading Company in Amsterdam in the 1660s as the origins of the first modern stock exchange. Lloyds of London was founded as a means of pooling funds to share risk and return in the shipping industry, thus becoming the first insurance firm. The fact that similar arrangements still exist centuries later is a testament to the value of intermediation and centralized financial trading. However, these arrangements are not without drawbacks. An obvious drawback of intermediation from the perspective of those wishing to trade is that those middlemen must get paid. That is, there are transaction costs. Another drawback of intermediation is that you typically must turn over control of your assets, such as savings or stocks, to the intermediary for them to be traded. This creates a classic "principal-agent" problem whereby incentives between the principal-you-and the agent-the intermediary-may not be aligned. That can raise concerns about custody arrangements and recourse to regain control of one's assets. Intermediation also requires recordkeeping arrangements that customers can trust accurately reflect their true holdings. In other words, centralized finance requires a substantial amount of trust. With all that in mind, let me turn to how and why technological innovations have given rise to defi. In a capitalist system, the existence of profits provides incentives for others to enter the market, offer a better product, and compete away any excess profits. This can be done by the creation of new financial firms that can provide the same or better service at a lower cost. Often that occurs through innovations and exploiting new technologies. Think about how the invention of the telegraph and the telephone revolutionized trading. More recently, the advent of the internet further advanced the ease and speed of financial trading. These are examples of how financial trading has evolved over time. And the next wave of innovations in financial market trading could be driven by technological advances that alleviate some potential drawbacks of the centralized approach. Often broad technological advances emanate from narrower efforts to design products or processes that solve specific problems. For example, one technology used to support portable home appliances like vacuum cleaners was originally developed to 4 support the space program. Similarly, the development of crypto-assets led to the development of technologies that are fueling possibilities in defi. We don't have enough time for me to cover the full history of crypto-assets, but I will focus on several key elements that have affected the evolution toward defi. An early crypto-asset-Bitcoin-was developed to function in a world in which trust among individuals did not exist. Rather than relying on intermediaries which require trust, Bitcoin relied on technology to facilitate trade. Bitcoin was also designed for privacy. No one would know who was buying or selling Bitcoin. This was achieved through cryptographic technology and private keys. In addition, it allowed individuals to maintain control of their crypto-assets throughout the entire trading process. That is, they no longer had to delegate control to others. Finally, all records were kept on a form of distributed ledger called a blockchain, which has design features that promote transparency and are censorship-proof. No individual or government could destroy the records of trades or take ownership of the objects traded. With that history in mind and before we delve into the question of whether defi and centralized finance are substitutes or complements, I think it is useful to carefully define some terms. This will make sure we're all talking about the same things. As I described in a speech last year, I think of the crypto ecosystem as consisting of three parts: a crypto-asset, which generally refers to any digital object traded using cryptographic techniques; technology that directly facilitates trading crypto-assets; this includes smart 5 contracts and tokenization; and a database management protocol used to record trades and ownership of assets, commonly referred to as the blockchain, which includes both permissioned and permissionless distributed ledger technologies. It is easy to see how the emergence of these technologies could lead one to think of defi as a substitute for centralized finance. For example, the technologies are allowing for individuals to trade assets without giving up control of those assets to an intermediary-a critical distinction with centralized finance. However, there are other uses emerging from these technologies that look more like complements to centralized finance. For example, distributed ledger technology, or DLT, may be an efficient and faster way to do recordkeeping in a 24/7 trading world. We already see several financial institutions experimenting with DLT for traditional repo trading that occurs 24/7. But before these ledgers can be used to facilitate transactions in traditional assets-like debt, equity, and real estate-these assets must be tokenized. Undertaking the process to tokenize assets and use distributed ledgers like blockchain can speed up transfers of assets and take advantage of another innovation: smart contracts. Rather than relying on each party to separately carry out the transaction, smart contracts can effectively combine multiple legs of a transaction into a single unified act executed by a smart contract. This can provide value as it can mitigate risks associated with settlement and counterparty risks by ensuring the buyer will not pay if the seller does not deliver. While these efforts are still in early stages, the functionality could expand to a broad set of financial activities. The bottom line is that things like DLT, tokenization, and smart contracts are just technologies for trading that can be used in defi or also to improve efficiency in centralized finance. That is why I see them as complements. Stablecoins are another important innovation in defi. Stablecoins were created in the crypto universe in hopes of providing a "safe" asset with a stable value for trading. Nearly all stablecoins are pegged to the U.S. dollar one-for-one. They provide an opportunity for buyers and sellers to transact in a decentralized fashion with the stablecoin used as the settlement instrument. Because they are effectively digital currency, stablecoins can reduce the need for payment intermediaries and thereby reduce costs of payments globally. But their safety is not assured. History is replete with cases in which synthetic dollars became subject to runs. Stablecoins thus face all of the same issues any substitute for genuine U.S. dollars faces. If appropriate guardrails can be erected to minimize run risk and mitigate other risks, such as their potential use in illicit finance, then stablecoins may have benefits in payments and by serving as a safe asset on a variety of new trading platforms. These technologies will almost certainly lead to efficiency gains over time, but as they develop, we should think carefully about their role in the broader financial landscape. Is it really possible to completely decentralize finance using these technologies? The answer is obviously "no." Intermediation is still valuable for the average person, and we see this by the existence of trading exchanges in the crypto world. All these platforms involve giving custody of one's crypto-assets to an intermediary, who conducts trades on behalf of the client. This reintroduces the need for trust in these platforms just as trust is needed in modern banking systems. Returning to the technologies behind defi, one must ask whether there are unique risks associated with the use of these technologies. If so, what is the nature of these risks? Are they contained to just those people directly engaging with the technologies, or could there be broader spillovers to society? For example, can these technologies increase the risk of inadvertently providing funds to bad actors? In centralized finance there are regulations that require banks to know who their clients are. Are similar rules and regulations needed around some of these new technologies? When it comes to our financial plumbing, which affects every person or business in one way or another, I think a balanced view of expeditious disruption and long-term sustainability is merited. So where does that leave us? Ultimately, I believe that advances in technology have the potential to drive efficiency gains in finance, just as technological innovation has done for centuries. While there are certain services emerging through defi that cannot be provided by centralized finance, the technological innovations stemming from defi are largely complementary to centralized finance. They have the potential to improve centralized finance, thereby increasing the significant value that financial intermediaries and centralized financial markets deliver. I look forward to seeing the continued evolution of financial technology and the benefits that evolution will bring to the households and businesses served by the financial system. 1 I would like to dedicate these remarks to an old friend and longtime participant of this conference, Paul Klein, who passed away unexpectedly two months ago. The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 The Quarterly Journal of See Ariel Rubinstein and Asher Wolinsky, "Middlemen," Economics 102 (August 1987): 581-93, https://academic.oup.com/qje/article-abstract /102/3/581/1887969. 3 See Benjamin Bromberg, " The origin of banking: religious finance in Babylonia (PDF) ," The Journal of Economic History 2 (May 1942): 77-88. 4 See National Aeronautics and Space Administration, "Spinoff from a Moon Tool (PDF) ," January 1, 1981. 5 See Christopher J. Waller, " Thoughts on the Crypto Ecosystem " (speech at Global Interdependence Center Conference: Digital Money, Decentralized Finance, and the Puzzle of Crypto, La Jolla, CA, February 10, 2023).	---[PAGE_BREAK]--- # Christopher J Waller: Centralized and decentralized finance substitutes or complements? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Vienna Macroeconomics Workshop, organised by the Institute of Advanced Studies, Vienna, Austria, 18 October 2024. Thank you for inviting me to speak today. $\underline{1}$ I have participated in this conference for nearly 20 years and have often presented my research on monetary theory, banking, and payments. So, I believe this is the right audience to speak to regarding the role of centralized finance and the emergence of decentralized finance, or defi for short. Over the past few years, there has been a lot of attention and work on defi, which will be a major focus of my remarks. Many argue that defi will replace traditional centralized finance while others argue that it merely extends traditional finance methods and trading activities onto new platforms. It is in this sense that I want to address the question of whether centralized finance and defi are substitutes or complements to each other. Advances associated with defi have the potential to profoundly affect financial market trading. While I believe these advances could lead to efficiency gains, I recognize the significant value that has been delivered for centuries by financial intermediaries and through centralized financial markets. Before I share my views on the promise of these new technologies, let me tell you where I'm coming from on these issues. I am an economist, and so my first inclination is to think about the underlying economics driving an issue. But to understand the value proposition of defi, it is useful to first recall why centralizedfinancial market trading arose in the first place. Centralized finance clearly provides benefits to people, but obviously also comes with some costs. I am going to take a few minutes to discuss those benefits and costs before turning to the question at hand. Let's start with the economics of trading. Most financial trades are "pairwise" in that the seller of an object needs to find a buyer of that exact object. The problem is that it is often complicated, costly, and time-consuming to search for a buyer. This gives rise to the need for someone to step in and help buyers and sellers match in a faster and less costly manner. In short, there is a profit opportunity for someone to intermediate the trade. Another name for intermediaries is middlemen. Why would we pay a middleman? In their paper from nearly 40 years ago, Ariel Rubenstein and Asher Wolinsky described it eloquently: "What makes the middlemen's activity possible is the time-consuming nature of the trade, which enables middlemen to extract surplus in return for shortening the time period that sellers and buyers have to wait for a transaction." ${ }^{2}$ Let me contextualize the value of middlemen with an example I used for years when teaching money and banking. Suppose you had some extra income from saving and wanted to lend it out to earn interest. How would you do that? First, you would have to ---[PAGE_BREAK]--- advertise that you had funds to lend. Then, you would have to wait for the right person who needed that exact amount of funds, which could be a long time. Once you met the right person, you would have to negotiate when repayment would occur. Next, you would need to know a lot of information about the person receiving your funds and the likelihood you would get repaid. This is needed to assess the risk of the transaction and the compensation you would need to give up your funds. You would also need a lot of legal advice to draw up a contract and stipulate how the contract would be enforced under a range of conditions. Finally, since you are the sole source of funding, you will bear the entire cost of a default. It should be clear that this would be a daunting exercise for most people and explains why they would turn to a middleman who specializes in this type of activity to do all this on their behalf. It is for these reasons that banks arose as early as in ancient Mesopotamia to carry out some of these functions. ${ }^{3}$ Similar issues arise when it comes to other ways of transferring resources from one person to another, as occurs from non-bank debt, equities and insurance contracts. Many point to trades of shares in the Dutch East India Trading Company in Amsterdam in the 1660s as the origins of the first modern stock exchange. Lloyds of London was founded as a means of pooling funds to share risk and return in the shipping industry, thus becoming the first insurance firm. The fact that similar arrangements still exist centuries later is a testament to the value of intermediation and centralized financial trading. However, these arrangements are not without drawbacks. An obvious drawback of intermediation from the perspective of those wishing to trade is that those middlemen must get paid. That is, there are transaction costs. Another drawback of intermediation is that you typically must turn over control of your assets, such as savings or stocks, to the intermediary for them to be traded. This creates a classic "principal-agent" problem whereby incentives between the principal-you-and the agent-the intermediary-may not be aligned. That can raise concerns about custody arrangements and recourse to regain control of one's assets. Intermediation also requires recordkeeping arrangements that customers can trust accurately reflect their true holdings. In other words, centralized finance requires a substantial amount of trust. With all that in mind, let me turn to how and why technological innovations have given rise to defi. In a capitalist system, the existence of profits provides incentives for others to enter the market, offer a better product, and compete away any excess profits. This can be done by the creation of new financial firms that can provide the same or better service at a lower cost. Often that occurs through innovations and exploiting new technologies. Think about how the invention of the telegraph and the telephone revolutionized trading. More recently, the advent of the internet further advanced the ease and speed of financial trading. These are examples of how financial trading has evolved over time. And the next wave of innovations in financial market trading could be driven by technological advances that alleviate some potential drawbacks of the centralized approach. Often broad technological advances emanate from narrower efforts to design products or processes that solve specific problems. For example, one technology used to support portable home appliances like vacuum cleaners was originally developed to support the space program. ${ }^{4}$ Similarly, the development of crypto-assets led to the development of technologies that are fueling possibilities in defi. ---[PAGE_BREAK]--- We don't have enough time for me to cover the full history of crypto-assets, but I will focus on several key elements that have affected the evolution toward defi. An early crypto-asset-Bitcoin-was developed to function in a world in which trust among individuals did not exist. Rather than relying on intermediaries which require trust, Bitcoin relied on technology to facilitate trade. Bitcoin was also designed for privacy. No one would know who was buying or selling Bitcoin. This was achieved through cryptographic technology and private keys. In addition, it allowed individuals to maintain control of their crypto-assets throughout the entire trading process. That is, they no longer had to delegate control to others. Finally, all records were kept on a form of distributed ledger called a blockchain, which has design features that promote transparency and are censorship-proof. No individual or government could destroy the records of trades or take ownership of the objects traded. With that history in mind and before we delve into the question of whether defi and centralized finance are substitutes or complements, I think it is useful to carefully define some terms. This will make sure we're all talking about the same things. As I described in a speech last year, I think of the crypto ecosystem as consisting of three parts: - a crypto-asset, which generally refers to any digital object traded using cryptographic techniques; - technology that directly facilitates trading crypto-assets; this includes smart contracts and tokenization; ${ }^{5}$ and - a database management protocol used to record trades and ownership of assets, commonly referred to as the blockchain, which includes both permissioned and permissionless distributed ledger technologies. It is easy to see how the emergence of these technologies could lead one to think of defi as a substitute for centralized finance. For example, the technologies are allowing for individuals to trade assets without giving up control of those assets to an intermediary-a critical distinction with centralized finance. However, there are other uses emerging from these technologies that look more like complements to centralized finance. For example, distributed ledger technology, or DLT, may be an efficient and faster way to do recordkeeping in a 24/7 trading world. We already see several financial institutions experimenting with DLT for traditional repo trading that occurs 24/7. But before these ledgers can be used to facilitate transactions in traditional assets-like debt, equity, and real estate-these assets must be tokenized. Undertaking the process to tokenize assets and use distributed ledgers like blockchain can speed up transfers of assets and take advantage of another innovation: smart contracts. Rather than relying on each party to separately carry out the transaction, smart contracts can effectively combine multiple legs of a transaction into a single unified act executed by a smart contract. This can provide value as it can mitigate risks associated with settlement and counterparty risks by ensuring the buyer will not pay if the seller does not deliver. While these efforts are still in early stages, the functionality could expand to a broad set of financial activities. The bottom line is that things like DLT, ---[PAGE_BREAK]--- tokenization, and smart contracts are just technologies for trading that can be used in defi or also to improve efficiency in centralized finance. That is why I see them as complements. Stablecoins are another important innovation in defi. Stablecoins were created in the crypto universe in hopes of providing a "safe" asset with a stable value for trading. Nearly all stablecoins are pegged to the U.S. dollar one-for-one. They provide an opportunity for buyers and sellers to transact in a decentralized fashion with the stablecoin used as the settlement instrument. Because they are effectively digital currency, stablecoins can reduce the need for payment intermediaries and thereby reduce costs of payments globally. But their safety is not assured. History is replete with cases in which synthetic dollars became subject to runs. Stablecoins thus face all of the same issues any substitute for genuine U.S. dollars faces. If appropriate guardrails can be erected to minimize run risk and mitigate other risks, such as their potential use in illicit finance, then stablecoins may have benefits in payments and by serving as a safe asset on a variety of new trading platforms. These technologies will almost certainly lead to efficiency gains over time, but as they develop, we should think carefully about their role in the broader financial landscape. Is it really possible to completely decentralize finance using these technologies? The answer is obviously "no." Intermediation is still valuable for the average person, and we see this by the existence of trading exchanges in the crypto world. All these platforms involve giving custody of one's crypto-assets to an intermediary, who conducts trades on behalf of the client. This reintroduces the need for trust in these platforms just as trust is needed in modern banking systems. Returning to the technologies behind defi, one must ask whether there are unique risks associated with the use of these technologies. If so, what is the nature of these risks? Are they contained to just those people directly engaging with the technologies, or could there be broader spillovers to society? For example, can these technologies increase the risk of inadvertently providing funds to bad actors? In centralized finance there are regulations that require banks to know who their clients are. Are similar rules and regulations needed around some of these new technologies? When it comes to our financial plumbing, which affects every person or business in one way or another, I think a balanced view of expeditious disruption and long-term sustainability is merited. So where does that leave us? Ultimately, I believe that advances in technology have the potential to drive efficiency gains in finance, just as technological innovation has done for centuries. While there are certain services emerging through defi that cannot be provided by centralized finance, the technological innovations stemming from defi are largely complementary to centralized finance. They have the potential to improve centralized finance, thereby increasing the significant value that financial intermediaries and centralized financial markets deliver. I look forward to seeing the continued evolution of financial technology and the benefits that evolution will bring to the households and businesses served by the financial system. [^0] [^0]: ${ }^{1}$ I would like to dedicate these remarks to an old friend and longtime participant of this conference, Paul Klein, who passed away unexpectedly two months ago. The views ---[PAGE_BREAK]--- expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See Ariel Rubinstein and Asher Wolinsky, "Middlemen," The Quarterly Journal of Economics 102 (August 1987): 581-93, https://academic.oup.com/qje/article-abstract /102/3/581/1887969. ${ }^{3}$ See Benjamin Bromberg, "The origin of banking: religious finance in Babylonia (PDF)," The Journal of Economic History 2 (May 1942): 77-88. ${ }^{4}$ See National Aeronautics and Space Administration, "Spinoff from a Moon Tool (PDF) ," January 1, 1981. ${ }^{5}$ See Christopher J. Waller, "Thoughts on the Crypto Ecosystem" (speech at Global Interdependence Center Conference: Digital Money, Decentralized Finance, and the Puzzle of Crypto, La Jolla, CA, February 10, 2023).	Christopher J Waller	United States	https://www.bis.org/review/r241021c.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Vienna Macroeconomics Workshop, organised by the Institute of Advanced Studies, Vienna, Austria, 18 October 2024. Thank you for inviting me to speak today. I have participated in this conference for nearly 20 years and have often presented my research on monetary theory, banking, and payments. So, I believe this is the right audience to speak to regarding the role of centralized finance and the emergence of decentralized finance, or defi for short. Over the past few years, there has been a lot of attention and work on defi, which will be a major focus of my remarks. Many argue that defi will replace traditional centralized finance while others argue that it merely extends traditional finance methods and trading activities onto new platforms. It is in this sense that I want to address the question of whether centralized finance and defi are substitutes or complements to each other. Advances associated with defi have the potential to profoundly affect financial market trading. While I believe these advances could lead to efficiency gains, I recognize the significant value that has been delivered for centuries by financial intermediaries and through centralized financial markets. Before I share my views on the promise of these new technologies, let me tell you where I'm coming from on these issues. I am an economist, and so my first inclination is to think about the underlying economics driving an issue. But to understand the value proposition of defi, it is useful to first recall why centralizedfinancial market trading arose in the first place. Centralized finance clearly provides benefits to people, but obviously also comes with some costs. I am going to take a few minutes to discuss those benefits and costs before turning to the question at hand. Let's start with the economics of trading. Most financial trades are "pairwise" in that the seller of an object needs to find a buyer of that exact object. The problem is that it is often complicated, costly, and time-consuming to search for a buyer. This gives rise to the need for someone to step in and help buyers and sellers match in a faster and less costly manner. In short, there is a profit opportunity for someone to intermediate the trade. Another name for intermediaries is middlemen. Why would we pay a middleman? In their paper from nearly 40 years ago, Ariel Rubenstein and Asher Wolinsky described it eloquently: "What makes the middlemen's activity possible is the time-consuming nature of the trade, which enables middlemen to extract surplus in return for shortening the time period that sellers and buyers have to wait for a transaction." Let me contextualize the value of middlemen with an example I used for years when teaching money and banking. Suppose you had some extra income from saving and wanted to lend it out to earn interest. How would you do that? First, you would have to advertise that you had funds to lend. Then, you would have to wait for the right person who needed that exact amount of funds, which could be a long time. Once you met the right person, you would have to negotiate when repayment would occur. Next, you would need to know a lot of information about the person receiving your funds and the likelihood you would get repaid. This is needed to assess the risk of the transaction and the compensation you would need to give up your funds. You would also need a lot of legal advice to draw up a contract and stipulate how the contract would be enforced under a range of conditions. Finally, since you are the sole source of funding, you will bear the entire cost of a default. It should be clear that this would be a daunting exercise for most people and explains why they would turn to a middleman who specializes in this type of activity to do all this on their behalf. It is for these reasons that banks arose as early as in ancient Mesopotamia to carry out some of these functions. Similar issues arise when it comes to other ways of transferring resources from one person to another, as occurs from non-bank debt, equities and insurance contracts. Many point to trades of shares in the Dutch East India Trading Company in Amsterdam in the 1660s as the origins of the first modern stock exchange. Lloyds of London was founded as a means of pooling funds to share risk and return in the shipping industry, thus becoming the first insurance firm. The fact that similar arrangements still exist centuries later is a testament to the value of intermediation and centralized financial trading. However, these arrangements are not without drawbacks. An obvious drawback of intermediation from the perspective of those wishing to trade is that those middlemen must get paid. That is, there are transaction costs. Another drawback of intermediation is that you typically must turn over control of your assets, such as savings or stocks, to the intermediary for them to be traded. This creates a classic "principal-agent" problem whereby incentives between the principal-you-and the agent-the intermediary-may not be aligned. That can raise concerns about custody arrangements and recourse to regain control of one's assets. Intermediation also requires recordkeeping arrangements that customers can trust accurately reflect their true holdings. In other words, centralized finance requires a substantial amount of trust. With all that in mind, let me turn to how and why technological innovations have given rise to defi. In a capitalist system, the existence of profits provides incentives for others to enter the market, offer a better product, and compete away any excess profits. This can be done by the creation of new financial firms that can provide the same or better service at a lower cost. Often that occurs through innovations and exploiting new technologies. Think about how the invention of the telegraph and the telephone revolutionized trading. More recently, the advent of the internet further advanced the ease and speed of financial trading. These are examples of how financial trading has evolved over time. And the next wave of innovations in financial market trading could be driven by technological advances that alleviate some potential drawbacks of the centralized approach. Often broad technological advances emanate from narrower efforts to design products or processes that solve specific problems. For example, one technology used to support portable home appliances like vacuum cleaners was originally developed to support the space program. Similarly, the development of crypto-assets led to the development of technologies that are fueling possibilities in defi. We don't have enough time for me to cover the full history of crypto-assets, but I will focus on several key elements that have affected the evolution toward defi. An early crypto-asset-Bitcoin-was developed to function in a world in which trust among individuals did not exist. Rather than relying on intermediaries which require trust, Bitcoin relied on technology to facilitate trade. Bitcoin was also designed for privacy. No one would know who was buying or selling Bitcoin. This was achieved through cryptographic technology and private keys. In addition, it allowed individuals to maintain control of their crypto-assets throughout the entire trading process. That is, they no longer had to delegate control to others. Finally, all records were kept on a form of distributed ledger called a blockchain, which has design features that promote transparency and are censorship-proof. No individual or government could destroy the records of trades or take ownership of the objects traded. With that history in mind and before we delve into the question of whether defi and centralized finance are substitutes or complements, I think it is useful to carefully define some terms. This will make sure we're all talking about the same things. As I described in a speech last year, I think of the crypto ecosystem as consisting of three parts: a crypto-asset, which generally refers to any digital object traded using cryptographic techniques;. technology that directly facilitates trading crypto-assets; this includes smart contracts and tokenization; and. a database management protocol used to record trades and ownership of assets, commonly referred to as the blockchain, which includes both permissioned and permissionless distributed ledger technologies. It is easy to see how the emergence of these technologies could lead one to think of defi as a substitute for centralized finance. For example, the technologies are allowing for individuals to trade assets without giving up control of those assets to an intermediary-a critical distinction with centralized finance. However, there are other uses emerging from these technologies that look more like complements to centralized finance. For example, distributed ledger technology, or DLT, may be an efficient and faster way to do recordkeeping in a 24/7 trading world. We already see several financial institutions experimenting with DLT for traditional repo trading that occurs 24/7. But before these ledgers can be used to facilitate transactions in traditional assets-like debt, equity, and real estate-these assets must be tokenized. Undertaking the process to tokenize assets and use distributed ledgers like blockchain can speed up transfers of assets and take advantage of another innovation: smart contracts. Rather than relying on each party to separately carry out the transaction, smart contracts can effectively combine multiple legs of a transaction into a single unified act executed by a smart contract. This can provide value as it can mitigate risks associated with settlement and counterparty risks by ensuring the buyer will not pay if the seller does not deliver. While these efforts are still in early stages, the functionality could expand to a broad set of financial activities. The bottom line is that things like DLT, tokenization, and smart contracts are just technologies for trading that can be used in defi or also to improve efficiency in centralized finance. That is why I see them as complements. Stablecoins are another important innovation in defi. Stablecoins were created in the crypto universe in hopes of providing a "safe" asset with a stable value for trading. Nearly all stablecoins are pegged to the U.S. dollar one-for-one. They provide an opportunity for buyers and sellers to transact in a decentralized fashion with the stablecoin used as the settlement instrument. Because they are effectively digital currency, stablecoins can reduce the need for payment intermediaries and thereby reduce costs of payments globally. But their safety is not assured. History is replete with cases in which synthetic dollars became subject to runs. Stablecoins thus face all of the same issues any substitute for genuine U.S. dollars faces. If appropriate guardrails can be erected to minimize run risk and mitigate other risks, such as their potential use in illicit finance, then stablecoins may have benefits in payments and by serving as a safe asset on a variety of new trading platforms. These technologies will almost certainly lead to efficiency gains over time, but as they develop, we should think carefully about their role in the broader financial landscape. Is it really possible to completely decentralize finance using these technologies? The answer is obviously "no." Intermediation is still valuable for the average person, and we see this by the existence of trading exchanges in the crypto world. All these platforms involve giving custody of one's crypto-assets to an intermediary, who conducts trades on behalf of the client. This reintroduces the need for trust in these platforms just as trust is needed in modern banking systems. Returning to the technologies behind defi, one must ask whether there are unique risks associated with the use of these technologies. If so, what is the nature of these risks? Are they contained to just those people directly engaging with the technologies, or could there be broader spillovers to society? For example, can these technologies increase the risk of inadvertently providing funds to bad actors? In centralized finance there are regulations that require banks to know who their clients are. Are similar rules and regulations needed around some of these new technologies? When it comes to our financial plumbing, which affects every person or business in one way or another, I think a balanced view of expeditious disruption and long-term sustainability is merited. So where does that leave us? Ultimately, I believe that advances in technology have the potential to drive efficiency gains in finance, just as technological innovation has done for centuries. While there are certain services emerging through defi that cannot be provided by centralized finance, the technological innovations stemming from defi are largely complementary to centralized finance. They have the potential to improve centralized finance, thereby increasing the significant value that financial intermediaries and centralized financial markets deliver. I look forward to seeing the continued evolution of financial technology and the benefits that evolution will bring to the households and businesses served by the financial system.
2024-10-23T00:00:00	Michelle W Bowman: Opening remarks - 8th Annual Fintech Conference	Opening remarks (virtually) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Eighth Annual Fintech Conference, Philadelphia, Pennsylvania, 23 October 2024.	Michelle W Bowman: Opening remarks - 8th Annual Fintech Conference Opening remarks (virtually) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Eighth Annual Fintech Conference, Philadelphia, Pennsylvania, 23 October 2024. * * * 1 Good morning. It is a pleasure to join you for the second day of the Eighth Annual Fintech Conference hosted by the Federal Reserve Bank of Philadelphia. While I am disappointed not to be able to join you in person this morning, I am pleased to be among the more than 1,000 participants joining today's discussion online. The agenda today promises to be just as informative and thought-provoking as yesterday's session. Given that this conference provides an opportunity to engage in discussions about fintech and its importance in the financial services industry, I'd like to reiterate something I have highlighted a number of times in the past. Regulators have an obligation to understand the functionality of new innovations, including the benefits that 2 innovation can bring and the accompanying risks. Conferences like this enable us to expand our knowledge and understanding of these benefits and risks by bringing together experts throughout the financial system to discuss important developments and emerging issues related to financial technology. These discussions help to inform our work throughout the Federal Reserve System. Often the pace of technological change can be rapid. New or improving technologies have the potential to make our banking system faster and more efficient. They can result in both lowering the cost of and expanding the availability of products and services for consumers. But they can also carry risks. To be effective in the face of this ongoing evolution, regulators must be aware of the potential risks and how existing technology could be leveraged for new services. Therefore, we must remain vigilant but nimble in our approach. This requires us to recognize and follow three innovation related principles: First, we must be willing to develop an understanding of new technology. Second, we must be open in considering how we approach innovation. And finally, we must prioritize how we integrate innovation as we revise or enhance regulatory frameworks. Turning back to why we are here today: This conference was launched back in 2017. It has grown in standing and relevance every year since. As President Harker noted in his remarks yesterday, the conference has become a System highlight because of its ability to focus on and keep pace with the change of technology. This conference also embodies the principles I just articulated of working to understand new technologies, having an openness to innovation, and considering policy choices that enable integration of financial technology in the banking and financial system. Year-after-year, this event provides an opportunity for us to come together to engage and learn about fintech issues, keeping an eye toward the future. But we must recognize that the success and growth of this conference is due to the leadership and vision of President Harker. For those who may not be aware, at the end of June next year, President Harker will reach the Federal Reserve retirement requirements, and unfortunately, this will be his final Fintech Conference as President and CEO of the Philadelphia Fed. I want to congratulate Pat on the creation and success of this conference, and to look forward to the ongoing and future legacy he has created for the Philadelphia Reserve Bank with this event. President Harker is, by his own admission, an "accidental economist." He's an engineer first and, in fact, came to the field of economics through an engineering issue that required economics to solve. Well, as someone who has sat at the Federal Open Market Committee conference table with President Harker for the past six years, I can attest to this approach-he enlists this engineering perspective to assist in understanding economic issues. That methodical approach to issues, and his willingness to look deep under the proverbial hood, is his hallmark at the Philadelphia Fed. Through his leadership, the Bank has built strong partnerships with communities throughout the Third District who know they can rely on this institution for expert knowledge and data research that are critical to working through local concerns. It was also under his leadership that the Philadelphia Fed's Consumer Finance Institute took its current shape. Today, the Institute's multidisciplinary approach to issuesbringing together economists, industry and regulatory experts, and community development specialists-is redefining our understanding of consumer credit and payments. And, he has positioned the Philadelphia Fed as a true thought leader in technology and innovation, and in the application of both hard and soft data. This conference is just the most public example of this. His decision, nearly a decade ago, to give the green light to a conference specifically geared to fintech proves that President Harker is clearly standing in the center of the intersection of engineering and economics. So, while I do not wish to detract from any of our speakers, panelists, and presenters today, I must recognize and thank President Harker for his forward-looking leadership. The Third District and the Federal Reserve System are both better for his service. Pat, thank you! To close, thank you again for allowing me these few moments to start the day. I look forward to today's discussion and to our conversations. 1 These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. Michelle W. Bowman, "Innovation in the Financial System" (speech at the Salzburg Global Seminar on Financial Technology Innovation, Social Impact, and Regulation: Do We Need New Paradigms?, Salzburg, Austria, June 17, 2024).	---[PAGE_BREAK]--- # Michelle W Bowman: Opening remarks - 8th Annual Fintech Conference Opening remarks (virtually) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Eighth Annual Fintech Conference, Philadelphia, Pennsylvania, 23 October 2024. Good morning. ${ }^{1}$ It is a pleasure to join you for the second day of the Eighth Annual Fintech Conference hosted by the Federal Reserve Bank of Philadelphia. While I am disappointed not to be able to join you in person this morning, I am pleased to be among the more than 1,000 participants joining today's discussion online. The agenda today promises to be just as informative and thought-provoking as yesterday's session. Given that this conference provides an opportunity to engage in discussions about fintech and its importance in the financial services industry, I'd like to reiterate something I have highlighted a number of times in the past. Regulators have an obligation to understand the functionality of new innovations, including the benefits that innovation can bring and the accompanying risks. ${ }^{2}$ Conferences like this enable us to expand our knowledge and understanding of these benefits and risks by bringing together experts throughout the financial system to discuss important developments and emerging issues related to financial technology. These discussions help to inform our work throughout the Federal Reserve System. Often the pace of technological change can be rapid. New or improving technologies have the potential to make our banking system faster and more efficient. They can result in both lowering the cost of and expanding the availability of products and services for consumers. But they can also carry risks. To be effective in the face of this ongoing evolution, regulators must be aware of the potential risks and how existing technology could be leveraged for new services. Therefore, we must remain vigilant but nimble in our approach. This requires us to recognize and follow three innovation related principles: First, we must be willing to develop an understanding of new technology. Second, we must be open in considering how we approach innovation. And finally, we must prioritize how we integrate innovation as we revise or enhance regulatory frameworks. Turning back to why we are here today: This conference was launched back in 2017. It has grown in standing and relevance every year since. As President Harker noted in his remarks yesterday, the conference has become a System highlight because of its ability to focus on and keep pace with the change of technology. This conference also embodies the principles I just articulated of working to understand new technologies, having an openness to innovation, and considering policy choices that enable integration of financial technology in the banking and financial system. Year-after-year, this event provides an opportunity for us to come together to engage and learn about fintech issues, keeping an eye toward the future. ---[PAGE_BREAK]--- But we must recognize that the success and growth of this conference is due to the leadership and vision of President Harker. For those who may not be aware, at the end of June next year, President Harker will reach the Federal Reserve retirement requirements, and unfortunately, this will be his final Fintech Conference as President and CEO of the Philadelphia Fed. I want to congratulate Pat on the creation and success of this conference, and to look forward to the ongoing and future legacy he has created for the Philadelphia Reserve Bank with this event. President Harker is, by his own admission, an "accidental economist." He's an engineer first and, in fact, came to the field of economics through an engineering issue that required economics to solve. Well, as someone who has sat at the Federal Open Market Committee conference table with President Harker for the past six years, I can attest to this approach-he enlists this engineering perspective to assist in understanding economic issues. That methodical approach to issues, and his willingness to look deep under the proverbial hood, is his hallmark at the Philadelphia Fed. Through his leadership, the Bank has built strong partnerships with communities throughout the Third District who know they can rely on this institution for expert knowledge and data research that are critical to working through local concerns. It was also under his leadership that the Philadelphia Fed's Consumer Finance Institute took its current shape. Today, the Institute's multidisciplinary approach to issuesbringing together economists, industry and regulatory experts, and community development specialists-is redefining our understanding of consumer credit and payments. And, he has positioned the Philadelphia Fed as a true thought leader in technology and innovation, and in the application of both hard and soft data. This conference is just the most public example of this. His decision, nearly a decade ago, to give the green light to a conference specifically geared to fintech proves that President Harker is clearly standing in the center of the intersection of engineering and economics. So, while I do not wish to detract from any of our speakers, panelists, and presenters today, I must recognize and thank President Harker for his forward-looking leadership. The Third District and the Federal Reserve System are both better for his service. Pat, thank you! To close, thank you again for allowing me these few moments to start the day. I look forward to today's discussion and to our conversations. [^0] [^0]: ${ }^{1}$ These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ---[PAGE_BREAK]--- ${ }^{2}$ Michelle W. Bowman, "Innovation in the Financial System" (speech at the Salzburg Global Seminar on Financial Technology Innovation, Social Impact, and Regulation: Do We Need New Paradigms?, Salzburg, Austria, June 17, 2024).	Michelle W Bowman	United States	https://www.bis.org/review/r241024f.pdf	Opening remarks (virtually) by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Eighth Annual Fintech Conference, Philadelphia, Pennsylvania, 23 October 2024. Good morning. It is a pleasure to join you for the second day of the Eighth Annual Fintech Conference hosted by the Federal Reserve Bank of Philadelphia. While I am disappointed not to be able to join you in person this morning, I am pleased to be among the more than 1,000 participants joining today's discussion online. The agenda today promises to be just as informative and thought-provoking as yesterday's session. Given that this conference provides an opportunity to engage in discussions about fintech and its importance in the financial services industry, I'd like to reiterate something I have highlighted a number of times in the past. Regulators have an obligation to understand the functionality of new innovations, including the benefits that innovation can bring and the accompanying risks. Conferences like this enable us to expand our knowledge and understanding of these benefits and risks by bringing together experts throughout the financial system to discuss important developments and emerging issues related to financial technology. These discussions help to inform our work throughout the Federal Reserve System. Often the pace of technological change can be rapid. New or improving technologies have the potential to make our banking system faster and more efficient. They can result in both lowering the cost of and expanding the availability of products and services for consumers. But they can also carry risks. To be effective in the face of this ongoing evolution, regulators must be aware of the potential risks and how existing technology could be leveraged for new services. Therefore, we must remain vigilant but nimble in our approach. This requires us to recognize and follow three innovation related principles: First, we must be willing to develop an understanding of new technology. Second, we must be open in considering how we approach innovation. And finally, we must prioritize how we integrate innovation as we revise or enhance regulatory frameworks. Turning back to why we are here today: This conference was launched back in 2017. It has grown in standing and relevance every year since. As President Harker noted in his remarks yesterday, the conference has become a System highlight because of its ability to focus on and keep pace with the change of technology. This conference also embodies the principles I just articulated of working to understand new technologies, having an openness to innovation, and considering policy choices that enable integration of financial technology in the banking and financial system. Year-after-year, this event provides an opportunity for us to come together to engage and learn about fintech issues, keeping an eye toward the future. But we must recognize that the success and growth of this conference is due to the leadership and vision of President Harker. For those who may not be aware, at the end of June next year, President Harker will reach the Federal Reserve retirement requirements, and unfortunately, this will be his final Fintech Conference as President and CEO of the Philadelphia Fed. I want to congratulate Pat on the creation and success of this conference, and to look forward to the ongoing and future legacy he has created for the Philadelphia Reserve Bank with this event. President Harker is, by his own admission, an "accidental economist." He's an engineer first and, in fact, came to the field of economics through an engineering issue that required economics to solve. Well, as someone who has sat at the Federal Open Market Committee conference table with President Harker for the past six years, I can attest to this approach-he enlists this engineering perspective to assist in understanding economic issues. That methodical approach to issues, and his willingness to look deep under the proverbial hood, is his hallmark at the Philadelphia Fed. Through his leadership, the Bank has built strong partnerships with communities throughout the Third District who know they can rely on this institution for expert knowledge and data research that are critical to working through local concerns. It was also under his leadership that the Philadelphia Fed's Consumer Finance Institute took its current shape. Today, the Institute's multidisciplinary approach to issuesbringing together economists, industry and regulatory experts, and community development specialists-is redefining our understanding of consumer credit and payments. And, he has positioned the Philadelphia Fed as a true thought leader in technology and innovation, and in the application of both hard and soft data. This conference is just the most public example of this. His decision, nearly a decade ago, to give the green light to a conference specifically geared to fintech proves that President Harker is clearly standing in the center of the intersection of engineering and economics. So, while I do not wish to detract from any of our speakers, panelists, and presenters today, I must recognize and thank President Harker for his forward-looking leadership. The Third District and the Federal Reserve System are both better for his service. Pat, thank you! To close, thank you again for allowing me these few moments to start the day. I look forward to today's discussion and to our conversations.
2024-10-24T00:00:00	Philip R Lane: Underlying inflation - an update	Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the "Inflation: Drivers and Dynamics Conference 2024", organised by the Federal Reserve Bank of Cleveland and the European Central Bank, Cleveland, 24 October 2024.	SPEECH Underlying inflation: an update Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Inflation: Drivers and Dynamics Conference 2024 organised by the Federal Reserve Bank of Cleveland and the ECB Cleveland, 24 October 2024 Introduction My aim today is to provide an update on underlying inflation in the euro area] The concept of underlying inflation plays a central role in the conduct of the ECB's monetary policy: our interest rate decisions are based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. This three-pronged reaction function complements the traditional focus on the inflation forecast for inflation-targeting central banks with the signals embodied in underlying inflation measures, while also incorporating the evolving evidence on the strength of monetary policy transmission in the calibration of the monetary stance. This pragmatic approach reflects the value of data dependence under highly atypical macroeconomic conditions. Latest developments in euro area underlying inflation Underlying inflation is the persistent component of inflation, signalling where headline inflation will settle in the medium term after temporary factors have vanished. In practice, underlying inflation is unobservable and needs to be proxied or estimated. There are two broad categories of measures that aim to capture this concept. Exclusion-based measures omit certain items - such as energy and food - that are typically volatile and more sensitive to global factors than domestic fundamentals. Model-based measures, meanwhile, capture more complex channels and dynamics, subject to the limitations imposed by sensitivity to model estimation. An overview of such measures is shown in Chart 1. Model-based measures at the ECB include the Persistent and Common Component of Inflation (PCCI), which is constructed by estimating a dynamic factor model that extracts the persistent and common component of inflation from granular price data at the item-country level, thereby exploiting the relative advantages of both cross-sectional and time series approaches.2] Another model-based measure is Supercore inflation, which picks out those items that are estimated to co-move with the business cycle. These model-based measures are reduced form in nature and, among other factors, reflect the empirical contribution of monetary policy tightening to delivering disinflation. That is to say, if current inflation is above target, one reason why underlying inflation might run below current inflation is that the projected mean reversion is partly driven by endogenous monetary policy tightening that has historically contributed to the return of inflation to the target over the medium term. In turn, monitoring the evolution of underlying inflation is an important element in diagnosing whether monetary policy is appropriately calibrated. Each of the underlying inflation indicators tracked by the ECB has declined significantly since the post- pandemic inflation surges, with the range narrowing towards its historical average. The majority of indicators are hovering around 1.9 per cent to 2.8 per cent, down from a much wider range between 3.4 per cent to 7.5 per cent at its peak (Chart 1). Core inflation is the most prominent exclusion-based measure, defined as HICP inflation excluding energy and food: this edged down to 2.7 per cent in September, continuing the marked decline from 4.5 per cent a year ago.lin terms of model-based measures, the PCCI today is at the bottom of the range, standing at 1.9 per cent in September and having hovered around 2.0 per cent since the end of last year. Most other measures that we regularly monitor have also come down over the past year and show signs of continued easing in September. One challenge in interpreting standard indicators of underlying inflation is that these were affected by the past extraordinary supply shocks, as well as by temporary mismatches between demand and supply. As I pointed out in my March 2023 speech, it is helpful to think of headline inflation as being driven by three factors: (i) underlying inflation; (ii) a reverting component; and (iii) pure noise./4! In particular, the major dislocations of recent years induced a substantial reverting component of inflation that was sufficiently long-lasting not to constitute pure noise but that was also expected to fade out over time. These dislocations included the impact of energy inflation and supply bottlenecks. To capture their indirect impact on measures of underlying inflation, we have in parallel monitored adjusted measures of underlying inflation that "partial out" these indirect influences. These adjusted measures had a significantly lower peak rate of underlying inflation than the un-adjusted measures but, by construction, were also less affected by the sharp turnaround in energy prices and easing of supply bottlenecks during 2023 that flattered the speed of progress in the un-adjusted measures. Currently, these adjustments bring down the range to between 2 per cent and 2.5 per cent, as the impact of past supply- side shocks has greatly diminished. In particular, the forward-looking PCCI measures are by now free of such impacts. Chart 1 Euro area underlying inflation measures and their adjusted counterpart (annual percentage changes) Exclusion-based measures Model-based measures = HICPX = HICP excluding energy =PCCl = PCCI excluding energy = HICPXX = HICP excluding unprocessed food and energy = Supercore 5 Standard measures Adjusted measures 3 Standard measures - Adjusted measures 7 7 7 7 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 0 0 0 0 01/23 06/23 11/23 04/24 09/24 01/23 06/23 11/23 04/24 09/24 01/23 06/23 11/23 04/24 09/24 01/23 06/23 11/23 04/24 09/24 Sources: Eurostat and ECB calculations. Notes: HICPX stands for HICP inflation excluding energy and food; HICPXX for HICP inflation excluding energy, food, travel-related items, clothing and footwear; PCCI is the persistent and common component of inflation, while Supercore aggregates HICPX items sensitive to domestic business cycle. See also Banbura et al. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB. The 'adjusted' measures abstract from energy and supply-bottlenecks shocks using a large SVAR, see Banbura, M., Bobeica, E. and Martinez-Hernandez, C. 2023, "What drives core inflation? The role of supply shocks.", ECB Working Paper No 2875. The latest observations are for September 2024. Each measure of underlying inflation provides useful information about future headline inflation, although their forecasting performance varies. Chart 2 shows the root mean squared forecast error (RMSFE) for each measure vis-a-vis inflation two years ahead and vis-a-vis a smoothed inflation rate. Forecasting performance is normalised to the predictive power of current headline inflation: that is, a ratio below unity means that the measure does a better job than current headline inflation in forecasting future inflation. Indeed, most measures beat current headline inflation in forecasting future inflation. The PCCI measures have the best predictive power, while most exclusion-based measures perform less well. However, in understanding the inflation process and calibrating monetary policy, it is essential to look beyond overall predictive power and also examine how the various underlying inflation measures can shed light on the speed and sequencing of the disinflation process. For instance, external shocks were a prominent feature of the post-pandemic economic landscape.) While the PCCI measures provided a powerful signal that these shocks would ultimately fade out, the delayed and lagged adjustment in indicators such as services inflation, domestic inflation and wage growth served to highlight that convergence to the medium-term target would not be immediate. I will focus on these indicators in the next part of my talk. Chart 2 Predictive properties of underlying inflation measures for HICP inflation (RMSFE of each measure relative to RMSFE of headline inflation) MM ERMSFE - smoothed HICP @sORMSFE - 24 months 07 08 09 1.0 OC << PCCI excluding energy TT HC TT <<< SUPeCOre EEE ---- HICP excluding energy Caen Weighted medi Eee ND ee eS ee and energy LC Tinned ncn 20%) TIME M22 (1050) eee ------- Sources: Eurostat and ECB calculations. Notes: RMSFE 24 months and RMSFE smoothed HICP are the root mean squared forecast errors of each measure with respect to headline inflation 24 months ahead and the two-year centred moving average of inflation covering two years of future data, respectively, divided by the RMSFE of headline inflation. A ratio lower than unity indicates that the measure performs better than headline inflation. The sample covers the period from April 2001 to September 2024. Services, domestic inflation and wages Domestic inflation captures price dynamics in consumption items that are less influenced by external factors, being more determined by domestic economic conditions, including monetary policy. While trends in the relative prices of globally-determined components (mostly in the energy, food and goods categories) mean that the two per cent target for overall inflation is not a target for domestic inflation, domestic inflation cannot remain at an excessive level if the target is to be sustainably achieved. Moreover, assessing the strength of domestic inflation is essential to the calibration of monetary policy, since domestic inflation will be more responsive than global inflation components to the impact of monetary policy via the dampening of domestic demand. The domestic inflation indicator monitored at the ECB is an aggregation of HICP items with low import content.!§1 As shown in Chart 3, domestic inflation and services inflation co-move closely. This reflects the dominance of services items in the domestic inflation measures, accounting for 97 per cent of the overall index. At the same time, it remains useful to maintain domestic inflation and services inflation as separate measures: while almost 80 per cent of the services items are included in the domestic inflation index, the overall services category also includes highly-traded services items (Chart 4). These internationally-traded services items currently have a lower contribution to services inflation than domestic services items. Chart 3 Services inflation and domestic inflation (annual percentage changes) === Services inflation === Domestic inflation 2020 2021 2022 2023 2024 09/24 Sources: Eurostat and ECB staff calculations. Notes: Domestic inflation is an aggregate of HICP items with a relatively low import intensity, as explained in Frohling, A., O'Brien, D. and Schaefer, S. (2022), "A new indicator of domestic inflation for the euro area", Economic Bulletin, Ilssue 4, ECB. The latest observations are for September 2024. Chart 4 Services inflation and domestic inflation (percentage point contribution to services inflation) Hf Domestic inflation items in services ff >=Non-domestic inflation items in services Restaurants, etc. Housing rents Accomm. serv. Repair of transport equip. Insurance of trans port Package holidays Social protection Recr_and sporting services (Pars)medical services eaith insurance Hairdressing Education Cultural services Hos pital services Other services - pers. trans port equip. Other services - dwelling ther services n.€.c. Dental services Domestic household services Canteens Mint and repsir of the dwelling Insurance - dwelling Refuse collection Sewerage collection Financial services ne.c. Passenger transpatt by rail Passengs transpatt by road Combined passenger transport Other insurance Postal services Other purchased trans ports ervices Passenger transport by water Clesning, repgir and hire of clothing Repair of household appliances Repsir of sudic-visual, photographic, info. process ing equip. Mainten. and repair of othe major durab. for recrest. and culture Passenger transport by air Repeir of furniture etc. Telephone & telefax equip. & serv -0.25 0 0.25 05 075 1 Sources: Eurostat and ECB staff calculations. Notes: The chart shows all services items and the x axis shows the contribution of each item to total services inflation in September 2024. In weighted terms, 80 per cent of services are in domestic inflation and 97 per cent of domestic inflation is composed of services items. Domestic inflation also includes three good items which are not shown on the chart. The large supply-side shocks of the post-pandemic period have been feeding through to domestic inflation with a lag compared with other measures of underlying inflation. Large supply-side shocks have travelled across sectors and consumption items at different speeds, so it is unsurprising that these had differential impacts on the various measures of underlying inflation, depending on their nature and construction. Domestic inflation and services inflation tend to lag headline inflation more than other measures, exhibiting a lower frequency of price adjustment compared with the energy, food and goods categories in the HICPFor this reason, many items in services inflation and domestic inflation were late movers that responded with a much longer lag to the latest inflationary shock, such that annual services inflation remains elevated." Chart 5 shows the impact of energy and supply-chain bottlenecks on the PCCls, domestic inflation and other measures of underlying inflation. Among these measures, PCCls are more forward-looking and have picked up certain shocks faster, but with the byproduct that the effects of the shocks also faded quicker. Other indicators, like domestic inflation, are more backward- looking, and the currently higher levels also reflect the still ongoing propagation of past shocks. In similar vein, the past shocks took longer to build up in domestic inflation and are also taking longer to dissipate. Chart 5 Impact of energy and supply-side bottlenecks shocks across measures of underlying inflation (percentage points) Impact of energy-related shocks Impact of global supply chain-related shocks = PCCI = PCC = Domestic inflation = Domestic inflation 20 20 15 15 1.0 1.0 05 05 0.0 00 05 05 1.0 1.0 2020 2021 2022 2023 2024 09/24 2020 2021 2022 2023 2024 = 09/24 Sources: Eurostat and ECB calculations Notes: The range covers the estimated impact of shocks across all monitored underlying inflation measures. The impact of the energy and supply bottleneck shocks are estimated in a large SVAR, see Banbura, M. et al. (2023), op. cit. The latest observations are for September 2024. The PCCI for services indicates that there is currently a sizeable gap between services inflation and its medium-term underlying trend, suggesting there is scope for downward adjustment in services inflation in the coming months. Services PCCI has been around 2.4 per cent since the end of last year, well below the current annual rate for services (Chart 6, left panel).""] This difference suggests that idiosyncratic and non-persistent factors are currently driving services inflation. Examples of such idiosyncratic factors include the base effect related to the introduction of the cheap travel Deutschland- ticket in Germany in May 2023, rent inflation in the Netherlands, and items that reprice less frequently, such as insurance or other administered prices (like hospital services) in some countries. Over time, the fading out of these idiosyncratic and temporary factors should means that services inflation declines towards the underlying rate. Indeed, momentum indicators for services confirm the slight easing of inflation dynamics. While services momentum (i.e. the three-month-on-three-month growth rate of the seasonally-adjusted index) remains high, it has been continuously easing since May (Chart 6, right panel). The month-on-month seasonally-adjusted rate markedly dropped in September. [12] Chart 6 Services inflation (annual percentage changes (left panel) and annualised three-month-on-three-month and month-on-month changes (right panel)) Gap compared with PCCI Momentum of services inflation = Senices inflation = Services year-on-year == Services PCC == Services three-month-on-three-month 7 7 = Services month-on-month 6 6 5 5 4 eerrey . 4 . 3 "s 3 Tee --: 2 2 1 1 0 0 01/23 05/23 09/23 01/24 05/24 09/24 01/24 03/24 05/24 07/24 09/24 Sources: Eurostat and ECB staff calculations. Note: The latest observations are for September 2024. Services and domestic inflation are closely linked to wage growth: the expected easing of wage growth in 2025, together with the impact of past monetary policy tightening, should contribute to further disinflation. Wages constitute a higher direct share in costs of services than goods and Chart 7 highlights the strong link between domestic inflation, services and wages: their level is normally similar and they closely co-move with each other.45] Chart 7 also shows how pressures in these three components can take time to moderate following a tightening in policy. Chart 7 Services and domestic inflation and wage growth after episodes of monetary policy tightening (annual percentage changes) m CPE tm Senices inflation tm Domestic inflation Tightening 1 Tightening 2 Tightening 3 (Nov. 2005 - Jun. 2008) (Mar. 2011 - Jun. 2011) (Mar. 2022 - Sep. 2023) 6 6 6 5 5 5 a N \ 4 4 4 . non ' - -= 3 3 3 2 2 2 1 1 1 0 0 0 12/05 06/07 1208 06/10 03/11 12/11 09/12 06/13 06/22 10/23 02/25 12/25 Sources: Eurostat, ECB and ECB calculations. Notes: Shaded areas show monetary policy tightening episodes. CPE stands for compensation per employee. The dotted line shows latest Eurostat data up to Q2 2024 for CPE carried forward with quarter-on-quarter rates from the September ECB staff projections. The latest observations are for the second quarter of 2024 for CPE and the third quarter of 2024 for the rest. Wage growth is expected to ease from its current high level, with the cumulative increase in nominal wages over 2023-2024 largely restoring the purchasing power that was lost during the inflation surges of 2021-2022. Wage pressures are currently still high: the growth rate of compensation per employee stood at 4.5 per cent in the second quarter of 2024, albeit down from its peak of 5.6 per cent in the second quarter of 2023. Recently, the incoming information for 2024 in the ECB wage tracker indicator of latest agreements shows that wage agreements signed in 2024 had substantially lower structural wage growth for the next 12 months if their previous agreement was signed in 2023 or 2022, as compared with 2021 (Chart 8, left panel). Moreover, in the months ahead, there are fewer wage agreements coming up for renegotiation that have not had an agreement since the surge in inflation (Chart 8, right panel). This suggests that the catching up motive in wage negotiations is losing ground as inflation normalises. Forward-looking indicators suggest further diminishing wage pressures into 2025 (Chart 9). The forward-looking wage tracker (dark blue line in Chart 9) shows the wage growth until the end of 2025 in the available contracts that have been agreed and signed. One caveat in interpreting developments in the forward- looking wage tracker is that, since it only considers agreements that are active in the future, the contract coverage on which it is based declines as contracts expire (solid grey area in Chart 9). For this reason, scenarios for the expiring contracts (in the grey striped area) can help to assess risks around the outlook for wages. The scenarios illustrated in Chart 9 assume different renegotiated annual wage growth for expired contracts: (i) full pass-through of HICP and real productivity growth top-up to wages; (ii) HICPX and real productivity growth top-up to wages; (iii) wages increase at the same very strong level as contracts signed in the second quarter of 2024 that were still recouping large real wage losses (this is an upper bound scenario). Even this upper-bound scenario points to a slowdown in wage pressures in 2025 compared with 2024. This reflects in part that base effects, for example those related to high one-off payments this year, will dampen future wage growth in year-on-year terms. Chart 8 Euro area wage tracker (annual percentage changes (left panel) and millions of workers (right panel)) 12-months-ahead growth for contracts signed in 2024 by ts preceding agreement signing year Expiring agreements by preceding contract signing 8 m 2021 =m 2024 mm 2022 Pre-2021 2023 7 16 7 14 5 12 4 10 8 3 6 2 4 P 0 2021 2022 2023 ate rae Q3 2024 Q42024 Q1 2025 Q2 2025 Sources: Calculated based on micro data on wage agreements provided by the Deutsche Bundesbank, Banco de Espafia, the Dutch employer association (AWVN), Oesterreichische Nationalbank, Bank of Greece, Banca d'Italia, Bank of Ireland and Banque de France. Note: The latest observations are for June 2025 for the workers under expiring agreements. Chart 9 Euro area wage tracker - forward-looking scenarios (annual percentage changes) ". Coverage for forecast scenarios (right-hand scale) = Forecast scenario HICP+PROD including one-off payments tm Coverage for active contracts (right-hand scale) = Forecast scenario HICPX+PROD including one-off payments = Wage tracker including one-off payments = Forecast scenario Q2 2024 including one-off payments 06/24 12/24 06/25 12/25 Sources: ECB staff calculations based on the ECB wage tracker database. Notes: The forecast scenarios take sectors with contracts expiring after the current date and assumes that new contracts are concluded with a structural wage increase per year based on a full pass-through of projected (September 2024 ECB staff projections) HICP or HICPX inflation and productivity growth (scenarios HICP+PROD and HICPX+PROD), or at the same rate of wage increase observed for contracts signed in the second quarter of 2024 (forecast scenario Q2 2024). The forward-looking tracker only considers active agreements. All scenarios include one-off payments smoothed over 12 months. The latest observations are for December 2025. The latest information from surveys reinforces the projection of easing wage growth that will underpin the moderation in services inflation and domestic inflation. Chart 10 presents consecutive rounds of various ECB surveys, which provide a wealth of valuable information that helps us gauge the pulse of the economy in real time. The incoming survey information on wage growth provided by both firms and professional forecasters confirm the narrative embedded in our September 2024 ECB staff projection that wage growth will ease in 2025 compared with 2024, primarily owing to the fading out of the catch- up dynamic that has dominated wage negotiations between 2022 and 2024. Chart 10 Eurosystem and ECB staff macroeconomic projections on wages and survey-based wage expectations (annual percentage changes) Ms September 2024 ECB staff projections WH CTS July 2024 Ms June 2024 Eurosystem staff projections Ms Consensus October 2024 = Survey of Professional Forecasters 2024 Q4 "4 Consensus September 2024 "2 - Survey of Professional Forecasters 2024 Q3 Mm OSAFE 2024 Q2 Mm CTS October 2024 Wa SAFE 2024Q1 5.0 jn 7) ZA 2024 2026 Sources: Survey of Professional Forecasters (SPF), June 2024 Eurosystem Staff Macroeconomic Projections and September 2024 ECB Staff Macroeconomic Projections, September and October 2024 Consensus Economics Forecasts, July and October Corporate Telephone Survey (CTS) and the survey on the access to finance of enterprises (SAFE) for the first and second quarters of 2024. Notes: The SAFE survey asks 12-month-ahead wage growth, while all the other surveys are for calendar years. In summary, in analysing services inflation and domestic inflation, it is crucial to distinguish between the underlying persistent component that matters for the medium term and the backward-looking reverting component that takes time to fade out but that ultimately reflects the staggered nature of the adjustment process to the original and extraordinary inflation shocks. This backward-looking component has been substantial: the inflation shocks of 2021-2022 spread across sectors at varying speeds. The slowest-moving sectors were those in which prices adjust more slowly or are most closely tied to wage adjustment. For these indicators, we need patience as the normalisation process takes time. Conclusion In my remarks today, I have sought to provide an update on the dynamics of underlying inflation. I have emphasised that underlying inflation measures not only serve to extract the persistent component from the latest inflation readings but also provide insights into the nature of disinflation, especially in relation to the staggered nature of the adjustment process. In particular, the analysis of underlying inflation suggests that 2024 is a transition year, in which backward-looking components are still playing out. But the analysis of underlying inflation also indicates that the disinflation process is well on track, and inflation is set to return to target in the course of 2025. I am grateful to Katalin Bodnar, Bruno Fagandini, Peter Healy, Eliza Lis and Lourdes Maria Zulli Gandur for their contributions to this speech. 2. Banbura, M. and Bobeica, E. (2020), "PCCI - a data-rich measure of underlying inflation in the euro area" Statistics Paper Series No. 38, ECB. The PCCI is similar in spirit to the New York's Fed Multivariate Core Trend. See Almuzara, M. and Sbordone, A. (2024), "Measurement and Theory of Core Inflation", Staff Reports No 1115, Federal Reserve Bank of New York. 3. Most of this decline happened by March this year, since then it has edged down only slightly. 4. Lane, P. (2023), "Underlying inflation", lecture at Trinity College Dublin, Dublin, 6 March 2023. 5. See, for instance, Forbes, K., Jongrim, H. and Ayhan, K. M. (2024), "Rate Cycles", presentation at the 2024 ECB Forum on Central Banking Sintra, Portugal, 3 July. 6. This is confirmed when employing a forecast combination algorithm for the available underlying inflation measures designed to minimise the two-year ahead RMSFE for headline inflation. Over time, the algorithm tends to pick one or more of the monitored measures, but recently PCCls have prevailed. 7. To the extent that trend productivity growth is higher in more tradable sectors such as manufacturing than in less tradable sectors such as services, the relative price of services will trend higher over time so that the average inflation rate for services will be higher than for goods. At the same time, the equilibrium relative price of services versus goods can shift over time due to a range of factors. 8. See Frohling, A., O'Brien, D. and Schaefer, S. (2022). "A new indicator of domestic inflation for the euro area", Economic Bulletin, Ilssue 4, ECB. Currently, the indicator includes those items where the import contents is below 18 per cent, where the threshold for inclusion was chosen by the forecasting performance of this indicator for medium-term inflation. 9. Dedola, L., Henkel, L., Hdynck, C., Osbat, C. and Santoro, S. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?," Economic Bulletin Articles, European Central Bank, vol. 3. 10. See Banca d'Italia (2023), "The heterogenous developments of the components of euro area-core inflation", Economic Bulletin, No 4. 11. The gap has already closed for goods inflation. 12. The seasonally adjusted month-on-month rate of services prices declined in September, in part correcting for the impact of the 2024 Olympics. Looking through this impact, the month-on-month rate moved down and was close to its long-term average in August and September pointing to disinflationary dynamics. 13. Fagandini, B., Goncalves, E., Rubene, I., Kouvavas, O., Bodnar, K. and Koester, G. (2024), "Decomposing HICPX inflation into energy-sensitive and wage-sensitive items", Economic Bulletin, Issue 3, European Central Bank. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # underlying inflation: an update ## Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Inflation: Drivers and Dynamics Conference 2024 organised by the Federal Reserve Bank of Cleveland and the ECB Cleveland, 24 October 2024 ## Introduction My aim today is to provide an update on underlying inflation in the euro area. ${ }^{[1]}$ The concept of underlying inflation plays a central role in the conduct of the ECB's monetary policy: our interest rate decisions are based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. This three-pronged reaction function complements the traditional focus on the inflation forecast for inflation-targeting central banks with the signals embodied in underlying inflation measures, while also incorporating the evolving evidence on the strength of monetary policy transmission in the calibration of the monetary stance. This pragmatic approach reflects the value of data dependence under highly atypical macroeconomic conditions. ## Latest developments in euro area underlying inflation Underlying inflation is the persistent component of inflation, signalling where headline inflation will settle in the medium term after temporary factors have vanished. In practice, underlying inflation is unobservable and needs to be proxied or estimated. There are two broad categories of measures that aim to capture this concept. Exclusion-based measures omit certain items - such as energy and food that are typically volatile and more sensitive to global factors than domestic fundamentals. Model-based measures, meanwhile, capture more complex channels and dynamics, subject to the limitations imposed by sensitivity to model estimation. An overview of such measures is shown in Chart 1. Model-based measures at the ECB include the Persistent and Common Component of Inflation (PCCI), which is constructed by estimating a dynamic factor model that extracts the persistent and common component of inflation from granular price data at the item-country level, thereby exploiting the relative advantages of both cross-sectional and time series approaches. ${ }^{[2]}$ Another model-based measure is Supercore inflation, which picks out those items that are estimated to co-move with the business cycle. These model-based measures are reduced form in nature and, among other factors, reflect the empirical contribution of monetary policy tightening to delivering disinflation. That is to say, if current inflation is above target, one reason why underlying inflation might run below current inflation is that the projected mean reversion is partly driven by endogenous monetary policy tightening that has historically contributed to the return of inflation to the target over the medium term. In turn, monitoring ---[PAGE_BREAK]--- the evolution of underlying inflation is an important element in diagnosing whether monetary policy is appropriately calibrated. Each of the underlying inflation indicators tracked by the ECB has declined significantly since the postpandemic inflation surges, with the range narrowing towards its historical average. The majority of indicators are hovering around 1.9 per cent to 2.8 per cent, down from a much wider range between 3.4 per cent to 7.5 per cent at its peak (Chart 1). Core inflation is the most prominent exclusion-based measure, defined as HICP inflation excluding energy and food: this edged down to 2.7 per cent in September, continuing the marked decline from 4.5 per cent a year ago. ${ }^{[3]}$ In terms of model-based measures, the PCCI today is at the bottom of the range, standing at 1.9 per cent in September and having hovered around 2.0 per cent since the end of last year. Most other measures that we regularly monitor have also come down over the past year and show signs of continued easing in September. One challenge in interpreting standard indicators of underlying inflation is that these were affected by the past extraordinary supply shocks, as well as by temporary mismatches between demand and supply. As I pointed out in my March 2023 speech, it is helpful to think of headline inflation as being driven by three factors: (i) underlying inflation; (ii) a reverting component; and (iii) pure noise. ${ }^{[5]}$ In particular, the major dislocations of recent years induced a substantial reverting component of inflation that was sufficiently long-lasting not to constitute pure noise but that was also expected to fade out over time. These dislocations included the impact of energy inflation and supply bottlenecks. To capture their indirect impact on measures of underlying inflation, we have in parallel monitored adjusted measures of underlying inflation that "partial out" these indirect influences. These adjusted measures had a significantly lower peak rate of underlying inflation than the un-adjusted measures but, by construction, were also less affected by the sharp turnaround in energy prices and easing of supply bottlenecks during 2023 that flattered the speed of progress in the un-adjusted measures. Currently, these adjustments bring down the range to between 2 per cent and 2.5 per cent, as the impact of past supplyside shocks has greatly diminished. In particular, the forward-looking PCCI measures are by now free of such impacts. ---[PAGE_BREAK]--- # Chart 1 Euro area underlying inflation measures and their adjusted counterpart (annual percentage changes) Exclusion-based measures Model-based measures ![img-0.jpeg](img-0.jpeg) Sources: Eurostat and ECB calculations. Notes: HICPX stands for HICP inflation excluding energy and food; HICPXX for HICP inflation excluding energy, food, travel-related items, clothing and footwear; PCCI is the persistent and common component of inflation, while Supercore aggregates HICPX items sensitive to domestic business cycle. See also Bańbura et al. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB. The 'adjusted' measures abstract from energy and supply-bottlenecks shocks using a large SVAR, see Bańbura, M., Bobeica, E. and Martínez-Hernández, C. 2023, "What drives core inflation? The role of supply shocks.", ECB Working Paper No 2875. The latest observations are for September 2024. Each measure of underlying inflation provides useful information about future headline inflation, although their forecasting performance varies. Chart 2 shows the root mean squared forecast error (RMSFE) for each measure vis-à-vis inflation two years ahead and vis-à-vis a smoothed inflation rate. Forecasting performance is normalised to the predictive power of current headline inflation: that is, a ratio below unity means that the measure does a better job than current headline inflation in forecasting future inflation. Indeed, most measures beat current headline inflation in forecasting future inflation. The PCCI measures have the best predictive power, while most exclusion-based measures perform less well. However, in understanding the inflation process and calibrating monetary policy, it is essential to look beyond overall predictive power and also examine how the various underlying inflation measures can shed light on the speed and sequencing of the disinflation process. For instance, external shocks were a prominent feature of the post-pandemic economic landscape. ${ }^{[5]}$ While the PCCI measures provided a powerful signal that these shocks would ultimately fade out, the delayed and lagged adjustment in indicators such as services inflation, domestic inflation and wage growth served to highlight that ---[PAGE_BREAK]--- convergence to the medium-term target would not be immediate. ${ }^{[5]}$ I will focus on these indicators in the next part of my talk. # Chart 2 Predictive properties of underlying inflation measures for HICP inflation (RMSFE of each measure relative to RMSFE of headline inflation) ![img-1.jpeg](img-1.jpeg) Sources: Eurostat and ECB calculations. Notes: RMSFE 24 months and RMSFE smoothed HICP are the root mean squared forecast errors of each measure with respect to headline inflation 24 months ahead and the two-year centred moving average of inflation covering two years of future data, respectively, divided by the RMSFE of headline inflation. A ratio lower than unity indicates that the measure performs better than headline inflation. The sample covers the period from April 2001 to September 2024. ## Services, domestic inflation and wages Domestic inflation captures price dynamics in consumption items that are less influenced by external factors, being more determined by domestic economic conditions, including monetary policy. While trends in the relative prices of globally-determined components (mostly in the energy, food and goods categories) mean that the two per cent target for overall inflation is not a target for domestic inflation, domestic inflation cannot remain at an excessive level if the target is to be sustainably achieved. ${ }^{[7]}$ Moreover, assessing the strength of domestic inflation is essential to the calibration of monetary policy, since domestic inflation will be more responsive than global inflation components to the impact of monetary policy via the dampening of domestic demand. The domestic inflation indicator monitored at the ECB is an aggregation of HICP items with low import content. ${ }^{[8]}$ As shown in Chart 3, domestic inflation and services inflation co-move closely. This reflects the dominance of services items in the domestic inflation measures, accounting for 97 per cent of the overall index. At the same time, it remains useful to maintain domestic inflation and services inflation as separate measures: while almost 80 per cent of the services items are included in the domestic inflation index, the overall services category also includes highly-traded services items (Chart 4). These internationally-traded services items currently have a lower contribution to services inflation than domestic services items. ---[PAGE_BREAK]--- # Chart 3 ## Services inflation and domestic inflation (annual percentage changes) ![img-2.jpeg](img-2.jpeg) Sources: Eurostat and ECB staff calculations. Notes: Domestic inflation is an aggregate of HICP items with a relatively low import intensity, as explained in Fröhling, A., O'Brien, D. and Schaefer, S. (2022), "A new indicator of domestic inflation for the euro area", Economic Bulletin, Issue 4, ECB. The latest observations are for September 2024. ---[PAGE_BREAK]--- # Chart 4 ## Services inflation and domestic inflation (percentage point contribution to services inflation) ![img-3.jpeg](img-3.jpeg) Sources: Eurostat and ECB staff calculations. Notes: The chart shows all services items and the $x$ axis shows the contribution of each item to total services inflation in September 2024. In weighted terms, 80 per cent of services are in domestic inflation and 97 per cent of domestic inflation is composed of services items. Domestic inflation also includes three good items which are not shown on the chart. The large supply-side shocks of the post-pandemic period have been feeding through to domestic inflation with a lag compared with other measures of underlying inflation. Large supply-side shocks have travelled across sectors and consumption items at different speeds, so it is unsurprising that these had differential impacts on the various measures of underlying inflation, depending on their nature and construction. Domestic inflation and services inflation tend to lag headline inflation more than other measures, exhibiting a lower frequency of price adjustment compared with the energy, food and goods categories in the HICP. ${ }^{[9]}$ For this reason, many items in services inflation and domestic inflation were late movers that responded with a much longer lag to the latest inflationary shock, such that annual services inflation remains elevated. ${ }^{[10]}$ Chart 5 shows the impact of energy and supply-chain bottlenecks on the PCCIs, domestic inflation and other measures of underlying inflation. Among these measures, PCCIs are more forward-looking and have picked up certain shocks faster, but with the byproduct that the effects of the shocks also faded quicker. Other indicators, like domestic inflation, are more backwardlooking, and the currently higher levels also reflect the still ongoing propagation of past shocks. In similar vein, the past shocks took longer to build up in domestic inflation and are also taking longer to dissipate. ---[PAGE_BREAK]--- # Chart 5 Impact of energy and supply-side bottlenecks shocks across measures of underlying inflation (percentage points) impact of energy-related shocks Impact of global supply chain-related shocks ![img-4.jpeg](img-4.jpeg) Sources: Eurostat and ECB calculations Notes: The range covers the estimated impact of shocks across all monitored underlying inflation measures. The impact of the energy and supply bottleneck shocks are estimated in a large SVAR, see Baribura, M. et al. (2023), op. cit.. The latest observations are for September 2024. The PCCI for services indicates that there is currently a sizeable gap between services inflation and its medium-term underlying trend, suggesting there is scope for downward adjustment in services inflation in the coming months. Services PCCI has been around 2.4 per cent since the end of last year, well below the current annual rate for services (Chart 6, left panel). ${ }^{[11]}$ This difference suggests that idiosyncratic and non-persistent factors are currently driving services inflation. Examples of such idiosyncratic factors include the base effect related to the introduction of the cheap travel Deutschlandticket in Germany in May 2023, rent inflation in the Netherlands, and items that reprice less frequently, such as insurance or other administered prices (like hospital services) in some countries. Over time, the fading out of these idiosyncratic and temporary factors should means that services inflation declines towards the underlying rate. Indeed, momentum indicators for services confirm the slight easing of inflation dynamics. While services momentum (i.e. the three-month-on-three-month growth rate of the seasonally-adjusted index) remains high, it has been continuously easing since May (Chart 6, right panel). The month-on-month seasonally-adjusted rate markedly dropped in September. ---[PAGE_BREAK]--- # Chart 6 ## Services inflation (annual percentage changes (left panel) and annualised three-month-on-three-month and month-on-month changes (right panel)) ![img-5.jpeg](img-5.jpeg) Sources: Eurostat and ECB staff calculations. Note: The latest observations are for September 2024. Services and domestic inflation are closely linked to wage growth: the expected easing of wage growth in 2025, together with the impact of past monetary policy tightening, should contribute to further disinflation. Wages constitute a higher direct share in costs of services than goods and Chart 7 highlights the strong link between domestic inflation, services and wages: their level is normally similar and they closely co-move with each other. ${ }^{[13]}$ Chart 7 also shows how pressures in these three components can take time to moderate following a tightening in policy. ---[PAGE_BREAK]--- # Chart 7 Services and domestic inflation and wage growth after episodes of monetary policy tightening ![img-6.jpeg](img-6.jpeg) Sources: Eurostat, ECB and ECB calculations. Notes: Shaded areas show monetary policy tightening episodes. CPE stands for compensation per employee. The dotted line shows latest Eurostat data up to Q2 2024 for CPE carried forward with quarter-on-quarter rates from the September ECB staff projections. The latest observations are for the second quarter of 2024 for CPE and the third quarter of 2024 for the rest. Wage growth is expected to ease from its current high level, with the cumulative increase in nominal wages over 2023-2024 largely restoring the purchasing power that was lost during the inflation surges of 2021-2022. Wage pressures are currently still high: the growth rate of compensation per employee stood at 4.5 per cent in the second quarter of 2024, albeit down from its peak of 5.6 per cent in the second quarter of 2023. Recently, the incoming information for 2024 in the ECB wage tracker indicator of latest agreements shows that wage agreements signed in 2024 had substantially lower structural wage growth for the next 12 months if their previous agreement was signed in 2023 or 2022, as compared with 2021 (Chart 8, left panel). Moreover, in the months ahead, there are fewer wage agreements coming up for renegotiation that have not had an agreement since the surge in inflation (Chart 8, right panel). This suggests that the catching up motive in wage negotiations is losing ground as inflation normalises. Forward-looking indicators suggest further diminishing wage pressures into 2025 (Chart 9). The forward-looking wage tracker (dark blue line in Chart 9) shows the wage growth until the end of 2025 in the available contracts that have been agreed and signed. ---[PAGE_BREAK]--- One caveat in interpreting developments in the forward- looking wage tracker is that, since it only considers agreements that are active in the future, the contract coverage on which it is based declines as contracts expire (solid grey area in Chart 9). For this reason, scenarios for the expiring contracts (in the grey striped area) can help to assess risks around the outlook for wages. The scenarios illustrated in Chart 9 assume different renegotiated annual wage growth for expired contracts: (i) full pass-through of HICP and real productivity growth top-up to wages; (ii) HICPX and real productivity growth top-up to wages; (iii) wages increase at the same very strong level as contracts signed in the second quarter of 2024 that were still recouping large real wage losses (this is an upper bound scenario). Even this upper-bound scenario points to a slowdown in wage pressures in 2025 compared with 2024. This reflects in part that base effects, for example those related to high one-off payments this year, will dampen future wage growth in year-on-year terms. # Chart 8 Euro area wage tracker (annual percentage changes (left panel) and millions of workers (right panel)) 12-months-ahead growth for contracts signed in 2024 by Expiring agreements by preceding contract signing ts preceding agreement signing year ![img-7.jpeg](img-7.jpeg) Sources: Calculated based on micro data on wage agreements provided by the Deutsche Bundesbank, Banco de España, the Dutch employer association (AWVN), Oesterreichische Nationalbank, Bank of Greece, Banca d'Italia, Bank of Ireland and Banque de France. Note: The latest observations are for June 2025 for the workers under expiring agreements. ---[PAGE_BREAK]--- # Chart 9 ## Euro area wage tracker - forward-looking scenarios ![img-8.jpeg](img-8.jpeg) Sources: ECB staff calculations based on the ECB wage tracker database. Notes: The forecast scenarios take sectors with contracts expiring after the current date and assumes that new contracts are concluded with a structural wage increase per year based on a full pass-through of projected (September 2024 ECB staff projections) HICP or HICPX inflation and productivity growth (scenarios HICP+PROD and HICPX+PROD), or at the same rate of wage increase observed for contracts signed in the second quarter of 2024 (forecast scenario Q2 2024). The forward-looking tracker only considers active agreements. All scenarios include one-off payments smoothed over 12 months. The latest observations are for December 2025. The latest information from surveys reinforces the projection of easing wage growth that will underpin the moderation in services inflation and domestic inflation. Chart 10 presents consecutive rounds of various ECB surveys, which provide a wealth of valuable information that helps us gauge the pulse of the economy in real time. The incoming survey information on wage growth provided by both firms and professional forecasters confirm the narrative embedded in our September 2024 ECB staff projection that wage growth will ease in 2025 compared with 2024, primarily owing to the fading out of the catchup dynamic that has dominated wage negotiations between 2022 and 2024. ---[PAGE_BREAK]--- Chart 10 Eurosystem and ECB staff macroeconomic projections on wages and survey-based wage expectations ![img-9.jpeg](img-9.jpeg) Sources: Survey of Professional Forecasters (SPF), June 2024 Eurosystem Staff Macroeconomic Projections and September 2024 ECB Staff Macroeconomic Projections, September and October 2024 Consensus Economics Forecasts, July and October Corporate Telephone Survey (CTS) and the survey on the access to finance of enterprises (SAFE) for the first and second quarters of 2024. Notes: The SAFE survey asks 12-month-ahead wage growth, while all the other surveys are for calendar years. In summary, in analysing services inflation and domestic inflation, it is crucial to distinguish between the underlying persistent component that matters for the medium term and the backward-looking reverting component that takes time to fade out but that ultimately reflects the staggered nature of the adjustment process to the original and extraordinary inflation shocks. This backward-looking component has been substantial: the inflation shocks of 2021-2022 spread across sectors at varying speeds. The slowest-moving sectors were those in which prices adjust more slowly or are most closely tied to wage adjustment. For these indicators, we need patience as the normalisation process takes time. # Conclusion In my remarks today, I have sought to provide an update on the dynamics of underlying inflation. I have emphasised that underlying inflation measures not only serve to extract the persistent component from the latest inflation readings but also provide insights into the nature of disinflation, especially in relation to the staggered nature of the adjustment process. In particular, the analysis of underlying inflation suggests that 2024 is a transition year, in which backward-looking components are still playing out. But the analysis of underlying inflation also indicates that the disinflation process is well on track, and inflation is set to return to target in the course of 2025. ---[PAGE_BREAK]--- I am grateful to Katalin Bodnar, Bruno Fagandini, Peter Healy, Eliza Lis and Lourdes María Zulli Gandur for their contributions to this speech. 2. Bańbura, M. and Bobeica, E. (2020), "PCCI - a data-rich measure of underlying inflation in the euro area" Statistics Paper Series No. 38, ECB. The PCCI is similar in spirit to the New York's Fed Multivariate Core Trend. See Almuzara, M. and Sbordone, A. (2024), "Measurement and Theory of Core Inflation", Staff Reports No 1115, Federal Reserve Bank of New York. 3. Most of this decline happened by March this year, since then it has edged down only slightly. 4. Lane, P. (2023), "Underlying inflation", lecture at Trinity College Dublin, Dublin, 6 March 2023. 5. See, for instance, Forbes, K., Jongrim, H. and Ayhan, K. M. (2024), "Rate Cycles", presentation at the 2024 ECB Forum on Central Banking Sintra, Portugal, 3 July. 6. This is confirmed when employing a forecast combination algorithm for the available underlying inflation measures designed to minimise the two-year ahead RMSFE for headline inflation. Over time, the algorithm tends to pick one or more of the monitored measures, but recently PCCIs have prevailed. 7. To the extent that trend productivity growth is higher in more tradable sectors such as manufacturing than in less tradable sectors such as services, the relative price of services will trend higher over time so that the average inflation rate for services will be higher than for goods. At the same time, the equilibrium relative price of services versus goods can shift over time due to a range of factors. 8. See Fröhling, A., O'Brien, D. and Schaefer, S. (2022). "A new indicator of domestic inflation for the euro area", Economic Bulletin, Issue 4, ECB. Currently, the indicator includes those items where the import contents is below 18 per cent, where the threshold for inclusion was chosen by the forecasting performance of this indicator for medium-term inflation. 9. Dedola, L., Henkel, L., Höynck, C., Osbat, C. and Santoro, S. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?," Economic Bulletin Articles, European Central Bank, vol. 3. 10. ---[PAGE_BREAK]--- See Banca d'Italia (2023), "The heterogenous developments of the components of euro area-core inflation", Economic Bulletin, No 4. 11. The gap has already closed for goods inflation. 12. The seasonally adjusted month-on-month rate of services prices declined in September, in part correcting for the impact of the 2024 Olympics. Looking through this impact, the month-on-month rate moved down and was close to its long-term average in August and September pointing to disinflationary dynamics. 13. Fagandini, B., Gonçalves, E., Rubene, I., Kouvavas, O., Bodnár, K. and Koester, G. (2024), "Decomposing HICPX inflation into energy-sensitive and wage-sensitive items", Economic Bulletin. Issue 3, European Central Bank.	Philip R Lane	Euro area	https://www.bis.org/review/r241028g.pdf	Cleveland, 24 October 2024 My aim today is to provide an update on underlying inflation in the euro area. The concept of underlying inflation plays a central role in the conduct of the ECB's monetary policy: our interest rate decisions are based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. This three-pronged reaction function complements the traditional focus on the inflation forecast for inflation-targeting central banks with the signals embodied in underlying inflation measures, while also incorporating the evolving evidence on the strength of monetary policy transmission in the calibration of the monetary stance. This pragmatic approach reflects the value of data dependence under highly atypical macroeconomic conditions. Underlying inflation is the persistent component of inflation, signalling where headline inflation will settle in the medium term after temporary factors have vanished. In practice, underlying inflation is unobservable and needs to be proxied or estimated. There are two broad categories of measures that aim to capture this concept. Exclusion-based measures omit certain items - such as energy and food that are typically volatile and more sensitive to global factors than domestic fundamentals. Model-based measures, meanwhile, capture more complex channels and dynamics, subject to the limitations imposed by sensitivity to model estimation. An overview of such measures is shown in Chart 1. Model-based measures at the ECB include the Persistent and Common Component of Inflation (PCCI), which is constructed by estimating a dynamic factor model that extracts the persistent and common component of inflation from granular price data at the item-country level, thereby exploiting the relative advantages of both cross-sectional and time series approaches. Another model-based measure is Supercore inflation, which picks out those items that are estimated to co-move with the business cycle. These model-based measures are reduced form in nature and, among other factors, reflect the empirical contribution of monetary policy tightening to delivering disinflation. That is to say, if current inflation is above target, one reason why underlying inflation might run below current inflation is that the projected mean reversion is partly driven by endogenous monetary policy tightening that has historically contributed to the return of inflation to the target over the medium term. In turn, monitoring the evolution of underlying inflation is an important element in diagnosing whether monetary policy is appropriately calibrated. Each of the underlying inflation indicators tracked by the ECB has declined significantly since the postpandemic inflation surges, with the range narrowing towards its historical average. The majority of indicators are hovering around 1.9 per cent to 2.8 per cent, down from a much wider range between 3.4 per cent to 7.5 per cent at its peak. Core inflation is the most prominent exclusion-based measure, defined as HICP inflation excluding energy and food: this edged down to 2.7 per cent in September, continuing the marked decline from 4.5 per cent a year ago. In terms of model-based measures, the PCCI today is at the bottom of the range, standing at 1.9 per cent in September and having hovered around 2.0 per cent since the end of last year. Most other measures that we regularly monitor have also come down over the past year and show signs of continued easing in September. One challenge in interpreting standard indicators of underlying inflation is that these were affected by the past extraordinary supply shocks, as well as by temporary mismatches between demand and supply. As I pointed out in my March 2023 speech, it is helpful to think of headline inflation as being driven by three factors: (i) underlying inflation; (ii) a reverting component; and (iii) pure noise. In particular, the major dislocations of recent years induced a substantial reverting component of inflation that was sufficiently long-lasting not to constitute pure noise but that was also expected to fade out over time. These dislocations included the impact of energy inflation and supply bottlenecks. To capture their indirect impact on measures of underlying inflation, we have in parallel monitored adjusted measures of underlying inflation that "partial out" these indirect influences. These adjusted measures had a significantly lower peak rate of underlying inflation than the un-adjusted measures but, by construction, were also less affected by the sharp turnaround in energy prices and easing of supply bottlenecks during 2023 that flattered the speed of progress in the un-adjusted measures. Currently, these adjustments bring down the range to between 2 per cent and 2.5 per cent, as the impact of past supplyside shocks has greatly diminished. In particular, the forward-looking PCCI measures are by now free of such impacts. Euro area underlying inflation measures and their adjusted counterpart Exclusion-based measures The latest observations are for September 2024. Each measure of underlying inflation provides useful information about future headline inflation, although their forecasting performance varies. Chart 2 shows the root mean squared forecast error (RMSFE) for each measure vis-à-vis inflation two years ahead and vis-à-vis a smoothed inflation rate. Forecasting performance is normalised to the predictive power of current headline inflation: that is, a ratio below unity means that the measure does a better job than current headline inflation in forecasting future inflation. Indeed, most measures beat current headline inflation in forecasting future inflation. The PCCI measures have the best predictive power, while most exclusion-based measures perform less well. However, in understanding the inflation process and calibrating monetary policy, it is essential to look beyond overall predictive power and also examine how the various underlying inflation measures can shed light on the speed and sequencing of the disinflation process. For instance, external shocks were a prominent feature of the post-pandemic economic landscape. I will focus on these indicators in the next part of my talk. Predictive properties of underlying inflation measures for HICP inflation Domestic inflation captures price dynamics in consumption items that are less influenced by external factors, being more determined by domestic economic conditions, including monetary policy. While trends in the relative prices of globally-determined components (mostly in the energy, food and goods categories) mean that the two per cent target for overall inflation is not a target for domestic inflation, domestic inflation cannot remain at an excessive level if the target is to be sustainably achieved. Moreover, assessing the strength of domestic inflation is essential to the calibration of monetary policy, since domestic inflation will be more responsive than global inflation components to the impact of monetary policy via the dampening of domestic demand. The domestic inflation indicator monitored at the ECB is an aggregation of HICP items with low import content. As shown in Chart 3, domestic inflation and services inflation co-move closely. This reflects the dominance of services items in the domestic inflation measures, accounting for 97 per cent of the overall index. At the same time, it remains useful to maintain domestic inflation and services inflation as separate measures: while almost 80 per cent of the services items are included in the domestic inflation index, the overall services category also includes highly-traded services items. These internationally-traded services items currently have a lower contribution to services inflation than domestic services items. The latest observations are for September 2024. The large supply-side shocks of the post-pandemic period have been feeding through to domestic inflation with a lag compared with other measures of underlying inflation. Large supply-side shocks have travelled across sectors and consumption items at different speeds, so it is unsurprising that these had differential impacts on the various measures of underlying inflation, depending on their nature and construction. Domestic inflation and services inflation tend to lag headline inflation more than other measures, exhibiting a lower frequency of price adjustment compared with the energy, food and goods categories in the HICP. Chart 5 shows the impact of energy and supply-chain bottlenecks on the PCCIs, domestic inflation and other measures of underlying inflation. Among these measures, PCCIs are more forward-looking and have picked up certain shocks faster, but with the byproduct that the effects of the shocks also faded quicker. Other indicators, like domestic inflation, are more backwardlooking, and the currently higher levels also reflect the still ongoing propagation of past shocks. In similar vein, the past shocks took longer to build up in domestic inflation and are also taking longer to dissipate. Impact of energy and supply-side bottlenecks shocks across measures of underlying inflation impact of energy-related shocks The latest observations are for September 2024. The PCCI for services indicates that there is currently a sizeable gap between services inflation and its medium-term underlying trend, suggesting there is scope for downward adjustment in services inflation in the coming months. Services PCCI has been around 2.4 per cent since the end of last year, well below the current annual rate for services (Chart 6, left panel). This difference suggests that idiosyncratic and non-persistent factors are currently driving services inflation. Examples of such idiosyncratic factors include the base effect related to the introduction of the cheap travel Deutschlandticket in Germany in May 2023, rent inflation in the Netherlands, and items that reprice less frequently, such as insurance or other administered prices (like hospital services) in some countries. Over time, the fading out of these idiosyncratic and temporary factors should means that services inflation declines towards the underlying rate. Indeed, momentum indicators for services confirm the slight easing of inflation dynamics. While services momentum (i.e. the three-month-on-three-month growth rate of the seasonally-adjusted index) remains high, it has been continuously easing since May (Chart 6, right panel). The month-on-month seasonally-adjusted rate markedly dropped in September. Services and domestic inflation are closely linked to wage growth: the expected easing of wage growth in 2025, together with the impact of past monetary policy tightening, should contribute to further disinflation. Wages constitute a higher direct share in costs of services than goods and Chart 7 highlights the strong link between domestic inflation, services and wages: their level is normally similar and they closely co-move with each other. Chart 7 also shows how pressures in these three components can take time to moderate following a tightening in policy. Wage growth is expected to ease from its current high level, with the cumulative increase in nominal wages over 2023-2024 largely restoring the purchasing power that was lost during the inflation surges of 2021-2022. Wage pressures are currently still high: the growth rate of compensation per employee stood at 4.5 per cent in the second quarter of 2024, albeit down from its peak of 5.6 per cent in the second quarter of 2023. Recently, the incoming information for 2024 in the ECB wage tracker indicator of latest agreements shows that wage agreements signed in 2024 had substantially lower structural wage growth for the next 12 months if their previous agreement was signed in 2023 or 2022, as compared with 2021 (Chart 8, left panel). Moreover, in the months ahead, there are fewer wage agreements coming up for renegotiation that have not had an agreement since the surge in inflation (Chart 8, right panel). This suggests that the catching up motive in wage negotiations is losing ground as inflation normalises. Forward-looking indicators suggest further diminishing wage pressures into 2025. The forward-looking wage tracker (dark blue line in Chart 9) shows the wage growth until the end of 2025 in the available contracts that have been agreed and signed. One caveat in interpreting developments in the forward- looking wage tracker is that, since it only considers agreements that are active in the future, the contract coverage on which it is based declines as contracts expire (solid grey area in Chart 9). For this reason, scenarios for the expiring contracts (in the grey striped area) can help to assess risks around the outlook for wages. The scenarios illustrated in Chart 9 assume different renegotiated annual wage growth for expired contracts: (i) full pass-through of HICP and real productivity growth top-up to wages; (ii) HICPX and real productivity growth top-up to wages; (iii) wages increase at the same very strong level as contracts signed in the second quarter of 2024 that were still recouping large real wage losses (this is an upper bound scenario). Even this upper-bound scenario points to a slowdown in wage pressures in 2025 compared with 2024. This reflects in part that base effects, for example those related to high one-off payments this year, will dampen future wage growth in year-on-year terms. Euro area wage tracker 12-months-ahead growth for contracts signed in 2024 by The latest observations are for December 2025. The latest information from surveys reinforces the projection of easing wage growth that will underpin the moderation in services inflation and domestic inflation. Chart 10 presents consecutive rounds of various ECB surveys, which provide a wealth of valuable information that helps us gauge the pulse of the economy in real time. The incoming survey information on wage growth provided by both firms and professional forecasters confirm the narrative embedded in our September 2024 ECB staff projection that wage growth will ease in 2025 compared with 2024, primarily owing to the fading out of the catchup dynamic that has dominated wage negotiations between 2022 and 2024. In summary, in analysing services inflation and domestic inflation, it is crucial to distinguish between the underlying persistent component that matters for the medium term and the backward-looking reverting component that takes time to fade out but that ultimately reflects the staggered nature of the adjustment process to the original and extraordinary inflation shocks. This backward-looking component has been substantial: the inflation shocks of 2021-2022 spread across sectors at varying speeds. The slowest-moving sectors were those in which prices adjust more slowly or are most closely tied to wage adjustment. For these indicators, we need patience as the normalisation process takes time. In my remarks today, I have sought to provide an update on the dynamics of underlying inflation. I have emphasised that underlying inflation measures not only serve to extract the persistent component from the latest inflation readings but also provide insights into the nature of disinflation, especially in relation to the staggered nature of the adjustment process. In particular, the analysis of underlying inflation suggests that 2024 is a transition year, in which backward-looking components are still playing out. But the analysis of underlying inflation also indicates that the disinflation process is well on track, and inflation is set to return to target in the course of 2025. I am grateful to Katalin Bodnar, Bruno Fagandini, Peter Healy, Eliza Lis and Lourdes María Zulli Gandur for their contributions to this speech.
2024-10-25T00:00:00	Elizabeth McCaul: Fading crises, shifting priorities - a supervisory perspective on the regulatory cycle	Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the conference "EU banking regulation at a turning point", Rome, 25 October 2024.	Elizabeth McCaul: Fading crises, shifting priorities - a supervisory perspective on the regulatory cycle Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the conference "EU banking regulation at a turning point", Rome, 25 October 2024. * * * Introduction Thank you very much for inviting me to today's conference. I regret that I am not able to join you in person but I am sure that you are having very productive and insightful discussions. The title of the conference, "EU banking regulation at a turning point", indicates that the regulatory environment seems to be undergoing a fundamental shift. While the years following the global financial crisis have been devoted to reinforcing the regulatory framework to prevent a recurrence of similar failures, the public debate seems to have shifted away from focusing on safety and stability towards placing greater emphasis on competitiveness. Shifts in public opinion on regulation are nothing new. There is a natural ebb and flow of regulatory intensity driven by crises, economic conditions and political priorities. After a crisis, there is often strong public support for stricter regulation, which tends to weaken over time as the crisis recedes. In today's remarks, I want to give you a supervisory perspective on the regulatory cycle and its shifting priorities. I would like to make three main points. First, it is a fundamental misconception to frame safety and competitiveness as opposing forces. A stable and secure financial system forms the bedrock of long-term competitiveness. Second, the post-crisis reform agenda in Europe is not yet complete. Notably, the banking union is still unfinished and the capital markets union requires more ambition. For me, there is a clear link here between these important policy objectives and buttressing the competitiveness of the sector. Third, we need to tackle emerging risks, such as the growth of the non-bank financial intermediation (NBFI) sector, and the rising geopolitical risk, which manifests itself in a number of ways, including in concerns about cyberattacks. Tackling these risks will contribute towards ensuring the continued resilience of the financial system. Heeding the lessons from the past As the great financial crisis fades into the rearview mirror, it seems that competitiveness considerations have taken the wheel. However, just as guardrails on a motorway do not impede drivers but ensure they stay on the road, a robust regulatory framework sets safe boundaries for banks, enabling them to fulfil their role of lending to the real economy. Let me take this traffic metaphor even further. There are countless studies showing that speed limits not only reduce danger but also minimise congestion, thereby reducing the overall travel time. It's a fallacy to think that higher speed limits mean faster travel, just as laxer regulation does not lead to more sustainable growth. Similarly, regulatory competition between jurisdictions is more likely to lead to a race to the bottom than to a robust regulatory framework. Research consistently shows that well-capitalised banks are better positioned to support the real economy thanks to their enhanced capacity to absorb losses and maintain stability, even under financial stress. Specifically, impact assessments for the Basel reforms have demonstrated that while there may be short-term economic costs, these are far outweighed by the long-term benefits, most notably increased economic resilience. As for concerns over competitive advantages or disadvantages, I am not convinced that EU banks are at a disadvantage. In fact, the notion that regulatory requirements are more stringent in the EU than in the United States does not hold up to scrutiny. Evidence shows that global systemically important banks (G-SIBs) in the United States face slightly higher capital requirements than their EU counterparts. Furthermore, when we account for differences in how banks calculate risk-weighted assets, it becomes clear that average capital requirements for significant institutions in the banking union would be somewhat higher under US rules. This directly challenges some of the industry reports that suggest otherwise.1 Completing the banking union and the capital markets union Let me now move to my second point: the need to complete the banking union and the capital markets union. In recent years, Europe's banking sector has demonstrated resilience amid unforeseen challenges, including the coronavirus pandemic, the energy supply shock following Russia's invasion of Ukraine and high inflation. This resilience is reflected in the numbers: in 2015 the average ratio of non-performing loans (NPLs) for significant banks in the banking union was 7.5%, at a time when some banking systems had ratios close to 50%. At the end of the second quarter of this year, this ratio had decreased to 2.3%, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from 12.7% in 2015 to 15.8% today. Bank profitability has increased considerably in recent quarters, benefiting from higher interest rates, and return on equity now stands at 10.1%. This resilience is also a result of the strengthened supervisory and regulatory framework after the global financial crisis, including the creation of European banking supervision. The limited repercussions from the March 2023 banking sector turmoil stand as a testament to the robustness of our banking union. However, while we have made significant strides to build a more resilient banking union, the journey is far from complete. Without a European deposit insurance scheme, there cannot be a truly single banking system. Depositors across the banking union should have a uniform level of confidence that their deposits are safeguarded during crises, irrespective of their Member State or the location of their bank. We must also enhance the crisis management and deposit insurance (CMDI) framework to effectively manage the failures of small and medium-sized banks. It is crucial that authorities have the flexibility to act and that adequate funding is available for a diverse range of scenarios. Losses from bank failures should primarily be borne by the bank's shareholders and creditors. Nonetheless, the framework should also allow for the use of industry-funded safety nets when necessary to protect financial stability. In particular, deposit guarantee schemes should be equipped to support the use of crisis management tools, for example by contributing to meeting the bail-in conditions for gaining access to the Single Resolution Fund. Smaller banks, which often rely heavily on deposits as a funding source, may face challenges in issuing financial instruments that could be bailed in if the bank fails. This issue can be mitigated by clarifying and broadening the least cost test and introducing a general depositor preference based on an equal ranking of all deposits. The current review of the CMDI framework is an opportunity to bring durable fixes to the flaws I have just described. We hope the co-legislators will reach an ambitious agreement and not settle for small-scale tweaks that would largely preserve the current - and less than satisfactory - status quo. Liquidity in resolution is another important aspect of crisis management where progress is needed. A resolved bank should primarily rely on market funding for liquidity, but a public liquidity backstop can be critical to maintain confidence in the resolution process, as demonstrated by recent crises in other jurisdictions. Unlike other jurisdictions, however, the banking union lacks an effective public sector backstop mechanism to provide this temporary liquidity funding. We therefore encourage all EU stakeholders to resume discussions on setting up a European-level public backstop to ensure liquidity is provided to banks facing resolution in a timely and effective manner. The incompleteness of the banking union is a significant impediment to creating a truly integrated banking sector in Europe and optimising its competitiveness. Achieving this goal means removing unnecessary barriers to cross-border banking and enabling crossborder groups to manage liquidity and capital at the group level. A fully integrated, cross-border European banking landscape would not only make banks more efficient but also more resilient to domestic shocks, by enabling them to diversify their risks and revenue streams. This would contribute to private risk sharing and enhance the overall economy's robustness and efficiency, benefiting European citizens. Let me now turn to the second element of what is missing in Europe's financial architecture: the capital markets union. The capital markets union and the banking union are complementary projects. Progress on the capital markets union provides opportunities for banks and vice versa. And deepening the capital markets union is vital for the European economy to attract the necessary private investments to support innovation and the digital and green transitions, thus bolstering EU competitiveness. For banks, this means more cross-border activities, which would make them more competitive compared with their international counterparts. In a more integrated panEuropean capital market, banks could fully exploit economies of scale by offering similar products and services across multiple countries. Targeted harmonisations across Member States could facilitate such cross-border lending, enabling banks to better assess risks and opportunities from borrowers in other Member States. Completing the banking union would significantly accelerate the push towards a truly integrated European banking landscape. Securitisation is another measure to advance the capital markets union where banks play a key role. Given the constraints on banks' balance sheets, capital markets can complement bank lending and increase the financing available to the private sector while transferring risks to other intermediaries. Securitisation is crucial as it provides a diversified funding base for banks, a tool to transfer credit risks and new assets for investors. This can also create space for additional lending to the economy. Tackling emerging risks - non-bank financial institutions and rising geopolitical risks While non-banks may help in financing the significant needs of the twin green and digital transition, they also necessitate adequate regulation and close monitoring. The growth in the NBFI sector is staggering. In the euro area the sector has more than doubled in size, from €15 trillion in 2008 to €32 trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from €87 trillion in 2008 to €200 trillion in 2022. The private credit market is a particular concern. It accounts for €1.6 trillion of the global market and has also seen significant growth recently. The European private credit market growth is accelerating by 29% in the last three years, but the market is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We recently completed a deep dive on the topic and found that banks are not able to fully identify the myriad ways they have exposure to private credit funds. Therefore, concentration risk could be significant. We know that risk from the NBFI sector can materialise through various channels. One such channel is the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque, we should further harmonise, enhance and expand reporting requirements and make information-sharing between authorities easier at the global level. The growth in the NBFI market is not the only concern we have about the current risk environment. There is ample evidence in our constant media feeds of rising risks. We need only switch on our news channels to see frightening images of human tragedy, Russia's invasion of Ukraine, the widening conflagration in the Middle East, and even what may be the most significant military exercise yet conducted by Chinese armed forces encircling Taiwan. There are many reasons to be concerned about rising geopolitical risk, such as supply chain disruptions, energy disruptions and inflationary pressures. They all pose threats to resilience. I'd like to highlight one resulting risk - the increased risk of cyberattacks, in particular the increased threat from nation state actors. Our IT risk questionnaire shows a significant uptick year after year. In 2022, 50% of our supervised entities were subject to at least one successful cyber attack, rising to 68% percent in 2023 as the upcoming publication of our annual horizontal analysis will show. On an absolute basis the number of reports has also risen significantly. The number of cyber incident reports that we have received in 2023 was 77% higher than in 2022, and we expect the total number of incident reports in 2024 to be similar to 2023. The IMF also reports that the number of attacks has doubled since the pandemic. Conclusion Let me conclude. While the public debate on banking regulation may have shifted, we need to continue to uphold robust regulatory frameworks that balance safety with competitiveness. Completing the banking union and the capital markets union remains a critical priority and one that can enhance the overall competitiveness of the sector. In addition, we must remain vigilant in addressing the emerging risks posed by the growing NBFI sector and rising geopolitical risks that threaten resilience. By staying committed to these priorities, we can build a stronger, more integrated European financial system that supports innovation, protects consumers and enhances the overall resilience of our economy for all Europe's citizens. Crises fading in the rearview mirror should not be a harbinger of shifting supervisory and regulatory priorities such that a weaker, less competitive and less resilient sector is the result. 1 Enria, A. (2023), " Banking supervision beyond capital ", speech at the EUROFI 2023 Financial Forum organised in association with the Spanish Presidency of the Council of the EU, Santiago de Compostela, 14 September.	---[PAGE_BREAK]--- # Elizabeth McCaul: Fading crises, shifting priorities - a supervisory perspective on the regulatory cycle Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the conference "EU banking regulation at a turning point", Rome, 25 October 2024. ## Introduction Thank you very much for inviting me to today's conference. I regret that I am not able to join you in person but I am sure that you are having very productive and insightful discussions. The title of the conference, "EU banking regulation at a turning point", indicates that the regulatory environment seems to be undergoing a fundamental shift. While the years following the global financial crisis have been devoted to reinforcing the regulatory framework to prevent a recurrence of similar failures, the public debate seems to have shifted away from focusing on safety and stability towards placing greater emphasis on competitiveness. Shifts in public opinion on regulation are nothing new. There is a natural ebb and flow of regulatory intensity driven by crises, economic conditions and political priorities. After a crisis, there is often strong public support for stricter regulation, which tends to weaken over time as the crisis recedes. In today's remarks, I want to give you a supervisory perspective on the regulatory cycle and its shifting priorities. I would like to make three main points. First, it is a fundamental misconception to frame safety and competitiveness as opposing forces. A stable and secure financial system forms the bedrock of long-term competitiveness. Second, the post-crisis reform agenda in Europe is not yet complete. Notably, the banking union is still unfinished and the capital markets union requires more ambition. For me, there is a clear link here between these important policy objectives and buttressing the competitiveness of the sector. Third, we need to tackle emerging risks, such as the growth of the non-bank financial intermediation (NBFI) sector, and the rising geopolitical risk, which manifests itself in a number of ways, including in concerns about cyberattacks. Tackling these risks will contribute towards ensuring the continued resilience of the financial system. ## Heeding the lessons from the past ---[PAGE_BREAK]--- As the great financial crisis fades into the rearview mirror, it seems that competitiveness considerations have taken the wheel. However, just as guardrails on a motorway do not impede drivers but ensure they stay on the road, a robust regulatory framework sets safe boundaries for banks, enabling them to fulfil their role of lending to the real economy. Let me take this traffic metaphor even further. There are countless studies showing that speed limits not only reduce danger but also minimise congestion, thereby reducing the overall travel time. It's a fallacy to think that higher speed limits mean faster travel, just as laxer regulation does not lead to more sustainable growth. Similarly, regulatory competition between jurisdictions is more likely to lead to a race to the bottom than to a robust regulatory framework. Research consistently shows that well-capitalised banks are better positioned to support the real economy thanks to their enhanced capacity to absorb losses and maintain stability, even under financial stress. Specifically, impact assessments for the Basel reforms have demonstrated that while there may be short-term economic costs, these are far outweighed by the long-term benefits, most notably increased economic resilience. As for concerns over competitive advantages or disadvantages, I am not convinced that EU banks are at a disadvantage. In fact, the notion that regulatory requirements are more stringent in the EU than in the United States does not hold up to scrutiny. Evidence shows that global systemically important banks (G-SIBs) in the United States face slightly higher capital requirements than their EU counterparts. Furthermore, when we account for differences in how banks calculate risk-weighted assets, it becomes clear that average capital requirements for significant institutions in the banking union would be somewhat higher under US rules. This directly challenges some of the industry reports that suggest otherwise. ${ }^{1}$ # Completing the banking union and the capital markets union Let me now move to my second point: the need to complete the banking union and the capital markets union. In recent years, Europe's banking sector has demonstrated resilience amid unforeseen challenges, including the coronavirus pandemic, the energy supply shock following Russia's invasion of Ukraine and high inflation. This resilience is reflected in the numbers: in 2015 the average ratio of non-performing loans (NPLs) for significant banks in the banking union was $7.5 \%$, at a time when some banking systems had ratios close to $50 \%$. At the end of the second quarter of this year, this ratio had decreased to $2.3 \%$, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from 12.7\% in 2015 to $15.8 \%$ today. Bank profitability has increased considerably in recent quarters, benefiting from higher interest rates, and return on equity now stands at $10.1 \%$. ---[PAGE_BREAK]--- This resilience is also a result of the strengthened supervisory and regulatory framework after the global financial crisis, including the creation of European banking supervision. The limited repercussions from the March 2023 banking sector turmoil stand as a testament to the robustness of our banking union. However, while we have made significant strides to build a more resilient banking union, the journey is far from complete. Without a European deposit insurance scheme, there cannot be a truly single banking system. Depositors across the banking union should have a uniform level of confidence that their deposits are safeguarded during crises, irrespective of their Member State or the location of their bank. We must also enhance the crisis management and deposit insurance (CMDI) framework to effectively manage the failures of small and medium-sized banks. It is crucial that authorities have the flexibility to act and that adequate funding is available for a diverse range of scenarios. Losses from bank failures should primarily be borne by the bank's shareholders and creditors. Nonetheless, the framework should also allow for the use of industry-funded safety nets when necessary to protect financial stability. In particular, deposit guarantee schemes should be equipped to support the use of crisis management tools, for example by contributing to meeting the bail-in conditions for gaining access to the Single Resolution Fund. Smaller banks, which often rely heavily on deposits as a funding source, may face challenges in issuing financial instruments that could be bailed in if the bank fails. This issue can be mitigated by clarifying and broadening the least cost test and introducing a general depositor preference based on an equal ranking of all deposits. The current review of the CMDI framework is an opportunity to bring durable fixes to the flaws I have just described. We hope the co-legislators will reach an ambitious agreement and not settle for small-scale tweaks that would largely preserve the current - and less than satisfactory - status quo. Liquidity in resolution is another important aspect of crisis management where progress is needed. A resolved bank should primarily rely on market funding for liquidity, but a public liquidity backstop can be critical to maintain confidence in the resolution process, as demonstrated by recent crises in other jurisdictions. Unlike other jurisdictions, however, the banking union lacks an effective public sector backstop mechanism to provide this temporary liquidity funding. We therefore encourage all EU stakeholders to resume discussions on setting up a European-level public backstop to ensure liquidity is provided to banks facing resolution in a timely and effective manner. The incompleteness of the banking union is a significant impediment to creating a truly integrated banking sector in Europe and optimising its competitiveness. Achieving this goal means removing unnecessary barriers to cross-border banking and enabling crossborder groups to manage liquidity and capital at the group level. A fully integrated, cross-border European banking landscape would not only make banks more efficient ---[PAGE_BREAK]--- but also more resilient to domestic shocks, by enabling them to diversify their risks and revenue streams. This would contribute to private risk sharing and enhance the overall economy's robustness and efficiency, benefiting European citizens. Let me now turn to the second element of what is missing in Europe's financial architecture: the capital markets union. The capital markets union and the banking union are complementary projects. Progress on the capital markets union provides opportunities for banks and vice versa. And deepening the capital markets union is vital for the European economy to attract the necessary private investments to support innovation and the digital and green transitions, thus bolstering EU competitiveness. For banks, this means more cross-border activities, which would make them more competitive compared with their international counterparts. In a more integrated panEuropean capital market, banks could fully exploit economies of scale by offering similar products and services across multiple countries. Targeted harmonisations across Member States could facilitate such cross-border lending, enabling banks to better assess risks and opportunities from borrowers in other Member States. Completing the banking union would significantly accelerate the push towards a truly integrated European banking landscape. Securitisation is another measure to advance the capital markets union where banks play a key role. Given the constraints on banks' balance sheets, capital markets can complement bank lending and increase the financing available to the private sector while transferring risks to other intermediaries. Securitisation is crucial as it provides a diversified funding base for banks, a tool to transfer credit risks and new assets for investors. This can also create space for additional lending to the economy. # Tackling emerging risks - non-bank financial institutions and rising geopolitical risks While non-banks may help in financing the significant needs of the twin green and digital transition, they also necessitate adequate regulation and close monitoring. The growth in the NBFI sector is staggering. In the euro area the sector has more than doubled in size, from $€ 15$ trillion in 2008 to $€ 32$ trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from $€ 87$ trillion in 2008 to $€ 200$ trillion in 2022. The private credit market is a particular concern. It accounts for $€ 1.6$ trillion of the global market and has also seen significant growth recently. The European private credit market growth is accelerating by $29 \%$ in the last three years, but the market is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We recently completed a deep dive on the topic and found that banks are not able to fully identify the myriad ways they have exposure to private credit funds. Therefore, concentration risk could be significant. ---[PAGE_BREAK]--- We know that risk from the NBFI sector can materialise through various channels. One such channel is the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque, we should further harmonise, enhance and expand reporting requirements and make information-sharing between authorities easier at the global level. The growth in the NBFI market is not the only concern we have about the current risk environment. There is ample evidence in our constant media feeds of rising risks. We need only switch on our news channels to see frightening images of human tragedy, Russia's invasion of Ukraine, the widening conflagration in the Middle East, and even what may be the most significant military exercise yet conducted by Chinese armed forces encircling Taiwan. There are many reasons to be concerned about rising geopolitical risk, such as supply chain disruptions, energy disruptions and inflationary pressures. They all pose threats to resilience. I'd like to highlight one resulting risk - the increased risk of cyberattacks, in particular the increased threat from nation state actors. Our IT risk questionnaire shows a significant uptick year after year. In 2022, $50 \%$ of our supervised entities were subject to at least one successful cyber attack, rising to $68 \%$ percent in 2023 as the upcoming publication of our annual horizontal analysis will show. On an absolute basis the number of reports has also risen significantly. The number of cyber incident reports that we have received in 2023 was $77 \%$ higher than in 2022, and we expect the total number of incident reports in 2024 to be similar to 2023. The IMF also reports that the number of attacks has doubled since the pandemic. # Conclusion Let me conclude. While the public debate on banking regulation may have shifted, we need to continue to uphold robust regulatory frameworks that balance safety with competitiveness. Completing the banking union and the capital markets union remains a critical priority and one that can enhance the overall competitiveness of the sector. In addition, we must remain vigilant in addressing the emerging risks posed by the growing NBFI sector and rising geopolitical risks that threaten resilience. By staying committed to these priorities, we can build a stronger, more integrated European financial system that supports innovation, protects consumers and enhances the overall resilience of our economy for all Europe's citizens. Crises fading in the rearview mirror should not be a harbinger of shifting supervisory and regulatory priorities such that a weaker, less competitive and less resilient sector is the result. [^0] [^0]: ${ }^{1}$ Enria, A. (2023), "Banking supervision beyond capital", speech at the EUROFI 2023 Financial Forum organised in association with the Spanish Presidency of the Council of the EU, Santiago de Compostela, 14 September. ---[PAGE_BREAK]--- BIS - Central bankers' speeches	Elizabeth McCaul	Euro area	https://www.bis.org/review/r241028q.pdf	Keynote speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European Central Bank, at the conference "EU banking regulation at a turning point", Rome, 25 October 2024. Thank you very much for inviting me to today's conference. I regret that I am not able to join you in person but I am sure that you are having very productive and insightful discussions. The title of the conference, "EU banking regulation at a turning point", indicates that the regulatory environment seems to be undergoing a fundamental shift. While the years following the global financial crisis have been devoted to reinforcing the regulatory framework to prevent a recurrence of similar failures, the public debate seems to have shifted away from focusing on safety and stability towards placing greater emphasis on competitiveness. Shifts in public opinion on regulation are nothing new. There is a natural ebb and flow of regulatory intensity driven by crises, economic conditions and political priorities. After a crisis, there is often strong public support for stricter regulation, which tends to weaken over time as the crisis recedes. In today's remarks, I want to give you a supervisory perspective on the regulatory cycle and its shifting priorities. I would like to make three main points. First, it is a fundamental misconception to frame safety and competitiveness as opposing forces. A stable and secure financial system forms the bedrock of long-term competitiveness. Second, the post-crisis reform agenda in Europe is not yet complete. Notably, the banking union is still unfinished and the capital markets union requires more ambition. For me, there is a clear link here between these important policy objectives and buttressing the competitiveness of the sector. Third, we need to tackle emerging risks, such as the growth of the non-bank financial intermediation (NBFI) sector, and the rising geopolitical risk, which manifests itself in a number of ways, including in concerns about cyberattacks. Tackling these risks will contribute towards ensuring the continued resilience of the financial system. As the great financial crisis fades into the rearview mirror, it seems that competitiveness considerations have taken the wheel. However, just as guardrails on a motorway do not impede drivers but ensure they stay on the road, a robust regulatory framework sets safe boundaries for banks, enabling them to fulfil their role of lending to the real economy. Let me take this traffic metaphor even further. There are countless studies showing that speed limits not only reduce danger but also minimise congestion, thereby reducing the overall travel time. It's a fallacy to think that higher speed limits mean faster travel, just as laxer regulation does not lead to more sustainable growth. Similarly, regulatory competition between jurisdictions is more likely to lead to a race to the bottom than to a robust regulatory framework. Research consistently shows that well-capitalised banks are better positioned to support the real economy thanks to their enhanced capacity to absorb losses and maintain stability, even under financial stress. Specifically, impact assessments for the Basel reforms have demonstrated that while there may be short-term economic costs, these are far outweighed by the long-term benefits, most notably increased economic resilience. As for concerns over competitive advantages or disadvantages, I am not convinced that EU banks are at a disadvantage. In fact, the notion that regulatory requirements are more stringent in the EU than in the United States does not hold up to scrutiny. Evidence shows that global systemically important banks (G-SIBs) in the United States face slightly higher capital requirements than their EU counterparts. Furthermore, when we account for differences in how banks calculate risk-weighted assets, it becomes clear that average capital requirements for significant institutions in the banking union would be somewhat higher under US rules. This directly challenges some of the industry reports that suggest otherwise. Let me now move to my second point: the need to complete the banking union and the capital markets union. In recent years, Europe's banking sector has demonstrated resilience amid unforeseen challenges, including the coronavirus pandemic, the energy supply shock following Russia's invasion of Ukraine and high inflation. This resilience is reflected in the numbers: in 2015 the average ratio of non-performing loans (NPLs) for significant banks in the banking union was $7.5 \%$, at a time when some banking systems had ratios close to $50 \%$. At the end of the second quarter of this year, this ratio had decreased to $2.3 \%$, driven mainly by the reduction of NPLs in high-NPL banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from 12.7\% in 2015 to $15.8 \%$ today. Bank profitability has increased considerably in recent quarters, benefiting from higher interest rates, and return on equity now stands at $10.1 \%$. This resilience is also a result of the strengthened supervisory and regulatory framework after the global financial crisis, including the creation of European banking supervision. The limited repercussions from the March 2023 banking sector turmoil stand as a testament to the robustness of our banking union. However, while we have made significant strides to build a more resilient banking union, the journey is far from complete. Without a European deposit insurance scheme, there cannot be a truly single banking system. Depositors across the banking union should have a uniform level of confidence that their deposits are safeguarded during crises, irrespective of their Member State or the location of their bank. We must also enhance the crisis management and deposit insurance (CMDI) framework to effectively manage the failures of small and medium-sized banks. It is crucial that authorities have the flexibility to act and that adequate funding is available for a diverse range of scenarios. Losses from bank failures should primarily be borne by the bank's shareholders and creditors. Nonetheless, the framework should also allow for the use of industry-funded safety nets when necessary to protect financial stability. In particular, deposit guarantee schemes should be equipped to support the use of crisis management tools, for example by contributing to meeting the bail-in conditions for gaining access to the Single Resolution Fund. Smaller banks, which often rely heavily on deposits as a funding source, may face challenges in issuing financial instruments that could be bailed in if the bank fails. This issue can be mitigated by clarifying and broadening the least cost test and introducing a general depositor preference based on an equal ranking of all deposits. The current review of the CMDI framework is an opportunity to bring durable fixes to the flaws I have just described. We hope the co-legislators will reach an ambitious agreement and not settle for small-scale tweaks that would largely preserve the current - and less than satisfactory - status quo. Liquidity in resolution is another important aspect of crisis management where progress is needed. A resolved bank should primarily rely on market funding for liquidity, but a public liquidity backstop can be critical to maintain confidence in the resolution process, as demonstrated by recent crises in other jurisdictions. Unlike other jurisdictions, however, the banking union lacks an effective public sector backstop mechanism to provide this temporary liquidity funding. We therefore encourage all EU stakeholders to resume discussions on setting up a European-level public backstop to ensure liquidity is provided to banks facing resolution in a timely and effective manner. The incompleteness of the banking union is a significant impediment to creating a truly integrated banking sector in Europe and optimising its competitiveness. Achieving this goal means removing unnecessary barriers to cross-border banking and enabling crossborder groups to manage liquidity and capital at the group level. A fully integrated, cross-border European banking landscape would not only make banks more efficient but also more resilient to domestic shocks, by enabling them to diversify their risks and revenue streams. This would contribute to private risk sharing and enhance the overall economy's robustness and efficiency, benefiting European citizens. Let me now turn to the second element of what is missing in Europe's financial architecture: the capital markets union. The capital markets union and the banking union are complementary projects. Progress on the capital markets union provides opportunities for banks and vice versa. And deepening the capital markets union is vital for the European economy to attract the necessary private investments to support innovation and the digital and green transitions, thus bolstering EU competitiveness. For banks, this means more cross-border activities, which would make them more competitive compared with their international counterparts. In a more integrated panEuropean capital market, banks could fully exploit economies of scale by offering similar products and services across multiple countries. Targeted harmonisations across Member States could facilitate such cross-border lending, enabling banks to better assess risks and opportunities from borrowers in other Member States. Completing the banking union would significantly accelerate the push towards a truly integrated European banking landscape. Securitisation is another measure to advance the capital markets union where banks play a key role. Given the constraints on banks' balance sheets, capital markets can complement bank lending and increase the financing available to the private sector while transferring risks to other intermediaries. Securitisation is crucial as it provides a diversified funding base for banks, a tool to transfer credit risks and new assets for investors. This can also create space for additional lending to the economy. While non-banks may help in financing the significant needs of the twin green and digital transition, they also necessitate adequate regulation and close monitoring. The growth in the NBFI sector is staggering. In the euro area the sector has more than doubled in size, from $€ 15$ trillion in 2008 to $€ 32$ trillion in 2024. Globally, the numbers are even more worrying, with the sector growing from $€ 87$ trillion in 2008 to $€ 200$ trillion in 2022. The private credit market is a particular concern. It accounts for $€ 1.6$ trillion of the global market and has also seen significant growth recently. The European private credit market growth is accelerating by $29 \%$ in the last three years, but the market is still much smaller than the market in the United States, which is where investors and asset managers are often based. The end investors are pension funds, sovereign wealth funds and insurance firms, but banks play a significant role in leveraging and providing bridge loans at various levels to credit funds. We recently completed a deep dive on the topic and found that banks are not able to fully identify the myriad ways they have exposure to private credit funds. Therefore, concentration risk could be significant. We know that risk from the NBFI sector can materialise through various channels. One such channel is the correlation of exposures, especially given the growth in private credit and equity markets. We supervisors do not have a full picture of the level of exposure and correlations between NBFI balance sheets and bank lending arrangements, lines of credit or derivatives to and from NBFIs. To make the market less opaque, we should further harmonise, enhance and expand reporting requirements and make information-sharing between authorities easier at the global level. The growth in the NBFI market is not the only concern we have about the current risk environment. There is ample evidence in our constant media feeds of rising risks. We need only switch on our news channels to see frightening images of human tragedy, Russia's invasion of Ukraine, the widening conflagration in the Middle East, and even what may be the most significant military exercise yet conducted by Chinese armed forces encircling Taiwan. There are many reasons to be concerned about rising geopolitical risk, such as supply chain disruptions, energy disruptions and inflationary pressures. They all pose threats to resilience. I'd like to highlight one resulting risk - the increased risk of cyberattacks, in particular the increased threat from nation state actors. Our IT risk questionnaire shows a significant uptick year after year. In 2022, $50 \%$ of our supervised entities were subject to at least one successful cyber attack, rising to $68 \%$ percent in 2023 as the upcoming publication of our annual horizontal analysis will show. On an absolute basis the number of reports has also risen significantly. The number of cyber incident reports that we have received in 2023 was $77 \%$ higher than in 2022, and we expect the total number of incident reports in 2024 to be similar to 2023. The IMF also reports that the number of attacks has doubled since the pandemic. Let me conclude. While the public debate on banking regulation may have shifted, we need to continue to uphold robust regulatory frameworks that balance safety with competitiveness. Completing the banking union and the capital markets union remains a critical priority and one that can enhance the overall competitiveness of the sector. In addition, we must remain vigilant in addressing the emerging risks posed by the growing NBFI sector and rising geopolitical risks that threaten resilience. By staying committed to these priorities, we can build a stronger, more integrated European financial system that supports innovation, protects consumers and enhances the overall resilience of our economy for all Europe's citizens. Crises fading in the rearview mirror should not be a harbinger of shifting supervisory and regulatory priorities such that a weaker, less competitive and less resilient sector is the result. BIS - Central bankers' speeches
2024-10-25T00:00:00	Christine Lagarde: International Monetary and Financial Committee statement	Statement by Ms Christine Lagarde, President of the European Central Bank, at the fiftieth meeting of the International Monetary and Financial Committee, IMF Annual Meetings, Washington DC, 25 October 2024.	Christine Lagarde: International Monetary and Financial Committee statement Statement by Ms Christine Lagarde, President of the European Central Bank, at the fiftieth meeting of the International Monetary and Financial Committee, IMF Annual Meetings, Washington DC, 25 October 2024. * * * Introduction Since our last meeting in April, the global growth outlook has remained broadly unchanged. While global growth is projected to expand at a moderate pace, risks to the outlook have shifted to the downside, reflecting rising economic policy uncertainty against a backdrop of heightened geopolitical tensions. Global headline inflation continues to recede amid falling energy prices, the normalisation of supply conditions and still tight monetary policy. In October the Governing Council lowered the three key ECB interest rates by 25 basis points. The decision to lower the deposit facility rate - the rate through which it steers the monetary policy stance - reflects the Governing Council's updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflation process is well on track. Recent indicators of economic activity have surprised somewhat to the downside and financing conditions remain restrictive. The Governing Council will keep policy rates sufficiently restrictive for as long as necessary to achieve its two per cent medium-term inflation target in a timely manner. The appropriate level and duration of restriction will continue to be determined by following a data-dependent and meeting-by-meeting approach. In particular, the Governing Council's interest rate decisions will be based on its assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular interest rate path. The Governing Council recently initiated an assessment of its monetary policy strategy, which will focus on the changed inflation environment and its implications for the monetary policy strategy, with conclusions expected in the second half of 2025. Economic activity After the broad stagnation in activity in 2023, euro area real GDP expanded moderately in the first half of this year, helped by the recovery in foreign demand and public spending. Private domestic demand remained weak, with households and firms still hesitant to consume and invest. Incoming data suggest economic activity may have softened again in the second half of the year amid rising geopolitical uncertainty. Looking ahead, we expect growth to strengthen over time, as rising real incomes support household consumption and the gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should contribute to the recovery as global demand rises. The labour market remains resilient, but indicators point towards cooling labour demand on the back of weaker economic activity. Employment continued to grow in the second quarter of 2024, albeit at a slower rate than in the first quarter of the year. In August the unemployment rate remained at 6.4%, its lowest level since the introduction of the euro. Labour productivity is expected to recover in the future as labour hoarding unwinds and profit margins moderate. Fiscal and structural policies should be aimed at making the economy more productive, competitive and resilient. That would help to raise potential growth and reduce price pressures in the medium term. To this end, it is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. Implementing the EU's revised economic governance framework fully, transparently and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Governments should now make a strong start in this direction in their medium-term plans for fiscal and structural policies. Risks to growth remain tilted to the downside. Lower confidence could prevent consumption and investment from recovering as quickly as expected. This could be amplified by sources of geopolitical risk, such as Russia's unjustified war against Ukraine and the conflict in the Middle East, which could disrupt energy supplies and global trade. Lower demand for euro area exports due, for instance, to a weaker world economy or an escalation in trade tensions between major economies would further weigh on euro area growth. Growth could be lower if the lagged impact of our monetary policy tightening turns out stronger than expected. However, growth could also be higher if the world economy grows more strongly than expected or if easier financing conditions and declining inflation lead to a faster rebound in consumption and investment. Inflation Headline inflation fell to 1.7% in September 2024 due mainly to a sharp drop in energy inflation, following a broadly declining path since the last IMFC meeting. Core inflation - HICP inflation excluding energy and food - began to moderate in recent months after an overall sideways trend, reflecting mainly declining goods inflation. Services inflation edged down in September, but has been more persistent, hovering around 4%. Most measures of underlying inflation have been gradually moderating in recent months. However, domestic inflation remains elevated, with strong price pressures coming from wages in particular. Wage growth has continued to be strong, but overall growth in labour costs has been moderating in recent quarters and profits have been buffering the impact of higher wages on inflation. Looking ahead, we expect inflation to temporarily increase again in the fourth quarter of this year as the previous sharp falls in energy prices drop out of the annual rates. Thereafter, inflation should resume its decline, reaching our target next year and averaging 1.9% in 2026 according to the September staff projections. Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could disrupt global trade and push energy prices and freight costs higher in the near term. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Financial stability, euro area banking sector and non-bank financial intermediation The financial stability of the euro area continues to be affected by geopolitical risks and uncertainties surrounding the macroeconomic outlook. The financial stability outlook remains fragile, with elevated vulnerabilities. Geopolitical risks from intra- and intercountry conflicts coupled with election uncertainties could trigger a sharp reversal of risk sentiment and weaken macro-financial conditions, leading to negative feedback loops between governments and both the non-financial and financial sectors. While the sharp corrections we saw in financial markets over the summer were short-lived, benign risk pricing underscores the potential for more disruptive developments. Additionally, although commercial real estate markets have shown signs of stabilising, the full scale of the correction may not yet have been reflected in valuations, which are slow to adjust. Euro area banks have been a source of resilience thanks to their sizeable liquidity and capital buffers, and their profitability has been robust thanks to improved net interest margins. However, these profits will likely begin to moderate alongside declining rates. Asset quality is starting to weaken from a historically high level, particularly in commercial property lending. Bank valuations remain subdued and are vulnerable to geopolitical uncertainty, although recent political events have had a limited impact on the financial sector more broadly. From a macroprudential policy perspective and against a background of headwinds and uncertainty, it is crucial that the existing requirements for releasable capital buffers are maintained, or in some countries increased, and that adequate borrower-based measures are implemented as required. It is important that key jurisdictions are making progress in implementing Basel III. A full, faithful and timely implementation of Basel III is crucial, as strong regulation and supervision ensure that banks remain safe and sound. Risks in the non-bank financial intermediation (NBFI) sector remain elevated, despite some rebalancing towards higher-quality assets. Asset price corrections and market volatility, as well as macroeconomic and geopolitical uncertainty, could trigger outflows from open-ended investment funds or margin calls for investment funds, insurance companies and pension funds. These dynamics would increase the likelihood of forced sales, which could negatively affect the markets in which non-bank financial intermediaries invest. Additionally, parts of the NBFI sector are highly leveraged, which could amplify liquidity shocks to the wider financial system. This underlines the need to strengthen the NBFI policy framework, including from a macroprudential perspective, in an internationally coordinated manner. International cooperation Geopolitical tensions are increasingly giving rise to economic and financial fragmentation and pose a significant risk to global prosperity, with trade flows already visibly decoupling along lines of geopolitical influence. So far, this decoupling has been limited to specific sectors, such as energy and key advanced technologies. ECB analysis suggests that trade fragmentation could result in global GDP losses ranging from nearly 6% in a scenario of higher trade barriers only being erected for strategic products, to 9% in a more severe scenario of full decoupling. Trade fragmentation could lead to renewed inflationary pressures globally, not only because of increased production input costs but also on account of reduced diversification opportunities. Overall, this would make it more challenging for central banks to ensure price stability. It is therefore crucial that legitimate concerns about security and supply chain resilience do not lead to a spiral of protectionism. Multilateral cooperation is more important than ever if we are to preserve the unparalleled achievements in global growth and poverty reduction of recent decades, and securing global peace is a precondition for economic prosperity. With the IMF marking its 80th anniversary this year, its role and work remain absolutely critical in the current complex global environment. The Fund's multilateral and bilateral surveillance function remains as important as ever in protecting member countries from crises, and the upcoming Comprehensive Surveillance Review will help establish the most relevant priorities for years to come. We welcome the recent decisions to strengthen the IMF's lending toolkit as part of the Review of Charges and the Surcharges Policy and the Review of the Poverty Reduction and Growth Trust Facilities and Financing. We support the IMF's position at the centre of the global financial safety net, with a strong core mandate, and we highly value its unique role in bridge-building and facilitating global cooperation to tackle common challenges. We welcome the fact that Sub-Saharan Africa will shortly occupy the newly created seat on the IMF's Executive Board, which will significantly contribute to improving the overall balance of regional representation. We continue to witness an increase in economic losses and financial risks stemming from extreme physical climate hazards, including record-breaking heatwaves in Asia, devastating floods and wildfires in the Americas and central and eastern Europe, and more frequent tropical storms in the Caribbean and South Asia. Adaptation measures to shield our lives and economies from the impact of climate change, alongside ambitious policies to put the climate transition on track, are more relevant than ever. We support international progress on transition planning, enabling corporations, financial institutions and governments to set up credible net-zero roadmaps in a systematic way. Furthermore, it is essential to further develop more systematic and comprehensive approaches to assess the impact of escalating nature-related economic and financial risks on price and financial stability, including integrated climate and nature risk analyses.	---[PAGE_BREAK]--- # Christine Lagarde: International Monetary and Financial Committee statement Statement by Ms Christine Lagarde, President of the European Central Bank, at the fiftieth meeting of the International Monetary and Financial Committee, IMF Annual Meetings, Washington DC, 25 October 2024. ## Introduction Since our last meeting in April, the global growth outlook has remained broadly unchanged. While global growth is projected to expand at a moderate pace, risks to the outlook have shifted to the downside, reflecting rising economic policy uncertainty against a backdrop of heightened geopolitical tensions. Global headline inflation continues to recede amid falling energy prices, the normalisation of supply conditions and still tight monetary policy. In October the Governing Council lowered the three key ECB interest rates by 25 basis points. The decision to lower the deposit facility rate - the rate through which it steers the monetary policy stance - reflects the Governing Council's updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflation process is well on track. Recent indicators of economic activity have surprised somewhat to the downside and financing conditions remain restrictive. The Governing Council will keep policy rates sufficiently restrictive for as long as necessary to achieve its two per cent medium-term inflation target in a timely manner. The appropriate level and duration of restriction will continue to be determined by following a data-dependent and meeting-by-meeting approach. In particular, the Governing Council's interest rate decisions will be based on its assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular interest rate path. The Governing Council recently initiated an assessment of its monetary policy strategy, which will focus on the changed inflation environment and its implications for the monetary policy strategy, with conclusions expected in the second half of 2025. ## Economic activity After the broad stagnation in activity in 2023, euro area real GDP expanded moderately in the first half of this year, helped by the recovery in foreign demand and public spending. Private domestic demand remained weak, with households and firms still hesitant to consume and invest. Incoming data suggest economic activity may have softened again in the second half of the year amid rising geopolitical uncertainty. Looking ahead, we expect growth to strengthen over time, as rising real incomes support household consumption and the gradually fading effects of restrictive monetary ---[PAGE_BREAK]--- policy should support consumption and investment. Exports should contribute to the recovery as global demand rises. The labour market remains resilient, but indicators point towards cooling labour demand on the back of weaker economic activity. Employment continued to grow in the second quarter of 2024, albeit at a slower rate than in the first quarter of the year. In August the unemployment rate remained at $6.4 \%$, its lowest level since the introduction of the euro. Labour productivity is expected to recover in the future as labour hoarding unwinds and profit margins moderate. Fiscal and structural policies should be aimed at making the economy more productive, competitive and resilient. That would help to raise potential growth and reduce price pressures in the medium term. To this end, it is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. Implementing the EU's revised economic governance framework fully, transparently and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Governments should now make a strong start in this direction in their medium-term plans for fiscal and structural policies. Risks to growth remain tilted to the downside. Lower confidence could prevent consumption and investment from recovering as quickly as expected. This could be amplified by sources of geopolitical risk, such as Russia's unjustified war against Ukraine and the conflict in the Middle East, which could disrupt energy supplies and global trade. Lower demand for euro area exports due, for instance, to a weaker world economy or an escalation in trade tensions between major economies would further weigh on euro area growth. Growth could be lower if the lagged impact of our monetary policy tightening turns out stronger than expected. However, growth could also be higher if the world economy grows more strongly than expected or if easier financing conditions and declining inflation lead to a faster rebound in consumption and investment. # Inflation Headline inflation fell to $1.7 \%$ in September 2024 due mainly to a sharp drop in energy inflation, following a broadly declining path since the last IMFC meeting. Core inflation HICP inflation excluding energy and food - began to moderate in recent months after an overall sideways trend, reflecting mainly declining goods inflation. Services inflation edged down in September, but has been more persistent, hovering around 4\%. Most measures of underlying inflation have been gradually moderating in recent months. However, domestic inflation remains elevated, with strong price pressures coming from wages in particular. Wage growth has continued to be strong, but overall growth in labour costs has been moderating in recent quarters and profits have been buffering the impact of higher wages on inflation. Looking ahead, we expect inflation to temporarily increase again in the fourth quarter of this year as the previous sharp falls in energy prices drop out of the annual rates. Thereafter, inflation should resume its decline, reaching our target next year and averaging $1.9 \%$ in 2026 according to the September staff projections. ---[PAGE_BREAK]--- Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could disrupt global trade and push energy prices and freight costs higher in the near term. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. # Financial stability, euro area banking sector and non-bank financial intermediation The financial stability of the euro area continues to be affected by geopolitical risks and uncertainties surrounding the macroeconomic outlook. The financial stability outlook remains fragile, with elevated vulnerabilities. Geopolitical risks from intra- and intercountry conflicts coupled with election uncertainties could trigger a sharp reversal of risk sentiment and weaken macro-financial conditions, leading to negative feedback loops between governments and both the non-financial and financial sectors. While the sharp corrections we saw in financial markets over the summer were short-lived, benign risk pricing underscores the potential for more disruptive developments. Additionally, although commercial real estate markets have shown signs of stabilising, the full scale of the correction may not yet have been reflected in valuations, which are slow to adjust. Euro area banks have been a source of resilience thanks to their sizeable liquidity and capital buffers, and their profitability has been robust thanks to improved net interest margins. However, these profits will likely begin to moderate alongside declining rates. Asset quality is starting to weaken from a historically high level, particularly in commercial property lending. Bank valuations remain subdued and are vulnerable to geopolitical uncertainty, although recent political events have had a limited impact on the financial sector more broadly. From a macroprudential policy perspective and against a background of headwinds and uncertainty, it is crucial that the existing requirements for releasable capital buffers are maintained, or in some countries increased, and that adequate borrower-based measures are implemented as required. It is important that key jurisdictions are making progress in implementing Basel III. A full, faithful and timely implementation of Basel III is crucial, as strong regulation and supervision ensure that banks remain safe and sound. Risks in the non-bank financial intermediation (NBFI) sector remain elevated, despite some rebalancing towards higher-quality assets. Asset price corrections and market volatility, as well as macroeconomic and geopolitical uncertainty, could trigger outflows from open-ended investment funds or margin calls for investment funds, insurance companies and pension funds. These dynamics would increase the likelihood of forced sales, which could negatively affect the markets in which non-bank financial intermediaries invest. Additionally, parts of the NBFI sector are highly leveraged, which could amplify liquidity shocks to the wider financial system. This underlines the need to strengthen the NBFI policy framework, including from a macroprudential perspective, in an internationally coordinated manner. ---[PAGE_BREAK]--- # International cooperation Geopolitical tensions are increasingly giving rise to economic and financial fragmentation and pose a significant risk to global prosperity, with trade flows already visibly decoupling along lines of geopolitical influence. So far, this decoupling has been limited to specific sectors, such as energy and key advanced technologies. ECB analysis suggests that trade fragmentation could result in global GDP losses ranging from nearly $6 \%$ in a scenario of higher trade barriers only being erected for strategic products, to $9 \%$ in a more severe scenario of full decoupling. Trade fragmentation could lead to renewed inflationary pressures globally, not only because of increased production input costs but also on account of reduced diversification opportunities. Overall, this would make it more challenging for central banks to ensure price stability. It is therefore crucial that legitimate concerns about security and supply chain resilience do not lead to a spiral of protectionism. Multilateral cooperation is more important than ever if we are to preserve the unparalleled achievements in global growth and poverty reduction of recent decades, and securing global peace is a precondition for economic prosperity. With the IMF marking its 80th anniversary this year, its role and work remain absolutely critical in the current complex global environment. The Fund's multilateral and bilateral surveillance function remains as important as ever in protecting member countries from crises, and the upcoming Comprehensive Surveillance Review will help establish the most relevant priorities for years to come. We welcome the recent decisions to strengthen the IMF's lending toolkit as part of the Review of Charges and the Surcharges Policy and the Review of the Poverty Reduction and Growth Trust Facilities and Financing. We support the IMF's position at the centre of the global financial safety net, with a strong core mandate, and we highly value its unique role in bridge-building and facilitating global cooperation to tackle common challenges. We welcome the fact that Sub-Saharan Africa will shortly occupy the newly created seat on the IMF's Executive Board, which will significantly contribute to improving the overall balance of regional representation. We continue to witness an increase in economic losses and financial risks stemming from extreme physical climate hazards, including record-breaking heatwaves in Asia, devastating floods and wildfires in the Americas and central and eastern Europe, and more frequent tropical storms in the Caribbean and South Asia. Adaptation measures to shield our lives and economies from the impact of climate change, alongside ambitious policies to put the climate transition on track, are more relevant than ever. We support international progress on transition planning, enabling corporations, financial institutions and governments to set up credible net-zero roadmaps in a systematic way. Furthermore, it is essential to further develop more systematic and comprehensive approaches to assess the impact of escalating nature-related economic and financial risks on price and financial stability, including integrated climate and nature risk analyses.	Christine Lagarde	Euro area	https://www.bis.org/review/r241028h.pdf	Statement by Ms Christine Lagarde, President of the European Central Bank, at the fiftieth meeting of the International Monetary and Financial Committee, IMF Annual Meetings, Washington DC, 25 October 2024. Since our last meeting in April, the global growth outlook has remained broadly unchanged. While global growth is projected to expand at a moderate pace, risks to the outlook have shifted to the downside, reflecting rising economic policy uncertainty against a backdrop of heightened geopolitical tensions. Global headline inflation continues to recede amid falling energy prices, the normalisation of supply conditions and still tight monetary policy. In October the Governing Council lowered the three key ECB interest rates by 25 basis points. The decision to lower the deposit facility rate - the rate through which it steers the monetary policy stance - reflects the Governing Council's updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflation process is well on track. Recent indicators of economic activity have surprised somewhat to the downside and financing conditions remain restrictive. The Governing Council will keep policy rates sufficiently restrictive for as long as necessary to achieve its two per cent medium-term inflation target in a timely manner. The appropriate level and duration of restriction will continue to be determined by following a data-dependent and meeting-by-meeting approach. In particular, the Governing Council's interest rate decisions will be based on its assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular interest rate path. The Governing Council recently initiated an assessment of its monetary policy strategy, which will focus on the changed inflation environment and its implications for the monetary policy strategy, with conclusions expected in the second half of 2025. After the broad stagnation in activity in 2023, euro area real GDP expanded moderately in the first half of this year, helped by the recovery in foreign demand and public spending. Private domestic demand remained weak, with households and firms still hesitant to consume and invest. Incoming data suggest economic activity may have softened again in the second half of the year amid rising geopolitical uncertainty. Looking ahead, we expect growth to strengthen over time, as rising real incomes support household consumption and the gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should contribute to the recovery as global demand rises. The labour market remains resilient, but indicators point towards cooling labour demand on the back of weaker economic activity. Employment continued to grow in the second quarter of 2024, albeit at a slower rate than in the first quarter of the year. In August the unemployment rate remained at $6.4 \%$, its lowest level since the introduction of the euro. Labour productivity is expected to recover in the future as labour hoarding unwinds and profit margins moderate. Fiscal and structural policies should be aimed at making the economy more productive, competitive and resilient. That would help to raise potential growth and reduce price pressures in the medium term. To this end, it is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. Implementing the EU's revised economic governance framework fully, transparently and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Governments should now make a strong start in this direction in their medium-term plans for fiscal and structural policies. Risks to growth remain tilted to the downside. Lower confidence could prevent consumption and investment from recovering as quickly as expected. This could be amplified by sources of geopolitical risk, such as Russia's unjustified war against Ukraine and the conflict in the Middle East, which could disrupt energy supplies and global trade. Lower demand for euro area exports due, for instance, to a weaker world economy or an escalation in trade tensions between major economies would further weigh on euro area growth. Growth could be lower if the lagged impact of our monetary policy tightening turns out stronger than expected. However, growth could also be higher if the world economy grows more strongly than expected or if easier financing conditions and declining inflation lead to a faster rebound in consumption and investment. Headline inflation fell to $1.7 \%$ in September 2024 due mainly to a sharp drop in energy inflation, following a broadly declining path since the last IMFC meeting. Core inflation HICP inflation excluding energy and food - began to moderate in recent months after an overall sideways trend, reflecting mainly declining goods inflation. Services inflation edged down in September, but has been more persistent, hovering around 4\%. Most measures of underlying inflation have been gradually moderating in recent months. However, domestic inflation remains elevated, with strong price pressures coming from wages in particular. Wage growth has continued to be strong, but overall growth in labour costs has been moderating in recent quarters and profits have been buffering the impact of higher wages on inflation. Looking ahead, we expect inflation to temporarily increase again in the fourth quarter of this year as the previous sharp falls in energy prices drop out of the annual rates. Thereafter, inflation should resume its decline, reaching our target next year and averaging $1.9 \%$ in 2026 according to the September staff projections. Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could disrupt global trade and push energy prices and freight costs higher in the near term. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. The financial stability of the euro area continues to be affected by geopolitical risks and uncertainties surrounding the macroeconomic outlook. The financial stability outlook remains fragile, with elevated vulnerabilities. Geopolitical risks from intra- and intercountry conflicts coupled with election uncertainties could trigger a sharp reversal of risk sentiment and weaken macro-financial conditions, leading to negative feedback loops between governments and both the non-financial and financial sectors. While the sharp corrections we saw in financial markets over the summer were short-lived, benign risk pricing underscores the potential for more disruptive developments. Additionally, although commercial real estate markets have shown signs of stabilising, the full scale of the correction may not yet have been reflected in valuations, which are slow to adjust. Euro area banks have been a source of resilience thanks to their sizeable liquidity and capital buffers, and their profitability has been robust thanks to improved net interest margins. However, these profits will likely begin to moderate alongside declining rates. Asset quality is starting to weaken from a historically high level, particularly in commercial property lending. Bank valuations remain subdued and are vulnerable to geopolitical uncertainty, although recent political events have had a limited impact on the financial sector more broadly. From a macroprudential policy perspective and against a background of headwinds and uncertainty, it is crucial that the existing requirements for releasable capital buffers are maintained, or in some countries increased, and that adequate borrower-based measures are implemented as required. It is important that key jurisdictions are making progress in implementing Basel III. A full, faithful and timely implementation of Basel III is crucial, as strong regulation and supervision ensure that banks remain safe and sound. Risks in the non-bank financial intermediation (NBFI) sector remain elevated, despite some rebalancing towards higher-quality assets. Asset price corrections and market volatility, as well as macroeconomic and geopolitical uncertainty, could trigger outflows from open-ended investment funds or margin calls for investment funds, insurance companies and pension funds. These dynamics would increase the likelihood of forced sales, which could negatively affect the markets in which non-bank financial intermediaries invest. Additionally, parts of the NBFI sector are highly leveraged, which could amplify liquidity shocks to the wider financial system. This underlines the need to strengthen the NBFI policy framework, including from a macroprudential perspective, in an internationally coordinated manner. Geopolitical tensions are increasingly giving rise to economic and financial fragmentation and pose a significant risk to global prosperity, with trade flows already visibly decoupling along lines of geopolitical influence. So far, this decoupling has been limited to specific sectors, such as energy and key advanced technologies. ECB analysis suggests that trade fragmentation could result in global GDP losses ranging from nearly $6 \%$ in a scenario of higher trade barriers only being erected for strategic products, to $9 \%$ in a more severe scenario of full decoupling. Trade fragmentation could lead to renewed inflationary pressures globally, not only because of increased production input costs but also on account of reduced diversification opportunities. Overall, this would make it more challenging for central banks to ensure price stability. It is therefore crucial that legitimate concerns about security and supply chain resilience do not lead to a spiral of protectionism. Multilateral cooperation is more important than ever if we are to preserve the unparalleled achievements in global growth and poverty reduction of recent decades, and securing global peace is a precondition for economic prosperity. With the IMF marking its 80th anniversary this year, its role and work remain absolutely critical in the current complex global environment. The Fund's multilateral and bilateral surveillance function remains as important as ever in protecting member countries from crises, and the upcoming Comprehensive Surveillance Review will help establish the most relevant priorities for years to come. We welcome the recent decisions to strengthen the IMF's lending toolkit as part of the Review of Charges and the Surcharges Policy and the Review of the Poverty Reduction and Growth Trust Facilities and Financing. We support the IMF's position at the centre of the global financial safety net, with a strong core mandate, and we highly value its unique role in bridge-building and facilitating global cooperation to tackle common challenges. We welcome the fact that Sub-Saharan Africa will shortly occupy the newly created seat on the IMF's Executive Board, which will significantly contribute to improving the overall balance of regional representation. We continue to witness an increase in economic losses and financial risks stemming from extreme physical climate hazards, including record-breaking heatwaves in Asia, devastating floods and wildfires in the Americas and central and eastern Europe, and more frequent tropical storms in the Caribbean and South Asia. Adaptation measures to shield our lives and economies from the impact of climate change, alongside ambitious policies to put the climate transition on track, are more relevant than ever. We support international progress on transition planning, enabling corporations, financial institutions and governments to set up credible net-zero roadmaps in a systematic way. Furthermore, it is essential to further develop more systematic and comprehensive approaches to assess the impact of escalating nature-related economic and financial risks on price and financial stability, including integrated climate and nature risk analyses.
