Axel A Weber: Financial markets and monetary policy
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
University of Constance, Constance, 25 June 2008.
* * *
1 Introduction
Ladies and gentlemen
It is a great pleasure to be here, at the University of Constance, where I myself studied
economics some 30 years ago. When I finished my studies, the university's postgraduate
studies programme "International Economic Relations" had not yet been launched. In
retrospect, I think there were many interesting topics to study in the late 70s and early 80s.
Think of the two oil price crises of the 1970s or the Great Inflation in the USA. In fact, both
topics are worryingly relevant today - even though the background story is now a different
one and our theoretical and empirical insights have advanced significantly.
I would therefore like to come back to both issues later on when I will also be able to talk
about the current monetary policy stance of the Eurosystem. Before doing so, however, I
would like to focus on yet another topic: financial markets and central banks. My choice
seems a natural one given the extent to which global financial markets have been
characterised by turmoil and volatility over the past 11 months. Indeed, what began as a
fairly contained deterioration in the (relatively small) US-subprime market in August last year
has rapidly developed into a severe test of the stability of the global financial system.
Financial markets perform an indispensable task for economic welfare. They provide the
services and products by which the intertemporal allocation of savings and investments is
accomplished. As such, financial market stability is a precondition for macroeconomic
stability and economic growth. In addition, monetary policy is largely transmitted to the real
economy and the price level through financial market operations. It should therefore come as
no surprise then that central banks have always had a keen interest in financial market
developments. And, most certainly, there was no need for the recent financial market turmoil
to drive home that point. I have chosen two topical questions to guide me in my following
remarks: First, what are the underlying causes of the recent financial market turmoil?
Second, how can central banks help avoid disturbances in the financial system?
2 The underlying causes of the recent financial market turmoil
When looking at the underlying causes of the recent tension in the global financial system, is
one particular development to blame as a clear cause? In fact, numerous culprits have been
put forward: securitisation, quality of risk management, credit rating agencies, compensation
schemes, accounting standards - to name just a few. Against this background, I am
extremely sceptical about monocausal explanations. Instead, I believe that a cocktail of
various ingredients triggered the shock waves for the financial system.
Many ingredients in this recipe stem from innovations in financial intermediation or, to be
more precise, from a combination of new and complex instruments to transfer credit risks
and the "originate and distribute" business model. The disruptions of the previous few
months have highlighted the increased complexity of credit risk transfer (CRT) instruments.
This would have been less problematic if the risk management systems of financial
intermediaries had kept pace with the changing characteristics of the financial landscape.
However, not all of them did. At the same time, the investor base has become more diffuse,
with some participants being only recent entrants to the CRT markets. All of this suggests
that several investors may not have fully appreciated the higher-risk nature of CRT products
and were therefore overly optimistic in their assessments of the risks involved.
As you probably know, the securitisation activity was promoted by the "originate and
distribute" model at large banks and securities firms. On a positive note, the securitising,
tranching and trading of credit risks has led to a fairly broad risk dispersion. But it has
become clear that the "originate and distribute" model can actually improve the resilience of
the financial system only if a high-quality standard is maintained at all levels of the transfer
process and no new concentrations of risk arise. The past few years, however, have been
characterised by a series of distorted incentives which has manifested itself in lax origination
standards for products such as subprime mortgages and an excessive reliance on credit
ratings by some investors.
As a final point, let me add that, at the end of the day, the "originate and distribute" model led
- rather unexpectedly - to a huge reintermediation of credit risks on to banks' balance
sheets. In other words, the financial market turmoil has demonstrated that removing assets
from bank balance sheets does not mean that banks are no longer exposed to the risks
associated with them. Hence, risk management systems should reconsider their view of
reputational risk, credit guarantees and credit lines to off-balance-sheet entities such as
structured investment vehicles and conduits. In a nutshell, securitisation, as Claudio Borio
aptly put it in 2008, has, in the end, "distributed fear rather than risks". However, while
financial innovation has undoubtedly increased vulnerabilities in the global financial system,
there is more to the present financial market turmoil than meets the eye of the casual
observer.
