to promise to keep interest rates low for longer in the future. Such commitments, if credible, lower longer-term interest rates and provide economic stimulus even if the current interest rate remains unchanged.9While forward guidance is a useful instrument, recent research has highlighted that its effectiveness can be improved if combined with other non-standard monetary policies.10 Research in both academia and in central banks has therefore re-examined alternative monetary policy tools, including so-called quantitative easing (QE) policies. And here the newly developed models with financial frictions have been useful.11 Earlier studies based on the assumption of frictionless financial markets had concluded that QE is completely ineffective. The renewed focus on financial frictions clarified that this conclusion is unwarranted, once it is recognised that financial intermediaries are subject to leverage constraints.12 Large-scale asset purchases can ease these constraints and increase investors’ risk-bearing capacity, leading to a portfolio rebalancing towards risky assets and to strengthened lending activity for banks. All in all, research has confirmed that central banks are not powerless at the effective lower bound. Provided they are willing to explore non-standard policy avenues, they can continue pursuing their price stability mandates even in the most adverse circumstances. The evolution of policymaking The policy response by central banks and governments has evolved along the two main lines suggested by research.
The notion that central banks have an unlimited capacity to create money is an illusion and thus cannot be used as an excuse not to reform the economy. Overall, the policy measures taken on several fronts were able to stem the risk of a credit flow fallout with related adverse implications for price stability. In particular, the role of bank credit in financing the private sector has been preserved, supported by an increased recourse to debt markets especially by large firms (see slide 6). The sovereign debt crisis and fragmentation of credit markets across national borders My discussion so far has focused on term and liquidity premia, which have taken centre stage since the very beginning of the financial crisis. Starting in May 2010, the crisis was marked by a new phenomenon, until then little known in euro area: the emergence of large and variable credit risk premia in the pricing of supposedly risk-free securities issued by euro area governments. This has led to questions about the creditworthiness of some sovereign issuers and to a fully-fledged sovereign debt crisis. This new phase of the crisis has taken on several dimensions. The first and most noticeable one has been the large sell-off of government debt issued by sovereigns in precarious fiscal positions (see slide 7). Markets have increased their scrutiny of the fiscal and structural conditions of Member States (the “fundamentals”) and assessed them with an increasing degree of risk aversion.