On 8 October, six of the world’s major central banks, including the ECB, cut official interest rates by half a percentage point in a coordinated move. Later in the month, the Eurosystem shifted the conduct of its monetary operations toward the injection of liquidity at fixed rates, with full allotment at the minimum bid rate, to ease funding concerns and to drive money market rates closer to official ones. A further half-point interest rate cut by the ECB followed in November, and yesterday we reduced rates by a further 75 basis points amid growing evidence that inflationary pressures are diminishing further. The crisis has so far had a limited impact on the domestic financial system and on the Maltese economy. While the latest data point to continued, if slower economic expansion in the third quarter, Maltese banks continue to benefit from an approach based on traditional intermediation between retail depositors and borrowers. Their funding model, therefore, eschews reliance on wholesale markets; they have substantial liquidity, adequate capital and prudent lending policies. Exposures to asset-backed securities or failed institutions are small, while lending in foreign currency to residents is limited. It would be naïve, indeed dangerous, however, to expect that the turmoil abroad will leave the Maltese economy and its financial system unscathed. First, Malta has a small open economy, highly dependent on trade. As the recession grips our major markets, Maltese exporters will be increasingly affected.
As the turbulence gathered strength, banks began to record growing valuation losses. The consequent erosion of their capital, and a reassessment of risk, led to a tightening of credit standards. In turn, this gave rise to concerns about “deleveraging” and a growing shortage of credit, which began to adversely affect the real economy. In the euro area, the Eurosystem’s response since the early stages of the crisis was to use the full range of instruments available to inject liquidity into the banking system. Here, the Eurosystem was fortunate in that it was already able to accept a wide range of assets as collateral and could deal with a large number of counterparties. Let us not forget, either, that the focus of the ECB’s monetary policy – correctly – was and remained price stability. Though driven by booming commodity prices, the major risk was that high levels of inflation would feed into inflation expectations and trigger second-round effects on wages and prices. At times of heightened uncertainty, the importance of price stability as the central objective of monetary policy cannot be overemphasized. As the financial crisis impacted the real economy, with the cost of financing rising and credit standards tightening, firms found it harder to raise money. Sovereign issuers, too, began to face higher borrowing costs. Evidence mounted of growing downside risks to economic activity and of moderating inflationary pressures. The monetary policy response was unprecedented.