The proliferation of structured finance products and the "originate and distribute" model
would arguably not have been possible without the benign economic and financial backdrop
notably robust global economic growth, low inflation, a low level of interest rates, low default
rates and rising asset prices in many countries, not just in the USA. This Goldilocks
economy, where conditions were neither "too cold" nor "too hot", had - as a side effect -
masked the gradual build-up of financial imbalances. Hence, while lending and risk-taking
experienced rapid growth, words of warning by central banks and other institutions were
largely disregarded on the basis of "this time, developments are surely different from the
past". The fact that minor financial market tensions in the spring of 2005 and in 2006 had left
financial markets more or less unscathed only reinforced that impression. Once, however,
the vulnerabilities in the global financial system were revealed in August last year and
financial imbalances started unwinding, we all witnessed that the scene changed
considerably.
3 Financial stability analysis at central banks
For some time now, there has been much talk about financial stability and the respective role
of central banks, and so I would like to address this topic here. A widely accepted definition
of financial stability is the ability of the financial system to perform its key functions efficiently
- namely, the allocation of capital and risks and the settlement of payments and securities
transactions. These functions must be fulfilled smoothly not only in normal times but also
during periods of structural adjustment and stress. Stable financial systems reduce
uncertainty and therefore develop positive external effects on the real economy, thereby
contributing to greater economic prosperity. However, the reverse is also true: Instability in
the financial system can have negative external effects and therefore cause high economic
costs.
Contributing to financial stability is thus part of a central bank's core area of responsibility, in
order to ensure price stability and avert negative repercussions of the financial system on the
real economy. Just over a year ago, some observers questioned this view, calling it a
temporary "fad" or even dismissing it as the result of central banks' searching for new
responsibilities - these voices have now been silenced for obvious reasons. Indeed, financial
stability analysis is anything but a passing fashion. It has established itself as a field of
research of its own right since the mid-1990s, when financial stability issues were boosted by
financial globalisation and an acceleration in financial innovation. This is reflected in the wide
dissemination of financial stability reports, which central banks now produce in more than 50
countries worldwide.
I would therefore like to give you a brief overview of the kind of challenges central banks face
when embarking on financial stability analysis. It starts with the fact that financial stability is
not easily measured. This is hardly surprising as, in contrast to monetary policy analysis,
there is no single indicator (such as inflation) to observe.
Similarly, initiatives to create some sort of an all-encompassing financial stability index have
failed to convince so far. Instead, the concept of financial stability involves various financial
intermediaries, financial market segments and infrastructure, for which a whole host of
different quantitative and qualitative indicators exist. As a consequence, determining the
degree of financial stability remains a highly complex task. Moreover, constructing theoretical
models and conducting model-based financial stability analysis are still in their infancy. One
particular difficulty lies in modelling periods of stress. To begin with, modellers face a lack of
relevant data as historical time series on episodes of stress are rare, luckily. More generally,
it is difficult to capture the behaviour of financial market participants because they are
affected by feedback effects between the financial system and the real economy. In many
cases, a shock to the financial system will be amplified by interrelationships between
financial markets and economic variables. For instance and without reference to the present
situation in the euro area, if, after a period of financial turbulence, financial intermediaries
experience a widespread process of deleveraging, credit crunch mechanisms might come
into play that could drive bigger second-round effects on the economy and, in turn, cause
further losses in the banking sector. How to model such feedback effects consistently is still
an open issue.
Another significant limitation to assessing a financial system's vulnerability to contagion and
system-wide stress is the fact that financial instability is inherently non-linear. As one
consequence of this non-linearity, risk factors typically are not normally distributed. Instead,
their distribution is characterised by fat tails, implying that extreme values are observed more
frequently than what would be predicted under the assumption of normality. Modelling
nonlinearities greatly complicates research, but it is indispensable, given the central focus of
financial stability analysis on default, contagion and spillover effects.
To sum up, it should come as no surprise that a standard analytical model of financial
stability has not yet been developed. At present, modelling is often scattered with respect to
risk categories, financial market segments and structural or regulatory issues. Mind you,
there is no reason to play down the progress achieved so far. On the contrary. Financial
stability analysis is becoming more and more sophisticated, as is borne witness by the
increasing number of related working papers and conferences. As for the recent financial
market turmoil, central banks (and other institutions) have frequently and in good time
warned of many aspects, notably excessive risk-taking and a general underpricing of risk.
