Ernst Welteke: Cross effects between monetary policy and financial markets
Lecture by Mr Ernst Welteke, President of the Deutsche Bundesbank, held at the Belgian Financial
Forum in Brussels, 14 June 2001.
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Ladies and gentleman,
It is a pleasure for me to speak today on "Cross effects between monetary policy and financial
markets" to such a distinguished audience here at the Belgian Financial Forum in Brussels.
The heading looks like an obvious choice for a central banker. The issue of cross effects is of ongoing
interest for policymakers and market participants alike. The introduction of the single currency and
concomitant changes in integrating European financial markets have brought these cross effects even
more into the spotlight. Not least, the BIS has - in its latest annual report - devoted considerable
space to these issues. Furthermore, - I trust you will grant me the quote - "irrational exuberance" in
major stock markets has reinvigorated the debate about financial market prices and their appropriate
role in monetary policy.
I
The European Central Bank (ECB) has been given a clear mandate to keep inflation in check. In
choosing the monetary policy framework for the euro area, the Governing Council has kept this
concept to the fore. Open market operations and the standing facilities play a prominent role. Thus, in
terms of monetary policy in the euro area, the European Central Bank makes ready use of financial
markets to get its policy across into the real economy - just as any other modern central bank does.
Monetary transmission is a complicated and permanently changing process. It is not yet fully
understood and is therefore always a field of fruitful research. Conceptually, the transmission process
can be broken down into two stages. Changes in official interest rates first affect financial markets.
Those markets react fast. In the next stage, a policy move makes itself felt in the broader economy,
thereby exerting the desired influence on consumer prices. That is by no means a straightforward
process. And it takes time. These time lags explain why the Eurosystem adopts a medium-term
perspective when shaping monetary policy.
Those parts of the European financial markets that are crucial for the transmission of the Eurosystem's
monetary policy are already integrated to our satisfaction. The wholesale market for interbank liquidity
in the euro area is now a single European money market.
Any change in official interest rates first affects the money market. Then rates along the entire yield
curve adapt. In addition, equities are repriced after a policy move due to two factors:
 First, a change in the discount factor
 and, second, revised earnings expectations stemming from changes in firms' financing costs
and prospective sales.
The adjustments in financial markets then translate into the broader economy via cost, income and
wealth effects. The speed and the relative weight of the transmission channels identified depend on
the structural conditions in the economy. Habits in finance and investment among businesses and
private households are important. As is overall flexibility of the economy. As the euro area as a whole
is a relatively closed economy - about 17 % of GDP is generated by exports -, the exchange rate
channel is of minor importance for monetary transmission.
II
Financial markets are dynamic and innovative; structural change is everyday business. Recently, the
introduction of the single currency in Europe has been seen to coincide with changes in investment
and financing habits. As central bankers, we in the European System of Central Banks monitor these
developments closely for their potential impact on monetary transmission.
The relative importance of banking systems vis-à-vis financial markets as a source of corporate
finance still varies in the euro area economies. So, consequently, does monetary transmission,
although not to a degree that would hamper the single monetary policy.
On the contrary, we see euro-area-wide disintermediation generating further convergence towards a
truly European monetary transmission mechanism. Companies are now tapping capital markets more
intensively. In other words, firms have begun to rely less on banks for corporate finance.
Capital markets are gaining importance as a means of obtaining corporate finance, as opposed to
bank credit. The amount outstanding of (domestic currency denominated) corporate bonds by
euro-area residents rose one-fifth last year; for short-term paper the figure is even two-fifths. Banks
are increasingly adapting to this trend. More and more they are providing corporate clients with
access to capital markets. The banks themselves profit from securitisation. It helps them to make more
efficient use of their capital and to generate the desired fee income. The role of banks in monetary
transmission is therefore changing.
Faced with competition from firms directly tapping capital markets, banks are now setting their interest
rates for lending more closely in line with prevailing market rates. Shrinking interest rate margins are
the result. Any change in official interest rates will therefore translate faster into adjusted spending
plans of the economic agents in the non-financial sector. Thus, there is an acceleration of monetary
policy transmission.
However, there is also a factor that potentially works towards slower transmission. Those countries in
the euro area with a history of higher inflation rates tend to rely more heavily on short-term lending and
on variable rates. In those countries, monetary policy stimulus affects the non-financial sector
considerably faster. As these countries are now experiencing a higher degree of price stability, market
participants will feel secure about shifting towards longer-term contracts and fixed rates. This will result
in monetary transmission being slowed down.