2024-10-28T00:00:00	Frank Elderson: Finance and Biodiversity Day of 16th United Nations Conference on Biological Diversity (COP16) - transcript of video recording	Contribution by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 16th meeting of the Conference of the Parties to the Convention on Biological Diversity – Finance and Biodiversity Day, Cali, 28 October 2024.	Frank Elderson: Finance and Biodiversity Day of 16th United Nations Conference on Biological Diversity (COP16) - transcript of video recording Contribution by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 16th meeting of the Conference of the Parties to the Convention on Biological Diversity - Finance and Biodiversity Day, Cali, 28 October 2024. * * * The global economy and finance need nature to survive. Analysis by the ECB shows that the economy depends critically on nature: 72% of non-financial businesses in the euro area - around 4.2 million individual companies - would experience significant problems as a result of ecosystem degradation. These businesses rely on ecosystem services like fertile soils, timber and clean water. And 75% of bank loans are tied to these businesses. So, if they run into trouble, the banks that finance them will too. This interdependence underscores why the ECB made nature one of the focus areas of its climate and nature plan for 2024 and 2025. It is also why we push banks under our supervision to manage all material nature-related risks. The ECB does not stand alone in recognising this threat. The value of nature for the economy is acknowledged by the global Network of Central Banks and Supervisors for Greening the Financial System, which has 141 members worldwide. Additionally, a recent stocktake by the Financial Stability Board showed that a growing number of policy authorities around the world are considering the potential implications of naturerelated risks for financial stability. In recognition of the vital importance of nature for the economy, international fora must ensure that nature considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. While central banks and supervisors are not nature policymakers, we must take nature into account to fulfil our mandate of price stability and safe and sound banks. Otherwise, we risk failing to deliver on our mandate. My message on this Finance and Biodiversity Day is clear: if you destroy nature, you destroy the economy. The right conditions must be established for nature - and consequently the economy - to thrive. The economy needs nature to survive. Financial stability needs nature to survive. To deliver on our mandate, we need nature to survive. And the survival of nature requires financing. Therefore, your success here in Cali is vitally important. Thank you. Buena suerte.	---[PAGE_BREAK]--- # Frank Elderson: Finance and Biodiversity Day of 16th United Nations Conference on Biological Diversity (COP16) - transcript of video recording Contribution by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 16th meeting of the Conference of the Parties to the Convention on Biological Diversity - Finance and Biodiversity Day, Cali, 28 October 2024. The global economy and finance need nature to survive. Analysis by the ECB shows that the economy depends critically on nature: $72 \%$ of non-financial businesses in the euro area - around 4.2 million individual companies - would experience significant problems as a result of ecosystem degradation. These businesses rely on ecosystem services like fertile soils, timber and clean water. And $75 \%$ of bank loans are tied to these businesses. So, if they run into trouble, the banks that finance them will too. This interdependence underscores why the ECB made nature one of the focus areas of its climate and nature plan for 2024 and 2025. It is also why we push banks under our supervision to manage all material nature-related risks. The ECB does not stand alone in recognising this threat. The value of nature for the economy is acknowledged by the global Network of Central Banks and Supervisors for Greening the Financial System, which has 141 members worldwide. Additionally, a recent stocktake by the Financial Stability Board showed that a growing number of policy authorities around the world are considering the potential implications of naturerelated risks for financial stability. In recognition of the vital importance of nature for the economy, international fora must ensure that nature considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. While central banks and supervisors are not nature policymakers, we must take nature into account to fulfil our mandate of price stability and safe and sound banks. Otherwise, we risk failing to deliver on our mandate. My message on this Finance and Biodiversity Day is clear: if you destroy nature, you destroy the economy. The right conditions must be established for nature - and consequently the economy - to thrive. The economy needs nature to survive. Financial stability needs nature to survive. To deliver on our mandate, we need nature to survive. And the survival of nature requires financing. Therefore, your success here in Cali is vitally important. Thank you. Buena suerte.	Frank Elderson	Euro area	https://www.bis.org/review/r241029e.pdf	Contribution by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 16th meeting of the Conference of the Parties to the Convention on Biological Diversity - Finance and Biodiversity Day, Cali, 28 October 2024. The global economy and finance need nature to survive. Analysis by the ECB shows that the economy depends critically on nature: $72 \%$ of non-financial businesses in the euro area - around 4.2 million individual companies - would experience significant problems as a result of ecosystem degradation. These businesses rely on ecosystem services like fertile soils, timber and clean water. And $75 \%$ of bank loans are tied to these businesses. So, if they run into trouble, the banks that finance them will too. This interdependence underscores why the ECB made nature one of the focus areas of its climate and nature plan for 2024 and 2025. It is also why we push banks under our supervision to manage all material nature-related risks. The ECB does not stand alone in recognising this threat. The value of nature for the economy is acknowledged by the global Network of Central Banks and Supervisors for Greening the Financial System, which has 141 members worldwide. Additionally, a recent stocktake by the Financial Stability Board showed that a growing number of policy authorities around the world are considering the potential implications of naturerelated risks for financial stability. In recognition of the vital importance of nature for the economy, international fora must ensure that nature considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. While central banks and supervisors are not nature policymakers, we must take nature into account to fulfil our mandate of price stability and safe and sound banks. Otherwise, we risk failing to deliver on our mandate. My message on this Finance and Biodiversity Day is clear: if you destroy nature, you destroy the economy. The right conditions must be established for nature - and consequently the economy - to thrive. The economy needs nature to survive. Financial stability needs nature to survive. To deliver on our mandate, we need nature to survive. And the survival of nature requires financing. Therefore, your success here in Cali is vitally important. Thank you. Buena suerte.
2024-10-28T00:00:00	Luis de Guindos: Monetary policy and financial stability in the euro area	Introductory remarks by Mr Luis de Guindos, Vice-President of the European Central Bank, at a meeting with business group Hotusa, Madrid, 28 October 2024.	Luis de Guindos: Monetary policy and financial stability in the euro area Introductory remarks by Mr Luis de Guindos, Vice-President of the European Central Bank, at a meeting with business group Hotusa, Madrid, 28 October 2024. * * * Inflation Inflation in the euro area has come a long way. After peaking at more than 10% in October 2022 (in Spain, it peaked in July 2022), headline inflation stood at 1.7% in September this year. This was 0.5 percentage points lower than in August, largely reflecting a sharp drop in energy inflation. Core inflation has also fallen substantially from its peak, edging down from 2.8% in August to 2.7% in September. Most measures of underlying inflation have declined or remained unchanged. Domestic inflation remains high, reflecting elevated services inflation as wage pressures remain strong, but it too is showing signs of moderation. Inflation is expected to rise again later this year - partly due to base effects, as previous sharp falls in energy prices drop out of annual rates - before declining to our target of 2% in the course of next year. Inflation expectations of euro area firms and consumers have declined across all horizons. Most measures of longer-term inflation expectations stand at around 2%. So, taken together, the incoming information shows that the disinflationary process is now well on track. The outlook, however, is surrounded by substantial risks. The geopolitical situation, especially the conflict in the Middle East and Russia's war against Ukraine, poses a particular upside risk to inflation. Heightened geopolitical tensions could push energy prices and freight costs higher in the near term and disrupt global trade. Extreme weather events could drive up food prices. And inflation could also turn out higher than anticipated if wages and profits increase by more than expected. But we may also see downside surprises in inflation - for example as a result of a stronger-than-expected dampening impact of monetary policy on demand, an unexpected worsening of the global economic environment, or a slower recovery in consumption and investment due to concerns about geopolitical events. Economic activity Economic activity in the euro area has been weaker than expected, with persisting differences across sectors. The composite output Purchasing Managers' Index (PMI) fell into contractionary territory in September, its deterioration broad-based across countries and sub-indices. The manufacturing output PMI fell further while the services sector continued to expand, though at a slowing pace, pointing to an overall weaker near-term outlook for growth. Despite rising incomes, household consumption remained weak and savings increased by more than expected. This was likely due to higher real returns on savings, efforts to recuperate past losses in real wealth and, more broadly, the lagged response of consumption to rising incomes. The labour market remains resilient, with the unemployment rate at 6.4% in August, its lowest level since the introduction of the euro. However, surveys point to slowing employment growth and a further moderation in the demand for labour. Economic activity is expected to strengthen as real incomes rise and the easing of financing conditions supports consumption and investment. With global demand increasing, exports are also expected to contribute to the recovery. However, risks to the growth outlook remain elevated and tilted to the downside. In particular, lower confidence could prevent consumption and investment from recovering as fast as expected and geopolitical risks continue to pose a threat to the world economy by disrupting energy supplies and global trade. But euro area growth could be higher if the world economy grows more strongly than expected or if declining inflation and less restrictive monetary policy lead to a faster recovery in consumption and investment. Financial stability As concerns about inflation abate, weaker growth prospects are weighing on the outlook for financial stability in the euro area. At the same time, geopolitical risks and political uncertainty continue to raise the likelihood of tail events. Let me mention three broad financial stability issues which stand out. First, while financial markets have shown resilience in recent periods of turmoil, they remain vulnerable to adverse dynamics as risk pricing appears too benign. Moreover, the nonbank financial sector - which is less transparent and subject to lighter regulation - could amplify any market correction, given concentrated exposures, liquidity and leverage vulnerabilities. Second, heightened political risks have highlighted closely interlinked vulnerabilities in sovereign, corporate, household, bank and non-bank sectors. Sovereign vulnerabilities are increasing, driven by heightened policy uncertainty and weak growth prospects. At the same time, interconnectedness between corporates, banks and non-banking intermediaries could create negative feedback loops if risks materialise in any of these sectors. Third, although conditions in commercial real estate markets have shown signs of stabilisation, there is a risk that the full scale of the correction is not yet reflected in valuations and that conditions could worsen again. Monetary policy The Governing Council of the ECB has responded forcefully to the largest euro area inflation surge on record. We raised our key policy rates by a total of 450 basis points between July 2022 and September 2023. We had kept them at those restrictive levels until June this year, with the key interest rates - in particular the deposit facility rate, through which we steer the monetary policy stance - contributing substantially to the ongoing disinflation process. Following the two 25 basis point cuts in June and September this year, we decided to lower the key ECB interest rates again at our October meeting, based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We remain determined to ensure that inflation returns to our 2% medium-term target in a timely manner. Our future decisions will ensure that our policy rates will stay sufficiently restrictive for as long as necessary. As we have made clear in our communication, the Governing Council is not pre-committing to a particular rate path. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction.	---[PAGE_BREAK]--- # Luis de Guindos: Monetary policy and financial stability in the euro area Introductory remarks by Mr Luis de Guindos, Vice-President of the European Central Bank, at a meeting with business group Hotusa, Madrid, 28 October 2024. ## Inflation Inflation in the euro area has come a long way. After peaking at more than 10\% in October 2022 (in Spain, it peaked in July 2022), headline inflation stood at $1.7 \%$ in September this year. This was 0.5 percentage points lower than in August, largely reflecting a sharp drop in energy inflation. Core inflation has also fallen substantially from its peak, edging down from $2.8 \%$ in August to $2.7 \%$ in September. Most measures of underlying inflation have declined or remained unchanged. Domestic inflation remains high, reflecting elevated services inflation as wage pressures remain strong, but it too is showing signs of moderation. Inflation is expected to rise again later this year - partly due to base effects, as previous sharp falls in energy prices drop out of annual rates - before declining to our target of $2 \%$ in the course of next year. Inflation expectations of euro area firms and consumers have declined across all horizons. Most measures of longer-term inflation expectations stand at around $2 \%$. So, taken together, the incoming information shows that the disinflationary process is now well on track. The outlook, however, is surrounded by substantial risks. The geopolitical situation, especially the conflict in the Middle East and Russia's war against Ukraine, poses a particular upside risk to inflation. Heightened geopolitical tensions could push energy prices and freight costs higher in the near term and disrupt global trade. Extreme weather events could drive up food prices. And inflation could also turn out higher than anticipated if wages and profits increase by more than expected. But we may also see downside surprises in inflation - for example as a result of a stronger-than-expected dampening impact of monetary policy on demand, an unexpected worsening of the global economic environment, or a slower recovery in consumption and investment due to concerns about geopolitical events. ## Economic activity Economic activity in the euro area has been weaker than expected, with persisting differences across sectors. The composite output Purchasing Managers' Index (PMI) fell into contractionary territory in September, its deterioration broad-based across countries and sub-indices. The manufacturing output PMI fell further while the services sector continued to expand, though at a slowing pace, pointing to an overall weaker near-term outlook for growth. ---[PAGE_BREAK]--- Despite rising incomes, household consumption remained weak and savings increased by more than expected. This was likely due to higher real returns on savings, efforts to recuperate past losses in real wealth and, more broadly, the lagged response of consumption to rising incomes. The labour market remains resilient, with the unemployment rate at $6.4 \%$ in August, its lowest level since the introduction of the euro. However, surveys point to slowing employment growth and a further moderation in the demand for labour. Economic activity is expected to strengthen as real incomes rise and the easing of financing conditions supports consumption and investment. With global demand increasing, exports are also expected to contribute to the recovery. However, risks to the growth outlook remain elevated and tilted to the downside. In particular, lower confidence could prevent consumption and investment from recovering as fast as expected and geopolitical risks continue to pose a threat to the world economy by disrupting energy supplies and global trade. But euro area growth could be higher if the world economy grows more strongly than expected or if declining inflation and less restrictive monetary policy lead to a faster recovery in consumption and investment. # Financial stability As concerns about inflation abate, weaker growth prospects are weighing on the outlook for financial stability in the euro area. At the same time, geopolitical risks and political uncertainty continue to raise the likelihood of tail events. Let me mention three broad financial stability issues which stand out. First, while financial markets have shown resilience in recent periods of turmoil, they remain vulnerable to adverse dynamics as risk pricing appears too benign. Moreover, the nonbank financial sector - which is less transparent and subject to lighter regulation - could amplify any market correction, given concentrated exposures, liquidity and leverage vulnerabilities. Second, heightened political risks have highlighted closely interlinked vulnerabilities in sovereign, corporate, household, bank and non-bank sectors. Sovereign vulnerabilities are increasing, driven by heightened policy uncertainty and weak growth prospects. At the same time, interconnectedness between corporates, banks and non-banking intermediaries could create negative feedback loops if risks materialise in any of these sectors. Third, although conditions in commercial real estate markets have shown signs of stabilisation, there is a risk that the full scale of the correction is not yet reflected in valuations and that conditions could worsen again. ## Monetary policy The Governing Council of the ECB has responded forcefully to the largest euro area inflation surge on record. We raised our key policy rates by a total of 450 basis points between July 2022 and September 2023. We had kept them at those restrictive levels until June this year, with the key interest rates - in particular the deposit facility rate, through which we steer the monetary policy stance - contributing substantially to the ongoing disinflation process. Following the two 25 basis point cuts in June and September this year, we decided to lower the key ECB interest rates again at our ---[PAGE_BREAK]--- October meeting, based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We remain determined to ensure that inflation returns to our $2 \%$ medium-term target in a timely manner. Our future decisions will ensure that our policy rates will stay sufficiently restrictive for as long as necessary. As we have made clear in our communication, the Governing Council is not pre-committing to a particular rate path. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction.	Luis de Guindos	Euro area	https://www.bis.org/review/r241029d.pdf	Introductory remarks by Mr Luis de Guindos, Vice-President of the European Central Bank, at a meeting with business group Hotusa, Madrid, 28 October 2024. Inflation in the euro area has come a long way. After peaking at more than 10\% in October 2022 (in Spain, it peaked in July 2022), headline inflation stood at $1.7 \%$ in September this year. This was 0.5 percentage points lower than in August, largely reflecting a sharp drop in energy inflation. Core inflation has also fallen substantially from its peak, edging down from $2.8 \%$ in August to $2.7 \%$ in September. Most measures of underlying inflation have declined or remained unchanged. Domestic inflation remains high, reflecting elevated services inflation as wage pressures remain strong, but it too is showing signs of moderation. Inflation is expected to rise again later this year - partly due to base effects, as previous sharp falls in energy prices drop out of annual rates - before declining to our target of $2 \%$ in the course of next year. Inflation expectations of euro area firms and consumers have declined across all horizons. Most measures of longer-term inflation expectations stand at around $2 \%$. So, taken together, the incoming information shows that the disinflationary process is now well on track. The outlook, however, is surrounded by substantial risks. The geopolitical situation, especially the conflict in the Middle East and Russia's war against Ukraine, poses a particular upside risk to inflation. Heightened geopolitical tensions could push energy prices and freight costs higher in the near term and disrupt global trade. Extreme weather events could drive up food prices. And inflation could also turn out higher than anticipated if wages and profits increase by more than expected. But we may also see downside surprises in inflation - for example as a result of a stronger-than-expected dampening impact of monetary policy on demand, an unexpected worsening of the global economic environment, or a slower recovery in consumption and investment due to concerns about geopolitical events. Economic activity in the euro area has been weaker than expected, with persisting differences across sectors. The composite output Purchasing Managers' Index (PMI) fell into contractionary territory in September, its deterioration broad-based across countries and sub-indices. The manufacturing output PMI fell further while the services sector continued to expand, though at a slowing pace, pointing to an overall weaker near-term outlook for growth. Despite rising incomes, household consumption remained weak and savings increased by more than expected. This was likely due to higher real returns on savings, efforts to recuperate past losses in real wealth and, more broadly, the lagged response of consumption to rising incomes. The labour market remains resilient, with the unemployment rate at $6.4 \%$ in August, its lowest level since the introduction of the euro. However, surveys point to slowing employment growth and a further moderation in the demand for labour. Economic activity is expected to strengthen as real incomes rise and the easing of financing conditions supports consumption and investment. With global demand increasing, exports are also expected to contribute to the recovery. However, risks to the growth outlook remain elevated and tilted to the downside. In particular, lower confidence could prevent consumption and investment from recovering as fast as expected and geopolitical risks continue to pose a threat to the world economy by disrupting energy supplies and global trade. But euro area growth could be higher if the world economy grows more strongly than expected or if declining inflation and less restrictive monetary policy lead to a faster recovery in consumption and investment. As concerns about inflation abate, weaker growth prospects are weighing on the outlook for financial stability in the euro area. At the same time, geopolitical risks and political uncertainty continue to raise the likelihood of tail events. Let me mention three broad financial stability issues which stand out. First, while financial markets have shown resilience in recent periods of turmoil, they remain vulnerable to adverse dynamics as risk pricing appears too benign. Moreover, the nonbank financial sector - which is less transparent and subject to lighter regulation - could amplify any market correction, given concentrated exposures, liquidity and leverage vulnerabilities. Second, heightened political risks have highlighted closely interlinked vulnerabilities in sovereign, corporate, household, bank and non-bank sectors. Sovereign vulnerabilities are increasing, driven by heightened policy uncertainty and weak growth prospects. At the same time, interconnectedness between corporates, banks and non-banking intermediaries could create negative feedback loops if risks materialise in any of these sectors. Third, although conditions in commercial real estate markets have shown signs of stabilisation, there is a risk that the full scale of the correction is not yet reflected in valuations and that conditions could worsen again. The Governing Council of the ECB has responded forcefully to the largest euro area inflation surge on record. We raised our key policy rates by a total of 450 basis points between July 2022 and September 2023. We had kept them at those restrictive levels until June this year, with the key interest rates - in particular the deposit facility rate, through which we steer the monetary policy stance - contributing substantially to the ongoing disinflation process. Following the two 25 basis point cuts in June and September this year, we decided to lower the key ECB interest rates again at our October meeting, based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We remain determined to ensure that inflation returns to our $2 \%$ medium-term target in a timely manner. Our future decisions will ensure that our policy rates will stay sufficiently restrictive for as long as necessary. As we have made clear in our communication, the Governing Council is not pre-committing to a particular rate path. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction.
2024-11-04T00:00:00	Frank Elderson: The first decade of European supervision - taking stock and looking ahead	Keynote speech by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the "10 years of SSM – looking back and looking forward" conference, organised by the European Banking Institute and the Hessisches Ministerium für Wissenschaft und Kunst, Frankfurt am Main, 4 November 2024.	SPEECH The first decade of European supervision: taking stock and looking ahead Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB at the "10 Years of SSM - Looking back and looking forward" conference organised by the European Banking Institute and the Hessisches Ministerium fur Wissenschaft und Kunst Frankfurt am Main, 4 November 2024 Introduction Thank you for your kind invitation. It's a pleasure to be with you this afternoon to reflect on the first decade of European banking supervision and, most importantly, to take a look at the path ahead of us. On this day ten years ago, the morning might have seemed just like a typical November morning in Frankfurt's Bankenviertel: a rainy autumn day, with people heading to their offices armed with umbrellas, wearing heavy coats. But that day ten years ago was anything but typical. Because it was the first time European supervisory teams got together and started work on an important task: making sure the banking system is safe and sound on behalf of European citizens. At the time, some argued that integrating a fragmented system of supervision was either impossible or would take forever. Well, those pioneer European supervisors who came together on 4 November 2014 have certainly proven the sceptics wrong. We have come a long way since that day. The last ten years have been transformative both for the Single Supervisory Mechanism (SSM) and the banks we supervise. We have evolved from a start-up to a mature, risk-based and effective supervisor. Banks under our supervision have also evolved significantly, building up remarkable resilience. Unlike in the crises that predated the banking union, banks have now become part of the solution to economic shocks rather than the source. That's good news. There is, however, no room for complacency. While past achievements provide a solid foundation, they are by no means a guarantee of future success. The macro-financial environment is changing profoundly. Unlike ten years ago, when the main risks emanated from banks themselves, today prudential risks are largely driven by an increasingly volatile and uncertain external environment. In my remarks, I will therefore focus on how supervisors and banks must adapt to this challenging environment. I will also address suggestions being put forward by some to relax banking regulation and supervision - suggestions which in my view are misguided. Compromising the resilience that has been carefully built up over the past ten years would undermine the objective of having a financial system that can support a competitive and sustainable economy. The first decade of European supervision: from start-up to maturity But before focusing on current challenges, I hope you'll allow me to take a brief walk down memory lane. Where did we start from? What were the expectations a decade ago? And how did we go about meeting them? As Europe was looking into the abyss of the euro area sovereign debt crisis in 2012, legislators agreed on nothing less than a paradigm shift - the banking union, which represented the most significant leap forward in European integration since the introduction of the euro. The banking union encompasses three pillars, each with a straightforward task: first, European banking supervision to ensure that banks across Europe are subject to the same rules and high-quality supervisory standards. Second, European resolution to make sure that if banks fail, they can get resolved in an orderly manner instead of relying on the public purse. And third, European deposit insurance, to make sure that when push comes to shove, all depositors enjoy the same protection, no matter where in the euro area they are based. As far as the supervisory pillar is concerned, the ECB and the national competent authorities that make up the SSM were given a clear mission: ensuring the safety and soundness of banks. This is not just an end in itself - it is necessary so that banks remain at the service of people and businesses by funding innovation, productivity and sustainable growth. The destination was clear. But we had no roadmap to show us how to get there. There was no blueprint on how to transform a fragmented system of supervision into an integrated one. So it was by no means a given that the SSM would be a success. In the start-up phase of the SSM we were essentially crossing the bridge we were still building: we spent the mornings recruiting the best risk experts from across Europe, the afternoons supervising significant banks, and the evenings setting up our processes. When we started, there were plenty of ways in which supervisors across Europe looked at risks and how best to mitigate them. They all focused on different things: while some put the emphasis on credit file reviews, others focused on scrutinising banks' internal risk management through the lens of the internal capital adequacy assessment process. Some supervisors chose to shine the spotlight more closely on governance or on-site culture. Thanks to the unwavering commitment and tireless energy of supervisors from the national competent authorities and the ECB, we consolidated the best practices from this wealth of supervisory experience into a common supervisory approach. What followed was a race to the top rather than to the bottom, resulting in high-quality supervision and a level playing field. On our path to becoming a mature organisation, we have adapted our processes along the way. Our supervision has evolved from being predominantly rule-based and heavily codified, to having a more flexible, agile and risk-focused approach. And banks under our supervision have also evolved significantly over the past ten years. Today, European banks are in much better shape than a decade ago. For instance, the financial resilience of SSM banks has notably improved. The aggregate Common Equity Tier 1 (CET1) ratio has increased from 12.7% in 2015 to 15.8% today, the liquidity coverage ratio has increased from 138% in 2016 to 159% today and the non-performing loan ratio of significant banks has declined from 7.5% in 2015 to 1.9% today. Moreover, risk management, the effectiveness of internal control functions and governance arrangements in SSM banks have all improved. Over the past ten years, banks under European supervision have shown remarkable resilience even under the most challenging circumstances. They have evolved from shock propagators to shock absorbers, stabilising rather than de-stabilising the economy as it experienced significant shocks such as the pandemic, Russia's unjustified war against Ukraine and the rapid changes to the interest rate environment. This resilience is also a testament to the crucial role played by European supervision, confirming that the SSM has lived up to the expectations that were placed on it a decade ago.!2] Highly complex, volatile and challenging risk landscape But there is no room for complacency. We can't assume that the achievements of the past ten years will automatically pave the way for another successful decade of resilient banks under European supervision. We can't ignore the fact that the world around us is changing. The macro-financial environment is characterised by unprecedented shocks, giving rise to new risk drivers. In the words of President Lagarde, in the last three years alone we have "faced the worst pandemic since the 1920s, the worst conflict in Europe since the 1940s and the worst energy shock since the 1970s"./5] And as former US Treasury secretary Larry Summers put it, "this is the most complex, disparate and cross-cutting set of challenges that I can remember in the 40 years that I have been paying attention to such things"./4] In fact, the current combination of risks, challenges and uncertainties is staggering. Awidening geopolitical divide and a global economy that is fragmenting into competing, increasingly protectionist blocs, give rise to new geopolitical risks. Heightened operational headwinds such as ever-more sophisticated cyberattacks and technology disruptions are challenging banks' operational resilience. And last, but, alas, not least, we see the climate and nature crises unfolding, as evidenced by the horrific events last week in Paiporta and other villages and towns in the Spanish region of Valencia. On top of the human tragedy and physical destruction, the climate and nature crises are increasingly leading to material risks for banks. What makes this period so unprecedented is that these challenges are not happening one after the other - they are all happening at the same time. And there is no clear sign of them going away any time soon, rather the contrary. So how can supervisors and banks adjust to this era of polycrises? Ensuring bank resilience in the era of polycrises First and foremost, banks' management bodies are the ones holding the steering wheel and must ensure that banks remain resilient and prepared for this new risk landscape. This involves making sure that banks have sound risk management that is commensurate to new risk drivers, that they maintain sufficient capital headroom to cushion against credible adverse scenarios, and that banks' management bodies are effective in their steering and oversight function. While acknowledging that banks' management bodies are in the driving seat, as supervisors we keep a close eye to ensure that no material risks are left unaddressed." This means that we must be able to identify the risks and then ensure that banks are resilient to these risks. To ensure that our risk identification can keep up with the changing risk landscape, we have made our supervisory processes more agile. We simply cannot look at every risk with the same intensity, every year, in every bank we supervise. We have therefore started to implement a supervisory risk tolerance framework aiming at freeing up the desks and minds of supervisors. This allows our supervisors to focus on those risks that are most pertinent and the supervisory actions that are most impactful. In the same vein, we have also reformed our Supervisory Review and Evaluation Process (SREP) to make it more targeted and risk-based. Moreover, we are increasingly using supervisory technology tools - also known as suptech - to detect risks early on and move closer to real-time supervision. These improvements to our processes give our supervisory teams more time to focus on the most relevant risks. By detecting vulnerabilities that would otherwise only surface later, we help banks to be better prepared and build up resilience proactively. Let me illustrate this with an example. Threats from cyberattacks are on the increase and are challenging banks' operational resilience. In 2022, 50% of our supervised entities were subject to at least one successful attack - that number rose to 68% in just one year. In order to help banks better identify their vulnerabilities to cyber risks and bolster their operational resilience, earlier this year we conducted a cyber resilience stress test!8l to gauge how well banks would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test was an important learning exercise for banks; it helped them pinpoint areas where they need to build greater operational resilience to cyberattacks, which are unlikely to fade away in the current geopolitical risk environment. Let's shift our focus from risk identification to remediation. As supervisors we must ensure that the risks we identify in our risk assessments are adequately managed. This also means that if we find deficiencies in the way banks are managing their risks, they must be remediated fully and in a timely manner, not at some unspecified point in the distant future. This is why we are putting more emphasis on impact and effectiveness. 2] To ensure full and timely remediation of our supervisory findings, we set out a time-bound remediation path. If a bank is not remedying the deficiency at a speed that will ensure full and timely remediation by the pre-established timeline, we will step up our supervisory action by deploying more intrusive measures from our ample supervisory toolkit. This is what we call the "escalation ladder'. The use of supervisory powers to compel banks to make concrete improvements is not just something we do within the SSM; it is international best practice." The disorderly events of the March 2023 banking turmoil were a clear reminder of what can happen when banks leave material shortcomings unaddressed for too long. Banks and supervisors need to have the capacity to focus on emerging challenges. That's why it is important to declutter our desks by tackling supervisory findings that have been with us for too long. While this is always an imperative, it is especially pertinent in the current challenging risk landscape. Let me illustrate this with the example of risk data aggregation and reporting. It is very hard to imagine any bank being able to appropriately manage its risks without strong risk data reporting. A bank's ability to manage and aggregate risk-related data effectively is a pre-requisite for sound decision-making and robust risk governance. In fact, the Capital Requirements Directive, as transposed into national law, requires banks to put processes in place to identify all material risks. Worryingly, risk data aggregation and reporting was the lowest-scoring sub-category of internal governance in the 2023 SREP. In other words, despite the work done by supervisors over the years, too many banks still don't have adequate risk data aggregation and reporting capabilities. It should not be a surprise that ECB Banking Supervision is stepping up the escalation ladder, using more intrusive supervisory tools to ensure that banks have adequate risk data aggregation capabilities. It's not about forcing banks to do something that is merely an added perk; it's about making sure they are able to manage material risks adequately and in good time. In a rapidly changing risk environment where prompt availability of reliable data has become essential, timely remediation of our supervisory findings on risk data aggregation is more important than ever. Deregulation and lenient supervision would compromise resilience After a decade of European supervision, it is not only the external risk environment that has changed. The current debate suggests that the perception by some of the role of financial regulation and supervision is also changing. Ten years ago, with the gloomy memories of the global financial crisis lingering in people's minds, there was a strong consensus across society on the need for strong financial regulation and supervision in order to safeguard the public good of financial stability. Today, it appears that the pendulum is slowly swinging in the opposite direction. Some have raised the question as to whether regulation and supervision have become too conservative, to the point that they may constrain growth. Let me be clear: the argument being put forward in favour of relaxing banking regulation and supervision in order to promote growth is misguided. We can't allow the memory of the global financial crisis to fade. Its lessons are as relevant today as they were back in 2012, when the banking union was created. As deputy governor of the Bank of England, Sam Woods, correctly said, the great financial crisis was "the biggest growth-destroying event in recent economic history"."2] The crisis was a stark reminder of the economic, social and fiscal hardship that weakly regulated and supervised banks can cause for people. The last thing we should do is ignore the lessons of the financial crisis and allow a regulatory race to the bottom, which would compromise the resilience that has been carefully built up over the last decade. It is a fundamental misconception to frame safety and competitiveness as opposing forces. It is essential to remember that resilient and well-capitalised banks are a pre-condition for competitiveness and sustainable growth. Strong and resilient banks are best equipped to lend to the real economy, funding innovation, investment and growth, even during economic downturns.!2] Banking deregulation or more lenient supervision would weaken the foundations of growth. It is true that European growth has been sluggish when compared with other regions, and addressing it is rightly a top priority. That is why we need policies to tackle the root causes of low productivity, promote innovation and bolster the single European market. For instance, the EU will need an additional €5.4 trillion between 2025 and 2031 to advance our green transformation, accelerate the digitalisation of our economy and bolster our defence capabilities."4] Faced with this mammoth task, deepening the capital markets union to help guide the required financing flows should be our highest priority. This will help channel private investments towards supporting innovation and the twin green and digital transition - ultimately fostering EU competitiveness. To speed up the integration of a single banking market in Europe, we should now move forward and complete the banking union. As a first step, we must enhance the crisis management and deposit insurance framework so that the failures of small and medium-sized banks can be dealt with more effectively. Second, we would welcome if Member States were to resume discussions on setting-up a European-level public backstop to provide temporary liquidity funding to banks following resolution. The credibility of the resolution framework in Europe would be significantly enhanced by setting up a framework for liquidity in resolution. Moreover, building on the strong foundations of the SSM and the Single Resolution Mechanism, we must pave the way for a common European deposit insurance scheme (EDIS). In the first decade of the SSM, risks have been significantly reduced and common supervisory standards have been established. These preconditions for EDIS have now been met, and moving it forward will be important for severing any remaining feedback loops between banks and sovereigns, given that these proved so harmful during the sovereign debt crisis. Conclusion Let me conclude. Ten years ago today, when European supervisory teams started to come together for the first time, it was not at all certain that the SSM would be a success. We have since built a strong and effective supervisory framework in Europe, perceptive to evolving risks and - whenever necessary and appropriate - insistent in making sure that material risks are addressed. European banks have notably improved, proving resilient to shocks that we couldn't have imagined a decade ago. This resilience is also a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis, including the creation of the banking union. Ten years ago, the first Vice-Chair of the SSM, Sabine Lautenschlager, invoked the parallel of an athlete at the beginning of a career, who trained extremely hard and achieved an excellent result in a first major tournament.) To turn this promising start into a track record of sustained high performance, the athlete clearly cannot afford to rest on her laurels. Instead, she needs to go right back to the routine of constant training, to keep developing her skills and thus continue to build the foundation for future success on a day-to-day basis. This conclusion is as relevant today as it was ten year ago, especially considering the challenges along the path ahead. Considering the macro-financial environment and volatile risk landscape, it is safe to say that there is a high likelinood of unprecedented shocks continuing to emerge over the next decade. To make sure banks continue to serve European households and businesses under these challenging circumstances, we must ensure they remain resilient. Because a stable banking system forms the bedrock of long-term competitiveness and sustainable growth. European supervisors will continue to work tirelessly to make sure banks are well capitalised and adequately manage their risks. In this way, in ten years' time we can celebrate another successful decade of resilient banks under European supervision. 1. This includes cash balances and other demand deposits. 2. This tangible impact has also been widely recognised in several external reviews by, among others, an external expert group, the European Court of Auditors and the European Commission. The reports unanimously confirm that ECB Banking Supervision has successfully established itself as an effective supervisor. 3. Lagarde, C. (2024), "Setbacks and strides forward: structural shifts and monetary policy in the twenties", speech at the 2024 Michel Camdessus Central Banking Lecture organised by the IMF, Washington, 20 September. 4. Financial Times (2022), "Welcome to the world of the polycrisis", 28 October. 5. This is enshrined in the BCBS core principles and has been a legal requirement for decades. According to this principle, banks must identify and adequately manage the risks they are exposed to. 6. 14 supervisory technology tools have already gone live and are making the daily work of 3,500 supervisors across the SSM easier, improving risk analysis, collaboration and the consistency of decision- making. 7. McCaul, E. (2024), "Fading crises, shifting priorities: a supervisory perspective on the regulatory cycle", speech at the conference on "EU banking regulation at a turning point', Rome, 25 October. 8. See also Tuominen, A. (2024), "Enhancing banks' resilience against cyber threats - a key priority for the ECB", The Supervision Blog, ECB, 26 July. 9. Elderson, F. (2023), "Powers, ability and willingness to act - the mainstay of effective banking supervision", speech at the House of the Euro, 7 December, and Elderson, F. (2024), "Preparing for the next decade of European banking supervision: risk-focused, impactful and legally sound", speech at the "10 years SSM and beyond" event organised by Allen & Overy, 27 June. 10. Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April, p. 8; Basel Committee on Banking Supervision (2023), Report on the 2023 banking turmoil, October, p. 26; International Monetary Fund (2023), Good Supervision: Lessons from the Field, September, pp. 4 et seq. 11. See also Buch, C. (2024), "Building_a resilient future: how Europe's financial stability fosters growth and competitiveness", speech at the Financial Forum 2024, Budapest, 12 September. 12. Woods, S. (2024), "Competing for growth", speech at the Annual City Banquet, Mansion House, 17 October. 13. Budnik, K., Dimitrov, I., Gross, J., Lampe, M. and Volk, M. (2021), "Macroeconomic impact of Basel III finalisation on the euro area", Macroprudential Bulletin, No 14, European Central Bank. See also Siciliani, P., Eccles, P., Netto, F., Vitello, E., Sivanathan, V. and van Hasselt, I. (2023), Paper 2: The links between prudential regulation, competitiveness and growth. Background working paper published by PRA staff in support of the conference on the role of financial regulation in international competitiveness and economic growth conference 2023, Bank of England Prudential Regulation Authority, 11 September. On the usability of buffers for bank lending, see Couaillier, C. et al. (2021), "Bank capital buffers and lending in the euro area during the pandemic", published as part of the Financial Stability Review, November 2021, and Couaillier, C. et al. (2022), "Caution: do not cross! Capital buffers and lending in Covid-19 times", ECB Working Paper, No 2644. 14. Bouabdallah, O., Dorrucci, E., Hoendervangers, L. and Nerlich, C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them", The ECB Blog, 27 June. 15. Lautenschlager, S. (2014), "Start of the Single Supervisory Mechanism: from the comprehensive assessment to day-to-day supervision", speech at the Euro Finance Week, Frankfurt am Main, 18 November. CONTACT	---[PAGE_BREAK]--- # The first decade of European supervision: taking stock and looking ahead ## Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB at the "10 Years of SSM - Looking back and looking forward" conference organised by the European Banking Institute and the Hessisches Ministerium für Wissenschaft und Kunst Frankfurt am Main, 4 November 2024 ## Introduction Thank you for your kind invitation. It's a pleasure to be with you this afternoon to reflect on the first decade of European banking supervision and, most importantly, to take a look at the path ahead of us. On this day ten years ago, the morning might have seemed just like a typical November morning in Frankfurt's Bankenviertel: a rainy autumn day, with people heading to their offices armed with umbrellas, wearing heavy coats. But that day ten years ago was anything but typical. Because it was the first time European supervisory teams got together and started work on an important task: making sure the banking system is safe and sound on behalf of European citizens. At the time, some argued that integrating a fragmented system of supervision was either impossible or would take forever. Well, those pioneer European supervisors who came together on 4 November 2014 have certainly proven the sceptics wrong. We have come a long way since that day. The last ten years have been transformative both for the Single Supervisory Mechanism (SSM) and the banks we supervise. We have evolved from a start-up to a mature, risk-based and effective supervisor. Banks under our supervision have also evolved significantly, building up remarkable resilience. Unlike in the crises that predated the banking union, banks have now become part of the solution to economic shocks rather than the source. That's good news. There is, however, no room for complacency. While past achievements provide a solid foundation, they are by no means a guarantee of future success. The macro-financial environment is changing profoundly. Unlike ten years ago, when the main risks emanated from banks themselves, today prudential risks are largely driven by an increasingly volatile and uncertain external environment. ---[PAGE_BREAK]--- In my remarks, I will therefore focus on how supervisors and banks must adapt to this challenging environment. I will also address suggestions being put forward by some to relax banking regulation and supervision - suggestions which in my view are misguided. Compromising the resilience that has been carefully built up over the past ten years would undermine the objective of having a financial system that can support a competitive and sustainable economy. # The first decade of European supervision: from start-up to maturity But before focusing on current challenges, I hope you'll allow me to take a brief walk down memory lane. Where did we start from? What were the expectations a decade ago? And how did we go about meeting them? As Europe was looking into the abyss of the euro area sovereign debt crisis in 2012, legislators agreed on nothing less than a paradigm shift - the banking union, which represented the most significant leap forward in European integration since the introduction of the euro. The banking union encompasses three pillars, each with a straightforward task: first, European banking supervision to ensure that banks across Europe are subject to the same rules and high-quality supervisory standards. Second, European resolution to make sure that if banks fail, they can get resolved in an orderly manner instead of relying on the public purse. And third, European deposit insurance, to make sure that when push comes to shove, all depositors enjoy the same protection, no matter where in the euro area they are based. As far as the supervisory pillar is concerned, the ECB and the national competent authorities that make up the SSM were given a clear mission: ensuring the safety and soundness of banks. This is not just an end in itself - it is necessary so that banks remain at the service of people and businesses by funding innovation, productivity and sustainable growth. The destination was clear. But we had no roadmap to show us how to get there. There was no blueprint on how to transform a fragmented system of supervision into an integrated one. So it was by no means a given that the SSM would be a success. In the start-up phase of the SSM we were essentially crossing the bridge we were still building: we spent the mornings recruiting the best risk experts from across Europe, the afternoons supervising significant banks, and the evenings setting up our processes. When we started, there were plenty of ways in which supervisors across Europe looked at risks and how best to mitigate them. They all focused on different things: while some put the emphasis on credit file reviews, others focused on scrutinising banks' internal risk management through the lens of the internal capital adequacy assessment process. Some supervisors chose to shine the spotlight more closely on governance or on-site culture. Thanks to the unwavering commitment and tireless energy of supervisors from the national competent authorities and the ECB, we consolidated the best practices from this wealth of supervisory experience ---[PAGE_BREAK]--- into a common supervisory approach. What followed was a race to the top rather than to the bottom, resulting in high-quality supervision and a level playing field. On our path to becoming a mature organisation, we have adapted our processes along the way. Our supervision has evolved from being predominantly rule-based and heavily codified, to having a more flexible, agile and risk-focused approach. And banks under our supervision have also evolved significantly over the past ten years. Today, European banks are in much better shape than a decade ago. For instance, the financial resilience of SSM banks has notably improved. The aggregate Common Equity Tier 1 (CET1) ratio has increased from 12.7\% in 2015 to 15.8\% today, the liquidity coverage ratio has increased from $138 \%$ in 2016 to $159 \%$ today and the non-performing loan ratio of significant banks has declined from $7.5 \%$ in 2015 to $1.9 \%$ today. ${ }^{[1]}$ Moreover, risk management, the effectiveness of internal control functions and governance arrangements in SSM banks have all improved. Over the past ten years, banks under European supervision have shown remarkable resilience even under the most challenging circumstances. They have evolved from shock propagators to shock absorbers, stabilising rather than de-stabilising the economy as it experienced significant shocks such as the pandemic, Russia's unjustified war against Ukraine and the rapid changes to the interest rate environment. This resilience is also a testament to the crucial role played by European supervision, confirming that the SSM has lived up to the expectations that were placed on it a decade ago. ${ }^{[2]}$ # Highly complex, volatile and challenging risk landscape But there is no room for complacency. We can't assume that the achievements of the past ten years will automatically pave the way for another successful decade of resilient banks under European supervision. We can't ignore the fact that the world around us is changing. The macro-financial environment is characterised by unprecedented shocks, giving rise to new risk drivers. In the words of President Lagarde, in the last three years alone we have "faced the worst pandemic since the 1920s, the worst conflict in Europe since the 1940s and the worst energy shock since the 1970s". ${ }^{[3]}$ And as former US Treasury secretary Larry Summers put it, "this is the most complex, disparate and cross-cutting set of challenges that I can remember in the 40 years that I have been paying attention to such things". ${ }^{[4]}$ In fact, the current combination of risks, challenges and uncertainties is staggering. A widening geopolitical divide and a global economy that is fragmenting into competing, increasingly protectionist blocs, give rise to new geopolitical risks. Heightened operational headwinds such as ever-more sophisticated cyberattacks and technology disruptions are challenging banks' operational resilience. ---[PAGE_BREAK]--- And last, but, alas, not least, we see the climate and nature crises unfolding, as evidenced by the horrific events last week in Paiporta and other villages and towns in the Spanish region of Valencia. On top of the human tragedy and physical destruction, the climate and nature crises are increasingly leading to material risks for banks. What makes this period so unprecedented is that these challenges are not happening one after the other they are all happening at the same time. And there is no clear sign of them going away any time soon, rather the contrary. So how can supervisors and banks adjust to this era of polycrises? # Ensuring bank resilience in the era of polycrises First and foremost, banks' management bodies are the ones holding the steering wheel and must ensure that banks remain resilient and prepared for this new risk landscape. This involves making sure that banks have sound risk management that is commensurate to new risk drivers, that they maintain sufficient capital headroom to cushion against credible adverse scenarios, and that banks' management bodies are effective in their steering and oversight function. While acknowledging that banks' management bodies are in the driving seat, as supervisors we keep a close eye to ensure that no material risks are left unaddressed. ${ }^{[5]}$ This means that we must be able to identify the risks and then ensure that banks are resilient to these risks. To ensure that our risk identification can keep up with the changing risk landscape, we have made our supervisory processes more agile. We simply cannot look at every risk with the same intensity, every year, in every bank we supervise. We have therefore started to implement a supervisory risk tolerance framework aiming at freeing up the desks and minds of supervisors. This allows our supervisors to focus on those risks that are most pertinent and the supervisory actions that are most impactful. In the same vein, we have also reformed our Supervisory Review and Evaluation Process (SREP) to make it more targeted and risk-based. Moreover, we are increasingly using supervisory technology tools - also known as suptech - to detect risks early on and move closer to real-time supervision. ${ }^{[6]}$ These improvements to our processes give our supervisory teams more time to focus on the most relevant risks. By detecting vulnerabilities that would otherwise only surface later, we help banks to be better prepared and build up resilience proactively. Let me illustrate this with an example. Threats from cyberattacks are on the increase and are challenging banks' operational resilience. In 2022, 50\% of our supervised entities were subject to at least one successful attack - that number rose to $68 \%$ in just one year. ${ }^{[7]}$ In order to help banks better identify their vulnerabilities to cyber risks and bolster their operational resilience, earlier this year we conducted a cyber resilience stress test ${ }^{[8]}$ to gauge how well banks would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test was an important learning exercise for banks; it helped them pinpoint areas where they need to build ---[PAGE_BREAK]--- greater operational resilience to cyberattacks, which are unlikely to fade away in the current geopolitical risk environment. Let's shift our focus from risk identification to remediation. As supervisors we must ensure that the risks we identify in our risk assessments are adequately managed. This also means that if we find deficiencies in the way banks are managing their risks, they must be remediated fully and in a timely manner, not at some unspecified point in the distant future. This is why we are putting more emphasis on impact and effectiveness. ${ }^{[9]}$ To ensure full and timely remediation of our supervisory findings, we set out a time-bound remediation path. If a bank is not remedying the deficiency at a speed that will ensure full and timely remediation by the pre-established timeline, we will step up our supervisory action by deploying more intrusive measures from our ample supervisory toolkit. This is what we call the "escalation ladder". The use of supervisory powers to compel banks to make concrete improvements is not just something we do within the SSM; it is international best practice. ${ }^{[10]}$ The disorderly events of the March 2023 banking turmoil were a clear reminder of what can happen when banks leave material shortcomings unaddressed for too long. Banks and supervisors need to have the capacity to focus on emerging challenges. That's why it is important to declutter our desks by tackling supervisory findings that have been with us for too long. While this is always an imperative, it is especially pertinent in the current challenging risk landscape. Let me illustrate this with the example of risk data aggregation and reporting. It is very hard to imagine any bank being able to appropriately manage its risks without strong risk data reporting. A bank's ability to manage and aggregate risk-related data effectively is a pre-requisite for sound decision-making and robust risk governance. In fact, the Capital Requirements Directive, as transposed into national law, requires banks to put processes in place to identify all material risks. Worryingly, risk data aggregation and reporting was the lowest-scoring sub-category of internal governance in the 2023 SREP. In other words, despite the work done by supervisors over the years, too many banks still don't have adequate risk data aggregation and reporting capabilities. It should not be a surprise that ECB Banking Supervision is stepping up the escalation ladder, using more intrusive supervisory tools to ensure that banks have adequate risk data aggregation capabilities. It's not about forcing banks to do something that is merely an added perk; it's about making sure they are able to manage material risks adequately and in good time. In a rapidly changing risk environment where prompt availability of reliable data has become essential, timely remediation of our supervisory findings on risk data aggregation is more important than ever. # Deregulation and lenient supervision would compromise resilience After a decade of European supervision, it is not only the external risk environment that has changed. The current debate suggests that the perception by some of the role of financial regulation and supervision is also changing. ---[PAGE_BREAK]--- Ten years ago, with the gloomy memories of the global financial crisis lingering in people's minds, there was a strong consensus across society on the need for strong financial regulation and supervision in order to safeguard the public good of financial stability. Today, it appears that the pendulum is slowly swinging in the opposite direction. Some have raised the question as to whether regulation and supervision have become too conservative, to the point that they may constrain growth. Let me be clear: the argument being put forward in favour of relaxing banking regulation and supervision in order to promote growth is misguided. ${ }^{[11]}$ We can't allow the memory of the global financial crisis to fade. Its lessons are as relevant today as they were back in 2012, when the banking union was created. As deputy governor of the Bank of England, Sam Woods, correctly said, the great financial crisis was "the biggest growth-destroying event in recent economic history". ${ }^{[12]}$ The crisis was a stark reminder of the economic, social and fiscal hardship that weakly regulated and supervised banks can cause for people. The last thing we should do is ignore the lessons of the financial crisis and allow a regulatory race to the bottom, which would compromise the resilience that has been carefully built up over the last decade. It is a fundamental misconception to frame safety and competitiveness as opposing forces. It is essential to remember that resilient and well-capitalised banks are a pre-condition for competitiveness and sustainable growth. Strong and resilient banks are best equipped to lend to the real economy, funding innovation, investment and growth, even during economic downturns. ${ }^{[13]}$ Banking deregulation or more lenient supervision would weaken the foundations of growth. It is true that European growth has been sluggish when compared with other regions, and addressing it is rightly a top priority. That is why we need policies to tackle the root causes of low productivity, promote innovation and bolster the single European market. For instance, the EU will need an additional $€ 5.4$ trillion between 2025 and 2031 to advance our green transformation, accelerate the digitalisation of our economy and bolster our defence capabilities. ${ }^{[14]}$ Faced with this mammoth task, deepening the capital markets union to help guide the required financing flows should be our highest priority. This will help channel private investments towards supporting innovation and the twin green and digital transition - ultimately fostering EU competitiveness. To speed up the integration of a single banking market in Europe, we should now move forward and complete the banking union. As a first step, we must enhance the crisis management and deposit insurance framework so that the failures of small and medium-sized banks can be dealt with more effectively. Second, we would welcome if Member States were to resume discussions on setting-up a European-level public backstop to provide temporary liquidity funding to banks following resolution. The credibility of the ---[PAGE_BREAK]--- resolution framework in Europe would be significantly enhanced by setting up a framework for liquidity in resolution. Moreover, building on the strong foundations of the SSM and the Single Resolution Mechanism, we must pave the way for a common European deposit insurance scheme (EDIS). In the first decade of the SSM, risks have been significantly reduced and common supervisory standards have been established. These preconditions for EDIS have now been met, and moving it forward will be important for severing any remaining feedback loops between banks and sovereigns, given that these proved so harmful during the sovereign debt crisis. # Conclusion Let me conclude. Ten years ago today, when European supervisory teams started to come together for the first time, it was not at all certain that the SSM would be a success. We have since built a strong and effective supervisory framework in Europe, perceptive to evolving risks and - whenever necessary and appropriate - insistent in making sure that material risks are addressed. European banks have notably improved, proving resilient to shocks that we couldn't have imagined a decade ago. This resilience is also a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis, including the creation of the banking union. Ten years ago, the first Vice-Chair of the SSM, Sabine Lautenschläger, invoked the parallel of an athlete at the beginning of a career, who trained extremely hard and achieved an excellent result in a first major tournament. ${ }^{[15]}$ To turn this promising start into a track record of sustained high performance, the athlete clearly cannot afford to rest on her laurels. Instead, she needs to go right back to the routine of constant training, to keep developing her skills and thus continue to build the foundation for future success on a day-to-day basis. This conclusion is as relevant today as it was ten year ago, especially considering the challenges along the path ahead. Considering the macro-financial environment and volatile risk landscape, it is safe to say that there is a high likelihood of unprecedented shocks continuing to emerge over the next decade. To make sure banks continue to serve European households and businesses under these challenging circumstances, we must ensure they remain resilient. Because a stable banking system forms the bedrock of long-term competitiveness and sustainable growth. European supervisors will continue to work tirelessly to make sure banks are well capitalised and adequately manage their risks. In this way, in ten years' time we can celebrate another successful decade of resilient banks under European supervision. 1 . This includes cash balances and other demand deposits. ---[PAGE_BREAK]--- 2. This tangible impact has also been widely recognised in several external reviews by, among others, an external expert group, the European Court of Auditors and the European Commission. The reports unanimously confirm that ECB Banking Supervision has successfully established itself as an effective supervisor. 3. Lagarde, C. (2024), "Setbacks and strides forward: structural shifts and monetary policy in the twenties", speech at the 2024 Michel Camdessus Central Banking Lecture organised by the IMF, Washington, 20 September. 4. Financial Times (2022), "Welcome to the world of the polycrisis", 28 October. 5. This is enshrined in the BCBS core principles and has been a legal requirement for decades. According to this principle, banks must identify and adequately manage the risks they are exposed to. 6. 14 supervisory technology tools have already gone live and are making the daily work of 3,500 supervisors across the SSM easier, improving risk analysis, collaboration and the consistency of decisionmaking. 7. McCaul, E. (2024), "Fading crises, shifting priorities: a supervisory perspective on the regulatory cycle", speech at the conference on "EU banking regulation at a turning point", Rome, 25 October. 8. See also Tuominen, A. (2024), "Enhancing banks' resilience against cyber threats - a key priority for the ECB", The Supervision Blog, ECB, 26 July. 9. Elderson, F. (2023), "Powers, ability and willingness to act - the mainstay of effective banking supervision", speech at the House of the Euro, 7 December, and Elderson, F. (2024), "Preparing for the next decade of European banking supervision: risk-focused, impactful and legally sound", speech at the "10 years SSM and beyond" event organised by Allen \& Overy, 27 June. 10. ---[PAGE_BREAK]--- Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April, p. 8; Basel Committee on Banking Supervision (2023), Report on the 2023 banking turmoil, October, p. 26; International Monetary Fund (2023), Good Supervision: Lessons from the Field, September, pp. 4 et seq. 11. See also Buch, C. (2024), "Building a resilient future: how Europe's financial stability fosters growth and competitiveness", speech at the Financial Forum 2024, Budapest, 12 September. 12. Woods, S. (2024), "Competing for growth", speech at the Annual City Banquet, Mansion House, 17 October. 13. Budnik, K., Dimitrov, I., Gross, J., Lampe, M. and Volk, M. (2021), "Macroeconomic impact of Basel III finalisation on the euro area", Macroprudential Bulletin, No 14, European Central Bank. See also Siciliani, P., Eccles, P., Netto, F., Vitello, E., Sivanathan, V. and van Hasselt, I. (2023), Paper 2: The links between prudential regulation, competitiveness and growth. Background working paper published by PRA staff in support of the conference on the role of financial regulation in international competitiveness and economic growth conference 2023, Bank of England Prudential Regulation Authority, 11 September. On the usability of buffers for bank lending, see Couaillier, C. et al. (2021), "Bank capital buffers and lending in the euro area during the pandemic", published as part of the Financial Stability Review, November 2021, and Couaillier, C. et al. (2022), "Caution: do not cross! Capital buffers and lending in Covid-19 times", ECB Working Paper, No 2644. 14. Bouabdallah, O., Dorrucci, E., Hoendervangers, L. and Nerlich, C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them", The ECB Blog, 27 June. 15. Lautenschläger, S. (2014), "Start of the Single Supervisory Mechanism: from the comprehensive assessment to day-to-day supervision", speech at the Euro Finance Week, Frankfurt am Main, 18 November.	Frank Elderson	Euro area	https://www.bis.org/review/r241106b.pdf	Frankfurt am Main, 4 November 2024 Thank you for your kind invitation. It's a pleasure to be with you this afternoon to reflect on the first decade of European banking supervision and, most importantly, to take a look at the path ahead of us. On this day ten years ago, the morning might have seemed just like a typical November morning in Frankfurt's Bankenviertel: a rainy autumn day, with people heading to their offices armed with umbrellas, wearing heavy coats. But that day ten years ago was anything but typical. Because it was the first time European supervisory teams got together and started work on an important task: making sure the banking system is safe and sound on behalf of European citizens. At the time, some argued that integrating a fragmented system of supervision was either impossible or would take forever. Well, those pioneer European supervisors who came together on 4 November 2014 have certainly proven the sceptics wrong. We have come a long way since that day. The last ten years have been transformative both for the Single Supervisory Mechanism (SSM) and the banks we supervise. We have evolved from a start-up to a mature, risk-based and effective supervisor. Banks under our supervision have also evolved significantly, building up remarkable resilience. Unlike in the crises that predated the banking union, banks have now become part of the solution to economic shocks rather than the source. That's good news. There is, however, no room for complacency. While past achievements provide a solid foundation, they are by no means a guarantee of future success. The macro-financial environment is changing profoundly. Unlike ten years ago, when the main risks emanated from banks themselves, today prudential risks are largely driven by an increasingly volatile and uncertain external environment. In my remarks, I will therefore focus on how supervisors and banks must adapt to this challenging environment. I will also address suggestions being put forward by some to relax banking regulation and supervision - suggestions which in my view are misguided. Compromising the resilience that has been carefully built up over the past ten years would undermine the objective of having a financial system that can support a competitive and sustainable economy. But before focusing on current challenges, I hope you'll allow me to take a brief walk down memory lane. Where did we start from? What were the expectations a decade ago? And how did we go about meeting them? As Europe was looking into the abyss of the euro area sovereign debt crisis in 2012, legislators agreed on nothing less than a paradigm shift - the banking union, which represented the most significant leap forward in European integration since the introduction of the euro. The banking union encompasses three pillars, each with a straightforward task: first, European banking supervision to ensure that banks across Europe are subject to the same rules and high-quality supervisory standards. Second, European resolution to make sure that if banks fail, they can get resolved in an orderly manner instead of relying on the public purse. And third, European deposit insurance, to make sure that when push comes to shove, all depositors enjoy the same protection, no matter where in the euro area they are based. As far as the supervisory pillar is concerned, the ECB and the national competent authorities that make up the SSM were given a clear mission: ensuring the safety and soundness of banks. This is not just an end in itself - it is necessary so that banks remain at the service of people and businesses by funding innovation, productivity and sustainable growth. The destination was clear. But we had no roadmap to show us how to get there. There was no blueprint on how to transform a fragmented system of supervision into an integrated one. So it was by no means a given that the SSM would be a success. In the start-up phase of the SSM we were essentially crossing the bridge we were still building: we spent the mornings recruiting the best risk experts from across Europe, the afternoons supervising significant banks, and the evenings setting up our processes. When we started, there were plenty of ways in which supervisors across Europe looked at risks and how best to mitigate them. They all focused on different things: while some put the emphasis on credit file reviews, others focused on scrutinising banks' internal risk management through the lens of the internal capital adequacy assessment process. Some supervisors chose to shine the spotlight more closely on governance or on-site culture. Thanks to the unwavering commitment and tireless energy of supervisors from the national competent authorities and the ECB, we consolidated the best practices from this wealth of supervisory experience into a common supervisory approach. What followed was a race to the top rather than to the bottom, resulting in high-quality supervision and a level playing field. On our path to becoming a mature organisation, we have adapted our processes along the way. Our supervision has evolved from being predominantly rule-based and heavily codified, to having a more flexible, agile and risk-focused approach. And banks under our supervision have also evolved significantly over the past ten years. Today, European banks are in much better shape than a decade ago. For instance, the financial resilience of SSM banks has notably improved. The aggregate Common Equity Tier 1 (CET1) ratio has increased from 12.7\% in 2015 to 15.8\% today, the liquidity coverage ratio has increased from $138 \%$ in 2016 to $159 \%$ today and the non-performing loan ratio of significant banks has declined from $7.5 \%$ in 2015 to $1.9 \%$ today. Moreover, risk management, the effectiveness of internal control functions and governance arrangements in SSM banks have all improved. Over the past ten years, banks under European supervision have shown remarkable resilience even under the most challenging circumstances. They have evolved from shock propagators to shock absorbers, stabilising rather than de-stabilising the economy as it experienced significant shocks such as the pandemic, Russia's unjustified war against Ukraine and the rapid changes to the interest rate environment. This resilience is also a testament to the crucial role played by European supervision, confirming that the SSM has lived up to the expectations that were placed on it a decade ago. But there is no room for complacency. We can't assume that the achievements of the past ten years will automatically pave the way for another successful decade of resilient banks under European supervision. We can't ignore the fact that the world around us is changing. The macro-financial environment is characterised by unprecedented shocks, giving rise to new risk drivers. In the words of President Lagarde, in the last three years alone we have "faced the worst pandemic since the 1920s, the worst conflict in Europe since the 1940s and the worst energy shock since the 1970s". And as former US Treasury secretary Larry Summers put it, "this is the most complex, disparate and cross-cutting set of challenges that I can remember in the 40 years that I have been paying attention to such things". In fact, the current combination of risks, challenges and uncertainties is staggering. A widening geopolitical divide and a global economy that is fragmenting into competing, increasingly protectionist blocs, give rise to new geopolitical risks. Heightened operational headwinds such as ever-more sophisticated cyberattacks and technology disruptions are challenging banks' operational resilience. And last, but, alas, not least, we see the climate and nature crises unfolding, as evidenced by the horrific events last week in Paiporta and other villages and towns in the Spanish region of Valencia. On top of the human tragedy and physical destruction, the climate and nature crises are increasingly leading to material risks for banks. What makes this period so unprecedented is that these challenges are not happening one after the other they are all happening at the same time. And there is no clear sign of them going away any time soon, rather the contrary. So how can supervisors and banks adjust to this era of polycrises? First and foremost, banks' management bodies are the ones holding the steering wheel and must ensure that banks remain resilient and prepared for this new risk landscape. This involves making sure that banks have sound risk management that is commensurate to new risk drivers, that they maintain sufficient capital headroom to cushion against credible adverse scenarios, and that banks' management bodies are effective in their steering and oversight function. While acknowledging that banks' management bodies are in the driving seat, as supervisors we keep a close eye to ensure that no material risks are left unaddressed. This means that we must be able to identify the risks and then ensure that banks are resilient to these risks. To ensure that our risk identification can keep up with the changing risk landscape, we have made our supervisory processes more agile. We simply cannot look at every risk with the same intensity, every year, in every bank we supervise. We have therefore started to implement a supervisory risk tolerance framework aiming at freeing up the desks and minds of supervisors. This allows our supervisors to focus on those risks that are most pertinent and the supervisory actions that are most impactful. In the same vein, we have also reformed our Supervisory Review and Evaluation Process (SREP) to make it more targeted and risk-based. Moreover, we are increasingly using supervisory technology tools - also known as suptech - to detect risks early on and move closer to real-time supervision. These improvements to our processes give our supervisory teams more time to focus on the most relevant risks. By detecting vulnerabilities that would otherwise only surface later, we help banks to be better prepared and build up resilience proactively. Let me illustrate this with an example. Threats from cyberattacks are on the increase and are challenging banks' operational resilience. In 2022, 50\% of our supervised entities were subject to at least one successful attack - that number rose to $68 \%$ in just one year. to gauge how well banks would be able to respond to and recover from a successful cyberattack while maintaining their critical functions and services. The cyber resilience stress test was an important learning exercise for banks; it helped them pinpoint areas where they need to build greater operational resilience to cyberattacks, which are unlikely to fade away in the current geopolitical risk environment. Let's shift our focus from risk identification to remediation. As supervisors we must ensure that the risks we identify in our risk assessments are adequately managed. This also means that if we find deficiencies in the way banks are managing their risks, they must be remediated fully and in a timely manner, not at some unspecified point in the distant future. This is why we are putting more emphasis on impact and effectiveness. To ensure full and timely remediation of our supervisory findings, we set out a time-bound remediation path. If a bank is not remedying the deficiency at a speed that will ensure full and timely remediation by the pre-established timeline, we will step up our supervisory action by deploying more intrusive measures from our ample supervisory toolkit. This is what we call the "escalation ladder". The use of supervisory powers to compel banks to make concrete improvements is not just something we do within the SSM; it is international best practice. The disorderly events of the March 2023 banking turmoil were a clear reminder of what can happen when banks leave material shortcomings unaddressed for too long. Banks and supervisors need to have the capacity to focus on emerging challenges. That's why it is important to declutter our desks by tackling supervisory findings that have been with us for too long. While this is always an imperative, it is especially pertinent in the current challenging risk landscape. Let me illustrate this with the example of risk data aggregation and reporting. It is very hard to imagine any bank being able to appropriately manage its risks without strong risk data reporting. A bank's ability to manage and aggregate risk-related data effectively is a pre-requisite for sound decision-making and robust risk governance. In fact, the Capital Requirements Directive, as transposed into national law, requires banks to put processes in place to identify all material risks. Worryingly, risk data aggregation and reporting was the lowest-scoring sub-category of internal governance in the 2023 SREP. In other words, despite the work done by supervisors over the years, too many banks still don't have adequate risk data aggregation and reporting capabilities. It should not be a surprise that ECB Banking Supervision is stepping up the escalation ladder, using more intrusive supervisory tools to ensure that banks have adequate risk data aggregation capabilities. It's not about forcing banks to do something that is merely an added perk; it's about making sure they are able to manage material risks adequately and in good time. In a rapidly changing risk environment where prompt availability of reliable data has become essential, timely remediation of our supervisory findings on risk data aggregation is more important than ever. After a decade of European supervision, it is not only the external risk environment that has changed. The current debate suggests that the perception by some of the role of financial regulation and supervision is also changing. Ten years ago, with the gloomy memories of the global financial crisis lingering in people's minds, there was a strong consensus across society on the need for strong financial regulation and supervision in order to safeguard the public good of financial stability. Today, it appears that the pendulum is slowly swinging in the opposite direction. Some have raised the question as to whether regulation and supervision have become too conservative, to the point that they may constrain growth. Let me be clear: the argument being put forward in favour of relaxing banking regulation and supervision in order to promote growth is misguided. We can't allow the memory of the global financial crisis to fade. Its lessons are as relevant today as they were back in 2012, when the banking union was created. As deputy governor of the Bank of England, Sam Woods, correctly said, the great financial crisis was "the biggest growth-destroying event in recent economic history". The crisis was a stark reminder of the economic, social and fiscal hardship that weakly regulated and supervised banks can cause for people. The last thing we should do is ignore the lessons of the financial crisis and allow a regulatory race to the bottom, which would compromise the resilience that has been carefully built up over the last decade. It is a fundamental misconception to frame safety and competitiveness as opposing forces. It is essential to remember that resilient and well-capitalised banks are a pre-condition for competitiveness and sustainable growth. Strong and resilient banks are best equipped to lend to the real economy, funding innovation, investment and growth, even during economic downturns. Banking deregulation or more lenient supervision would weaken the foundations of growth. It is true that European growth has been sluggish when compared with other regions, and addressing it is rightly a top priority. That is why we need policies to tackle the root causes of low productivity, promote innovation and bolster the single European market. For instance, the EU will need an additional $€ 5.4$ trillion between 2025 and 2031 to advance our green transformation, accelerate the digitalisation of our economy and bolster our defence capabilities. Faced with this mammoth task, deepening the capital markets union to help guide the required financing flows should be our highest priority. This will help channel private investments towards supporting innovation and the twin green and digital transition - ultimately fostering EU competitiveness. To speed up the integration of a single banking market in Europe, we should now move forward and complete the banking union. As a first step, we must enhance the crisis management and deposit insurance framework so that the failures of small and medium-sized banks can be dealt with more effectively. Second, we would welcome if Member States were to resume discussions on setting-up a European-level public backstop to provide temporary liquidity funding to banks following resolution. The credibility of the resolution framework in Europe would be significantly enhanced by setting up a framework for liquidity in resolution. Moreover, building on the strong foundations of the SSM and the Single Resolution Mechanism, we must pave the way for a common European deposit insurance scheme (EDIS). In the first decade of the SSM, risks have been significantly reduced and common supervisory standards have been established. These preconditions for EDIS have now been met, and moving it forward will be important for severing any remaining feedback loops between banks and sovereigns, given that these proved so harmful during the sovereign debt crisis. Let me conclude. Ten years ago today, when European supervisory teams started to come together for the first time, it was not at all certain that the SSM would be a success. We have since built a strong and effective supervisory framework in Europe, perceptive to evolving risks and - whenever necessary and appropriate - insistent in making sure that material risks are addressed. European banks have notably improved, proving resilient to shocks that we couldn't have imagined a decade ago. This resilience is also a result of the strengthened supervisory and regulatory framework put in place after the global financial crisis, including the creation of the banking union. Ten years ago, the first Vice-Chair of the SSM, Sabine Lautenschläger, invoked the parallel of an athlete at the beginning of a career, who trained extremely hard and achieved an excellent result in a first major tournament. To turn this promising start into a track record of sustained high performance, the athlete clearly cannot afford to rest on her laurels. Instead, she needs to go right back to the routine of constant training, to keep developing her skills and thus continue to build the foundation for future success on a day-to-day basis. This conclusion is as relevant today as it was ten year ago, especially considering the challenges along the path ahead. Considering the macro-financial environment and volatile risk landscape, it is safe to say that there is a high likelihood of unprecedented shocks continuing to emerge over the next decade. To make sure banks continue to serve European households and businesses under these challenging circumstances, we must ensure they remain resilient. Because a stable banking system forms the bedrock of long-term competitiveness and sustainable growth. European supervisors will continue to work tirelessly to make sure banks are well capitalised and adequately manage their risks. In this way, in ten years' time we can celebrate another successful decade of resilient banks under European supervision. 1 . This includes cash balances and other demand deposits. 6. 14 supervisory technology tools have already gone live and are making the daily work of 3,500 supervisors across the SSM easier, improving risk analysis, collaboration and the consistency of decisionmaking.
2024-11-05T00:00:00	Christine Lagarde: Competition policy in a changing world	Speech by Ms Christine Lagarde, President of the European Central Bank, at an event to mark the 15th anniversary of the Autorité de la concurrence, Paris, 5 November 2024.	SPEECH Competition policy in a changing world Speech by Christine Lagarde, President of the ECB, at an event to mark the 15th anniversary of the Autorité de la concurrence Paris, 5 November 2024 It is truly a pleasure to be back here today to celebrate the 15th anniversary of the Autorité de la concurrence. Competition policy in Europe has always played an important role in ensuring the functioning of our Economic and Monetary Union. The main objective of competition policy has been to preserve competition within Member States and within the Single Market. At the political level, these policy objectives were sometimes challenged, as they were seen as an obstacle to the goal of creating national champions in some sectors. This apparent contradiction has now been aggravated by profound changes in the global economic and political landscape. New technologies are transforming markets, new competitors are emerging globally, and governments are facing a new set of priorities, including louder calls for state aid and industrial policy. As a result, some argue that the supposed trade-off between competition and competitiveness is becoming more accentuated - in the sense that competition policy is limiting EU companies' ability to compete against larger, in many cases state-backed, global rivals. In my view, this trade-off is not inherent. We should avoid walking backwards into the future. With a careful approach, Europe can preserve the benefits of competition while adapting to the changing world we are facing. So, in these remarks, I would like to recall why competition is vital to our economies and the new challenges facing competition policy today. I will then offer three key principles that can help us navigate this environment without sacrificing our competitive framework. These are consistency, complementarity and competence. The benefits of a strong competition framework There are well-founded reasons for strong competition policy and enforcement. Let me briefly mention three. First, competition has positive effects on growth. It leads to resources being reallocated to the most productive firms more effectively, managers running their businesses more efficiently, and greater innovation and investment. As a result, a recent review by the European Commission finds clear and consistent evidence that industries which experience greater competition also experience stronger productivity growth, and that weaker competition undermines productivity growth." Second, competition leads to lower and less volatile prices./41 It not only prevents firms from charging excessive markups, but also ensures that companies quickly re- optimise production after cost shocks, keeping inflation subdued. In France, for example, products subject to online competition displayed lower inflation during the period from 2009 to 2018.2] The difference in inflation between a basket of supermarket products sold only offline and those same products also sold online was 2 percentage points. Third, competition makes the economy more sensitive to interest rates, which supports macroeconomic management by the central bank and the transmission of monetary policy. When markets are competitive, firms typically have lower profits and cash reserves. As a result, they are less able to fund investments internally and need to look outside for finance. This exposure to external financing makes them more sensitive to changes in interest rates by the central bank. ECB research finds that the lower the concentration of the market in which firms operate, the greater the impact of monetary policy changes on those firms.!4! Conversely, a concentration of market power is found to reduce the responsiveness of the economy to interest rate changes. So, as competition improves productivity, lowers inflation and strengthens policy transmission, it should be no surprise that the ECB has always supported a robust competition framework. Since the start of the euro, there has been a relatively stable consensus in Europe about the approach to competition. This approach was built around implementing the Single Market, strong antitrust enforcement and a strict approach towards state aid. And, by and large, it was a success. Single Market integration did not prevent markups from rising in Europe, but they remained well below the levels seen in the United States. The instances of extreme market concentration in the United States - in terms of firms and sectors - were far less of an issue in Europe.!& And state aid was controlled, averaging just 0.7% of EU GDP each year between 2000 and 2019.!1 Overall, the system of shared competence - with the Commission and national authorities jointly enforcing EU law - was effective. In fact, 90% of all competition decisions taken under EU law are taken by national authorities. New challenges for competition policy But in recent times, we have seen increasing tension between the internal and external dimensions of competition. With the United States being the home of tech giants and China producing at astonishing scale, the question is whether Europe needs to change its competition policy to compete globally. In some sectors, like telecoms, there are proposals to redefine the relevant market to encourage larger European players that can invest more and match their international rivals. 2] In other sectors, like tech, the Commission is being encouraged to give greater consideration to "innovation criteria" when considering mergers to facilitate large investments. And in the defence and space sectors, for example, there are calls to give more weight to "resilience criteria" as geopolitical dependencies are at stake.2 This shift is also being reflected in a new attitude towards industrial policy and state aid. In 2022, almost 1.5% of EU GDP was spent on state aid - more than double the pre-pandemic average. 65% of this spending took place in the three largest EU countries." Much of this aid was related to the pandemic and the energy crisis. But there is also a clear trend among governments to provide more funding to "strategic" industries such as chips and batteries. We cannot wish these changes away. We are facing a new global landscape. But we must also be clear that, if we prioritise fending off external competition over preserving internal competition, it will mean sacrificing other goals that matter to us today. It is now widely understood that Europe needs to boost its lagging productivity growth, and that a key driver of our weak productivity is a static industrial structure. Unlike in the United States, the same "middle tech" companies dominate R&D spending year after year, while too few innovative companies rise up in high tech sectors. There is also broad agreement that the best way to facilitate the scaling-up of young firms is to complete the Single Market. Allowing more state aid or industry consolidation might seem attractive to protect the competitive position of incumbent companies. But if the price we pay is a more fragmented Single Market or new entry barriers for young firms, we will end up losing more than we gain. So, the key challenge for Europe will be to construct a framework through which we can deliver on governments' new policy goals without sacrificing the benefits of competition. Key principles to move forward In my view, three principles will be key for success: consistency, complementarity and competence. First, we need consistency in how we assess competition and deliver state support. An unfortunate trend we are seeing today is the fragmentation of competition law at the national level, especially in new markets, like digital markets. Some countries are attempting to enforce their own rulebooks for large digital companies or adding national rules to EU legislation. The singleness of EU competition law is what binds our whole competition framework together, so this trend must be stamped out to preserve the level playing field. Likewise, if we are entering a world in which we systematically allow more state support for companies, it must be done, as much as possible, in a European way. The optimal level for action is the EU budget, and I am encouraged by the Commission's intention to refocus the next Multiannual Financial Framework on competitiveness and simplify access to EU financing. But I also recognise the limitations here. We need to reflect deeply on how we can embed European principles in state aid policy when it remains largely a national concern. Second, industrial and competition policies must be seen as complements, not substitutes. From the competition side, there is no inherent trade-off with industrial policy if competition authorities take into account innovation, resilience and sustainability in their decisions - which they can already do within the existing EU rules. And from the industrial policy side, interventions can be designed in an innovation-focused way that is pro- competition - not to protect national champions or "pick winners".42] As Philippe Aghion, Jean Tirole and Mathias Dewatripont recently argued, the mRNA vaccines introduced during the pandemic are a good example of how this approach can work.43] When COVID-19 emerged, the US Biomedical Advanced Research and Development Authority concentrated its funding on three technologies, with two projects per technology. The authorities did not pretend to know which technologies would work and offered no incumbency advantage. While all six projects ended up being approved, the two main winners, the US firm Moderna and the German firm BioNTech, were actually small biotechs. This experience provides a useful model for Europe for how to combine state-led goals with innovation and competition. The third principle is competence, by which I mean both assigning responsibility appropriately and drawing on the best available expertise. Specifically, competition authorities must remain in the driving seat in determining the appropriate level of concentration in different types of markets. There may be circumstances where allowing consolidation is justified to achieve wider policy goals. For example, economists in the Schumpeterian tradition have suggested that, to promote innovation, there is an optimal intermediate level of competition that balances some market power - creating a surplus for firms to invest in R&D - and competition to leave room for new entrants. [14] But it is difficult to judge where different sectors lie on this curve. Studies find opposing results on the impact of mergers on innovation activity, driven by factors like differences in market structure and the reduction in the number of competitors." So careful analysis, carried out on a case-by-case basis by experts with deep understanding, will be essential. Competition policy is a field where both lawyers and economists will have to closely interact. Conclusion On that positive note, let me conclude. Competition policy is entering a new phase, with internal and external forces pulling in different directions. Should this lead to less competition, it would be bad for Europe. But I believe there is a path ahead that will allow us to achieve our wider policy goals in a way that is pro-competition. We will only be able to take this path if we refuse to accept false trade-offs, and if competition authorities remain at the heart of the process. As Frédéric Bastiat said, "Détruire la concurrence, c'est tuer l'intelligence". Fortunately, the Autorité will be here for many years to come, keeping us on our toes. 1. European Commission (2024), "Protecting competition in a changing world: Evidence on the evolution of 2. See, for example, Przybyla, M. and Roma, M. (2005), "Does product market competition reduce inflation? Evidence from EU countries and sectors", Working Paper Series, No 453, ECB, March; and Andrews, D., Gal, P. and Witheridge, W. (2018), "A genie in a bottle? Globalisation, competition and inflation', OECD Economics Department Working Papers, No 1462, OECD, March. However, other studies find that greater market power, as measured by markups, reduces the cyclicality of inflation. See Kouvavas, O., Osbat, C., Reinelt, T. and Vansteenkiste, I. (2021), "Markups and inflation cyclicality in the euro area", Working Paper Series, No 2617, ECB, November. 3. Dedola, L., Ehrmann, M., Hoffmann, P., Lamo, A., Paz Pardo, G., Slacalek, J. and Strasser, G. (2023), "Digitalisation and the economy", Working Paper Series, No 2809, ECB. 4. Ferrando, A., McAdam, P., Petroulakis, F. and Vives, X. (2023), "Monetary Policy, Market Power, and SMEs", AEA Papers and Proceedings, Vol. 113, May, pp. 105-109. 5. European Commission (2024), op. cit. 6. Cavalleri, M.C., Eliet, A., McAdam, P., Petroulakis, F., Soares, A. and Vansteenkiste, I. (2019), "Concentration, market power and dynamism in the euro area", Working Paper Series, No 2253, ECB, March. 7. European Commission State Aid Scoreboard. 8. Letta, E. (2024), "Much More Than a Market: Speed, Security, Solidarity - Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens", Institut Jacques Delors, France, 27 April. 9. Eurostat and European Commission (2024), "The Future of European Competitiveness: A Competitiveness Strategy for Europe". 10. European Commission State Aid Scoreboard. 11. Fuest, C., Gros, D., Mengel, P.-L., Presidente, G. and Tirole, J. (2024), "EU Innovation Policy: How to Escape the Middle Technology Trap", EconPol Policy Report Series, April. 12. OECD (2024), "Pro-competitive Industrial Policy", OECD Roundtables on Competition Policy Papers, No 309, OECD Publishing, Paris, 27 September. 13. Aghion, P., Dewatripont, M. and Tirole, J. (2024), "Can Europe Create an Innovation Economy?", Project Syndicate, 7 October. 14. Aghion, P, Bloom, N., Blundell, R., Griffith, R. and Howitt, P. (2005), "Competition and Innovation: An Inverted-U Relationship", The Quarterly Journal of Economics, Vol. 120, No 2, May, pp. 701-728. 15. For a review see Haucap, J. and Stiebale, J. (2023), "Non-price Effects of Mergers and Acquisitions", DICE Discussion Paper Series, No 402, Dusseldorf Institute for Competition Economics (DICE), Heinrich- Heine-University Dusseldorf, July. CONTACT	---[PAGE_BREAK]--- # SPEECH ## Competition policy in a changing world ## Speech by Christine Lagarde, President of the ECB, at an event to mark the 15th anniversary of the Autorité de la concurrence Paris, 5 November 2024 It is truly a pleasure to be back here today to celebrate the 15th anniversary of the Autorité de la concurrence. Competition policy in Europe has always played an important role in ensuring the functioning of our Economic and Monetary Union. The main objective of competition policy has been to preserve competition within Member States and within the Single Market. At the political level, these policy objectives were sometimes challenged, as they were seen as an obstacle to the goal of creating national champions in some sectors. This apparent contradiction has now been aggravated by profound changes in the global economic and political landscape. New technologies are transforming markets, new competitors are emerging globally, and governments are facing a new set of priorities, including louder calls for state aid and industrial policy. As a result, some argue that the supposed trade-off between competition and competitiveness is becoming more accentuated - in the sense that competition policy is limiting EU companies' ability to compete against larger, in many cases state-backed, global rivals. In my view, this trade-off is not inherent. We should avoid walking backwards into the future. With a careful approach, Europe can preserve the benefits of competition while adapting to the changing world we are facing. So, in these remarks, I would like to recall why competition is vital to our economies and the new challenges facing competition policy today. I will then offer three key principles that can help us navigate this environment without sacrificing our competitive framework. These are consistency, complementarity and competence. ## The benefits of a strong competition framework There are well-founded reasons for strong competition policy and enforcement. Let me briefly mention three. First, competition has positive effects on growth. ---[PAGE_BREAK]--- It leads to resources being reallocated to the most productive firms more effectively, managers running their businesses more efficiently, and greater innovation and investment. As a result, a recent review by the European Commission finds clear and consistent evidence that industries which experience greater competition also experience stronger productivity growth, and that weaker competition undermines productivity growth. ${ }^{[1]}$ Second, competition leads to lower and less volatile prices. ${ }^{[2]}$ It not only prevents firms from charging excessive markups, but also ensures that companies quickly reoptimise production after cost shocks, keeping inflation subdued. In France, for example, products subject to online competition displayed lower inflation during the period from 2009 to 2018. ${ }^{[3]}$ The difference in inflation between a basket of supermarket products sold only offline and those same products also sold online was 2 percentage points. Third, competition makes the economy more sensitive to interest rates, which supports macroeconomic management by the central bank and the transmission of monetary policy. When markets are competitive, firms typically have lower profits and cash reserves. As a result, they are less able to fund investments internally and need to look outside for finance. This exposure to external financing makes them more sensitive to changes in interest rates by the central bank. ECB research finds that the lower the concentration of the market in which firms operate, the greater the impact of monetary policy changes on those firms. ${ }^{[4]}$ Conversely, a concentration of market power is found to reduce the responsiveness of the economy to interest rate changes. So, as competition improves productivity, lowers inflation and strengthens policy transmission, it should be no surprise that the ECB has always supported a robust competition framework. Since the start of the euro, there has been a relatively stable consensus in Europe about the approach to competition. This approach was built around implementing the Single Market, strong antitrust enforcement and a strict approach towards state aid. And, by and large, it was a success. Single Market integration did not prevent markups from rising in Europe, but they remained well below the levels seen in the United States. ${ }^{[5]}$ The instances of extreme market concentration in the United States - in terms of firms and sectors - were far less of an issue in Europe. ${ }^{[6]}$ And state aid was controlled, averaging just $0.7 \%$ of EU GDP each year between 2000 and 2019. ${ }^{[7]}$ Overall, the system of shared competence - with the Commission and national authorities jointly enforcing EU law - was effective. In fact, $90 \%$ of all competition decisions taken under EU law are taken by national authorities. # New challenges for competition policy ---[PAGE_BREAK]--- But in recent times, we have seen increasing tension between the internal and external dimensions of competition. With the United States being the home of tech giants and China producing at astonishing scale, the question is whether Europe needs to change its competition policy to compete globally. In some sectors, like telecoms, there are proposals to redefine the relevant market to encourage larger European players that can invest more and match their international rivals. ${ }^{[8]}$ In other sectors, like tech, the Commission is being encouraged to give greater consideration to "innovation criteria" when considering mergers to facilitate large investments. And in the defence and space sectors, for example, there are calls to give more weight to "resilience criteria" as geopolitical dependencies are at stake. ${ }^{[9]}$ This shift is also being reflected in a new attitude towards industrial policy and state aid. In 2022, almost 1.5\% of EU GDP was spent on state aid - more than double the pre-pandemic average. $65 \%$ of this spending took place in the three largest EU countries. ${ }^{[10]}$ Much of this aid was related to the pandemic and the energy crisis. But there is also a clear trend among governments to provide more funding to "strategic" industries such as chips and batteries. We cannot wish these changes away. We are facing a new global landscape. But we must also be clear that, if we prioritise fending off external competition over preserving internal competition, it will mean sacrificing other goals that matter to us today. It is now widely understood that Europe needs to boost its lagging productivity growth, and that a key driver of our weak productivity is a static industrial structure. Unlike in the United States, the same "middle tech" companies dominate R\&D spending year after year, while too few innovative companies rise up in high tech sectors. ${ }^{[11]}$ There is also broad agreement that the best way to facilitate the scaling-up of young firms is to complete the Single Market. Allowing more state aid or industry consolidation might seem attractive to protect the competitive position of incumbent companies. But if the price we pay is a more fragmented Single Market or new entry barriers for young firms, we will end up losing more than we gain. So, the key challenge for Europe will be to construct a framework through which we can deliver on governments' new policy goals without sacrificing the benefits of competition. # Key principles to move forward In my view, three principles will be key for success: consistency, complementarity and competence. First, we need consistency in how we assess competition and deliver state support. An unfortunate trend we are seeing today is the fragmentation of competition law at the national level, especially in new markets, like digital markets. Some countries are attempting to enforce their own rulebooks for large digital companies or adding national rules to EU legislation. ---[PAGE_BREAK]--- The singleness of EU competition law is what binds our whole competition framework together, so this trend must be stamped out to preserve the level playing field. Likewise, if we are entering a world in which we systematically allow more state support for companies, it must be done, as much as possible, in a European way. The optimal level for action is the EU budget, and I am encouraged by the Commission's intention to refocus the next Multiannual Financial Framework on competitiveness and simplify access to EU financing. But I also recognise the limitations here. We need to reflect deeply on how we can embed European principles in state aid policy when it remains largely a national concern. Second, industrial and competition policies must be seen as complements, not substitutes. From the competition side, there is no inherent trade-off with industrial policy if competition authorities take into account innovation, resilience and sustainability in their decisions - which they can already do within the existing EU rules. And from the industrial policy side, interventions can be designed in an innovation-focused way that is procompetition - not to protect national champions or "pick winners".[12] As Philippe Aghion, Jean Tirole and Mathias Dewatripont recently argued, the mRNA vaccines introduced during the pandemic are a good example of how this approach can work. [13] When COVID-19 emerged, the US Biomedical Advanced Research and Development Authority concentrated its funding on three technologies, with two projects per technology. The authorities did not pretend to know which technologies would work and offered no incumbency advantage. While all six projects ended up being approved, the two main winners, the US firm Moderna and the German firm BioNTech, were actually small biotechs. This experience provides a useful model for Europe for how to combine state-led goals with innovation and competition. The third principle is competence, by which I mean both assigning responsibility appropriately and drawing on the best available expertise. Specifically, competition authorities must remain in the driving seat in determining the appropriate level of concentration in different types of markets. There may be circumstances where allowing consolidation is justified to achieve wider policy goals. For example, economists in the Schumpeterian tradition have suggested that, to promote innovation, there is an optimal intermediate level of competition that balances some market power - creating a surplus for firms to invest in R\&D - and competition to leave room for new entrants. [14] But it is difficult to judge where different sectors lie on this curve. Studies find opposing results on the impact of mergers on innovation activity, driven by factors like differences in market structure and the reduction in the number of competitors. ${ }^{[15]}$ So careful analysis, carried out on a case-by-case basis by experts with deep understanding, will be essential. Competition policy is a field where both lawyers and economists will have to closely interact. ---[PAGE_BREAK]--- # Conclusion On that positive note, let me conclude. Competition policy is entering a new phase, with internal and external forces pulling in different directions. Should this lead to less competition, it would be bad for Europe. But I believe there is a path ahead that will allow us to achieve our wider policy goals in a way that is pro-competition. We will only be able to take this path if we refuse to accept false trade-offs, and if competition authorities remain at the heart of the process. As Frédéric Bastiat said, "Détruire la concurrence, c'est tuer l'intelligence". Fortunately, the Autorité will be here for many years to come, keeping us on our toes. ## 1. European Commission (2024), "Protecting competition in a changing world: Evidence on the evolution of competition in the EU during the past 25 years". ## 2. See, for example, Przybyla, M. and Roma, M. (2005), "Does product market competition reduce inflation? Evidence from EU countries and sectors", Working Paper Series, No 453, ECB, March; and Andrews, D., Gal, P. and Witheridge, W. (2018), "A genie in a bottle? Globalisation. competition and inflation", OECD Economics Department Working Papers, No 1462, OECD, March. However, other studies find that greater market power, as measured by markups, reduces the cyclicality of inflation. See Kouvavas, O., Osbat, C., Reinelt, T. and Vansteenkiste, I. (2021), "Markups and inflation cyclicality in the euro area", Working Paper Series, No 2617, ECB, November. 3. Dedola, L., Ehrmann, M., Hoffmann, P., Lamo, A., Paz Pardo, G., Slacalek, J. and Strasser, G. (2023), "Digitalisation and the economy", Working Paper Series, No 2809, ECB. 4. Ferrando, A., McAdam, P., Petroulakis, F. and Vives, X. (2023), "Monetary Policy, Market Power, and SMEs", AEA Papers and Proceedings, Vol. 113, May, pp. 105-109. 5. European Commission (2024), op. cit. 6. Cavalleri, M.C., Eliet, A., McAdam, P., Petroulakis, F., Soares, A. and Vansteenkiste, I. (2019), "Concentration, market power and dynamism in the euro area", Working Paper Series, No 2253, ECB, March. ---[PAGE_BREAK]--- 7. European Commission State Aid Scoreboard. 8. Letta, E. (2024), "Much More Than a Market: Speed, Security, Solidarity - Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens", Institut Jacques Delors, France, 27 April. 9. Eurostat and European Commission (2024), "The Future of European Competitiveness: A Competitiveness Strategy for Europe". 10. European Commission State Aid Scoreboard. 11. Fuest, C., Gros, D., Mengel, P.-L., Presidente, G. and Tirole, J. (2024), "EU Innovation Policy: How to Escape the Middle Technology Trap", EconPol Policy Report Series, April. 12. OECD (2024), "Pro-competitive Industrial Policy", OECD Roundtables on Competition Policy Papers, No 309, OECD Publishing, Paris, 27 September. 13. Aghion, P., Dewatripont, M. and Tirole, J. (2024), "Can Europe Create an Innovation Economy?", Project Syndicate, 7 October. 14. Aghion, P, Bloom, N., Blundell, R., Griffith, R. and Howitt, P. (2005), "Competition and Innovation: An Inverted-U Relationship", The Quarterly Journal of Economics, Vol. 120, No 2, May, pp. 701-728. 15. For a review see Haucap, J. and Stiebale, J. (2023), "Non-price Effects of Mergers and Acquisitions", DICE Discussion Paper Series, No 402, Düsseldorf Institute for Competition Economics (DICE), Heinrich-Heine-University Düsseldorf, July.	Christine Lagarde	Euro area	https://www.bis.org/review/r241106a.pdf	Paris, 5 November 2024 It is truly a pleasure to be back here today to celebrate the 15th anniversary of the Autorité de la concurrence. Competition policy in Europe has always played an important role in ensuring the functioning of our Economic and Monetary Union. The main objective of competition policy has been to preserve competition within Member States and within the Single Market. At the political level, these policy objectives were sometimes challenged, as they were seen as an obstacle to the goal of creating national champions in some sectors. This apparent contradiction has now been aggravated by profound changes in the global economic and political landscape. New technologies are transforming markets, new competitors are emerging globally, and governments are facing a new set of priorities, including louder calls for state aid and industrial policy. As a result, some argue that the supposed trade-off between competition and competitiveness is becoming more accentuated - in the sense that competition policy is limiting EU companies' ability to compete against larger, in many cases state-backed, global rivals. In my view, this trade-off is not inherent. We should avoid walking backwards into the future. With a careful approach, Europe can preserve the benefits of competition while adapting to the changing world we are facing. So, in these remarks, I would like to recall why competition is vital to our economies and the new challenges facing competition policy today. I will then offer three key principles that can help us navigate this environment without sacrificing our competitive framework. These are consistency, complementarity and competence. There are well-founded reasons for strong competition policy and enforcement. Let me briefly mention three. First, competition has positive effects on growth. It leads to resources being reallocated to the most productive firms more effectively, managers running their businesses more efficiently, and greater innovation and investment. As a result, a recent review by the European Commission finds clear and consistent evidence that industries which experience greater competition also experience stronger productivity growth, and that weaker competition undermines productivity growth. Second, competition leads to lower and less volatile prices. It not only prevents firms from charging excessive markups, but also ensures that companies quickly reoptimise production after cost shocks, keeping inflation subdued. In France, for example, products subject to online competition displayed lower inflation during the period from 2009 to 2018. The difference in inflation between a basket of supermarket products sold only offline and those same products also sold online was 2 percentage points. Third, competition makes the economy more sensitive to interest rates, which supports macroeconomic management by the central bank and the transmission of monetary policy. When markets are competitive, firms typically have lower profits and cash reserves. As a result, they are less able to fund investments internally and need to look outside for finance. This exposure to external financing makes them more sensitive to changes in interest rates by the central bank. ECB research finds that the lower the concentration of the market in which firms operate, the greater the impact of monetary policy changes on those firms. Conversely, a concentration of market power is found to reduce the responsiveness of the economy to interest rate changes. So, as competition improves productivity, lowers inflation and strengthens policy transmission, it should be no surprise that the ECB has always supported a robust competition framework. Since the start of the euro, there has been a relatively stable consensus in Europe about the approach to competition. This approach was built around implementing the Single Market, strong antitrust enforcement and a strict approach towards state aid. And, by and large, it was a success. Single Market integration did not prevent markups from rising in Europe, but they remained well below the levels seen in the United States. The instances of extreme market concentration in the United States - in terms of firms and sectors - were far less of an issue in Europe. And state aid was controlled, averaging just $0.7 \%$ of EU GDP each year between 2000 and 2019. Overall, the system of shared competence - with the Commission and national authorities jointly enforcing EU law - was effective. In fact, $90 \%$ of all competition decisions taken under EU law are taken by national authorities. But in recent times, we have seen increasing tension between the internal and external dimensions of competition. With the United States being the home of tech giants and China producing at astonishing scale, the question is whether Europe needs to change its competition policy to compete globally. In some sectors, like telecoms, there are proposals to redefine the relevant market to encourage larger European players that can invest more and match their international rivals. In other sectors, like tech, the Commission is being encouraged to give greater consideration to "innovation criteria" when considering mergers to facilitate large investments. And in the defence and space sectors, for example, there are calls to give more weight to "resilience criteria" as geopolitical dependencies are at stake. This shift is also being reflected in a new attitude towards industrial policy and state aid. In 2022, almost 1.5\% of EU GDP was spent on state aid - more than double the pre-pandemic average. $65 \%$ of this spending took place in the three largest EU countries. Much of this aid was related to the pandemic and the energy crisis. But there is also a clear trend among governments to provide more funding to "strategic" industries such as chips and batteries. We cannot wish these changes away. We are facing a new global landscape. But we must also be clear that, if we prioritise fending off external competition over preserving internal competition, it will mean sacrificing other goals that matter to us today. It is now widely understood that Europe needs to boost its lagging productivity growth, and that a key driver of our weak productivity is a static industrial structure. Unlike in the United States, the same "middle tech" companies dominate R\&D spending year after year, while too few innovative companies rise up in high tech sectors. There is also broad agreement that the best way to facilitate the scaling-up of young firms is to complete the Single Market. Allowing more state aid or industry consolidation might seem attractive to protect the competitive position of incumbent companies. But if the price we pay is a more fragmented Single Market or new entry barriers for young firms, we will end up losing more than we gain. So, the key challenge for Europe will be to construct a framework through which we can deliver on governments' new policy goals without sacrificing the benefits of competition. In my view, three principles will be key for success: consistency, complementarity and competence. First, we need consistency in how we assess competition and deliver state support. An unfortunate trend we are seeing today is the fragmentation of competition law at the national level, especially in new markets, like digital markets. Some countries are attempting to enforce their own rulebooks for large digital companies or adding national rules to EU legislation. The singleness of EU competition law is what binds our whole competition framework together, so this trend must be stamped out to preserve the level playing field. Likewise, if we are entering a world in which we systematically allow more state support for companies, it must be done, as much as possible, in a European way. The optimal level for action is the EU budget, and I am encouraged by the Commission's intention to refocus the next Multiannual Financial Framework on competitiveness and simplify access to EU financing. But I also recognise the limitations here. We need to reflect deeply on how we can embed European principles in state aid policy when it remains largely a national concern. Second, industrial and competition policies must be seen as complements, not substitutes. From the competition side, there is no inherent trade-off with industrial policy if competition authorities take into account innovation, resilience and sustainability in their decisions - which they can already do within the existing EU rules. And from the industrial policy side, interventions can be designed in an innovation-focused way that is procompetition - not to protect national champions or "pick winners". As Philippe Aghion, Jean Tirole and Mathias Dewatripont recently argued, the mRNA vaccines introduced during the pandemic are a good example of how this approach can work. When COVID-19 emerged, the US Biomedical Advanced Research and Development Authority concentrated its funding on three technologies, with two projects per technology. The authorities did not pretend to know which technologies would work and offered no incumbency advantage. While all six projects ended up being approved, the two main winners, the US firm Moderna and the German firm BioNTech, were actually small biotechs. This experience provides a useful model for Europe for how to combine state-led goals with innovation and competition. The third principle is competence, by which I mean both assigning responsibility appropriately and drawing on the best available expertise. Specifically, competition authorities must remain in the driving seat in determining the appropriate level of concentration in different types of markets. There may be circumstances where allowing consolidation is justified to achieve wider policy goals. For example, economists in the Schumpeterian tradition have suggested that, to promote innovation, there is an optimal intermediate level of competition that balances some market power - creating a surplus for firms to invest in R\&D - and competition to leave room for new entrants. But it is difficult to judge where different sectors lie on this curve. Studies find opposing results on the impact of mergers on innovation activity, driven by factors like differences in market structure and the reduction in the number of competitors. So careful analysis, carried out on a case-by-case basis by experts with deep understanding, will be essential. Competition policy is a field where both lawyers and economists will have to closely interact. On that positive note, let me conclude. Competition policy is entering a new phase, with internal and external forces pulling in different directions. Should this lead to less competition, it would be bad for Europe. But I believe there is a path ahead that will allow us to achieve our wider policy goals in a way that is pro-competition. We will only be able to take this path if we refuse to accept false trade-offs, and if competition authorities remain at the heart of the process. As Frédéric Bastiat said, "Détruire la concurrence, c'est tuer l'intelligence". Fortunately, the Autorité will be here for many years to come, keeping us on our toes.
2024-11-06T00:00:00	Christine Lagarde: Welcome address - tenth anniversary of the Single Supervisory Mechanism	Welcome address by Ms Christine Lagarde, President of the European Central Bank, at the event celebrating the tenth anniversary of the Single Supervisory Mechanism, Frankfurt am Main, 6 November 2024.	Christine Lagarde: Welcome address - tenth anniversary of the Single Supervisory Mechanism Welcome address by Ms Christine Lagarde, President of the European Central Bank, at the event celebrating the tenth anniversary of the Single Supervisory Mechanism, Frankfurt am Main, 6 November 2024. * * * It is a pleasure to welcome you to this event celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). The SSM became operational ten years ago, almost to the day, on 4 November 2014. It was the most significant step forward in European integration since the introduction of the euro. If we think back to how the banking sector was faring a decade ago, we can see just how much has changed. The euro crisis had exposed significant weaknesses: low equity buffers, high levels of non-performing loans and deep exposures to domestic sovereigns. Our challenge, as Danièle Nouy said at the time, was to "help rebuild confidence in the balance sheets of SSM area banks" amid a fragmented supervisory landscape.1 Today, however, the situation is vastly different. Despite the major shocks that have hit the euro area in recent years, our banking sector is resilient. The aggregate Common Equity Tier 1 (CET1) ratio rose from 12.7% in 2015 to 15.8% in mid-2024, while the liquidity coverage ratio increased from 138% to 159% over the same period. The main risks we face today no longer stem from the banks themselves, but from an increasingly volatile external environment. And single supervision allows us to address these risks through a common, forward-looking approach. So, have we achieved the initial aims of this single supervision? The achievements of single supervision If we consider the tumultuous events of the past few years, it is clear that European supervision has exceeded expectations. European banks have become considerably more resilient, providing critical stabilisation during the recent periods of disruption. In essence, European supervision has successfully addressed what Herman Van Rompuy identified in 2012 as the need to "correct the weakness of the policy infrastructure of the common currency".2 First, more rigorous and more uniform supervision has bolstered public confidence, ensuring that bank deposits are seen as equally safe across the euro area, thereby preserving the integrity of our monetary union. Since the start of single supervision, household's cross-border deposits have more than doubled to €151 billion today.3 Second, sound banks have ensured that major shocks have not disrupted the effectiveness of monetary policy. Both when we eased policy to avert deflation during the pandemic and when we raised rates rapidly to combat inflation after the pandemic, the banks enabled our policy impulses to be transmitted smoothly across the euro area. But we must also recognise that these stability-oriented goals, which arose from the conditions that led to the banking union agenda, are not ends in themselves. They are merely the foundation. Our ultimate aim is for banks to be sound and for the policy framework to be complete, so that they can safely tap into resources from across the euro area and use them to fund innovation, investment and growth. And it is on this particular objective that Europe is falling short in the transformative era we are living in today. We are facing a quadruple challenge: decarbonisation, deglobalisation, digitalisation and decoupling. These forces are putting our competitiveness and strategic autonomy to the test. To emerge stronger, we need massive investment in both physical and human capital. In the EU, an additional €5.4 trillion will be needed between 2025 and 2031 to advance the green transformation, accelerate the digitalisation of our economy and bolster our military defence capabilities.4 I have argued previously, and will continue to argue, that deepening Europe's capital 5 markets will be essential for this monumental task. But this is no threat to banks, as they have a vital role to play, too. The benefits of truly European banks There are two main ways we can make sure banks contribute. First, we can strengthen banks' intermediation capacity by building a more integrated banking sector. Currently, only two banks incorporated in the euro area rank among the ten largest 6 banks in the world, holding the eighth and tenth positions. Moreover, on average, the cross-border exposure of euro area banks is more than one-third higher outside the 7 euro area than within it. This fragmentation makes it more difficult for our banks to serve the European economy effectively. And the obstacles to cross-border banking are substantial. Therefore, we need to create a single jurisdiction for banks - one that is essentially "country blind" in terms of its regulatory, supervisory and crisis management frameworks. For example, reducing the ring-fencing of capital and liquidity along national lines would allow funds to flow freely within banking groups and facilitate lending across borders. Only then would we be able to harness the benefits of genuine European banking groups in funding the upcoming transformations. And those benefits are substantial. Truly European banks can effectively diversify their risks across sectors and regions. They have the capacity to lend more at scale and thus handle cross-border financing projects that smaller locally focused banks cannot. More integrated banks can also play a pivotal role as key capital market makers. This brings me to the second way in which banks can help to improve Europe's financing capacity. More integrated banks have the critical mass to attract companies across the euro area for stock market listings, debt securities placements, private equity transactions, mergers and acquisitions, and support for international growth. Moreover, progress in establishing a genuine capital markets union can help to remove the differences in national regulatory frameworks that currently hinder cross-border bank activity, paving the way for a sufficiently large securitisation market. Banks would then be able to transfer risk to investors and unlock additional lending. To put this into perspective, banks in the United States currently benefit from a securitisation market that is three times the size of Europe's. Even without a statesponsored framework, safely expanding our own market could unlock tremendous potential within our bank-based financial system. And robust supervisory standards would be key to ensuring that the risks tied to securitisation are managed effectively. Conclusion Let me conclude. A decade ago, we embarked on a journey to establish European supervision to address the vulnerabilities exposed by the financial crisis and complete our monetary union. It was a bold step, born out of necessity and vision. Ten years later, it is clear that European banking supervision has not only met, but exceeded, our expectations. The achievements we are celebrating today are the result of our joint efforts. Many of you have played a pivotal role in this success, and I want to express my deep gratitude for your unwavering commitment and tireless energy. As we look ahead to the next decade, we must harness this same determination and energy. Our aim is clear: to ensure that European banks are in an even better position to fund the economy. This means creating the conditions for a genuine single banking market - one that allows us to leverage the combined financing power of our banking system to overcome the challenges Europe is facing. As Benjamin Franklin wisely said, "Energy and persistence conquer all things". We currently need both - and you have both in spades. Thank you. 1 Nouy, D. (2014), "Toward the European Banking Union: achievements and challenges ", speech at the OeNB Economics Conference, Vienna, 12 May. 2 Reuters (2012), " Euro zone can reach banking union deal quickly: Van Rompuy ", 18 June. 3 Rumpf, M. (2024), " Cross-border deposits: growing trust in the euro area ", The ECB Blog , ECB, 24 October. 4 Bouabdallah, O., Dorrucci, E., Hoendervangers, L. and Nerlich, C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them ", The ECB Blog, ECB, 27 June. 5 Lagarde, C. (2023), " A Kantian shift for the capital markets union ", speech at the European Banking Congress, 17 November. 6 By assets. See, S&P Global (2024), " The world's largest banks by assets, 2024 ", 30 April. 7 Lenoci, F. and Molitor, P. (2024), "Intra-euro area cross-border bank lending: a boost Financial Integration and Structure in the Euro to banking market integration? ", Area, ECB, June.	---[PAGE_BREAK]--- # Christine Lagarde: Welcome address - tenth anniversary of the Single Supervisory Mechanism Welcome address by Ms Christine Lagarde, President of the European Central Bank, at the event celebrating the tenth anniversary of the Single Supervisory Mechanism, Frankfurt am Main, 6 November 2024. It is a pleasure to welcome you to this event celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). The SSM became operational ten years ago, almost to the day, on 4 November 2014. It was the most significant step forward in European integration since the introduction of the euro. If we think back to how the banking sector was faring a decade ago, we can see just how much has changed. The euro crisis had exposed significant weaknesses: low equity buffers, high levels of non-performing loans and deep exposures to domestic sovereigns. Our challenge, as Danièle Nouy said at the time, was to "help rebuild confidence in the balance sheets of SSM area banks" amid a fragmented supervisory landscape. $\underline{1}$ Today, however, the situation is vastly different. Despite the major shocks that have hit the euro area in recent years, our banking sector is resilient. The aggregate Common Equity Tier 1 (CET1) ratio rose from 12.7\% in 2015 to 15.8\% in mid-2024, while the liquidity coverage ratio increased from $138 \%$ to $159 \%$ over the same period. The main risks we face today no longer stem from the banks themselves, but from an increasingly volatile external environment. And single supervision allows us to address these risks through a common, forward-looking approach. So, have we achieved the initial aims of this single supervision? ## The achievements of single supervision If we consider the tumultuous events of the past few years, it is clear that European supervision has exceeded expectations. European banks have become considerably more resilient, providing critical stabilisation during the recent periods of disruption. In essence, European supervision has successfully addressed what Herman Van Rompuy identified in 2012 as the need to "correct the weakness of the policy infrastructure of the common currency". $\underline{2}$ ---[PAGE_BREAK]--- First, more rigorous and more uniform supervision has bolstered public confidence, ensuring that bank deposits are seen as equally safe across the euro area, thereby preserving the integrity of our monetary union. Since the start of single supervision, household's cross-border deposits have more than doubled to $€ 151$ billion today. $\underline{3}$ Second, sound banks have ensured that major shocks have not disrupted the effectiveness of monetary policy. Both when we eased policy to avert deflation during the pandemic and when we raised rates rapidly to combat inflation after the pandemic, the banks enabled our policy impulses to be transmitted smoothly across the euro area. But we must also recognise that these stability-oriented goals, which arose from the conditions that led to the banking union agenda, are not ends in themselves. They are merely the foundation. Our ultimate aim is for banks to be sound and for the policy framework to be complete, so that they can safely tap into resources from across the euro area and use them to fund innovation, investment and growth. And it is on this particular objective that Europe is falling short in the transformative era we are living in today. We are facing a quadruple challenge: decarbonisation, deglobalisation, digitalisation and decoupling. These forces are putting our competitiveness and strategic autonomy to the test. To emerge stronger, we need massive investment in both physical and human capital. In the EU, an additional $€ 5.4$ trillion will be needed between 2025 and 2031 to advance the green transformation, accelerate the digitalisation of our economy and bolster our military defence capabilities. $\underline{4}$ I have argued previously, and will continue to argue, that deepening Europe's capital markets will be essential for this monumental task. $\underline{5}$ But this is no threat to banks, as they have a vital role to play, too. # The benefits of truly European banks There are two main ways we can make sure banks contribute. First, we can strengthen banks' intermediation capacity by building a more integrated banking sector. Currently, only two banks incorporated in the euro area rank among the ten largest banks in the world, holding the eighth and tenth positions. ${ }^{6}$ Moreover, on average, the cross-border exposure of euro area banks is more than one-third higher outside the euro area than within it. $\underline{7}$ This fragmentation makes it more difficult for our banks to serve the European economy effectively. And the obstacles to cross-border banking are substantial. ---[PAGE_BREAK]--- Therefore, we need to create a single jurisdiction for banks - one that is essentially "country blind" in terms of its regulatory, supervisory and crisis management frameworks. For example, reducing the ring-fencing of capital and liquidity along national lines would allow funds to flow freely within banking groups and facilitate lending across borders. Only then would we be able to harness the benefits of genuine European banking groups in funding the upcoming transformations. And those benefits are substantial. Truly European banks can effectively diversify their risks across sectors and regions. They have the capacity to lend more at scale and thus handle cross-border financing projects that smaller locally focused banks cannot. More integrated banks can also play a pivotal role as key capital market makers. This brings me to the second way in which banks can help to improve Europe's financing capacity. More integrated banks have the critical mass to attract companies across the euro area for stock market listings, debt securities placements, private equity transactions, mergers and acquisitions, and support for international growth. Moreover, progress in establishing a genuine capital markets union can help to remove the differences in national regulatory frameworks that currently hinder cross-border bank activity, paving the way for a sufficiently large securitisation market. Banks would then be able to transfer risk to investors and unlock additional lending. To put this into perspective, banks in the United States currently benefit from a securitisation market that is three times the size of Europe's. Even without a statesponsored framework, safely expanding our own market could unlock tremendous potential within our bank-based financial system. And robust supervisory standards would be key to ensuring that the risks tied to securitisation are managed effectively. # Conclusion Let me conclude. A decade ago, we embarked on a journey to establish European supervision to address the vulnerabilities exposed by the financial crisis and complete our monetary union. It was a bold step, born out of necessity and vision. Ten years later, it is clear that European banking supervision has not only met, but exceeded, our expectations. The achievements we are celebrating today are the result of our joint efforts. Many of you have played a pivotal role in this success, and I want to express my deep gratitude for your unwavering commitment and tireless energy. As we look ahead to the next decade, we must harness this same determination and energy. Our aim is clear: to ensure that European banks are in an even better position to fund the economy. This means creating the conditions for a genuine single banking ---[PAGE_BREAK]--- market - one that allows us to leverage the combined financing power of our banking system to overcome the challenges Europe is facing. As Benjamin Franklin wisely said, "Energy and persistence conquer all things". We currently need both - and you have both in spades. Thank you. ${ }^{1}$ Nouy, D. (2014), "Toward the European Banking Union: achievements and challenges ", speech at the OeNB Economics Conference, Vienna, 12 May. ${ }^{2}$ Reuters (2012), "Euro zone can reach banking union deal quickly: Van Rompuy", 18 June. ${ }^{3}$ Rumpf, M. (2024), "Cross-border deposits: growing trust in the euro area", The ECB Blog, ECB, 24 October. ${ }^{4}$ Bouabdallah, O., Dorrucci, E., Hoendervangers, L. and Nerlich, C. (2024), "Mind the gap: Europe's strategic investment needs and how to support them", The ECB Blog, ECB, 27 June. ${ }^{5}$ Lagarde, C. (2023), "A Kantian shift for the capital markets union", speech at the European Banking Congress, 17 November. ${ }^{6}$ By assets. See, S\&P Global (2024), "The world's largest banks by assets, 2024", 30 April. ${ }^{7}$ Lenoci, F. and Molitor, P. (2024), "Intra-euro area cross-border bank lending: a boost to banking market integration?", Financial Integration and Structure in the Euro Area, ECB, June.	Christine Lagarde	Euro area	https://www.bis.org/review/r241107b.pdf	Welcome address by Ms Christine Lagarde, President of the European Central Bank, at the event celebrating the tenth anniversary of the Single Supervisory Mechanism, Frankfurt am Main, 6 November 2024. It is a pleasure to welcome you to this event celebrating the tenth anniversary of the Single Supervisory Mechanism (SSM). The SSM became operational ten years ago, almost to the day, on 4 November 2014. It was the most significant step forward in European integration since the introduction of the euro. If we think back to how the banking sector was faring a decade ago, we can see just how much has changed. The euro crisis had exposed significant weaknesses: low equity buffers, high levels of non-performing loans and deep exposures to domestic sovereigns. Our challenge, as Danièle Nouy said at the time, was to "help rebuild confidence in the balance sheets of SSM area banks" amid a fragmented supervisory landscape. Today, however, the situation is vastly different. Despite the major shocks that have hit the euro area in recent years, our banking sector is resilient. The aggregate Common Equity Tier 1 (CET1) ratio rose from 12.7\% in 2015 to 15.8\% in mid-2024, while the liquidity coverage ratio increased from $138 \%$ to $159 \%$ over the same period. The main risks we face today no longer stem from the banks themselves, but from an increasingly volatile external environment. And single supervision allows us to address these risks through a common, forward-looking approach. So, have we achieved the initial aims of this single supervision? If we consider the tumultuous events of the past few years, it is clear that European supervision has exceeded expectations. European banks have become considerably more resilient, providing critical stabilisation during the recent periods of disruption. In essence, European supervision has successfully addressed what Herman Van Rompuy identified in 2012 as the need to "correct the weakness of the policy infrastructure of the common currency". First, more rigorous and more uniform supervision has bolstered public confidence, ensuring that bank deposits are seen as equally safe across the euro area, thereby preserving the integrity of our monetary union. Since the start of single supervision, household's cross-border deposits have more than doubled to $€ 151$ billion today. Second, sound banks have ensured that major shocks have not disrupted the effectiveness of monetary policy. Both when we eased policy to avert deflation during the pandemic and when we raised rates rapidly to combat inflation after the pandemic, the banks enabled our policy impulses to be transmitted smoothly across the euro area. But we must also recognise that these stability-oriented goals, which arose from the conditions that led to the banking union agenda, are not ends in themselves. They are merely the foundation. Our ultimate aim is for banks to be sound and for the policy framework to be complete, so that they can safely tap into resources from across the euro area and use them to fund innovation, investment and growth. And it is on this particular objective that Europe is falling short in the transformative era we are living in today. We are facing a quadruple challenge: decarbonisation, deglobalisation, digitalisation and decoupling. These forces are putting our competitiveness and strategic autonomy to the test. To emerge stronger, we need massive investment in both physical and human capital. In the EU, an additional $€ 5.4$ trillion will be needed between 2025 and 2031 to advance the green transformation, accelerate the digitalisation of our economy and bolster our military defence capabilities. I have argued previously, and will continue to argue, that deepening Europe's capital markets will be essential for this monumental task. But this is no threat to banks, as they have a vital role to play, too. There are two main ways we can make sure banks contribute. First, we can strengthen banks' intermediation capacity by building a more integrated banking sector. Currently, only two banks incorporated in the euro area rank among the ten largest banks in the world, holding the eighth and tenth positions. This fragmentation makes it more difficult for our banks to serve the European economy effectively. And the obstacles to cross-border banking are substantial. Therefore, we need to create a single jurisdiction for banks - one that is essentially "country blind" in terms of its regulatory, supervisory and crisis management frameworks. For example, reducing the ring-fencing of capital and liquidity along national lines would allow funds to flow freely within banking groups and facilitate lending across borders. Only then would we be able to harness the benefits of genuine European banking groups in funding the upcoming transformations. And those benefits are substantial. Truly European banks can effectively diversify their risks across sectors and regions. They have the capacity to lend more at scale and thus handle cross-border financing projects that smaller locally focused banks cannot. More integrated banks can also play a pivotal role as key capital market makers. This brings me to the second way in which banks can help to improve Europe's financing capacity. More integrated banks have the critical mass to attract companies across the euro area for stock market listings, debt securities placements, private equity transactions, mergers and acquisitions, and support for international growth. Moreover, progress in establishing a genuine capital markets union can help to remove the differences in national regulatory frameworks that currently hinder cross-border bank activity, paving the way for a sufficiently large securitisation market. Banks would then be able to transfer risk to investors and unlock additional lending. To put this into perspective, banks in the United States currently benefit from a securitisation market that is three times the size of Europe's. Even without a statesponsored framework, safely expanding our own market could unlock tremendous potential within our bank-based financial system. And robust supervisory standards would be key to ensuring that the risks tied to securitisation are managed effectively. Let me conclude. A decade ago, we embarked on a journey to establish European supervision to address the vulnerabilities exposed by the financial crisis and complete our monetary union. It was a bold step, born out of necessity and vision. Ten years later, it is clear that European banking supervision has not only met, but exceeded, our expectations. The achievements we are celebrating today are the result of our joint efforts. Many of you have played a pivotal role in this success, and I want to express my deep gratitude for your unwavering commitment and tireless energy. As we look ahead to the next decade, we must harness this same determination and energy. Our aim is clear: to ensure that European banks are in an even better position to fund the economy. This means creating the conditions for a genuine single banking market - one that allows us to leverage the combined financing power of our banking system to overcome the challenges Europe is facing. As Benjamin Franklin wisely said, "Energy and persistence conquer all things". We currently need both - and you have both in spades. Thank you.
2024-11-06T00:00:00	Luis de Guindos: Economic developments and monetary policy in the euro area	Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Distinguished Speakers Seminar, organised by the European Economics and Financial Centre, University of London, London, 6 November 2024.	SPEECH Economic developments and monetary policy in the euro area Speech by Luis de Guindos, Vice-President of the ECB, at the Distinguished Speakers Seminar organised by the European Economics and Financial Centre, University of London London, 6 November 2024 I am delighted to be here today at the European Economics and Financial Centre seminar, hosted by the University of London." My comments today will focus on the economic developments in the euro area and the Governing Council's monetary policy decisions taken in October. I will discuss our assessment of the outlook for the euro area economy and the current disconnect between growing real incomes and weak consumption growth. I will also share some reflections on the distributional implications of the recent inflation surge and what these mean for monetary policy. I will conclude by explaining the rationale for our recent decision to take another step in moderating the degree of monetary policy restriction. Inflation developments and monetary policy response In the aftermath of the pandemic, inflation rose rapidly over the course of 2021 and 2022, peaking at 10.6% in October 2022. This inflation surge was predominantly driven by a sequence of large and overlapping supply shocks, including the dynamics of post-pandemic reopening, which put severe strain on global supply chains and Russia's war against Ukraine that led to a further spike in energy prices. The Governing Council responded forcefully to the inflation surge, in particular by raising our policy rate by 450 basis points between July 2022 and September 2023. Inflation has come down steadily from its peak. Headline inflation declined to 1.7% in September, its lowest level since April 2021 but picked again to 2.0% in October, according to Eurostat's flash estimate (Chart 1). These gyrations notwithstanding, the recent inflation releases reinforce the signs that price pressures have weakened and that the disinflation process is well on track. This largely reflects an unwinding of the forces that led to strong increases in the prices of energy, food and goods. Falling energy prices continued to be the main downward force for inflation in October. Services inflation - which remains more persistent - remained unchanged at 3.9%. Non-energy industrial goods inflation, while increasing to 0.5% in October, has fallen back to its pre-pandemic average. As a result, core inflation remained unchanged at 2.7% in October, down from its peak of 5.7% in March 2023. Inflation is expected to rise further in the coming months, partly because the sharp declines in energy prices during 2023 will drop out of the annual rates. It is then projected to decline to the 2% target over the course of next year, as labour cost pressures ease and the past monetary policy tightening gradually feeds through to prices. Chart 1 HICP inflation (annual percentage changes and percentage point contributions) Services Goods Food Energy HICP. 2 01/20 07/20 01/21 07/21 01/22 07/22 01/23 07/23 01/24 07/24 Based on an ongoing assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, the Governing Council decided to begin moderating the degree of policy restriction in June by cutting interest rates by 25 basis points. Since then, we have reduced the rate on the deposit facility - the rate through which we steer the monetary policy stance - by a further 50 basis points to its current level of 3.25%. The outlook for the euro area economy - income and consumption growth Turning to the growth outlook, euro area GDP rose by 0.4% in the third quarter of 2024, up from 0.2% in the second quarter, possibly reflecting the buoyant summer tourism season and one-off factors such as the Olympics in France. But, after a mild recovery in the first half of 2024, the latest economic indicators continue to suggest a weakening in activity across countries and sectors. Industrial production has been particularly volatile over the summer and the more interest-sensitive manufacturing sector has contracted for the 19th consecutive month, though at a slightly slower pace than in September. The manufacturing output Purchasing Managers' Index (PMI) has remained well below 50 since August 2022, registering 45.9 this October. In the services sector, activity in August was probably supported by a strong summer tourism season. That sector is still expanding, but at a slower pace, with the PMI edging down to 51.2 in October from 52.9 in August. These latest readings signal a weaker near-term outlook than projected by ECB staff in September. A key mechanism underpinning the growth outlook is the recovery in private consumption, supported by growth in households' real incomes. As inflation has declined, households' real disposable incomes have recovered. Private consumption growth, on the other hand, has slowed, and remains anaemic. As a result, the savings rate, which had declined sharply after the pandemic shock, has risen steadily since mid-2022, and reached 15.7% in the second quarter of this year, significantly above the pre-pandemic average of 12.9% (Chart 2). This raises the question of why household consumption growth in the euro area has remained so weak. Why are households saving larger proportions of their incomes? And what does this mean for the growth outlook? Chart 2 Evolution of savings rate (percentage) =tm Euro area == United States tm United Kingdom 30 15 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Sources: Eurostat, Bureau of Economic Analysis, Office for National Statistics. Notes: Data are seasonally adjusted. Savings rate correspond to the ratio between gross savings and gross disposable income. The latest observations are for the second quarter of 2024 for the EA and the UK and for the third quarter of 2024 for the US. The recent increase in the savings rate can be attributed to several factors. First, as I have already discussed, both high inflation and rising interest rates in response to the inflation surge may have eroded real net wealth. Over the past two years, real net wealth has declined by 4%. This may have encouraged saving to recuperate past losses. Second, higher real returns on savings and a higher cost of borrowing may have increased incentives to postpone consumption and reduce new borrowing. Third, non-labour income, such as self-employment remuneration, net interest receipts, dividends and rents has grown by 4.1% over the past two years. But the propensity to save out of those sources of income is much higher than for, say, wages, because non-labour income typically accrues to wealthier households that have a low marginal propensity to consume. Indeed, the data tell us that the savings rate is higher among households in the top income quintile. Fourth, inertia or persistence in consumption and savings habits is also likely to create a lag in the way consumption responds to rising incomes. Finally, the concept of permanent income can also be an important determinant of consumer spending. Households may limit their spending if they fear that their permanent income, expected over their lifetime, has not increased by as much as their current disposable income today. Fiscal policy also plays a role here. Consumers may save more if they expect taxes to rise to service higher public debt in the future - in the spirit of the so- called Ricardian equivalence. So, what does this mean for the current state of the economy? Is there a disconnect between growing real incomes and weak consumption growth? The key determinants of high savings are expected to persist, though likely to a lesser extent, over the course of next year. In particular, the drive to recover net wealth and the slow adjustment in consumption should become less relevant as factors holding back higher spending dissipate. Indeed, survey evidence points to a gradual recovery in household spending, with retail sales edging up in August and the European Commission's consumer confidence indicator rising in September. Price and wage adjustments should also play a powerful role in reviving consumption. Over the past three years, the slowdown in consumption growth has been primarily due to a drop in purchases of non-durable goods like food and energy, which have been most affected by the rising prices. However, with food and energy inflation moderating and purchasing power increasing, spending should start to respond. And there are already indications that the consumption of goods increased over the summer, with a small uptick in retail trade in August. Overall, this evidence suggests that private consumption growth will pick up, supported by ongoing robust growth in real labour income, lower inflation and improving consumer confidence. This expectation is also consistent with our September 2024 projections, which indicate that, as incomes continue to rise, inflation moderates and confidence strengthens, consumption will grow, albeit with savings remaining above pre- pandemic levels. Notwithstanding the near-term headwinds, the overall conditions for a pick-up in growth remain in place. The gradually fading-out of the effects of restrictive monetary policy should support both consumption and investment, and exports should contribute to the recovery as global demand rises. Distributional effects of inflation and monetary policy This brings me on to monetary policy transmission, a key element of our reaction function. One important factor affecting transmission of monetary policy to inflation and growth relates to the distribution of income and wealth across households. Inflation surges, along with the response of monetary policy, can have significant distributional effects.2] This matters for central banks because both the distribution and sources of income and wealth influence households' consumption and savings decisions, and ultimately, inflation. Inflation is often said to be a tax on the poor, especially when wages do not keep up with prices./! To the extent that inflation often goes hand-in-hand with rising food and energy prices, for example, it disproportionately affects poorer households because these items make up a larger share of their consumption basket. According to the most recent Eurostat Income, Consumption and Wealth experimental statistics, energy and food items together make up around 30% of the disposable income of households in the lowest income quintile, compared to 12% for the highest quintile.4] And poorer households typically have lower savings buffers to be able to withstand a temporary erosion of their real purchasing power. However, inflation can also act as a transfer of resources from net savers to net borrowers, partly because it lowers the real value of debt. This potentially reduces wealth inequality. As such, the composition of assets and liabilities influences how inflation surges, such as those observed recently, affect household wealth across the distribution. In particular, on the face of it, unanticipated inflation appears to reduce wealth inequality by redistributing wealth from lenders to borrowers through changes in the real value of assets and liabilities - a mechanism known as the Fisher channel. This channel is strongest when incomes adjust to inflation, reducing the payment burdens falling on indebted households, who are usually in the lower half of the wealth distribution (Chart 3). At the same time, changes in real interest rates have different valuation effects on different types of assets and liabilities. The Fisher channel weakens when unexpected inflation reduces the real interest income of low and medium-income households, who often hold their wealth in bank deposits, and increases the profit income of high-income households, who often also have wealth invested in stock markets.!© These different wealth channels are important as they influence the transmission of monetary policy to aggregate consumption and spending, and ultimately to inflation. Wealthier households typically have a lower marginal propensity to consume and carry less debt, making them less sensitive to interest rate changes. The newly developed Distributional Wealth Accounts (DWA) are experimental statistics that can be used to analyse the distributional effects of inflation and monetary policy in the euro area. A recent study, published in the ECB's Economic Bulletin, shows that around 80% of financial securities - such as equities, investment fund shares and bonds - are held by the top 10% of wealthiest households, while the bottom 50% hold a greater proportion of their wealth in bank deposits and housing, though the latter is often financed by mortgage debt (Chart 3). Chart 3 Composition of net wealth distribution (percentages of group-specific net wealth; percentage point changes) Deposits @ Other loans lM Housing @ Net wealth mtm@ Business wealth Mm Financial securities Mortgages Bottom 50% Next 40% Top 10% Sources: ECB (DWA) and ECB calculations. Notes: Net wealth is shown with a negative sign. Financial securities include equities, debt securities, investment funds and life insurance. The latest observations are for the fourth quarter of 2023. To assess the impact of inflation on the distribution of wealth, changes in real net wealth can be decomposed into contributions from transactions, real asset revaluations, and erosion due to inflation [2] Since mid-2021, real net wealth has declined across all wealth groups, but higher inflation has mitigated losses for poorer households by reducing the real value of their liabilities by more than their assets. Conversely, wealthier households have seen losses amplified by their larger nominal asset holdings. This wealth redistribution from savers to borrowers occurs mechanically through balance sheet positions but does not account for other factors such as interest income flows and debt repayments. Wealthier households have experienced larger real losses primarily due to the revaluation of financial assets like shares and bonds amid rising interest rates, even though they saved more and faced less dramatic declines in real house prices than poorer households. By aiming to keep inflation close to target, monetary policy can help to mitigate these distributional effects. But monetary policy itself can affect the distribution of income and wealth through several, often offsetting, channels. The primary channels are changes in asset prices and the differing effects of interest rates on savings versus debt costs. Empirical evidence suggests that monetary policy tightening reduces net wealth across the wealth distribution." The bottom 50% of households are mainly affected through housing wealth, while the top 10% feel more of an impact through financial wealth. Despite larger initial losses, the wealthiest tend to recover more quickly due to faster rebounds in equity prices compared with house prices."4] Rising interest rates are also likely to be more challenging for poorer, more indebted households, as they increase the interest burden of debt. And because poorer households tend to have lower cash buffers and are less able to access lines of credit, if needed, it may be harder for them to cope with these rising financing costs. This is then also likely to weigh on their consumption via a debt overhang channel.) The forceful monetary policy response has helped limit the direct effects of surging inflation on poorer households. At the same time, our monetary policy tightening may have eroded net wealth across the spectrum while also having important distributional consequences, with implications for the economic outlook as we continue to battle inflation. Conclusions The decision in October to lower the deposit facility rate - the rate through which we steer the monetary policy stance - by 25 basis points was based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflationary process is well on track. The inflation outlook is also affected by recent downside surprises indicators of economic activity, while financing conditions remain restrictive. Fine-tuning monetary policy decisions is complex but the medium-term orientation of inflation is clear. Our interest rate decisions will continue to be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction, without pre-committing to a particular rate path. 1. I am grateful to Margherita Giuzio, Thomas McGregor and Elisa Saporito for their contributions to this speech. 2. See, for example, Easterly, W. and Fischer, S. (2001), "Inflation and the Poor", Journal of Money, Credit and Banking, Vol. 33, No 2, pp. 160-178; Acemoglu, D. and Johnson, S. (2012) "Who Captured the Fed?", The New York Times, 29; Coibion, O., Gorodnichenko, Y., Kueng, L. and Silvia, J. (2017), "Innocent J. (2015), "Inequality and Economic Growth", The Political Quarterly, Vol. 86, No 1, pp. 134-155; Furceri, D., Loungani, P. and Zdzienicka, A. (2018), "The effects of monetary policy shocks on inequality", Journal of International Money and Finance, Vol. 85, pp. 168-186; Feiveson, L., Goernemann, N., Hotchkiss, J., Mertens, K., Simet, J. (2020), "Distributional Considerations for Monetary Policy Strategy", Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System, No 73; and Hansen, N. H., Lin, A. and Mano, R. (2020), "Should Inequality Factor into Central Banks' Decisions?", Working Paper Series , No 196, International Monetary Fund. 3. See, for example, Easterly, W. and Fischer, S., op. cit. 4. Energy includes electricity, gas and other fuels, while food excludes alcoholic beverages. See Bobascu, A., Dobrew, M. and Pepele, A. (2024), "Energy price shocks, monetary policy and inequality", Working Paper Series, No 2967, ECB. 5. See Fisher, I. (1933), "The Debt-Deflation Theory of Great Depressions", Econometrica, Vol. 1, No 4, pp. 337-357. See also Chiang, Y.-T., Karger, E. and Dueholm, M. (2024), "How much households gain and lose from unexpected inflation", On The Economy blog, Federal Reserve Bank of St Louis, 22 October. 6. See Erosa, A. and Ventura, G. (2002), "On inflation as a regressive consumption tax", Journal of Monetary Economics, Vol 49, Issue 4, May, pp 761-795 and Heer, B. and Sussmuth, B. (2007), "Effects of inflation on wealth distribution: Do stock market participation fees and capital income taxation matter?", Journal of Economic Dynamics and Control, Vol. 31, Issue 1, January, pp. 277-303. 7. See Blatnik, N., Bobasu, A., Krustev, G. and Tujula, M. (2024), "Introducing the Distributional Wealth Accounts for euro area households", Economic Bulletin, Issue 5, ECB. 8. More on this approach in Infante, L., Loschiavo, D., Neri, A., Spuri, M. and Vercelli, F. (2023), "The heterogeneous impact of inflation across the joint distribution of household income and wealth", Occasional Paper Series, No 817, Banca d'Italia, November. 9. See Blatnik, N., Bobasu, A., Krustev, G. and Tujula, M., op. cit. 10. The impact on capital gains/losses from lower/higher interest rates depends on whether assets have longer durations than liabilities. See Ampudia, M., Georgarakos, D., Slaéalek, J., Tristani, O., Vermeulen, P., and Violante, G. (2018), "Monetary policy and household inequality", Working Paper Series No 2170, ECB, July; Dossche, M., Slaéalek, J., and Wolswijk, G. (2021), "Monetary policy and inequality", Economic Bulletin, Issue 2, ECB; Bobasu, A., di Nino, V., and Osbat, C. (2023) "The impact of the recent inflation surge across households", Economic Bulletin, Issue 3, ECB. 11. See literature on debt overhangs, for example, Mian, A., Rao, K. and Sufi, A. (2013), "Household balance sheets, consumption, and the economic slump", The Quarterly Journal of Economics, Vol. 128, No 4, pp 1687-1726. Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # Economic developments and monetary policy in the euro area ## Speech by Luis de Guindos, Vice-President of the ECB, at the Distinguished Speakers Seminar organised by the European Economics and Financial Centre, University of London London, 6 November 2024 I am delighted to be here today at the European Economics and Financial Centre seminar, hosted by the University of London. ${ }^{[1]}$ My comments today will focus on the economic developments in the euro area and the Governing Council's monetary policy decisions taken in October. I will discuss our assessment of the outlook for the euro area economy and the current disconnect between growing real incomes and weak consumption growth. I will also share some reflections on the distributional implications of the recent inflation surge and what these mean for monetary policy. I will conclude by explaining the rationale for our recent decision to take another step in moderating the degree of monetary policy restriction. ## Inflation developments and monetary policy response In the aftermath of the pandemic, inflation rose rapidly over the course of 2021 and 2022, peaking at 10.6\% in October 2022. This inflation surge was predominantly driven by a sequence of large and overlapping supply shocks, including the dynamics of post-pandemic reopening, which put severe strain on global supply chains and Russia's war against Ukraine that led to a further spike in energy prices. The Governing Council responded forcefully to the inflation surge, in particular by raising our policy rate by 450 basis points between July 2022 and September 2023. Inflation has come down steadily from its peak. Headline inflation declined to 1.7\% in September, its lowest level since April 2021 but picked again to 2.0\% in October, according to Eurostat's flash estimate (Chart 1). These gyrations notwithstanding, the recent inflation releases reinforce the signs that price pressures have weakened and that the disinflation process is well on track. This largely reflects an unwinding of the forces that led to strong increases in the prices of energy, food and goods. Falling energy prices continued to be the main downward force for inflation in October. Services inflation - which remains more persistent - remained unchanged at 3.9\%. Non-energy industrial goods inflation, while increasing to $0.5 \%$ in October, has fallen back to its pre-pandemic average. As a result, core inflation remained unchanged at $2.7 \%$ in October, down from its peak of $5.7 \%$ in March 2023. Inflation is expected to rise further in the coming months, partly because the sharp declines in energy prices during 2023 will drop out of the annual rates. It is then projected to decline to the $2 \%$ target over the course of next year, as labour cost pressures ease and the past monetary policy tightening gradually feeds through to prices. ---[PAGE_BREAK]--- # Chart 1 <br> HICP inflation (annual percentage changes and percentage point contributions) ![img-0.jpeg](img-0.jpeg) Based on an ongoing assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, the Governing Council decided to begin moderating the degree of policy restriction in June by cutting interest rates by 25 basis points. Since then, we have reduced the rate on the deposit facility - the rate through which we steer the monetary policy stance - by a further 50 basis points to its current level of $3.25 \%$. ## The outlook for the euro area economy - income and consumption growth Turning to the growth outlook, euro area GDP rose by $0.4 \%$ in the third quarter of 2024, up from $0.2 \%$ in the second quarter, possibly reflecting the buoyant summer tourism season and one-off factors such as the Olympics in France. But, after a mild recovery in the first half of 2024, the latest economic indicators continue to suggest a weakening in activity across countries and sectors. Industrial production has been particularly volatile over the summer and the more interest-sensitive manufacturing sector has contracted for the 19th consecutive month, though at a slightly slower pace than in September. The manufacturing output Purchasing Managers' Index (PMI) has remained well below 50 since August 2022, registering 45.9 this October. In the services sector, activity in August was probably supported by a strong summer tourism season. That sector is still expanding, but at a slower pace, with the PMI edging down to 51.2 in October from 52.9 in August. These latest readings signal a weaker near-term outlook than projected by ECB staff in September. A key mechanism underpinning the growth outlook is the recovery in private consumption, supported by growth in households' real incomes. As inflation has declined, households' real disposable incomes have ---[PAGE_BREAK]--- recovered. Private consumption growth, on the other hand, has slowed, and remains anaemic. As a result, the savings rate, which had declined sharply after the pandemic shock, has risen steadily since mid-2022, and reached $15.7 \%$ in the second quarter of this year, significantly above the pre-pandemic average of 12.9\% (Chart 2). This raises the question of why household consumption growth in the euro area has remained so weak. Why are households saving larger proportions of their incomes? And what does this mean for the growth outlook? # Chart 2 ## Evolution of savings rate ![img-1.jpeg](img-1.jpeg) Sources: Eurostat, Bureau of Economic Analysis, Office for National Statistics. Notes: Data are seasonally adjusted. Savings rate correspond to the ratio between gross savings and gross disposable income. The latest observations are for the second quarter of 2024 for the EA and the UK and for the third quarter of 2024 for the US. The recent increase in the savings rate can be attributed to several factors. First, as I have already discussed, both high inflation and rising interest rates in response to the inflation surge may have eroded real net wealth. Over the past two years, real net wealth has declined by $4 \%$. This may have encouraged saving to recuperate past losses. Second, higher real returns on savings and a higher cost of borrowing may have increased incentives to postpone consumption and reduce new borrowing. Third, non-labour income, such as self-employment remuneration, net interest receipts, dividends and rents has grown by $4.1 \%$ over the past two years. But the propensity to save out of those sources of income is much higher than for, say, wages, because non-labour income typically accrues to wealthier households that have a low marginal propensity to consume. Indeed, the data tell us that the savings rate is higher among households in the top income quintile. Fourth, inertia or persistence in consumption and savings habits is ---[PAGE_BREAK]--- also likely to create a lag in the way consumption responds to rising incomes. Finally, the concept of permanent income can also be an important determinant of consumer spending. Households may limit their spending if they fear that their permanent income, expected over their lifetime, has not increased by as much as their current disposable income today. Fiscal policy also plays a role here. Consumers may save more if they expect taxes to rise to service higher public debt in the future - in the spirit of the socalled Ricardian equivalence. So, what does this mean for the current state of the economy? Is there a disconnect between growing real incomes and weak consumption growth? The key determinants of high savings are expected to persist, though likely to a lesser extent, over the course of next year. In particular, the drive to recover net wealth and the slow adjustment in consumption should become less relevant as factors holding back higher spending dissipate. Indeed, survey evidence points to a gradual recovery in household spending, with retail sales edging up in August and the European Commission's consumer confidence indicator rising in September. Price and wage adjustments should also play a powerful role in reviving consumption. Over the past three years, the slowdown in consumption growth has been primarily due to a drop in purchases of non-durable goods like food and energy, which have been most affected by the rising prices. However, with food and energy inflation moderating and purchasing power increasing, spending should start to respond. And there are already indications that the consumption of goods increased over the summer, with a small uptick in retail trade in August. Overall, this evidence suggests that private consumption growth will pick up, supported by ongoing robust growth in real labour income, lower inflation and improving consumer confidence. This expectation is also consistent with our September 2024 projections, which indicate that, as incomes continue to rise, inflation moderates and confidence strengthens, consumption will grow, albeit with savings remaining above prepandemic levels. Notwithstanding the near-term headwinds, the overall conditions for a pick-up in growth remain in place. The gradually fading-out of the effects of restrictive monetary policy should support both consumption and investment, and exports should contribute to the recovery as global demand rises. # Distributional effects of inflation and monetary policy This brings me on to monetary policy transmission, a key element of our reaction function. One important factor affecting transmission of monetary policy to inflation and growth relates to the distribution of income and wealth across households. Inflation surges, along with the response of monetary policy, can have significant distributional effects. ${ }^{[2]}$ This matters for central banks because both the distribution and sources of income and wealth influence households' consumption and savings decisions, and ultimately, inflation. Inflation is often said to be a tax on the poor, especially when wages do not keep up with prices. ${ }^{[3]}$ To the extent that inflation often goes hand-in-hand with rising food and energy prices, for example, it disproportionately affects poorer households because these items make up a larger share of their consumption basket. According to the most recent Eurostat Income, Consumption and Wealth ---[PAGE_BREAK]--- experimental statistics, energy and food items together make up around 30\% of the disposable income of households in the lowest income quintile, compared to $12 \%$ for the highest quintile. ${ }^{[4]}$ And poorer households typically have lower savings buffers to be able to withstand a temporary erosion of their real purchasing power. However, inflation can also act as a transfer of resources from net savers to net borrowers, partly because it lowers the real value of debt. This potentially reduces wealth inequality. As such, the composition of assets and liabilities influences how inflation surges, such as those observed recently, affect household wealth across the distribution. In particular, on the face of it, unanticipated inflation appears to reduce wealth inequality by redistributing wealth from lenders to borrowers through changes in the real value of assets and liabilities - a mechanism known as the Fisher channel. ${ }^{[5]}$ This channel is strongest when incomes adjust to inflation, reducing the payment burdens falling on indebted households, who are usually in the lower half of the wealth distribution (Chart 3). At the same time, changes in real interest rates have different valuation effects on different types of assets and liabilities. The Fisher channel weakens when unexpected inflation reduces the real interest income of low and medium-income households, who often hold their wealth in bank deposits, and increases the profit income of high-income households, who often also have wealth invested in stock markets. ${ }^{[6]}$ These different wealth channels are important as they influence the transmission of monetary policy to aggregate consumption and spending, and ultimately to inflation. Wealthier households typically have a lower marginal propensity to consume and carry less debt, making them less sensitive to interest rate changes. The newly developed Distributional Wealth Accounts (DWA) are experimental statistics that can be used to analyse the distributional effects of inflation and monetary policy in the euro area. A recent study, published in the ECB's Economic Bulletin, shows that around 80\% of financial securities - such as equities, investment fund shares and bonds - are held by the top 10\% of wealthiest households, while the bottom $50 \%$ hold a greater proportion of their wealth in bank deposits and housing, though the latter is often financed by mortgage debt (Chart 3). ${ }^{[7]}$ ---[PAGE_BREAK]--- # Chart 3 Composition of net wealth distribution (percentages of group-specific net wealth; percentage point changes) ![img-2.jpeg](img-2.jpeg) Sources: ECB (DWA) and ECB calculations. Notes: Net wealth is shown with a negative sign. Financial securities include equities, debt securities, investment funds and life insurance. The latest observations are for the fourth quarter of 2023. To assess the impact of inflation on the distribution of wealth, changes in real net wealth can be decomposed into contributions from transactions, real asset revaluations, and erosion due to inflation. 5] Since mid-2021, real net wealth has declined across all wealth groups, but higher inflation has mitigated losses for poorer households by reducing the real value of their liabilities by more than their assets. Conversely, wealthier households have seen losses amplified by their larger nominal asset holdings. This wealth redistribution from savers to borrowers occurs mechanically through balance sheet positions but does not account for other factors such as interest income flows and debt repayments. Wealthier households have experienced larger real losses primarily due to the revaluation of financial assets like shares and bonds amid rising interest rates, even though they saved more and faced less dramatic declines in real house prices than poorer households. By aiming to keep inflation close to target, monetary policy can help to mitigate these distributional effects. But monetary policy itself can affect the distribution of income and wealth through several, often offsetting, channels. The primary channels are changes in asset prices and the differing effects of interest rates on savings versus debt costs. Empirical evidence suggests that monetary policy tightening reduces net wealth across the wealth distribution. 5] The bottom 50\% of households are mainly affected through housing wealth, while the top 10\% feel more of an impact through financial wealth. Despite larger initial ---[PAGE_BREAK]--- losses, the wealthiest tend to recover more quickly due to faster rebounds in equity prices compared with house prices. ${ }^{[10]}$ Rising interest rates are also likely to be more challenging for poorer, more indebted households, as they increase the interest burden of debt. And because poorer households tend to have lower cash buffers and are less able to access lines of credit, if needed, it may be harder for them to cope with these rising financing costs. This is then also likely to weigh on their consumption via a debt overhang channel. ${ }^{[11]}$ The forceful monetary policy response has helped limit the direct effects of surging inflation on poorer households. At the same time, our monetary policy tightening may have eroded net wealth across the spectrum while also having important distributional consequences, with implications for the economic outlook as we continue to battle inflation. # Conclusions The decision in October to lower the deposit facility rate - the rate through which we steer the monetary policy stance - by 25 basis points was based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflationary process is well on track. The inflation outlook is also affected by recent downside surprises indicators of economic activity, while financing conditions remain restrictive. Fine-tuning monetary policy decisions is complex but the medium-term orientation of inflation is clear. Our interest rate decisions will continue to be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction, without pre-committing to a particular rate path. 1 . I am grateful to Margherita Giuzio, Thomas McGregor and Elisa Saporito for their contributions to this speech. ## 2. See, for example, Easterly, W. and Fischer, S. (2001), "Inflation and the Poor", Journal of Money, Credit and Banking, Vol. 33, No 2, pp. 160-178; Acemoglu, D. and Johnson, S. (2012) "Who Captured the Fed?", The New York Times, 29; Coibion, O., Gorodnichenko, Y., Kueng, L. and Silvia, J. (2017), "Innocent Bystanders? Monetary policy and inequality", Journal of Monetary Economics, Vol. 88, pp. 70-89; Stiglitz, J. (2015), "Inequality and Economic Growth", The Political Quarterly, Vol. 86, No 1, pp. 134-155; Furceri, D., Loungani, P. and Zdzienicka, A. (2018), "The effects of monetary policy shocks on inequality", Journal of International Money and Finance, Vol. 85, pp. 168-186; Feiveson, L., Goernemann, N., Hotchkiss, J., ---[PAGE_BREAK]--- Mertens, K., Simet, J. (2020), "Distributional Considerations for Monetary Policy Strategy", Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System, No 73; and Hansen, N. H., Lin, A. and Mano, R. (2020), "Should Inequality Factor into Central Banks' Decisions?", Working Paper Series, No 196, International Monetary Fund. 3. See, for example, Easterly, W. and Fischer, S., op. cit. 4. Energy includes electricity, gas and other fuels, while food excludes alcoholic beverages. See Bobascu, A., Dobrew, M. and Pepele, A. (2024), "Energy price shocks, monetary policy and inequality", Working Paper Series, No 2967, ECB. 5. See Fisher, I. (1933), "The Debt-Deflation Theory of Great Depressions", Econometrica, Vol. 1, No 4, pp. 337-357. See also Chiang, Y.-T., Karger, E. and Dueholm, M. (2024), "How much households gain and lose from unexpected inflation", On The Economy blog, Federal Reserve Bank of St Louis, 22 October. 6. See Erosa, A. and Ventura, G. (2002), "On inflation as a regressive consumption tax", Journal of Monetary Economics, Vol 49, Issue 4, May, pp 761-795 and Heer, B. and Süssmuth, B. (2007), "Effects of inflation on wealth distribution: Do stock market participation fees and capital income taxation matter?", Journal of Economic Dynamics and Control, Vol. 31, Issue 1, January, pp. 277-303. 7. See Blatnik, N., Bobasu, A., Krustev, G. and Tujula, M. (2024), "Introducing the Distributional Wealth Accounts for euro area households", Economic Bulletin, Issue 5, ECB. 8. More on this approach in Infante, L., Loschiavo, D., Neri, A., Spuri, M. and Vercelli, F. (2023), "The heterogeneous impact of inflation across the joint distribution of household income and wealth", Occasional Paper Series, No 817, Banca d'Italia, November. 9. See Blatnik, N., Bobasu, A., Krustev, G. and Tujula, M., op. cit. 10. The impact on capital gains/losses from lower/higher interest rates depends on whether assets have longer durations than liabilities. See Ampudia, M., Georgarakos, D., Slačálek, J., Tristani, O., Vermeulen, P., and Violante, G. (2018), "Monetary policy and household inequality", Working Paper Series No 2170, ---[PAGE_BREAK]--- ECB, July; Dossche, M., Slačálek, J., and Wolswijk, G. (2021), "Monetary policy and inequality", Economic Bulletin, Issue 2, ECB; Bobasu, A., di Nino, V., and Osbat, C. (2023) "The impact of the recent inflation surge across households", Economic Bulletin, Issue 3, ECB. 11. See literature on debt overhangs, for example, Mian, A., Rao, K. and Sufi, A. (2013), "Household balance sheets, consumption, and the economic slump", The Quarterly Journal of Economics, Vol. 128, No 4, pp 1687-1726.	Luis de Guindos	Euro area	https://www.bis.org/review/r241107a.pdf	London, 6 November 2024 I am delighted to be here today at the European Economics and Financial Centre seminar, hosted by the University of London. My comments today will focus on the economic developments in the euro area and the Governing Council's monetary policy decisions taken in October. I will discuss our assessment of the outlook for the euro area economy and the current disconnect between growing real incomes and weak consumption growth. I will also share some reflections on the distributional implications of the recent inflation surge and what these mean for monetary policy. I will conclude by explaining the rationale for our recent decision to take another step in moderating the degree of monetary policy restriction. In the aftermath of the pandemic, inflation rose rapidly over the course of 2021 and 2022, peaking at 10.6\% in October 2022. This inflation surge was predominantly driven by a sequence of large and overlapping supply shocks, including the dynamics of post-pandemic reopening, which put severe strain on global supply chains and Russia's war against Ukraine that led to a further spike in energy prices. The Governing Council responded forcefully to the inflation surge, in particular by raising our policy rate by 450 basis points between July 2022 and September 2023. Inflation has come down steadily from its peak. Headline inflation declined to 1.7\% in September, its lowest level since April 2021 but picked again to 2.0\% in October, according to Eurostat's flash estimate. These gyrations notwithstanding, the recent inflation releases reinforce the signs that price pressures have weakened and that the disinflation process is well on track. This largely reflects an unwinding of the forces that led to strong increases in the prices of energy, food and goods. Falling energy prices continued to be the main downward force for inflation in October. Services inflation - which remains more persistent - remained unchanged at 3.9\%. Non-energy industrial goods inflation, while increasing to $0.5 \%$ in October, has fallen back to its pre-pandemic average. As a result, core inflation remained unchanged at $2.7 \%$ in October, down from its peak of $5.7 \%$ in March 2023. Inflation is expected to rise further in the coming months, partly because the sharp declines in energy prices during 2023 will drop out of the annual rates. It is then projected to decline to the $2 \%$ target over the course of next year, as labour cost pressures ease and the past monetary policy tightening gradually feeds through to prices. Based on an ongoing assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, the Governing Council decided to begin moderating the degree of policy restriction in June by cutting interest rates by 25 basis points. Since then, we have reduced the rate on the deposit facility - the rate through which we steer the monetary policy stance - by a further 50 basis points to its current level of $3.25 \%$. Turning to the growth outlook, euro area GDP rose by $0.4 \%$ in the third quarter of 2024, up from $0.2 \%$ in the second quarter, possibly reflecting the buoyant summer tourism season and one-off factors such as the Olympics in France. But, after a mild recovery in the first half of 2024, the latest economic indicators continue to suggest a weakening in activity across countries and sectors. Industrial production has been particularly volatile over the summer and the more interest-sensitive manufacturing sector has contracted for the 19th consecutive month, though at a slightly slower pace than in September. The manufacturing output Purchasing Managers' Index (PMI) has remained well below 50 since August 2022, registering 45.9 this October. In the services sector, activity in August was probably supported by a strong summer tourism season. That sector is still expanding, but at a slower pace, with the PMI edging down to 51.2 in October from 52.9 in August. These latest readings signal a weaker near-term outlook than projected by ECB staff in September. The recent increase in the savings rate can be attributed to several factors. First, as I have already discussed, both high inflation and rising interest rates in response to the inflation surge may have eroded real net wealth. Over the past two years, real net wealth has declined by $4 \%$. This may have encouraged saving to recuperate past losses. Second, higher real returns on savings and a higher cost of borrowing may have increased incentives to postpone consumption and reduce new borrowing. Third, non-labour income, such as self-employment remuneration, net interest receipts, dividends and rents has grown by $4.1 \%$ over the past two years. But the propensity to save out of those sources of income is much higher than for, say, wages, because non-labour income typically accrues to wealthier households that have a low marginal propensity to consume. Indeed, the data tell us that the savings rate is higher among households in the top income quintile. Fourth, inertia or persistence in consumption and savings habits is also likely to create a lag in the way consumption responds to rising incomes. Finally, the concept of permanent income can also be an important determinant of consumer spending. Households may limit their spending if they fear that their permanent income, expected over their lifetime, has not increased by as much as their current disposable income today. Fiscal policy also plays a role here. Consumers may save more if they expect taxes to rise to service higher public debt in the future - in the spirit of the socalled Ricardian equivalence. So, what does this mean for the current state of the economy? Is there a disconnect between growing real incomes and weak consumption growth? The key determinants of high savings are expected to persist, though likely to a lesser extent, over the course of next year. In particular, the drive to recover net wealth and the slow adjustment in consumption should become less relevant as factors holding back higher spending dissipate. Indeed, survey evidence points to a gradual recovery in household spending, with retail sales edging up in August and the European Commission's consumer confidence indicator rising in September. Price and wage adjustments should also play a powerful role in reviving consumption. Over the past three years, the slowdown in consumption growth has been primarily due to a drop in purchases of non-durable goods like food and energy, which have been most affected by the rising prices. However, with food and energy inflation moderating and purchasing power increasing, spending should start to respond. And there are already indications that the consumption of goods increased over the summer, with a small uptick in retail trade in August. Overall, this evidence suggests that private consumption growth will pick up, supported by ongoing robust growth in real labour income, lower inflation and improving consumer confidence. This expectation is also consistent with our September 2024 projections, which indicate that, as incomes continue to rise, inflation moderates and confidence strengthens, consumption will grow, albeit with savings remaining above prepandemic levels. Notwithstanding the near-term headwinds, the overall conditions for a pick-up in growth remain in place. The gradually fading-out of the effects of restrictive monetary policy should support both consumption and investment, and exports should contribute to the recovery as global demand rises. This brings me on to monetary policy transmission, a key element of our reaction function. One important factor affecting transmission of monetary policy to inflation and growth relates to the distribution of income and wealth across households. Inflation surges, along with the response of monetary policy, can have significant distributional effects. This matters for central banks because both the distribution and sources of income and wealth influence households' consumption and savings decisions, and ultimately, inflation. Inflation is often said to be a tax on the poor, especially when wages do not keep up with prices. And poorer households typically have lower savings buffers to be able to withstand a temporary erosion of their real purchasing power. However, inflation can also act as a transfer of resources from net savers to net borrowers, partly because it lowers the real value of debt. This potentially reduces wealth inequality. As such, the composition of assets and liabilities influences how inflation surges, such as those observed recently, affect household wealth across the distribution. In particular, on the face of it, unanticipated inflation appears to reduce wealth inequality by redistributing wealth from lenders to borrowers through changes in the real value of assets and liabilities - a mechanism known as the Fisher channel. This channel is strongest when incomes adjust to inflation, reducing the payment burdens falling on indebted households, who are usually in the lower half of the wealth distribution. At the same time, changes in real interest rates have different valuation effects on different types of assets and liabilities. The Fisher channel weakens when unexpected inflation reduces the real interest income of low and medium-income households, who often hold their wealth in bank deposits, and increases the profit income of high-income households, who often also have wealth invested in stock markets. Composition of net wealth distribution To assess the impact of inflation on the distribution of wealth, changes in real net wealth can be decomposed into contributions from transactions, real asset revaluations, and erosion due to inflation. 5] Since mid-2021, real net wealth has declined across all wealth groups, but higher inflation has mitigated losses for poorer households by reducing the real value of their liabilities by more than their assets. Conversely, wealthier households have seen losses amplified by their larger nominal asset holdings. This wealth redistribution from savers to borrowers occurs mechanically through balance sheet positions but does not account for other factors such as interest income flows and debt repayments. Wealthier households have experienced larger real losses primarily due to the revaluation of financial assets like shares and bonds amid rising interest rates, even though they saved more and faced less dramatic declines in real house prices than poorer households. By aiming to keep inflation close to target, monetary policy can help to mitigate these distributional effects. But monetary policy itself can affect the distribution of income and wealth through several, often offsetting, channels. The primary channels are changes in asset prices and the differing effects of interest rates on savings versus debt costs. Empirical evidence suggests that monetary policy tightening reduces net wealth across the wealth distribution. 5] The bottom 50\% of households are mainly affected through housing wealth, while the top 10\% feel more of an impact through financial wealth. Despite larger initial losses, the wealthiest tend to recover more quickly due to faster rebounds in equity prices compared with house prices. The forceful monetary policy response has helped limit the direct effects of surging inflation on poorer households. At the same time, our monetary policy tightening may have eroded net wealth across the spectrum while also having important distributional consequences, with implications for the economic outlook as we continue to battle inflation. The decision in October to lower the deposit facility rate - the rate through which we steer the monetary policy stance - by 25 basis points was based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The incoming information on inflation shows that the disinflationary process is well on track. The inflation outlook is also affected by recent downside surprises indicators of economic activity, while financing conditions remain restrictive. Fine-tuning monetary policy decisions is complex but the medium-term orientation of inflation is clear. Our interest rate decisions will continue to be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction, without pre-committing to a particular rate path. 1 . I am grateful to Margherita Giuzio, Thomas McGregor and Elisa Saporito for their contributions to this speech.