However, the trigger for the recent financial market turbulence, the speed at which it spread
across global financial markets and its persistence were not foreseen, but that does not
conflict with my statement. Far from it - financial stability analysis does not aim for
clairvoyance. Instead, it is most likely that financial crises will continue to emerge in spite of
perceptible progress in financial stability analysis. But the crucial point is that their impact can
be alleviated by warnings, moral suasion and - if necessary - adjustments to the institutional
and regulatory framework.
Right now, national, European and international institutions and forums are putting a lot of
effort into identifying the lessons to be learned. In an international context, most notably, the
analysis and recommendations by the Financial Stability Forum and the recently published
"Principles for Sound Liquidity Risk Management and Supervision" by the Basel Committee
on Banking Supervision deserve close attention. They are an important step forward in
making the international financial system more resilient.
4 The Eurosystem's current monetary policy stance
Even though financial stability is of vital interest to the Eurosystem, our primary objective is
the maintenance of price stability in the euro area. During the past ten years, the Eurosystem
has lived up to this mandate. Since the inception of the euro, annual inflation in the euro area
has, on average, remained in the close vicinity of 2% (at 2.05% to be precise), which is only
marginally above the Eurosystem's benchmark for price stability. Recently, however,
euroarea inflation has accelerated, remaining above 3% for the past seven months and reaching
a worrying record high of 3.7% in May. This confirms that the current upward pressures on
euro-area inflation, which result largely from sharp increases in energy and food prices at the
global level, are rather persistent.
On the face of it, the present inflationary pattern seems to bear some resemblance to that of
the 1970s. Not only is inflation unusually high in many countries but the oil price increase that
has occurred gradually over the past few years is now comparable in real terms to that of the
1970s. Furthermore, economic growth is slowing down on a global scale, even though, as far
as the euro area is concerned, we do expect it to remain robust, but certainly less dynamic in
the quarters ahead.
On closer observation, however, there are several caveats worth mentioning. They might
explain why the present oil price shock has so far been less damaging than that of the
1970s. First, oil intensity has decreased substantially over the past 30 years both as a
consequence of the declining relative weight of the energy-intensive industrial sector in the
industrialised countries and growing ecological awareness. Second, whereas the shocks of
the 1970s were caused mainly by sizeable disruptions to the oil supply, the present episode
is largely driven by unexpectedly buoyant demand for oil, particularly from the rapidly
growing emerging market countries - notably China. The latest price hikes, however, are
primarily related to supply-side factors. The third, and arguably most important, difference
between today and the 1970s is the accumulated advance in the theory of monetary policy
making. Monetary theory no longer sees inflation as a by-product of real-sector forces which
are largely outside the control of the central bank. On the contrary, in the long run inflation is
generally believed to be a monetary phenomenon. Therefore, there is widespread agreement
on the substantial benefits of price stability and central bank independence, on the
forwardlooking nature of monetary policy and its need for credibility and commitment.
Given these changes in monetary policy, the re-emergence of an inflationary wage-price
spiral which was characteristic of the 1970s now appears less likely. But even if these
differences to the 1970s are reassuring, there is no room for complacency. First, oil prices
have hiked more strongly and persistently than generally anticipated. Their present level in
real terms even surpasses that of the 1970s. In addition, the uncertainty surrounding future
oil price developments greatly complicates the accurate forecasting of inflation and therefore
poses a further challenge to monetary policy. Second, apprehension is growing that inflation
expectations are on the rise. In the euro area, this is chiefly true for short-term to
mediumterm inflation expectations, which cover the policy-relevant time horizon of monetary policy.
By contrast, medium to longer-term inflation expectations which are the best indicator of the
public confidence in the central bank and its credibility have not moved significantly. This is
especially true for survey-based measures. Yet, even if the rise in longer-term inflation
expectations is only marginal compared to the substantial temporary increase in the current
HICP rate, this is not guaranteed to remain unchanged.
