Philipp Hildebrand: Monetary policy and financial markets
Speech by Mr Philipp Hildebrand, Member of the Governing Board of the Swiss National Bank, at the
Schweizerische Gesellschaft für Finanzmarktforschung, Zurich, 7 April 2006.
References to the speech can be found on the Swiss National Bank's website.
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Introduction
Today marks the twentieth anniversary of the Swiss Society for Financial Market Research. I am
honored to be able to address you on this occasion. As a central banker and as a former market
participant, it is a special privilege to talk to you about how monetary policy and financial markets
relate to each other. But before I begin, let me extend my congratulations and best wishes. I trust that
the efforts of the society will continue to foster our understanding of financial markets for many years
to come.
Monetary policy and financial markets are intrinsically linked. Central banks conduct monetary policy
by directly and indirectly influencing financial market prices. Since financial market participants seek to
extract profits from buying and selling securities, markets inevitably pay close attention to both words
and deeds of central banks. The relationship between monetary policy and financial markets is by no
means a one way street, however. Financial market prices reflect the expectations of market
participants about future economic and monetary developments. These expectations, in turn, provide
valuable information for central banks in determining the optimal future course of monetary policy.
In today's remarks, I will begin by discussing how monetary policy influences various financial market
prices. My point of departure will be the monetary policy instrument, which is typically a short-term
interest rate. In light of the close links between monetary policy and financial markets, I will then
explain the benefits of central bank transparency. My comments will end with a note of caution
concerning the information value of financial market prices in a world of increasingly market oriented
and transparent central banks.
1. How does monetary policy affect financial markets?
Monetary policy is aimed at preserving price stability. In some countries, central banks operate under
mandates that refer to additional objectives such as full employment, maximum sustainable growth,
stable interest rates or stable exchange rates. To meet their objectives, central banks intervene in
financial markets. It is through the financial markets that monetary policy affects the real economy. In
other words, financial markets are the connecting link in the transmission mechanism between
monetary policy and the real economy. I will focus on the first part of the transmission mechanism
only, i.e. the transmission from the monetary policy instrument to financial markets.
Monetary policy affects financial markets through various channels. However, the transmission
process from monetary policy to financial markets and finally to the real economy has a single source:
the monetary policy instrument. Typically, the monetary policy instrument is a financial market price
which is directly set or closely controlled by the central bank. For most central banks with floating
exchange rates today, the monetary policy instrument is a short-term interest rate. Under fixed
exchange rate regimes, a particular exchange rate serves as the instrument. Under monetary targeting
regimes, the instrument is typically the quantity of central bank money in the banking system.1
The Swiss National Bank (SNB) has used all of the above-mentioned instruments in its recent history.
During the Bretton Woods period of fixed exchange rates, the SNB intervened in foreign exchange
markets to keep exchange rates stable. After the collapse of the Bretton Woods system in the early
1970s until 1999, the SNB adopted a monetary targeting strategy. During this period, the SNB used
the level of bank reserves as operational target. From 1978 to 1979, the SNB temporarily abandoned
the strategy of targeting bank reserves in favour of targeting the exchange rate. Since the introduction
of the new monetary policy framework in 2000, the SNB has used the three month CHF Libor as its
operational target.2
The precise sequence of the monetary transmission mechanism depends on the instrument which is
used. I will assume that the monetary policy instrument is a short-term interest rate. This reflects
common practice for central banks with floating exchange rates.
Bond prices and the exchange rate
Short-term interest rates alone have only limited direct effects on the economy. Interest rates which
determine savings and investment decisions and therefore have a stronger impact on the economy
typically have longer maturities. In order to impact the economy, monetary policy impulses must
therefore first be transmitted from the money market to the capital market. The money market and the
capital market are linked by expectations. Neglecting transaction costs and risk premiums, the
expectations theory of the term structure views the long-term interest rate as an average of the
shortterm interest rates expected to prevail until the maturity of the respective bond. Although current
shortterm interest rates have some effect on longer-term bond yields, the expectations theory of the term
expected
structure tells us that it is primarily future short-term interest rates which determine bond
yields. In practice, due to uncertainty about the future evolution of short-term interest rates and due to
time-varying risk premiums, the longer the maturity, the weaker the link between current short-term
rates and long-term rates. Therefore, in practice, a central bank would often find it difficult to guide
longer-term interest rates to a level commensurate with what it considers to be the optimal monetary
policy stance.