The ultimate effect of those two opposite trends is still uncertain. I tend to lean towards expecting
monetary transmission to accelerate. Capital markets are dynamic; they are innovative and they
permanently create new instruments that increase flexibility in terms of finance. In flexible financial
markets, however, monetary impulses should be passed through at a faster rather than a slower pace.
Disintermediation in corporate finance coincides with the institutionalisation of savings. Private
households shift funds from bank accounts into pension funds and mutual fund shares. Share
ownership - direct and indirect - is on the increase. As the value of equities tends to be more volatile
than that of other financial assets, changes in financial wealth may impinge on consumption decisions
with greater frequency. However, the wealth effect for the euro area is considered to be rather small.
In Germany we estimate the marginal propensity to consume out of financial wealth to be about 1%.
That is, an increase in financial wealth of 100 euros would spark additional demand of 1 euro.
Given this change in investor attitude, should central banks actively target asset prices? The potential
influence of asset prices on the economy and concerns about financial market stability lie behind such
considerations. However, objections against targeting asset prices by far outweigh any potential
benefits.
 First, there is the issue of knowing the appropriate asset price level. There is no way for a
central bank to know that better than the market.
 Second, stabilising consumer prices and stabilising asset prices may call for diverging policy
paths. Central banks may well find themselves faced with the dilemma of having to decide to
which goal to give priority.
 Third, targeting asset prices creates "moral hazard".
Therefore, it would be unwise for monetary policy to even try to target asset prices.
Nonetheless, monetary policy contributes to a sound development of asset prices. The ECB's
monetary policy strategy emphasises money supply in the first pillar of its strategy. An adequate
money supply - that is, money supply which is in line with potential output growth - is a necessary
condition for preventing the emergence of speculative bubbles. In addition, a low inflation rate of itself
fosters long-term investment and helps to stabilise asset prices.
III
Financial markets naturally play a part in shaping monetary policy. In the second pillar of the ECB's
monetary policy strategy, a broad set of indicators for the medium-term outlook for price stability and
for economic growth are observed.
It is in three respects that financial market prices are particularly valuable for monetary policymakers.
First, they provide us early on with leading indicators as to market expectations about macroeconomic
developments. For example, changes in the term structure of interest rates relate to future economic
growth. A steepening of the yield curve typically forecasts stronger economic growth.
Such an increase in the term spread would, however, not convey unambiguous information. Higher
long-term rates could also reflect expectations of higher future inflation or a change in risk premia.
Additional information from asset and money markets may therefore be necessary to interpret market
expectations in this regard.
Second, measuring the expected volatility of future financial market prices shows us the degree of
uncertainty attached to expectations. Implied volatility derived from options on long-term bonds is an
example. However, there is no consensus on how to read volatility exactly. We do not know for sure
which particular component of the long-term bond yield - the real interest rate, expected inflation or
risk premia - determines volatility. Thus, the informational value of these measurements is limited.
Third, financial market prices give us insights into the expectations of market participants with regard
to monetary policy action. EURIBOR rates are especially helpful in this respect. They allow us to
construct a yield curve for the money market. Additional information can be derived from three-month
futures. Thus, we havea pretty good picture of anticipations prevailing in the market with regard to
monetary policy moves. All in all, financial markets provide central bankers with helpful information.
The use of market information is, however, subject to some caveats. Financial market prices are open
to a whole host of influences - including distortions by institutional features, irrational behaviour and
herding behaviour, for instance.
Market expectations can therefore never be a substitute for the central bank's own independent
assessment of the economic situation and of future developments. We use financial market prices to
complement and cross-check our own economic assessments.
While we try to figure out what the markets think, the markets are busy trying to figure out what we
think. We watch them - and they watch us. If the central bank always met market expectations,
destabilising circularity could occur. Monetary policy decisions have to be based mainly on
fundamental economic data.
Reducing uncertainty as far as possible is clearly one of the aims of the Eurosystem. The Eurosystem
therefore communicates extensively with the markets. Which is why, for example, we decided to
publish our staff economic projections.
The increased role of communication and transparency reflects a change in the relationship between
monetary policy and financial markets. Monetary policy today makes use of financial markets a lot
more actively and openly than it did in earlier times.
IV
Ladies and gentlemen, having presented you some general remarks on monetary policy let me now
get down to the specifics of the current situation of monetary policy in the euro area.