2024-11-07T00:00:00	Isabel Schnabel: The European Central Bank's balance sheet reduction - an interim assessment	Speech by Ms Isabel Schnabel, Member of the Executive Board of the European Central Bank, at the annual European Central Bank Conference on Money Markets, Frankfurt am Main, 7 November 2024.	SPEECH The ECB's balance sheet reduction: an interim assessment Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the annual ECB Conference on Money Markets Frankfurt, 7 November 2024 Excess liquidity in the euro area has declined measurably over the past two years. It has fallen by more than a third relative to its peak in 2022, and it dropped below €3 trillion about a month ago. This decline in excess liquidity predominantly resulted from banks repaying the loans they had taken under the third series of targeted longer-term refinancing operations (TLTROs). More recently, the phasing-out of reinvestments of bonds maturing under the Eurosystem's monetary policy portfolios has increasingly contributed to the decline. As of January 2025, the Eurosystem will no longer reinvest any of its monetary policy bond holdings, leading to a run-off in our portfolios of around €40 billion per month. The ECB is closely monitoring the impact of the decline in excess liquidity on financial markets, the banking system and the economy at large to assess how these developments are affected by the changes to our operational framework that we announced earlier this year. In my remarks, I would like to take stock of where we stand today. My main message is that, while excess liquidity is remaining ample, the ECB's balance sheet reduction is progressing smoothly and has helped improve market functioning, with clear signs of increased market activity and a redistribution of reserves across banks and borders. Supplying reserves on demand reduces uncertainty Historical episodes of central banks reducing the size of their balance sheets, let alone by significant amounts, have been rare. For this reason, all major central banks are closely monitoring the transition from abundant to less ample excess liquidity. For the ECB, staff projections suggest that, from a historical perspective, excess liquidity will remain ample for some time (Slide 2). However, there is significant uncertainty about banks' ultimate liquidity preferences, as well as about the capacity of money markets to efficiently distribute excess liquidity across the euro area] If banks wished to hold a higher level of excess reserves, for instance due to stricter prudential regulation, the projected decline in excess liquidity might put upward pressure on money market rates earlier than suggested by historical regularities. To cater for this uncertainty, the Governing Council in March decided on changes to the ECB's operational framework for implementing monetary policy.!2] The framework has three key characteristics (Slide 3).!] The first is that it is a demand-driven system, meaning that the marginal unit of reserves is provided elastically on demand through our standard refinancing operations and against a broad set of collateral. A demand-driven system allows banks to hold the level of reserves that they find optimal and insures against risks of fragmentation and sudden liquidity imbalances as reserves become less ample. This requires banks to regard access to our standard refinancing operations as an integral part of their liquidity management, without any stigma attached, while retaining a diversified funding mix. The second key characteristic of our framework is the mix of instruments used to supply reserves. Our short-term refinancing operations are at the centre of liquidity provision. At a later stage, we will gradually complement them with new structural longer-term lending operations and a new structural bond portfolio, taking into account legacy bond holdings. Both will provide a more stable source of liquidity to reflect the economy's growing currency demand. The third key characteristic is that monetary policy is implemented through a "soft" floor with a narrow spread. As reserves become less ample, money market rates could rise relative to the deposit facility rate (DFR) - the rate through which we steer our monetary policy stance - and could potentially become too volatile. In view of this, on 18 September, the spread between the rate on the main refinancing operations (MROs) and the DFR was reduced from 50 basis points to 15 basis points. This historically narrow spread limits both the scope for upward pressure on money market rates and their volatility, and it sets incentives for banks to borrow liquidity in our operations as our balance sheet normalises. In this context, a "soft" floor means that the Governing Council will tolerate deviations from the DFR in both directions, provided such movements do not blur the signal about the intended monetary policy stance. At the same time, the reduced spread is still large enough to preserve incentives for banks to find market- based funding solutions to insure themselves against liquidity shocks, thereby avoiding the risk of excessive liquidity transformation through the Eurosystem balance sheet./4] Balance sheet reduction progresses smoothly Clarity on the operational framework has helped banks, and financial markets more broadly, prepare for a period with less ample reserves. Since we announced the changes to our framework in March, further significant balance sheet reduction has taken place. This reduction has been progressing smoothly, and many of the concerns over the potential impact of the decline in our balance sheet on the economy have not materialised. This is illustrated by three developments. First, the phasing-out of reinvestments by the Eurosystem has not led to any bottlenecks in the absorption of bonds so far, in spite of increased net issuance by governments. Foreign investors have been absorbing the largest share of the net issuance of bonds in the euro area since the Eurosystem ended its reinvestment of securities under the asset purchase programme (APP), with households also playing an important role in some economies (Slide 4, left-hand side)./&] Second, we have not seen an excessive rise in long-term interest rates. While the term premium initially increased from historically unprecedented negative territory, it has recently fallen again and stabilised at low levels (Slide 4, right-hand side). The fact that the impact on the term premium has been contained reflects the gradual and transparent approach central banks have taken when reducing their balance sheets. This gradualism is probably one reason why announcements of quantitative tightening are often found to have smaller effects on bond prices than announcements of quantitative easing.!! Since bonds held by the central bank mature only gradually, investors may heavily discount redemptions that are due far out in the future. Third, subdued credit growth over the past two years cannot be attributed to the reduction in excess liquidity, and in our monetary policy bond portfolios, in particular. Instead, it has been, by and large, the result of weak loan demand and higher interest rates. According to our most recent bank lending survey, 95% of banks reported that the ECB's monetary policy asset portfolio had no impact on their lending volumes to firms over the past six months. 96% of banks expect this to remain the case over the next six months. That is, banks do not mechanically make their lending decisions dependent on the level of excess liquidity, with base money "multiplying" into broad money. The decline in excess liquidity may even contribute to higher rather than lower credit growth. New evidence for the United States suggests that reserves injected during quantitative easing crowded out bank lending, possibly because regulation has made bank balance sheet capacity costly.!8 The impact of falling excess liquidity on money markets So, balance sheet reduction has not left any significant footprint in many areas, at least so far. But in other areas, especially in the euro area money market, the ongoing decline of excess liquidity is starting to leave some traces on activity and prices. I would now like to explain what these traces are and what they imply for monetary policy and the likely future evolution of money market rates. In a demand-driven system, gauging the ampleness of reserves is not necessary for informing the process of quantitative tightening, which is running steadily and predictably in the background. The reason is that, in contrast to a supply-driven system, our framework does not require estimating the volume of reserves necessary to steer short-term money market rates towards the steering rate. In the euro area, the narrow corridor ensures that overnight rates will remain close to the DFR. But it matters for the implementation of our monetary policy how the decline in excess liquidity affects the take-up in our standard refinancing operations, how it shapes the distribution of reserve holdings across the euro area and how it influences the rates at which banks borrow in money markets. We have therefore developed a comprehensive monitoring toolbox to allow us to understand how banks adapt to the decline in excess liquidity and whether this process may eventually require changes to our operational framework. A review of the key parameters of the operational framework is scheduled for 2026.1 Based on this analysis, I would like to discuss three developments that have emerged over the course of this year and that suggest that the changes to our framework have been effective in supporting market functioning, in reviving market activity and in implementing our policy stance. Easing of collateral scarcity has led to normalisation in repo markets The first development relates to a steady and measurable rise in secured money market rates in the euro area and beyond (Slide 5, left-hand side). While in some parts of the world repo rates are already trading above the main policy rate, or have temporarily drifted outside of the target range, in the euro area the repo funds rate is now trading broadly at the level of the DFR. Within the euro area, repo rates have also converged across collateral classes (Slide 5, right-hand side). Over the past years, transactions secured by German government collateral, in particular, were trading at a significant premium over others. This premium has declined considerably. The increase in repo rates could result from two factors: higher collateral availability and lower excess liquidity."2] Depending on which factor dominates, the implications for monetary policy would differ. One of the main conclusions of our monitoring work is that it was primarily the reversal of collateral scarcity that was driving repo rates higher. Between 2021 and 2023, the ECB's large bond holdings and the significant take-up in our TLTROs resulted in a sharp decline in the collateral available for secured lending. Collateral scarcity, in turn, caused repo rates to drop sharply. At the peak, more than 70% of repos were trading at least 30 basis points below the DFR (Slide 6, left-hand side). Repos against German collateral temporarily traded more than 100 basis points below the DFR. Collateral availability has improved significantly over the past 18 months. Large issuance by euro area sovereigns, the Eurosystem's reduced market footprint from the gradual run- down of the monetary policy bond portfolio and the return of collateral mobilised with the Eurosystem all contributed to easing the strains in repo markets and thus to the gradual normalisation of repo rates from extreme conditions (Slide 6, right-hand side). The question is whether the rise in repo rates will continue. Any answer to this question is inherently speculative. But for as long as there is ample excess liquidity, it is likely that repo rates will stay in the vicinity of the DFR, as banks would be expected to lend reserves in the repo market if there were persistent gains to be made there as opposed to depositing these reserves with the ECB. And, for now, the DFR is anchoring one-day repo rates, even for collateral of lower-rated sovereign bonds (Slide 7, left-hand side). This is because most Eurosystem counterparties still have excess liquidity several times larger than their minimum reserve requirements, especially the larger ones (Slide 7, right-hand side). The extent to which markets can mitigate upward pressure on repo rates critically depends on market participants taking advantage of arbitrage opportunities arising from the spread between money market rates and the DFR. This includes banks' willingness to lend reserves across borders, as the distribution of excess liquidity holdings is highly uneven across countries and institutions (Slide 8, left-hand side). So, on reporting dates, or at lower levels of excess liquidity, repo rates could rise above the DFR. This may happen, for example, if banks start to refrain from lending reserves in money markets, for instance to keep their regulatory liquidity ratios above a certain threshold. Such intermediation constraints may help explain the premium that we are seeing today for repo transactions covering the year-end, even for the most liquid collateral (Slide 8, right-hand side). High price mark-ups often reflect trades with non-banks that have no access to our lending facilities. Pick-up in market-based funding and redistribution of excess liquidity This brings me to the second development. As excess liquidity has declined, we have seen a notable pick- up in market-based funding activity, which has also contributed to reserves circulating from banks with abundant liquidity to those with less liquidity. Repo volumes of transactions between euro area counterparties have grown by nearly 25% since excess liquidity started to decline, with the strongest growth seen for cross-border transactions (Slide 9, left-hand side). With the repayment of the TLTROs, we have also seen a considerable rise in liquidity-motivated transactions, which now seem to have stabilised at a comparatively high level (Slide 9, right-hand side). The issuance of bank bonds has also played an important role in providing market-based funding and in redistributing central bank reserves.12] Since 2022 banks have issued a record amount of covered and senior unsecured bonds to substitute maturing TLTRO funding, with several issuers returning to the market after a long absence (Slide 10, left- hand side). For covered bonds, last year saw a record number of issuers tapping this market, including a variety of small-sized issuers. Banks were major investors in the covered bonds issued by other banks. From 2022 to mid-2024, banks absorbed the lion share of the net issuance of covered bonds (Slide 10, right-hand side). Cross-border transactions played an important part in this, as banks with abundant liquidity invested in covered bonds of their peers located elsewhere (Slide 11, left-hand side). These cross-border flows suggest that there are no signs of fragmentation. So does the fact that changes in TARGET2 balances, reflecting cross-border flows, have measurably contributed to recent changes in excess liquidity (Slide 11, right-hand side). In Italy, for example, large TARGET2 inflows offset a significant part of the decline in excess liquidity related to the repayments of TLTRO III.9] In reserve-rich countries, the opposite effect prevailed. This smooth redistribution of reserves is another indication that Eurosystem excess liquidity remains ample, and it is likely to have reduced the need of banks to use the ECB's standard refinancing operations (Slide 12). Less than 1% of the peak of outstanding TLTROs was rolled over into MROs or the three- month longer-term refinancing operations. Moreover, the take-up of our operations did not materially increase after we reduced the spread between the rate on the MROs and the DFR to 15 basis points. One reason is that, in most cases, funding via market-based sources remains more attractive than the recourse to ECB operations, even with a narrower spread (Slide 13, left-hand side). Currently, borrowing from the ECB may be more economical only for some non-high-quality liquid assets (HQLA) collateral. In addition, we are seeing that banks are willing to reduce the share of reserves in their holdings of HQLA. This share fell from a peak of 78% in late 2022 to 56% today (Slide 13, right-hand side). As the aggregate liquidity coverage ratio (LCR) has stabilised around 160% over the past two years, banks have started to substitute reserves for other HQLA. Yet, as excess liquidity declines further, we expect more and more banks to tap our liquidity-providing operations, also because a substantial share of euro area banks - representing about 25% of minimum reserve requirements - are currently not active in repo markets. While this may change, membership requirements for central clearing counterparties, such as size, credit rating and operational capacity, may currently make it difficult for smaller banks to obtain collateralised credit.[14] Low sensitivity of €STR to changes in excess liquidity Borrowing in the unsecured money market could, in principle, be an alternative for these banks, especially because sourcing liquidity via unsecured trades has become cheaper compared with secured trades in the repo market since the middle of last year. While repo rates have trended upwards, €STR - the euro area's benchmark rate representing banks' overnight unsecured borrowing conditions - has barely budged (Slide 14). The stickiness of €STR is the third development I would like to discuss today. What does it imply for monetary policy? And why is this stickiness not necessarily surprising? The unsecured segment of the euro area money market is special in two respects. First, banks are rarely on the lending side, mostly for regulatory reasons. The Basel III reforms treat secured lending preferentially, establishing repo as the preferred choice for banks' short-term lending overall. From a borrower's perspective, too, secured borrowing is more attractive than unsecured as leverage ratio costs can be significantly mitigated by netting lending and borrowing through central counterparty (CCP) clearing in the secured market. As a result, the unsecured market is primarily used by banks to intermediate deposits from non-banks without access to the ECB's balance sheet. Since 2022, an average of around 85% of the volume of trades have had non-banks as a counterparty, especially money market funds. Since this intermediation service carries the costs of balance sheet expansion through the leverage ratio, banks typically demand a spread relative to the DFR to compensate them for binding their balance sheet capacity,(15] Second, trades in the unsecured money market are typically relationship-based. Around 80% of €STR trading volumes come from depositor-bank relationships that are active almost every day (Slide 15, left- hand side). Relationship trading has important implications for the pricing of the trade. Specifically, banks impose higher intermediation fees on customers that come only sporadically and are less predictable. Empirical evidence suggests that banks reduce the extent of regulatory cost pass-through to their most stable clients by 2.4 basis points for taking on unsecured deposits (Slide 15, right-hand side). Such discounts are economically significant and can, in part, be explained by banks' ability to profit from cross- selling other, more lucrative business to their stable depositors. So, the microstructure of the unsecured money market is consistent with a weak responsiveness of €STR to changes in excess liquidity. The question is whether, and to what extent, this will change as excess liquidity declines further. There are two sides to this. On the one hand, as many smaller banks do not have access to the repo market, they may start competing for liquidity in the unsecured market once borrowing needs become more imminent. Increased competition could put upward pressure on €STR. On the other hand, lenders in the unsecured market seem price-insensitive. As repo rates trade well above €STR, lenders should have an incentive to place their cash in the repo market. However, so far there has been little migration across the two segments. This is predominantly because most lenders that are active in the unsecured market do not have access to repo markets (Slide 16, left-hand side). Moreover, those that have a more diversified liquidity management may find it difficult to lend excess cash in secured markets, which operate mainly in the morning hours (Slide 16, right-hand side). Money market funds, for example, allow redemption notices until 14:00 and need to preserve liquidity to meet any potential outflows until then." Unsecured markets may thus be the only viable option for them to place liquidity in the afternoon. This suggests that banks are likely to maintain some pricing power in this market, keeping the sensitivity of €STR to changes in excess liquidity more muted. Overall, it is uncertain which channel will dominate. It is therefore too early to assess whether €STR is an appropriate indicator of reserve scarcity. Its resilience so far may simply suggest that reserves remain ample. But should the gap between repo rates and €STR continue to widen as excess liquidity declines, it will be necessary to assess how this affects the transmission of monetary policy to the real economy. Conclusion All in all, and with this I would like to conclude, our analysis suggests that excess liquidity remains ample in the euro area. Recent upward pressure on rates in some segments of the money market reflects, by and large, a reduction in collateral scarcity, due to the increased bond issuance by governments and the reduced Eurosystem market footprint. The improved availability of collateral has helped to significantly improve market functioning in the euro area. In addition, increasing market-based funding activity and growing signs of redistribution of reserves across banks and borders suggest that banks have started adapting to an environment with less ample reserves. We expect this process to continue as excess liquidity declines further, with banks increasingly sourcing liquidity through our standard refinancing operations, as these constitute an integral part of a smooth implementation of monetary policy in our operational framework. Thank you. Annexes 7 November 2024 The ECB's balance sheet reduction: an interim assessment 1. Schnabel, I. (2023), "Back to normal? Balance sheet size and interest rate control", speech at an event organised by Columbia University and SGH Macro Advisors, New York, 27 March. 2. ECB (2024), Changes to the operational framework for implementing monetary policy, Statement by the Governing Council, 13 March. 3. Schnabel, I. (2024), "The Eurosystem's operational framework", speech at the Money Market Contact Group meeting, Frankfurt am Main, 14 March. 4. Since excess reserves count towards the fulfilment of prudential liquidity ratios, the combination of a very low cost of carry and a broad collateral framework could encourage banks to engage in excessive liquidity transformation, as they receive Level 1 high-quality liquid assets (HQLA) by pledging non-HQLA as collateral. These risks are especially high when banks have access to longer-term refinancing operations and are permitted to pledge non-marketable assets as collateral, as our framework foresees. 5. Ferrara, F.M. et al. (2024), "Who buys bonds now? How markets deal with a smaller Eurosystem balance sheet', The ECB Blog, 22 March. 6. Du, W., Forbes, K. and Luzzetti, M.N. (2024), "Quantitative Tightening Around the Globe: What Have We Learned?", NBER Working Paper, No 32321, National Bureau of Economic Research, April. See also Schnabel, I. (2024), "The benefits and costs of asset purchases", speech at the 2024 BOJ-IMES Conference on "Price Dynamics and Monetary Policy Challenges: Lessons Learned and Going Forward", Tokyo, 28 May. 7. Schnabel, I. (2023), ,Money and inflation', Thunen Lecture at the annual conference of the Verein fur Socialpolitik, Regensburg, 25 September. 8. Diamond, W. et al. (2024), "The reserve supply channel of unconventional monetary policy", Journal of Financial Economics, Vol. 159, September. While preliminary research by ECB staff suggests that reserves may in some instances have crowded-in rather than crowded-out bank lending in the euro area, this may reflect the partly different nature of reserve creation in the euro area, where the TLTROs were designed specifically with the aim to stimulate bank lending. 9. In March 2024 the Governing Council also clarified that it stands ready to adjust the design and parameters of the framework earlier, if necessary, to ensure that the implementation of monetary policy remains in line with the established principles (see footnote 2). 10. Other factors, such as intermediation capacity constraints, could also affect repo rates. 11. These effects were reinforced by stopping the rise in inflation. As monetary policy restriction is gradually being removed, interest rate expectations are adjusting lower, making bonds more valuable in nominal terms. In addition, during the period of high inflation, some market participants sought collateral in the repo market to facilitate short-selling. A surge in net securities borrowing by hedge funds probably exerted downward pressures on special repo rates. This trend has now reversed. 12. See also Hudeponhl, T. et al. (2024), "How banks deal with declining excess liquidity", The ECB Blog, 18 June. 13. The increase in inflows may also be related to other cross-border transactions. In particular, over the past two years non-resident holdings of Italian government bonds have increased notably. 14. Bilateral repo trading is an alternative, but it does not offer the same advantages as CCPs in terms of balance sheet impact, credit risk and operational efficiency. In particular, transactions can be netted when conducted through the same CCP. 15. The impact of regulatory costs on €STR is most visible on days when banks aim to optimise their regulatory ratios. On these days, mostly quarter-ends, some banks lower their rates by more than 10 basis points below the DFR for warehousing overnight deposits of non-banks. While these costs also occur in the secured market, they can be significantly reduced by netting lending and borrowing through CCP clearing. For the banks that are most active in the repo market, netting potential can reach up to 70% of total repo borrowing volumes. 16. For example, the repo market's close link to bond markets means that trades need to be executed early in a day to give bond dealers a clear guideline for available liquidity and securities. 17. Similarly, pension funds value intraday flexibility as their liquid buffers serve to fulfil potential margin calls that may arise over the course of the business day.	---[PAGE_BREAK]--- # The ECB's balance sheet reduction: an interim assessment ## Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the annual ECB Conference on Money Markets Frankfurt, 7 November 2024 Excess liquidity in the euro area has declined measurably over the past two years. It has fallen by more than a third relative to its peak in 2022, and it dropped below €3 trillion about a month ago. This decline in excess liquidity predominantly resulted from banks repaying the loans they had taken under the third series of targeted longer-term refinancing operations (TLTROs). More recently, the phasing-out of reinvestments of bonds maturing under the Eurosystem's monetary policy portfolios has increasingly contributed to the decline. As of January 2025, the Eurosystem will no longer reinvest any of its monetary policy bond holdings, leading to a run-off in our portfolios of around €40 billion per month. The ECB is closely monitoring the impact of the decline in excess liquidity on financial markets, the banking system and the economy at large to assess how these developments are affected by the changes to our operational framework that we announced earlier this year. In my remarks, I would like to take stock of where we stand today. My main message is that, while excess liquidity is remaining ample, the ECB's balance sheet reduction is progressing smoothly and has helped improve market functioning, with clear signs of increased market activity and a redistribution of reserves across banks and borders. ## Supplying reserves on demand reduces uncertainty Historical episodes of central banks reducing the size of their balance sheets, let alone by significant amounts, have been rare. For this reason, all major central banks are closely monitoring the transition from abundant to less ample excess liquidity. For the ECB, staff projections suggest that, from a historical perspective, excess liquidity will remain ample for some time (Slide 2). However, there is significant uncertainty about banks' ultimate liquidity preferences, as well as about the capacity of money markets to efficiently distribute excess liquidity across the euro area. ${ }^{[1]}$ If banks wished to hold a higher level of excess reserves, for instance due to stricter prudential regulation, the projected decline in excess liquidity might put upward pressure on money market rates earlier than suggested by historical regularities. ---[PAGE_BREAK]--- To cater for this uncertainty, the Governing Council in March decided on changes to the ECB's operational framework for implementing monetary policy. ${ }^{[2]}$ The framework has three key characteristics (Slide 3). ${ }^{[3]}$ The first is that it is a demand-driven system, meaning that the marginal unit of reserves is provided elastically on demand through our standard refinancing operations and against a broad set of collateral. A demand-driven system allows banks to hold the level of reserves that they find optimal and insures against risks of fragmentation and sudden liquidity imbalances as reserves become less ample. This requires banks to regard access to our standard refinancing operations as an integral part of their liquidity management, without any stigma attached, while retaining a diversified funding mix. The second key characteristic of our framework is the mix of instruments used to supply reserves. Our short-term refinancing operations are at the centre of liquidity provision. At a later stage, we will gradually complement them with new structural longer-term lending operations and a new structural bond portfolio, taking into account legacy bond holdings. Both will provide a more stable source of liquidity to reflect the economy's growing currency demand. The third key characteristic is that monetary policy is implemented through a "soft" floor with a narrow spread. As reserves become less ample, money market rates could rise relative to the deposit facility rate (DFR) the rate through which we steer our monetary policy stance - and could potentially become too volatile. In view of this, on 18 September, the spread between the rate on the main refinancing operations (MROs) and the DFR was reduced from 50 basis points to 15 basis points. This historically narrow spread limits both the scope for upward pressure on money market rates and their volatility, and it sets incentives for banks to borrow liquidity in our operations as our balance sheet normalises. In this context, a "soft" floor means that the Governing Council will tolerate deviations from the DFR in both directions, provided such movements do not blur the signal about the intended monetary policy stance. At the same time, the reduced spread is still large enough to preserve incentives for banks to find marketbased funding solutions to insure themselves against liquidity shocks, thereby avoiding the risk of excessive liquidity transformation through the Eurosystem balance sheet. ${ }^{[4]}$ # Balance sheet reduction progresses smoothly Clarity on the operational framework has helped banks, and financial markets more broadly, prepare for a period with less ample reserves. Since we announced the changes to our framework in March, further significant balance sheet reduction has taken place. This reduction has been progressing smoothly, and many of the concerns over the potential impact of the decline in our balance sheet on the economy have not materialised. ---[PAGE_BREAK]--- This is illustrated by three developments. First, the phasing-out of reinvestments by the Eurosystem has not led to any bottlenecks in the absorption of bonds so far, in spite of increased net issuance by governments. Foreign investors have been absorbing the largest share of the net issuance of bonds in the euro area since the Eurosystem ended its reinvestment of securities under the asset purchase programme (APP), with households also playing an important role in some economies (Slide 4, left-hand side). ${ }^{[5]}$ Second, we have not seen an excessive rise in long-term interest rates. While the term premium initially increased from historically unprecedented negative territory, it has recently fallen again and stabilised at low levels (Slide 4, right-hand side). The fact that the impact on the term premium has been contained reflects the gradual and transparent approach central banks have taken when reducing their balance sheets. This gradualism is probably one reason why announcements of quantitative tightening are often found to have smaller effects on bond prices than announcements of quantitative easing. ${ }^{[6]}$ Since bonds held by the central bank mature only gradually, investors may heavily discount redemptions that are due far out in the future. Third, subdued credit growth over the past two years cannot be attributed to the reduction in excess liquidity, and in our monetary policy bond portfolios, in particular. Instead, it has been, by and large, the result of weak loan demand and higher interest rates. According to our most recent bank lending survey, 95\% of banks reported that the ECB's monetary policy asset portfolio had no impact on their lending volumes to firms over the past six months. 96\% of banks expect this to remain the case over the next six months. That is, banks do not mechanically make their lending decisions dependent on the level of excess liquidity, with base money "multiplying" into broad money. ${ }^{[7]}$ The decline in excess liquidity may even contribute to higher rather than lower credit growth. New evidence for the United States suggests that reserves injected during quantitative easing crowded out bank lending, possibly because regulation has made bank balance sheet capacity costly. ${ }^{[8]}$ # The impact of falling excess liquidity on money markets So, balance sheet reduction has not left any significant footprint in many areas, at least so far. But in other areas, especially in the euro area money market, the ongoing decline of excess liquidity is starting to leave some traces on activity and prices. I would now like to explain what these traces are and what they imply for monetary policy and the likely future evolution of money market rates. In a demand-driven system, gauging the ampleness of reserves is not necessary for informing the process of quantitative tightening, which is running steadily and predictably in the background. ---[PAGE_BREAK]--- The reason is that, in contrast to a supply-driven system, our framework does not require estimating the volume of reserves necessary to steer short-term money market rates towards the steering rate. In the euro area, the narrow corridor ensures that overnight rates will remain close to the DFR. But it matters for the implementation of our monetary policy how the decline in excess liquidity affects the take-up in our standard refinancing operations, how it shapes the distribution of reserve holdings across the euro area and how it influences the rates at which banks borrow in money markets. We have therefore developed a comprehensive monitoring toolbox to allow us to understand how banks adapt to the decline in excess liquidity and whether this process may eventually require changes to our operational framework. A review of the key parameters of the operational framework is scheduled for 2026. ${ }^{[9]}$ Based on this analysis, I would like to discuss three developments that have emerged over the course of this year and that suggest that the changes to our framework have been effective in supporting market functioning, in reviving market activity and in implementing our policy stance. # Easing of collateral scarcity has led to normalisation in repo markets The first development relates to a steady and measurable rise in secured money market rates in the euro area and beyond (Slide 5, left-hand side). While in some parts of the world repo rates are already trading above the main policy rate, or have temporarily drifted outside of the target range, in the euro area the repo funds rate is now trading broadly at the level of the DFR. Within the euro area, repo rates have also converged across collateral classes (Slide 5, right-hand side). Over the past years, transactions secured by German government collateral, in particular, were trading at a significant premium over others. This premium has declined considerably. The increase in repo rates could result from two factors: higher collateral availability and lower excess liquidity. ${ }^{[10]}$ Depending on which factor dominates, the implications for monetary policy would differ. One of the main conclusions of our monitoring work is that it was primarily the reversal of collateral scarcity that was driving repo rates higher. Between 2021 and 2023, the ECB's large bond holdings and the significant take-up in our TLTROs resulted in a sharp decline in the collateral available for secured lending. Collateral scarcity, in turn, caused repo rates to drop sharply. At the peak, more than $70 \%$ of repos were trading at least 30 basis points below the DFR (Slide 6, left-hand side). Repos against German collateral temporarily traded more than 100 basis points below the DFR. Collateral availability has improved significantly over the past 18 months. Large issuance by euro area sovereigns, the Eurosystem's reduced market footprint from the gradual rundown of the monetary policy bond portfolio and the return of collateral mobilised with the Eurosystem all contributed to easing the strains in repo markets and thus to the gradual normalisation of repo rates from extreme conditions (Slide 6, right-hand side). ${ }^{[11]}$ ---[PAGE_BREAK]--- The question is whether the rise in repo rates will continue. Any answer to this question is inherently speculative. But for as long as there is ample excess liquidity, it is likely that repo rates will stay in the vicinity of the DFR, as banks would be expected to lend reserves in the repo market if there were persistent gains to be made there as opposed to depositing these reserves with the ECB. And, for now, the DFR is anchoring one-day repo rates, even for collateral of lower-rated sovereign bonds (Slide 7, left-hand side). This is because most Eurosystem counterparties still have excess liquidity several times larger than their minimum reserve requirements, especially the larger ones (Slide 7, right-hand side). The extent to which markets can mitigate upward pressure on repo rates critically depends on market participants taking advantage of arbitrage opportunities arising from the spread between money market rates and the DFR. This includes banks' willingness to lend reserves across borders, as the distribution of excess liquidity holdings is highly uneven across countries and institutions (Slide 8, left-hand side). So, on reporting dates, or at lower levels of excess liquidity, repo rates could rise above the DFR. This may happen, for example, if banks start to refrain from lending reserves in money markets, for instance to keep their regulatory liquidity ratios above a certain threshold. Such intermediation constraints may help explain the premium that we are seeing today for repo transactions covering the year-end, even for the most liquid collateral (Slide 8, right-hand side). High price mark-ups often reflect trades with non-banks that have no access to our lending facilities. # Pick-up in market-based funding and redistribution of excess liquidity This brings me to the second development. As excess liquidity has declined, we have seen a notable pickup in market-based funding activity, which has also contributed to reserves circulating from banks with abundant liquidity to those with less liquidity. Repo volumes of transactions between euro area counterparties have grown by nearly $25 \%$ since excess liquidity started to decline, with the strongest growth seen for cross-border transactions (Slide 9, left-hand side). With the repayment of the TLTROs, we have also seen a considerable rise in liquidity-motivated transactions, which now seem to have stabilised at a comparatively high level (Slide 9, right-hand side). The issuance of bank bonds has also played an important role in providing market-based funding and in redistributing central bank reserves. ${ }^{[12]}$ Since 2022 banks have issued a record amount of covered and senior unsecured bonds to substitute maturing TLTRO funding, with several issuers returning to the market after a long absence (Slide 10, lefthand side). For covered bonds, last year saw a record number of issuers tapping this market, including a variety of small-sized issuers. Banks were major investors in the covered bonds issued by other banks. From 2022 to mid-2024, banks absorbed the lion share of the net issuance of covered bonds (Slide 10, right-hand side). ---[PAGE_BREAK]--- Cross-border transactions played an important part in this, as banks with abundant liquidity invested in covered bonds of their peers located elsewhere (Slide 11, left-hand side). These cross-border flows suggest that there are no signs of fragmentation. So does the fact that changes in TARGET2 balances, reflecting cross-border flows, have measurably contributed to recent changes in excess liquidity (Slide 11, right-hand side). In Italy, for example, large TARGET2 inflows offset a significant part of the decline in excess liquidity related to the repayments of TLTRO III. ${ }^{[13]}$ In reserve-rich countries, the opposite effect prevailed. This smooth redistribution of reserves is another indication that Eurosystem excess liquidity remains ample, and it is likely to have reduced the need of banks to use the ECB's standard refinancing operations (Slide 12). Less than 1\% of the peak of outstanding TLTROs was rolled over into MROs or the threemonth longer-term refinancing operations. Moreover, the take-up of our operations did not materially increase after we reduced the spread between the rate on the MROs and the DFR to 15 basis points. One reason is that, in most cases, funding via market-based sources remains more attractive than the recourse to ECB operations, even with a narrower spread (Slide 13, left-hand side). Currently, borrowing from the ECB may be more economical only for some non-high-quality liquid assets (HQLA) collateral. In addition, we are seeing that banks are willing to reduce the share of reserves in their holdings of HQLA. This share fell from a peak of $78 \%$ in late 2022 to $56 \%$ today (Slide 13, right-hand side). As the aggregate liquidity coverage ratio (LCR) has stabilised around 160\% over the past two years, banks have started to substitute reserves for other HQLA. Yet, as excess liquidity declines further, we expect more and more banks to tap our liquidity-providing operations, also because a substantial share of euro area banks - representing about $25 \%$ of minimum reserve requirements - are currently not active in repo markets. While this may change, membership requirements for central clearing counterparties, such as size, credit rating and operational capacity, may currently make it difficult for smaller banks to obtain collateralised credit. ${ }^{[14]}$ # Low sensitivity of $€$ STR to changes in excess liquidity Borrowing in the unsecured money market could, in principle, be an alternative for these banks, especially because sourcing liquidity via unsecured trades has become cheaper compared with secured trades in the repo market since the middle of last year. While repo rates have trended upwards, €STR - the euro area's benchmark rate representing banks' overnight unsecured borrowing conditions - has barely budged (Slide 14). The stickiness of €STR is the third development I would like to discuss today. What does it imply for monetary policy? And why is this stickiness not necessarily surprising? The unsecured segment of the euro area money market is special in two respects. ---[PAGE_BREAK]--- First, banks are rarely on the lending side, mostly for regulatory reasons. The Basel III reforms treat secured lending preferentially, establishing repo as the preferred choice for banks' short-term lending overall. From a borrower's perspective, too, secured borrowing is more attractive than unsecured as leverage ratio costs can be significantly mitigated by netting lending and borrowing through central counterparty (CCP) clearing in the secured market. As a result, the unsecured market is primarily used by banks to intermediate deposits from non-banks without access to the ECB's balance sheet. Since 2022, an average of around $85 \%$ of the volume of trades have had non-banks as a counterparty, especially money market funds. Since this intermediation service carries the costs of balance sheet expansion through the leverage ratio, banks typically demand a spread relative to the DFR to compensate them for binding their balance sheet capacity. ${ }^{[15]}$ Second, trades in the unsecured money market are typically relationship-based. Around 80\% of $€$ STR trading volumes come from depositor-bank relationships that are active almost every day (Slide 15, lefthand side). Relationship trading has important implications for the pricing of the trade. Specifically, banks impose higher intermediation fees on customers that come only sporadically and are less predictable. Empirical evidence suggests that banks reduce the extent of regulatory cost pass-through to their most stable clients by 2.4 basis points for taking on unsecured deposits (Slide 15, right-hand side). Such discounts are economically significant and can, in part, be explained by banks' ability to profit from crossselling other, more lucrative business to their stable depositors. So, the microstructure of the unsecured money market is consistent with a weak responsiveness of €STR to changes in excess liquidity. The question is whether, and to what extent, this will change as excess liquidity declines further. There are two sides to this. On the one hand, as many smaller banks do not have access to the repo market, they may start competing for liquidity in the unsecured market once borrowing needs become more imminent. Increased competition could put upward pressure on €STR. On the other hand, lenders in the unsecured market seem price-insensitive. As repo rates trade well above €STR, lenders should have an incentive to place their cash in the repo market. However, so far there has been little migration across the two segments. This is predominantly because most lenders that are active in the unsecured market do not have access to repo markets (Slide 16, left-hand side). Moreover, those that have a more diversified liquidity management may find it difficult to lend excess cash in secured markets, which operate mainly in the morning hours (Slide 16, right-hand side). ${ }^{[16]}$ ---[PAGE_BREAK]--- Money market funds, for example, allow redemption notices until 14:00 and need to preserve liquidity to meet any potential outflows until then. ${ }^{[17]}$ Unsecured markets may thus be the only viable option for them to place liquidity in the afternoon. This suggests that banks are likely to maintain some pricing power in this market, keeping the sensitivity of €STR to changes in excess liquidity more muted. Overall, it is uncertain which channel will dominate. It is therefore too early to assess whether €STR is an appropriate indicator of reserve scarcity. Its resilience so far may simply suggest that reserves remain ample. But should the gap between repo rates and €STR continue to widen as excess liquidity declines, it will be necessary to assess how this affects the transmission of monetary policy to the real economy. # Conclusion All in all, and with this I would like to conclude, our analysis suggests that excess liquidity remains ample in the euro area. Recent upward pressure on rates in some segments of the money market reflects, by and large, a reduction in collateral scarcity, due to the increased bond issuance by governments and the reduced Eurosystem market footprint. The improved availability of collateral has helped to significantly improve market functioning in the euro area. In addition, increasing market-based funding activity and growing signs of redistribution of reserves across banks and borders suggest that banks have started adapting to an environment with less ample reserves. We expect this process to continue as excess liquidity declines further, with banks increasingly sourcing liquidity through our standard refinancing operations, as these constitute an integral part of a smooth implementation of monetary policy in our operational framework. Thank you. ## Annexes 7 November 2024 The ECB's balance sheet reduction: an interim assessment 1. Schnabel, I. (2023), "Back to normal? Balance sheet size and interest rate control", speech at an event organised by Columbia University and SGH Macro Advisors, New York, 27 March. 2. ---[PAGE_BREAK]--- ECB (2024), Changes to the operational framework for implementing monetary policy, Statement by the Governing Council, 13 March. 3. Schnabel, I. (2024), "The Eurosystem's operational framework", speech at the Money Market Contact Group meeting, Frankfurt am Main, 14 March. 4. Since excess reserves count towards the fulfilment of prudential liquidity ratios, the combination of a very low cost of carry and a broad collateral framework could encourage banks to engage in excessive liquidity transformation, as they receive Level 1 high-quality liquid assets (HQLA) by pledging non-HQLA as collateral. These risks are especially high when banks have access to longer-term refinancing operations and are permitted to pledge non-marketable assets as collateral, as our framework foresees. 5. Ferrara, F.M. et al. (2024), "Who buys bonds now? How markets deal with a smaller Eurosystem balance sheet", The ECB Blog, 22 March. 6. Du, W., Forbes, K. and Luzzetti, M.N. (2024), "Quantitative Tightening Around the Globe: What Have We Learned?", NBER Working Paper, No 32321, National Bureau of Economic Research, April. See also Schnabel, I. (2024), "The benefits and costs of asset purchases", speech at the 2024 BOJ-IMES Conference on "Price Dynamics and Monetary Policy Challenges: Lessons Learned and Going Forward", Tokyo, 28 May. 7. Schnabel, I. (2023), „Money and inflation", Thünen Lecture at the annual conference of the Verein für Socialpolitik, Regensburg, 25 September. 8. Diamond, W. et al. (2024), "The reserve supply channel of unconventional monetary policy", Journal of Financial Economics, Vol. 159, September. While preliminary research by ECB staff suggests that reserves may in some instances have crowded-in rather than crowded-out bank lending in the euro area, this may reflect the partly different nature of reserve creation in the euro area, where the TLTROs were designed specifically with the aim to stimulate bank lending. 9. In March 2024 the Governing Council also clarified that it stands ready to adjust the design and parameters of the framework earlier, if necessary, to ensure that the implementation of monetary policy ---[PAGE_BREAK]--- remains in line with the established principles (see footnote 2). 10. Other factors, such as intermediation capacity constraints, could also affect repo rates. 11. These effects were reinforced by stopping the rise in inflation. As monetary policy restriction is gradually being removed, interest rate expectations are adjusting lower, making bonds more valuable in nominal terms. In addition, during the period of high inflation, some market participants sought collateral in the repo market to facilitate short-selling. A surge in net securities borrowing by hedge funds probably exerted downward pressures on special repo rates. This trend has now reversed. 12. See also Hudepohl, T. et al. (2024), "How banks deal with declining excess liquidity", The ECB Blog, 18 June. 13. The increase in inflows may also be related to other cross-border transactions. In particular, over the past two years non-resident holdings of Italian government bonds have increased notably. 14. Bilateral repo trading is an alternative, but it does not offer the same advantages as CCPs in terms of balance sheet impact, credit risk and operational efficiency. In particular, transactions can be netted when conducted through the same CCP. 15. The impact of regulatory costs on €STR is most visible on days when banks aim to optimise their regulatory ratios. On these days, mostly quarter-ends, some banks lower their rates by more than 10 basis points below the DFR for warehousing overnight deposits of non-banks. While these costs also occur in the secured market, they can be significantly reduced by netting lending and borrowing through CCP clearing. For the banks that are most active in the repo market, netting potential can reach up to $70 \%$ of total repo borrowing volumes. 16. For example, the repo market's close link to bond markets means that trades need to be executed early in a day to give bond dealers a clear guideline for available liquidity and securities. 17. Similarly, pension funds value intraday flexibility as their liquid buffers serve to fulfil potential margin calls that may arise over the course of the business day.	Isabel Schnabel	Euro area	https://www.bis.org/review/r241112g.pdf	Frankfurt, 7 November 2024 Excess liquidity in the euro area has declined measurably over the past two years. It has fallen by more than a third relative to its peak in 2022, and it dropped below €3 trillion about a month ago. This decline in excess liquidity predominantly resulted from banks repaying the loans they had taken under the third series of targeted longer-term refinancing operations (TLTROs). More recently, the phasing-out of reinvestments of bonds maturing under the Eurosystem's monetary policy portfolios has increasingly contributed to the decline. As of January 2025, the Eurosystem will no longer reinvest any of its monetary policy bond holdings, leading to a run-off in our portfolios of around €40 billion per month. The ECB is closely monitoring the impact of the decline in excess liquidity on financial markets, the banking system and the economy at large to assess how these developments are affected by the changes to our operational framework that we announced earlier this year. In my remarks, I would like to take stock of where we stand today. My main message is that, while excess liquidity is remaining ample, the ECB's balance sheet reduction is progressing smoothly and has helped improve market functioning, with clear signs of increased market activity and a redistribution of reserves across banks and borders. Historical episodes of central banks reducing the size of their balance sheets, let alone by significant amounts, have been rare. For this reason, all major central banks are closely monitoring the transition from abundant to less ample excess liquidity. For the ECB, staff projections suggest that, from a historical perspective, excess liquidity will remain ample for some time (Slide 2). However, there is significant uncertainty about banks' ultimate liquidity preferences, as well as about the capacity of money markets to efficiently distribute excess liquidity across the euro area. If banks wished to hold a higher level of excess reserves, for instance due to stricter prudential regulation, the projected decline in excess liquidity might put upward pressure on money market rates earlier than suggested by historical regularities. To cater for this uncertainty, the Governing Council in March decided on changes to the ECB's operational framework for implementing monetary policy. The framework has three key characteristics (Slide 3). The first is that it is a demand-driven system, meaning that the marginal unit of reserves is provided elastically on demand through our standard refinancing operations and against a broad set of collateral. A demand-driven system allows banks to hold the level of reserves that they find optimal and insures against risks of fragmentation and sudden liquidity imbalances as reserves become less ample. This requires banks to regard access to our standard refinancing operations as an integral part of their liquidity management, without any stigma attached, while retaining a diversified funding mix. The second key characteristic of our framework is the mix of instruments used to supply reserves. Our short-term refinancing operations are at the centre of liquidity provision. At a later stage, we will gradually complement them with new structural longer-term lending operations and a new structural bond portfolio, taking into account legacy bond holdings. Both will provide a more stable source of liquidity to reflect the economy's growing currency demand. The third key characteristic is that monetary policy is implemented through a "soft" floor with a narrow spread. As reserves become less ample, money market rates could rise relative to the deposit facility rate (DFR) the rate through which we steer our monetary policy stance - and could potentially become too volatile. In view of this, on 18 September, the spread between the rate on the main refinancing operations (MROs) and the DFR was reduced from 50 basis points to 15 basis points. This historically narrow spread limits both the scope for upward pressure on money market rates and their volatility, and it sets incentives for banks to borrow liquidity in our operations as our balance sheet normalises. In this context, a "soft" floor means that the Governing Council will tolerate deviations from the DFR in both directions, provided such movements do not blur the signal about the intended monetary policy stance. At the same time, the reduced spread is still large enough to preserve incentives for banks to find marketbased funding solutions to insure themselves against liquidity shocks, thereby avoiding the risk of excessive liquidity transformation through the Eurosystem balance sheet. Clarity on the operational framework has helped banks, and financial markets more broadly, prepare for a period with less ample reserves. Since we announced the changes to our framework in March, further significant balance sheet reduction has taken place. This reduction has been progressing smoothly, and many of the concerns over the potential impact of the decline in our balance sheet on the economy have not materialised. This is illustrated by three developments. First, the phasing-out of reinvestments by the Eurosystem has not led to any bottlenecks in the absorption of bonds so far, in spite of increased net issuance by governments. Foreign investors have been absorbing the largest share of the net issuance of bonds in the euro area since the Eurosystem ended its reinvestment of securities under the asset purchase programme (APP), with households also playing an important role in some economies (Slide 4, left-hand side). Second, we have not seen an excessive rise in long-term interest rates. While the term premium initially increased from historically unprecedented negative territory, it has recently fallen again and stabilised at low levels (Slide 4, right-hand side). The fact that the impact on the term premium has been contained reflects the gradual and transparent approach central banks have taken when reducing their balance sheets. This gradualism is probably one reason why announcements of quantitative tightening are often found to have smaller effects on bond prices than announcements of quantitative easing. Since bonds held by the central bank mature only gradually, investors may heavily discount redemptions that are due far out in the future. Third, subdued credit growth over the past two years cannot be attributed to the reduction in excess liquidity, and in our monetary policy bond portfolios, in particular. Instead, it has been, by and large, the result of weak loan demand and higher interest rates. According to our most recent bank lending survey, 95\% of banks reported that the ECB's monetary policy asset portfolio had no impact on their lending volumes to firms over the past six months. 96\% of banks expect this to remain the case over the next six months. That is, banks do not mechanically make their lending decisions dependent on the level of excess liquidity, with base money "multiplying" into broad money. The decline in excess liquidity may even contribute to higher rather than lower credit growth. New evidence for the United States suggests that reserves injected during quantitative easing crowded out bank lending, possibly because regulation has made bank balance sheet capacity costly. So, balance sheet reduction has not left any significant footprint in many areas, at least so far. But in other areas, especially in the euro area money market, the ongoing decline of excess liquidity is starting to leave some traces on activity and prices. I would now like to explain what these traces are and what they imply for monetary policy and the likely future evolution of money market rates. In a demand-driven system, gauging the ampleness of reserves is not necessary for informing the process of quantitative tightening, which is running steadily and predictably in the background. The reason is that, in contrast to a supply-driven system, our framework does not require estimating the volume of reserves necessary to steer short-term money market rates towards the steering rate. In the euro area, the narrow corridor ensures that overnight rates will remain close to the DFR. But it matters for the implementation of our monetary policy how the decline in excess liquidity affects the take-up in our standard refinancing operations, how it shapes the distribution of reserve holdings across the euro area and how it influences the rates at which banks borrow in money markets. We have therefore developed a comprehensive monitoring toolbox to allow us to understand how banks adapt to the decline in excess liquidity and whether this process may eventually require changes to our operational framework. A review of the key parameters of the operational framework is scheduled for 2026. Based on this analysis, I would like to discuss three developments that have emerged over the course of this year and that suggest that the changes to our framework have been effective in supporting market functioning, in reviving market activity and in implementing our policy stance. The first development relates to a steady and measurable rise in secured money market rates in the euro area and beyond (Slide 5, left-hand side). While in some parts of the world repo rates are already trading above the main policy rate, or have temporarily drifted outside of the target range, in the euro area the repo funds rate is now trading broadly at the level of the DFR. Within the euro area, repo rates have also converged across collateral classes (Slide 5, right-hand side). Over the past years, transactions secured by German government collateral, in particular, were trading at a significant premium over others. This premium has declined considerably. The increase in repo rates could result from two factors: higher collateral availability and lower excess liquidity. Depending on which factor dominates, the implications for monetary policy would differ. One of the main conclusions of our monitoring work is that it was primarily the reversal of collateral scarcity that was driving repo rates higher. Between 2021 and 2023, the ECB's large bond holdings and the significant take-up in our TLTROs resulted in a sharp decline in the collateral available for secured lending. Collateral scarcity, in turn, caused repo rates to drop sharply. At the peak, more than $70 \%$ of repos were trading at least 30 basis points below the DFR (Slide 6, left-hand side). Repos against German collateral temporarily traded more than 100 basis points below the DFR. Collateral availability has improved significantly over the past 18 months. Large issuance by euro area sovereigns, the Eurosystem's reduced market footprint from the gradual rundown of the monetary policy bond portfolio and the return of collateral mobilised with the Eurosystem all contributed to easing the strains in repo markets and thus to the gradual normalisation of repo rates from extreme conditions (Slide 6, right-hand side). The question is whether the rise in repo rates will continue. Any answer to this question is inherently speculative. But for as long as there is ample excess liquidity, it is likely that repo rates will stay in the vicinity of the DFR, as banks would be expected to lend reserves in the repo market if there were persistent gains to be made there as opposed to depositing these reserves with the ECB. And, for now, the DFR is anchoring one-day repo rates, even for collateral of lower-rated sovereign bonds (Slide 7, left-hand side). This is because most Eurosystem counterparties still have excess liquidity several times larger than their minimum reserve requirements, especially the larger ones (Slide 7, right-hand side). The extent to which markets can mitigate upward pressure on repo rates critically depends on market participants taking advantage of arbitrage opportunities arising from the spread between money market rates and the DFR. This includes banks' willingness to lend reserves across borders, as the distribution of excess liquidity holdings is highly uneven across countries and institutions (Slide 8, left-hand side). So, on reporting dates, or at lower levels of excess liquidity, repo rates could rise above the DFR. This may happen, for example, if banks start to refrain from lending reserves in money markets, for instance to keep their regulatory liquidity ratios above a certain threshold. Such intermediation constraints may help explain the premium that we are seeing today for repo transactions covering the year-end, even for the most liquid collateral (Slide 8, right-hand side). High price mark-ups often reflect trades with non-banks that have no access to our lending facilities. This brings me to the second development. As excess liquidity has declined, we have seen a notable pickup in market-based funding activity, which has also contributed to reserves circulating from banks with abundant liquidity to those with less liquidity. Repo volumes of transactions between euro area counterparties have grown by nearly $25 \%$ since excess liquidity started to decline, with the strongest growth seen for cross-border transactions (Slide 9, left-hand side). With the repayment of the TLTROs, we have also seen a considerable rise in liquidity-motivated transactions, which now seem to have stabilised at a comparatively high level (Slide 9, right-hand side). The issuance of bank bonds has also played an important role in providing market-based funding and in redistributing central bank reserves. Since 2022 banks have issued a record amount of covered and senior unsecured bonds to substitute maturing TLTRO funding, with several issuers returning to the market after a long absence (Slide 10, lefthand side). For covered bonds, last year saw a record number of issuers tapping this market, including a variety of small-sized issuers. Banks were major investors in the covered bonds issued by other banks. From 2022 to mid-2024, banks absorbed the lion share of the net issuance of covered bonds (Slide 10, right-hand side). Cross-border transactions played an important part in this, as banks with abundant liquidity invested in covered bonds of their peers located elsewhere (Slide 11, left-hand side). These cross-border flows suggest that there are no signs of fragmentation. So does the fact that changes in TARGET2 balances, reflecting cross-border flows, have measurably contributed to recent changes in excess liquidity (Slide 11, right-hand side). In Italy, for example, large TARGET2 inflows offset a significant part of the decline in excess liquidity related to the repayments of TLTRO III. In reserve-rich countries, the opposite effect prevailed. This smooth redistribution of reserves is another indication that Eurosystem excess liquidity remains ample, and it is likely to have reduced the need of banks to use the ECB's standard refinancing operations (Slide 12). Less than 1\% of the peak of outstanding TLTROs was rolled over into MROs or the threemonth longer-term refinancing operations. Moreover, the take-up of our operations did not materially increase after we reduced the spread between the rate on the MROs and the DFR to 15 basis points. One reason is that, in most cases, funding via market-based sources remains more attractive than the recourse to ECB operations, even with a narrower spread (Slide 13, left-hand side). Currently, borrowing from the ECB may be more economical only for some non-high-quality liquid assets (HQLA) collateral. In addition, we are seeing that banks are willing to reduce the share of reserves in their holdings of HQLA. This share fell from a peak of $78 \%$ in late 2022 to $56 \%$ today (Slide 13, right-hand side). As the aggregate liquidity coverage ratio (LCR) has stabilised around 160\% over the past two years, banks have started to substitute reserves for other HQLA. Yet, as excess liquidity declines further, we expect more and more banks to tap our liquidity-providing operations, also because a substantial share of euro area banks - representing about $25 \%$ of minimum reserve requirements - are currently not active in repo markets. While this may change, membership requirements for central clearing counterparties, such as size, credit rating and operational capacity, may currently make it difficult for smaller banks to obtain collateralised credit. Borrowing in the unsecured money market could, in principle, be an alternative for these banks, especially because sourcing liquidity via unsecured trades has become cheaper compared with secured trades in the repo market since the middle of last year. While repo rates have trended upwards, €STR - the euro area's benchmark rate representing banks' overnight unsecured borrowing conditions - has barely budged (Slide 14). The stickiness of €STR is the third development I would like to discuss today. What does it imply for monetary policy? And why is this stickiness not necessarily surprising? The unsecured segment of the euro area money market is special in two respects. First, banks are rarely on the lending side, mostly for regulatory reasons. The Basel III reforms treat secured lending preferentially, establishing repo as the preferred choice for banks' short-term lending overall. From a borrower's perspective, too, secured borrowing is more attractive than unsecured as leverage ratio costs can be significantly mitigated by netting lending and borrowing through central counterparty (CCP) clearing in the secured market. As a result, the unsecured market is primarily used by banks to intermediate deposits from non-banks without access to the ECB's balance sheet. Since 2022, an average of around $85 \%$ of the volume of trades have had non-banks as a counterparty, especially money market funds. Since this intermediation service carries the costs of balance sheet expansion through the leverage ratio, banks typically demand a spread relative to the DFR to compensate them for binding their balance sheet capacity. Second, trades in the unsecured money market are typically relationship-based. Around 80\% of $€$ STR trading volumes come from depositor-bank relationships that are active almost every day (Slide 15, lefthand side). Relationship trading has important implications for the pricing of the trade. Specifically, banks impose higher intermediation fees on customers that come only sporadically and are less predictable. Empirical evidence suggests that banks reduce the extent of regulatory cost pass-through to their most stable clients by 2.4 basis points for taking on unsecured deposits (Slide 15, right-hand side). Such discounts are economically significant and can, in part, be explained by banks' ability to profit from crossselling other, more lucrative business to their stable depositors. So, the microstructure of the unsecured money market is consistent with a weak responsiveness of €STR to changes in excess liquidity. The question is whether, and to what extent, this will change as excess liquidity declines further. There are two sides to this. On the one hand, as many smaller banks do not have access to the repo market, they may start competing for liquidity in the unsecured market once borrowing needs become more imminent. Increased competition could put upward pressure on €STR. On the other hand, lenders in the unsecured market seem price-insensitive. As repo rates trade well above €STR, lenders should have an incentive to place their cash in the repo market. However, so far there has been little migration across the two segments. This is predominantly because most lenders that are active in the unsecured market do not have access to repo markets (Slide 16, left-hand side). Moreover, those that have a more diversified liquidity management may find it difficult to lend excess cash in secured markets, which operate mainly in the morning hours (Slide 16, right-hand side). Money market funds, for example, allow redemption notices until 14:00 and need to preserve liquidity to meet any potential outflows until then. Unsecured markets may thus be the only viable option for them to place liquidity in the afternoon. This suggests that banks are likely to maintain some pricing power in this market, keeping the sensitivity of €STR to changes in excess liquidity more muted. Overall, it is uncertain which channel will dominate. It is therefore too early to assess whether €STR is an appropriate indicator of reserve scarcity. Its resilience so far may simply suggest that reserves remain ample. But should the gap between repo rates and €STR continue to widen as excess liquidity declines, it will be necessary to assess how this affects the transmission of monetary policy to the real economy. All in all, and with this I would like to conclude, our analysis suggests that excess liquidity remains ample in the euro area. Recent upward pressure on rates in some segments of the money market reflects, by and large, a reduction in collateral scarcity, due to the increased bond issuance by governments and the reduced Eurosystem market footprint. The improved availability of collateral has helped to significantly improve market functioning in the euro area. In addition, increasing market-based funding activity and growing signs of redistribution of reserves across banks and borders suggest that banks have started adapting to an environment with less ample reserves. We expect this process to continue as excess liquidity declines further, with banks increasingly sourcing liquidity through our standard refinancing operations, as these constitute an integral part of a smooth implementation of monetary policy in our operational framework. Thank you. The ECB's balance sheet reduction: an interim assessment
2024-11-12T00:00:00	Christopher J Waller: What roles should the private sector and the Federal Reserve play in payments?	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Clearing House Annual Conference 2024, New York City,12 November 2024.	Christopher J Waller: What roles should the private sector and the Federal Reserve play in payments? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Clearing House Annual Conference 2024, New York City,12 November 2024. * * * 1 Thank you for inviting me to speak here today. The Clearing House is a great place to talk about the evolution of clearing and settlement of payments in the United States. The key question I want to address today is, what roles should the private sector and the Federal Reserve play in payments? As a strong believer in the benefits of a capitalist system, I hold the view that it is generally the private sector that can most reliably and efficiently provide goods and services to the economy. And I apply this view to the payments ecosystem. It is that perspective that underlies a question I often ask when forming my positions on the appropriate role the Federal Reserve should play in a wide variety of initiatives: What is the fundamental market inefficiency that would be solved by government intervention and can only be solved by government intervention? If there isn't a satisfactory answer, then I believe government shouldn't intervene in private markets. Does this mean I believe the Federal Reserve should not be involved in payments? No. While I generally believe that government shouldn't directly compete with the private sector, there are situations where government involvement is needed to solve for market inefficiencies that may arise because of things like incomplete markets, coordination problems, or a lack of resilience. As a policymaker, I have applied that same question to issues ranging from bank regulation to monetary policy. For an example in the payments area, three years ago there was an increase in public discussion about creating a new payment instrument called a central bank digital currency (CBDC). The Federal Reserve Board was compiling a report and seeking public comment on the potential benefits and risks of the idea. In a speech I gave in August 2021, I asked, what problem would a CBDC solve? In other words, what market failure or inefficiency demands this specific intervention?2 In more than three years, I have yet to hear a satisfactory answer as applied to CBDC. Given today's audience and my position serving as the chair of the Board's payments committees, I want to focus on the important roles the private sector and the Federal Reserve play in our ever-evolving payment system. To set the stage for that discussion, I think it is helpful to recap some history around payments and clearing in the United States.3 In the early decades following the country's founding, banks generally had state charters. While state banknotes and checks circulated locally as payment instruments, there were difficulties clearing and settling checks across states. One way of describing this is to say that the early U.S. payment system suffered from incomplete markets. The Second Bank of the United States was created in 1816 and, due to its federal charter, it was able to create a national system for clearing checks and banknotes. This in turn led to a more complete national clearing and settlement process. When the charter for the Second Bank lapsed, clearing and settlement of banknotes and checks fell back to state-chartered banks. Many of the earlier inefficiencies resurfaced. For example, porters in New York City would deliver checks and exchange them for gold or other coins and then transport that "specie" to the payee. Hauling these money bags around New York posed obvious risks, and these risks multiplied by the mid-19th century when the number of banks in New York grew rapidly. As this audience is well aware, the New York Clearing House Association (NYCH) was founded in 1853 and served as a central location for the clearing process, which soon evolved, with certificates replacing coins. Furthermore, by being part of a common infrastructure, all members had a reasonably good idea of the quality of each other's balance sheets. In modern economic language, the NYCH became a coordination mechanism that improved clearing by getting banks to clear and settle payments in a well-organized manner. It also reduced asymmetric information about the quality of member balance sheets. By performing this function for New York banks, which constituted a relatively large share of the U.S. financial system, the clearing and settling of payments improved nationally. In this sense, the NYCH was the closest thing the United States had at that time to a central bank.4 While this was an improvement, not all important financial intermediaries were members of the NYCH or other such private arrangements. That is, there were gaps. And financial panics, sometimes driven by gaps and problems in check clearing, were a regular feature of the latter 19th and early 20th century. The Panic of 1907 was a classic example of that. Depositors and investors lost confidence in certain New York banks that had been combined into large, complex, and opaque trust companies that were not members of the NYCH. This resulted in runs on those trusts, which led to broader liquidity problems. Although the NYCH had the ability to provide liquidity to those trusts, the provision of that liquidity was delayed. It appears that at the time, the NYCH was, reasonably, observing some form of Bagehot's dictum when deciding whether to provide liquidity. Under that dictum, you want to know that the institution to which you're providing liquidity is solvent. If it isn't, then the liquidity extension could be akin to throwing good money after bad. But because the trust companies at the time weren't member institutions, the clearinghouse didn't have a good enough understanding of their balance sheets to know whether they were solvent.5 Some banks refused to clear checks from other institutions, which led to an erosion of depositor confidence and more failures. This historical example points to another aspect of a payment system that is important-resilience of the system. These problems highlighted by the 1907 panic-coordination failures and a lack of resilience-could have been mitigated with the help of a central bank. Paul Warburg, an influential banker at the time, argued that such a central bank could "establish and maintain a perfect system of credit, enabling the general banks to transform cash credits into actual cash with such absolute ease and certainty that the use of cash credit, instead of actual cash, will not cease, no matter what may happen."6 In 1913, Congress agreed and created the Federal Reserve. It positioned the Federal Reserve at the center of the banking system by establishing a nationwide check- clearing system and a telegraph wire transfer service that is now known as Fedwire®. The Fed was also intended to function as a lender of last resort so that suspension of payments would no longer be necessary. In the 1970s, the Fed promoted more efficient check-clearing by adding the automated clearinghouse service. Our job in providing these services and carrying out our responsibilities was and continues to be to make sure the payment system functions efficiently and resiliently, promoting the kind of confidence that is vital for a modern economy. The lesson from this history, as relevant now as ever, is that the payment system has been one of those areas in which the best efforts of the private sector have sometimes fallen short. The decentralized and diverse nature of banks in the United States is a feature that goes back to the 1800s and has the merits of promoting competition and a vibrant economy. However, when engaging in clearing and settling payments, coordination problems and information asymmetries across banks can be, and were, destabilizing. While the private sector made advances in resolving those issues, the Panic of 1907 showed that those steps were not sufficient. As successful as the NYCH was for its members, it could not protect its members and the economy from risks in the growing share of finance occurring outside its walls. This contributed to the motivation to establish the Federal Reserve and its role in payments. Fast forward to today, and we are once again in an era of rapid change and innovation in money and payments. Some of this will not pan out. Some of this change is about delivering services already available but doing so with new technologies. And some of it is leveraging new technology to rethink existing payment, clearing, and settlement structures. How will all of this come together? And what will be the respective roles of the private sector and the Federal Reserve? Let's break it down, keeping in mind my principle that the Federal Reserve should focus on addressing issues that the private sector cannot address alone and, in doing so, promote an efficient and resilient U.S. payment system. I'll start by discussing the important roles that the private sector now plays in the payment system and in the evolution of payments under way. The private sector connects consumers and businesses to the payment system, with financial institutions competing to provide services to their customers. Such competition can lead to better products and services for consumers as profit-seeking competitors look for opportunities to win over customers including through the adoption of new technologies. I have noted my concern that some see these new technologies as an opportunity for bigger the public sector to play a role in payments, which may crowd out private investment. I believe this would be a policy mistake and a better approach is one in which the private sector continues to have a significant footprint, with the role of government limited. One important reason for that is that the private sector, through competition, is typically best situated to sort out good ideas from bad ideas, rather than central banks or other public-sector institutions choosing winners and losers. At the early stages of innovation, the true value-added of the application of new technologies is murky. Market competition helps sort that out and typically leads to a wider range of products that can be better suited to the needs of consumers. But just as was the case in the time of Warburg, there remain problems in payments that can't be fully resolved by the private sector. And just as we have done throughout history, the Federal Reserve stands ready to support the evolution in payments and do so primarily through our operational role in the payment system, by providing core clearing and settlement infrastructure on which the private sector can innovate. Notably, the Fed has the unique ability to provide the infrastructure to reliably settle interbank obligations using balances at the central bank, which enhances the stability of the banking system and the broader economy, reflecting the lessons learned in 1907 and through earlier banking panics. Compared with many other countries where a small number of large banks dominate, the United States has thousands of banks and credit unions. Connecting those many organizations to a payment network requires a significant amount of coordination. One recent example of an area in which we're playing such a coordination role is in instant payments. The role we're playing with FedNow is to help with that coordination problem using our existing connections to those thousands of institutions. And that approach is consistent with my overall view of the appropriate role of government-to narrowly address problems like those of coordination that can't always be efficiently solved by the private sector alone. In doing so, we complement the private sector and promote responsible and efficient innovation in the broader market. With respect to new and emerging technologies in finance, I can think of two ways in which the private sector is uniquely positioned to develop and deploy them while the government is not well suited to do so. First is the question of innovation risk-the investment in new payment technologies is large and comes with risk of failure. Privatesector entities, risking their own funds and seeking to turn a profit, will have a greater incentive to accurately gauge demand for these technologies and bring those products to market faster. Second, despite the current fascination around the world with industrial policy, rarely can the government match the ability of the private sector to efficiently allocate resources and explore how well new technologies can address actual shortcomings in the current payment system. It is too early to tell whether some of the new technologies will relieve significant frictions in the payment system, but it is going to be the private sector, betting with its own money, that is best positioned to explore this question. If problems emerge, as they did with check clearing in the 19th century, then government can play a constructive role in overcoming them. Well before this point, however, it makes sense for the public and private sectors to look down the road together and engage in dialogue about potential issues and opportunities that might arise. For example, through the Bank for International Settlements, the Fed is engaged with the private sector to explore how tokenization technology might be used to facilitate cross-border payments in a faster and cheaper manner. This project brings together multiple central banks and private-sector financial firms in collaboration to potentially 7 facilitate a better-functioning monetary system. That process of working together to promote the efficiency and safety of the payment system, as the Federal Reserve has done for decades, can lead to outcomes that benefit households, businesses, and the overall economy. American entrepreneurship and technical prowess have generated exciting innovations in payments, and they will continue to do so. The role of the Federal Reserve is to support that initiative and engage with the private sector to promote innovation while guarding against risks to financial stability. We've managed this balancing act before and will continue to do so. And, together, we will ensure that the payments ecosystem continues to move forward for the benefit of households and businesses. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board. 2 See Christopher J. Waller (2021), " CBDC: A Solution in Search of a Problem? " speech delivered at the American Enterprise Institute, Washington (via webcast), August 5. 3 I am drawing on material in Stephen Quinn and William Roberds (2008), "The Evolution of the Check as a Means of Payment: A Historical Survey," Federal Reserve Economic Review, Bank of Atlanta, vol. 93 (4), pp. 1-28. 4 The Regulation and Reform of the American See Eugene Nelson White (2016), Banking System, 1900-1929 (Princeton, N.J.: Princeton University Press). 5 See Jon R. Moen and Ellis W. Tallman (1999), "Why Didn't the United States Establish a Central Bank until after the Panic of 1907?" Working Paper Series 99-16 (Atlanta: Federal Reserve Bank of Atlanta, November) 6 See Paul M. Warburg (1911), "A United Reserve Bank of the United States," Proceedings of the Academy of Political Science in the City of New York, vol. 1 (January), pp. 302-42. 7 See Bank for International Settlements (2024), "Private Sector Partners Join Project Agorá," webpage, September 16.	---[PAGE_BREAK]--- # Christopher J Waller: What roles should the private sector and the Federal Reserve play in payments? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Clearing House Annual Conference 2024, New York City, 12 November 2024. Thank you for inviting me to speak here today. ${ }^{1}$ The Clearing House is a great place to talk about the evolution of clearing and settlement of payments in the United States. The key question I want to address today is, what roles should the private sector and the Federal Reserve play in payments? As a strong believer in the benefits of a capitalist system, I hold the view that it is generally the private sector that can most reliably and efficiently provide goods and services to the economy. And I apply this view to the payments ecosystem. It is that perspective that underlies a question I often ask when forming my positions on the appropriate role the Federal Reserve should play in a wide variety of initiatives: What is the fundamental market inefficiency that would be solved by government intervention and can only be solved by government intervention? If there isn't a satisfactory answer, then I believe government shouldn't intervene in private markets. Does this mean I believe the Federal Reserve should not be involved in payments? No. While I generally believe that government shouldn't directly compete with the private sector, there are situations where government involvement is needed to solve for market inefficiencies that may arise because of things like incomplete markets, coordination problems, or a lack of resilience. As a policymaker, I have applied that same question to issues ranging from bank regulation to monetary policy. For an example in the payments area, three years ago there was an increase in public discussion about creating a new payment instrument called a central bank digital currency (CBDC). The Federal Reserve Board was compiling a report and seeking public comment on the potential benefits and risks of the idea. In a speech I gave in August 2021, I asked, what problem would a CBDC solve? In other words, what market failure or inefficiency demands this specific intervention? ${ }^{2}$ In more than three years, I have yet to hear a satisfactory answer as applied to CBDC. Given today's audience and my position serving as the chair of the Board's payments committees, I want to focus on the important roles the private sector and the Federal Reserve play in our ever-evolving payment system. To set the stage for that discussion, I think it is helpful to recap some history around payments and clearing in the United States. ${ }^{3}$ In the early decades following the country's founding, banks generally had state charters. While state banknotes and checks circulated locally as payment instruments, there were difficulties clearing and settling checks across states. One way of describing this is to say that the early U.S. payment system suffered from incomplete markets. The Second Bank of the United States was created in 1816 and, due to its federal charter, it ---[PAGE_BREAK]--- was able to create a national system for clearing checks and banknotes. This in turn led to a more complete national clearing and settlement process. When the charter for the Second Bank lapsed, clearing and settlement of banknotes and checks fell back to state-chartered banks. Many of the earlier inefficiencies resurfaced. For example, porters in New York City would deliver checks and exchange them for gold or other coins and then transport that "specie" to the payee. Hauling these money bags around New York posed obvious risks, and these risks multiplied by the mid-19th century when the number of banks in New York grew rapidly. As this audience is well aware, the New York Clearing House Association (NYCH) was founded in 1853 and served as a central location for the clearing process, which soon evolved, with certificates replacing coins. Furthermore, by being part of a common infrastructure, all members had a reasonably good idea of the quality of each other's balance sheets. In modern economic language, the NYCH became a coordination mechanism that improved clearing by getting banks to clear and settle payments in a well-organized manner. It also reduced asymmetric information about the quality of member balance sheets. By performing this function for New York banks, which constituted a relatively large share of the U.S. financial system, the clearing and settling of payments improved nationally. In this sense, the NYCH was the closest thing the United States had at that time to a central bank. 4 While this was an improvement, not all important financial intermediaries were members of the NYCH or other such private arrangements. That is, there were gaps. And financial panics, sometimes driven by gaps and problems in check clearing, were a regular feature of the latter 19th and early 20th century. The Panic of 1907 was a classic example of that. Depositors and investors lost confidence in certain New York banks that had been combined into large, complex, and opaque trust companies that were not members of the NYCH. This resulted in runs on those trusts, which led to broader liquidity problems. Although the NYCH had the ability to provide liquidity to those trusts, the provision of that liquidity was delayed. It appears that at the time, the NYCH was, reasonably, observing some form of Bagehot's dictum when deciding whether to provide liquidity. Under that dictum, you want to know that the institution to which you're providing liquidity is solvent. If it isn't, then the liquidity extension could be akin to throwing good money after bad. But because the trust companies at the time weren't member institutions, the clearinghouse didn't have a good enough understanding of their balance sheets to know whether they were solvent. ${ }^{5}$ Some banks refused to clear checks from other institutions, which led to an erosion of depositor confidence and more failures. This historical example points to another aspect of a payment system that is important-resilience of the system. These problems highlighted by the 1907 panic-coordination failures and a lack of resilience-could have been mitigated with the help of a central bank. Paul Warburg, an influential banker at the time, argued that such a central bank could "establish and maintain a perfect system of credit, enabling the general banks to transform cash credits into actual cash with such absolute ease and certainty that the use of cash credit, instead of actual cash, will not cease, no matter what may happen." ${ }^{6}$ In 1913, Congress agreed and created the Federal Reserve. It positioned the Federal Reserve at the center of the banking system by establishing a nationwide check- ---[PAGE_BREAK]--- clearing system and a telegraph wire transfer service that is now known as Fedwire®. The Fed was also intended to function as a lender of last resort so that suspension of payments would no longer be necessary. In the 1970s, the Fed promoted more efficient check-clearing by adding the automated clearinghouse service. Our job in providing these services and carrying out our responsibilities was and continues to be to make sure the payment system functions efficiently and resiliently, promoting the kind of confidence that is vital for a modern economy. The lesson from this history, as relevant now as ever, is that the payment system has been one of those areas in which the best efforts of the private sector have sometimes fallen short. The decentralized and diverse nature of banks in the United States is a feature that goes back to the 1800s and has the merits of promoting competition and a vibrant economy. However, when engaging in clearing and settling payments, coordination problems and information asymmetries across banks can be, and were, destabilizing. While the private sector made advances in resolving those issues, the Panic of 1907 showed that those steps were not sufficient. As successful as the NYCH was for its members, it could not protect its members and the economy from risks in the growing share of finance occurring outside its walls. This contributed to the motivation to establish the Federal Reserve and its role in payments. Fast forward to today, and we are once again in an era of rapid change and innovation in money and payments. Some of this will not pan out. Some of this change is about delivering services already available but doing so with new technologies. And some of it is leveraging new technology to rethink existing payment, clearing, and settlement structures. How will all of this come together? And what will be the respective roles of the private sector and the Federal Reserve? Let's break it down, keeping in mind my principle that the Federal Reserve should focus on addressing issues that the private sector cannot address alone and, in doing so, promote an efficient and resilient U.S. payment system. I'll start by discussing the important roles that the private sector now plays in the payment system and in the evolution of payments under way. The private sector connects consumers and businesses to the payment system, with financial institutions competing to provide services to their customers. Such competition can lead to better products and services for consumers as profit-seeking competitors look for opportunities to win over customers including through the adoption of new technologies. I have noted my concern that some see these new technologies as an opportunity for the public sector to play a bigger role in payments, which may crowd out private investment. I believe this would be a policy mistake and a better approach is one in which the private sector continues to have a significant footprint, with the role of government limited. One important reason for that is that the private sector, through competition, is typically best situated to sort out good ideas from bad ideas, rather than central banks or other public-sector institutions choosing winners and losers. At the early stages of innovation, the true value-added of the application of new technologies is murky. Market competition helps sort that out and typically leads to a wider range of products that can be better suited to the needs of consumers. ---[PAGE_BREAK]--- But just as was the case in the time of Warburg, there remain problems in payments that can't be fully resolved by the private sector. And just as we have done throughout history, the Federal Reserve stands ready to support the evolution in payments and do so primarily through our operational role in the payment system, by providing core clearing and settlement infrastructure on which the private sector can innovate. Notably, the Fed has the unique ability to provide the infrastructure to reliably settle interbank obligations using balances at the central bank, which enhances the stability of the banking system and the broader economy, reflecting the lessons learned in 1907 and through earlier banking panics. Compared with many other countries where a small number of large banks dominate, the United States has thousands of banks and credit unions. Connecting those many organizations to a payment network requires a significant amount of coordination. One recent example of an area in which we're playing such a coordination role is in instant payments. The role we're playing with FedNow is to help with that coordination problem using our existing connections to those thousands of institutions. And that approach is consistent with my overall view of the appropriate role of government-to narrowly address problems like those of coordination that can't always be efficiently solved by the private sector alone. In doing so, we complement the private sector and promote responsible and efficient innovation in the broader market. With respect to new and emerging technologies in finance, I can think of two ways in which the private sector is uniquely positioned to develop and deploy them while the government is not well suited to do so. First is the question of innovation risk-the investment in new payment technologies is large and comes with risk of failure. Privatesector entities, risking their own funds and seeking to turn a profit, will have a greater incentive to accurately gauge demand for these technologies and bring those products to market faster. Second, despite the current fascination around the world with industrial policy, rarely can the government match the ability of the private sector to efficiently allocate resources and explore how well new technologies can address actual shortcomings in the current payment system. It is too early to tell whether some of the new technologies will relieve significant frictions in the payment system, but it is going to be the private sector, betting with its own money, that is best positioned to explore this question. If problems emerge, as they did with check clearing in the 19th century, then government can play a constructive role in overcoming them. Well before this point, however, it makes sense for the public and private sectors to look down the road together and engage in dialogue about potential issues and opportunities that might arise. For example, through the Bank for International Settlements, the Fed is engaged with the private sector to explore how tokenization technology might be used to facilitate cross-border payments in a faster and cheaper manner. This project brings together multiple central banks and private-sector financial firms in collaboration to potentially facilitate a better-functioning monetary system. ${ }^{7}$ That process of working together to promote the efficiency and safety of the payment system, as the Federal Reserve has done for decades, can lead to outcomes that benefit households, businesses, and the overall economy. ---[PAGE_BREAK]--- American entrepreneurship and technical prowess have generated exciting innovations in payments, and they will continue to do so. The role of the Federal Reserve is to support that initiative and engage with the private sector to promote innovation while guarding against risks to financial stability. We've managed this balancing act before and will continue to do so. And, together, we will ensure that the payments ecosystem continues to move forward for the benefit of households and businesses. ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board. ${ }^{2}$ See Christopher J. Waller (2021), "CBDC: A Solution in Search of a Problem?" speech delivered at the American Enterprise Institute, Washington (via webcast), August 5. ${ }^{3}$ I am drawing on material in Stephen Quinn and William Roberds (2008), "The Evolution of the Check as a Means of Payment: A Historical Survey," Federal Reserve Bank of Atlanta, Economic Review, vol. 93 (4), pp. 1-28. ${ }^{4}$ See Eugene Nelson White (2016), The Regulation and Reform of the American Banking System, 1900-1929 (Princeton, N.J.: Princeton University Press). ${ }^{5}$ See Jon R. Moen and Ellis W. Tallman (1999), "Why Didn't the United States Establish a Central Bank until after the Panic of 1907?" Working Paper Series 99-16 (Atlanta: Federal Reserve Bank of Atlanta, November) ${ }^{6}$ See Paul M. Warburg (1911), "A United Reserve Bank of the United States," Proceedings of the Academy of Political Science in the City of New York, vol. 1 (January), pp. 302-42. ${ }^{7}$ See Bank for International Settlements (2024), "Private Sector Partners Join Project Agorá," webpage, September 16.	Christopher J Waller	United States	https://www.bis.org/review/r241113a.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the Clearing House Annual Conference 2024, New York City, 12 November 2024. Thank you for inviting me to speak here today. The Clearing House is a great place to talk about the evolution of clearing and settlement of payments in the United States. The key question I want to address today is, what roles should the private sector and the Federal Reserve play in payments? As a strong believer in the benefits of a capitalist system, I hold the view that it is generally the private sector that can most reliably and efficiently provide goods and services to the economy. And I apply this view to the payments ecosystem. It is that perspective that underlies a question I often ask when forming my positions on the appropriate role the Federal Reserve should play in a wide variety of initiatives: What is the fundamental market inefficiency that would be solved by government intervention and can only be solved by government intervention? If there isn't a satisfactory answer, then I believe government shouldn't intervene in private markets. Does this mean I believe the Federal Reserve should not be involved in payments? No. While I generally believe that government shouldn't directly compete with the private sector, there are situations where government involvement is needed to solve for market inefficiencies that may arise because of things like incomplete markets, coordination problems, or a lack of resilience. As a policymaker, I have applied that same question to issues ranging from bank regulation to monetary policy. For an example in the payments area, three years ago there was an increase in public discussion about creating a new payment instrument called a central bank digital currency (CBDC). The Federal Reserve Board was compiling a report and seeking public comment on the potential benefits and risks of the idea. In a speech I gave in August 2021, I asked, what problem would a CBDC solve? In other words, what market failure or inefficiency demands this specific intervention? In more than three years, I have yet to hear a satisfactory answer as applied to CBDC. Given today's audience and my position serving as the chair of the Board's payments committees, I want to focus on the important roles the private sector and the Federal Reserve play in our ever-evolving payment system. To set the stage for that discussion, I think it is helpful to recap some history around payments and clearing in the United States. In the early decades following the country's founding, banks generally had state charters. While state banknotes and checks circulated locally as payment instruments, there were difficulties clearing and settling checks across states. One way of describing this is to say that the early U.S. payment system suffered from incomplete markets. The Second Bank of the United States was created in 1816 and, due to its federal charter, it was able to create a national system for clearing checks and banknotes. This in turn led to a more complete national clearing and settlement process. When the charter for the Second Bank lapsed, clearing and settlement of banknotes and checks fell back to state-chartered banks. Many of the earlier inefficiencies resurfaced. For example, porters in New York City would deliver checks and exchange them for gold or other coins and then transport that "specie" to the payee. Hauling these money bags around New York posed obvious risks, and these risks multiplied by the mid-19th century when the number of banks in New York grew rapidly. As this audience is well aware, the New York Clearing House Association (NYCH) was founded in 1853 and served as a central location for the clearing process, which soon evolved, with certificates replacing coins. Furthermore, by being part of a common infrastructure, all members had a reasonably good idea of the quality of each other's balance sheets. In modern economic language, the NYCH became a coordination mechanism that improved clearing by getting banks to clear and settle payments in a well-organized manner. It also reduced asymmetric information about the quality of member balance sheets. By performing this function for New York banks, which constituted a relatively large share of the U.S. financial system, the clearing and settling of payments improved nationally. In this sense, the NYCH was the closest thing the United States had at that time to a central bank. While this was an improvement, not all important financial intermediaries were members of the NYCH or other such private arrangements. That is, there were gaps. And financial panics, sometimes driven by gaps and problems in check clearing, were a regular feature of the latter 19th and early 20th century. The Panic of 1907 was a classic example of that. Depositors and investors lost confidence in certain New York banks that had been combined into large, complex, and opaque trust companies that were not members of the NYCH. This resulted in runs on those trusts, which led to broader liquidity problems. Although the NYCH had the ability to provide liquidity to those trusts, the provision of that liquidity was delayed. It appears that at the time, the NYCH was, reasonably, observing some form of Bagehot's dictum when deciding whether to provide liquidity. Under that dictum, you want to know that the institution to which you're providing liquidity is solvent. If it isn't, then the liquidity extension could be akin to throwing good money after bad. But because the trust companies at the time weren't member institutions, the clearinghouse didn't have a good enough understanding of their balance sheets to know whether they were solvent. Some banks refused to clear checks from other institutions, which led to an erosion of depositor confidence and more failures. This historical example points to another aspect of a payment system that is important-resilience of the system. These problems highlighted by the 1907 panic-coordination failures and a lack of resilience-could have been mitigated with the help of a central bank. Paul Warburg, an influential banker at the time, argued that such a central bank could "establish and maintain a perfect system of credit, enabling the general banks to transform cash credits into actual cash with such absolute ease and certainty that the use of cash credit, instead of actual cash, will not cease, no matter what may happen." In 1913, Congress agreed and created the Federal Reserve. It positioned the Federal Reserve at the center of the banking system by establishing a nationwide check- clearing system and a telegraph wire transfer service that is now known as Fedwire®. The Fed was also intended to function as a lender of last resort so that suspension of payments would no longer be necessary. In the 1970s, the Fed promoted more efficient check-clearing by adding the automated clearinghouse service. Our job in providing these services and carrying out our responsibilities was and continues to be to make sure the payment system functions efficiently and resiliently, promoting the kind of confidence that is vital for a modern economy. The lesson from this history, as relevant now as ever, is that the payment system has been one of those areas in which the best efforts of the private sector have sometimes fallen short. The decentralized and diverse nature of banks in the United States is a feature that goes back to the 1800s and has the merits of promoting competition and a vibrant economy. However, when engaging in clearing and settling payments, coordination problems and information asymmetries across banks can be, and were, destabilizing. While the private sector made advances in resolving those issues, the Panic of 1907 showed that those steps were not sufficient. As successful as the NYCH was for its members, it could not protect its members and the economy from risks in the growing share of finance occurring outside its walls. This contributed to the motivation to establish the Federal Reserve and its role in payments. Fast forward to today, and we are once again in an era of rapid change and innovation in money and payments. Some of this will not pan out. Some of this change is about delivering services already available but doing so with new technologies. And some of it is leveraging new technology to rethink existing payment, clearing, and settlement structures. How will all of this come together? And what will be the respective roles of the private sector and the Federal Reserve? Let's break it down, keeping in mind my principle that the Federal Reserve should focus on addressing issues that the private sector cannot address alone and, in doing so, promote an efficient and resilient U.S. payment system. I'll start by discussing the important roles that the private sector now plays in the payment system and in the evolution of payments under way. The private sector connects consumers and businesses to the payment system, with financial institutions competing to provide services to their customers. Such competition can lead to better products and services for consumers as profit-seeking competitors look for opportunities to win over customers including through the adoption of new technologies. I have noted my concern that some see these new technologies as an opportunity for the public sector to play a bigger role in payments, which may crowd out private investment. I believe this would be a policy mistake and a better approach is one in which the private sector continues to have a significant footprint, with the role of government limited. One important reason for that is that the private sector, through competition, is typically best situated to sort out good ideas from bad ideas, rather than central banks or other public-sector institutions choosing winners and losers. At the early stages of innovation, the true value-added of the application of new technologies is murky. Market competition helps sort that out and typically leads to a wider range of products that can be better suited to the needs of consumers. But just as was the case in the time of Warburg, there remain problems in payments that can't be fully resolved by the private sector. And just as we have done throughout history, the Federal Reserve stands ready to support the evolution in payments and do so primarily through our operational role in the payment system, by providing core clearing and settlement infrastructure on which the private sector can innovate. Notably, the Fed has the unique ability to provide the infrastructure to reliably settle interbank obligations using balances at the central bank, which enhances the stability of the banking system and the broader economy, reflecting the lessons learned in 1907 and through earlier banking panics. Compared with many other countries where a small number of large banks dominate, the United States has thousands of banks and credit unions. Connecting those many organizations to a payment network requires a significant amount of coordination. One recent example of an area in which we're playing such a coordination role is in instant payments. The role we're playing with FedNow is to help with that coordination problem using our existing connections to those thousands of institutions. And that approach is consistent with my overall view of the appropriate role of government-to narrowly address problems like those of coordination that can't always be efficiently solved by the private sector alone. In doing so, we complement the private sector and promote responsible and efficient innovation in the broader market. With respect to new and emerging technologies in finance, I can think of two ways in which the private sector is uniquely positioned to develop and deploy them while the government is not well suited to do so. First is the question of innovation risk-the investment in new payment technologies is large and comes with risk of failure. Privatesector entities, risking their own funds and seeking to turn a profit, will have a greater incentive to accurately gauge demand for these technologies and bring those products to market faster. Second, despite the current fascination around the world with industrial policy, rarely can the government match the ability of the private sector to efficiently allocate resources and explore how well new technologies can address actual shortcomings in the current payment system. It is too early to tell whether some of the new technologies will relieve significant frictions in the payment system, but it is going to be the private sector, betting with its own money, that is best positioned to explore this question. If problems emerge, as they did with check clearing in the 19th century, then government can play a constructive role in overcoming them. Well before this point, however, it makes sense for the public and private sectors to look down the road together and engage in dialogue about potential issues and opportunities that might arise. For example, through the Bank for International Settlements, the Fed is engaged with the private sector to explore how tokenization technology might be used to facilitate cross-border payments in a faster and cheaper manner. This project brings together multiple central banks and private-sector financial firms in collaboration to potentially facilitate a better-functioning monetary system. That process of working together to promote the efficiency and safety of the payment system, as the Federal Reserve has done for decades, can lead to outcomes that benefit households, businesses, and the overall economy. American entrepreneurship and technical prowess have generated exciting innovations in payments, and they will continue to do so. The role of the Federal Reserve is to support that initiative and engage with the private sector to promote innovation while guarding against risks to financial stability. We've managed this balancing act before and will continue to do so. And, together, we will ensure that the payments ecosystem continues to move forward for the benefit of households and businesses.
2024-11-14T00:00:00	Jerome H Powell: Economic outlook	Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, to the World Affairs Council, the Federal Reserve Bank of Dallas and the Dallas Regional Chamber, Dallas, Texas, 14 November 2024.	Jerome H Powell: Economic outlook Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, to the World Affairs Council, the Federal Reserve Bank of Dallas and the Dallas Regional Chamber, Dallas, Texas, 14 November 2024. * * * Good afternoon. Thank you to the World Affairs Council, the Federal Reserve Bank of Dallas, and the Dallas Regional Chamber for the kind invitation to be with you today. I will start with some brief comments on the economy and monetary policy. Looking back, the U.S. economy has weathered a global pandemic and its aftermath and is now back to a good place. The economy has made significant progress toward our dual-mandate goals of maximum employment and stable prices. The labor market remains in solid condition. Inflation has eased substantially from its peak, and we believe it is on a sustainable path to our 2 percent goal. We are committed to maintaining our economy's strength by returning inflation to our goal while supporting maximum employment. Recent Economic Data Economic growth The recent performance of our economy has been remarkably good, by far the best of any major economy in the world. Economic output grew by more than 3 percent last year and is expanding at a stout 2.5 percent rate so far this year. Growth in consumer spending has remained strong, supported by increases in disposable income and solid household balance sheets. Business investment in equipment and intangibles has accelerated over the past year. In contrast, activity in the housing sector has been weak. Improving supply conditions have supported this strong performance of the economy. The labor force has expanded rapidly, and productivity has grown faster over the past five years than its pace in the two decades before the pandemic, increasing the productive capacity of the economy and allowing rapid economic growth without overheating. The labor market The labor market remains in solid condition, having cooled off from the significantly overheated conditions of a couple of years ago, and is now by many metrics back to more normal levels that are consistent with our employment mandate. The number of job openings is now just slightly above the number of unemployed Americans seeking work. The rate at which workers quit their jobs is below the pre-pandemic pace, after touching historic highs two years ago. Wages are still increasing, but at a more sustainable pace. Hiring has slowed from earlier in the year. The most recent jobs report for October reflected significant effects from hurricanes and labor strikes, making it difficult to get a clear signal. Finally, at 4.1 percent, the unemployment rate is notably higher than a year ago but has flattened out in recent months and remains historically low. Inflation The labor market has cooled to the point where it is no longer a source of significant inflationary pressures. This cooling and the substantial improvement in broader supply conditions have brought inflation down significantly over the past two years from its mid2022 peak above 7 percent. Progress on inflation has been broad based. Estimates based on the consumer price index and other data released this week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October and that, excluding the volatile food and energy categories, core PCE prices rose 2.8 percent. Core measures of goods and services inflation, excluding housing, fell rapidly over the past two years and have returned to rates closer to those consistent with our goals. We expect that these rates will continue to fluctuate in their recent ranges. We are watching carefully to be sure that they do, however, just as we are closely tracking the gradual decline in housing services inflation, which has yet to fully normalize. Inflation is running much closer to our 2 percent longer-run goal, but it is not there yet. We are committed to finishing the job. With labor market conditions in rough balance and inflation expectations well anchored, I expect inflation to continue to come down toward our 2 percent objective, albeit on a sometimes-bumpy path. Monetary Policy Given progress toward our inflation goal and the cooling of labor market conditions, last week my Federal Open Market Committee colleagues and I took another step in reducing the degree of policy restraint by lowering our policy interest rate 1/4 percentage point. We are confident that with an appropriate recalibration of our policy stance, strength in the economy and the labor market can be maintained, with inflation moving sustainably down to 2 percent. We see the risks to achieving our employment and inflation goals as being roughly in balance, and we are attentive to the risks to both sides. We know that reducing policy restraint too quickly could hinder progress on inflation. At the same time, reducing policy restraint too slowly could unduly weaken economic activity and employment. We are moving policy over time to a more neutral setting. But the path for getting there is not preset. In considering additional adjustments to the target range for the federal funds rate, we will carefully assess incoming data, the evolving outlook, and the balance of risks. The economy is not sending any signals that we need to be in a hurry to lower rates. The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully. Ultimately, the path of the policy rate will depend on how the incoming data and the economic outlook evolve. We remain resolute in our commitment to the dual mandate given to us by Congress: maximum employment and price stability. Our aim has been to return inflation to our objective without the kind of painful rise in unemployment that has often accompanied past efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. Thank you, and I look forward to our discussion.	---[PAGE_BREAK]--- # Jerome H Powell: Economic outlook Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, to the World Affairs Council, the Federal Reserve Bank of Dallas and the Dallas Regional Chamber, Dallas, Texas, 14 November 2024. Good afternoon. Thank you to the World Affairs Council, the Federal Reserve Bank of Dallas, and the Dallas Regional Chamber for the kind invitation to be with you today. I will start with some brief comments on the economy and monetary policy. Looking back, the U.S. economy has weathered a global pandemic and its aftermath and is now back to a good place. The economy has made significant progress toward our dual-mandate goals of maximum employment and stable prices. The labor market remains in solid condition. Inflation has eased substantially from its peak, and we believe it is on a sustainable path to our 2 percent goal. We are committed to maintaining our economy's strength by returning inflation to our goal while supporting maximum employment. ## Recent Economic Data ## Economic growth The recent performance of our economy has been remarkably good, by far the best of any major economy in the world. Economic output grew by more than 3 percent last year and is expanding at a stout 2.5 percent rate so far this year. Growth in consumer spending has remained strong, supported by increases in disposable income and solid household balance sheets. Business investment in equipment and intangibles has accelerated over the past year. In contrast, activity in the housing sector has been weak. Improving supply conditions have supported this strong performance of the economy. The labor force has expanded rapidly, and productivity has grown faster over the past five years than its pace in the two decades before the pandemic, increasing the productive capacity of the economy and allowing rapid economic growth without overheating. ## The labor market The labor market remains in solid condition, having cooled off from the significantly overheated conditions of a couple of years ago, and is now by many metrics back to more normal levels that are consistent with our employment mandate. The number of job openings is now just slightly above the number of unemployed Americans seeking work. The rate at which workers quit their jobs is below the pre-pandemic pace, after touching historic highs two years ago. Wages are still increasing, but at a more sustainable pace. Hiring has slowed from earlier in the year. The most recent jobs report for October reflected significant effects from hurricanes and labor strikes, making it difficult to get a clear signal. Finally, at 4.1 percent, the unemployment rate is notably higher than a year ago but has flattened out in recent months and remains historically low. ---[PAGE_BREAK]--- # Inflation The labor market has cooled to the point where it is no longer a source of significant inflationary pressures. This cooling and the substantial improvement in broader supply conditions have brought inflation down significantly over the past two years from its mid2022 peak above 7 percent. Progress on inflation has been broad based. Estimates based on the consumer price index and other data released this week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October and that, excluding the volatile food and energy categories, core PCE prices rose 2.8 percent. Core measures of goods and services inflation, excluding housing, fell rapidly over the past two years and have returned to rates closer to those consistent with our goals. We expect that these rates will continue to fluctuate in their recent ranges. We are watching carefully to be sure that they do, however, just as we are closely tracking the gradual decline in housing services inflation, which has yet to fully normalize. Inflation is running much closer to our 2 percent longer-run goal, but it is not there yet. We are committed to finishing the job. With labor market conditions in rough balance and inflation expectations well anchored, I expect inflation to continue to come down toward our 2 percent objective, albeit on a sometimes-bumpy path. ## Monetary Policy Given progress toward our inflation goal and the cooling of labor market conditions, last week my Federal Open Market Committee colleagues and I took another step in reducing the degree of policy restraint by lowering our policy interest rate $1 / 4$ percentage point. We are confident that with an appropriate recalibration of our policy stance, strength in the economy and the labor market can be maintained, with inflation moving sustainably down to 2 percent. We see the risks to achieving our employment and inflation goals as being roughly in balance, and we are attentive to the risks to both sides. We know that reducing policy restraint too quickly could hinder progress on inflation. At the same time, reducing policy restraint too slowly could unduly weaken economic activity and employment. We are moving policy over time to a more neutral setting. But the path for getting there is not preset. In considering additional adjustments to the target range for the federal funds rate, we will carefully assess incoming data, the evolving outlook, and the balance of risks. The economy is not sending any signals that we need to be in a hurry to lower rates. The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully. Ultimately, the path of the policy rate will depend on how the incoming data and the economic outlook evolve. We remain resolute in our commitment to the dual mandate given to us by Congress: maximum employment and price stability. Our aim has been to return inflation to our objective without the kind of painful rise in unemployment that has often accompanied past efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. Thank you, and I look forward to our discussion.	Jerome H Powell	United States	https://www.bis.org/review/r241125c.pdf	Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, to the World Affairs Council, the Federal Reserve Bank of Dallas and the Dallas Regional Chamber, Dallas, Texas, 14 November 2024. Good afternoon. Thank you to the World Affairs Council, the Federal Reserve Bank of Dallas, and the Dallas Regional Chamber for the kind invitation to be with you today. I will start with some brief comments on the economy and monetary policy. Looking back, the U.S. economy has weathered a global pandemic and its aftermath and is now back to a good place. The economy has made significant progress toward our dual-mandate goals of maximum employment and stable prices. The labor market remains in solid condition. Inflation has eased substantially from its peak, and we believe it is on a sustainable path to our 2 percent goal. We are committed to maintaining our economy's strength by returning inflation to our goal while supporting maximum employment. The recent performance of our economy has been remarkably good, by far the best of any major economy in the world. Economic output grew by more than 3 percent last year and is expanding at a stout 2.5 percent rate so far this year. Growth in consumer spending has remained strong, supported by increases in disposable income and solid household balance sheets. Business investment in equipment and intangibles has accelerated over the past year. In contrast, activity in the housing sector has been weak. Improving supply conditions have supported this strong performance of the economy. The labor force has expanded rapidly, and productivity has grown faster over the past five years than its pace in the two decades before the pandemic, increasing the productive capacity of the economy and allowing rapid economic growth without overheating. The labor market remains in solid condition, having cooled off from the significantly overheated conditions of a couple of years ago, and is now by many metrics back to more normal levels that are consistent with our employment mandate. The number of job openings is now just slightly above the number of unemployed Americans seeking work. The rate at which workers quit their jobs is below the pre-pandemic pace, after touching historic highs two years ago. Wages are still increasing, but at a more sustainable pace. Hiring has slowed from earlier in the year. The most recent jobs report for October reflected significant effects from hurricanes and labor strikes, making it difficult to get a clear signal. Finally, at 4.1 percent, the unemployment rate is notably higher than a year ago but has flattened out in recent months and remains historically low. The labor market has cooled to the point where it is no longer a source of significant inflationary pressures. This cooling and the substantial improvement in broader supply conditions have brought inflation down significantly over the past two years from its mid2022 peak above 7 percent. Progress on inflation has been broad based. Estimates based on the consumer price index and other data released this week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October and that, excluding the volatile food and energy categories, core PCE prices rose 2.8 percent. Core measures of goods and services inflation, excluding housing, fell rapidly over the past two years and have returned to rates closer to those consistent with our goals. We expect that these rates will continue to fluctuate in their recent ranges. We are watching carefully to be sure that they do, however, just as we are closely tracking the gradual decline in housing services inflation, which has yet to fully normalize. Inflation is running much closer to our 2 percent longer-run goal, but it is not there yet. We are committed to finishing the job. With labor market conditions in rough balance and inflation expectations well anchored, I expect inflation to continue to come down toward our 2 percent objective, albeit on a sometimes-bumpy path. Given progress toward our inflation goal and the cooling of labor market conditions, last week my Federal Open Market Committee colleagues and I took another step in reducing the degree of policy restraint by lowering our policy interest rate $1 / 4$ percentage point. We are confident that with an appropriate recalibration of our policy stance, strength in the economy and the labor market can be maintained, with inflation moving sustainably down to 2 percent. We see the risks to achieving our employment and inflation goals as being roughly in balance, and we are attentive to the risks to both sides. We know that reducing policy restraint too quickly could hinder progress on inflation. At the same time, reducing policy restraint too slowly could unduly weaken economic activity and employment. We are moving policy over time to a more neutral setting. But the path for getting there is not preset. In considering additional adjustments to the target range for the federal funds rate, we will carefully assess incoming data, the evolving outlook, and the balance of risks. The economy is not sending any signals that we need to be in a hurry to lower rates. The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully. Ultimately, the path of the policy rate will depend on how the incoming data and the economic outlook evolve. We remain resolute in our commitment to the dual mandate given to us by Congress: maximum employment and price stability. Our aim has been to return inflation to our objective without the kind of painful rise in unemployment that has often accompanied past efforts to bring down high inflation. That would be a highly desirable result for the communities, families, and businesses we serve. While the task is not complete, we have made a good deal of progress toward that outcome. Thank you, and I look forward to our discussion.
2024-11-14T00:00:00	Adriana D Kugler: Central bank independence and the conduct of monetary policy	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Albert Hirschman Lecture, 2024 Annual Meeting of the Latin American and Caribbean Economic Association and the Latin American and Caribbean Chapter of the Econometric Society, Montevideo, Uruguay, 14 November 2024.	For release on delivery 7:00 a.m. EST (9:00 a.m. local time) November 14, 2024 Central Bank Independence and the Conduct of Monetary Policy Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Albert Hirschman Lecture 2024 Annual Meeting of the Latin American and Caribbean Economic Association and the Latin American and Caribbean Chapter of the Econometric Society Montevideo, Uruguay November 14, 2024 Thank you for your generous introduction, Marcela, and thank you for the opportunity to be here and speak to you today.1 I believe I am the first central banker from the U.S. to address this annual meeting, but I know, and am proud to say, that I am the first who is also Latin American. And, of course, I have been part of the LACEA Executive Committee and I have presented papers at many LACEA conferences over the years, so it is a pleasure to be back here among many colleagues. When the United States suffered very high inflation beginning in 2021, it was a new and unfamiliar experience for many too young to recall the last time this occurred in the 1970s and 1980s. Of course, very high inflation is not such a distant memory for people from Latin America and the Caribbean, and that includes me. Growing up in Colombia, I vividly recall the daily challenges of trying to plan and live with sustained double-digit inflation, and I especially remember the pain it imposed on disadvantaged people. Gaining control over inflation requires a commitment by society to accept the tradeoffs and sacrifices often needed, and it also requires deliberate and principled decision making by central banks.2 Central bankers must both formulate their best judgment of the correct policies that will achieve a desired level of inflation and follow through by executing and maintaining those policies. It has been widely recognized- and is a finding of economic research-that central bank independence is fundamental to achieving good policy and good economic outcomes. It is not sufficient by itself to achieve those goals, but, over time, it is almost always necessary. - 2 - Let me start by defining terms. An independent central bank is one that can carry out monetary policy insulated from pressures arising from other parts of government or elsewhere. When there is central bank independence, the role of national or jurisdictional governments is typically one of representing the public in specifying a mandate for the central bank and holding the central bank accountable by monitoring its performance and appointing central bank leadership. In this arrangement, the public, through representative government, specifies the overall objectives that central banks should pursue. Some noteworthy examples of central bank mandates include the dual mandate established by the U.S. Congress that requires the Federal Reserve Board and the Federal Open Market Committee (FOMC) to promote maximum employment and price stability. The European Central Bank's primary mandate of price stability is spelled out in a treaty enacted by the legislatures of its constituent member states. The central bank of Brazil pursues price stability as its primary objective as well. In the United Kingdom, its parliament has mandated that the Bank of England pursue monetary and financial stability.3 Similarly, the objectives of the central banks of Chile and Uruguay are both to keep inflation low and stable and to foster the stability and efficiency of the financial system. Before we discuss why monetary policy independence can benefit the economy, let me take a step back and discuss the tradeoffs associated with the conduct of monetary policy. Central banks significantly influence prices, interest rates, employment, and income in the economy, so it is natural that sometimes there would be differing views on - 3 - their decisions. For instance, monetary policy actions that promote economic activity and employment growth can put upward pressure on inflation. Conversely, policies to lower inflation tend to slow economic activity and employment growth. This tradeoff typically means that returning inflation to a specific target level when inflation has been allowed to run high may require more restrictive policy and a reduction in demand and higher unemployment. As I pointed out in a speech last spring at Stanford University, however, we have seen this tradeoff dissipate over the past couple of years, pointing to the possibility that we have been now for some time on the steep part of the Phillips curve, where inflation can come down substantially without a big increase in unemployment. Yet there is a possibility that this tradeoff may become more prominent as we move toward the flatter part of the Phillips curve. The economic literature points out that striking a balance in these tradeoffs can be difficult for an elected or otherwise representative government for various reasons. One reason highlighted in the literature is that an elected government may be naturally focused on the short-term goals of its constituents and may have an incentive to try to lower the unemployment rate in the short run, with less concern about the longer-term effects on inflation and growth. The literature has labeled this fundamental problem "time inconsistency."4 This incentive may generate undesirable economic cycles, potentially destabilizing prices. And if the public learns over time that the central bank is responsive to these incentives to increase inflation to boost employment temporarily, expectations of future inflation would rise, a symptom of a loss of credibility of the monetary policy authority. Governments also may have an incentive to increase inflation - 4 - to monetize their debts, which become effectively smaller as the purchasing power of money declines. Also, if elected officials are responsible for monetary policy decisions, the typical alternation in control of government between different parties may lead to different preferences in the tradeoff between employment and inflation, destabilizing prices and the economy in the long term.5 In summary, economic research argues that demands on government to address concerns in the short term may result in excessively discretionary monetary policy and do not provide the best incentives for effective monetary policy that promotes the long-term health of the economy. A solution devised by governments and explored in economic research is to delegate monetary policy to an independent entity: the central bank.6 By establishing policy mandates in laws or treaties, the government voluntarily constrains itself from suddenly altering policy, and thus it also discourages public pressure to do so. As in Homer's Odyssey, in which Odysseus asks his crew to tie him to the mast of his ship to avoid being bewitched by the Sirens' songs, policy mandates help central banks avoid being swayed by short-term desires to the detriment of longer-term goals. Now that we have discussed the reasons for delegating the authority to conduct monetary policy to an independent entity, we are left with the task of describing how such independence should be designed and implemented in practice. There are two broad categories of central bank independence. The first of these is goal independence-to what extent is the central bank free to define its goals? The research literature makes a - 5 - distinction between instrument independence-the prerogative to make monetary policy decisions, which I will discuss more later-and goal independence.7 In particular, the Federal Reserve's goals are defined by law, so it is not goal independent. Nevertheless, in spelling out those goals, the law provides the Federal Reserve with some degree of independence in defining them in detail. First, let's talk about the extent to which the law has defined the Federal Reserve's monetary policy goals. Unlike some other central banks that target inflation, the FOMC has been handed two coequal goals-maximum employment and price stability. The Committee is not free to pursue one or the other-it must pursue both. And these two sides of the mandate are pretty clear. Maximum employment means, in effect, the lowest unemployment rate that is consistent with stable prices. The law does not spell out a level of inflation that fulfills the goal of stable prices, but it has traditionally been viewed as a low and stable inflation rate. Mandates limit goal independence, but the form of those mandates can allow some role for the central bank in setting out its goals. The 1977 law defined the Federal Reserve's dual mandate, allowing the FOMC to work out the details. In 2012, the FOMC defined price stability as a longer-run annual inflation rate of 2 percent, as measured by the Commerce Department's estimate of the rate of increase in the personal consumption expenditures (PCE) deflator. Because maximum employment is unobserved and likely changes over time, it can be estimated only with considerable uncertainty; thus, the Committee chose not to define it in numerical terms. But Committee participants - 6 - estimate a related number, the longer-run rate of unemployment, which is published every three months in the Summary of Economic Projections. Another aspect of independence is instrument independence, which affords central banks flexibility in how to use the tools of monetary policy, such as policy interest rates, to achieve their goals. In the case of the FOMC, instrument independence has allowed it to adopt new ways to achieve its goals, as the financial system has evolved over the decades. This has been particularly important when the economy faced unprecedented challenges, as it did during the 2008 Global Financial Crisis and during the 2020 pandemic. Because of this flexibility, the Federal Reserve Board and the FOMC were able to respond promptly and, as it turned out, very effectively. Across countries and jurisdictions, goal independence and instrument independence have different dimensions and many variations. In some countries, including India, Brazil, and South Korea, the targets for inflation rates are jointly decided by the central bank and the ministry of finance. In contrast, the central banks of Chile, Colombia, Mexico, and Peru, among others, are given authority to choose their own inflation objectives. To understand how governments have come to embrace the independence of central banks, it is helpful to review how they have evolved from their origins in the 17th century. Sweden's Riksbank was established by the private sector in 1688 to lend the government funds, and the Bank of England followed in 1694, with a similar structure and purpose.8 Other European central banks followed in the 19th century and a wave of many more in the 20th, including the Federal Reserve. At different times, these central - 7 - banks made the transition from wholly private to wholly public institutions and became accountable to government, and by the mid-20th century, there was a growing recognition that independence made for a more practical and, ultimately, more effective central bank. In the United States, the moment of truth came in 1951. During World War II, the Federal Reserve had agreed to peg interest rates on Treasury securities in order to ensure smooth funding of the war effort, and after the war, it continued to peg the longer-term Treasury rate. In the early 1950s, inflation soared, but Treasury favored continuing a cap on longer-term interest rates so that debt management costs could continue to be low during the Korean War. After a series of high-level meetings, the Federal Reserve and the Treasury reached an agreement in 1951 that freed the Fed from the obligation to fix interest rates and allowed it to use monetary policy independently to pursue national economic goals. Researchers have analyzed the historical experiences of particular central banks, such as the Federal Reserve, to understand the transition toward central bank independence and how it affects economic performance.9 In addition, researchers have also developed large cross-country indexes measuring the level of central bank independence while capturing multifaceted aspects of this independence based on banks' legal statutes over long periods.10 The empirical regularity that stands out in many different studies analyzing these indexes is the rise in central bank independence starting in the 1980s, with studies analyzing at least 120 countries.11 - 8 - Economic research has cited several factors driving this adoption of central bank independence. In the 1980s and 1990s, emerging economies saw central bank independence as a way to facilitate access to global trade and financial markets, which were liberalized during that time.12 Another important factor was the experience of developing country debt crises during this period, which led to demands by creditor banks and international lenders for central bank independence.13 To whatever extent these other factors pushed governments toward central bank independence, a consensus developed that such an arrangement yielded better economic outcomes. Based on measures of central bank independence, researchers indeed have found a relationship between independence and lower inflation, especially for advanced economies.14 While evidence of a negative relationship between independence and inflation has been a bit more elusive in the case of emerging market and developing economies (EMDEs), the economic literature does find a relationship between independence and lower inflation volatility in these countries.15 Among the reasons I would cite for why it is more difficult to find a relationship between independence and lower inflation in EMDEs is that legal measures of central bank independence, also called "de jure independence," may not reflect the relationship between the central bank and the government that exists in practice-referred to as "de facto independence." In countries where the rule of law is not as strongly embedded in their institutions, there can be wide gaps between the formal, legal institutional arrangements and their practical effect.16 - 9 - Indeed, alternative measures of independence, such as turnover of central bank governors, point to de facto measures being negatively associated with inflation, especially in emerging economies.17 Another possible reason is that emerging economies may be more exposed to volatile shocks and governmental regime changes, leading to greater turnover in central bank leadership and clouding the relationship between central bank independence and inflation.18 The relationship between central bank independence and lower inflation and inflation volatility is therefore clear. But the connection to faster growth in economic activity is not. On the one hand, the primary reason for central bank independence in most countries with a single mandate is to provide price stability, so the lack of association between monetary policy independence and adverse economic consequences is not surprising.19 On the other hand, indexes of central bank independence may be biased. Most indexes of central bank independence tend to penalize the presence of additional mandates or responsibilities beyond price stability.20 However, a mandate that excludes full employment does not seem optimal, given that a central banker should focus on the consequences of its actions on long-term growth and economic activity. Research has emphasized complementarities between price stability, economic stability, and financial stability, providing a rationale for these overlapping objectives at many central banks.21 Also, in practice, although the recent inflation run-up showcased the commitment of most central banks to fight inflation, it also appears that they have been willing to provide some accommodation after having gained greater confidence that inflationary pressures have dissipated. In fact, most central banks have initiated an easing cycle even with inflation still somewhat above their respective targets and regardless of the presence or not of an employment goal in their mandates. So if central bank independence does improve inflation outcomes, one question is how it accomplishes this. Let me return to an issue I mentioned earlier: credibility. If the central bank is credible about its longer-run inflation target, it would be a natural outcome that long-run inflation expectations will tend to be closer to the target than when that credibility is lacking. And a central bank will be more credible if it takes actions that lead the public to be confident that the central bank is actively pursuing its stated goal. It is possible to formalize the channel through which a central bank chooses a long-run inflation target and the public slowly learns about its commitment to achieving it, thus gradually anchoring long-run expectations.22 The public observes inflation and economic activity outcomes as well as the central bank actions (say, changes in the federal funds rate), and it updates its long-run inflation expectations, which, in this model, coincide with its perception of the long-run target. For instance, a nominal interest rate that is higher than expected, given observed inflation and economic activity and the public's long-run inflation expectations, leads to an updated-lower-value of the perceived inflation target. If the central bank's policy actions are consistent with its long-run inflation goal, the public's long-run expectations will gradually settle at the central bank's long-run goal: This dynamic will anchor inflation expectations to the long-run target. The stock of credibility of a central bank will be reflected in long-run inflation expectations moving in a relatively narrow range close to the stated inflation goal. Conversely, inconsistent actions will imply that agents will update their long-run expectations higher or lower, depending on the direction of surprises in central bank actions, causing de-anchoring of expectations. Despite a very large inflation shock starting in 2021, available measures of long-run inflation expectations, such as those in the Survey of Professional Forecasters or the Livingston Survey, increased just a bit compared with the inflation run-up and quickly descended in 2023. That can be taken as a sign of anchoring and sufficient central bank credibility through the lens of the model just described. And, to the extent that long-run inflation expectations matter to the dynamics of actual inflation, such as in some Phillips curve models, anchoring of inflation expectations is one of the key elements leading to stable inflation.23 The model also offers an interpretation of and a contrast to the behavior of inflation and inflation expectations during the Great Inflation of the 1970s and in the post-pandemic period. As inflation rose in the 1970s and monetary policy actions failed to rein it in, the Federal Reserve lost credibility, and longer-term expectations of future inflation rose toward the end of the decade. The Federal Reserve struggled for years to rebuild that credibility, resulting in high and volatile inflation. Conversely, in the recent episode, inflation has traveled a long way from its peak, with no deterioration in economic activity and comparatively limited movement in long-run inflation expectations. Credibility is enhanced by transparency and accountability, and I will conclude with a discussion of how these principles are carried out by the Federal Reserve. The Federal Reserve seeks to explain as clearly as possible what it is trying to do in carrying out its dual-mandate objectives and how it is trying to do it. Such transparency and accountability are necessary under our democratic system but are perhaps especially important for the Federal Reserve, which has been assigned such an important role in promoting a healthy economy. In addition to conferring legitimacy for decisions, transparency makes monetary policy more effective, as the public better understands our monetary policy reaction function, which informs the public on how our decisions are shaped by economic conditions. Monetary policy works in part by trying to influence the public's view of future economic conditions, so it is crucial that these intentions are clearly communicated. The Federal Reserve promotes transparency by issuing a postmeeting statement explaining its decision and then following up with more detailed minutes three weeks later. Every three months, FOMC participants' projections for inflation, unemployment, economic activity, and the likely path of monetary policy are published in the Summary of Economic Projections. The Chair conducts press conferences after each FOMC meeting, and both the Chair and FOMC participants further explain their reasoning on policy in speeches, news interviews, and other public appearances. The Chair testifies to Congress on monetary policy twice a year, responding to questions from lawmakers. Transcripts of FOMC meetings are published after five years. More recently, the Fed has adopted the practice of periodically reviewing its monetary policy strategy, tools, and communication practices, including holding public Fed Listens sessions around the country to get public input. Transparency is likewise seen in other economies as fundamental to monetary policy independence, which has increasingly been recognized for delivering better policy decisions that are more focused on the longer-term health of an economy. Research continues to add to our understanding of the extent of these better outcomes in different economies and also how independence works in different institutional arrangements. The goal, of course, is more stable economies that deliver broadly rising living standards-in Latin America, the Caribbean, and around the world. Let me now turn to the current economic outlook in the United States and how our monetary policy independence has permitted us to get where we are now. The United States has seen considerable disinflation while experiencing a cooling but still resilient labor market. Numbers just released this week show headline and core PCE inflation have fallen substantially from 7.1 percent to an estimated 2.3 percent and from 5.6 percent to an estimated 2.8 percent, respectively. While wage moderation and anchored inflation expectations may allow us to continue making progress on inflation, stubborn housing inflation and high inflation in certain goods and services categories may stall progress in reaching our target. At the same time, labor markets have rebalanced, given greater labor supply from immigration and prime-age workers and lower demand from restrictive monetary policy. Thus, although the labor market experienced an extended period of low unemployment and job creation these past several years and strong real wage growth, the labor market has cooled. This combination of a continued but slowing trend in disinflation and cooling labor markets means that we need to continue paying attention to both sides of our mandate. If any risks arise that stall progress or reaccelerate inflation, it would be appropriate to pause our policy rate cuts. But if the labor market slows down suddenly, it would be appropriate to continue to gradually reduce the policy rate. Thank you again for inviting me to address you today. I would be glad to spend some time on further discussion of my presentation and to respond to your other questions. References Alesina, Alberto, and Andrea Stella (2010). "The Politics of Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3. Amsterdam: Elsevier, pp. 1001-54. Alesina, Alberto, and Lawrence H. Summers (1993). "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, vol. 25 (May), pp. 151-62. Barro, Robert J., and David B. Gordon (1983). "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, vol. 91 (August), pp. 589-610. Binder, Sarah, and Mark Spindel (2017). The Myth of Independence: How Congress Governs the Federal Reserve. Princeton, N.J.: Princeton University Press. Board of Governors of the Federal Reserve System (2024). Monetary Policy Report. Washington: Board of Governors, July, https://www.federalreserve.gov/monetarypolicy/files/20240705_mprfullreport.pdf. Bordo, Michael D. (2007). "A Brief History of Central Banks," Economic Commentary. Cleveland: Federal Reserve Bank of Cleveland, December, https://www.clevelandfed.org/publications/economic-commentary/2007/ec-20071201-abrief-history-of-central-banks. Calvo, Guillermo A. (1978). "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, vol. 46 (November), pp. 1411-28. Crowe, Christopher, and Ellen E. Meade (2008). "Central Bank Independence and Transparency: Evolution and Effectiveness," European Journal of Political Economy, vol. 24 (December), pp 763-77. Cukierman, Alex (2008). "Central Bank Independence and Monetary Policymaking Institutions-Past, Present and Future," European Journal of Political Economy, vol. 24 (December), pp. 722-36. Cukierman, Alex, Geoffrey P. Miller, and Bilin Neyapti (2002). "Central Bank Reform, Liberalization and Inflation in Transition Economies-An International Perspective." Journal of Monetary Economics, vol. 49 (2), pp. 237-264. Cukierman, Alex, Steven B. Webb, and Bilin Neyapti (1992). "Measuring the Independence of Central Banks and Its Effect on Policy Outcomes," World Bank Economic Review, vol. 6 (3), pp. 353-98. Debelle, Guy, and Stanley Fischer (1994). "How Independent Should a Central Bank Be?" in Jeffrey C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing Monetary Policymakers, Conference Series 38. Boston: Federal Reserve Bank of Boston, pp. 195-221. Dincer, Nergiz, Barry Eichengreen, and Joan J. Martinez (2024). "Central Bank Independence: Views from History and Machine Learning," Annual Review of Economics, vol. 16 (August), pp. 393-428. Fischer, Stanley (1994). "Modern Central Banking," in Forrest Capie, Stanley Fischer, Charles Goodhart, and Norbert Schnadt, eds., The Future of Central Banking: The Tercentenary Symposium of the Bank of England. Cambridge, U.K.: Cambridge University Press. Garriga, Ana Carolina, and Cesar M. Rodriguez (2020). "More Effective Than We Thought: Central Bank Independence and Inflation in Developing Countries," Economic Modelling, vol. 85 (February), pp. 87-105. Jácome, Luis I., and Francisco Vázquez (2008). "Is There Any Link between Legal Central Bank Independence and Inflation? Evidence from Latin America and the Caribbean," European Journal of Political Economy, vol. 24 (December), pp. 788-801. Kiley, Michael T. (2008). "Monetary Policy Actions and Long-Run Inflation Expectations," Finance and Economics Discussion Series 2008-03. Washington: Board of Governors of the Federal Reserve System, February, https://www.federalreserve.gov/econres/feds/monetary-policy-actions-and-long-runinflation-expectations.htm. Kiley, Michael T., and Frederic S. Mishkin (2024), "Central Banking Post Crises," Finance and Economics Discussion Series 2024-035. Washington: Board of Governors of the Federal Reserve System, May, https://doi.org/10.17016/FEDS.2024.035. Kydland, Finn E., and Edward C. Prescott (1977). "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, vol. 85 (June), pp. 473-91. Maxfield, Sylvia (1997). Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries. Princeton, N.J.: Princeton University Press. Persson, Torsten, and Guido Tabellini (1993). "Designing Institutions for Monetary Stability," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 53-84. Rogoff, Kenneth (1985). "The Optimal Degree of Commitment to an Intermediate Monetary Target," Quarterly Journal of Economics, vol. 100 (November), pp. 1169-89. Romelli, Davide (2024). Trends in Central Bank Independence: A De-jure Perspective," Working Paper 217. Milan: BAFFI Centre on Economics, Finance and Regulation, Bocconi University, February, https://repec.unibocconi.it/baffic/baf/papers/cbafwp24217.pdf. Vuletin, Guillermo, and Ling Zhu (2011). "Replacing a 'Disobedient' Central Bank Governor with a 'Docile' One: A Novel Measure of Central Bank Independence and Its Effect on Inflation," Journal of Money, Credit and Banking, vol. 43 (September), pp. 1185-1215. Walsh, Carl E. (2003). Monetary Theory and Policy, 2nd ed. Cambridge, Mass.: MIT Press. Yellen, Janet L. (2015). "Inflation Dynamics and Monetary Policy," speech delivered at the Philip Gamble Memorial Lecture, University of Massachusetts, Amherst, September 24, https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm.	---[PAGE_BREAK]--- For release on delivery 7:00 a.m. EST (9:00 a.m. local time) November 14, 2024 Central Bank Independence and the Conduct of Monetary Policy Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Albert Hirschman Lecture 2024 Annual Meeting of the Latin American and Caribbean Economic Association and the Latin American and Caribbean Chapter of the Econometric Society Montevideo, Uruguay November 14, 2024 ---[PAGE_BREAK]--- Thank you for your generous introduction, Marcela, and thank you for the opportunity to be here and speak to you today. ${ }^{1}$ I believe I am the first central banker from the U.S. to address this annual meeting, but I know, and am proud to say, that I am the first who is also Latin American. And, of course, I have been part of the LACEA Executive Committee and I have presented papers at many LACEA conferences over the years, so it is a pleasure to be back here among many colleagues. When the United States suffered very high inflation beginning in 2021, it was a new and unfamiliar experience for many too young to recall the last time this occurred in the 1970s and 1980s. Of course, very high inflation is not such a distant memory for people from Latin America and the Caribbean, and that includes me. Growing up in Colombia, I vividly recall the daily challenges of trying to plan and live with sustained double-digit inflation, and I especially remember the pain it imposed on disadvantaged people. Gaining control over inflation requires a commitment by society to accept the tradeoffs and sacrifices often needed, and it also requires deliberate and principled decision making by central banks. ${ }^{2}$ Central bankers must both formulate their best judgment of the correct policies that will achieve a desired level of inflation and follow through by executing and maintaining those policies. It has been widely recognizedand is a finding of economic research-that central bank independence is fundamental to achieving good policy and good economic outcomes. It is not sufficient by itself to achieve those goals, but, over time, it is almost always necessary. [^0] [^0]: ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See the box "Monetary Policy Independence, Transparency, and Accountability" in Board of Governors (2024, pp. 42-44). ---[PAGE_BREAK]--- Let me start by defining terms. An independent central bank is one that can carry out monetary policy insulated from pressures arising from other parts of government or elsewhere. When there is central bank independence, the role of national or jurisdictional governments is typically one of representing the public in specifying a mandate for the central bank and holding the central bank accountable by monitoring its performance and appointing central bank leadership. In this arrangement, the public, through representative government, specifies the overall objectives that central banks should pursue. Some noteworthy examples of central bank mandates include the dual mandate established by the U.S. Congress that requires the Federal Reserve Board and the Federal Open Market Committee (FOMC) to promote maximum employment and price stability. The European Central Bank's primary mandate of price stability is spelled out in a treaty enacted by the legislatures of its constituent member states. The central bank of Brazil pursues price stability as its primary objective as well. In the United Kingdom, its parliament has mandated that the Bank of England pursue monetary and financial stability. ${ }^{3}$ Similarly, the objectives of the central banks of Chile and Uruguay are both to keep inflation low and stable and to foster the stability and efficiency of the financial system. Before we discuss why monetary policy independence can benefit the economy, let me take a step back and discuss the tradeoffs associated with the conduct of monetary policy. Central banks significantly influence prices, interest rates, employment, and income in the economy, so it is natural that sometimes there would be differing views on [^0] [^0]: ${ }^{3}$ The European Central Bank, the central bank of Brazil, and the Bank of England have as additional objectives, without the prejudice of their monetary stability mandates, to contribute to economic growth. ---[PAGE_BREAK]--- their decisions. For instance, monetary policy actions that promote economic activity and employment growth can put upward pressure on inflation. Conversely, policies to lower inflation tend to slow economic activity and employment growth. This tradeoff typically means that returning inflation to a specific target level when inflation has been allowed to run high may require more restrictive policy and a reduction in demand and higher unemployment. As I pointed out in a speech last spring at Stanford University, however, we have seen this tradeoff dissipate over the past couple of years, pointing to the possibility that we have been now for some time on the steep part of the Phillips curve, where inflation can come down substantially without a big increase in unemployment. Yet there is a possibility that this tradeoff may become more prominent as we move toward the flatter part of the Phillips curve. The economic literature points out that striking a balance in these tradeoffs can be difficult for an elected or otherwise representative government for various reasons. One reason highlighted in the literature is that an elected government may be naturally focused on the short-term goals of its constituents and may have an incentive to try to lower the unemployment rate in the short run, with less concern about the longer-term effects on inflation and growth. The literature has labeled this fundamental problem "time inconsistency." ${ }^{4}$ This incentive may generate undesirable economic cycles, potentially destabilizing prices. And if the public learns over time that the central bank is responsive to these incentives to increase inflation to boost employment temporarily, expectations of future inflation would rise, a symptom of a loss of credibility of the monetary policy authority. Governments also may have an incentive to increase inflation [^0] [^0]: ${ }^{4}$ Research on "time inconsistency" was pioneered by Kydland and Prescott (1977) and Calvo (1978). This problem was analyzed in more detail in the context of monetary policy by Barro and Gordon (1983). ---[PAGE_BREAK]--- to monetize their debts, which become effectively smaller as the purchasing power of money declines. Also, if elected officials are responsible for monetary policy decisions, the typical alternation in control of government between different parties may lead to different preferences in the tradeoff between employment and inflation, destabilizing prices and the economy in the long term. ${ }^{5}$ In summary, economic research argues that demands on government to address concerns in the short term may result in excessively discretionary monetary policy and do not provide the best incentives for effective monetary policy that promotes the long-term health of the economy. A solution devised by governments and explored in economic research is to delegate monetary policy to an independent entity: the central bank. ${ }^{6}$ By establishing policy mandates in laws or treaties, the government voluntarily constrains itself from suddenly altering policy, and thus it also discourages public pressure to do so. As in Homer's Odyssey, in which Odysseus asks his crew to tie him to the mast of his ship to avoid being bewitched by the Sirens' songs, policy mandates help central banks avoid being swayed by short-term desires to the detriment of longer-term goals. Now that we have discussed the reasons for delegating the authority to conduct monetary policy to an independent entity, we are left with the task of describing how such independence should be designed and implemented in practice. There are two broad categories of central bank independence. The first of these is goal independence-to what extent is the central bank free to define its goals? The research literature makes a [^0] [^0]: ${ }^{5}$ Alesina and Stella (2010) and Kiley and Mishkin (2024) provide summaries of the literature on rules versus discretion. ${ }^{6}$ Rogoff (1985) suggested the appointment of a central banker predisposed toward keeping inflation low and stable as a solution to the time-inconsistency problem; additional discussions are presented in Persson and Tabellini (1993) and Walsh (2003, chap. 8). ---[PAGE_BREAK]--- distinction between instrument independence-the prerogative to make monetary policy decisions, which I will discuss more later-and goal independence. ${ }^{7}$ In particular, the Federal Reserve's goals are defined by law, so it is not goal independent. Nevertheless, in spelling out those goals, the law provides the Federal Reserve with some degree of independence in defining them in detail. First, let's talk about the extent to which the law has defined the Federal Reserve's monetary policy goals. Unlike some other central banks that target inflation, the FOMC has been handed two coequal goals-maximum employment and price stability. The Committee is not free to pursue one or the other-it must pursue both. And these two sides of the mandate are pretty clear. Maximum employment means, in effect, the lowest unemployment rate that is consistent with stable prices. The law does not spell out a level of inflation that fulfills the goal of stable prices, but it has traditionally been viewed as a low and stable inflation rate. Mandates limit goal independence, but the form of those mandates can allow some role for the central bank in setting out its goals. The 1977 law defined the Federal Reserve's dual mandate, allowing the FOMC to work out the details. In 2012, the FOMC defined price stability as a longer-run annual inflation rate of 2 percent, as measured by the Commerce Department's estimate of the rate of increase in the personal consumption expenditures (PCE) deflator. Because maximum employment is unobserved and likely changes over time, it can be estimated only with considerable uncertainty; thus, the Committee chose not to define it in numerical terms. But Committee participants [^0] [^0]: ${ }^{7}$ See Debelle and Fischer (1994) and Fischer (1994). ---[PAGE_BREAK]--- estimate a related number, the longer-run rate of unemployment, which is published every three months in the Summary of Economic Projections. Another aspect of independence is instrument independence, which affords central banks flexibility in how to use the tools of monetary policy, such as policy interest rates, to achieve their goals. In the case of the FOMC, instrument independence has allowed it to adopt new ways to achieve its goals, as the financial system has evolved over the decades. This has been particularly important when the economy faced unprecedented challenges, as it did during the 2008 Global Financial Crisis and during the 2020 pandemic. Because of this flexibility, the Federal Reserve Board and the FOMC were able to respond promptly and, as it turned out, very effectively. Across countries and jurisdictions, goal independence and instrument independence have different dimensions and many variations. In some countries, including India, Brazil, and South Korea, the targets for inflation rates are jointly decided by the central bank and the ministry of finance. In contrast, the central banks of Chile, Colombia, Mexico, and Peru, among others, are given authority to choose their own inflation objectives. To understand how governments have come to embrace the independence of central banks, it is helpful to review how they have evolved from their origins in the 17th century. Sweden's Riksbank was established by the private sector in 1688 to lend the government funds, and the Bank of England followed in 1694, with a similar structure and purpose. ${ }^{8}$ Other European central banks followed in the 19th century and a wave of many more in the 20th, including the Federal Reserve. At different times, these central [^0] [^0]: ${ }^{8}$ See Bordo (2007). ---[PAGE_BREAK]--- banks made the transition from wholly private to wholly public institutions and became accountable to government, and by the mid-20th century, there was a growing recognition that independence made for a more practical and, ultimately, more effective central bank. In the United States, the moment of truth came in 1951. During World War II, the Federal Reserve had agreed to peg interest rates on Treasury securities in order to ensure smooth funding of the war effort, and after the war, it continued to peg the longer-term Treasury rate. In the early 1950s, inflation soared, but Treasury favored continuing a cap on longer-term interest rates so that debt management costs could continue to be low during the Korean War. After a series of high-level meetings, the Federal Reserve and the Treasury reached an agreement in 1951 that freed the Fed from the obligation to fix interest rates and allowed it to use monetary policy independently to pursue national economic goals. Researchers have analyzed the historical experiences of particular central banks, such as the Federal Reserve, to understand the transition toward central bank independence and how it affects economic performance. ${ }^{9}$ In addition, researchers have also developed large cross-country indexes measuring the level of central bank independence while capturing multifaceted aspects of this independence based on banks' legal statutes over long periods. ${ }^{10}$ The empirical regularity that stands out in many different studies analyzing these indexes is the rise in central bank independence starting in the 1980s, with studies analyzing at least 120 countries. ${ }^{11}$ [^0] [^0]: ${ }^{9}$ For a review of the historical experience of the United States in particular, see Binder S, Spindel M. (2017). ${ }^{10}$ One early index is due to Cukierman, Webb, and Neyapti (1992). It captures some aspects of various institutional arrangements, such as the presence of a mandate on price stability or additional mandates. ${ }^{11}$ See Dincer, Eichengreen, and Martinez (2024). See also Romelli (2024). ---[PAGE_BREAK]--- Economic research has cited several factors driving this adoption of central bank independence. In the 1980s and 1990s, emerging economies saw central bank independence as a way to facilitate access to global trade and financial markets, which were liberalized during that time. ${ }^{12}$ Another important factor was the experience of developing country debt crises during this period, which led to demands by creditor banks and international lenders for central bank independence. ${ }^{13}$ To whatever extent these other factors pushed governments toward central bank independence, a consensus developed that such an arrangement yielded better economic outcomes. Based on measures of central bank independence, researchers indeed have found a relationship between independence and lower inflation, especially for advanced economies. ${ }^{14}$ While evidence of a negative relationship between independence and inflation has been a bit more elusive in the case of emerging market and developing economies (EMDEs), the economic literature does find a relationship between independence and lower inflation volatility in these countries. ${ }^{15}$ Among the reasons I would cite for why it is more difficult to find a relationship between independence and lower inflation in EMDEs is that legal measures of central bank independence, also called "de jure independence," may not reflect the relationship between the central bank and the government that exists in practice-referred to as "de facto independence." In countries where the rule of law is not as strongly embedded in their institutions, there can be wide gaps between the formal, legal institutional arrangements and their practical effect. ${ }^{16}$ [^0] [^0]: ${ }^{12}$ See Maxfield (1997). ${ }^{13}$ See Cukierman (2008). ${ }^{14}$ See Crowe and Meade (2008). ${ }^{15}$ See Garriga and Rodriguez (2020). ${ }^{16}$ Cukierman and others (2002) provide some evidence on the relationship between inflation and central bank independence across different countries. ---[PAGE_BREAK]--- Indeed, alternative measures of independence, such as turnover of central bank governors, point to de facto measures being negatively associated with inflation, especially in emerging economies. ${ }^{17}$ Another possible reason is that emerging economies may be more exposed to volatile shocks and governmental regime changes, leading to greater turnover in central bank leadership and clouding the relationship between central bank independence and inflation. ${ }^{18}$ The relationship between central bank independence and lower inflation and inflation volatility is therefore clear. But the connection to faster growth in economic activity is not. On the one hand, the primary reason for central bank independence in most countries with a single mandate is to provide price stability, so the lack of association between monetary policy independence and adverse economic consequences is not surprising. ${ }^{19}$ On the other hand, indexes of central bank independence may be biased. Most indexes of central bank independence tend to penalize the presence of additional mandates or responsibilities beyond price stability. ${ }^{20}$ However, a mandate that excludes full employment does not seem optimal, given that a central banker should focus on the consequences of its actions on long-term growth and economic activity. Research has emphasized complementarities between price stability, economic stability, and financial stability, providing a rationale for these overlapping objectives at many central banks. ${ }^{21}$ Also, in practice, although the recent inflation run-up showcased the [^0] [^0]: ${ }^{17}$ See, for instance, Jácome and Vázquez (2008) and Vuletín and Zhu (2011). ${ }^{18}$ See Jácome and Vázquez (2008). ${ }^{19}$ For instance, Alesina and Summers (1993) find no increase in business cycle volatility in developed countries. ${ }^{20}$ Take, for instance, the very recently updated index by Romelli (2024): The joint presence of price stability together with economic growth or full employment or responsibilities in bank supervision, as is the case for the Federal Reserve, depresses the score. ${ }^{21}$ See Kiley and Mishkin (2024). ---[PAGE_BREAK]--- commitment of most central banks to fight inflation, it also appears that they have been willing to provide some accommodation after having gained greater confidence that inflationary pressures have dissipated. In fact, most central banks have initiated an easing cycle even with inflation still somewhat above their respective targets and regardless of the presence or not of an employment goal in their mandates. So if central bank independence does improve inflation outcomes, one question is how it accomplishes this. Let me return to an issue I mentioned earlier: credibility. If the central bank is credible about its longer-run inflation target, it would be a natural outcome that long-run inflation expectations will tend to be closer to the target than when that credibility is lacking. And a central bank will be more credible if it takes actions that lead the public to be confident that the central bank is actively pursuing its stated goal. It is possible to formalize the channel through which a central bank chooses a long-run inflation target and the public slowly learns about its commitment to achieving it, thus gradually anchoring long-run expectations. ${ }^{22}$ The public observes inflation and economic activity outcomes as well as the central bank actions (say, changes in the federal funds rate), and it updates its long-run inflation expectations, which, in this model, coincide with its perception of the long-run target. For instance, a nominal interest rate that is higher than expected, given observed inflation and economic activity and the public's long-run inflation expectations, leads to an updated-lower-value of the perceived inflation target. [^0] [^0]: ${ }^{22}$ Kiley (2008) develops a model in which the public does not observe the central bank inflation target and it has to infer the target from observations on macro variables and interest rates. Long-run inflation expectations in Kiley's model are the optimal estimates of the unobserved long-run target. The estimates in Kiley (2008) suggest that the updating of long-run inflation expectations is affected by monetary policy, in contrast to alternative frameworks, such as adaptive expectations. ---[PAGE_BREAK]--- If the central bank's policy actions are consistent with its long-run inflation goal, the public's long-run expectations will gradually settle at the central bank's long-run goal: This dynamic will anchor inflation expectations to the long-run target. The stock of credibility of a central bank will be reflected in long-run inflation expectations moving in a relatively narrow range close to the stated inflation goal. Conversely, inconsistent actions will imply that agents will update their long-run expectations higher or lower, depending on the direction of surprises in central bank actions, causing de-anchoring of expectations. Despite a very large inflation shock starting in 2021, available measures of long-run inflation expectations, such as those in the Survey of Professional Forecasters or the Livingston Survey, increased just a bit compared with the inflation run-up and quickly descended in 2023. That can be taken as a sign of anchoring and sufficient central bank credibility through the lens of the model just described. And, to the extent that long-run inflation expectations matter to the dynamics of actual inflation, such as in some Phillips curve models, anchoring of inflation expectations is one of the key elements leading to stable inflation. ${ }^{23}$ The model also offers an interpretation of and a contrast to the behavior of inflation and inflation expectations during the Great Inflation of the 1970s and in the post-pandemic period. As inflation rose in the 1970s and monetary policy actions failed to rein it in, the Federal Reserve lost credibility, and longer-term expectations of future inflation rose toward the end of the decade. The Federal Reserve struggled for years to rebuild that credibility, resulting in high and volatile inflation. Conversely, in the recent episode, inflation has traveled a long way from its peak, with no deterioration in [^0] [^0]: ${ }^{23}$ See Yellen (2015). ---[PAGE_BREAK]--- economic activity and comparatively limited movement in long-run inflation expectations. Credibility is enhanced by transparency and accountability, and I will conclude with a discussion of how these principles are carried out by the Federal Reserve. The Federal Reserve seeks to explain as clearly as possible what it is trying to do in carrying out its dual-mandate objectives and how it is trying to do it. Such transparency and accountability are necessary under our democratic system but are perhaps especially important for the Federal Reserve, which has been assigned such an important role in promoting a healthy economy. In addition to conferring legitimacy for decisions, transparency makes monetary policy more effective, as the public better understands our monetary policy reaction function, which informs the public on how our decisions are shaped by economic conditions. Monetary policy works in part by trying to influence the public's view of future economic conditions, so it is crucial that these intentions are clearly communicated. The Federal Reserve promotes transparency by issuing a postmeeting statement explaining its decision and then following up with more detailed minutes three weeks later. Every three months, FOMC participants' projections for inflation, unemployment, economic activity, and the likely path of monetary policy are published in the Summary of Economic Projections. The Chair conducts press conferences after each FOMC meeting, and both the Chair and FOMC participants further explain their reasoning on policy in speeches, news interviews, and other public appearances. The Chair testifies to Congress on monetary policy twice a year, responding to questions from lawmakers. Transcripts of FOMC meetings are published after five years. More recently, the Fed has adopted the practice of periodically ---[PAGE_BREAK]--- reviewing its monetary policy strategy, tools, and communication practices, including holding public Fed Listens sessions around the country to get public input. Transparency is likewise seen in other economies as fundamental to monetary policy independence, which has increasingly been recognized for delivering better policy decisions that are more focused on the longer-term health of an economy. Research continues to add to our understanding of the extent of these better outcomes in different economies and also how independence works in different institutional arrangements. The goal, of course, is more stable economies that deliver broadly rising living standards-in Latin America, the Caribbean, and around the world. Let me now turn to the current economic outlook in the United States and how our monetary policy independence has permitted us to get where we are now. The United States has seen considerable disinflation while experiencing a cooling but still resilient labor market. Numbers just released this week show headline and core PCE inflation have fallen substantially from 7.1 percent to an estimated 2.3 percent and from 5.6 percent to an estimated 2.8 percent, respectively. While wage moderation and anchored inflation expectations may allow us to continue making progress on inflation, stubborn housing inflation and high inflation in certain goods and services categories may stall progress in reaching our target. At the same time, labor markets have rebalanced, given greater labor supply from immigration and prime-age workers and lower demand from restrictive monetary policy. Thus, although the labor market experienced an extended period of low unemployment and job creation these past several years and strong real wage growth, the labor market has cooled. This combination of a continued but slowing trend in disinflation and cooling labor markets means that we need to continue paying ---[PAGE_BREAK]--- attention to both sides of our mandate. If any risks arise that stall progress or reaccelerate inflation, it would be appropriate to pause our policy rate cuts. But if the labor market slows down suddenly, it would be appropriate to continue to gradually reduce the policy rate. Thank you again for inviting me to address you today. I would be glad to spend some time on further discussion of my presentation and to respond to your other questions. # References Alesina, Alberto, and Andrea Stella (2010). "The Politics of Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3. Amsterdam: Elsevier, pp. 1001-54. Alesina, Alberto, and Lawrence H. Summers (1993). "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, vol. 25 (May), pp. 151-62. Barro, Robert J., and David B. Gordon (1983). "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, vol. 91 (August), pp. 589-610. Binder, Sarah, and Mark Spindel (2017). The Myth of Independence: How Congress Governs the Federal Reserve. Princeton, N.J.: Princeton University Press. Board of Governors of the Federal Reserve System (2024). Monetary Policy Report. Washington: Board of Governors, July, https://www.federalreserve.gov/monetarypolicy/files/20240705_mprfullreport.pdf. Bordo, Michael D. (2007). "A Brief History of Central Banks," Economic Commentary. Cleveland: Federal Reserve Bank of Cleveland, December, https://www.clevelandfed.org/publications/economic-commentary/2007/ec-20071201-a-brief-history-of-central-banks. Calvo, Guillermo A. (1978). "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, vol. 46 (November), pp. 1411-28. Crowe, Christopher, and Ellen E. Meade (2008). "Central Bank Independence and Transparency: Evolution and Effectiveness," European Journal of Political Economy, vol. 24 (December), pp 763-77. ---[PAGE_BREAK]--- Cukierman, Alex (2008). "Central Bank Independence and Monetary Policymaking Institutions-Past, Present and Future," European Journal of Political Economy, vol. 24 (December), pp. 722-36. Cukierman, Alex, Geoffrey P. Miller, and Bilin Neyapti (2002). "Central Bank Reform, Liberalization and Inflation in Transition Economies-An International Perspective." Journal of Monetary Economics, vol. 49 (2), pp. 237-264. Cukierman, Alex, Steven B. Webb, and Bilin Neyapti (1992). "Measuring the Independence of Central Banks and Its Effect on Policy Outcomes," World Bank Economic Review, vol. 6 (3), pp. 353-98. Debelle, Guy, and Stanley Fischer (1994). "How Independent Should a Central Bank Be?" in Jeffrey C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing Monetary Policymakers, Conference Series 38. Boston: Federal Reserve Bank of Boston, pp. 195-221. Dincer, Nergiz, Barry Eichengreen, and Joan J. Martinez (2024). "Central Bank Independence: Views from History and Machine Learning," Annual Review of Economics, vol. 16 (August), pp. 393-428. Fischer, Stanley (1994). "Modern Central Banking," in Forrest Capie, Stanley Fischer, Charles Goodhart, and Norbert Schnadt, eds., The Future of Central Banking: The Tercentenary Symposium of the Bank of England. Cambridge, U.K.: Cambridge University Press. Garriga, Ana Carolina, and Cesar M. Rodriguez (2020). "More Effective Than We Thought: Central Bank Independence and Inflation in Developing Countries," Economic Modelling, vol. 85 (February), pp. 87-105. Jácome, Luis I., and Francisco Vázquez (2008). "Is There Any Link between Legal Central Bank Independence and Inflation? Evidence from Latin America and the Caribbean," European Journal of Political Economy, vol. 24 (December), pp. 788-801. Kiley, Michael T. (2008). "Monetary Policy Actions and Long-Run Inflation Expectations," Finance and Economics Discussion Series 2008-03. Washington: Board of Governors of the Federal Reserve System, February, https://www.federalreserve.gov/econres/feds/monetary-policy-actions-and-long-run-inflation-expectations.htm. Kiley, Michael T., and Frederic S. Mishkin (2024), "Central Banking Post Crises," Finance and Economics Discussion Series 2024-035. Washington: Board of Governors of the Federal Reserve System, May, https://doi.org/10.17016/FEDS.2024.035. Kydland, Finn E., and Edward C. Prescott (1977). "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, vol. 85 (June), pp. 473-91. Maxfield, Sylvia (1997). Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries. Princeton, N.J.: Princeton University Press. ---[PAGE_BREAK]--- Persson, Torsten, and Guido Tabellini (1993). "Designing Institutions for Monetary Stability," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 53-84. Rogoff, Kenneth (1985). "The Optimal Degree of Commitment to an Intermediate Monetary Target," Quarterly Journal of Economics, vol. 100 (November), pp. 1169-89. Romelli, Davide (2024). Trends in Central Bank Independence: A De-jure Perspective," Working Paper 217. Milan: BAFFI Centre on Economics, Finance and Regulation, Bocconi University, February, https://repec.unibocconi.it/baffic/baf/papers/cbafwp24217.pdf. Vuletin, Guillermo, and Ling Zhu (2011). "Replacing a 'Disobedient' Central Bank Governor with a 'Docile' One: A Novel Measure of Central Bank Independence and Its Effect on Inflation," Journal of Money, Credit and Banking, vol. 43 (September), pp. 1185-1215. Walsh, Carl E. (2003). Monetary Theory and Policy, 2nd ed. Cambridge, Mass.: MIT Press. Yellen, Janet L. (2015). "Inflation Dynamics and Monetary Policy," speech delivered at the Philip Gamble Memorial Lecture, University of Massachusetts, Amherst, September 24, https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm.	Adriana D Kugler	United States	https://www.bis.org/review/r241125b.pdf	For release on delivery 7:00 a.m. EST (9:00 a.m. local time) November 14, 2024 Central Bank Independence and the Conduct of Monetary Policy Remarks by Adriana D. Kugler Member Board of Governors of the Federal Reserve System at the Albert Hirschman Lecture Montevideo, Uruguay November 14, 2024 Thank you for your generous introduction, Marcela, and thank you for the opportunity to be here and speak to you today. I believe I am the first central banker from the U.S. to address this annual meeting, but I know, and am proud to say, that I am the first who is also Latin American. And, of course, I have been part of the LACEA Executive Committee and I have presented papers at many LACEA conferences over the years, so it is a pleasure to be back here among many colleagues. When the United States suffered very high inflation beginning in 2021, it was a new and unfamiliar experience for many too young to recall the last time this occurred in the 1970s and 1980s. Of course, very high inflation is not such a distant memory for people from Latin America and the Caribbean, and that includes me. Growing up in Colombia, I vividly recall the daily challenges of trying to plan and live with sustained double-digit inflation, and I especially remember the pain it imposed on disadvantaged people. Gaining control over inflation requires a commitment by society to accept the tradeoffs and sacrifices often needed, and it also requires deliberate and principled decision making by central banks. Central bankers must both formulate their best judgment of the correct policies that will achieve a desired level of inflation and follow through by executing and maintaining those policies. It has been widely recognizedand is a finding of economic research-that central bank independence is fundamental to achieving good policy and good economic outcomes. It is not sufficient by itself to achieve those goals, but, over time, it is almost always necessary. Let me start by defining terms. An independent central bank is one that can carry out monetary policy insulated from pressures arising from other parts of government or elsewhere. When there is central bank independence, the role of national or jurisdictional governments is typically one of representing the public in specifying a mandate for the central bank and holding the central bank accountable by monitoring its performance and appointing central bank leadership. In this arrangement, the public, through representative government, specifies the overall objectives that central banks should pursue. Some noteworthy examples of central bank mandates include the dual mandate established by the U.S. Congress that requires the Federal Reserve Board and the Federal Open Market Committee (FOMC) to promote maximum employment and price stability. The European Central Bank's primary mandate of price stability is spelled out in a treaty enacted by the legislatures of its constituent member states. The central bank of Brazil pursues price stability as its primary objective as well. In the United Kingdom, its parliament has mandated that the Bank of England pursue monetary and financial stability. Similarly, the objectives of the central banks of Chile and Uruguay are both to keep inflation low and stable and to foster the stability and efficiency of the financial system. Before we discuss why monetary policy independence can benefit the economy, let me take a step back and discuss the tradeoffs associated with the conduct of monetary policy. Central banks significantly influence prices, interest rates, employment, and income in the economy, so it is natural that sometimes there would be differing views on their decisions. For instance, monetary policy actions that promote economic activity and employment growth can put upward pressure on inflation. Conversely, policies to lower inflation tend to slow economic activity and employment growth. This tradeoff typically means that returning inflation to a specific target level when inflation has been allowed to run high may require more restrictive policy and a reduction in demand and higher unemployment. As I pointed out in a speech last spring at Stanford University, however, we have seen this tradeoff dissipate over the past couple of years, pointing to the possibility that we have been now for some time on the steep part of the Phillips curve, where inflation can come down substantially without a big increase in unemployment. Yet there is a possibility that this tradeoff may become more prominent as we move toward the flatter part of the Phillips curve. The economic literature points out that striking a balance in these tradeoffs can be difficult for an elected or otherwise representative government for various reasons. One reason highlighted in the literature is that an elected government may be naturally focused on the short-term goals of its constituents and may have an incentive to try to lower the unemployment rate in the short run, with less concern about the longer-term effects on inflation and growth. The literature has labeled this fundamental problem "time inconsistency." This incentive may generate undesirable economic cycles, potentially destabilizing prices. And if the public learns over time that the central bank is responsive to these incentives to increase inflation to boost employment temporarily, expectations of future inflation would rise, a symptom of a loss of credibility of the monetary policy authority. Governments also may have an incentive to increase inflation to monetize their debts, which become effectively smaller as the purchasing power of money declines. Also, if elected officials are responsible for monetary policy decisions, the typical alternation in control of government between different parties may lead to different preferences in the tradeoff between employment and inflation, destabilizing prices and the economy in the long term. In summary, economic research argues that demands on government to address concerns in the short term may result in excessively discretionary monetary policy and do not provide the best incentives for effective monetary policy that promotes the long-term health of the economy. A solution devised by governments and explored in economic research is to delegate monetary policy to an independent entity: the central bank. By establishing policy mandates in laws or treaties, the government voluntarily constrains itself from suddenly altering policy, and thus it also discourages public pressure to do so. As in Homer's Odyssey, in which Odysseus asks his crew to tie him to the mast of his ship to avoid being bewitched by the Sirens' songs, policy mandates help central banks avoid being swayed by short-term desires to the detriment of longer-term goals. Now that we have discussed the reasons for delegating the authority to conduct monetary policy to an independent entity, we are left with the task of describing how such independence should be designed and implemented in practice. There are two broad categories of central bank independence. The first of these is goal independence-to what extent is the central bank free to define its goals? The research literature makes a distinction between instrument independence-the prerogative to make monetary policy decisions, which I will discuss more later-and goal independence. In particular, the Federal Reserve's goals are defined by law, so it is not goal independent. Nevertheless, in spelling out those goals, the law provides the Federal Reserve with some degree of independence in defining them in detail. First, let's talk about the extent to which the law has defined the Federal Reserve's monetary policy goals. Unlike some other central banks that target inflation, the FOMC has been handed two coequal goals-maximum employment and price stability. The Committee is not free to pursue one or the other-it must pursue both. And these two sides of the mandate are pretty clear. Maximum employment means, in effect, the lowest unemployment rate that is consistent with stable prices. The law does not spell out a level of inflation that fulfills the goal of stable prices, but it has traditionally been viewed as a low and stable inflation rate. Mandates limit goal independence, but the form of those mandates can allow some role for the central bank in setting out its goals. The 1977 law defined the Federal Reserve's dual mandate, allowing the FOMC to work out the details. In 2012, the FOMC defined price stability as a longer-run annual inflation rate of 2 percent, as measured by the Commerce Department's estimate of the rate of increase in the personal consumption expenditures (PCE) deflator. Because maximum employment is unobserved and likely changes over time, it can be estimated only with considerable uncertainty; thus, the Committee chose not to define it in numerical terms. But Committee participants estimate a related number, the longer-run rate of unemployment, which is published every three months in the Summary of Economic Projections. Another aspect of independence is instrument independence, which affords central banks flexibility in how to use the tools of monetary policy, such as policy interest rates, to achieve their goals. In the case of the FOMC, instrument independence has allowed it to adopt new ways to achieve its goals, as the financial system has evolved over the decades. This has been particularly important when the economy faced unprecedented challenges, as it did during the 2008 Global Financial Crisis and during the 2020 pandemic. Because of this flexibility, the Federal Reserve Board and the FOMC were able to respond promptly and, as it turned out, very effectively. Across countries and jurisdictions, goal independence and instrument independence have different dimensions and many variations. In some countries, including India, Brazil, and South Korea, the targets for inflation rates are jointly decided by the central bank and the ministry of finance. In contrast, the central banks of Chile, Colombia, Mexico, and Peru, among others, are given authority to choose their own inflation objectives. To understand how governments have come to embrace the independence of central banks, it is helpful to review how they have evolved from their origins in the 17th century. Sweden's Riksbank was established by the private sector in 1688 to lend the government funds, and the Bank of England followed in 1694, with a similar structure and purpose. Other European central banks followed in the 19th century and a wave of many more in the 20th, including the Federal Reserve. At different times, these central banks made the transition from wholly private to wholly public institutions and became accountable to government, and by the mid-20th century, there was a growing recognition that independence made for a more practical and, ultimately, more effective central bank. In the United States, the moment of truth came in 1951. During World War II, the Federal Reserve had agreed to peg interest rates on Treasury securities in order to ensure smooth funding of the war effort, and after the war, it continued to peg the longer-term Treasury rate. In the early 1950s, inflation soared, but Treasury favored continuing a cap on longer-term interest rates so that debt management costs could continue to be low during the Korean War. After a series of high-level meetings, the Federal Reserve and the Treasury reached an agreement in 1951 that freed the Fed from the obligation to fix interest rates and allowed it to use monetary policy independently to pursue national economic goals. Researchers have analyzed the historical experiences of particular central banks, such as the Federal Reserve, to understand the transition toward central bank independence and how it affects economic performance. Economic research has cited several factors driving this adoption of central bank independence. In the 1980s and 1990s, emerging economies saw central bank independence as a way to facilitate access to global trade and financial markets, which were liberalized during that time. To whatever extent these other factors pushed governments toward central bank independence, a consensus developed that such an arrangement yielded better economic outcomes. Based on measures of central bank independence, researchers indeed have found a relationship between independence and lower inflation, especially for advanced economies. Indeed, alternative measures of independence, such as turnover of central bank governors, point to de facto measures being negatively associated with inflation, especially in emerging economies. The relationship between central bank independence and lower inflation and inflation volatility is therefore clear. But the connection to faster growth in economic activity is not. On the one hand, the primary reason for central bank independence in most countries with a single mandate is to provide price stability, so the lack of association between monetary policy independence and adverse economic consequences is not surprising. Also, in practice, although the recent inflation run-up showcased the commitment of most central banks to fight inflation, it also appears that they have been willing to provide some accommodation after having gained greater confidence that inflationary pressures have dissipated. In fact, most central banks have initiated an easing cycle even with inflation still somewhat above their respective targets and regardless of the presence or not of an employment goal in their mandates. So if central bank independence does improve inflation outcomes, one question is how it accomplishes this. Let me return to an issue I mentioned earlier: credibility. If the central bank is credible about its longer-run inflation target, it would be a natural outcome that long-run inflation expectations will tend to be closer to the target than when that credibility is lacking. And a central bank will be more credible if it takes actions that lead the public to be confident that the central bank is actively pursuing its stated goal. It is possible to formalize the channel through which a central bank chooses a long-run inflation target and the public slowly learns about its commitment to achieving it, thus gradually anchoring long-run expectations. The public observes inflation and economic activity outcomes as well as the central bank actions (say, changes in the federal funds rate), and it updates its long-run inflation expectations, which, in this model, coincide with its perception of the long-run target. For instance, a nominal interest rate that is higher than expected, given observed inflation and economic activity and the public's long-run inflation expectations, leads to an updated-lower-value of the perceived inflation target. If the central bank's policy actions are consistent with its long-run inflation goal, the public's long-run expectations will gradually settle at the central bank's long-run goal: This dynamic will anchor inflation expectations to the long-run target. The stock of credibility of a central bank will be reflected in long-run inflation expectations moving in a relatively narrow range close to the stated inflation goal. Conversely, inconsistent actions will imply that agents will update their long-run expectations higher or lower, depending on the direction of surprises in central bank actions, causing de-anchoring of expectations. Despite a very large inflation shock starting in 2021, available measures of long-run inflation expectations, such as those in the Survey of Professional Forecasters or the Livingston Survey, increased just a bit compared with the inflation run-up and quickly descended in 2023. That can be taken as a sign of anchoring and sufficient central bank credibility through the lens of the model just described. And, to the extent that long-run inflation expectations matter to the dynamics of actual inflation, such as in some Phillips curve models, anchoring of inflation expectations is one of the key elements leading to stable inflation. The model also offers an interpretation of and a contrast to the behavior of inflation and inflation expectations during the Great Inflation of the 1970s and in the post-pandemic period. As inflation rose in the 1970s and monetary policy actions failed to rein it in, the Federal Reserve lost credibility, and longer-term expectations of future inflation rose toward the end of the decade. The Federal Reserve struggled for years to rebuild that credibility, resulting in high and volatile inflation. Conversely, in the recent episode, inflation has traveled a long way from its peak, with no deterioration in economic activity and comparatively limited movement in long-run inflation expectations. Credibility is enhanced by transparency and accountability, and I will conclude with a discussion of how these principles are carried out by the Federal Reserve. The Federal Reserve seeks to explain as clearly as possible what it is trying to do in carrying out its dual-mandate objectives and how it is trying to do it. Such transparency and accountability are necessary under our democratic system but are perhaps especially important for the Federal Reserve, which has been assigned such an important role in promoting a healthy economy. In addition to conferring legitimacy for decisions, transparency makes monetary policy more effective, as the public better understands our monetary policy reaction function, which informs the public on how our decisions are shaped by economic conditions. Monetary policy works in part by trying to influence the public's view of future economic conditions, so it is crucial that these intentions are clearly communicated. The Federal Reserve promotes transparency by issuing a postmeeting statement explaining its decision and then following up with more detailed minutes three weeks later. Every three months, FOMC participants' projections for inflation, unemployment, economic activity, and the likely path of monetary policy are published in the Summary of Economic Projections. The Chair conducts press conferences after each FOMC meeting, and both the Chair and FOMC participants further explain their reasoning on policy in speeches, news interviews, and other public appearances. The Chair testifies to Congress on monetary policy twice a year, responding to questions from lawmakers. Transcripts of FOMC meetings are published after five years. More recently, the Fed has adopted the practice of periodically reviewing its monetary policy strategy, tools, and communication practices, including holding public Fed Listens sessions around the country to get public input. Transparency is likewise seen in other economies as fundamental to monetary policy independence, which has increasingly been recognized for delivering better policy decisions that are more focused on the longer-term health of an economy. Research continues to add to our understanding of the extent of these better outcomes in different economies and also how independence works in different institutional arrangements. The goal, of course, is more stable economies that deliver broadly rising living standards-in Latin America, the Caribbean, and around the world. Let me now turn to the current economic outlook in the United States and how our monetary policy independence has permitted us to get where we are now. The United States has seen considerable disinflation while experiencing a cooling but still resilient labor market. Numbers just released this week show headline and core PCE inflation have fallen substantially from 7.1 percent to an estimated 2.3 percent and from 5.6 percent to an estimated 2.8 percent, respectively. While wage moderation and anchored inflation expectations may allow us to continue making progress on inflation, stubborn housing inflation and high inflation in certain goods and services categories may stall progress in reaching our target. At the same time, labor markets have rebalanced, given greater labor supply from immigration and prime-age workers and lower demand from restrictive monetary policy. Thus, although the labor market experienced an extended period of low unemployment and job creation these past several years and strong real wage growth, the labor market has cooled. This combination of a continued but slowing trend in disinflation and cooling labor markets means that we need to continue paying attention to both sides of our mandate. If any risks arise that stall progress or reaccelerate inflation, it would be appropriate to pause our policy rate cuts. But if the labor market slows down suddenly, it would be appropriate to continue to gradually reduce the policy rate. Thank you again for inviting me to address you today. I would be glad to spend some time on further discussion of my presentation and to respond to your other questions.
