Axel A Weber: Challenges for monetary policy in the financial crisis
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the Konstanz
Seminar on Monetary Theory and Policy, Island of Reichenau, 28 May 2009.
* * *
1 Introduction
Ladies and gentlemen,
I am very honoured to have been invited once more to hold a policy session at the Konstanz
Seminar on Monetary Theory and Policy. I not only enjoy the beautiful surroundings of the
Isle of Reichenau and Lake Constance, I am also looking forward to productive discussions.
The financial crisis may dominate the discussions of this year's conference as a matter of
course. My contribution will not be an exception in this respect as I shall be commenting on
the challenges to monetary policy in the financial crisis. In particular, I shall be raising the
questions of whether we are currently experiencing changes in the transmission process of
monetary policy and of the longer-term lessons that we should draw from the financial crisis.
2 The transmission process of monetary policy in the euro area
When thinking about the longer-term lessons for monetary policy to be drawn from the
financial crisis, we very quickly hit upon a topic that has always been a key point of interest to
all central bankers and, by extension, the subject of decades of theoretical and empirical
research: the monetary policy transmission process. Understanding this is a prerequisite for
the design of monetary policy since the transmission process describes how monetary
impulses are transmitted to the real sector - that is how they influence economic activity and
finally inflation. For the following it is helpful to decompose the transmission process into a
stylised way so that it can be conceived as consisting of different channels, through which
monetary impulses are transmitted to the real economy. As the world is always in a state of
flux, the relative importance and the composition of these channels do, however, vary to
some extent. Consequently, as technological progress and constant change are key
characteristics of modern economies, the whole transmission mechanism may be evolving
over time. The constant evaluation of how monetary (and other) impulses transmit into
inflation rates remains one of the key tasks of monetary policy.
Before turning to specific questions concerning the transmission process that have arisen
especially during the financial crisis, I would like to make some more general remarks on
whether and how the transmission process could have changed throughout the past two
decades before the crisis. Prominent candidates for driving forces behind such a potential
change are globalisation, the creation of EMU and financial development. As I have already
mentioned, the literature is ample and monetary transmission has been discussed and
analyzed in detail before. Therefore, it is not my intention to deliver a comprehensive
overview of this strand of research. Instead, I will outline some driving forces that could have
changed specific transmission channels, such as the exchange-rate, the interest-rate and the
credit channel in the euro area. In doing so, I shall provide examples of the dependency of
the monetary transmission on structural change and point out some identification problems
that arise.
2.1 Exchange rate channel
Concerning the exchange rate channel, there are theoretical arguments for its strength
having either increased or decreased in recent years. On the one hand, the creation of the
single currency has led to a weaker exchange rate channel of monetary policy in euro area
countries because nominal exchange rate changes within the euro area have simply
disappeared. On the other hand, the increase in international trade and integration on a
global scale has heightened the relative importance of the exchange rate, which, in turn, has
fostered the role of the exchange rate in the transmission mechanism.
A priori the net effect is open and can only be determined empirically. However, the evidence
is mixed. For example, there is some evidence that the exchange rate channel may have
become more powerful in the monetary union.1 However, there is also some evidence that
removing the exchange-rate risk for intra euro area trade combined with a stronger monetary
policy commitment to stabilising inflation and output may have led to aggregate economic
activity and inflation becoming more muted in their response to monetary policy shocks.
2.2 Interest rate channel
Theoretical considerations as well as empirical results point mainly to a stronger and faster
pass-through from policy rates to other interest rates due to increased competition among
different financial market segments and an ongoing consolidation process in the banking
system. Both results in a closer link between different interest rates and thereby increase the
speed at which changes in monetary policy rates are transmitted to other financial variables
and to the real economy. Moreover, the deepening of financial markets we have witnessed in
the period before the financial crisis is likely to have enhanced the role of expectations. This
has led to monetary policy impulses spreading more rapidly from the money market to other
market segments of the financial system.