Assuming a flexible exchange rate regime, the exchange rate is arguably the quickest transmission
channel for monetary policy, particularly in open economies. Exchange rate movements rapidly affect
prices (via import prices) and subsequently demand (by boosting imports and slowing down exports,
or vice versa). In theory, monetary policy impacts exchange rates via the yield curve and from there
via interest rate parity relations. To be more precise, it is the yield curve of both the home and the
foreign country, and thus the monetary policies of both the home and the foreign country which affect
the exchange rate between two currencies. In practice, exchange rate movements often deviate
significantly from what interest rate differentials would suggest. In light of the practical uncertainties
about the effects of monetary policy on exchange rates, the exchange rate transmission channel for
monetary policy is also not easily exploitable.
Other assets
Apart from bonds and exchange rates, monetary policy also affects the stock market. The relationship
between monetary policy and stock prices is complex, because stocks are influenced by monetary
policy through several channels. First, if stocks are priced using the dividend discount model, then
monetary policy affects stock prices via the interest rate which is used to discount future dividends.
Interest rates may also affect the value of domestic assets of a company, and the exchange rate
affects the value of its foreign assets and foreign profits. In addition, monetary policy influences the
financing cost of a company as well as the availability of loans. Moreover, the medium-term effects of
monetary policy on the real economy can influence a firm's profits.
Monetary policy can also affect commodity prices. Expansionary or restrictive monetary policy
supports or weakens real activity in the medium run and can thus influence the demand and the price
for commodities. Obviously, this dynamic can only occur in economies large enough to impact the
global demand for commodities. In addition, monetary policy can affect some commodities to the
extent that their prices may reflect a change in inflation expectations.
Last, but not least, monetary policy affects housing prices. In general, the transmission from monetary
policy to housing prices tends to be stickier than is the case for other financial market prices. This is
because real estate is not a standardised good which is traded on organised markets. Nonetheless, at
least in theory, the transmission from monetary policy to housing prices is relatively straightforward:
Real estate, like a long-dated bond, has a very long maturity, as the yield it returns, namely housing,
will accumulate for several decades. Monetary policy affects the discount rate which must be used to
discount future yields. Apart from that, the medium-term real effects of monetary policy may affect
demand, rental prices and thus house prices.
An important determinant for the price of all long-dated assets is the risk premium. One of the risks
compensated for by the risk premium is purchasing power risk, i.e. the risk arising from the uncertain
purchasing power of future expected proceeds from an asset. Since it is monetary policy which
ultimately determines the purchasing power of money, monetary policy affects the perceived
purchasing power risk. A further risk compensated by the risk premium derives from the expected
volatility of an asset price during its lifespan. As monetary policy affects asset prices, it can also impact
the expected volatility of asset prices and, in turn, again affect the risk premium.
The link between the monetary policy instrument and any one financial market price is subtle and
variable. Central banks would face an exceedingly difficult task if they had to rely on a single price to
transmit monetary policy impulses to the real economy. The fact that monetary policy works
simultaneously through several financial market prices reinforces the precision and the impact of
monetary policy.
So far, I have tried to outline how monetary policy impulses are transmitted to financial markets. The
monetary policy instrument itself, typically a short-term interest rate, has only a limited impact on the
real economy. Monetary policy works through its aggregate impact on financial markets. Monetary
policy impacts financial markets mainly through expectations. Indeed, Michael Woodford (2004, p.16)
argues that "for not only do expectations about policy matter, but, at least under current conditions,
very little else matters". Expectations influence financial markets in two ways: first, directly via the yield
curve, i.e. through expectations about the future evolution of the monetary policy instrument, and
second, indirectly, via the expected effect of monetary policy on the real economy, which then feeds
back to financial market prices. In practice, it is difficult to distinguish between direct and indirect
effects. Arguably, bond prices and exchange rates are mostly affected directly via the expectations
hypothesis of the term structure and interest rate parity relations, while the effects on other assets are
likely to be more indirect. Let me give an example: Imagine a central bank which eases its monetary
policy stance by lowering expectations about the future path of short-term interest rates. Lower
expected short-term rates will directly affect bond prices and the exchange rate. They will also
increase other asset prices by lowering the discount rate to be applied when discounting future
proceeds. The indirect effects due to higher expected demand will raise stock and housing prices and
further contribute to the total impact of monetary policy.
