Monetary Policy Impact: Financial Conditions & Credit

Welcome address by Philip R. Lane, Member of the Executive Board of the ECB, at the 5th WE_ARE_IN Macroeconomics and Finance Conference 2025

It is an honour to participate in the fifth edition of the WE_ARE_IN Macroeconomics and Finance Conference and I congratulate the organising committee for putting together an excellent programme.

Let me start this speech by outlining how the ECB makes monetary policy decisions.^[1]

As expressed in our monetary policy statement:^[2]

The Governing Council is determined to ensure that inflation stabilises at its 2% target in the medium term. It will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, the Governing Council's interest rate decisions will be based on its assessment of the inflation outlook and the risks surrounding it, in light of the incoming economic and financial data, as well as the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

My aim today is to review one dimension of this multi-pronged assessment: how we assess the strength of monetary policy transmission. In what follows, I describe some of the analysis that has underpinned this assessment in recent monetary policy meetings.

I will begin by outlining the contribution of monetary policy to financial conditions before reviewing aggregate credit dynamics. Next, I will move to three key factors in determining monetary transmission: first, heterogeneity across member countries; second, the implications of a high level of uncertainty for monetary transmission; and third, the transmission impact of external factors, namely trade tensions and the exchange rate.

Between July 2022 and September 2023, the ECB raised interest rates from -50 basis points to 400 basis points.^[3]

After a nine-month holding phase, the monetary policy easing cycle started in June 2024. Between then and June 2025, we lowered our policy rates by a cumulative 200 basis points. Since June, our policy rates have remained unchanged.

In capturing the impact of changes in policy rates on the wider financial environment, it is useful to assess blended measures such as financial conditions indices (FCIs), which synthesise the information from a variety of financial asset prices. As such, FCIs extend the concept of the monetary policy stance to a wider set of financial markets and beyond the level of accommodation or restrictiveness that is under the central bank's direct control. Akin to a stance measure, loose or tight financial conditions tend to stimulate or dampen economic activity, thus representing an upside or downside force acting on inflation.

Typically, FCIs combine - in a static manner that does not allow for feedback from the economy - a broad set of financial variables, including risk-free rates, sovereign and corporate spreads, equity valuations and exchange rates. It is a standard part of our assessment to study a range of FCI measures, including those developed at the ECB, international policy organisations and private-sector versions. Today, I will focus on a new addition to the family of FCI measures: a new "Macro-Finance" FCI that has been developed by ECB staff in order to overcome the "lack of feedback" problem. ^[4]

The new methodology incorporates mutual feedback between macroeconomic and financial dynamics, such that the Macro-Financial FCI reflects the joint dynamics of macroeconomic variables and financial conditions. As can be seen from the left panel of Chart 1, the overnight rate (€STR), which is closely tied to our policy rates, typically comoves with and sets the direction of the overall index. But there are also several phases in which financial conditions have moved even when the policy rate was stable (Chart 1, left panel).

The decomposition (Chart 1, middle panel) illustrates that, at the onset of the global financial crisis in 2008, plummeting risk asset prices (dark green area) turned from being a stimulative influence on the FCI to acting as a sudden and sharply tightening factor. The widening of sovereign bond spreads during the European debt crisis (light blue area) also provided extra restriction in the years around 2012. During the episode when policy rates were close to their lower bound, compressed long-term nominal rates and negative real interest rates were important sources of accommodation. As a result, the Macro-Finance FCI reached historically supportive levels in late 2021. It then climbed rapidly in the run-up to the first interest rate hike in July 2022, since the term structure of interest rates sequentially moved higher well ahead and in anticipation of our rate hikes and quantitative tightening.

Chart 1

A new "Macro-Finance Financial Conditions Index"

(percentages)

In recent years, the Macro-Finance FCI peaked around the end of the 2022-23 monetary tightening cycle. The increase in the index during this period was primarily driven by rising risk-free rates, with adjustments in risk assets playing a more limited role. Since the peak of the tightening cycle, the index has indicated that financial conditions have become noticeably less restrictive, supported by lower short-term interest rates and higher valuations for risk assets, although this has been partly offset by a stronger euro.

Despite this easing, the level of the Macro-Finance FCI remains well above its historical sample average. In part, this can be attributed to a permanent component to the 2022 shift in the monetary policy stance: the re-anchoring of inflation expectations at the two per cent target means that markets do not expect a return to the "low for long" rate environment that had been expected before the pandemic to continue on an open-ended basis.

The new index outperforms other measures when it comes to describing the macroeconomic dynamics of the euro area (Chart 1, right panel). In this regard, it is key to understand that the financial prices and yields that are aggregated into the Macro-Finance FCI influence bank loan dynamics and loan pricing: this summary statistic of (mostly market-based) financial conditions can be interpreted as an important determinant of broader funding conditions, including those set by the banks, which can be collectively labelled as "financing conditions". In the next section, we turn to a review of credit dynamics.