However, there is also an ongoing debate on whether international financial integration could
have eroded the influence of monetary policy on national long-term interest rates. Indeed, at
a first glance, the high degree of synchronisation between movements in long-term nominal
interest rates across key industrial countries in recent years supports this hypothesis.
However, this co-movement in long-term interest rates might also be the outcome of global
shocks which affect different countries in much the same way and, therefore, prompting
similar national monetary policy responses. In this case, the co-movement in national
longterm interest rates does not necessarily imply that central banks no longer exert an influence
on their domestic long-term rates.
2.3 Credit channel
The credit channel consists of several sub-channels with the bank lending channel and the
balance sheet channel probably being the ones that have been most analyzed. Whereas the
bank lending channel concentrates on the supply of bank loans, the balance sheet channel
looks at the effects of monetary policy on the overall supply of funds via borrowers' net worth.
As concerns the bank lending channel, a number of studies document that financial
innovation - such as securitisation or credit derivatives - have led to banks becoming more
flexible in reacting to monetary policy. More specifically, they may have become able to
better isolate their loan costumers from restrictive monetary policy impulses.2 Consequently,
financial developments may have made the bank lending channel less important. However,
to the extent that credit protection through credit derivatives is associated with an increase in
bank credit supply the importance of the bank lending channel has not necessarily changed.
3
For example, the possibility of transferring credit risk may not result in reducing risk from a
specific activity (such as lending) may increase that activity. In such a case, monetary policy
would still operate through a bank lending channel as capital requirements would still be
effective.
According to the balance sheet channel, possible interest rate changes influence the
creditworthiness of borrowers via the evaluation of their assets. Creditworthiness, in turn,
influences the premium that borrowers have to pay for external financing, and, thus,
economic activity. While the analysis of the balance sheet channel was originally applied to
non-financial institutions, the deepening of financial markets, along with financial innovations,
has presumably extended its importance to the household sector as well as to the banking
sector. With respect to the household sector, financial liberalisation and innovation have
generally facilitated borrowers' access to standardised credit and thereby heightened the
importance of asset prices in the households' balance sheet. Consequently, households, too,
have become more sensitive to interest rate and asset price volatility. It should be clear by
now that the credit channel, in particular, is not only complex but also sensitive to changes in
the financial sphere.
2.4 Methodological issues
At this point, I would like to draw your attention to two methodological issues. When
discussing the likely effects of individual channels, it should be kept in mind that the empirical
identification of changes regarding a particular transmission channel has to deal with at least
the following two fundamental problems: First, it may be technically very demanding.
Challenges are posed not only by the empirical identification of the transmission channel
which is of interest. Isolating the driving factors of specific channels from other potential
influences is usually a difficult task, too. Second, findings about the change of an individual
channel do not allow any conclusions to be drawn about a likely change in the overall
effectiveness of monetary policy, as causes and effects might interact and either reinforce or
weaken each other. Therefore, it is reasonable to complement the partial approach by
considering the transmission process as a whole. This is because only a macroeconomic
perspective allows conclusions to be drawn about the potential overall changes in the
monetary transmission process in the euro area.
3 The financial crisis and changes in monetary policy transmission
But let me now turn to the current financial crisis and its potential implications for monetary
policy transmission. The shocks we have experienced during the financial crisis have not
only caused the deepest global recession since World War II but also severely harmed the
interbank market. It is evident that in the short-term the monetary policy transmission process
is being affected by these events. More specifically, two questions arise:
•
"How does the transmission process work in times of financial turmoil like those we
are currently observing?"
•
"Will the transmission process change in the long-run as a result of the financial
crisis - and if so, how?"
3.1 Current changes
There are two reasons why it is important for us to carefully observe changes in monetary
transmission resulting from the financial crisis. The first reason is that such observations
might teach us new details and characteristics of the transmission process in general, as the
financial crisis is providing us with a rich and interesting database. However, insights of that
kind will be of more use to us in the long-run. What is most important at present is to observe
the functioning of the credit lending and interest rate channels. That is, to what extent and
under what conditions banks lend to non-financial institutions and whether they pass on the
enhanced terms of financing which they have been given by a looser monetary policy.
