Peter Praet: Financial cycles and monetary policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, in
the context of a panel on "International Monetary Policy", Beijing, 31 August 2016.
* * *
I would like to thank Fédéric Holm-Hadulla for his contributions to this speech.
Financial asset prices and credit creation in the global economy are characterised by
pronounced and recurrent ebbs and flows - a pattern we have come to refer to as the
financial cycle.1
In my remarks today, I will discuss the role of monetary policy and other policy domains in
steering this cycle.
Financial cycles derive from two closely related factors. The first is a natural tendency
towards occasional bouts of "irrational exuberance" - for instance in response to promising
scientific discoveries or technological advances - that lead investors to radically upgrade
their future income expectations. The second factor is the capacity of financial intermediaries
to transfer this expected increase in future income into the present through credit creation,
thus establishing a financial upswing that constitutes the real-world counterpart to the
upswing in economic optimism.
But when some of the expected benefits that investors ascribed to the new discoveries or
technologies do not come to pass, this process goes in reverse. A period of collective
retrenchment ensues and the financial cycle enters into a downswing.
Such cycles, while certainly painful for individual investors, are not necessarily harmful for
the economy as a whole: productivity growth and technological progress rely on investments
in promising but risky ventures, which are driven by entrepreneurial zeal and often financed
by credit. As such, financial exuberance often acts as a by-product of economic progress.2
But this is not always the case: some asset price bubbles, for example in housing markets,
may go along with a misallocation of resources and lower productivity growth. And in all
instances the flip-side of financial exuberance is an increased risk of regular, and potentially
violent, reversals3 - a pattern we have seen repeatedly in history, going back at least to the
Dutch Tulip Mania in 1636.4
Hence, for policymakers concerned with financial stability, financial cycles present two
related questions. First, how should they identify when it is justified to intervene in the cycle?
And second, if intervention is justified, which policy domain should act?
Criteria for policy intervention
A key criterion to identify the case for pre-emptive policy intervention is the presence of
systemic negative externalities. In the most general terms, such externalities arise whenever
the costs of failed endeavours are not only borne by those who stood to benefit from the
initial risk-taking activity, but also spill over to the wider financial sector and economy.
Though they have macroeconomic consequences, these externalities typically originate from
misaligned incentives at a microeconomic level - for instance pervasive moral hazard that
induces agents into excessive risk-taking in their contractual relations. Not all such market
failures are relevant for financial stability, but insofar as they aggregate up to a systemic level
they may become relevant.
There is one specific embodiment of such externalities that has proven in the past to be
particularly deleterious. This relates to the tendency for financial intermediaries to adopt
unstable and run-prone funding patterns - a tendency that was particularly pronounced in the
run-up to the last financial crisis when financial intermediaries, including depository but also
non-depository institutions that operate in non-bank forms of intermediation such as the repo
market, increasingly funded their exposures in the wholesale market.
These intermediaries had an incentive to reap liquidity premia that other investors were
willing to pay for short-term assets that could be readily converted into currency and thus to
finance long-term asset exposures with very short-term funding. This pattern of funding,
however, exposes the system to fire-sale damage in case of a run on such short-term
funding instruments. The externality, in turn, resides in the failure of financial intermediaries
to internalise this fire sale damage, which affects the broader economy and not just the
institutions engaging in such funding patterns.
Accordingly, when assessing the implications of swings in the financial cycle, the key issue
for policymakers is not so much to diagnose irrational exuberance as to identify its funding
patterns - namely, whether rising asset prices are being fuelled by excessive leverage and
maturity transformation which will have systemic consequences when the cycle turns.
When such risks to financial stability are identified, however, the second question becomes
salient: which policy domain should act to quell financial exuberance?
Responsibilities for managing the financial cycle
To my mind the first line of defence must be a strong institutional and legal framework that
directly targets the sources of market failure.
Such a framework would include sound financial regulation and macroprudential policy tools
that limit excessive risk-taking in the boom and make banks more resilient to losses in the
bust, for instance through higher, and potentially counter-cyclical, capital requirements,
leverage limits and stable funding ratios. It would include strong resolution frameworks for
banks and insolvency regimes to accelerate deleveraging and balance sheets repair after a
crash. And it would include effective regulatory frameworks in other non-financial policy
domains - especially in the housing market which has often acted as a key amplifier of
financial boom and bust cycles. Housing bubbles, for example, can be fuelled by rigid zoning
and land use regulations which cap housing supply, coupled with permissive underwriting
standards for mortgages which stoke housing demand.5
In other words, ensuring financial stability requires the commitment of many policy actors -
supervisors, regulators, governments - all of whom have to act in their own areas of
responsibility.
