Alan Bollard: Economic surveillance after the crisis - reflections from a
small full service central bank
Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Enzo
Cassino, Acting Manager, Financial Markets Research, to the Sim Kee Boon Institute
Conference on Financial Economics, Singapore, 5 May 2011.
The speech was delivered by Dr John McDermott, Assistant Governor of the Reserve Bank of New Zealand.
* * *
Introduction
Nearly four years after it began, the Global Financial Crisis continues to impact the changing
behaviour and practices of the world's central banks. In particular, it has affected the way
central banks monitor and analyse economic conditions to formulate monetary and financial
stability policies. We can describe this monitoring and analysis process as "economic
surveillance".
Economic surveillance refers to all the various channels we use to obtain information about
the financial system and the economy to support our decision-making. This monitoring
covers both the global and domestic economies. It also covers a wide spectrum of sources
and methods, including statistics, financial market data, the functioning of the payments and
liquidity infrastructure, external commentaries, and intelligence gathered from contacts in the
financial and business sectors. Collecting, analysing and interpreting this range of data
requires a wide range of skills and expertise in central banks, including macroeconomics,
financial modelling and market liaison. The financial crisis has led to some changes in the
way we do economic surveillance and presents new challenges and opportunities for central
banks. Our perspective on this task at the Reserve Bank of New Zealand comes from being
a small "full service" central bank responsible for both monetary policy setting and
supervising the financial system. Our view is also impacted by New Zealand being a small
open economy. This makes us a price taker in the markets for many tradeable goods and
also exposes us to the impact of economic and financial shocks in larger economies. It also
makes it more difficult for us to set standards of regulatory compliance for our financial sector
in isolation and independently of regulatory developments in larger economies.
Surveillance before the crisis
To better understand the impact of the crisis on central banks' behaviour, it is useful to start
by describing how monetary authorities behaved before the crisis. In the pre-crisis world,
monetary policy setters were often able to inform their decisions using a number of
reasonably reliable empirical correlations between real or financial variables that had been
historically quite stable. While structural change and the breakdown of empirical relationships
still commonly occurred at times, many empirical regularities appeared to be robust enough
to be useful for forecasting and policy making. One example in the New Zealand context, and
in many other countries, was the very tight relationship observed between changes in house
prices and household consumption spending through the early-mid 2000s, which was of
considerable benefit in forecasting domestic demand. There was also a relatively close
correlation between house price growth and growth in credit provided to the household
sector during this period.
Another key feature of policy-making before the crisis was the clear separation between
monetary policy formulation and financial stability policy in full service central banks. In
addition, independence between monetary and fiscal policy decision making was a basic
aspect of central banks' institutional structure in many countries since the 1980s. As part of
this separation, there was usually separate monitoring, with different data sources and
analysis for monetary policy and financial stability policy formulation.
Following the crisis, there have been several significant changes to this structure. First, some
of the historically stable empirical relationships appear to have become weaker during the
crisis compared to the mid 2000s. For example, in New Zealand, house prices fell more
sharply than consumption during the crisis. Likewise, while house prices declined, household
credit continued to grow during 2008-9, albeit at a slower pace.1 It is too early to confirm
econometrically whether these divergences represent permanent structural breaks, or
whether the historical correlations will be quickly re-established. However, these divergences
have at times made it more difficult to interpret household behaviour and to forecast the
economic outlook.
Secondly, the separation of monitoring for monetary and financial stability policies highlighted
a lack of coordination between these various roles for the identification of issues and risks.
For example, in 2006 most financial stability reports still identified national financial systems
as healthy.2 In addition, IMF commentaries identified current account imbalances in many
countries, but did not link them to systemic risks in financial systems.3 The instability in the
global financial crisis and its flow-on effect on the real economy has required much greater
co-ordination and interaction between monetary and financial stability policy setting by
central banks. As a result, the distinction between information flows gathered for monetary
policy and financial stability purposes is now far less distinct. There is now a greater focus on
financial system information and financial market data in monetary policy formulation,
triggered by the breakdown in the forecasting performance of structural and statistical
models. Likewise, more attention is paid to real economy imbalances and sectoral financial
positions, by looking at household and business sector balance sheets, when assessing
financial sector risks. As a result, there is a very active research agenda aiming to
incorporate housing and financial sectors into the dynamic stochastic general equilibrium
models used in many central banks.4 This broader outlook and greater overlap between
monetary and financial stability policy is reflected in the RBNZ's "Cobweb" diagram, which is
used to indicate financial stability risks across several different dimensions.5 In this
framework, financial stability risks could be reflected in the global and domestic economies,
and in financial market conditions. All of these areas are also routinely monitored for
monetary policy formulation.