Credit channel
When we try to detect changes in the lending behaviour of banks using the available data on
credit contracts, we are confronted with the technical problem of separating credit supply
from credit demand. In this respect, the Eurosystem's Bank Lending Survey (BLS), which
was introduced six years ago, is a very helpful tool because it provides qualitative information
on the lending behaviour of the surveyed banks. It has proved to be very valuable in the
current financial crisis because it supplies us with some information that can be used to
judge whether the euro area economy is facing a credit crunch or not.
The results of the BLS for Germany show that credit standards for loans to enterprises and,
to a lesser extent, also loans to households, have been tightened on average by the
surveyed institutions since the outbreak of the financial crisis in summer 2007. There was a
marked tightening in the credit standard for loans to enterprises, however, in the third quarter
of 2008, after the collapse of Lehman Brothers.
According to the surveyed institutions, refinancing costs and balance sheet constraints have
been playing a major role in developments in credit standards since the beginning of the
financial crisis. However, in the two most recent survey rounds, in which there was a very
marked tightening of credit standards, additional factors were in play: the impact of the
deterioration in the general economic situation and the increasing importance of industry or
firm-specific developments.
Interest rate channel
In order to examine the extent to which financial institutions have passed on their lower
short-term refinancing costs in the current situation, the Deutsche Bundesbank has analysed
financial institutions' short-term interest rates for corporate and housing loans.4 The reason
for focusing solely on the short-term interest rate is that the longer-term refinancing
behaviour of financial institutions may have changed markedly in the course of the financial
crisis. Consequently, conventional measures for long-term refinancing conditions that have
been used in the past may no longer be suitable.
Comparing the development in the three-month money market rate (EURIBOR) from the end
of September 2008 until the end of March this year with changes in short-term bank lending
rates, we find that financial institutions have passed on roughly 80% of their refinancing
advantage to borrowers from the corporate sector and around 60% to house owners.
Moreover, up to now, this analysis gives no evidence that the interest rate pass-through
since fall 2008 is happening more hesitantly than in the period before the crisis.
3.2 Long-run changes
As concerns possible long-run changes to the transmission process, it is certainly much too
early to draw firm conclusions. Hence, please allow me to share some of my thoughts on this
issue with you. Most obviously, we might see a reversal of some of the changes in the
transmission process that took place in the period before the financial crisis. For example,
insofar as the importance of securitisation in banks' financing declines, changes in the
transmission process triggered by securitisation will go partly into reverse. In addition to this,
the financial crisis has drawn the attention of researchers and policymakers to a new aspect
of the transmission process that might have been neglected in the past: that is the dealing
with risk.
In this context, a debate on a possibly new channel of monetary policy - known as the
risktaking channel - has evolved, based on a paper by Borio and Zhu5, published in 2008.6 The
risk-taking channel tries to capture the consequences of risk for the monetary policy
transmission process by linking two possible perspectives in our financial system: The
perspective of financial institutions (finance perspective), which emphasises the
measurement and evaluation of risk. And the perspective of financial regulators and central
banks (economics perspective), which focuses on the financing conditions in an economy.
As the mechanisms through which monetary policy might influence market participants'
risktaking are complex, at least three dimensions have been attributed to the risk-taking channel.
The first dimension is closely connected to the balance sheet channel which I mentioned
earlier. It takes into account the fact that monetary policy might influence the evaluation of
collateral, asset prices and cash flows, thereby changing risk behaviour in an economy.