2024-11-15T00:00:00	John C Williams: 100 years at 33 Liberty Street	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the New York Fed Alumni "Celebrating 100 Years of Making Our Mission Possible", Federal Reserve Bank of New York, New York City, 15 November 2024.	John C Williams: 100 years at 33 Liberty Street Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the New York Fed Alumni "Celebrating 100 Years of Making Our Mission Possible", Federal Reserve Bank of New York, New York City, 15 November 2024. * * * As prepared for delivery Introduction Welcome back! It's wonderful to see so many of our alumni joining us today as we celebrate the 110th anniversary of the New York Fed-and the centennial of our Liberty Street home. Buildings tell stories. And this unique building-made of sandstone and limestone, with vaulted ceilings and a gold vault in the basement-has much to say about where we've been, where we are, and where we're going. It stood as a beacon of strength during crises: Black Thursday, Black Monday, 9/11, the Global Financial Crisis, and the COVID-19 pandemic. And it's witnessed remarkable change-in the global economy and financial markets, in technology and the ways we work, and, as you see in the photos, in hair styles and office attire. But just as 33 Liberty Street kept its distinctive stone exterior as glass skyscrapers grew around it, our dedication to the mission of serving the American public has remained constant. And throughout our history, our ability to be at the forefront of anticipating, adapting, and acting in a fast-changing world has helped us ensure the strength of the U.S. economy and the stability of the global financial system. Each of you has played a critical role in this journey. And today, we're excited to share a little bit about what we're doing to prepare for the future. You'll hear about our plans for the new Cash Services Center and the ways technology is transforming our work-including how we are using artificial intelligence. We'll also discuss the work we do with communities within the Second District, as well as how we are adapting to a changing workplace, including increased flexibility in where and how we do our work. Before we break into sessions that will delve deeper into these topics, I'll provide some of the backstory. And since we are celebrating our building's centennial, I'll use 33 Liberty Street as the backdrop. But first, as you all know, I must give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. Paper and Pages When you look at photographs from the past, what's most striking is how technology has altered how we do our work. This is true throughout the history of the New York Fed. The early days were defined by paper. Lots of paper. Paper cards, paper tape, stacks of paper on desks, folders of paper in file cabinets. We communicated by paper, gave authorizations on paper, and recorded transactions on paper. Pages hurried down the halls, delivering important papers to people across the Bank. And of course, there were landline telephones-those box-like devices with buttons, curly cords, and handles that you would hold up to your ear. Now they sit at the corner of our desks, gathering dust. In fact, with the advent of more integrated communications technology, we will soon dispense with desktop phones altogether. We still are tied to our phones, but not by cords. Many of you remember your BlackBerry-some with fondness, others, well maybe not so much. Now, we are all connected 24/7/365. Some of you may have even started your New York Fed careers working on huge, boxlike computers. Although these technologies often look antiquated today, they were state of the art at the time. Thankfully, computers have gotten smaller and lighter, wireless networks have made them portable, and data and processing are moving to the cloud. There was also a time when our cash business was based in this building, with currency verification on the third floor. Employees would flip through bills like casino dealers dealing cards, eyeballing money to spot counterfeits. Later, we turned to using jewelers' microscopes. Now, the microscopes have mostly been replaced by very hightech sensors. Our cash operations business expanded so much that in 1992, we moved it to EROC, our East Rutherford Operations Center. EROC was also one of many places in the Second District that processed checks. This is another business that has changed radically. At its peak in 2001, EROC alone processed an average of over three million checks per day. But by 2006, check usage had declined dramatically, and EROC stopped processing them altogether. EROC is now solely focused on the storage, distribution, and processing of U.S. currency and coin-not just for the Second District, but internationally as well. The Best of Who We Are Bringing the story to more recent times, the pandemic shutdowns and their aftermath meant the New York Fed once again was called on to play its pivotal part in helping to stabilize the economy and financial markets. Historians will long write about events of the past five years and the role the New York Fed played. As an institution, we moved quickly and decisively. We carried out record amounts of open market operations. And we set up and operated emergency facilities that, in short order, restored calm and stability to financial markets disrupted by the onset of the pandemic. My favorite quote from this time is from a colleague who said that she never imagined doing the best work of her career in pajamas and flipflops. Left unwritten is that our people were also caring for children and ensuring their elderly parents were safe. Some lost loved ones. We lost loved ones. And while many of us worked from home, our essential on-site workers came to the office every day. I will always remember how we supported each other while we worked tirelessly to carry out our mission. The crisis brought out the best of who we are. And it forever changed the ways we work. It wasn't just about going virtual. Technology helped foster greater collaborationwithin teams, among groups, and across the System. We discovered that video calls can be more personal than phone calls. Brainstorming, once done sitting around a white board, can now be performed in shared documents from different locations. And processes are becoming automated and less fragmented. All of this has empowered our people to apply their diverse perspectives and unique talents in new ways. It's one of the many reasons we are committed to making the most of the hybrid work model-what we call our flexible work evolution. And once futuristic technologies are now part of our present. Our robots (or automated guided vehicles)-with cool names like Johnny 5, Megahertz, and Super Bad Decepticonhelp us process up to $700 million of cash each day. Innovating and Driving Progress Technology has made our work easier, but it's our people who are innovating and driving progress. Our culture is shifting. We're using Agile methods to innovate and experiment. To try new things and not be afraid to fail. To learn from failure and try again. This mindset of experimentation is already paying dividends. For example, our Data & Statistics team is using generative AI and developing prototypes to analyze data, spot anomalies, and suggest follow-ups. These efforts will provide deeper insights and save analysts' time. Of course, this is in an exploratory stage. But the opportunities feel endless. We are also collaborating with our peers from around the world through the New York Innovation Center, which is studying the potential of new technologies in central banking. And we are modernizing technologies in some of our most critical responsibilities in supplying currency and implementing monetary policy. Plans are now underway to create a next-generation Cash Services Center that eventually will replace EROC. And earlier this week, our Markets Group announced the development of FedTrade Plus, an innovative new trading platform for open market operations and the account services we provide to other central banks. This is a critical system that is core to what we do at the Fed: Annually, we carry out nearly 900 operations and process around $32 trillion-that's trillion with a "T." Going back to our history, auction bids have been submitted in person, by mail, by phone, and electronically-with every innovation seeming like a giant step forward. This new platform will allow us to analyze the performance of open market operations in real time, and it will substantially simplify the user experience. Our Greatest Strength Change has defined our century at 33 Liberty Street. We have reinvented ourselves many times, and we can only imagine how our work will evolve over the next 100 years. But the story of 33 Liberty Street is very much about its people. Our people-people like you-have been, and always will be, our greatest strength. Our mission is what brings us together. We are here to serve our communities, to support the strength of the U.S. economy and global financial system, and to do so in an environment where we innovate, learn, and move forward together with agility. So today is a day to celebrate our building's centennial-and the people who make us who we are.	---[PAGE_BREAK]--- # John C Williams: 100 years at 33 Liberty Street Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the New York Fed Alumni "Celebrating 100 Years of Making Our Mission Possible", Federal Reserve Bank of New York, New York City, 15 November 2024. ## As prepared for delivery ## Introduction Welcome back! It's wonderful to see so many of our alumni joining us today as we celebrate the 110th anniversary of the New York Fed-and the centennial of our Liberty Street home. Buildings tell stories. And this unique building-made of sandstone and limestone, with vaulted ceilings and a gold vault in the basement-has much to say about where we've been, where we are, and where we're going. It stood as a beacon of strength during crises: Black Thursday, Black Monday, 9/11, the Global Financial Crisis, and the COVID-19 pandemic. And it's witnessed remarkable change-in the global economy and financial markets, in technology and the ways we work, and, as you see in the photos, in hair styles and office attire. But just as 33 Liberty Street kept its distinctive stone exterior as glass skyscrapers grew around it, our dedication to the mission of serving the American public has remained constant. And throughout our history, our ability to be at the forefront of anticipating, adapting, and acting in a fast-changing world has helped us ensure the strength of the U.S. economy and the stability of the global financial system. Each of you has played a critical role in this journey. And today, we're excited to share a little bit about what we're doing to prepare for the future. You'll hear about our plans for the new Cash Services Center and the ways technology is transforming our work-including how we are using artificial intelligence. We'll also discuss the work we do with communities within the Second District, as well as how we are adapting to a changing workplace, including increased flexibility in where and how we do our work. Before we break into sessions that will delve deeper into these topics, I'll provide some of the backstory. And since we are celebrating our building's centennial, I'll use 33 Liberty Street as the backdrop. ---[PAGE_BREAK]--- But first, as you all know, I must give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. # Paper and Pages When you look at photographs from the past, what's most striking is how technology has altered how we do our work. This is true throughout the history of the New York Fed. The early days were defined by paper. Lots of paper. Paper cards, paper tape, stacks of paper on desks, folders of paper in file cabinets. We communicated by paper, gave authorizations on paper, and recorded transactions on paper. Pages hurried down the halls, delivering important papers to people across the Bank. And of course, there were landline telephones-those box-like devices with buttons, curly cords, and handles that you would hold up to your ear. Now they sit at the corner of our desks, gathering dust. In fact, with the advent of more integrated communications technology, we will soon dispense with desktop phones altogether. We still are tied to our phones, but not by cords. Many of you remember your BlackBerry-some with fondness, others, well maybe not so much. Now, we are all connected 24/7/365. Some of you may have even started your New York Fed careers working on huge, boxlike computers. Although these technologies often look antiquated today, they were state of the art at the time. Thankfully, computers have gotten smaller and lighter, wireless networks have made them portable, and data and processing are moving to the cloud. There was also a time when our cash business was based in this building, with currency verification on the third floor. Employees would flip through bills like casino dealers dealing cards, eyeballing money to spot counterfeits. Later, we turned to using jewelers' microscopes. Now, the microscopes have mostly been replaced by very hightech sensors. Our cash operations business expanded so much that in 1992, we moved it to EROC, our East Rutherford Operations Center. EROC was also one of many places in the Second District that processed checks. This is another business that has changed radically. At its peak in 2001, EROC alone processed an average of over three million checks per day. But by 2006, check usage had declined dramatically, and EROC stopped processing them altogether. EROC is now solely focused on the storage, distribution, and processing of U.S. currency and coin-not just for the Second District, but internationally as well. ---[PAGE_BREAK]--- # The Best of Who We Are Bringing the story to more recent times, the pandemic shutdowns and their aftermath meant the New York Fed once again was called on to play its pivotal part in helping to stabilize the economy and financial markets. Historians will long write about events of the past five years and the role the New York Fed played. As an institution, we moved quickly and decisively. We carried out record amounts of open market operations. And we set up and operated emergency facilities that, in short order, restored calm and stability to financial markets disrupted by the onset of the pandemic. My favorite quote from this time is from a colleague who said that she never imagined doing the best work of her career in pajamas and flipflops. Left unwritten is that our people were also caring for children and ensuring their elderly parents were safe. Some lost loved ones. We lost loved ones. And while many of us worked from home, our essential on-site workers came to the office every day. I will always remember how we supported each other while we worked tirelessly to carry out our mission. The crisis brought out the best of who we are. And it forever changed the ways we work. It wasn't just about going virtual. Technology helped foster greater collaborationwithin teams, among groups, and across the System. We discovered that video calls can be more personal than phone calls. Brainstorming, once done sitting around a white board, can now be performed in shared documents from different locations. And processes are becoming automated and less fragmented. All of this has empowered our people to apply their diverse perspectives and unique talents in new ways. It's one of the many reasons we are committed to making the most of the hybrid work model-what we call our flexible work evolution. And once futuristic technologies are now part of our present. Our robots (or automated guided vehicles)-with cool names like Johnny 5, Megahertz, and Super Bad Decepticonhelp us process up to $\$ 700$ million of cash each day. ## Innovating and Driving Progress Technology has made our work easier, but it's our people who are innovating and driving progress. Our culture is shifting. We're using Agile methods to innovate and experiment. To try new things and not be afraid to fail. To learn from failure and try again. This mindset of experimentation is already paying dividends. For example, our Data \& Statistics team is using generative AI and developing prototypes to analyze data, spot anomalies, and suggest follow-ups. These efforts will provide deeper insights and save analysts' time. Of course, this is in an exploratory stage. But the opportunities feel endless. ---[PAGE_BREAK]--- We are also collaborating with our peers from around the world through the New York Innovation Center, which is studying the potential of new technologies in central banking. And we are modernizing technologies in some of our most critical responsibilities in supplying currency and implementing monetary policy. Plans are now underway to create a next-generation Cash Services Center that eventually will replace EROC. And earlier this week, our Markets Group announced the development of FedTrade Plus, an innovative new trading platform for open market operations and the account services we provide to other central banks. This is a critical system that is core to what we do at the Fed: Annually, we carry out nearly 900 operations and process around $\$ 32$ trillion-that's trillion with a "T." Going back to our history, auction bids have been submitted in person, by mail, by phone, and electronically-with every innovation seeming like a giant step forward. This new platform will allow us to analyze the performance of open market operations in real time, and it will substantially simplify the user experience. # Our Greatest Strength Change has defined our century at 33 Liberty Street. We have reinvented ourselves many times, and we can only imagine how our work will evolve over the next 100 years. But the story of 33 Liberty Street is very much about its people. Our people-people like you-have been, and always will be, our greatest strength. Our mission is what brings us together. We are here to serve our communities, to support the strength of the U.S. economy and global financial system, and to do so in an environment where we innovate, learn, and move forward together with agility. So today is a day to celebrate our building's centennial-and the people who make us who we are.	John C Williams	United States	https://www.bis.org/review/r241125r.pdf	Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the New York Fed Alumni "Celebrating 100 Years of Making Our Mission Possible", Federal Reserve Bank of New York, New York City, 15 November 2024. Welcome back! It's wonderful to see so many of our alumni joining us today as we celebrate the 110th anniversary of the New York Fed-and the centennial of our Liberty Street home. Buildings tell stories. And this unique building-made of sandstone and limestone, with vaulted ceilings and a gold vault in the basement-has much to say about where we've been, where we are, and where we're going. It stood as a beacon of strength during crises: Black Thursday, Black Monday, 9/11, the Global Financial Crisis, and the COVID-19 pandemic. And it's witnessed remarkable change-in the global economy and financial markets, in technology and the ways we work, and, as you see in the photos, in hair styles and office attire. But just as 33 Liberty Street kept its distinctive stone exterior as glass skyscrapers grew around it, our dedication to the mission of serving the American public has remained constant. And throughout our history, our ability to be at the forefront of anticipating, adapting, and acting in a fast-changing world has helped us ensure the strength of the U.S. economy and the stability of the global financial system. Each of you has played a critical role in this journey. And today, we're excited to share a little bit about what we're doing to prepare for the future. You'll hear about our plans for the new Cash Services Center and the ways technology is transforming our work-including how we are using artificial intelligence. We'll also discuss the work we do with communities within the Second District, as well as how we are adapting to a changing workplace, including increased flexibility in where and how we do our work. Before we break into sessions that will delve deeper into these topics, I'll provide some of the backstory. And since we are celebrating our building's centennial, I'll use 33 Liberty Street as the backdrop. But first, as you all know, I must give the standard Fed disclaimer that the views I express today are mine alone and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or others in the Federal Reserve System. When you look at photographs from the past, what's most striking is how technology has altered how we do our work. This is true throughout the history of the New York Fed. The early days were defined by paper. Lots of paper. Paper cards, paper tape, stacks of paper on desks, folders of paper in file cabinets. We communicated by paper, gave authorizations on paper, and recorded transactions on paper. Pages hurried down the halls, delivering important papers to people across the Bank. And of course, there were landline telephones-those box-like devices with buttons, curly cords, and handles that you would hold up to your ear. Now they sit at the corner of our desks, gathering dust. In fact, with the advent of more integrated communications technology, we will soon dispense with desktop phones altogether. We still are tied to our phones, but not by cords. Many of you remember your BlackBerry-some with fondness, others, well maybe not so much. Now, we are all connected 24/7/365. Some of you may have even started your New York Fed careers working on huge, boxlike computers. Although these technologies often look antiquated today, they were state of the art at the time. Thankfully, computers have gotten smaller and lighter, wireless networks have made them portable, and data and processing are moving to the cloud. There was also a time when our cash business was based in this building, with currency verification on the third floor. Employees would flip through bills like casino dealers dealing cards, eyeballing money to spot counterfeits. Later, we turned to using jewelers' microscopes. Now, the microscopes have mostly been replaced by very hightech sensors. Our cash operations business expanded so much that in 1992, we moved it to EROC, our East Rutherford Operations Center. EROC was also one of many places in the Second District that processed checks. This is another business that has changed radically. At its peak in 2001, EROC alone processed an average of over three million checks per day. But by 2006, check usage had declined dramatically, and EROC stopped processing them altogether. EROC is now solely focused on the storage, distribution, and processing of U.S. currency and coin-not just for the Second District, but internationally as well. Bringing the story to more recent times, the pandemic shutdowns and their aftermath meant the New York Fed once again was called on to play its pivotal part in helping to stabilize the economy and financial markets. Historians will long write about events of the past five years and the role the New York Fed played. As an institution, we moved quickly and decisively. We carried out record amounts of open market operations. And we set up and operated emergency facilities that, in short order, restored calm and stability to financial markets disrupted by the onset of the pandemic. My favorite quote from this time is from a colleague who said that she never imagined doing the best work of her career in pajamas and flipflops. Left unwritten is that our people were also caring for children and ensuring their elderly parents were safe. Some lost loved ones. We lost loved ones. And while many of us worked from home, our essential on-site workers came to the office every day. I will always remember how we supported each other while we worked tirelessly to carry out our mission. The crisis brought out the best of who we are. And it forever changed the ways we work. It wasn't just about going virtual. Technology helped foster greater collaborationwithin teams, among groups, and across the System. We discovered that video calls can be more personal than phone calls. Brainstorming, once done sitting around a white board, can now be performed in shared documents from different locations. And processes are becoming automated and less fragmented. All of this has empowered our people to apply their diverse perspectives and unique talents in new ways. It's one of the many reasons we are committed to making the most of the hybrid work model-what we call our flexible work evolution. And once futuristic technologies are now part of our present. Our robots (or automated guided vehicles)-with cool names like Johnny 5, Megahertz, and Super Bad Decepticonhelp us process up to $\$ 700$ million of cash each day. Technology has made our work easier, but it's our people who are innovating and driving progress. Our culture is shifting. We're using Agile methods to innovate and experiment. To try new things and not be afraid to fail. To learn from failure and try again. This mindset of experimentation is already paying dividends. For example, our Data \& Statistics team is using generative AI and developing prototypes to analyze data, spot anomalies, and suggest follow-ups. These efforts will provide deeper insights and save analysts' time. Of course, this is in an exploratory stage. But the opportunities feel endless. We are also collaborating with our peers from around the world through the New York Innovation Center, which is studying the potential of new technologies in central banking. And we are modernizing technologies in some of our most critical responsibilities in supplying currency and implementing monetary policy. Plans are now underway to create a next-generation Cash Services Center that eventually will replace EROC. And earlier this week, our Markets Group announced the development of FedTrade Plus, an innovative new trading platform for open market operations and the account services we provide to other central banks. This is a critical system that is core to what we do at the Fed: Annually, we carry out nearly 900 operations and process around $\$ 32$ trillion-that's trillion with a "T." Going back to our history, auction bids have been submitted in person, by mail, by phone, and electronically-with every innovation seeming like a giant step forward. This new platform will allow us to analyze the performance of open market operations in real time, and it will substantially simplify the user experience. Change has defined our century at 33 Liberty Street. We have reinvented ourselves many times, and we can only imagine how our work will evolve over the next 100 years. But the story of 33 Liberty Street is very much about its people. Our people-people like you-have been, and always will be, our greatest strength. Our mission is what brings us together. We are here to serve our communities, to support the strength of the U.S. economy and global financial system, and to do so in an environment where we innovate, learn, and move forward together with agility. So today is a day to celebrate our building's centennial-and the people who make us who we are.
2024-11-18T00:00:00	Philip R Lane: The 2021-2022 inflation surges and the monetary policy response through the lens of macroeconomic models	Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the SUERF Marjolin Lecture, hosted by the Bank of Italy, Rome, 18 November 2024.	SPEECH The 2021-2022 inflation surges and the monetary policy response through the lens of macroeconomic models Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the SUERF Marjolin Lecture hosted by the Banca d'ltalia Rome, 18 November 2024 Introduction My aim today is to explain how macroeconomic models can help in understanding the extraordinary 2021-2022 inflation surges and the monetary policy response, in the context of the euro area. By and large, the scale and persistence of the inflation surge surprised the central banking community, external experts and market participants. The unexpected nature of the inflation surge triggered many questions about the performance of macroeconomic forecasters. At the same time, macroeconomic models can help us understand why the baseline projections did not foresee the inflation surge in its full scale and speed, while shedding light on the possible mechanisms and channels that may have been missed or under-stated. Scenario analysis has been enhanced and new models have been developed to enrich our understanding of the shocks that hit the economy over this period, as well as the mechanisms through which these shocks were transmitted to inflation. Models also play a central role in constructing some of the measures of underlying inflation that the Governing Council uses as an important cross-check for the inflation outlook. And models are essential in constructing policy counterfactuals to assess whether alternative monetary policy responses might have substantially reduced the scale of the inflation surge. Models therefore play an important role in strengthening our understanding of the recent inflationary surge and assessing the monetary policy response. Model-based retrospective analysis provides several insights into the 2021-2022 inflation surges. The large forecast errors in the inflation outlook over this period were driven, at least initially, by energy and commodity price shocks, especially following the Russia-Ukraine war, and pandemic-related bottlenecks. Subsequently, changes in the transmission of shocks through the pricing chain, and in the behaviour of firms and consumers, likely played an important role in amplifying and propagating these shocks across the economy, converting relative price shocks into a general inflation shock. Supply shocks, primarily originating from external sources, were key drivers of the inflation surges. While global and domestic surges in sectoral demand patterns also contributed to sectoral demand- supply mismatches (in the goods sector in 2020-2021 during the most intense phases of global pandemic lockdowns; in the services sector in 2022 during the post-pandemic reopening phase), the overall level of aggregate demand in the euro area was only barely above pre-pandemic levels by the end of 2022. The pre-dominant role of supply shocks, combined with the fact that inflation expectations were initially signalling significant downside risks, supported the initial looking-through approach for monetary policy. In this context, it is also essential to recall the sequential nature of the shocks: the focus in 2021 was on pandemic-related supply disruptions and sectoral demand-supply mismatches, while the unjustified Russian invasion of Ukraine in February 2022 subsequently triggered extraordinary jumps in gas and oil prices.!2] The post-pandemic full-scale reopening of contact-intensive services sectors also took place in early 2022, after the ending of Omicron-related lockdowns. Put together, the second and third quarters of 2022 saw an extraordinary cocktail of inflation shocks, between the war-related commodity and supply chain shocks and the demand-supply mismatches in the reopening contact- intensive service sectors. If policymakers had had perfect foresight about the shocks that were about to hit the economy, interest rates would have been raised earlier and more sharply. However, conditional on the real-time information available to policymakers (including how this information shaped baseline macroeconomic projections), monetary policy decisions in 2021-2022 were broadly in line with the policy paths indicated by the macroeconomic models.!! This assessment includes both the initial phase in which monetary policy did not respond to the early stages of the rise in inflation and the subsequent phase of a sharp and sustained tightening cycle. This monetary policy response was, and continues to be, an important contributor to the disinflation process. Macroeconomic models have played a central role in helping policymakers in charting this monetary policy course, through their roles in: (a) macroeconomic forecasting; (b) estimating underlying inflation; and (c) calibrating the appropriate interest rate path. This assessment puts the spotlight on the quality of the information set available to policymakers, especially in relation to the macroeconomic projections. I will cover this topic in the next section. The 2021-2022 inflation surges: what did models miss? The inflation surges in 2021 and 2022 surprised professional forecasters, both at the ECB and across other institutions and countries.! Inflation turned out to be much higher and more persistent than had been projected. This is clear from the very large and persistent forecast errors at both short and medium-term horizons in the Eurosystem and ECB staff projections for headline and core inflation. For example, forecast errors at the one-quarter ahead horizon during this period were more than five times larger than the average errors over the previous twenty years for headline inflation (and around twice as large for core inflation) and had the same direction for several successive quarters (Chart 1, left and middle panels). Indeed, the projection error in the December 2021 Broad Macroeconomic Projection Exercise (BMPE) for the year-over-year inflation rate at the end of 2022 was the largest ever, at around eight percentage points. Projection errors were also materially larger than historical averages at medium-term horizons, with projections made early in the period suggesting that inflation would either return to target or fall below target well within the projection horizon. The errors in inflation at a four-quarter horizon, for example, were more than nine times larger during 2022 than the historic pre-pandemic average. This is important, since the medium-term inflation outlook is typically the most relevant for policymakers, given significant lags in the transmission of policy rate changes to inflation. The projection errors for GDP growth were smaller than for inflation, but still significantly above their historical range (Chart 1, right panel). Chart 1 One-quarter-ahead errors in the inflation projections of Eurosystem/ECB staff HICP inflation HICPX inflation Real GDP growth (annual percentage changes) (annual percentage changes) (annual percentage changes) @HICP tm HICPX tm Real GDP growth 25 tm +/-Pre-COVID mean absolute error 25" +/-Pre-COVID mean absolute error 67 +/- Pre-COVID mean absolute error 20 20 15 16 3 05 00 a 202002: -14.64 15 15 6 SERBEAKI VENTER SEQBEAI MEN ZEA er err ere SESSSSssaaegs BESSSSsssaags SBSSS88ssanass SRRRRRRRRRRAR BRRRRRRRRRRAR BRRRRRRRRRAAR Sources: Eurosystem/ECB staff macroeconomic projections for the euro area and Eurostat. Notes: An error is defined as the outturn for a given quarter minus the projection made for that quarter in the previous quarter (for example, the outturn for the fourth quarter of 2022 minus the figure projected for that quarter in the September 2022 ECB staff macroeconomic projections). The latest observation is from the September 2024 ECB staff Macroeconomic Projection Exercise (MPE). In understanding these large forecast errors over 2021-2022, it is important to differentiate between errors due to conditioning assumptions - especially linked to shocks to key variables such as energy or food prices - and errors in the way these assumptions were propagated through the forecasting models. The starting point for the ECB staff projections is a set of conditioning assumptions for the future evolution of key input variables, known as "technical assumptions". For example, the paths for inputs such as commodity prices, including oil and gas prices, and short-term interest rates are based on market expectations at the time of the projection cut-off date.{©! The right panel of Chart 2 shows that the expected paths for oil and gas prices were revised up repeatedly over successive projection rounds at the end of 2021 and throughout 2022. This highlights how energy prices were repeatedly expected by markets - and therefore by our projection models - to decline. However, a sequence of upward surprises to energy prices materialised, especially following the Russian invasion of Ukraine. This sequence of shocks pushed up inflation and compounded forecast errors over successive projection rounds. Chart 2 Headline inflation and energy composite projections from Q1 2020 to Q3 2024 HICP inflation projections Synthetic energy price projections (annual percentage changes) (annual percentage changes) Actual SECPI 12 = Actual HICP inflation (year-on-year) 420 tue 10 100 8 80 6 60 4 40 2 20 0 2 0 RRAKRNNKRKRARRRAR RRARNARRAR RRR 3858585858585 8 685858585353 58 Sources: Eurosystem/ECB staff projections and Eurostat for left-hand scale. Refinitiv and ECB staff calculations for right-hand scale. Notes: Projections for the synthetic energy price index were introduced in 2021. Its methodology was changed in 2023. To account for this, projections before 2023 have been rebased to the new Synthetic Energy Commodity Price Index (SECPI) index. The latest observation is from the September 2024 MPE for the left-hand scale and for the third quarter of 2024 for the right-hand scale. In order to quantify the importance of energy price and other shocks in driving inflation projection errors, we can use models to construct counterfactual paths for inflation under a scenario in which forecasters had perfect foresight at each projection round about how energy prices and other conditioning variables would actually evolve over the projection horizon. This allows projection errors from incorrect technical assumptions to be isolated from the errors related to the transmission of shocks as embedded in models. Of course, the results from such a decomposition depend on the specific model. It is also important to keep in mind that the ECB/Eurosystem staff macroeconomic projections are not purely model based but also include staff judgement. One way to carry out this counterfactual exercise is to use the Basic Model Elasticities (BMEs) of the Eurosystem national central banks (NCBs), which summarise the key relations between projection variables.[8] This exercise suggests that a substantial share of forecast errors for inflation during 2021 and 2022 was due to errors in the technical assumptions.!2! For example, errors in assumptions about oil and gas prices accounted for the majority of the one-quarter ahead inflation projection error until early 2022 (yellow and green bars in Chart 3).42 Subsequently, however, the importance of other factors affecting food and core inflation grew in importance. Chart 3 Decomposition of recent one-quarter-ahead HICP inflation errors in Eurosystem/ECB staff projections (annual percentage points; percentage point contributions) @ Total error ®@ Other factors affecting HICP energy ®@ Oil and gas price assumptions on HICP energy Other factors affecting HICP food M@ Oil and gas price assumptions on HICP excl.energy Mm Other factors affecting HICP excl. energy and food @ Other conditioning assumptions Q4 20 for Q1 21 for Q221 for Q321 for Q4 21 for Q1 22 for Q2 22 for Q322 for Q4 22 for Q1 23 for Q223 for Q323 for Q4 23 for Q1 24 for Q2 24 for Q121. -Q221. -Q321. 421.122) 222) 322) 422) 123) 223 323) 423 124 2243 24 Source: ECB calculations. Notes: "Total error" is the outturn minus the projection. The labels on the horizontal axis indicate the quarter in which the projections were published and the quarter to which those projections relate (i.e. "Q4 20 for Q1 21" denotes projections for the first quarter of 2021 that were published in the fourth quarter of 2020). The decomposition is based on updated elasticities derived from Eurosystem staff macroeconomic projection models as at late 2023. "Other assumptions' refers to exchange rates, short and long-term interest rates, stock prices, foreign demand, competitors' export prices and food prices". The latest observation is from the June 2024 Eurosystem staff Broad Macroeconomic Projection Exercise (BMPE). Further insight can be gained by running this counterfactual exercise in a fully-fledged macroeconomic model. ECB-BASE is the workhorse large-scale estimated semi-structural model used at the ECB to support and cross-check the staff projection exercises.""] Decomposing the eight percentage point projection error at the peak of inflation in the fourth quarter of 2022 - relative to what had been projected in December 2021 - confirms that around half was due to unexpected developments in technical assumptions around oil and gas prices (red and yellow bars in Chart 4). Nearly one third, on the other hand, was due to errors in food inflation (dark grey bar in Chart 4), while the remainder was due to other factors that drove the error in core inflation (light grey bars in Chart 4). As such, errors in the set of technical assumptions go a long way towards explaining the forecast errors.(12] At the same time, a sizeable share of the inflation forecast errors over this period cannot be explained by errors in the assumptions around energy and food prices. Two explanations for the remaining errors seem plausible. The first explanation relates to statistical uncertainty. Macroeconomic forecasting models are underpinned by empirical estimates of model relations that are based on historical regularities. Statistical uncertainty around these estimates maps into statistical uncertainty around the central tendency of the inflation projection. Conditioning on the ex-post values for the technical assumptions, the statistical distribution around the inflation projections from the vantage point of December 2021 is relatively wide (Chart 4, blue area).!"5] The actual inflation outturns (solid blue line in Chart 4) experienced during the inflation surge were close to the bounds of this model uncertainty, although inflation was still slightly too high to be compatible with the model in the second half of 2022 and the first half of 2023. Overall, correcting for the actual path of energy prices and other conditioning variables, it cannot be ruled out that actual inflation was largely consistent with the historically-estimated statistical distribution around forecasts. This would imply that the economic relations estimated in the models to capture the transmission of shocks to inflation have remained broadly valid during the inflation surge, so long as the full statistical distribution is taken into account. Chart 4 Decomposition of HICP inflation projection errors in December 2021 BMPE conditioning on December 2022 BMPE assumptions using ECB-BASE (annual percentage changes) (percentage point contributions) Other factors = = = = December 2021 BMPE Impact of HICP food = Actual (Solid) + June 2024 projections = Impact of other assumptions - - December 2021 BMPE + assumptions = Indirect impact of HICP energy '4 9 = Direct impact of HICP energy 10 I 8 e 9 I 8 I 7 7} 6 6 I 5 5 I 4 4 3 3 2 2 11 0 1 al 0 2021 2022 2023 2024 December 2021 BMPE for Q4 2022 Source: ECB-BASE, Eurostat, December 2021 BMPE and June 2024 BMPE. Note: "December 2021 BMPE + assumptions' is simulated using the December BMPE baseline, but imposing the paths of HICP energy, HICP food and other technical assumptions from the June 2024 BMPE. The second explanation is that economic relations might also have (temporarily) shifted during this extraordinary episode, including through an array of non-linear responses to the scale and combination of the shocks and the shift in the level of inflation. For example, in a high inflation environment, firms may adjust their prices more often than normal, in an attempt to pass on rapidly rising input and operational costs and protect their profits." Furthermore, the broadening of the inflation shock from the energy sector (including via the food sector) to the services sector may also have been amplified during 2022 by the strong demand for contact-intensive services (tourism, hospitality) due to the reopening of these sectors after the final pandemic lockdowns. While costs were increasing quickly, the price elasticity of demand for services was plausibly atypically low due to this pandemic reopening phase, allowing for a greater pass-through of the cost shocks. Furthermore, these conditions were ripe for a non-linear responses feedback loop between inflation and short-term inflation expectations. It is plausible that short-term inflation expectations are more sensitive to large inflation shocks than to small inflation shocks. Although longer-term inflation expectations remained broadly stable throughout, perceptions of past inflation and short-term expected inflation rates did increase in response to the inflation surges. In the event of a large inflation shock, an increase in near-term inflation expectations may take hold among households and firms, with firms anxious to avoid suffering relative price declines and households more likely to attribute individual price increases to general inflation than to a relative price increase. Indeed, the evidence suggests that there was a marked increase in the frequency of price increases over the course of 2022 (Chart 5).!"5] This state-dependent increase in the frequency of price adjustments resulted in the faster-than-normal pass-through of the unique and large sectoral shocks. In terms of the key Phillips Curve macroeconomic relation between slack and inflation (whether at aggregate or sectoral levels), this can be interpreted as some combination of a shift up in the curve and an increase in the slope of the Phillips Curve. And indeed, estimates from a time-varying parameter model show some increase in the slope of the Phillips curve from early 2021 (Chart 6, left panel). Furthermore, the evidence based on sectoral data also shows a shift in the correlation between sectoral capacity utilisation and sectoral prices increases (Chart 6, right panel).!"©] While the 2021- 2022 inflation surges should not be interpreted as primarily originating in the recovery of product and labour markets from the 2020 pandemic lows, the domestic rebound added to overall inflationary pressures. I return to the contribution of domestic demand in the next section. Chart 5 Frequency of consumer price changes over time, by aggregate product category (percentages) += Frequency of price changes Frequency of price increases «= Frequency of price decreases a) Food 5 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 b) Non-energy industrial goods 15 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 c) Services 20 15 10 perro Pak RE RT REIT) ran 7 aC 2015 2016 2017 2018 2019 2020 2021 2022 2023 Sources: Consumer price micro-datasets from the national statistical institutes of Germany, Estonia, Spain, France, Italy, Latvia and Lithuania. Notes: The chart shows the weighted average frequencies of price changes (excluding sales). VAT changes in Germany (2020-21) and Spain (2020-23) have been excluded. The solid lines plot the average over the period 2015-21 and half-year averages over the period 2021-23. The latest observations are for December 2023. Chart 6 Increasing pass-through from slack to inflation Slope of the Phillips curve Correlation between sectoral capacity utilisation and inflation (percentages) (annual percentage changes; deviation from long term average) 75-84% 25-75% 25% 1013-19 ©2013-19 018 16-25 Median 2002 «2005 «= 2008)39 «2011S 2014 )9= 2017 = 2020 2024 Services capactty utilisation Manufactur Sources: Eurostat, DG-ECFIN and Eurosystem calculations. Notes: Left chart: the Phillips curve specification relates the quarter-on-quarter growth rate of the seasonally adjusted HICP index to its own lag, capacity utilisation in industry, the lagged growth rate in import prices and medium-term survey-based inflation expectations. Time-varying parameter estimates where coefficients and log variance of residuals are assumed to follow a random walk. Right chart: services and manufacturing capacity utilisation are shown in deviation from the pre-COVID long-term average. Faced with large forecast errors and significant uncertainty, ECB staff worked to develop new models and enhance the scenario analysis in the policy process. The new models developed include models of underlying inflation, satellite models that allow for alternative transmission channels, and machine learning models that try to allow for important non-linearities."4 Each of these approaches can help to cross-check projections from the main forecasting models. In turn, the staff judgement element in the forecasting process enables the incorporation of the results from these supplementary analytical exercises, both in the baseline and in the risk assessment. No doubt the lessons learned from the 2021-2022 high inflation episode will prove to be especially valuable in the future if a similar configuration of shocks were to arise. The recent experience certainly highlights the risks of over-reliance on baseline projections. Scenarios can be an effective way to represent risks when uncertainty is large or hard to quantify.) In 2020 and 2021, each set of quarterly staff projections included scenario analyses based on alternative assumptions regarding the future evolution of the pandemic and its economic consequences. In 2022, alternative scenarios focused on the economic consequences of the war in Ukraine, especially as regards uncertainties about energy supply. More recently, the scenario analysis has focused on more specific risks, such as a slowdown in the Chinese economy or a potential escalation of the conflict in the Red Sea area. In my May 2024 Stanford speech, I discussed how these alternative scenarios can be used to construct policy counterfactuals and will go into more details in a forthcoming speech on the use of scenarios to assess the robustness of alternative policy paths.I In addition to scenario analysis, the macroeconomic projections are accompanied by a large set of sensitivity analyses in relation to shifts in the technical assumptions and alternative parameter choices in model calibration. Demand versus supply shocks Models have also been deployed to interpret forecast errors through the lens of identified structural shocks and to quantify their contribution to inflation. Estimates from a large structural vector autoregressive (VAR) model - which employs sign and zero restrictions to identify the global and domestic demand and supply shocks driving deviations of inflation from the model-implied mean - indicate that external supply shocks were the main driver of the initial inflation surge in the euro area, although shocks to external demand and domestic demand also played a role, especially during 2022 (Chart 7).29 In particular, the shock decomposition points to various phases. The initial inflation increase was mainly driven by global supply shocks, related to supply chain disruptions, surging oil and gas prices and higher commodity prices more generally. These results supported an initially-circumspect monetary policy response, as the central bank still gathered evidence about the persistence of the inflation shock and its likelihood to affect materially expectations and other behavioural relations in the economy. In particular, in the absence of a clear understanding of the nature and expected persistence of the shocks, a more patient and deliberate policy response that weighs up the risks to different options, appeared appropriate. In a second phase, the indirect effects from energy and food price spikes, as well as supply chain bottlenecks, passing through into core inflation led to the broadening of inflation pressures. Increasing demand, in particular in supply-constrained contact-intensive services, such as tourism and hospitality, added to inflationary pressures. Together with the risk that high inflation might de-stabilise inflation expectations, the increasing contribution of domestic demand add to the case for the aggressive monetary policy reaction that took place in this phase. In a third phase, as the energy and supply chain disruptions abated and monetary policy dampened demand, headline inflation started to decline rapidly. Chart 7 Supply and demand drivers of inflation dynamics (annual percentage changes and percentage change contributions; deviations from mean) Global supply tm@ Idiosyncratic tm Domestic supply = HICP-Headline Global demand I Domestic demand 0 =m Pa PeeTrereerii lid 4 2020 2021 2022 2023 2024 Sources: Eurostat, ECB, Eurosystem, and ECB staff calculations. Notes: historical decomposition based on a large BVAR model accounting for a rich set of inflation drivers, identified with zero and sign restrictions, see Banbura, M., Bobeica, E. and Martinez Hernandez, C., (2024) "What drives core inflation? The role of supply shocks", ECB Working Paper No. 2875. The chart shows the deviations of HICP inflation from the mean implied by the model. The latest observation is for September 2024. Of course, inference is sensitive to the type of model and the set of identifying assumptions.!24] A key challenge is to correctly capture the information set. A model needs to contain sufficient information to span the space of the structural shocks of interest. Otherwise, the correct shocks cannot be recovered from the history of observed variables. In stylised terms, the larger the model (or the more variables that are included), the more room there is to control for the different factors that affect inflation and, in particular, to separate out shocks from structural drivers. This is particularly relevant when inflation is driven by a multifaceted and unusual set of shocks and structural drivers, originating both at home and abroad, as was the case over the 2021-2022 period. The dramatic fallout from the pandemic and the rapid bounce back following the reopening of economies after lockdowns are cases in point. In turn, amongst its many other effects, the shock of the Russian invasion of Ukraine constituted an extraordinarily-disruptive supply shock to the energy sector. As it turns out, models that rely on a small information set tend to assign a stronger role to demand factors and predict over-smooth dynamics of inflation and growth because such small-scale models are not designed to capture the type of sudden changes witnessed in that episode. [22] The policy implications of model-based identification of demand and supply influences are not always easy to draw. That is, the policy implications not only depend on the source and nature of the shock but also its size and persistence. For example, a supply shock that is highly transitory (such as a temporary limitation in oil production in response to a short-lived geopolitical event) or a temporary surge in sectoral demand during the pandemic reopening phase (compounded by initially-limited supply capacity in the contact-intensive services sectors) may call for a looking-through policy response given the significant lags in the transmission of monetary policy.22! By contrast, a string of large and persistent supply shocks in the same direction requires central banks to tighten in order to avoid longer-lasting inflation effects via wage-price spirals and dislocations in expectations. In relation to the latter risk, the de-anchoring of longer-term inflation expectations warrants close monitoring, and models can help policymakers understand the risks of de-anchoring under alternative shocks and scenarios. For instance, simulations using a regime-switching DSGE model suggest that substantial downward de-anchoring risks prevailed throughout most of 2021, due to the low inflation of the previous periods exerting a persistent dampening effect on expectations as well as the initial inflationary shocks being largely understood to be temporary in nature.!24! The further increase in inflation in early 2022 saw a rapid decline in downward de-anchoring risks and an increase in upward de-anchoring risks. The forceful policy response over the course of 2022 and 2023 helped to limit, and then reduce, these upward de-anchoring risks (Chart 8). Later on, risks became more balanced as inflation came down tangibly. Chart 8 Risks of de-anchoring of medium-term inflation expectations (percentage risk of upside and downside de-anchoring risks) @ Downward de-anchoring tm® Upward de-anchoring 60 50 40 30 20 ; BR e eee eee 8 g§ a g§ & & & a 21 21 22 22 2: 2 24 Jun Dec-21 Sep. Mar- Jun Sep: Dec. Mar- Jun: Sep- Dec- Mar- Jun Sep. Sources: ECB calculations based on Christoffel, K. and Farkas, M. (2025), "Managing the Risks of Inflation Expectation De-anchoring", IMF Working Paper Series, 2025, forthcoming. Notes: The charts show the risk of de-anchoring for the staff projections from June 2021 to September 2024. The simulations are based on a regime switching version of the NAWM I (Christoffel, K.. Coenen, G. and Warne, A. (2007)), where the credible regime is defined as the estimated version of the NAWM I, with a fixed inflation target, the de-anchored regime is characterised by a time varying inflation target. Upward de-anchoring is defined as a situation in a de-anchoring episode, where the perceived inflation target is above 2%. The share of de-anchoring is based on 1,000 simulations over a ten-quarter evaluation horizon. The latest observations are from the September 2024 MPE. The speed and strength of monetary policy transmission is also important when calibrating the appropriate monetary policy response.!25! Provided that monetary policy tightening transmits through to inflation in line with historical regularities, then our models should provide a good guide as to how fast and how far policy rates would need to be increased in response to the inflation shock. However, there is evidence that the aggressive rate hikes in response to inflation, and the highly restrictive monetary policy stance, have resulted in a faster-than-expected rise in lending rates as well as a larger contraction in credit flows, in particular to firms (Chart 9). This is important, because stronger- than-expected transmission would, all else being equal, call for smaller, or more gradual, rate increases in response to rising inflation. Chart 9 Monetary policy transmission to firms and households compared to past cycles (x-axis: years; y-axis: cumulative changes in percentage points for rates, credit growth in deviation from the start of the cycle (t) in p.p. for credit to firms and loans to households) Range of past hiking cycles ---= Current hiking cycle Policy rate Lending rates to firms Lending rates to Credit to firms Loans to households households 5 5 5 8 8 4 4 4 4 4 3 3 3 2 2 2 0 0 1 1 1 0 0 0 4 4 4 -1 1 2 2 2 7 os vo + oe Qo SYr"EPE LAT EMS NAT EYES LRAT ERE LI Eee Sources: ECB (MIR) and ECB calculations. Notes: The ECB relevant policy rate is the Lombard rate up to December 1998, the main refinancing operations rate up to May 2014 and the deposit facility rate thereafter. Starting months correspond to the month immediately preceding the first hike, or explicit announcement of the hike, of the cycle. The hiking cycles considered are those starting in June 1988, October 1999, November 2005 and May 2022. Credit to firms is the sum of bank loans and debt securities. Bank loans are adjusted for sales and securitisation and cash pooling. Lending rates refer only to bank loans. The latest observations are for October 2024 for the policy rate and for September 2024 for lending rates, credit to firms and loans to households. Cross-checking the outlook with measures of underlying inflation The high level of uncertainty surrounding the inflation outlook over the 2021-2022 period called for the development of additional metrics to distinguish between temporary and more long-lasting inflation dynamics. Models played an important role in the development of underlying measures of inflation, which aim to filter out the short-term volatility in headline inflation and better capture the low-frequency component of inflation. Such metrics provide a useful cross-check to the inflation projections, especially in times of elevated uncertainty. Most measures of underlying inflation have come down significantly from their peak (Chart 10).!25 Exclusion-based measures, which peaked around the beginning of 2023 have fallen steadily, and now sit just below three per cent. Model-based measures of Persistent and Common Component of Inflation (PCCI) measures, which have tended to perform the best in predicting HICP inflation since the pandemic, peaked earlier (around the middle of 2022) before declining quickly, and have now hovered around two per cent for several months. [24] In interpreting measures of underlying inflation, it is important to keep in mind that these can be temporarily distorted by the economy-wide impact of cost shocks such as bottlenecks and energy shocks. Models can be used to "partial out" these influences from the underlying inflation measures to give a better sense of the medium-term dynamics of inflation. These adjusted measures had a significantly lower peak rate of underlying inflation than the unadjusted measures but, by construction, were also less affected by the sharp turnaround in energy prices and easing of supply bottlenecks during 2023 that flattered the speed of progress in the unadjusted measures. Chart 10 Euro area underlying inflation measures and their adjusted counterpart Exclusion-based measures Model-based measures (annual percentage changes) (annual percentage changes) = HICPX = HICP excluding energy = PCCI tm PCCI excluding energy m= HICPXX = HICP excluding unprocessed food and energy = Supercore 5 Standard measures 5 Adjusted measures 5 Standard measures Adjusted measures 7 7 7 7 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 0 0 0 0 01/21 11/21 09/22 07/23 = 10/24 ~=-:01/21: 11/21 09/22 07/23 10/24 01/21 11/21 09/22 07/23 10/24 01/21 11/21 09/22 07/23 10/24 Sources: Eurostat and ECB staff calculations. Notes: HICPX stands for HICP inflation excluding energy and food; HICPXX for HICP inflation excluding energy, food, travel-related items, clothing and footwear; PCCI is the persistent and common component of inflation, while Supercore aggregates HICPX items sensitive to domestic business cycle. See also Banbura et al. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB. The "adjusted" measures abstract from energy and supply-bottlenecks shocks using a large SVAR, see Banbura, M., Bobeica, E. and Martinez-Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB, November. The latest observation is for October 2024 (flash estimate) for HICPX, HICP excluding energy and HICP excluding unprocessed food and energy and September 2024 for the rest. It is also important to understand what the various measures tell us about the speed and sequencing of the disinflation process. The delayed and lagged adjustment in indicators such as services inflation, domestic inflation and wage growth highlight that convergence to the medium-term target may still take time. It will be important to continue to monitor developments in domestic inflation, which has declined only slowly, mainly due to the delayed adjustment in services inflation, which itself is closely linked to wage developments.!28) Policy counterfactuals The complex shocks that hit the euro area economy in 2021 and 2022 and the high inflation which emerged also raise the question of the appropriate monetary policy response of the ECB. This can be analysed by constructing policy counterfactuals that give an indication of what would have happened to inflation had the ECB acted differently. Staff use macroeconomic models to build these counterfactuals in real time, under different assumptions for the policy rate path and the expected path for inflation and growth. But the same models can also be used to construct counterfactuals with the benefit of hindsight, thus providing insight on what appropriate monetary policy might have looked like had the extent of the inflation surge been known from the outset. As an example, counterfactuals can be constructed using two policy models developed by ECB staff: the MMR model and the NAWM model.!22] Given projections for inflation and a measure of economic slack, as well as assumptions about the interest rate path, it is possible to construct policy paths that minimise a loss function featuring squared terms for the deviation of inflation from target, the output gap, and the change in the interest rate. The last term is a proxy for financial or other stress that could be created if the monetary stance changes very rapidly.2" According to the model simulations, had the exact nature and size of shocks that were about to hit the economy been known back in the fourth quarter of 2021, the model-implied optimal policy (as defined by the minimisation of this loss function) would have called for interest rates to be increased earlier and more forcefully (Chart 11 black dashed). Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have come with large output costs, with quarter- on-quarter growth rates 1 to 2 percentage points lower, depending on the model. Of course, the ECB did not possess perfect foresight. The projections by ECB and Eurosystem staff, as well as those of other forecasters, predicted much lower and less persistent inflation as the baseline. In looking at the policy paths that were constructed using the actual information available to policymakers at the time - as reflected in the ECB/Eurosystem staff projections for inflation and growth - it shows the actual interest rate path during the hiking cycle was broadly in line with the model- implied optimal policy path (Chart 11, blue lines vs. coloured lines). Chart 11 Optimal policy in real-time and with hindsight (left panel: percentage per annum; middle panel: annual percentage changes; right panel: quarterly percentage changes) MMR wee Actual mmm =Dec-21 meee = Jun-22 we Dec-22 eee = Jun-23 Dec-23 eee Jun-24 ome = With hindsight 7 Interest rate 1 Inflation 3 Real GDP growth "boat 2022 2023 2024 2025 2026 Son 2022 2023 2024 2025 2026 NAWM eee = Actual www = Dec-21 ee = Jun-22 we Dec-22 ees Jun-23 Dec-23 wees Jun-24 mes = With hindsight 7 Interest rate "1 Inflation 3 Real GDP growth 1 2 2021 2022 2023 2024 2025 2026 2021 +2022 2023 2024 2025 2026 2021 2022 2023 2024 2025 2026 Source: ECB calculations based on the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)), and the NAWM II model (see Darracq Pariés, M. Kornprobst, A., Priftis, R. (2024), op. cit.). Notes: The optimal policy rate path simulations beyond the third quarter of 2024 are not shown for confidentiality reasons. "Actual" denotes historical data. The other dashed lines on the left graph are a sequence of optimal policy counterfactuals computed in real time at each projection vintage from the fourth quarter of 2021 to the second quarter of 2024. The "With hindsight" lines denote the optimal policy counterfactual computed in the fourth quarter of 2021 with the benefit of hindsight by assuming that the same information that we now have on subsequent inflation and output developments was already available in the fourth quarter of 2021. The middle and right panels show implied inflation and output growth respectively. Chart 12 Early tightening counterfactual Interest rate Inflation (percentages per annum) (annual percentage changes of the unconstrained case relative to the constrained == Baseline tm== = June 2022 counterfactual) == December 2021 4 = June 2022 constrained == Baseline = - june 2022 4 December 2021 constrained === December 2021 § 0.10 4 0.05 3 2 0.00 1 ~0.05 0 a A -0.10 2021 2022 = 2023-2024 2025 2026 2021 2022 «© 2023-Stst«CD 2005 2026 Source: ECB calculations based on the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). Notes: "Baseline" denotes historical data available in the third quarter of 2024. The solid lines in the left-hand side chart are the counterfactuals in Q4 2021 and Q2 2022 from Chart 11. Each of the lines with a marker on the left panel is a counterfactual rate path computed by constraining the lift-date to match the actual one and letting policy evolve optimally afterwards. The lines on the right panel are the difference in impact on inflation between the unconstrained and constrained case. Two instances can be identified in the MMR model in which the model-implied optimal policy prescriptions differed slightly from the path of interest rates followed by the ECB. The first instance was in early 2022, when optimal policy would have called for interest rate hikes already in the first quarter. The implications of this delayed start to rate hikes can be assessed by comparing inflation outcomes under a counterfactual in which the optimal interest rate path is constrained not to increase until the time in which the ECB started increasing rates and under the alternative assumption that the rate path is unconstrained. The inflation outcomes in the two cases are very close to each other, in the order a few basis points, suggesting that small changes in the exact timing of lift off were not consequential: what matters in the model is the overall direction of travel of monetary policy rather than whether one rate action is brought forward or backward by one quarter. The second episode (not shown in the chart) was in September 2023 when the model-implied optimal policy would have called for one fewer interest rate hike. However, the model-implied optimal policy path should be checked against an array of risk considerations. The optimal policy paths above are drawn around the central tendency of the BMPE projections: especially during periods of high uncertainty about the macroeconomic outcomes, it is prudent to also consider alternative scenarios. In particular, choosing a policy path that avoids the worst scenario from happening is a form of insurance and can in practice call for either a more aggressive or more gradual policy response than indicated by a simple loss function that is conditioned on the baseline projections. S21 Policy models can also be employed to compute counterfactuals to quantify the impact of the actual monetary policy tightening on the disinflation process. The exercise is conducted using the ECB's main policy models - NAWM, MMR and ECB-BASE.!25! According to these models, without the unprecedented tightening, inflation would have been about two percentage points higher on average in each year between 2023 and 2026 (Chart 13). The exact effects of monetary policy on inflation and output are subject to significant uncertainty and depend, among other things, on the assumed expectations formation process in the model. Semi-structural models such as the ECB-BASE have typically more backward-looking expectations, resulting in a slower propagation of shocks and thus smaller effects from monetary policy. By contrast, the effects can be larger in DSGE models, such as NAWM and MMR due to the strong forward-looking behaviour of agents in these models. In addition, monetary policy likely had an additional important role in keeping long-term inflation expectations anchored: that is not incorporated in the quantification of the impact of policy tightening reported above. 4] The message emerging from these results indicates that monetary policy has played a significant role in contributing to the disinflation process and, given the information available at the time, it did so ata rather appropriate pace. As noted above, the policy simulations that condition on baseline projections alone suggest that the first increase in interest rates should have been implemented about a quarter earlier. But several other considerations beyond those captured in these models were relevant to the monetary policy decisions taken in the spring of 2022, especially in the context of the uncertainty surrounding the Russian invasion of Ukraine. A slightly earlier lift-off would only have had a very limited effect in dampening the scale of the inflation surge and a one quarter delay in liftoff provided insurance against the risks of tightening too early. Of course, as indicated earlier, the monetary policy tightening would have occurred at a significantly earlier date if the scale and persistence of the inflation shock had been better anticipated: the projections in early 2022 still signalled a return to below-target inflation over the medium term as they could not foresee as central tendency the protracted war in Ukraine and the drastic disruptions in the supply of Russian gas to some European countries. The final hike at the September 2023 meeting also incorporated risk management considerations.24 In particular, in view of some signs of an increase in inflation risks over the course of the summer, it was judged to be safer to increase the policy rate by a further 25 basis points, which would reinforce progress towards the target for two basic reasons. First, if the economy evolved in line with the staff baseline case, the decision to hike would bolster confidence that inflation would return to target within the projection horizon. Second, a higher interest rate would more strongly limit the amplification of any upside shocks to the inflation path. In consequence, a more secure pace of disinflation and greater insurance against upside risks would also reinforce the anchoring of inflation expectations, which remained a precondition for the disinflation process to keep up its pace. Chart 13 Impact of monetary policy tightening according to a suite of models (annual percentage changes) = BASE BASE - reactive = NAWM II NAVVM - adaptive =MMR = MMR - unanticipated «Mean a) HICP inflation b) GDP growth 2 I I ob ash, sy a I I I - Ua -1 'A 2 -2 3 3 4 4 5 5 6 6 2022 2023 2024 2025 2026 2022 2023 2024 2025 2026 Sources: ECB calculations based on the NAWM II model (see Coenen, G., Karadi, P., Schmidt, S., Warne, A. (2018), "The New Area-Wide Model II: an extended version of the ECB's micro-founded model for forecasting and policy analysis with a financial sector', Working Paper Series, No 2200, ECB, November), the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)), and the ECB-BASE model (see Angelini, E., Bokan, N., Christoffel, K., Ciccarelli, M., Zimic, S. (2019), "Introducing ECB-BASE: The blueprint of the new ECB semi-structural model for the euro area", Working Paper Series, No 2315, ECB, September). Notes: This chart reports the results of a simulation involving changes to short-term rate expectations between December 2021 and September 2024 and changes to expectations regarding the ECB's balance sheet between October 2021 (to account for anticipation) and September 2024. "Mean" denotes the average across the six model variants. The latest observation is for 16 August 2024 for the underlying short rate expectations from MP-dated ESTR forward contracts. Conclusions My remarks today have sought to explain how macroeconomic models have been deployed at the ECB to help understand the 2021-2022 inflation surges and the appropriate monetary policy response. While models have their limitations, models can help us understand where and how our projections fell short. Models are also essential in the construction of scenarios and policy counterfactuals, which play an important role in the policy making process. The model-based analyses reported in this speech suggest that forecast errors in the inflation outlook were initially driven by unanticipated energy price shocks but that multiple changes in the transmission of shocks to inflation also played an important role in the broadening of the inflation shock, increasing its size and persistence. If the ECB had had perfect foresight in late 2021 on the exact nature and size of shocks that were about to hit the economy, the model-implied optimal policy would have called for interest rates to be increased more rapidly and more aggressively. Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have come with large output costs, with quarter-on-quarter growth ending up 1 to 2 percentage points lower, depending on the model. Without the benefit of hindsight, the model-based analysis indicates that monetary policy was set ina broadly appropriate manner during 2021 and 2022, given the real-time information available to policymakers (including as incorporated in the baseline macroeconomic projections). While some risk considerations might have called for an earlier start to the hiking cycle, other risk considerations pushed in the opposite direction (including the uncertainty associated with the Russian invasion of Ukraine). In any event, the model analysis included in this speech suggests that minor variations in the start date would not have had a large impact. Most important, the interest rate path actually followed has delivered substantial and timely progress in disinflation. 1. I am grateful to Thomas McGregor, Annukka Ristiniemi, Elise Dupin, Antonio Greco, Kai Christoffel, Romanos Priftis, Srecko Zimic, Antoine Kornprobst and Catalina Martinez Hernandez for their contributions to this speech. The views expressed here are personal and should not be interpreted as representing the collective view of the Governing Council. 2. The build-up to the invasion also affected energy price dynamics in 2021. 3. For a meeting-by-meeting narrative account of monetary policy decisions during this period in a recent contribution, see Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area," The ECB Blog, 11 March. The analysis in this speech also builds on the analysis contained in an earlier speech: see Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", Virtual Lecture at Stanford Graduate School of Business, 2 May. 4. By and large, the forecasting community (and market traders) significantly underestimated inflation over 2021 and 2022. This illustrates the significant challenges in forecasting inflation in a period characterised by extreme volatility in economic developments, and in energy commodity prices in particular. See Chart B in ECB (2024), "An update on the accuracy of recent Eurosystem/ECB staff projections for short-term inflation", Economic Bulletin, \ssue 2.. 5. The Broad Macroeconomic Projection Exercise, or BMPE, is produced jointly by Eurosystem and ECB staff twice per year (in June and December), while in March and September, projections are produced by ECB staff (MPE). 6. The market forward curve implicitly takes into account the expected impact of global monetary policies on the future path for commodity prices. Internal staff analysis indicates that ECB monetary policy has only a marginal impact on global oil prices. 7. See ECB (2016), A guide to the Eurosystem/ECB staff macroeconomic projection exercises, July. See also Ciccarelli, M., Darracq Paries, M. and Prifitis, R. (eds.) (2024), "ECB macroeconometric models for forecasting and policy analysis", Occasional Paper series, No 344, ECB. 8. The Basic Model Elasticities (BMEs) summarise the unconditional dynamics responses of variables across models used by NCBs and ECB staff. They do not come from a fully structural macroeconomic model. 9. The specific approach adopted here uses BMEs from the NCBs in the Eurosystem that summarise the key relationships between projection variables. 10. See ECB (2024), "An update on the accuracy of recent Eurosystem/ECB staff projections for short- term inflation", Economic Bulletin, Issue 2 11. See Cicarelli et al (2019), "Introducing ECB-BASE", ECB Working paper No. 2315, September 2019. 12. These counterfactual results may under-state the size of forecast errors not due to technical assumptions (i.e. model specific errors) because the conditioning is done on HICP energy inflation, rather than on the oil and gas price assumptions directly. The mapping of oil and gas price assumptions to HICP energy is done using satellite models, which may themselves suffer from model errors. The strong pass-through of wholesale energy prices to retail and service sectors may also have played a role during this period, particularly given the impact of gas supply disruptions on electricity prices as a result of the war. 13. It is also possible that the level of uncertainty itself may be underestimated, especially since the ECB- BASE model was estimated on a 20-year sample (first quarter of 1995-fourth quarter of 2016), when inflation volatility was low. Uncertainty may have been significantly larger had the estimation sample included the 1970s. For example, results from estimating a structural VAR model reveal that the distribution of shocks to inflation since the COVID-19 pandemic has been significantly larger than during the period following the global financial crisis. This would imply that the economic relations may not have changed during the inflation surge, but rather that the shocks and parameter uncertainty have become larger than was assumed in the models. This, in turn, would imply a wider distribution around the inflation projections, which could render the difference between inflation outturns and model predictions statistically insignificant. 14. Large cost shocks might both induce firms to increase the frequency of price adjustment in order to avoid making losses and increase the customer acceptance of price hikes, whereas prices might be less responsive to demand shocks. See also L'Huillier, J.P. and Phelan, G. (2024), "Can supply shocks be inflationary with a flat Phillips curve?," mimeo, Brandeis University. 15. See Dedola et al. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?", ECB Economic Bulletin, Issue 3/2024. 16. See US Benigno and Eggertsson (2023), "It's Baaack: The surge in inflation in the 2020s and the return of the nonOlinear Phillips curve" and Gitti (2024), "Nonlinearities in the Regional Phillips Curve with Labor Market Tightness" for evidence on the US. From a theoretical perspective, Karadi et al. (2024) provide micro-foundations for a nonlinear Phillips curve whereby the sensitivity of inflation to activity increases after large shocks due to an endogenous rise in the frequency of price changes. 17. I will return to model-based underlying inflation measures in a later section. For a stocktake of the forecasting and policy models used at the ECB, see Ciccarelli, M. et al., "ECB macroeconometric models for forecasting and policy analysis", op. cit. 18. For example, see the discussion of scenarios and uncertainty in: Bernanke, B. (2024), Forecasting for monetary policy making and communication at the Bank of England: a review, Bank of England, 12 April. 19. See Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", speech at Stanford Graduate School of business, 2 May 20. See Banbura, M., Bobeica, E. and Martinez Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper series, No 2875, ECB. 21. See e.g. Arce et al. (2024), Ascari et al (2023), Ascari et al. (2024), Banbura et al (2023), Bergholt et al. (2024), Bonomolo et al (2024), Delle Monache, Pacella (2024), Depalo and Lo Bello (2024), De Santis (2024), Eickmeier, Hoffmann (2022), Garcia-Revelo (2024), Giannone and Primiceri (2024), Goncalves and Koester (2022), Hoynck and Rossi (2023), Kataryniuk et al. (2024) Neri et al. (2023), Pallara et al. (2023), Bonomolo et al. (2024). 22. See, for example, Giannone, D. and Primiceri, G. (2024), "The Drivers of Post-Pandemic Inflation," NBER Working Papers, No 32859, National Bureau of Economic Research. 23. Allowing for transmission lags, a substantial tightening of monetary policy during 2021 might have tempered the 2022 post-pandemic rebound in the contact-intensive services sector. However, the level of uncertainty about the course of the pandemic remained elevated throughout 2021 and even in early 2022 due to the Omicron wave. 24. Christoffel, K. and Farkas, M. (2025), "Managing the Risks of Inflation Expectation De-anchoring", MF Working Paper Series, 2025, forthcoming. The still-high prominence of the risk of downside de- anchoring until March 2022 is connected to the assessment in these projection rounds that inflation would fall below target by the end of the projection horizon: that is, the rise in inflation was projected to be temporary. 25. For a more comprehensive discussion of the importance of monetary policy transmission for inflation, see Lane, PR. (2024), "The analytics of the monetary policy tightening cycle", guest lecture at Stanford Graduate School of Business, 2 May and Lane P.R. (2024), "The effectiveness and transmission of monetary policy in the euro area", contribution to the panel on "Reassessing the effectiveness and transmission of monetary policy" at the Federal Reserve Bank of Kansas City Economic Symposium. 26. See Lane, P. R. (2024), "Underlying inflation: an update", speech at the Inflation: Dynamics and Drivers Conference 2024 organised by the Federal Reserve Bank of Cleveland and the ECB, 24 October and Economic Bulletin, Issue 5, ECB, 2023. The importance of underlying inflation for monetary policy decision-making was highlighted in the 2021 monetary policy strategy review of the ECB. 27. Model-based measures of the Persistent and Common Component of Inflation (PCCI) are constructed by estimating a dynamic factor model that extracts the persistent and common component of inflation from granular price data at the item-country level, thereby exploiting the relative advantages of both cross-sectional and time series approaches. See Banbura, M. and Bobeica, E. (2020), "PCCI - a data- rich measure of underlying inflation in the euro area", Statistics Paper Series, No 38, ECB, October. The PCClI is similar in spirit to the New York's Fed Multivariate Core Trend. The PCCI is similar in spirit to the New York's Fed Multivariate Core Trend. See Almuzara, M. and Sbordone, A. (2024), "Measurement and Theory of Core Inflation', Staff Reports, No 1115, Federal Reserve Bank of New York. 28. See Lane, P.R. (2024), "Underlying inflation: an update", op. cit. 29. The focus here is on the path for the policy rate, which is the primary policy instrument. A discussion of the associated adjustments in the additional policy instruments (bond purchase programmes, the targeted lending programme) is beyond the scope of this speech. The optimal policy counterfactuals in both models are conducted using the COPPs toolkit. For further details see de Groot, O., Mazelis, F., Motto, R. and Ristiniemi, A. (2021), "A toolkit for computing Constrained Optimal Policy Projections (COPPs)", Working Paper Series, No 2555, ECB, May. The first of the two models used is the Mazelis, Motto and Ristiniemi (MMR) model, see see Mazelis, F., Motto, R. and Ristiniemi, A. (2023), "Monetary No 2797, ECB, March, and the exercises are documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). For optimal policy simulations using the NAWM see Darracq Pariés, M., Kornprobst, A. and Priftis, R. (2024), "Monetary policy strategies to navigate post-pandemic inflation: an assessment using the ECB's New Area-Wide Model", Working Paper Series, No 2935, ECB, April. 30. The loss function specification is consistent with common practice in academia and policy evaluations. The loss function weights used in the MMR model are estimated. The weight on inflation is 1, on the output gap 0.2, and the weight on the change in annualised interest rate 1.4. The weights used in the NAWM model are calibrated and are 1 for inflation, 0.1 for output gap, and 4 for the change in annualised interest rate. 31. The insure perspective of the two instances highlighted above - the March 2022 and the September 2023 policy meetings - are well reflected in the Accounts of the monetary policy meetings. According to the ECB's published Accounts of the policy meeting of March 2022, the uncertainty related to the recent Russian invasion of Ukraine was extensively debated, and I pointed out that "More than ever there was a need to maintain optionality in the conduct of monetary policy. In the current conditions, it was especially important for monetary policy to remain data-dependent and for optionality to be two- sided." According to the Accounts of the ECB policy meeting of September 2023, I again pointed out that "[...] the choice between holding the deposit facility rate at 3.75% and moving to 4.00% was finely balanced. However, at the margin it was safer to decide on an additional hike, given the highly uncertain environment and the significant disinflation that was still required to return to the inflation target in a timely manner. [...] In consequence, a more secure pace of disinflation and greater insurance against upside risks would also reinforce the anchoring of inflation expectations, which remained a precondition for the disinflation process to keep up its pace." 32. Risks to the baseline forecasts in an uncertain environment are typically explored through a robust control approach that compares policy for each of the scenarios and the risks of setting policy for a wrong scenario. Using a min-max strategy, it then chooses the policy option that avoids the worse outcome. For an application, see the forthcoming Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). An alternative approach is to create scenarios within a model by varying parameters and shocks and computing optimal policy on those scenarios. See Wieles, Kwakkel, Auping, Willem van den End (2024) "Scenario discovery to address deep uncertainty in monetary policy" DNB Working Paper No. 818. 33. For the MMR model see Mazelis, F., Motto, R., Ristiniemi, A. (2023), "Monetary policy strategies for the euro area: optimal rules in the presence of the ELB", Working Paper Series, No 2797, ECB, March, for the NAWM model, Coenen, G., Karadi, P., Schmidt, S. and Warne, A. (2018), "The New Area-Wide Model Il: an extended version of the ECB's micro-founded model for forecasting and policy analysis with a financial sector", Working Paper Series, No 2200, ECB, November (revised December 2019), and for the ECB-BASE model See Angelini, E., Bokan, N., Christoffel, K., Ciccarelli, M. and Zimic, S. (2019), "Introducing ECB-BASE: The blueprint of the new ECB semi-structural model for the euro area", Working Paper Series, No 2315, ECB, September. Of course, optimal policy could also be studied under different model specifications, including allowing for nonlinearities. For instance, the frequency of price adjustment might be endogenous to the anticipated monetary policy response: see Karadi, P., Nakov, A., Nufio, G., Pasten, E. and Thaler, D. (2024), "Strike while the iron is hot: optimal monetary policy with a nonlinear Phillips Curve", CEPR Discussion Papers, No 19339, Centre for Economic Policy Research. See also: Erceg, C., Linde, J. and Trabandt, M. (2024), "Monetary Policy and Inflation Scares," mimeo, International Monetary Fund; 34. The optimal monetary policy response when expectations are formed by boundedly-rational agents is explored by Dupraz, S. and Marx, M. (2024), "Anchoring Boundedly Rational Expectations," mimeo, Banque de France. 35. This point follows Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", op. cit. CONTACT Copyright 2024, European Central Bank	---[PAGE_BREAK]--- # The 2021-2022 inflation surges and the monetary policy response through the lens of macroeconomic models ## Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the SUERF Marjolin Lecture hosted by the Banca d'Italia Rome, 18 November 2024 ## Introduction My aim today is to explain how macroeconomic models can help in understanding the extraordinary 2021-2022 inflation surges and the monetary policy response, in the context of the euro area. ${ }^{[1]}$ By and large, the scale and persistence of the inflation surge surprised the central banking community, external experts and market participants. The unexpected nature of the inflation surge triggered many questions about the performance of macroeconomic forecasters. At the same time, macroeconomic models can help us understand why the baseline projections did not foresee the inflation surge in its full scale and speed, while shedding light on the possible mechanisms and channels that may have been missed or under-stated. Scenario analysis has been enhanced and new models have been developed to enrich our understanding of the shocks that hit the economy over this period, as well as the mechanisms through which these shocks were transmitted to inflation. Models also play a central role in constructing some of the measures of underlying inflation that the Governing Council uses as an important cross-check for the inflation outlook. And models are essential in constructing policy counterfactuals to assess whether alternative monetary policy responses might have substantially reduced the scale of the inflation surge. Models therefore play an important role in strengthening our understanding of the recent inflationary surge and assessing the monetary policy response. Model-based retrospective analysis provides several insights into the 2021-2022 inflation surges. The large forecast errors in the inflation outlook over this period were driven, at least initially, by energy and commodity price shocks, especially following the Russia-Ukraine war, and pandemic-related bottlenecks. Subsequently, changes in the transmission of shocks through the pricing chain, and in the behaviour of firms and consumers, likely played an important role in amplifying and propagating these shocks across the economy, converting relative price shocks into a general inflation shock. Supply shocks, primarily originating from external sources, were key drivers of the inflation surges. While global and domestic surges in sectoral demand patterns also contributed to sectoral demandsupply mismatches (in the goods sector in 2020-2021 during the most intense phases of global pandemic lockdowns; in the services sector in 2022 during the post-pandemic reopening phase), the ---[PAGE_BREAK]--- overall level of aggregate demand in the euro area was only barely above pre-pandemic levels by the end of 2022. The pre-dominant role of supply shocks, combined with the fact that inflation expectations were initially signalling significant downside risks, supported the initial looking-through approach for monetary policy. In this context, it is also essential to recall the sequential nature of the shocks: the focus in 2021 was on pandemic-related supply disruptions and sectoral demand-supply mismatches, while the unjustified Russian invasion of Ukraine in February 2022 subsequently triggered extraordinary jumps in gas and oil prices. ${ }^{[2]}$ The post-pandemic full-scale reopening of contact-intensive services sectors also took place in early 2022, after the ending of Omicron-related lockdowns. Put together, the second and third quarters of 2022 saw an extraordinary cocktail of inflation shocks, between the war-related commodity and supply chain shocks and the demand-supply mismatches in the reopening contactintensive service sectors. If policymakers had had perfect foresight about the shocks that were about to hit the economy, interest rates would have been raised earlier and more sharply. However, conditional on the real-time information available to policymakers (including how this information shaped baseline macroeconomic projections), monetary policy decisions in 2021-2022 were broadly in line with the policy paths indicated by the macroeconomic models. ${ }^{[3]}$ This assessment includes both the initial phase in which monetary policy did not respond to the early stages of the rise in inflation and the subsequent phase of a sharp and sustained tightening cycle. This monetary policy response was, and continues to be, an important contributor to the disinflation process. Macroeconomic models have played a central role in helping policymakers in charting this monetary policy course, through their roles in: (a) macroeconomic forecasting; (b) estimating underlying inflation; and (c) calibrating the appropriate interest rate path. This assessment puts the spotlight on the quality of the information set available to policymakers, especially in relation to the macroeconomic projections. I will cover this topic in the next section. # The 2021-2022 inflation surges: what did models miss? The inflation surges in 2021 and 2022 surprised professional forecasters, both at the ECB and across other institutions and countries. ${ }^{[4]}$ Inflation turned out to be much higher and more persistent than had been projected. This is clear from the very large and persistent forecast errors at both short and medium-term horizons in the Eurosystem and ECB staff projections for headline and core inflation. For example, forecast errors at the one-quarter ahead horizon during this period were more than five times larger than the average errors over the previous twenty years for headline inflation (and around twice as large for core inflation) and had the same direction for several successive quarters (Chart 1, left and middle panels). Indeed, the projection error in the December 2021 Broad Macroeconomic Projection Exercise (BMPE) for the year-over-year inflation rate at the end of 2022 was the largest ever, at around eight percentage points. Projection errors were also materially larger than historical averages at medium-term horizons, with projections made early in the period suggesting that inflation would either return to target or fall below target well within the projection horizon. The errors in inflation at a four-quarter horizon, for example, ---[PAGE_BREAK]--- were more than nine times larger during 2022 than the historic pre-pandemic average. This is important, since the medium-term inflation outlook is typically the most relevant for policymakers, given significant lags in the transmission of policy rate changes to inflation. The projection errors for GDP growth were smaller than for inflation, but still significantly above their historical range (Chart 1, right panel). # Chart 1 One-quarter-ahead errors in the inflation projections of Eurosystem/ECB staff ![img-0.jpeg](img-0.jpeg) Sources: Eurosystem/ECB staff macroeconomic projections for the euro area and Eurostat. Notes: An error is defined as the outturn for a given quarter minus the projection made for that quarter in the previous quarter (for example, the outturn for the fourth quarter of 2022 minus the figure projected for that quarter in the September 2022 ECB staff macroeconomic projections). The latest observation is from the September 2024 ECB staff Macroeconomic Projection Exercise (MPE). In understanding these large forecast errors over 2021-2022, it is important to differentiate between errors due to conditioning assumptions - especially linked to shocks to key variables such as energy or food prices - and errors in the way these assumptions were propagated through the forecasting models. The starting point for the ECB staff projections is a set of conditioning assumptions for the future evolution of key input variables, known as "technical assumptions". ${ }^{[5]}$ For example, the paths for inputs such as commodity prices, including oil and gas prices, and short-term interest rates are based on market expectations at the time of the projection cut-off date. ${ }^{[6]}$ The right panel of Chart 2 shows that the expected paths for oil and gas prices were revised up repeatedly over successive projection rounds at the end of 2021 and throughout 2022. This highlights how energy prices were repeatedly expected by markets - and therefore by our projection models - to decline. However, a sequence of upward surprises to energy prices materialised, especially following the Russian invasion of Ukraine. ---[PAGE_BREAK]--- This sequence of shocks pushed up inflation and compounded forecast errors over successive projection rounds. # Chart 2 Headline inflation and energy composite projections from Q1 2020 to Q3 2024 ![img-1.jpeg](img-1.jpeg) Sources: Eurosystem/ECB staff projections and Eurostat for left-hand scale. Refinitiv and ECB staff calculations for right-hand scale. Notes: Projections for the synthetic energy price index were introduced in 2021. Its methodology was changed in 2023. To account for this, projections before 2023 have been rebased to the new Synthetic Energy Commodity Price Index (SECPI) index. The latest observation is from the September 2024 MPE for the left-hand scale and for the third quarter of 2024 for the right-hand scale. In order to quantify the importance of energy price and other shocks in driving inflation projection errors, we can use models to construct counterfactual paths for inflation under a scenario in which forecasters had perfect foresight at each projection round about how energy prices and other conditioning variables would actually evolve over the projection horizon. This allows projection errors from incorrect technical assumptions to be isolated from the errors related to the transmission of shocks as embedded in models. Of course, the results from such a decomposition depend on the specific model. It is also important to keep in mind that the ECB/Eurosystem staff macroeconomic projections are not purely model based but also include staff judgement. ${ }^{[7]}$ One way to carry out this counterfactual exercise is to use the Basic Model Elasticities (BMEs) of the Eurosystem national central banks (NCBs), which summarise the key relations between projection variables. ${ }^{[8]}$ This exercise suggests that a substantial share of forecast errors for inflation during 2021 and 2022 was due to errors in the technical assumptions. ${ }^{[9]}$ For example, errors in assumptions about oil and gas prices accounted for the majority of the one-quarter ahead inflation projection error until early 2022 (yellow and green bars in Chart 3). ${ }^{[10]}$ Subsequently, however, the importance of other factors affecting food and core inflation grew in importance. ---[PAGE_BREAK]--- # Chart 3 <br> Decomposition of recent one-quarter-ahead HICP inflation errors in Eurosystem/ECB staff projections ![img-2.jpeg](img-2.jpeg) Source: ECB calculations. Notes: "Total error" is the outturn minus the projection. The labels on the horizontal axis indicate the quarter in which the projections were published and the quarter to which those projections relate (i.e. "Q4 20 for Q1 21" denotes projections for the first quarter of 2021 that were published in the fourth quarter of 2020). The decomposition is based on updated elasticities derived from Eurosystem staff macroeconomic projection models as at late 2023. "Other assumptions" refers to exchange rates, short and long-term interest rates, stock prices, foreign demand, competitors' export prices and food prices". The latest observation is from the June 2024 Eurosystem staff Broad Macroeconomic Projection Exercise (BMPE). Further insight can be gained by running this counterfactual exercise in a fully-fledged macroeconomic model. ECB-BASE is the workhorse large-scale estimated semi-structural model used at the ECB to support and cross-check the staff projection exercises. ${ }^{[11]}$ Decomposing the eight percentage point projection error at the peak of inflation in the fourth quarter of 2022 - relative to what had been projected in December 2021 - confirms that around half was due to unexpected developments in technical assumptions around oil and gas prices (red and yellow bars in Chart 4). Nearly one third, on the other hand, was due to errors in food inflation (dark grey bar in Chart 4), while the remainder was due to other factors that drove the error in core inflation (light grey bars in Chart 4). As such, errors in the set of technical assumptions go a long way towards explaining the forecast errors. ${ }^{[12]}$ At the same time, a sizeable share of the inflation forecast errors over this period cannot be explained by errors in the assumptions around energy and food prices. Two explanations for the remaining errors seem plausible. The first explanation relates to statistical uncertainty. Macroeconomic forecasting models are underpinned by empirical estimates of model relations that are based on historical regularities. Statistical uncertainty around these estimates maps into statistical uncertainty around the central tendency of the inflation projection. Conditioning on the ex-post values for the technical assumptions, the statistical distribution around the inflation projections from the vantage point of December 2021 is ---[PAGE_BREAK]--- relatively wide (Chart 4, blue area). ${ }^{[13]}$ The actual inflation outturns (solid blue line in Chart 4) experienced during the inflation surge were close to the bounds of this model uncertainty, although inflation was still slightly too high to be compatible with the model in the second half of 2022 and the first half of 2023. Overall, correcting for the actual path of energy prices and other conditioning variables, it cannot be ruled out that actual inflation was largely consistent with the historically-estimated statistical distribution around forecasts. This would imply that the economic relations estimated in the models to capture the transmission of shocks to inflation have remained broadly valid during the inflation surge, so long as the full statistical distribution is taken into account. # Chart 4 <br> Decomposition of HICP inflation projection errors in December 2021 BMPE conditioning on December 2022 BMPE assumptions using ECB-BASE ![img-3.jpeg](img-3.jpeg) Source: ECB-BASE, Eurostat, December 2021 BMPE and June 2024 BMPE. Note: "December 2021 BMPE + assumptions" is simulated using the December BMPE baseline, but imposing the paths of HICP energy, HICP food and other technical assumptions from the June 2024 BMPE. The second explanation is that economic relations might also have (temporarily) shifted during this extraordinary episode, including through an array of non-linear responses to the scale and combination of the shocks and the shift in the level of inflation. For example, in a high inflation environment, firms may adjust their prices more often than normal, in an attempt to pass on rapidly rising input and operational costs and protect their profits. ${ }^{[14]}$ Furthermore, the broadening of the inflation shock from the energy sector (including via the food sector) to the services sector may also have been amplified during 2022 by the strong demand for contact-intensive services (tourism, hospitality) due to the reopening of these sectors after the final pandemic lockdowns. While costs were increasing quickly, the price elasticity of demand for services was plausibly atypically low due to this pandemic reopening phase, allowing for a greater pass-through of the cost shocks. Furthermore, these conditions were ripe for a non-linear responses feedback loop between inflation and short-term inflation expectations. It is plausible that short-term inflation expectations are more ---[PAGE_BREAK]--- sensitive to large inflation shocks than to small inflation shocks. Although longer-term inflation expectations remained broadly stable throughout, perceptions of past inflation and short-term expected inflation rates did increase in response to the inflation surges. In the event of a large inflation shock, an increase in near-term inflation expectations may take hold among households and firms, with firms anxious to avoid suffering relative price declines and households more likely to attribute individual price increases to general inflation than to a relative price increase. Indeed, the evidence suggests that there was a marked increase in the frequency of price increases over the course of 2022 (Chart 5). ${ }^{[15]}$ This state-dependent increase in the frequency of price adjustments resulted in the faster-than-normal pass-through of the unique and large sectoral shocks. In terms of the key Phillips Curve macroeconomic relation between slack and inflation (whether at aggregate or sectoral levels), this can be interpreted as some combination of a shift up in the curve and an increase in the slope of the Phillips Curve. And indeed, estimates from a time-varying parameter model show some increase in the slope of the Phillips curve from early 2021 (Chart 6, left panel). Furthermore, the evidence based on sectoral data also shows a shift in the correlation between sectoral capacity utilisation and sectoral prices increases (Chart 6, right panel). ${ }^{[16]}$ While the 20212022 inflation surges should not be interpreted as primarily originating in the recovery of product and labour markets from the 2020 pandemic lows, the domestic rebound added to overall inflationary pressures. I return to the contribution of domestic demand in the next section. ---[PAGE_BREAK]--- # Chart 5 ## Frequency of consumer price changes over time, by aggregate product category ![img-4.jpeg](img-4.jpeg) Sources: Consumer price micro-datasets from the national statistical institutes of Germany, Estonia, Spain, France, Italy, Latvia and Lithuania. Notes: The chart shows the weighted average frequencies of price changes (excluding sales). VAT changes in Germany (2020-21) and Spain (2020-23) have been excluded. The solid lines plot the average over the period 2015-21 and half-year averages over the period 2021-23. The latest observations are for December 2023. ---[PAGE_BREAK]--- # Chart 6 <br> Increasing pass-through from slack to inflation Slope of the Phillips curve ![img-5.jpeg](img-5.jpeg) Correlation between sectoral capacity utilisation and inflation ![img-6.jpeg](img-6.jpeg) Sources: Eurostat, DG-ECFIN and Eurosystem calculations. Notes: Left chart: the Phillips curve specification relates the quarter-on-quarter growth rate of the seasonally adjusted HICP index to its own lag, capacity utilisation in industry, the lagged growth rate in import prices and medium-term survey-based inflation expectations. Time-varying parameter estimates where coefficients and log variance of residuals are assumed to follow a random walk. Right chart: services and manufacturing capacity utilisation are shown in deviation from the pre-COVID long-term average. Faced with large forecast errors and significant uncertainty, ECB staff worked to develop new models and enhance the scenario analysis in the policy process. The new models developed include models of underlying inflation, satellite models that allow for alternative transmission channels, and machine learning models that try to allow for important non-linearities. 117 Each of these approaches can help to cross-check projections from the main forecasting models. In turn, the staff judgement element in the forecasting process enables the incorporation of the results from these supplementary analytical exercises, both in the baseline and in the risk assessment. No doubt the lessons learned from the 2021-2022 high inflation episode will prove to be especially valuable in the future if a similar configuration of shocks were to arise. The recent experience certainly highlights the risks of over-reliance on baseline projections. Scenarios can be an effective way to represent risks when uncertainty is large or hard to quantify. 118 In 2020 and 2021, each set of quarterly staff projections included scenario analyses based on alternative assumptions regarding the future evolution of the pandemic and its economic consequences. In 2022, alternative scenarios focused on the economic consequences of the war in Ukraine, especially as regards uncertainties about energy supply. More recently, the scenario analysis has focused on more specific risks, such as a slowdown in the Chinese economy or a potential escalation of the conflict in the Red Sea area. In my May 2024 Stanford speech, I discussed how these alternative scenarios can be used to construct policy counterfactuals and will go into more details in a forthcoming speech on ---[PAGE_BREAK]--- the use of scenarios to assess the robustness of alternative policy paths. ${ }^{[19]}$ In addition to scenario analysis, the macroeconomic projections are accompanied by a large set of sensitivity analyses in relation to shifts in the technical assumptions and alternative parameter choices in model calibration. # Demand versus supply shocks Models have also been deployed to interpret forecast errors through the lens of identified structural shocks and to quantify their contribution to inflation. Estimates from a large structural vector autoregressive (VAR) model - which employs sign and zero restrictions to identify the global and domestic demand and supply shocks driving deviations of inflation from the model-implied mean indicate that external supply shocks were the main driver of the initial inflation surge in the euro area, although shocks to external demand and domestic demand also played a role, especially during 2022 (Chart 7). ${ }^{[20]}$ In particular, the shock decomposition points to various phases. The initial inflation increase was mainly driven by global supply shocks, related to supply chain disruptions, surging oil and gas prices and higher commodity prices more generally. These results supported an initially-circumspect monetary policy response, as the central bank still gathered evidence about the persistence of the inflation shock and its likelihood to affect materially expectations and other behavioural relations in the economy. In particular, in the absence of a clear understanding of the nature and expected persistence of the shocks, a more patient and deliberate policy response that weighs up the risks to different options, appeared appropriate. In a second phase, the indirect effects from energy and food price spikes, as well as supply chain bottlenecks, passing through into core inflation led to the broadening of inflation pressures. Increasing demand, in particular in supply-constrained contact-intensive services, such as tourism and hospitality, added to inflationary pressures. Together with the risk that high inflation might de-stabilise inflation expectations, the increasing contribution of domestic demand add to the case for the aggressive monetary policy reaction that took place in this phase. In a third phase, as the energy and supply chain disruptions abated and monetary policy dampened demand, headline inflation started to decline rapidly. ---[PAGE_BREAK]--- # Chart 7 <br> Supply and demand drivers of inflation dynamics ![img-7.jpeg](img-7.jpeg) Sources: Eurostat, ECB, Eurosystem, and ECB staff calculations. Notes: historical decomposition based on a large BVAR model accounting for a rich set of inflation drivers, identified with zero and sign restrictions, see Baribura, M., Bobeica, E. and Martínez Hernández, C., (2024) "What drives core inflation? The role of supply shocks", ECB Working Paper No. 2875. The chart shows the deviations of HICP inflation from the mean implied by the model. The latest observation is for September 2024. Of course, inference is sensitive to the type of model and the set of identifying assumptions. ${ }^{[21]}$ A key challenge is to correctly capture the information set. A model needs to contain sufficient information to span the space of the structural shocks of interest. Otherwise, the correct shocks cannot be recovered from the history of observed variables. In stylised terms, the larger the model (or the more variables that are included), the more room there is to control for the different factors that affect inflation and, in particular, to separate out shocks from structural drivers. This is particularly relevant when inflation is driven by a multifaceted and unusual set of shocks and structural drivers, originating both at home and abroad, as was the case over the 2021-2022 period. The dramatic fallout from the pandemic and the rapid bounce back following the reopening of economies after lockdowns are cases in point. In turn, amongst its many other effects, the shock of the Russian invasion of Ukraine constituted an extraordinarily-disruptive supply shock to the energy sector. As it turns out, models that rely on a small information set tend to assign a stronger role to demand factors and predict over-smooth dynamics of inflation and growth because such small-scale models are not designed to capture the type of sudden changes witnessed in that episode. ${ }^{[22]}$ The policy implications of model-based identification of demand and supply influences are not always easy to draw. That is, the policy implications not only depend on the source and nature of the shock but also its size and persistence. For example, a supply shock that is highly transitory (such as a temporary limitation in oil production in response to a short-lived geopolitical event) or a temporary surge in sectoral demand during the pandemic reopening phase (compounded by initially-limited supply capacity in the contact-intensive services sectors) may call for a looking-through policy ---[PAGE_BREAK]--- response given the significant lags in the transmission of monetary policy. ${ }^{[23]}$ By contrast, a string of large and persistent supply shocks in the same direction requires central banks to tighten in order to avoid longer-lasting inflation effects via wage-price spirals and dislocations in expectations. In relation to the latter risk, the de-anchoring of longer-term inflation expectations warrants close monitoring, and models can help policymakers understand the risks of de-anchoring under alternative shocks and scenarios. For instance, simulations using a regime-switching DSGE model suggest that substantial downward de-anchoring risks prevailed throughout most of 2021, due to the low inflation of the previous periods exerting a persistent dampening effect on expectations as well as the initial inflationary shocks being largely understood to be temporary in nature. ${ }^{[24]}$ The further increase in inflation in early 2022 saw a rapid decline in downward de-anchoring risks and an increase in upward de-anchoring risks. The forceful policy response over the course of 2022 and 2023 helped to limit, and then reduce, these upward de-anchoring risks (Chart 8). Later on, risks became more balanced as inflation came down tangibly. # Chart 8 ## Risks of de-anchoring of medium-term inflation expectations (percentage risk of upside and downside de-anchoring risks) ![img-8.jpeg](img-8.jpeg) Sources: ECB calculations based on Christoffel, K. and Farkas, M. (2025), "Managing the Risks of Inflation Expectation De-anchoring", IMF Working Paper Series, 2025, forthcoming. Notes: The charts show the risk of de-anchoring for the staff projections from June 2021 to September 2024. The simulations are based on a regime switching version of the NAWM I (Christoffel, K., Coenen, G. and Warne, A. (2007)), where the credible regime is defined as the estimated version of the NAWM I, with a fixed inflation target, the de-anchored regime is characterised by a time varying inflation target. Upward de-anchoring is defined as a situation in a de-anchoring episode, where the perceived inflation target is above $2 \%$. The share of de-anchoring is based on 1,000 simulations over a ten-quarter evaluation horizon. The latest observations are from the September 2024 MPE. The speed and strength of monetary policy transmission is also important when calibrating the appropriate monetary policy response. ${ }^{[25]}$ Provided that monetary policy tightening transmits through to inflation in line with historical regularities, then our models should provide a good guide as to how fast and how far policy rates would need to be increased in response to the inflation shock. However, ---[PAGE_BREAK]--- there is evidence that the aggressive rate hikes in response to inflation, and the highly restrictive monetary policy stance, have resulted in a faster-than-expected rise in lending rates as well as a larger contraction in credit flows, in particular to firms (Chart 9). This is important, because stronger-than-expected transmission would, all else being equal, call for smaller, or more gradual, rate increases in response to rising inflation. # Chart 9 <br> Monetary policy transmission to firms and households compared to past cycles (x-axis: years; y-axis: cumulative changes in percentage points for rates, credit growth in deviation from the start of the cycle (t) in p.p. for credit to firms and loans to households) ![img-9.jpeg](img-9.jpeg) Sources: ECB (MIR) and ECB calculations. Notes: The ECB relevant policy rate is the Lombard rate up to December 1998, the main refinancing operations rate up to May 2014 and the deposit facility rate thereafter. Starting months correspond to the month immediately preceding the first hike, or explicit announcement of the hike, of the cycle. The hiking cycles considered are those starting in June 1988, October 1999, November 2005 and May 2022. Credit to firms is the sum of bank loans and debt securities. Bank loans are adjusted for sales and securitisation and cash pooling. Lending rates refer only to bank loans. The latest observations are for October 2024 for the policy rate and for September 2024 for lending rates, credit to firms and loans to households. ## Cross-checking the outlook with measures of underlying inflation The high level of uncertainty surrounding the inflation outlook over the 2021-2022 period called for the development of additional metrics to distinguish between temporary and more long-lasting inflation dynamics. Models played an important role in the development of underlying measures of inflation, which aim to filter out the short-term volatility in headline inflation and better capture the low-frequency component of inflation. Such metrics provide a useful cross-check to the inflation projections, especially in times of elevated uncertainty. Most measures of underlying inflation have come down significantly from their peak (Chart 10). ${ }^{[26]}$ Exclusion-based measures, which peaked around the beginning of 2023 have fallen steadily, and now sit just below three per cent. Model-based measures of Persistent and Common Component of Inflation (PCCI) measures, which have tended to perform the best in predicting HICP inflation since ---[PAGE_BREAK]--- the pandemic, peaked earlier (around the middle of 2022) before declining quickly, and have now hovered around two per cent for several months. ${ }^{[27]}$ In interpreting measures of underlying inflation, it is important to keep in mind that these can be temporarily distorted by the economy-wide impact of cost shocks such as bottlenecks and energy shocks. Models can be used to "partial out" these influences from the underlying inflation measures to give a better sense of the medium-term dynamics of inflation. These adjusted measures had a significantly lower peak rate of underlying inflation than the unadjusted measures but, by construction, were also less affected by the sharp turnaround in energy prices and easing of supply bottlenecks during 2023 that flattered the speed of progress in the unadjusted measures. # Chart 10 ## Euro area underlying inflation measures and their adjusted counterpart ![img-10.jpeg](img-10.jpeg) Sources: Eurostat and ECB staff calculations. Notes: HICPX stands for HICP inflation excluding energy and food; HICPXX for HICP inflation excluding energy, food, travel-related items, clothing and footwear; PCCI is the persistent and common component of inflation, while Supercore aggregates HICPX items sensitive to domestic business cycle. See also Bańbura et al. (2023), "Underlying inflation measures: an analytical guide for the euro area", Economic Bulletin, Issue 5, ECB. The "adjusted" measures abstract from energy and supply-bottlenecks shocks using a large SVAR, see Bańbura, M., Bobeica, E. and Martínez-Hernández, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper Series, No 2875, ECB, November. The latest observation is for October 2024 (flash estimate) for HICPX, HICP excluding energy and HICP excluding unprocessed food and energy and September 2024 for the rest. It is also important to understand what the various measures tell us about the speed and sequencing of the disinflation process. The delayed and lagged adjustment in indicators such as services inflation, domestic inflation and wage growth highlight that convergence to the medium-term target may still take time. It will be important to continue to monitor developments in domestic inflation, which has declined only slowly, mainly due to the delayed adjustment in services inflation, which itself is closely linked to wage developments. ${ }^{[28]}$ ---[PAGE_BREAK]--- # Policy counterfactuals The complex shocks that hit the euro area economy in 2021 and 2022 and the high inflation which emerged also raise the question of the appropriate monetary policy response of the ECB. This can be analysed by constructing policy counterfactuals that give an indication of what would have happened to inflation had the ECB acted differently. Staff use macroeconomic models to build these counterfactuals in real time, under different assumptions for the policy rate path and the expected path for inflation and growth. But the same models can also be used to construct counterfactuals with the benefit of hindsight, thus providing insight on what appropriate monetary policy might have looked like had the extent of the inflation surge been known from the outset. As an example, counterfactuals can be constructed using two policy models developed by ECB staff: the MMR model and the NAWM model. ${ }^{[29]}$ Given projections for inflation and a measure of economic slack, as well as assumptions about the interest rate path, it is possible to construct policy paths that minimise a loss function featuring squared terms for the deviation of inflation from target, the output gap, and the change in the interest rate. The last term is a proxy for financial or other stress that could be created if the monetary stance changes very rapidly. ${ }^{[30]}$ According to the model simulations, had the exact nature and size of shocks that were about to hit the economy been known back in the fourth quarter of 2021, the model-implied optimal policy (as defined by the minimisation of this loss function) would have called for interest rates to be increased earlier and more forcefully (Chart 11 black dashed). Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have come with large output costs, with quarter-on-quarter growth rates 1 to 2 percentage points lower, depending on the model. Of course, the ECB did not possess perfect foresight. The projections by ECB and Eurosystem staff, as well as those of other forecasters, predicted much lower and less persistent inflation as the baseline. In looking at the policy paths that were constructed using the actual information available to policymakers at the time - as reflected in the ECB/Eurosystem staff projections for inflation and growth - it shows the actual interest rate path during the hiking cycle was broadly in line with the modelimplied optimal policy path (Chart 11, blue lines vs. coloured lines). ---[PAGE_BREAK]--- # Chart 11 <br> Optimal policy in real-time and with hindsight (left panel: percentage per annum; middle panel: annual percentage changes; right panel: quarterly percentage changes) ![img-11.jpeg](img-11.jpeg) Source: ECB calculations based on the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)), and the NAWM II model (see Darracq Pariès, M. Kornprobst, A., Priftis, R. (2024), op. cit.). Notes: The optimal policy rate path simulations beyond the third quarter of 2024 are not shown for confidentiality reasons. "Actual" denotes historical data. The other dashed lines on the left graph are a sequence of optimal policy counterfactuals computed in real time at each projection vintage from the fourth quarter of 2021 to the second quarter of 2024. The "With hindsight" lines denote the optimal policy counterfactual computed in the fourth quarter of 2021 with the benefit of hindsight by assuming that the same information that we now have on subsequent inflation and output developments was already available in the fourth quarter of 2021. The middle and right panels show implied inflation and output growth respectively. ---[PAGE_BREAK]--- # Chart 12 <br> Early tightening counterfactual ![img-12.jpeg](img-12.jpeg) Source: ECB calculations based on the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). Notes: "Baseline" denotes historical data available in the third quarter of 2024. The solid lines in the left-hand side chart are the counterfactuals in Q4 2021 and Q2 2022 from Chart 11. Each of the lines with a marker on the left panel is a counterfactual rate path computed by constraining the lift-date to match the actual one and letting policy evolve optimally afterwards. The lines on the right panel are the difference in impact on inflation between the unconstrained and constrained case. Two instances can be identified in the MMR model in which the model-implied optimal policy prescriptions differed slightly from the path of interest rates followed by the ECB. The first instance was in early 2022, when optimal policy would have called for interest rate hikes already in the first quarter. The implications of this delayed start to rate hikes can be assessed by comparing inflation outcomes under a counterfactual in which the optimal interest rate path is constrained not to increase until the time in which the ECB started increasing rates and under the alternative assumption that the rate path is unconstrained. The inflation outcomes in the two cases are very close to each other, in the order a few basis points, suggesting that small changes in the exact timing of lift off were not consequential: what matters in the model is the overall direction of travel of monetary policy rather than whether one rate action is brought forward or backward by one quarter. The second episode (not shown in the chart) was in September 2023 when the model-implied optimal policy would have called for one fewer interest rate hike. However, the model-implied optimal policy path should be checked against an array of risk considerations. The optimal policy paths above are drawn around the central tendency of the BMPE projections: especially during periods of high uncertainty about the macroeconomic outcomes, it is prudent to also consider alternative scenarios. In particular, choosing a policy path that avoids the worst scenario from happening is a form of insurance and can in practice call for either a more aggressive or more gradual policy response than indicated by a simple loss function that is conditioned on the baseline projections. ${ }^{[31]}$ [32] ---[PAGE_BREAK]--- Policy models can also be employed to compute counterfactuals to quantify the impact of the actual monetary policy tightening on the disinflation process. The exercise is conducted using the ECB's main policy models - NAWM, MMR and ECB-BASE. ${ }^{[33]}$ According to these models, without the unprecedented tightening, inflation would have been about two percentage points higher on average in each year between 2023 and 2026 (Chart 13). The exact effects of monetary policy on inflation and output are subject to significant uncertainty and depend, among other things, on the assumed expectations formation process in the model. Semi-structural models such as the ECB-BASE have typically more backward-looking expectations, resulting in a slower propagation of shocks and thus smaller effects from monetary policy. By contrast, the effects can be larger in DSGE models, such as NAWM and MMR due to the strong forward-looking behaviour of agents in these models. In addition, monetary policy likely had an additional important role in keeping long-term inflation expectations anchored: that is not incorporated in the quantification of the impact of policy tightening reported above. ${ }^{[34]}$ The message emerging from these results indicates that monetary policy has played a significant role in contributing to the disinflation process and, given the information available at the time, it did so at a rather appropriate pace. As noted above, the policy simulations that condition on baseline projections alone suggest that the first increase in interest rates should have been implemented about a quarter earlier. But several other considerations beyond those captured in these models were relevant to the monetary policy decisions taken in the spring of 2022, especially in the context of the uncertainty surrounding the Russian invasion of Ukraine. A slightly earlier lift-off would only have had a very limited effect in dampening the scale of the inflation surge and a one quarter delay in liftoff provided insurance against the risks of tightening too early. Of course, as indicated earlier, the monetary policy tightening would have occurred at a significantly earlier date if the scale and persistence of the inflation shock had been better anticipated: the projections in early 2022 still signalled a return to below-target inflation over the medium term as they could not foresee as central tendency the protracted war in Ukraine and the drastic disruptions in the supply of Russian gas to some European countries. The final hike at the September 2023 meeting also incorporated risk management considerations. ${ }^{[35]}$ In particular, in view of some signs of an increase in inflation risks over the course of the summer, it was judged to be safer to increase the policy rate by a further 25 basis points, which would reinforce progress towards the target for two basic reasons. First, if the economy evolved in line with the staff baseline case, the decision to hike would bolster confidence that inflation would return to target within the projection horizon. Second, a higher interest rate would more strongly limit the amplification of any upside shocks to the inflation path. In consequence, a more secure pace of disinflation and greater insurance against upside risks would also reinforce the anchoring of inflation expectations, which remained a precondition for the disinflation process to keep up its pace. ---[PAGE_BREAK]--- # Chart 13 <br> Impact of monetary policy tightening according to a suite of models ![img-13.jpeg](img-13.jpeg) Sources: ECB calculations based on the NAWM II model (see Coenen, G., Karadi, P., Schmidt, S., Warne, A. (2018), "The New Area-Wide Model II: an extended version of the ECB's micro-founded model for forecasting and policy analysis with a financial sector", Working Paper Series, No 2200, ECB, November), the MMR model (see Mazelis, F., Motto, R., Ristiniemi, A. (2023), op. cit.) with the exercises documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)), and the ECB-BASE model (see Angelini, E., Bokan, N., Christoffel, K., Ciccarelli, M., Zimic, S. (2019), "Introducing ECB-BASE: The blueprint of the new ECB semi-structural model for the euro area", Working Paper Series, No 2315, ECB, September). Notes: This chart reports the results of a simulation involving changes to short-term rate expectations between December 2021 and September 2024 and changes to expectations regarding the ECB's balance sheet between October 2021 (to account for anticipation) and September 2024. "Mean" denotes the average across the six model variants. The latest observation is for 16 August 2024 for the underlying short rate expectations from MP-dated ESTR forward contracts. ## Conclusions My remarks today have sought to explain how macroeconomic models have been deployed at the ECB to help understand the 2021-2022 inflation surges and the appropriate monetary policy response. While models have their limitations, models can help us understand where and how our projections fell short. Models are also essential in the construction of scenarios and policy counterfactuals, which play an important role in the policy making process. The model-based analyses reported in this speech suggest that forecast errors in the inflation outlook were initially driven by unanticipated energy price shocks but that multiple changes in the transmission of shocks to inflation also played an important role in the broadening of the inflation shock, increasing its size and persistence. If the ECB had had perfect foresight in late 2021 on the exact nature and size of shocks that were about to hit the economy, the model-implied optimal policy would have called for interest rates to be increased more rapidly and more aggressively. Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have ---[PAGE_BREAK]--- come with large output costs, with quarter-on-quarter growth ending up 1 to 2 percentage points lower, depending on the model. Without the benefit of hindsight, the model-based analysis indicates that monetary policy was set in a broadly appropriate manner during 2021 and 2022, given the real-time information available to policymakers (including as incorporated in the baseline macroeconomic projections). While some risk considerations might have called for an earlier start to the hiking cycle, other risk considerations pushed in the opposite direction (including the uncertainty associated with the Russian invasion of Ukraine). In any event, the model analysis included in this speech suggests that minor variations in the start date would not have had a large impact. Most important, the interest rate path actually followed has delivered substantial and timely progress in disinflation. # 1. I am grateful to Thomas McGregor, Annukka Ristiniemi, Elise Dupin, Antonio Greco, Kai Christoffel, Romanos Priftis, Srecko Zimic, Antoine Kornprobst and Catalina Martinez Hernandez for their contributions to this speech. The views expressed here are personal and should not be interpreted as representing the collective view of the Governing Council. ## 2. The build-up to the invasion also affected energy price dynamics in 2021. ## 3. For a meeting-by-meeting narrative account of monetary policy decisions during this period in a recent contribution, see Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area," The ECB Blog, 11 March. The analysis in this speech also builds on the analysis contained in an earlier speech: see Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", Virtual Lecture at Stanford Graduate School of Business, 2 May. ## 4. By and large, the forecasting community (and market traders) significantly underestimated inflation over 2021 and 2022. This illustrates the significant challenges in forecasting inflation in a period characterised by extreme volatility in economic developments, and in energy commodity prices in particular. See Chart B in ECB (2024), "An update on the accuracy of recent Eurosystem/ECB staff projections for short-term inflation", Economic Bulletin, Issue 2.. ## 5. The Broad Macroeconomic Projection Exercise, or BMPE, is produced jointly by Eurosystem and ECB staff twice per year (in June and December), while in March and September, projections are produced by ECB staff (MPE). 6. ---[PAGE_BREAK]--- The market forward curve implicitly takes into account the expected impact of global monetary policies on the future path for commodity prices. Internal staff analysis indicates that ECB monetary policy has only a marginal impact on global oil prices. 7. See ECB (2016), A guide to the Eurosystem/ECB staff macroeconomic projection exercises, July. See also Ciccarelli, M., Darracq Paries, M. and Prifitis, R. (eds.) (2024), "ECB macroeconometric models for forecasting and policy analysis", Occasional Paper series, No 344, ECB. 8. The Basic Model Elasticities (BMEs) summarise the unconditional dynamics responses of variables across models used by NCBs and ECB staff. They do not come from a fully structural macroeconomic model. 9. The specific approach adopted here uses BMEs from the NCBs in the Eurosystem that summarise the key relationships between projection variables. 10. See ECB (2024), "An update on the accuracy of recent Eurosystem/ECB staff projections for shortterm inflation", Economic Bulletin, Issue 2 11. See Cicarelli et al (2019), "Introducing ECB-BASE", ECB Working paper No. 2315, September 2019. 12. These counterfactual results may under-state the size of forecast errors not due to technical assumptions (i.e. model specific errors) because the conditioning is done on HICP energy inflation, rather than on the oil and gas price assumptions directly. The mapping of oil and gas price assumptions to HICP energy is done using satellite models, which may themselves suffer from model errors. The strong pass-through of wholesale energy prices to retail and service sectors may also have played a role during this period, particularly given the impact of gas supply disruptions on electricity prices as a result of the war. 13. It is also possible that the level of uncertainty itself may be underestimated, especially since the ECBBASE model was estimated on a 20-year sample (first quarter of 1995-fourth quarter of 2016), when inflation volatility was low. Uncertainty may have been significantly larger had the estimation sample included the 1970s. For example, results from estimating a structural VAR model reveal that the distribution of shocks to inflation since the COVID-19 pandemic has been significantly larger than during the period following the global financial crisis. This would imply that the economic relations may ---[PAGE_BREAK]--- not have changed during the inflation surge, but rather that the shocks and parameter uncertainty have become larger than was assumed in the models. This, in turn, would imply a wider distribution around the inflation projections, which could render the difference between inflation outturns and model predictions statistically insignificant. 14. Large cost shocks might both induce firms to increase the frequency of price adjustment in order to avoid making losses and increase the customer acceptance of price hikes, whereas prices might be less responsive to demand shocks. See also L'Huillier, J.P. and Phelan, G. (2024), "Can supply shocks be inflationary with a flat Phillips curve?," mimeo, Brandeis University. 15. See Dedola et al. (2024), "What does new micro price evidence tell us about inflation dynamics and monetary policy transmission?", ECB Economic Bulletin, Issue 3/2024. 16. See US Benigno and Eggertsson (2023), "It's Baaack: The surge in inflation in the 2020s and the return of the non0linear Phillips curve" and Gitti (2024), "Nonlinearities in the Regional Phillips Curve with Labor Market Tightness" for evidence on the US. From a theoretical perspective, Karadi et al. (2024) provide micro-foundations for a nonlinear Phillips curve whereby the sensitivity of inflation to activity increases after large shocks due to an endogenous rise in the frequency of price changes. 17. I will return to model-based underlying inflation measures in a later section. For a stocktake of the forecasting and policy models used at the ECB, see Ciccarelli, M. et al., "ECB macroeconometric models for forecasting and policy analysis", op. cit. 18. For example, see the discussion of scenarios and uncertainty in: Bernanke, B. (2024), Forecasting for monetary policy making and communication at the Bank of England: a review, Bank of England, 12 April. 19. See Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", speech at Stanford Graduate School of business, 2 May 20. See Bańbura, M., Bobeica, E. and Martinez Hernandez, C. (2023), "What drives core inflation? The role of supply shocks", Working Paper series, No 2875, ECB. 21. ---[PAGE_BREAK]--- See e.g. Arce et al. (2024), Ascari et al (2023), Ascari et al. (2024), Banbura et al (2023), Bergholt et al. (2024), Bonomolo et al (2024), Delle Monache, Pacella (2024), Depalo and Lo Bello (2024), De Santis (2024), Eickmeier, Hoffmann (2022), Garcia-Revelo (2024), Giannone and Primiceri (2024), Goncalves and Koester (2022), Hoynck and Rossi (2023), Kataryniuk et al. (2024) Neri et al. (2023), Pallara et al. (2023), Bonomolo et al. (2024). 22. See, for example, Giannone, D. and Primiceri, G. (2024), "The Drivers of Post-Pandemic Inflation," NBER Working Papers, No 32859, National Bureau of Economic Research. 23. Allowing for transmission lags, a substantial tightening of monetary policy during 2021 might have tempered the 2022 post-pandemic rebound in the contact-intensive services sector. However, the level of uncertainty about the course of the pandemic remained elevated throughout 2021 and even in early 2022 due to the Omicron wave. 24. Christoffel, K. and Farkas, M. (2025), "Managing the Risks of Inflation Expectation De-anchoring", IMF Working Paper Series, 2025, forthcoming. The still-high prominence of the risk of downside deanchoring until March 2022 is connected to the assessment in these projection rounds that inflation would fall below target by the end of the projection horizon: that is, the rise in inflation was projected to be temporary. 25. For a more comprehensive discussion of the importance of monetary policy transmission for inflation, see Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", guest lecture at Stanford Graduate School of Business, 2 May and Lane P.R. (2024), "The effectiveness and transmission of monetary policy in the euro area", contribution to the panel on "Reassessing the effectiveness and transmission of monetary policy" at the Federal Reserve Bank of Kansas City Economic Symposium. 26. See Lane, P. R. (2024), "Underlying inflation: an update", speech at the Inflation: Dynamics and Drivers Conference 2024 organised by the Federal Reserve Bank of Cleveland and the ECB, 24 October and Economic Bulletin, Issue 5, ECB, 2023. The importance of underlying inflation for monetary policy decision-making was highlighted in the 2021 monetary policy strategy review of the ECB. 27. Model-based measures of the Persistent and Common Component of Inflation (PCCI) are constructed by estimating a dynamic factor model that extracts the persistent and common component of inflation ---[PAGE_BREAK]--- from granular price data at the item-country level, thereby exploiting the relative advantages of both cross-sectional and time series approaches. See Bańbura, M. and Bobeica, E. (2020), "PCCI - a datarich measure of underlying inflation in the euro area", Statistics Paper Series, No 38, ECB, October. The PCCI is similar in spirit to the New York's Fed Multivariate Core Trend. The PCCI is similar in spirit to the New York's Fed Multivariate Core Trend. See Almuzara, M. and Sbordone, A. (2024), "Measurement and Theory of Core Inflation", Staff Reports, No 1115, Federal Reserve Bank of New York. 28. See Lane, P.R. (2024), "Underlying inflation: an update", op. cit. 29. The focus here is on the path for the policy rate, which is the primary policy instrument. A discussion of the associated adjustments in the additional policy instruments (bond purchase programmes, the targeted lending programme) is beyond the scope of this speech. The optimal policy counterfactuals in both models are conducted using the COPPs toolkit. For further details see de Groot, O., Mazelis, F., Motto, R. and Ristiniemi, A. (2021), "A toolkit for computing Constrained Optimal Policy Projections (COPPs)", Working Paper Series, No 2555, ECB, May. The first of the two models used is the Mazelis, Motto and Ristiniemi (MMR) model, see see Mazelis, F., Motto, R. and Ristiniemi, A. (2023), "Monetary policy strategies for the euro area: optimal rules in the presence of the ELB", Working Paper Series, No 2797, ECB, March, and the exercises are documented in the Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). For optimal policy simulations using the NAWM see Darracq Pariès, M., Kornprobst, A. and Priftis, R. (2024), "Monetary policy strategies to navigate post-pandemic inflation: an assessment using the ECB's New Area-Wide Model", Working Paper Series, No 2935, ECB, April. 30. The loss function specification is consistent with common practice in academia and policy evaluations. The loss function weights used in the MMR model are estimated. The weight on inflation is 1 , on the output gap 0.2 , and the weight on the change in annualised interest rate 1.4. The weights used in the NAWM model are calibrated and are 1 for inflation, 0.1 for output gap, and 4 for the change in annualised interest rate. 31. The insure perspective of the two instances highlighted above - the March 2022 and the September 2023 policy meetings - are well reflected in the Accounts of the monetary policy meetings. According to the ECB's published Accounts of the policy meeting of March 2022, the uncertainty related to the recent Russian invasion of Ukraine was extensively debated, and I pointed out that "More than ever there was a need to maintain optionality in the conduct of monetary policy. In the current conditions, it ---[PAGE_BREAK]--- was especially important for monetary policy to remain data-dependent and for optionality to be twosided." According to the Accounts of the ECB policy meeting of September 2023, I again pointed out that "[...] the choice between holding the deposit facility rate at $3.75 \%$ and moving to $4.00 \%$ was finely balanced. However, at the margin it was safer to decide on an additional hike, given the highly uncertain environment and the significant disinflation that was still required to return to the inflation target in a timely manner. [...] In consequence, a more secure pace of disinflation and greater insurance against upside risks would also reinforce the anchoring of inflation expectations, which remained a precondition for the disinflation process to keep up its pace." 32. Risks to the baseline forecasts in an uncertain environment are typically explored through a robust control approach that compares policy for each of the scenarios and the risks of setting policy for a wrong scenario. Using a min-max strategy, it then chooses the policy option that avoids the worse outcome. For an application, see the forthcoming Handbook on Inflation (Coenen, Mazelis, Motto, Ristiniemi, Smets, Warne, Wouters (forthcoming)). An alternative approach is to create scenarios within a model by varying parameters and shocks and computing optimal policy on those scenarios. See Wieles, Kwakkel, Auping, Willem van den End (2024) "Scenario discovery to address deep uncertainty in monetary policy" DNB Working Paper No. 818. 33. For the MMR model see Mazelis, F., Motto, R., Ristiniemi, A. (2023), "Monetary policy strategies for the euro area: optimal rules in the presence of the ELB", Working Paper Series, No 2797, ECB, March, for the NAWM model, Coenen, G., Karadi, P., Schmidt, S. and Warne, A. (2018), "The New Area-Wide Model II: an extended version of the ECB's micro-founded model for forecasting and policy analysis with a financial sector", Working Paper Series, No 2200, ECB, November (revised December 2019), and for the ECB-BASE model See Angelini, E., Bokan, N., Christoffel, K., Ciccarelli, M. and Zimic, S. (2019), "Introducing ECB-BASE: The blueprint of the new ECB semi-structural model for the euro area", Working Paper Series, No 2315, ECB, September. Of course, optimal policy could also be studied under different model specifications, including allowing for nonlinearities. For instance, the frequency of price adjustment might be endogenous to the anticipated monetary policy response: see Karadi, P., Nakov, A., Nuño, G., Pasten, E. and Thaler, D. (2024), "Strike while the iron is hot: optimal monetary policy with a nonlinear Phillips Curve", CEPR Discussion Papers, No 19339, Centre for Economic Policy Research. See also: Erceg, C., Linde, J. and Trabandt, M. (2024), "Monetary Policy and Inflation Scares," mimeo, International Monetary Fund; 34. The optimal monetary policy response when expectations are formed by boundedly-rational agents is explored by Dupraz, S. and Marx, M. (2024), "Anchoring Boundedly Rational Expectations," mimeo, ---[PAGE_BREAK]--- Banque de France. 35. This point follows Lane, P.R. (2024), "The analytics of the monetary policy tightening cycle", op. cit. # CONTACT Copyright 2024, European Central Bank	Philip R Lane	Euro area	https://www.bis.org/review/r241125x.pdf	Rome, 18 November 2024 My aim today is to explain how macroeconomic models can help in understanding the extraordinary 2021-2022 inflation surges and the monetary policy response, in the context of the euro area. By and large, the scale and persistence of the inflation surge surprised the central banking community, external experts and market participants. The unexpected nature of the inflation surge triggered many questions about the performance of macroeconomic forecasters. At the same time, macroeconomic models can help us understand why the baseline projections did not foresee the inflation surge in its full scale and speed, while shedding light on the possible mechanisms and channels that may have been missed or under-stated. Scenario analysis has been enhanced and new models have been developed to enrich our understanding of the shocks that hit the economy over this period, as well as the mechanisms through which these shocks were transmitted to inflation. Models also play a central role in constructing some of the measures of underlying inflation that the Governing Council uses as an important cross-check for the inflation outlook. And models are essential in constructing policy counterfactuals to assess whether alternative monetary policy responses might have substantially reduced the scale of the inflation surge. Models therefore play an important role in strengthening our understanding of the recent inflationary surge and assessing the monetary policy response. Model-based retrospective analysis provides several insights into the 2021-2022 inflation surges. The large forecast errors in the inflation outlook over this period were driven, at least initially, by energy and commodity price shocks, especially following the Russia-Ukraine war, and pandemic-related bottlenecks. Subsequently, changes in the transmission of shocks through the pricing chain, and in the behaviour of firms and consumers, likely played an important role in amplifying and propagating these shocks across the economy, converting relative price shocks into a general inflation shock. Supply shocks, primarily originating from external sources, were key drivers of the inflation surges. While global and domestic surges in sectoral demand patterns also contributed to sectoral demandsupply mismatches (in the goods sector in 2020-2021 during the most intense phases of global pandemic lockdowns; in the services sector in 2022 during the post-pandemic reopening phase), the overall level of aggregate demand in the euro area was only barely above pre-pandemic levels by the end of 2022. The pre-dominant role of supply shocks, combined with the fact that inflation expectations were initially signalling significant downside risks, supported the initial looking-through approach for monetary policy. In this context, it is also essential to recall the sequential nature of the shocks: the focus in 2021 was on pandemic-related supply disruptions and sectoral demand-supply mismatches, while the unjustified Russian invasion of Ukraine in February 2022 subsequently triggered extraordinary jumps in gas and oil prices. The post-pandemic full-scale reopening of contact-intensive services sectors also took place in early 2022, after the ending of Omicron-related lockdowns. Put together, the second and third quarters of 2022 saw an extraordinary cocktail of inflation shocks, between the war-related commodity and supply chain shocks and the demand-supply mismatches in the reopening contactintensive service sectors. If policymakers had had perfect foresight about the shocks that were about to hit the economy, interest rates would have been raised earlier and more sharply. However, conditional on the real-time information available to policymakers (including how this information shaped baseline macroeconomic projections), monetary policy decisions in 2021-2022 were broadly in line with the policy paths indicated by the macroeconomic models. This assessment includes both the initial phase in which monetary policy did not respond to the early stages of the rise in inflation and the subsequent phase of a sharp and sustained tightening cycle. This monetary policy response was, and continues to be, an important contributor to the disinflation process. Macroeconomic models have played a central role in helping policymakers in charting this monetary policy course, through their roles in: (a) macroeconomic forecasting; (b) estimating underlying inflation; and (c) calibrating the appropriate interest rate path. This assessment puts the spotlight on the quality of the information set available to policymakers, especially in relation to the macroeconomic projections. I will cover this topic in the next section. The inflation surges in 2021 and 2022 surprised professional forecasters, both at the ECB and across other institutions and countries. Inflation turned out to be much higher and more persistent than had been projected. This is clear from the very large and persistent forecast errors at both short and medium-term horizons in the Eurosystem and ECB staff projections for headline and core inflation. For example, forecast errors at the one-quarter ahead horizon during this period were more than five times larger than the average errors over the previous twenty years for headline inflation (and around twice as large for core inflation) and had the same direction for several successive quarters (Chart 1, left and middle panels). Indeed, the projection error in the December 2021 Broad Macroeconomic Projection Exercise (BMPE) for the year-over-year inflation rate at the end of 2022 was the largest ever, at around eight percentage points. Projection errors were also materially larger than historical averages at medium-term horizons, with projections made early in the period suggesting that inflation would either return to target or fall below target well within the projection horizon. The errors in inflation at a four-quarter horizon, for example, were more than nine times larger during 2022 than the historic pre-pandemic average. This is important, since the medium-term inflation outlook is typically the most relevant for policymakers, given significant lags in the transmission of policy rate changes to inflation. The projection errors for GDP growth were smaller than for inflation, but still significantly above their historical range (Chart 1, right panel). The latest observation is from the September 2024 ECB staff Macroeconomic Projection Exercise (MPE). In understanding these large forecast errors over 2021-2022, it is important to differentiate between errors due to conditioning assumptions - especially linked to shocks to key variables such as energy or food prices - and errors in the way these assumptions were propagated through the forecasting models. The starting point for the ECB staff projections is a set of conditioning assumptions for the future evolution of key input variables, known as "technical assumptions". The right panel of Chart 2 shows that the expected paths for oil and gas prices were revised up repeatedly over successive projection rounds at the end of 2021 and throughout 2022. This highlights how energy prices were repeatedly expected by markets - and therefore by our projection models - to decline. However, a sequence of upward surprises to energy prices materialised, especially following the Russian invasion of Ukraine. This sequence of shocks pushed up inflation and compounded forecast errors over successive projection rounds. The latest observation is from the September 2024 MPE for the left-hand scale and for the third quarter of 2024 for the right-hand scale. In order to quantify the importance of energy price and other shocks in driving inflation projection errors, we can use models to construct counterfactual paths for inflation under a scenario in which forecasters had perfect foresight at each projection round about how energy prices and other conditioning variables would actually evolve over the projection horizon. This allows projection errors from incorrect technical assumptions to be isolated from the errors related to the transmission of shocks as embedded in models. Of course, the results from such a decomposition depend on the specific model. It is also important to keep in mind that the ECB/Eurosystem staff macroeconomic projections are not purely model based but also include staff judgement. The latest observation is from the June 2024 Eurosystem staff Broad Macroeconomic Projection Exercise (BMPE). Further insight can be gained by running this counterfactual exercise in a fully-fledged macroeconomic model. ECB-BASE is the workhorse large-scale estimated semi-structural model used at the ECB to support and cross-check the staff projection exercises. At the same time, a sizeable share of the inflation forecast errors over this period cannot be explained by errors in the assumptions around energy and food prices. Two explanations for the remaining errors seem plausible. The first explanation relates to statistical uncertainty. Macroeconomic forecasting models are underpinned by empirical estimates of model relations that are based on historical regularities. Statistical uncertainty around these estimates maps into statistical uncertainty around the central tendency of the inflation projection. Conditioning on the ex-post values for the technical assumptions, the statistical distribution around the inflation projections from the vantage point of December 2021 is relatively wide (Chart 4, blue area). The actual inflation outturns (solid blue line in Chart 4) experienced during the inflation surge were close to the bounds of this model uncertainty, although inflation was still slightly too high to be compatible with the model in the second half of 2022 and the first half of 2023. The second explanation is that economic relations might also have (temporarily) shifted during this extraordinary episode, including through an array of non-linear responses to the scale and combination of the shocks and the shift in the level of inflation. For example, in a high inflation environment, firms may adjust their prices more often than normal, in an attempt to pass on rapidly rising input and operational costs and protect their profits. Furthermore, the broadening of the inflation shock from the energy sector (including via the food sector) to the services sector may also have been amplified during 2022 by the strong demand for contact-intensive services (tourism, hospitality) due to the reopening of these sectors after the final pandemic lockdowns. While costs were increasing quickly, the price elasticity of demand for services was plausibly atypically low due to this pandemic reopening phase, allowing for a greater pass-through of the cost shocks. Furthermore, these conditions were ripe for a non-linear responses feedback loop between inflation and short-term inflation expectations. It is plausible that short-term inflation expectations are more sensitive to large inflation shocks than to small inflation shocks. Although longer-term inflation expectations remained broadly stable throughout, perceptions of past inflation and short-term expected inflation rates did increase in response to the inflation surges. In the event of a large inflation shock, an increase in near-term inflation expectations may take hold among households and firms, with firms anxious to avoid suffering relative price declines and households more likely to attribute individual price increases to general inflation than to a relative price increase. Faced with large forecast errors and significant uncertainty, ECB staff worked to develop new models and enhance the scenario analysis in the policy process. The new models developed include models of underlying inflation, satellite models that allow for alternative transmission channels, and machine learning models that try to allow for important non-linearities. Each of these approaches can help to cross-check projections from the main forecasting models. In turn, the staff judgement element in the forecasting process enables the incorporation of the results from these supplementary analytical exercises, both in the baseline and in the risk assessment. No doubt the lessons learned from the 2021-2022 high inflation episode will prove to be especially valuable in the future if a similar configuration of shocks were to arise. The recent experience certainly highlights the risks of over-reliance on baseline projections. Scenarios can be an effective way to represent risks when uncertainty is large or hard to quantify. In 2020 and 2021, each set of quarterly staff projections included scenario analyses based on alternative assumptions regarding the future evolution of the pandemic and its economic consequences. In 2022, alternative scenarios focused on the economic consequences of the war in Ukraine, especially as regards uncertainties about energy supply. More recently, the scenario analysis has focused on more specific risks, such as a slowdown in the Chinese economy or a potential escalation of the conflict in the Red Sea area. In my May 2024 Stanford speech, I discussed how these alternative scenarios can be used to construct policy counterfactuals and will go into more details in a forthcoming speech on the use of scenarios to assess the robustness of alternative policy paths. In addition to scenario analysis, the macroeconomic projections are accompanied by a large set of sensitivity analyses in relation to shifts in the technical assumptions and alternative parameter choices in model calibration. Models have also been deployed to interpret forecast errors through the lens of identified structural shocks and to quantify their contribution to inflation. Estimates from a large structural vector autoregressive (VAR) model - which employs sign and zero restrictions to identify the global and domestic demand and supply shocks driving deviations of inflation from the model-implied mean indicate that external supply shocks were the main driver of the initial inflation surge in the euro area, although shocks to external demand and domestic demand also played a role, especially during 2022. In particular, the shock decomposition points to various phases. The initial inflation increase was mainly driven by global supply shocks, related to supply chain disruptions, surging oil and gas prices and higher commodity prices more generally. These results supported an initially-circumspect monetary policy response, as the central bank still gathered evidence about the persistence of the inflation shock and its likelihood to affect materially expectations and other behavioural relations in the economy. In particular, in the absence of a clear understanding of the nature and expected persistence of the shocks, a more patient and deliberate policy response that weighs up the risks to different options, appeared appropriate. The latest observation is for September 2024. Of course, inference is sensitive to the type of model and the set of identifying assumptions. A key challenge is to correctly capture the information set. A model needs to contain sufficient information to span the space of the structural shocks of interest. Otherwise, the correct shocks cannot be recovered from the history of observed variables. In stylised terms, the larger the model (or the more variables that are included), the more room there is to control for the different factors that affect inflation and, in particular, to separate out shocks from structural drivers. This is particularly relevant when inflation is driven by a multifaceted and unusual set of shocks and structural drivers, originating both at home and abroad, as was the case over the 2021-2022 period. The dramatic fallout from the pandemic and the rapid bounce back following the reopening of economies after lockdowns are cases in point. In turn, amongst its many other effects, the shock of the Russian invasion of Ukraine constituted an extraordinarily-disruptive supply shock to the energy sector. As it turns out, models that rely on a small information set tend to assign a stronger role to demand factors and predict over-smooth dynamics of inflation and growth because such small-scale models are not designed to capture the type of sudden changes witnessed in that episode. The policy implications of model-based identification of demand and supply influences are not always easy to draw. That is, the policy implications not only depend on the source and nature of the shock but also its size and persistence. For example, a supply shock that is highly transitory (such as a temporary limitation in oil production in response to a short-lived geopolitical event) or a temporary surge in sectoral demand during the pandemic reopening phase (compounded by initially-limited supply capacity in the contact-intensive services sectors) may call for a looking-through policy response given the significant lags in the transmission of monetary policy. By contrast, a string of large and persistent supply shocks in the same direction requires central banks to tighten in order to avoid longer-lasting inflation effects via wage-price spirals and dislocations in expectations. In relation to the latter risk, the de-anchoring of longer-term inflation expectations warrants close monitoring, and models can help policymakers understand the risks of de-anchoring under alternative shocks and scenarios. For instance, simulations using a regime-switching DSGE model suggest that substantial downward de-anchoring risks prevailed throughout most of 2021, due to the low inflation of the previous periods exerting a persistent dampening effect on expectations as well as the initial inflationary shocks being largely understood to be temporary in nature. The further increase in inflation in early 2022 saw a rapid decline in downward de-anchoring risks and an increase in upward de-anchoring risks. The forceful policy response over the course of 2022 and 2023 helped to limit, and then reduce, these upward de-anchoring risks. Later on, risks became more balanced as inflation came down tangibly. The latest observations are from the September 2024 MPE. The speed and strength of monetary policy transmission is also important when calibrating the appropriate monetary policy response. Provided that monetary policy tightening transmits through to inflation in line with historical regularities, then our models should provide a good guide as to how fast and how far policy rates would need to be increased in response to the inflation shock. However, there is evidence that the aggressive rate hikes in response to inflation, and the highly restrictive monetary policy stance, have resulted in a faster-than-expected rise in lending rates as well as a larger contraction in credit flows, in particular to firms. This is important, because stronger-than-expected transmission would, all else being equal, call for smaller, or more gradual, rate increases in response to rising inflation. The latest observations are for October 2024 for the policy rate and for September 2024 for lending rates, credit to firms and loans to households. The high level of uncertainty surrounding the inflation outlook over the 2021-2022 period called for the development of additional metrics to distinguish between temporary and more long-lasting inflation dynamics. Models played an important role in the development of underlying measures of inflation, which aim to filter out the short-term volatility in headline inflation and better capture the low-frequency component of inflation. Such metrics provide a useful cross-check to the inflation projections, especially in times of elevated uncertainty. Most measures of underlying inflation have come down significantly from their peak. The latest observation is for October 2024 (flash estimate) for HICPX, HICP excluding energy and HICP excluding unprocessed food and energy and September 2024 for the rest. It is also important to understand what the various measures tell us about the speed and sequencing of the disinflation process. The delayed and lagged adjustment in indicators such as services inflation, domestic inflation and wage growth highlight that convergence to the medium-term target may still take time. It will be important to continue to monitor developments in domestic inflation, which has declined only slowly, mainly due to the delayed adjustment in services inflation, which itself is closely linked to wage developments. The complex shocks that hit the euro area economy in 2021 and 2022 and the high inflation which emerged also raise the question of the appropriate monetary policy response of the ECB. This can be analysed by constructing policy counterfactuals that give an indication of what would have happened to inflation had the ECB acted differently. Staff use macroeconomic models to build these counterfactuals in real time, under different assumptions for the policy rate path and the expected path for inflation and growth. But the same models can also be used to construct counterfactuals with the benefit of hindsight, thus providing insight on what appropriate monetary policy might have looked like had the extent of the inflation surge been known from the outset. As an example, counterfactuals can be constructed using two policy models developed by ECB staff: the MMR model and the NAWM model. According to the model simulations, had the exact nature and size of shocks that were about to hit the economy been known back in the fourth quarter of 2021, the model-implied optimal policy (as defined by the minimisation of this loss function) would have called for interest rates to be increased earlier and more forcefully (Chart 11 black dashed). Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have come with large output costs, with quarter-on-quarter growth rates 1 to 2 percentage points lower, depending on the model. Of course, the ECB did not possess perfect foresight. The projections by ECB and Eurosystem staff, as well as those of other forecasters, predicted much lower and less persistent inflation as the baseline. In looking at the policy paths that were constructed using the actual information available to policymakers at the time - as reflected in the ECB/Eurosystem staff projections for inflation and growth - it shows the actual interest rate path during the hiking cycle was broadly in line with the modelimplied optimal policy path (Chart 11, blue lines vs. coloured lines). Two instances can be identified in the MMR model in which the model-implied optimal policy prescriptions differed slightly from the path of interest rates followed by the ECB. The first instance was in early 2022, when optimal policy would have called for interest rate hikes already in the first quarter. The implications of this delayed start to rate hikes can be assessed by comparing inflation outcomes under a counterfactual in which the optimal interest rate path is constrained not to increase until the time in which the ECB started increasing rates and under the alternative assumption that the rate path is unconstrained. The inflation outcomes in the two cases are very close to each other, in the order a few basis points, suggesting that small changes in the exact timing of lift off were not consequential: what matters in the model is the overall direction of travel of monetary policy rather than whether one rate action is brought forward or backward by one quarter. The second episode (not shown in the chart) was in September 2023 when the model-implied optimal policy would have called for one fewer interest rate hike. However, the model-implied optimal policy path should be checked against an array of risk considerations. The optimal policy paths above are drawn around the central tendency of the BMPE projections: especially during periods of high uncertainty about the macroeconomic outcomes, it is prudent to also consider alternative scenarios. In particular, choosing a policy path that avoids the worst scenario from happening is a form of insurance and can in practice call for either a more aggressive or more gradual policy response than indicated by a simple loss function that is conditioned on the baseline projections. Policy models can also be employed to compute counterfactuals to quantify the impact of the actual monetary policy tightening on the disinflation process. The exercise is conducted using the ECB's main policy models - NAWM, MMR and ECB-BASE. The message emerging from these results indicates that monetary policy has played a significant role in contributing to the disinflation process and, given the information available at the time, it did so at a rather appropriate pace. As noted above, the policy simulations that condition on baseline projections alone suggest that the first increase in interest rates should have been implemented about a quarter earlier. But several other considerations beyond those captured in these models were relevant to the monetary policy decisions taken in the spring of 2022, especially in the context of the uncertainty surrounding the Russian invasion of Ukraine. A slightly earlier lift-off would only have had a very limited effect in dampening the scale of the inflation surge and a one quarter delay in liftoff provided insurance against the risks of tightening too early. Of course, as indicated earlier, the monetary policy tightening would have occurred at a significantly earlier date if the scale and persistence of the inflation shock had been better anticipated: the projections in early 2022 still signalled a return to below-target inflation over the medium term as they could not foresee as central tendency the protracted war in Ukraine and the drastic disruptions in the supply of Russian gas to some European countries. The latest observation is for 16 August 2024 for the underlying short rate expectations from MP-dated ESTR forward contracts. My remarks today have sought to explain how macroeconomic models have been deployed at the ECB to help understand the 2021-2022 inflation surges and the appropriate monetary policy response. While models have their limitations, models can help us understand where and how our projections fell short. Models are also essential in the construction of scenarios and policy counterfactuals, which play an important role in the policy making process. The model-based analyses reported in this speech suggest that forecast errors in the inflation outlook were initially driven by unanticipated energy price shocks but that multiple changes in the transmission of shocks to inflation also played an important role in the broadening of the inflation shock, increasing its size and persistence. If the ECB had had perfect foresight in late 2021 on the exact nature and size of shocks that were about to hit the economy, the model-implied optimal policy would have called for interest rates to be increased more rapidly and more aggressively. Inflation would have peaked at around 8 per cent rather than the 10 per cent observed in the fourth quarter of 2022. However, this tightening would have come with large output costs, with quarter-on-quarter growth ending up 1 to 2 percentage points lower, depending on the model. Without the benefit of hindsight, the model-based analysis indicates that monetary policy was set in a broadly appropriate manner during 2021 and 2022, given the real-time information available to policymakers (including as incorporated in the baseline macroeconomic projections). While some risk considerations might have called for an earlier start to the hiking cycle, other risk considerations pushed in the opposite direction (including the uncertainty associated with the Russian invasion of Ukraine). In any event, the model analysis included in this speech suggests that minor variations in the start date would not have had a large impact. Most important, the interest rate path actually followed has delivered substantial and timely progress in disinflation. I am grateful to Thomas McGregor, Annukka Ristiniemi, Elise Dupin, Antonio Greco, Kai Christoffel, Romanos Priftis, Srecko Zimic, Antoine Kornprobst and Catalina Martinez Hernandez for their contributions to this speech. The views expressed here are personal and should not be interpreted as representing the collective view of the Governing Council. The build-up to the invasion also affected energy price dynamics in 2021. The Broad Macroeconomic Projection Exercise, or BMPE, is produced jointly by Eurosystem and ECB staff twice per year (in June and December), while in March and September, projections are produced by ECB staff (MPE). These counterfactual results may under-state the size of forecast errors not due to technical assumptions (i.e. model specific errors) because the conditioning is done on HICP energy inflation, rather than on the oil and gas price assumptions directly. The mapping of oil and gas price assumptions to HICP energy is done using satellite models, which may themselves suffer from model errors. The strong pass-through of wholesale energy prices to retail and service sectors may also have played a role during this period, particularly given the impact of gas supply disruptions on electricity prices as a result of the war. Banque de France. Copyright 2024, European Central Bank
2024-11-18T00:00:00	Luis de Guindos: Financial stability in the euro area	Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Frankfurt Euro Finance Week, organised by the dfv Euro Finance Group, Frankfurt am Main, 18 November 2024.	Luis de Guindos: Financial stability in the euro area Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the dfv Frankfurt Euro Finance Week, organised by the Euro Finance Group, Frankfurt am Main, 18 November 2024. * * * It is my great pleasure to continue the tradition of joining you at the Frankfurt Euro Finance Week. In today's remarks I will provide you with our latest assessment of the risks to financial stability in the euro area, which we will soon publish in more detail in the ECB's Financial Stability Review - a publication that celebrates its twentieth anniversary this week. I will then discuss the resilience of euro area banks and nonbanks. And finally, with Europe at the crossroads, I will emphasise the importance of strengthening financial integration, completing banking union and moving forward on the capital markets union. Volatile and uncertain macro-financial outlook If you look at where we are now compared with a year ago, the balance of macro-risks has shifted from concerns about high inflation to fears over economic growth. Consumer price inflation has moved closer to our 2% target. But economic activity has been weaker than expected: we have revised down our projections twice - before the summer and in September. The growth outlook is clouded by uncertainty about economic policies and the geopolitical landscape, both in the euro area and globally. Trade tensions could rise further, increasing the risk of tail events materialising. These cyclical headwinds compound structural issues of low productivity and weak potential euro area growth. Against a background of heightened uncertainty, our upcoming Financial Stability Review highlights three main vulnerabilities that shape the euro area outlook. Key financial stability vulnerabilities The first vulnerability relates to financial markets, which remain susceptible to sudden, sharp adjustments. While recent high-volatility episodes were short-lived and had only limited impact on the financial system, underlying vulnerabilities make financial markets prone to bouts of volatility in the future. First, record-low equity premia and compressed corporate bond spreads are signs that investors may be underestimating the likelihood and potential impact of adverse scenarios. Second, concentration of equity market capitalisation and earnings among a handful of companies, notably in the United States, has increased greatly in recent years, raising concerns over the possibility of an asset price bubble connected to artificial intelligence. Given how deeply integrated global equity markets are, negative firm-specific or sector-specific surprises could easily spillover across the borders. The second vulnerability relates to rising sovereign risks. While the aggregate euro area debt-to-GDP ratio has declined considerably from its peak during the pandemic, debt levels remain high in many countries owing to persistent primary deficits. Under these circumstances, fiscal slippage or questions around fiscal consolidation paths could trigger further repricing of sovereign risk. Current large primary deficits will also make it harder for governments to support the economy if adverse shocks materialise, and they will make it more difficult to provide additional investment to cope with structural challenges, including climate change, defence spending, digitalisation and low productivity. This in turn could give rise to a negative feedback loop between low growth and sovereign debt sustainability. The third vulnerability relates to credit risk. Amid weak growth prospects, credit risk remains a concern for some euro area firms and households and could affect asset quality of banks and non-banks. Overall, firms and households have weathered the impact of past interest rate increases and appear resilient generally. Nevertheless high - albeit declining - lending rates remain a challenge for some borrowers. Insolvencies - a lagged indicator of corporate financial health - have been rising across sectors and countries, although from relatively low levels. The debt servicing capacity of small and medium-sized enterprises and of commercial real estate firms appears to be particularly vulnerable to a slowdown in economic activity and higher borrowing costs. At the same time, the euro area commercial real estate markets show signs of stabilisation, with investor demand slowly recovering, in line with less restrictive monetary policy. In addition, higher interest rates continue to challenge households with lower incomes and floating-rate mortgages. Slower growth and a weakening labour market could further undermine the debt servicing capacity of these borrowers. Financial sector's resilience The previous point in particular raises the question: are euro area financial institutions well prepared to cope with these risks? Here the good news is that bank balance sheets are strong, making it easier for banks to absorb losses, if asset quality deterioration were to accelerate. Lower operating expenses and strong net interest margins have enabled euro area banks to maintain high levels of profitability. Banking sector resilience is bolstered by solid capital ratios and liquidity buffers, despite the gradual phasing-out of funding from targeted longerterm refinancing operations. That being said, bank profitability may have peaked, with earnings on floating-rate assets becoming a headwind for interest income and credit losses starting to rise. Turning to the non-bank financial intermediation (NBFI) sector, non-banks remain vulnerable to, and could amplify, macroeconomic and financial market shocks. A significant proportion of non-banks' holdings - especially of corporate bonds and equities - are from issuers in countries projected to experience low economic growth and high levels of sovereign debt. Consequently, any potential downturn could weigh on asset quality in NBFI portfolios. Additionally, the rising exposure of the NBFI sector to global markets, including US-based technology firms, makes non-banks vulnerable to shocks and volatility in those markets. This could expose the sector to sudden sharp declines in asset values and returns, putting further strain on their resilience. Some segments of the NBFI sector also face structural vulnerabilities related to liquidity mismatches and high leverage. These issues make the sector more susceptible to amplifying shocks through forced asset sales. When asset values or returns decline sharply, open-ended investment funds - such as real estate funds - may be forced to sell assets to meet redemption demands. This risk is heightened in sectors like commercial real estate, as in some euro area countries a potential fall in property prices has not yet been fully reflected in fund valuations. This implies that the risk of price corrections and subsequent outflows remains elevated. Furthermore, pockets of high financial and synthetic leverage in the investment fund sector - most notably in hedge funds - introduces another layer of vulnerability. As we have seen in previous crises, leverage can magnify losses, making the sector more prone to systemic risks in times of market stress. Safeguarding resilience and strengthening financial integration Looking at the current highly uncertain geopolitical and economic environment, regulatory standards remain key to preserve the resilience of banks and non-banks' alike. Existing macroprudential capital buffer requirements for banks as well as borrower-based measures should be maintained. In this context, it is reassuring that the final elements of Basel III were implemented in EU law in June 2024. While sound capital and liquidity buffers are the first line of defence against bank failures, they must be complemented by steady and agile supervision in a full banking union. Our work on this front is not yet done. To complete the banking union, we must address key gaps in our institutional framework. This includes finalising the crisis management toolkit for EU large banks and making progress in other areas, such as liquidity in resolution and a backstop to the Single Resolution Fund. A critical gap that 1 demands attention is the absence of a European deposit insurance scheme. Progress towards a full banking union that would remove barriers to greater financial system integration across euro area countries remains a priority if we want to make our banking system more efficient. It is also essential to strengthen the resilience of the NBFI sector, not only to protect individual institutions but also to safeguard the broader stability of the financial system, especially since a more resilient non-bank sector will reduce the likelihood of spillovers 2 to the banking sector. A sound NBFI sector is also a prerequisite for achieving deeper financial integration in the euro area and completing of the capital markets union. Progress on the capital markets union should be central to a revised strategy to enhance Europe's productivity and economic growth. Greater economic integration goes hand-in-hand with greater financial integration. By mobilising capital markets more effectively, we can deepen the Single Market and provide much-needed financing to innovative and productive firms across Europe. This is crucial for supporting long-term growth and securing the financing of the green transition. However, achieving these objectives will not be without its challenges. The ambition to strengthen capital markets must be accompanied by concrete policies. A more prominent role for the non-bank financial sector should go along with a robust macroprudential framework to ensure its resilience. The European Commission's consultation on macroprudential policies for NBFI is an important step toward addressing the risks in this industry. Let me conclude with a clear message on the financial sector. Now is not the time to roll back hard- won regulatory progress. With sources of risk and vulnerability remaining elevated against a background of great uncertainty and weak growth prospects, our current moment is one for upholding regulation, preserving resilience and pressing ahead with macroprudential policies for non-banks. A stronger and stable financial system with developed capital markets can be a vital engine of growth for Europe in the years ahead. 1 See de Guindos, L., (2023), "Banking Union and Capital Markets Union: high time to move on", speech at the Annual Joint Conference of the European Commission and the European Central Bank on European Financial Integration, Brussels, 7 June. 2 See Franceschi, E. et. al., (2023), "Key linkages between banks and the non-bank financial sector ", Financial Stability Review, ECB, May.	---[PAGE_BREAK]--- # Luis de Guindos: Financial stability in the euro area Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Frankfurt Euro Finance Week, organised by the dfv Euro Finance Group, Frankfurt am Main, 18 November 2024. It is my great pleasure to continue the tradition of joining you at the Frankfurt Euro Finance Week. In today's remarks I will provide you with our latest assessment of the risks to financial stability in the euro area, which we will soon publish in more detail in the ECB's Financial Stability Review - a publication that celebrates its twentieth anniversary this week. I will then discuss the resilience of euro area banks and nonbanks. And finally, with Europe at the crossroads, I will emphasise the importance of strengthening financial integration, completing banking union and moving forward on the capital markets union. ## Volatile and uncertain macro-financial outlook If you look at where we are now compared with a year ago, the balance of macro-risks has shifted from concerns about high inflation to fears over economic growth. Consumer price inflation has moved closer to our 2\% target. But economic activity has been weaker than expected: we have revised down our projections twice - before the summer and in September. The growth outlook is clouded by uncertainty about economic policies and the geopolitical landscape, both in the euro area and globally. Trade tensions could rise further, increasing the risk of tail events materialising. These cyclical headwinds compound structural issues of low productivity and weak potential euro area growth. Against a background of heightened uncertainty, our upcoming Financial Stability Review highlights three main vulnerabilities that shape the euro area outlook. ## Key financial stability vulnerabilities The first vulnerability relates to financial markets, which remain susceptible to sudden, sharp adjustments. While recent high-volatility episodes were short-lived and had only limited impact on the financial system, underlying vulnerabilities make financial markets prone to bouts of volatility in the future. First, record-low equity premia and compressed corporate bond spreads are signs that investors may be underestimating the likelihood and potential impact of adverse scenarios. Second, concentration of equity market capitalisation and earnings among a handful of companies, notably in the United States, has increased greatly in recent years, raising concerns over the possibility of an asset price bubble connected to artificial intelligence. Given how deeply integrated global equity markets are, negative firm-specific or sector-specific surprises could easily spillover across the borders. The second vulnerability relates to rising sovereign risks. While the aggregate euro area debt-to-GDP ratio has declined considerably from its peak during the pandemic, debt levels remain high in many countries owing to persistent primary deficits. Under these ---[PAGE_BREAK]--- circumstances, fiscal slippage or questions around fiscal consolidation paths could trigger further repricing of sovereign risk. Current large primary deficits will also make it harder for governments to support the economy if adverse shocks materialise, and they will make it more difficult to provide additional investment to cope with structural challenges, including climate change, defence spending, digitalisation and low productivity. This in turn could give rise to a negative feedback loop between low growth and sovereign debt sustainability. The third vulnerability relates to credit risk. Amid weak growth prospects, credit risk remains a concern for some euro area firms and households and could affect asset quality of banks and non-banks. Overall, firms and households have weathered the impact of past interest rate increases and appear resilient generally. Nevertheless high - albeit declining - lending rates remain a challenge for some borrowers. Insolvencies a lagged indicator of corporate financial health - have been rising across sectors and countries, although from relatively low levels. The debt servicing capacity of small and medium-sized enterprises and of commercial real estate firms appears to be particularly vulnerable to a slowdown in economic activity and higher borrowing costs. At the same time, the euro area commercial real estate markets show signs of stabilisation, with investor demand slowly recovering, in line with less restrictive monetary policy. In addition, higher interest rates continue to challenge households with lower incomes and floating-rate mortgages. Slower growth and a weakening labour market could further undermine the debt servicing capacity of these borrowers. # Financial sector's resilience The previous point in particular raises the question: are euro area financial institutions well prepared to cope with these risks? Here the good news is that bank balance sheets are strong, making it easier for banks to absorb losses, if asset quality deterioration were to accelerate. Lower operating expenses and strong net interest margins have enabled euro area banks to maintain high levels of profitability. Banking sector resilience is bolstered by solid capital ratios and liquidity buffers, despite the gradual phasing-out of funding from targeted longerterm refinancing operations. That being said, bank profitability may have peaked, with earnings on floating-rate assets becoming a headwind for interest income and credit losses starting to rise. Turning to the non-bank financial intermediation (NBFI) sector, non-banks remain vulnerable to, and could amplify, macroeconomic and financial market shocks. A significant proportion of non-banks' holdings - especially of corporate bonds and equities - are from issuers in countries projected to experience low economic growth and high levels of sovereign debt. Consequently, any potential downturn could weigh on asset quality in NBFI portfolios. Additionally, the rising exposure of the NBFI sector to global markets, including US-based technology firms, makes non-banks vulnerable to shocks and volatility in those markets. This could expose the sector to sudden sharp declines in asset values and returns, putting further strain on their resilience. Some segments of the NBFI sector also face structural vulnerabilities related to liquidity mismatches and high leverage. These issues make the sector more susceptible to amplifying shocks through forced asset sales. When asset values or returns decline ---[PAGE_BREAK]--- sharply, open-ended investment funds - such as real estate funds - may be forced to sell assets to meet redemption demands. This risk is heightened in sectors like commercial real estate, as in some euro area countries a potential fall in property prices has not yet been fully reflected in fund valuations. This implies that the risk of price corrections and subsequent outflows remains elevated. Furthermore, pockets of high financial and synthetic leverage in the investment fund sector - most notably in hedge funds - introduces another layer of vulnerability. As we have seen in previous crises, leverage can magnify losses, making the sector more prone to systemic risks in times of market stress. # Safeguarding resilience and strengthening financial integration Looking at the current highly uncertain geopolitical and economic environment, regulatory standards remain key to preserve the resilience of banks and non-banks' alike. Existing macroprudential capital buffer requirements for banks as well as borrower-based measures should be maintained. In this context, it is reassuring that the final elements of Basel III were implemented in EU law in June 2024. While sound capital and liquidity buffers are the first line of defence against bank failures, they must be complemented by steady and agile supervision in a full banking union. Our work on this front is not yet done. To complete the banking union, we must address key gaps in our institutional framework. This includes finalising the crisis management toolkit for EU large banks and making progress in other areas, such as liquidity in resolution and a backstop to the Single Resolution Fund. A critical gap that demands attention is the absence of a European deposit insurance scheme. ${ }^{1}$ Progress towards a full banking union that would remove barriers to greater financial system integration across euro area countries remains a priority if we want to make our banking system more efficient. It is also essential to strengthen the resilience of the NBFI sector, not only to protect individual institutions but also to safeguard the broader stability of the financial system, especially since a more resilient non-bank sector will reduce the likelihood of spillovers to the banking sector. ${ }^{2}$ A sound NBFI sector is also a prerequisite for achieving deeper financial integration in the euro area and completing of the capital markets union. Progress on the capital markets union should be central to a revised strategy to enhance Europe's productivity and economic growth. Greater economic integration goes hand-in-hand with greater financial integration. By mobilising capital markets more effectively, we can deepen the Single Market and provide much-needed financing to innovative and productive firms across Europe. This is crucial for supporting long-term growth and securing the financing of the green transition. However, achieving these objectives will not be without its challenges. The ambition to strengthen capital markets must be accompanied by concrete policies. A more prominent role for the non-bank financial sector should go along with a robust macroprudential framework to ensure its resilience. The European Commission's consultation on macroprudential policies for NBFI is an important step toward addressing the risks in this industry. ---[PAGE_BREAK]--- Let me conclude with a clear message on the financial sector. Now is not the time to roll back hard- won regulatory progress. With sources of risk and vulnerability remaining elevated against a background of great uncertainty and weak growth prospects, our current moment is one for upholding regulation, preserving resilience and pressing ahead with macroprudential policies for non-banks. A stronger and stable financial system with developed capital markets can be a vital engine of growth for Europe in the years ahead. ${ }^{1}$ See de Guindos, L., (2023), "Banking Union and Capital Markets Union: high time to move on", speech at the Annual Joint Conference of the European Commission and the European Central Bank on European Financial Integration, Brussels, 7 June. ${ }^{2}$ See Franceschi, E. et. al., (2023), "Key linkages between banks and the non-bank financial sector", Financial Stability Review, ECB, May.	Luis de Guindos	Euro area	https://www.bis.org/review/r241125u.pdf	Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Frankfurt Euro Finance Week, organised by the dfv Euro Finance Group, Frankfurt am Main, 18 November 2024. It is my great pleasure to continue the tradition of joining you at the Frankfurt Euro Finance Week. In today's remarks I will provide you with our latest assessment of the risks to financial stability in the euro area, which we will soon publish in more detail in the ECB's Financial Stability Review - a publication that celebrates its twentieth anniversary this week. I will then discuss the resilience of euro area banks and nonbanks. And finally, with Europe at the crossroads, I will emphasise the importance of strengthening financial integration, completing banking union and moving forward on the capital markets union. If you look at where we are now compared with a year ago, the balance of macro-risks has shifted from concerns about high inflation to fears over economic growth. Consumer price inflation has moved closer to our 2\% target. But economic activity has been weaker than expected: we have revised down our projections twice - before the summer and in September. The growth outlook is clouded by uncertainty about economic policies and the geopolitical landscape, both in the euro area and globally. Trade tensions could rise further, increasing the risk of tail events materialising. These cyclical headwinds compound structural issues of low productivity and weak potential euro area growth. Against a background of heightened uncertainty, our upcoming Financial Stability Review highlights three main vulnerabilities that shape the euro area outlook. The first vulnerability relates to financial markets, which remain susceptible to sudden, sharp adjustments. While recent high-volatility episodes were short-lived and had only limited impact on the financial system, underlying vulnerabilities make financial markets prone to bouts of volatility in the future. First, record-low equity premia and compressed corporate bond spreads are signs that investors may be underestimating the likelihood and potential impact of adverse scenarios. Second, concentration of equity market capitalisation and earnings among a handful of companies, notably in the United States, has increased greatly in recent years, raising concerns over the possibility of an asset price bubble connected to artificial intelligence. Given how deeply integrated global equity markets are, negative firm-specific or sector-specific surprises could easily spillover across the borders. The second vulnerability relates to rising sovereign risks. While the aggregate euro area debt-to-GDP ratio has declined considerably from its peak during the pandemic, debt levels remain high in many countries owing to persistent primary deficits. Under these circumstances, fiscal slippage or questions around fiscal consolidation paths could trigger further repricing of sovereign risk. Current large primary deficits will also make it harder for governments to support the economy if adverse shocks materialise, and they will make it more difficult to provide additional investment to cope with structural challenges, including climate change, defence spending, digitalisation and low productivity. This in turn could give rise to a negative feedback loop between low growth and sovereign debt sustainability. The third vulnerability relates to credit risk. Amid weak growth prospects, credit risk remains a concern for some euro area firms and households and could affect asset quality of banks and non-banks. Overall, firms and households have weathered the impact of past interest rate increases and appear resilient generally. Nevertheless high - albeit declining - lending rates remain a challenge for some borrowers. Insolvencies a lagged indicator of corporate financial health - have been rising across sectors and countries, although from relatively low levels. The debt servicing capacity of small and medium-sized enterprises and of commercial real estate firms appears to be particularly vulnerable to a slowdown in economic activity and higher borrowing costs. At the same time, the euro area commercial real estate markets show signs of stabilisation, with investor demand slowly recovering, in line with less restrictive monetary policy. In addition, higher interest rates continue to challenge households with lower incomes and floating-rate mortgages. Slower growth and a weakening labour market could further undermine the debt servicing capacity of these borrowers. The previous point in particular raises the question: are euro area financial institutions well prepared to cope with these risks? Here the good news is that bank balance sheets are strong, making it easier for banks to absorb losses, if asset quality deterioration were to accelerate. Lower operating expenses and strong net interest margins have enabled euro area banks to maintain high levels of profitability. Banking sector resilience is bolstered by solid capital ratios and liquidity buffers, despite the gradual phasing-out of funding from targeted longerterm refinancing operations. That being said, bank profitability may have peaked, with earnings on floating-rate assets becoming a headwind for interest income and credit losses starting to rise. Turning to the non-bank financial intermediation (NBFI) sector, non-banks remain vulnerable to, and could amplify, macroeconomic and financial market shocks. A significant proportion of non-banks' holdings - especially of corporate bonds and equities - are from issuers in countries projected to experience low economic growth and high levels of sovereign debt. Consequently, any potential downturn could weigh on asset quality in NBFI portfolios. Additionally, the rising exposure of the NBFI sector to global markets, including US-based technology firms, makes non-banks vulnerable to shocks and volatility in those markets. This could expose the sector to sudden sharp declines in asset values and returns, putting further strain on their resilience. Some segments of the NBFI sector also face structural vulnerabilities related to liquidity mismatches and high leverage. These issues make the sector more susceptible to amplifying shocks through forced asset sales. When asset values or returns decline sharply, open-ended investment funds - such as real estate funds - may be forced to sell assets to meet redemption demands. This risk is heightened in sectors like commercial real estate, as in some euro area countries a potential fall in property prices has not yet been fully reflected in fund valuations. This implies that the risk of price corrections and subsequent outflows remains elevated. Furthermore, pockets of high financial and synthetic leverage in the investment fund sector - most notably in hedge funds - introduces another layer of vulnerability. As we have seen in previous crises, leverage can magnify losses, making the sector more prone to systemic risks in times of market stress. Looking at the current highly uncertain geopolitical and economic environment, regulatory standards remain key to preserve the resilience of banks and non-banks' alike. Existing macroprudential capital buffer requirements for banks as well as borrower-based measures should be maintained. In this context, it is reassuring that the final elements of Basel III were implemented in EU law in June 2024. While sound capital and liquidity buffers are the first line of defence against bank failures, they must be complemented by steady and agile supervision in a full banking union. Our work on this front is not yet done. To complete the banking union, we must address key gaps in our institutional framework. This includes finalising the crisis management toolkit for EU large banks and making progress in other areas, such as liquidity in resolution and a backstop to the Single Resolution Fund. A critical gap that demands attention is the absence of a European deposit insurance scheme. Progress towards a full banking union that would remove barriers to greater financial system integration across euro area countries remains a priority if we want to make our banking system more efficient. It is also essential to strengthen the resilience of the NBFI sector, not only to protect individual institutions but also to safeguard the broader stability of the financial system, especially since a more resilient non-bank sector will reduce the likelihood of spillovers to the banking sector. A sound NBFI sector is also a prerequisite for achieving deeper financial integration in the euro area and completing of the capital markets union. Progress on the capital markets union should be central to a revised strategy to enhance Europe's productivity and economic growth. Greater economic integration goes hand-in-hand with greater financial integration. By mobilising capital markets more effectively, we can deepen the Single Market and provide much-needed financing to innovative and productive firms across Europe. This is crucial for supporting long-term growth and securing the financing of the green transition. However, achieving these objectives will not be without its challenges. The ambition to strengthen capital markets must be accompanied by concrete policies. A more prominent role for the non-bank financial sector should go along with a robust macroprudential framework to ensure its resilience. The European Commission's consultation on macroprudential policies for NBFI is an important step toward addressing the risks in this industry. Let me conclude with a clear message on the financial sector. Now is not the time to roll back hard- won regulatory progress. With sources of risk and vulnerability remaining elevated against a background of great uncertainty and weak growth prospects, our current moment is one for upholding regulation, preserving resilience and pressing ahead with macroprudential policies for non-banks. A stronger and stable financial system with developed capital markets can be a vital engine of growth for Europe in the years ahead.