Lending rates have been declining broadly in line with historical regularities (Chart 2). But there is a detectable difference between developments in the lending rates to households and to firms: the relatively muted decrease in long-term market rates has contained the decline in the cost of household loans, which tend to be priced off the longer end of the term structure of interest rates and have longer fixed-rate periods, relative to loans to enterprises. As outlined above, this is consistent with a permanent component in the 2022 upward shift in policy rates, with no return expected to the "low for long" zone.

Chart 2

Lending rates across hiking and easing cycles

(percentages per annum, series normalised at 0 in t, where t corresponds to the beginning of the policy hike)

In terms of credit volumes, household borrowing, primarily for home purchases, has increased steadily. According to the bank lending survey (BLS), the recovery in mortgage demand is supported by improved housing market prospects and lower interest rates (Chart 3, panel A). Corporate borrowing is also gradually recovering, though BLS responses suggest that corporate demand for credit remains subdued, also reflecting global uncertainty and trade tensions.^[5]

This evidence raises the question of how credit is evolving compared to past regularities, given macroeconomic conditions and considering the current phase of the policy cycle. The strength of credit dynamics relative to the broader economy can be gauged through a credit-to-GDP gap analysis, which captures the deviation of the credit-to-GDP ratio from historical benchmarks.^[6]

This gap can be estimated using a range of methodologies, from simple univariate approaches to more sophisticated models that account for the broader state of the economy. Regardless of the method, the gap remains in negative territory (Chart 3, panel B). This may reflect both structural factors and cyclical conditions. However, using multivariate models to control for prevailing cyclical conditions does not change the inference: credit seems to be weak if assessed against past regularities.^[7]

A number of structural shifts have been cited to explain a diminished role of credit in advanced economies. For example, households spend less on durable goods and more on services, for which they do not typically need to borrow. Demographic trends can reinforce these trends and explain why mortgages might be in lower demand than in the past. Also, spending on intangible assets - including intellectual property, software and code - has surpassed tangible investments as a share of GDP in major economies since the global financial crisis. And intangibles tend to be financed using internal funds or equity, being harder to pledge as collateral for loans. Even the AI-related investment boom in physical infrastructure, including data centres, has been primarily financed by equity.

But such structural shifts matter less for the euro area than for other economies, which leaves the effects of the previous tightening cycle as an important candidate explanation for the persistent weakness in credit that we observe today.^[8]

That is, the current credit dynamics most likely reflect the cross-currents arising from the recent easing overlapping with the delayed effects of the past tightening, together with the fact that there is a permanent component to the rate tightening compared to the pre-pandemic levels. For instance, lending rates on new loans are still above those on outstanding loans, and BLS indicators show that the cumulative tightening has not yet been fully reversed.

Chart 3

Credit dynamics

Changes in demand for loans to firms and households	Credit-to-GDP gap across univariate filters and multivariate model-based approaches
(net percentages of banks reporting an increase in demand)	(percentages of GDP)

A range of other factors that are not unrelated to the cycle may also help explain why the credit gap indicators remain negative. Heightened risk perceptions and higher bank funding costs, combined with declining excess liquidity, have played a role. In addition, pressures from supervisory and regulatory requirements to maintain solid balance sheets amid rising uncertainties, alongside the goal of supporting financial stability, have kept credit standards tight through the cycle, even as monetary policy has been eased in recent quarters. At the same time, financing from non-bank lenders has remained contained since the start of the monetary policy tightening, despite their secular increasing role in funding the real economy.

Looking in more detail at the sources of external financing for firms other than borrowing from banks, corporate bond issuance has benefited from foreign inflows into euro area bond funds in recent quarters, amid a shift in investor cross-border funds in favour of the euro area. Non-listed equities have also increased recently, likely reflecting activities of private equity funds. One segment of non-bank financing that has been growing significantly in recent years is private credit. Private credit generally refers to non-bank corporate credit provided through bilateral agreements or small "club deals" involving lenders outside the realm of securities investors or commercial banks. Despite a clear expansion in the euro area over recent years, the lion's share of private credit is originated in the United States.^[9]

Although numbers vary depending on the exact definition of private credit and source, the size of private credit in the United States is well above €1 trillion, while for the euro area numbers range from around €100 billion to around €300 billion.^[10]

Taken together, non-bank financing has not grown enough to counteract the weakness in bank lending. The dynamics of all the sources of external finance for euro area firms, including equity financing, but also trade credit and non-bank financing, remain contained by historical standards (Chart 4), hence overall measures of the credit gap, as shown in Chart 3, remain negative.

On net, the ongoing transmission of monetary policy easing to credit volumes has been more gradual than anticipated building on past regularities. Equally unusual has been the pronounced heterogeneity across sectors and across borrower characteristics, which I will discuss next.

