Managing Financial Instability
Repairing the intermediation role of banks
In normal times, policy rates set by Central Banks affect real economy straightforwardly through the bank lending channel. However, in the aftermath of the financial crisis, several distortions hampered this direct cascade effect because of risk aversion (lack of confidence in the quality of bank assets and in their solvency) and lack of confidence. Financial innovation, essentially in the securitization market, enabled banks to insulate themselves from Central Banks’ refinancing rates while having access to liquidity more directly on financial markets. In turn, financial asset prices impacted their balance sheets which had automatic consequences on their ability and willingness to lend to end households/corporations.
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A recent ECB working paper demonstrates market fragmentation remains a vibrant issue in the euro area despite several waves of credit easing with former LTRO and current TLRO (ECB, 2014). The European overnight money market is widely disrupted thus damaging the monetary transmission channel though individual countries are unevenly affected.
Furthermore, a BIS working paper argues there has been a significant surge in the mark-up between lending and policy rates, the two being even more disconnected since the global financial crisis.
Illes and al. (BIS, 2015) adopt a challenging viewpoint, arguing the interest rate pass-through remained stable despite the financial crisis. The so-called disruption has more to do with misconceptions and measurement errors than a real credit crunch. Indeed, policy rates should not be compared to lending rates as commercial banks only partially finance themselves at policy rates. They faced rising financing costs which they did not necessarily pass on end borrowers.
Gertler and Karadi (2015) highlight the importance of the credit channel of monetary policy, especially in times of tightening. Indeed, rising term premia and credit spreads, following policy rates ' hikes, fuel into higher credit costs for commercial banks. Therefore, monetary policy-makers should not only focus on direct refinancing costs but also on indirect responses of credit costs to monetary movements.
Financial stability and the “leaning against the wind” debate
FED's recent attempt to raise short-term interest rates so as to increase long-term rates and mitigate the blossoming of another asset-price bubble fell into a trap. The decoupling between short and long-term evolutions refers to the Greenspan conundrum which raises a number of challenges. Free Exchange, November 20th (2014): "Yet rising short-term rates did not lead to the expected increases in long-term rates. That was a problem, because the Fed very much wanted mortgage rates to go up in order to take some air out of an inflating housing bubble". Read more...
The last financial stability review released by the ECB (November, 2014) warns about the decoupling between business and financial cycles, the latter being much more volatile. Therefore, leading indicators predicting inflating bubbles are all the more necessary. This is a challenging issue in the euro area which is characterized by country heterogeneity and divergent underlying trends. For instance, complementary variables such as consumer price inflation should be integrated into the traditional pool of indicators (housing, equity and asset prices) for macro surveillance.
Why is it so important to manage excessive financial growth? Because it crowds out the growth of total factor productivity, especially in R&D intensive industries (BIS, 2015). In the same line, counter-cyclical interest rates are proved to impact positively on productivity growth both for credit- and liquidity-constrained industries (Aghion and al., 2015).
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Hyun Song Shin BIS, 2015): "Financial stability, then, is not a separate area of concern, but just the flip side to the transmission of monetary policy". Read more...
Svensson (2014) considers leaning against the wind as potentially extremely costly to economic recovery. Read more...
Matthew Klein (FT, January 2015) comes up with two take-away messages: (1) the growth rate in private borrowing during an economic expansion predicts the severity of the subsequent downturn even when there is no financial crisis; (2) the growth of the financial sector since the 1970s can be attributed almost entirely to the explosion of mortgage credit.
What role for UMPs in the longer run?
Although Mario Draghi announced a dual implementation of QE (through ABS and covered bond purchases) and credit easing (through LTRO) on November 21st, 2014, economists are wondering if this late intervention will have any beneficiary effects in the medium term. Indeed, the yield curve already sent a gloomy signal stressing that bond yields are low not because of easing but tightening monetary policy. This echoes the so-called yield fallacy as stressed out by Milton Friedman decades ago (Market Monetarist).
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Although long-lasting risks of deflation in te euro zone may require further unprecedented intervention on the part of the ECB, Sabine Lautenschlager (member of the ECB Executive Board) reminds "innovative measures must therefore be judged against our mandate of maintaining and creating price stability. As with any decision, innovation demands a sober analysis of the costs and benefits, the opportunities and risks. When making a comparison with the measures of other central banks, people often forget that innovative aspects of monetary policy need to be adapted to the institutional conditions, economic specifics and financing structure which characterise a currency area. The euro area is characterised by a bank-based financial system which makes it quite different from more strongly market-based financial systems, particularly in the United Kingdom and the United States. This explains our focus on refinancing operations"...rather than pure and full-blown quantitative easing. This speech given in November, 2014 contrast with the ECB Vice-President Constancio's announcement that the European Central Bank may engage into sovereign bond purchases in 2015. Once again, internal divisions and hesitations a brought into the surface that shed light on the controversies associated with optimal UMPs in a currency area such as the euro zone. The lack of a coherent and consensual stance might be detrimental to the euro zone financial stability due to agitations of financial markets.
According to Jean-Pierre Landau (VoxEU), unconventional monetary policies (UMPs) are meant to last in the eurozone because of persisting low inflation. Such UMPs will have to be coupled with sound fiscal policies : " Things are very different when the central bank engages in direct and massive purchases of private (risky) assets. In that case, the net amount of safe assets does increase. This is exactly what the ECB is currently doing through its programme of asset-backed securities (ABS) and covered bond purchases. This action will potentially bring huge benefits to the Eurozone economy".
The Economist, November 18th (2014): "QE may help underpin asset prices, but not feed through to the wider real economy, or if it does the lags involved could be especially long". Read more...
What are the practicalities associated with financial stability?
Macroprudential supervision stands as a growing concern that comes on the forefront of Central Bankers' rethinking of monetary policy. More emphasis should be put on systemic interactions' management alongside individual credit institutions' financial health (ECB , 2014; IMF, 2013).
Are Central Banks too close to financial and credit institutions therefore endangering both effectiveness and neutrality of their surveillance functions? FT, November 20th (2014): " The Federal Reserve board is conducting a major review of how the regulator and its reserve banks supervise large financial institutions, amid mounting criticism that it is too close to and too lenient with the Wall Street groups it oversees". More to read...
In a BIS working paper (2015), Obstfeld highlights the entanglement of two trilemmas, with monetary and financial characteristics respectively, and for which the exchange rate regime acts as the bridge. In a flexible exchange rate regime, monetary policy is not as independent as the traditional perspective from the Mundell trilemma would otherwise suggest. Because of financial integration, the volatility of capital flows remains a conundrum for macroprudential supersivors and monetary policy-makers aiming at guaranteeing financial stability. Global financial and monetary cycles may not coincide and put at risk the business cycle: this is especially true for emerging markets.
In a ECB working paper, Jobst and Ugolini give further insight on the long-term dynamics of the coevolution of money markets and monetary policy. They tend to show the linkages are not linear nor consistent over time, as phases of convergence follow ones of divergence. Exogenous factors play a key role in this joint evolution, therefore modifying the theoretical framework in which optimal monetary policies should be designed and implemented.
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FT, November 19th (2014) : "Haruhiko Kuroda, Bank of Japan governor, has quashed a rebellion by board members opposed to last month’s extension of the bank’s easing programme, winning over three dissenters to his plan to pump up the monetary base by about Y80tn ($682bn) a year". Read more...