2024-11-19T00:00:00	Frank Elderson: Taking account of nature, naturally	Speech by Mr Frank Elderson, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the tenth Green Finance Forum "Innovate in Nature", Frankfurt am Main, 19 November 2024.	SPEECH Taking account of nature, naturally Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the tenth Green Finance Forum "Innovate in Nature" Frankfurt am Main, 19 November 2024 Thank you for inviting me to speak at the opening of the tenth Green Finance Forum. I fully subscribe to the theme of today's forum, given how vitally important it is to "innovate in nature". Especially because in many ways nature is still not accounted for in policies, regulation and risk management, but it should be, considering its vital importance for the economy - including the financial system. This morning I will outline how the relevance of nature is being confirmed by incoming research and how the European Central Bank (ECB) is acting on this to deliver on its mandate of maintaining price stability and preserving the safety and soundness of banks. A thriving natural environment provides many benefits that sustain human well-being and the global economy. Think of fertile soils, pollination, timber, fishing stocks, clean water and clean air. Unfortunately, intensive land use, climate change, pollution, overexploitation and other human pressures are rapidly and seriously damaging our natural resources. The Intergovernmental Science- Policy Platform on Biodiversity and Ecosystem Services already sounded the alarm back in 2019, shortly before the outbreak of the pandemic."] The degradation of nature is primarily caused by human activity and is being made worse by global heating. In addition to the depletion of non- renewable resources, natural inputs to the economy that are renewable are also increasingly being degraded. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths. This nature loss poses a serious risk to humanity as it threatens vital areas, such as the supply of food and medicine. Such threats are also existential for the economy and the financial system, as our economy cannot exist without nature.!2! One of the papers presented at the annual ECB Forum on Central Banking in Sintra, Portugal, in July of this year shows how biodiversity loss can cause losses to economic output while at the same time decreasing the resilience of that output to future biodiversity losses. However, in practice, at least thus far, the contribution of the inputs nature provides to the economy is rarely measured directly in statistics like GDP. Central banks and supervisors like the ECB need to gain a better understanding of just how vulnerable the economy and the financial system are to nature degradation. We need to incorporate nature into the analysis of the drivers of economic development and the assessment of future productive capacity. 4] Degradation of nature can impair production processes and consequently weaken the creditworthiness of many companies, which might in turn impair loans extended by banks. How nature affects the economy As is the case with climate change, nature affects companies and banks via two main channels: physical risks and transition risks. Physical risks may be acute risks, such as increasingly severe natural disasters, or chronic risks, such as dwindling ecosystems. The effects could include falling crop yields owing to a decline in pollinating insects or the degradation of agricultural land. The scarcity of natural products could lead to supply-side shocks for the pharmaceutical industry or make some tourist destinations less attractive. Nature loss can also amplify the t ansition risks of banks and their borrowers. Governments are stepping up their efforts to protect the environment: the UN Convention on Biological Diversity set global targets in 2022, including the conservation by 2030 of at least 30% of the world's lands, inland waters, coastal areas and oceans.!©! Such government measures could lead to changes in regulation and policy, limiting the exploitation of natural resources or banning certain environmentally harmful products. Technological innovation, new business models and changes in consumer or investor sentiment could also lead to transition risks and transition costs as companies are forced to adapt. Some established business models could disappear, while others might become too expensive and lose market share. At the ECB, we looked at the dependence on nature of more than 4.2 million individual companies accounting for over €4.2 trillion in corporate loans. We assessed how dependent companies and banks in the euro area are on the various benefits that humanity obtains from nature - experts call this concept "ecosystem services". Examples of the services that ecosystems provide are products such as food, drinking water, timber and minerals; protection against natural hazards; and carbon uptake and storage by vegetation. To assess the associated physical risk, we assessed the extent to which companies financed by euro area banks are dependent on ecosystem services. The principal assumption behind this assessment is that greater dependence on ecosystem services is likely to result in greater exposure to ecosystem degradation. If nature degradation continues, economic activities dependent on ecosystem services will be affected by issues such as supply chain disruptions, which have an impact on prices and ultimately on inflation. Moreover, reduced turnover could result in defaults and, as a consequence, losses for the banks that lend to these companies. This could ultimately lead to financial stability concerns. Our analysis shows that euro area companies are significantly exposed to several ecosystem services, both directly and via their supply chains. The most important services are mass stabilisation and erosion control, surface and ground water supply, flood and storm protection, and carbon uptake and storage. Indirect dependency via supply chains is particularly significant for sectors such as agriculture, manufacturing and wholesale, and the retail trade. Our assessment shows that in the euro area, around three million individual companies are highly dependent on at least one ecosystem service. Severe losses of functionality in the relevant ecosystem would translate into critical economic problems for those companies. We also found that almost 75% of bank loans to companies in the euro area are granted to companies that are highly dependent on at least one ecosystem service. We observed only moderate differences between countries, as indirect supply chain dependencies offset smaller direct dependencies, especially in small and open economies. Accounting for nature in central banking and supervision The results of our research confirm that the European economy is highly dependent on ecosystem services and that these risks can spread to the financial system, potentially triggering instability. If nature degradation continues at its current pace, companies will be affected and banks' credit portfolios will deteriorate. This is why we expect banks under our supervision to manage all material nature-related risks, consistent with the supervisory guide that we published in 2020 with expectations about banks' risk management practices for both climate-related and environmental risks. It is also the reason the ECB has made nature one of the focus areas of its climate and nature plan for 2024 and 2025. Our ongoing work confirms the profound impact of nature degradation on the economy, including the financial system and price stability, which mirrors that of climate change. Nature degradation and climate change are therefore both relevant to our mandate and our monetary policy strategy. From my point of view, the ECB's upcoming assessment of the monetary policy strategy provides an opportunity to confirm the relevance of nature degradation and climate change for monetary policy in the euro area. An integrated approach to climate and nature is critical, because they are interconnected and amplify the effects of physical and transition risks. Given the high level of uncertainty regarding impacts, non- linearities, tipping points and irreversibility, gauging nature-related risks is complex. We cannot do this alone. Scientific input is needed to learn more about the transmission channels to our economies. Work is progressing at the international level. The Network for Greening the Financial System (NGFS) - a network of 141 central banks and supervisors from around the world - had already acknowledged the relevance of nature-related risks to the mandates of these institutions back in March 2022.[8! The NGFS has since developed a conceptual framework offering central banks and supervisors a common understanding of nature-related financial risks and a principle-based risk assessment approach. Moreover, in July this year the NGFS published a report on nature-related litigation to raise awareness among financial institutions, central banks and supervisors.) The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. This trend underlines the real risk of doing too little: for governments, companies, banks, central banks and supervisors. Policymakers, regulators and supervisors are in fact taking action. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications nature-related risks have for the financial sector" This work must continue. International fora must ensure that nature- related considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. This does not mean that economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop the means to transpose insights from environmental science into variables of economic interest like growth, inflation and financial risks. Since our economy relies on nature, destroying nature means destroying the economy. Preventing the destruction of nature is the responsibility of elected governments, as they are the ones who make environmental policies. For their part, central banks and supervisors have to take nature-related risks into account in the pursuit of their mandates, just as they do with any other factors that are vitally important to price stability and the safety and soundness of banks. Naturally, at the ECB we are committed to doing exactly that. Naturally, within our mandate. Naturally, because of our mandate. 1. Diaz, S., et al. (eds.) (2019), The global assessment report on biodiversity and ecosystem services - summary for policymakers, Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services, Bonn, Germany. 2. Dasgupta, P. (2021), The Economics of Biodiversity: The Dasgupta Review, HM Treasury, London. 3. Kuchler, T. et al. (2024), "The economics of biodiversity loss", paper presented at the ECB Forum on Central Banking, June. 4. Martins Cardoso, M. and Parker, M. (2024), "Accounting for nature in euro area economic activity", Economic Bulletin, Ilssue 6, ECB. 5. Convention on Biological Diversity (2022), "Nations Adopt Four Goals, 23 Targets for 2030 in Landmark UN Biodiversity Agreement", press release, Montreal, 19 December. 6. Boldrini, S., Ceglar, A., Lelli, C., Parisi, L. and Heemskerk, I. (2023), "Living in a world of disappearing nature: physical risk and the implications for financial stability", Occasional Paper Series, No 333, ECB. 7. ECB (2020), Guide on climate-related and environmental risks, November. 8. NGFS (2022), "NGFS acknowledges that nature-related risks could have significant macroeconomic and financial implications", press release, 24 March. 9. NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 10. NGFS (2024), Nature-related litigation: emerging_trends and lessons learned from climate-related litigation, July. 11. Financial Stability Board (2024), Stocktake on Nature-related risks: Supervisory and regulatory	---[PAGE_BREAK]--- # SPEECH ## Taking account of nature, naturally ## Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the tenth Green Finance Forum "Innovate in Nature" Frankfurt am Main, 19 November 2024 Thank you for inviting me to speak at the opening of the tenth Green Finance Forum. I fully subscribe to the theme of today's forum, given how vitally important it is to "innovate in nature". Especially because in many ways nature is still not accounted for in policies, regulation and risk management, but it should be, considering its vital importance for the economy - including the financial system. This morning I will outline how the relevance of nature is being confirmed by incoming research and how the European Central Bank (ECB) is acting on this to deliver on its mandate of maintaining price stability and preserving the safety and soundness of banks. A thriving natural environment provides many benefits that sustain human well-being and the global economy. Think of fertile soils, pollination, timber, fishing stocks, clean water and clean air. Unfortunately, intensive land use, climate change, pollution, overexploitation and other human pressures are rapidly and seriously damaging our natural resources. The Intergovernmental SciencePolicy Platform on Biodiversity and Ecosystem Services already sounded the alarm back in 2019, shortly before the outbreak of the pandemic. ${ }^{[1]}$ The degradation of nature is primarily caused by human activity and is being made worse by global heating. In addition to the depletion of nonrenewable resources, natural inputs to the economy that are renewable are also increasingly being degraded. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths. This nature loss poses a serious risk to humanity as it threatens vital areas, such as the supply of food and medicine. Such threats are also existential for the economy and the financial system, as our economy cannot exist without nature. ${ }^{[2]}$ One of the papers presented at the annual ECB Forum on Central Banking in Sintra, Portugal, in July of this year shows how biodiversity loss can cause losses to economic output while at the same time decreasing the resilience of that output to future biodiversity losses. ${ }^{[3]}$ However, in practice, at least thus far, the contribution of the inputs nature provides to the economy is rarely measured directly in statistics like GDP. Central banks and supervisors like the ECB need to gain a better understanding of just how vulnerable the economy and the financial system are to nature degradation. We need to incorporate nature into the analysis of the drivers of economic development and the assessment of future productive capacity. ${ }^{[4]}$ Degradation of nature can impair production processes and consequently weaken the creditworthiness of many companies, which might in turn impair loans extended by banks. ---[PAGE_BREAK]--- # How nature affects the economy As is the case with climate change, nature affects companies and banks via two main channels: physical risks and transition risks. Physical risks may be acute risks, such as increasingly severe natural disasters, or chronic risks, such as dwindling ecosystems. The effects could include falling crop yields owing to a decline in pollinating insects or the degradation of agricultural land. The scarcity of natural products could lead to supply-side shocks for the pharmaceutical industry or make some tourist destinations less attractive. Nature loss can also amplify the $t$ ansition risks of banks and their borrowers. Governments are stepping up their efforts to protect the environment: the UN Convention on Biological Diversity set global targets in 2022, including the conservation by 2030 of at least 30\% of the world's lands, inland waters, coastal areas and oceans. $\underline{5}$ Such government measures could lead to changes in regulation and policy, limiting the exploitation of natural resources or banning certain environmentally harmful products. Technological innovation, new business models and changes in consumer or investor sentiment could also lead to transition risks and transition costs as companies are forced to adapt. Some established business models could disappear, while others might become too expensive and lose market share. At the ECB, we looked at the dependence on nature of more than 4.2 million individual companies accounting for over $€ 4.2$ trillion in corporate loans. $\underline{6}$ We assessed how dependent companies and banks in the euro area are on the various benefits that humanity obtains from nature - experts call this concept "ecosystem services". Examples of the services that ecosystems provide are products such as food, drinking water, timber and minerals; protection against natural hazards; and carbon uptake and storage by vegetation. To assess the associated physical risk, we assessed the extent to which companies financed by euro area banks are dependent on ecosystem services. The principal assumption behind this assessment is that greater dependence on ecosystem services is likely to result in greater exposure to ecosystem degradation. If nature degradation continues, economic activities dependent on ecosystem services will be affected by issues such as supply chain disruptions, which have an impact on prices and ultimately on inflation. Moreover, reduced turnover could result in defaults and, as a consequence, losses for the banks that lend to these companies. This could ultimately lead to financial stability concerns. Our analysis shows that euro area companies are significantly exposed to several ecosystem services, both directly and via their supply chains. The most important services are mass stabilisation and erosion control, surface and ground water supply, flood and storm protection, and carbon uptake and storage. Indirect dependency via supply chains is particularly significant for sectors such as agriculture, manufacturing and wholesale, and the retail trade. Our assessment shows that in the euro area, around three million individual companies are highly dependent on at least one ecosystem service. Severe losses of functionality in the relevant ecosystem would translate into critical economic problems for those companies. We also found that almost $75 \%$ of bank loans to companies in the euro area are granted to companies that are highly dependent on at least one ecosystem service. We observed only moderate differences between countries, as indirect ---[PAGE_BREAK]--- supply chain dependencies offset smaller direct dependencies, especially in small and open economies. # Accounting for nature in central banking and supervision The results of our research confirm that the European economy is highly dependent on ecosystem services and that these risks can spread to the financial system, potentially triggering instability. If nature degradation continues at its current pace, companies will be affected and banks' credit portfolios will deteriorate. This is why we expect banks under our supervision to manage all material nature-related risks, consistent with the supervisory guide that we published in 2020 with expectations about banks' risk management practices for both climate-related and environmental risks. ${ }^{[7]}$ It is also the reason the ECB has made nature one of the focus areas of its climate and nature plan for 2024 and 2025. Our ongoing work confirms the profound impact of nature degradation on the economy, including the financial system and price stability, which mirrors that of climate change. Nature degradation and climate change are therefore both relevant to our mandate and our monetary policy strategy. From my point of view, the ECB's upcoming assessment of the monetary policy strategy provides an opportunity to confirm the relevance of nature degradation and climate change for monetary policy in the euro area. An integrated approach to climate and nature is critical, because they are interconnected and amplify the effects of physical and transition risks. Given the high level of uncertainty regarding impacts, nonlinearities, tipping points and irreversibility, gauging nature-related risks is complex. We cannot do this alone. Scientific input is needed to learn more about the transmission channels to our economies. Work is progressing at the international level. The Network for Greening the Financial System (NGFS) - a network of 141 central banks and supervisors from around the world - had already acknowledged the relevance of nature-related risks to the mandates of these institutions back in March 2022. ${ }^{[8]}$ The NGFS has since developed a conceptual framework offering central banks and supervisors a common understanding of nature-related financial risks and a principle-based risk assessment approach. ${ }^{[9]}$ Moreover, in July this year the NGFS published a report on nature-related litigation to raise awareness among financial institutions, central banks and supervisors. ${ }^{[10]}$ The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. This trend underlines the real risk of doing too little: for governments, companies, banks, central banks and supervisors. Policymakers, regulators and supervisors are in fact taking action. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications nature-related risks have for the financial sector. ${ }^{[11]}$ This work must continue. International fora must ensure that naturerelated considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. This does not mean that economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop the means to transpose ---[PAGE_BREAK]--- insights from environmental science into variables of economic interest like growth, inflation and financial risks. Since our economy relies on nature, destroying nature means destroying the economy. Preventing the destruction of nature is the responsibility of elected governments, as they are the ones who make environmental policies. For their part, central banks and supervisors have to take nature-related risks into account in the pursuit of their mandates, just as they do with any other factors that are vitally important to price stability and the safety and soundness of banks. Naturally, at the ECB we are committed to doing exactly that. Naturally, within our mandate. Naturally, because of our mandate. 1. Díaz, S., et al. (eds.) (2019), The global assessment report on biodiversity and ecosystem services summary for policymakers, Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services, Bonn, Germany. 2. Dasgupta, P. (2021), The Economics of Biodiversity: The Dasgupta Review, HM Treasury, London. 3. Kuchler, T. et al. (2024), "The economics of biodiversity loss", paper presented at the ECB Forum on Central Banking, June. 4. Martins Cardoso, M. and Parker, M. (2024), "Accounting for nature in euro area economic activity", Economic Bulletin, Issue 6, ECB. 5. Convention on Biological Diversity (2022), "Nations Adopt Four Goals. 23 Targets for 2030 in Landmark UN Biodiversity Agreement", press release, Montreal, 19 December. 6. Boldrini, S., Ceglar, A., Lelli, C., Parisi, L. and Heemskerk, I. (2023), "Living in a world of disappearing nature: physical risk and the implications for financial stability", Occasional Paper Series, No 333, ECB. 7. ECB (2020), Guide on climate-related and environmental risks, November. 8. NGFS (2022), "NGFS acknowledges that nature-related risks could have significant macroeconomic and financial implications", press release, 24 March. 9. ---[PAGE_BREAK]--- NGFS (2024), Nature-related Financial Risks: a Conceptual Framework to guide Action by Central Banks and Supervisors, July. 10. NGFS (2024), Nature-related litigation: emerging trends and lessons learned from climate-related litigation, July. 11. Financial Stability Board (2024), Stocktake on Nature-related risks: Supervisory and regulatory approaches and perspectives on financial risk, 18 July.	Frank Elderson	Euro area	https://www.bis.org/review/r241125z.pdf	Frankfurt am Main, 19 November 2024 Thank you for inviting me to speak at the opening of the tenth Green Finance Forum. I fully subscribe to the theme of today's forum, given how vitally important it is to "innovate in nature". Especially because in many ways nature is still not accounted for in policies, regulation and risk management, but it should be, considering its vital importance for the economy - including the financial system. This morning I will outline how the relevance of nature is being confirmed by incoming research and how the European Central Bank (ECB) is acting on this to deliver on its mandate of maintaining price stability and preserving the safety and soundness of banks. A thriving natural environment provides many benefits that sustain human well-being and the global economy. Think of fertile soils, pollination, timber, fishing stocks, clean water and clean air. Unfortunately, intensive land use, climate change, pollution, overexploitation and other human pressures are rapidly and seriously damaging our natural resources. The Intergovernmental SciencePolicy Platform on Biodiversity and Ecosystem Services already sounded the alarm back in 2019, shortly before the outbreak of the pandemic. The degradation of nature is primarily caused by human activity and is being made worse by global heating. In addition to the depletion of nonrenewable resources, natural inputs to the economy that are renewable are also increasingly being degraded. Scientists have calculated that humanity is using natural resources 1.7 times faster than ecosystems can regenerate them - in other words, we are consuming resources equivalent to 1.7 planet Earths. This nature loss poses a serious risk to humanity as it threatens vital areas, such as the supply of food and medicine. Such threats are also existential for the economy and the financial system, as our economy cannot exist without nature. However, in practice, at least thus far, the contribution of the inputs nature provides to the economy is rarely measured directly in statistics like GDP. Central banks and supervisors like the ECB need to gain a better understanding of just how vulnerable the economy and the financial system are to nature degradation. We need to incorporate nature into the analysis of the drivers of economic development and the assessment of future productive capacity. Degradation of nature can impair production processes and consequently weaken the creditworthiness of many companies, which might in turn impair loans extended by banks. As is the case with climate change, nature affects companies and banks via two main channels: physical risks and transition risks. Physical risks may be acute risks, such as increasingly severe natural disasters, or chronic risks, such as dwindling ecosystems. The effects could include falling crop yields owing to a decline in pollinating insects or the degradation of agricultural land. The scarcity of natural products could lead to supply-side shocks for the pharmaceutical industry or make some tourist destinations less attractive. Nature loss can also amplify the $t$ ansition risks of banks and their borrowers. Governments are stepping up their efforts to protect the environment: the UN Convention on Biological Diversity set global targets in 2022, including the conservation by 2030 of at least 30\% of the world's lands, inland waters, coastal areas and oceans. Such government measures could lead to changes in regulation and policy, limiting the exploitation of natural resources or banning certain environmentally harmful products. Technological innovation, new business models and changes in consumer or investor sentiment could also lead to transition risks and transition costs as companies are forced to adapt. Some established business models could disappear, while others might become too expensive and lose market share. At the ECB, we looked at the dependence on nature of more than 4.2 million individual companies accounting for over $€ 4.2$ trillion in corporate loans. We assessed how dependent companies and banks in the euro area are on the various benefits that humanity obtains from nature - experts call this concept "ecosystem services". Examples of the services that ecosystems provide are products such as food, drinking water, timber and minerals; protection against natural hazards; and carbon uptake and storage by vegetation. To assess the associated physical risk, we assessed the extent to which companies financed by euro area banks are dependent on ecosystem services. The principal assumption behind this assessment is that greater dependence on ecosystem services is likely to result in greater exposure to ecosystem degradation. If nature degradation continues, economic activities dependent on ecosystem services will be affected by issues such as supply chain disruptions, which have an impact on prices and ultimately on inflation. Moreover, reduced turnover could result in defaults and, as a consequence, losses for the banks that lend to these companies. This could ultimately lead to financial stability concerns. Our analysis shows that euro area companies are significantly exposed to several ecosystem services, both directly and via their supply chains. The most important services are mass stabilisation and erosion control, surface and ground water supply, flood and storm protection, and carbon uptake and storage. Indirect dependency via supply chains is particularly significant for sectors such as agriculture, manufacturing and wholesale, and the retail trade. Our assessment shows that in the euro area, around three million individual companies are highly dependent on at least one ecosystem service. Severe losses of functionality in the relevant ecosystem would translate into critical economic problems for those companies. We also found that almost $75 \%$ of bank loans to companies in the euro area are granted to companies that are highly dependent on at least one ecosystem service. We observed only moderate differences between countries, as indirect supply chain dependencies offset smaller direct dependencies, especially in small and open economies. The results of our research confirm that the European economy is highly dependent on ecosystem services and that these risks can spread to the financial system, potentially triggering instability. If nature degradation continues at its current pace, companies will be affected and banks' credit portfolios will deteriorate. This is why we expect banks under our supervision to manage all material nature-related risks, consistent with the supervisory guide that we published in 2020 with expectations about banks' risk management practices for both climate-related and environmental risks. It is also the reason the ECB has made nature one of the focus areas of its climate and nature plan for 2024 and 2025. Our ongoing work confirms the profound impact of nature degradation on the economy, including the financial system and price stability, which mirrors that of climate change. Nature degradation and climate change are therefore both relevant to our mandate and our monetary policy strategy. From my point of view, the ECB's upcoming assessment of the monetary policy strategy provides an opportunity to confirm the relevance of nature degradation and climate change for monetary policy in the euro area. An integrated approach to climate and nature is critical, because they are interconnected and amplify the effects of physical and transition risks. Given the high level of uncertainty regarding impacts, nonlinearities, tipping points and irreversibility, gauging nature-related risks is complex. We cannot do this alone. Scientific input is needed to learn more about the transmission channels to our economies. Work is progressing at the international level. The Network for Greening the Financial System (NGFS) - a network of 141 central banks and supervisors from around the world - had already acknowledged the relevance of nature-related risks to the mandates of these institutions back in March 2022. The report highlighted that while nature-related litigation is still in its infancy, the number of cases is expected to grow rapidly. This trend underlines the real risk of doing too little: for governments, companies, banks, central banks and supervisors. Policymakers, regulators and supervisors are in fact taking action. The Financial Stability Board recently took stock of supervisory and regulatory initiatives among its members and established that a growing number of financial authorities are considering the potential implications nature-related risks have for the financial sector. This work must continue. International fora must ensure that naturerelated considerations are fully integrated into regulation and supervision, alongside ongoing efforts to account for climate-related considerations. This starts with identifying exposures and vulnerabilities to nature-related risks. This does not mean that economists should start counting ants in Aragon, butterflies in Bavaria or worms in Wallonia. Instead, economists must develop the means to transpose insights from environmental science into variables of economic interest like growth, inflation and financial risks. Since our economy relies on nature, destroying nature means destroying the economy. Preventing the destruction of nature is the responsibility of elected governments, as they are the ones who make environmental policies. For their part, central banks and supervisors have to take nature-related risks into account in the pursuit of their mandates, just as they do with any other factors that are vitally important to price stability and the safety and soundness of banks. Naturally, at the ECB we are committed to doing exactly that. Naturally, within our mandate. Naturally, because of our mandate.
2024-11-20T00:00:00	Lisa D Cook: Economic outlook	Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve System, at the University of Virginia, Charlottesville, Virginia, 20 November 2024.	For release on delivery 11:00 a.m. EST November 20, 2024 Economic Outlook Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the University of Virginia Charlottesville, Virginia November 20, 2024 Thank you, Christa. It is wonderful to be with you here on the University of Virginia's beautiful campus. This is my first visit here as an adult. As a child, I was fortunate enough to be able to attend the commencement ceremony of my aunt and uncle, who received their doctoral degrees from UVA several decades ago. My family and I are grateful to the University of Virginia for all the educational opportunities it has afforded us over the years. I look forward to connecting with many of the exceptional students and faculty during my visit.1 As a member of the Federal Reserve Board, I always find it a pleasure to hear from people in communities across the country and to share some views of my own. At the Fed, I am committed to pursuing the best policy to achieve the dual-mandate goals given to us by Congress of maximum employment and price stability. Today, I would like to share with you my outlook for the economy, including some international comparisons of productivity and inflation, and offer my views on U.S. monetary policy. Broadly, I view the economy as being in a good position. Inflation has substantially eased from its peak in mid-2022, though core inflation remains somewhat elevated. Unemployment remains historically low, but the labor market is no longer overheated. Economic growth has been robust this year, and I forecast the expansion will continue. Looking ahead, I remain confident that inflation is moving sustainably toward our 2 percent objective, even if the path is occasionally bumpy. Meanwhile, I see employment risks as weighted to the downside, but those risks appear to have diminished somewhat in recent months. - 2 - Inflation Inflation, as measured by the personal consumption expenditures (PCE) price index, has eased notably from a peak of 7.2 percent in June 2022. Estimates based on the consumer price index and other data released last week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October. Core PCE prices-which exclude the volatile food and energy categories-increased 2.8 percent, down from a peak of 5.6 percent in February 2022. Despite this significant progress on disinflation, the elevated core figure suggests that we have further to go before credibly achieving our inflation target of 2 percent. Although most price indicators suggest that progress is ongoing, I anticipate bumps along the road. For instance, when measured on a monthly basis, estimated core PCE inflation stepped up in September and October after four months of lower readings. Even so, I still see headline and core inflation falling to 2.2 percent next year and to lower levels after that. Moreover, disinflation has been widespread across a broad range of goods and services. Taken together, recent data support my view that the disinflationary process is continuing. Thinking of the components of inflation, core goods and core services inflation excluding housing are now at rates consistent with previous periods when inflation averaged about 2 percent. As a result, housing services account for most of the excess of core inflation over our target. Despite a slowing in rent increases for new tenants over the past two years, recent research from the Federal Reserve Bank of Cleveland suggests that existing rents for continuing tenants may still be notably below new tenant rent - 3 - levels.2 Existing rents rising toward market rent levels is keeping housing services inflation temporarily elevated. My view is that housing services inflation will come down gradually over the next two years as the earlier slowing of growth in new tenant rent feeds through into the overall rate. Recently, other inflation factors have been subdued. Core import prices have continued to step down from the surprisingly strong pace in the first half of the year. Global oil prices have fluctuated, largely in response to developments in the Middle East, but are back near the lows reached in late summer. My confidence in continued disinflation is further reinforced by the moderation in wage growth. The employment cost index report showed that hourly compensation for private-sector workers rose at a 2.9 percent annual rate in the third quarter, the lowest since 2021. The 12-month change in average hourly earnings in October was 4 percent, down from 4.3 percent during the previous year. The wage premium for job switchers, a significant contributor to wage growth early in the pandemic recovery, has largely disappeared, according to data from the Federal Reserve Bank of Atlanta. Labor Market Turning to the labor market, on balance, recent data suggest that it remains solid. Monthly increases in firms' payrolls have slowed from earlier this year but are consistent with only a gradual cooling in the labor market. The October employment report did - 4 - show a sharp slowdown in job creation, but that was largely due to the temporary effects of recent hurricanes and a labor strike. While economists and forecasters often focus on aggregate data for the national economy, it is important to acknowledge that hurricanes Helene and Milton resulted in the tragic loss of life and devastating destruction in many parts of the country, including some here in the state of Virginia. My thoughts remain with those affected communities. The Federal Reserve System remains in touch with these communities to help the financial institutions that serve them in any way we can.3 The broader trend I see is that national job growth is solid but perhaps not quite strong enough to keep unemployment at the current low rate. Net hiring so far this year is running somewhat below estimates for what economists call the breakeven pace, or the rate of hiring needed to keep the unemployment rate constant, when accounting for changes to the size of the labor force. With job growth coming in below the breakeven pace, which was likely more than 200,000 jobs a month over the past year, the unemployment rate has risen from a historical low of 3.4 percent in April 2023 to 4.1 percent in October. Other data are also consistent with a gradual cooling in labor demand. The vacancies-to-unemployment ratio has fallen from a peak of 2.0 in 2022 to 1.1 in 3 See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and State Financial Regulators (2024), "Federal and State Financial Regulatory Agencies Issue Interagency Statement on Supervisory Practices regarding Financial Institutions Affected by Hurricane Helene," joint press release, October 2, https://www.federalreserve.gov/newsevents/pressreleases/other20241002a.htm. See also Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Florida Office of Financial Regulation, National Credit Union Administration, and Office of the Comptroller of the Currency (2024), "Federal and State Financial Regulatory Agencies Issue Interagency Statement on Supervisory Practices regarding Financial Institutions Affected by Hurricane Milton," joint press release, October 15, https://www.federalreserve.gov/newsevents/pressreleases/other20241015a.htm. - 5 - September, slightly below where it stood just before the pandemic. The rate at which workers are quitting their jobs continued to slide in recent months to well below its pre- pandemic level, which could indicate that workers are less optimistic about finding a better job should they leave their current role. Notably, firms' hiring rates and hiring plans remain subdued, while workers report reduced availability of jobs. Although layoffs remain low, less hiring makes it harder for labor market entrants and reentrants to find jobs. Also, our contacts report that employers are being more selective, waiting to find workers with the skills they seek, rather than pursuing a hire-and-train strategy. Overall, I see a labor market that has largely normalized after being overheated because of pandemic disruptions and dislocations. The labor market is in a good position-with the supply and demand for workers being roughly in balance-such that it is no longer a source of inflationary pressure in the economy. I will continue to watch incoming data carefully and remain attuned to signs of undesirable further cooling in the labor market. Economic Output and Productivity Growth Along with generally solid labor market data and moderating inflation, recent indicators show economic activity moving along at a strong pace. Real gross domestic product (GDP) increased at a 2.8 percent annual rate in the third quarter, consistent with the solid growth recorded in the first half of the year. American consumers remain resilient, with broad-based gains in household spending on both goods and services. This supports broader economic growth because consumer spending constitutes roughly two-thirds of GDP. Spending at retailers and restaurants rose 2.8 percent in October from a year earlier, a faster 12-month rate of - 6 - increase than the prior two months. Recent data revisions show that household income and savings have been higher than previously thought, improving the outlook for consumer spending and GDP growth. It is remarkable that the U.S. economy has been growing rapidly even as inflation has been declining significantly over the past two years. One reason why this solid growth could be occurring is that potential growth, or the maximum rate at which an economy can grow without causing inflation over the medium term, may have increased. One factor that appears to have supported both potential and actual growth is a faster pace of productivity gains. Recent data indicate labor productivity has grown at a 1.8 percent annual rate since the end of 2019, surpassing its 1.5 percent growth rate over the previous 12 years. Several forces could have boosted productivity in recent years. As I discussed in a recent speech in South Carolina, the U.S. experienced a surge in new business formation since the start of the pandemic.4 These newer firms are more likely to innovate and adopt new technologies and business processes, thus boosting productivity. Two other factors boosting productivity relate in part to changes in the U.S. economy during and after the pandemic. Worker reallocation across jobs and locations surged early in the pandemic and remained high for some time. There is some research suggesting that such reallocation resulted in better and more productive matches between some workers and jobs, thus raising labor productivity.5 At the same time, severe labor shortages during the post-pandemic recovery spurred many businesses to invest in labor- - 7 - saving technologies and to restructure aspects of production more efficiently, which may also have given at least a one-time boost to productivity. More broadly, the continued sizable investment in new technologies may promote ongoing strength in productivity growth. Much of this investment has gone toward artificial intelligence (AI), which has the potential to transform many aspects of the economy and job market, as I discussed in speeches earlier this fall.6,7 International Comparisons Compared with productivity abroad, recent U.S. productivity growth looks quite exceptional. As shown in figure 1, before the pandemic, the U.S. had faster productivity growth-as shown by the green portion of the bars-than other advanced economies, but the difference was small. Since the pandemic, however, U.S. productivity growth has far exceeded that of Europe, Canada, and Australia, as shown in figure 2. To explain this notable outperformance, some have highlighted our country's relatively flexible labor market and greater business dynamism compared with these other economies.8 Moreover, to the extent that investment in technology has been a driver of cross-country differences, it is notable that private investment in AI has been much higher in the U.S. than abroad.9 6 See Lisa D. Cook, "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, Georgia, held in Atlanta, Ga., October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. 7 See Lisa D. Cook, "What Will Artificial Intelligence Mean for America's Workers?" speech delivered at The Ohio State University, Columbus, Ohio, September 26, https://www.federalreserve.gov/newsevents/speech/cook20240926a.htm. 8 See François de Soyres, Joaquin Garcia-Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why is the U.S. GDP Recovering Faster than other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://doi.org/10.17016/2380-7172.3495. 9 See Chirag Chopra, Ankit Kasare, and Piyush Gupta (2024), "How Venture Capital is Investing in AI in the Top Five Global Economies-and Shaping the AI Ecosystem," World Economic Forum, May 24. - 8 - This productivity outperformance is likely a main reason why U.S. GDP growth has been stronger than that of foreign economies; the path of inflation, however, has largely been similar across the globe. As shown in figure 3, inflation in the U.S. and abroad rose sharply in 2021 and 2022, amid supply bottlenecks and a post-pandemic recovery in demand. Inflation reached a higher peak in European economies that were most directly affected by the energy price shock from Russia's war in Ukraine. Inflation has since declined globally as supply normalized and monetary policy tightening restrained demand. U.S. inflation, as shown by the black line, is nearly back to its 2 percent target level, while core inflation, as shown in figure 4, has come down but remains somewhat above 2 percent. Monetary Policy As I stated, the totality of the data suggests that a disinflationary trajectory is still in place and that the labor market is gradually cooling. As such, I view the risks to achieving the Federal Reserve's dual mandate of maximum employment and price stability as being roughly in balance. Consistent with those balanced risks, in my view, it likely will be appropriate to move the policy rate toward a more neutral stance over time. My colleagues on the Federal Open Market Committee and I acted earlier this month to lower the target range for the federal funds rate by 1/4 percentage point. That action came after we reduced the rate by 1/2 percentage point in September. Together, these moves were a strong step toward removing policy restriction. Going forward, I still see the direction of the appropriate policy rate path to be downward, but the magnitude and timing of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. I do not view policy as being on a preset - 9 - course, and I am ready to respond to a changing outlook. In fact, I find it helpful to consider a range of scenarios when thinking about the path of policy. If the labor market and inflation continue to progress in line with my forecast, it could well be appropriate to lower the level of policy restriction over time until we near the neutral rate of interest, or the point when monetary policy is neither stimulating nor restricting economic growth. However, if inflation progress slows and the labor market remains solid, I could see a scenario where we pause along the downward path. Alternatively, should the labor market weaken in a substantial way, it could be appropriate to ease policy more quickly. My policy decisions will be guided by our dual mandate of maximum employment and stable prices, and I know delivering on those goals will produce the best economic outcomes for all Americans. Thank you for having me here today. I look forward to your questions.	---[PAGE_BREAK]--- For release on delivery 11:00 a.m. EST November 20, 2024 Economic Outlook Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the University of Virginia Charlottesville, Virginia November 20, 2024 ---[PAGE_BREAK]--- Thank you, Christa. It is wonderful to be with you here on the University of Virginia's beautiful campus. This is my first visit here as an adult. As a child, I was fortunate enough to be able to attend the commencement ceremony of my aunt and uncle, who received their doctoral degrees from UVA several decades ago. My family and I are grateful to the University of Virginia for all the educational opportunities it has afforded us over the years. I look forward to connecting with many of the exceptional students and faculty during my visit. ${ }^{1}$ As a member of the Federal Reserve Board, I always find it a pleasure to hear from people in communities across the country and to share some views of my own. At the Fed, I am committed to pursuing the best policy to achieve the dual-mandate goals given to us by Congress of maximum employment and price stability. Today, I would like to share with you my outlook for the economy, including some international comparisons of productivity and inflation, and offer my views on U.S. monetary policy. Broadly, I view the economy as being in a good position. Inflation has substantially eased from its peak in mid-2022, though core inflation remains somewhat elevated. Unemployment remains historically low, but the labor market is no longer overheated. Economic growth has been robust this year, and I forecast the expansion will continue. Looking ahead, I remain confident that inflation is moving sustainably toward our 2 percent objective, even if the path is occasionally bumpy. Meanwhile, I see employment risks as weighted to the downside, but those risks appear to have diminished somewhat in recent months. [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. ---[PAGE_BREAK]--- # Inflation Inflation, as measured by the personal consumption expenditures (PCE) price index, has eased notably from a peak of 7.2 percent in June 2022. Estimates based on the consumer price index and other data released last week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October. Core PCE prices-which exclude the volatile food and energy categories-increased 2.8 percent, down from a peak of 5.6 percent in February 2022. Despite this significant progress on disinflation, the elevated core figure suggests that we have further to go before credibly achieving our inflation target of 2 percent. Although most price indicators suggest that progress is ongoing, I anticipate bumps along the road. For instance, when measured on a monthly basis, estimated core PCE inflation stepped up in September and October after four months of lower readings. Even so, I still see headline and core inflation falling to 2.2 percent next year and to lower levels after that. Moreover, disinflation has been widespread across a broad range of goods and services. Taken together, recent data support my view that the disinflationary process is continuing. Thinking of the components of inflation, core goods and core services inflation excluding housing are now at rates consistent with previous periods when inflation averaged about 2 percent. As a result, housing services account for most of the excess of core inflation over our target. Despite a slowing in rent increases for new tenants over the past two years, recent research from the Federal Reserve Bank of Cleveland suggests that existing rents for continuing tenants may still be notably below new tenant rent ---[PAGE_BREAK]--- levels. ${ }^{2}$ Existing rents rising toward market rent levels is keeping housing services inflation temporarily elevated. My view is that housing services inflation will come down gradually over the next two years as the earlier slowing of growth in new tenant rent feeds through into the overall rate. Recently, other inflation factors have been subdued. Core import prices have continued to step down from the surprisingly strong pace in the first half of the year. Global oil prices have fluctuated, largely in response to developments in the Middle East, but are back near the lows reached in late summer. My confidence in continued disinflation is further reinforced by the moderation in wage growth. The employment cost index report showed that hourly compensation for private-sector workers rose at a 2.9 percent annual rate in the third quarter, the lowest since 2021. The 12-month change in average hourly earnings in October was 4 percent, down from 4.3 percent during the previous year. The wage premium for job switchers, a significant contributor to wage growth early in the pandemic recovery, has largely disappeared, according to data from the Federal Reserve Bank of Atlanta. # Labor Market Turning to the labor market, on balance, recent data suggest that it remains solid. Monthly increases in firms' payrolls have slowed from earlier this year but are consistent with only a gradual cooling in the labor market. The October employment report did [^0] [^0]: ${ }^{2}$ See Lara Loewenstein, Jason Meyer, and Randal J. Verbrugge (2024), "New-Tenant Rent Passthrough and the Future of Rent Inflation," Economic Commentary 2024-17 (Cleveland: Federal Reserve Bank of Cleveland, October), https://www.clevelandfed.org/publications/economic-commentary/2024/ec-202417-new-tenant-rent-passthrough-and-future-of-rent-inflation. ---[PAGE_BREAK]--- show a sharp slowdown in job creation, but that was largely due to the temporary effects of recent hurricanes and a labor strike. While economists and forecasters often focus on aggregate data for the national economy, it is important to acknowledge that hurricanes Helene and Milton resulted in the tragic loss of life and devastating destruction in many parts of the country, including some here in the state of Virginia. My thoughts remain with those affected communities. The Federal Reserve System remains in touch with these communities to help the financial institutions that serve them in any way we can. ${ }^{3}$ The broader trend I see is that national job growth is solid but perhaps not quite strong enough to keep unemployment at the current low rate. Net hiring so far this year is running somewhat below estimates for what economists call the breakeven pace, or the rate of hiring needed to keep the unemployment rate constant, when accounting for changes to the size of the labor force. With job growth coming in below the breakeven pace, which was likely more than 200,000 jobs a month over the past year, the unemployment rate has risen from a historical low of 3.4 percent in April 2023 to 4.1 percent in October. Other data are also consistent with a gradual cooling in labor demand. The vacancies-to-unemployment ratio has fallen from a peak of 2.0 in 2022 to 1.1 in [^0] [^0]: ${ }^{3}$ See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and State Financial Regulators (2024), "Federal and State Financial Regulatory Agencies Issue Interagency Statement on Supervisory Practices regarding Financial Institutions Affected by Hurricane Helene," joint press release, October 2, https://www.federalreserve.gov/newsevents/pressreleases/other20241002a.htm. See also Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Florida Office of Financial Regulation, National Credit Union Administration, and Office of the Comptroller of the Currency (2024), "Federal and State Financial Regulatory Agencies Issue Interagency Statement on Supervisory Practices regarding Financial Institutions Affected by Hurricane Milton," joint press release, October 15, https://www.federalreserve.gov/newsevents/pressreleases/other20241015a.htm. ---[PAGE_BREAK]--- September, slightly below where it stood just before the pandemic. The rate at which workers are quitting their jobs continued to slide in recent months to well below its prepandemic level, which could indicate that workers are less optimistic about finding a better job should they leave their current role. Notably, firms' hiring rates and hiring plans remain subdued, while workers report reduced availability of jobs. Although layoffs remain low, less hiring makes it harder for labor market entrants and reentrants to find jobs. Also, our contacts report that employers are being more selective, waiting to find workers with the skills they seek, rather than pursuing a hire-and-train strategy. Overall, I see a labor market that has largely normalized after being overheated because of pandemic disruptions and dislocations. The labor market is in a good position-with the supply and demand for workers being roughly in balance-such that it is no longer a source of inflationary pressure in the economy. I will continue to watch incoming data carefully and remain attuned to signs of undesirable further cooling in the labor market. # Economic Output and Productivity Growth Along with generally solid labor market data and moderating inflation, recent indicators show economic activity moving along at a strong pace. Real gross domestic product (GDP) increased at a 2.8 percent annual rate in the third quarter, consistent with the solid growth recorded in the first half of the year. American consumers remain resilient, with broad-based gains in household spending on both goods and services. This supports broader economic growth because consumer spending constitutes roughly two-thirds of GDP. Spending at retailers and restaurants rose 2.8 percent in October from a year earlier, a faster 12-month rate of ---[PAGE_BREAK]--- increase than the prior two months. Recent data revisions show that household income and savings have been higher than previously thought, improving the outlook for consumer spending and GDP growth. It is remarkable that the U.S. economy has been growing rapidly even as inflation has been declining significantly over the past two years. One reason why this solid growth could be occurring is that potential growth, or the maximum rate at which an economy can grow without causing inflation over the medium term, may have increased. One factor that appears to have supported both potential and actual growth is a faster pace of productivity gains. Recent data indicate labor productivity has grown at a 1.8 percent annual rate since the end of 2019, surpassing its 1.5 percent growth rate over the previous 12 years. Several forces could have boosted productivity in recent years. As I discussed in a recent speech in South Carolina, the U.S. experienced a surge in new business formation since the start of the pandemic. ${ }^{4}$ These newer firms are more likely to innovate and adopt new technologies and business processes, thus boosting productivity. Two other factors boosting productivity relate in part to changes in the U.S. economy during and after the pandemic. Worker reallocation across jobs and locations surged early in the pandemic and remained high for some time. There is some research suggesting that such reallocation resulted in better and more productive matches between some workers and jobs, thus raising labor productivity. ${ }^{5}$ At the same time, severe labor shortages during the post-pandemic recovery spurred many businesses to invest in labor- [^0] [^0]: ${ }^{4}$ Lisa D. Cook (2024), "Entrepreneurs, Innovation, and Participation," speech delivered at the 2024 Women for Women Summit, Charleston, S.C., October 10, https://www.federalreserve.gov/newsevents/speech/cook20241010a.htm. ${ }^{5}$ See David Autor, Arindrajit Dube, and Annie McGrew (2023), "The Unexpected Compression: Competition at Work in the Low Wage Labor Market," NBER Working Paper Series 31010 (Cambridge, Mass.: National Bureau of Economic Research, March; revised May 2024), https://www.nber.org/papers/w31010. ---[PAGE_BREAK]--- saving technologies and to restructure aspects of production more efficiently, which may also have given at least a one-time boost to productivity. More broadly, the continued sizable investment in new technologies may promote ongoing strength in productivity growth. Much of this investment has gone toward artificial intelligence (AI), which has the potential to transform many aspects of the economy and job market, as I discussed in speeches earlier this fall. ${ }^{6,7}$ # International Comparisons Compared with productivity abroad, recent U.S. productivity growth looks quite exceptional. As shown in figure 1, before the pandemic, the U.S. had faster productivity growth—as shown by the green portion of the bars-than other advanced economies, but the difference was small. Since the pandemic, however, U.S. productivity growth has far exceeded that of Europe, Canada, and Australia, as shown in figure 2. To explain this notable outperformance, some have highlighted our country's relatively flexible labor market and greater business dynamism compared with these other economies. ${ }^{8}$ Moreover, to the extent that investment in technology has been a driver of cross-country differences, it is notable that private investment in AI has been much higher in the U.S. than abroad. ${ }^{9}$ [^0] [^0]: ${ }^{6}$ See Lisa D. Cook, "Artificial Intelligence, Big Data, and the Path Ahead for Productivity," speech delivered at "Technology-Enabled Disruption: Implications of AI, Big Data, and Remote Work," a conference organized by the Federal Reserve Banks of Atlanta, Boston, and Richmond, Atlanta, Georgia, held in Atlanta, Ga., October 1, https://www.federalreserve.gov/newsevents/speech/cook20241001a.htm. ${ }^{7}$ See Lisa D. Cook, "What Will Artificial Intelligence Mean for America's Workers?" speech delivered at The Ohio State University, Columbus, Ohio, September 26, https://www.federalreserve.gov/newsevents/speech/cook20240926a.htm. ${ }^{8}$ See François de Soyres, Joaquin Garcia-Cabo Herrero, Nils Goernemann, Sharon Jeon, Grace Lofstrom, and Dylan Moore (2024), "Why is the U.S. GDP Recovering Faster than other Advanced Economies?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 17), https://doi.org/10.17016/2380-7172.3495. ${ }^{9}$ See Chirag Chopra, Ankit Kasare, and Piyush Gupta (2024), "How Venture Capital is Investing in AI in the Top Five Global Economies-and Shaping the AI Ecosystem," World Economic Forum, May 24. ---[PAGE_BREAK]--- This productivity outperformance is likely a main reason why U.S. GDP growth has been stronger than that of foreign economies; the path of inflation, however, has largely been similar across the globe. As shown in figure 3, inflation in the U.S. and abroad rose sharply in 2021 and 2022, amid supply bottlenecks and a post-pandemic recovery in demand. Inflation reached a higher peak in European economies that were most directly affected by the energy price shock from Russia's war in Ukraine. Inflation has since declined globally as supply normalized and monetary policy tightening restrained demand. U.S. inflation, as shown by the black line, is nearly back to its 2 percent target level, while core inflation, as shown in figure 4, has come down but remains somewhat above 2 percent. # Monetary Policy As I stated, the totality of the data suggests that a disinflationary trajectory is still in place and that the labor market is gradually cooling. As such, I view the risks to achieving the Federal Reserve's dual mandate of maximum employment and price stability as being roughly in balance. Consistent with those balanced risks, in my view, it likely will be appropriate to move the policy rate toward a more neutral stance over time. My colleagues on the Federal Open Market Committee and I acted earlier this month to lower the target range for the federal funds rate by $1 / 4$ percentage point. That action came after we reduced the rate by $1 / 2$ percentage point in September. Together, these moves were a strong step toward removing policy restriction. Going forward, I still see the direction of the appropriate policy rate path to be downward, but the magnitude and timing of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. I do not view policy as being on a preset ---[PAGE_BREAK]--- course, and I am ready to respond to a changing outlook. In fact, I find it helpful to consider a range of scenarios when thinking about the path of policy. If the labor market and inflation continue to progress in line with my forecast, it could well be appropriate to lower the level of policy restriction over time until we near the neutral rate of interest, or the point when monetary policy is neither stimulating nor restricting economic growth. However, if inflation progress slows and the labor market remains solid, I could see a scenario where we pause along the downward path. Alternatively, should the labor market weaken in a substantial way, it could be appropriate to ease policy more quickly. My policy decisions will be guided by our dual mandate of maximum employment and stable prices, and I know delivering on those goals will produce the best economic outcomes for all Americans. Thank you for having me here today. I look forward to your questions. ---[PAGE_BREAK]--- # Contribution to Cumulative GDP Growth from 2015:Q4 to 2019:Q4 ![img-0.jpeg](img-0.jpeg) Note: GDP is gross domestic product. Output per hour is GDP divided by total hours worked. Hours per employee is the total number of hours worked divided by employment. Employment and population includes those aged 15 years or older in Australia, Canada, and the euro area and those aged 16 years or older in the U.K. and the U.S. Source: Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Contribution to Cumulative GDP Growth from 2019:Q4 to 2024:Q2 ![img-1.jpeg](img-1.jpeg) Note: GDP is gross domestic product. Output per hour is GDP divided by total hours worked. Hours per employee is the total number of hours worked divided by employment. Employment and population include those aged 15 years or older in Australia, Canada, and the euro area and those aged 16 years or older in the U.K. and the U.S. Source: Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Headline Inflation ![img-2.jpeg](img-2.jpeg) Note: Data are quarterly for Australia and monthly for all other economies. Data extend through the third quarter for Australia, October for the euro area, and September for the U.K., the U.S., and Canada. Source: Haver Analytics; Federal Reserve Board staff calculations. ---[PAGE_BREAK]--- # Core Inflation ![img-3.jpeg](img-3.jpeg) Note: Data are quarterly for Australia and monthly for all other economies. Data extend through the third quarter for Australia, October for the euro area, and September for the U.K., the U.S., and Canada. Source: Haver Analytics; Federal Reserve Board staff calculations.	Lisa D Cook	United States	https://www.bis.org/review/r241125n.pdf	For release on delivery 11:00 a.m. EST November 20, 2024 Economic Outlook Remarks by Lisa D. Cook Member Board of Governors of the Federal Reserve System at the University of Virginia Charlottesville, Virginia November 20, 2024 Thank you, Christa. It is wonderful to be with you here on the University of Virginia's beautiful campus. This is my first visit here as an adult. As a child, I was fortunate enough to be able to attend the commencement ceremony of my aunt and uncle, who received their doctoral degrees from UVA several decades ago. My family and I are grateful to the University of Virginia for all the educational opportunities it has afforded us over the years. I look forward to connecting with many of the exceptional students and faculty during my visit. As a member of the Federal Reserve Board, I always find it a pleasure to hear from people in communities across the country and to share some views of my own. At the Fed, I am committed to pursuing the best policy to achieve the dual-mandate goals given to us by Congress of maximum employment and price stability. Today, I would like to share with you my outlook for the economy, including some international comparisons of productivity and inflation, and offer my views on U.S. monetary policy. Broadly, I view the economy as being in a good position. Inflation has substantially eased from its peak in mid-2022, though core inflation remains somewhat elevated. Unemployment remains historically low, but the labor market is no longer overheated. Economic growth has been robust this year, and I forecast the expansion will continue. Looking ahead, I remain confident that inflation is moving sustainably toward our 2 percent objective, even if the path is occasionally bumpy. Meanwhile, I see employment risks as weighted to the downside, but those risks appear to have diminished somewhat in recent months. Inflation, as measured by the personal consumption expenditures (PCE) price index, has eased notably from a peak of 7.2 percent in June 2022. Estimates based on the consumer price index and other data released last week indicate that total PCE prices rose 2.3 percent over the 12 months ending in October. Core PCE prices-which exclude the volatile food and energy categories-increased 2.8 percent, down from a peak of 5.6 percent in February 2022. Despite this significant progress on disinflation, the elevated core figure suggests that we have further to go before credibly achieving our inflation target of 2 percent. Although most price indicators suggest that progress is ongoing, I anticipate bumps along the road. For instance, when measured on a monthly basis, estimated core PCE inflation stepped up in September and October after four months of lower readings. Even so, I still see headline and core inflation falling to 2.2 percent next year and to lower levels after that. Moreover, disinflation has been widespread across a broad range of goods and services. Taken together, recent data support my view that the disinflationary process is continuing. Thinking of the components of inflation, core goods and core services inflation excluding housing are now at rates consistent with previous periods when inflation averaged about 2 percent. As a result, housing services account for most of the excess of core inflation over our target. Despite a slowing in rent increases for new tenants over the past two years, recent research from the Federal Reserve Bank of Cleveland suggests that existing rents for continuing tenants may still be notably below new tenant rent levels. Existing rents rising toward market rent levels is keeping housing services inflation temporarily elevated. My view is that housing services inflation will come down gradually over the next two years as the earlier slowing of growth in new tenant rent feeds through into the overall rate. Recently, other inflation factors have been subdued. Core import prices have continued to step down from the surprisingly strong pace in the first half of the year. Global oil prices have fluctuated, largely in response to developments in the Middle East, but are back near the lows reached in late summer. My confidence in continued disinflation is further reinforced by the moderation in wage growth. The employment cost index report showed that hourly compensation for private-sector workers rose at a 2.9 percent annual rate in the third quarter, the lowest since 2021. The 12-month change in average hourly earnings in October was 4 percent, down from 4.3 percent during the previous year. The wage premium for job switchers, a significant contributor to wage growth early in the pandemic recovery, has largely disappeared, according to data from the Federal Reserve Bank of Atlanta. Turning to the labor market, on balance, recent data suggest that it remains solid. Monthly increases in firms' payrolls have slowed from earlier this year but are consistent with only a gradual cooling in the labor market. The October employment report did show a sharp slowdown in job creation, but that was largely due to the temporary effects of recent hurricanes and a labor strike. While economists and forecasters often focus on aggregate data for the national economy, it is important to acknowledge that hurricanes Helene and Milton resulted in the tragic loss of life and devastating destruction in many parts of the country, including some here in the state of Virginia. My thoughts remain with those affected communities. The Federal Reserve System remains in touch with these communities to help the financial institutions that serve them in any way we can. The broader trend I see is that national job growth is solid but perhaps not quite strong enough to keep unemployment at the current low rate. Net hiring so far this year is running somewhat below estimates for what economists call the breakeven pace, or the rate of hiring needed to keep the unemployment rate constant, when accounting for changes to the size of the labor force. With job growth coming in below the breakeven pace, which was likely more than 200,000 jobs a month over the past year, the unemployment rate has risen from a historical low of 3.4 percent in April 2023 to 4.1 percent in October. Other data are also consistent with a gradual cooling in labor demand. The vacancies-to-unemployment ratio has fallen from a peak of 2.0 in 2022 to 1.1 in September, slightly below where it stood just before the pandemic. The rate at which workers are quitting their jobs continued to slide in recent months to well below its prepandemic level, which could indicate that workers are less optimistic about finding a better job should they leave their current role. Notably, firms' hiring rates and hiring plans remain subdued, while workers report reduced availability of jobs. Although layoffs remain low, less hiring makes it harder for labor market entrants and reentrants to find jobs. Also, our contacts report that employers are being more selective, waiting to find workers with the skills they seek, rather than pursuing a hire-and-train strategy. Overall, I see a labor market that has largely normalized after being overheated because of pandemic disruptions and dislocations. The labor market is in a good position-with the supply and demand for workers being roughly in balance-such that it is no longer a source of inflationary pressure in the economy. I will continue to watch incoming data carefully and remain attuned to signs of undesirable further cooling in the labor market. Along with generally solid labor market data and moderating inflation, recent indicators show economic activity moving along at a strong pace. Real gross domestic product (GDP) increased at a 2.8 percent annual rate in the third quarter, consistent with the solid growth recorded in the first half of the year. American consumers remain resilient, with broad-based gains in household spending on both goods and services. This supports broader economic growth because consumer spending constitutes roughly two-thirds of GDP. Spending at retailers and restaurants rose 2.8 percent in October from a year earlier, a faster 12-month rate of increase than the prior two months. Recent data revisions show that household income and savings have been higher than previously thought, improving the outlook for consumer spending and GDP growth. It is remarkable that the U.S. economy has been growing rapidly even as inflation has been declining significantly over the past two years. One reason why this solid growth could be occurring is that potential growth, or the maximum rate at which an economy can grow without causing inflation over the medium term, may have increased. One factor that appears to have supported both potential and actual growth is a faster pace of productivity gains. Recent data indicate labor productivity has grown at a 1.8 percent annual rate since the end of 2019, surpassing its 1.5 percent growth rate over the previous 12 years. Several forces could have boosted productivity in recent years. As I discussed in a recent speech in South Carolina, the U.S. experienced a surge in new business formation since the start of the pandemic. These newer firms are more likely to innovate and adopt new technologies and business processes, thus boosting productivity. Two other factors boosting productivity relate in part to changes in the U.S. economy during and after the pandemic. Worker reallocation across jobs and locations surged early in the pandemic and remained high for some time. There is some research suggesting that such reallocation resulted in better and more productive matches between some workers and jobs, thus raising labor productivity. At the same time, severe labor shortages during the post-pandemic recovery spurred many businesses to invest in labor- saving technologies and to restructure aspects of production more efficiently, which may also have given at least a one-time boost to productivity. More broadly, the continued sizable investment in new technologies may promote ongoing strength in productivity growth. Much of this investment has gone toward artificial intelligence (AI), which has the potential to transform many aspects of the economy and job market, as I discussed in speeches earlier this fall. Compared with productivity abroad, recent U.S. productivity growth looks quite exceptional. As shown in figure 1, before the pandemic, the U.S. had faster productivity growth—as shown by the green portion of the bars-than other advanced economies, but the difference was small. Since the pandemic, however, U.S. productivity growth has far exceeded that of Europe, Canada, and Australia, as shown in figure 2. To explain this notable outperformance, some have highlighted our country's relatively flexible labor market and greater business dynamism compared with these other economies. Moreover, to the extent that investment in technology has been a driver of cross-country differences, it is notable that private investment in AI has been much higher in the U.S. than abroad. This productivity outperformance is likely a main reason why U.S. GDP growth has been stronger than that of foreign economies; the path of inflation, however, has largely been similar across the globe. As shown in figure 3, inflation in the U.S. and abroad rose sharply in 2021 and 2022, amid supply bottlenecks and a post-pandemic recovery in demand. Inflation reached a higher peak in European economies that were most directly affected by the energy price shock from Russia's war in Ukraine. Inflation has since declined globally as supply normalized and monetary policy tightening restrained demand. U.S. inflation, as shown by the black line, is nearly back to its 2 percent target level, while core inflation, as shown in figure 4, has come down but remains somewhat above 2 percent. As I stated, the totality of the data suggests that a disinflationary trajectory is still in place and that the labor market is gradually cooling. As such, I view the risks to achieving the Federal Reserve's dual mandate of maximum employment and price stability as being roughly in balance. Consistent with those balanced risks, in my view, it likely will be appropriate to move the policy rate toward a more neutral stance over time. My colleagues on the Federal Open Market Committee and I acted earlier this month to lower the target range for the federal funds rate by $1 / 4$ percentage point. That action came after we reduced the rate by $1 / 2$ percentage point in September. Together, these moves were a strong step toward removing policy restriction. Going forward, I still see the direction of the appropriate policy rate path to be downward, but the magnitude and timing of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. I do not view policy as being on a preset course, and I am ready to respond to a changing outlook. In fact, I find it helpful to consider a range of scenarios when thinking about the path of policy. If the labor market and inflation continue to progress in line with my forecast, it could well be appropriate to lower the level of policy restriction over time until we near the neutral rate of interest, or the point when monetary policy is neither stimulating nor restricting economic growth. However, if inflation progress slows and the labor market remains solid, I could see a scenario where we pause along the downward path. Alternatively, should the labor market weaken in a substantial way, it could be appropriate to ease policy more quickly. My policy decisions will be guided by our dual mandate of maximum employment and stable prices, and I know delivering on those goals will produce the best economic outcomes for all Americans.
2024-11-20T00:00:00	Michelle W Bowman: Approaching policymaking pragmatically	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Forum Club of the Palm Beaches, West Palm Beach, Florida, 20 November 2024.	Michelle W Bowman: Approaching policymaking pragmatically Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Forum Club of the Palm Beaches, West Palm Beach, Florida, 20 November 2024. * * * 1 Good afternoon. It is a pleasure to join you for today's meeting of the Forum Club of the Palm Beaches. It is truly humbling for me to be invited to speak to your membership, in the company of the many influential leaders, authors, and other public figures this organization has hosted since its founding in 1976. Before turning to the main topic of my remarks today, I want to briefly share with you a bit about my background. I am one of the longest serving members currently on the Board of Governors of the Federal Reserve System (Board), having served as a Board member since November 26, 2018. As a member of the Board, I am a permanent voting member of the Federal Open Market Committee (FOMC) and serve in other capacities-I lead the Board committees on smaller and community banks and on consumer and community affairs and serve as a member on other committees that broadly address supervision and regulation and payments. I also provide input into the full range of matters that come before the Board. I am the first Governor appointed to fill the role created by Congress for someone with demonstrated primary experience working in or supervising community banks, banks 2 with less than $10 billion in assets. I have been both a banker, working in the community bank owned and operated by my family since 1882, and a bank supervisoras the Kansas State Bank Commissioner. Early in my career, I spent almost a decade working in public service in several federal government roles, including setting up the Department of Homeland Security after 9/11 and as a Deputy Assistant Secretary and policy advisor to the first Homeland Security Secretary, Tom Ridge. I also served as a counsel on several U.S. House Committees, and as a staff member for the former U.S. Senator from Kansas, Bob Dole. These experiences have provided me with a uniquely broad perspective about the role of government and the functioning of the U.S. economy-from the view of a regulated business, an executive branch agency, the legislative branch, and state and federal regulatory agencies. Throughout my career, but particularly in my current role as a member of the Board of Governors, I have approached my responsibilities in an independent way, relying on facts, analysis, my own experience and judgment, and the pursuit of the congressionally mandated goals that guide the work of the Board. In some cases, this approach has led me to depart from the views of my colleagues. At its September meeting, the FOMC voted to lower the target range for the federal funds rate, for the first time since we began tightening to combat inflation, by 1/2 percentage point to 4-3/4 to 5 percent. I dissented from that decision, preferring instead to lower the target range by 1/4 percentage point. In my statement published after the meeting, I agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by beginning the process of recalibrating the policy stance toward a more neutral setting. As my statement noted, I preferred a smaller initial cut in the policy rate. With inflation continuing to hover well above our 2 percent goal, I saw the risk that the Committee's large policy action might be interpreted as a premature declaration of victory on our price-stability mandate. In addition, with the U.S. economy remaining strong, moving the policy rate down too quickly, in my view, would carry the risk of stoking demand unnecessarily and potentially reigniting inflationary pressures. My dissent was notable in that the last dissenting vote from a Fed Board member on an FOMC vote occurred nearly 20 years ago. My dissent was guided by my view and interpretation of the available data and my understanding of the Fed's dual mandate of maximum employment and stable prices, which I will discuss more in a moment. Everyone in this room knows that experience is important. My experiences have shaped and reinforced my views on how policymakers can best serve the publicnarrowly, including in monetary policy decisionmaking and the regulation of the banking industry, but also more broadly in thinking about policymaking in support of an agency's mission balanced with its extensive impact on the affected industry and the U.S. economy. A Pragmatic Approach to Policymaking A Goal-Oriented Approach In the past, I have discussed the role of policymaking from the perspective of a Federal Reserve Board member. But taking a step back, there are some broader themes relevant to agency policymaking more generally, themes that are useful beyond the context of the Federal Reserve. At a basic level, I think of this as a pragmatic approach. It requires tradeoffs to balance regulation while also not inhibiting economic growth. The first question I like to ask when confronted with a policy issue is, "Why are we here?" You may recognize this question from Philosophy 101, but this question also applies to the exercise of executive authority by regulatory agencies. The Federal Reserve has extensive responsibilities, and equally extensive powers, but it must exercise these powers only in furtherance of specific goals established by statute. The sheer scope of the Fed's powers can present a temptation to go beyond the statutory authority. For example, to play a more active role in the allocation of credit, or to displace other sources of bank funding even when market sources of liquidity are functioning well. It could also include the temptation to venture into policy matters unrelated to the Fed's responsibilities that are better addressed by Congress or other policymakers (here, a push for banking sector climate change related regulation comes to mind). The goals Congress has laid out for the Fed are complicated and important. Congress should not expect the Federal Reserve, or any other agency for that matter, to solve problems beyond that agency's limited purpose. Doing so would contravene the intent and authority of Congress. To begin, I will provide a few concrete examples of how the starting point for policy is the agency's mission, including in: (1) the execution of monetary policy, and (2) the conduct of banking regulation and supervision. In conducting monetary policy, Congress has given us the dual mandate of maximum employment and price stability. Achieving these goals has often proven challenging, particularly over the last several years, as these policy objectives can sometimes be in tension. Policy actions to tame inflation, like raising the target range for the federal funds rate, can have an adverse effect on employment. A critical input to the FOMC decisionmaking process is an analysis of economic conditions and outlook. The real economy continues to be strong, with solid momentum in economic activity, robust household spending and business investment, and a healthy labor market that remains near full employment. Although economic conditions have been supportive of our employment mandate, they have been unsatisfying for our price stability mandate as inflation continues to be elevated. We have seen considerable progress in lowering inflation since early 2023, but progress seems to have stalled in recent months. The 12-month measure of core personal consumption expenditures inflation-which excludes food and energy priceshas moved sideways at around 2.7 percent since May, and the latest consumer and producer price index reports point to a similarly elevated or even higher reading for October. The persistently high core inflation largely reflects pressures on housing services prices, perhaps due to an increase in demand for affordable housing and an inelastic supply. Gross domestic product (GDP) increased at a solid pace in the third quarter, maintaining the momentum from the previous four quarters. Growth continued to be driven by private domestic final purchases, as personal consumption, and retail sales in particular, strongly increased last quarter, more than offsetting further weakness in housing activity due to high mortgage rates. Retail sales continued to rise in October, even though Hurricanes Helene and Milton may have exerted a small drag on sales last month. The annual revision of the national income and product accounts confirmed that GDP has been providing the right signal about the ongoing strength in economic activity, as gross domestic income and personal income were revised up considerably for 2023 and the first half of this year. The October employment report seems to have been affected by the recent hurricanes and the Boeing strike. It also featured the lowest response rate to the payroll survey in decades. After accounting for these special factors, it seems that payroll employment continued to increase in October at a pace close to the average monthly gain seen in the second and third quarters. The unemployment rate remained low at 4.1 percent in October, down from 4.3 percent in July. The labor force participation rate remains well below pre-pandemic levels and edged down further in October due to lower prime-age participation. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has been close to the historically elevated pre-pandemic level in recent months. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength. Wage growth has slowed further in recent months, but it continues to indicate a tight labor market. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, a mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. Monetary Policy In the monetary policy function, we rely on the best data available, but without question the data are imperfect. We also consider a range of possible future economic conditions to help inform our monetary policy decisionmaking, which requires that we make assumptions and predictions about the future. Looking back over time, our crystal ball has never been perfect at predicting the risks that may emerge, how those risks may influence economic conditions, and how that should be considered in analyzing our monetary policy goals. To illustrate this point in terms of recent events, we have not yet met our inflation goal and, as I noted earlier, progress in lowering inflation appears to have stalled. I see greater risks to the price stability side of our mandate, especially while the labor market remains near full employment, but it is also possible that we could see a deterioration in labor market conditions. These predictions always come with a dose of humility, however, particularly because they rely on imperfect data. The labor market data have become increasingly difficult to interpret, as surveys and other measurements struggle to incorporate large numbers of new workers and to account for other influences that we do not yet fully understand and have not yet been able to accurately measure. As the dynamics of immigration and business creation and closures continue to change, it has become increasingly difficult to understand the payroll employment data. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. While the mandate for monetary policy is straightforward, its execution is complex. Our decisions are guided by our dual mandate, but arriving at them entails careful analysis of sometimes flawed data, and informed judgments about unknowable future conditions. Bank Regulation and Supervision In conducting bank regulation and supervision, the Federal Reserve promotes the safe and sound operation of individual banks, and the stability of the broader financial system. These bank regulatory goals have obvious synergies-individual banks operating in a safe and sound manner tends to create conditions that promote financial stability in the banking sector. The Fed's bank regulatory objectives include implicit tradeoffs: we aim to foster a banking system that is safe, sound, and efficient, while serving the U.S. economy, and facilitating economic growth. The objectives must also support the full breadth of the banking system from the very largest to the very smallest. Striking a balance among these competing goals can certainly be a challenge, and policy views on where that balance should be struck may vary. We should approach the task of bank regulation with an understanding and appreciation of these tradeoffs, coupled with an affirmative acknowledgment that the banking system is an important driver of business formation, economic expansion, and opportunity. A banking system that is safe and sound yet irrelevant would not fulfill our regulatory objectives, but would be the inevitable outcome of following a path that strives for elimination of risks rather than promotion of effective risk management. Banks are unique individual businesses, not public utilities. The pursuit of these bank regulatory goals requires an approach that considers a range of regulatory and supervisory tools, from the quantitative-like the setting of bank capital and liquidity requirements-to the more subjective-like evaluating bank management during the examination process. And while the goals themselves seem straightforward, the tools available and the complexity and evolution of the financial system over time present real challenges from a policymaking perspective. When we consider drafting a new regulation, we should always ask "What problem would this new regulation solve?" Policymakers should exercise restraint in the promulgation of a new regulation, by articulating the problem it purports to solve and presenting an efficient way to address it. Identifying the problem that requires addressing often poses one of the most significant challenges. Ideally, the process would begin by identifying the problem, then move to an analysis of whether proposed solutions are within the agency's statutory authorities, and finally whether targeted changes to the regulatory framework could result in improvements, remediation of gaps, or elimination of redundant and unnecessary requirements. But for a number of reasons, the problem identification process can result in misidentification of issues, and a resulting failure to prioritize the most important ones. Take for example the failure of Silicon Valley Bank (SVB), and the regulatory response. At its root, this bank's failure exposed significant flaws in the bank's management and the regulators' oversight and supervision. The interest rate and funding risks, rapid growth, and the idiosyncratic business model and concentrated customer base of the bank, were apparent and obvious. These risks were mismanaged by SVB and not acted on early enough by bank supervisors. These were not the only factors contributing to the firm's failure, but these critical elements should have been the key priorities for the supervisory function to address after the bank's failure. And yet in the aftermath of SVB's demise, we have focused on regulatory proposals ranging from substantial increases in bank capital requirements, to pushing down global systemically important bank (G-SIB) and large bank requirements to much smaller firms, finding supervisory deficiencies in the management of wellcapitalized and financially sound firms, and considering widespread changes to the funding and liquidity requirements and expectations that apply to all banks. A crisis is not a regulatory blank check. In some ways, it presents heightened risks that should prompt us to show our work even more carefully. A deliberate, transparent, and fact-based approach to pursuing statutory objectives also serves the goal of avoiding the impression of pursuing unrelated policy goals, particularly those that venture into political concerns outside of an agency's purposes or functions. Promoting safety, soundness, and financial stability should not devolve into an exercise of regulatory allocation of credit-picking winners and losers-or promoting an ideological position through more open-ended processes like bank supervision and examination. Effective and Efficient Solutions Once we have a clear and thorough understanding of our statutory objectives and have a framework to identify issues, gaps, or redundancies, the next task is to focus on finding efficient solutions to those issues. In doing so, we should consider policy alternatives and perspectives that may differ from our past approach. We should also acknowledge that we may not have all the facts or information necessary to immediately identify an effective solution. Successful policymaking requires openness and humility, caution, and a deliberate approach. With respect to monetary policy, uncertainty surrounding available data and the many variables that can affect future economic conditions suggest that we should pursue a cautious approach. At the most recent meeting in November, the Committee decided to take an additional step along the path of moving toward a more neutral policy setting. I agreed to support this action, since it aligns with my preference to lower the policy rate gradually, especially in light of elevated inflation and the uncertainty about the level of the neutral rate. My estimate of the neutral policy rate is much higher than it was before the pandemic, and therefore we may be closer to a neutral policy stance than we currently think. I would prefer to proceed cautiously in bringing the policy rate down to better assess how far we are from the end point, while recognizing that we have not yet achieved our inflation goal and closely watching the evolution of the labor market. We should also not rule out the risk that the policy rate may attain or even fall below its neutral level before we achieve our price stability goal. It is important to note that monetary policy is not on a preset course. At each FOMC meeting, my colleagues and I will make our decisions based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. During each intermeeting period, we typically receive a range of economic data and information. In addition to closely watching the incoming data, I meet with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. Especially in light of the data measurement challenges that I mentioned earlier, engaging with contacts helps me interpret the signals provided by the data and gain a better understanding of how the economy is evolving. Consistent with this pragmatic approach, I am pleased that the November post meeting statement included a flexible, data-dependent approach, providing the Committee with optionality in deciding future policy adjustments. As I noted earlier, my view is that inflation remains a concern, and I continue to see price stability as essential for fostering a strong labor market and an economy that works for everyone in the longer term. In banking regulation, this pragmatic approach requires us to consider the costs and benefits of any proposed change, as well as incentive effects, impacts on markets, and potential unintended consequences. But it also means that we must consider the limits of regulatory responsibility-grounded by our statutory objectives-when taking regulatory action. In my view, these considerations apply beyond Federal Reserve policymaking to regulatory actions taken by any agency. As I noted previously, statutory mandates guiding the Fed's bank regulatory responsibilities provide an important grounding for agency action. But they must be viewed in the broader context of promoting an effective and efficient banking system that supports market functioning and encourages economic growth, business creation and expansion, and opportunity. Our responsibility is not to look only at whether a proposal will promote greater safety and soundness, but to consider the broader context, including whether regulatory incentives will skew the allocation of credit, adversely affect capital markets, or push traditional banking activities outside of the banking system into less regulated non-banks. Is the bank regulatory framework efficient? Does it allow banks sufficient freedom and flexibility to operate and meet customer needs? And importantly, are there areas within the approach to regulation and supervision that simply cannot be justified based on a cost-benefit analysis? The answer to the latter is "Yes." There are a number of areas where right-sizing regulation and our supervisory approach would be appropriate and can be done in a way that does not sacrifice safety and soundness or threaten financial stability. Regulation is most effective when it strikes an appropriate balance between competing goals and objectives. In the banking system, this means operating in a safe, sound, and financially stable way, while also supporting economic growth and efficiency. When we fail to consider this broader context, we risk disincentivizing growth, imposing overly burdensome and unnecessary regulations, setting opaque and unreasonable expectations through the supervisory process, and forcing the inefficient allocation of capital. Sometimes this debate escapes from the dusty offices of the banking regulators into plain view, as during the past year on the Basel III Endgame package of bank capital reforms. While this proposal prompted extensive comment from a wide range of commenters, it also inspired a negative television and radio advertising campaign, which is unprecedented for a relatively technical bank regulatory issue. But these ads highlighted an uncomfortable truth: the regulatory approach we took failed to consider or deliver a reasonable proposal, one aligned with the original Basel agreement yet suited to the particulars of the U.S. banking system. Instead, the proposal released last year opted for significant capital increases for some banks, in excess of 20 percent, departing significantly from the approach adopted by our international counterparts. This public engagement has been useful, and it seems to have softened some of the over-calibrated positions underpinning the original capital reform proposal. But this level of public engagement and debate was also a byproduct of the rulemaking process. While regulatory overreach can threaten the credibility of agency action in the eyes of the public, a transparent process allows public commenters to pressure test and pushback on agency action. However, when agencies overwhelm the process by publishing thousands of pages of rulemakings in a short period of time, the public's ability to provide meaningful feedback on our rules is compromised. Last year the federal financial agencies published over 5,000 pages of rules and proposals. And yet, even when the public is able to comment on these voluminous proposals, regulators often ignore this constructive feedback and move forward to publish final rules with minimal or no changes relative to their proposals, as with the Community Reinvestment Act rule. Maintenance of an existing regulatory framework is not glamorous but is perhaps one of the more important agency functions to ensure that the framework is striking the right balance between promoting a strong banking system and supporting economic growth. This requires reviewing and updating regulations to ensure that prior agency actions 3 continue to address problems efficiently as industries and conditions change. When agencies prioritize the creation of new regulation in the absence of a statutory mandate, harmful and unintended consequences can result. One such example is the adverse effects of regulatory constraints on Treasury market functioning. Rules like the Supplementary Leverage Ratio, the G-SIB Surcharge, and the Liquidity Coverage Ratio pose known and identified constraints on the Treasury market that may contribute to future stress and market disruption if left unaddressed. Finally, while transparency-like that intended by the rulemaking process-can lead to better public engagement and outcomes, it is important that agency actions are transparent even when not legally mandated. The most obvious opportunity for additional transparency in the banking framework is in supervision. Supervision by its nature involves confidential and detailed inquiries into bank operations, with examiners evaluating quantitative measures like capital and liquidity, while making judgmental assessments of the activities and risks of the institution, and its risk-management approach. Supervisory expectations should not surprise regulated firms, and yet transparency of these expectations is often challenging to achieve. In fact, since the failure of SVB supervisory surprises have become more common in bank examinations. In light of the recent Supreme Court cases regarding agency actions, agencies should respond in a way that furthers the goals of transparency and accountability, and act as a check on regulatory overreach. The elimination of Chevron deference has the potential to transform agency rulemakings positively-in a way that promotes the pragmatic approach I outlined in this discussion. The same considerations we follow in the pursuit of our statutory objectives could help support rulemakings that are built upon a stronger factual and analytical basis, with a thorough and more comprehensive explanation of an agency's policy approach. Closing Thoughts While my remarks today have largely focused on Federal Reserve responsibilities, a pragmatic approach has broader applicability. Agencies can build public support for their activities by following these simple principles-a rigorous focus on statutory objectives, a foundation based on facts and careful analysis in forming policy, crafting efficient solutions, and public transparency and accountability. Agencies and their regulated businesses will benefit from a rigorous process that considers different perspectives, the intended and unintended consequences of decisions, and the costs and benefits of actions. The ability of the banking system to finance the future growth of the U.S. economy hinges upon our ability and willingness to shift our approach to regulation and supervisory oversight. A pragmatic approach to policymaking will better enable the U.S. economy to continue to grow now and into the future. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 See 12 U.S.C. § 241. 3 In February, the Board announced the initiation of its review of its regulations to identify those regulations that are outdated, unnecessary, or overly burdensome in accordance with the Economic Growth and Regulatory Paperwork Reduction Act. See Michelle W. Bowman (2024), "Statement by Governor Michelle W. Bowman on the Review of the Board's Regulations under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA)" press release, February 6.	---[PAGE_BREAK]--- # Michelle W Bowman: Approaching policymaking pragmatically Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Forum Club of the Palm Beaches, West Palm Beach, Florida, 20 November 2024. Good afternoon. ${ }^{1}$ It is a pleasure to join you for today's meeting of the Forum Club of the Palm Beaches. It is truly humbling for me to be invited to speak to your membership, in the company of the many influential leaders, authors, and other public figures this organization has hosted since its founding in 1976. Before turning to the main topic of my remarks today, I want to briefly share with you a bit about my background. I am one of the longest serving members currently on the Board of Governors of the Federal Reserve System (Board), having served as a Board member since November 26, 2018. As a member of the Board, I am a permanent voting member of the Federal Open Market Committee (FOMC) and serve in other capacities-I lead the Board committees on smaller and community banks and on consumer and community affairs and serve as a member on other committees that broadly address supervision and regulation and payments. I also provide input into the full range of matters that come before the Board. I am the first Governor appointed to fill the role created by Congress for someone with demonstrated primary experience working in or supervising community banks, banks with less than $\$ 10$ billion in assets. ${ }^{2}$ I have been both a banker, working in the community bank owned and operated by my family since 1882, and a bank supervisorso as the Kansas State Bank Commissioner. Early in my career, I spent almost a decade working in public service in several federal government roles, including setting up the Department of Homeland Security after 9/11 and as a Deputy Assistant Secretary and policy advisor to the first Homeland Security Secretary, Tom Ridge. I also served as a counsel on several U.S. House Committees, and as a staff member for the former U.S. Senator from Kansas, Bob Dole. These experiences have provided me with a uniquely broad perspective about the role of government and the functioning of the U.S. economy-from the view of a regulated business, an executive branch agency, the legislative branch, and state and federal regulatory agencies. Throughout my career, but particularly in my current role as a member of the Board of Governors, I have approached my responsibilities in an independent way, relying on facts, analysis, my own experience and judgment, and the pursuit of the congressionally mandated goals that guide the work of the Board. In some cases, this approach has led me to depart from the views of my colleagues. At its September meeting, the FOMC voted to lower the target range for the federal funds rate, for the first time since we began tightening to combat inflation, by $1 / 2$ percentage point to $4-3 / 4$ to 5 percent. I dissented from that decision, preferring instead to lower the target range by $1 / 4$ percentage point. In my statement published after the meeting, I ---[PAGE_BREAK]--- agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by beginning the process of recalibrating the policy stance toward a more neutral setting. As my statement noted, I preferred a smaller initial cut in the policy rate. With inflation continuing to hover well above our 2 percent goal, I saw the risk that the Committee's large policy action might be interpreted as a premature declaration of victory on our price-stability mandate. In addition, with the U.S. economy remaining strong, moving the policy rate down too quickly, in my view, would carry the risk of stoking demand unnecessarily and potentially reigniting inflationary pressures. My dissent was notable in that the last dissenting vote from a Fed Board member on an FOMC vote occurred nearly 20 years ago. My dissent was guided by my view and interpretation of the available data and my understanding of the Fed's dual mandate of maximum employment and stable prices, which I will discuss more in a moment. Everyone in this room knows that experience is important. My experiences have shaped and reinforced my views on how policymakers can best serve the publicnarrowly, including in monetary policy decisionmaking and the regulation of the banking industry, but also more broadly in thinking about policymaking in support of an agency's mission balanced with its extensive impact on the affected industry and the U.S. economy. # A Pragmatic Approach to Policymaking ## A Goal-Oriented Approach In the past, I have discussed the role of policymaking from the perspective of a Federal Reserve Board member. But taking a step back, there are some broader themes relevant to agency policymaking more generally, themes that are useful beyond the context of the Federal Reserve. At a basic level, I think of this as a pragmatic approach. It requires tradeoffs to balance regulation while also not inhibiting economic growth. The first question I like to ask when confronted with a policy issue is, "Why are we here?" You may recognize this question from Philosophy 101, but this question also applies to the exercise of executive authority by regulatory agencies. The Federal Reserve has extensive responsibilities, and equally extensive powers, but it must exercise these powers only in furtherance of specific goals established by statute. The sheer scope of the Fed's powers can present a temptation to go beyond the statutory authority. For example, to play a more active role in the allocation of credit, or to displace other sources of bank funding even when market sources of liquidity are functioning well. It could also include the temptation to venture into policy matters unrelated to the Fed's responsibilities that are better addressed by Congress or other policymakers (here, a push for banking sector climate change related regulation comes to mind). The goals Congress has laid out for the Fed are complicated and important. Congress should not expect the Federal Reserve, or any other agency for that matter, to solve problems beyond that agency's limited purpose. Doing so would contravene the intent and authority of Congress. ---[PAGE_BREAK]--- To begin, I will provide a few concrete examples of how the starting point for policy is the agency's mission, including in: (1) the execution of monetary policy, and (2) the conduct of banking regulation and supervision. In conducting monetary policy, Congress has given us the dual mandate of maximum employment and price stability. Achieving these goals has often proven challenging, particularly over the last several years, as these policy objectives can sometimes be in tension. Policy actions to tame inflation, like raising the target range for the federal funds rate, can have an adverse effect on employment. A critical input to the FOMC decisionmaking process is an analysis of economic conditions and outlook. The real economy continues to be strong, with solid momentum in economic activity, robust household spending and business investment, and a healthy labor market that remains near full employment. Although economic conditions have been supportive of our employment mandate, they have been unsatisfying for our price stability mandate as inflation continues to be elevated. We have seen considerable progress in lowering inflation since early 2023, but progress seems to have stalled in recent months. The 12-month measure of core personal consumption expenditures inflation-which excludes food and energy priceshas moved sideways at around 2.7 percent since May, and the latest consumer and producer price index reports point to a similarly elevated or even higher reading for October. The persistently high core inflation largely reflects pressures on housing services prices, perhaps due to an increase in demand for affordable housing and an inelastic supply. Gross domestic product (GDP) increased at a solid pace in the third quarter, maintaining the momentum from the previous four quarters. Growth continued to be driven by private domestic final purchases, as personal consumption, and retail sales in particular, strongly increased last quarter, more than offsetting further weakness in housing activity due to high mortgage rates. Retail sales continued to rise in October, even though Hurricanes Helene and Milton may have exerted a small drag on sales last month. The annual revision of the national income and product accounts confirmed that GDP has been providing the right signal about the ongoing strength in economic activity, as gross domestic income and personal income were revised up considerably for 2023 and the first half of this year. The October employment report seems to have been affected by the recent hurricanes and the Boeing strike. It also featured the lowest response rate to the payroll survey in decades. After accounting for these special factors, it seems that payroll employment continued to increase in October at a pace close to the average monthly gain seen in the second and third quarters. The unemployment rate remained low at 4.1 percent in October, down from 4.3 percent in July. The labor force participation rate remains well below pre-pandemic levels and edged down further in October due to lower prime-age participation. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has been close to the ---[PAGE_BREAK]--- historically elevated pre-pandemic level in recent months. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength. Wage growth has slowed further in recent months, but it continues to indicate a tight labor market. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, a mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. # Monetary Policy In the monetary policy function, we rely on the best data available, but without question the data are imperfect. We also consider a range of possible future economic conditions to help inform our monetary policy decisionmaking, which requires that we make assumptions and predictions about the future. Looking back over time, our crystal ball has never been perfect at predicting the risks that may emerge, how those risks may influence economic conditions, and how that should be considered in analyzing our monetary policy goals. To illustrate this point in terms of recent events, we have not yet met our inflation goal and, as I noted earlier, progress in lowering inflation appears to have stalled. I see greater risks to the price stability side of our mandate, especially while the labor market remains near full employment, but it is also possible that we could see a deterioration in labor market conditions. These predictions always come with a dose of humility, however, particularly because they rely on imperfect data. The labor market data have become increasingly difficult to interpret, as surveys and other measurements struggle to incorporate large numbers of new workers and to account for other influences that we do not yet fully understand and have not yet been able to accurately measure. As the dynamics of immigration and business creation and closures continue to change, it has become increasingly difficult to understand the payroll employment data. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. While the mandate for monetary policy is straightforward, its execution is complex. Our decisions are guided by our dual mandate, but arriving at them entails careful analysis of sometimes flawed data, and informed judgments about unknowable future conditions. ## Bank Regulation and Supervision In conducting bank regulation and supervision, the Federal Reserve promotes the safe and sound operation of individual banks, and the stability of the broader financial system. These bank regulatory goals have obvious synergies-individual banks operating in a safe and sound manner tends to create conditions that promote financial stability in the banking sector. The Fed's bank regulatory objectives include implicit tradeoffs: we aim to foster a banking system that is safe, sound, and efficient, while ---[PAGE_BREAK]--- serving the U.S. economy, and facilitating economic growth. The objectives must also support the full breadth of the banking system from the very largest to the very smallest. Striking a balance among these competing goals can certainly be a challenge, and policy views on where that balance should be struck may vary. We should approach the task of bank regulation with an understanding and appreciation of these tradeoffs, coupled with an affirmative acknowledgment that the banking system is an important driver of business formation, economic expansion, and opportunity. A banking system that is safe and sound yet irrelevant would not fulfill our regulatory objectives, but would be the inevitable outcome of following a path that strives for elimination of risks rather than promotion of effective risk management. Banks are unique individual businesses, not public utilities. The pursuit of these bank regulatory goals requires an approach that considers a range of regulatory and supervisory tools, from the quantitative-like the setting of bank capital and liquidity requirements-to the more subjective-like evaluating bank management during the examination process. And while the goals themselves seem straightforward, the tools available and the complexity and evolution of the financial system over time present real challenges from a policymaking perspective. When we consider drafting a new regulation, we should always ask "What problem would this new regulation solve?" Policymakers should exercise restraint in the promulgation of a new regulation, by articulating the problem it purports to solve and presenting an efficient way to address it. Identifying the problem that requires addressing often poses one of the most significant challenges. Ideally, the process would begin by identifying the problem, then move to an analysis of whether proposed solutions are within the agency's statutory authorities, and finally whether targeted changes to the regulatory framework could result in improvements, remediation of gaps, or elimination of redundant and unnecessary requirements. But for a number of reasons, the problem identification process can result in misidentification of issues, and a resulting failure to prioritize the most important ones. Take for example the failure of Silicon Valley Bank (SVB), and the regulatory response. At its root, this bank's failure exposed significant flaws in the bank's management and the regulators' oversight and supervision. The interest rate and funding risks, rapid growth, and the idiosyncratic business model and concentrated customer base of the bank, were apparent and obvious. These risks were mismanaged by SVB and not acted on early enough by bank supervisors. These were not the only factors contributing to the firm's failure, but these critical elements should have been the key priorities for the supervisory function to address after the bank's failure. And yet in the aftermath of SVB's demise, we have focused on regulatory proposals ranging from substantial increases in bank capital requirements, to pushing down global systemically important bank (G-SIB) and large bank requirements to much smaller firms, finding supervisory deficiencies in the management of wellcapitalized and financially sound firms, and considering widespread changes to the funding and liquidity requirements and expectations that apply to all banks. A crisis is not a regulatory blank check. In some ways, it presents heightened risks that should prompt us to show our work even more carefully. A deliberate, transparent, and ---[PAGE_BREAK]--- fact-based approach to pursuing statutory objectives also serves the goal of avoiding the impression of pursuing unrelated policy goals, particularly those that venture into political concerns outside of an agency's purposes or functions. Promoting safety, soundness, and financial stability should not devolve into an exercise of regulatory allocation of credit-picking winners and losers-or promoting an ideological position through more open-ended processes like bank supervision and examination. # Effective and Efficient Solutions Once we have a clear and thorough understanding of our statutory objectives and have a framework to identify issues, gaps, or redundancies, the next task is to focus on finding efficient solutions to those issues. In doing so, we should consider policy alternatives and perspectives that may differ from our past approach. We should also acknowledge that we may not have all the facts or information necessary to immediately identify an effective solution. Successful policymaking requires openness and humility, caution, and a deliberate approach. With respect to monetary policy, uncertainty surrounding available data and the many variables that can affect future economic conditions suggest that we should pursue a cautious approach. At the most recent meeting in November, the Committee decided to take an additional step along the path of moving toward a more neutral policy setting. I agreed to support this action, since it aligns with my preference to lower the policy rate gradually, especially in light of elevated inflation and the uncertainty about the level of the neutral rate. My estimate of the neutral policy rate is much higher than it was before the pandemic, and therefore we may be closer to a neutral policy stance than we currently think. I would prefer to proceed cautiously in bringing the policy rate down to better assess how far we are from the end point, while recognizing that we have not yet achieved our inflation goal and closely watching the evolution of the labor market. We should also not rule out the risk that the policy rate may attain or even fall below its neutral level before we achieve our price stability goal. It is important to note that monetary policy is not on a preset course. At each FOMC meeting, my colleagues and I will make our decisions based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. During each intermeeting period, we typically receive a range of economic data and information. In addition to closely watching the incoming data, I meet with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. Especially in light of the data measurement challenges that I mentioned earlier, engaging with contacts helps me interpret the signals provided by the data and gain a better understanding of how the economy is evolving. Consistent with this pragmatic approach, I am pleased that the November post meeting statement included a flexible, data-dependent approach, providing the Committee with optionality in deciding future policy adjustments. As I noted earlier, my view is that inflation remains a concern, and I continue to see price stability as essential for fostering a strong labor market and an economy that works for everyone in the longer term. ---[PAGE_BREAK]--- In banking regulation, this pragmatic approach requires us to consider the costs and benefits of any proposed change, as well as incentive effects, impacts on markets, and potential unintended consequences. But it also means that we must consider the limits of regulatory responsibility-grounded by our statutory objectives-when taking regulatory action. In my view, these considerations apply beyond Federal Reserve policymaking to regulatory actions taken by any agency. As I noted previously, statutory mandates guiding the Fed's bank regulatory responsibilities provide an important grounding for agency action. But they must be viewed in the broader context of promoting an effective and efficient banking system that supports market functioning and encourages economic growth, business creation and expansion, and opportunity. Our responsibility is not to look only at whether a proposal will promote greater safety and soundness, but to consider the broader context, including whether regulatory incentives will skew the allocation of credit, adversely affect capital markets, or push traditional banking activities outside of the banking system into less regulated non-banks. Is the bank regulatory framework efficient? Does it allow banks sufficient freedom and flexibility to operate and meet customer needs? And importantly, are there areas within the approach to regulation and supervision that simply cannot be justified based on a cost-benefit analysis? The answer to the latter is "Yes." There are a number of areas where right-sizing regulation and our supervisory approach would be appropriate and can be done in a way that does not sacrifice safety and soundness or threaten financial stability. Regulation is most effective when it strikes an appropriate balance between competing goals and objectives. In the banking system, this means operating in a safe, sound, and financially stable way, while also supporting economic growth and efficiency. When we fail to consider this broader context, we risk disincentivizing growth, imposing overly burdensome and unnecessary regulations, setting opaque and unreasonable expectations through the supervisory process, and forcing the inefficient allocation of capital. Sometimes this debate escapes from the dusty offices of the banking regulators into plain view, as during the past year on the Basel III Endgame package of bank capital reforms. While this proposal prompted extensive comment from a wide range of commenters, it also inspired a negative television and radio advertising campaign, which is unprecedented for a relatively technical bank regulatory issue. But these ads highlighted an uncomfortable truth: the regulatory approach we took failed to consider or deliver a reasonable proposal, one aligned with the original Basel agreement yet suited to the particulars of the U.S. banking system. Instead, the proposal released last year opted for significant capital increases for some banks, in excess of 20 percent, departing significantly from the approach adopted by our international counterparts. This public engagement has been useful, and it seems to have softened some of the over-calibrated positions underpinning the original capital reform proposal. But this level of public engagement and debate was also a byproduct of the rulemaking process. While regulatory overreach can threaten the credibility of agency action in the eyes of the public, a transparent process allows public commenters to pressure test and pushback on agency action. ---[PAGE_BREAK]--- However, when agencies overwhelm the process by publishing thousands of pages of rulemakings in a short period of time, the public's ability to provide meaningful feedback on our rules is compromised. Last year the federal financial agencies published over 5,000 pages of rules and proposals. And yet, even when the public is able to comment on these voluminous proposals, regulators often ignore this constructive feedback and move forward to publish final rules with minimal or no changes relative to their proposals, as with the Community Reinvestment Act rule. Maintenance of an existing regulatory framework is not glamorous but is perhaps one of the more important agency functions to ensure that the framework is striking the right balance between promoting a strong banking system and supporting economic growth. This requires reviewing and updating regulations to ensure that prior agency actions continue to address problems efficiently as industries and conditions change. ${ }^{3}$ When agencies prioritize the creation of new regulation in the absence of a statutory mandate, harmful and unintended consequences can result. One such example is the adverse effects of regulatory constraints on Treasury market functioning. Rules like the Supplementary Leverage Ratio, the G-SIB Surcharge, and the Liquidity Coverage Ratio pose known and identified constraints on the Treasury market that may contribute to future stress and market disruption if left unaddressed. Finally, while transparency-like that intended by the rulemaking process-can lead to better public engagement and outcomes, it is important that agency actions are transparent even when not legally mandated. The most obvious opportunity for additional transparency in the banking framework is in supervision. Supervision by its nature involves confidential and detailed inquiries into bank operations, with examiners evaluating quantitative measures like capital and liquidity, while making judgmental assessments of the activities and risks of the institution, and its risk-management approach. Supervisory expectations should not surprise regulated firms, and yet transparency of these expectations is often challenging to achieve. In fact, since the failure of SVB supervisory surprises have become more common in bank examinations. In light of the recent Supreme Court cases regarding agency actions, agencies should respond in a way that furthers the goals of transparency and accountability, and act as a check on regulatory overreach. The elimination of Chevrondeference has the potential to transform agency rulemakings positively-in a way that promotes the pragmatic approach I outlined in this discussion. The same considerations we follow in the pursuit of our statutory objectives could help support rulemakings that are built upon a stronger factual and analytical basis, with a thorough and more comprehensive explanation of an agency's policy approach. # Closing Thoughts While my remarks today have largely focused on Federal Reserve responsibilities, a pragmatic approach has broader applicability. Agencies can build public support for their activities by following these simple principles-a rigorous focus on statutory objectives, a foundation based on facts and careful analysis in forming policy, crafting efficient solutions, and public transparency and accountability. Agencies and their regulated businesses will benefit from a rigorous process that considers different perspectives, the intended and unintended consequences of decisions, and the costs ---[PAGE_BREAK]--- and benefits of actions. The ability of the banking system to finance the future growth of the U.S. economy hinges upon our ability and willingness to shift our approach to regulation and supervisory oversight. A pragmatic approach to policymaking will better enable the U.S. economy to continue to grow now and into the future. ${ }^{1}$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See 12 U.S.C. § 241. ${ }^{3}$ In February, the Board announced the initiation of its review of its regulations to identify those regulations that are outdated, unnecessary, or overly burdensome in accordance with the Economic Growth and Regulatory Paperwork Reduction Act. See Michelle W. Bowman (2024), "Statement by Governor Michelle W. Bowman on the Review of the Board's Regulations under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA)" press release, February 6.	Michelle W Bowman	United States	https://www.bis.org/review/r241126e.pdf	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the Forum Club of the Palm Beaches, West Palm Beach, Florida, 20 November 2024. Good afternoon. It is a pleasure to join you for today's meeting of the Forum Club of the Palm Beaches. It is truly humbling for me to be invited to speak to your membership, in the company of the many influential leaders, authors, and other public figures this organization has hosted since its founding in 1976. Before turning to the main topic of my remarks today, I want to briefly share with you a bit about my background. I am one of the longest serving members currently on the Board of Governors of the Federal Reserve System (Board), having served as a Board member since November 26, 2018. As a member of the Board, I am a permanent voting member of the Federal Open Market Committee (FOMC) and serve in other capacities-I lead the Board committees on smaller and community banks and on consumer and community affairs and serve as a member on other committees that broadly address supervision and regulation and payments. I also provide input into the full range of matters that come before the Board. I am the first Governor appointed to fill the role created by Congress for someone with demonstrated primary experience working in or supervising community banks, banks with less than $\$ 10$ billion in assets. I have been both a banker, working in the community bank owned and operated by my family since 1882, and a bank supervisorso as the Kansas State Bank Commissioner. Early in my career, I spent almost a decade working in public service in several federal government roles, including setting up the Department of Homeland Security after 9/11 and as a Deputy Assistant Secretary and policy advisor to the first Homeland Security Secretary, Tom Ridge. I also served as a counsel on several U.S. House Committees, and as a staff member for the former U.S. Senator from Kansas, Bob Dole. These experiences have provided me with a uniquely broad perspective about the role of government and the functioning of the U.S. economy-from the view of a regulated business, an executive branch agency, the legislative branch, and state and federal regulatory agencies. Throughout my career, but particularly in my current role as a member of the Board of Governors, I have approached my responsibilities in an independent way, relying on facts, analysis, my own experience and judgment, and the pursuit of the congressionally mandated goals that guide the work of the Board. In some cases, this approach has led me to depart from the views of my colleagues. At its September meeting, the FOMC voted to lower the target range for the federal funds rate, for the first time since we began tightening to combat inflation, by $1 / 2$ percentage point to $4-3 / 4$ to 5 percent. I dissented from that decision, preferring instead to lower the target range by $1 / 4$ percentage point. In my statement published after the meeting, I agreed with the Committee's assessment that, given the progress we have seen since the middle of 2023 on both lowering inflation and cooling the labor market, it was appropriate to reflect this progress by beginning the process of recalibrating the policy stance toward a more neutral setting. As my statement noted, I preferred a smaller initial cut in the policy rate. With inflation continuing to hover well above our 2 percent goal, I saw the risk that the Committee's large policy action might be interpreted as a premature declaration of victory on our price-stability mandate. In addition, with the U.S. economy remaining strong, moving the policy rate down too quickly, in my view, would carry the risk of stoking demand unnecessarily and potentially reigniting inflationary pressures. My dissent was notable in that the last dissenting vote from a Fed Board member on an FOMC vote occurred nearly 20 years ago. My dissent was guided by my view and interpretation of the available data and my understanding of the Fed's dual mandate of maximum employment and stable prices, which I will discuss more in a moment. Everyone in this room knows that experience is important. My experiences have shaped and reinforced my views on how policymakers can best serve the publicnarrowly, including in monetary policy decisionmaking and the regulation of the banking industry, but also more broadly in thinking about policymaking in support of an agency's mission balanced with its extensive impact on the affected industry and the U.S. economy. In the past, I have discussed the role of policymaking from the perspective of a Federal Reserve Board member. But taking a step back, there are some broader themes relevant to agency policymaking more generally, themes that are useful beyond the context of the Federal Reserve. At a basic level, I think of this as a pragmatic approach. It requires tradeoffs to balance regulation while also not inhibiting economic growth. The first question I like to ask when confronted with a policy issue is, "Why are we here?" You may recognize this question from Philosophy 101, but this question also applies to the exercise of executive authority by regulatory agencies. The Federal Reserve has extensive responsibilities, and equally extensive powers, but it must exercise these powers only in furtherance of specific goals established by statute. The sheer scope of the Fed's powers can present a temptation to go beyond the statutory authority. For example, to play a more active role in the allocation of credit, or to displace other sources of bank funding even when market sources of liquidity are functioning well. It could also include the temptation to venture into policy matters unrelated to the Fed's responsibilities that are better addressed by Congress or other policymakers (here, a push for banking sector climate change related regulation comes to mind). The goals Congress has laid out for the Fed are complicated and important. Congress should not expect the Federal Reserve, or any other agency for that matter, to solve problems beyond that agency's limited purpose. Doing so would contravene the intent and authority of Congress. To begin, I will provide a few concrete examples of how the starting point for policy is the agency's mission, including in: (1) the execution of monetary policy, and (2) the conduct of banking regulation and supervision. In conducting monetary policy, Congress has given us the dual mandate of maximum employment and price stability. Achieving these goals has often proven challenging, particularly over the last several years, as these policy objectives can sometimes be in tension. Policy actions to tame inflation, like raising the target range for the federal funds rate, can have an adverse effect on employment. A critical input to the FOMC decisionmaking process is an analysis of economic conditions and outlook. The real economy continues to be strong, with solid momentum in economic activity, robust household spending and business investment, and a healthy labor market that remains near full employment. Although economic conditions have been supportive of our employment mandate, they have been unsatisfying for our price stability mandate as inflation continues to be elevated. We have seen considerable progress in lowering inflation since early 2023, but progress seems to have stalled in recent months. The 12-month measure of core personal consumption expenditures inflation-which excludes food and energy priceshas moved sideways at around 2.7 percent since May, and the latest consumer and producer price index reports point to a similarly elevated or even higher reading for October. The persistently high core inflation largely reflects pressures on housing services prices, perhaps due to an increase in demand for affordable housing and an inelastic supply. Gross domestic product (GDP) increased at a solid pace in the third quarter, maintaining the momentum from the previous four quarters. Growth continued to be driven by private domestic final purchases, as personal consumption, and retail sales in particular, strongly increased last quarter, more than offsetting further weakness in housing activity due to high mortgage rates. Retail sales continued to rise in October, even though Hurricanes Helene and Milton may have exerted a small drag on sales last month. The annual revision of the national income and product accounts confirmed that GDP has been providing the right signal about the ongoing strength in economic activity, as gross domestic income and personal income were revised up considerably for 2023 and the first half of this year. The October employment report seems to have been affected by the recent hurricanes and the Boeing strike. It also featured the lowest response rate to the payroll survey in decades. After accounting for these special factors, it seems that payroll employment continued to increase in October at a pace close to the average monthly gain seen in the second and third quarters. The unemployment rate remained low at 4.1 percent in October, down from 4.3 percent in July. The labor force participation rate remains well below pre-pandemic levels and edged down further in October due to lower prime-age participation. While unemployment is notably higher than a year ago, it is still at a historically low level and below my and the Congressional Budget Office's estimates of full employment. The labor market has loosened from the extremely tight conditions of the past few years. The ratio of job vacancies to unemployed workers has been close to the historically elevated pre-pandemic level in recent months. But there are still more available jobs than available workers, a condition that before 2018 has only occurred twice for a prolonged period since World War II, further signaling ongoing labor market strength. Wage growth has slowed further in recent months, but it continues to indicate a tight labor market. The rise in the unemployment rate this year largely reflects weaker hiring, as job seekers entering or re-entering the labor force are taking longer to find work, while layoffs remain low. In addition to some cooling in labor demand, a mismatch between the skills of the new workers and available jobs could further raise unemployment, suggesting that higher unemployment has been partly driven by the stronger supply of workers. In the monetary policy function, we rely on the best data available, but without question the data are imperfect. We also consider a range of possible future economic conditions to help inform our monetary policy decisionmaking, which requires that we make assumptions and predictions about the future. Looking back over time, our crystal ball has never been perfect at predicting the risks that may emerge, how those risks may influence economic conditions, and how that should be considered in analyzing our monetary policy goals. To illustrate this point in terms of recent events, we have not yet met our inflation goal and, as I noted earlier, progress in lowering inflation appears to have stalled. I see greater risks to the price stability side of our mandate, especially while the labor market remains near full employment, but it is also possible that we could see a deterioration in labor market conditions. These predictions always come with a dose of humility, however, particularly because they rely on imperfect data. The labor market data have become increasingly difficult to interpret, as surveys and other measurements struggle to incorporate large numbers of new workers and to account for other influences that we do not yet fully understand and have not yet been able to accurately measure. As the dynamics of immigration and business creation and closures continue to change, it has become increasingly difficult to understand the payroll employment data. In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases. While the mandate for monetary policy is straightforward, its execution is complex. Our decisions are guided by our dual mandate, but arriving at them entails careful analysis of sometimes flawed data, and informed judgments about unknowable future conditions. In conducting bank regulation and supervision, the Federal Reserve promotes the safe and sound operation of individual banks, and the stability of the broader financial system. These bank regulatory goals have obvious synergies-individual banks operating in a safe and sound manner tends to create conditions that promote financial stability in the banking sector. The Fed's bank regulatory objectives include implicit tradeoffs: we aim to foster a banking system that is safe, sound, and efficient, while serving the U.S. economy, and facilitating economic growth. The objectives must also support the full breadth of the banking system from the very largest to the very smallest. Striking a balance among these competing goals can certainly be a challenge, and policy views on where that balance should be struck may vary. We should approach the task of bank regulation with an understanding and appreciation of these tradeoffs, coupled with an affirmative acknowledgment that the banking system is an important driver of business formation, economic expansion, and opportunity. A banking system that is safe and sound yet irrelevant would not fulfill our regulatory objectives, but would be the inevitable outcome of following a path that strives for elimination of risks rather than promotion of effective risk management. Banks are unique individual businesses, not public utilities. The pursuit of these bank regulatory goals requires an approach that considers a range of regulatory and supervisory tools, from the quantitative-like the setting of bank capital and liquidity requirements-to the more subjective-like evaluating bank management during the examination process. And while the goals themselves seem straightforward, the tools available and the complexity and evolution of the financial system over time present real challenges from a policymaking perspective. When we consider drafting a new regulation, we should always ask "What problem would this new regulation solve?" Policymakers should exercise restraint in the promulgation of a new regulation, by articulating the problem it purports to solve and presenting an efficient way to address it. Identifying the problem that requires addressing often poses one of the most significant challenges. Ideally, the process would begin by identifying the problem, then move to an analysis of whether proposed solutions are within the agency's statutory authorities, and finally whether targeted changes to the regulatory framework could result in improvements, remediation of gaps, or elimination of redundant and unnecessary requirements. But for a number of reasons, the problem identification process can result in misidentification of issues, and a resulting failure to prioritize the most important ones. Take for example the failure of Silicon Valley Bank (SVB), and the regulatory response. At its root, this bank's failure exposed significant flaws in the bank's management and the regulators' oversight and supervision. The interest rate and funding risks, rapid growth, and the idiosyncratic business model and concentrated customer base of the bank, were apparent and obvious. These risks were mismanaged by SVB and not acted on early enough by bank supervisors. These were not the only factors contributing to the firm's failure, but these critical elements should have been the key priorities for the supervisory function to address after the bank's failure. And yet in the aftermath of SVB's demise, we have focused on regulatory proposals ranging from substantial increases in bank capital requirements, to pushing down global systemically important bank (G-SIB) and large bank requirements to much smaller firms, finding supervisory deficiencies in the management of wellcapitalized and financially sound firms, and considering widespread changes to the funding and liquidity requirements and expectations that apply to all banks. A crisis is not a regulatory blank check. In some ways, it presents heightened risks that should prompt us to show our work even more carefully. A deliberate, transparent, and fact-based approach to pursuing statutory objectives also serves the goal of avoiding the impression of pursuing unrelated policy goals, particularly those that venture into political concerns outside of an agency's purposes or functions. Promoting safety, soundness, and financial stability should not devolve into an exercise of regulatory allocation of credit-picking winners and losers-or promoting an ideological position through more open-ended processes like bank supervision and examination. Once we have a clear and thorough understanding of our statutory objectives and have a framework to identify issues, gaps, or redundancies, the next task is to focus on finding efficient solutions to those issues. In doing so, we should consider policy alternatives and perspectives that may differ from our past approach. We should also acknowledge that we may not have all the facts or information necessary to immediately identify an effective solution. Successful policymaking requires openness and humility, caution, and a deliberate approach. With respect to monetary policy, uncertainty surrounding available data and the many variables that can affect future economic conditions suggest that we should pursue a cautious approach. At the most recent meeting in November, the Committee decided to take an additional step along the path of moving toward a more neutral policy setting. I agreed to support this action, since it aligns with my preference to lower the policy rate gradually, especially in light of elevated inflation and the uncertainty about the level of the neutral rate. My estimate of the neutral policy rate is much higher than it was before the pandemic, and therefore we may be closer to a neutral policy stance than we currently think. I would prefer to proceed cautiously in bringing the policy rate down to better assess how far we are from the end point, while recognizing that we have not yet achieved our inflation goal and closely watching the evolution of the labor market. We should also not rule out the risk that the policy rate may attain or even fall below its neutral level before we achieve our price stability goal. It is important to note that monetary policy is not on a preset course. At each FOMC meeting, my colleagues and I will make our decisions based on the incoming data and the implications for and risks to the outlook and guided by the Fed's dual-mandate goals of maximum employment and stable prices. During each intermeeting period, we typically receive a range of economic data and information. In addition to closely watching the incoming data, I meet with a broad range of contacts to discuss economic conditions as I assess the appropriateness of our monetary policy stance. Especially in light of the data measurement challenges that I mentioned earlier, engaging with contacts helps me interpret the signals provided by the data and gain a better understanding of how the economy is evolving. Consistent with this pragmatic approach, I am pleased that the November post meeting statement included a flexible, data-dependent approach, providing the Committee with optionality in deciding future policy adjustments. As I noted earlier, my view is that inflation remains a concern, and I continue to see price stability as essential for fostering a strong labor market and an economy that works for everyone in the longer term. In banking regulation, this pragmatic approach requires us to consider the costs and benefits of any proposed change, as well as incentive effects, impacts on markets, and potential unintended consequences. But it also means that we must consider the limits of regulatory responsibility-grounded by our statutory objectives-when taking regulatory action. In my view, these considerations apply beyond Federal Reserve policymaking to regulatory actions taken by any agency. As I noted previously, statutory mandates guiding the Fed's bank regulatory responsibilities provide an important grounding for agency action. But they must be viewed in the broader context of promoting an effective and efficient banking system that supports market functioning and encourages economic growth, business creation and expansion, and opportunity. Our responsibility is not to look only at whether a proposal will promote greater safety and soundness, but to consider the broader context, including whether regulatory incentives will skew the allocation of credit, adversely affect capital markets, or push traditional banking activities outside of the banking system into less regulated non-banks. Is the bank regulatory framework efficient? Does it allow banks sufficient freedom and flexibility to operate and meet customer needs? And importantly, are there areas within the approach to regulation and supervision that simply cannot be justified based on a cost-benefit analysis? The answer to the latter is "Yes." There are a number of areas where right-sizing regulation and our supervisory approach would be appropriate and can be done in a way that does not sacrifice safety and soundness or threaten financial stability. Regulation is most effective when it strikes an appropriate balance between competing goals and objectives. In the banking system, this means operating in a safe, sound, and financially stable way, while also supporting economic growth and efficiency. When we fail to consider this broader context, we risk disincentivizing growth, imposing overly burdensome and unnecessary regulations, setting opaque and unreasonable expectations through the supervisory process, and forcing the inefficient allocation of capital. Sometimes this debate escapes from the dusty offices of the banking regulators into plain view, as during the past year on the Basel III Endgame package of bank capital reforms. While this proposal prompted extensive comment from a wide range of commenters, it also inspired a negative television and radio advertising campaign, which is unprecedented for a relatively technical bank regulatory issue. But these ads highlighted an uncomfortable truth: the regulatory approach we took failed to consider or deliver a reasonable proposal, one aligned with the original Basel agreement yet suited to the particulars of the U.S. banking system. Instead, the proposal released last year opted for significant capital increases for some banks, in excess of 20 percent, departing significantly from the approach adopted by our international counterparts. This public engagement has been useful, and it seems to have softened some of the over-calibrated positions underpinning the original capital reform proposal. But this level of public engagement and debate was also a byproduct of the rulemaking process. While regulatory overreach can threaten the credibility of agency action in the eyes of the public, a transparent process allows public commenters to pressure test and pushback on agency action. However, when agencies overwhelm the process by publishing thousands of pages of rulemakings in a short period of time, the public's ability to provide meaningful feedback on our rules is compromised. Last year the federal financial agencies published over 5,000 pages of rules and proposals. And yet, even when the public is able to comment on these voluminous proposals, regulators often ignore this constructive feedback and move forward to publish final rules with minimal or no changes relative to their proposals, as with the Community Reinvestment Act rule. Maintenance of an existing regulatory framework is not glamorous but is perhaps one of the more important agency functions to ensure that the framework is striking the right balance between promoting a strong banking system and supporting economic growth. This requires reviewing and updating regulations to ensure that prior agency actions continue to address problems efficiently as industries and conditions change. When agencies prioritize the creation of new regulation in the absence of a statutory mandate, harmful and unintended consequences can result. One such example is the adverse effects of regulatory constraints on Treasury market functioning. Rules like the Supplementary Leverage Ratio, the G-SIB Surcharge, and the Liquidity Coverage Ratio pose known and identified constraints on the Treasury market that may contribute to future stress and market disruption if left unaddressed. Finally, while transparency-like that intended by the rulemaking process-can lead to better public engagement and outcomes, it is important that agency actions are transparent even when not legally mandated. The most obvious opportunity for additional transparency in the banking framework is in supervision. Supervision by its nature involves confidential and detailed inquiries into bank operations, with examiners evaluating quantitative measures like capital and liquidity, while making judgmental assessments of the activities and risks of the institution, and its risk-management approach. Supervisory expectations should not surprise regulated firms, and yet transparency of these expectations is often challenging to achieve. In fact, since the failure of SVB supervisory surprises have become more common in bank examinations. In light of the recent Supreme Court cases regarding agency actions, agencies should respond in a way that furthers the goals of transparency and accountability, and act as a check on regulatory overreach. The elimination of Chevrondeference has the potential to transform agency rulemakings positively-in a way that promotes the pragmatic approach I outlined in this discussion. The same considerations we follow in the pursuit of our statutory objectives could help support rulemakings that are built upon a stronger factual and analytical basis, with a thorough and more comprehensive explanation of an agency's policy approach. While my remarks today have largely focused on Federal Reserve responsibilities, a pragmatic approach has broader applicability. Agencies can build public support for their activities by following these simple principles-a rigorous focus on statutory objectives, a foundation based on facts and careful analysis in forming policy, crafting efficient solutions, and public transparency and accountability. Agencies and their regulated businesses will benefit from a rigorous process that considers different perspectives, the intended and unintended consequences of decisions, and the costs and benefits of actions. The ability of the banking system to finance the future growth of the U.S. economy hinges upon our ability and willingness to shift our approach to regulation and supervisory oversight. A pragmatic approach to policymaking will better enable the U.S. economy to continue to grow now and into the future.