But it is clear to me that central banks also have a role to play. Monetary policy inevitably
interacts with the financial cycle - a view that has been borne out by a large and growing
body of empirical evidence.6 This interaction derives from the powerful impact that monetary
policy can exert on risk-taking incentives, especially of financial intermediaries. Insofar as
financial and business cycles are in sync, this may either magnify or moderate the ups and
downs of financial markets.7 And the interactions extend well-beyond country borders, since
monetary policy affects yields and asset prices both in its domestic economy and, through
portfolio balance effects, in foreign economies. Through these channels, monetary policy in
large advanced economies can have a significant impact on financial stability elsewhere,
especially in emerging markets.8
Importantly, this interaction does not weaken the case for a strong first line of defence. The
alternative would be to rely on monetary policy to compensate for failures in other policy
domains. But this would overburden monetary policy and lead to sub-optimal outcomes with
regard to both - financial stability and broader macroeconomic stabilisation objectives; and
this holds not only at the domestic level but also internationally. In fact, a large body of
empirical work in recent years has shown that fiscal, macro-prudential, regulatory and
supervisory policies can help mitigate the adverse effects of foreign monetary policy on
domestic financial stability.9
Meanwhile, the experience with the taper tantrum in 2013 showed how differences in policy
frameworks shaped how severely different economies were affected by financial spillovers.10
Still, even with an improved first line of defence, the question how central banks should
incorporate financial stability in their reaction functions would remain relevant.11
One prominent view in the debate surrounding this issue is that, since price stability typically
focuses on a shorter time horizon than is appropriate for interpreting financial cycles, there is
6
See Rey, H., "Dilemma not Trilemma: The global Financial Cycle and Monetary Policy Independence", NBER
Working Paper, No. 21162, May 2015; Adrian, T., A. Estrella and H. S. Shin, "Monetary Cycles, Financial
Cycles, and the Business Cycle", Federal Reserve Bank of New York Staff Reports, no. 421, January 2010;
Juselius, M., C. Borio, P. Disyatat and M. Drehmann "Monetary policy, the financial cycle and ultra-low interest
rates", BIS Working Papers, No. 569, July 2016; Schularick, M. and A. M. Taylor, "Credit Booms Gone Bust:
Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008.", American Economic Review, Volume
102, No. 2, April 2012, pp.1029-61; Bruno, V. and H. S. Shin, "Capital flows and the risk-taking channel of
monetary policy", Journal of Monetary Economics, Volume 71, 2015, pp. 119-132; Hiebert, P., "Characterising
the financial cycle: A multivariate and time-varying approach", ECB-IMF 1st annual macroprudential policy and
research conference, 26 April 2016.
7
See Black, l. K. and R. J. Rosen, "Monetary Policy, Loan Maturity, and Credit Availability", International
Journal of Central Banking, Volume 12, No. 1, March 2016, pp. 199-230; Borio, C., L. Gambacorta and
B. Hofmann, "The influence of monetary policy on bank profitability", BIS Working Papers, No. 514, October
2015; De Groot, O., "The Risk Channel of Monetary Policy", International Journal of Central Banking, Volume
10, No. 2, June 2014, pp. 115-159.
8
See for example Koepke, R., "Determinants of of Emerging Market Crises: The Role of U.S. Monetary Policy",
IIF Working Paper.
9
See, for example, Blanchard et al. (2015), "Can Foreign Exchange Intervention Stem Exchange Rate
Pressures from Global Capital Flow Shocks?", NBER Working Papers, no. 21427; Forbes et al. (2015),
"Capital flow management measures: What are they good for?," Journal of International Economics,
vol. 96(S1), pp. S76-S97; Afanasieff et al. (2015), "Implementing loan-to-value ratios: the case of auto loans in
Brazil (2010-11)," Central Bank of Brazil Working Paper Series, no. 380; Wong et al. (2015), "Using
macroprudential tools to address systemic risks in the property sector in Singapore", SEACEN Financial Stability
Journal, vol 4, pp. 27-41; Ostry et al. (2012), "Tools for managing financial-stability risks from capital inflows",
Journal of International Economics, vol. 88(2), pp. 407-421; Habermeier et al. (2011), "The effectiveness of
capital controls and prudential policies in managing large inflows", IMF Staff Discussion Note, SDN/11/14 ;Lim
et al. (2011), "Macro-prudential policy: What instruments and how to use them? Lessons from country
experiences", IMF Working Paper WP/11/238.
