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10. 9. 2024 I Frait Jan Zeisel Viktor

A "new normal", or a continued "Great
Macrofinancial Volatility"?

Jan Frait, CNB Deputy Governor and Viktor Zeisel, advisor to the Bank Board of the Czech
National Bank

Lecture for the International Conference on Finance and Economics (ICFE 2024)

Faculty of Management and Economics, Tomas Bata University

Zlin, 10 September 2024

I'd like to thank the conference organisers for inviting me to a part of our country where I
spent a good part of my life - my childhood and early youth. My identity documents at the
time stated that I lived in the Gottwaldov district, but at home we always said "we're going to
Zlin'". I'm glad of this opportunity to return.

I was first appointed to the Bank Board of the Czech National Bank at the beginning of this
century. The deep macroeconomic and financial crisis was still being felt in the Czech
Republic, and especially in its banking sector. By then, however, the CNB was one of the
central banks using the relatively new system of inflation targeting. The development of the
associated analytical and forecasting toolkit to support monetary policy decision-making was
well underway. Like the Anglo-Saxon central banks whose example we followed, we drew on
the theoretical and empirical approaches of New Keynesian Macroeconomics, which had
started to gain dominance in academia and central banks through DSGE models at the start
of the century. As is often the case, these approaches were a product of their time, not the
other way around. It was an era characterised by optimistic expectations about long-term
economic developments. In response to the favourable trends of the 1990s,
macroeconomists believed in a "Great Moderation" (Great Moderation (external link)) and
predicted that we would see decades of low and stable inflation amid brisk economic growth.
This optimism was further fuelled by a stabilisation of public budgets and a significant
reduction in public debt in advanced economies.

The belief in an ongoing and continued "Great Moderation" was reflected very strongly in the
notion of optimal monetary policy, which would enable central banks to maintain
macroeconomic stability through relatively subtle measures, with no significant cyclical
fluctuations. It was assumed that it would be enough for monetary policy rates to move only
slightly around the nominal neutral rate (external link) (the sum of the real natural rate and
e.. target rate). There was also a belief that monetary policy tools would be targeted
e'2Mively at macroeconomic objectives. Financial stability would be the sole responsibility

of financial market regulatory and supervisory authorities. To be fair, even before the Global
Financial Crisis (GFC) of 2007-2008, many economists fear d that the "Great Moderation"
was being driven more by "good luck" than by the "smart policies" that central bank
researchers (external link) had put their faith in.

We are now coming to the end of the first quarter of the 21S century. The contrast between
what we thought lay ahead at the start of the century and what actually transpired is stark.
Instead of a continued "Great Moderation", we experienced large cyclical fluctuations, waves
of deflation and inflation, and turbulent cycles in credit growth and asset prices. Private and
public sector debt soared. I call this period the "Great Macrofinancial Volatility'. In some
recent presentations, I have explored whether what we saw was merely the result of bad
luck and unpredictable shocks, or whether inappropriate theories and wrong economic
policies also played a significant role. Today, however, I will focus more on macroeconomic
and financial variables from a historical perspective.

Are we approaching - or already in - a "new normal"?
y

Economists - and indeed the general public - began last year to expect the economy to
return to the more favourable conditions of the 2000s and 2010s as the inflationary shock of
2021 and 2022 faded. Specifically, they expected that as inflation declined, interest rates
would also drop significantly, access to credit would improve, consumption and investment
would increase and buoyant growth would return amid high employment. Looking at the past
two years, however, it is clear that the dream "ideal" has far from returned. Most market
participants are hoping that what we are experiencing is not a "new normal". The
macrofinancial situation remains highly unsettled.

The considerable uncertainty is evident in interest rates, represented here by typically
relatively stable five-year interest rate swap rates (Chart 1). After having gone up in response
to the inflation shock, they have been fluctuating within a fairly wide band - even in
advanced economies - as market participants have reassessed the future actions of central
banks. The uncertainty surrounding the real economy is also clearly visible in the behaviour
of traditional energy commodity prices (Chart 2). The recent relatively low oil price can be
readily interpreted as a lack of confidence in a global economic recovery. Few people now
remember that the rapid rise in oil prices seen during the pre-GFC boom years was blamed
on financial speculators. Serious thought was given to finding ways to curb such speculation.
This was a fairly typical example of the dead ends we repeatedly find ourselves in when
reacting to economic shocks. At such times, simple explanations are often sought, and even
those that are clearly flawed but headline-grabbing are readily accepted.

The high level of uncertainty in recent years is perhaps best seen in exchange rates (Chart
3). In recent years, the US dollar has appreciated and at times depreciated by tens of per
cent year on year against other currencies. If currencies with fixed exchange rates came
under such depreciation pressure, there would be talk of a currency crisis and there would

probably be significant political repercussions. In the case of floating rates, it is merely
regarded as increased volatility - an unpleasant but common enough occurrence. This is
one of the few, yet very big, advantages of floating exchange rates.