Following the crisis, concerns about the sustainability of sovereign debt have risen in many
countries, most notably in the peripheral euro zone economies. Consequently, central
bankers have also needed to co-ordinate their policies more closely with fiscal policy
decisions. As a result of these changes, policymakers now need a much wider spectrum of
information to set policy, and central banks are now required to have broader concept of
"economic surveillance" in mind to inform their decisions. The Global Financial Crisis showed
economic surveillance is more important than ever and how we go about that has been
permanently changed. During the rest of the discussion, we will consider how different
aspects of surveillance have been altered.
International financial surveillance
This crisis was initially about financial institutions and markets and we have learned that it is
necessary for central banks and regulators to know more about financial market flows, about
non-traditional financial institutions and instruments, and about the inter-connectedness of
institutions, especially in the presence of instruments that can go viral. Before the crisis, it
was assumed that financial markets were efficient in transmitting changes in policy interest
rates through conventional financial instruments via the traditional banking system and
ultimately into the wider economy. Factors such as securitisation through leveraged
derivatives, often carried out by "shadow" banking institutions, generally attracted little
attention in policy discussions. In addition, financial spreads had been historically stable
enough to accurately reflect the degree of risk on investments.
Yet in the crisis environment of September 2008, financial prices failed to convey the
collapse in confidence and paralysis across the international financial system, as
policymakers and private financial institutions alike grappled to understand the extent of
contagion of exposure to toxic assets through shadow banks and opaque derivative
products. Therefore, central banks had to rely increasingly on alternative sources of
information to guide policy in restabilising the system.
At the Reserve Bank of New Zealand, international financial surveillance has always been
important, with a particular focus on Australia, given the strong links between our four
systemically important banks and their Australian parent institutions. However, despite an
active surveillance programme and the advantage of some distance from northern
hemisphere financial centres, like other institutions, we were wracked by surprises when the
crisis began. Being a full service central bank helped. In September 2008 we were seeing
the lead up and likely consequences of the Lehman's crisis through our bank regulator
reports, our traders' views of funding markets and our domestic markets analysis of overnight
bank trading. But information also came from some less typical sources, including our
Payment and Settlement Systems monitoring of the size of and timing bank payments, which
provided a useful perspective on the degree of nervousness in financial institutions. Our
currency manager was also able to relay to us banks' requests for special deliveries of high
denomination bank notes, which warned us about a growing nervousness among some
members of the public during the heat of the crisis.
Using these new sources has expanded our surveillance toolkit in ways that may be useful in
the future. However, many aspects of international financial surveillance remain unresolved.
Some key issues include:

What will be the future of high risk instruments similar to sub-prime and how will they
be monitored?

What will be the relationship between the traditional and shadow banking sectors
and will there be accurate data transparently available?

What will Basel III compliance require in terms of new surveillance and what new
information will it offer?
In this regard, the shift towards exchange-based trading of derivative products and away
from "over-the-counter" markets may be a welcome move towards increased transparency,
centralised data collection and better monitoring. Electronic trading and data will mean
greater availability of a wide range of financial market data. These data will provide
information about market pricing, volumes, liquidity and investors' appetite for risk. However,
just as important as information gathering is filtering, analysis, and transmission in forms
suitable for economic interpretation and forecasting. Much more work will need to be done on
developing suitable analytical methods to achieve this.
International economic surveillance
What had been thought to be a financial crisis turned into an economic one in late 2008
when fast-growing economies including Asian economies like Singapore (which had been
the subject of a debate on international economic decoupling), were suddenly hit with a
vicious reduction in trade flows, industrial production and growth. Before the crisis, models of
the international transmission of economic shocks were based mainly on trade linkages. The
crisis reminded us that financial market channels can cause contagion in ways that may not
always be obvious.
Although the possibility of contagion through financial channels has long been recognised,
macroeconomic models and analysis have typically relied more heavily on trade linkages as
the key transmission channel of shocks across countries. However, during the crisis, the
explosion in risk premiums and a changed pattern of capital flows transmitted the shock
much more quickly to many economies. As a result, there has been greater focus on
financial market conditions and linkages to understand the impact of international shocks on
real economies.
More recently, the rapid development of commodities as an asset class has meant policy
easing by major central banks can be transmitted through higher commodity prices to the
rest of the world. As easier monetary conditions make funding cheaper and reduce returns
on fixed income investments like government bonds, investors may look for higher returns on
riskier assets, such as commodities. This could potentially cause a (temporary) divergence
between commodity prices and market fundamentals, and has prompted concern about
rising inflationary pressures in many countries during recent months. This has provided new
challenges for understanding transmission channels between economies and for forecasting
inflation.6 At the same time, however, the stronger relationship between commodity markets
and investment flows could potentially allow us to use commodity prices as new indicators of
financial conditions in global markets, although determining the precise nature of the
relationship is still very difficult, given our current level of understanding of the market
linkages.