2024-11-21T00:00:00	Piero Cipollone: Building a solid cyber defence for the new geopolitical season	Introductory remarks by Mr Piero Cipollone, Member of the Executive Board of the European Central Bank, at the tenth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures, Frankfurt am Main, 21 November 2024.	SPEECH Building a solid cyber defence for the new geopolitical season Introductory remarks by Piero Cipollone, Member of the Executive Board of the ECB, at the tenth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures Frankfurt am Main, 21 November 2024 As any good sports coach will tell you, you need to deploy different defensive tactics against different teams. As an example, let me talk about a couple of different opponents you may face in the world of football. You may have to play a team that uses the high-press approach - or gegenpressing - as popularised by Jurgen Klopp's Borussia Dortmund. This team aggressively chases after your defenders, hoping to force a mistake and win the ball off you as quickly as possible. Or you could play against a more counter-attacking team such as José Mourinho's Inter Milan. They will patiently sit back and let you play and, when the moment is right, use their quick forwards to surprise you with a break-away goal. I will argue that what we face today in the world of cyber security is similar to the challenges faced by football managers as they prepare their defence for the season to come. In both cases, the different tactics of the opposing teams' attack will require different defensive strategies. Facing cyber threats in a new geopolitical and technological environment So, with this analogy in mind, let me start by outlining what threats we are facing in the current geopolitical environment. I will focus on two key trends: geopolitics and technology. Geopolitics It is a long-held truism that geopolitical tension drives cyber activity. As competing nation states seek to advance their interests and disrupt their adversaries, more intense cyberattacks take place. But this is not just a truism, it is also backed up by hard data - and these data reveal that we are not moving in the right direction. At the aggregate level, recent empirical analysis by the IMF" confirms that countries facing heightened geopolitical tensions have a relatively greater likelihood of experiencing a cyberattack. And here in Europe our exposure to such tensions has increased significantly. For evidence of this, look no further than the geopolitical risk index of the euro area, which is now at a historically very heightened level], as my colleague Claudia Buch recently highlighted. This picture is also reflected in recent European cyber threat assessment reports, which provide evidence on the activities of new state-related threat actors. For example, the latest ENISA Threat Landscape report! highlights a significant increase in the number of cyber events that have occurred in the EU over the past year, with the financial sector being the third-most targeted segment. The report attributes the increase in large part to the various geopolitical tensions that the EU is currently facing. Multiple analyses - including from French! and US authorities - provide details on the increasing number of observed attacks whose aim seems to be espionage. These are often undertaken by state- backed actors and are becoming more sophisticated in their use of stealthy techniques.! Technology The second key driver of the threat landscape relates to technology. Various technological changes are ongoing, and each tends to expose more potential targets to cyber attackers. The number of online devices we use is growing and so is the amount of time we are spending on them. In addition, as I emphasised in my remarks at the last ECRB meeting, infrastructure operators are increasing their reliance on outsourcing and other types of third-party service provision. Together, these trends multiply the number of potential cyberattack targets and increase the amount of time per day that those targets are available. So, we face an apparent proliferation of sophisticated and deep-pocketed state-sponsored threat actors launching complex cyberattacks. And at the same time, there are more and more potential targets available to them. It is therefore difficult to escape the conclusion that the overall threat outlook is deteriorating. In other words, our team will have its work cut out to defend our goal this season. Policy and oversight in support of strong cyber defence Thankfully, infrastructure operators do not have to face these challenges alone. Let me share my thoughts on how policy and oversight can support operators in firming up their defences. The recently updated Eurosystem cyber resilience strategy sets out the three pillars of this support: entity readiness, sector resilience and regulator-industry engagement.!2] Overseers work with entities to enhance their individual cyber readiness and assess their cyber maturity in an objective way using the Eurosystem's cyber resilience oversight expectations and the TIBER-EU framework for red-team testing. We will continue to strengthen these efforts to firm up entity readiness over time. Given the highly interconnected nature of financial market infrastructures, sound risk management requires a strong emphasis on sector-wide resilience. Overseers have various tools to assess cyber risk and supply-chain risk at the sectoral level. This includes the Eurosystem's critical service provider survey, which is based on a self-assessment by the entities. This enables overseers to accurately map the sector, identifying the critical nodes and interdependencies within the European financial ecosystem. To come back to my footballing analogy, if someone on the European financial infrastructures team concedes a goal in the cyber "game", we are all in danger of losing. It is therefore important to test the match fitness of our defences from a collective perspective. In this context, the updated cyber strategy introduces industry-wide scenario-based testing exercises to assess sectoral preparedness. Exercises will simulate an extreme but plausible cyberattack to test how prepared the sector is to respond to attacks, including in terms of the time needed to resume services. Most relevant for today's event, the ECRB helps to stimulate a healthy level of strategic engagement between regulators and the industry. In an environment where the attackers we face and the techniques they use are quickly shifting, this forum provides leaders with a valuable opportunity to exchange ideas on how best to tackle emerging challenges. This dialogue is vital to address our shared challenges. I look forward to making further progress together in key areas, such as sustainably building up the labour force in cyber security. Like in football, the market for talent is highly competitive. According to a recent IMF report!, there is a global shortage of approximately four million cybersecurity professionals. In this context, it feels like we are all chasing the same scarce talent to boost our cyber defences. But unlike competing football clubs, our incentives are more aligned. There is greater scope for collaborative solutions to nurture cyber talent, and I would welcome creative ideas on how to achieve this. Investing in cyber security at entity level to support long-term success Notwithstanding this collective dimension to cyber security, let me also emphasise that the ultimate responsibility for ensuring an institution's cyber resilience lies with the institution itself. Unfortunately, in today's geopolitical and technological environment the overall cyber threat level is steadily increasing. Entities face a growing number of deep-pocketed state cyber actors and must protect an attack surface that is broadening due to technological trends. In this context, entities may find that maintaining robust cyber defences will require even more time and effort. Committing more resources to defence may create tensions within organisations, as this may divert them from other endeavours. However, in the end, achieving high cyber resilience is a core part of the product offering of financial market infrastructures. So investing sufficiently to achieve a high level of cyber resilience is necessary for long-term success. In addition, the geopolitical environment is tilting the threat landscape further towards state actors. For some time now, these players have been responsible for the most serious cyber threats, and this is likely to continue. Our defensive tactics must consider this reality. Rather than preparing for traditional criminally motivated cyberattacks seeking ransoms, we must be nimble in devising ways to detect attackers that take a more patient, underhand and counter-attacking approach. Conclusion To conclude, let me say that the challenges we face in organising our cyber defences are clearly greater than those faced in the world of football. After all, football managers only need to organise their defence to face one team at a time, and once the 90 minutes are over, there is time to rest and recover. By contrast, in the cyber environment we need to defend against all cyber actors at the same time, all day every day. In other words, our defence must play against the attackers of all our opponents at the same time - and the referee will never blow for full-time. But we do have some things on our side. Unlike in football management, we have much more scope to collaborate. This allows us to strengthen our defences both at the individual and the collective level. So, with that in mind, I look forward to open discussions today and to sharing knowledge and ideas on how we can further boost our defensive capabilities. Thank you. 1. International Monetary Fund (2024), "Rising Cyber Threats Pose Serious Concerns for Financial Stability", IMF Blog, 9 April. 2. Geopolitical tensions are captured by the geopolitical risk index (see Caldara, D. and lacoviello, M. (2022), "Measuring Geopolitical Risk," American Economic Review, April, Vol. 112, No 4, pp.1194- 1225), which consists of a measure of adverse geopolitical events and risks based on a tally of newspaper articles. 3. Buch, C. (2024), "Global rifts and financial shifts: supervising banks in an era of geopolitical instability", speech at the eighth European Systemic Risk Board (ESRB) annual conference on "New Frontiers in Macroprudential Policy", 26 September. 4. ENISA (2024), EN/SA Threat Landscape 2024, 19 September. 5. French National Cyber Security Agency (2023), Cyber Threat Overview. 6. Such stealthy techniques can include "living off the land", which allows attackers to avoid detection by blending in with normal built-in Windows system and network activities. See CISA (2023), People's Republic of China State-Sponsored Cyber Actor Living off the Land to Evade Detection, 24 May. 7. speech at the ninth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures, 17 January. 8. Cyber resilience and financial market infrastructures. 9. World Economic Forum (2024), "Global financial stability at risk due to cyber threats, IMF warns. Here's what to know", Centre for Cybersecurity, 15 May. CONTACT	---[PAGE_BREAK]--- # Building a solid cyber defence for the new geopolitical season ## Introductory remarks by Piero Cipollone, Member of the Executive Board of the ECB, at the tenth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures Frankfurt am Main, 21 November 2024 As any good sports coach will tell you, you need to deploy different defensive tactics against different teams. As an example, let me talk about a couple of different opponents you may face in the world of football. You may have to play a team that uses the high-press approach - or gegenpressing - as popularised by Jürgen Klopp's Borussia Dortmund. This team aggressively chases after your defenders, hoping to force a mistake and win the ball off you as quickly as possible. Or you could play against a more counter-attacking team such as José Mourinho's Inter Milan. They will patiently sit back and let you play and, when the moment is right, use their quick forwards to surprise you with a break-away goal. I will argue that what we face today in the world of cyber security is similar to the challenges faced by football managers as they prepare their defence for the season to come. In both cases, the different tactics of the opposing teams' attack will require different defensive strategies. ## Facing cyber threats in a new geopolitical and technological environment So, with this analogy in mind, let me start by outlining what threats we are facing in the current geopolitical environment. I will focus on two key trends: geopolitics and technology. ## Geopolitics It is a long-held truism that geopolitical tension drives cyber activity. As competing nation states seek to advance their interests and disrupt their adversaries, more intense cyberattacks take place. But this is not just a truism, it is also backed up by hard data - and these data reveal that we are not moving in the right direction. At the aggregate level, recent empirical analysis by the IMF[1] confirms that countries facing heightened geopolitical tensions have a relatively greater likelihood of experiencing a cyberattack. And here in Europe our exposure to such tensions has increased significantly. For evidence of this, look no further than the geopolitical risk index of the euro area, which is now at a historically very heightened level ${ }^{[2]}$, as my colleague Claudia Buch recently highlighted. ${ }^{[3]}$ This picture is also reflected in recent European cyber threat assessment reports, which provide evidence on the activities of new state-related threat actors. ---[PAGE_BREAK]--- For example, the latest ENISA Threat Landscape report ${ }^{[4]}$ highlights a significant increase in the number of cyber events that have occurred in the EU over the past year, with the financial sector being the third-most targeted segment. The report attributes the increase in large part to the various geopolitical tensions that the EU is currently facing. Multiple analyses - including from French ${ }^{[5]}$ and US authorities - provide details on the increasing number of observed attacks whose aim seems to be espionage. These are often undertaken by statebacked actors and are becoming more sophisticated in their use of stealthy techniques. ${ }^{[6]}$ # Technology The second key driver of the threat landscape relates to technology. Various technological changes are ongoing, and each tends to expose more potential targets to cyber attackers. The number of online devices we use is growing and so is the amount of time we are spending on them. In addition, as I emphasised in my remarks at the last ECRB meeting ${ }^{[7]}$, infrastructure operators are increasing their reliance on outsourcing and other types of third-party service provision. Together, these trends multiply the number of potential cyberattack targets and increase the amount of time per day that those targets are available. So, we face an apparent proliferation of sophisticated and deep-pocketed state-sponsored threat actors launching complex cyberattacks. And at the same time, there are more and more potential targets available to them. It is therefore difficult to escape the conclusion that the overall threat outlook is deteriorating. In other words, our team will have its work cut out to defend our goal this season. ## Policy and oversight in support of strong cyber defence Thankfully, infrastructure operators do not have to face these challenges alone. Let me share my thoughts on how policy and oversight can support operators in firming up their defences. The recently updated Eurosystem cyber resilience strategy sets out the three pillars of this support: entity readiness, sector resilience and regulator-industry engagement. ${ }^{[8]}$ Overseers work with entities to enhance their individual cyber readiness and assess their cyber maturity in an objective way using the Eurosystem's cyber resilience oversight expectations and the TIBER-EU framework for red-team testing. We will continue to strengthen these efforts to firm up entity readiness over time. Given the highly interconnected nature of financial market infrastructures, sound risk management requires a strong emphasis on sector-wide resilience. Overseers have various tools to assess cyber risk and supply-chain risk at the sectoral level. This includes the Eurosystem's critical service provider survey, which is based on a self-assessment by the entities. This enables overseers to accurately map the sector, identifying the critical nodes and interdependencies within the European financial ecosystem. To come back to my footballing analogy, if someone on the European financial infrastructures team concedes a goal in the cyber "game", we are all in danger of losing. It is therefore important to test the ---[PAGE_BREAK]--- match fitness of our defences from a collective perspective. In this context, the updated cyber strategy introduces industry-wide scenario-based testing exercises to assess sectoral preparedness. Exercises will simulate an extreme but plausible cyberattack to test how prepared the sector is to respond to attacks, including in terms of the time needed to resume services. Most relevant for today's event, the ECRB helps to stimulate a healthy level of strategic engagement between regulators and the industry. In an environment where the attackers we face and the techniques they use are quickly shifting, this forum provides leaders with a valuable opportunity to exchange ideas on how best to tackle emerging challenges. This dialogue is vital to address our shared challenges. I look forward to making further progress together in key areas, such as sustainably building up the labour force in cyber security. Like in football, the market for talent is highly competitive. According to a recent IMF report ${ }^{[5]}$, there is a global shortage of approximately four million cybersecurity professionals. In this context, it feels like we are all chasing the same scarce talent to boost our cyber defences. But unlike competing football clubs, our incentives are more aligned. There is greater scope for collaborative solutions to nurture cyber talent, and I would welcome creative ideas on how to achieve this. # Investing in cyber security at entity level to support long-term success Notwithstanding this collective dimension to cyber security, let me also emphasise that the ultimate responsibility for ensuring an institution's cyber resilience lies with the institution itself. Unfortunately, in today's geopolitical and technological environment the overall cyber threat level is steadily increasing. Entities face a growing number of deep-pocketed state cyber actors and must protect an attack surface that is broadening due to technological trends. In this context, entities may find that maintaining robust cyber defences will require even more time and effort. Committing more resources to defence may create tensions within organisations, as this may divert them from other endeavours. However, in the end, achieving high cyber resilience is a core part of the product offering of financial market infrastructures. So investing sufficiently to achieve a high level of cyber resilience is necessary for long-term success. In addition, the geopolitical environment is tilting the threat landscape further towards state actors. For some time now, these players have been responsible for the most serious cyber threats, and this is likely to continue. Our defensive tactics must consider this reality. Rather than preparing for traditional criminally motivated cyberattacks seeking ransoms, we must be nimble in devising ways to detect attackers that take a more patient, underhand and counter-attacking approach. ## Conclusion To conclude, let me say that the challenges we face in organising our cyber defences are clearly greater than those faced in the world of football. ---[PAGE_BREAK]--- After all, football managers only need to organise their defence to face one team at a time, and once the 90 minutes are over, there is time to rest and recover. By contrast, in the cyber environment we need to defend against all cyber actors at the same time, all day every day. In other words, our defence must play against the attackers of all our opponents at the same time - and the referee will never blow for full-time. But we do have some things on our side. Unlike in football management, we have much more scope to collaborate. This allows us to strengthen our defences both at the individual and the collective level. So, with that in mind, I look forward to open discussions today and to sharing knowledge and ideas on how we can further boost our defensive capabilities. Thank you. 1 . International Monetary Fund (2024), "Rising Cyber Threats Pose Serious Concerns for Financial Stability", IMF Blog, 9 April. 2. Geopolitical tensions are captured by the geopolitical risk index (see Caldara, D. and lacoviello, M. (2022), "Measuring Geopolitical Risk," American Economic Review, April, Vol. 112, No 4, pp.11941225), which consists of a measure of adverse geopolitical events and risks based on a tally of newspaper articles. 3. Buch, C. (2024), "Global rifts and financial shifts: supervising banks in an era of geopolitical instability", speech at the eighth European Systemic Risk Board (ESRB) annual conference on "New Frontiers in Macroprudential Policy", 26 September. 4. ENISA (2024), ENISA Threat Landscape 2024, 19 September. 5. French National Cyber Security Agency (2023), Cyber Threat Overview. 6. Such stealthy techniques can include "living off the land", which allows attackers to avoid detection by blending in with normal built-in Windows system and network activities. See CISA (2023), People's Republic of China State-Sponsored Cyber Actor Living off the Land to Evade Detection, 24 May. 7. Cipollone, P. (2024), "One step ahead: protecting the cyber resilience of financial infrastructures", speech at the ninth meeting of the Euro Cyber Resilience Board for pan-European Financial Infrastructures, 17 January. 8. ---[PAGE_BREAK]--- Cyber resilience and financial market infrastructures. 9. World Economic Forum (2024), "Global financial stability at risk due to cyber threats. IMF warns, Here's what to know", Centre for Cybersecurity, 15 May.	Piero Cipollone	Euro area	https://www.bis.org/review/r241125k.pdf	Frankfurt am Main, 21 November 2024 As any good sports coach will tell you, you need to deploy different defensive tactics against different teams. As an example, let me talk about a couple of different opponents you may face in the world of football. You may have to play a team that uses the high-press approach - or gegenpressing - as popularised by Jürgen Klopp's Borussia Dortmund. This team aggressively chases after your defenders, hoping to force a mistake and win the ball off you as quickly as possible. Or you could play against a more counter-attacking team such as José Mourinho's Inter Milan. They will patiently sit back and let you play and, when the moment is right, use their quick forwards to surprise you with a break-away goal. I will argue that what we face today in the world of cyber security is similar to the challenges faced by football managers as they prepare their defence for the season to come. In both cases, the different tactics of the opposing teams' attack will require different defensive strategies. So, with this analogy in mind, let me start by outlining what threats we are facing in the current geopolitical environment. I will focus on two key trends: geopolitics and technology. It is a long-held truism that geopolitical tension drives cyber activity. As competing nation states seek to advance their interests and disrupt their adversaries, more intense cyberattacks take place. But this is not just a truism, it is also backed up by hard data - and these data reveal that we are not moving in the right direction. At the aggregate level, recent empirical analysis by the IMF confirms that countries facing heightened geopolitical tensions have a relatively greater likelihood of experiencing a cyberattack. And here in Europe our exposure to such tensions has increased significantly. For evidence of this, look no further than the geopolitical risk index of the euro area, which is now at a historically very heightened level This picture is also reflected in recent European cyber threat assessment reports, which provide evidence on the activities of new state-related threat actors. For example, the latest ENISA Threat Landscape report highlights a significant increase in the number of cyber events that have occurred in the EU over the past year, with the financial sector being the third-most targeted segment. The report attributes the increase in large part to the various geopolitical tensions that the EU is currently facing. Multiple analyses - including from French The second key driver of the threat landscape relates to technology. Various technological changes are ongoing, and each tends to expose more potential targets to cyber attackers. The number of online devices we use is growing and so is the amount of time we are spending on them. In addition, as I emphasised in my remarks at the last ECRB meeting , infrastructure operators are increasing their reliance on outsourcing and other types of third-party service provision. Together, these trends multiply the number of potential cyberattack targets and increase the amount of time per day that those targets are available. So, we face an apparent proliferation of sophisticated and deep-pocketed state-sponsored threat actors launching complex cyberattacks. And at the same time, there are more and more potential targets available to them. It is therefore difficult to escape the conclusion that the overall threat outlook is deteriorating. In other words, our team will have its work cut out to defend our goal this season. Thankfully, infrastructure operators do not have to face these challenges alone. Let me share my thoughts on how policy and oversight can support operators in firming up their defences. The recently updated Eurosystem cyber resilience strategy sets out the three pillars of this support: entity readiness, sector resilience and regulator-industry engagement. Overseers work with entities to enhance their individual cyber readiness and assess their cyber maturity in an objective way using the Eurosystem's cyber resilience oversight expectations and the TIBER-EU framework for red-team testing. We will continue to strengthen these efforts to firm up entity readiness over time. Given the highly interconnected nature of financial market infrastructures, sound risk management requires a strong emphasis on sector-wide resilience. Overseers have various tools to assess cyber risk and supply-chain risk at the sectoral level. This includes the Eurosystem's critical service provider survey, which is based on a self-assessment by the entities. This enables overseers to accurately map the sector, identifying the critical nodes and interdependencies within the European financial ecosystem. To come back to my footballing analogy, if someone on the European financial infrastructures team concedes a goal in the cyber "game", we are all in danger of losing. It is therefore important to test the match fitness of our defences from a collective perspective. In this context, the updated cyber strategy introduces industry-wide scenario-based testing exercises to assess sectoral preparedness. Exercises will simulate an extreme but plausible cyberattack to test how prepared the sector is to respond to attacks, including in terms of the time needed to resume services. Most relevant for today's event, the ECRB helps to stimulate a healthy level of strategic engagement between regulators and the industry. In an environment where the attackers we face and the techniques they use are quickly shifting, this forum provides leaders with a valuable opportunity to exchange ideas on how best to tackle emerging challenges. This dialogue is vital to address our shared challenges. I look forward to making further progress together in key areas, such as sustainably building up the labour force in cyber security. Like in football, the market for talent is highly competitive. According to a recent IMF report , there is a global shortage of approximately four million cybersecurity professionals. In this context, it feels like we are all chasing the same scarce talent to boost our cyber defences. But unlike competing football clubs, our incentives are more aligned. There is greater scope for collaborative solutions to nurture cyber talent, and I would welcome creative ideas on how to achieve this. Notwithstanding this collective dimension to cyber security, let me also emphasise that the ultimate responsibility for ensuring an institution's cyber resilience lies with the institution itself. Unfortunately, in today's geopolitical and technological environment the overall cyber threat level is steadily increasing. Entities face a growing number of deep-pocketed state cyber actors and must protect an attack surface that is broadening due to technological trends. In this context, entities may find that maintaining robust cyber defences will require even more time and effort. Committing more resources to defence may create tensions within organisations, as this may divert them from other endeavours. However, in the end, achieving high cyber resilience is a core part of the product offering of financial market infrastructures. So investing sufficiently to achieve a high level of cyber resilience is necessary for long-term success. In addition, the geopolitical environment is tilting the threat landscape further towards state actors. For some time now, these players have been responsible for the most serious cyber threats, and this is likely to continue. Our defensive tactics must consider this reality. Rather than preparing for traditional criminally motivated cyberattacks seeking ransoms, we must be nimble in devising ways to detect attackers that take a more patient, underhand and counter-attacking approach. To conclude, let me say that the challenges we face in organising our cyber defences are clearly greater than those faced in the world of football. After all, football managers only need to organise their defence to face one team at a time, and once the 90 minutes are over, there is time to rest and recover. By contrast, in the cyber environment we need to defend against all cyber actors at the same time, all day every day. In other words, our defence must play against the attackers of all our opponents at the same time - and the referee will never blow for full-time. But we do have some things on our side. Unlike in football management, we have much more scope to collaborate. This allows us to strengthen our defences both at the individual and the collective level. So, with that in mind, I look forward to open discussions today and to sharing knowledge and ideas on how we can further boost our defensive capabilities. Thank you. 1 .
2024-11-28T00:00:00	Philip R Lane: The 25th anniversary of the Euro50 Group - looking ahead to the 50th anniversary	Remarks by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the 25th Anniversary of the Euro50 Group event at the Bank of France, Paris, 28 November 2024.	SPEECH The 25th anniversary of the Euro50 Group: looking ahead to the 50th anniversary Remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the 25th Anniversary of the Euro50 Group event at the Banque de France Paris, 28 November 2024 Let me start by congratulating the Euro50 Group on its 25th anniversary: since the start of the euro, the Euro50 Group has convened many important discussions about the development of the euro area as a monetary union and the euro as a single currency. Looking back at the first quarter of a century of the Euro50 Group naturally invites speculation about the next 25 years: what will we be discussing at the 50th anniversary of the Euro50 Group? Let me list four major structural factors that look set to shape the next 25 years:] (a) the next wave of technological change (digitalisation, artificial intelligence, automation, robotification);!2! (b) climate change, nature degradation and the green transition; (c) the shifting configuration of geo-economics and geo-politics;!4] and (d) demographic trends (increasing longevity, low fertility, migration patterns)./®] Of course, these structural factors interact with each other in many ways, such that it is essential to adopt a holistic approach in assessing their implications for societies, economies, political systems, governments, institutions - including central banks - and policymakers. Before turning to how a central bank should respond to these structural changes, I want first to emphasise that the common nature of these structural trends means that international coordination and collective action is the best approach to navigating these challenges. At the European level, there is considerable scope to work together as a European Union. In terms of economic and financial policy, the recent Draghi and Letta reports show how further integration can improve both the dynamism and the resilience of Europe, which would make it much easier to deal with the challenges I have just mentioned. This includes the high potential gains in stepping up progress in relation the capital markets union and the banking union. First, a basic task is to analyse these developments: strong analytical foundations are a precondition for good policymaking. Of course, the primary focus of the analytical work should be to assess the implications of these structural trends for the central bank. This spans not only the implications for inflation dynamics but also the role of money in the economy and the financial system and the modalities of monetary policy implementation. The full arsenal of analytical firepower needs to be deployed: research projects to uncover evidence about structural change in the incoming data; a greater use of surveys to find out how households, firms and financial intermediaries are coping with structural change; and the tracing-out of various scenarios in the "laboratories" provided by macroeconomic models.!2] Second, a forward-looking central bank should update and modify the tools and modalities of how it underpins the monetary system and implements monetary policy. In relation to the former, the digital euro project is devoted to ensuring that the euro area can benefit from the full potential of a digitised financial system while preserving, even in the new digital world, the security and freedom provided by central bank money." The gains from a digital euro extend far beyond the personal benefits that will be reaped by individual European citizens from a digital currency that can be used wherever digital payments are accepted, throughout the euro area. The digital euro will also introduce an alternative to the currently-dominant international payment solutions, both reducing our external dependencies and lowering costs for merchants. And it will provide the underlying infrastructural platform and acceptance network that can level the playing field for euro area banks, payment providers and payment schemes in offering a wide range of financial services across the euro area. In relation to the latter, the ECB is working to ensure that its policy toolkit and implementation framework are aligned with the EU policy commitments to the green transition." It goes without saying that we closely assess the various elements of this work programme to make sure these do not compromise our commitment to delivering our primary mandate of price stability.42] Third, a central bank should work through the implications of structural change for price stability. Structural changes can affect not only inflation dynamics, but also the natural rate of interest, and therefore can have important consequences for the central bank's price stability mandate.45] At a heuristic level, it is important to differentiate between different pathways. Without trying to be comprehensive, let's consider a few scenarios: Scenario A: This may have little impact on inflation: loosely speaking, if demand and supply adapt at the same speed, the net impact on inflation is limited. Scenario B: news arrives about a future structural shift. If the news is good - future supply capacity improves - this can stimulate investment and raise consumption today, in line with the permanent income hypothesis. Since demand improves but short-run supply is limited, this may create a burst of short-run inflation. In the other direction, if the news is bad - future supply capacity declines - this constitutes a negative demand shock today, which is disinflationary. In either case, whether monetary policy should respond will depend on the expected size and duration of the inflation shock, together with an assessment of the fragility of the inflation anchor to the shock. Scenario C: a disruptive event occurs today. This could be an adverse disruptive event (a pandemic, a trade war, an actual war) that generates an unexpected contraction in supply capacity. In the other direction, it could also take the form of a faster-than-expected roll-out of a general purpose technology, such as the 1990s internet boom in the United States). In the case of an adverse shock, supply falling more quickly than demand creates inflationary pressure; in the case of a positive shock, supply increasing more quickly than demand eases inflationary pressure. Of course, both types of disruptive event may also have implications for financial stability, in view of the associated implications for asset pricing. In essence, the challenge for central bankers will be to calculate and re-calculate the appropriate monetary policy stance that is robust to the emergence of these various scenarios or combinations of scenarios: at any given time, there may be elements of scenarios A, B and C operating in different sectors and in different countries, given the wide variety of structural changes that are underway.!"4 1. For more on how monetary transmission will be affected by structural shifts and how to adjust the analytical frameworks to these shifts, see Lagarde, C. (2024), "Setbacks and strides forward: structural shifts and monetary policy in the twenties", speech at the 2024 Michel Camdessus Central Banking Lecture organised by the IMF, Washington, DC, 20 September. 2. Dedola, L. et al. (2023), "Digitalisation and the economy", Working Paper Series, No 2809, ECB, 25 April; Baldwin, R. (2022), "Globotics and macroeconomics: Globalisation and automation of the service sector", paper presented at the ECB Forum on Central Banking, Sintra, June; Jaumotte, F. et al. (2023), "Digitalization During the COVID-19 Crisis: Implications for Productivity and Labor Markets in Advanced Economies", Staff Discussion Notes, No 2023/003, IMF, 13 March; and Albanesi, S. et al. (2023), "New technologies and jobs in Europe", Working Paper Series, No 2831, ECB, 14 July. 3. Breckenfelder, J. et al. (2023), "The climate and the economy", Working Paper Series, No. 2793, ECB, 7 March; Christine, L. (2024) "Mind the gap: what it takes to finance a greener future", The ECB of the effects of climate change on the macroeconomy", Working Paper Series, No 2608, ECB, 14 October; and Ciccarelli, M., Kuik, F. and Martinez Hernandez, C. (2024), "The asymmetric effects of temperature shocks on inflation in the largest euro area countries", European Economic Review, Vol. 168, September. 4. Attinasi, M. G., Mancini, C. et al. (2024, forthcoming), "Navigating a fragmenting global trading system: Some lessons for central banks", Occasional Paper Series, ECB; Georgieva, K. (2023), "Confronting Fragmentation Where It Matters Most: Trade, Debt, and Climate Action", IMF Blog, 16 January; and Attinasi, M.-G., Boeckelmann, L. and Meunier, B. (2023), "The economic costs of supply chain decoupling", Working Paper Series, No 2839, ECB, 3 August. 5. Freier, M., Lichtenauer, B. and Schroth, J. (2023), "EUROPOP2023 demographic trends and their euro area economic implications", Economic Bulletin, Ilssue 3, ECB 6. For recent discussions of the challenges presented by technological change, shifting geopolitical trends and climate change, see speeches by President Lagarde on "The economic and human challenges of a transforming era', "Setbacks and strides forward: structural shifts and monetary policy in the twenties", "Policymaking_in a new risk environment" and "Central banks in a changing world: the role of the ECB in the face of climate and environmental risks". 7. Letta, E. (2024), "Much more than a market", April; and Draghi, M. (2024), "The future of European competitiveness", September. 8. For speeches on the capital markets union, see Lagarde, C. (2024), "Follow the money: channelling savings into investment and innovation in Europe", speech at the 34th European Banking Congress: "Out of the Comfort Zone: Europe and the New World Order", Frankfurt am Main, 22 November. For speeches on the banking union, see Lagarde, C. (2024), "Welcome address at the tenth anniversary of the Single Supervisory Mechanism", Frankfurt am Main, 6 November. 9. For recent discussions on how the ECB incorporates analyses coming from macroeconomic models for policymaking, see Lane, P.R. (2024), "Monetary policy under uncertainty", speech at the Bank of England Watchers' Conference 2024, King's College London, 25 November; and Lane, P.R. (2024), "The 2021-2022 inflation surges and the monetary policy response through the lens of macroeconomic models", speech at the SUERF Marjolin Lecture hosted by the Banca d'Italia, Rome, 18 November. 10. For an overview of the digital euro project, see Cipollone, P. (2024), "Monetary sovereignty in the digital age: the case for a digital euro", speech at the Economics of Payments XIII Conference organised by the Oesterreichische Nationalbank, Vienna, 27 September; and Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", speech at the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 23 September. 11. For more information on climate change work at the ECB, see the dedicated section of the ECB website. 12. See Elderson, F. (2024), "Taking account of nature, naturally", speech at the tenth Green Finance Forum "Innovate in Nature", Frankfurt am Main, 19 November and recent research by Ferdinandusse, M., Kuik, F. and Priftis, R. (2024), "Assessing the macroeconomic effects of climate change transition policies", Economic Bulletin, lssue 1, European Central Bank, Frankfurt am Main; and Ferdinandusse, M., Lis, E., Kuik, F. and Sun, Y. (2023), "Climate-related policies in the Eurosystem/ECB staff measures", Economic Bulletin, Issue 1, European Central Bank, Frankfurt am Main. 13. For a discussion of changes in neutral rates and their policy implications see Brand, C., Lisack, N. and Mazelis, F. (2024), "Estimates of the natural interest rate for the euro area: an update", Economic Bulletin, Ilssue 1, ECB and Lane, P.R. (2019) "Determinants of the real interest rate" Remarks at the National Treasury Management Agency, Dublin, 28 November 2019. 14. Recent studies that emphasise the importance of general equilibrium analysis in assessing the policy implications of structural changes include: Fornaro, L., Guerrieri, V. and Reichlin, L. (2024), "Monetary Policy for the Green Transition', report prepared for the BIS Green Swan conference 2024 and Tenreyro, S., Ambrosino, L. and Chan, J. (2024), "Trade fragmentation, inflationary pressures, and monetary policy," B/S working paper, No 1225. For monetary policy actions taken by the ECB in response to the inflation shock in 2021-22, see Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", The ECB Blog, 11 March. CONTACT European Central Bank Directorate General Communications > Sonnemannstrasse 20 > 60314 Frankfurt am Main, Germany > +49 69 1344 7455 > [email protected]	---[PAGE_BREAK]--- # The 25th anniversary of the Euro50 Group: looking ahead to the 50th anniversary ## Remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the 25th Anniversary of the Euro50 Group event at the Banque de France Paris, 28 November 2024 Let me start by congratulating the Euro50 Group on its 25th anniversary: since the start of the euro, the Euro50 Group has convened many important discussions about the development of the euro area as a monetary union and the euro as a single currency. Looking back at the first quarter of a century of the Euro50 Group naturally invites speculation about the next 25 years: what will we be discussing at the 50th anniversary of the Euro50 Group? Let me list four major structural factors that look set to shape the next 25 years: ${ }^{[1]}$ (a) the next wave of technological change (digitalisation, artificial intelligence, automation, robotification); ${ }^{[2]}$ (b) climate change, nature degradation and the green transition; ${ }^{[3]}$ (c) the shifting configuration of geo-economics and geo-politics; ${ }^{[4]}$ and (d) demographic trends (increasing longevity, low fertility, migration patterns). ${ }^{[5]}$ Of course, these structural factors interact with each other in many ways, such that it is essential to adopt a holistic approach in assessing their implications for societies, economies, political systems, governments, institutions - including central banks - and policymakers. ${ }^{[6]}$ Before turning to how a central bank should respond to these structural changes, I want first to emphasise that the common nature of these structural trends means that international coordination and collective action is the best approach to navigating these challenges. At the European level, there is considerable scope to work together as a European Union. In terms of economic and financial policy, the recent Draghi and Letta reports show how further integration can improve both the dynamism and the resilience of Europe, which would make it much easier to deal with the challenges I have just mentioned. ${ }^{[7]}$ This includes the high potential gains in stepping up progress in relation the capital markets union and the banking union. ${ }^{[8]}$ First, a basic task is to analyse these developments: strong analytical foundations are a precondition for good policymaking. Of course, the primary focus of the analytical work should be to assess the implications of these structural trends for the central bank. This spans not only the implications for inflation dynamics but also the role of money in the economy and the financial system and the modalities of monetary policy implementation. The full arsenal of analytical firepower needs to be deployed: research projects to uncover evidence about structural change in the incoming data; a greater use of surveys to find out how households, firms and financial intermediaries are coping with ---[PAGE_BREAK]--- structural change; and the tracing-out of various scenarios in the "laboratories" provided by macroeconomic models. ${ }^{[9]}$ Second, a forward-looking central bank should update and modify the tools and modalities of how it underpins the monetary system and implements monetary policy. In relation to the former, the digital euro project is devoted to ensuring that the euro area can benefit from the full potential of a digitised financial system while preserving, even in the new digital world, the security and freedom provided by central bank money. ${ }^{[10]}$ The gains from a digital euro extend far beyond the personal benefits that will be reaped by individual European citizens from a digital currency that can be used wherever digital payments are accepted, throughout the euro area. The digital euro will also introduce an alternative to the currently-dominant international payment solutions, both reducing our external dependencies and lowering costs for merchants. And it will provide the underlying infrastructural platform and acceptance network that can level the playing field for euro area banks, payment providers and payment schemes in offering a wide range of financial services across the euro area. In relation to the latter, the ECB is working to ensure that its policy toolkit and implementation framework are aligned with the EU policy commitments to the green transition. ${ }^{[11]}$ It goes without saying that we closely assess the various elements of this work programme to make sure these do not compromise our commitment to delivering our primary mandate of price stability. ${ }^{[12]}$ Third, a central bank should work through the implications of structural change for price stability. Structural changes can affect not only inflation dynamics, but also the natural rate of interest, and therefore can have important consequences for the central bank's price stability mandate. ${ }^{[13]}$ At a heuristic level, it is important to differentiate between different pathways. Without trying to be comprehensive, let's consider a few scenarios: Scenario A: This may have little impact on inflation: loosely speaking, if demand and supply adapt at the same speed, the net impact on inflation is limited. Scenario B: news arrives about a future structural shift. If the news is good - future supply capacity improves - this can stimulate investment and raise consumption today, in line with the permanent income hypothesis. Since demand improves but short-run supply is limited, this may create a burst of short-run inflation. In the other direction, if the news is bad - future supply capacity declines - this constitutes a negative demand shock today, which is disinflationary. In either case, whether monetary policy should respond will depend on the expected size and duration of the inflation shock, together with an assessment of the fragility of the inflation anchor to the shock. Scenario C: a disruptive event occurs today. This could be an adverse disruptive event (a pandemic, a trade war, an actual war) that generates an unexpected contraction in supply capacity. In the other direction, it could also take the form of a faster-than-expected roll-out of a general purpose technology, such as the 1990s internet boom in the United States). In the case of an adverse shock, supply falling more quickly than demand creates inflationary pressure; in the case of a positive shock, supply increasing more quickly than demand eases inflationary pressure. Of course, both types of disruptive ---[PAGE_BREAK]--- event may also have implications for financial stability, in view of the associated implications for asset pricing. In essence, the challenge for central bankers will be to calculate and re-calculate the appropriate monetary policy stance that is robust to the emergence of these various scenarios or combinations of scenarios: at any given time, there may be elements of scenarios $A, B$ and $C$ operating in different sectors and in different countries, given the wide variety of structural changes that are underway. ${ }^{[14]}$ # 1. For more on how monetary transmission will be affected by structural shifts and how to adjust the analytical frameworks to these shifts, see Lagarde, C. (2024), "Setbacks and strides forward: structural shifts and monetary policy in the twenties", speech at the 2024 Michel Camdessus Central Banking Lecture organised by the IMF, Washington, DC, 20 September. 2. Dedola, L. et al. (2023), "Digitalisation and the economy", Working Paper Series, No 2809, ECB, 25 April; Baldwin, R. (2022), "Globotics and macroeconomics: Globalisation and automation of the service sector", paper presented at the ECB Forum on Central Banking, Sintra, June; Jaumotte, F. et al. (2023), "Digitalization During the COVID-19 Crisis: Implications for Productivity and Labor Markets in Advanced Economies", Staff Discussion Notes, No 2023/003, IMF, 13 March; and Albanesi, S. et al. (2023), "New technologies and jobs in Europe", Working Paper Series, No 2831, ECB, 14 July. 3. Breckenfelder, J. et al. (2023), "The climate and the economy", Working Paper Series, No. 2793, ECB, 7 March; Christine, L. (2024) "Mind the gap: what it takes to finance a greener future", The ECB Blog,12 November. Ciccarelli, M. and Marotta, F. (2021), "Demand or supply? An empirical exploration of the effects of climate change on the macroeconomy", Working Paper Series, No 2608, ECB, 14 October; and Ciccarelli, M., Kuik, F. and Martínez Hernandez, C. (2024), "The asymmetric effects of temperature shocks on inflation in the largest euro area countries", European Economic Review, Vol. 168, September. 4. Attinasi, M. G., Mancini, C. et al. (2024, forthcoming), "Navigating a fragmenting global trading system: Some lessons for central banks", Occasional Paper Series, ECB; Georgieva, K. (2023), "Confronting Fragmentation Where It Matters Most: Trade, Debt, and Climate Action", IMF Blog, 16 January; and Attinasi, M.-G., Boeckelmann, L. and Meunier, B. (2023), "The economic costs of supply chain decoupling", Working Paper Series, No 2839, ECB, 3 August. 5. ---[PAGE_BREAK]--- Freier, M., Lichtenauer, B. and Schroth, J. (2023), "EUROPOP2023 demographic trends and their euro area economic implications", Economic Bulletin, Issue 3, ECB 6 . For recent discussions of the challenges presented by technological change, shifting geopolitical trends and climate change, see speeches by President Lagarde on "The economic and human challenges of a transforming era", "Setbacks and strides forward: structural shifts and monetary policy in the twenties", "Policymaking in a new risk environment" and "Central banks in a changing world: the role of the ECB in the face of climate and environmental risks". 7. Letta, E. (2024), "Much more than a market", April; and Draghi, M. (2024), "The future of European competitiveness", September. 8. For speeches on the capital markets union, see Lagarde, C. (2024), "Follow the money: channelling savings into investment and innovation in Europe", speech at the 34th European Banking Congress: "Out of the Comfort Zone: Europe and the New World Order", Frankfurt am Main, 22 November. For speeches on the banking union, see Lagarde, C. (2024), "Welcome address at the tenth anniversary of the Single Supervisory Mechanism", Frankfurt am Main, 6 November. 9. For recent discussions on how the ECB incorporates analyses coming from macroeconomic models for policymaking, see Lane, P.R. (2024), "Monetary policy under uncertainty", speech at the Bank of England Watchers' Conference 2024, King's College London, 25 November; and Lane, P.R. (2024), "The 2021-2022 inflation surges and the monetary policy response through the lens of macroeconomic models", speech at the SUERF Marjolin Lecture hosted by the Banca d'Italia, Rome, 18 November. 10 . For an overview of the digital euro project, see Cipollone, P. (2024), "Monetary sovereignty in the digital age: the case for a digital euro", speech at the Economics of Payments XIII Conference organised by the Oesterreichische Nationalbank, Vienna, 27 September; and Cipollone, P. (2024), "From dependency to autonomy: the role of a digital euro in the European payment landscape", speech at the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 23 September. 11. For more information on climate change work at the ECB, see the dedicated section of the ECB website. ---[PAGE_BREAK]--- See Elderson, F. (2024), "Taking account of nature, naturally", speech at the tenth Green Finance Forum "Innovate in Nature", Frankfurt am Main, 19 November and recent research by Ferdinandusse, M., Kuik, F. and Priftis, R. (2024), "Assessing the macroeconomic effects of climate change transition policies", Economic Bulletin, Issue 1, European Central Bank, Frankfurt am Main; and Ferdinandusse, M., Lis, E., Kuik, F. and Sun, Y. (2023), "Climate-related policies in the Eurosystem/ECB staff macroeconomic projections for the euro area and the macroeconomic impact of green fiscal measures", Economic Bulletin, Issue 1, European Central Bank, Frankfurt am Main. 13. For a discussion of changes in neutral rates and their policy implications see Brand, C., Lisack, N. and Mazelis, F. (2024), "Estimates of the natural interest rate for the euro area: an update", Economic Bulletin, Issue 1, ECB and Lane, P.R. (2019) "Determinants of the real interest rate" Remarks at the National Treasury Management Agency, Dublin, 28 November 2019. 14. Recent studies that emphasise the importance of general equilibrium analysis in assessing the policy implications of structural changes include: Fornaro, L., Guerrieri, V. and Reichlin, L. (2024), "Monetary Policy for the Green Transition", report prepared for the BIS Green Swan conference 2024 and Tenreyro, S., Ambrosino, L. and Chan, J. (2024), "Trade fragmentation, inflationary pressures, and monetary policy," BIS working paper, No 1225. For monetary policy actions taken by the ECB in response to the inflation shock in 2021-22, see Lane, P.R. (2024), "The 2021-2022 inflation surges and monetary policy in the euro area", The ECB Blog, 11 March. # CONTACT <br> European Central Bank <br> Directorate General Communications $>$ Sonnemannstrasse 20 $>60314$ Frankfurt am Main, Germany $>+496913447455$ $>$ [email protected]	Philip R Lane	Euro area	https://www.bis.org/review/r241202b.pdf	Paris, 28 November 2024 Let me start by congratulating the Euro50 Group on its 25th anniversary: since the start of the euro, the Euro50 Group has convened many important discussions about the development of the euro area as a monetary union and the euro as a single currency. Looking back at the first quarter of a century of the Euro50 Group naturally invites speculation about the next 25 years: what will we be discussing at the 50th anniversary of the Euro50 Group? Let me list four major structural factors that look set to shape the next 25 years: Before turning to how a central bank should respond to these structural changes, I want first to emphasise that the common nature of these structural trends means that international coordination and collective action is the best approach to navigating these challenges. At the European level, there is considerable scope to work together as a European Union. In terms of economic and financial policy, the recent Draghi and Letta reports show how further integration can improve both the dynamism and the resilience of Europe, which would make it much easier to deal with the challenges I have just mentioned. First, a basic task is to analyse these developments: strong analytical foundations are a precondition for good policymaking. Of course, the primary focus of the analytical work should be to assess the implications of these structural trends for the central bank. This spans not only the implications for inflation dynamics but also the role of money in the economy and the financial system and the modalities of monetary policy implementation. The full arsenal of analytical firepower needs to be deployed: research projects to uncover evidence about structural change in the incoming data; a greater use of surveys to find out how households, firms and financial intermediaries are coping with structural change; and the tracing-out of various scenarios in the "laboratories" provided by macroeconomic models. Second, a forward-looking central bank should update and modify the tools and modalities of how it underpins the monetary system and implements monetary policy. In relation to the former, the digital euro project is devoted to ensuring that the euro area can benefit from the full potential of a digitised financial system while preserving, even in the new digital world, the security and freedom provided by central bank money. The gains from a digital euro extend far beyond the personal benefits that will be reaped by individual European citizens from a digital currency that can be used wherever digital payments are accepted, throughout the euro area. The digital euro will also introduce an alternative to the currently-dominant international payment solutions, both reducing our external dependencies and lowering costs for merchants. And it will provide the underlying infrastructural platform and acceptance network that can level the playing field for euro area banks, payment providers and payment schemes in offering a wide range of financial services across the euro area. In relation to the latter, the ECB is working to ensure that its policy toolkit and implementation framework are aligned with the EU policy commitments to the green transition. Third, a central bank should work through the implications of structural change for price stability. Structural changes can affect not only inflation dynamics, but also the natural rate of interest, and therefore can have important consequences for the central bank's price stability mandate. At a heuristic level, it is important to differentiate between different pathways. Without trying to be comprehensive, let's consider a few scenarios: Scenario A: This may have little impact on inflation: loosely speaking, if demand and supply adapt at the same speed, the net impact on inflation is limited. Scenario B: news arrives about a future structural shift. If the news is good - future supply capacity improves - this can stimulate investment and raise consumption today, in line with the permanent income hypothesis. Since demand improves but short-run supply is limited, this may create a burst of short-run inflation. In the other direction, if the news is bad - future supply capacity declines - this constitutes a negative demand shock today, which is disinflationary. In either case, whether monetary policy should respond will depend on the expected size and duration of the inflation shock, together with an assessment of the fragility of the inflation anchor to the shock. Scenario C: a disruptive event occurs today. This could be an adverse disruptive event (a pandemic, a trade war, an actual war) that generates an unexpected contraction in supply capacity. In the other direction, it could also take the form of a faster-than-expected roll-out of a general purpose technology, such as the 1990s internet boom in the United States). In the case of an adverse shock, supply falling more quickly than demand creates inflationary pressure; in the case of a positive shock, supply increasing more quickly than demand eases inflationary pressure. Of course, both types of disruptive event may also have implications for financial stability, in view of the associated implications for asset pricing. In essence, the challenge for central bankers will be to calculate and re-calculate the appropriate monetary policy stance that is robust to the emergence of these various scenarios or combinations of scenarios: at any given time, there may be elements of scenarios $A, B$ and $C$ operating in different sectors and in different countries, given the wide variety of structural changes that are underway. 6 . For recent discussions of the challenges presented by technological change, shifting geopolitical trends and climate change, see speeches by President Lagarde on "The economic and human challenges of a transforming era", "Setbacks and strides forward: structural shifts and monetary policy in the twenties", "Policymaking in a new risk environment" and "Central banks in a changing world: the role of the ECB in the face of climate and environmental risks". 10 . $>+496913447455$ $>$ [email protected]
2024-12-02T00:00:00	Christopher J Waller: Cut or skip?	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the American Institute for Economic Research Monetary Conference on "Building a Better Fed Framework", Washington DC, 2 December 2024.	Christopher J Waller: Cut or skip? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the American Institute for Economic Research Monetary Conference on "Building a Better Fed Framework", Washington DC, 2 December 2024. * * * Thank you, Lydia, and thank you for the opportunity to speak to you today. I thought I might use my time with you to address the Federal Open Market Committee's (FOMC) ongoing effort to return inflation to our 2 percent target while keeping the labor market and the economy strong.1 After significant progress in reducing inflation and evident moderation in the labor market, in September the Committee judged that the time had come to begin easing monetary policy toward a more neutral setting to limit the risk of unduly weakening the labor market as progress continues toward 2 percent inflation. After reducing the policy rate 75 basis points since our September meeting, I believe that monetary policy is still restrictive and putting downward pressure on inflation without creating undesirable weakness in the labor market. I expect rate cuts to continue over the next year until we approach a more neutral setting of the policy rate. But recent data have raised the possibility that progress on inflation may be stalling at a level meaningfully above 2 percent. This risk has raised concerns that the FOMC should consider holding the policy rate constant at our upcoming meeting to collect more information about the future path of inflation and the economy. Based on the economic data in hand today and forecasts that show that inflation will continue on its downward path to 2 percent over the medium term, at present I lean toward supporting a cut to the policy rate at our December meeting. But that decision will depend on whether data that we will receive before then surprises to the upside and alters my forecast for the path of inflation. Let me turn to the economic outlook. Real gross domestic product (GDP) grew at a strong annual pace of 2.8 percent in the third quarter of 2024, and indications are that growth in the fourth quarter will be a bit slower. An average of private sectors forecasts predicts 2.2 percent, while based on fairly limited data so far, the Atlanta Fed's GDPNow model currently predicts 3.2 percent. On the consumer side of the economy, real personal consumption expenditures (PCE) increased 0.1 percent in October after a 0.5 percent rise in September. Given the recent volatility in these numbers, I won't read too much into the monthly swing. The modest increase in October might partially reflect some payback to the stronger growth in September. Overall, household balance sheets continue to be in generally good shape, and this position should help maintain spending going forward. On the business side of the economy, the S&P Global U.S. manufacturing purchasing managers index (PMI) rose slightly in November but still stands at a level indicating a slight deterioration in overall business conditions among manufacturers for the fifth straight month. Today's Institute for Supply Management manufacturing survey had a similar leaning. These readings are consistent with industrial production data for manufacturing remaining flat, as it has been for the past several months. But these aggregate data mask quite different performances for interest-sensitive sectors and other businesses not so affected by rates. In the spring of 2022, when the FOMC began raising interest rates, production by more interest rate-sensitive manufacturers, such as business equipment, grew at about the same rate as production by less rate-sensitive manufacturers. But starting around the middle of 2023, when the policy rate hit its peak, those stories diverged, and production by interest-sensitive manufacturing declined, while other manufacturing rose, driving a sizable gap between the two types of industries. This divergence is an indication to me that, even after the Committee cut rates 75 basis points, restrictive policy is working the way it is intended to, affecting production in sectors where rates matter. It is also a reminder that there is still some distance to go in reducing the policy rate to neutral. As that occurs, I expect the gap between the two types of industries will narrow. As for the service sector, which is the larger share of business activity, the November S&P Global U.S. PMI continued to increase, extending the strong momentum for services over the past year or two. While the picture for economic activity is pretty clear right now across the major data that we look at, things aren't as clear in recent data on the labor market. As expected, the October employment report showed very little increase in the number of jobs, but likely because of the temporary effects of the recent hurricanes and the strike at Boeing, which also affected businesses serving Boeing and its workers. The strike is over, and it is likely that most of the job losses from the hurricane have reversed. So I do expect a rebound in payroll data in the November employment report that is due out later this week, but it may take more time for the full swings in the payroll data to fully wash out. For that reason, I am leaning on other metrics to reveal what is really going on in the labor market. And when I look at a broader range of data, it tells a fairly consistent story over the past year about moderating demand relative to supply, consistent with continued progress toward 2 percent inflation and without an undesirable weakening in the labor market. The unemployment rate started 2024 at 3.7 percent and climbed gradually, briefly hitting 4.3 percent before falling back down to 4.1 percent in September and October. While that is still quite low in historical terms, it indicates a labor market significantly looser than we saw from the middle of 2022 to the middle of 2023, when unemployment was close to 3.5 percent and fast wage growth contributed to high inflation. Other data sharpen this image of a looser but still-strong labor market. The share of workers voluntarily quitting their jobs, an indication of tightness in the labor market, has trended down to levels lower than before the pandemic. The number of job openings continues to gradually fall, another sign of moderating demand relative to supply, but the number of layoffs is still low, consistent with a healthy labor market. Growth in wages and other forms of compensation has moderated at the same time that labor productivity has grown strongly. This story is very different than a couple of years ago when, for example, average hourly wages grew at an annual rate above 5 percent in 2022, at the same time that the productivity of workers was declining. This double whammy put significant upward pressure on inflation. But over the second and third quarters of 2024, average hourly wages have grown at less than a 4 percent annual rate, while productivity has grown around 2 percent. The math is pretty simple-4 percent wage growth minus the 2 percent gain from higher productivity tells you that wage growth is consistent with bringing inflation down to 2 percent.2 While I am pleased at how well the labor market has held up under restrictive monetary policy, I am less pleased about what the data have been telling us the past couple of months about inflation. After making a lot of progress over the past year and a half, the recent data indicate that progress may be stalling. Inflation based on the Commerce Department's measure of prices for PCE rose more than expected in September and October and so did "core" PCE inflation, which excludes more volatile food and energy prices and is a better guide to future inflation. Three-month annualized core PCE inflation has risen over the past two months, while six-month annualized inflation has made only a small improvement. These rates now stand at 2.8 percent and 2.3 percent, respectively. These recent readings have contributed to 12-month core PCE inflation of 2.8 percent in October. If we compare components of core inflation this October with last October, we see 12month housing services inflation has softened and goods inflation has moved to slight deflation, but there has been an increase in nonmarket core services excluding housing. Overall, I feel like an MMA fighter who keeps getting inflation in a choke hold, waiting for it to tap out yet it keeps slipping out of my grasp at the last minute. But let me assure you that submission is inevitable-inflation isn't getting out of the octagon. While the recent increase and the level of inflation raise concerns that it may be getting stuck above the FOMC's 2 percent goal, let me emphasize that this is a risk but not a certainty. I take the recent inflation data seriously, but we saw a similar uptick in inflation a year ago that was followed by a continued decline, so I also don't want to overreact. And I expect housing services inflation to continue to moderate and I do not take much signal from the elevated inflation for other non-market services. Now let me turn to the implications for monetary policy based on my assessment of the underlying economic outlook. While some near-term aspects of the outlook may be a little unclear, something that is clear is the direction for monetary policy and our policy rate over the medium term, which is down. This downward trajectory reflects the fact that the level of aggregate demand in the economy, relative to supply, has moderated significantly over the past year-it is plainly visible in the data on spending and the labor market. Inflation over that time is also significantly lower, so it makes sense to be moving policy rates toward a more neutral setting. And there is a ways to go. In September, the median of the projections of FOMC participants was that the federal funds rate would be 3.4 percent at the end of next year, which is about 100 basis points lower than it is today. That number can and probably will change over time, but whatever the destination, there will be a variety of ways to get there, with the speed and timing of cuts determined by economic conditions we encounter on the way. The motivation for continuing to cut the policy rate at the FOMC's next meeting begins with how restrictive the current setting is. After we cut by 75 basis points, I believe the evidence is strong that policy continues to be significantly restrictive and that cutting again will only mean that we aren't pressing on the brake pedal quite as hard. Although monthly core inflation has flattened out in recent months, there is no indication that the pace of price increases for key service categories such as housing and nonmarket services should remain at their current levels or increase. Another factor that supports a further rate cut is that the labor market appears to finally be in balance, and we should aim to keep it that way. Conversely, based on what we know today, one could argue that there is a case for skipping a rate cut at the next meeting. Monthly readings on inflation have moved up noticeably recently, and we don't know whether this uptick in inflation will persist, or reverse, as we saw a year ago. Due to strikes and hurricanes, recent labor market data are giving us a cloudy view of the true state of the labor market that won't be clearer for a couple of months. As a result, one could advocate for not changing the policy rate at our upcoming meeting and adjusting our policy stance in a measured way going forward. In fact, if policymakers' estimates of the target range at the end of next year are close to correct, then the Committee will most likely be skipping rate cuts multiple times on the way to that destination. In deciding which of these two approaches to take at the FOMC's next meeting, I will be watching additional data very closely. Tomorrow, we get the Labor Department's Job Openings and Labor Turnover Survey. On Friday, we get the employment report, which, as I noted, may have misleading payroll data. Then next week, we get consumer and producer price indexes for November, which will allow a good estimate of PCE inflation for the month. Finally, on the first day of the FOMC meeting, we receive retail sales data for November that will give us an idea of how consumer spending is holding up. All of that information will help me decide whether to cut or skip. As of today, I am leaning toward continuing the work we have started in returning monetary policy to a more neutral setting. Policy is still restrictive enough that an additional cut at our next meeting will not dramatically change the stance of monetary policy and allow ample scope to later slow the pace of rate cuts, if needed, to maintain progress toward our inflation target. That said, if the data we receive between today and the next meeting surprise in a way that suggests our forecasts of slowing inflation and a moderating but still-solid economy are wrong, then I will be supportive of holding the policy rate constant. I will be watching the incoming data closely over the next couple weeks to help me make my decision as to what path to take. 1 The views expressed here are my own and are not necessarily those of my colleagues on the Federal Open Market Committee. 2 A similar story holds true if one looks at growth in labor productivity and hourly compensation from the Productivity and Cost release. Here the wedge between the two series has narrowed over this time period.	---[PAGE_BREAK]--- # Christopher J Waller: Cut or skip? Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the American Institute for Economic Research Monetary Conference on "Building a Better Fed Framework", Washington DC, 2 December 2024. Thank you, Lydia, and thank you for the opportunity to speak to you today. I thought I might use my time with you to address the Federal Open Market Committee's (FOMC) ongoing effort to return inflation to our 2 percent target while keeping the labor market and the economy strong. ${ }^{1}$ After significant progress in reducing inflation and evident moderation in the labor market, in September the Committee judged that the time had come to begin easing monetary policy toward a more neutral setting to limit the risk of unduly weakening the labor market as progress continues toward 2 percent inflation. After reducing the policy rate 75 basis points since our September meeting, I believe that monetary policy is still restrictive and putting downward pressure on inflation without creating undesirable weakness in the labor market. I expect rate cuts to continue over the next year until we approach a more neutral setting of the policy rate. But recent data have raised the possibility that progress on inflation may be stalling at a level meaningfully above 2 percent. This risk has raised concerns that the FOMC should consider holding the policy rate constant at our upcoming meeting to collect more information about the future path of inflation and the economy. Based on the economic data in hand today and forecasts that show that inflation will continue on its downward path to 2 percent over the medium term, at present I lean toward supporting a cut to the policy rate at our December meeting. But that decision will depend on whether data that we will receive before then surprises to the upside and alters my forecast for the path of inflation. Let me turn to the economic outlook. Real gross domestic product (GDP) grew at a strong annual pace of 2.8 percent in the third quarter of 2024, and indications are that growth in the fourth quarter will be a bit slower. An average of private sectors forecasts predicts 2.2 percent, while based on fairly limited data so far, the Atlanta Fed's GDPNow model currently predicts 3.2 percent. On the consumer side of the economy, real personal consumption expenditures (PCE) increased 0.1 percent in October after a 0.5 percent rise in September. Given the recent volatility in these numbers, I won't read too much into the monthly swing. The modest increase in October might partially reflect some payback to the stronger growth in September. Overall, household balance sheets continue to be in generally good shape, and this position should help maintain spending going forward. On the business side of the economy, the S\&P Global U.S. manufacturing purchasing managers index (PMI) rose slightly in November but still stands at a level indicating a slight deterioration in overall business conditions among manufacturers for the fifth straight month. Today's Institute for Supply Management manufacturing survey had a ---[PAGE_BREAK]--- similar leaning. These readings are consistent with industrial production data for manufacturing remaining flat, as it has been for the past several months. But these aggregate data mask quite different performances for interest-sensitive sectors and other businesses not so affected by rates. In the spring of 2022, when the FOMC began raising interest rates, production by more interest rate-sensitive manufacturers, such as business equipment, grew at about the same rate as production by less rate-sensitive manufacturers. But starting around the middle of 2023, when the policy rate hit its peak, those stories diverged, and production by interest-sensitive manufacturing declined, while other manufacturing rose, driving a sizable gap between the two types of industries. This divergence is an indication to me that, even after the Committee cut rates 75 basis points, restrictive policy is working the way it is intended to, affecting production in sectors where rates matter. It is also a reminder that there is still some distance to go in reducing the policy rate to neutral. As that occurs, I expect the gap between the two types of industries will narrow. As for the service sector, which is the larger share of business activity, the November S\&P Global U.S. PMI continued to increase, extending the strong momentum for services over the past year or two. While the picture for economic activity is pretty clear right now across the major data that we look at, things aren't as clear in recent data on the labor market. As expected, the October employment report showed very little increase in the number of jobs, but likely because of the temporary effects of the recent hurricanes and the strike at Boeing, which also affected businesses serving Boeing and its workers. The strike is over, and it is likely that most of the job losses from the hurricane have reversed. So I do expect a rebound in payroll data in the November employment report that is due out later this week, but it may take more time for the full swings in the payroll data to fully wash out. For that reason, I am leaning on other metrics to reveal what is really going on in the labor market. And when I look at a broader range of data, it tells a fairly consistent story over the past year about moderating demand relative to supply, consistent with continued progress toward 2 percent inflation and without an undesirable weakening in the labor market. The unemployment rate started 2024 at 3.7 percent and climbed gradually, briefly hitting 4.3 percent before falling back down to 4.1 percent in September and October. While that is still quite low in historical terms, it indicates a labor market significantly looser than we saw from the middle of 2022 to the middle of 2023, when unemployment was close to 3.5 percent and fast wage growth contributed to high inflation. Other data sharpen this image of a looser but still-strong labor market. The share of workers voluntarily quitting their jobs, an indication of tightness in the labor market, has trended down to levels lower than before the pandemic. The number of job openings continues to gradually fall, another sign of moderating demand relative to supply, but the number of layoffs is still low, consistent with a healthy labor market. Growth in wages and other forms of compensation has moderated at the same time that labor productivity has grown strongly. This story is very different than a couple of years ago when, for example, average hourly wages grew at an annual rate above 5 percent in 2022, at the same time that the productivity of workers was declining. This double whammy put significant upward pressure on inflation. But over the second and ---[PAGE_BREAK]--- third quarters of 2024, average hourly wages have grown at less than a 4 percent annual rate, while productivity has grown around 2 percent. The math is pretty simple-4 percent wage growth minus the 2 percent gain from higher productivity tells you that wage growth is consistent with bringing inflation down to 2 percent. ${ }^{2}$ While I am pleased at how well the labor market has held up under restrictive monetary policy, I am less pleased about what the data have been telling us the past couple of months about inflation. After making a lot of progress over the past year and a half, the recent data indicate that progress may be stalling. Inflation based on the Commerce Department's measure of prices for PCE rose more than expected in September and October and so did "core" PCE inflation, which excludes more volatile food and energy prices and is a better guide to future inflation. Three-month annualized core PCE inflation has risen over the past two months, while six-month annualized inflation has made only a small improvement. These rates now stand at 2.8 percent and 2.3 percent, respectively. These recent readings have contributed to 12-month core PCE inflation of 2.8 percent in October. If we compare components of core inflation this October with last October, we see 12month housing services inflation has softened and goods inflation has moved to slight deflation, but there has been an increase in nonmarket core services excluding housing. Overall, I feel like an MMA fighter who keeps getting inflation in a choke hold, waiting for it to tap out yet it keeps slipping out of my grasp at the last minute. But let me assure you that submission is inevitable-inflation isn't getting out of the octagon. While the recent increase and the level of inflation raise concerns that it may be getting stuck above the FOMC's 2 percent goal, let me emphasize that this is a risk but not a certainty. I take the recent inflation data seriously, but we saw a similar uptick in inflation a year ago that was followed by a continued decline, so I also don't want to overreact. And I expect housing services inflation to continue to moderate and I do not take much signal from the elevated inflation for other non-market services. Now let me turn to the implications for monetary policy based on my assessment of the underlying economic outlook. While some near-term aspects of the outlook may be a little unclear, something that is clear is the direction for monetary policy and our policy rate over the medium term, which is down. This downward trajectory reflects the fact that the level of aggregate demand in the economy, relative to supply, has moderated significantly over the past year-it is plainly visible in the data on spending and the labor market. Inflation over that time is also significantly lower, so it makes sense to be moving policy rates toward a more neutral setting. And there is a ways to go. In September, the median of the projections of FOMC participants was that the federal funds rate would be 3.4 percent at the end of next year, which is about 100 basis points lower than it is today. That number can and probably will change over time, but whatever the destination, there will be a variety of ways to get there, with the speed and timing of cuts determined by economic conditions we encounter on the way. The motivation for continuing to cut the policy rate at the FOMC's next meeting begins with how restrictive the current setting is. After we cut by 75 basis points, I believe the evidence is strong that policy continues to be significantly restrictive and that cutting ---[PAGE_BREAK]--- again will only mean that we aren't pressing on the brake pedal quite as hard. Although monthly core inflation has flattened out in recent months, there is no indication that the pace of price increases for key service categories such as housing and nonmarket services should remain at their current levels or increase. Another factor that supports a further rate cut is that the labor market appears to finally be in balance, and we should aim to keep it that way. Conversely, based on what we know today, one could argue that there is a case for skipping a rate cut at the next meeting. Monthly readings on inflation have moved up noticeably recently, and we don't know whether this uptick in inflation will persist, or reverse, as we saw a year ago. Due to strikes and hurricanes, recent labor market data are giving us a cloudy view of the true state of the labor market that won't be clearer for a couple of months. As a result, one could advocate for not changing the policy rate at our upcoming meeting and adjusting our policy stance in a measured way going forward. In fact, if policymakers' estimates of the target range at the end of next year are close to correct, then the Committee will most likely be skipping rate cuts multiple times on the way to that destination. In deciding which of these two approaches to take at the FOMC's next meeting, I will be watching additional data very closely. Tomorrow, we get the Labor Department's Job Openings and Labor Turnover Survey. On Friday, we get the employment report, which, as I noted, may have misleading payroll data. Then next week, we get consumer and producer price indexes for November, which will allow a good estimate of PCE inflation for the month. Finally, on the first day of the FOMC meeting, we receive retail sales data for November that will give us an idea of how consumer spending is holding up. All of that information will help me decide whether to cut or skip. As of today, I am leaning toward continuing the work we have started in returning monetary policy to a more neutral setting. Policy is still restrictive enough that an additional cut at our next meeting will not dramatically change the stance of monetary policy and allow ample scope to later slow the pace of rate cuts, if needed, to maintain progress toward our inflation target. That said, if the data we receive between today and the next meeting surprise in a way that suggests our forecasts of slowing inflation and a moderating but still-solid economy are wrong, then I will be supportive of holding the policy rate constant. I will be watching the incoming data closely over the next couple weeks to help me make my decision as to what path to take. $\qquad$ $\qquad$ The views expressed here are my own and are not necessarily those of my colleagues on the Federal Open Market Committee. $\stackrel{2}{2}$ A similar story holds true if one looks at growth in labor productivity and hourly compensation from the Productivity and Cost release. Here the wedge between the two series has narrowed over this time period.	Christopher J Waller	United States	https://www.bis.org/review/r241203a.pdf	Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve System, at the American Institute for Economic Research Monetary Conference on "Building a Better Fed Framework", Washington DC, 2 December 2024. Thank you, Lydia, and thank you for the opportunity to speak to you today. I thought I might use my time with you to address the Federal Open Market Committee's (FOMC) ongoing effort to return inflation to our 2 percent target while keeping the labor market and the economy strong. After significant progress in reducing inflation and evident moderation in the labor market, in September the Committee judged that the time had come to begin easing monetary policy toward a more neutral setting to limit the risk of unduly weakening the labor market as progress continues toward 2 percent inflation. After reducing the policy rate 75 basis points since our September meeting, I believe that monetary policy is still restrictive and putting downward pressure on inflation without creating undesirable weakness in the labor market. I expect rate cuts to continue over the next year until we approach a more neutral setting of the policy rate. But recent data have raised the possibility that progress on inflation may be stalling at a level meaningfully above 2 percent. This risk has raised concerns that the FOMC should consider holding the policy rate constant at our upcoming meeting to collect more information about the future path of inflation and the economy. Based on the economic data in hand today and forecasts that show that inflation will continue on its downward path to 2 percent over the medium term, at present I lean toward supporting a cut to the policy rate at our December meeting. But that decision will depend on whether data that we will receive before then surprises to the upside and alters my forecast for the path of inflation. Let me turn to the economic outlook. Real gross domestic product (GDP) grew at a strong annual pace of 2.8 percent in the third quarter of 2024, and indications are that growth in the fourth quarter will be a bit slower. An average of private sectors forecasts predicts 2.2 percent, while based on fairly limited data so far, the Atlanta Fed's GDPNow model currently predicts 3.2 percent. On the consumer side of the economy, real personal consumption expenditures (PCE) increased 0.1 percent in October after a 0.5 percent rise in September. Given the recent volatility in these numbers, I won't read too much into the monthly swing. The modest increase in October might partially reflect some payback to the stronger growth in September. Overall, household balance sheets continue to be in generally good shape, and this position should help maintain spending going forward. On the business side of the economy, the S\&P Global U.S. manufacturing purchasing managers index (PMI) rose slightly in November but still stands at a level indicating a slight deterioration in overall business conditions among manufacturers for the fifth straight month. Today's Institute for Supply Management manufacturing survey had a similar leaning. These readings are consistent with industrial production data for manufacturing remaining flat, as it has been for the past several months. But these aggregate data mask quite different performances for interest-sensitive sectors and other businesses not so affected by rates. In the spring of 2022, when the FOMC began raising interest rates, production by more interest rate-sensitive manufacturers, such as business equipment, grew at about the same rate as production by less rate-sensitive manufacturers. But starting around the middle of 2023, when the policy rate hit its peak, those stories diverged, and production by interest-sensitive manufacturing declined, while other manufacturing rose, driving a sizable gap between the two types of industries. This divergence is an indication to me that, even after the Committee cut rates 75 basis points, restrictive policy is working the way it is intended to, affecting production in sectors where rates matter. It is also a reminder that there is still some distance to go in reducing the policy rate to neutral. As that occurs, I expect the gap between the two types of industries will narrow. As for the service sector, which is the larger share of business activity, the November S\&P Global U.S. PMI continued to increase, extending the strong momentum for services over the past year or two. While the picture for economic activity is pretty clear right now across the major data that we look at, things aren't as clear in recent data on the labor market. As expected, the October employment report showed very little increase in the number of jobs, but likely because of the temporary effects of the recent hurricanes and the strike at Boeing, which also affected businesses serving Boeing and its workers. The strike is over, and it is likely that most of the job losses from the hurricane have reversed. So I do expect a rebound in payroll data in the November employment report that is due out later this week, but it may take more time for the full swings in the payroll data to fully wash out. For that reason, I am leaning on other metrics to reveal what is really going on in the labor market. And when I look at a broader range of data, it tells a fairly consistent story over the past year about moderating demand relative to supply, consistent with continued progress toward 2 percent inflation and without an undesirable weakening in the labor market. The unemployment rate started 2024 at 3.7 percent and climbed gradually, briefly hitting 4.3 percent before falling back down to 4.1 percent in September and October. While that is still quite low in historical terms, it indicates a labor market significantly looser than we saw from the middle of 2022 to the middle of 2023, when unemployment was close to 3.5 percent and fast wage growth contributed to high inflation. Other data sharpen this image of a looser but still-strong labor market. The share of workers voluntarily quitting their jobs, an indication of tightness in the labor market, has trended down to levels lower than before the pandemic. The number of job openings continues to gradually fall, another sign of moderating demand relative to supply, but the number of layoffs is still low, consistent with a healthy labor market. Growth in wages and other forms of compensation has moderated at the same time that labor productivity has grown strongly. This story is very different than a couple of years ago when, for example, average hourly wages grew at an annual rate above 5 percent in 2022, at the same time that the productivity of workers was declining. This double whammy put significant upward pressure on inflation. But over the second and third quarters of 2024, average hourly wages have grown at less than a 4 percent annual rate, while productivity has grown around 2 percent. The math is pretty simple-4 percent wage growth minus the 2 percent gain from higher productivity tells you that wage growth is consistent with bringing inflation down to 2 percent. While I am pleased at how well the labor market has held up under restrictive monetary policy, I am less pleased about what the data have been telling us the past couple of months about inflation. After making a lot of progress over the past year and a half, the recent data indicate that progress may be stalling. Inflation based on the Commerce Department's measure of prices for PCE rose more than expected in September and October and so did "core" PCE inflation, which excludes more volatile food and energy prices and is a better guide to future inflation. Three-month annualized core PCE inflation has risen over the past two months, while six-month annualized inflation has made only a small improvement. These rates now stand at 2.8 percent and 2.3 percent, respectively. These recent readings have contributed to 12-month core PCE inflation of 2.8 percent in October. If we compare components of core inflation this October with last October, we see 12month housing services inflation has softened and goods inflation has moved to slight deflation, but there has been an increase in nonmarket core services excluding housing. Overall, I feel like an MMA fighter who keeps getting inflation in a choke hold, waiting for it to tap out yet it keeps slipping out of my grasp at the last minute. But let me assure you that submission is inevitable-inflation isn't getting out of the octagon. While the recent increase and the level of inflation raise concerns that it may be getting stuck above the FOMC's 2 percent goal, let me emphasize that this is a risk but not a certainty. I take the recent inflation data seriously, but we saw a similar uptick in inflation a year ago that was followed by a continued decline, so I also don't want to overreact. And I expect housing services inflation to continue to moderate and I do not take much signal from the elevated inflation for other non-market services. Now let me turn to the implications for monetary policy based on my assessment of the underlying economic outlook. While some near-term aspects of the outlook may be a little unclear, something that is clear is the direction for monetary policy and our policy rate over the medium term, which is down. This downward trajectory reflects the fact that the level of aggregate demand in the economy, relative to supply, has moderated significantly over the past year-it is plainly visible in the data on spending and the labor market. Inflation over that time is also significantly lower, so it makes sense to be moving policy rates toward a more neutral setting. And there is a ways to go. In September, the median of the projections of FOMC participants was that the federal funds rate would be 3.4 percent at the end of next year, which is about 100 basis points lower than it is today. That number can and probably will change over time, but whatever the destination, there will be a variety of ways to get there, with the speed and timing of cuts determined by economic conditions we encounter on the way. The motivation for continuing to cut the policy rate at the FOMC's next meeting begins with how restrictive the current setting is. After we cut by 75 basis points, I believe the evidence is strong that policy continues to be significantly restrictive and that cutting again will only mean that we aren't pressing on the brake pedal quite as hard. Although monthly core inflation has flattened out in recent months, there is no indication that the pace of price increases for key service categories such as housing and nonmarket services should remain at their current levels or increase. Another factor that supports a further rate cut is that the labor market appears to finally be in balance, and we should aim to keep it that way. Conversely, based on what we know today, one could argue that there is a case for skipping a rate cut at the next meeting. Monthly readings on inflation have moved up noticeably recently, and we don't know whether this uptick in inflation will persist, or reverse, as we saw a year ago. Due to strikes and hurricanes, recent labor market data are giving us a cloudy view of the true state of the labor market that won't be clearer for a couple of months. As a result, one could advocate for not changing the policy rate at our upcoming meeting and adjusting our policy stance in a measured way going forward. In fact, if policymakers' estimates of the target range at the end of next year are close to correct, then the Committee will most likely be skipping rate cuts multiple times on the way to that destination. In deciding which of these two approaches to take at the FOMC's next meeting, I will be watching additional data very closely. Tomorrow, we get the Labor Department's Job Openings and Labor Turnover Survey. On Friday, we get the employment report, which, as I noted, may have misleading payroll data. Then next week, we get consumer and producer price indexes for November, which will allow a good estimate of PCE inflation for the month. Finally, on the first day of the FOMC meeting, we receive retail sales data for November that will give us an idea of how consumer spending is holding up. All of that information will help me decide whether to cut or skip. As of today, I am leaning toward continuing the work we have started in returning monetary policy to a more neutral setting. Policy is still restrictive enough that an additional cut at our next meeting will not dramatically change the stance of monetary policy and allow ample scope to later slow the pace of rate cuts, if needed, to maintain progress toward our inflation target. That said, if the data we receive between today and the next meeting surprise in a way that suggests our forecasts of slowing inflation and a moderating but still-solid economy are wrong, then I will be supportive of holding the policy rate constant. I will be watching the incoming data closely over the next couple weeks to help me make my decision as to what path to take. $\qquad$
2024-12-03T00:00:00	Adriana D Kugler: A year in review - a tale of two supply shocks	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Detroit Economic Club, Detroit, Michigan, 3 December 2024.	Adriana D Kugler: A year in review - a tale of two supply shocks Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Detroit Economic Club, Detroit, Michigan, 3 December 2024. * * * Thank you, Jason, and thank you for the opportunity to speak here in Detroit today.1 This visit has allowed me to see the many encouraging signs in this region: growth here in downtown; the area's famously hard-working labor force; and the gritty Detroit Lions, with 11 wins this season and counting. The nation has taken notice. But, truly, one of my favorite parts of serving as a Governor on the Federal Reserve Board is visiting communities across the country and hearing directly from the families, workers, and businesses we serve. I am also glad to have the chance to speak with you near the end of the year. I think it is an appropriate time to look back and assess how the U.S. economy has developed over the course of 2024. I will also share with you my outlook and offer my views on U. S. monetary policy. I will start by saying that I view the economy as being in a good position after making significant progress in recent years toward our dual-mandate goals of maximum employment and stable prices. The labor market remains solid, and inflation appears to be on a sustainable path to our 2 percent goal, even if there have been some bumps along the way, as I will discuss later. Reaching this point for the economy was far from assured, especially if you reflect on the pandemic disruptions of nearly five years ago. Even the more recent performance of the economy, at least on the surface, has been surprising to many forecasters. Economic growth remained solid, while inflation moderated from its recent peak without the painful job losses that have often accompanied past efforts to counter high inflation. Heading into this year, that was not necessarily the forecast of many observers, who were expecting a notable deceleration of economic activity. For example, the Blue Chip Economic Indicators in December 2023 expected 1.3 percent GDP growth for all of 2024. More recent estimates show the economy is on track to grow at almost twice that rate this year.2 So how does one interpret these positive, if somewhat unexpected, results? For me, I turned to looking at not just the realities around me and listening to people around the country, but also to my background as an academic researcher who uses an evidencebased approach to recognize two very important developments that have shaped the economy this year: growth in the labor force stemming from an increase in immigration, and a surge in productivity. I have been closely monitoring these developments and discussing them for more than a year. Assessing the Economy Entering 2024 Entering this year, I took notice of several peculiar puzzles that seemed to be playing out in the economy. In terms of overall growth, I noticed a significant divergence between two important measures of output: gross domestic product, or GDP, and gross domestic income, or GDI. While, over time, these two gauges should move together, they appeared to be out of sync heading into this year. The GDI data suggested rather anemic growth, averaging about 1 percent a quarter in 2023, contrary to very strong GDP readings of more than 2.5 percent. The two measures of output had contrasting implications for productivity growth. There was a second puzzle in the labor market. Many forecasters expected that the labor market would remain somewhat tight this year, as rebalancing in the labor market had already attracted a large fraction of the available working-age population: The labor force participation of prime-age workers had reached levels not seen since the late 1990s. However, upon closer examination, I saw a more mixed picture. On the one hand, payroll gains, while slowing, were still averaging a very robust pace of more than 200,000 jobs per month. Data from that time suggest that workers were easily able to find jobs, and measures of layoffs were low by historical standards. In fact, in certain industries, such as health care as well as leisure and hospitality, employment had not yet returned to pre-pandemic levels. That raised questions about whether the supply of workers for those fields could keep pace with demand. But, on the other hand, the unemployment rate was flat instead of declining. This was puzzling considering a robust pace of payroll gains and the assumption that labor supply was constrained. And the two most important labor market surveys sent somewhat divergent signals. The payroll survey of employers showed hiring was abnormally above the gain recorded by the survey of households. Was the economy expanding at a robust pace, as indicated by the payroll survey? Or was it slowing more, as suggested by the household survey? In considering these questions, I interpreted the strong pace of payrolls from the establishment survey and the cooling of various measures of resource utilization as a signal that perhaps the official population estimates were understated to the downside. Starting at the end of 2023, I asked, what if substantial increases in the labor force due to the arrival of workers from other countries had not yet been picked up in Census estimates? We had seen something similar before. In the late 1990s, official measures of the population were substantially revised up due to mismeasured immigration. During this period, establishment and household counts of workers also significantly diverged. And a third puzzle, with inflation, also warrants attention. Inflation had steadily progressed toward the FOMC's target during 2023, perhaps faster than some economists expected. The personal consumption expenditures (PCE) price index eased from a peak of 7.2 percent in June 2022 to about 3 percent at the end of 2023, measured on a 12-month basis. When excluding volatile food and energy prices, core inflation similarly eased from a peak of 5.6 percent in February 2022 to 3 percent at the end of last year. Wage growth measures were consistent with inflation declining. Economic Developments This Year At the turn of the new year, new data and other economic developments appeared to cloud the picture further. An uptick in consumer spending and overall economic activity in the fourth quarter of 2023 as well as a stretch of above-trend hiring gave a signal of unexpected strength to start the year. Adding to the puzzling figures, core inflation rose 0.5 percent in January, a notable acceleration from an average monthly increase of 0.15 percent in the previous quarter. Stronger-than-expected economic activity, faster hiring, and a reacceleration of prices gave some economists pause: Was this a temporary acceleration, or a more sustained reheating of the economy? I viewed it as likely temporary, as it turned out to be. My view has always been that progress in the fight against inflation has to be judged from trends, not from a data release or two. I also anticipated that the process of bringing down inflation was likely to be sometimes bumpy. However, I viewed the elevated inflation readings as partly stemming from seasonal and one-off factors not fully accounted for in the data. In addition, price changes in some categories are difficult 3 to measure, as I have described in previous speeches. That is particularly true for certain services categories for which direct sources of prices are not available; for example, the cost of living in an owner-occupied home or costs associated with certain financial transactions. And, as I have also discussed, the slow adjustment in workers' wages and relative prices may have contributed to bumps on the road to disinflation. Indeed, by the second quarter of the year, it became clear that the earlier firmer inflation figures were indeed temporary. Inflation stepped back down to average monthly increases of less than 0.2 percent. A factor in that was a cooling labor market, which I will discuss in a moment. With the labor market less tight, wage growth leveled off, and that in turn allowed prices for labor-intensive services to moderate. There was another important development early this year: Estimates of population growth were revised substantially higher, according to a Congressional Budget Office 4 report. The report showed about 6 million additional immigrants than were included in official estimates. Those workers added to the supply of labor, which had rebounded early in the pandemic recovery at a time when the unemployment rate was trending near half-century lows. That information was consistent with my hypothesis that the strength in the economy was in part due to a larger-than-estimated labor force, or what economists call a positive supply shock. You may be more familiar with negative shocks, like the pandemic causing constrained supply chains. But the increase of workers was a positive shock and is notable because the underlying demographics of the U.S. heading into the pandemic were consistent with a slow-growing population and lower labor force participation, and that dynamic got worse as the pandemic generated excess retirements and a fall in immigration. In terms of the labor market, I anticipated that after several months of strong job growth at the turn of the year, the labor market would cool significantly. And, indeed, by the middle of this year, the process of the labor market normalizing was taking shape. Payroll gains declined from an average pace of 260,000 in the first quarter to less than 200,000 in the second. Reports on the labor market included unusually large downward revisions to previous gains, and the unemployment rate moved higher, from 3.7 percent in January to 4.1 percent in June. At this point, other economists quickly shifted from worrying about a labor market that might be too hot early in the year to one that might be cooling too quickly. As a Fed policymaker, I had to consider if this movement was consistent with our mandate for maximum employment. Even with the easing in the labor market, consumer spending and overall economic activity continued to show solid growth. The combination of strong spending data and a cooling labor market was confounding. In thinking about this, I examined the productivity data that I follow closely and did not see the type of productivity growth I would have expected based on several other observations of the economy. For example, new business formation had surged in the post-pandemic period. It has been shown that newer firms foster innovation and boost productivity growth. Business formation has remained elevated, from which I infer that the boost to productivity growth is not just a one-time phenomenon. Also, in the post-pandemic period, workers switched jobs at much higher rates than typical. This likely led to better matches where workers can find more productive uses of their skills. In some cases, immigrants filled job openings for which employers traditionally struggle to attract workers. Therefore, immigration can also contribute to improvements in job matches in specific but key sectors. As the economy reopened from the pandemic, many firms also invested in technology to substitute for workers, who were in short supply, which should support productivity gains. Emerging technologies, most notably artificial intelligence, may also be starting to contribute to enhanced productivity. Therefore, my speculation was that higher productivity was a possible explanation for the unusual combination of strong economic output, a cooling labor market, and declining inflation-even if it was not apparent in the quarterly data. That hunch was confirmed in September, when annual revisions to important economic data showed that economic activity and productivity growth had been stronger than previously estimated. The new figures indicated an average annual rate of productivity growth of 1.9 percent since 2020, notably higher than the approximate 1.4 percent annual rate in the five years before the pandemic. So that reveals our second positive shock: American workers have been more productive in recent years. This is a hugely important development because it increases the productive capacity of the economy and allows more rapid economic growth without overheating. What's more, revisions resulted in much better aligned GDP and GDI measures, and the two measures now also had much more aligned implications for productivity. In summary, the surprising and largely desirable outcomes for the economy in 2024 are easier to understand once we solve the puzzles I discussed. My thorough assessment of a wide range of data sources revealed that an unusual combination of reports over the past year were gradually resolved once we understood the two positive supply shocks I discussed: growth in the labor force due to an increase in immigration, and higher productivity growth. Economic Outlook The data we have received in recent weeks have been consistent with the economic forces I described earlier. Real GDP increased at a 2.8 percent annual rate in the third quarter. The latest readings of retail sales have been strong. If household demand remains resilient, that would support growth in the fourth quarter and into next year. Monthly payroll gains have eased from earlier in the year, consistent with a gradual cooling of the labor market. It was difficult to draw a clear signal from the most recent jobs report, due to significant effects from hurricanes and labor strikes. I look forward to reviewing additional labor data on Friday. The unemployment rate, at 4.1 percent in October, is near the level I judge as roughly consistent with our maximum-employment mandate. After rising earlier this year, the rate has stabilized, though this was partly due to some withdrawals from the labor force. That bears watching moving forward. The trend in immigration slowed in the second half of this year, and there is reason to expect immigration flows could further slow. I will closely monitor this data. Inflation readings released last week show that overall PCE prices rose 2.3 percent over the 12 months ending in October, and core PCE prices increased 2.8 percent. I still view those readings, as of now, as consistent with inflation on a path to return to our 2 percent goal, and I am encouraged that inflation expectations appear to remain well anchored. But they also show the job is not yet done. Housing services inflation, in particular, remains elevated. And while global inputs to inflation have been mostly modest in recent months, it is difficult to predict future pressures. I have observed that the trade policy uncertainty index has risen in recent months, likely 5 reflecting risks of changes in trade policy. Of course, the incoming Administration and Congress have not enacted any policies yet, so it is too early to make judgements. Studying the specifics, when they come out, will be important, as trade policy may affect productivity and prices. I will make assessments about what the net effects of any policy changes will be on prices or employment and how the balance between the two legs of our mandate will be affected. Outlook for Monetary Policy Given how the economy has developed this year, most notably the continuation of disinflation and a modest cooling in the labor market, I see the Fed's dual-mandate goals of maximum employment and price stability as being roughly in balance. In light of the progress toward our goals, my colleagues and I on the FOMC judged it appropriate to lower our policy rate in September and again last month. These actions were steps toward removing restraint, as we are in the process of moving policy toward a more neutral setting. Looking ahead, it is important to emphasize that policy is not on a preset course. I will make decisions meeting by meeting and carefully assess incoming data, the evolving outlook, and the balance of risks. While I have gained more confidence that the two positive supply shocks I described have helped create the solid economic conditions that are currently in place, I will vigilantly monitor for incoming risks or negative supply shocks that may undo the progress that we have achieved in reducing inflation. I view our current policy setting as well positioned to deal with any uncertainties we face in pursuing both sides of our dual mandate. Thank you for your time, and I look forward to your questions. The views expressed here are my own and not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. 2 See Wolters Kluwer (2023), Blue Chip Economic Indicators, vol. 48 (December 8). 3 See Adriana D. Kugler (2024), "The Challenges Facing Economic Measurement and Creative Solutions," speech delivered at the 21st Annual Economic Measurement Seminar, National Association for Business Economics Foundation, Washington, July 16. 4 See Congressional Budget Office (2024), The Demographic Outlook: 2024 to 2025 (Washington: CBO, January). 5 See Dario Caldara, Matteo Iacoviello, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2020), "The Economic Effects of Trade Policy Uncertainty," Journal of Monetary Economics, vol. 109 (January), pp. 38-59.	---[PAGE_BREAK]--- # Adriana D Kugler: A year in review - a tale of two supply shocks Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Detroit Economic Club, Detroit, Michigan, 3 December 2024. Thank you, Jason, and thank you for the opportunity to speak here in Detroit today. ${ }^{1}$ This visit has allowed me to see the many encouraging signs in this region: growth here in downtown; the area's famously hard-working labor force; and the gritty Detroit Lions, with 11 wins this season and counting. The nation has taken notice. But, truly, one of my favorite parts of serving as a Governor on the Federal Reserve Board is visiting communities across the country and hearing directly from the families, workers, and businesses we serve. I am also glad to have the chance to speak with you near the end of the year. I think it is an appropriate time to look back and assess how the U.S. economy has developed over the course of 2024. I will also share with you my outlook and offer my views on U. S. monetary policy. I will start by saying that I view the economy as being in a good position after making significant progress in recent years toward our dual-mandate goals of maximum employment and stable prices. The labor market remains solid, and inflation appears to be on a sustainable path to our 2 percent goal, even if there have been some bumps along the way, as I will discuss later. Reaching this point for the economy was far from assured, especially if you reflect on the pandemic disruptions of nearly five years ago. Even the more recent performance of the economy, at least on the surface, has been surprising to many forecasters. Economic growth remained solid, while inflation moderated from its recent peak without the painful job losses that have often accompanied past efforts to counter high inflation. Heading into this year, that was not necessarily the forecast of many observers, who were expecting a notable deceleration of economic activity. For example, the Blue Chip Economic Indicators in December 2023 expected 1.3 percent GDP growth for all of 2024. More recent estimates show the economy is on track to grow at almost twice that rate this year. ${ }^{2}$ So how does one interpret these positive, if somewhat unexpected, results? For me, I turned to looking at not just the realities around me and listening to people around the country, but also to my background as an academic researcher who uses an evidencebased approach to recognize two very important developments that have shaped the economy this year: growth in the labor force stemming from an increase in immigration, and a surge in productivity. I have been closely monitoring these developments and discussing them for more than a year. ## Assessing the Economy Entering 2024 ---[PAGE_BREAK]--- Entering this year, I took notice of several peculiar puzzles that seemed to be playing out in the economy. In terms of overall growth, I noticed a significant divergence between two important measures of output: gross domestic product, or GDP, and gross domestic income, or GDI. While, over time, these two gauges should move together, they appeared to be out of sync heading into this year. The GDI data suggested rather anemic growth, averaging about 1 percent a quarter in 2023, contrary to very strong GDP readings of more than 2.5 percent. The two measures of output had contrasting implications for productivity growth. There was a second puzzle in the labor market. Many forecasters expected that the labor market would remain somewhat tight this year, as rebalancing in the labor market had already attracted a large fraction of the available working-age population: The labor force participation of prime-age workers had reached levels not seen since the late 1990s. However, upon closer examination, I saw a more mixed picture. On the one hand, payroll gains, while slowing, were still averaging a very robust pace of more than 200,000 jobs per month. Data from that time suggest that workers were easily able to find jobs, and measures of layoffs were low by historical standards. In fact, in certain industries, such as health care as well as leisure and hospitality, employment had not yet returned to pre-pandemic levels. That raised questions about whether the supply of workers for those fields could keep pace with demand. But, on the other hand, the unemployment rate was flat instead of declining. This was puzzling considering a robust pace of payroll gains and the assumption that labor supply was constrained. And the two most important labor market surveys sent somewhat divergent signals. The payroll survey of employers showed hiring was abnormally above the gain recorded by the survey of households. Was the economy expanding at a robust pace, as indicated by the payroll survey? Or was it slowing more, as suggested by the household survey? In considering these questions, I interpreted the strong pace of payrolls from the establishment survey and the cooling of various measures of resource utilization as a signal that perhaps the official population estimates were understated to the downside. Starting at the end of 2023, I asked, what if substantial increases in the labor force due to the arrival of workers from other countries had not yet been picked up in Census estimates? We had seen something similar before. In the late 1990s, official measures of the population were substantially revised up due to mismeasured immigration. During this period, establishment and household counts of workers also significantly diverged. And a third puzzle, with inflation, also warrants attention. Inflation had steadily progressed toward the FOMC's target during 2023, perhaps faster than some economists expected. The personal consumption expenditures (PCE) price index eased from a peak of 7.2 percent in June 2022 to about 3 percent at the end of 2023, measured on a 12-month basis. When excluding volatile food and energy prices, core inflation similarly eased from a peak of 5.6 percent in February 2022 to 3 percent at the end of last year. Wage growth measures were consistent with inflation declining. ---[PAGE_BREAK]--- # Economic Developments This Year At the turn of the new year, new data and other economic developments appeared to cloud the picture further. An uptick in consumer spending and overall economic activity in the fourth quarter of 2023 as well as a stretch of above-trend hiring gave a signal of unexpected strength to start the year. Adding to the puzzling figures, core inflation rose 0.5 percent in January, a notable acceleration from an average monthly increase of 0.15 percent in the previous quarter. Stronger-than-expected economic activity, faster hiring, and a reacceleration of prices gave some economists pause: Was this a temporary acceleration, or a more sustained reheating of the economy? I viewed it as likely temporary, as it turned out to be. My view has always been that progress in the fight against inflation has to be judged from trends, not from a data release or two. I also anticipated that the process of bringing down inflation was likely to be sometimes bumpy. However, I viewed the elevated inflation readings as partly stemming from seasonal and one-off factors not fully accounted for in the data. In addition, price changes in some categories are difficult to measure, as I have described in previous speeches. ${ }^{3}$ That is particularly true for certain services categories for which direct sources of prices are not available; for example, the cost of living in an owner-occupied home or costs associated with certain financial transactions. And, as I have also discussed, the slow adjustment in workers' wages and relative prices may have contributed to bumps on the road to disinflation. Indeed, by the second quarter of the year, it became clear that the earlier firmer inflation figures were indeed temporary. Inflation stepped back down to average monthly increases of less than 0.2 percent. A factor in that was a cooling labor market, which I will discuss in a moment. With the labor market less tight, wage growth leveled off, and that in turn allowed prices for labor-intensive services to moderate. There was another important development early this year: Estimates of population growth were revised substantially higher, according to a Congressional Budget Office report. ${ }^{4}$ The report showed about 6 million additional immigrants than were included in official estimates. Those workers added to the supply of labor, which had rebounded early in the pandemic recovery at a time when the unemployment rate was trending near half-century lows. That information was consistent with my hypothesis that the strength in the economy was in part due to a larger-than-estimated labor force, or what economists call a positive supply shock. You may be more familiar with negative shocks, like the pandemic causing constrained supply chains. But the increase of workers was a positive shock and is notable because the underlying demographics of the U.S. heading into the pandemic were consistent with a slow-growing population and lower labor force participation, and that dynamic got worse as the pandemic generated excess retirements and a fall in immigration. In terms of the labor market, I anticipated that after several months of strong job growth at the turn of the year, the labor market would cool significantly. And, indeed, by the middle of this year, the process of the labor market normalizing was taking shape. Payroll gains declined from an average pace of 260,000 in the first quarter to less than 200,000 in the second. Reports on the labor market included unusually large downward revisions to previous gains, and the unemployment rate moved higher, from 3.7 percent ---[PAGE_BREAK]--- in January to 4.1 percent in June. At this point, other economists quickly shifted from worrying about a labor market that might be too hot early in the year to one that might be cooling too quickly. As a Fed policymaker, I had to consider if this movement was consistent with our mandate for maximum employment. Even with the easing in the labor market, consumer spending and overall economic activity continued to show solid growth. The combination of strong spending data and a cooling labor market was confounding. In thinking about this, I examined the productivity data that I follow closely and did not see the type of productivity growth I would have expected based on several other observations of the economy. For example, new business formation had surged in the post-pandemic period. It has been shown that newer firms foster innovation and boost productivity growth. Business formation has remained elevated, from which I infer that the boost to productivity growth is not just a one-time phenomenon. Also, in the post-pandemic period, workers switched jobs at much higher rates than typical. This likely led to better matches where workers can find more productive uses of their skills. In some cases, immigrants filled job openings for which employers traditionally struggle to attract workers. Therefore, immigration can also contribute to improvements in job matches in specific but key sectors. As the economy reopened from the pandemic, many firms also invested in technology to substitute for workers, who were in short supply, which should support productivity gains. Emerging technologies, most notably artificial intelligence, may also be starting to contribute to enhanced productivity. Therefore, my speculation was that higher productivity was a possible explanation for the unusual combination of strong economic output, a cooling labor market, and declining inflation-even if it was not apparent in the quarterly data. That hunch was confirmed in September, when annual revisions to important economic data showed that economic activity and productivity growth had been stronger than previously estimated. The new figures indicated an average annual rate of productivity growth of 1.9 percent since 2020, notably higher than the approximate 1.4 percent annual rate in the five years before the pandemic. So that reveals our second positive shock: American workers have been more productive in recent years. This is a hugely important development because it increases the productive capacity of the economy and allows more rapid economic growth without overheating. What's more, revisions resulted in much better aligned GDP and GDI measures, and the two measures now also had much more aligned implications for productivity. In summary, the surprising and largely desirable outcomes for the economy in 2024 are easier to understand once we solve the puzzles I discussed. My thorough assessment of a wide range of data sources revealed that an unusual combination of reports over the past year were gradually resolved once we understood the two positive supply shocks I discussed: growth in the labor force due to an increase in immigration, and higher productivity growth. # Economic Outlook The data we have received in recent weeks have been consistent with the economic forces I described earlier. Real GDP increased at a 2.8 percent annual rate in the third ---[PAGE_BREAK]--- quarter. The latest readings of retail sales have been strong. If household demand remains resilient, that would support growth in the fourth quarter and into next year. Monthly payroll gains have eased from earlier in the year, consistent with a gradual cooling of the labor market. It was difficult to draw a clear signal from the most recent jobs report, due to significant effects from hurricanes and labor strikes. I look forward to reviewing additional labor data on Friday. The unemployment rate, at 4.1 percent in October, is near the level I judge as roughly consistent with our maximum-employment mandate. After rising earlier this year, the rate has stabilized, though this was partly due to some withdrawals from the labor force. That bears watching moving forward. The trend in immigration slowed in the second half of this year, and there is reason to expect immigration flows could further slow. I will closely monitor this data. Inflation readings released last week show that overall PCE prices rose 2.3 percent over the 12 months ending in October, and core PCE prices increased 2.8 percent. I still view those readings, as of now, as consistent with inflation on a path to return to our 2 percent goal, and I am encouraged that inflation expectations appear to remain well anchored. But they also show the job is not yet done. Housing services inflation, in particular, remains elevated. And while global inputs to inflation have been mostly modest in recent months, it is difficult to predict future pressures. I have observed that the trade policy uncertainty index has risen in recent months, likely reflecting risks of changes in trade policy. ${ }^{8}$ Of course, the incoming Administration and Congress have not enacted any policies yet, so it is too early to make judgements. Studying the specifics, when they come out, will be important, as trade policy may affect productivity and prices. I will make assessments about what the net effects of any policy changes will be on prices or employment and how the balance between the two legs of our mandate will be affected. # Outlook for Monetary Policy Given how the economy has developed this year, most notably the continuation of disinflation and a modest cooling in the labor market, I see the Fed's dual-mandate goals of maximum employment and price stability as being roughly in balance. In light of the progress toward our goals, my colleagues and I on the FOMC judged it appropriate to lower our policy rate in September and again last month. These actions were steps toward removing restraint, as we are in the process of moving policy toward a more neutral setting. Looking ahead, it is important to emphasize that policy is not on a preset course. I will make decisions meeting by meeting and carefully assess incoming data, the evolving outlook, and the balance of risks. While I have gained more confidence that the two positive supply shocks I described have helped create the solid economic conditions that are currently in place, I will vigilantly monitor for incoming risks or negative supply shocks that may undo the progress that we have achieved in reducing inflation. I view our current policy setting as well positioned to deal with any uncertainties we face in pursuing both sides of our dual mandate. Thank you for your time, and I look forward to your questions. ---[PAGE_BREAK]--- ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee. ${ }^{2}$ See Wolters Kluwer (2023), Blue Chip Economic Indicators, vol. 48 (December 8). ${ }^{3}$ See Adriana D. Kugler (2024), "The Challenges Facing Economic Measurement and Creative Solutions," speech delivered at the 21st Annual Economic Measurement Seminar, National Association for Business Economics Foundation, Washington, July 16 . ${ }^{4}$ See Congressional Budget Office (2024), The Demographic Outlook: 2024 to 2025 (Washington: CBO, January). ${ }^{5}$ See Dario Caldara, Matteo lacoviello, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2020), "The Economic Effects of Trade Policy Uncertainty," Journal of Monetary Economics, vol. 109 (January), pp. 38-59.	Adriana D Kugler	United States	https://www.bis.org/review/r241204b.pdf	Speech by Ms Adriana D Kugler, Member of the Board of Governors of the Federal Reserve System, at the Detroit Economic Club, Detroit, Michigan, 3 December 2024. Thank you, Jason, and thank you for the opportunity to speak here in Detroit today. This visit has allowed me to see the many encouraging signs in this region: growth here in downtown; the area's famously hard-working labor force; and the gritty Detroit Lions, with 11 wins this season and counting. The nation has taken notice. But, truly, one of my favorite parts of serving as a Governor on the Federal Reserve Board is visiting communities across the country and hearing directly from the families, workers, and businesses we serve. I am also glad to have the chance to speak with you near the end of the year. I think it is an appropriate time to look back and assess how the U.S. economy has developed over the course of 2024. I will also share with you my outlook and offer my views on U. S. monetary policy. I will start by saying that I view the economy as being in a good position after making significant progress in recent years toward our dual-mandate goals of maximum employment and stable prices. The labor market remains solid, and inflation appears to be on a sustainable path to our 2 percent goal, even if there have been some bumps along the way, as I will discuss later. Reaching this point for the economy was far from assured, especially if you reflect on the pandemic disruptions of nearly five years ago. Even the more recent performance of the economy, at least on the surface, has been surprising to many forecasters. Economic growth remained solid, while inflation moderated from its recent peak without the painful job losses that have often accompanied past efforts to counter high inflation. Heading into this year, that was not necessarily the forecast of many observers, who were expecting a notable deceleration of economic activity. For example, the Blue Chip Economic Indicators in December 2023 expected 1.3 percent GDP growth for all of 2024. More recent estimates show the economy is on track to grow at almost twice that rate this year. So how does one interpret these positive, if somewhat unexpected, results? For me, I turned to looking at not just the realities around me and listening to people around the country, but also to my background as an academic researcher who uses an evidencebased approach to recognize two very important developments that have shaped the economy this year: growth in the labor force stemming from an increase in immigration, and a surge in productivity. I have been closely monitoring these developments and discussing them for more than a year. Entering this year, I took notice of several peculiar puzzles that seemed to be playing out in the economy. In terms of overall growth, I noticed a significant divergence between two important measures of output: gross domestic product, or GDP, and gross domestic income, or GDI. While, over time, these two gauges should move together, they appeared to be out of sync heading into this year. The GDI data suggested rather anemic growth, averaging about 1 percent a quarter in 2023, contrary to very strong GDP readings of more than 2.5 percent. The two measures of output had contrasting implications for productivity growth. There was a second puzzle in the labor market. Many forecasters expected that the labor market would remain somewhat tight this year, as rebalancing in the labor market had already attracted a large fraction of the available working-age population: The labor force participation of prime-age workers had reached levels not seen since the late 1990s. However, upon closer examination, I saw a more mixed picture. On the one hand, payroll gains, while slowing, were still averaging a very robust pace of more than 200,000 jobs per month. Data from that time suggest that workers were easily able to find jobs, and measures of layoffs were low by historical standards. In fact, in certain industries, such as health care as well as leisure and hospitality, employment had not yet returned to pre-pandemic levels. That raised questions about whether the supply of workers for those fields could keep pace with demand. But, on the other hand, the unemployment rate was flat instead of declining. This was puzzling considering a robust pace of payroll gains and the assumption that labor supply was constrained. And the two most important labor market surveys sent somewhat divergent signals. The payroll survey of employers showed hiring was abnormally above the gain recorded by the survey of households. Was the economy expanding at a robust pace, as indicated by the payroll survey? Or was it slowing more, as suggested by the household survey? In considering these questions, I interpreted the strong pace of payrolls from the establishment survey and the cooling of various measures of resource utilization as a signal that perhaps the official population estimates were understated to the downside. Starting at the end of 2023, I asked, what if substantial increases in the labor force due to the arrival of workers from other countries had not yet been picked up in Census estimates? We had seen something similar before. In the late 1990s, official measures of the population were substantially revised up due to mismeasured immigration. During this period, establishment and household counts of workers also significantly diverged. And a third puzzle, with inflation, also warrants attention. Inflation had steadily progressed toward the FOMC's target during 2023, perhaps faster than some economists expected. The personal consumption expenditures (PCE) price index eased from a peak of 7.2 percent in June 2022 to about 3 percent at the end of 2023, measured on a 12-month basis. When excluding volatile food and energy prices, core inflation similarly eased from a peak of 5.6 percent in February 2022 to 3 percent at the end of last year. Wage growth measures were consistent with inflation declining. At the turn of the new year, new data and other economic developments appeared to cloud the picture further. An uptick in consumer spending and overall economic activity in the fourth quarter of 2023 as well as a stretch of above-trend hiring gave a signal of unexpected strength to start the year. Adding to the puzzling figures, core inflation rose 0.5 percent in January, a notable acceleration from an average monthly increase of 0.15 percent in the previous quarter. Stronger-than-expected economic activity, faster hiring, and a reacceleration of prices gave some economists pause: Was this a temporary acceleration, or a more sustained reheating of the economy? I viewed it as likely temporary, as it turned out to be. My view has always been that progress in the fight against inflation has to be judged from trends, not from a data release or two. I also anticipated that the process of bringing down inflation was likely to be sometimes bumpy. However, I viewed the elevated inflation readings as partly stemming from seasonal and one-off factors not fully accounted for in the data. In addition, price changes in some categories are difficult to measure, as I have described in previous speeches. That is particularly true for certain services categories for which direct sources of prices are not available; for example, the cost of living in an owner-occupied home or costs associated with certain financial transactions. And, as I have also discussed, the slow adjustment in workers' wages and relative prices may have contributed to bumps on the road to disinflation. Indeed, by the second quarter of the year, it became clear that the earlier firmer inflation figures were indeed temporary. Inflation stepped back down to average monthly increases of less than 0.2 percent. A factor in that was a cooling labor market, which I will discuss in a moment. With the labor market less tight, wage growth leveled off, and that in turn allowed prices for labor-intensive services to moderate. There was another important development early this year: Estimates of population growth were revised substantially higher, according to a Congressional Budget Office report. The report showed about 6 million additional immigrants than were included in official estimates. Those workers added to the supply of labor, which had rebounded early in the pandemic recovery at a time when the unemployment rate was trending near half-century lows. That information was consistent with my hypothesis that the strength in the economy was in part due to a larger-than-estimated labor force, or what economists call a positive supply shock. You may be more familiar with negative shocks, like the pandemic causing constrained supply chains. But the increase of workers was a positive shock and is notable because the underlying demographics of the U.S. heading into the pandemic were consistent with a slow-growing population and lower labor force participation, and that dynamic got worse as the pandemic generated excess retirements and a fall in immigration. In terms of the labor market, I anticipated that after several months of strong job growth at the turn of the year, the labor market would cool significantly. And, indeed, by the middle of this year, the process of the labor market normalizing was taking shape. Payroll gains declined from an average pace of 260,000 in the first quarter to less than 200,000 in the second. Reports on the labor market included unusually large downward revisions to previous gains, and the unemployment rate moved higher, from 3.7 percent in January to 4.1 percent in June. At this point, other economists quickly shifted from worrying about a labor market that might be too hot early in the year to one that might be cooling too quickly. As a Fed policymaker, I had to consider if this movement was consistent with our mandate for maximum employment. Even with the easing in the labor market, consumer spending and overall economic activity continued to show solid growth. The combination of strong spending data and a cooling labor market was confounding. In thinking about this, I examined the productivity data that I follow closely and did not see the type of productivity growth I would have expected based on several other observations of the economy. For example, new business formation had surged in the post-pandemic period. It has been shown that newer firms foster innovation and boost productivity growth. Business formation has remained elevated, from which I infer that the boost to productivity growth is not just a one-time phenomenon. Also, in the post-pandemic period, workers switched jobs at much higher rates than typical. This likely led to better matches where workers can find more productive uses of their skills. In some cases, immigrants filled job openings for which employers traditionally struggle to attract workers. Therefore, immigration can also contribute to improvements in job matches in specific but key sectors. As the economy reopened from the pandemic, many firms also invested in technology to substitute for workers, who were in short supply, which should support productivity gains. Emerging technologies, most notably artificial intelligence, may also be starting to contribute to enhanced productivity. Therefore, my speculation was that higher productivity was a possible explanation for the unusual combination of strong economic output, a cooling labor market, and declining inflation-even if it was not apparent in the quarterly data. That hunch was confirmed in September, when annual revisions to important economic data showed that economic activity and productivity growth had been stronger than previously estimated. The new figures indicated an average annual rate of productivity growth of 1.9 percent since 2020, notably higher than the approximate 1.4 percent annual rate in the five years before the pandemic. So that reveals our second positive shock: American workers have been more productive in recent years. This is a hugely important development because it increases the productive capacity of the economy and allows more rapid economic growth without overheating. What's more, revisions resulted in much better aligned GDP and GDI measures, and the two measures now also had much more aligned implications for productivity. In summary, the surprising and largely desirable outcomes for the economy in 2024 are easier to understand once we solve the puzzles I discussed. My thorough assessment of a wide range of data sources revealed that an unusual combination of reports over the past year were gradually resolved once we understood the two positive supply shocks I discussed: growth in the labor force due to an increase in immigration, and higher productivity growth. The data we have received in recent weeks have been consistent with the economic forces I described earlier. Real GDP increased at a 2.8 percent annual rate in the third quarter. The latest readings of retail sales have been strong. If household demand remains resilient, that would support growth in the fourth quarter and into next year. Monthly payroll gains have eased from earlier in the year, consistent with a gradual cooling of the labor market. It was difficult to draw a clear signal from the most recent jobs report, due to significant effects from hurricanes and labor strikes. I look forward to reviewing additional labor data on Friday. The unemployment rate, at 4.1 percent in October, is near the level I judge as roughly consistent with our maximum-employment mandate. After rising earlier this year, the rate has stabilized, though this was partly due to some withdrawals from the labor force. That bears watching moving forward. The trend in immigration slowed in the second half of this year, and there is reason to expect immigration flows could further slow. I will closely monitor this data. Inflation readings released last week show that overall PCE prices rose 2.3 percent over the 12 months ending in October, and core PCE prices increased 2.8 percent. I still view those readings, as of now, as consistent with inflation on a path to return to our 2 percent goal, and I am encouraged that inflation expectations appear to remain well anchored. But they also show the job is not yet done. Housing services inflation, in particular, remains elevated. And while global inputs to inflation have been mostly modest in recent months, it is difficult to predict future pressures. I have observed that the trade policy uncertainty index has risen in recent months, likely reflecting risks of changes in trade policy. Of course, the incoming Administration and Congress have not enacted any policies yet, so it is too early to make judgements. Studying the specifics, when they come out, will be important, as trade policy may affect productivity and prices. I will make assessments about what the net effects of any policy changes will be on prices or employment and how the balance between the two legs of our mandate will be affected. Given how the economy has developed this year, most notably the continuation of disinflation and a modest cooling in the labor market, I see the Fed's dual-mandate goals of maximum employment and price stability as being roughly in balance. In light of the progress toward our goals, my colleagues and I on the FOMC judged it appropriate to lower our policy rate in September and again last month. These actions were steps toward removing restraint, as we are in the process of moving policy toward a more neutral setting. Looking ahead, it is important to emphasize that policy is not on a preset course. I will make decisions meeting by meeting and carefully assess incoming data, the evolving outlook, and the balance of risks. While I have gained more confidence that the two positive supply shocks I described have helped create the solid economic conditions that are currently in place, I will vigilantly monitor for incoming risks or negative supply shocks that may undo the progress that we have achieved in reducing inflation. I view our current policy setting as well positioned to deal with any uncertainties we face in pursuing both sides of our dual mandate. Thank you for your time, and I look forward to your questions.
2024-12-04T00:00:00	Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 4 December 2024.	Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 4 December 2024. * * * Charts accompanying the speech I am pleased to return to this Committee to discuss the ECB's monetary policy at such a critical juncture for Europe. We are witnessing a rapidly shifting geopolitical landscape, but also enduring major structural challenges to our economic model. Europe's response must be swift. It should focus on spurring investment, fostering innovation and raising productivity. This will require bold policy action and, together with the new European Commission and the Council, this Parliament will have an important role to play. In my remarks today, I will discuss an important element of this response - the new economic governance framework - which you have chosen as one of the topics of this hearing. But I would like to start by updating you on the ECB's assessment of the euro area economy and our monetary policy stance. The economic outlook and the ECB's monetary policy stance The euro area saw moderate growth in the first half of this year, following five quarters of stagnation. Real GDP growth was largely driven by exports and government consumption. Domestic private demand remained weak amid high economic policy uncertainty and the effects of past monetary policy tightening. More recently, in the third quarter, real GDP rose by 0.4%, driven in part by temporary factors such as the Paris Olympics. However, survey-based data suggest that growth will be weaker in the short term, on the back of slowing growth in the services sector and a continued contraction in manufacturing. Further ahead, the euro area's economic recovery should start to gather some steam. Consumer spending is expected to pick up as real incomes rise, and investment is expected to recover as the impact of past monetary policy tightening fades. The euro area labour market has so far proven resilient. The unemployment rate remained historically low at 6.3% in October, while employment expanded by 300,000 jobs in the third quarter. At the same time, surveys point to slowing employment growth and further moderation in the demand for labour. The medium-term economic outlook is uncertain, however, and dominated by downside risks. Geopolitical risks are elevated, with growing threats to international trade. High degrees of trade openness and integration into global supply chains make the euro area vulnerable to foreign shocks, with potential trade barriers posing threats to manufacturing and investment. Turning to inflation, headline inflation increased further to 2.3% in November from 2.0% in October, according to Eurostat's flash estimate. The increase in the last two months - following a deceleration in previous months - was driven mainly by a moderation in the fall in energy prices and an increase in food inflation. Core inflation - excluding energy and food - remained unchanged at 2.7% in November and is expected to hover around current levels until early 2025. Services inflation remains the biggest contributor to inflation and stood at 3.9% in November, driven in part by recent high wage growth. Overall, growth in labour costs has been moderating in recent quarters - notwithstanding the volatility of negotiated wage growth over the summer - and is set to continue easing. Domestic inflationary pressures are also receding as profits have been buffering still elevated labour cost developments. Looking ahead, inflation is expected to temporarily increase in the fourth quarter of this year, as previous sharp falls in energy prices drop out of the annual rates, before declining to target in the course of next year. Let me now turn to our monetary policy stance. In October the ECB lowered its key interest rates by 25 basis points, following the previous rate cuts in June and September. The information available at our October meeting confirmed that the disinflationary process was well on track. Our deposit facility rate, the rate through which we steer the monetary policy stance, now stands at 3.25%. We will review our stance again next week, following our data-dependent and meetingby-meeting approach. We are therefore not pre-committing to a particular rate path. The new economic governance framework Let me turn now to the second topic you have chosen for our hearing today - the EU's new economic governance framework. Fiscal policy is essential to address the multiple challenges Europe is currently facing, ranging from the green and digital transitions to economic security and defence. But for fiscal policy to be credible and powerful, it also needs to rest on strong foundations. The EU's new economic governance framework strikes a balance between ensuring medium-term fiscal sustainability and fostering strategic investments and growthenhancing reforms. If implemented effectively, it will provide three major benefits. First, it can help address the challenges related to elevated debt levels, which have partly arisen from policies designed to buffer the impact of recent crises across the economy. The framework focuses on debt sustainability, thereby also supporting monetary policy transmission. Second, the framework strives to balance gradual and sustained fiscal consolidation with incentives for much-needed investment and structural reforms. It introduces the possibility of extending fiscal adjustment paths from four to seven years. Such extensions are contingent on growth-enhancing investments and reforms being implemented, which would in turn further strengthen debt sustainability by raising potential growth. Reducing high debt levels also increases the space for strategic investments at the national and European levels. Third, the new framework can help to make the fiscal stance more countercyclical, smoothing out economic fluctuations and thereby supporting long-term growth in conditions of price stability. Implementing the revised economic governance framework fully and transparently is thus key to safeguarding Member States' capacity to invest now and in the future. The challenges we face also require us to rethink the EU's role in addressing strategic investment needs. As Enrico Letta and Mario Draghi observed in their reports, Europe is currently falling short of its potential. A key idea running through the reports is that Europe is bigger than its constituent parts. Well-defined joint EU investments would boost potential growth and contribute to macroeconomic stability. They would allow us to harness economies of scale and address cross-border challenges, to the benefit of all Europeans, adding value beyond what national investments could achieve alone. They would also send a strong signal of unity to private investors within and outside the EU. Such investments must be accompanied by coordinated and ambitious reform efforts. At the EU level, completing the capital markets union, which we discussed in my previous hearing before this committee, and deepening the Single Market are essential. Member States also play a crucial role in reducing obstacles to entrepreneurship, helping firms to innovate and grow and aiding the efficient allocation of capital and labour. Progress towards closer European integration paired with national reform efforts is essential for a more dynamic and competitive economy - one that supports citizens' standards of living and enables businesses to thrive. Conclusion Let me now conclude. Europe's geopolitical and structural challenges require coordinated and determined action from policymakers. As the Greek storyteller Aesop wisely said, "In union there is strength", and citizens' trust in the European Union is at its highest level in over 15 1 years. The Commission has set an ambitious policy agenda to tackle these challenges, which you have endorsed. It is now up to you to make it happen. The ECB will play its role in supporting Europe's longer-term sustainable growth by fulfilling its mandate of price stability. Thank you for your attention. I now look forward to your questions. European Commission (2024), Standard Eurobarometer 102 - Autumn 2024.	---[PAGE_BREAK]--- # Christine Lagarde: Hearing of the Committee on Economic and Monetary Affairs of the European Parliament Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 4 December 2024. ## Charts accompanying the speech I am pleased to return to this Committee to discuss the ECB's monetary policy at such a critical juncture for Europe. We are witnessing a rapidly shifting geopolitical landscape, but also enduring major structural challenges to our economic model. Europe's response must be swift. It should focus on spurring investment, fostering innovation and raising productivity. This will require bold policy action and, together with the new European Commission and the Council, this Parliament will have an important role to play. In my remarks today, I will discuss an important element of this response - the new economic governance framework - which you have chosen as one of the topics of this hearing. But I would like to start by updating you on the ECB's assessment of the euro area economy and our monetary policy stance. ## The economic outlook and the ECB's monetary policy stance The euro area saw moderate growth in the first half of this year, following five quarters of stagnation. Real GDP growth was largely driven by exports and government consumption. Domestic private demand remained weak amid high economic policy uncertainty and the effects of past monetary policy tightening. More recently, in the third quarter, real GDP rose by $0.4 \%$, driven in part by temporary factors such as the Paris Olympics. However, survey-based data suggest that growth will be weaker in the short term, on the back of slowing growth in the services sector and a continued contraction in manufacturing. Further ahead, the euro area's economic recovery should start to gather some steam. Consumer spending is expected to pick up as real incomes rise, and investment is expected to recover as the impact of past monetary policy tightening fades. The euro area labour market has so far proven resilient. The unemployment rate remained historically low at $6.3 \%$ in October, while employment expanded by 300,000 jobs in the third quarter. At the same time, surveys point to slowing employment growth and further moderation in the demand for labour. The medium-term economic outlook is uncertain, however, and dominated by downside risks. Geopolitical risks are elevated, with growing threats to international trade. High degrees of trade openness and integration into global supply chains make the euro ---[PAGE_BREAK]--- area vulnerable to foreign shocks, with potential trade barriers posing threats to manufacturing and investment. Turning to inflation, headline inflation increased further to $2.3 \%$ in November from $2.0 \%$ in October, according to Eurostat's flash estimate. The increase in the last two months - following a deceleration in previous months - was driven mainly by a moderation in the fall in energy prices and an increase in food inflation. Core inflation - excluding energy and food - remained unchanged at 2.7\% in November and is expected to hover around current levels until early 2025. Services inflation remains the biggest contributor to inflation and stood at $3.9 \%$ in November, driven in part by recent high wage growth. Overall, growth in labour costs has been moderating in recent quarters - notwithstanding the volatility of negotiated wage growth over the summer - and is set to continue easing. Domestic inflationary pressures are also receding as profits have been buffering still elevated labour cost developments. Looking ahead, inflation is expected to temporarily increase in the fourth quarter of this year, as previous sharp falls in energy prices drop out of the annual rates, before declining to target in the course of next year. Let me now turn to our monetary policy stance. In October the ECB lowered its key interest rates by 25 basis points, following the previous rate cuts in June and September. The information available at our October meeting confirmed that the disinflationary process was well on track. Our deposit facility rate, the rate through which we steer the monetary policy stance, now stands at $3.25 \%$. We will review our stance again next week, following our data-dependent and meeting-by-meeting approach. We are therefore not pre-committing to a particular rate path. # The new economic governance framework Let me turn now to the second topic you have chosen for our hearing today - the EU's new economic governance framework. Fiscal policy is essential to address the multiple challenges Europe is currently facing, ranging from the green and digital transitions to economic security and defence. But for fiscal policy to be credible and powerful, it also needs to rest on strong foundations. The EU's new economic governance framework strikes a balance between ensuring medium-term fiscal sustainability and fostering strategic investments and growthenhancing reforms. If implemented effectively, it will provide three major benefits. First, it can help address the challenges related to elevated debt levels, which have partly arisen from policies designed to buffer the impact of recent crises across the economy. The framework focuses on debt sustainability, thereby also supporting monetary policy transmission. ---[PAGE_BREAK]--- Second, the framework strives to balance gradual and sustained fiscal consolidation with incentives for much-needed investment and structural reforms. It introduces the possibility of extending fiscal adjustment paths from four to seven years. Such extensions are contingent on growth-enhancing investments and reforms being implemented, which would in turn further strengthen debt sustainability by raising potential growth. Reducing high debt levels also increases the space for strategic investments at the national and European levels. Third, the new framework can help to make the fiscal stance more countercyclical, smoothing out economic fluctuations and thereby supporting long-term growth in conditions of price stability. Implementing the revised economic governance framework fully and transparently is thus key to safeguarding Member States' capacity to invest now and in the future. The challenges we face also require us to rethink the EU's role in addressing strategic investment needs. As Enrico Letta and Mario Draghi observed in their reports, Europe is currently falling short of its potential. A key idea running through the reports is that Europe is bigger than its constituent parts. Well-defined joint EU investments would boost potential growth and contribute to macroeconomic stability. They would allow us to harness economies of scale and address cross-border challenges, to the benefit of all Europeans, adding value beyond what national investments could achieve alone. They would also send a strong signal of unity to private investors within and outside the EU. Such investments must be accompanied by coordinated and ambitious reform efforts. At the EU level, completing the capital markets union, which we discussed in my previous hearing before this committee, and deepening the Single Market are essential. Member States also play a crucial role in reducing obstacles to entrepreneurship, helping firms to innovate and grow and aiding the efficient allocation of capital and labour. Progress towards closer European integration paired with national reform efforts is essential for a more dynamic and competitive economy - one that supports citizens' standards of living and enables businesses to thrive. # Conclusion Let me now conclude. Europe's geopolitical and structural challenges require coordinated and determined action from policymakers. As the Greek storyteller Aesop wisely said, "In union there is strength", and citizens' trust in the European Union is at its highest level in over 15 years. ${ }^{1}$ The Commission has set an ambitious policy agenda to tackle these challenges, which you have endorsed. It is now up to you to make it happen. The ECB will play its role in supporting Europe's longer-term sustainable growth by fulfilling its mandate of price stability. Thank you for your attention. I now look forward to your questions. ---[PAGE_BREAK]--- 1 European Commission (2024), Standard Eurobarometer 102 - Autumn 2024.	Christine Lagarde	Euro area	https://www.bis.org/review/r241206b.pdf	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 4 December 2024. I am pleased to return to this Committee to discuss the ECB's monetary policy at such a critical juncture for Europe. We are witnessing a rapidly shifting geopolitical landscape, but also enduring major structural challenges to our economic model. Europe's response must be swift. It should focus on spurring investment, fostering innovation and raising productivity. This will require bold policy action and, together with the new European Commission and the Council, this Parliament will have an important role to play. In my remarks today, I will discuss an important element of this response - the new economic governance framework - which you have chosen as one of the topics of this hearing. But I would like to start by updating you on the ECB's assessment of the euro area economy and our monetary policy stance. The euro area saw moderate growth in the first half of this year, following five quarters of stagnation. Real GDP growth was largely driven by exports and government consumption. Domestic private demand remained weak amid high economic policy uncertainty and the effects of past monetary policy tightening. More recently, in the third quarter, real GDP rose by $0.4 \%$, driven in part by temporary factors such as the Paris Olympics. However, survey-based data suggest that growth will be weaker in the short term, on the back of slowing growth in the services sector and a continued contraction in manufacturing. Further ahead, the euro area's economic recovery should start to gather some steam. Consumer spending is expected to pick up as real incomes rise, and investment is expected to recover as the impact of past monetary policy tightening fades. The euro area labour market has so far proven resilient. The unemployment rate remained historically low at $6.3 \%$ in October, while employment expanded by 300,000 jobs in the third quarter. At the same time, surveys point to slowing employment growth and further moderation in the demand for labour. The medium-term economic outlook is uncertain, however, and dominated by downside risks. Geopolitical risks are elevated, with growing threats to international trade. High degrees of trade openness and integration into global supply chains make the euro area vulnerable to foreign shocks, with potential trade barriers posing threats to manufacturing and investment. Turning to inflation, headline inflation increased further to $2.3 \%$ in November from $2.0 \%$ in October, according to Eurostat's flash estimate. The increase in the last two months - following a deceleration in previous months - was driven mainly by a moderation in the fall in energy prices and an increase in food inflation. Core inflation - excluding energy and food - remained unchanged at 2.7\% in November and is expected to hover around current levels until early 2025. Services inflation remains the biggest contributor to inflation and stood at $3.9 \%$ in November, driven in part by recent high wage growth. Overall, growth in labour costs has been moderating in recent quarters - notwithstanding the volatility of negotiated wage growth over the summer - and is set to continue easing. Domestic inflationary pressures are also receding as profits have been buffering still elevated labour cost developments. Looking ahead, inflation is expected to temporarily increase in the fourth quarter of this year, as previous sharp falls in energy prices drop out of the annual rates, before declining to target in the course of next year. Let me now turn to our monetary policy stance. In October the ECB lowered its key interest rates by 25 basis points, following the previous rate cuts in June and September. The information available at our October meeting confirmed that the disinflationary process was well on track. Our deposit facility rate, the rate through which we steer the monetary policy stance, now stands at $3.25 \%$. We will review our stance again next week, following our data-dependent and meeting-by-meeting approach. We are therefore not pre-committing to a particular rate path. Let me turn now to the second topic you have chosen for our hearing today - the EU's new economic governance framework. Fiscal policy is essential to address the multiple challenges Europe is currently facing, ranging from the green and digital transitions to economic security and defence. But for fiscal policy to be credible and powerful, it also needs to rest on strong foundations. The EU's new economic governance framework strikes a balance between ensuring medium-term fiscal sustainability and fostering strategic investments and growthenhancing reforms. If implemented effectively, it will provide three major benefits. First, it can help address the challenges related to elevated debt levels, which have partly arisen from policies designed to buffer the impact of recent crises across the economy. The framework focuses on debt sustainability, thereby also supporting monetary policy transmission. Second, the framework strives to balance gradual and sustained fiscal consolidation with incentives for much-needed investment and structural reforms. It introduces the possibility of extending fiscal adjustment paths from four to seven years. Such extensions are contingent on growth-enhancing investments and reforms being implemented, which would in turn further strengthen debt sustainability by raising potential growth. Reducing high debt levels also increases the space for strategic investments at the national and European levels. Third, the new framework can help to make the fiscal stance more countercyclical, smoothing out economic fluctuations and thereby supporting long-term growth in conditions of price stability. Implementing the revised economic governance framework fully and transparently is thus key to safeguarding Member States' capacity to invest now and in the future. The challenges we face also require us to rethink the EU's role in addressing strategic investment needs. As Enrico Letta and Mario Draghi observed in their reports, Europe is currently falling short of its potential. A key idea running through the reports is that Europe is bigger than its constituent parts. Well-defined joint EU investments would boost potential growth and contribute to macroeconomic stability. They would allow us to harness economies of scale and address cross-border challenges, to the benefit of all Europeans, adding value beyond what national investments could achieve alone. They would also send a strong signal of unity to private investors within and outside the EU. Such investments must be accompanied by coordinated and ambitious reform efforts. At the EU level, completing the capital markets union, which we discussed in my previous hearing before this committee, and deepening the Single Market are essential. Member States also play a crucial role in reducing obstacles to entrepreneurship, helping firms to innovate and grow and aiding the efficient allocation of capital and labour. Progress towards closer European integration paired with national reform efforts is essential for a more dynamic and competitive economy - one that supports citizens' standards of living and enables businesses to thrive. Let me now conclude. Europe's geopolitical and structural challenges require coordinated and determined action from policymakers. As the Greek storyteller Aesop wisely said, "In union there is strength", and citizens' trust in the European Union is at its highest level in over 15 years. The Commission has set an ambitious policy agenda to tackle these challenges, which you have endorsed. It is now up to you to make it happen. The ECB will play its role in supporting Europe's longer-term sustainable growth by fulfilling its mandate of price stability. Thank you for your attention. I now look forward to your questions.