Residential property prices tell a specific story (Chart 4). In advanced countries, largely due
to developments in inflation-targeting countries, prices rose rapidly until 2022 and then fell
back somewhat in response to monetary policy tightening. In some countries, the reversal in
prices was more pronounced, while in others, it hardly occurred at all. The fact that the
situation in emerging economies was noticeably calmer should be cause for deep reflection
for economic policymakers in advanced countries, most of which target inflation.

Stock indices have also seen year-on-year fluctuations of tens of per cent (Chart 5). This is
not historically unusual. During the recent surge in inflation, equities - like residential
property and some unconventional "reserve" commodities (Chart 6) - have established
themselves as assets offering some protection against inflation. However, the current surge
in US shares is being driven almost exclusively by a small number of tech stocks. The
lacklustre growth of the rest of the equity portfolio suggests that market participants lack
confidence in stable and long-term growth across the economy. Furthermore, the greater
concentration in a smaller number of large stocks is not fostering a return of the "Great
Moderation." This has been very evident in recent weeks.

Was the "Great Moderation" just an illusion?

The belief in the "Great Moderation" arose in response to the stabilisation of two closely
linked variables - inflation and interest rates. While the 1970s and 1980s were characterised
by large fluctuations in these variables, associated with oil shocks, the 1990s saw a marked
decline and stabilisation. Today, we agree that the decline in inflation pressures (Chart 7)
initially in advanced countries and then in emerging economies was primarily due to
globalisation. As inflation decreased, so, naturally, did nominal interest rates (Chart 8 and
Chart 9). This contributed to a significant reduction in fluctuations of economic activity.
Unfortunately, the complacency about this new-found stability found its way into policy
recommendations and into policies themselves. The initially unobserved tendencies that
ultimately triggered the GFC started to develop.

One disappointment for not only macroeconomists is the high volatility of the nominal
exchange rates of currencies that operate in the floating regime (Chart 10). This began with
the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. Since
then, there has been a persistent feeling that exchange rates are more volatile than would be
desirable. Although histograms showing the magnitude of the changes in the two periods
(Chart 11) indicate some calming since the mid-1990s (such as in the case of the key
currency pair), it is not particularly significant. Large year-on-year swings are more common
in the case of energy commodity prices and stock prices (Chart 12). The fact that the
counterpart to the stabilisation of inflation and interest rates was increased volatility in asset

markets is clearly visible in residential property prices (Chart 13). Historical databases, which
should be approached with great caution, suggest fairly convincingly that cyclical fluctuations
in house prices intensified globally after the collapse of the Bretton Woods system. The
histograms of residential property prices in the USA and Germany tell the same story (Chart
14). Discussing why this happened would require a separate lecture. Significant factors
include the strong credit cycle in advanced countries, which was also driven by significantly
relaxed banking regulation, manifested, among other things, in low capital requirements for
banks (Chart 15).

With hindsight, we can safely say that the "Great Moderation" involved just a few advanced
countries and didn't last long. As a central banker, I can't even recall a long period of calm. At
the beginning of the century, we were struggling with the aftermath of a deep crisis in the
domestic banking sector. Then came a credit boom that ended with the GFC. No sooner had
we dealt with that than the euro area debt crisis began. It was followed by a long recession in
our country and then by Covid-19, which significantly disrupted global supply chains. After
Covid came Russia's invasion of Ukraine, an energy crisis and a wave of inflation. The GFC
was undoubtedly a pivotal event that will affect Western economies for decades to come. It
left a particularly harsh legacy in Europe due to the subsequent poorly managed euro area
debt crisis. Many of the issues that now trouble us in Europe and cause us to fear for its
economic future have their roots right there.

Following the onset of the GFC, a consensus emerged that its roots lay in poorly designed
regulation of financial markets and insufficient oversight of banks. Supranational and national
authorities responded forcefully to the GFC by implementing a wide range of reforms, now
usually referred to in the banking sector as Basel III. When this process began in 2009-
2010, we believed the proposed reforms would generate a range of substantial
improvements. We expected banks to be less risky (less leveraged), as they would have to
hold more and higher-quality capital in new types of buffers. We thought that the requirement
to issue bail-inable near-capital would mean that shareholders, not taxpayers, would bear
the losses in case of problems. We anticipated that banks would better reflect credit risk in
risk weights, create forward-looking loan loss provisions through the cycle and manage
liquidity risk using sophisticated quantitative methods. And we believed that large and
interconnected banks would be less "too big to fail" and we would have better resolution
tools. Bank shares and bonds were ultimately expected to become attractive assets for
investors, maybe generating lower returns than before, but also offering much lower levels of
risk.