2. The role of transparency and credibility in monetary policy
The previous example illustrates that monetary policy primarily works through expectations about
future changes in short-term interest rates. It is therefore useful to think of any interest rate decision as
"the first step along a path", as Alan Blinder put it (1998). In other words, it is not so much current
short-term interest rates which define the stance of monetary policy. What matters is what financial
market participants expect the future path of short-term interest rates to be, as well as the
consequences of that path on financial markets and ultimately on the real economy.
Setting the interest rate at official board meetings is therefore only one part of conducting monetary
policy. The other part relates to the release of information that affects market expectations. Monetary
policy is really conducted whenever a central bank releases information that affects markets'
expectations about the future path of short-term interest rates and about the expected effects of that
path on the economy. Monetary policy could therefore be defined as the process of managing
expectations about the future path of the monetary policy instrument and the probable effects of that
path on the economy.
In this context, transparency is a crucial element of a successful monetary policy strategy.3 If a central
bank wants to implement its monetary policy strategy efficiently, it should communicate its intentions
and expectations to financial markets and to the public as clearly as possible. In other words, based
on its assessment of the available data, it should lay out the likely direction of the monetary policy path
as well as the expected economic effects of that path. Central bank transparency then allows markets
to better anticipate the future path of short-term rates, the effect of this path on other financial market
prices and ultimately the impact on the real economy. The monetary policy transmission process is
thus rendered more efficient.
Transparency has a second advantage: It reduces uncertainty and may therefore lead to lower
volatility in various financial markets. If markets can better anticipate the behaviour of a central bank
and the effects of monetary policy, there should be less scope for monetary policy surprises, better
anchored inflation expectations, less monetary policy-induced volatility in asset prices and ultimately
less macroeconomic volatility.
Less volatility should translate into a lower risk premium and may thus promote investment and
positively affect economic growth. Lower risk premiums also lead to higher asset prices. Indeed,
throughout the world and for most asset classes, there seems to be a trend in recent years to higher
valuations. These higher valuations can probably partly be attributed to the reduction of the risk
premium due to lower expected volatility. To the extent that market participants correctly gauge a
reduction in the risk premium, higher asset valuations can be expected to endure and represent lasting
wealth creation.
There is a third reason why central bank transparency has become pertinent. With the world's capital
stock growing faster than the world's economies, real effects attributable to asset prices are becoming
more important.4 On the one hand, this is good news, as it creates wealth and strengthens the
transmission process of monetary policy. On the other hand, a sudden increase in asset price volatility
could have more adverse consequences for the real economy than what we might infer from past
experience. If that is so, central banks clearly have an incentive to avoid becoming the source of
unnecessary asset price volatility. The growing importance of balance sheet considerations in
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monetary policy only reinforces the importance of transparency in central bank communication.
Finally, let me make an obvious but nonetheless crucial point, even if it goes beyond today's topic.
Transparency is a valuable good in its own right. For good reasons, central banks are powerful and for
the most part politically independent institutions. Moreover, the officials who run central banks are
typically appointed for lengthy terms and are difficult to remove from their positions. Transparency is a
crucial element in creating democratic legitimacy for politically independent institutions whose actions
can have wide-ranging consequences for a country's citizens and its elected government. As former
Fed Chairman Alan Greenspan (1996) said ten years ago, it "cannot be acceptable in a democratic
society that a group of unelected individuals are vested with important responsibilities, without being
open to full public scrutiny and accountability."
Transparency is of little use if markets and the public do not believe what a central bank says.
Credibility is therefore a condition that is a sine qua non for a successful monetary policy. How can
credibility be established? Alan Blinder (1998) summarises credibility as a "painstakingly built up
history of matching deeds to words". A long history of actually matching deeds to words, of honest
communication and a reputation for delivering price stability will therefore ensure central bank
credibility. In practice, only a small number of central banks can draw on a sustained history of
successful monetary policy, amongst them, the Federal Reserve, the Bundesbank and the Swiss
National Bank. Fortunately, in recent years, an increasing number of central banks are rapidly
accruing credibility in that painstaking process referred to by Alan Blinder.6
When we think about expectations, transparency and credibility in the context of monetary policy, it is
important to remember that they cannot and should not be substitutes for action. It is often said that a
high level of transparency in conducting monetary policy means that the central bank has less work to
do, because stating clear intentions will induce financial markets to do some of the work for the central
banks. For example, a credible and transparent central bank might indicate that, on the basis of its
assessment of available economic data, it intends to embark on a gradual tightening or easing cycle.
