Guy Quaden: Towards an integrated macro-finance framework for
monetary policy analysis
Introductory speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the
Biennial NBB Conference "Towards an integrated macro-finance framework for monetary
policy analysis", Brussels, 16 October 2008.
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It is my great pleasure to welcome you to this biennial NBB Conference.
At a time when we are experiencing the biggest financial crisis since the 1930's, it doesn't
take much motivation to explain why it is extremely important for central banks to have at
their disposal a coherent framework that can explain and analyse the interaction between
financial markets and the real economy. The theme of this conference - "Towards an
integrated macro-finance framework for monetary policy analysis" - is now even more up to
date than we could have anticipated at the time it was chosen. Although I would have
preferred a different course of events, even if that would have meant a less topical
conference today, it is quite clear that the current crisis poses important challenges for
monetary policy.
Central banks around the world have at least two immediate concerns in this respect:
providing sufficient liquidity to keep the financial system functioning, and adopting the
appropriate monetary policy stance in a highly uncertain and rapidly changing environment.
Let me summarise briefly the approach that has been taken by the ECB over the last 15
months.
Our first challenge was (and still is) to make sure that solvent financial institutions obtain the
liquidity they need. As the liabilities of financial intermediaries are more liquid than their
assets, they are by nature subject to liquidity shocks. If the effects of such shocks are not
properly managed, illiquidity problems can lead to bankruptcy, even when the intermediary is
fundamentally sound. Therefore, it is important to make sure that solvent financial institutions
can obtain liquidity with the central bank.
So far, we have coped with this challenge. One stabilising factor has certainly been the fact
that, well before the start of all this financial turmoil, the Eurosystem already accepted a
broad range of assets as collateral in its refinancing operations. Another element was that we
were able to flexibly adapt the existing framework to new challenges. We did so by adopting
an ample allotment policy in our main refinancing operations, particularly at the beginning of
each reserve maintenance period, by having wider recourse to fine-tuning operations when
market conditions were rapidly changing, and by increasing the share of long-term
refinancing operations. Last week, for our main refinancing operations, we decided to switch
from a variable-rate tender with a minimum bid rate to a fixed-rate tender at the policy rate
with full allotment, implying that financial intermediaries no longer face uncertainty about the
share they will be allocated. Together with our decision to narrow the interest rate corridor for
the standing facilities, this should also improve our ability to stabilise the overnight money
market rate close to the policy rate and to adequately signal our monetary policy stance.
Since December of last year, we have also provided liquidity in US dollars against
ECBeligible collateral, as part of a coordinated action by the central banks of several major
advanced economies, including notably the United States' Federal Reserve. The amount of
US dollar liquidity provision has in the meantime been increased, in view of the growing
tension.
Yesterday, the Governing Council decided to further enhance the provision of longer term
financing operations through fixed rate tenders with full allotment. Taking into account the
substantial extension of the liquidity, as well in euro as in dollars, provided by the
Eurosystem and as there were signs that some counterparties were getting constrained by
collateral, it was further decided to expand the list of Eurosystem collateral.
In a climate of generalised distrust, some financial institutions have come under particularly
strong pressure. When they are systemically relevant, public authorities had to intervene in
order to avoid contagion effects. In the euro area, it is up to national central banks to provide
emergency liquidity assistance and to governments to reinforce the solvency of such
institutions in order to restore confidence. Governments have recapitalised some institutions
and have provided public guarantees to restore confidence in the interbank market. Smooth
cooperation among all players involved is crucial. In particular, when the central bank does
not directly supervise credit institutions, it is essential for it to receive without delay all
relevant information.
Our second concern is that, at the same time, we need to think about and choose the
appropriate monetary policy stance. In doing so, we have to take a somewhat longer
perspective and weigh up the implications of the financial turbulence for the consumption and
investment decisions of the various sectors in the economy, as these will in turn determine
future outcomes for economic growth, employment and inflation. Eventually, the policy
stance is set to optimise macro-economic outcomes, given all ongoing shocks (and that
includes other shocks like rising oil and commodity prices which have also been buffeting the
economy) and taking into account the underlying structure of the euro area economy.