The reforms also pursued broader macroeconomic goals. The new macroprudential policy
tools should protect banks from the cycle but also protect the cycle from banks. In other
words, fluctuations in bank lending should cause smaller fluctuations in the business cycle
and on asset markets. Banks should be more resilient to property market swings. Nearly 15
years after the reform efforts began, we can say that most of the objectives have been

achieved. However, the attempts to introduce through-the-cycle provisions have largely
failed. The goal that banks should provide greater support for the development of non-
financial corporations other than those active in the real estate business has not been fully
achieved. In the EU, we have unsuccessfully tried - in response to the euro area debt crisis
- to reduce the sovereign risk that financial markets are exposed to as a result of investing in
government debt. To sum up, the system as a whole is not as countercyclical as we initially
envisaged. In addition, for most of the post-GFC period, European banking stocks have not
been drivers of stock index growth.

Conclusion

In conclusion, we have to say that we don't consider an early return of the "Great
Moderation" to be the baseline scenario. This is not only because geopolitical, social, climate
and cyber risks have become more pronounced in recent years, but also because modern
monetary and financial systems, despite their manifold advantages, contain mechanisms
that support cyclicality and volatility. We have mitigated some of these mechanisms by
reforming financial regulation in response to the GFC. I expect changes to monetary policy
frameworks in response to the assessments of the roots of the recent inflation wave to have
a positive impact in the coming years. Many central banks, including the CNB, are now
undergoing reviews of their analytical, forecasting and decision-making processes. I expect
that in the end, there will be an acknowledgement that monetary policy, like in the past, is not
only a science but also an art, and that monetary policy tools have big impacts on the
economy, impacts that have highly variable lags and show up in very different ways over
time. First and foremost, therefore, central banks as monetary policymakers should identify
the significant stories unfolding in the economy and refrain from reacting to individual
statistics. They should be aware that economic processes are often non-linear, discontinuous
and subject to multiple equilibria (external link) - the situations when a specific monetary
policy action can ultimately result in very different macroeconomic outcomes. They should
therefore be holistic, non-dogmatic and flexible in conducting monetary policy. All this while
being mindful of their core mandates - a sound currency, price stability and financial stability
- and being aware of their shared responsibility for the internal and external balance of the
economy.

Chart 1a - Selected 5Y swap rates (%)

5/19 11919 5/20 11/20 5/21 11/21 5/22 11/22 5/23) 11/23 5/24
-_--USD --EUR --JPY --GBP --CZK

Source: Bloomberg

Chart 1b - Emerging Europe 5Y swap rates (%)

14 5

12 4

0+ T

S19 11/19 5/20 11/20 S21 11/21 Sf22 11/22 5/23 11/23 5/24
-HUF --RON --PLN

Source: Bloomberg

Chart 2a - Commodity prices

140 5 280
120 4 240
100 4 200
20 I 160
60 + 120
40 4 80
20 4 40
0+ + ; : : , : , r : i)
519 11/19 5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
--Oil (USD) --Gas (EUR, rhs)

Source: Bloomberg

Chart 2b - Dynamics of commodity prices (y-o-y in %)

200 800
150 600
100 400
50 200

0 0
-60 -200
-100 -400

519 11/19 5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
-<0Oil --Gas (rhs)

Source: Bloomberg

Chart 3a - Developed countries nominal FX rates (y-o-y in %)

40 5

20 4
819 11/19 5/20 11/20 5/21 «11/21 5/22 11/22 5/23 «11/23 5/24

- EUR/USD --GBP/USD -JPY/USD -=-=SEKIUSD ---<=CHF/USD

Source: Refinitiv Datastream

Chart 3b - CEE nominal FX rates (y-o-y in %)

«20 4
5/19 11/19 5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
_-CZK/USD =-=RON/USD -==HUFIUSD --=PLN/USD

Source: Refinitiv Datastream

Chart 4a - Nominal house price index (30.6.2019 = 100)

136
130
125
120
115
110

105

100

T T T T T T T T T
6/19 12/19 6/20 12/20 6/21 12/21 6/22 12/22 6/23 12/23

-Emerging countries ---Developed countries

Source: BIS

Chart 4b - Dynamics of nominal house prices (y-o-y in %)

16
14
12

10

6/20 12/20 6/21 12/21 6/22 12/22 6/23 12/23

-Emerging countries --Developed countries

Source: BIS

Chart 5a - Equity indices (index)

6000 » 180
5500 170
5000 160
4500 150
4000 140
3500 130
3000 120
2500 110
2000 + 7 r 100

5/19 11/19 5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
--S&P Index ---MSCl Europe

Source: Bloomberg
Chart 5b - Dynamics of equity indices (y-o-y in %)

60 -

-20 4

-30 -
519 14/19 5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
-SPX --MSCl Europe

Source: Bloomberg

Chart 6a - Commodity prices (USD)