10
See Eichengreen and Gupta (2013), "Fed tapering and emerging markets", VoxEU.org.
11
For a review see Smets, F., "Financial Stability and Monetary Policy: How Closely Interlinked?", International
Journal of Central Banking, June 2014.
an inherent conflict between those different objectives. Only by opting for a "financial
stability-oriented monetary policy", the thinking goes, can such tensions be resolved - which
would, in turn, support the achievement of both goals over a longer-term horizon.12
I would agree that such conflicts between objectives are possible. As an example, consider a
"rigid" inflation-targeting central bank that interprets any deviation from its price stability
target as an immediate call to action, independently of the nature and persistence of the
underlying shock. And suppose this central bank is faced with a sequence of positive
costpush shocks that curb domestic price pressures for a prolonged period of time - for instance
due to the gradual penetration of new technologies that boost productivity, or the emergence
of new and cheaper sources of global production. The accelerating diffusion of the internet
and related digital technologies in recent decades may provide an example of the former,
while the emergence of China as a global manufacturing hub exemplifies the latter.13
If the central bank is too narrowly focused on achieving a specific inflation target over a
specific period of time, it will aim to reinvigorate price dynamics by running a looser monetary
policy than would otherwise have been the case. But with that response, it may reinforce the
exuberance that is already mushrooming with rising economic optimism. In these conditions,
an overly loose monetary policy would fuel the financial cycle, which in turn may encourage a
build-up of imbalances in the financial industry characterised by excessive dependence on
unstable short-term funding, high levels of leverage, weak underwriting standards, and poor
risk measurement and risk management.14
This is more than just a hypothetical scenario: empirical evidence suggests that it has been
the rule - rather than an exception - for stock market booms to coincide with atypically low
inflation. The run-up to the dotcom bubble in the late 1990s, which dovetailed with the
positive cost-push shocks described above, provides one particularly vivid example of this
pattern.15
In such cases, a misguided monetary policy reaction amplifies the impact of the initial supply
shock and turns it into a demand shock with long run implications for price stability when the
cycle eventually turns.
The flexibility of existing monetary policy frameworks
But these insights do not automatically lead to the conclusion that central banks must adjust
their monetary policy frameworks.
This is because the representation of monetary policy as focusing on a short policy horizon
and with little regard for broader financial cycles does not do justice to the strategies that
many central banks follow today, and certainly not to the strategy of the ECB. In fact, our
monetary policy framework is more flexible than the aforementioned scenario of a rigid
inflation-targeter suggests. Our strategy includes important safeguards to prevent an overly
narrow and zealous interpretation of price stability from becoming a source of financial
instability. Indeed, it incorporated a "leaning-against-the-wind" approach even when the
academic consensus pointed in a different direction.16
There are two elements to our monetary policy strategy that institutionalise this approach.
The first is the flexible and shock-dependent medium-term horizon, which ensures that
supply shocks do not automatically elicit a monetary policy response unless there is a danger
that they become embedded in inflation expectations. The second is the monetary pillar,
which alerts the Governing Council when trends in credit markets may presage emerging
risks to financial stability - even when inflation is quiescent.17
Together, these elements coalesce into a leaning-against-the-wind orientation which helps
us evaluate the impact of economic shocks over sufficiently long horizons and account for
their implications for lower-frequency asset price cycles. Monetary analysis, in turn, informs
us about the funding patterns that underlie these asset price cycles and alerts us, for
instance, to situations in which a generalised upswing in asset prices is fuelled by excess
creation of liquidity and over-extension of credit. Detecting and understanding this link helps
the ECB form an opinion on whether observed financial market developments are morphing
into an unsustainable bubble.18
As a consequence, if price and volume indicators of prevailing financing conditions were
inappropriate to guarantee sustained macroeconomic and price stability, the ECB would
change its policy stance whether or not current or projected inflation already signalled those
risks.
This approach guided our monetary policy already prior to the crisis. In fact, buoyant money
and credit growth were key factors that motivated the policy tightening cycle that began in
2005. Today our leaning-against-the-wind orientation clearly backs our prevailing
accommodative monetary policy stance. The liquidity and demand support provided by
monetary policy has countered the downturn and aided the reversal of the financial cycle,
thus preventing it from morphing into a chronic credit crunch with persistent dangers for price
stability.
Taken together, the ECB's two pillar strategy thus features key elements that facilitate a
leaning-against-the-wind approach.
Challenges and lessons from the crisis
Nonetheless, the global financial crisis - which has hit also the euro area with full force and
was followed by an exceptionally prolonged economic slump - illustrates that this approach
was not sufficient to pre-empt major imbalances. Accordingly, we need to ask ourselves how
we can further strengthen the resilience of the macroeconomic policy framework.
