All these measures aimed to support bank funding markets and ensure that the flow and pricing of credit to the real economy was in accordance with our intended monetary policy stance. But a question often asked is why we did not resort to large-scale asset purchases at this point, as the Fed was already doing. Bear in mind that inflation developments in the euro area at the time did not suggest a tight stance. Headline inflation was rising steeply from its 2009 trough, exceeding 3% in October 2011, partly driven by an increase in underlying inflation. Inflation expectations were well anchored around our objective. Hence our diagnosis of the problem in this period focused more on monetarytransmission than on the policy stance. Our stance was not being transmitted evenly across all parts of the euro area. And so our measures in this period were specifically designed to remove those impairments in transmission. The main issue we faced was the perverse interaction between the euro area banking sector and institutional incompleteness of our monetary union, which had fundamental implications for our policy in a system of bank-based monetary transmission. While the first phase of the crisis can be interpreted as a severe recession amenable to monetary policy, this second phase was the consequence of institutional challenges that monetary policy could only aim to mitigate, but could not overcome.
The first phase: combating a systemic shock The first phase of the crisis had its origin in the US. In 2006, many experts considered the subprime crisis to be a minor incident with only local impact, but then it escalated into a financial crisis of systemic proportions that propagated to the whole advanced world. Many banks experienced a sudden stop in their access to money markets, and the ensuing liquidity squeeze in interbank markets affected credit provision across the United States and euro area. The effects on the real economy were immediate and large. Both regions went through severe recessions. But the respective central banks and fiscal authorities responded promptly and decisively. The Federal Reserve quickly cut its target for the fed funds rate to close to zero, then embarked on a series of large-scale asset purchases of US government bonds and mortgage-backed securities. Likewise, the ECB cut its main refinancing rate by more than 300 basis points between October 2008 and May 2009. To ease the liquidity constraints of the banking system we altered the mode and maturity of our operations and widened the range of eligible collateral. These responses were, in many ways, an extension of the existing operational frameworks. The asset side of the Fed’s balance sheet traditionally consisted mainly of holdings of US government bonds. By contrast, the ECB, lacking a single fiscal counterpart, injected liquidity mainly through repos with banks. This mode of operation reflected in turn the predominance of bank-based intermediation in the euro area.