One question that could arise here is whether the massive injections of liquidity into the
banking system come at the price of either an inappropriate monetary policy stance or a less
than optimal signalling of it. In practice, this is very unlikely to be the case. Indeed, since the
beginning of the financial turmoil in August 2007, the ECB has repeatedly emphasised that
the policy stance is defined in terms of the interest rate at which financial intermediaries can
obtain liquidity, rather than by fixing the quantity of liquidity which is provided. As early as
1970, William Poole's classical analysis of the instrument-choice problem taught us that
using the interest rate as policy instrument is desirable when short-term uncertainty
stemming from instability in the money multiplier or from money demand shocks is high
relative to the uncertainty stemming from aggregate demand shocks. The provision of
liquidity then becomes an endogenous variable as it is steered in order to stabilise the money
market rate at its desired level. In this framework, the sometimes substantial liquidity
injections by the Eurosystem should be seen as simply offsetting the sudden and sharp
declines in the money multiplier induced by the financial crisis.
As far as our monetary policy decisions are concerned, they depend on our medium-term
assessment of the risks to price stability and are based on our two-pillar strategy, which
enables us to cross-check developments in the money, credit and financial markets with the
signals provided by economic analysis. Given existing upward inflationary pressures from oil
and other commodity prices and the associated likelihood of second-round effects, euro area
monetary policy was until recently faced with predominantly upward risks to price stability.
However, as the financial crisis intensified further, financial conditions for the private
nonfinancial sector have tightened - independently of monetary policy - and the supply of credit
from financial institutions might be reduced. As a result, expectations regarding economic
activity have rapidly deteriorated over the last two months and the upward inflationary
pressures have eased, partly as a result of lower commodity prices but also because of the
change in the outlook for domestic economic activity. Therefore, the coordinated interest rate
cut of 50bp last week was also the appropriate response for the euro area to the
materialisation of previously identified downside risks to growth and the associated decline in
the upward risks to price stability. For the near future, we will continue to closely monitor all
relevant economic, financial and monetary developments and act firmly whenever necessary.
Particularly at the current juncture, we expect monetary analysis to provide us with relevant
information about how banks' balance sheets are adjusting to the financial crisis and what
this implies for credit and money and, eventually, for economic activity and inflation. The
present situation is indeed exceptional in this regard, as financial frictions or constraints,
which might seem only marginal in normal times, may now suddenly become predominant
for understanding and forecasting economic developments. This comes on top of regular
empirical analysis and reduced-form models which show systematic and quite robust
relationships between monetary and financial developments and future economic activity and
inflation. Money and credit developments tend to precede long-run inflation developments.
Current asset prices influence future investment decisions, and measured risk premiums
predict future cyclical developments.
These aspects are poorly developed in our standard econometric macro-models, as well as
in the benchmark new-Keynesian model which is so prominent in the academic literature. For
the time being, it is difficult to reproduce these statistical relationships and their time-varying
nature in state-of-the-art structural models. That is the main reason why the Eurosystem's
monetary policy strategy now deals with these aspects in a separate pillar. But it would
obviously be extremely useful to have models that can integrate these relationships in a
structural way. This is clearly the way forward for research on these issues. I firmly believe
that this kind of conference helps to encourage research work on such integrated models
and that policymakers will eventually benefit from these research efforts.
Let me conclude by stressing that the financial developments unfolding before us also reveal
that we face important challenges beyond the business cycle horizon. Indeed, we have to
rethink the role of asset prices, risk premiums and money and credit developments for the
systematic conduct of monetary policy, for ensuring financial stability and for re-designing the
regulation of the financial sector. Here again, we could clearly benefit from models which
integrate real, monetary and financial developments. If there are actually common cycles in
monetary, financial and real economic activity and inflation, it would be appropriate to adopt
a longer-term perspective that concentrates on avoiding boom-bust cycles. Structural models
that incorporate these interactions should be helpful to answer a crucial question: to what
extent can monetary policy contribute to preventing excessive liquidity and financial bubbles
from building up in prosperous times? They should also help clarify the role of financial
regulation and the extent to which it should be designed to avoid any excessive accumulation
of risk during good times and prevent binding capital constraints from adding to deflationary
pressures during bad times.
It is important to better outline the relative role of monetary policy and financial regulation for
price and financial stability, both in terms of strategies and institutional design. In today's
integrated financial world, international coordination at appropriate level seems desirable for
policies to be effective in this respect. In Europe, the organisation of banking supervision at
quasi purely national level contrasts with financial market integration and the existence of
cross-border financial institutions.
The current crisis raises all these challenges much more strongly than before. I am
convinced that academic research in these domains will be boosted in the near future and
that new and clarifying insights will result from this work. I sincerely hope our conference can
help stimulate research in these directions.