Looking ahead we need to realise that macroeconomics will remain inextricably linked to
financial market conditions. Consequently our economic surveillance will need to focus on
the macro-financial and macroeconomic interactions to a much greater extent than in the
past. As the crisis demonstrated, sometimes these interactions can be quite complex.
Domestic economic surveillance
In the domestic macroeconomic arena we have learnt other lessons from the crisis. The
crisis challenged traditional economic forecasting, especially model-based forecasts. For
example, the lack of factors such as balance sheet positions, financing or credit constraints
in many simple models of consumption based on a single representative agent has proved
unsatisfactory in the post-crisis environment. As a result, we have had to learn about
householders' new attitudes to consumption and saving as they focus on "deleveraging" and
rebuilding savings. In this new environment there has been much greater attention to
modelling the behaviour of different types of consumers, with differing asset holdings, access
to finance and risk attitudes. This has led to the development of new types of models which
allow for this heterogeneity. An example of this has been the recent focus in the economics
literature on "agent-based" computational modelling.7 It has also led to greater reliance on
alternative data sources such as household balance sheets and more up-to-date indicators
of spending such as that provided by electronic measures of payments. There has also been
greater attention to micro-level survey datasets to obtain information about individuals'
consumption and saving behaviour. Of course, these more detailed data present new
challenges in terms of identifying signals from noisier data. As a result, a range of new
technical tools will be needed to filter and synthesise the data from these new sources.8
A further lesson for future economic surveillance, is the increased prominence that credit
flows and asset prices may play in policy analysis. In contrast to the pre-crisis consensus
view that it is difficult to identify an incipient asset bubble, let alone prick it, most central
banks today are putting a lot of effort into monitoring the housing sector, household balance
sheets and other assets in an attempt to do just that. Before the crisis, monetary policy
setting was often characterised as being represented by some form of "Taylor rule" (or some
inflation-targeting rule), under which policy rates changed only in response to deviations of
inflation from target and to the output gap, with no direct reaction to asset price movements.
As The Economist recently described it, "monetary policy took on... the trappings of a
quasiscientific discipline: the judicious adjustment of the short-term interest rate could keep
inflation low and thus iron out the bumps of the business cycle".9
Financial markets also expressed a high level of confidence in central banks' skills, with
indicators of inflation expectations generally well anchored at central banks' inflation
objectives in most developed economies. This vote of confidence from markets was despite
warnings from central banks that the era of the "Great Moderation" with steady growth, and
low stable inflation may not last indefinitely. For example, Bank of England Governor Mervyn
King, who frequently referred to the Great Moderation as the NICE era (Non-Inflationary
Consistently Expansionary), warned in 2004 "...the combination of low and stable inflation
and continuously falling unemployment must come to an end at some point, and may already
have done so."10 But since the crisis, there has been vigorous academic debate about the
ability of central banks to identify asset price bubbles and their ability to "lean against the
wind" in response.11 However, this requires a great deal of judgement, and better information
from a wide range of sources. Identifying the equilibrium value of asset prices will be the new
challenge for central banks, in the same way that identifying potential output or the NAIRU
was the challenge in earlier decades. Identifying bubbles will require new empirical tools,
such as the regression-based methods being developed by Peter Phillips,12 but as with
assessing disequilibrium in the goods or labour markets, we will still probably need to rely on
information from a wide range of qualitative and quantitative sources to help identify the
presence of a bubble and understand the nature of it. How successful we will be remains an
open question.
The crisis has prompted a revival of interest in money and credit, which in recent decades
central bankers, including ourselves at the RBNZ, have tended to put less weight on in the
monetary policy formulation process. Several factors have contributed to this revival. First,
the impairment of the flow of credit as a result of the financial crisis has led to fears of a
creditless recovery, or at least a recovery held back by less plentiful credit. Second, there
has been a significant change in money flows during the crisis (with depositors favouring the
banks over the non-banks).
Overall, there has also been a recognition that credit growth over the past decade was
excessive and a potential risk to financial stability given the build-up in leverage and rising
asset prices that accompanied it. We are continuing to build our understanding of money and
credit at the RBNZ, and its inter-relationship with both sectoral financial decision making and
potential risks for the banking sector. However, much still needs to be learned about the
relationships, especially the nature of causality and how policy makers can utilise the
relationships to achieve their goals.
Inside regulatory institutions
Within the area of prudential supervision, there has been more focus on the funding markets
and balance sheets of the main banks, including their debt maturity and risk management
policies. This follows the closure of international funding markets in late 2008 and the
increased fragility of markets generally.