In that respect, the Great Inflation of the 1970s should serve as a cautionary tale.
Subsequent to the two oil price shocks, many industrialised countries experienced a period
of elevated inflation. As a word of warning I would like to add that correlation should not be
confounded with causation. Obviously, global developments at that time were affected by
more than just high and rising oil prices. Nonetheless, I will focus my remarks on the nexus
between oil price hikes and monetary policy. In particular, I will touch on two examples of the
1970s, that of Germany (which I am most familiar with) and the USA (which has been widely
discussed in the macroeconomic literature). Germany suffered to a much lesser extent from
the Great Inflation than many economies elsewhere. One reason for that might be the high
inflation aversion in the German public that had evolved as a consequence of the two periods
of hyperinflation in Germany in the first half of the 20th century. It enabled the Bundesbank to
adopt a firmer monetary policy stance than many of its counterparts. The start was not
perfect. In 1973, right after gaining freedom of action after the collapse of the Bretton Woods
system, the Bundesbank tried to keep inflation low by means of moral suasion rather than by
committing itself to a clear strategy. Trade unions more or less ignored the Bundesbank's
signals and pushed through high increases in nominal wages, trying to compensate for the
loss in real disposable income. As a consequence, inflation went up.
But the Bundesbank learned from that experience and, in 1975, together with the Swiss
National Bank, was the first central bank worldwide to adopt a monetary targeting strategy,
thereby committing itself publicly to a stability-oriented policy. After the second oil price
shock, from 1979 to 1981, the Bundesbank sent out clear signals for restoring price stability
by raising its key interest rates sharply. As a consequence, German inflation did not rise as
much as in the USA and started to decline earlier. At the same time, output losses also
remained lower than in the USA, demonstrating that a restrictive monetary policy can, in the
medium term, prove superior also in real terms.
The situation in the USA and in many other industrialised countries was different. In the USA,
consumer prices started to hike as early as the mid-1960s for reasons which were at first
unrelated to the oil market (Vietnam War, food prices, monetary policy geared to combating
recession) from 11⁄2% in 1965 to 6% in 1970 and in the aftermath of the oil price shocks to
more than 14% in 1980. In response to this persistent upward trend in actual inflation,
shortterm inflation expectations also drifted upwards, until they peaked at 12% in 1981. Such a
spiral of mutually reinforcing increases in inflation and inflation expectations suggests that
monetary policy somehow did not rise to the challenge of that period.
The macroeconomic literature has put forward numerous, often complementary explanations,
and I would like to focus on two of them. First, it has been argued that monetary policy in the
USA - though broadly committed to price stability - did not respond sufficiently strongly to
high and rising inflation rates before 1979 (technically speaking, it did not adhere to the
Taylor principle).1 By not readily raising key interest rates, the Fed allowed public inflation
expectations to become unhinged, which gave rise to a damaging wage-price spiral and
further fuelled inflation. According to this view, monetary policy itself injected volatility into the
US economy, thereby contributing markedly to the large and persistent inflation fluctuations
of the 1970s. As I noted earlier, both the macroeconomic framework of the 1970s and the
general understanding of monetary policy have undergone notable changes. Nonetheless,
the US experience demonstrates how quickly inflation expectations can drift upwards if
actual inflation is persistently above the stability norm of the central bank and if,
consequently, market participants lose confidence in the central bank's will to restore price
stability.
Another explanation of the Great Inflation focuses on the Fed's response to output.2 This
view does not regard the Fed's weak response to inflation as problematic, but the importance
it attached to output stabilisation. Indeed, a strongly activist monetary policy, which strives to
keep the economy close to potential, suffers from a fundamental conceptual problem.
