In a bank-based economy, such as the euro area, the short-term interest rate may simply not be sufficient to characterise the monetary policy stance and, hence, the financial conditions ultimately determining the decisions by households and firms. The imperfect substitutability between market-based financing and bank loans was already recognised by Modigliani (1963) and later refined by Bernanke and Blinder (1988). Indeed, it is enough to recall the period after the outbreak of the sovereign debt crisis, and the associated financial fragmentation, to see that the interbank market rate is a biased measure of the financing conditions facing the private sector. 13 In other words, unless there is a perfect transmission from changes in short-term rates to the ultimately relevant borrowing rates, estimates using the former will yield inconclusive results. This conjecture is also supported by the data. In specification 6 we replaced the short-term interest rate with a measure of the composite bank-based cost of borrowing for non-financial firms. If we use this measure instead, the real ex ante interest gap in our IS curve has the expected sign and becomes statistically significant at the 10% level: a 1 percentage point reduction in the gap increases output by 0.13 percentage point. The interest rate channel becomes even more powerful once we estimate a New Keynesian IScurve that is closer to first principles – that is, one that is also forward-looking in output, as in specification 7.
The fact that inflation remains subdued rather reflects constraints operating at the third stage of transmission – from activity to prices – that are often outside the control of monetary policy. Before I conclude I would like to illustrate one last point. Bank lending rates are without doubt a key variable in explaining output movements in the euro area. The evidence I provided today further emphasises this point. At the same time, the financial conditions that are ultimately relevant for firms and households may be broader than that. One of them – the exchange rate – I discussed in more detail earlier in my remarks.16 Other factors may include equity prices or long-term interest rates that are often relevant for household mortgages.17 One way to summarise these factors is to use financial conditions indexes (FCIs). My colleague 10 / 14  BIS central bankers' speeches  Peter Praet gave a detailed speech on such indices earlier this year, which I strongly recommend reading.18 Here I would like to focus on the relevance of these broad measures for economic activity. As you can see in column 9 of slide 7, FCIs are highly statistically significant when used in a New Keynesian IS curve. This is unlikely to be a statistical artefact.