The continuation of the market turmoil does not allow me to talk to you with the benefit of detachment and the comfort of an ex-post assessment. However, I should like to take advantage of the occasion to share with you some considerations on the ECB’s response to the market turmoil drawing on the experience of the past year. 1  I am very grateful to Cornelia Holthausen for her valuable contributions. BIS Review 116/2008  1  2. The separation between monetary policy formulation and its implementation  Central bankers have, naturally, eyed the developments of the past year of financial turmoil – and, particularly, their recent intensification – with great concern, as they have the potential to influence adversely the ability of central banks to steer monetary policy rates, affect the transmission mechanism of monetary policy and, more generally, may pose a threat to financial stability. Once the credit concerns that had built up in the sub-prime mortgage market segment started to affect interest rates and traded volumes in the euro area money market, the ECB responded to these highly unusual market events by timely and forcefully adjusting its liquidity policy. I will not deal with the specificities of the ECB’s liquidity management over the past year – this will be carried out by the ECB staff in tomorrow’s session on “The Experience with Crisis Management” – but I would like to stress one fundamental principle underlying our response to the turmoil: “the separation principle”.
This principle relates to the dichotomy between the ECB’s monetary policy and its liquidity policy or, in other words, between the formulation and implementation of monetary policy. During the turmoil, the separation principle proved to be very effective. Supported by the flexibility of its operational framework, the ECB was able to react in a flexible and quick manner to a changing market environment, and it allowed the steering of interest rates close to the policy rate by means of temporary quantity adjustments, albeit without increasing the aggregate supply of euro liquidity to the banking sector. The main objective of the ECB’s immediate and lasting responses to tensions in the money market was to keep under to control the very short-term interest rates as the first step in the transmission of monetary policy. Broadly speaking, the ECB’s liquidity policy response consisted of three elements: First, it changed the timing of the liquidity provision within the maintenance period (the so-called “front-loading policy”), and thereby allowed banks to build up temporary liquidity buffers. Second, it lengthened the average maturity of its tender operations: before the turmoil, the bulk of liquidity was supplied through one-week operations, and only about 30% was auctioned for three months. As the turmoil unfolded, the ECB gradually increased the share of the three-month operations and moreover introduced a six-month maturity operation. Finally, it participated in the joint coordination effort of an increasing number of central banks around the world within the context of the Term Auction Facility.