Also here, the "first line of defence" lies in the broader institutional and legal framework. In
fact, the ease with which a central bank can operationalise a leaning-against-the-wind
strategy is inevitably affected by the broader policy framework. In a weak macroeconomic
framework, the central bank will not just have to "lean against the wind" - it will be forced to
"lean against a storm" that will inevitably put strains on - and ultimately overburden - any
type of monetary policy strategy. The euro area crisis, characterised by mutually reinforcing
vulnerabilities in the sovereign space and the banking system - both of which were
precipitated by a weak institutional framework - provides a vivid example of such scenario.
By contrast, a more effective first line of defence will support a leaning-against-the-wind
approach, both: because other policy domains reinforce the thrust of monetary policy, and
because any trade-offs that result are likely to be more favourable. In this context, it may be
noted, for instance, that the notion that accommodative monetary policy sustains "zombie
banks" is rarely heard in the US context, in view of the stronger institutions for resolving
banks and resolving non-performing loans.
Overall, we are now seeing progress being made in the euro area and internationally that will
improve the first line of defence going forward. The Basel III agenda has tackled several of
the weaknesses of pre-crisis banking landscape, while countries have made important
strides in terms of operationalising new macro-prudential instruments. Meanwhile, the euro
area has moved ahead in its efforts to establish a banking union and the tools available to
policymakers to clean up after crises are being progressively strengthened, although
difficulties persist in reducing legacy non-performing loans on bank balance sheets. There is
thus still work to be done, but the institutional environment has become more conducive to a
leaning-against-the-win strategy than before the crisis. The early indications already suggest
it has increased the resilience of the financial sector to shocks.
Despite this improved first line of defence, implementing a leaning-against-the-wind
approach will remain challenging though. It will require us to identify and model latent
financial stability risks, as well as the potential future cost of letting such risks fester at a
systemic level. As noted in the past, this task was hampered by crucial knowledge gaps as
the common macroeconometric frameworks were not well designed to capture the
interactions between financial and real variables.19
These knowledge gaps, in turn, led the economics profession to underestimate the potential
cost that systemic financial crises may impose on broader macroeconomic prospects.
Also on this front, we have seen some progress in economic research, especially in
integrating real-financial feedback loops into the standard toolkit for macroeconomic analysis,
which has enhanced the operational feasibility of leaning-against-the-wind. This toolkit may
help distinguish more clearly between benign and malign episodes of financial exuberance
and divine better the appropriate monetary policy response. At the same time, the
experience of the financial crisis and ensuing recession has shown that the costs generated
by malign episodes are more substantial than we thought.
Our challenge going forward is therefore, in my view, to build on our improved monetary
policy and regulatory frameworks and focus on their steadfast implementation, rather than to
establish a lasting trade-off between financial stability and price stability in central banks'
objective functions.
Such a trade-off would not solve the implementation challenges of leaning-against-the-wind,
while it may rekindle the deeper policy challenges that central banks encountered in the past
when they sacrificed price stability for other policy concerns. Indeed, the lesson from the
1970s is that, if a central bank downgrades its inflation mandate to a point where inflation
expectations become seriously de-anchored, sooner or later it will be called upon to assume
full responsibility for bringing inflation back under control. At that point, inflation stabilisation
and a re-anchoring of expectations may have to come at a very high cost in terms of output
losses and financial stability risks.
Conclusion
Let me summarise.
Monetary policy has a powerful impact on the incentive structure of market participants and,
via this channel, on the cycle in asset prices and monetary aggregates. Since this cycle is
propagated via global financial markets, domestic monetary policy inevitably entails
international spillovers.
Monetary policy geared towards domestic price stability generally supports financial stability.
In the current situation, for instance, the ECB's continued monetary accommodation not only
supports a return of inflation to levels closer to 2% but also aids balance sheet repair in the
euro area and mitigates the risk of adverse spillovers to the financial systems in other
economies.
An overly rigid interpretation of the price stability objective, however, may at times give rise to
conflicts between price stability and financial stability. And a failure of major central banks to
appropriately account for this risk in their monetary policy strategies can create new, or
reinforce existing, financial vulnerabilities at global level.
Against this background, the ECB follows a flexible medium-term horizon and, as part of its
two-pillar strategy, closely monitors the dynamics in money and credit which may act as
signals for the build-up of financial imbalances. But in confronting such imbalances, other
policy domains - including on the macroprudential and regulatory side - have to play their
part to ensure stability in a context of sound macroeconomic performance.