Christian Noyer: Monetary policy and the crisis - some lessons for the
future
Keynote address by Mr Christian Noyer, Governor of the Bank of France, at the
ParisEuroplace Financial Forum, Tokyo, 16 November 2009.
* * *
Central banks have been very active over the last two years in containing the impact of the
financial crisis. Monetary policy has made an important contribution to stabilizing financial
markets and the real economy. Today, however, I will not talk about our response to the
crisis, whether by conventional or unconventional measures. I will rather focus on the longer
term and address two questions: "Was monetary policy the cause of the crisis?" and "How
can it contribute to preventing future crisis?" These are two different questions. And they call
for differentiated answers. While I doubt very much that monetary policy played a major role
in triggering the crisis, I also believe that it can - and should - help in the future to better
contribute to financial stability.
Was monetary policy the cause of the crisis?
One major success in the two last decades has been the achievement of price stability in
most industrialized and many emerging economies. This success has rightly been ascribed
to the monetary policy framework almost universally adopted in the world, which, beyond
national differences and specific features, is based on two common pillars: Central bank
independence and price stability as a primary objective. Price stability itself has coincided
with - some would say produced - a prolonged period of strong growth and low output
volatility, which, as you know, has been dubbed the "great moderation".
One major disappointment however, has been that price stability has not led to financial
stability. On the contrary, it seems that, over the last two decades, financial crises have
become more frequent, with increasingly serious consequences for growth and welfare.
To get a sense of this puzzle, it may be useful to look at the intrinsic dynamics of the financial
system. Both in normal times and times of stress, amplification mechanisms are at work,
which exacerbate the impact of any specific shock. These mechanisms act through changes
in leverage, liquidity, and risk aversion. These three factors interact in a complex and
sometimes unpredictable way. For instance, growth in leverage may be fuelled by an
increase in risk appetite. In turn, larger balance sheets of financial intermediaries give rise to
liquidity expansion and growing risk appetite. It is easy to see how these dynamics can
create strong procyclicality in the evolution of asset prices and credit aggregates. It is also
likely that procyclicality is partly created, or accentuated, by our accounting and prudential
regimes.
If financial procyclicality was a short-term, mean-reverting, phenomenon, there would be little
cause for concern. Unfortunately, those same mechanisms allow for the progressive
buildup, over a long period of time, of significant imbalances and deviations in asset prices. At
some stage, the correction becomes unavoidable, and is generally abrupt. That's where the
crisis starts. It is important to note the asymmetry in these developments: imbalances are
slow to build up but very fast to unwind. And the adjustment process can be disorderly and
traumatic.
What role does monetary policy play? In a very basic sense, monetary policy is about
determining the level of short-term interest rates. And it is equally basic to state that the
interest rate is the price of liquidity. Therefore, it may happen that, because inflation is
contained, interest rates are kept at a low level, and liquidity is cheap and easily accessible
for financial intermediaries. In turn, abundant liquidity may increase risk appetite, induce
maturity transformation and lead to growth in leverage. This has been called the "risk-taking
channel" of monetary policy. Ultimately, it creates a link between the level of interest rates
and those of risk premia. And this, of course, means that movements in interest rates have,
all other things being equal, a bigger (and possibly less predictable) impact on the financial
system, credit aggregates and asset prices. A lot of work remains to be done to precisely
quantify that channel and disentangle its effects from those of the more "traditional" credit
channel. Nevertheless it is clear that, in the future, central banks will need to pay greater
attention to the impact of their decisions on the level of risk in the financial system.
Some analysts would go a step further. They would state that that the ultimate responsibility
for the crisis rests with monetary policy. Specifically, according to this view, by keeping
interest rates too low for too long a time, central banks have tolerated - or even condoned -
the build-up in risk and financial imbalances. They "created", so to speak, the credit bubble
which burst in 2007.
Let me state clearly that I don't share this view. It is very apparent that some features of
recent financial innovation - including securitisation - have contributed to excessive risk
taking and increased financial fragility. They explain why the crisis has been so severe. It is
also striking that real - not only nominal - interest rates have stayed at low levels for an
extended period of time. Over the medium run, long term real interest rates are beyond the
control of monetary authorities. They have been driven by the continuous increase in saving
rates which occurred over the last decade, especially in emerging economies. This created a
demand for safe and liquid assets which could not be met by equivalent supply in those
countries. Because of this "asset shortage", saving flows were directed towards industrialized
countries, first of all the USA. At the same time the financial system in those industrialized
countries worked to produce "complex" assets which looked safe and liquid - and were rated
as such. Apparently, supply matched demand. But we know now that this was an illusion.
