Interview with Athanasios Orphanides, Governor of the Central Bank of Cyprus, conducted on 22 February 2009 by Nina Koeppen
Q. Given the sharp slowdown in economic activity, do you see a risk of deflation, or a protracted period of falling prices in the euro zone?
I don't see a significant risk of a protracted fall in prices in the euro area. However given recent sharp falls in oil prices and other commodity prices, I would not be surprised if year-on-year HICP registered a small negative reading in the coming months. But I don't expect those negative readings to persist for long. Also, the annual rate of HICP inflation excluding energy should not turn negative.
Q. The ECB seems to regard deflation as a very low probability outcome. Some economists argue that the ECB is about to significantly undershoot its medium-term inflation goal. Could you please comment?
It's important to keep inflation expectations solidly anchored in line with our definition of price stability. Our objective is to avoid protracted deviations from our definition of price stability -- both to the upside and the downside. So, if economic developments indicate increased risks that inflation will be significantly below 2% for a persistent period, then we would need to take the appropriate action to avoid such an outcome.
At present, the outlook for inflation is below what we had expected it to be a few months ago. The information we have from surveys, such as the Survey of Professional Forecasters, does suggest that inflation expectations for 2009 and 2010 are now below 2%. It's important to monitor those developments very carefully. At the same time, five-year-ahead inflation expectations stand at 1.9%, which is in line with our definition of price stability. But I believe it's important to look also at expectations at the shorter horizons.
Q. In a speech from late January, you argued that a central bank could be "ill advised to save its ammunition". Does that imply that you wouldn't necessarily oppose more radical policy steps?
An objective of the remarks I made at the end of January was to dispel the notion that monetary policy becomes ineffective if short-term rates become very, very low or zero. This notion could potentially be counterproductive; it might adversely affect confidence in policy and promote the false idea that policy runs out of tools to employ in order to achieve its objective. It is important to understand and communicate that the ECB can and will pursue the appropriate action to attain its primary objective, namely price stability in the euro area. This may necessitate the use of unconventional measures. But with the ECB's policy rate at 2%, we are not yet close to the zero bound of interest rates. There is still room to maneuver with conventional policy action.
Q. What could those unconventional policy measures look like?
At the ECB, we have already engaged in non-standard measures: One such measure is the provision of unlimited liquidity with maturities of up to six-month, at the policy rate. In addition, the balance sheet of the Eurosystem has expanded significantly. Those unconventional measures can remain in place as long as needed and they could even be expanded, if deemed appropriate.
We should recognize that conducting and communicating additional monetary policy easing is far more challenging when it is not accompanied by a reduction in the policy rate. This is one of the inconveniences of operating monetary policy at near-zero interest rates. But it doesn't mean that monetary policy shouldn't do what it takes in order to pursue its objective. This can be done through conventional and unconventional means. All those options must be put on the table for policymakers to choose from.
Q. Could you please explain the importance of the debate about unconventional measures for the ECB's future policy?
With a policy rate of 2%, we are not in the same situation as some other central banks, for example the Federal Reserve or the Bank of England, in terms of having to discuss in detail what might be necessary to pursue going forward. But it is always important for central bankers to be ready to respond to the eventuality of an unusual situation. In that context, it is useful to study what the best options would be for the ECB. It may never be necessary to expand on unconventional measures beyond what we have already done; but it is useful to be ready for that contingency in case we need to embark on additional measures. In this light, possible options are under study and there is an internal discussion. But I do not think it would be appropriate to elaborate on this internal discussion at the moment.
Q. Could you please comment on the argument that gradualism has remained a critical aspect of the ECB's monetary policy, even in light of the current crisis?
Gradualism, in the sense of inertia in setting interest rates, is a useful feature of policy. It has been an aspect of the ECB's policy over the past 10 years and it has remained and continues to be a useful aspect.
Q. Should a central bank be more or less gradualist in light of current market developments?
In my view, it would not be appropriate for the interest rate policy response to economic developments to be more gradualist than usual in the present circumstances. But going forward, there may come a point where additional policy easing will no longer be reflected in short-term, nominal interest rates. At that point, non-standard policy action could provide the additional stimulus needed.
Q. In a 1999 working paper entitled "Efficient Monetary Policy Design near Price Stability: Athanasios Orphanides and Volker Wieland" you argued that other channels of monetary transmission may gain importance near the zero bound, such as the expansion of the monetary base. Could you please elaborate?
At the time, the Bank of Japan pursued the so-called ZIRP (zero interest rate policy). The overnight interest rate in Japan was essentially zero so further policy easing could not be achieved by a reduction in the overnight rate. One of the main policy questions on the table was the effectiveness and the communication of monetary policy in such an environment. We discussed quantitative easing, that is policy focusing more closely on the quantities of money and credit in the economy, instead of the overnight interest rate to gauge the stance of monetary policy. In that context, increasing the rate of growth of the monetary base would be one way to pursue additional policy easing.
Q. Could you please tell us a bit more about your conclusions on how monetary policy can be efficiently communicated near the zero interest rate bound?
One of the possibilities suggested in that study is that policy could be communicated by focusing on interest rates at maturities that are not close to zero. For example, instead of focusing on a very short-term interest rate one could potentially communicate policy with a three-month or a six-month interest rate. Additional policy easing could be reflected in a reduction in those interest rates and could be communicated in that way even if very short-term interest rates remain unchanged.
Indeed, there are a number of different ways in which unconventional measures could be pursued and communicated. When we study unconventional monetary policy today, we can benefit from all the earlier work on the issue and learn from the related historical experience. This can help our thinking about what is most appropriate under the circumstances. But, of course, institutional settings can differ from one central bank to another and these differences need to be factored in.
Q. Does the lack of a common fiscal authority make quantitative easing hard to pursue in the euro zone?
Although we have one central bank and many fiscal authorities in the euro area, it does not mean that we cannot pursue unconventional policies. The ECB is already engaged in some unconventional measures. One could envision expanding those measures and, of course, examine other actions that are consistent with the institutional arrangements. But it is too early to talk about specifics at the moment.
Q. Could you please describe the current state of the Cyprus banking system?
The Cyprus banking system is sound, well capitalized and in a satisfactory financial condition. Our banks have no material exposure to so-called toxic assets that created problems for banks in other countries. As a result the international financial crisis did not have a material direct impact on Cyprus banks.
Q. Cypriot banks handle a lot of foreign deposits, such as funds from Russia and the Middle East. Does that place extra stress on the system?
It is true that we have a large volume of foreign deposits in our banking system. In order to avoid any potential liquidity problems that might arise on the back of it, we introduced regulation that foreign deposits are subject to a 70% liquidity ratio -- a ratio others may have considered far too high in the past. That highlights the high level of comfort that we have in the banking system, even under the current challenging circumstances.