Such a clearly stated policy intention could lead to changes in financial market prices - say long-term
interest rates or the exchange rate - resulting in a change in the monetary policy stance without any
formal change in the level of the official policy instrument. The idea here, as Kohn and Sack (2003, p
28) have stated, is that "statements and policy actions can serve as effective substitutes for one
another, at least in the short run."
I would argue strongly that central bankers must not draw too much comfort from the notion that
statements can substitute for policy actions beyond the very short run. As was pointed out by Blinder,
credibility is ultimately premised on "matching deeds to words". If deeds systematically fail to match
words, credibility will be at risk. Transparency undoubtedly helps a central bank to conduct its
monetary policy more efficiently and more effectively by rapidly transmitting its intentions to the market
place and affecting a potentially wide ranging set of financial market prices. These monetary policy
efficiency and effectiveness gains attributable to transparency have become broadly accepted by both
practitioners and theoreticians.7 Nonetheless, ultimately, a central bank still has to do its job. A central
bank should never signal an intention to do something if it does not intend to act accordingly. Market
participants would in due time recognise that the emperor has no clothes and alter their expectations
in line with this recognition. If a credible central bank decides to use words with the explicit aim of
substituting them for action, it will risk losing credibility and, with that, its ability to guide market
expectations.
This does not mean that central banks should always deliver what they have signalled in the past.
Central bank communication should simply reflect policy intentions based on the data and information
available at the time of communication. Naturally, as time progresses, new information will emerge,
which may require a change in the assessment of the likely future monetary policy course. Reviewing
monetary policy based on new information is not the same as deliberately deceiving financial markets.
In their interaction with a transparent and credible central bank, financial market participants accept
the need for continuous re-evaluation of the likely future monetary policy path. Indeed, markets expect
such an update. Moreover, market participants continuously review and update their own assessment
of future economic and monetary policy developments. Financial market prices therefore reflect a
realtime and continuous update of market expectations about future economic and monetary policy
developments.
3. How do financial markets affect monetary policy?
As I mentioned at the outset, the link between monetary policy and financial markets is not a one way
street. Financial market prices reflect market expectations about future economic developments, such
as inflation, output, and the likely course of monetary policy. It is therefore natural and appropriate for
central banks to evaluate closely the information contained in market prices. In other words, market
expectations can and should influence the setting of monetary policy. However, central banks must
exercise caution in using the information extracted from market expectations as an input to formulating
monetary policy.
My previous comments illustrate that the more credible and the more transparent a central bank is, the
more market prices will reflect the central bank's own expectations about the future. In other words,
the information value of financial market prices for monetary policy purposes decreases to the extent
that they no longer reflect an independent evaluation by millions of market participants about probable
future developments in the economy and in financial markets.
An example may illustrate the potential pitfalls of a central bank relying excessively on market
expectations in formulating policy. Consider a country with a liquid inflation-indexed bond market. In
principle, these bonds reflect what the market expects inflation to be in, say, ten years time. Now,
imagine a highly credible and transparent central bank with an inflation target of 2%. If the credibility of
this particular central bank is such that, no matter what it does in the short run, market participants
believe that inflation in the long run will remain solidly anchored at 2%, then the 10-year inflation-
indexed bond will always reflect an expected inflation rate of 2% in ten years time. If the central bank
takes excessive comfort from the fact that market expectations reflect stable inflation expectations, it
may over time deviate from the optimal policy path. At some point, markets will detect the policy error.
In such an admittedly extreme scenario, the likely reaction of the market place would be a sudden
adjustment of inflation expectations with a corresponding costly loss of credibility for the central bank.8
This example illustrates what Alan Blinder (1998) calls the "dog chasing its tail" problem: Financial
markets look for guidance from the central bank, the central bank looks for guidance from financial
markets, and both parties temporarily lose sight of the underlying factors determining inflation, namely
the output gap in the short to medium-run, and money growth in the long-run. To avoid this trap,
central banks should exercise due caution when making use of financial market expectations.
Financial markets provide useful information for a central bank in search of the optimal monetary
policy path. But, as Otmar Issing (2005, p. 70) recently put it, central banks must ensure that they do
"not end up merely executing the expectations developed in the market". The information about
expected future developments reflected in market prices must be continuously cross-checked against
a wide range of monetary and economic indicators in what amounts to a "checks and balances"
approach to monetary policy.