In normal times, when risk factors are contained and can be diversified away, the interest rate channel, working through inter-temporal arbitrage, is the prime conduit of monetary policy (see slide 2). It sets the floor for term borrowing costs. Parsing longer-term yields into two components – the average level of the short-term policy interest rate expected over the term to maturity of the asset, and the risk premia – expectations of monetary policy pin down the first component. The mechanism through which this occurs is the inter-temporal financial arbitrage I just described. Term and liquidity premia are the additional returns that investors demand as a compensation for their reluctance to bear interest rate risk over long-duration assets, and for their decision to forgo liquidity services – I am abstracting here from credit risk, to which I will return later. When markets are properly functioning, non-depository institutions – dealers, hedge funds, investment banks – provide immediacy by offering lenders and borrowers their capacity to take positions on both sides of the market. Their ready availability to take positions as lenders and borrowers supports market liquidity, namely the ease with which a lender can liquidate a position before maturity. When market liquidity is secure, lenders are willing to engage in finance, trades in long-duration assets are active and the liquidity premia are contained. And, most importantly, they are steady. With a steady premium, the expectations  2  There are two reasons for idiosyncratic fluctuations of reserve demand by individual banks.
A passive fiscal policy means that the fiscal authority must be ready and willing to adjust its policy stance (revenues and primary spending) in such a way as to stabilise its debt at any level of the interest rate that the central bank may choose. Or, to put it another way, borrowing from Woodford’s terminology, 8 fiscal policy needs to be “Ricardian”. 9 Although the Treaty shows an awareness of the need for consistency between monetary and fiscal policy, in the sense described above, to ensure lasting stability, it did not foresee that fiscal policy could go off track to an extent that requires dedicated institutions and policies able to provide financial assistance, against conditionality, in order to restore sustainability and preserve financial stability in the euro area. The creation of the EFSF/ESM in charge of providing support to euro area Member States in difficulties and enforcing appropriate conditionality has filled this gap. It provides the euro area with a means to restore “Ricardianess”, thereby minimising the risk of “fiscal dominance”. Against this background, it is easy to understand the ECB’s decision on 6 September to undertake Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area, and to understand the specific framework within which they will be implemented. The aim of OMTs is to preserve the singleness of monetary policy and to ensure the proper transmission of the monetary policy stance to the real economy throughout the euro area.