Christian Noyer: Challenges of financial innovation for the conduct of
monetary policy
Speech by Mr Christian Noyer, Governor of the Bank of France, at the International Monetary
Fund-Bank of France-Bank of England Conference, Paris, 29 January 2008.
* * *
The current financial turmoil is here to remind us that financial innovation, like technical
innovation, is not a smooth process. The flip side of the recent years of exuberant financial
innovation, what might be seen in retrospect as the golden age of structured finance, comes
now to the fore. However, after two or more decades in which major, multi-faceted financial
innovation has brought about far-reaching changes in the global economic environment, it
would be unfair to forget the benefits economic agents have collectively reaped from tools
that are fundamentally aimed at allowing an easier and broader access to funding and a
more efficient risk allocation.
I am delighted to co-introduce this conference which will tackle some major issues. Rather
than giving an exhaustive overview of the nature and magnitude of financial innovation, I
think it more useful here, as a central banker, to focus on how financial innovation affects
monetary policy decision-making. I know this seminar will dig further into some of these
issues but I selected two main issues, whose scope goes beyond the current events:
- firstly, how the last wave of financial innovation has affected the monetary
transmission process of monetary policy. Implicitly, this also raises the question of
whether and to what extent the current state of the innovation cycle challenges our
understanding of what has changed over the last decade.
- and secondly, how financial innovation challenges the role of monetary analysis in
monetary policymaking.
I shall then conclude by a few words on the difficult task of communicating about monetary
policy in times of financial stress. This is a concern that does not feature formally in our
programme today but lurks in the background and I am sure many of us will have it in mind
throughout the day.
Challenges for our understanding of the MP transmission process
An appropriate knowledge of the mechanisms through which monetary policy affects the
economy is of crucial importance for central banks. Financial innovation affects these
mechanisms both by altering the channels through which monetary policy operates and by
changing the overall impact of monetary policy decisions. But the magnitude of the changes
and the exact impact of financial innovation at a time when other factors such as
globalisation are at work are not well known.
Financial innovation certainly contributes to enhancing wealth effects and thus probably also
to strengthening the interest rate channel. First, financial innovation fosters faster
dissemination of information and its more rapid incorporation into financial market prices.
This is of course particularly true for monetary policy decisions and can therefore increase
the effectiveness of monetary policy via the interest rate channel. Second, financial
innovation contributes to an increased holding of financial assets by lowering transaction
costs and facilitating arbitrage, hedging, funding and investment strategies. Third, financial
innovation often relies on greater leverage, increasing the effect of interest rate moves by the
central bank.
However, in times of combination of financial stress and adverse supply shocks, such as we
are now facing, the risk of destabilising highly-leveraged financial institutions of potential
systemic importance could complicate the task of the monetary policymaker wishing to raise
the policy rate in a timely manner so as to prevent inflationary risks from materialising.
Besides, when conditions are less benign than usual, the transmission process along the
interest rate curve may become non-linear: a striking feature of this summer's events was the
surge in short-term money market spreads in the euro area as well as in the United States
and the United Kingdom. Wider and variable spreads between term funding rates, of which
many bank loans are priced off, and policy rates are worrying in as much as they may reduce
the efficiency of interest rate moves when needed. That said, as this situation stems from a
sharp reduction in term liquidity due to a general fear of withdrawal among providers of
liquidity, e.g. money market funds, its unwinding requires an appropriate provision of central
bank liquidity to the short-term interbank markets but not necessarily a change in the policy
stance.
In contrast to the enhancement of the interest rate channel, at least in normal times, financial
innovation is traditionally expected to have weakened significantly the so-called bank lending
channel. Financial innovation gives firms broader access to securities markets and, as such,
makes them less dependent on bank funding. Similarly, banks may be more able to issue
debt securities and less dependent on the constraint of funding themselves with secured
deposits. Moreover, securitisation by banks was expected to alleviate their liquidity
constraints and thus to further weaken the credit channel. Indeed, previous research has
generally found that banks have used credit market innovations such as loan sales and
securitisation to diversify credit risk exposures and increase lending.
However, recent research has highlighted the potential for bank capital regulation and market
discipline to shape a bank capital channel of monetary transmission. Viewed as an extension
of the standard bank-firms agency problem to the relationship between banks and their
creditors, this capital channel could reinforce the standard financial accelerator mechanism.
This last concern is closely related to the fears of a credit crunch that have been voiced in
the last six months.
Current events show that the tide of financial innovation may recede and the future of the
originate-and-distribute model of banking is a topic of renewed work. What we see now
suggests that an unprecedented reintermediation process is underway, which might imply in
the end a strengthening of the credit channel.
To sum up, financial innovation is on the whole expected to have facilitated the job of
monetary policymakers by accelerating the transmission of monetary impulses to the
economy. However, in times of stress, when financial sophistication may have gone further
and quicker than risk-management practice, the confidence crunch that may ensue paves
the way to non-linear responses of the economy that seriously challenge our common
understanding of how monetary policy impulses are transmitted to the economy.