The Governing Council of the ECB is, at present, taking its decisions in a climate of considerable
global economic uncertainty. In a situation like this it is particularly important to pursue a clear and
consistent rule-based policy. The monetary policy strategy developed by the Governing Council of the
ECB meets precisely that need. The public is right to expect the Governing Council of the ECB to stick
to its strategy and to present its own interest rate assessments.
Let's start with the money supply. It plays a prominent role as the "first pillar" of monetary policy, the
underlying perception being that inflation is, in the long term, essentially a monetary phenomenon. The
money supply in the euro area increased by 4.6 % from February to April, compared with the same
months one year previously. This increase is roughly in line with the 41⁄2 % reference value - in other
words, the level which is in keeping with price stability and trend economic growth.
Monetary growth has been tending to slow down since the spring of 2000. Because of some statistical
distortions, even more, in fact, than was initially expected. There are two main causes of these
distortions.
First, non-euro-area residents have considerable holdings of money market fund units. However, the
money supply concept relates to euro-area residents, mainly because the amount of cash residents
hold in the euro area is relevant in terms of expenditure. The latest figures from the ECB currently put
this distortion at 0.5 percentage point. The money growth rate figure I mentioned a moment ago has
already been adjusted.
Second, other short-term money market instruments, which are likewise held by non-euro-area
residents, also exaggerate the extent of monetary growth. Precise statistical data for this category of
instrument are still being collected by the ECB and will be published at the end of the year.
If all these facets are taken into account, monetary growth is well below the quoted figure and cannot
therefore be described as expansionary. From a medium-term perspective, there is no indication of
price risks.
In connection with the second pillar of the ECB's strategy, the data point to decreasing pressure on
prices. This would appear to be at odds with the current unsatisfactory price trend; euro-area inflation
was 3.0 % in April. However, this was largely due to special factors, the effect of which is likely to
subside in the coming months. Basically, these factors are the higher prices of crude oil and, as a
result, of fuel, together with the effect on prices produced by the crisis in the food sector.
Wage negotiators have been right to assume that the inflationary effects are temporary, as there have
been no second-round effects so far. In stating that, I refer to the most recent wage settlement in the
German banking sector. Negotiators have agreed on a wage increase of slightly less than 3 %. Now
that economic risks can no longer be ignored, it is extremely important to negotiate moderate wage
settlements.
The rise in the cost of energy is currently driving overall prices up, while at the same time putting the
brake on the economy. The outlook and forecasts in the euro area for this year have had to be
adjusted. Industrial output and capacity utilisation have already declined somewhat. Surveys show
that industrial sentiment, in particular, has become far more gloomy. Viewed from this angle, this could
also entail limited price risks for the period ahead.
While the economic outlook is running counter to inflationary pressures, the euro exchange rate must
be watched very closely for possible risks to price stability. Let me again stress our utmost interest in a
strong currency. The external value of the euro is an important indicator in the second pillar of the
ECB's monetary policy strategy.
Financial markets share our medium-term expectations for price developments. Capital market rates
are still at a low level - a reflection of the expectation that possible inflationary pressure will be under
control over the longer term. Interest rates, at least, are not an impediment to an economic upturn.
After weighing up all the factors and taking account of the medium-term orientation of monetary policy,
I have reached the conclusion that the current monetary policy stance is appropriate at the present
juncture.
V
Ladies and gentlemen,
Let me now try to summarise the main features of the interdependence between monetary policy and
financial markets:
 Central banks need well-functioning financial markets. They work as the crucial link between
monetary policy-setting and its ultimate goal, price stability. Disintermediation further
heightens the importance of financial markets in the transmission mechanism of monetary
policy. Therefore, monetary policymakers need to analyse structural changes in financial
markets thoroughly.
 Central banks acquire information about the expectations of financial market participants by
monitoring financial market prices. They cross-check their own forecasts against these data.
 Finally, in order to avoid misperceptions of the policy stance in the markets, there has to be a
consistent communication policy.
With capital markets integrating and habits in the fields of finance and investment changing, as central
bankers in the euro area we have now entered a period of heightened uncertainty. The ECB has opted
for a monetary policy strategy that anchors the markets' expectations of future price stability. The
twopillar approach to assessing the outlook for prices is appropriate in times of structural change, as it is
not only credible, but also highly flexible. Financial markets therefore have a reliable partner in the
Eurosystem - one that is well equipped to meet current and future challenges.