Although such a policy performs well under ideal conditions, it may well produce markedly
sub-optimal outcomes given the inevitable uncertainties associated with estimating the
output gap in real time. The latter is what happened during the Great Inflation. It is argued
that the Fed did not detect the productivity slowdown in the USA, which started in the mid-
1960s, in real time. In a similar vein, the Fed (and probably many other central banks) did not
immediately take account of the fact that a persistent increase in oil prices has a dampening
effect on potential output, even if the exact magnitude is difficult to quantify with any
precision both directly via a reduction in energy inputs and indirectly via making some of the
existing capital stock redundant. Both factors led to a systematic overestimation of US
potential output. Consequently, the slow-down in the US economy after the first oil price
shock was (wrongly) perceived as a significant increase in economic slack, which the central
bank did not want to counter with a tightening monetary policy. For the same reasons, the
central bank systematically underestimated inflationary pressures and, hence, thought its
monetary policy stance more restrictive than it actually was. In any case, the lesson to be
learned from this explanation is that monetary policy has to factor in changes in potential
output even if they are unobservable in real time. In particular, central banks should keep in
mind that persistent oil price hikes are likely to cause a decline in potential output. Against
the background of the Great Inflation, the most pressing issue at the current juncture is
whether there is any danger that the Eurosystem will repeat the policy mistakes of the 1970s.
To give you the answer straightaway, no, I do not think so. As for the risk of inaccurately
assessing potential output, I would first like to emphasise that the Eurosystem does not
primarily aim at output stabilisation. Our primary objective is price stability. However,
potential output, the output gap and capacity utilisation are part and parcel of the collection of
data that the ECB Governing Council monitors to assess the short and medium-term risks to
price stability. But we are aware of the uncertainties surrounding such data and make
allowance for it by cross-checking the short to medium-term indications for monetary policy
coming from the economic analysis with the medium to long-term perspective stemming from
the monetary analysis.
Given the Eurosystem's stability orientation, we take the dampening impact of oil price
shocks on potential output into account and have therefore not yielded to calls to relax our
monetary policy stance. If we did, monetary policy would only strengthen the shock-related
inflationary pressures. At the current juncture, however, with inflation in the euro area having
reached a record high and inflation risks still on the upside, there is the concrete risk that
longer-term inflation expectations will start creeping up more strongly. The experience of the
Great Inflation demonstrates that a stability-oriented central bank is well-advised to fight the
risk of broad-based second-round effects decisively and proactively. By doing so, it will keep
the costs of curbing inflation dynamics relatively low. Our commitment to a systematic focus
on price stability is even more important, as the recent rounds of wage settlement in the euro
area have not contributed to curbing inflation pressures. On the contrary, recent wage
dynamics in conjunction with elevated and persistent energy and food price pressures have
increased the risk of a prolonged period of intolerably high inflation.
At our last meeting of the ECB Governing Council, we emphasised that, given the uncertainty
about the economic outlook and the prevailing downside risks to economic growth, the
continued vigorous expansion of money and credit and the strong upside risks to price
stability, the Governing Council is in a state of heightened alertness. Financial markets
should by now have understood our readiness to act. It is our strong determination to secure
a firm anchoring of medium and long-term inflation expectations in line with price stability.
After all, the best contribution that the Eurosystem can make to sustainable growth in the
euro area is to safeguard price stability in the medium to long term And lastly we should also
not forget that a reliable monetary policy also helps to reduce uncertainty in times of an
ongoing financial market turmoil.
Thank you for your attention.
References
Beyer A., V. Gaspar, C. Gerberding and O. Issing: "Opting out of the Great Inflation: German
Monetary Policy after the Breakdown of Bretton Woods", paper prepared for the NBER
Conference "A Retrospective on the Great Inflation", organised by Michael Bordo and
Athanasios Orphanides, Woodstock, September 2008.
Borio, C. (2008), "The financial turmoil of 2007-?: a preliminary assessment and some policy
considerations", BIS Working Paper No 251, March 2008.
Clarida, R., J. Galí and M. Gertler (2000): Monetary Policy Rules and Macroeconomic
Stability: Evidence and Some Theory, Quarterly Journal of Economics 115 (1), 147-180.
Issing, O. (2005), "Why did the Great Inflation not happen in Germany?", Federal Reserve
Bank of St. Louis Review, March/April.
Orphanides, A. (2003): "The Quest for Prosperity without Inflation", Journal of Monetary
Economics 50 (3), 633-663.
Orphanides, A. (2004): "Monetary Policy Rules; Macroeconomic Stability and Inflation: A
View from the Trenches", Journal of Money, Credit and Banking 36 (2), 151-177.