2024-12-05T00:00:00	Patrick Montagner: Learning from the past, preparing for the future	Keynote speech by Mr Patrick Montagner, Member of the Supervisory Board of the European Central Bank, at the 11th Institute of International Finance (IIF) Colloquium on European Banking Regulation and Supervision, Frankfurt am Main, 5 December 2024.	Patrick Montagner: Learning from the past, preparing for the future Keynote speech by Mr Patrick Montagner, Member of the Supervisory Board of the European Central Bank, at the 11th Institute of International Finance (IIF) Colloquium on European Banking Regulation and Supervision, Frankfurt am Main, 5 December 2024. * * * Thank you for inviting me to speak here in my new capacity as a member of the ECB's Supervisory Board. I've been asked to give you the ECB's view on the preparedness and competitiveness of the EU's banking system, and on how the regulatory and supervisory framework can foster conditions that help to balance growth and resilience. Above all, a resilient banking sector is a precondition for economic growth. That's why the Basel Committee on Banking Supervision has just publicly reaffirmed its expectation concerning the Basel III framework being implemented in full, consistently and as soon as possible. Let me first recall some facts about the recent past. The aim of prudential supervision is not to avoid all risks, but to have sufficient confidence in the preparedness of each individual bank to face all its risks. A cornerstone of what we do is assessing whether all material risks are being properly managed by the banks. If we look back on the great financial crisis, we can see that there were a lot of imbalances within the global economy. On top of that, the banking sector was not prepared to face these shocks and had taken a lot of risks which had either not been assessed properly or, in some cases, not assessed at all. This was mainly due to the race to the bottom in financial regulation that started in the 1990s, driven by the belief that light regulation and supervision could act as a catalyst for economic growth. Up until 2014, we were faced with huge fragmentation within the EU, with different adaptations of the Capital Requirements 1 Directive , different supervisory practices and different requirements. And the banking sector itself was complaining about this situation, with each bank thinking its competitors were benefiting from a friendlier regime. The result was the worst depletion of wealth since the Great Depression of the 1930s, including a huge bailout by taxpayers and the failure of several major banks - unable to survive due to their poor governance and risk culture. Turning to the current situation, we can all be satisfied with how far we have come in the last ten years. Over the past decade the overall profitability of European banks has increased. In 2024 banks under European banking supervision reported a return on equity of around 10%, compared with 6% in 2015. Banks' return on assets rose from 0.4% to 0.7% over the same period. During the years of low interest rates and low inflation profitability was much lower and it only recovered when interest rates increased. The non-performing loans ratio has decreased dramatically, from 7% in 2015 to below 2% today. Meanwhile, all banks under European banking supervision, whether significant or less significant, are now subject to the same supervisory standards - applied in the same way across all 21 countries. And harmonisation with practices in the rest of the EU has also greatly improved. So, clearly, good regulation and good supervision have been essential to create a safe and harmonised level playing field and to allow the EU banking system to play its role in the economy without compromising banks' lending capacity. They have also helped banks withstand some unexpected turmoil in recent years: Russia's war of aggression in Ukraine and the energy supply shock, as well as the banking turmoil of March 2023 in some other countries. Weakening banking regulation and supervision would not boost the competitiveness of the EU economy. The issue of competitiveness should be addressed in a different way and the recent report by Mario Draghi has delivered some key messages, notably the need to encourage innovation and productivity in the European Union. We all know that there are still significant discrepancies between countries that could create market distortions, in particular discrepancies in tax and corporate insolvency laws. Achieving a harmonised single market also requires structural reform in all countries. I won't repeat here the rationale behind the need to create a truly single market for capital, but I would nevertheless like to emphasise that we need to complete the banking union. This requires, first, a fully-fledged European deposit insurance scheme and, second, a stronger European framework for crisis management (and here I am referring to the crisis management and deposit insurance, or CMDI, framework). Both will promote integration and reduce national fragmentation. A more integrated European banking sector will be more efficient and competitive. Of course, the ECB remains open to discussing possible simplifications and streamlining of its approach to banking supervision. The reform of our Supervisory Review and Evaluation Process (SREP) is one key element. Changes will be implemented gradually, starting in the second half of 2024, and will be finalised for the 2026 SREP cycle. The SREP reform will enable us to be more efficient, more comprehensive, and more effective - and will enhance our communication with banks. Allow me to elaborate further on my point by taking climate and nature-related risks as an example. The EU legislator did not invent climate risk or the burden of ensuring an orderly transition. The risk has been around for a long time. The Intergovernmental Panel on Climate Change (IPCC) was created in 1988 to provide scientific assessments and recommendations related to the current state of knowledge about climate change. The Paris Agreement was adopted in 2015 at the UN Climate Change Conference 2 COP21 after the Fifth Assessment Report of the IPCC. So clearly, all the facts have been on the table for decades. The latest tragedy in Spain has shown that the financial cost can severely hit the economy, not just at the regional but also at the national level. And we have many other recent examples showing the macro-financial relevance of climate and nature-related risks. On the one hand, the cost of the transition will be high. On the other hand, analysis consistently confirms that the costs of doing too little too late are much higher. The ECB supervisory stress test in 2022 confirmed this analysis for the banking sector. The reinsurance sector, which is exposed to natural catastrophes more routinely than the banking sector, has clearly understood this and shown that, without rapid adaptation, insurance could become unaffordable in some regions. Regrettably, the prevailing consensus in climate science tells us that we are far from on track to meet the goal of limiting global heating to two degrees Celsius, as set out in the Paris Agreement. Diluting regulation, supervisory intensity and effectiveness will do nothing to change the scale and magnitude of these risks, either in the very near future or in the medium and long term. Instead, we need to renew our efforts and banks need to demonstrate their ability to correctly assess and properly manage these risks - risks which will undoubtedly have a negative impact on their profitability and resilience. Digitalisation is another important factor that will drive bank profitability in the future. And once again, the facts leave no room for doubt. Customers expect the same from their banks as they do from any other business: they want to be able to easily access all of the services associated with their bank account. Banks also now face competition from newcomers that are not held back by legacy IT systems. They will therefore need to implement efficient digital solutions for their customers, find economies of scale and ensure the highest levels of IT security. At the same time, digitalisation doesn't mean the end of face-to-face interactions between banks and their customers: some people still want to go into their local branch in person, especially older people and those carrying out more complex financial transactions. The ability to respond to customers' evolving needs will be crucial for the future of established banks. They are facing competition from new financial service providers that are trying to attract business in the most profitable segment of banking operations: payments. In addition, banks need to make major investments in their cyber and IT resilience to stay at the forefront of technological developments and prevent disruptions or breaches. Investment in IT will be key to ensuring the banking sector remains sound and competitive in the future. Economies of scale and a more integrated EU market are likely to be needed in order to absorb the cost and boost profitability. That's a key point: IT investment needs to be strengthened to maintain competitiveness vis-à-vis US 3 peers. A study last year observed that the annual IT budget for US global systemically important banks (G-SIBs) in 2021 was around 0.36% of total assets, compared with 0.19% for euro area G-SIBs. Therefore, one of our supervisory priorities at the ECB is assessing how banks formulate, implement and monitor their digitalisation strategies, and how they manage the related risks. Building on our findings and surveys, we recently published criteria and best practices for banks' digital activities.4 But some questions related to technology are far from being solved. Generative artificial intelligence (AI) tools have the potential to transform some parts of the banking business, although as yet there is no clear evidence that they have been fully incorporated into banks' digitalisation strategies. Crucially, consumer rights and privacy must also be respected when issues related to AI are being addressed. And without good IT systems, AI tools won't be correctly fed by banks' data. Let me conclude. The ECB's mandate to keep banks safe and sound makes a critical contribution to the overall competitiveness of the banking sector. And this works both ways, as the resilience of the banking sector is also about its competitiveness. We are therefore looking closely at the sustainability of banks' business models and their future profitability. Moreover, by establishing a harmonised framework for its supervisory activities through the Single Rulebook, the ECB has reduced the fragmentation that existed previously. And the SREP reform is another important milestone in our efforts to better assess risks while stabilising the methodologies we use. However, much of the work that still needs to be done falls outside of the ECB's remit. A strong supervisory framework plays a key role in supporting the growth and competitiveness of the economy but will never replace the need for structural reforms to boost productivity. Other factors will also play a major role, such as changing demographics, including ageing societies, and geopolitical risks. Overall, the profitability of European banks has increased significantly in recent years, but they need to continue adapting to a changing environment presenting a cluster of challenges. Long-term investment and a strong capital base will be crucial for banks to meet these challenges. From the ECB's perspective, there is no room for complacency. 1 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176, 27.6.2013, p. 338). 2 Conference of the Parties (or "COP") to the United Nations Framework Convention on Climate Change (UNFCCC). 3 Di Vito, L., Martín Fuentes, N. and Matos Leite, J. (2023), "Understanding the profitability gap between euro area and US global systemically important banks ", Occasional Paper Series , No 327, ECB, August. 4 ECB (2024), Digitalisation: key assessment criteria and collection of sound practices , 11 July.	---[PAGE_BREAK]--- # Patrick Montagner: Learning from the past, preparing for the future Keynote speech by Mr Patrick Montagner, Member of the Supervisory Board of the European Central Bank, at the 11th Institute of International Finance (IIF) Colloquium on European Banking Regulation and Supervision, Frankfurt am Main, 5 December 2024. Thank you for inviting me to speak here in my new capacity as a member of the ECB's Supervisory Board. I've been asked to give you the ECB's view on the preparedness and competitiveness of the EU's banking system, and on how the regulatory and supervisory framework can foster conditions that help to balance growth and resilience. Above all, a resilient banking sector is a precondition for economic growth. That's why the Basel Committee on Banking Supervision has just publicly reaffirmed its expectation concerning the Basel III framework being implemented in full, consistently and as soon as possible. Let me first recall some facts about the recent past. The aim of prudential supervision is not to avoid all risks, but to have sufficient confidence in the preparedness of each individual bank to face all its risks. A cornerstone of what we do is assessing whether all material risks are being properly managed by the banks. If we look back on the great financial crisis, we can see that there were a lot of imbalances within the global economy. On top of that, the banking sector was not prepared to face these shocks and had taken a lot of risks which had either not been assessed properly or, in some cases, not assessed at all. This was mainly due to the race to the bottom in financial regulation that started in the 1990s, driven by the belief that light regulation and supervision could act as a catalyst for economic growth. Up until 2014, we were faced with huge fragmentation within the EU, with different adaptations of the Capital Requirements Directive ${ }^{1}$, different supervisory practices and different requirements. And the banking sector itself was complaining about this situation, with each bank thinking its competitors were benefiting from a friendlier regime. The result was the worst depletion of wealth since the Great Depression of the 1930s, including a huge bailout by taxpayers and the failure of several major banks - unable to survive due to their poor governance and risk culture. Turning to the current situation, we can all be satisfied with how far we have come in the last ten years. Over the past decade the overall profitability of European banks has increased. In 2024 banks under European banking supervision reported a return on equity of around $10 \%$, compared with $6 \%$ in 2015. Banks' return on assets rose from $0.4 \%$ to $0.7 \%$ over the same period. During the years of low interest rates and low inflation profitability was much lower and it only recovered when interest rates increased. The non-performing loans ratio has decreased dramatically, from 7\% in 2015 to below 2\% today. Meanwhile, all banks under European banking supervision, whether significant or less significant, are now subject to the same supervisory standards applied in the same way across all 21 countries. And harmonisation with practices in the rest of the EU has also greatly improved. ---[PAGE_BREAK]--- So, clearly, good regulation and good supervision have been essential to create a safe and harmonised level playing field and to allow the EU banking system to play its role in the economy without compromising banks' lending capacity. They have also helped banks withstand some unexpected turmoil in recent years: Russia's war of aggression in Ukraine and the energy supply shock, as well as the banking turmoil of March 2023 in some other countries. Weakening banking regulation and supervision would not boost the competitiveness of the EU economy. The issue of competitiveness should be addressed in a different way and the recent report by Mario Draghi has delivered some key messages, notably the need to encourage innovation and productivity in the European Union. We all know that there are still significant discrepancies between countries that could create market distortions, in particular discrepancies in tax and corporate insolvency laws. Achieving a harmonised single market also requires structural reform in all countries. I won't repeat here the rationale behind the need to create a truly single market for capital, but I would nevertheless like to emphasise that we need to complete the banking union. This requires, first, a fully-fledged European deposit insurance scheme and, second, a stronger European framework for crisis management (and here I am referring to the crisis management and deposit insurance, or CMDI, framework). Both will promote integration and reduce national fragmentation. A more integrated European banking sector will be more efficient and competitive. Of course, the ECB remains open to discussing possible simplifications and streamlining of its approach to banking supervision. The reform of our Supervisory Review and Evaluation Process (SREP) is one key element. Changes will be implemented gradually, starting in the second half of 2024, and will be finalised for the 2026 SREP cycle. The SREP reform will enable us to be more efficient, more comprehensive, and more effective - and will enhance our communication with banks. Allow me to elaborate further on my point by taking climate and nature-related risks as an example. The EU legislator did not invent climate risk or the burden of ensuring an orderly transition. The risk has been around for a long time. The Intergovernmental Panel on Climate Change (IPCC) was created in 1988 to provide scientific assessments and recommendations related to the current state of knowledge about climate change. The Paris Agreement was adopted in 2015 at the UN Climate Change Conference COP21 ${ }^{2}$ after the Fifth Assessment Report of the IPCC. So clearly, all the facts have been on the table for decades. The latest tragedy in Spain has shown that the financial cost can severely hit the economy, not just at the regional but also at the national level. And we have many other recent examples showing the macro-financial relevance of climate and nature-related risks. On the one hand, the cost of the transition will be high. On the other hand, analysis consistently confirms that the costs of doing too little too late are much higher. The ECB supervisory stress test in 2022 confirmed this analysis for the banking sector. The reinsurance sector, which is exposed to natural catastrophes more routinely than the banking sector, has clearly understood this and shown that, without rapid adaptation, insurance could become unaffordable in some regions. Regrettably, the prevailing consensus in climate science tells us that we are far from on track to meet the goal of limiting global heating to two degrees Celsius, as set out in the Paris Agreement. Diluting regulation, supervisory intensity and effectiveness will do nothing to change the scale and magnitude of these risks, either in the very near future or in the medium and long term. Instead, we need to renew our efforts and banks ---[PAGE_BREAK]--- need to demonstrate their ability to correctly assess and properly manage these risks risks which will undoubtedly have a negative impact on their profitability and resilience. Digitalisation is another important factor that will drive bank profitability in the future. And once again, the facts leave no room for doubt. Customers expect the same from their banks as they do from any other business: they want to be able to easily access all of the services associated with their bank account. Banks also now face competition from newcomers that are not held back by legacy IT systems. They will therefore need to implement efficient digital solutions for their customers, find economies of scale and ensure the highest levels of IT security. At the same time, digitalisation doesn't mean the end of face-to-face interactions between banks and their customers: some people still want to go into their local branch in person, especially older people and those carrying out more complex financial transactions. The ability to respond to customers' evolving needs will be crucial for the future of established banks. They are facing competition from new financial service providers that are trying to attract business in the most profitable segment of banking operations: payments. In addition, banks need to make major investments in their cyber and IT resilience to stay at the forefront of technological developments and prevent disruptions or breaches. Investment in IT will be key to ensuring the banking sector remains sound and competitive in the future. Economies of scale and a more integrated EU market are likely to be needed in order to absorb the cost and boost profitability. That's a key point: IT investment needs to be strengthened to maintain competitiveness vis-à-vis US peers. A study last year ${ }^{3}$ observed that the annual IT budget for US global systemically important banks (G-SIBs) in 2021 was around 0.36\% of total assets, compared with $0.19 \%$ for euro area G-SIBs. Therefore, one of our supervisory priorities at the ECB is assessing how banks formulate, implement and monitor their digitalisation strategies, and how they manage the related risks. Building on our findings and surveys, we recently published criteria and best practices for banks' digital activities. ${ }^{4}$ But some questions related to technology are far from being solved. Generative artificial intelligence (AI) tools have the potential to transform some parts of the banking business, although as yet there is no clear evidence that they have been fully incorporated into banks' digitalisation strategies. Crucially, consumer rights and privacy must also be respected when issues related to AI are being addressed. And without good IT systems, AI tools won't be correctly fed by banks' data. Let me conclude. The ECB's mandate to keep banks safe and sound makes a critical contribution to the overall competitiveness of the banking sector. And this works both ways, as the resilience of the banking sector is also about its competitiveness. We are therefore looking closely at the sustainability of banks' business models and their future profitability. Moreover, by establishing a harmonised framework for its supervisory activities through the Single Rulebook, the ECB has reduced the fragmentation that existed previously. And the SREP reform is another important milestone in our efforts to better assess risks while stabilising the methodologies we use. However, much of the work that still needs to be done falls outside of the ECB's remit. A strong supervisory framework plays a key role in supporting the growth and competitiveness of the economy but will never replace the need for structural reforms to boost productivity. ---[PAGE_BREAK]--- Other factors will also play a major role, such as changing demographics, including ageing societies, and geopolitical risks. Overall, the profitability of European banks has increased significantly in recent years, but they need to continue adapting to a changing environment presenting a cluster of challenges. Long-term investment and a strong capital base will be crucial for banks to meet these challenges. From the ECB's perspective, there is no room for complacency. ${ }^{1}$ Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176, 27.6.2013, p. 338). ${ }^{2}$ Conference of the Parties (or "COP") to the United Nations Framework Convention on Climate Change (UNFCCC). ${ }^{3}$ Di Vito, L., Martín Fuentes, N. and Matos Leite, J. (2023), "Understanding the profitability gap between euro area and US global systemically important banks", Occasional Paper Series, No 327, ECB, August. ${ }^{4}$ ECB (2024), Digitalisation: key assessment criteria and collection of sound practices, 11 July.	Patrick Montagner	Euro area	https://www.bis.org/review/r241211b.pdf	Keynote speech by Mr Patrick Montagner, Member of the Supervisory Board of the European Central Bank, at the 11th Institute of International Finance (IIF) Colloquium on European Banking Regulation and Supervision, Frankfurt am Main, 5 December 2024. Thank you for inviting me to speak here in my new capacity as a member of the ECB's Supervisory Board. I've been asked to give you the ECB's view on the preparedness and competitiveness of the EU's banking system, and on how the regulatory and supervisory framework can foster conditions that help to balance growth and resilience. Above all, a resilient banking sector is a precondition for economic growth. That's why the Basel Committee on Banking Supervision has just publicly reaffirmed its expectation concerning the Basel III framework being implemented in full, consistently and as soon as possible. Let me first recall some facts about the recent past. The aim of prudential supervision is not to avoid all risks, but to have sufficient confidence in the preparedness of each individual bank to face all its risks. A cornerstone of what we do is assessing whether all material risks are being properly managed by the banks. If we look back on the great financial crisis, we can see that there were a lot of imbalances within the global economy. On top of that, the banking sector was not prepared to face these shocks and had taken a lot of risks which had either not been assessed properly or, in some cases, not assessed at all. This was mainly due to the race to the bottom in financial regulation that started in the 1990s, driven by the belief that light regulation and supervision could act as a catalyst for economic growth. Up until 2014, we were faced with huge fragmentation within the EU, with different adaptations of the Capital Requirements Directive , different supervisory practices and different requirements. And the banking sector itself was complaining about this situation, with each bank thinking its competitors were benefiting from a friendlier regime. The result was the worst depletion of wealth since the Great Depression of the 1930s, including a huge bailout by taxpayers and the failure of several major banks - unable to survive due to their poor governance and risk culture. Turning to the current situation, we can all be satisfied with how far we have come in the last ten years. Over the past decade the overall profitability of European banks has increased. In 2024 banks under European banking supervision reported a return on equity of around $10 \%$, compared with $6 \%$ in 2015. Banks' return on assets rose from $0.4 \%$ to $0.7 \%$ over the same period. During the years of low interest rates and low inflation profitability was much lower and it only recovered when interest rates increased. The non-performing loans ratio has decreased dramatically, from 7\% in 2015 to below 2\% today. Meanwhile, all banks under European banking supervision, whether significant or less significant, are now subject to the same supervisory standards applied in the same way across all 21 countries. And harmonisation with practices in the rest of the EU has also greatly improved. So, clearly, good regulation and good supervision have been essential to create a safe and harmonised level playing field and to allow the EU banking system to play its role in the economy without compromising banks' lending capacity. They have also helped banks withstand some unexpected turmoil in recent years: Russia's war of aggression in Ukraine and the energy supply shock, as well as the banking turmoil of March 2023 in some other countries. Weakening banking regulation and supervision would not boost the competitiveness of the EU economy. The issue of competitiveness should be addressed in a different way and the recent report by Mario Draghi has delivered some key messages, notably the need to encourage innovation and productivity in the European Union. We all know that there are still significant discrepancies between countries that could create market distortions, in particular discrepancies in tax and corporate insolvency laws. Achieving a harmonised single market also requires structural reform in all countries. I won't repeat here the rationale behind the need to create a truly single market for capital, but I would nevertheless like to emphasise that we need to complete the banking union. This requires, first, a fully-fledged European deposit insurance scheme and, second, a stronger European framework for crisis management (and here I am referring to the crisis management and deposit insurance, or CMDI, framework). Both will promote integration and reduce national fragmentation. A more integrated European banking sector will be more efficient and competitive. Of course, the ECB remains open to discussing possible simplifications and streamlining of its approach to banking supervision. The reform of our Supervisory Review and Evaluation Process (SREP) is one key element. Changes will be implemented gradually, starting in the second half of 2024, and will be finalised for the 2026 SREP cycle. The SREP reform will enable us to be more efficient, more comprehensive, and more effective - and will enhance our communication with banks. Allow me to elaborate further on my point by taking climate and nature-related risks as an example. The EU legislator did not invent climate risk or the burden of ensuring an orderly transition. The risk has been around for a long time. The Intergovernmental Panel on Climate Change (IPCC) was created in 1988 to provide scientific assessments and recommendations related to the current state of knowledge about climate change. The Paris Agreement was adopted in 2015 at the UN Climate Change Conference COP21 after the Fifth Assessment Report of the IPCC. So clearly, all the facts have been on the table for decades. The latest tragedy in Spain has shown that the financial cost can severely hit the economy, not just at the regional but also at the national level. And we have many other recent examples showing the macro-financial relevance of climate and nature-related risks. On the one hand, the cost of the transition will be high. On the other hand, analysis consistently confirms that the costs of doing too little too late are much higher. The ECB supervisory stress test in 2022 confirmed this analysis for the banking sector. The reinsurance sector, which is exposed to natural catastrophes more routinely than the banking sector, has clearly understood this and shown that, without rapid adaptation, insurance could become unaffordable in some regions. Regrettably, the prevailing consensus in climate science tells us that we are far from on track to meet the goal of limiting global heating to two degrees Celsius, as set out in the Paris Agreement. Diluting regulation, supervisory intensity and effectiveness will do nothing to change the scale and magnitude of these risks, either in the very near future or in the medium and long term. Instead, we need to renew our efforts and banks need to demonstrate their ability to correctly assess and properly manage these risks risks which will undoubtedly have a negative impact on their profitability and resilience. Digitalisation is another important factor that will drive bank profitability in the future. And once again, the facts leave no room for doubt. Customers expect the same from their banks as they do from any other business: they want to be able to easily access all of the services associated with their bank account. Banks also now face competition from newcomers that are not held back by legacy IT systems. They will therefore need to implement efficient digital solutions for their customers, find economies of scale and ensure the highest levels of IT security. At the same time, digitalisation doesn't mean the end of face-to-face interactions between banks and their customers: some people still want to go into their local branch in person, especially older people and those carrying out more complex financial transactions. The ability to respond to customers' evolving needs will be crucial for the future of established banks. They are facing competition from new financial service providers that are trying to attract business in the most profitable segment of banking operations: payments. In addition, banks need to make major investments in their cyber and IT resilience to stay at the forefront of technological developments and prevent disruptions or breaches. Investment in IT will be key to ensuring the banking sector remains sound and competitive in the future. Economies of scale and a more integrated EU market are likely to be needed in order to absorb the cost and boost profitability. That's a key point: IT investment needs to be strengthened to maintain competitiveness vis-à-vis US peers. A study last year observed that the annual IT budget for US global systemically important banks (G-SIBs) in 2021 was around 0.36\% of total assets, compared with $0.19 \%$ for euro area G-SIBs. Therefore, one of our supervisory priorities at the ECB is assessing how banks formulate, implement and monitor their digitalisation strategies, and how they manage the related risks. Building on our findings and surveys, we recently published criteria and best practices for banks' digital activities. But some questions related to technology are far from being solved. Generative artificial intelligence (AI) tools have the potential to transform some parts of the banking business, although as yet there is no clear evidence that they have been fully incorporated into banks' digitalisation strategies. Crucially, consumer rights and privacy must also be respected when issues related to AI are being addressed. And without good IT systems, AI tools won't be correctly fed by banks' data. Let me conclude. The ECB's mandate to keep banks safe and sound makes a critical contribution to the overall competitiveness of the banking sector. And this works both ways, as the resilience of the banking sector is also about its competitiveness. We are therefore looking closely at the sustainability of banks' business models and their future profitability. Moreover, by establishing a harmonised framework for its supervisory activities through the Single Rulebook, the ECB has reduced the fragmentation that existed previously. And the SREP reform is another important milestone in our efforts to better assess risks while stabilising the methodologies we use. However, much of the work that still needs to be done falls outside of the ECB's remit. A strong supervisory framework plays a key role in supporting the growth and competitiveness of the economy but will never replace the need for structural reforms to boost productivity. Other factors will also play a major role, such as changing demographics, including ageing societies, and geopolitical risks. Overall, the profitability of European banks has increased significantly in recent years, but they need to continue adapting to a changing environment presenting a cluster of challenges. Long-term investment and a strong capital base will be crucial for banks to meet these challenges. From the ECB's perspective, there is no room for complacency.
2024-12-08T00:00:00	Michelle W Bowman: New year's resolutions for bank regulatory policymakers	Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, at the South Carolina Bankers Association 2024 Community Bankers Conference, Columbia, South Carolina, 8 December 2024.	For release on delivery 4:30 p.m. EST January 8, 2024 New Year's Resolutions for Bank Regulatory Policymakers Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The South Carolina Bankers Association 2024 Community Bankers Conference Columbia, South Carolina January 8, 2024 It is a pleasure to join you this afternoon for the South Carolina Community Bankers Conference.' I always welcome the opportunity to learn from and share my perspective with bankers on issues affecting the U.S. economy and the financial industry. Today, I will focus my discussion on monetary policy, bank regulatory reforms, the evolving standards in bank supervision, and new developments in the payments system. I look forward to learning from your insights and perspectives on these issues, particularly your views on bank supervision, regulatory reforms, and your thoughts on the direction of the economy. As we kick off the new year, it's also a good time to look back on 2023 and consider a few New Year's resolutions for the coming year. Before discussing bank regulation and supervision, I'd like to offer my thoughts on the economy and monetary policy. Our Federal Open Market Committee (FOMC) meeting in December left the target range for the federal funds rate at 5-1/4 to 5-1/2 percent and continued the run-off of the Fed's securities holdings. Inflation data over the past six months indicate that the Committee's past policy actions are having the intended effect of bringing demand and supply into better balance. This continued progress on lowering inflation reflects a restrictive policy stance with the most recent 12-month total and core personal consumption expenditures inflation readings through November at 2.6 and 3.2 percent respectively. Employment data, though often significantly revised, continue to show signs of a tight labor market with reports of healthy job gains. The average pace of job gains has slowed over the past year, which may be a sign that labor market supply and demand are coming into better balance. The economy has remained strong even with ' The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. -2- the pace of real gross domestic product projected to moderate from the third quarter 2023 strength. Considering this progress, I voted to maintain the policy rate at its current level while we continue to monitor the incoming data and assess the implications for the inflation and economic outlook. And based on this progress, my view has evolved to consider the possibility that the rate of inflation could decline further with the policy rate held at the current level for some time. Should inflation continue to fall closer to our 2 percent goal over time, it will eventually become appropriate to begin the process of lowering our policy rate to prevent policy from becoming overly restrictive. In my view, we are not yet at that point. And important upside inflation risks remain. To the extent that both food and energy markets remain exposed to geopolitical influences, they present upside risks to inflation. There is also the risk that the recent easing in financial conditions encourages a reacceleration of growth, stalling the progress in lowering inflation, or even causing inflation to reaccelerate. Finally, there is a risk that continued labor market tightness could lead to persistently high core services inflation. While I do not tend to take too much signal from one report, last Friday's employment report showed continued strength in job gains and wage growth, and the labor force participation rate declined. Given these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely-including data revisions, which have increased in magnitude and frequency since the pandemic-as I assess the appropriate path of monetary policy. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each meeting based on the incoming data and the implications for the -3- outlook. While the current stance of monetary policy appears to be sufficiently restrictive to bring inflation down to 2 percent over time, I remain willing to raise the federal funds rate further at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment and stable prices over the longer run. Twenty-twenty-three was a particularly busy year for banking regulators. Before I dig deeper into bank regulation, I'd like to recap a few of 2023's notable banking industry events. And since we are embarking on a journey into the new year, I will conclude by offering a few ideas for New Year's resolutions for regulators to consider prioritizing for 2024. These resolutions borrow heavily from principles that I have discussed publicly a number of times in the past, but they continue to be critical in guiding my thinking and approach to regulation. And I encourage my colleagues in banking regulation and supervision to consider these ideas as we begin 2024 with a full regulatory agenda. Key Developments in 2023 Twenty-twenty-three brought many significant developments in bank regulation and supervision, beginning with speculation about the now-issued proposal to finalize the Basel III "endgame" capital rules. The Basel III capital rules were designed to apply only to the largest banks with significant cross-border activities, so much of the speculation early last year focused on scope-which banks would be subject to the rules under the new proposal-and calibration, how the capital requirements would change-whether they would increase, decrease, or remain the same. On the question of calibration, much of the speculation centered around whether regulators would propose significant increases to aggregate capital requirements or adopt a "capital neutral" approach by refining standards but keeping aggregate capital levels largely the -4. same. The objective of having a "capital neutral" proposal seemed reasonable to many, based on the understanding that a holistic review of the capital framework was in process at the Federal Reserve Board. In March, however, priorities and focus changed. The failures of Silicon Valley Bank (SVB) and Signature Bank resulted in the exceedingly rare steps to invoke the systemic risk exception to guarantee all depositors of Silicon Valley Bank and Signature Bank," and to create the Bank Term Funding Program.? These were significant emergency actions to support and stabilize the banking system. It is important to note that the Bank Term Funding Program is scheduled to expire in mid-March of this year. Understandably, the bank failures led regulators to take a hard look at what may have been missed in our supervision and what had driven regulatory and supervisory priorities leading up to these bank failures. Several post-mortem reviews were conducted in the immediate aftermath of the failures to identify and analyze the circumstances and factors that contributed to the bank failures. Many of these reviews suffered from serious shortcomings, including compressed timeframes for completion and the significantly limited matters that were within the scope of review. Nevertheless, these reviews were, and continue to be, singularly relied upon as a basis for resetting regulatory and supervisory priorities. The findings of these limited reviews have also continued to influence proposals that had long been in the pipeline, especially those related to capital reforms. I view the remainder of last year as something akin to a regulatory tidal wave, in light of the sheer volume of regulatory initiatives considered, published, and finalized. Many were 2 See 12 U.S.C. § 1823(c)(4)(G). 3 See 12 U.S.C. § 343. -5- undertaken or expanded with the purported goal to help address root causes of the bank failures and banking system stress. But this also included a rulemaking agenda that at times had little to no nexus with the root causes of the failures. Without a doubt, it was a challenge to support the regulatory agenda this past year. The published capital rulemaking proposal incorporated an expansive scope, a notable shift in approach, pushing down new Basel capital requirements to all banks with over $100 billion in assets, regardless of their international activities.4 At the same time, the capital proposal would substantially increase regulatory capital buffer and minimum requirements for the covered firms. In close succession, the agencies proposed new "long-term debt" requirements. This long-term debt proposal would require firms with over $100 billion in assets to issue debt at the top-tier parent level that could better absorb losses during bankruptcy, which only becomes relevant after the bank fails, not in order to prevent a failure. In part, these proposals were characterized as helping to address the root causes of the bank failures. As I've noted in the past, I think there are reasons to question whether these proposed revisions are effective and appropriately targeted and calibrated, particularly when considering that bank management and supervisory shortcomings more directly contributed to the bank failures than regulatory shortcomings. The banking agencies simply cannot regulate better or more effective supervision. We must appropriately manage our supervisory programs and teams to ensure that effective and consistent supervision is implemented within each firm and that it is effective and consistent across our regulated entities. 4 See dissenting statement, "Statement by Governor Michelle W. Bowman" on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230727.htm. -6- For community banks, two of the most important developments last year were the finalization of revisions to the Community Reinvestment Act regulations, and the proposal to amend the debit interchange fee cap in the Board's Regulation II. Many in the banking industry have expressed concern with the amendments to the CRA regulations, noting among other things the increased cost and burden associated with a number of the proposed revisions and new data systems required for compliance. In addition, many raised concerns about the potential adverse consequences of the rules, which include the possibility that these rules will reduce the availability of credit in some underserved markets if banks cut back lending activities due to revisions made to assessment areas defined in the new rules.* Similarly, the proposed revisions to Regulation II have generated concern from banks directly subject to the rules, but also from exempt banks concerned that the practical effect will be to push lower interchange fees down to all debit card issuers.° Of course, supervision also saw significant changes in 2023, with the publication of new guidance on third-party risk management applicable to all financial institutions, without tailoring or guidance to assist the smallest banks in compliance,' and climate guidance that on its face applies only to institutions with more than $100 billion in assets.* In 2023, many banks also reported very material shifts in bank examinations, with a renewed focus on interest rate risk, 5 See dissenting statement, "Statement on the Community Reinvestment Act Final Rule by Governor Michelle W. Bowman," news release, October 24, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman- statement-20231024.htm. © See dissenting statement, "Statement on Proposed Revisions to Regulation II's Interchange Fee Cap by Governor Michelle W. Bowman," news release, October 25, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20231025.htm. 7 See dissenting statement, "Statement on Third-Party Risk Management Guidance by Governor Michelle W. Bowman," news release, June 6, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman- statement-20230606.htm. 8 See dissenting statement "Statement by Governor Bowman on Principles for Climate-Related Financial Risk Management for Large Financial Institutions," news release, December 2, 2022, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20221202.htm. -7- liquidity risk, and management, and banks continue to see ongoing changes in supervisory expectations. Many of these examination-related shifts have received little public acknowledgement or attention, in large part because the rules designed to protect confidential supervisory information frustrate visibility into structural shifts in the supervisory process. As you all know well, changes in supervisory expectations frequently come without the benefit of guidance, advance notice, or published rulemaking, and in the worst-case scenario these shifts, cloaked by the veil of supervisory opacity, can have significant financial and reputational impacts. Resolutions for 2024 The new year provides a prime opportunity to reflect on the past 12 months and think about how the Federal Reserve can improve our approach. I'm sure many of us took the opportunity to reflect on recent experiences as we rang in 2024. I see the new year as a perfect time to think about how the banking regulators can implement some recent lessons learned. This very brief snapshot of the past year does not cover all of the important developments in the banking system, and the bank regulatory framework, that occurred in 2023. But it is a helpful starting point for considering the year ahead. So now, I'd like to offer three new year's resolutions for bank regulators. Prioritize Safety and Soundness First, safety and soundness should be renewed as the highest priority supervisory concern. This is a regulator's greatest responsibility and ensures the safe and sound continuous operation of the financial system. Last year's stress, precipitated by the spring bank failures, validated the tenet that supervision, when implemented effectively and appropriately, is the single most effective tool to support a safe and sound banking system. In the case of SVB, -8- supervisors failed to appreciate, appropriately identify, and mitigate the known significant, idiosyncratic risks of a business model that relied on a highly concentrated, uninsured base of depositors, and the buildup of interest rate risk without appropriate risk management. But as every banker in this room knows, concentration risk and interest rate risk are not novel or unique risks, and these good old-fashioned risks can create vulnerabilities fatal to individual institutions if not appropriately anticipated and managed. Banking regulators and supervisors at all levels of our dual banking system have long focused on these risks. Therefore, I recommend that regulators collectively resolve to renew the focus on these and other longstanding and fundamental risks to banks and the banking system. So, what should bank regulators do differently to prioritize safety and soundness? In my view, the problems in 2023 resulted from a failure to identify and prioritize the appropriate areas of risk. Instead, the focus was on broader, more qualitative, more process- and policy-oriented areas of risk. This focus resulted in a disproportionate emphasis on issues that distracted from the fundamental risks to the bank's balance sheet. Regulators often identify evolving conditions and emerging risks before they materialize as pronounced stress in the banking system. But too often, regulators fail to take appropriately decisive measures to address them. Regulators can also fall into the trap of getting distracted from core financial risks, and instead focus on issues that are tangential to statutory mandates and critical areas of responsibility. Focusing on risks that pose fewer safety and soundness concerns increases the risk that regulators miss other, more foundational and pressing areas that require more immediate attention. In my view, the new climate guidance introduced by the federal banking agencies last year effectively illustrates this lost focus. While perhaps well-intended, this guidance mandates -9- a diversion of limited supervisory resources away from critical, near-term safety and soundness risks. Setting aside differing views about the appropriateness of the content of the guidance, the fundamental question is whether climate change is a core, present-tense risk to safety and soundness-not whether climate change is an important public policy issue. And here, the evidence suggests that climate change is not currently a prominent financial risk to the banking system. This lack of attention and focus on the most material safety and soundness risks may result from intentional policy preferences, or simply may be the product of allowing ourselves to be distracted from known, longstanding risks over calm periods of banking conditions. Whatever the cause, it comes at a significant cost, as both banks and regulators shift resources and supervisory attention away from the most pressing risks. Renewed Commitment to Tailoring Second, is a renewed commitment to our Congressionally mandated obligation to tailoring. The current bank regulatory framework relies upon a risk-based, tailored approach, which strives to fulfill the congressional mandate to tailor the prudential regulatory framework for institutions with more than $100 billion in assets by aligning regulation with risk.? As we engage in ongoing regulatory reform, we must not lose sight of the virtues of this approach, for institutions of all sizes. Tailoring helps regulators prioritize the allocation of supervisory resources to focus on the most important risks and emerging threats to the financial system. Tailoring regulations does not mean that regulators can or should ignore safety and soundness issues at smaller institutions, or that the standards for smaller institutions should not be robust. As this audience knows well, a// banks are subject to periodic examinations, capital ° Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. No. 115-174, 132 Stat. 1296 (2018). -10- requirements, and regulatory reporting requirements, and have regular engagement with bank examiners at the state and or federal levels. Starting with an approach that acknowledges the importance of tailoring helps us avoid the impulse to simply crank regulatory dials to their highest level for all firms (or "up to 11," like the amplifiers in the classic film, This Is Spinal Tap).'° This type of approach overlooks fundamental differences in business model and asset size, while tailoring ensures that we appropriately calibrate regulations and expectations to the size, complexity, and business model of institutions. The existing capital framework provides a well-reasoned model for how this tailored approach results in appropriate requirements based on firm characteristics. The largest firms are divided into four categories based on size and complexity, with the largest and most complex firms being subject to the most stringent requirements. Regional banks, with $10 billion to $100 billion in assets, are subject to a somewhat more streamlined capital framework. And finally, the simplest rules are reserved for community banks that rely on a less complex, relationship-based business model. As this example illustrates, incorporating graduated requirements not only helps to effectively allocate limited supervisory resources, but it also avoids creating regulatory incentives that could unintentionally alter the banking landscape. For example, without tailoring, it is likely that the requirements for the largest and most complex banks would be pushed down to smaller banks that have simple, straightforward business models, either directly through changes to regulation, or indirectly through opaque supervisory expectations. This environment would create overwhelming incentives for industry consolidation, since a bank with a simple business model would be subject to and expected to comply with requirements designed for '0 This Is Spinal Tap, directed by Rob Reiner (1984). -ll- larger and more complex banks, and consolidation creates economies of scale that make it more cost-effective to comply with these requirements. My concern is that an overbroad application of requirements-requirements that are not tailored-could become a characteristic of future regulatory reforms. The Basel capital proposal highlights this concern. While the comment period is still open until January 16, much of the feedback shared with me so far has focused on two prominent concerns: (1) that the increases to capital requirements would be significantly higher than stakeholders anticipated, and (2) that the proposal would largely "flatten" the regulatory requirements for all banks over $100 billion, creating a severe cliff effect for firms approaching or crossing that threshold. Banks within this asset range are already carefully considering the ongoing viability of remaining at an asset size near that threshold. Firms just above the threshold will face strong pressure to shrink below the threshold or to merge to achieve economies of scale to comply with the breadth and complexity of the new requirements. Firms just below the threshold will need to be very intentional about approaching it and may consider revising business strategies and activities to remain below the threshold. While the capital proposal does not directly apply to regional and community banks, all banks are affected when policymakers shift away from or deemphasize tailoring. When we fail to recognize fundamental differences among firms, there is a strong temptation to continually push down requirements designed and calibrated for larger and more complex banks, to smaller and less complex banks that cannot reasonably be expected to comply with these standards. As we look to the future and the anticipated regulatory agenda for 2024, the critical role of tailoring must be incorporated as a foundational element of these regulatory reforms. -12- Increase Transparency The third and final resolution is increasing transparency in supervisory expectations. While policymakers may have different views on the decisions embedded in the regulatory framework, such as where thresholds should be set, and the calibration of different requirements, one virtue of regulation is that the requirements are spelled out in public, in advance, and in some specificity and granularity. If you are a bank, you know which regulations apply to your business model. But is this true in practice? As a banker, do you always know the standards to which you will be held prior to the examination? One of the concerning trends in 2023 were reports, including from state banking regulators, that some supervisory actions were excessive in light of the risks posed by some smaller institutions. It seems reasonable that the banking system stress played a role in tightening supervisory expectations. But we must also ensure that supervisory expectations and the resulting actions are appropriately calibrated and based on existing conditions, rather than driven by premature judgments and uncertain or unsupported supervisory predictions or assumptions. Transparency allows bankers to understand supervisory expectations in advance and work to meet those expectations. As you know, bankers have a deep commitment to operate safely and soundly but have no ability to look inside the mind of an examiner to divine that expectations have shifted. Opaque shifts in expectations can create unwelcome surprises in the examination process. These "surprises," in the form of ratings downgrades, can create significant issues for banks: they can disrupt business plans, including bank mergers and acquisitions, and create pressure on a bank to divert resources away from serving customers to addressing non-critical supervisory matters. -13- The increasing trend of supervisory "surprises" we saw in 2023 suggests to me a shortcoming in supervisory transparency. This by no means suggests that banks should not be held to high standards. To the contrary, it means that we should hold banks to standards that are known and identifiable, and when those standards inevitably evolve over time, we should give advance notice to our regulated institutions so they can manage their businesses accordingly to ensure continued compliance. Closing Thoughts I will conclude by expressing my appreciation for the opportunity to speak to you today. We are entering the new year at a time when significant changes to the banking system and bank regulatory framework are actively being considered. Many of these changes will have a lasting impact on banks of all sizes and their current and future customers, how banks run their businesses, and the broader U.S. economy. My hope is that you, as bankers, and other interested stakeholders play an active role in this process, by sharing your views and concerns broadly, including with regulators directly. This input provides valuable insights into the specific impacts-intended and unintended-of changes to the bank regulatory framework. Voicing your concerns enables us to identify, and where needed, address, the real-world consequences of regulatory and supervisory reforms. I certainly don't need to remind this audience that the stakes are extremely high. My sincere hope for 2024 is that policymakers have the humility to acknowledge the intended and unintended consequences of these and upcoming regulatory reform efforts, and the courage to change course, when necessary, to mitigate and minimize these consequences. The future of the banking system and the ongoing strength of the U.S. economy depend on it.	---[PAGE_BREAK]--- For release on delivery 4:30 p.m. EST January 8, 2024 New Year's Resolutions for Bank Regulatory Policymakers Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The South Carolina Bankers Association 2024 Community Bankers Conference Columbia, South Carolina January 8, 2024 ---[PAGE_BREAK]--- It is a pleasure to join you this afternoon for the South Carolina Community Bankers Conference. ${ }^{1}$ I always welcome the opportunity to learn from and share my perspective with bankers on issues affecting the U.S. economy and the financial industry. Today, I will focus my discussion on monetary policy, bank regulatory reforms, the evolving standards in bank supervision, and new developments in the payments system. I look forward to learning from your insights and perspectives on these issues, particularly your views on bank supervision, regulatory reforms, and your thoughts on the direction of the economy. As we kick off the new year, it's also a good time to look back on 2023 and consider a few New Year's resolutions for the coming year. Before discussing bank regulation and supervision, I'd like to offer my thoughts on the economy and monetary policy. Our Federal Open Market Committee (FOMC) meeting in December left the target range for the federal funds rate at 5-1/4 to 5-1/2 percent and continued the run-off of the Fed's securities holdings. Inflation data over the past six months indicate that the Committee's past policy actions are having the intended effect of bringing demand and supply into better balance. This continued progress on lowering inflation reflects a restrictive policy stance with the most recent 12-month total and core personal consumption expenditures inflation readings through November at 2.6 and 3.2 percent respectively. Employment data, though often significantly revised, continue to show signs of a tight labor market with reports of healthy job gains. The average pace of job gains has slowed over the past year, which may be a sign that labor market supply and demand are coming into better balance. The economy has remained strong even with [^0] [^0]: ${ }^{1}$ The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors. ---[PAGE_BREAK]--- the pace of real gross domestic product projected to moderate from the third quarter 2023 strength. Considering this progress, I voted to maintain the policy rate at its current level while we continue to monitor the incoming data and assess the implications for the inflation and economic outlook. And based on this progress, my view has evolved to consider the possibility that the rate of inflation could decline further with the policy rate held at the current level for some time. Should inflation continue to fall closer to our 2 percent goal over time, it will eventually become appropriate to begin the process of lowering our policy rate to prevent policy from becoming overly restrictive. In my view, we are not yet at that point. And important upside inflation risks remain. To the extent that both food and energy markets remain exposed to geopolitical influences, they present upside risks to inflation. There is also the risk that the recent easing in financial conditions encourages a reacceleration of growth, stalling the progress in lowering inflation, or even causing inflation to reaccelerate. Finally, there is a risk that continued labor market tightness could lead to persistently high core services inflation. While I do not tend to take too much signal from one report, last Friday's employment report showed continued strength in job gains and wage growth, and the labor force participation rate declined. Given these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely-including data revisions, which have increased in magnitude and frequency since the pandemic-as I assess the appropriate path of monetary policy. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each meeting based on the incoming data and the implications for the ---[PAGE_BREAK]--- outlook. While the current stance of monetary policy appears to be sufficiently restrictive to bring inflation down to 2 percent over time, I remain willing to raise the federal funds rate further at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment and stable prices over the longer run. Twenty-twenty-three was a particularly busy year for banking regulators. Before I dig deeper into bank regulation, I'd like to recap a few of 2023's notable banking industry events. And since we are embarking on a journey into the new year, I will conclude by offering a few ideas for New Year's resolutions for regulators to consider prioritizing for 2024. These resolutions borrow heavily from principles that I have discussed publicly a number of times in the past, but they continue to be critical in guiding my thinking and approach to regulation. And I encourage my colleagues in banking regulation and supervision to consider these ideas as we begin 2024 with a full regulatory agenda. # Key Developments in 2023 Twenty-twenty-three brought many significant developments in bank regulation and supervision, beginning with speculation about the now-issued proposal to finalize the Basel III "endgame" capital rules. The Basel III capital rules were designed to apply only to the largest banks with significant cross-border activities, so much of the speculation early last year focused on scope-which banks would be subject to the rules under the new proposal—and calibration, how the capital requirements would change-whether they would increase, decrease, or remain the same. On the question of calibration, much of the speculation centered around whether regulators would propose significant increases to aggregate capital requirements or adopt a "capital neutral" approach by refining standards but keeping aggregate capital levels largely the ---[PAGE_BREAK]--- same. The objective of having a "capital neutral" proposal seemed reasonable to many, based on the understanding that a holistic review of the capital framework was in process at the Federal Reserve Board. In March, however, priorities and focus changed. The failures of Silicon Valley Bank (SVB) and Signature Bank resulted in the exceedingly rare steps to invoke the systemic risk exception to guarantee all depositors of Silicon Valley Bank and Signature Bank, ${ }^{2}$ and to create the Bank Term Funding Program. ${ }^{3}$ These were significant emergency actions to support and stabilize the banking system. It is important to note that the Bank Term Funding Program is scheduled to expire in mid-March of this year. Understandably, the bank failures led regulators to take a hard look at what may have been missed in our supervision and what had driven regulatory and supervisory priorities leading up to these bank failures. Several post-mortem reviews were conducted in the immediate aftermath of the failures to identify and analyze the circumstances and factors that contributed to the bank failures. Many of these reviews suffered from serious shortcomings, including compressed timeframes for completion and the significantly limited matters that were within the scope of review. Nevertheless, these reviews were, and continue to be, singularly relied upon as a basis for resetting regulatory and supervisory priorities. The findings of these limited reviews have also continued to influence proposals that had long been in the pipeline, especially those related to capital reforms. I view the remainder of last year as something akin to a regulatory tidal wave, in light of the sheer volume of regulatory initiatives considered, published, and finalized. Many were [^0] [^0]: ${ }^{2}$ See 12 U.S.C. § 1823(c)(4)(G). ${ }^{3}$ See 12 U.S.C. § 343. ---[PAGE_BREAK]--- undertaken or expanded with the purported goal to help address root causes of the bank failures and banking system stress. But this also included a rulemaking agenda that at times had little to no nexus with the root causes of the failures. Without a doubt, it was a challenge to support the regulatory agenda this past year. The published capital rulemaking proposal incorporated an expansive scope, a notable shift in approach, pushing down new Basel capital requirements to all banks with over $\$ 100$ billion in assets, regardless of their international activities. ${ }^{4}$ At the same time, the capital proposal would substantially increase regulatory capital buffer and minimum requirements for the covered firms. In close succession, the agencies proposed new "long-term debt" requirements. This long-term debt proposal would require firms with over $\$ 100$ billion in assets to issue debt at the top-tier parent level that could better absorb losses during bankruptcy, which only becomes relevant after the bank fails, not in order to prevent a failure. In part, these proposals were characterized as helping to address the root causes of the bank failures. As I've noted in the past, I think there are reasons to question whether these proposed revisions are effective and appropriately targeted and calibrated, particularly when considering that bank management and supervisory shortcomings more directly contributed to the bank failures than regulatory shortcomings. The banking agencies simply cannot regulate better or more effective supervision. We must appropriately manage our supervisory programs and teams to ensure that effective and consistent supervision is implemented within each firm and that it is effective and consistent across our regulated entities. [^0] [^0]: ${ }^{4}$ See dissenting statement, "Statement by Governor Michelle W. Bowman" on the proposed rule to implement the Basel III endgame agreement for large banks, news release, July 27, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230727.htm. ---[PAGE_BREAK]--- For community banks, two of the most important developments last year were the finalization of revisions to the Community Reinvestment Act regulations, and the proposal to amend the debit interchange fee cap in the Board's Regulation II. Many in the banking industry have expressed concern with the amendments to the CRA regulations, noting among other things the increased cost and burden associated with a number of the proposed revisions and new data systems required for compliance. In addition, many raised concerns about the potential adverse consequences of the rules, which include the possibility that these rules will reduce the availability of credit in some underserved markets if banks cut back lending activities due to revisions made to assessment areas defined in the new rules. ${ }^{5}$ Similarly, the proposed revisions to Regulation II have generated concern from banks directly subject to the rules, but also from exempt banks concerned that the practical effect will be to push lower interchange fees down to all debit card issuers. ${ }^{6}$ Of course, supervision also saw significant changes in 2023, with the publication of new guidance on third-party risk management applicable to all financial institutions, without tailoring or guidance to assist the smallest banks in compliance, ${ }^{7}$ and climate guidance that on its face applies only to institutions with more than $\$ 100$ billion in assets. ${ }^{8}$ In 2023, many banks also reported very material shifts in bank examinations, with a renewed focus on interest rate risk, [^0] [^0]: ${ }^{5}$ See dissenting statement, "Statement on the Community Reinvestment Act Final Rule by Governor Michelle W. Bowman," news release, October 24, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20231024.htm. ${ }^{6}$ See dissenting statement, "Statement on Proposed Revisions to Regulation II's Interchange Fee Cap by Governor Michelle W. Bowman," news release, October 25, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20231025.htm. ${ }^{7}$ See dissenting statement, "Statement on Third-Party Risk Management Guidance by Governor Michelle W. Bowman," news release, June 6, 2023, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230606.htm. ${ }^{8}$ See dissenting statement "Statement by Governor Bowman on Principles for Climate-Related Financial Risk Management for Large Financial Institutions," news release, December 2, 2022, https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20221202.htm. ---[PAGE_BREAK]--- liquidity risk, and management, and banks continue to see ongoing changes in supervisory expectations. Many of these examination-related shifts have received little public acknowledgement or attention, in large part because the rules designed to protect confidential supervisory information frustrate visibility into structural shifts in the supervisory process. As you all know well, changes in supervisory expectations frequently come without the benefit of guidance, advance notice, or published rulemaking, and in the worst-case scenario these shifts, cloaked by the veil of supervisory opacity, can have significant financial and reputational impacts. # Resolutions for 2024 The new year provides a prime opportunity to reflect on the past 12 months and think about how the Federal Reserve can improve our approach. I'm sure many of us took the opportunity to reflect on recent experiences as we rang in 2024. I see the new year as a perfect time to think about how the banking regulators can implement some recent lessons learned. This very brief snapshot of the past year does not cover all of the important developments in the banking system, and the bank regulatory framework, that occurred in 2023. But it is a helpful starting point for considering the year ahead. So now, I'd like to offer three new year's resolutions for bank regulators. ## Prioritize Safety and Soundness First, safety and soundness should be renewed as the highest priority supervisory concern. This is a regulator's greatest responsibility and ensures the safe and sound continuous operation of the financial system. Last year's stress, precipitated by the spring bank failures, validated the tenet that supervision, when implemented effectively and appropriately, is the single most effective tool to support a safe and sound banking system. In the case of SVB, ---[PAGE_BREAK]--- supervisors failed to appreciate, appropriately identify, and mitigate the known significant, idiosyncratic risks of a business model that relied on a highly concentrated, uninsured base of depositors, and the buildup of interest rate risk without appropriate risk management. But as every banker in this room knows, concentration risk and interest rate risk are not novel or unique risks, and these good old-fashioned risks can create vulnerabilities fatal to individual institutions if not appropriately anticipated and managed. Banking regulators and supervisors at all levels of our dual banking system have long focused on these risks. Therefore, I recommend that regulators collectively resolve to renew the focus on these and other longstanding and fundamental risks to banks and the banking system. So, what should bank regulators do differently to prioritize safety and soundness? In my view, the problems in 2023 resulted from a failure to identify and prioritize the appropriate areas of risk. Instead, the focus was on broader, more qualitative, more process- and policy-oriented areas of risk. This focus resulted in a disproportionate emphasis on issues that distracted from the fundamental risks to the bank's balance sheet. Regulators often identify evolving conditions and emerging risks before they materialize as pronounced stress in the banking system. But too often, regulators fail to take appropriately decisive measures to address them. Regulators can also fall into the trap of getting distracted from core financial risks, and instead focus on issues that are tangential to statutory mandates and critical areas of responsibility. Focusing on risks that pose fewer safety and soundness concerns increases the risk that regulators miss other, more foundational and pressing areas that require more immediate attention. In my view, the new climate guidance introduced by the federal banking agencies last year effectively illustrates this lost focus. While perhaps well-intended, this guidance mandates ---[PAGE_BREAK]--- a diversion of limited supervisory resources away from critical, near-term safety and soundness risks. Setting aside differing views about the appropriateness of the content of the guidance, the fundamental question is whether climate change is a core, present-tense risk to safety and soundness-not whether climate change is an important public policy issue. And here, the evidence suggests that climate change is not currently a prominent financial risk to the banking system. This lack of attention and focus on the most material safety and soundness risks may result from intentional policy preferences, or simply may be the product of allowing ourselves to be distracted from known, longstanding risks over calm periods of banking conditions. Whatever the cause, it comes at a significant cost, as both banks and regulators shift resources and supervisory attention away from the most pressing risks. # Renewed Commitment to Tailoring Second, is a renewed commitment to our Congressionally mandated obligation to tailoring. The current bank regulatory framework relies upon a risk-based, tailored approach, which strives to fulfill the congressional mandate to tailor the prudential regulatory framework for institutions with more than $\$ 100$ billion in assets by aligning regulation with risk. ${ }^{9}$ As we engage in ongoing regulatory reform, we must not lose sight of the virtues of this approach, for institutions of all sizes. Tailoring helps regulators prioritize the allocation of supervisory resources to focus on the most important risks and emerging threats to the financial system. Tailoring regulations does not mean that regulators can or should ignore safety and soundness issues at smaller institutions, or that the standards for smaller institutions should not be robust. As this audience knows well, all banks are subject to periodic examinations, capital [^0] [^0]: ${ }^{9}$ Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. No. 115-174, 132 Stat. 1296 (2018). ---[PAGE_BREAK]--- requirements, and regulatory reporting requirements, and have regular engagement with bank examiners at the state and or federal levels. Starting with an approach that acknowledges the importance of tailoring helps us avoid the impulse to simply crank regulatory dials to their highest level for all firms (or "up to 11," like the amplifiers in the classic film, This Is Spinal Tap). ${ }^{10}$ This type of approach overlooks fundamental differences in business model and asset size, while tailoring ensures that we appropriately calibrate regulations and expectations to the size, complexity, and business model of institutions. The existing capital framework provides a well-reasoned model for how this tailored approach results in appropriate requirements based on firm characteristics. The largest firms are divided into four categories based on size and complexity, with the largest and most complex firms being subject to the most stringent requirements. Regional banks, with $\$ 10$ billion to $\$ 100$ billion in assets, are subject to a somewhat more streamlined capital framework. And finally, the simplest rules are reserved for community banks that rely on a less complex, relationship-based business model. As this example illustrates, incorporating graduated requirements not only helps to effectively allocate limited supervisory resources, but it also avoids creating regulatory incentives that could unintentionally alter the banking landscape. For example, without tailoring, it is likely that the requirements for the largest and most complex banks would be pushed down to smaller banks that have simple, straightforward business models, either directly through changes to regulation, or indirectly through opaque supervisory expectations. This environment would create overwhelming incentives for industry consolidation, since a bank with a simple business model would be subject to and expected to comply with requirements designed for [^0] [^0]: ${ }^{10}$ This Is Spinal Tap, directed by Rob Reiner (1984). ---[PAGE_BREAK]--- larger and more complex banks, and consolidation creates economies of scale that make it more cost-effective to comply with these requirements. My concern is that an overbroad application of requirements-requirements that are not tailored-could become a characteristic of future regulatory reforms. The Basel capital proposal highlights this concern. While the comment period is still open until January 16, much of the feedback shared with me so far has focused on two prominent concerns: (1) that the increases to capital requirements would be significantly higher than stakeholders anticipated, and (2) that the proposal would largely "flatten" the regulatory requirements for all banks over $\$ 100$ billion, creating a severe cliff effect for firms approaching or crossing that threshold. Banks within this asset range are already carefully considering the ongoing viability of remaining at an asset size near that threshold. Firms just above the threshold will face strong pressure to shrink below the threshold or to merge to achieve economies of scale to comply with the breadth and complexity of the new requirements. Firms just below the threshold will need to be very intentional about approaching it and may consider revising business strategies and activities to remain below the threshold. While the capital proposal does not directly apply to regional and community banks, all banks are affected when policymakers shift away from or deemphasize tailoring. When we fail to recognize fundamental differences among firms, there is a strong temptation to continually push down requirements designed and calibrated for larger and more complex banks, to smaller and less complex banks that cannot reasonably be expected to comply with these standards. As we look to the future and the anticipated regulatory agenda for 2024, the critical role of tailoring must be incorporated as a foundational element of these regulatory reforms. ---[PAGE_BREAK]--- # Increase Transparency The third and final resolution is increasing transparency in supervisory expectations. While policymakers may have different views on the decisions embedded in the regulatory framework, such as where thresholds should be set, and the calibration of different requirements, one virtue of regulation is that the requirements are spelled out in public, in advance, and in some specificity and granularity. If you are a bank, you know which regulations apply to your business model. But is this true in practice? As a banker, do you always know the standards to which you will be held prior to the examination? One of the concerning trends in 2023 were reports, including from state banking regulators, that some supervisory actions were excessive in light of the risks posed by some smaller institutions. It seems reasonable that the banking system stress played a role in tightening supervisory expectations. But we must also ensure that supervisory expectations and the resulting actions are appropriately calibrated and based on existing conditions, rather than driven by premature judgments and uncertain or unsupported supervisory predictions or assumptions. Transparency allows bankers to understand supervisory expectations in advance and work to meet those expectations. As you know, bankers have a deep commitment to operate safely and soundly but have no ability to look inside the mind of an examiner to divine that expectations have shifted. Opaque shifts in expectations can create unwelcome surprises in the examination process. These "surprises," in the form of ratings downgrades, can create significant issues for banks: they can disrupt business plans, including bank mergers and acquisitions, and create pressure on a bank to divert resources away from serving customers to addressing non-critical supervisory matters. ---[PAGE_BREAK]--- The increasing trend of supervisory "surprises" we saw in 2023 suggests to me a shortcoming in supervisory transparency. This by no means suggests that banks should not be held to high standards. To the contrary, it means that we should hold banks to standards that are known and identifiable, and when those standards inevitably evolve over time, we should give advance notice to our regulated institutions so they can manage their businesses accordingly to ensure continued compliance. # Closing Thoughts I will conclude by expressing my appreciation for the opportunity to speak to you today. We are entering the new year at a time when significant changes to the banking system and bank regulatory framework are actively being considered. Many of these changes will have a lasting impact on banks of all sizes and their current and future customers, how banks run their businesses, and the broader U.S. economy. My hope is that you, as bankers, and other interested stakeholders play an active role in this process, by sharing your views and concerns broadly, including with regulators directly. This input provides valuable insights into the specific impacts-intended and unintended-of changes to the bank regulatory framework. Voicing your concerns enables us to identify, and where needed, address, the real-world consequences of regulatory and supervisory reforms. I certainly don't need to remind this audience that the stakes are extremely high. My sincere hope for 2024 is that policymakers have the humility to acknowledge the intended and unintended consequences of these and upcoming regulatory reform efforts, and the courage to change course, when necessary, to mitigate and minimize these consequences. The future of the banking system and the ongoing strength of the U.S. economy depend on it.	Michelle W Bowman	United States	https://www.bis.org/review/r240109a.pdf	For release on delivery 4:30 p.m. EST January 8, 2024 New Year's Resolutions for Bank Regulatory Policymakers Remarks by Michelle W. Bowman Member Board of Governors of the Federal Reserve System at The South Carolina Bankers Association Columbia, South Carolina January 8, 2024 It is a pleasure to join you this afternoon for the South Carolina Community Bankers Conference. I always welcome the opportunity to learn from and share my perspective with bankers on issues affecting the U.S. economy and the financial industry. Today, I will focus my discussion on monetary policy, bank regulatory reforms, the evolving standards in bank supervision, and new developments in the payments system. I look forward to learning from your insights and perspectives on these issues, particularly your views on bank supervision, regulatory reforms, and your thoughts on the direction of the economy. As we kick off the new year, it's also a good time to look back on 2023 and consider a few New Year's resolutions for the coming year. Before discussing bank regulation and supervision, I'd like to offer my thoughts on the economy and monetary policy. Our Federal Open Market Committee (FOMC) meeting in December left the target range for the federal funds rate at 5-1/4 to 5-1/2 percent and continued the run-off of the Fed's securities holdings. Inflation data over the past six months indicate that the Committee's past policy actions are having the intended effect of bringing demand and supply into better balance. This continued progress on lowering inflation reflects a restrictive policy stance with the most recent 12-month total and core personal consumption expenditures inflation readings through November at 2.6 and 3.2 percent respectively. Employment data, though often significantly revised, continue to show signs of a tight labor market with reports of healthy job gains. The average pace of job gains has slowed over the past year, which may be a sign that labor market supply and demand are coming into better balance. The economy has remained strong even with the pace of real gross domestic product projected to moderate from the third quarter 2023 strength. Considering this progress, I voted to maintain the policy rate at its current level while we continue to monitor the incoming data and assess the implications for the inflation and economic outlook. And based on this progress, my view has evolved to consider the possibility that the rate of inflation could decline further with the policy rate held at the current level for some time. Should inflation continue to fall closer to our 2 percent goal over time, it will eventually become appropriate to begin the process of lowering our policy rate to prevent policy from becoming overly restrictive. In my view, we are not yet at that point. And important upside inflation risks remain. To the extent that both food and energy markets remain exposed to geopolitical influences, they present upside risks to inflation. There is also the risk that the recent easing in financial conditions encourages a reacceleration of growth, stalling the progress in lowering inflation, or even causing inflation to reaccelerate. Finally, there is a risk that continued labor market tightness could lead to persistently high core services inflation. While I do not tend to take too much signal from one report, last Friday's employment report showed continued strength in job gains and wage growth, and the labor force participation rate declined. Given these risks, and the general uncertainty regarding the economic outlook, I will continue to watch the data closely-including data revisions, which have increased in magnitude and frequency since the pandemic-as I assess the appropriate path of monetary policy. I will remain cautious in my approach to considering future changes in the stance of policy. It is important to note that monetary policy is not on a preset course. My colleagues and I will make our decisions at each meeting based on the incoming data and the implications for the outlook. While the current stance of monetary policy appears to be sufficiently restrictive to bring inflation down to 2 percent over time, I remain willing to raise the federal funds rate further at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed. Restoring price stability is essential for achieving maximum employment and stable prices over the longer run. Twenty-twenty-three was a particularly busy year for banking regulators. Before I dig deeper into bank regulation, I'd like to recap a few of 2023's notable banking industry events. And since we are embarking on a journey into the new year, I will conclude by offering a few ideas for New Year's resolutions for regulators to consider prioritizing for 2024. These resolutions borrow heavily from principles that I have discussed publicly a number of times in the past, but they continue to be critical in guiding my thinking and approach to regulation. And I encourage my colleagues in banking regulation and supervision to consider these ideas as we begin 2024 with a full regulatory agenda. Twenty-twenty-three brought many significant developments in bank regulation and supervision, beginning with speculation about the now-issued proposal to finalize the Basel III "endgame" capital rules. The Basel III capital rules were designed to apply only to the largest banks with significant cross-border activities, so much of the speculation early last year focused on scope-which banks would be subject to the rules under the new proposal—and calibration, how the capital requirements would change-whether they would increase, decrease, or remain the same. On the question of calibration, much of the speculation centered around whether regulators would propose significant increases to aggregate capital requirements or adopt a "capital neutral" approach by refining standards but keeping aggregate capital levels largely the same. The objective of having a "capital neutral" proposal seemed reasonable to many, based on the understanding that a holistic review of the capital framework was in process at the Federal Reserve Board. In March, however, priorities and focus changed. The failures of Silicon Valley Bank (SVB) and Signature Bank resulted in the exceedingly rare steps to invoke the systemic risk exception to guarantee all depositors of Silicon Valley Bank and Signature Bank, These were significant emergency actions to support and stabilize the banking system. It is important to note that the Bank Term Funding Program is scheduled to expire in mid-March of this year. Understandably, the bank failures led regulators to take a hard look at what may have been missed in our supervision and what had driven regulatory and supervisory priorities leading up to these bank failures. Several post-mortem reviews were conducted in the immediate aftermath of the failures to identify and analyze the circumstances and factors that contributed to the bank failures. Many of these reviews suffered from serious shortcomings, including compressed timeframes for completion and the significantly limited matters that were within the scope of review. Nevertheless, these reviews were, and continue to be, singularly relied upon as a basis for resetting regulatory and supervisory priorities. The findings of these limited reviews have also continued to influence proposals that had long been in the pipeline, especially those related to capital reforms. I view the remainder of last year as something akin to a regulatory tidal wave, in light of the sheer volume of regulatory initiatives considered, published, and finalized. Many were undertaken or expanded with the purported goal to help address root causes of the bank failures and banking system stress. But this also included a rulemaking agenda that at times had little to no nexus with the root causes of the failures. Without a doubt, it was a challenge to support the regulatory agenda this past year. The published capital rulemaking proposal incorporated an expansive scope, a notable shift in approach, pushing down new Basel capital requirements to all banks with over $\$ 100$ billion in assets, regardless of their international activities. At the same time, the capital proposal would substantially increase regulatory capital buffer and minimum requirements for the covered firms. In close succession, the agencies proposed new "long-term debt" requirements. This long-term debt proposal would require firms with over $\$ 100$ billion in assets to issue debt at the top-tier parent level that could better absorb losses during bankruptcy, which only becomes relevant after the bank fails, not in order to prevent a failure. In part, these proposals were characterized as helping to address the root causes of the bank failures. As I've noted in the past, I think there are reasons to question whether these proposed revisions are effective and appropriately targeted and calibrated, particularly when considering that bank management and supervisory shortcomings more directly contributed to the bank failures than regulatory shortcomings. The banking agencies simply cannot regulate better or more effective supervision. We must appropriately manage our supervisory programs and teams to ensure that effective and consistent supervision is implemented within each firm and that it is effective and consistent across our regulated entities. For community banks, two of the most important developments last year were the finalization of revisions to the Community Reinvestment Act regulations, and the proposal to amend the debit interchange fee cap in the Board's Regulation II. Many in the banking industry have expressed concern with the amendments to the CRA regulations, noting among other things the increased cost and burden associated with a number of the proposed revisions and new data systems required for compliance. In addition, many raised concerns about the potential adverse consequences of the rules, which include the possibility that these rules will reduce the availability of credit in some underserved markets if banks cut back lending activities due to revisions made to assessment areas defined in the new rules. Of course, supervision also saw significant changes in 2023, with the publication of new guidance on third-party risk management applicable to all financial institutions, without tailoring or guidance to assist the smallest banks in compliance, In 2023, many banks also reported very material shifts in bank examinations, with a renewed focus on interest rate risk, liquidity risk, and management, and banks continue to see ongoing changes in supervisory expectations. Many of these examination-related shifts have received little public acknowledgement or attention, in large part because the rules designed to protect confidential supervisory information frustrate visibility into structural shifts in the supervisory process. As you all know well, changes in supervisory expectations frequently come without the benefit of guidance, advance notice, or published rulemaking, and in the worst-case scenario these shifts, cloaked by the veil of supervisory opacity, can have significant financial and reputational impacts. The new year provides a prime opportunity to reflect on the past 12 months and think about how the Federal Reserve can improve our approach. I'm sure many of us took the opportunity to reflect on recent experiences as we rang in 2024. I see the new year as a perfect time to think about how the banking regulators can implement some recent lessons learned. This very brief snapshot of the past year does not cover all of the important developments in the banking system, and the bank regulatory framework, that occurred in 2023. But it is a helpful starting point for considering the year ahead. So now, I'd like to offer three new year's resolutions for bank regulators. First, safety and soundness should be renewed as the highest priority supervisory concern. This is a regulator's greatest responsibility and ensures the safe and sound continuous operation of the financial system. Last year's stress, precipitated by the spring bank failures, validated the tenet that supervision, when implemented effectively and appropriately, is the single most effective tool to support a safe and sound banking system. In the case of SVB, supervisors failed to appreciate, appropriately identify, and mitigate the known significant, idiosyncratic risks of a business model that relied on a highly concentrated, uninsured base of depositors, and the buildup of interest rate risk without appropriate risk management. But as every banker in this room knows, concentration risk and interest rate risk are not novel or unique risks, and these good old-fashioned risks can create vulnerabilities fatal to individual institutions if not appropriately anticipated and managed. Banking regulators and supervisors at all levels of our dual banking system have long focused on these risks. Therefore, I recommend that regulators collectively resolve to renew the focus on these and other longstanding and fundamental risks to banks and the banking system. So, what should bank regulators do differently to prioritize safety and soundness? In my view, the problems in 2023 resulted from a failure to identify and prioritize the appropriate areas of risk. Instead, the focus was on broader, more qualitative, more process- and policy-oriented areas of risk. This focus resulted in a disproportionate emphasis on issues that distracted from the fundamental risks to the bank's balance sheet. Regulators often identify evolving conditions and emerging risks before they materialize as pronounced stress in the banking system. But too often, regulators fail to take appropriately decisive measures to address them. Regulators can also fall into the trap of getting distracted from core financial risks, and instead focus on issues that are tangential to statutory mandates and critical areas of responsibility. Focusing on risks that pose fewer safety and soundness concerns increases the risk that regulators miss other, more foundational and pressing areas that require more immediate attention. In my view, the new climate guidance introduced by the federal banking agencies last year effectively illustrates this lost focus. While perhaps well-intended, this guidance mandates a diversion of limited supervisory resources away from critical, near-term safety and soundness risks. Setting aside differing views about the appropriateness of the content of the guidance, the fundamental question is whether climate change is a core, present-tense risk to safety and soundness-not whether climate change is an important public policy issue. And here, the evidence suggests that climate change is not currently a prominent financial risk to the banking system. This lack of attention and focus on the most material safety and soundness risks may result from intentional policy preferences, or simply may be the product of allowing ourselves to be distracted from known, longstanding risks over calm periods of banking conditions. Whatever the cause, it comes at a significant cost, as both banks and regulators shift resources and supervisory attention away from the most pressing risks. Second, is a renewed commitment to our Congressionally mandated obligation to tailoring. The current bank regulatory framework relies upon a risk-based, tailored approach, which strives to fulfill the congressional mandate to tailor the prudential regulatory framework for institutions with more than $\$ 100$ billion in assets by aligning regulation with risk. As we engage in ongoing regulatory reform, we must not lose sight of the virtues of this approach, for institutions of all sizes. Tailoring helps regulators prioritize the allocation of supervisory resources to focus on the most important risks and emerging threats to the financial system. Tailoring regulations does not mean that regulators can or should ignore safety and soundness issues at smaller institutions, or that the standards for smaller institutions should not be robust. As this audience knows well, all banks are subject to periodic examinations, capital requirements, and regulatory reporting requirements, and have regular engagement with bank examiners at the state and or federal levels. Starting with an approach that acknowledges the importance of tailoring helps us avoid the impulse to simply crank regulatory dials to their highest level for all firms (or "up to 11," like the amplifiers in the classic film, This Is Spinal Tap). This type of approach overlooks fundamental differences in business model and asset size, while tailoring ensures that we appropriately calibrate regulations and expectations to the size, complexity, and business model of institutions. The existing capital framework provides a well-reasoned model for how this tailored approach results in appropriate requirements based on firm characteristics. The largest firms are divided into four categories based on size and complexity, with the largest and most complex firms being subject to the most stringent requirements. Regional banks, with $\$ 10$ billion to $\$ 100$ billion in assets, are subject to a somewhat more streamlined capital framework. And finally, the simplest rules are reserved for community banks that rely on a less complex, relationship-based business model. As this example illustrates, incorporating graduated requirements not only helps to effectively allocate limited supervisory resources, but it also avoids creating regulatory incentives that could unintentionally alter the banking landscape. For example, without tailoring, it is likely that the requirements for the largest and most complex banks would be pushed down to smaller banks that have simple, straightforward business models, either directly through changes to regulation, or indirectly through opaque supervisory expectations. This environment would create overwhelming incentives for industry consolidation, since a bank with a simple business model would be subject to and expected to comply with requirements designed for larger and more complex banks, and consolidation creates economies of scale that make it more cost-effective to comply with these requirements. My concern is that an overbroad application of requirements-requirements that are not tailored-could become a characteristic of future regulatory reforms. The Basel capital proposal highlights this concern. While the comment period is still open until January 16, much of the feedback shared with me so far has focused on two prominent concerns: (1) that the increases to capital requirements would be significantly higher than stakeholders anticipated, and (2) that the proposal would largely "flatten" the regulatory requirements for all banks over $\$ 100$ billion, creating a severe cliff effect for firms approaching or crossing that threshold. Banks within this asset range are already carefully considering the ongoing viability of remaining at an asset size near that threshold. Firms just above the threshold will face strong pressure to shrink below the threshold or to merge to achieve economies of scale to comply with the breadth and complexity of the new requirements. Firms just below the threshold will need to be very intentional about approaching it and may consider revising business strategies and activities to remain below the threshold. While the capital proposal does not directly apply to regional and community banks, all banks are affected when policymakers shift away from or deemphasize tailoring. When we fail to recognize fundamental differences among firms, there is a strong temptation to continually push down requirements designed and calibrated for larger and more complex banks, to smaller and less complex banks that cannot reasonably be expected to comply with these standards. As we look to the future and the anticipated regulatory agenda for 2024, the critical role of tailoring must be incorporated as a foundational element of these regulatory reforms. The third and final resolution is increasing transparency in supervisory expectations. While policymakers may have different views on the decisions embedded in the regulatory framework, such as where thresholds should be set, and the calibration of different requirements, one virtue of regulation is that the requirements are spelled out in public, in advance, and in some specificity and granularity. If you are a bank, you know which regulations apply to your business model. But is this true in practice? As a banker, do you always know the standards to which you will be held prior to the examination? One of the concerning trends in 2023 were reports, including from state banking regulators, that some supervisory actions were excessive in light of the risks posed by some smaller institutions. It seems reasonable that the banking system stress played a role in tightening supervisory expectations. But we must also ensure that supervisory expectations and the resulting actions are appropriately calibrated and based on existing conditions, rather than driven by premature judgments and uncertain or unsupported supervisory predictions or assumptions. Transparency allows bankers to understand supervisory expectations in advance and work to meet those expectations. As you know, bankers have a deep commitment to operate safely and soundly but have no ability to look inside the mind of an examiner to divine that expectations have shifted. Opaque shifts in expectations can create unwelcome surprises in the examination process. These "surprises," in the form of ratings downgrades, can create significant issues for banks: they can disrupt business plans, including bank mergers and acquisitions, and create pressure on a bank to divert resources away from serving customers to addressing non-critical supervisory matters. The increasing trend of supervisory "surprises" we saw in 2023 suggests to me a shortcoming in supervisory transparency. This by no means suggests that banks should not be held to high standards. To the contrary, it means that we should hold banks to standards that are known and identifiable, and when those standards inevitably evolve over time, we should give advance notice to our regulated institutions so they can manage their businesses accordingly to ensure continued compliance. I will conclude by expressing my appreciation for the opportunity to speak to you today. We are entering the new year at a time when significant changes to the banking system and bank regulatory framework are actively being considered. Many of these changes will have a lasting impact on banks of all sizes and their current and future customers, how banks run their businesses, and the broader U.S. economy. My hope is that you, as bankers, and other interested stakeholders play an active role in this process, by sharing your views and concerns broadly, including with regulators directly. This input provides valuable insights into the specific impacts-intended and unintended-of changes to the bank regulatory framework. Voicing your concerns enables us to identify, and where needed, address, the real-world consequences of regulatory and supervisory reforms. I certainly don't need to remind this audience that the stakes are extremely high. My sincere hope for 2024 is that policymakers have the humility to acknowledge the intended and unintended consequences of these and upcoming regulatory reform efforts, and the courage to change course, when necessary, to mitigate and minimize these consequences. The future of the banking system and the ongoing strength of the U.S. economy depend on it.
2024-12-12T00:00:00	Christine Lagarde: ECB press conference - introductory statement	Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 12 December 2024.	Christine Lagarde: ECB press conference - introductory statement Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 12 December 2024. * * * Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The disinflation process is well on track. Staff see headline inflation averaging 2.4 per cent in 2024, 2.1 per cent in 2025, 1.9 per cent in 2026 and 2.1 per cent in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff project an average of 2.9 per cent in 2024, 2.3 per cent in 2025 and 1.9 per cent in both 2026 and 2027. Most measures of underlying inflation suggest that inflation will settle at around our two per cent medium-term target on a sustained basis. Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay. Financing conditions are easing, as our recent interest rate cuts gradually make new borrowing less expensive for firms and households. But they continue to be tight because our monetary policy remains restrictive and past interest rate hikes are still transmitting to the outstanding stock of credit. Staff now expect a slower economic recovery than in the September projections. Although growth picked up in the third quarter of this year, survey indicators suggest it has slowed in the current quarter. Staff see the economy growing by 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. The projected recovery rests mainly on rising real incomes - which should allow households to consume more - and firms increasing investment. Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. Economic activity The economy grew by 0.4 per cent in the third quarter, exceeding expectations. Growth was driven mainly by an increase in consumption, partly reflecting one-off factors that boosted tourism over the summer, and by firms building up inventories. But the latest information suggests it is losing momentum. Surveys indicate that manufacturing is still contracting and growth in services is slowing. Firms are holding back their investment spending in the face of weak demand and a highly uncertain outlook. Exports are also weak, with some European industries finding it challenging to remain competitive. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again by more than expected. The unemployment rate remained at its historical low of 6.3 per cent in October. Meanwhile, demand for labour continues to weaken. The job vacancy rate declined to 2.5% in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. The economy should strengthen over time, although more slowly than previously expected. The rise in real wages should strengthen household spending. More affordable credit should boost consumption and investment. Provided trade tensions do not escalate, exports should support the recovery as global demand rises. Fiscal and structural policies should make the economy more productive, competitive and resilient. It is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. We welcome the European Commission's assessment of governments' medium-term plans for fiscal and structural policies, as part of the EU's revised economic governance framework. Governments should now focus on implementing their commitments under this framework fully and without delay. This will help bring down budget deficits and debt ratios on a sustained basis, while prioritising growth-enhancing reforms and investment. Inflation Annual inflation increased to 2.3 per cent in November according to Eurostat's flash estimate, from 2.0 per cent in October. The increase was expected and primarily reflected an energy-related upward base effect. Food price inflation edged down to 2.8 per cent and services inflation to 3.9 per cent. Goods inflation went up to 0.7 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at 4.2%, it remains high. This reflects strong wage pressures and the fact that some services prices are still adjusting with a delay to the past inflation surge. That said, underlying inflation is overall developing in line with a sustained return of inflation to target. The increase in compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second. Amid stable productivity, this contributed to slower growth in unit labour costs. Staff expect labour costs to increase more slowly over the projection horizon as a result of lower wage growth and higher productivity growth. Moreover, profits should continue to partially offset the effects of higher labour costs on prices, especially in the near term. We expect inflation to fluctuate around its current level in the near term, as previous sharp falls in energy prices continue to drop out of the annual rates. It should then settle sustainably at around the two per cent medium-term target. Easing labour cost pressures and the continuing impact of our past monetary policy tightening on consumer prices should help this process. Most measures of longer-term inflation expectations stand at around 2 per cent, and market-based indicators of medium to longer-term inflation compensation have decreased measurably since the Governing Council's October meeting. Risk assessment The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. Financial and monetary conditions Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook. Although financing conditions remain restrictive, our interest rate cuts are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages, at 3.6 per cent in October, is about half a percentage point lower than at its highest point in 2023, even though the average rate on the outstanding stock of mortgages is still set to rise. Bank lending to firms has gradually picked up from low levels, and increased by 1.2 per cent in October compared with a year earlier. Debt securities issued by firms were up 3.1% in annual terms, which was similar to the increase in the previous few months. Mortgage lending continued to rise gradually in October, with an annual growth rate of 0.8 per cent. In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient and there are few signs of financial market stress. Financial stability risks nonetheless remain elevated. Macroprudential policy remains the first line of defence against the build-up of financial vulnerabilities, enhancing resilience and preserving macroprudential space. Conclusion The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a datadependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation stabilises sustainably at our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.	---[PAGE_BREAK]--- # Christine Lagarde: ECB press conference - introductory statement Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 12 December 2024. Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The disinflation process is well on track. Staff see headline inflation averaging 2.4 per cent in 2024, 2.1 per cent in 2025, 1.9 per cent in 2026 and 2.1 per cent in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff project an average of 2.9 per cent in 2024, 2.3 per cent in 2025 and 1.9 per cent in both 2026 and 2027. Most measures of underlying inflation suggest that inflation will settle at around our two per cent medium-term target on a sustained basis. Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay. Financing conditions are easing, as our recent interest rate cuts gradually make new borrowing less expensive for firms and households. But they continue to be tight because our monetary policy remains restrictive and past interest rate hikes are still transmitting to the outstanding stock of credit. Staff now expect a slower economic recovery than in the September projections. Although growth picked up in the third quarter of this year, survey indicators suggest it has slowed in the current quarter. Staff see the economy growing by 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. The projected recovery rests mainly on rising real incomes - which should allow households to consume more - and firms increasing investment. Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. ---[PAGE_BREAK]--- I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. # Economic activity The economy grew by 0.4 per cent in the third quarter, exceeding expectations. Growth was driven mainly by an increase in consumption, partly reflecting one-off factors that boosted tourism over the summer, and by firms building up inventories. But the latest information suggests it is losing momentum. Surveys indicate that manufacturing is still contracting and growth in services is slowing. Firms are holding back their investment spending in the face of weak demand and a highly uncertain outlook. Exports are also weak, with some European industries finding it challenging to remain competitive. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again by more than expected. The unemployment rate remained at its historical low of 6.3 per cent in October. Meanwhile, demand for labour continues to weaken. The job vacancy rate declined to $2.5 \%$ in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. The economy should strengthen over time, although more slowly than previously expected. The rise in real wages should strengthen household spending. More affordable credit should boost consumption and investment. Provided trade tensions do not escalate, exports should support the recovery as global demand rises. Fiscal and structural policies should make the economy more productive, competitive and resilient. It is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. We welcome the European Commission's assessment of governments' medium-term plans for fiscal and structural policies, as part of the EU's revised economic governance framework. Governments should now focus on implementing their commitments under this framework fully and without delay. This will help bring down budget deficits and debt ratios on a sustained basis, while prioritising growth-enhancing reforms and investment. ## Inflation Annual inflation increased to 2.3 per cent in November according to Eurostat's flash estimate, from 2.0 per cent in October. The increase was expected and primarily reflected an energy-related upward base effect. Food price inflation edged down to 2.8 per cent and services inflation to 3.9 per cent. Goods inflation went up to 0.7 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at $4.2 \%$, it remains high. This reflects strong wage pressures and the fact that some services prices are still adjusting with a delay to the past inflation surge. That said, underlying inflation is overall developing in line with a sustained return of inflation to target. The increase in compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second. Amid stable productivity, this contributed to slower growth in unit labour costs. Staff expect labour costs to increase more slowly ---[PAGE_BREAK]--- over the projection horizon as a result of lower wage growth and higher productivity growth. Moreover, profits should continue to partially offset the effects of higher labour costs on prices, especially in the near term. We expect inflation to fluctuate around its current level in the near term, as previous sharp falls in energy prices continue to drop out of the annual rates. It should then settle sustainably at around the two per cent medium-term target. Easing labour cost pressures and the continuing impact of our past monetary policy tightening on consumer prices should help this process. Most measures of longer-term inflation expectations stand at around 2 per cent, and market-based indicators of medium to longer-term inflation compensation have decreased measurably since the Governing Council's October meeting. # Risk assessment The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. ## Financial and monetary conditions Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook. Although financing conditions remain restrictive, our interest rate cuts are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages, at 3.6 per cent in October, is about half a percentage point lower than at its highest point in 2023, even though the average rate on the outstanding stock of mortgages is still set to rise. ---[PAGE_BREAK]--- Bank lending to firms has gradually picked up from low levels, and increased by 1.2 per cent in October compared with a year earlier. Debt securities issued by firms were up $3.1 \%$ in annual terms, which was similar to the increase in the previous few months. Mortgage lending continued to rise gradually in October, with an annual growth rate of 0.8 per cent. In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient and there are few signs of financial market stress. Financial stability risks nonetheless remain elevated. Macroprudential policy remains the first line of defence against the build-up of financial vulnerabilities, enhancing resilience and preserving macroprudential space. # Conclusion The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a datadependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation stabilises sustainably at our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.	Christine Lagarde	Euro area	https://www.bis.org/review/r241219c.pdf	Introductory statement by Ms Christine Lagarde, President of the European Central Bank, and Mr Luis de Guindos, Vice-President of the European Central Bank, Frankfurt am Main, 12 December 2024. Good afternoon, the Vice-President and I welcome you to our press conference. The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The disinflation process is well on track. Staff see headline inflation averaging 2.4 per cent in 2024, 2.1 per cent in 2025, 1.9 per cent in 2026 and 2.1 per cent in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff project an average of 2.9 per cent in 2024, 2.3 per cent in 2025 and 1.9 per cent in both 2026 and 2027. Most measures of underlying inflation suggest that inflation will settle at around our two per cent medium-term target on a sustained basis. Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay. Financing conditions are easing, as our recent interest rate cuts gradually make new borrowing less expensive for firms and households. But they continue to be tight because our monetary policy remains restrictive and past interest rate hikes are still transmitting to the outstanding stock of credit. Staff now expect a slower economic recovery than in the September projections. Although growth picked up in the third quarter of this year, survey indicators suggest it has slowed in the current quarter. Staff see the economy growing by 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. The projected recovery rests mainly on rising real incomes - which should allow households to consume more - and firms increasing investment. Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions. The economy grew by 0.4 per cent in the third quarter, exceeding expectations. Growth was driven mainly by an increase in consumption, partly reflecting one-off factors that boosted tourism over the summer, and by firms building up inventories. But the latest information suggests it is losing momentum. Surveys indicate that manufacturing is still contracting and growth in services is slowing. Firms are holding back their investment spending in the face of weak demand and a highly uncertain outlook. Exports are also weak, with some European industries finding it challenging to remain competitive. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again by more than expected. The unemployment rate remained at its historical low of 6.3 per cent in October. Meanwhile, demand for labour continues to weaken. The job vacancy rate declined to $2.5 \%$ in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. The economy should strengthen over time, although more slowly than previously expected. The rise in real wages should strengthen household spending. More affordable credit should boost consumption and investment. Provided trade tensions do not escalate, exports should support the recovery as global demand rises. Fiscal and structural policies should make the economy more productive, competitive and resilient. It is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi's proposals for enhancing European competitiveness and Enrico Letta's proposals for empowering the Single Market. We welcome the European Commission's assessment of governments' medium-term plans for fiscal and structural policies, as part of the EU's revised economic governance framework. Governments should now focus on implementing their commitments under this framework fully and without delay. This will help bring down budget deficits and debt ratios on a sustained basis, while prioritising growth-enhancing reforms and investment. Annual inflation increased to 2.3 per cent in November according to Eurostat's flash estimate, from 2.0 per cent in October. The increase was expected and primarily reflected an energy-related upward base effect. Food price inflation edged down to 2.8 per cent and services inflation to 3.9 per cent. Goods inflation went up to 0.7 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at $4.2 \%$, it remains high. This reflects strong wage pressures and the fact that some services prices are still adjusting with a delay to the past inflation surge. That said, underlying inflation is overall developing in line with a sustained return of inflation to target. The increase in compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second. Amid stable productivity, this contributed to slower growth in unit labour costs. Staff expect labour costs to increase more slowly over the projection horizon as a result of lower wage growth and higher productivity growth. Moreover, profits should continue to partially offset the effects of higher labour costs on prices, especially in the near term. We expect inflation to fluctuate around its current level in the near term, as previous sharp falls in energy prices continue to drop out of the annual rates. It should then settle sustainably at around the two per cent medium-term target. Easing labour cost pressures and the continuing impact of our past monetary policy tightening on consumer prices should help this process. Most measures of longer-term inflation expectations stand at around 2 per cent, and market-based indicators of medium to longer-term inflation compensation have decreased measurably since the Governing Council's October meeting. The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook. Although financing conditions remain restrictive, our interest rate cuts are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages, at 3.6 per cent in October, is about half a percentage point lower than at its highest point in 2023, even though the average rate on the outstanding stock of mortgages is still set to rise. Bank lending to firms has gradually picked up from low levels, and increased by 1.2 per cent in October compared with a year earlier. Debt securities issued by firms were up $3.1 \%$ in annual terms, which was similar to the increase in the previous few months. Mortgage lending continued to rise gradually in October, with an annual growth rate of 0.8 per cent. In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient and there are few signs of financial market stress. Financial stability risks nonetheless remain elevated. Macroprudential policy remains the first line of defence against the build-up of financial vulnerabilities, enhancing resilience and preserving macroprudential space. The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate - the rate through which we steer the monetary policy stance - is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a datadependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation stabilises sustainably at our medium-term target and to preserve the smooth functioning of monetary policy transmission. We are now ready to take your questions.
2024-12-16T00:00:00	Isabel Schnabel: Navigating towards neutral	Keynote speech by Ms Isabel Schnabel, Member of the Executive Board of the European Central Bank, at the CEPR Paris Symposium 2024, hosted by the Banque de France, Paris, 16 December 2024.	SPEECH Navigating towards neutral Keynote speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the CEPR Paris Symposium 2024 hosted by the Banque de France Paris, 16 December 2024 Monetary policy is at a critical juncture. Growing confidence in a sustainable decline of inflation towards our 2% target has allowed the Governing Council to remove substantial policy restriction over the past six months. With our decision last week to cut the three key policy rates by a further 25 basis points, the deposit facility rate is now at 3%, one percentage point below its peak. Today I will argue that, with interest rates approaching neutral territory and with risks to the inflation outlook broadly balanced, monetary policy should proceed gradually and remain data-dependent. In this way, we can ensure that disinflation does not stall above our 2% target, while avoiding unnecessary weakness in the labour market and the economy at large. I will also argue that, once price stability has been restored, the challenges for monetary policy will change. As inflation becomes dominated by idiosyncratic shocks again, central banks can afford to be more tolerant of moderate deviations from target - in both directions. Staff projections confirm nearing return to price stability Incoming data and the new Eurosystem staff projections have confirmed that the disinflation process remains well on track. Inflation is now expected to decline towards our 2% target in the course of 2025 and to oscillate around this level over the projection horizon, as domestic price pressures ease and base effects from energy prices fade (Slide 2, left-hand side). Growth has been revised down but is still expected to accelerate next year, as consumption and investment recover on the back of rising real incomes and less restrictive financing conditions (Slide 2, right-hand side). As ECB staff continue to project that the euro area economy will expand at a pace around its potential growth rate in the coming years, inflation should neither over- nor undershoot our 2% target materially over the projection horizon once past shocks have fully unwound. Three factors support the assumptions underlying this projected recovery. One is the upside surprise to growth in the third quarter, with private consumption picking up and inventories no longer weighing on growth (Slide 3, left-hand side). A turnaround in the inventory cycle would remove a significant drag on aggregate demand. Second, confidence in the retail trade sector as well as consumer expectations for major purchases over the next twelve months continued to improve in November, while savings intentions declined somewhat (Slide 3, right-hand side). Third, according to model-based analyses, over the next twelve months an economic expansion is still much more probable than a recession, despite the prospect of more trade barriers clouding the euro area economic outlook (Slide 4, left-hand side). Although the baseline forecast does not incorporate the potential impact of concrete policy measures of the new Trump administration, as these remain uncertain, recent sentiment indicators are likely to partially reflect the surge in trade policy uncertainty already (Slide 4, right-hand side). Empirical research suggests that, rather than the actual tariff increase itself, it is the rise in uncertainty that will be the main drag on growth. But these effects are often estimated to be short-lived, with growth rebounding sharply once uncertainty fades. Gradual removal of policy restriction remains appropriate The staff projections are therefore consistent with bringing interest rates to a neutral setting as inflation stabilises sustainably around our 2% target. The question then is how fast we should remove policy restriction. Our decision last week to cut our key policy rates by 25 basis points reflects the conviction that a gradual and data-dependent approach remains the most appropriate strategy.!2] There are three reasons for this. Dot the i's and cross the t's First, while we are increasingly confident that price stability is within reach, an important part of disinflation has yet to materialise. Services inflation, in particular, remains high at 3.9%. At the same time, momentum indicators, such as the three-month-on-three-month rate, suggest that price pressures have started to ease. But such signals critically depend on the way the seasonal adjustment is done. For example, shifts in households' consumption patterns in the wake of the pandemic may be making the seasonal adjustment more difficult. Estimates by financial market participants suggest that, when correcting for these potential shifts, momentum could be measurably higher than what our current estimates imply./2] Indeed, over the past two years, November has turned out to be a notable outlier in terms of the month-on-month change in services inflation (Slide 5, left-hand side). Also, while the baseline scenario assumes a cyclical recovery in productivity growth that is expected to ease the growth in unit labour costs, hysteresis effects or other structural factors could weigh on productivity and investment over an extended period of time. Recent scenario analysis conducted by ECB staff shows that, in that case, growth would be lower and inflation higher - 0.3 percentage points cumulatively by 2026 - than in the baseline (Slide 5, right-hand side).4] These effects would rise notably if the forces weighing on productivity growth were more permanent. So, even if most of the evidence points to continued disinflation, we should remain alert to signs that cast doubt on our baseline. A gradual approach allows us to react to such signs. Balance of risks can shift as new shocks materialise Second, new shocks keep hitting the euro area economy, many of them posing upside risks to inflation. Gas prices, for example, have doubled since February (Slide 6, left-hand side). As a result, wholesale electricity prices have increased substantially. Food prices, too, have started rising at a concerning pace, at an annualised three-month-on-three-month rate of 4.6% in November, up from 0.9% in May (Slide 6, right-hand side). Moreover, climate mitigation measures are increasingly affecting prices over the medium term. In 2027, for example, Eurosystem staff expect inflation to rise above 2%, mainly due to the planned expansion of the EU emissions trading system to buildings, road transport and small industry (ETS2). [5] In addition, while the direction and persistence of the various effects of potential tariffs on inflation are ambiguous, their net effect is often estimated to be positive. While a decline in foreign demand for euro area goods as well as trade diversion, especially from China, are likely to be disinflationary, several channels could mitigate or even offset these forces. For example, the EU may retaliate with tariffs of its own, as it did in 2018. Also, the parallel impulse to the US economy coming from expansionary fiscal and supply-side policies could support foreign demand, even as tariffs increase, because many products are not substitutable in the short run. Finally, since the end of September the euro has depreciated by more than 6% against the US dollar, largely in anticipation of the incoming US administration's economic policy intentions. This is already putting upward pressure on import prices. Such inflationary shocks are of particular concern in the current environment, as people are paying more attention to inflation after recent experiences. The latest Eurobarometer reveals that inflation remains people's biggest concern in most euro area countries.!©! This attention makes inflation expectations more vulnerable after a long period of high inflation. Proceeding gradually allows us to respond to new shocks in an environment of elevated uncertainty and volatility. Data dependence needed to assess the degree of policy restriction Third, a gradual approach is the most appropriate course of action the closer we are getting to neutral territory. There are two related sets of benchmarks for monetary policy. One is simple Taylor-type policy rules that are used in most structural models to replicate the systematic response of monetary policy to movements in inflation and growth. While such rules need to be treated with caution, they are a useful policy benchmark. As there are many ways such rules can be formulated and estimated, it is helpful to use a thick- modelling framework that reduces some of the data and model uncertainty. Such a framework currently suggests that the median rule points to a gradual dialling back of policy restriction (Slide 7). It also suggests that the distribution of projected interest rate outcomes is skewed to the upside. The second benchmark is the natural real rate of interest, r. There is no consensus on what its main drivers are, or on how to best estimate it. As a result, the range of estimates is exceptionally large, both within and across models. Recent analysis by ECB staff across a suite of models suggest that the point estimate of r ranges from about -0.5% to 1%, or about 1.5% to 3% in nominal terms. This is similar to recent estimates by economists from the Bank for International Settlements. ©] Significant parameter uncertainty makes it even more challenging to use the natural rate as a guidepost for monetary policy. In this uncertain environment, it is helpful to focus on what has changed in recent years to understand whether real equilibrium rates could be higher today than during the 2010s. An increase would warrant a more cautious approach by central banks removing policy restriction. Changes in the demand for and supply of global savings suggest that equilibrium rates may have increased in recent years. The pandemic, Russia's invasion of Ukraine and other shocks have led to an increase in public debt around the world (Slide 8, left-hand side). Net borrowing by governments remains substantial. In 2024, the public deficit will be around 5% of GDP across advanced economies and it is expected to decline only marginally in the coming years, also reflecting borrowing requirements associated with the digital and green transitions (Slide 8, right-hand side). The International Monetary Fund (IMF) projects that, in the coming years, overall global investment - public and private - will reach the highest share in GDP since the 1980s. It is likely that, as a result, real interest rates need to rise to clear the global market for savings. This may especially be the case as rising geopolitical fragmentation contributes to reducing the supply of savings, including those provided by price-insensitive investors. In the United States, for example, the decline in the share of foreign official holdings of US Treasury securities has accelerated in recent years (Slide 9, left-hand side). It is now at the lowest level in more than twenty years.l2] Incidentally, since about late 2022, asset swap spreads started to widen measurably in both the euro area and the United States, suggesting that investors are gradually demanding a higher return to warehouse the supply of global public bonds (Slide 9, right-hand side).4 These developments are contributing to the reversal of the global savings glut, which put notable downward pressure on real rates for the greater part of the 21st century.) This has repercussions for the assessment of the monetary policy stance. For example, given the notable increase in real short-term rates expected to prevail in the distant future, which are often taken as proxies for the natural rate, the policy stance today may already be in neutral territory, as real spot rates have started to fall below their equilibrium levels (Slide 10). Other indicators point in a similar direction. In our most recent bank lending survey, for example, 93% of banks report that the general level of interest rates no longer plays a role in explaining weak loan demand. This contrasts sharply with a year ago when almost half of the banks said that interest rates were a factor contributing to lower loan demand. Similarly, the survey on the access to finance of enterprises shows that the pressure from interest expenses is gradually easing. The net percentage of firms indicating an increase in interest expenses fell from 36% to 19%, reaching similar levels to those recorded at the end of 2021. Finally, among households, we have observed a notable turnaround in the demand for housing loans. Anet 39% of banks reported higher demand in the third quarter, a share close to the historical peak of 45% and well above the historical average (Slide 11, left-hand side). This increase in the demand for housing loans is broad-based across countries. Banks expect it to continue, reflecting both the decline in mortgage rates and improving housing market prospects. In the second quarter, the euro area house price index rose for the first time in more than a year (Slide 11, right-hand side). Return to price stability requires different conduct of monetary policy All this suggests that we should proceed with caution and remain data-dependent, assessing at each monetary policy meeting whether disinflation remains on track and whether, and to what extent, interest rates remain restrictive. In doing so, we can continuously cross-check the assumptions underlying the staff projections and thereby retain a forward-looking perspective. This is especially important at a time when past pandemic-related shocks are starting to recede, and new shocks are increasingly driving price and wage dynamics. This shift in regime - from a high-inflation environment to one where inflation is consistent with price stability - has two important implications for the conduct of monetary policy.2] The effectiveness of monetary policy depends on the inflation regime One is that it has a direct impact on the effectiveness of monetary policy. The success of central banks in paving the way towards restoring price stability after the recent inflation surge has a lot to do with how monetary policy works. In a high-inflation regime, price increases tend to reflect factors common to most goods and services. This is what has happened in recent years. The common component of inflation rose sharply as firms reacted to the combination of higher energy prices, supply-side bottlenecks and pent-up demand after the pandemic-induced lockdowns. This was reflected in the rapid broadening of inflation pressures across the goods and services contained in the consumption basket (Slide 12). Ultimately, these shocks affected all sectors of the economy, especially when second-round effects pushed wage demands higher across firms. Wage-price spirals are often the clearest sign of a regime shift, when changes in the general price level become a coordination device for price and wage setters. As monetary policy affects aggregate demand as well as the inflation expectations of both firms and households, it is powerful in counteracting such common shocks (Slide 13, left-hand side). As this process is nearing completion and we are re-entering a regime of price stability, idiosyncratic price shocks that reflect relative price changes, and that are mostly independent of each other, will again dominate in driving aggregate inflation. This is reflected in the measurable decline of the common component. Idiosyncratic price changes, however, tend to be less responsive to changes in aggregate demand and hence to changes in monetary policy (Slide 13, right-hand side). As a result, monetary policy becomes less effective in steering overall inflation. Central banks then need to carefully weigh the benefits and costs of trying to lean against relative price shocks. The strongest case for acting is when prices start to co-move again, either because of a new large shock or a series of shocks that move prices in the same direction. But in the absence of such shocks, policy should be careful not to overreact. This is especially the case if idiosyncratic shocks reflect structural forces. While it is inherently difficult to separate cyclical from structural factors, surveys among firms suggest that a significant part of the current weakness in parts of our economy relates to forces outside the realm of monetary policy. In our latest corporate telephone survey, for example, firms reported that the recent decline in business sentiment was driven by growing concerns about political developments, both in Europe and globally, and waning competitiveness amid high energy costs and the green transition. Firms expressed concerns about rising regulatory costs, such as those resulting from the Corporate Sustainability Reporting Directive (CSRD) or the Corporate Sustainability Due Diligence Directive (CSDDD). Compliance with these and other directives is seen as complex and resource-intensive, especially for smaller firms.] In other cases, such as the General Data Protection Regulation (GDPR) or the Artificial Intelligence (Al) Act, there is mounting concern that regulation is increasingly stifling innovation and competition, especially in important areas such as Al.[44] Particularly in Germany and France, these structural headwinds are causing businesses to postpone, or even refrain from, transformative investments and focus instead on efficiency and cost-cutting, which, in turn, is weighing on consumer confidence and spending. An expansionary monetary policy stance will change this dynamic only marginally, if at all. Recent research by Oscar Jorda, Sanjay Singh and Alan Taylor corroborates this view. It shows that, while the effects of tight monetary policy can be persistent, central banks cannot boost potential output by bringing rates into expansionary territory (Slide 14, left-hand side). And while the benefits of using monetary policy to deal with idiosyncratic shocks are likely to be limited, the welfare costs that it has for society can be significant. One of the costs is that relative price adjustments support the efficient allocation of resources within the economy. Leaning too strongly against them in the absence of clear risks to price stability may inhibit this process. The other is that valuable policy space is lost and so will not be available to support employment and growth when the economy faces shocks that monetary policy can deal with more effectively. This was the case when the pandemic hit. At that time, interest rates were already close to their effective lower bound. As a result, central banks needed to resort to unconventional policy instruments. However, the effectiveness of such measures in stimulating aggregate demand is more uncertain, while their potential side effects are larger." Greater tolerance for moderate deviations of inflation from target The second implication is that, when relative price shocks dominate, inflation is largely self-stabilising. As a result, central banks can have a greater tolerance for moderate deviations of inflation from target, in both directions. The reason is that the impact of changes in aggregate demand on inflation is weaker in an environment in which price changes are largely independent from each other. That is, the Phillips curve is highly non-linear: its slope is often steep when inflation is high, and it is flat when inflation is low. In this environment, it takes a large shock to aggregate demand for inflation to measurably and persistently drift away from the economy's nominal anchor - our 2% target. So there is less need for policy to respond to moderate shocks. This is especially true for disinflationary shocks. Overwhelming empirical evidence suggests that nominal wage cuts are extremely rare and that the frequency at which firms adjust prices lower is highly stable over time (Slide 14, right-hand side).(48] And when prices and wages do not chase each other as they did over the past years, inflation is largely self-stabilising. As such, the risk of falling into a truly harmful deflationary spiral is limited. Monetary policy can then be more patient and allow inflation to deviate from target for longer than in a situation in which risks of second-round effects are larger. This can also be seen in the historical properties of commodity price shocks. When oil prices fell sharply and persistently in 2014, the pass-through to consumer prices and wages was moderate. Underlying inflation, while weak, never fundamentally drifted away from our 2% target. But in 2022, when inflation was already rising on the back of the repercussions of the pandemic, firms raised their prices considerably and much more frequently than when inflation was low and stable. Conclusion Let me now conclude with three main take-aways. First, price stability is within reach. Considering the risks and uncertainties we are still facing, lowering policy rates gradually towards a neutral level is the most appropriate course of action. Second, once price stability has been restored in a sustainable manner, the behaviour of inflation will change such that central banks can afford to tolerate moderate deviations of inflation from target, in both directions. Given limited policy space, monetary policy should focus on responding forcefully to shocks that have the capacity to destabilise inflation expectations by pushing inflation measurably and persistently away from our 2% target over the medium term. Third, monetary policy is not a supply-side instrument. It cannot resolve structural issues that durably weigh on price pressures, as was the case during the 2010s, when a highly accommodative monetary policy stance over a long period was unable to lift the economy out of the low-growth, low-inflation environment. Structural policies are the responsibility of governments. Thank you. Annexes 16 December 2024 Presentation slides 1. Bloom, N. (2009), "The Impact of Uncertainty Shocks', Econometrica, Vol. 77(3), pp. 623-685. 2. Lagarde, C. (2024), "Monetary policy in the euro area", speech at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, Lithuania, 16 December. 3. Choraria, N. (2024), Inflation Trading, Goldman Sachs International, 9 November. 4. ECB (2024), Eurosystem staff macroeconomic projections for the euro area, June. 5. European Commission, ETS2: buildings, road transport and additional sectors. 6. Eurobarometer, November 2024. 7. Brand, C., Lisack, N. and Mazelis, F. (2024), "Estimates of the natural interest rate for the euro area: an update", Economic Bulletin, Issue 1, ECB. 8. Benigno, G., Hofmann, B., Nufio, G. and Sandri, D. (2024), "Quo vadis, r*? The natural rate of interest after the pandemic", B/S Quarterly Review, March. 9. This has coincided with the price of gold - the world's other safe haven asset - having more than doubled over the past ten years. 10. Real rates could rise more substantially if investors were to regard government bonds as less safe, pushing equilibrium risk premia higher. Analysis by the IMF, for example, suggests that if the premia were to rise back to pre-2000 average levels, they could bring up natural rates in advanced economies by 70 basis points. See IMF (2023), "The natural rate of interest: drivers and policy implications', World Economic Outlook, April. 11. Bernanke, B. (2005), The Global Saving Glut and the U.S. Current Account Deficit", remarks at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, 10 March. 12. This part of the speech builds on insights contained in Borio, C., Lombardi, M., Yetman, J. and ZakrajSek, E. (2023), "The two-regime view of inflation', BIS Papers, No 133. 13. For instance, Mario Draghi's report on the future of European competitiveness presented estimates of the costs for complying with the Corporate Sustainability Reporting Directive ranging from €150,000 for non-listed businesses to €1 million for listed companies. Also, according to the 2024 European Investment Bank survey, nearly a third of small and medium-sized firms report that more than 10% of their staff are employed to assess and comply with regulatory requirements and standards. 14. Goldberg, S. (2023), "Balancing act: Protecting privacy, protecting competition", Stanford Institute for Economic Policy Research, Policy Brief, January; Gal, M. and Aviv, O. (2020), "The Competitive Effects of the GDPR'", Journal of Competition Law & Economics, Vol. 16(3), pp. 349-391; and Chivot, E. and Castro, D. (2019), The EU Needs to Reform the GDPR to Remain Competitive in the Algorithmic Economy, Center for Data Innovation, 13 May. 15. Jorda, O., Singh, S. and Taylor, A. (2020), "The Long-Run Effects of Monetary Policy", NBER Working Paper, No 26666. 16. Schnabel, I. (2024), "The benefits and costs of asset purchases", speech at the 2024 BOJ-IMES Conference on "Price Dynamics and Monetary Policy Challenges: Lessons Learned and Going Forward", Tokyo, 28 May; and Schnabel, I. (2024), "Reassessing monetary policy tools in a volatile macroeconomic environment", speech at the 25th Jacques Polak Annual Research Conference, Washington, D.C., 14 November. 17. Benigno, P. and Eggertsson, G. (2023), "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve", NBER Working Paper, No 31197. See also Hooper, P., Mishkin, F.S. and Sufi, A. (2019), "Prospects for Inflation in a High Pressure Economy: is the Phillips Curve Dead or is it Just Hibernating?", NBER Working Paper, No 25792. 18. More recent contributions are Grigsby, J., Hurst, E. and Yildirmaz, A. (2021), "Aggregate nominal wage adjustments: new evidence from administrative payroll data', American Economic Review, Vol. 111, No 2, pp. 428-471 and Schaefer, D. and Singleton, C. (2023), "The extent of downward nominal wage rigidity: New evidence from payroll data', Review of Economic Dynamics, Vol. 51, pp. 60-76. 19. Lagarde (2024, op.cit.). CONTACT	---[PAGE_BREAK]--- # Navigating towards neutral ## Keynote speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the CEPR Paris Symposium 2024 hosted by the Banque de France Paris, 16 December 2024 Monetary policy is at a critical juncture. Growing confidence in a sustainable decline of inflation towards our $2 \%$ target has allowed the Governing Council to remove substantial policy restriction over the past six months. With our decision last week to cut the three key policy rates by a further 25 basis points, the deposit facility rate is now at $3 \%$, one percentage point below its peak. Today I will argue that, with interest rates approaching neutral territory and with risks to the inflation outlook broadly balanced, monetary policy should proceed gradually and remain data-dependent. In this way, we can ensure that disinflation does not stall above our $2 \%$ target, while avoiding unnecessary weakness in the labour market and the economy at large. I will also argue that, once price stability has been restored, the challenges for monetary policy will change. As inflation becomes dominated by idiosyncratic shocks again, central banks can afford to be more tolerant of moderate deviations from target - in both directions. ## Staff projections confirm nearing return to price stability Incoming data and the new Eurosystem staff projections have confirmed that the disinflation process remains well on track. Inflation is now expected to decline towards our 2\% target in the course of 2025 and to oscillate around this level over the projection horizon, as domestic price pressures ease and base effects from energy prices fade (Slide 2, left-hand side). Growth has been revised down but is still expected to accelerate next year, as consumption and investment recover on the back of rising real incomes and less restrictive financing conditions (Slide 2, right-hand side). As ECB staff continue to project that the euro area economy will expand at a pace around its potential growth rate in the coming years, inflation should neither over- nor undershoot our $2 \%$ target materially over the projection horizon once past shocks have fully unwound. Three factors support the assumptions underlying this projected recovery. One is the upside surprise to growth in the third quarter, with private consumption picking up and inventories no longer weighing on growth (Slide 3, left-hand side). A turnaround in the inventory cycle would remove a significant drag on aggregate demand. ---[PAGE_BREAK]--- Second, confidence in the retail trade sector as well as consumer expectations for major purchases over the next twelve months continued to improve in November, while savings intentions declined somewhat (Slide 3, right-hand side). Third, according to model-based analyses, over the next twelve months an economic expansion is still much more probable than a recession, despite the prospect of more trade barriers clouding the euro area economic outlook (Slide 4, left-hand side). Although the baseline forecast does not incorporate the potential impact of concrete policy measures of the new Trump administration, as these remain uncertain, recent sentiment indicators are likely to partially reflect the surge in trade policy uncertainty already (Slide 4, right-hand side). Empirical research suggests that, rather than the actual tariff increase itself, it is the rise in uncertainty that will be the main drag on growth. But these effects are often estimated to be short-lived, with growth rebounding sharply once uncertainty fades. $\underline{[1]}$ # Gradual removal of policy restriction remains appropriate The staff projections are therefore consistent with bringing interest rates to a neutral setting as inflation stabilises sustainably around our $2 \%$ target. The question then is how fast we should remove policy restriction. Our decision last week to cut our key policy rates by 25 basis points reflects the conviction that a gradual and data-dependent approach remains the most appropriate strategy. $\underline{[2]}$ There are three reasons for this. ## Dot the i's and cross the t's First, while we are increasingly confident that price stability is within reach, an important part of disinflation has yet to materialise. Services inflation, in particular, remains high at 3.9\%. At the same time, momentum indicators, such as the three-month-on-three-month rate, suggest that price pressures have started to ease. But such signals critically depend on the way the seasonal adjustment is done. For example, shifts in households' consumption patterns in the wake of the pandemic may be making the seasonal adjustment more difficult. Estimates by financial market participants suggest that, when correcting for these potential shifts, momentum could be measurably higher than what our current estimates imply. $\underline{[3]}$ Indeed, over the past two years, November has turned out to be a notable outlier in terms of the month-on-month change in services inflation (Slide 5, left-hand side). Also, while the baseline scenario assumes a cyclical recovery in productivity growth that is expected to ease the growth in unit labour costs, hysteresis effects or other structural factors could weigh on productivity and investment over an extended period of time. Recent scenario analysis conducted by ECB staff shows that, in that case, growth would be lower and inflation higher -0.3 percentage points cumulatively by 2026 - than in the baseline (Slide 5, right-hand ---[PAGE_BREAK]--- side). ${ }^{[4]}$ These effects would rise notably if the forces weighing on productivity growth were more permanent. So, even if most of the evidence points to continued disinflation, we should remain alert to signs that cast doubt on our baseline. A gradual approach allows us to react to such signs. # Balance of risks can shift as new shocks materialise Second, new shocks keep hitting the euro area economy, many of them posing upside risks to inflation. Gas prices, for example, have doubled since February (Slide 6, left-hand side). As a result, wholesale electricity prices have increased substantially. Food prices, too, have started rising at a concerning pace, at an annualised three-month-on-three-month rate of $4.6 \%$ in November, up from $0.9 \%$ in May (Slide 6, right-hand side). Moreover, climate mitigation measures are increasingly affecting prices over the medium term. In 2027, for example, Eurosystem staff expect inflation to rise above 2\%, mainly due to the planned expansion of the EU emissions trading system to buildings, road transport and small industry (ETS2). $[5]$ In addition, while the direction and persistence of the various effects of potential tariffs on inflation are ambiguous, their net effect is often estimated to be positive. While a decline in foreign demand for euro area goods as well as trade diversion, especially from China, are likely to be disinflationary, several channels could mitigate or even offset these forces. For example, the EU may retaliate with tariffs of its own, as it did in 2018. Also, the parallel impulse to the US economy coming from expansionary fiscal and supply-side policies could support foreign demand, even as tariffs increase, because many products are not substitutable in the short run. Finally, since the end of September the euro has depreciated by more than 6\% against the US dollar, largely in anticipation of the incoming US administration's economic policy intentions. This is already putting upward pressure on import prices. Such inflationary shocks are of particular concern in the current environment, as people are paying more attention to inflation after recent experiences. The latest Eurobarometer reveals that inflation remains people's biggest concern in most euro area countries. ${ }^{[6]}$ This attention makes inflation expectations more vulnerable after a long period of high inflation. Proceeding gradually allows us to respond to new shocks in an environment of elevated uncertainty and volatility. ## Data dependence needed to assess the degree of policy restriction Third, a gradual approach is the most appropriate course of action the closer we are getting to neutral territory. There are two related sets of benchmarks for monetary policy. ---[PAGE_BREAK]--- One is simple Taylor-type policy rules that are used in most structural models to replicate the systematic response of monetary policy to movements in inflation and growth. While such rules need to be treated with caution, they are a useful policy benchmark. As there are many ways such rules can be formulated and estimated, it is helpful to use a thickmodelling framework that reduces some of the data and model uncertainty. Such a framework currently suggests that the median rule points to a gradual dialling back of policy restriction (Slide 7). It also suggests that the distribution of projected interest rate outcomes is skewed to the upside. The second benchmark is the natural real rate of interest, $r^{}$. There is no consensus on what its main drivers are, or on how to best estimate it. As a result, the range of estimates is exceptionally large, both within and across models. Recent analysis by ECB staff across a suite of models suggest that the point estimate of $r^{}$ ranges from about $-0.5 \%$ to $1 \%$, or about $1.5 \%$ to $3 \%$ in nominal terms. ${ }^{[7]}$ This is similar to recent estimates by economists from the Bank for International Settlements. ${ }^{[8]}$ Significant parameter uncertainty makes it even more challenging to use the natural rate as a guidepost for monetary policy. In this uncertain environment, it is helpful to focus on what has changed in recent years to understand whether real equilibrium rates could be higher today than during the 2010s. An increase would warrant a more cautious approach by central banks removing policy restriction. Changes in the demand for and supply of global savings suggest that equilibrium rates may have increased in recent years. The pandemic, Russia's invasion of Ukraine and other shocks have led to an increase in public debt around the world (Slide 8, left-hand side). Net borrowing by governments remains substantial. In 2024, the public deficit will be around 5\% of GDP across advanced economies and it is expected to decline only marginally in the coming years, also reflecting borrowing requirements associated with the digital and green transitions (Slide 8, right-hand side). The International Monetary Fund (IMF) projects that, in the coming years, overall global investment public and private - will reach the highest share in GDP since the 1980s. It is likely that, as a result, real interest rates need to rise to clear the global market for savings. This may especially be the case as rising geopolitical fragmentation contributes to reducing the supply of savings, including those provided by price-insensitive investors. In the United States, for example, the decline in the share of foreign official holdings of US Treasury securities has accelerated in recent years (Slide 9, left-hand side). It is now at the lowest level in more than twenty years. ${ }^{[9]}$ Incidentally, since about late 2022, asset swap spreads started to widen measurably in both the euro area and the United States, suggesting that investors are gradually demanding a higher return to warehouse the supply of global public bonds (Slide 9, right-hand side). ${ }^{[10]}$ ---[PAGE_BREAK]--- These developments are contributing to the reversal of the global savings glut, which put notable downward pressure on real rates for the greater part of the 21st century. ${ }^{[11]}$ This has repercussions for the assessment of the monetary policy stance. For example, given the notable increase in real short-term rates expected to prevail in the distant future, which are often taken as proxies for the natural rate, the policy stance today may already be in neutral territory, as real spot rates have started to fall below their equilibrium levels (Slide 10). Other indicators point in a similar direction. In our most recent bank lending survey, for example, 93\% of banks report that the general level of interest rates no longer plays a role in explaining weak loan demand. This contrasts sharply with a year ago when almost half of the banks said that interest rates were a factor contributing to lower loan demand. Similarly, the survey on the access to finance of enterprises shows that the pressure from interest expenses is gradually easing. The net percentage of firms indicating an increase in interest expenses fell from $36 \%$ to $19 \%$, reaching similar levels to those recorded at the end of 2021. Finally, among households, we have observed a notable turnaround in the demand for housing loans. A net 39\% of banks reported higher demand in the third quarter, a share close to the historical peak of $45 \%$ and well above the historical average (Slide 11, left-hand side). This increase in the demand for housing loans is broad-based across countries. Banks expect it to continue, reflecting both the decline in mortgage rates and improving housing market prospects. In the second quarter, the euro area house price index rose for the first time in more than a year (Slide 11, right-hand side). # Return to price stability requires different conduct of monetary policy All this suggests that we should proceed with caution and remain data-dependent, assessing at each monetary policy meeting whether disinflation remains on track and whether, and to what extent, interest rates remain restrictive. In doing so, we can continuously cross-check the assumptions underlying the staff projections and thereby retain a forward-looking perspective. This is especially important at a time when past pandemic-related shocks are starting to recede, and new shocks are increasingly driving price and wage dynamics. This shift in regime - from a high-inflation environment to one where inflation is consistent with price stability - has two important implications for the conduct of monetary policy. ${ }^{[12]}$ ## The effectiveness of monetary policy depends on the inflation regime One is that it has a direct impact on the effectiveness of monetary policy. The success of central banks in paving the way towards restoring price stability after the recent inflation surge has a lot to do with how monetary policy works. In a high-inflation regime, price increases tend to reflect factors common to most goods and services. ---[PAGE_BREAK]--- This is what has happened in recent years. The common component of inflation rose sharply as firms reacted to the combination of higher energy prices, supply-side bottlenecks and pent-up demand after the pandemic-induced lockdowns. This was reflected in the rapid broadening of inflation pressures across the goods and services contained in the consumption basket (Slide 12). Ultimately, these shocks affected all sectors of the economy, especially when second-round effects pushed wage demands higher across firms. Wage-price spirals are often the clearest sign of a regime shift, when changes in the general price level become a coordination device for price and wage setters. As monetary policy affects aggregate demand as well as the inflation expectations of both firms and households, it is powerful in counteracting such common shocks (Slide 13, left-hand side). As this process is nearing completion and we are re-entering a regime of price stability, idiosyncratic price shocks that reflect relative price changes, and that are mostly independent of each other, will again dominate in driving aggregate inflation. This is reflected in the measurable decline of the common component. Idiosyncratic price changes, however, tend to be less responsive to changes in aggregate demand and hence to changes in monetary policy (Slide 13, right-hand side). As a result, monetary policy becomes less effective in steering overall inflation. Central banks then need to carefully weigh the benefits and costs of trying to lean against relative price shocks. The strongest case for acting is when prices start to co-move again, either because of a new large shock or a series of shocks that move prices in the same direction. But in the absence of such shocks, policy should be careful not to overreact. This is especially the case if idiosyncratic shocks reflect structural forces. While it is inherently difficult to separate cyclical from structural factors, surveys among firms suggest that a significant part of the current weakness in parts of our economy relates to forces outside the realm of monetary policy. In our latest corporate telephone survey, for example, firms reported that the recent decline in business sentiment was driven by growing concerns about political developments, both in Europe and globally, and waning competitiveness amid high energy costs and the green transition. Firms expressed concerns about rising regulatory costs, such as those resulting from the Corporate Sustainability Reporting Directive (CSRD) or the Corporate Sustainability Due Diligence Directive (CSDDD). Compliance with these and other directives is seen as complex and resource-intensive, especially for smaller firms. ${ }^{[13]}$ In other cases, such as the General Data Protection Regulation (GDPR) or the Artificial Intelligence (AI) Act, there is mounting concern that regulation is increasingly stifling innovation and competition, especially in important areas such as AI. ${ }^{[14]}$ Particularly in Germany and France, these structural headwinds are causing businesses to postpone, or even refrain from, transformative investments and focus instead on efficiency and cost-cutting, which, in turn, is weighing on consumer confidence and spending. An expansionary monetary policy stance will change this dynamic only marginally, if at all. ---[PAGE_BREAK]--- Recent research by Óscar Jordà, Sanjay Singh and Alan Taylor corroborates this view. ${ }^{[15]}$ It shows that, while the effects of tight monetary policy can be persistent, central banks cannot boost potential output by bringing rates into expansionary territory (Slide 14, left-hand side). And while the benefits of using monetary policy to deal with idiosyncratic shocks are likely to be limited, the welfare costs that it has for society can be significant. One of the costs is that relative price adjustments support the efficient allocation of resources within the economy. Leaning too strongly against them in the absence of clear risks to price stability may inhibit this process. The other is that valuable policy space is lost and so will not be available to support employment and growth when the economy faces shocks that monetary policy can deal with more effectively. This was the case when the pandemic hit. At that time, interest rates were already close to their effective lower bound. As a result, central banks needed to resort to unconventional policy instruments. However, the effectiveness of such measures in stimulating aggregate demand is more uncertain, while their potential side effects are larger. ${ }^{[16]}$ # Greater tolerance for moderate deviations of inflation from target The second implication is that, when relative price shocks dominate, inflation is largely self-stabilising. As a result, central banks can have a greater tolerance for moderate deviations of inflation from target, in both directions. The reason is that the impact of changes in aggregate demand on inflation is weaker in an environment in which price changes are largely independent from each other. That is, the Phillips curve is highly non-linear: its slope is often steep when inflation is high, and it is flat when inflation is low. ${ }^{[17]}$ In this environment, it takes a large shock to aggregate demand for inflation to measurably and persistently drift away from the economy's nominal anchor - our 2\% target. So there is less need for policy to respond to moderate shocks. This is especially true for disinflationary shocks. Overwhelming empirical evidence suggests that nominal wage cuts are extremely rare and that the frequency at which firms adjust prices lower is highly stable over time (Slide 14, right-hand side). ${ }^{[18]}$ And when prices and wages do not chase each other as they did over the past years, inflation is largely self-stabilising. As such, the risk of falling into a truly harmful deflationary spiral is limited. Monetary policy can then be more patient and allow inflation to deviate from target for longer than in a situation in which risks of second-round effects are larger. ${ }^{[19]}$ This can also be seen in the historical properties of commodity price shocks. When oil prices fell sharply and persistently in 2014, the pass-through to consumer prices and wages was moderate. Underlying inflation, while weak, never fundamentally drifted away from our 2\% target. But in 2022, when inflation was already rising on the back of the repercussions of the pandemic, firms raised their prices considerably and much more frequently than when inflation was low and stable. ---[PAGE_BREAK]--- # Conclusion Let me now conclude with three main take-aways. First, price stability is within reach. Considering the risks and uncertainties we are still facing, lowering policy rates gradually towards a neutral level is the most appropriate course of action. Second, once price stability has been restored in a sustainable manner, the behaviour of inflation will change such that central banks can afford to tolerate moderate deviations of inflation from target, in both directions. Given limited policy space, monetary policy should focus on responding forcefully to shocks that have the capacity to destabilise inflation expectations by pushing inflation measurably and persistently away from our $2 \%$ target over the medium term. Third, monetary policy is not a supply-side instrument. It cannot resolve structural issues that durably weigh on price pressures, as was the case during the 2010s, when a highly accommodative monetary policy stance over a long period was unable to lift the economy out of the low-growth, low-inflation environment. Structural policies are the responsibility of governments. Thank you. ## Annexes 16 December 2024 Presentation slides 1. Bloom, N. (2009), "The Impact of Uncertainty Shocks", Econometrica, Vol. 77(3), pp. 623-685. 2. Lagarde, C. (2024), "Monetary policy in the euro area", speech at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, Lithuania, 16 December. 3. Choraria, N. (2024), Inflation Trading, Goldman Sachs International, 9 November. 4. ECB (2024), Eurosystem staff macroeconomic projections for the euro area, June. 5. European Commission, ETS2: buildings, road transport and additional sectors. 6. Eurobarometer, November 2024. 7. ---[PAGE_BREAK]--- Brand, C., Lisack, N. and Mazelis, F. (2024), "Estimates of the natural interest rate for the euro area: an update", Economic Bulletin, Issue 1, ECB. 8. Benigno, G., Hofmann, B., Nuño, G. and Sandri, D. (2024), "Quo vadis, r*? The natural rate of interest after the pandemic", BIS Quarterly Review, March. 9. This has coincided with the price of gold - the world's other safe haven asset - having more than doubled over the past ten years. 10. Real rates could rise more substantially if investors were to regard government bonds as less safe, pushing equilibrium risk premia higher. Analysis by the IMF, for example, suggests that if the premia were to rise back to pre-2000 average levels, they could bring up natural rates in advanced economies by 70 basis points. See IMF (2023), "The natural rate of interest: drivers and policy implications", World Economic Outlook, April. 11. Bernanke, B. (2005), "The Global Saving Glut and the U.S. Current Account Deficit", remarks at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, 10 March. 12. This part of the speech builds on insights contained in Borio, C., Lombardi, M., Yetman, J. and Zakrajšek, E. (2023), "The two-regime view of inflation", BIS Papers, No 133. 13. For instance, Mario Draghi's report on the future of European competitiveness presented estimates of the costs for complying with the Corporate Sustainability Reporting Directive ranging from €150,000 for non-listed businesses to €1 million for listed companies. Also, according to the 2024 European Investment Bank survey, nearly a third of small and medium-sized firms report that more than 10\% of their staff are employed to assess and comply with regulatory requirements and standards. 14. Goldberg, S. (2023), "Balancing act: Protecting privacy, protecting competition", Stanford Institute for Economic Policy Research, Policy Brief, January; Gal, M. and Aviv, O. (2020), "The Competitive Effects of the GDPR", Journal of Competition Law \& Economics, Vol. 16(3), pp. 349-391; and Chivot, E. and Castro, D. (2019), The EU Needs to Reform the GDPR to Remain Competitive in the Algorithmic Economy, Center for Data Innovation, 13 May. 15. ---[PAGE_BREAK]--- Jordà, O., Singh, S. and Taylor, A. (2020), "The Long-Run Effects of Monetary Policy", NBER Working Paper, No 26666. 16. Schnabel, I. (2024), "The benefits and costs of asset purchases", speech at the 2024 BOJ-IMES Conference on "Price Dynamics and Monetary Policy Challenges: Lessons Learned and Going Forward", Tokyo, 28 May; and Schnabel, I. (2024), "Reassessing monetary policy tools in a volatile macroeconomic environment", speech at the 25th Jacques Polak Annual Research Conference, Washington, D.C., 14 November. 17. Benigno, P. and Eggertsson, G. (2023), "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve", NBER Working Paper, No 31197. See also Hooper, P., Mishkin, F.S. and Sufi, A. (2019), "Prospects for Inflation in a High Pressure Economy: is the Phillips Curve Dead or is it Just Hibernating?", NBER Working Paper, No 25792. 18. More recent contributions are Grigsby, J., Hurst, E. and Yildirmaz, A. (2021), "Aggregate nominal wage adjustments: new evidence from administrative payroll data", American Economic Review, Vol. 111, No 2, pp. 428-471 and Schaefer, D. and Singleton, C. (2023), "The extent of downward nominal wage rigidity: New evidence from payroll data", Review of Economic Dynamics, Vol. 51, pp. 60-76. 19. Lagarde (2024, op.cit.).	Isabel Schnabel	Euro area	https://www.bis.org/review/r241218e.pdf	Paris, 16 December 2024 Monetary policy is at a critical juncture. Growing confidence in a sustainable decline of inflation towards our $2 \%$ target has allowed the Governing Council to remove substantial policy restriction over the past six months. With our decision last week to cut the three key policy rates by a further 25 basis points, the deposit facility rate is now at $3 \%$, one percentage point below its peak. Today I will argue that, with interest rates approaching neutral territory and with risks to the inflation outlook broadly balanced, monetary policy should proceed gradually and remain data-dependent. In this way, we can ensure that disinflation does not stall above our $2 \%$ target, while avoiding unnecessary weakness in the labour market and the economy at large. I will also argue that, once price stability has been restored, the challenges for monetary policy will change. As inflation becomes dominated by idiosyncratic shocks again, central banks can afford to be more tolerant of moderate deviations from target - in both directions. Incoming data and the new Eurosystem staff projections have confirmed that the disinflation process remains well on track. Inflation is now expected to decline towards our 2\% target in the course of 2025 and to oscillate around this level over the projection horizon, as domestic price pressures ease and base effects from energy prices fade (Slide 2, left-hand side). Growth has been revised down but is still expected to accelerate next year, as consumption and investment recover on the back of rising real incomes and less restrictive financing conditions (Slide 2, right-hand side). As ECB staff continue to project that the euro area economy will expand at a pace around its potential growth rate in the coming years, inflation should neither over- nor undershoot our $2 \%$ target materially over the projection horizon once past shocks have fully unwound. Three factors support the assumptions underlying this projected recovery. One is the upside surprise to growth in the third quarter, with private consumption picking up and inventories no longer weighing on growth (Slide 3, left-hand side). A turnaround in the inventory cycle would remove a significant drag on aggregate demand. Second, confidence in the retail trade sector as well as consumer expectations for major purchases over the next twelve months continued to improve in November, while savings intentions declined somewhat (Slide 3, right-hand side). Third, according to model-based analyses, over the next twelve months an economic expansion is still much more probable than a recession, despite the prospect of more trade barriers clouding the euro area economic outlook (Slide 4, left-hand side). Although the baseline forecast does not incorporate the potential impact of concrete policy measures of the new Trump administration, as these remain uncertain, recent sentiment indicators are likely to partially reflect the surge in trade policy uncertainty already (Slide 4, right-hand side). Empirical research suggests that, rather than the actual tariff increase itself, it is the rise in uncertainty that will be the main drag on growth. But these effects are often estimated to be short-lived, with growth rebounding sharply once uncertainty fades. The staff projections are therefore consistent with bringing interest rates to a neutral setting as inflation stabilises sustainably around our $2 \%$ target. The question then is how fast we should remove policy restriction. Our decision last week to cut our key policy rates by 25 basis points reflects the conviction that a gradual and data-dependent approach remains the most appropriate strategy. There are three reasons for this. First, while we are increasingly confident that price stability is within reach, an important part of disinflation has yet to materialise. Services inflation, in particular, remains high at 3.9\%. At the same time, momentum indicators, such as the three-month-on-three-month rate, suggest that price pressures have started to ease. But such signals critically depend on the way the seasonal adjustment is done. For example, shifts in households' consumption patterns in the wake of the pandemic may be making the seasonal adjustment more difficult. Estimates by financial market participants suggest that, when correcting for these potential shifts, momentum could be measurably higher than what our current estimates imply. Indeed, over the past two years, November has turned out to be a notable outlier in terms of the month-on-month change in services inflation (Slide 5, left-hand side). Also, while the baseline scenario assumes a cyclical recovery in productivity growth that is expected to ease the growth in unit labour costs, hysteresis effects or other structural factors could weigh on productivity and investment over an extended period of time. Recent scenario analysis conducted by ECB staff shows that, in that case, growth would be lower and inflation higher -0.3 percentage points cumulatively by 2026 - than in the baseline (Slide 5, right-hand side). These effects would rise notably if the forces weighing on productivity growth were more permanent. So, even if most of the evidence points to continued disinflation, we should remain alert to signs that cast doubt on our baseline. A gradual approach allows us to react to such signs. Second, new shocks keep hitting the euro area economy, many of them posing upside risks to inflation. Gas prices, for example, have doubled since February (Slide 6, left-hand side). As a result, wholesale electricity prices have increased substantially. Food prices, too, have started rising at a concerning pace, at an annualised three-month-on-three-month rate of $4.6 \%$ in November, up from $0.9 \%$ in May (Slide 6, right-hand side). Moreover, climate mitigation measures are increasingly affecting prices over the medium term. In 2027, for example, Eurosystem staff expect inflation to rise above 2\%, mainly due to the planned expansion of the EU emissions trading system to buildings, road transport and small industry (ETS2). $$ In addition, while the direction and persistence of the various effects of potential tariffs on inflation are ambiguous, their net effect is often estimated to be positive. While a decline in foreign demand for euro area goods as well as trade diversion, especially from China, are likely to be disinflationary, several channels could mitigate or even offset these forces. For example, the EU may retaliate with tariffs of its own, as it did in 2018. Also, the parallel impulse to the US economy coming from expansionary fiscal and supply-side policies could support foreign demand, even as tariffs increase, because many products are not substitutable in the short run. Finally, since the end of September the euro has depreciated by more than 6\% against the US dollar, largely in anticipation of the incoming US administration's economic policy intentions. This is already putting upward pressure on import prices. Such inflationary shocks are of particular concern in the current environment, as people are paying more attention to inflation after recent experiences. The latest Eurobarometer reveals that inflation remains people's biggest concern in most euro area countries. This attention makes inflation expectations more vulnerable after a long period of high inflation. Proceeding gradually allows us to respond to new shocks in an environment of elevated uncertainty and volatility. Third, a gradual approach is the most appropriate course of action the closer we are getting to neutral territory. There are two related sets of benchmarks for monetary policy. One is simple Taylor-type policy rules that are used in most structural models to replicate the systematic response of monetary policy to movements in inflation and growth. While such rules need to be treated with caution, they are a useful policy benchmark. As there are many ways such rules can be formulated and estimated, it is helpful to use a thickmodelling framework that reduces some of the data and model uncertainty. Such a framework currently suggests that the median rule points to a gradual dialling back of policy restriction (Slide 7). It also suggests that the distribution of projected interest rate outcomes is skewed to the upside. The second benchmark is the natural real rate of interest, $r^{}$. There is no consensus on what its main drivers are, or on how to best estimate it. As a result, the range of estimates is exceptionally large, both within and across models. Recent analysis by ECB staff across a suite of models suggest that the point estimate of $r^{}$ ranges from about $-0.5 \%$ to $1 \%$, or about $1.5 \%$ to $3 \%$ in nominal terms. Significant parameter uncertainty makes it even more challenging to use the natural rate as a guidepost for monetary policy. In this uncertain environment, it is helpful to focus on what has changed in recent years to understand whether real equilibrium rates could be higher today than during the 2010s. An increase would warrant a more cautious approach by central banks removing policy restriction. Changes in the demand for and supply of global savings suggest that equilibrium rates may have increased in recent years. The pandemic, Russia's invasion of Ukraine and other shocks have led to an increase in public debt around the world (Slide 8, left-hand side). Net borrowing by governments remains substantial. In 2024, the public deficit will be around 5\% of GDP across advanced economies and it is expected to decline only marginally in the coming years, also reflecting borrowing requirements associated with the digital and green transitions (Slide 8, right-hand side). The International Monetary Fund (IMF) projects that, in the coming years, overall global investment public and private - will reach the highest share in GDP since the 1980s. It is likely that, as a result, real interest rates need to rise to clear the global market for savings. This may especially be the case as rising geopolitical fragmentation contributes to reducing the supply of savings, including those provided by price-insensitive investors. In the United States, for example, the decline in the share of foreign official holdings of US Treasury securities has accelerated in recent years (Slide 9, left-hand side). It is now at the lowest level in more than twenty years. Incidentally, since about late 2022, asset swap spreads started to widen measurably in both the euro area and the United States, suggesting that investors are gradually demanding a higher return to warehouse the supply of global public bonds (Slide 9, right-hand side). These developments are contributing to the reversal of the global savings glut, which put notable downward pressure on real rates for the greater part of the 21st century. This has repercussions for the assessment of the monetary policy stance. For example, given the notable increase in real short-term rates expected to prevail in the distant future, which are often taken as proxies for the natural rate, the policy stance today may already be in neutral territory, as real spot rates have started to fall below their equilibrium levels (Slide 10). Other indicators point in a similar direction. In our most recent bank lending survey, for example, 93\% of banks report that the general level of interest rates no longer plays a role in explaining weak loan demand. This contrasts sharply with a year ago when almost half of the banks said that interest rates were a factor contributing to lower loan demand. Similarly, the survey on the access to finance of enterprises shows that the pressure from interest expenses is gradually easing. The net percentage of firms indicating an increase in interest expenses fell from $36 \%$ to $19 \%$, reaching similar levels to those recorded at the end of 2021. Finally, among households, we have observed a notable turnaround in the demand for housing loans. A net 39\% of banks reported higher demand in the third quarter, a share close to the historical peak of $45 \%$ and well above the historical average (Slide 11, left-hand side). This increase in the demand for housing loans is broad-based across countries. Banks expect it to continue, reflecting both the decline in mortgage rates and improving housing market prospects. In the second quarter, the euro area house price index rose for the first time in more than a year (Slide 11, right-hand side). All this suggests that we should proceed with caution and remain data-dependent, assessing at each monetary policy meeting whether disinflation remains on track and whether, and to what extent, interest rates remain restrictive. In doing so, we can continuously cross-check the assumptions underlying the staff projections and thereby retain a forward-looking perspective. This is especially important at a time when past pandemic-related shocks are starting to recede, and new shocks are increasingly driving price and wage dynamics. This shift in regime - from a high-inflation environment to one where inflation is consistent with price stability - has two important implications for the conduct of monetary policy. One is that it has a direct impact on the effectiveness of monetary policy. The success of central banks in paving the way towards restoring price stability after the recent inflation surge has a lot to do with how monetary policy works. In a high-inflation regime, price increases tend to reflect factors common to most goods and services. This is what has happened in recent years. The common component of inflation rose sharply as firms reacted to the combination of higher energy prices, supply-side bottlenecks and pent-up demand after the pandemic-induced lockdowns. This was reflected in the rapid broadening of inflation pressures across the goods and services contained in the consumption basket (Slide 12). Ultimately, these shocks affected all sectors of the economy, especially when second-round effects pushed wage demands higher across firms. Wage-price spirals are often the clearest sign of a regime shift, when changes in the general price level become a coordination device for price and wage setters. As monetary policy affects aggregate demand as well as the inflation expectations of both firms and households, it is powerful in counteracting such common shocks (Slide 13, left-hand side). As this process is nearing completion and we are re-entering a regime of price stability, idiosyncratic price shocks that reflect relative price changes, and that are mostly independent of each other, will again dominate in driving aggregate inflation. This is reflected in the measurable decline of the common component. Idiosyncratic price changes, however, tend to be less responsive to changes in aggregate demand and hence to changes in monetary policy (Slide 13, right-hand side). As a result, monetary policy becomes less effective in steering overall inflation. Central banks then need to carefully weigh the benefits and costs of trying to lean against relative price shocks. The strongest case for acting is when prices start to co-move again, either because of a new large shock or a series of shocks that move prices in the same direction. But in the absence of such shocks, policy should be careful not to overreact. This is especially the case if idiosyncratic shocks reflect structural forces. While it is inherently difficult to separate cyclical from structural factors, surveys among firms suggest that a significant part of the current weakness in parts of our economy relates to forces outside the realm of monetary policy. In our latest corporate telephone survey, for example, firms reported that the recent decline in business sentiment was driven by growing concerns about political developments, both in Europe and globally, and waning competitiveness amid high energy costs and the green transition. Firms expressed concerns about rising regulatory costs, such as those resulting from the Corporate Sustainability Reporting Directive (CSRD) or the Corporate Sustainability Due Diligence Directive (CSDDD). Compliance with these and other directives is seen as complex and resource-intensive, especially for smaller firms. In other cases, such as the General Data Protection Regulation (GDPR) or the Artificial Intelligence (AI) Act, there is mounting concern that regulation is increasingly stifling innovation and competition, especially in important areas such as AI. Particularly in Germany and France, these structural headwinds are causing businesses to postpone, or even refrain from, transformative investments and focus instead on efficiency and cost-cutting, which, in turn, is weighing on consumer confidence and spending. An expansionary monetary policy stance will change this dynamic only marginally, if at all. Recent research by Óscar Jordà, Sanjay Singh and Alan Taylor corroborates this view. It shows that, while the effects of tight monetary policy can be persistent, central banks cannot boost potential output by bringing rates into expansionary territory (Slide 14, left-hand side). And while the benefits of using monetary policy to deal with idiosyncratic shocks are likely to be limited, the welfare costs that it has for society can be significant. One of the costs is that relative price adjustments support the efficient allocation of resources within the economy. Leaning too strongly against them in the absence of clear risks to price stability may inhibit this process. The other is that valuable policy space is lost and so will not be available to support employment and growth when the economy faces shocks that monetary policy can deal with more effectively. This was the case when the pandemic hit. At that time, interest rates were already close to their effective lower bound. As a result, central banks needed to resort to unconventional policy instruments. However, the effectiveness of such measures in stimulating aggregate demand is more uncertain, while their potential side effects are larger. The second implication is that, when relative price shocks dominate, inflation is largely self-stabilising. As a result, central banks can have a greater tolerance for moderate deviations of inflation from target, in both directions. The reason is that the impact of changes in aggregate demand on inflation is weaker in an environment in which price changes are largely independent from each other. That is, the Phillips curve is highly non-linear: its slope is often steep when inflation is high, and it is flat when inflation is low. In this environment, it takes a large shock to aggregate demand for inflation to measurably and persistently drift away from the economy's nominal anchor - our 2\% target. So there is less need for policy to respond to moderate shocks. This is especially true for disinflationary shocks. Overwhelming empirical evidence suggests that nominal wage cuts are extremely rare and that the frequency at which firms adjust prices lower is highly stable over time (Slide 14, right-hand side). And when prices and wages do not chase each other as they did over the past years, inflation is largely self-stabilising. As such, the risk of falling into a truly harmful deflationary spiral is limited. Monetary policy can then be more patient and allow inflation to deviate from target for longer than in a situation in which risks of second-round effects are larger. This can also be seen in the historical properties of commodity price shocks. When oil prices fell sharply and persistently in 2014, the pass-through to consumer prices and wages was moderate. Underlying inflation, while weak, never fundamentally drifted away from our 2\% target. But in 2022, when inflation was already rising on the back of the repercussions of the pandemic, firms raised their prices considerably and much more frequently than when inflation was low and stable. Let me now conclude with three main take-aways. First, price stability is within reach. Considering the risks and uncertainties we are still facing, lowering policy rates gradually towards a neutral level is the most appropriate course of action. Second, once price stability has been restored in a sustainable manner, the behaviour of inflation will change such that central banks can afford to tolerate moderate deviations of inflation from target, in both directions. Given limited policy space, monetary policy should focus on responding forcefully to shocks that have the capacity to destabilise inflation expectations by pushing inflation measurably and persistently away from our $2 \%$ target over the medium term. Third, monetary policy is not a supply-side instrument. It cannot resolve structural issues that durably weigh on price pressures, as was the case during the 2010s, when a highly accommodative monetary policy stance over a long period was unable to lift the economy out of the low-growth, low-inflation environment. Structural policies are the responsibility of governments. Thank you. Presentation slides
2024-12-16T00:00:00	Christine Lagarde: Monetary policy in the euro area	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, 16 December 2024.	Christine Lagarde: Monetary policy in the euro area Speech by Ms Christine Lagarde, President of the European Central Bank, at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, 16 December 2024. * * * It is an honour to be here today to mark 10 years of Lithuania in the euro. " Laisv , Vienyb , Gerov" - freedom, unity and well-being. These are core national values in Lithuania - and accordingly, they are engraved in the edge-lettering on Lithuania's €2 coin. Freedom, because of the liberation from Soviet occupation. Unity, because of the need for national solidarity. And well-being, expressing hope for economic and social prosperity. These three words capture the spirit of the Lithuanian people. And I believe that being part of the euro has strengthened each of them. The country is now an equal partner in setting monetary policy by one of the world's most important central banks in the third largest economy, the euro area. That gives Lithuania freedom in charting its own macroeconomic destiny that smaller economies cannot typically claim, who often have to import the monetary policy of their larger neighbours. Lithuania now also issues the world's second most important reserve and invoicing currency. That provides unity in the face of a more volatile world, as foreign shocks do not penetrate the domestic economy as much, owing to domestic currency invoicing. Lithuania is especially resilient on this front, invoicing 78% of its exports to non-member countries in euros last year, the fourth highest share across the EU. well-being And being part of the euro has increased the of the Lithuanian people. When Lithuania joined the euro area in 2015, GDP per capita in purchasing power standard terms was around 70% of the euro area average. By 2023, it exceeded 83%. But more recently, the country has dealt with very high inflation, peaking at 22.5% in September 2022 - more than double the peak seen in the euro area as a whole. This high-inflation episode has led to a pronounced monetary policy cycle, with the ECB raising rates by 450 basis points, holding them steady for 9 months, and then cutting rates by 100 basis points since June as we entered the "dialling back" phase of our policy. However, even in this "dialling back" phase, until recently we retained a restrictive bias in our future policy orientation. At our last meeting, we dropped that bias. Today, I would like to explain what motivated this change and what it implies for the future. In a nutshell, we have seen the environment change in three important ways that increase our confidence that inflation is returning to our target. These changes concern path of inflation shocks driving inflation risks to inflation the , the and the . The path of inflation The first important change relates to the path of inflation . In the earlier part of our monetary policy cycle, the path of inflation was characterised by high uncertainty. We consistently saw the return of inflation to target in our projections being pushed back. At the same time, the incoming inflation data were surprising on the upside, casting further doubt on the accuracy of those projections. 1 ECB staff models using machine learning indicate that in 2022 and 2023 uncertainty around inflation forecasts was around four to five times higher than in the long-term average. This uncertainty about the inflation path had implications for the policy horizon - that is, the period within which we want to see inflation converging to our target. Normally, the medium-term policy horizon is flexible and can be extended depending on the nature, size and persistence of the shocks. But if there is a risk of inflation expectations becoming de-anchored, the horizon must be shortened to the nearest possible date that monetary policy can take effect to prevent that risk materialising - which given normal transmission lags is around two years. With inflation rising and its return to target continually being pushed back, at a certain point we considered that the risk of de-anchoring had become too high. So, in September 2022 we introduced the notion that the return of inflation to our target had to be "timely". Our aim was to fix the policy horizon and thereby build confidence among the public that there would be no more delays. Now, after a lengthy period of restrictive policy, our confidence that we are seeing a "timely" return to target has increased. Since September last year, we have had six consecutive forecast rounds showing inflation returning to target in the course of 2025. And this arrival date has stayed constant even as we have drawn closer to it. The uncertainty around these projections has decreased significantly. Our machine learning models now put the uncertainty bands at close to pre-pandemic levels. The incoming data have, over time, validated the path laid out in the forecasts. Since early 2023, the accuracy of staff projections has returned to the levels seen pre-COVID, especially for headline inflation. While errors for core inflation have taken longer to normalise, this year they have also returned to historical standards. And this confidence is confirmed in inflation expectations. Among households, median expectations for inflation three years ahead are close to 2%, and market-based indicators of longer-term inflation expectations have also fallen in recent months. The shocks driving inflation The second change in the environment relates to the shocks driving inflation . The major challenge for monetary policy during this cycle is that we have faced a sequence of very large shocks which - given staggered wage- and price-setting in the euro area - have transmitted through the economy in persistent and hard-to-forecast ways. So, even as our confidence in our projections increased, we had to be careful in making our policy stance less restrictive too quickly. We needed a policy framework that would allow us to better understand this complex inflation process. That is why we built our reaction function around our well-known three criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission. Focusing on the dynamics of underlying inflation allowed us to extract more robustly the trend in inflation based on the data we could see in front of us, complementing the information provided by our forecasts. And for a given inflation path, assessing the strength of monetary transmission allowed us to judge whether our tightening impulse was being passed on through the transmission chain and was thus effective in steering inflation back towards 2%. This forward-looking framework has provided a way of broadening our information set to capture the pace at which a very large past shock - 10.6% inflation at its peak - was running its course, and how our monetary policy stance was transmitting through the economy and affecting medium-term inflation. For some time, the signals from underlying inflation were still flagging the risk that inflation might not decline as quickly as indicated in our forecasts. But recently this risk has declined and there is now greater alignment between our forecasts and underlying inflation. The width of the range of measures of underlying inflation that we monitor has narrowed towards its historical average, with most indicators hovering between 2% and 2.8%, which we take as an indicator of receding uncertainty on future inflation dynamics. The Persistent and Common Component of Inflation (PCCI), which has the best predictive power for future inflation, has remained at around 2% since the end of last year. There is one measure that is still above this range, which is domestic inflation, capturing items with a low import content. But this is a year-on-year measures that is made up 97% of services items, and so it is still registering repricing events that took place earlier this year that are keeping services inflation around 4%. However, if we look at the PCCI for services, which strips out base effects, the measure currently stands at 2.5%. Inflation momentum for services has also dropped steeply recently. These data suggest that there is scope for a downward adjustment in services inflation, and thereby domestic inflation, in the coming months. Confirming this picture, wage growth - which is the main cost factor driving services - is on a downward trajectory and continues to be buffered by negative growth in unit profits, buffering the pass-through of rising wages to prices. The ECB wage tracker - which captures wage agreements in seven euro area countries representing around 85% of total wages in the euro area - sees wage growth slowing from 4.8% this year to around 3% in 2025, the level we generally consider to be consistent with our target. The risks to inflation The third change in the environment relates to the risks to inflation . The fact that past shocks were expected to travel slowly along the pricing chain meant that, in recent years, the risks to inflation were mostly to the upside. And despite the progress we have seen in underlying inflation, these risks have not disappeared entirely. The composition of inflation remains unbalanced, with the recent slowdown being driven mostly by energy inflation, which is particularly volatile, and industrial goods. The adjustment process for slower-moving services inflation is still unfinished. So, we will have to remain watchful until the downward adjustment in services inflation that we expect is confirmed by the data. However, as past shocks fade, the risks to the inflation outlook have changed. And crucially, these risks are now related more to potential future shocks than to the transmission of past ones. The main downside risks relate to the weaker-than-expected growth outlook and the increased uncertainty surrounding growth triggered by geopolitical events. For some time now, we have been seeing small sequential downward revisions to the growth outlook which have cumulatively amounted to a quite significant downgrade over time. For example, if we go back to our June 2023 projections, we expected average growth of 1.5% in 2024. Now, we expect 0.7%. One driver of this delayed recovery has been sluggish export growth, driven by the competitive challenges facing euro area companies. But the most important driver of our growth forecast misses has been the domestic economy. In fact, around half of the misses since end-2021 relate to investment and a quarter relate to consumption. The behaviour of investment can be attributed to a combination of factors, including the stronger-than-expected impact of higher interest rates, higher energy prices and structural deterrents. The inertia in consumption has been striking given that the conditions for a recovery are in place. Employment is historically high and real incomes are rising. But households continue to save an unusually high share of their income and take a cautious approach to spending. One reason for this caution is that many households have a perception of their real income growth that is well below measured data. Just 37% of households in our consumer survey believe that their real income has risen or stayed the same, even though 50% of all households have experienced actual increases. And these households have significantly lower consumption growth than those with correct perceptions. This pessimism about real incomes is largely driven by past inflation, and so in principle it should dissipate as the high-inflation episode moves further into the rearview mirror.2 But increasing geopolitical uncertainty could create new dents in household sentiment. In particular, if the United States - our largest export market - takes a protectionist turn, growth in the euro area is likely to take a hit. Our exporters also specialise in capital goods that other countries use for export production, which makes them particularly sensitive to shifts in confidence about world trade. The main upside risks we see in the future also relate to external shocks. A rise in geopolitical tensions could push energy prices and freight costs higher in the near term, while extreme weather events could drive up food prices. The net effect of trade fragmentation and tariffs on inflation remains uncertain, as it involves assumptions that are impossible to anticipate with precision. These include potential retaliatory actions as well as exchange rate and commodity price movements. Implications for monetary policy So what does this changing environment mean for our monetary policy? There are three main implications. The first concerns our current policy stance and its future orientation . The current policy stance is restrictive. But if the incoming data continue to confirm our baseline, the direction of travel is clear and we expect to lower interest rates further. In terms of the future orientation, we previously said that "we will keep policy rates sufficiently restrictive for as long as necessary". This bias was necessary in an environment of high realised inflation and high uncertainty about future inflation. But it no longer reflects the evolving macroeconomic landscape, our outlook for inflation or the balance of risks around it. With the disinflation process well on track, and downside risks to growth, this bias in our communication is no longer warranted. These considerations are reflected in the monetary policy statement adopted by the Governing Council last week. We no longer aim for "sufficiently restrictive" policy, but rather intend to deliver an "appropriate" policy stance. The second implication for monetary policy concerns our reaction function. The high-inflation period has proven the value of the three criteria we have been using to take decisions, which is why the Governing Council confirmed this policy framework at last week's meeting. And these criteria will be invaluable in the period ahead, even as the risks to inflation move from past shocks to future ones. In an uncertain environment, we will need to continue complementing our baseline outlook with a rich distribution of possible risks derived from current data. But our framework is flexible, in the sense that we can change the weight we put on the different legs of our reaction function depending on the nature of the shocks we are facing. For example, if we face large geopolitical shocks that significantly increase uncertainty about the inflation projections, we will need to draw on other sources of data to make the risk assessment surrounding our baseline outlook more robust. At the same time, the purpose of monitoring underlying inflation is to help us differentiate noise in the inflation data from underlying trends. So, if underlying trends are not affected, it will help increase confidence in the baseline projection. And assessing monetary transmission will continue to be important, as geopolitical uncertainty may affect monetary transmission by altering the risk appetite of investors, borrowers and financial intermediaries. policy horizon The third implication concerns the . Even though we are not there yet, we are close to achieving our target. So, we are no longer in a situation where we need to fix the policy horizon at the shortest possible transmission lag. We can return to a situation where the policy horizon can adjust depending on the nature, size and persistence of the shocks as needed. This change explains why we have removed the notion of "timeliness" from our monetary policy statement, focusing instead on achieving "sustainable" inflation convergence. And it puts us in the best position to react to future shocks. Conclusion Let me conclude. The Lithuanian poem "The Seasons" ( Metai ), written by Kristijonas Donelaitis, charts the cyclical nature of the rural life of Lithuanians. The ECB is also moving through its monetary policy cycle, and we are now at a stage where the darkest days of winter look to be behind us, and we can start to look forward instead. We certainly hope that the days ahead will be better. But winds are blowing in different directions and there is much uncertainty before us. So, our monetary policy will be prepared for all scenarios to come. [This speech was updated on 16 December 2024 at 11:25 CET to correct the ECB's June 2023 average growth projections for 2024.] 1 Lenza, M., Moutachaker, I. and Paredes, J. (2023), "Density forecasts of inflation: a quantile regression forest approach ", Working Paper Series, No 2830, ECB. 2 The ECB's consumer expectations survey shows that perceptions of past inflation have declined by more than 5 percentage points from their peak of 8.4% in September 2023.	---[PAGE_BREAK]--- # Christine Lagarde: Monetary policy in the euro area Speech by Ms Christine Lagarde, President of the European Central Bank, at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, 16 December 2024. It is an honour to be here today to mark 10 years of Lithuania in the euro. "Laisv, Vienyb, Gerov" - freedom, unity and well-being. These are core national values in Lithuania - and accordingly, they are engraved in the edge-lettering on Lithuania's €2 coin. Freedom, because of the liberation from Soviet occupation. Unity, because of the need for national solidarity. And well-being, expressing hope for economic and social prosperity. These three words capture the spirit of the Lithuanian people. And I believe that being part of the euro has strengthened each of them. The country is now an equal partner in setting monetary policy by one of the world's most important central banks in the third largest economy, the euro area. That gives Lithuania freedom in charting its own macroeconomic destiny that smaller economies cannot typically claim, who often have to import the monetary policy of their larger neighbours. Lithuania now also issues the world's second most important reserve and invoicing currency. That provides unity in the face of a more volatile world, as foreign shocks do not penetrate the domestic economy as much, owing to domestic currency invoicing. Lithuania is especially resilient on this front, invoicing $78 \%$ of its exports to non-member countries in euros last year, the fourth highest share across the EU. And being part of the euro has increased the well-being of the Lithuanian people. When Lithuania joined the euro area in 2015, GDP per capita in purchasing power standard terms was around $70 \%$ of the euro area average. By 2023, it exceeded $83 \%$. But more recently, the country has dealt with very high inflation, peaking at $22.5 \%$ in September 2022 - more than double the peak seen in the euro area as a whole. This high-inflation episode has led to a pronounced monetary policy cycle, with the ECB raising rates by 450 basis points, holding them steady for 9 months, and then cutting rates by 100 basis points since June as we entered the "dialling back" phase of our policy. However, even in this "dialling back" phase, until recently we retained a restrictive bias in our future policy orientation. At our last meeting, we dropped that bias. ---[PAGE_BREAK]--- Today, I would like to explain what motivated this change and what it implies for the future. In a nutshell, we have seen the environment change in three important ways that increase our confidence that inflation is returning to our target. These changes concern the path of inflation, the shocks driving inflation and the risks to inflation. # The path of inflation The first important change relates to the path of inflation. In the earlier part of our monetary policy cycle, the path of inflation was characterised by high uncertainty. We consistently saw the return of inflation to target in our projections being pushed back. At the same time, the incoming inflation data were surprising on the upside, casting further doubt on the accuracy of those projections. ECB staff models using machine learning ${ }^{1}$ indicate that in 2022 and 2023 uncertainty around inflation forecasts was around four to five times higher than in the long-term average. This uncertainty about the inflation path had implications for the policy horizon - that is, the period within which we want to see inflation converging to our target. Normally, the medium-term policy horizon is flexible and can be extended depending on the nature, size and persistence of the shocks. But if there is a risk of inflation expectations becoming de-anchored, the horizon must be shortened to the nearest possible date that monetary policy can take effect to prevent that risk materialising which given normal transmission lags is around two years. With inflation rising and its return to target continually being pushed back, at a certain point we considered that the risk of de-anchoring had become too high. So, in September 2022 we introduced the notion that the return of inflation to our target had to be "timely". Our aim was to fix the policy horizon and thereby build confidence among the public that there would be no more delays. Now, after a lengthy period of restrictive policy, our confidence that we are seeing a "timely" return to target has increased. Since September last year, we have had six consecutive forecast rounds showing inflation returning to target in the course of 2025. And this arrival date has stayed constant even as we have drawn closer to it. The uncertainty around these projections has decreased significantly. Our machine learning models now put the uncertainty bands at close to pre-pandemic levels. The incoming data have, over time, validated the path laid out in the forecasts. Since early 2023, the accuracy of staff projections has returned to the levels seen pre-COVID, especially for headline inflation. While errors for core inflation have taken longer to normalise, this year they have also returned to historical standards. ---[PAGE_BREAK]--- And this confidence is confirmed in inflation expectations. Among households, median expectations for inflation three years ahead are close to $2 \%$, and market-based indicators of longer-term inflation expectations have also fallen in recent months. # The shocks driving inflation The second change in the environment relates to the shocks driving inflation. The major challenge for monetary policy during this cycle is that we have faced a sequence of very large shocks which - given staggered wage- and price-setting in the euro area - have transmitted through the economy in persistent and hard-to-forecast ways. So, even as our confidence in our projections increased, we had to be careful in making our policy stance less restrictive too quickly. We needed a policy framework that would allow us to better understand this complex inflation process. That is why we built our reaction function around our well-known three criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission. Focusing on the dynamics of underlying inflation allowed us to extract more robustly the trend in inflation based on the data we could see in front of us, complementing the information provided by our forecasts. And for a given inflation path, assessing the strength of monetary transmission allowed us to judge whether our tightening impulse was being passed on through the transmission chain and was thus effective in steering inflation back towards $2 \%$. This forward-looking framework has provided a way of broadening our information set to capture the pace at which a very large past shock - 10.6\% inflation at its peak - was running its course, and how our monetary policy stance was transmitting through the economy and affecting medium-term inflation. For some time, the signals from underlying inflation were still flagging the risk that inflation might not decline as quickly as indicated in our forecasts. But recently this risk has declined and there is now greater alignment between our forecasts and underlying inflation. The width of the range of measures of underlying inflation that we monitor has narrowed towards its historical average, with most indicators hovering between $2 \%$ and $2.8 \%$, which we take as an indicator of receding uncertainty on future inflation dynamics. The Persistent and Common Component of Inflation (PCCI), which has the best predictive power for future inflation, has remained at around $2 \%$ since the end of last year. There is one measure that is still above this range, which is domestic inflation, capturing items with a low import content. But this is a year-on-year measures that is made up $97 \%$ of services items, and so it is still registering repricing events that took place earlier this year that are keeping services inflation around $4 \%$. ---[PAGE_BREAK]--- However, if we look at the PCCI for services, which strips out base effects, the measure currently stands at $2.5 \%$. Inflation momentum for services has also dropped steeply recently. These data suggest that there is scope for a downward adjustment in services inflation, and thereby domestic inflation, in the coming months. Confirming this picture, wage growth - which is the main cost factor driving services - is on a downward trajectory and continues to be buffered by negative growth in unit profits, buffering the pass-through of rising wages to prices. The ECB wage tracker - which captures wage agreements in seven euro area countries representing around $85 \%$ of total wages in the euro area - sees wage growth slowing from $4.8 \%$ this year to around $3 \%$ in 2025, the level we generally consider to be consistent with our target. # The risks to inflation The third change in the environment relates to the risks to inflation. The fact that past shocks were expected to travel slowly along the pricing chain meant that, in recent years, the risks to inflation were mostly to the upside. And despite the progress we have seen in underlying inflation, these risks have not disappeared entirely. The composition of inflation remains unbalanced, with the recent slowdown being driven mostly by energy inflation, which is particularly volatile, and industrial goods. The adjustment process for slower-moving services inflation is still unfinished. So, we will have to remain watchful until the downward adjustment in services inflation that we expect is confirmed by the data. However, as past shocks fade, the risks to the inflation outlook have changed. And crucially, these risks are now related more to potential future shocks than to the transmission of past ones. The main downside risks relate to the weaker-than-expected growth outlook and the increased uncertainty surrounding growth triggered by geopolitical events. For some time now, we have been seeing small sequential downward revisions to the growth outlook which have cumulatively amounted to a quite significant downgrade over time. For example, if we go back to our June 2023 projections, we expected average growth of $1.5 \%$ in 2024 . Now, we expect $0.7 \%$. One driver of this delayed recovery has been sluggish export growth, driven by the competitive challenges facing euro area companies. But the most important driver of our growth forecast misses has been the domestic economy. In fact, around half of the misses since end-2021 relate to investment and a quarter relate to consumption. The behaviour of investment can be attributed to a combination of factors, including the stronger-than-expected impact of higher interest rates, higher energy prices and structural deterrents. The inertia in consumption has been striking given that the conditions for a recovery are in place. Employment is historically high and real incomes ---[PAGE_BREAK]--- are rising. But households continue to save an unusually high share of their income and take a cautious approach to spending. One reason for this caution is that many households have a perception of their real income growth that is well below measured data. Just $37 \%$ of households in our consumer survey believe that their real income has risen or stayed the same, even though $50 \%$ of all households have experienced actual increases. And these households have significantly lower consumption growth than those with correct perceptions. This pessimism about real incomes is largely driven by past inflation, and so in principle it should dissipate as the high-inflation episode moves further into the rearview mirror. ${ }^{2}$ But increasing geopolitical uncertainty could create new dents in household sentiment. In particular, if the United States - our largest export market - takes a protectionist turn, growth in the euro area is likely to take a hit. Our exporters also specialise in capital goods that other countries use for export production, which makes them particularly sensitive to shifts in confidence about world trade. The main upside risks we see in the future also relate to external shocks. A rise in geopolitical tensions could push energy prices and freight costs higher in the near term, while extreme weather events could drive up food prices. The net effect of trade fragmentation and tariffs on inflation remains uncertain, as it involves assumptions that are impossible to anticipate with precision. These include potential retaliatory actions as well as exchange rate and commodity price movements. # Implications for monetary policy So what does this changing environment mean for our monetary policy? There are three main implications. The first concerns our current policy stance and its future orientation. The current policy stance is restrictive. But if the incoming data continue to confirm our baseline, the direction of travel is clear and we expect to lower interest rates further. In terms of the future orientation, we previously said that "we will keep policy rates sufficiently restrictive for as long as necessary". This bias was necessary in an environment of high realised inflation and high uncertainty about future inflation. But it no longer reflects the evolving macroeconomic landscape, our outlook for inflation or the balance of risks around it. With the disinflation process well on track, and downside risks to growth, this bias in our communication is no longer warranted. These considerations are reflected in the monetary policy statement adopted by the Governing Council last week. We no longer aim for "sufficiently restrictive" policy, but rather intend to deliver an "appropriate" policy stance. The second implication for monetary policy concerns our reaction function. ---[PAGE_BREAK]--- The high-inflation period has proven the value of the three criteria we have been using to take decisions, which is why the Governing Council confirmed this policy framework at last week's meeting. And these criteria will be invaluable in the period ahead, even as the risks to inflation move from past shocks to future ones. In an uncertain environment, we will need to continue complementing our baseline outlook with a rich distribution of possible risks derived from current data. But our framework is flexible, in the sense that we can change the weight we put on the different legs of our reaction function depending on the nature of the shocks we are facing. For example, if we face large geopolitical shocks that significantly increase uncertainty about the inflation projections, we will need to draw on other sources of data to make the risk assessment surrounding our baseline outlook more robust. At the same time, the purpose of monitoring underlying inflation is to help us differentiate noise in the inflation data from underlying trends. So, if underlying trends are not affected, it will help increase confidence in the baseline projection. And assessing monetary transmission will continue to be important, as geopolitical uncertainty may affect monetary transmission by altering the risk appetite of investors, borrowers and financial intermediaries. The third implication concerns the policy horizon. Even though we are not there yet, we are close to achieving our target. So, we are no longer in a situation where we need to fix the policy horizon at the shortest possible transmission lag. We can return to a situation where the policy horizon can adjust depending on the nature, size and persistence of the shocks as needed. This change explains why we have removed the notion of "timeliness" from our monetary policy statement, focusing instead on achieving "sustainable" inflation convergence. And it puts us in the best position to react to future shocks. # Conclusion Let me conclude. The Lithuanian poem "The Seasons" (Metak, written by Kristijonas Donelaitis, charts the cyclical nature of the rural life of Lithuanians. The ECB is also moving through its monetary policy cycle, and we are now at a stage where the darkest days of winter look to be behind us, and we can start to look forward instead. We certainly hope that the days ahead will be better. But winds are blowing in different directions and there is much uncertainty before us. So, our monetary policy will be prepared for all scenarios to come. ---[PAGE_BREAK]--- [This speech was updated on 16 December 2024 at 11:25 CET to correct the ECB's June 2023 average growth projections for 2024.] 1 Lenza, M., Moutachaker, I. and Paredes, J. (2023), "Density forecasts of inflation: a quantile regression forest approach", Working Paper Series, No 2830, ECB. ${ }^{2}$ The ECB's consumer expectations survey shows that perceptions of past inflation have declined by more than 5 percentage points from their peak of $8.4 \%$ in September 2023.	Christine Lagarde	Euro area	https://www.bis.org/review/r241216n.pdf	Speech by Ms Christine Lagarde, President of the European Central Bank, at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, 16 December 2024. It is an honour to be here today to mark 10 years of Lithuania in the euro. "Laisv, Vienyb, Gerov" - freedom, unity and well-being. These are core national values in Lithuania - and accordingly, they are engraved in the edge-lettering on Lithuania's €2 coin. Freedom, because of the liberation from Soviet occupation. Unity, because of the need for national solidarity. And well-being, expressing hope for economic and social prosperity. These three words capture the spirit of the Lithuanian people. And I believe that being part of the euro has strengthened each of them. The country is now an equal partner in setting monetary policy by one of the world's most important central banks in the third largest economy, the euro area. That gives Lithuania freedom in charting its own macroeconomic destiny that smaller economies cannot typically claim, who often have to import the monetary policy of their larger neighbours. Lithuania now also issues the world's second most important reserve and invoicing currency. That provides unity in the face of a more volatile world, as foreign shocks do not penetrate the domestic economy as much, owing to domestic currency invoicing. Lithuania is especially resilient on this front, invoicing $78 \%$ of its exports to non-member countries in euros last year, the fourth highest share across the EU. And being part of the euro has increased the well-being of the Lithuanian people. When Lithuania joined the euro area in 2015, GDP per capita in purchasing power standard terms was around $70 \%$ of the euro area average. By 2023, it exceeded $83 \%$. But more recently, the country has dealt with very high inflation, peaking at $22.5 \%$ in September 2022 - more than double the peak seen in the euro area as a whole. This high-inflation episode has led to a pronounced monetary policy cycle, with the ECB raising rates by 450 basis points, holding them steady for 9 months, and then cutting rates by 100 basis points since June as we entered the "dialling back" phase of our policy. However, even in this "dialling back" phase, until recently we retained a restrictive bias in our future policy orientation. At our last meeting, we dropped that bias. Today, I would like to explain what motivated this change and what it implies for the future. In a nutshell, we have seen the environment change in three important ways that increase our confidence that inflation is returning to our target. These changes concern the path of inflation, the shocks driving inflation and the risks to inflation. The first important change relates to the path of inflation. In the earlier part of our monetary policy cycle, the path of inflation was characterised by high uncertainty. We consistently saw the return of inflation to target in our projections being pushed back. At the same time, the incoming inflation data were surprising on the upside, casting further doubt on the accuracy of those projections. ECB staff models using machine learning indicate that in 2022 and 2023 uncertainty around inflation forecasts was around four to five times higher than in the long-term average. This uncertainty about the inflation path had implications for the policy horizon - that is, the period within which we want to see inflation converging to our target. Normally, the medium-term policy horizon is flexible and can be extended depending on the nature, size and persistence of the shocks. But if there is a risk of inflation expectations becoming de-anchored, the horizon must be shortened to the nearest possible date that monetary policy can take effect to prevent that risk materialising which given normal transmission lags is around two years. With inflation rising and its return to target continually being pushed back, at a certain point we considered that the risk of de-anchoring had become too high. So, in September 2022 we introduced the notion that the return of inflation to our target had to be "timely". Our aim was to fix the policy horizon and thereby build confidence among the public that there would be no more delays. Now, after a lengthy period of restrictive policy, our confidence that we are seeing a "timely" return to target has increased. Since September last year, we have had six consecutive forecast rounds showing inflation returning to target in the course of 2025. And this arrival date has stayed constant even as we have drawn closer to it. The uncertainty around these projections has decreased significantly. Our machine learning models now put the uncertainty bands at close to pre-pandemic levels. The incoming data have, over time, validated the path laid out in the forecasts. Since early 2023, the accuracy of staff projections has returned to the levels seen pre-COVID, especially for headline inflation. While errors for core inflation have taken longer to normalise, this year they have also returned to historical standards. And this confidence is confirmed in inflation expectations. Among households, median expectations for inflation three years ahead are close to $2 \%$, and market-based indicators of longer-term inflation expectations have also fallen in recent months. The second change in the environment relates to the shocks driving inflation. The major challenge for monetary policy during this cycle is that we have faced a sequence of very large shocks which - given staggered wage- and price-setting in the euro area - have transmitted through the economy in persistent and hard-to-forecast ways. So, even as our confidence in our projections increased, we had to be careful in making our policy stance less restrictive too quickly. We needed a policy framework that would allow us to better understand this complex inflation process. That is why we built our reaction function around our well-known three criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission. Focusing on the dynamics of underlying inflation allowed us to extract more robustly the trend in inflation based on the data we could see in front of us, complementing the information provided by our forecasts. And for a given inflation path, assessing the strength of monetary transmission allowed us to judge whether our tightening impulse was being passed on through the transmission chain and was thus effective in steering inflation back towards $2 \%$. This forward-looking framework has provided a way of broadening our information set to capture the pace at which a very large past shock - 10.6\% inflation at its peak - was running its course, and how our monetary policy stance was transmitting through the economy and affecting medium-term inflation. For some time, the signals from underlying inflation were still flagging the risk that inflation might not decline as quickly as indicated in our forecasts. But recently this risk has declined and there is now greater alignment between our forecasts and underlying inflation. The width of the range of measures of underlying inflation that we monitor has narrowed towards its historical average, with most indicators hovering between $2 \%$ and $2.8 \%$, which we take as an indicator of receding uncertainty on future inflation dynamics. The Persistent and Common Component of Inflation (PCCI), which has the best predictive power for future inflation, has remained at around $2 \%$ since the end of last year. There is one measure that is still above this range, which is domestic inflation, capturing items with a low import content. But this is a year-on-year measures that is made up $97 \%$ of services items, and so it is still registering repricing events that took place earlier this year that are keeping services inflation around $4 \%$. However, if we look at the PCCI for services, which strips out base effects, the measure currently stands at $2.5 \%$. Inflation momentum for services has also dropped steeply recently. These data suggest that there is scope for a downward adjustment in services inflation, and thereby domestic inflation, in the coming months. Confirming this picture, wage growth - which is the main cost factor driving services - is on a downward trajectory and continues to be buffered by negative growth in unit profits, buffering the pass-through of rising wages to prices. The ECB wage tracker - which captures wage agreements in seven euro area countries representing around $85 \%$ of total wages in the euro area - sees wage growth slowing from $4.8 \%$ this year to around $3 \%$ in 2025, the level we generally consider to be consistent with our target. The third change in the environment relates to the risks to inflation. The fact that past shocks were expected to travel slowly along the pricing chain meant that, in recent years, the risks to inflation were mostly to the upside. And despite the progress we have seen in underlying inflation, these risks have not disappeared entirely. The composition of inflation remains unbalanced, with the recent slowdown being driven mostly by energy inflation, which is particularly volatile, and industrial goods. The adjustment process for slower-moving services inflation is still unfinished. So, we will have to remain watchful until the downward adjustment in services inflation that we expect is confirmed by the data. However, as past shocks fade, the risks to the inflation outlook have changed. And crucially, these risks are now related more to potential future shocks than to the transmission of past ones. The main downside risks relate to the weaker-than-expected growth outlook and the increased uncertainty surrounding growth triggered by geopolitical events. For some time now, we have been seeing small sequential downward revisions to the growth outlook which have cumulatively amounted to a quite significant downgrade over time. For example, if we go back to our June 2023 projections, we expected average growth of $1.5 \%$ in 2024 . Now, we expect $0.7 \%$. One driver of this delayed recovery has been sluggish export growth, driven by the competitive challenges facing euro area companies. But the most important driver of our growth forecast misses has been the domestic economy. In fact, around half of the misses since end-2021 relate to investment and a quarter relate to consumption. The behaviour of investment can be attributed to a combination of factors, including the stronger-than-expected impact of higher interest rates, higher energy prices and structural deterrents. The inertia in consumption has been striking given that the conditions for a recovery are in place. Employment is historically high and real incomes are rising. But households continue to save an unusually high share of their income and take a cautious approach to spending. One reason for this caution is that many households have a perception of their real income growth that is well below measured data. Just $37 \%$ of households in our consumer survey believe that their real income has risen or stayed the same, even though $50 \%$ of all households have experienced actual increases. And these households have significantly lower consumption growth than those with correct perceptions. This pessimism about real incomes is largely driven by past inflation, and so in principle it should dissipate as the high-inflation episode moves further into the rearview mirror. But increasing geopolitical uncertainty could create new dents in household sentiment. In particular, if the United States - our largest export market - takes a protectionist turn, growth in the euro area is likely to take a hit. Our exporters also specialise in capital goods that other countries use for export production, which makes them particularly sensitive to shifts in confidence about world trade. The main upside risks we see in the future also relate to external shocks. A rise in geopolitical tensions could push energy prices and freight costs higher in the near term, while extreme weather events could drive up food prices. The net effect of trade fragmentation and tariffs on inflation remains uncertain, as it involves assumptions that are impossible to anticipate with precision. These include potential retaliatory actions as well as exchange rate and commodity price movements. So what does this changing environment mean for our monetary policy? There are three main implications. The first concerns our current policy stance and its future orientation. The current policy stance is restrictive. But if the incoming data continue to confirm our baseline, the direction of travel is clear and we expect to lower interest rates further. In terms of the future orientation, we previously said that "we will keep policy rates sufficiently restrictive for as long as necessary". This bias was necessary in an environment of high realised inflation and high uncertainty about future inflation. But it no longer reflects the evolving macroeconomic landscape, our outlook for inflation or the balance of risks around it. With the disinflation process well on track, and downside risks to growth, this bias in our communication is no longer warranted. These considerations are reflected in the monetary policy statement adopted by the Governing Council last week. We no longer aim for "sufficiently restrictive" policy, but rather intend to deliver an "appropriate" policy stance. The second implication for monetary policy concerns our reaction function. The high-inflation period has proven the value of the three criteria we have been using to take decisions, which is why the Governing Council confirmed this policy framework at last week's meeting. And these criteria will be invaluable in the period ahead, even as the risks to inflation move from past shocks to future ones. In an uncertain environment, we will need to continue complementing our baseline outlook with a rich distribution of possible risks derived from current data. But our framework is flexible, in the sense that we can change the weight we put on the different legs of our reaction function depending on the nature of the shocks we are facing. For example, if we face large geopolitical shocks that significantly increase uncertainty about the inflation projections, we will need to draw on other sources of data to make the risk assessment surrounding our baseline outlook more robust. At the same time, the purpose of monitoring underlying inflation is to help us differentiate noise in the inflation data from underlying trends. So, if underlying trends are not affected, it will help increase confidence in the baseline projection. And assessing monetary transmission will continue to be important, as geopolitical uncertainty may affect monetary transmission by altering the risk appetite of investors, borrowers and financial intermediaries. The third implication concerns the policy horizon. Even though we are not there yet, we are close to achieving our target. So, we are no longer in a situation where we need to fix the policy horizon at the shortest possible transmission lag. We can return to a situation where the policy horizon can adjust depending on the nature, size and persistence of the shocks as needed. This change explains why we have removed the notion of "timeliness" from our monetary policy statement, focusing instead on achieving "sustainable" inflation convergence. And it puts us in the best position to react to future shocks. Let me conclude. The Lithuanian poem "The Seasons" (Metak, written by Kristijonas Donelaitis, charts the cyclical nature of the rural life of Lithuanians. The ECB is also moving through its monetary policy cycle, and we are now at a stage where the darkest days of winter look to be behind us, and we can start to look forward instead. We certainly hope that the days ahead will be better. But winds are blowing in different directions and there is much uncertainty before us. So, our monetary policy will be prepared for all scenarios to come.