According to the second dimension, risk-taking by market participants is influenced via their
target returns. More specifically, in the case of rigid nominal target returns, a tight monetary
policy can induce a wedge between nominal returns that are achievable in the financial
markets and the nominal target returns of market participants. This - in combination with an
ample range of investment possibilities - might trigger a "search for yield process": market
participants invest in riskier assets in order to achieve satisfying returns. Finally, the third
dimension of the risk-taking channel links the communication of monetary policy to higher
risk-taking. This link can either work through the desired effect of good monetary policy
communication, which is known as the "transparency effect" as enhanced transparency
might reduce the uncertainty about future monetary policy and through this the risk-premia.
Or - and this is the case that monetary policy should wish to avoid - market participants
might increase their risk-taking if they take into account the fact that monetary policy will be
relaxed in the case of decreasing asset prices in a financial downturn. In this case - the
socalled insurance effect - market participants are implicitly insured against downside risks and
therefore tend to take excessive risk. Hence, we have to deal with a classic moral hazard
problem. The questions that follow on from these rather theoretical considerations are "What
empirical evidence do we have on this transmission channel?" and "What lessons should
monetary policy draw from its existence?"
Empirical evidence
Some observations seem to confirm the existence of the risk-taking channel. The economic
boom that began in 2002 was characterised by the coexistence of low monetary policy rates,
very high asset prices and unusually low short-term risk perception. This suggests that the
first dimension of the risk-taking channel was at work. In addition, a comprehensive "search
for yield" process could also be observed in this market environment - that is the risk-taking
channel worked via its second dimension of rigid nominal target returns. Concerning the third
dimension of the risk-taking channel, simple observation is not very helpful because it
requires the empirical identification of the two effects. While the transparency effects is
difficult to isolate from other effects which are at work, there is, however, some empirical
evidence for the insurance effect.7
Apart from this, empirical research on the risk-taking channel is in its early stage and is
consequently rather thin on the ground. Therefore, we do not yet have firm empirical
evidence for the existence and the relative importance of the risk-taking channel. However,
recent ECB research shows for the euro area that low interest rates soften bank lending
standards. As loan characteristics are typically not adjusted for increased risk, banks tend to
have a lower risk aversion when low interest rates prevail for a long time.8 Two further
research papers that are worth to be mentioned have found evidence of a risk-taking channel
10
for Spain and Bolivia, using ex ante and ex post loan characteristics to model risk-taking.9
4 Longer-term lessons for monetary policy
Although, there is a strong need for further research at the risk-taking channel so that the
right lessons for monetary policy can be drawn, there are some considerations that we can
already take into account. In particular, the notion we obtain from the risk-taking channel
about the way monetary policy can influence market participants' risk perception supports the
call for a more symmetric monetary policy across asset price cycles. Such a more symmetric
approach would treat boom and bust episodes not as isolated events but would try to look
through the financial cycle. To be more specific, a more symmetric policy would also realise
implicit risks in times when money and credit growth is dynamic, asset prices go up and risk
perceptions decline, possibly creating a need to act despite current inflation rates being
sufficiently low. This, however, does not mean that monetary policy should downgrade the
price stability objective for the sake of other objectives. Rather, it means that central banks
should take a longer-term perspective which takes due account of the future inflationary
consequences of such unfavourable developments.
Here, the Eurosystem's monetary policy strategy already possesses such a stabilising
element, in the shape of its monetary analysis, which is especially suited to analysing
longterm developments. The recent financial turmoil has shown that the often-criticised monetary
and credit analysis has a valuable role to play in monetary policy analysis.
5 Conclusion
Ladies and gentlemen,
Today, I have spoken about the challenges that the financial crisis is posing for monetary
policy in terms of the transmission process. Of course, this is not the only challenge which
monetary policy is facing at present. It is, however, a very crucial one, as we should study
the transmission process in order to learn from the current financial crisis. Research in this
field of monetary policy is still in its infancy. Nevertheless, there are very promising research
papers that have already pointed out some key questions. As we are dealing with a very
interesting field of research, I am sure that more work on this topic will follow.
Thank you very much for your attention.