Complex assets were neither safe nor liquid. The root causes of the crisis, therefore, are
deeply structural. There was a combination of excess savings and asymmetry in financial
developments between countries which was conducive to the formation of bubbles. This
disequilibrium was amplified and compounded by distorted financial innovation. There was
little, or no, role for monetary policy in that process.
Looking to the future, however, it is legitimate to ask how monetary policy can better
contribute to financial stability.
Here, I would make four points
1. Financial instability should first be addressed and dealt with by specific tools. Those
tools come in many forms, such as capital or margin requirements, loan to value
ratios and liquidity constraints. Most are currently available to regulators and
supervisors. They have been used, however, with one objective: ensuring the
robustness and viability of individual institutions. There is now a need, which is
widely recognized, for a change in perspective. Regulation and supervision should
be designed and implemented in a broader, systemic perspective, with the objective
of ensuring the stability and integrity of the financial system as a whole.
2. There is a strong case for giving central banks a pivotal role in this new "macro
financial supervision". They have intimate knowledge of financial systems and
markets. They have an incentive to act since monetary policy works better when
financial institutions are robust and financial markets are stable and efficient. And,
finally, they are well placed to have an integrated view of the economy and its
interaction with the financial sector. Indeed, in many countries, it is envisaged to
make the central bank the "systemic supervisor" or, at least, a central pillar in the
macro-supervisory architecture.
3. A key question, however, is how this new financial stability function would interact
with monetary policy. In theory, things are simple. Central banks would have several
tools available for different objectives. One set of tools (interest rates, international
reserves) would, as now, be used to fulfil the price stability mandate. On the other
hand, macro-prudential tools would support and foster financial stability. In such an
ideal "Tinberghen" world, each instrument would be precisely assigned to a single
objective.
Things may be more complex in the real world because these instruments are not
independent. For instance, changes in capital requirements will affect credit growth
and the transmission channel of monetary policy. Conversely, as I said, levels of or
movements in monetary policy rates may increase or decrease the level of risk
inside the financial system, hence its vulnerability to shocks. Finally, there may be
circumstances in which the objectives of price and financial stability may not be fully
compatible.
4. When instruments overlap and the objectives possibly conflict with each other, the
potential for confusion is real and significant. To avoid any damage to central banks'
credibility and ability to fulfil their mandate, it is essential that a clear and transparent
framework should be in place. It should be made clear, in particular, that, whatever
the new tasks and functions of central banks, price stability should remain the
primary objective of monetary policy. As I said, this may not be a sufficient condition
to ensure financial stability. But it is certainly a necessary one. Looking at recent
events, the credibility of central banks has enormously helped to contain financial
instability and its effects, both directly and indirectly. Directly, because their
credibility has allowed central banks to act forcefully in the knowledge that they
could do so without "disanchoring" inflation expectations. And indirectly, because,
with expectations firmly anchored, the risk of a deflationary spiral has been
considerably reduced. Indeed, even when instant inflation turned negative in many
countries for several months in a row, long-term inflation expectations remained
remarkably stable.
To maintain and preserve this necessary clarity, we are fortunate, in the Eurosystem, in
having an appropriate and efficient framework. The Treaty specifies that the primary
objective of monetary policy should be to achieve price stability; and that other goals can
only be pursued without prejudice to this primary objective. The financial stability function fits
naturally into this hierarchy. It cannot be pursued at the expense of the main objective.
As you know, our approach to monetary policy making is organized around two "pillars", with
one specifically focused on monetary and credit aggregates. We have mainly used this
second pillar to detect potential long-term risks to price stability. It has long been known,
however, that strong growth in credit and money aggregates often signals or accompanies
the emergence of bubble-like asset price movements or incipient financial imbalances. We
can therefore expect to obtain useful insights, in the future, from this second pillar in the
fulfilment of our financial stability mission.
Looking ahead, central banks face significant challenges. They are well equipped, however,
both in terms of expertise and institutional framework, to take on new responsibilities without
in any way compromising their core mandate, their independence or their credibility.
Thank you.
References
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