2024-12-17T00:00:00	Claudia Buch: Results of the 2024 Supervisory Review and Evaluation Process (SREP) and the supervisory priorities for 2025-27	Introductory statement by Prof Claudia Buch, Chair of the Supervisory Board of the European Central Bank, at the press conference on the 2024 Supervisory Review and Evaluation Process (SREP) results and the supervisory priorities for 2025-27, Frankfurt am Main, 17 December 2024.	SPEECH Introductory statement Speech by Claudia Buch, Chair of the Supervisory Board of the ECB, at the press conference on the 2024 SREP results and the supervisory priorities for 2025-27 Frankfurt am Main, 17 December 2024 Jump to the transcript of the questions and answers Introduction Let me welcome you to my first press conference as the Chair of the Supervisory Board of the ECB. This year marks the tenth anniversary of the Single Supervisory Mechanism, which provides a good opportunity to reflect upon what we have achieved so far and what we can improve on. Over the past decade, European banking supervision has contributed to the increased resilience of European banks and thus to financial stability. The results of the annual Supervisory Review and Evaluation Process (SREP) for 2024, which we have published today, show that the banks directly supervised by the ECB generally have strong fundamentals. The asset quality of European banks is robust, they have overall solid capital positions, good levels of profitability, and are a reliable source of funding and financial services for European households and firms. Looking ahead, banks will need to adapt to a changing environment. Faced with heightened geopolitical risks, structural change, climate and environmental risks, and downside risks to the macroeconomic outlook, strong financial and operational resilience will remain key. Corporate insolvencies are on the increase, potentially leading to higher credit risk. The public sector may have more limited capacity than in the past to buffer adverse shocks. The digitalisation of financial services is changing the competitive landscape. Banks must therefore remain vigilant and prudent to sustain their business and operations. Their currently good levels of profitability provide them with an opportunity to strengthen their resilience. Against this background, the current SREP cycle has not resulted in major changes to banks' SREP scores or overall Pillar 2 requirements in aggregate terms. The annual Supervisory Review and Evaluation Process assesses each bank's risks, business model viability and resilience. Where we identify shortcomings, supervisory measures are put in place that ensure remediation by the banks. Banks' individual SREP scores and Pillar 2 requirements take bank-specific risks into account. The supervisory priorities for the years 2025-27 continue to focus on risks related to macro-financial threats and geopolitical shocks, as well as on challenges stemming from the digital transformation, while emphasising the need to remediate shortcomings, particularly those related to governance and risk management. This year, we have taken a large step forward to make ECB Banking Supervision more efficient and effective. We have launched a comprehensive reform of the SREP to respond to emerging risks in a more targeted way, to simplify, and to reduce complexity. The reform will be implemented over the next two years. Overall resilience of the banking system Let me provide an overview of the resilience of the European banking system. Chart 1: CET1 capital and leverage ratios of significant institutions 18% CET1 ratio 16% 14% mer 12% 10% 8% Leverage ratio 6% a ee ee 4% 2% 0% 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Source: ECB supervisory banking statistics. Banks directly supervised by the ECB have overall solid capital and liquidity positions, which is a significant improvement compared with the situation ten years ago.) The aggregate Common Equity Tier 1 (CET1) ratio stood at 15.8% in mid-2024, which is a slight improvement compared with the previous year. Similarly, the leverage ratio increased slightly to 5.8%. Chart 2: Distribution of capital headroom between CET1 capital ratios and CET1 overall requirements and Pillar 2 guidance after 2024 SREP 100 90 80 70 60 50 Projected Current 40 30 20 I : a) a I <0% [0-0.5%) [0.5-1%) [1-2%) [2-5%) [5-10%) >10% Capital headroom (%) Number of institutions oO oO Sources: ECB supervisory banking statistics and SREP database. Notes: Projected capital headroom is based on the 2024 SREP decisions and will be applied in 2025; current capital headroom is based on the 2023 SREP decisions and applicable in 2024. Pillar 2 CET1 requirements and Pillar 2 guidance are as per the published list of Pillar 2 requirements applicable as of the first quarter of 2025. CET1 ratios are as at the second quarter of 2024. For systemic buffers (global systemically important institutions, other systemically important institutions and systemic risk buffers) and the countercyclical capital buffer, the levels shown are those anticipated for the first quarter of 2025 and included in 2024 CET1 requirements and guidance. CET1 ratios have been adjusted for AT1/T2 shortfalls. Capital headroom compared with overall capital requirements has remained broadly stable on the previous year. Next year, 85% of institutions are expected to have capital headroom of over 200 basis points; only a few are projected to have capital headroom below 100 basis points. Chart 3: Liquidity ratios 180% 170% Liquidity coverage ratio 160% 150% 140% 130% Net stable funding ratio 120% 110% 100% 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Source: ECB supervisory banking statistics. Overall liquidity conditions have remained favourable. After the ECB started a period of quantitative tightening, banks turned smoothly to the markets to meet their financing needs. The share of funding through deposits remained largely stable. Generally, banks have good access to retail and wholesale funding. Yet some banks need to better prepare for an environment with potentially tighter liquidity conditions. This is the result of targeted reviews of banks' funding plans, of their capabilities to mobilise collateral and of their asset and liability management. Chart 4: Non-performing loans by counterparty sector 9% 9% 8% 8% 7% 7% 6% 6% 5% 5% 4% NPL ratio forloanstoNFCs 4% 3% 3% NPL ratio for loans to households 2% 2% 1% 1% 0% 0% 2020 2021 2022 2023 2024 2020 2021 2022 2023 2024 9% 9% 8% 8% 7% 7% 6% 6% 5% 5% 4% = : : 4% of which small and medium-sized of which collateralised by commercial enterprises 3% immovable property 3% 2% 2% 1% 1% 0% 0% 2020 = 2021 2022 2023 2024 2020 2021 2022 2023 2024 Source: ECB supervisory banking statistics. Note: "NFC" stands for "non-financial corporations". The quality of banks' assets has remained strong. The ratio of non-performing loans to total loans has remained around 2.2% over the last two years and is close to historical lows. 2] However, there are initial signs of weakening asset quality driven by exposures to commercial real estate and small and medium-sized enterprises (SMEs), the latter accounting for about 50% of European banks' lending portfolios. Non-performing loans are rising in Austria and Germany, and to a lesser extent in France, albeit from very low levels. Low levels of credit risk reflect the strong fundamentals of households and firms but also stem partly from the public support during the COVID-19 pandemic and the energy crises. Generally, the debt sustainability of households is benefiting from a strong labour market, rising wages and decreasing levels of indebtedness. Corporate balance sheets and profitability have generally remained resilient in 2024, thanks also to declining input and energy costs. Chart 5: Insolvencies and real GDP in the euro area-4 10% 30,000 25,000 5% 7 20,000 = = € : DUadh ah i DS » re} - \ evant m 5000 f 8 \ 3 = o Qa & 10.000 § -5% - 5,000 10% I 0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 Sources: Eurostat and national statistics. Notes: The series is based on developments in Germany, Spain, France and Italy (euro area-4). Insolvencies are shown as the average number of firms per quarter within each year. Real GDP is the 4-quarter moving sum growth rate. The latest observation is for the second quarter of 2024. But pockets of vulnerabilities are emerging, reflecting higher borrowing costs, weaker growth and structural changes in the real economy. Even during the pandemic, when GDP declined, corporate insolvencies fell. Since mid-2022, however, corporate insolvencies have been on the rise, signalling a potential future deterioration in asset quality. Chart 6: Return on equity and return on assets 12% 1.2% Return on equity (Ihs) 10% 1.0% 8% 0.8% 6% 0.6% Return on assets 4% (ths) 0.4% 2% 0.2% 0% 0.0% 2016 2017 2018 2019 2020 2021 2022 2023 = =2024 Source: ECB supervisory banking statistics. Bank profitability has remained strong, with an annualised return on equity of 10.1% in mid-2024. Higher interest rates are a key driver: during the low interest rate environment, banks' average return on equity was 5.5%; following the normalisation of interest rates, it increased to 9.2%.) in addition, the average cost-to-income ratio declined from 66% in 2020 to 54% in 2024. Cost of risk has remained muted. Chart 7: Aggregate net interest margin 1.7% 1.6% 1.5% 1.4% 1.3% 1.2% 1.1% = -xo TTS 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Source: ECB supervisory banking statistics. Chart 8: Share of fixed versus variable rate lending to non-financial corporations LT So = @ Fixed © Mixed @ Variable 10% 20% 30% 40% 50% 60% 70% 80% 90% = o ao 2 70 Source: ECB (2024), Financial Stability Review, May. Notes: Lending shares refer to outstanding amounts for loans to non-financial corporations. "Fixed" indicates a rate that both parties to the loan contract agree to at inception. "Variable" indicates a rate linked to an exogenous parameter (e.g. EURIBOR). "Mixed" indicates a combination of fixed and variable rates. Aggregate net interest margins have widened across euro area banks. In countries where floating rate loan contracts prevail, the pass-through of higher interest rates has been relatively fast. In countries where fixed rate loan contracts are more common, the impact of higher interest rates on profitability and borrower default risks has been delayed. On the funding side, shifts from demand to term deposits with higher interest rates have so far been relatively slow. Variations in the pass-through also reflect differences in banks' pricing power across countries. Cross-border competition in deposit taking is particularly limited, with only around 1.6% of deposits held across borders.!4] Banks' distribution plans foresee a relatively stable aggregate payout ratio. Supervised banks expect to pay out 49% of profits for 2024 or one percentage point less than in the previous year. Share buybacks have become less prominent, representing a little less than one-quarter of distributions compared with one-third a year ago. The future performance of banks will depend on the economic outlook, their resilience to adverse shocks, shifts in the yield curve and interest rate pass-through. Banks' ability to contain costs while investing in the digitalisation of their business models will be crucial to sustain profitability. Distribution plans thus need to be aligned with sufficiently forward-looking capital plans that also consider relevant adverse scenarios. Risk outlook and supervisory responses From a macroeconomic perspective, the year 2024 has been characterised by a resilient euro area economy, which is projected to grow at a rate of 0.7%./5] But the short and medium-term outlook for growth remains subdued and subject to considerable uncertainty. The likelihood of tail events materialising appears higher than a year ago. Geopolitical tensions alongside growing deglobalisation trends could push energy prices and freight costs higher in the short term and disrupt global trade. Our supervisory priorities reflect this risk outlook. Chart 9: Measures of uncertainty in the euro area Political uncertainty Systemic stress 2k 2007 2009 2011 2013 2015 2017 2019 2021 2023 Sources: ECB, policyuncertainty.com and ECB staff calculations. Notes: The composite indicator of systemic stress (CISS) and the economic policy uncertainty index are monthly data series (standardised by the standard deviation from the mean over the period January 1999-December 2019). A value of 2 should be read as meaning that the uncertainty measure exceeds its historical average level by two standard deviations. The latest observations are for November 2024. Heightened geopolitical risks affect banks through various channels. Adverse geopolitical events are often not priced in by financial markets, which can lead to an abrupt repricing of risks if such events materialise. Financial sanctions and cyberattacks can affect banks, including through outsourcing arrangements. In terms of the real economy, higher costs for firms and disruptions to global trade could increase credit risk. Credit risk management therefore remains a priority for ECB Banking Supervision. Novel risks may not be adequately captured by risk models that are based on past data. Accounting overlays are thus one instrument that can be used to address novel risks in a forward-looking way. From our supervisory perspective, we are therefore addressing deficiencies in IFRS 9 accounting frameworks in terms of identifying and monitoring risk. To address the deterioration in asset quality, we have carried out targeted reviews on commercial and residential real estate as well as SME portfolios, and we are taking supervisory measures where we have identified weaknesses. To provide transparency on our risk assessment methodologies, today we are publishing a comprehensive supervisory methodology for assessing interest rate risk and credit spread risk in the banking book. To deal with heightened risks and uncertainties, banks' decision-making bodies need reliable information. Over the years, however, we have identified ongoing deficiencies in risk data aggregation and risk reporting. These deficiencies prevent management from receiving timely and comprehensive information on relevant risks and they also increase the cost of responding to supervisory requests. At the ECB, we have therefore intensified our efforts to encourage banks to improve their information systems and address IT security and cyber risks. More generally, banks need to speed up their digitalisation efforts. SREP scores for operational and ICT risk remain among the worst. We are therefore focusing on addressing outsourcing risks and enhancing banks' cyber resilience, also taking into account the Digital Operational Resilience Act, which comes into force in 2025. This year, we conducted a cyber resilience stress test to assess banks' ability to respond to cyber incidents. The stress test showed that banks are prepared, but it also revealed areas for improvement in cybersecurity. Moreover, climate-related and environmental risks are increasingly relevant and continue to be a significant concern. Banks need to fully account for transition and physical risks. They have started to make progress in integrating these risks into their governance and risk management frameworks, addressing our supervisory expectations. However, we found that some banks were still lacking key elements needed to adequately manage climate and environmental risks, prompting further supervisory actions. 2024 SREP assessment Let me now turn to this year's SREP assessment, which was carried out against the backdrop of the risk outlook I have just described. Chart 10: Overall SREP scores 35% 30% 2024 SREP 3+ 3 3- 4 Source: ECB SREP database. Notes: 2022 SREP values are based on assessments of 101 banks, 2023 SREP values are based on assessments of 106 banks, and 2024 SREP values are based on assessments of 104 banks. There were no banks with an overall SREP score of 1 in 2022, 2023 or 2024. 2023 SREP 25% 2022 SREP 20% 15% 10% 5% 0% ieee O+ The average overall SREP score in 2024 remained stable at 2.6, with 74% of banks scoring the same as last year. 11% of banks saw their scores worsen, mainly because of their exposure to the commercial real estate sector and interest rate risk, while 15% of banks achieved a better score, mainly because of increased profitability. This year's SREP resulted in more binding measures to address severe weaknesses. This reflects our increased focus on ensuring that supervised banks remediate any findings in a timely manner. More specifically, we imposed the following quantitative and qualitative supervisory measures. Chart 11: Evolution of overall capital requirements and Pillar 2 guidance - the total capital stack @ Pillar 1 requirements CET1 M@ Systemic risk buffers CET1 © Pillar 1 requirements AT1+T2 @ Countercyclical capital buffer CET1 @ Pillar 2 requirements CET1 @ Pillar 2 guidance CET1 ®@ Pillar 2 requirements AT1+T2 = Overall capital requirements and guidance tm Capital conservation buffer CET1 18% 15.6% 0, 16% 14.8% 14.5% 14.7% 15.1% 19.5% "" 14% 12% 10% 8% 6% 4% 2% 0% 2020 2021 2022 2023 2024 2025 Sources: ECB supervisory banking statistics and SREP database. Notes: The sample selection follows the approach taken in the methodological note for the supervisory banking statistics. For 2020 the first quarter sample is based on 112 entities; for 2021 the first quarter sample is based on 114 entities; for 2022 the first quarter sample is based on 112 entities; for 2023 the first quarter sample is based on 111 entities; and for 2024 the first quarter sample is based on 110 entities. For 2025 the first quarter sample is based on 109 entities, with the Pillar 2 requirement (P2R) being applicable from January 2025. The chart shows RWA-weighted data from the second quarter of 2024. "Overall capital requirements" comprise the Pillar 1 minimum requirement, the Pillar 2 requirement, combined buffer requirements (i.e. the capital conservation buffer and systemic buffers (global systemically important institutions, other systemically important institutions and systemic risk buffers) and the countercyclical capital buffer). Rounding differences may apply. The reference period for the combined buffer requirement is the first quarter of each year. For the first quarter of 2025 buffers are estimated based on announced rates applicable at this date. Estimated values are shown with a lighter colour and marked with an asterisk. The Pillar 2 guidance is added on top of the overall capital requirements. Under CRD V, which came into effect on 1 January 2021, the P2R capital should have the same composition as Pillar 1 - i.e. at least 56.25% should fall under CET1 capital and at least 75% should fall under Tier 1 capital, in line with the minimum requirements. By way of derogation from the first sub-paragraph of paragraph 4, Article 104a CRD V, the competent authority may require an institution to meet its additional own funds requirements with a higher share of Tier 1 capital or CET1 capital, where necessary, and considering the specific circumstances of the institution. In terms of quantitative requirements, the overall CET1 capital requirements and guidance stand at 11.3% of risk-weighted assets, compared with 11.2% last year. Overall capital requirements and Pillar 2 guidance have thus increased slightly.'2] Changes in the risk profiles of individual banks led to three types of Pillar 2 add-ons being applied. > For nine banks, an average add-on of 14 basis points addresses excessive risk arising from leveraged finance. > For 18 banks, an average add-on of 5 basis points addresses shortfalls in the coverage of non- performing exposures. > For 13 banks, an add-on of between 10 and 40 basis points was applied to the leverage ratio requirement. Quantitative liquidity measures were issued for four banks. Qualitative measures were issued for 95 banks, mainly to address deficiencies in the areas of credit risk management, internal governance and capital adequacy. The stability of the banks' SREP scores reflects, on the one hand, an improvement in key risk indicators and, on the other hand, the high degree of uncertainty concerning the economic outlook. We have therefore taken a number of measures to ensure that banks assess risks in a sufficiently forward- looking way. These include supervisory focus on capital and liquidity planning that takes relevant adverse scenarios into account; on provisioning frameworks that capture novel risks; on operational resilience, particularly in relation to cyber and outsourcing risks; and on stress tests that capture geopolitical risks. Microprudential supervision needs to be complemented by a strong macroprudential framework. Releasable macroprudential buffers in the banking union have in fact increased in recent years: the weighted average rate for countercyclical capital buffers and (sectoral) systemic risk buffers rose from about 0.3% at the end of 2019 to 0.8% in mid-2024 5] We very much welcome the progress made in this area in addressing uncertainties and risks to financial stability. Supervisory priorities Figure 1: Supervisory priorities Priority 1: Banks should strengthen their ability to withstand immediate macro-financial threats and severe geopolitical shocks Address deficiencies in credit risk management frameworks lt) Credit risk Address deficiencies in operational resilience frameworks as regards IT Operational risk outsourcing and IT security/cyber risks ose SI Special focus: Incorporating the management of geopolitical risks in OSS yee Te supervisory priorities P 9 Priority 2: Banks should remedy persistent material shortcomings in an effective and timely manner Address deficiencies in business strategies and risk management as regards Climate-related and climate-related and environmental risks environmental risks Address deficiencies in risk data aggregation and reporting & Governance Priority 3: Banks should strengthen their digitalisation strategies and tackle emerging challenges stemming from the use of new technologies Address deficiencies in digital transformation strategies © Business model Our supervisory priorities for the years 2025-27 continue to focus on external challenges for banks, while putting greater emphasis on remediating persistent shortcomings. First, resilience to macro-financial threats and geopolitical shocks requires the attention of banks' boards and senior management. Improving credit risk management and maintaining adequate levels of provisioning remain important for financial resilience, while increased IT and cybersecurity risks require adequate governance structures and sufficient investment. Second, banks need to address shortcomings related to governance, climate-related and environmental risk management and risk data aggregation and reporting capabilities. We will continue to monitor these areas and take supervisory action as necessary. And third, risks associated with digitalisation require adequate safeguards. We will continue to assess banks' digital strategies to ensure that risks are mitigated, and we are publishing an updated SREP methodology for operational and ICT risk today. SREP reform Just like the banks, supervisors have to respond to changes in the external environment. During its first decade, ECB Banking Supervision has become an internationally recognised supervisor, delivering on its mandate. But our supervisory procedures have become complex, potentially impairing our ability to react to new developments in a timely manner. The SREP reform that we announced earlier this year will make our supervision more efficient, more effective and more intrusive. We will sharpen the focus on bank-specific risks, better integrate different supervisory activities and communicate more clearly with banks. We will use our full supervisory toolkit to ensure that findings are remediated more promptly. We will make methodologies more stable to achieve greater consistency. And investing in advanced IT and analytics will simplify data submissions, while enabling us to provide more tailored and timely feedback to banks. These reforms will be fully implemented by 2026, and we will carefully monitor their impact. Conclusion Chart 12: Consolidated gross debt of the non-financial private sector in the euro area == Total debt (consolidated) tm Debt securities tm Loans from MFIs M@ Other loans @ Loans from non-MFls @ Loans from rest of the world 160% 140% a. 120% a © 100% 80% 60% % of nominal 40% 20% 0% 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 Sources: Eurostat, ECB and ECB calculations. Notes: MFI" stands for "monetary financial institutions. Consolidated gross debt is defined as total gross debt minus loans granted by firms and households. The latest observations are for the second quarter of 2024. Let me conclude. European banks have overall strong fundamentals in terms of their asset quality, capitalisation and profitability. This contributes to financial stability and the provision of financial services to households and firms across the banking union. Bank loans remain a key source of funding to the real economy, while non-bank financial intermediaries have grown in importance. Looking ahead, heightened uncertainty will require a high level of prudence. Banks' ability to maintain robust business models depends on their resilience to shocks and their ability to adapt to the new environment, particularly the digitalisation of finance. Sound profitability enables banks to further strengthen their resilience and to remain a reliable foundation for the euro area economy, including during periods of stress. As supervisors, we will continue to focus on the resilience of European banks. Weakening standards of supervision would weaken banks, making it harder for them to support the real economy and compete successfully. At the same time, we need to ensure that our supervision is as efficient and effective as possible. This is the aim of our SREP reform, which will also bring benefits for the banks we supervise. We in ECB Banking Supervision rely on strong support from policymakers and regulators to achieve our goals. Completing the banking union and capital markets union, rather than relaxing banking rules or delaying the implementation of Basel Ill, is critical to enhancing financial stability and fostering economic growth. Decisive action would further bolster our capacity to cope with future shocks effectively. Thank you very much for your attention. I now look forward to your questions. kK Two questions from my side. The first on "efficient and effective". As you redeploy resources - you have spoken a lot about geopolitical risk - as you focus more on that, what are you focusing less on? And I ask this question also with respect to banks complaining about rising demands from supervisors. What are you giving them an easier ride on at the same time? And then the other question on significant risk transfers [SRTs], I mean the capital relief type. I was wondering if you could confirm that you now will be shortening the period that banks have to apply in advance to get these. Why are you doing that? I assume it's because you like SRTs? And if you have any words of warning to banks on this front? I'm thinking specifically about leverage employed to buy SRTs, so whether risk is not actually leaving the financial system, but is getting more and more complicated. Thank you for these very good questions, which allow me to explain a bit more what we are doing with the Supervisory Review and Evaluation Process [SREP] reform to become more efficient and effective. So first of all, very simply speaking, what it does is that we are giving more flexibility to the Joint Supervisory Teams, to the supervisors, to adjust their supervisory action to the risks being faced and that are most relevant for the specific bank. So we have overall risks and priorities that are being defined by the Supervisory Board, but then of course the relevance of specific risks might be very different for different types of banks. So, the teams have more flexibility. It's not that they ignore certain types of risk, but rather say: what is really relevant for this bank? What do we need to focus on? We have a risk tolerance framework that allows the teams to actually do this, and they can also spread out their risk assessment over a three-year period. We have a multi-year approach so that not every risk needs to be looked at with the same intensity in each year for each bank. So we become more targeted - this is our role, this is also how we define good supervision - we become more targeted to the relevant risks. You also mentioned: is there an ever-rising demand of supervisory requests? No, there isn't. The demand of supervisory requests is again linked to the risks that we see, because this is our role: to keep European banks safe and stable. And if the environment changes, if climate and environmental risks are relevant and not fully addressed by the banks, we need to react to that. If the geopolitical risk environment changes, then we need to address the risks that are relevant for the specific banks. Of course, we also need to do this in an efficient and effective way. So what we will do even more in the future is use what we call integrated planning, so that all our activities - whether they are horizontal across different banks or vertical for specific banks - are integrated even more closely and can also inform each other, so that we don't have to duplicate certain types of activities. But it's very important for us that we address the relevant risks that are there and don't lose relevant risks out of sight. And the teams have more flexibility now. By the way, the risk tolerance framework, the multi-year approach, has already been in place since 2023, but we are rolling it out now more forcefully and we monitor the progress being made. As to your second question on the significant risk transfers, this is related obviously to securitisation and we generally think that securitisation can be a useful instrument to move risks to the part of the financial system where they can be better borne than on banks' balance sheets. But at the same time, of course, we need to make sure that there are no spillover effects on the banking sector - this is a bit the second part of your question. So who's financing these significant risk transfers and could there be amplification effects in the financial system? Of course, we need to monitor this very closely. Now, within this framework that we have and also within the regulatory framework that we have, there was actually room for improvement, and this is what you mentioned. In terms of, for a given risk transfer, can we speed up the process until we approve a certain significant risk transfer? And here we have worked with the European Banking Federation to get a pilot started. Of course, we need some products for which we can run the pilot. We will do this next year and then hopefully speed up our efforts - to the benefit of us, because less resources will go into that, and also to the benefit of the industry. But let me reassure you, we will never lose resilience out of sight. This is given a certain risk that is being transferred and we will also carefully monitor the effects on the financial system, because this is mainly about efficiency - it's not about weakening resilience. Question one: how exactly shall banks consider geopolitical risks? It's a very broad term and I would like to have an idea what the banks specifically should do about it. The other question is a little bit more specific. It's on the recalibration of the SREP. Deutsche Bank, whose Pillar 2 requirement [P2R] has increased, suggested that their higher Pillar 2 requirement is due to the recalibration of your SREP and it would have nothing to do with any reassessment of the riskiness of Deutsche Bank. So is this view or description of Deutsche Bank accurate? So can I imagine that you don't see Deutsche Bank as more risky, but nevertheless the Pillar 2 requirement can increase? Thank you very much for the first question on geopolitical risk, which is indeed an issue about which we have been thinking hard to get to some extent a conceptual framework around it, because different people may have different understandings of what geopolitical risk is actually about. What we have done is we've published our way of thinking about this in September this year, and the main idea is that geopolitical risk is not a new risk category for the banks. It's affecting the banks through credit risk, market risk, operational risk. But there are dimensions of this risk which you wouldn't cover if you didn't think about it in terms of the geopolitical environment. And here it's relatively broad, it's anything that's related to conflicts and tensions internationally. And so, as I've said, if you think for example about the financial markets channel, relevant parts of geopolitical risk are not priced in by markets. So this can affect banks' exposure to market risk if there's an abrupt repricing of risk. The second channel is through the real economy. So what if global value chains become more fragmented because of conflicts? How should that lead to a reassessment of credit risk? And then there's cyber risk, exposure to financial sanction risk. And so we work very closely with the banks to see whether they address these risks properly. We have also gone through our activities to see whether we are missing any of these channels, and we actually found that there's relatively little that we are missing. I mentioned the provisioning framework, I mentioned the work we are doing on cyber risk - all this is very much related to geopolitical risk. We're now working with the banks to see that they capture risks that are relevant for the individual bank - that they capture this in their risk management. And maybe the most important aspect here is that it really needs to be at the attention of top management, of the boards, because geopolitical risk is something which you can't properly price. There's a lot of uncertainty, so the banks need to use scenario analysis that is relevant for their capital planning, and this is really something which needs steering from the top. And we now look very carefully at what the banks are doing in this space. The second question was about a specific bank and my apologies but for reasons of confidentiality I don't comment. So it's OK if you answer generally if it's possible that a bank gets a higher Pillar 2 requirement without you considering this, an unspecific bank, more risky? Again, I don't comment on any specific bank and we have not changed the Pillar 2 methodology for how the risks are being calculated. Actually, today we are publishing a lot of detail about how our methodology is applied. There's also one element of our SREP reform, but this is not for this year's SREP, it's for the next two years. We are currently working on the P2R, the Pillar 2 methodology, to make it even more risk-based, to make it more targeted, to simplify. But this is not for now, this has not affected the 2024 SREP cycle - there will be again a pilot, a dry run next year and then it will only be effective one year later. We also aim to stabilise methodologies more in order to simplify and to reduce complexity. My first question is on profitability. How do you expect it to evolve in a context of lower interest rates and possibly also an increase in non-performing loans? Second, what are your considerations about the consolidation process ongoing in Europe and what are the main elements that you want to ensure about the authorisation process in cases, of course, like UniCredit and Commerzbank and UniCredit and Banco BPM? To your first question about profitability: so we don't have any forecast of interest rates that is underlying our assessment here, so we need to see how rates are evolving. What market analysts are saying is that we now have a higher level of net interest margins and that it wouldn't go down to the levels that we saw during the period of low interest rates. But as I've explained, this also depends on the pass-through into lending rates and into deposit rates. As you're rightly saying, when it comes to credit risk, asset quality, we are as of now not seeing a significant deterioration of asset quality. Non- performing loans are actually close to historical lows, but of course we all need to remain vigilant as to how does the risk that we have just been talking about, how does that play out? How does the structural change in the real economy play out? So we don't really have a forecast here on bank profitability. What is our aim? And this is also part of the SREP, it is of course to make sure that banks have sustainable business models, that they have sustainable long-run profitability. One important factor here will also be their IT investments, their ability to compete in a world of ever-more digitalised finance. The second question on consolidation, and here again I need to make the statement up front that I'm not talking about individual banks that you have mentioned. Our role here is actually very clear when it comes to the approval process of qualified holdings. We have clear criteria in the legislation, what we look at in terms of financial soundness, reputation of the buyers and so forth. We generally take a very neutral approach when it comes to cross-border versus domestic mergers. In the end it's a decision of the stakeholders, the shareholders in the banks - how they want to respond to increasing competitive pressure, digitalisation. And mergers are certainly one way to respond. But we don't have a specific preference as to how they should respond. We have a clear role given to us by the legislation on the indicators that we look at. This year's cyber stress test showed that there are still many shortcomings in banks' cyber defences. Have you taken any measures in the context of the SREP to address the shortcomings? The second question is about Russia. Compared to when you took over in January, are you happy with the progress made by the banks that are still there in leaving the country? As regards the cyber stress test, just to clarify what it was: the question was how do banks respond to a hypothetical successful cyberattack? So it was about their response. We actually found that the banks were quite well prepared. So because you mentioned the shortcomings, we always find, of course, issues that need to be addressed, but here I think we found the banks also well prepared. My impression is that the banking industry also appreciated the consistent exercise across all the banks, from which they also learn where they stand relative to their peers. So to the extent that it doesn't violate any confidentiality requirements, we also share with the banks this benchmarking. So as I said, we always, when we do these exercises, we also find issues and we indeed take this into consideration in the SREP, because this is information that we need for our supervision. And as I've said, cyber resilience, digitalisation, all this has been and will be a priority for the SSM also going forward. Appropriate measures were taken, and in many cases, these are qualitative measures. As regards the exposure of banks to Russia and risks arising from Russia, given the tragedy of the situation, I'm a little bit hesitant to talk about happiness in that context. What was done in the SSM after the Russian invasion into Ukraine was to take stock of the exposures of European banks, which were limited in absolute terms, but of course there was exposure to financial sanction risk. We're not the sanction authority, but of course, we need to take into account what are potential implications for reputation and risk management of the banks. We've addressed this with the banks. We've asked them to downsize and exit from Russia and I think the latest number we have is that the exposures have been reduced by 53%. We're working very closely with the banks to make sure that they comply with our decisions. Again, apologies that I can't go into the specifics for individual banks, but there has been progress and we need to see how the situation will evolve. For next year looking forward, most economists expect a lot of rate cuts. Do you see any risks connected with that for the banking sector and how do you think it will affect the banking sector? And my second question: you mentioned the importance of completing the banking union. Do you expect some progress on EDIS and how important is it from your supervisor's perspective? I don't want to comment on potential rate cuts, this is not our business to do any forecasts and to consider potential scenarios. What we do do, of course, is that we make sure that the banks' exposure to interest rate risk is well managed. We're following up very closely in case we feel that this is not being the case, but we don't do any specific forecast or analysis of where do we think interest rates could move. I mentioned a few other points already when I discussed profitability impacts. As to the second question on the banking union, I'm not sure whether I should also comment or make any forecasts about the likelihood of potential dossiers to be followed through. But clearly, the European deposit insurance scheme [EDIS] is very important for supervisors. Basically we have an incomplete banking union. So we have the first pillar lve described, the successes that have been made, the achievements; we have the second pillar with the resolution framework, and deposit insurance and supervision is inevitably linked together. So I think it would be good to have progress on EDIS to make sure that all deposits across the banking union have the same level of protection. It would also promote cross-border integration obviously, and it would also make, in the end, the whole work by the Single Resolution Board less complex in dealing with banks that are under stress. But let me mention also another very important file which is currently on the table in Brussels, which is crisis management and deposit insurance, or CMDI. So this is basically a dossier which aims to close the remaining gaps with regard to resolution. On the one hand, to bring more banks, mid-size banks, which can have systemic implications, under resolution, and also provide the funding for this resolution through the use of deposit guarantee schemes. It's somehow linked, but it's a separate dossier related to EDIS. And I think this is crucially important, so the more credible resolution is, the better it is for supervision, because it's setting the right incentives not to engage in risk-taking and it's just good for the clarity of the overall framework of how we deal with banks in the going concern but also banks that come under stress. And in the end, also making sure that we don't have to use taxpayers' money again for banks that are under stress, so I think this is an additional benefit of the CMDI package. Quick question on crypto-assets: as everybody, of course, has noticed a different approach coming from the US administration, I don't know what's going to happen with the US financial authorities, but as regards the ECB supervision, is there an intention, is there an orientation towards stricter rules or looser rules regarding crypto portfolios within bank balance sheets? I don't want to speculate on what's happening in the US, but let me say how we view crypto-assets and what has been done in Europe. So first of all, I think there's risk related to crypto-assets in terms of risks that are prevalent in other financial market segments as well. So there can be excessive leverage, there can be intransparency, there can be conflicts of interest. So I think it's very important to also preventively manage and regulate these risks. That, of course, requires first and foremost good information about crypto markets and what is happening in this space, in particular related to leverage and misaligned incentives. I think with the Markets in Crypto-Assets (MiCA) regulation, Europe has done a lot to move into that direction to get better information, and also to regulate to the extent necessary. And the third leg is certainly that, because many of these activities are somewhat borderless; it's also important, and there have been important initiatives in the G20 and in the FSB, to make sure that there's also an internationally agreed approach to this. So we need to see where this moves, we monitor this very carefully. We also monitor very carefully that the exposure of banks to crypto-assets is very limited and that also we deal with the competitive pressure that may arise from these markets on banks to provide crypto-related financial services. We have a very close eye on this. The first question is when can we expect a decision on UniCredit's request to build up its stake in Commerzbank? Second one is can you shed light on the ECB's interpretation of the Danish compromise? Can a financial conglomerate risk weigh all assets bought via its insurance arm? This has been described as a regulatory arbitrage that favours conglomerates. Well, the answer to the first question is unfortunately very short, because I don't comment on individual cases, including deadlines. The second is the Danish compromise. We have clarified our approach and our publication on options and discretions, I think in 2016 if I'm not mistaken, and we currently have under consultation a new guide which also clarifies our approach there. In the end, it's an issue that we would also assess on a case-by-case basis for individual institutions. I have noticed in some cases the SSM has been reducing Pillar 2 capital requirements while raising P2R leverage ratio. What is the rationale behind that? To the extent that you're referring to individual banks, I couldn't comment on this. Generally the P2R and the P2R leverage ratio add-on have different purposes. So the P2R is basically to cover risks that are not covered or not sufficiently covered under Pillar 1, and the Pillar 2 leverage ratio add-on is about the risk of excessive leverage. It may well be that there are cases where the risk of excessive leverage is increasing, and there's less risks of the type that have just been described that are not sufficiently accounted for in Pillar 1, where that is declining, or the other way round. So there's not necessarily a link between these two, as you've been suggesting. So these are just different assessments. We take a very detailed approach, risk by risk. We look at all the banks, we look at the different elements of the SREP and this can be one outcome, but again this is not a statement about an individual bank where this may have happened. 1. The CET1 ratio was 12.7% and the leverage ratio was 5.3% in the second quarter of 2015 and the third quarter of 2016 respectively. 2. As at the second quarter of 2024, including cash balances at central banks and other demand deposits. Excluding cash balances at central banks and other demand deposits, the figure is 2.3%. 3. The 5.5% return on equity corresponds to the period from the second quarter of 2015 until the second quarter of 2022, while the 9.2% return on equity corresponds to the period from the second quarter of 2022 until the second quarter of 2024. 4. Rumpf, M. (2024), "Cross-border deposits: growing trust in the euro area", The ECB Blog, ECB, 24 October. 5. 6. The overall SREP score ranges from 1 to 4, with higher scores reflecting higher risks to a bank's viability. 7. A similar increase was measured in terms of total capital (comprising CET1, Tier 1 and Tier 2 capital), where the overall requirements and Pillar 2 guidance increased slightly to 15.6% of risk-weighted assets from 15.5% in the 2023 SREP cycle. 8. European Systemic Risk Board (2024), Overview of national macroprudential measures, September. CONTACT European Central Bank Directorate General Communications > Sonnemannstrasse 20 > 60314 Frankfurt am Main, Germany > +49 69 1344 7455 > [email protected]	---[PAGE_BREAK]--- # SPEECH ## Introductory statement ## Speech by Claudia Buch, Chair of the Supervisory Board of the ECB, at the press conference on the 2024 SREP results and the supervisory priorities for 2025-27 Frankfurt am Main, 17 December 2024 Jump to the transcript of the questions and answers ## Introduction Let me welcome you to my first press conference as the Chair of the Supervisory Board of the ECB. This year marks the tenth anniversary of the Single Supervisory Mechanism, which provides a good opportunity to reflect upon what we have achieved so far and what we can improve on. Over the past decade, European banking supervision has contributed to the increased resilience of European banks and thus to financial stability. The results of the annual Supervisory Review and Evaluation Process (SREP) for 2024, which we have published today, show that the banks directly supervised by the ECB generally have strong fundamentals. The asset quality of European banks is robust, they have overall solid capital positions, good levels of profitability, and are a reliable source of funding and financial services for European households and firms. Looking ahead, banks will need to adapt to a changing environment. Faced with heightened geopolitical risks, structural change, climate and environmental risks, and downside risks to the macroeconomic outlook, strong financial and operational resilience will remain key. Corporate insolvencies are on the increase, potentially leading to higher credit risk. The public sector may have more limited capacity than in the past to buffer adverse shocks. The digitalisation of financial services is changing the competitive landscape. Banks must therefore remain vigilant and prudent to sustain their business and operations. Their currently good levels of profitability provide them with an opportunity to strengthen their resilience. Against this background, the current SREP cycle has not resulted in major changes to banks' SREP scores or overall Pillar 2 requirements in aggregate terms. The annual Supervisory Review and Evaluation Process assesses each bank's risks, business model viability and resilience. Where we identify shortcomings, supervisory measures are put in place that ensure remediation by the banks. Banks' individual SREP scores and Pillar 2 requirements take bank-specific risks into account. The supervisory priorities for the years 2025-27 continue to focus on risks related to macro-financial threats and geopolitical shocks, as well as on challenges stemming from the digital transformation, while emphasising the need to remediate shortcomings, particularly those related to governance and risk management. ---[PAGE_BREAK]--- This year, we have taken a large step forward to make ECB Banking Supervision more efficient and effective. We have launched a comprehensive reform of the SREP to respond to emerging risks in a more targeted way, to simplify, and to reduce complexity. The reform will be implemented over the next two years. # Overall resilience of the banking system Let me provide an overview of the resilience of the European banking system. ## Chart 1: CET1 capital and leverage ratios of significant institutions ![img-0.jpeg](img-0.jpeg) Source: ECB supervisory banking statistics. Banks directly supervised by the ECB have overall solid capital and liquidity positions, which is a significant improvement compared with the situation ten years ago. ${ }^{[1]}$ The aggregate Common Equity Tier 1 (CET1) ratio stood at $15.8 \%$ in mid-2024, which is a slight improvement compared with the previous year. Similarly, the leverage ratio increased slightly to $5.8 \%$. ---[PAGE_BREAK]--- Chart 2: Distribution of capital headroom between CET1 capital ratios and CET1 overall requirements and Pillar 2 guidance after 2024 SREP ![img-1.jpeg](img-1.jpeg) Sources: ECB supervisory banking statistics and SREP database. Notes: Projected capital headroom is based on the 2024 SREP decisions and will be applied in 2025; current capital headroom is based on the 2023 SREP decisions and applicable in 2024. Pillar 2 CET1 requirements and Pillar 2 guidance are as per the published list of Pillar 2 requirements applicable as of the first quarter of 2025. CET1 ratios are as at the second quarter of 2024. For systemic buffers (global systemically important institutions, other systemically important institutions and systemic risk buffers) and the countercyclical capital buffer, the levels shown are those anticipated for the first quarter of 2025 and included in 2024 CET1 requirements and guidance. CET1 ratios have been adjusted for AT1/T2 shortfalls. Capital headroom compared with overall capital requirements has remained broadly stable on the previous year. Next year, $85 \%$ of institutions are expected to have capital headroom of over 200 basis points; only a few are projected to have capital headroom below 100 basis points. ---[PAGE_BREAK]--- Chart 3: Liquidity ratios ![img-2.jpeg](img-2.jpeg) Source: ECB supervisory banking statistics. Overall liquidity conditions have remained favourable. After the ECB started a period of quantitative tightening, banks turned smoothly to the markets to meet their financing needs. The share of funding through deposits remained largely stable. Generally, banks have good access to retail and wholesale funding. Yet some banks need to better prepare for an environment with potentially tighter liquidity conditions. This is the result of targeted reviews of banks' funding plans, of their capabilities to mobilise collateral and of their asset and liability management. ---[PAGE_BREAK]--- Chart 4: Non-performing loans by counterparty sector ![img-3.jpeg](img-3.jpeg) Source: ECB supervisory banking statistics. Note: "NFC" stands for "non-financial corporations". The quality of banks' assets has remained strong. The ratio of non-performing loans to total loans has remained around $2.2 \%$ over the last two years and is close to historical lows. ${ }^{[2]}$ However, there are initial signs of weakening asset quality driven by exposures to commercial real estate and small and medium-sized enterprises (SMEs), the latter accounting for about 50\% of European banks' lending portfolios. Non-performing loans are rising in Austria and Germany, and to a lesser extent in France, albeit from very low levels. Low levels of credit risk reflect the strong fundamentals of households and firms but also stem partly from the public support during the COVID-19 pandemic and the energy crises. Generally, the debt sustainability of households is benefiting from a strong labour market, rising wages and decreasing levels of indebtedness. Corporate balance sheets and profitability have generally remained resilient in 2024, thanks also to declining input and energy costs. ---[PAGE_BREAK]--- Chart 5: Insolvencies and real GDP in the euro area-4 ![img-4.jpeg](img-4.jpeg) Sources: Eurostat and national statistics. Notes: The series is based on developments in Germany, Spain, France and Italy (euro area-4). Insolvencies are shown as the average number of firms per quarter within each year. Real GDP is the 4-quarter moving sum growth rate. The latest observation is for the second quarter of 2024. But pockets of vulnerabilities are emerging, reflecting higher borrowing costs, weaker growth and structural changes in the real economy. Even during the pandemic, when GDP declined, corporate insolvencies fell. Since mid-2022, however, corporate insolvencies have been on the rise, signalling a potential future deterioration in asset quality. ---[PAGE_BREAK]--- Chart 6: Return on equity and return on assets ![img-5.jpeg](img-5.jpeg) Source: ECB supervisory banking statistics. Bank profitability has remained strong, with an annualised return on equity of $10.1 \%$ in mid-2024. Higher interest rates are a key driver: during the low interest rate environment, banks' average return on equity was $5.5 \%$; following the normalisation of interest rates, it increased to $9.2 \%$. ${ }^{[3]}$ In addition, the average cost-to-income ratio declined from $66 \%$ in 2020 to $54 \%$ in 2024 . Cost of risk has remained muted. Chart 7: Aggregate net interest margin ![img-6.jpeg](img-6.jpeg) Source: ECB supervisory banking statistics. ---[PAGE_BREAK]--- Chart 8: Share of fixed versus variable rate lending to non-financial corporations ---[PAGE_BREAK]--- \| \| Fixed <br> Mixed <br> Variable \| \| :--: \| :--: \| \| DE \| \| \| NL \| \| \| FR \| \| \| EA \| \| \| BE \| \| \| HR \| \| \| ES \| \| \| LU \| \| \| GR \| \| \| IE \| \| \| SK \| \| \| IT \| \| \| AT \| \| \| SI \| \| \| PT \| \| \| LV \| \| \| MT \| \| \| FI \| \| \| EE \| \| \| CY \| \| \| LT \| \| \| 0\% \| 10\% 20\% 30\% 40\% 50\% 60\% 70\% 80\% 90\% 100\% \| ---[PAGE_BREAK]--- Source: ECB (2024), Financial Stability Review, May. Notes: Lending shares refer to outstanding amounts for loans to non-financial corporations. "Fixed" indicates a rate that both parties to the loan contract agree to at inception. "Variable" indicates a rate linked to an exogenous parameter (e.g. EURIBOR). "Mixed" indicates a combination of fixed and variable rates. Aggregate net interest margins have widened across euro area banks. In countries where floating rate loan contracts prevail, the pass-through of higher interest rates has been relatively fast. In countries where fixed rate loan contracts are more common, the impact of higher interest rates on profitability and borrower default risks has been delayed. On the funding side, shifts from demand to term deposits with higher interest rates have so far been relatively slow. Variations in the pass-through also reflect differences in banks' pricing power across countries. Cross-border competition in deposit taking is particularly limited, with only around $1.6 \%$ of deposits held across borders. ${ }^{[4]}$ Banks' distribution plans foresee a relatively stable aggregate payout ratio. Supervised banks expect to pay out $49 \%$ of profits for 2024 or one percentage point less than in the previous year. Share buybacks have become less prominent, representing a little less than one-quarter of distributions compared with one-third a year ago. The future performance of banks will depend on the economic outlook, their resilience to adverse shocks, shifts in the yield curve and interest rate pass-through. Banks' ability to contain costs while investing in the digitalisation of their business models will be crucial to sustain profitability. Distribution plans thus need to be aligned with sufficiently forward-looking capital plans that also consider relevant adverse scenarios. # Risk outlook and supervisory responses From a macroeconomic perspective, the year 2024 has been characterised by a resilient euro area economy, which is projected to grow at a rate of $0.7 \%$. ${ }^{[5]}$ But the short and medium-term outlook for growth remains subdued and subject to considerable uncertainty. The likelihood of tail events materialising appears higher than a year ago. Geopolitical tensions alongside growing deglobalisation trends could push energy prices and freight costs higher in the short term and disrupt global trade. Our supervisory priorities reflect this risk outlook. ---[PAGE_BREAK]--- Chart 9: Measures of uncertainty in the euro area ![img-7.jpeg](img-7.jpeg) Sources: ECB, policyuncertainty.com and ECB staff calculations. Notes: The composite indicator of systemic stress (CISS) and the economic policy uncertainty index are monthly data series (standardised by the standard deviation from the mean over the period January 1999-December 2019). A value of 2 should be read as meaning that the uncertainty measure exceeds its historical average level by two standard deviations. The latest observations are for November 2024. Heightened geopolitical risks affect banks through various channels. Adverse geopolitical events are often not priced in by financial markets, which can lead to an abrupt repricing of risks if such events materialise. Financial sanctions and cyberattacks can affect banks, including through outsourcing arrangements. In terms of the real economy, higher costs for firms and disruptions to global trade could increase credit risk. Credit risk management therefore remains a priority for ECB Banking Supervision. Novel risks may not be adequately captured by risk models that are based on past data. Accounting overlays are thus one instrument that can be used to address novel risks in a forward-looking way. From our supervisory perspective, we are therefore addressing deficiencies in IFRS 9 accounting frameworks in terms of identifying and monitoring risk. To address the deterioration in asset quality, we have carried out targeted reviews on commercial and residential real estate as well as SME portfolios, and we are taking supervisory measures where we have identified weaknesses. To provide transparency on our risk assessment methodologies, today we are publishing a comprehensive supervisory methodology for assessing interest rate risk and credit spread risk in the banking book. To deal with heightened risks and uncertainties, banks' decision-making bodies need reliable information. Over the years, however, we have identified ongoing deficiencies in risk data aggregation and risk reporting. These deficiencies prevent management from receiving timely and comprehensive information on relevant risks and they also increase the cost of responding to supervisory requests. At ---[PAGE_BREAK]--- the ECB, we have therefore intensified our efforts to encourage banks to improve their information systems and address IT security and cyber risks. More generally, banks need to speed up their digitalisation efforts. SREP scores for operational and ICT risk remain among the worst. We are therefore focusing on addressing outsourcing risks and enhancing banks' cyber resilience, also taking into account the Digital Operational Resilience Act, which comes into force in 2025. This year, we conducted a cyber resilience stress test to assess banks' ability to respond to cyber incidents. The stress test showed that banks are prepared, but it also revealed areas for improvement in cybersecurity. Moreover, climate-related and environmental risks are increasingly relevant and continue to be a significant concern. Banks need to fully account for transition and physical risks. They have started to make progress in integrating these risks into their governance and risk management frameworks, addressing our supervisory expectations. However, we found that some banks were still lacking key elements needed to adequately manage climate and environmental risks, prompting further supervisory actions. # 2024 SREP assessment Let me now turn to this year's SREP assessment, which was carried out against the backdrop of the risk outlook I have just described. ## Chart 10: Overall SREP scores ![img-8.jpeg](img-8.jpeg) Source: ECB SREP database. Notes: 2022 SREP values are based on assessments of 101 banks, 2023 SREP values are based on assessments of 106 banks, and 2024 SREP values are based on assessments of 104 banks. There were no banks with an overall SREP score of 1 in 2022, 2023 or 2024. ---[PAGE_BREAK]--- The average overall SREP score in 2024 remained stable at 2.6, ${ }^{[5]}$ with $74 \%$ of banks scoring the same as last year. $11 \%$ of banks saw their scores worsen, mainly because of their exposure to the commercial real estate sector and interest rate risk, while $15 \%$ of banks achieved a better score, mainly because of increased profitability. This year's SREP resulted in more binding measures to address severe weaknesses. This reflects our increased focus on ensuring that supervised banks remediate any findings in a timely manner. More specifically, we imposed the following quantitative and qualitative supervisory measures. # Chart 11: Evolution of overall capital requirements and Pillar 2 guidance - the total capital stack ![img-9.jpeg](img-9.jpeg) Sources: ECB supervisory banking statistics and SREP database. Notes: The sample selection follows the approach taken in the methodological note for the supervisory banking statistics. For 2020 the first quarter sample is based on 112 entities; for 2021 the first quarter sample is based on 114 entities; for 2022 the first quarter sample is based on 112 entities; for 2023 the first quarter sample is based on 111 entities; and for 2024 the first quarter sample is based on 110 entities. For 2025 the first quarter sample is based on 109 entities, with the Pillar 2 requirement (P2R) being applicable from January 2025. The chart shows RWA-weighted data from the second quarter of 2024. "Overall capital requirements" comprise the Pillar 1 minimum requirement, the Pillar 2 requirement, combined buffer requirements (i.e. the capital conservation buffer and systemic buffers (global systemically important institutions, other systemically important institutions and systemic risk buffers) and the countercyclical capital buffer). Rounding differences may apply. The reference period for the combined buffer requirement is the first quarter of each year. For the first quarter of 2025 buffers are estimated based on announced rates applicable at this date. Estimated values are shown with a lighter colour and marked with an asterisk. The Pillar 2 guidance is added on top of the overall capital requirements. Under CRD V, which came into effect on 1 January 2021, the P2R capital should have the same composition as Pillar 1 - i.e. at least $56.25 \%$ should fall under CET1 capital and at least $75 \%$ should fall under Tier 1 capital, in line with the minimum requirements. By way of derogation from the first sub-paragraph of paragraph 4, Article 104a CRD V, the competent authority may require an institution to meet its additional own funds requirements with a higher share of Tier 1 capital or CET1 capital, where necessary, and considering the specific circumstances of the institution. ---[PAGE_BREAK]--- In terms of quantitative requirements, the overall CET1 capital requirements and guidance stand at $11.3 \%$ of risk-weighted assets, compared with $11.2 \%$ last year. Overall capital requirements and Pillar 2 guidance have thus increased slightly. $\underline{[7]}$ Changes in the risk profiles of individual banks led to three types of Pillar 2 add-ons being applied. > For nine banks, an average add-on of 14 basis points addresses excessive risk arising from leveraged finance. > For 18 banks, an average add-on of 5 basis points addresses shortfalls in the coverage of nonperforming exposures. > For 13 banks, an add-on of between 10 and 40 basis points was applied to the leverage ratio requirement. Quantitative liquidity measures were issued for four banks. Qualitative measures were issued for 95 banks, mainly to address deficiencies in the areas of credit risk management, internal governance and capital adequacy. The stability of the banks' SREP scores reflects, on the one hand, an improvement in key risk indicators and, on the other hand, the high degree of uncertainty concerning the economic outlook. We have therefore taken a number of measures to ensure that banks assess risks in a sufficiently forwardlooking way. These include supervisory focus on capital and liquidity planning that takes relevant adverse scenarios into account; on provisioning frameworks that capture novel risks; on operational resilience, particularly in relation to cyber and outsourcing risks; and on stress tests that capture geopolitical risks. Microprudential supervision needs to be complemented by a strong macroprudential framework. Releasable macroprudential buffers in the banking union have in fact increased in recent years: the weighted average rate for countercyclical capital buffers and (sectoral) systemic risk buffers rose from about $0.3 \%$ at the end of 2019 to $0.8 \%$ in mid-2024. 8 We very much welcome the progress made in this area in addressing uncertainties and risks to financial stability. # Supervisory priorities ---[PAGE_BREAK]--- Figure 1: Supervisory priorities Priority 1: Banks should strengthen their ability to withstand immediate macro-financial threats and severe geopolitical shocks Address deficiencies in credit risk management frameworks Address deficiencies in operational resilience frameworks as regards IT outsourcing and IT security/cyber risks Special focus: Incorporating the management of geopolitical risks in supervisory priorities (C) Credit risk Operational risk Multiple risk categories Priority 2: Banks should remedy persistent material shortcomings in an effective and timely manner Address deficiencies in business strategies and risk management as regards climate-related and environmental risks Address deficiencies in risk data aggregation and reporting (C) Climate-related and environmental risks Priority 3: Banks should strengthen their digitalisation strategies and tackle emerging challenges stemming from the use of new technologies Address deficiencies in digital transformation strategies # Business model Our supervisory priorities for the years 2025-27 continue to focus on external challenges for banks, while putting greater emphasis on remediating persistent shortcomings. First, resilience to macro-financial threats and geopolitical shocks requires the attention of banks' boards and senior management. Improving credit risk management and maintaining adequate levels of provisioning remain important for financial resilience, while increased IT and cybersecurity risks require adequate governance structures and sufficient investment. Second, banks need to address shortcomings related to governance, climate-related and environmental risk management and risk data aggregation and reporting capabilities. We will continue to monitor these areas and take supervisory action as necessary. And third, risks associated with digitalisation require adequate safeguards. We will continue to assess banks' digital strategies to ensure that risks are mitigated, and we are publishing an updated SREP ---[PAGE_BREAK]--- methodology for operational and ICT risk today. # SREP reform Just like the banks, supervisors have to respond to changes in the external environment. During its first decade, ECB Banking Supervision has become an internationally recognised supervisor, delivering on its mandate. But our supervisory procedures have become complex, potentially impairing our ability to react to new developments in a timely manner. The SREP reform that we announced earlier this year will make our supervision more efficient, more effective and more intrusive. We will sharpen the focus on bank-specific risks, better integrate different supervisory activities and communicate more clearly with banks. We will use our full supervisory toolkit to ensure that findings are remediated more promptly. We will make methodologies more stable to achieve greater consistency. And investing in advanced IT and analytics will simplify data submissions, while enabling us to provide more tailored and timely feedback to banks. These reforms will be fully implemented by 2026, and we will carefully monitor their impact. ## Conclusion Chart 12: Consolidated gross debt of the non-financial private sector in the euro area ![img-10.jpeg](img-10.jpeg) Sources: Eurostat, ECB and ECB calculations. Notes: MFI" stands for "monetary financial institutions. Consolidated gross debt is defined as total gross debt minus loans granted by firms and households. The latest observations are for the second quarter of 2024. Let me conclude. European banks have overall strong fundamentals in terms of their asset quality, capitalisation and profitability. This contributes to financial stability and the provision of financial services to households and firms across the banking union. Bank loans remain a key source of funding to the real economy, while non-bank financial intermediaries have grown in importance. ---[PAGE_BREAK]--- Looking ahead, heightened uncertainty will require a high level of prudence. Banks' ability to maintain robust business models depends on their resilience to shocks and their ability to adapt to the new environment, particularly the digitalisation of finance. Sound profitability enables banks to further strengthen their resilience and to remain a reliable foundation for the euro area economy, including during periods of stress. As supervisors, we will continue to focus on the resilience of European banks. Weakening standards of supervision would weaken banks, making it harder for them to support the real economy and compete successfully. At the same time, we need to ensure that our supervision is as efficient and effective as possible. This is the aim of our SREP reform, which will also bring benefits for the banks we supervise. We in ECB Banking Supervision rely on strong support from policymakers and regulators to achieve our goals. Completing the banking union and capital markets union, rather than relaxing banking rules or delaying the implementation of Basel III, is critical to enhancing financial stability and fostering economic growth. Decisive action would further bolster our capacity to cope with future shocks effectively. Thank you very much for your attention. I now look forward to your questions. *** Two questions from my side. The first on "efficient and effective". As you redeploy resources you have spoken a lot about geopolitical risk - as you focus more on that, what are you focusing less on? And I ask this question also with respect to banks complaining about rising demands from supervisors. What are you giving them an easier ride on at the same time? And then the other question on significant risk transfers [SRTs], I mean the capital relief type. I was wondering if you could confirm that you now will be shortening the period that banks have to apply in advance to get these. Why are you doing that? I assume it's because you like SRTs? And if you have any words of warning to banks on this front? I'm thinking specifically about leverage employed to buy SRTs, so whether risk is not actually leaving the financial system, but is getting more and more complicated. Thank you for these very good questions, which allow me to explain a bit more what we are doing with the Supervisory Review and Evaluation Process [SREP] reform to become more efficient and effective. So first of all, very simply speaking, what it does is that we are giving more flexibility to the Joint Supervisory Teams, to the supervisors, to adjust their supervisory action to the risks being faced and that are most relevant for the specific bank. So we have overall risks and priorities that are being defined by the Supervisory Board, but then of course the relevance of specific risks might be very different for different types of banks. So, the teams have more flexibility. It's not that they ignore certain types of risk, but rather say: what is really relevant for this bank? What do we need to focus on? We have a risk tolerance framework that allows the teams to actually do this, and they can also spread out their risk assessment over a three-year period. We have a multi-year approach so that not every risk needs to be looked at with the same intensity in each year for each bank. So we become more targeted - this is our role, this is also how we define good supervision - we become more targeted to the relevant risks. ---[PAGE_BREAK]--- You also mentioned: is there an ever-rising demand of supervisory requests? No, there isn't. The demand of supervisory requests is again linked to the risks that we see, because this is our role: to keep European banks safe and stable. And if the environment changes, if climate and environmental risks are relevant and not fully addressed by the banks, we need to react to that. If the geopolitical risk environment changes, then we need to address the risks that are relevant for the specific banks. Of course, we also need to do this in an efficient and effective way. So what we will do even more in the future is use what we call integrated planning, so that all our activities - whether they are horizontal across different banks or vertical for specific banks - are integrated even more closely and can also inform each other, so that we don't have to duplicate certain types of activities. But it's very important for us that we address the relevant risks that are there and don't lose relevant risks out of sight. And the teams have more flexibility now. By the way, the risk tolerance framework, the multi-year approach, has already been in place since 2023, but we are rolling it out now more forcefully and we monitor the progress being made. As to your second question on the significant risk transfers, this is related obviously to securitisation and we generally think that securitisation can be a useful instrument to move risks to the part of the financial system where they can be better borne than on banks' balance sheets. But at the same time, of course, we need to make sure that there are no spillover effects on the banking sector - this is a bit the second part of your question. So who's financing these significant risk transfers and could there be amplification effects in the financial system? Of course, we need to monitor this very closely. Now, within this framework that we have and also within the regulatory framework that we have, there was actually room for improvement, and this is what you mentioned. In terms of, for a given risk transfer, can we speed up the process until we approve a certain significant risk transfer? And here we have worked with the European Banking Federation to get a pilot started. Of course, we need some products for which we can run the pilot. We will do this next year and then hopefully speed up our efforts - to the benefit of us, because less resources will go into that, and also to the benefit of the industry. But let me reassure you, we will never lose resilience out of sight. This is given a certain risk that is being transferred and we will also carefully monitor the effects on the financial system, because this is mainly about efficiency - it's not about weakening resilience. # Question one: how exactly shall banks consider geopolitical risks? It's a very broad term and I would like to have an idea what the banks specifically should do about it. The other question is a little bit more specific. It's on the recalibration of the SREP. Deutsche Bank, whose Pillar 2 requirement [P2R] has increased, suggested that their higher Pillar 2 requirement is due to the recalibration of your SREP and it would have nothing to do with any reassessment of the riskiness of Deutsche Bank. So is this view or description of Deutsche Bank accurate? So can I imagine that you don't see Deutsche Bank as more risky, but nevertheless the Pillar 2 requirement can increase? Thank you very much for the first question on geopolitical risk, which is indeed an issue about which we have been thinking hard to get to some extent a conceptual framework around it, because different people may have different understandings of what geopolitical risk is actually about. What we have done is we've published our way of thinking about this in September this year, and the main idea is ---[PAGE_BREAK]--- that geopolitical risk is not a new risk category for the banks. It's affecting the banks through credit risk, market risk, operational risk. But there are dimensions of this risk which you wouldn't cover if you didn't think about it in terms of the geopolitical environment. And here it's relatively broad, it's anything that's related to conflicts and tensions internationally. And so, as l've said, if you think for example about the financial markets channel, relevant parts of geopolitical risk are not priced in by markets. So this can affect banks' exposure to market risk if there's an abrupt repricing of risk. The second channel is through the real economy. So what if global value chains become more fragmented because of conflicts? How should that lead to a reassessment of credit risk? And then there's cyber risk, exposure to financial sanction risk. And so we work very closely with the banks to see whether they address these risks properly. We have also gone through our activities to see whether we are missing any of these channels, and we actually found that there's relatively little that we are missing. I mentioned the provisioning framework, I mentioned the work we are doing on cyber risk - all this is very much related to geopolitical risk. We're now working with the banks to see that they capture risks that are relevant for the individual bank - that they capture this in their risk management. And maybe the most important aspect here is that it really needs to be at the attention of top management, of the boards, because geopolitical risk is something which you can't properly price. There's a lot of uncertainty, so the banks need to use scenario analysis that is relevant for their capital planning, and this is really something which needs steering from the top. And we now look very carefully at what the banks are doing in this space. The second question was about a specific bank and my apologies but for reasons of confidentiality I don't comment. So it's OK if you answer generally if it's possible that a bank gets a higher Pillar 2 requirement without you considering this, an unspecific bank, more risky? Again, I don't comment on any specific bank and we have not changed the Pillar 2 methodology for how the risks are being calculated. Actually, today we are publishing a lot of detail about how our methodology is applied. There's also one element of our SREP reform, but this is not for this year's SREP, it's for the next two years. We are currently working on the P2R, the Pillar 2 methodology, to make it even more risk-based, to make it more targeted, to simplify. But this is not for now, this has not affected the 2024 SREP cycle - there will be again a pilot, a dry run next year and then it will only be effective one year later. We also aim to stabilise methodologies more in order to simplify and to reduce complexity. # My first question is on profitability. How do you expect it to evolve in a context of lower interest rates and possibly also an increase in non-performing loans? Second, what are your considerations about the consolidation process ongoing in Europe and what are the main elements that you want to ensure about the authorisation process in cases, of course, like UniCredit and Commerzbank and UniCredit and Banco BPM? To your first question about profitability: so we don't have any forecast of interest rates that is underlying our assessment here, so we need to see how rates are evolving. What market analysts are saying is that we now have a higher level of net interest margins and that it wouldn't go down to the levels that we saw during the period of low interest rates. But as l've explained, this also depends on the pass-through into lending rates and into deposit rates. As you're rightly saying, when it comes to ---[PAGE_BREAK]--- credit risk, asset quality, we are as of now not seeing a significant deterioration of asset quality. Nonperforming loans are actually close to historical lows, but of course we all need to remain vigilant as to how does the risk that we have just been talking about, how does that play out? How does the structural change in the real economy play out? So we don't really have a forecast here on bank profitability. What is our aim? And this is also part of the SREP, it is of course to make sure that banks have sustainable business models, that they have sustainable long-run profitability. One important factor here will also be their IT investments, their ability to compete in a world of ever-more digitalised finance. The second question on consolidation, and here again I need to make the statement up front that I'm not talking about individual banks that you have mentioned. Our role here is actually very clear when it comes to the approval process of qualified holdings. We have clear criteria in the legislation, what we look at in terms of financial soundness, reputation of the buyers and so forth. We generally take a very neutral approach when it comes to cross-border versus domestic mergers. In the end it's a decision of the stakeholders, the shareholders in the banks - how they want to respond to increasing competitive pressure, digitalisation. And mergers are certainly one way to respond. But we don't have a specific preference as to how they should respond. We have a clear role given to us by the legislation on the indicators that we look at. This year's cyber stress test showed that there are still many shortcomings in banks' cyber defences. Have you taken any measures in the context of the SREP to address the shortcomings? The second question is about Russia. Compared to when you took over in January, are you happy with the progress made by the banks that are still there in leaving the country? As regards the cyber stress test, just to clarify what it was: the question was how do banks respond to a hypothetical successful cyberattack? So it was about their response. We actually found that the banks were quite well prepared. So because you mentioned the shortcomings, we always find, of course, issues that need to be addressed, but here I think we found the banks also well prepared. My impression is that the banking industry also appreciated the consistent exercise across all the banks, from which they also learn where they stand relative to their peers. So to the extent that it doesn't violate any confidentiality requirements, we also share with the banks this benchmarking. So as I said, we always, when we do these exercises, we also find issues and we indeed take this into consideration in the SREP, because this is information that we need for our supervision. And as l've said, cyber resilience, digitalisation, all this has been and will be a priority for the SSM also going forward. Appropriate measures were taken, and in many cases, these are qualitative measures. As regards the exposure of banks to Russia and risks arising from Russia, given the tragedy of the situation, I'm a little bit hesitant to talk about happiness in that context. What was done in the SSM after the Russian invasion into Ukraine was to take stock of the exposures of European banks, which were limited in absolute terms, but of course there was exposure to financial sanction risk. We're not the sanction authority, but of course, we need to take into account what are potential implications for reputation and risk management of the banks. We've addressed this with the banks. We've asked them to downsize and exit from Russia and I think the latest number we have is that the exposures ---[PAGE_BREAK]--- have been reduced by $53 \%$. We're working very closely with the banks to make sure that they comply with our decisions. Again, apologies that I can't go into the specifics for individual banks, but there has been progress and we need to see how the situation will evolve. For next year looking forward, most economists expect a lot of rate cuts. Do you see any risks connected with that for the banking sector and how do you think it will affect the banking sector? And my second question: you mentioned the importance of completing the banking union. Do you expect some progress on EDIS and how important is it from your supervisor's perspective? I don't want to comment on potential rate cuts, this is not our business to do any forecasts and to consider potential scenarios. What we do do, of course, is that we make sure that the banks' exposure to interest rate risk is well managed. We're following up very closely in case we feel that this is not being the case, but we don't do any specific forecast or analysis of where do we think interest rates could move. I mentioned a few other points already when I discussed profitability impacts. As to the second question on the banking union, I'm not sure whether I should also comment or make any forecasts about the likelihood of potential dossiers to be followed through. But clearly, the European deposit insurance scheme [EDIS] is very important for supervisors. Basically we have an incomplete banking union. So we have the first pillar l've described, the successes that have been made, the achievements; we have the second pillar with the resolution framework, and deposit insurance and supervision is inevitably linked together. So I think it would be good to have progress on EDIS to make sure that all deposits across the banking union have the same level of protection. It would also promote cross-border integration obviously, and it would also make, in the end, the whole work by the Single Resolution Board less complex in dealing with banks that are under stress. But let me mention also another very important file which is currently on the table in Brussels, which is crisis management and deposit insurance, or CMDI. So this is basically a dossier which aims to close the remaining gaps with regard to resolution. On the one hand, to bring more banks, mid-size banks, which can have systemic implications, under resolution, and also provide the funding for this resolution through the use of deposit guarantee schemes. It's somehow linked, but it's a separate dossier related to EDIS. And I think this is crucially important, so the more credible resolution is, the better it is for supervision, because it's setting the right incentives not to engage in risk-taking and it's just good for the clarity of the overall framework of how we deal with banks in the going concern but also banks that come under stress. And in the end, also making sure that we don't have to use taxpayers' money again for banks that are under stress, so I think this is an additional benefit of the CMDI package. Quick question on crypto-assets: as everybody, of course, has noticed a different approach coming from the US administration, I don't know what's going to happen with the US financial authorities, but as regards the ECB supervision, is there an intention, is there an orientation towards stricter rules or looser rules regarding crypto portfolios within bank balance sheets? I don't want to speculate on what's happening in the US, but let me say how we view crypto-assets and what has been done in Europe. So first of all, I think there's risk related to crypto-assets in terms of risks that are prevalent in other financial market segments as well. So there can be excessive ---[PAGE_BREAK]--- leverage, there can be intransparency, there can be conflicts of interest. So I think it's very important to also preventively manage and regulate these risks. That, of course, requires first and foremost good information about crypto markets and what is happening in this space, in particular related to leverage and misaligned incentives. I think with the Markets in Crypto-Assets (MiCA) regulation, Europe has done a lot to move into that direction to get better information, and also to regulate to the extent necessary. And the third leg is certainly that, because many of these activities are somewhat borderless; it's also important, and there have been important initiatives in the G20 and in the FSB, to make sure that there's also an internationally agreed approach to this. So we need to see where this moves, we monitor this very carefully. We also monitor very carefully that the exposure of banks to crypto-assets is very limited and that also we deal with the competitive pressure that may arise from these markets on banks to provide crypto-related financial services. We have a very close eye on this. The first question is when can we expect a decision on UniCredit's request to build up its stake in Commerzbank? Second one is can you shed light on the ECB's interpretation of the Danish compromise? Can a financial conglomerate risk weigh all assets bought via its insurance arm? This has been described as a regulatory arbitrage that favours conglomerates. Well, the answer to the first question is unfortunately very short, because I don't comment on individual cases, including deadlines. The second is the Danish compromise. We have clarified our approach and our publication on options and discretions, I think in 2016 if I'm not mistaken, and we currently have under consultation a new guide which also clarifies our approach there. In the end, it's an issue that we would also assess on a case-by-case basis for individual institutions. I have noticed in some cases the SSM has been reducing Pillar 2 capital requirements while raising P2R leverage ratio. What is the rationale behind that? To the extent that you're referring to individual banks, I couldn't comment on this. Generally the P2R and the P2R leverage ratio add-on have different purposes. So the P2R is basically to cover risks that are not covered or not sufficiently covered under Pillar 1, and the Pillar 2 leverage ratio add-on is about the risk of excessive leverage. It may well be that there are cases where the risk of excessive leverage is increasing, and there's less risks of the type that have just been described that are not sufficiently accounted for in Pillar 1, where that is declining, or the other way round. So there's not necessarily a link between these two, as you've been suggesting. So these are just different assessments. We take a very detailed approach, risk by risk. We look at all the banks, we look at the different elements of the SREP and this can be one outcome, but again this is not a statement about an individual bank where this may have happened. 1. The CET1 ratio was $12.7 \%$ and the leverage ratio was $5.3 \%$ in the second quarter of 2015 and the third quarter of 2016 respectively. ---[PAGE_BREAK]--- As at the second quarter of 2024, including cash balances at central banks and other demand deposits. Excluding cash balances at central banks and other demand deposits, the figure is $2.3 \%$. 3. The $5.5 \%$ return on equity corresponds to the period from the second quarter of 2015 until the second quarter of 2022, while the $9.2 \%$ return on equity corresponds to the period from the second quarter of 2022 until the second quarter of 2024. 4. Rumpf, M. (2024), "Cross-border deposits: growing trust in the euro area", The ECB Blog, ECB, 24 October. 5. ECB (2024), Eurosystem staff macroeconomic projections for the euro area., December. 6. The overall SREP score ranges from 1 to 4, with higher scores reflecting higher risks to a bank's viability. 7. A similar increase was measured in terms of total capital (comprising CET1, Tier 1 and Tier 2 capital), where the overall requirements and Pillar 2 guidance increased slightly to $15.6 \%$ of risk-weighted assets from $15.5 \%$ in the 2023 SREP cycle. 8. European Systemic Risk Board (2024), Overview of national macroprudential measures, September. # CONTACT <br> European Central Bank <br> Directorate General Communications $>\quad$ Sonnemannstrasse 20 $>\quad 60314$ Frankfurt am Main, Germany $>\quad+496913447455$ $>\quad$ [email protected]	Claudia Buch	Euro area	https://www.bis.org/review/r241218d.pdf	Frankfurt am Main, 17 December 2024 Jump to the transcript of the questions and answers Let me welcome you to my first press conference as the Chair of the Supervisory Board of the ECB. This year marks the tenth anniversary of the Single Supervisory Mechanism, which provides a good opportunity to reflect upon what we have achieved so far and what we can improve on. Over the past decade, European banking supervision has contributed to the increased resilience of European banks and thus to financial stability. The results of the annual Supervisory Review and Evaluation Process (SREP) for 2024, which we have published today, show that the banks directly supervised by the ECB generally have strong fundamentals. The asset quality of European banks is robust, they have overall solid capital positions, good levels of profitability, and are a reliable source of funding and financial services for European households and firms. Looking ahead, banks will need to adapt to a changing environment. Faced with heightened geopolitical risks, structural change, climate and environmental risks, and downside risks to the macroeconomic outlook, strong financial and operational resilience will remain key. Corporate insolvencies are on the increase, potentially leading to higher credit risk. The public sector may have more limited capacity than in the past to buffer adverse shocks. The digitalisation of financial services is changing the competitive landscape. Banks must therefore remain vigilant and prudent to sustain their business and operations. Their currently good levels of profitability provide them with an opportunity to strengthen their resilience. Against this background, the current SREP cycle has not resulted in major changes to banks' SREP scores or overall Pillar 2 requirements in aggregate terms. The annual Supervisory Review and Evaluation Process assesses each bank's risks, business model viability and resilience. Where we identify shortcomings, supervisory measures are put in place that ensure remediation by the banks. Banks' individual SREP scores and Pillar 2 requirements take bank-specific risks into account. The supervisory priorities for the years 2025-27 continue to focus on risks related to macro-financial threats and geopolitical shocks, as well as on challenges stemming from the digital transformation, while emphasising the need to remediate shortcomings, particularly those related to governance and risk management. This year, we have taken a large step forward to make ECB Banking Supervision more efficient and effective. We have launched a comprehensive reform of the SREP to respond to emerging risks in a more targeted way, to simplify, and to reduce complexity. The reform will be implemented over the next two years. Banks directly supervised by the ECB have overall solid capital and liquidity positions, which is a significant improvement compared with the situation ten years ago. The aggregate Common Equity Tier 1 (CET1) ratio stood at $15.8 \%$ in mid-2024, which is a slight improvement compared with the previous year. Similarly, the leverage ratio increased slightly to $5.8 \%$. Capital headroom compared with overall capital requirements has remained broadly stable on the previous year. Next year, $85 \%$ of institutions are expected to have capital headroom of over 200 basis points; only a few are projected to have capital headroom below 100 basis points. Overall liquidity conditions have remained favourable. After the ECB started a period of quantitative tightening, banks turned smoothly to the markets to meet their financing needs. The share of funding through deposits remained largely stable. Generally, banks have good access to retail and wholesale funding. Yet some banks need to better prepare for an environment with potentially tighter liquidity conditions. This is the result of targeted reviews of banks' funding plans, of their capabilities to mobilise collateral and of their asset and liability management. The quality of banks' assets has remained strong. The ratio of non-performing loans to total loans has remained around $2.2 \%$ over the last two years and is close to historical lows. However, there are initial signs of weakening asset quality driven by exposures to commercial real estate and small and medium-sized enterprises (SMEs), the latter accounting for about 50\% of European banks' lending portfolios. Non-performing loans are rising in Austria and Germany, and to a lesser extent in France, albeit from very low levels. Low levels of credit risk reflect the strong fundamentals of households and firms but also stem partly from the public support during the COVID-19 pandemic and the energy crises. Generally, the debt sustainability of households is benefiting from a strong labour market, rising wages and decreasing levels of indebtedness. Corporate balance sheets and profitability have generally remained resilient in 2024, thanks also to declining input and energy costs. Insolvencies are shown as the average number of firms per quarter within each year. Real GDP is the 4-quarter moving sum growth rate. The latest observation is for the second quarter of 2024. But pockets of vulnerabilities are emerging, reflecting higher borrowing costs, weaker growth and structural changes in the real economy. Even during the pandemic, when GDP declined, corporate insolvencies fell. Since mid-2022, however, corporate insolvencies have been on the rise, signalling a potential future deterioration in asset quality. Bank profitability has remained strong, with an annualised return on equity of $10.1 \%$ in mid-2024. Higher interest rates are a key driver: during the low interest rate environment, banks' average return on equity was $5.5 \%$; following the normalisation of interest rates, it increased to $9.2 \%$. In addition, the average cost-to-income ratio declined from $66 \%$ in 2020 to $54 \%$ in 2024 . Cost of risk has remained muted. Aggregate net interest margins have widened across euro area banks. In countries where floating rate loan contracts prevail, the pass-through of higher interest rates has been relatively fast. In countries where fixed rate loan contracts are more common, the impact of higher interest rates on profitability and borrower default risks has been delayed. On the funding side, shifts from demand to term deposits with higher interest rates have so far been relatively slow. Variations in the pass-through also reflect differences in banks' pricing power across countries. Cross-border competition in deposit taking is particularly limited, with only around $1.6 \%$ of deposits held across borders. Banks' distribution plans foresee a relatively stable aggregate payout ratio. Supervised banks expect to pay out $49 \%$ of profits for 2024 or one percentage point less than in the previous year. Share buybacks have become less prominent, representing a little less than one-quarter of distributions compared with one-third a year ago. The future performance of banks will depend on the economic outlook, their resilience to adverse shocks, shifts in the yield curve and interest rate pass-through. Banks' ability to contain costs while investing in the digitalisation of their business models will be crucial to sustain profitability. Distribution plans thus need to be aligned with sufficiently forward-looking capital plans that also consider relevant adverse scenarios. From a macroeconomic perspective, the year 2024 has been characterised by a resilient euro area economy, which is projected to grow at a rate of $0.7 \%$. But the short and medium-term outlook for growth remains subdued and subject to considerable uncertainty. The likelihood of tail events materialising appears higher than a year ago. Geopolitical tensions alongside growing deglobalisation trends could push energy prices and freight costs higher in the short term and disrupt global trade. Our supervisory priorities reflect this risk outlook. Heightened geopolitical risks affect banks through various channels. Adverse geopolitical events are often not priced in by financial markets, which can lead to an abrupt repricing of risks if such events materialise. Financial sanctions and cyberattacks can affect banks, including through outsourcing arrangements. In terms of the real economy, higher costs for firms and disruptions to global trade could increase credit risk. Credit risk management therefore remains a priority for ECB Banking Supervision. Novel risks may not be adequately captured by risk models that are based on past data. Accounting overlays are thus one instrument that can be used to address novel risks in a forward-looking way. From our supervisory perspective, we are therefore addressing deficiencies in IFRS 9 accounting frameworks in terms of identifying and monitoring risk. To address the deterioration in asset quality, we have carried out targeted reviews on commercial and residential real estate as well as SME portfolios, and we are taking supervisory measures where we have identified weaknesses. To provide transparency on our risk assessment methodologies, today we are publishing a comprehensive supervisory methodology for assessing interest rate risk and credit spread risk in the banking book. To deal with heightened risks and uncertainties, banks' decision-making bodies need reliable information. Over the years, however, we have identified ongoing deficiencies in risk data aggregation and risk reporting. These deficiencies prevent management from receiving timely and comprehensive information on relevant risks and they also increase the cost of responding to supervisory requests. At the ECB, we have therefore intensified our efforts to encourage banks to improve their information systems and address IT security and cyber risks. More generally, banks need to speed up their digitalisation efforts. SREP scores for operational and ICT risk remain among the worst. We are therefore focusing on addressing outsourcing risks and enhancing banks' cyber resilience, also taking into account the Digital Operational Resilience Act, which comes into force in 2025. This year, we conducted a cyber resilience stress test to assess banks' ability to respond to cyber incidents. The stress test showed that banks are prepared, but it also revealed areas for improvement in cybersecurity. Moreover, climate-related and environmental risks are increasingly relevant and continue to be a significant concern. Banks need to fully account for transition and physical risks. They have started to make progress in integrating these risks into their governance and risk management frameworks, addressing our supervisory expectations. However, we found that some banks were still lacking key elements needed to adequately manage climate and environmental risks, prompting further supervisory actions. The average overall SREP score in 2024 remained stable at 2.6, with $74 \%$ of banks scoring the same as last year. $11 \%$ of banks saw their scores worsen, mainly because of their exposure to the commercial real estate sector and interest rate risk, while $15 \%$ of banks achieved a better score, mainly because of increased profitability. In terms of quantitative requirements, the overall CET1 capital requirements and guidance stand at $11.3 \%$ of risk-weighted assets, compared with $11.2 \%$ last year. Overall capital requirements and Pillar 2 guidance have thus increased slightly. Changes in the risk profiles of individual banks led to three types of Pillar 2 add-ons being applied. > For nine banks, an average add-on of 14 basis points addresses excessive risk arising from leveraged finance. > For 18 banks, an average add-on of 5 basis points addresses shortfalls in the coverage of nonperforming exposures. > For 13 banks, an add-on of between 10 and 40 basis points was applied to the leverage ratio requirement. Quantitative liquidity measures were issued for four banks. Qualitative measures were issued for 95 banks, mainly to address deficiencies in the areas of credit risk management, internal governance and capital adequacy. The stability of the banks' SREP scores reflects, on the one hand, an improvement in key risk indicators and, on the other hand, the high degree of uncertainty concerning the economic outlook. We have therefore taken a number of measures to ensure that banks assess risks in a sufficiently forwardlooking way. These include supervisory focus on capital and liquidity planning that takes relevant adverse scenarios into account; on provisioning frameworks that capture novel risks; on operational resilience, particularly in relation to cyber and outsourcing risks; and on stress tests that capture geopolitical risks. Microprudential supervision needs to be complemented by a strong macroprudential framework. Releasable macroprudential buffers in the banking union have in fact increased in recent years: the weighted average rate for countercyclical capital buffers and (sectoral) systemic risk buffers rose from about $0.3 \%$ at the end of 2019 to $0.8 \%$ in mid-2024. We very much welcome the progress made in this area in addressing uncertainties and risks to financial stability. Priority 1: Banks should strengthen their ability to withstand immediate macro-financial threats and severe geopolitical shocks Address deficiencies in credit risk management frameworks Address deficiencies in operational resilience frameworks as regards IT outsourcing and IT security/cyber risks Special focus: Incorporating the management of geopolitical risks in supervisory priorities (C) Credit risk Operational risk Multiple risk categories Priority 2: Banks should remedy persistent material shortcomings in an effective and timely manner Address deficiencies in business strategies and risk management as regards climate-related and environmental risks Address deficiencies in risk data aggregation and reporting (C) Climate-related and environmental risks Priority 3: Banks should strengthen their digitalisation strategies and tackle emerging challenges stemming from the use of new technologies Address deficiencies in digital transformation strategies Our supervisory priorities for the years 2025-27 continue to focus on external challenges for banks, while putting greater emphasis on remediating persistent shortcomings. First, resilience to macro-financial threats and geopolitical shocks requires the attention of banks' boards and senior management. Improving credit risk management and maintaining adequate levels of provisioning remain important for financial resilience, while increased IT and cybersecurity risks require adequate governance structures and sufficient investment. Second, banks need to address shortcomings related to governance, climate-related and environmental risk management and risk data aggregation and reporting capabilities. We will continue to monitor these areas and take supervisory action as necessary. And third, risks associated with digitalisation require adequate safeguards. We will continue to assess banks' digital strategies to ensure that risks are mitigated, and we are publishing an updated SREP methodology for operational and ICT risk today. Just like the banks, supervisors have to respond to changes in the external environment. During its first decade, ECB Banking Supervision has become an internationally recognised supervisor, delivering on its mandate. But our supervisory procedures have become complex, potentially impairing our ability to react to new developments in a timely manner. The SREP reform that we announced earlier this year will make our supervision more efficient, more effective and more intrusive. We will sharpen the focus on bank-specific risks, better integrate different supervisory activities and communicate more clearly with banks. We will use our full supervisory toolkit to ensure that findings are remediated more promptly. We will make methodologies more stable to achieve greater consistency. And investing in advanced IT and analytics will simplify data submissions, while enabling us to provide more tailored and timely feedback to banks. These reforms will be fully implemented by 2026, and we will carefully monitor their impact. Let me conclude. European banks have overall strong fundamentals in terms of their asset quality, capitalisation and profitability. This contributes to financial stability and the provision of financial services to households and firms across the banking union. Bank loans remain a key source of funding to the real economy, while non-bank financial intermediaries have grown in importance. Looking ahead, heightened uncertainty will require a high level of prudence. Banks' ability to maintain robust business models depends on their resilience to shocks and their ability to adapt to the new environment, particularly the digitalisation of finance. Sound profitability enables banks to further strengthen their resilience and to remain a reliable foundation for the euro area economy, including during periods of stress. As supervisors, we will continue to focus on the resilience of European banks. Weakening standards of supervision would weaken banks, making it harder for them to support the real economy and compete successfully. At the same time, we need to ensure that our supervision is as efficient and effective as possible. This is the aim of our SREP reform, which will also bring benefits for the banks we supervise. We in ECB Banking Supervision rely on strong support from policymakers and regulators to achieve our goals. Completing the banking union and capital markets union, rather than relaxing banking rules or delaying the implementation of Basel III, is critical to enhancing financial stability and fostering economic growth. Decisive action would further bolster our capacity to cope with future shocks effectively. Thank you very much for your attention. I now look forward to your questions. *** Two questions from my side. The first on "efficient and effective". As you redeploy resources you have spoken a lot about geopolitical risk - as you focus more on that, what are you focusing less on? And I ask this question also with respect to banks complaining about rising demands from supervisors. What are you giving them an easier ride on at the same time? And then the other question on significant risk transfers , I mean the capital relief type. I was wondering if you could confirm that you now will be shortening the period that banks have to apply in advance to get these. Why are you doing that? I assume it's because you like SRTs? And if you have any words of warning to banks on this front? I'm thinking specifically about leverage employed to buy SRTs, so whether risk is not actually leaving the financial system, but is getting more and more complicated. Thank you for these very good questions, which allow me to explain a bit more what we are doing with the Supervisory Review and Evaluation Process reform to become more efficient and effective. So first of all, very simply speaking, what it does is that we are giving more flexibility to the Joint Supervisory Teams, to the supervisors, to adjust their supervisory action to the risks being faced and that are most relevant for the specific bank. So we have overall risks and priorities that are being defined by the Supervisory Board, but then of course the relevance of specific risks might be very different for different types of banks. So, the teams have more flexibility. It's not that they ignore certain types of risk, but rather say: what is really relevant for this bank? What do we need to focus on? We have a risk tolerance framework that allows the teams to actually do this, and they can also spread out their risk assessment over a three-year period. We have a multi-year approach so that not every risk needs to be looked at with the same intensity in each year for each bank. So we become more targeted - this is our role, this is also how we define good supervision - we become more targeted to the relevant risks. You also mentioned: is there an ever-rising demand of supervisory requests? No, there isn't. The demand of supervisory requests is again linked to the risks that we see, because this is our role: to keep European banks safe and stable. And if the environment changes, if climate and environmental risks are relevant and not fully addressed by the banks, we need to react to that. If the geopolitical risk environment changes, then we need to address the risks that are relevant for the specific banks. Of course, we also need to do this in an efficient and effective way. So what we will do even more in the future is use what we call integrated planning, so that all our activities - whether they are horizontal across different banks or vertical for specific banks - are integrated even more closely and can also inform each other, so that we don't have to duplicate certain types of activities. But it's very important for us that we address the relevant risks that are there and don't lose relevant risks out of sight. And the teams have more flexibility now. By the way, the risk tolerance framework, the multi-year approach, has already been in place since 2023, but we are rolling it out now more forcefully and we monitor the progress being made. As to your second question on the significant risk transfers, this is related obviously to securitisation and we generally think that securitisation can be a useful instrument to move risks to the part of the financial system where they can be better borne than on banks' balance sheets. But at the same time, of course, we need to make sure that there are no spillover effects on the banking sector - this is a bit the second part of your question. So who's financing these significant risk transfers and could there be amplification effects in the financial system? Of course, we need to monitor this very closely. Now, within this framework that we have and also within the regulatory framework that we have, there was actually room for improvement, and this is what you mentioned. In terms of, for a given risk transfer, can we speed up the process until we approve a certain significant risk transfer? And here we have worked with the European Banking Federation to get a pilot started. Of course, we need some products for which we can run the pilot. We will do this next year and then hopefully speed up our efforts - to the benefit of us, because less resources will go into that, and also to the benefit of the industry. But let me reassure you, we will never lose resilience out of sight. This is given a certain risk that is being transferred and we will also carefully monitor the effects on the financial system, because this is mainly about efficiency - it's not about weakening resilience. The other question is a little bit more specific. It's on the recalibration of the SREP. Deutsche Bank, whose Pillar 2 requirement has increased, suggested that their higher Pillar 2 requirement is due to the recalibration of your SREP and it would have nothing to do with any reassessment of the riskiness of Deutsche Bank. So is this view or description of Deutsche Bank accurate? So can I imagine that you don't see Deutsche Bank as more risky, but nevertheless the Pillar 2 requirement can increase? Thank you very much for the first question on geopolitical risk, which is indeed an issue about which we have been thinking hard to get to some extent a conceptual framework around it, because different people may have different understandings of what geopolitical risk is actually about. What we have done is we've published our way of thinking about this in September this year, and the main idea is that geopolitical risk is not a new risk category for the banks. It's affecting the banks through credit risk, market risk, operational risk. But there are dimensions of this risk which you wouldn't cover if you didn't think about it in terms of the geopolitical environment. And here it's relatively broad, it's anything that's related to conflicts and tensions internationally. And so, as l've said, if you think for example about the financial markets channel, relevant parts of geopolitical risk are not priced in by markets. So this can affect banks' exposure to market risk if there's an abrupt repricing of risk. The second channel is through the real economy. So what if global value chains become more fragmented because of conflicts? How should that lead to a reassessment of credit risk? And then there's cyber risk, exposure to financial sanction risk. And so we work very closely with the banks to see whether they address these risks properly. We have also gone through our activities to see whether we are missing any of these channels, and we actually found that there's relatively little that we are missing. I mentioned the provisioning framework, I mentioned the work we are doing on cyber risk - all this is very much related to geopolitical risk. We're now working with the banks to see that they capture risks that are relevant for the individual bank - that they capture this in their risk management. And maybe the most important aspect here is that it really needs to be at the attention of top management, of the boards, because geopolitical risk is something which you can't properly price. There's a lot of uncertainty, so the banks need to use scenario analysis that is relevant for their capital planning, and this is really something which needs steering from the top. And we now look very carefully at what the banks are doing in this space. The second question was about a specific bank and my apologies but for reasons of confidentiality I don't comment. So it's OK if you answer generally if it's possible that a bank gets a higher Pillar 2 requirement without you considering this, an unspecific bank, more risky? Again, I don't comment on any specific bank and we have not changed the Pillar 2 methodology for how the risks are being calculated. Actually, today we are publishing a lot of detail about how our methodology is applied. There's also one element of our SREP reform, but this is not for this year's SREP, it's for the next two years. We are currently working on the P2R, the Pillar 2 methodology, to make it even more risk-based, to make it more targeted, to simplify. But this is not for now, this has not affected the 2024 SREP cycle - there will be again a pilot, a dry run next year and then it will only be effective one year later. We also aim to stabilise methodologies more in order to simplify and to reduce complexity. Second, what are your considerations about the consolidation process ongoing in Europe and what are the main elements that you want to ensure about the authorisation process in cases, of course, like UniCredit and Commerzbank and UniCredit and Banco BPM? To your first question about profitability: so we don't have any forecast of interest rates that is underlying our assessment here, so we need to see how rates are evolving. What market analysts are saying is that we now have a higher level of net interest margins and that it wouldn't go down to the levels that we saw during the period of low interest rates. But as l've explained, this also depends on the pass-through into lending rates and into deposit rates. As you're rightly saying, when it comes to credit risk, asset quality, we are as of now not seeing a significant deterioration of asset quality. Nonperforming loans are actually close to historical lows, but of course we all need to remain vigilant as to how does the risk that we have just been talking about, how does that play out? How does the structural change in the real economy play out? So we don't really have a forecast here on bank profitability. What is our aim? And this is also part of the SREP, it is of course to make sure that banks have sustainable business models, that they have sustainable long-run profitability. One important factor here will also be their IT investments, their ability to compete in a world of ever-more digitalised finance. The second question on consolidation, and here again I need to make the statement up front that I'm not talking about individual banks that you have mentioned. Our role here is actually very clear when it comes to the approval process of qualified holdings. We have clear criteria in the legislation, what we look at in terms of financial soundness, reputation of the buyers and so forth. We generally take a very neutral approach when it comes to cross-border versus domestic mergers. In the end it's a decision of the stakeholders, the shareholders in the banks - how they want to respond to increasing competitive pressure, digitalisation. And mergers are certainly one way to respond. But we don't have a specific preference as to how they should respond. We have a clear role given to us by the legislation on the indicators that we look at. This year's cyber stress test showed that there are still many shortcomings in banks' cyber defences. Have you taken any measures in the context of the SREP to address the shortcomings? The second question is about Russia. Compared to when you took over in January, are you happy with the progress made by the banks that are still there in leaving the country? As regards the cyber stress test, just to clarify what it was: the question was how do banks respond to a hypothetical successful cyberattack? So it was about their response. We actually found that the banks were quite well prepared. So because you mentioned the shortcomings, we always find, of course, issues that need to be addressed, but here I think we found the banks also well prepared. My impression is that the banking industry also appreciated the consistent exercise across all the banks, from which they also learn where they stand relative to their peers. So to the extent that it doesn't violate any confidentiality requirements, we also share with the banks this benchmarking. So as I said, we always, when we do these exercises, we also find issues and we indeed take this into consideration in the SREP, because this is information that we need for our supervision. And as l've said, cyber resilience, digitalisation, all this has been and will be a priority for the SSM also going forward. Appropriate measures were taken, and in many cases, these are qualitative measures. As regards the exposure of banks to Russia and risks arising from Russia, given the tragedy of the situation, I'm a little bit hesitant to talk about happiness in that context. What was done in the SSM after the Russian invasion into Ukraine was to take stock of the exposures of European banks, which were limited in absolute terms, but of course there was exposure to financial sanction risk. We're not the sanction authority, but of course, we need to take into account what are potential implications for reputation and risk management of the banks. We've addressed this with the banks. We've asked them to downsize and exit from Russia and I think the latest number we have is that the exposures have been reduced by $53 \%$. We're working very closely with the banks to make sure that they comply with our decisions. Again, apologies that I can't go into the specifics for individual banks, but there has been progress and we need to see how the situation will evolve. For next year looking forward, most economists expect a lot of rate cuts. Do you see any risks connected with that for the banking sector and how do you think it will affect the banking sector? And my second question: you mentioned the importance of completing the banking union. Do you expect some progress on EDIS and how important is it from your supervisor's perspective? I don't want to comment on potential rate cuts, this is not our business to do any forecasts and to consider potential scenarios. What we do do, of course, is that we make sure that the banks' exposure to interest rate risk is well managed. We're following up very closely in case we feel that this is not being the case, but we don't do any specific forecast or analysis of where do we think interest rates could move. I mentioned a few other points already when I discussed profitability impacts. As to the second question on the banking union, I'm not sure whether I should also comment or make any forecasts about the likelihood of potential dossiers to be followed through. But clearly, the European deposit insurance scheme is very important for supervisors. Basically we have an incomplete banking union. So we have the first pillar l've described, the successes that have been made, the achievements; we have the second pillar with the resolution framework, and deposit insurance and supervision is inevitably linked together. So I think it would be good to have progress on EDIS to make sure that all deposits across the banking union have the same level of protection. It would also promote cross-border integration obviously, and it would also make, in the end, the whole work by the Single Resolution Board less complex in dealing with banks that are under stress. But let me mention also another very important file which is currently on the table in Brussels, which is crisis management and deposit insurance, or CMDI. So this is basically a dossier which aims to close the remaining gaps with regard to resolution. On the one hand, to bring more banks, mid-size banks, which can have systemic implications, under resolution, and also provide the funding for this resolution through the use of deposit guarantee schemes. It's somehow linked, but it's a separate dossier related to EDIS. And I think this is crucially important, so the more credible resolution is, the better it is for supervision, because it's setting the right incentives not to engage in risk-taking and it's just good for the clarity of the overall framework of how we deal with banks in the going concern but also banks that come under stress. And in the end, also making sure that we don't have to use taxpayers' money again for banks that are under stress, so I think this is an additional benefit of the CMDI package. Quick question on crypto-assets: as everybody, of course, has noticed a different approach coming from the US administration, I don't know what's going to happen with the US financial authorities, but as regards the ECB supervision, is there an intention, is there an orientation towards stricter rules or looser rules regarding crypto portfolios within bank balance sheets? I don't want to speculate on what's happening in the US, but let me say how we view crypto-assets and what has been done in Europe. So first of all, I think there's risk related to crypto-assets in terms of risks that are prevalent in other financial market segments as well. So there can be excessive leverage, there can be intransparency, there can be conflicts of interest. So I think it's very important to also preventively manage and regulate these risks. That, of course, requires first and foremost good information about crypto markets and what is happening in this space, in particular related to leverage and misaligned incentives. I think with the Markets in Crypto-Assets (MiCA) regulation, Europe has done a lot to move into that direction to get better information, and also to regulate to the extent necessary. And the third leg is certainly that, because many of these activities are somewhat borderless; it's also important, and there have been important initiatives in the G20 and in the FSB, to make sure that there's also an internationally agreed approach to this. So we need to see where this moves, we monitor this very carefully. We also monitor very carefully that the exposure of banks to crypto-assets is very limited and that also we deal with the competitive pressure that may arise from these markets on banks to provide crypto-related financial services. We have a very close eye on this. The first question is when can we expect a decision on UniCredit's request to build up its stake in Commerzbank? Second one is can you shed light on the ECB's interpretation of the Danish compromise? Can a financial conglomerate risk weigh all assets bought via its insurance arm? This has been described as a regulatory arbitrage that favours conglomerates. Well, the answer to the first question is unfortunately very short, because I don't comment on individual cases, including deadlines. The second is the Danish compromise. We have clarified our approach and our publication on options and discretions, I think in 2016 if I'm not mistaken, and we currently have under consultation a new guide which also clarifies our approach there. In the end, it's an issue that we would also assess on a case-by-case basis for individual institutions. I have noticed in some cases the SSM has been reducing Pillar 2 capital requirements while raising P2R leverage ratio. What is the rationale behind that? To the extent that you're referring to individual banks, I couldn't comment on this. Generally the P2R and the P2R leverage ratio add-on have different purposes. So the P2R is basically to cover risks that are not covered or not sufficiently covered under Pillar 1, and the Pillar 2 leverage ratio add-on is about the risk of excessive leverage. It may well be that there are cases where the risk of excessive leverage is increasing, and there's less risks of the type that have just been described that are not sufficiently accounted for in Pillar 1, where that is declining, or the other way round. So there's not necessarily a link between these two, as you've been suggesting. So these are just different assessments. We take a very detailed approach, risk by risk. We look at all the banks, we look at the different elements of the SREP and this can be one outcome, but again this is not a statement about an individual bank where this may have happened. As at the second quarter of 2024, including cash balances at central banks and other demand deposits. Excluding cash balances at central banks and other demand deposits, the figure is $2.3 \%$. 3. The $5.5 \%$ return on equity corresponds to the period from the second quarter of 2015 until the second quarter of 2022, while the $9.2 \%$ return on equity corresponds to the period from the second quarter of 2022 until the second quarter of 2024. $>\quad+496913447455$ $>\quad$ [email protected]
2024-12-18T00:00:00	Philip R Lane: The euro area outlook and monetary policy	Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at the MNI Webcast, Frankfurt am Main, 18 December 2024.	SPEECH The euro area outlook and monetary policy Speech by Philip R. Lane, Member of the Executive Board of the ECB, MNI Webcast Frankfurt am Main, 18 December 2024 Introduction The Governing Council last week decided to lower the deposit facility rate - the rate through which we steer the monetary policy stance - from 3.25 per cent to 3.0 per cent. This decision was justified by our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. In my remarks, I would like to discuss these three elements of our reaction function 2] The inflation outlook The December Eurosystem staff projections expect headline inflation to average 2.4 per cent in 2024, 2.1 per cent in 2025 and 1.9 per cent in 2026. It is then projected to increase to 2.1 per cent in 2027 as a result of the expanded EU Emissions Trading System. The projections continue to foresee a rapid decline in core inflation, from 2.9 per cent this year to 2.3 per cent in 2025 and 1.9 per cent in 2026 and 2027. Compared to the September 2024 macroeconomic projections exercise (MPE), the projections have been revised down by 0.1 percentage points in 2024 and 2025 for headline inflation, and in 2026 for core inflation. The latest Survey of Monetary Analysts is broadly in line with the December projections for headline inflation. Market-based indicators of inflation compensation are also consistent with a timely return of inflation to target, while also showing a marked compression in inflation risk premia. This may suggest that markets have revised downwards the risk of future adverse supply shocks and revised upwards the risk of future adverse demand shocks. The economic outlook plays a central role in determining the inflation outlook. The incoming information suggests a slowdown in the near term. Looking ahead, conditions are in place for growth to strengthen over the forecast horizon. According to the staff assessment, while structural factors have weighed on the euro area economy, especially the manufacturing sector, the weak productivity growth since 2022 has also included a significant cyclical component, largely driven by the past tightening of monetary policy and weak external demand. Domestic demand should therefore benefit from rising real wages, the gradual fading of the effects of restrictive monetary policy and the ongoing recovery in the global economy. Although fiscal policies are set to remain on a consolidation path overall, funds from the Next Generation EU programme will still support investment in the next two years. On the external side, euro area export growth is expected to benefit from strengthening foreign demand. At the same time, trade uncertainty has increased materially and the effects of a potential increase in tariffs on the euro area economy will depend on the extent, timing and magnitude of tariff and non-tariff measures, as well as on the responses of the EU and other countries. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again surprising to the upside, and the unemployment rate remained at its historical low of 6.3 per cent in October. However, labour demand continues to soften. The job vacancy rate declined to 2.5 per cent in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. According to the December Eurosystem staff projections, real GDP growth is expected to average 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. Compared to the September projections, real GDP growth has been revised down by 0.1 percentage points in 2024 and 2025. The latest Survey of Monetary Analysts indicates a lower growth profile than the staff projections for 2025, 2026 and 2027. The inflation outlook also encompasses the assessment of the risks surrounding the baseline path. The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster, which would also make the euro area more resilient to global shocks. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. Underlying inflation The indicators of underlying inflation with the highest predictive power are developing in line with a sustained return of inflation to target; in particular, the Persistent and Common Component of Inflation (PCCl) measure remains at around 2.0 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at 4.2 per cent, it remained high, reflecting strong wage pressures and the fact that some services prices have still been adjusting to the past inflation surge. At the same time, the incoming information points to a moderation in services inflation dynamics, which should support an easing of domestic inflation. The three-month-on-three-month seasonally adjusted services inflation rate fell to 2.6 per cent in November from 3.4 per cent in October, indicating a further softening in momentum. Meanwhile, the sizeable gap between services inflation and its medium-term underlying trend - captured by the PCCI for services, which stands at 2.5 per cent - suggests there should be further downward adjustment in services inflation in the coming months. The incoming wage data broadly confirm our previous assessment of elevated but easing wage pressures. The growth rate of compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second quarter, 0.1 percentage points below the December projection. The growth rate of unit labour costs eased to 4.3 per cent from 5.2 per cent. Profit margins continue to buffer the impact of elevated labour costs on inflation: annual growth in unit profits remained negative in the third quarter. Forward-looking wage trackers continue to point to a material easing of wage growth in 2025. The strength of monetary policy transmission Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook and the consequent repricing of policy rate expectations. Our past interest rate cuts - together with the anticipation of future cuts - are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages has also come down, to 3.6 per cent in October, around half a percentage point below its peak in 2023. But financing conditions remain restrictive. The cost of new credit for firms is elevated in historical comparison, particularly in real terms, and the cumulative tightening of credit standards since the beginning of the hiking cycle remains elevated. The average rate on the outstanding stock of mortgages is set to rise as loans granted at fixed rates reprice at higher levels. Bank lending to firms has only gradually picked up, from subdued levels, with the annual rate of increase rising to 1.2 per cent in October. The annual growth rate of debt securities issued by firms stood at 3.1 per cent in October, remaining within the narrow range observed over recent months. Mortgage lending continued to drift up gradually, to an annual growth rate of 0.8 per cent in October. Conclusion In summary, the incoming information and the latest staff projections indicate that the disinflation process remains well on track. While domestic inflation is still high, it should come down as services inflation dynamics moderate and labour cost pressures ease. Recent policy rate cuts are also gradually transmitting to funding costs, but financing conditions along the entire transmission chain, starting with the level of our policy rate and including the market interest rates that financial intermediaries charge on credit to households and firms, remain restrictive. This assessment explains the decision to lower the deposit facility rate by 25 basis points. Looking to the future, in the current environment of elevated uncertainty, it is prudent to maintain agility on a meeting-by-meeting basis and not pre-commit to any particular rate path. In terms of risk management, monetary easing can proceed more slowly compared to the interest rate path embedded in the December projections in the event of upside shocks to the inflation outlook and/or to economic momentum. Equally, in the event of downside shocks to the inflation outlook and/or to economic momentum, monetary easing can proceed more quickly. All else equal, the rate path will also be influenced by our ongoing assessment of underlying inflation dynamics and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. Annexes 18 December 2024 Slides 1. A slide deck to accompany these remarks is available on the ECB website. 2. For further discussion of last week's monetary policy decision, see Lagarde, C. (2024), "Monetary policy in the euro area", speech at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction, Vilnius, Lithuania, 16 December. CONTACT European Central Bank Directorate General Communications > Sonnemannstrasse 20 > 60314 Frankfurt am Main, Germany > +49 69 1344 7455 > [email protected]	---[PAGE_BREAK]--- # The euro area outlook and monetary policy ## Speech by Philip R. Lane, Member of the Executive Board of the ECB, MNI Webcast Frankfurt am Main, 18 December 2024 ## Introduction The Governing Council last week decided to lower the deposit facility rate - the rate through which we steer the monetary policy stance - from 3.25 per cent to 3.0 per cent. This decision was justified by our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. In my remarks, I would like to discuss these three elements of our reaction function. ${ }^{[1][2]}$ ## The inflation outlook The December Eurosystem staff projections expect headline inflation to average 2.4 per cent in 2024, 2.1 per cent in 2025 and 1.9 per cent in 2026. It is then projected to increase to 2.1 per cent in 2027 as a result of the expanded EU Emissions Trading System. The projections continue to foresee a rapid decline in core inflation, from 2.9 per cent this year to 2.3 per cent in 2025 and 1.9 per cent in 2026 and 2027. Compared to the September 2024 macroeconomic projections exercise (MPE), the projections have been revised down by 0.1 percentage points in 2024 and 2025 for headline inflation, and in 2026 for core inflation. The latest Survey of Monetary Analysts is broadly in line with the December projections for headline inflation. Market-based indicators of inflation compensation are also consistent with a timely return of inflation to target, while also showing a marked compression in inflation risk premia. This may suggest that markets have revised downwards the risk of future adverse supply shocks and revised upwards the risk of future adverse demand shocks. The economic outlook plays a central role in determining the inflation outlook. The incoming information suggests a slowdown in the near term. Looking ahead, conditions are in place for growth to strengthen over the forecast horizon. According to the staff assessment, while structural factors have weighed on the euro area economy, especially the manufacturing sector, the weak productivity growth since 2022 has also included a significant cyclical component, largely driven by the past tightening of monetary policy and weak external demand. Domestic demand should therefore benefit from rising real wages, the gradual fading of the effects of restrictive monetary policy and the ongoing recovery in the global economy. Although fiscal policies are set to remain on a consolidation path overall, funds from the Next Generation EU programme will still support investment in the next two years. ---[PAGE_BREAK]--- On the external side, euro area export growth is expected to benefit from strengthening foreign demand. At the same time, trade uncertainty has increased materially and the effects of a potential increase in tariffs on the euro area economy will depend on the extent, timing and magnitude of tariff and non-tariff measures, as well as on the responses of the EU and other countries. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again surprising to the upside, and the unemployment rate remained at its historical low of 6.3 per cent in October. However, labour demand continues to soften. The job vacancy rate declined to 2.5 per cent in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. According to the December Eurosystem staff projections, real GDP growth is expected to average 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. Compared to the September projections, real GDP growth has been revised down by 0.1 percentage points in 2024 and 2025. The latest Survey of Monetary Analysts indicates a lower growth profile than the staff projections for 2025, 2026 and 2027. The inflation outlook also encompasses the assessment of the risks surrounding the baseline path. The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster, which would also make the euro area more resilient to global shocks. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. # Underlying inflation The indicators of underlying inflation with the highest predictive power are developing in line with a sustained return of inflation to target; in particular, the Persistent and Common Component of Inflation (PCCI) measure remains at around 2.0 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at 4.2 per cent, it remained high, reflecting strong wage pressures and the fact that some services prices have still been adjusting to the past inflation surge. ---[PAGE_BREAK]--- At the same time, the incoming information points to a moderation in services inflation dynamics, which should support an easing of domestic inflation. The three-month-on-three-month seasonally adjusted services inflation rate fell to 2.6 per cent in November from 3.4 per cent in October, indicating a further softening in momentum. Meanwhile, the sizeable gap between services inflation and its medium-term underlying trend - captured by the PCCI for services, which stands at 2.5 per cent suggests there should be further downward adjustment in services inflation in the coming months. The incoming wage data broadly confirm our previous assessment of elevated but easing wage pressures. The growth rate of compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second quarter, 0.1 percentage points below the December projection. The growth rate of unit labour costs eased to 4.3 per cent from 5.2 per cent. Profit margins continue to buffer the impact of elevated labour costs on inflation: annual growth in unit profits remained negative in the third quarter. Forward-looking wage trackers continue to point to a material easing of wage growth in 2025. # The strength of monetary policy transmission Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook and the consequent repricing of policy rate expectations. Our past interest rate cuts - together with the anticipation of future cuts - are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages has also come down, to 3.6 per cent in October, around half a percentage point below its peak in 2023. But financing conditions remain restrictive. The cost of new credit for firms is elevated in historical comparison, particularly in real terms, and the cumulative tightening of credit standards since the beginning of the hiking cycle remains elevated. The average rate on the outstanding stock of mortgages is set to rise as loans granted at fixed rates reprice at higher levels. Bank lending to firms has only gradually picked up, from subdued levels, with the annual rate of increase rising to 1.2 per cent in October. The annual growth rate of debt securities issued by firms stood at 3.1 per cent in October, remaining within the narrow range observed over recent months. Mortgage lending continued to drift up gradually, to an annual growth rate of 0.8 per cent in October. ## Conclusion In summary, the incoming information and the latest staff projections indicate that the disinflation process remains well on track. While domestic inflation is still high, it should come down as services inflation dynamics moderate and labour cost pressures ease. Recent policy rate cuts are also gradually transmitting to funding costs, but financing conditions along the entire transmission chain, starting with the level of our policy rate and including the market interest rates that financial intermediaries charge on credit to households and firms, remain restrictive. This assessment explains the decision to lower the deposit facility rate by 25 basis points. Looking to the future, in the current environment of elevated uncertainty, it is prudent to maintain agility on a ---[PAGE_BREAK]--- meeting-by-meeting basis and not pre-commit to any particular rate path. In terms of risk management, monetary easing can proceed more slowly compared to the interest rate path embedded in the December projections in the event of upside shocks to the inflation outlook and/or to economic momentum. Equally, in the event of downside shocks to the inflation outlook and/or to economic momentum, monetary easing can proceed more quickly. All else equal, the rate path will also be influenced by our ongoing assessment of underlying inflation dynamics and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. # Annexes 18 December 2024 Slides 1. A slide deck to accompany these remarks is available on the ECB website. 2. For further discussion of last week's monetary policy decision, see Lagarde, C. (2024), "Monetary policy in the euro area", speech at the Bank of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global Geopolitical Shifts", on the occasion of the $10^{\text {th }}$ anniversary of euro introduction, Vilnius, Lithuania, 16 December. ## CONTACT <br> European Central Bank <br> Directorate General Communications $>$ Sonnemannstrasse 20 $>60314$ Frankfurt am Main, Germany $>+496913447455$ $>$ [email protected]	Philip R Lane	Euro area	https://www.bis.org/review/r241218f.pdf	Frankfurt am Main, 18 December 2024 The Governing Council last week decided to lower the deposit facility rate - the rate through which we steer the monetary policy stance - from 3.25 per cent to 3.0 per cent. This decision was justified by our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. In my remarks, I would like to discuss these three elements of our reaction function. The December Eurosystem staff projections expect headline inflation to average 2.4 per cent in 2024, 2.1 per cent in 2025 and 1.9 per cent in 2026. It is then projected to increase to 2.1 per cent in 2027 as a result of the expanded EU Emissions Trading System. The projections continue to foresee a rapid decline in core inflation, from 2.9 per cent this year to 2.3 per cent in 2025 and 1.9 per cent in 2026 and 2027. Compared to the September 2024 macroeconomic projections exercise (MPE), the projections have been revised down by 0.1 percentage points in 2024 and 2025 for headline inflation, and in 2026 for core inflation. The latest Survey of Monetary Analysts is broadly in line with the December projections for headline inflation. Market-based indicators of inflation compensation are also consistent with a timely return of inflation to target, while also showing a marked compression in inflation risk premia. This may suggest that markets have revised downwards the risk of future adverse supply shocks and revised upwards the risk of future adverse demand shocks. The economic outlook plays a central role in determining the inflation outlook. The incoming information suggests a slowdown in the near term. Looking ahead, conditions are in place for growth to strengthen over the forecast horizon. According to the staff assessment, while structural factors have weighed on the euro area economy, especially the manufacturing sector, the weak productivity growth since 2022 has also included a significant cyclical component, largely driven by the past tightening of monetary policy and weak external demand. Domestic demand should therefore benefit from rising real wages, the gradual fading of the effects of restrictive monetary policy and the ongoing recovery in the global economy. Although fiscal policies are set to remain on a consolidation path overall, funds from the Next Generation EU programme will still support investment in the next two years. On the external side, euro area export growth is expected to benefit from strengthening foreign demand. At the same time, trade uncertainty has increased materially and the effects of a potential increase in tariffs on the euro area economy will depend on the extent, timing and magnitude of tariff and non-tariff measures, as well as on the responses of the EU and other countries. The labour market remains resilient. Employment grew by 0.2 per cent in the third quarter, again surprising to the upside, and the unemployment rate remained at its historical low of 6.3 per cent in October. However, labour demand continues to soften. The job vacancy rate declined to 2.5 per cent in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter. According to the December Eurosystem staff projections, real GDP growth is expected to average 0.7 per cent in 2024, 1.1 per cent in 2025, 1.4 per cent in 2026 and 1.3 per cent in 2027. Compared to the September projections, real GDP growth has been revised down by 0.1 percentage points in 2024 and 2025. The latest Survey of Monetary Analysts indicates a lower growth profile than the staff projections for 2025, 2026 and 2027. The inflation outlook also encompasses the assessment of the risks surrounding the baseline path. The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia's unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster, which would also make the euro area more resilient to global shocks. Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain. The indicators of underlying inflation with the highest predictive power are developing in line with a sustained return of inflation to target; in particular, the Persistent and Common Component of Inflation (PCCI) measure remains at around 2.0 per cent. Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at 4.2 per cent, it remained high, reflecting strong wage pressures and the fact that some services prices have still been adjusting to the past inflation surge. At the same time, the incoming information points to a moderation in services inflation dynamics, which should support an easing of domestic inflation. The three-month-on-three-month seasonally adjusted services inflation rate fell to 2.6 per cent in November from 3.4 per cent in October, indicating a further softening in momentum. Meanwhile, the sizeable gap between services inflation and its medium-term underlying trend - captured by the PCCI for services, which stands at 2.5 per cent suggests there should be further downward adjustment in services inflation in the coming months. The incoming wage data broadly confirm our previous assessment of elevated but easing wage pressures. The growth rate of compensation per employee moderated to 4.4 per cent in the third quarter from 4.7 per cent in the second quarter, 0.1 percentage points below the December projection. The growth rate of unit labour costs eased to 4.3 per cent from 5.2 per cent. Profit margins continue to buffer the impact of elevated labour costs on inflation: annual growth in unit profits remained negative in the third quarter. Forward-looking wage trackers continue to point to a material easing of wage growth in 2025. Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook and the consequent repricing of policy rate expectations. Our past interest rate cuts - together with the anticipation of future cuts - are gradually making it less expensive for firms and households to borrow. The average interest rate on new loans to firms was 4.7 per cent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages has also come down, to 3.6 per cent in October, around half a percentage point below its peak in 2023. But financing conditions remain restrictive. The cost of new credit for firms is elevated in historical comparison, particularly in real terms, and the cumulative tightening of credit standards since the beginning of the hiking cycle remains elevated. The average rate on the outstanding stock of mortgages is set to rise as loans granted at fixed rates reprice at higher levels. Bank lending to firms has only gradually picked up, from subdued levels, with the annual rate of increase rising to 1.2 per cent in October. The annual growth rate of debt securities issued by firms stood at 3.1 per cent in October, remaining within the narrow range observed over recent months. Mortgage lending continued to drift up gradually, to an annual growth rate of 0.8 per cent in October. In summary, the incoming information and the latest staff projections indicate that the disinflation process remains well on track. While domestic inflation is still high, it should come down as services inflation dynamics moderate and labour cost pressures ease. Recent policy rate cuts are also gradually transmitting to funding costs, but financing conditions along the entire transmission chain, starting with the level of our policy rate and including the market interest rates that financial intermediaries charge on credit to households and firms, remain restrictive. This assessment explains the decision to lower the deposit facility rate by 25 basis points. Looking to the future, in the current environment of elevated uncertainty, it is prudent to maintain agility on a meeting-by-meeting basis and not pre-commit to any particular rate path. In terms of risk management, monetary easing can proceed more slowly compared to the interest rate path embedded in the December projections in the event of upside shocks to the inflation outlook and/or to economic momentum. Equally, in the event of downside shocks to the inflation outlook and/or to economic momentum, monetary easing can proceed more quickly. All else equal, the rate path will also be influenced by our ongoing assessment of underlying inflation dynamics and the strength of monetary policy transmission. We are determined to ensure that inflation stabilises sustainably at our two per cent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path. Slides $>+496913447455$ $>$ [email protected]

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