90000

75000

60000

45000

30000

15000
0 T T T T T T T T T T T 0
5/19 117/19 «5/20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
-Gold --BitCoin (rhs)
Source: Bloomberg
Chart 6b -- Commodity prices (y-o-y in %)
50 5 1000
40 800
30 600
20 400
10 200
0 0
-10 4 -200
-20 J -400
5/19 1119 =§f20 11/20 5/21 11/21 5/22 11/22 5/23 11/23 5/24
-Gold --BitCoin (rhs)

Source: Bloomberg

Chart 7 - Inflation rate in selected advanced economies (y-o-y in %)

30 5

70 «61/74 «1/78 1/82 1/86 1/90 1/94 1/98 1/02 1/06 1/10 1/14 1/18 1/22

US UK om Germany Netherlands --=--=-Sweden ---Japan
Source: Refinitiv Datastream
Chart 8 - Short-term interest rates in selected advanced economies (%)

25 4

5 J
70 «41/74 «1/78 1/82 1/86 1/90 1/94 1/98 1/02 1/06 1/10 1/14 1/18 1/22

-US --UK Germany Netherlands -=--=-=Sweden Japan

Source: FRED

Chart 9 - Long-term interest rates in selected advanced economies (%)

1/70 «1/74 «1/78 1/82 1/86 1/90 1/94 1/98 1/02 1/06 1/10 1/14 1/18 1/22
-_-US --UK

Germany

Netherlands -=--=-~=Sweden

Japan
Source: FRED
Chart 10 - Selected nominal exchange rate (y-o-y in %)

18

LS)

70 «61/74 «1/78 1/82 1/86 1/90 1/94 1/98 1/02 1/06 1/10 1/14 1/18 1/22
-_--US --UK

Germany Netherlands --=-=Sweden

Japan
Source: Refinitiv Datastream

Chart 11a - Histogram - USD/EUR (%, y-o-y)

40%

35%

30%

25%

20%

15%

10%

5%

0%
0% to 5% 5% to 10% 10% to 15% more than 15%
@Bi971-1997 1997-2024
Source: Refinitiv Datastream

Chart 11b - Histogram - U.S. long-term interest rates (y-o-y in pp)

90% 7

T LJ

Opp to Ipp ipp to 2pp 2pp to 3pp more than 3pp
@1971-1997 m1997-2024

Source: Fred

Chart 12a - Histogram - Oil prices (%, y-o-y)
50% 7
45%
40%
35%
30%
25%
20%
15%
10%

5%

" 0% to 10% 10% to 20% 20% to 30% more than 30%
@i971-1997 mi1997-2024

Source: Refinitiv Datastream
Chart 12b - Histogram - S&P Index (%, y-o-y)
45% 5
40% +
35%
30%
25%
20%
15%
10%

5%

0%

0% to 10% 10% to 20% 20% ta 30% more than 30%
@1971-1997 1997-2024

Source: Refinitiv Datastream

Chart 13 - House prices took off after World War Il; cyclicality more pronounced since
the 1970s
(Index, 1975 = 100)

250 7 aaa U.S. real prices, Dallas Fed
. . @ 231.5
-- U.S. real prices, Macrohistory Database
200 4 --Global (ex. U.S.) real prices, Macrohistory Database
steeee Global (ex. U.S.) real prices, Dallas Fed J 174.7
International House .
150 4 Price Database :
coverage begins
World War I World War II
Franco-Prussian War
100
50
0 + r t r r r r
1870 1895 1920 1945 1970 1995 2020

Source: Dallas Fed: Threat of global housing slide looms amid rising rates
Chart 14a - Histogram - US housing prices (y-o-y in %)

60%

50%

40%

30%

20%

10%
0%
0% to 5% 5% to 10% 10% to 15% more than 15%
1971-1997 mi997-2024
Source: BIS

Chart 14b - Histogram - German housing prices (y-o-y in %)

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

O%
0% to 5% 5% ta 10% 10% to 15% more than 15%

@1971-1997 1997-2024

Source: BIS

Chart 15a - Growth of credit to private non-financial sector (%, y-o-y, in selected
advanced economies)

25

20

15

10

5
1970 1976 1982 1988 4994 =. 2000 2008 «62012-2018

Source: Jorda-Schularick-Taylor Macrohistory Database

Chart 15b - Leverage ratio in banking sector of selected advanced economies (capital
to risk-nonweighted assets, %)

26 5

20 +

18 4

0

1890 1905 1920 1935 1950 1965 1980 1995 2010
Source: Jorda-Schularick-Taylor Macrohistory Database
Jan Frait is the Deputy Governor of the Czech National Bank and Viktor Zeisel serves an

advisor to the Bank Board of the Czech National Bank. At the ICFE 2024 conference, Jan
Frait personally presented this lecture.