At the RBNZ, our focus is particularly on the four systemically important banks in New
Zealand, which are all subsidiaries of Australian owned parent banks. During the Global
Financial Crisis we learned that much of the mandated disclosure of public information from
the banks was available with too long a lag and was too general to be much use in predicting
stress vulnerability. Consequently we have reduced the information we require to be made
public but are requiring more real time private information about funding, bad debt, deposits,
loans etc. These receive very close attention from the regulator.
The need for timely information has required much greater use of financial market data, and
detailed, up-to-the-minute institutional data in assessing the condition of financial institutions.
As a result, there has been greater co-ordination between financial market monitoring and
bank supervisors. This co-operation between supervisors and financial market monitoring is
much easier in a full service central bank without institutional or legal impediments to
information flows.
The Financial Crisis has also inspired a large international push through the Basel
Committee on Bank Supervision and the Financial Stability Board, including Basel III, new
accounting standards and other forms of bank regulation. The broad aim of these changes
has been to lead to a more resilient banking sector. However the new environment also
requires more oversight of banks and more early warning systems. As a result, there has
been a resurgence in interest in early warning indicators of financial sector crises, which first
emerged in response to the Asian Financial Crisis in the late 1990s.13 More recent early
warning techniques, such as Contingent Capital Analysis (CCA),14 which combine
information from institutional balance sheets and financial market data, are being actively
investigated by central banks, bank supervisors and other financial regulators. While the aim
here is a worthy one, we do need to keep our expectations realistic about our ability to
develop robust and reliable early warning indicators.
More generally, within central banks and regulators the crisis means that more attention is
being paid to the financial markets intelligence function. Information is now being swapped
much more readily between central banks and regulators. There is much discussion about
the relative interplay of microfinancial policies, macrofinancial policies and monetary policy.
Relations with Treasuries and Ministers of Finance have also become closer as government
funding has been required for deposit guarantee schemes and as central banks take into
account the more fragile state of sovereign funding markets. At the RBNZ we have also
strengthened our links with regulators in other countries. Well before the crisis we had strong
formal links with our Australian counterparts at the Reserve Bank of Australia and the
Australian Prudential Regulation Authority (APRA). These links have continued to develop in
recent years, with good two-way information flows ensuring that both sides are more alert to
emerging prudential issues. We are also building better ties with our Asian central bank
partners in EMEAP (Executives' Meeting of East Asia Pacific Central Banks).
Conclusion
In a recent article,15 Professor Robert Shiller argued that "the Depression of the 1930s was
blamed on a lack of knowledge...one result was an improvement in our measurement
systems". Shiller notes that the development of national accounts data began as a reaction
to the "information black spots" of the Depression. In the same way, the Global Financial
Crisis has changed the nature of economic monitoring and surveillance required by central
banks. Central banks now require information from a wider range of sources and much
greater interaction between monitoring for monetary and financial stability. But economic
surveillance is not just about capturing developments - it is about reading the risks and
threats to the economy, and the mood of the markets, public and business sector, or, in other
words, gauging the "atmospherics". However, despite these innovations, central bankers will
need to be realistic about their goals. Good surveillance usually will not stop nasty surprises,
but it may buy some lead time and help policymakers to make better sense of surprises
when they happen. As ECB President Trichet noted in a recent interview "central banks need
formidable analytical capacities and skills. You need both state-of-the-art analytical work, as
deep and robust as possible, and you need judgement, based on experience and solid
capacity to synthesise all pertinent analyses. This is true in absolutely all circumstances, and
particularly in times of crisis".16
Ultimately, the aim of central bank policy and its main contribution to increasing social
wellbeing remains, as before the crisis, to maintain macroeconomic stability. However, since the
crisis it has been increasingly acknowledged that consumer price stability is not, on its own, a
sufficient condition for overall macroeconomic stability, as was probably assumed during the
Great Moderation. Traditional policy tools need to be augmented with macro-prudential
instruments targeting financial stability goals. Going forward, the aim is to set monetary and
financial policy instruments to take account of the inter-relationship between the financial
sector and the real economy, which will require a broader framework for economic
surveillance.
But this new environment will present new challenges for central bankers and academics.
New empirical tools will need to be developed to identify the signal from the noise in a vastly
expanded range of data sources, to make the maximum contribution to policy decisions. The
quality of the new data, from both official and un-official sources will vary widely, making it
difficult for policy makers to interpret.17 In addition, understanding the relationship between
traditional monetary policy tools and new macro-prudential tools is a key priority for the
research agenda in order to co-ordinate them effectively. As Professor Shiller argues, "We
should respond just as we did to the Depression, by starting the long process of redefining
our measurements so we can better understand the risk of another financial shock. The past
suggests that this project will take many years to complete. But it will be worth the effort".