Chart 4

Firms' external financing over time

(annual percentage change and percentage point contributions)

Heterogeneity in the transmission of monetary policy can affect its overall macroeconomic impact. Differences in sectoral balance sheets and sectoral exposures to macroeconomic shocks can influence the responses of households, firms and banks to changes in financing conditions.^[11]

For instance, the growth rate of loans to the manufacturing sector, although recently supported by the surge in activity due to frontloading of euro area shipments to the United States, has been weaker than that of loans to the services sector (Chart 5, Panel A).^[12]

As manufacturing is capital-intensive, this development connects to the anaemic growth in investment in recent years. Moreover, manufacturing is also working-capital intensive, and therefore especially affected by the cost channel of monetary policy. That a stronger recovery in the manufacturing sector has so far not materialised helps explain a weaker pass‑through of monetary easing via the cost channel than would normally be expected. The underlying reasons could be related to the greater exposure of manufacturing to the external environment, a topic that I will get back to later. By contrast, credit dynamics in the services sector have been driven largely by real estate and leasing activities, supported by recovering domestic demand for housing and durable goods in the euro area.

Chart 5

Heterogeneous credit dynamics across sectors and type of firm

Loans to firms by sector	Lending by firm size and riskiness
(left panel: index = 0 for January 2024, right panel: percentages per annum)	(left panel: index = 0 for January 2024, right panel: annual percentage changes)

At the firm level, credit growth is increasingly concentrated among larger and less risky firms (Chart 5, panel B). Results from the survey on the access to finance of enterprises (SAFE) confirm that small firms have experienced a more muted decline in external financing costs than larger producers. This points to contained transmission via the balance sheet channel and the risk-taking channel of monetary policy. Smaller firms, being more vulnerable to current macroeconomic risks, have therefore suffered sharper balance sheet losses. At the same time, banks have been more reluctant to extend credit to riskier borrowers.^[13]

Since small firms also face greater obstacles in accessing alternative sources of funding, banks' reluctance to lend further tightens the financial constraints facing smaller and riskier firms and weighs on their ability to invest.^[14]

Chart 6

Heterogeneous monetary policy pass-through in mortgage and housing markets

Growth momentum of bank loans to households by country	Changes in new mortgage applications by households by income quintile
(percentages per annum)	(percentage points)

Household loan dynamics have also shown dispersion across countries, highlighting the role of both the collateral and cash-flow channels in monetary transmission during the tightening and easing phases of the cycle (Chart 6, panel A). Differences in national mortgage markets are a key factor, reflecting institutional features such as the share of adjustable-rate mortgages (ARMs) and their maturities.^[15]

Historical regularities show that the pass-through is stronger in mortgage markets with a higher share of adjustable-rate mortgages and shorter maturities, reflecting both the larger movements in short-term compared to long-term market rates and the faster repricing of the total stock of outstanding loans when fixation periods are shorter.^[16]

Indeed, over the past two decades, floating-rate mortgages - which are more reactive to the policy rates - have become less popular in the major euro area economies. The shift in the types of mortgages means monetary policy takes longer to work its way into households' debt payments. This delay in transmission means that, despite recent rate cuts, average mortgage rates are expected to rise further and drag on consumption for a number of years to come as households remortgage on to higher rates after completing long-term fixed deals.^[17]

Moreover, through the collateral channel, recent interest rate cuts have pushed up asset values more in countries with high ARM shares, thereby boosting collateral values.

After a period of declining mortgage applications during the tightening period, mortgage applications have started to increase in recent quarters. Higher income households, however, have maintained lower mortgage applications compared to the pre-tightening period (Chart 6, panel B). Instead, mortgage application growth has come mostly from lower-income households, possibly reflecting the need to maintain consumption or housing purchase plans in spite of declining real wages and with less savings, especially if they spend a large share of their income on basic goods. Thus, we see a shift in the composition of mortgage demand.^[18]

Summing up, the change in borrower composition and the muted risk appetite of banks point towards the risk-taking and balance sheet channels of monetary policy operating less strongly for lower-income households and smaller firms during the easing cycle. Since these groups typically have higher marginal propensities to consume and invest, this heterogeneity in transmission may reduce the effectiveness of recent interest rate cuts in stimulating aggregate demand in the current context of high global uncertainty.^[19]

An important factor that may distort and at times suppress the transmission of monetary policy is uncertainty. Over the past year, economic policy uncertainty has risen sharply, reaching record levels in April, largely driven by trade tensions and geopolitical risks (Chart 7, left panel). Financial market volatility has, instead, remained subdued (Chart 7, right panel). While uncertainty has eased somewhat in recent months, it remains at historically high levels on both sides of the Atlantic according to newspaper-based measures, close to the peak seen during the COVID-19 pandemic.

Monitoring elevated uncertainty is crucial in analysing credit dynamics for two main reasons.

First, it directly lowers credit demand and credit supply. ECB staff finds that unexpected increases in economic policy uncertainty have a negative effect on bank lending in the euro area.^[20]