Challenges for our reliance on monetary indicators
As you know, the Eurosystem's monetary policy strategy assigns an important role to money,
which is based on the premise that monetary developments provide valuable information on
future inflation in the longer run. I would like to ground this with two reasons, a well-known
stylised fact and a conjecture. The stylised fact first: there is ample statistical evidence, in the
euro area and elsewhere, that low frequency movements in money growth are closely
correlated with trend inflation, e.g. for frequencies corresponding to cycles of eight to ten
years. The conjecture, then, brings us to an issue that will be tackled this afternoon, namely
the flattening of the Phillips curve: changing inflation dynamics, which can partly be viewed
as a consequence of a successful anchoring by credible monetary policies, tend to reduce
the sensitivity of inflation to incipient imbalances in the economy. To prevent the risk that
central banks react too late to such imbalances, the monetary policy strategy has to enlarge
its informational basis: monetary indicators, including money but also credit developments,
may then be a good candidate to detect inflationary pressures early on.
However, the theoretically founded long-term relationship between money and inflation may
be blurred in econometric estimates of long run money demand equations, and part of this
could be due to financial innovation. Indeed, as far as the euro area is concerned, recent
Banque de France research has pointed to a structural break around 2001 in the income
velocity of money. In the euro area, the velocity of money seems to have now established
along a new, faster declining trend. This is consistent with the hypothesis of a financial
deepening in the economy, in particular an increase in financial wealth held by households.
Although the precise role of financial innovation in this process is still not fully understood, we
should think of it in terms of both new players and new products:
- In terms of new players, a plausible explanation is the rapid pace of expansion in the
business of the so-called other financial institutions (OFIs). These institutions
include mutual funds as well as financial vehicles that buy and repackage loans that
are securitised by banks. This activity reduces mechanically the growth of MFI loans
to the private sector, while it is mirrored in the strong increase in OFIs' deposits
holdings, hence contributing to M3 growth. How much of this business will resist the
current period of stress remains an open issue, but euro area monetary statistics
have shown no sign of a major decline in these money holdings so far.
- In terms of new products, the recent emergence, at least in France, of high-yield
liquid deposits that are accessible via direct banking on the internet is very likely to
have reduced the interest elasticity of money.
Of course, monetary policy, in the euro area and elsewhere, is not committed to react
mechanically to monetary developments. Nevertheless, to make the best use of the
informational role of money, central banks must be able to filter out the noise that affects
current monetary data, disentangling temporary factors from shifts in trends, supply shocks
from demand shocks, with the latter possibly resulting from certain financial innovations in
the context of globalisation. Fully assessing the effects of financial innovation is thus a real
challenge for monetary analysis. Considering the practical difficulties ahead, this seems to
me to offer a fruitful field for applied research.
Challenges for communication in times of stress: disentangling monetary and
financial stability objectives
Financial market disruptions that may follow times of exuberant financial innovation may
pose significant risks to macroeconomic stability. However, by their very nature and notably
the highly non-linear dynamics they may trigger, such events, as well as the magnitude and
speed of their macroeconomic consequences are uncertain.
To meet its stability objectives in periods of financial instability, the monetary policymaker
must probably put more emphasis on high-frequency financial markets information than he
would otherwise do, because in normal times regular flows of macroeconomic statistics more
or less suffice to form a correct assessment of the outlook.
Special communication efforts are also required. One big challenge for communication in
times of stress is to make the public understand that short-term liquidity management can be
completely separate from the definition of the monetary policy stance with a medium-term
perspective. As I have already pointed out1, a standard result in economic theory (William
Poole's paper from 1970) states that, when demand for central bank money is uncertain,
then it is optimal to stabilise the short-term interest rate, letting money supply adjust
endogenously. That is precisely what has happened in the euro area over the last half year.
Indeed, the bulk of liquidity injections since last August was merely an attempt to align the
timing and maturity of the liquidity supply with a changing demand within the reserve
maintenance periods, in order to stabilize the very short-term interest rate on the interbank
market. Of course, this is always a difficult task, since the increase in the precautionary
demand for liquidity altered the behaviour of banks and rendered less efficient, at least
temporarily, the forecasting models we use to calculate the benchmark need for liquidity.
However, since the Eurosystem acted as a price taker during these liquidity injections, it is
obvious that the interest rates at which these fine-tuning and longer-term operations were
settled had no information content for the monetary policy stance. In a period of increasing
inflationary risks stemming notably from excess demand for commodities and energy
worldwide, it is crucial that our liquidity management is not misinterpreted and does not
contribute to a deterioration of inflation expectations.
Conclusion
To conclude briefly, I shall invite you not to expect too much of monetary policy. Not only, to
quote the Economist2, are we, central bankers, "only human", but also, to put in more
classical words, monetary policy alone cannot do everything with one single tool, the policy
rate.
A lesson that the subprime crisis has taught us is that a lot has still to be done in order to
improve the regulatory framework in which the financial innovation process takes place. I
have no time to develop this further, but I am confident that in particular the implementation
of Basel II will bring significant improvements in the measure and management of risks,
providing a sounder basis for the next wave of financial innovation.