National monetary policy must not only be determined within a domestic framework but is also influenced by global economic indicators. In the new era, central banks face serious challenges, says Jacques de Larosiére.

There have been three main periods in monetary policy. The third period, which we are now experiencing, is characterised by significant changes in financial markets, by globalisation and the explosion of different and sophisticated forms of credit. This new environment poses serious new challenges to central banks.

In the first period, before the 1980s, governments were convinced that there was a trade off between ‘a little more inflation’ and less unemployment. They were thus biased towards low interest rates and used to engage central banks in ‘fine tuning’. This policy eventually led to double-digit inflation in advanced economies and galloping inflation in a number of developing countries. High inflation was finally recognised as inimical to growth and socially disruptive. In 1979-80, the game of systematically seeking employment at the expense of price stability came to an end. The whole process had entailed high economic and social costs.

In the second period, in the 1980s and 1990s, monetary policy managed to reduce inflation – not only actual inflation, but also expected inflation. Most central banks were gradually made independent from governments and acquired renewed credibility. This was the period of the ‘triumph of central bankers’. US inflation (Consumer Price Index – CPI) came down from 13% in 1979-80 to 2.2% in 1999.

New challenges

Among the challenges for central banks of the current period of monetary policy, as world markets are becoming increasingly globalised, traditional indicators are losing some of their significance. For example, inflation seems less sensitive to traditional measures of domestic resource utilisation. Indeed, in an increasingly integrated world, ‘global slack’ might well be a more meaningful yardstick of inflation than domestic rates of capacity utilisation. When about 40 million low wage earners enter each year into the world competition, it is understandable that wages in advanced countries tend to show restraint. This is one of the reasons that explains that the ‘non-accelerating inflation rate of unemployment’ is on a lower trend. This beneficial global dampening of inflation has played a significant role in the monetary policy stance of a number of central banks over the past few years; it has allowed them to keep price stability while not restricting growth.

Also, the traditional relation between money and inflation – which, no doubt, remains valid in the long run – is more difficult to establish in the short run because financial institutions have been developing money substitutes that, in turn, make the demand for money more unstable. This is one of the reasons why a number of central banks have been abandoning monetary targeting, let alone exchange rate targeting, for inflation targeting.

The previous factors – flattening of the Philips curve, greater wage restraint in a increasingly competitive world, and blurred interpretation of money aggregates – have made the conduct of monetary policy more complex and may have inclined some central banks to a more benign stance than might have been warranted otherwise. A national monetary policy has to be determined in the framework of its domestic setting (including fiscal and structural policies, as well as medium-term potential growth), but it is also heavily influenced by global inflation and by interest rate convergence due to a financially integrated world. This duality is not easy to deal with.

Future concerns

As CPI inflation – especially core inflation – appears tamed (in part for globalisation reasons but also because of productivity gains) and as energy and commodity price hikes (which are also a reflection of globalisation) have not yet ‘contaminated’ headline inflation, monetary policy has been relatively accommodating over the past few years. This is in spite of the gradual tightening (up to 5.25%) initiated by the US Federal Reserve (Fed) in June 2004 when the rate was at 1%. The European Central Bank has also more recently (end 2005) engaged in a process of increasing rates.

But given the delayed effects of past expansion and the present position in the economic cycle, are monetary conditions really neutral? It is difficult to give a clear-cut answer to this question. Global liquidity remains high: money and credit are so abundant that the price of almost all types of assets (equity, real estate, bonds, commodities, etc) has been rising, signalling possible bubbles in the system. When they are not justified by ‘real’ and structural reasons to believe in higher long-term returns, asset price hikes are a sign of inflationary expectations.

Modern financial instruments have contributed to this expansion in liquidity and credit – securitisation and credit derivatives, for example. The former is a way for financial institutions to reduce their credit risk in selling it to (usually non or less regulated) market investors. Thus, collateralised loan obligations (CLOs) repackage bank credit and sell it to the market as asset-backed loans. Loans have become therefore as tradable as bonds. Credit derivatives activity has grown explosively, to the extent that banks are net buyers of protection (from less or differently controlled entities such as investment funds or pension funds or even insurance companies). This frees regulatory capital for new lending and therefore contributes to the increase of net domestic assets.

Hedge funds and private equity funds are highly leveraged entities. Their multiples (exposure/equity) are much higher than was the case when banks were the main source of financing. This shift of power, in terms of credit creation, from the banks to the market tends to loosen the classical transmission channels of central banks.

The pricing of risk is low. Too much money chasing too scarce assets leads to thin spreads and under-priced risk. This low level of spreads is due in part to the large liquidity enhanced by derivative instruments. But if things were to reverse, how would financial institutions cope with the situation? What would be the impact of hedge funds or private equity failures on banks (through increased provisions)? How would the other lenders (non banks) and the buyers of packaged loans behave and withstand the shocks? Would they rush out? How would that compare with the more ‘institutional’ reaction of banks when they were the major lenders? And how would banks react to reputational risk?

In spite of some tightening in monetary policies, long-term rates remain stubbornly low and yield curves flat. This conundrum is the result of a number of factors:

  • excess liquidity;

 

  • structural reasons: insurance companies and pension funds need to match their long-term liabilities with long-term, and safe bonds;

 

  • the credibility gained by central banks may also explain that inflationary expectations remain strikingly low;

 

  • the massive acquisition of US Treasury bonds by central banks of emerging countries is also a major reason for the low level of long-term interest rates over the past years. A recent National Bureau of Economic Research study shows that such foreign flows have an “economically large and statistically significant impact on long-term US interest rates”. The difficulty for emerging markets central banks in fully sterilising their interventions leads to a ‘loose’ bias in their monetary policy.

But the question remains: is there a future for a world in which the level of long-term interest rates is low (about 2% in real terms) and remains to a large extent disconnected from tightening moves by central banks, thus undermining the effectiveness of monetary policy? Is this, as some suggest, the manifestation of too weak global productivity, too low marginal returns on capital, in addition to excess savings and insufficient investment opportunities (which would signal that global equilibrium interest rates have gone down and, as a consequence, that monetary policy might be seen as too restrictive)?

This thesis does not seem consistent with the vigorous world growth rates (4%-5%), with rising asset prices and the strong performance of productivity and corporate profits. That is why I tend to believe that the present situation is more the result of excess liquidity and of a revival of monetary illusion.

According to this interpretation, monetary policy has been allowing too much credit expansion and too high asset valuations. Therefore, down the road, in case of a sharp economic slowdown, looms the old scenario of a fall in equity values, liquidity issues for some over-leveraged institutions, bad debts, risk repricing, higher spreads, contagion, and so on. This out-turn could be all the more damaging if monetary conditions and over-leveraging were to get out of hand. Hence the importance of adopting a reasonably vigilant and prudent approach to monetary policy and to financial stability.

It is difficult to conduct a cautious monetary policy when inflation remains apparently low. Politicians are particularly sensitive to this issue. Perhaps the dramatic insistence US policy makers put on the dangers of price deflation a few years ago has something to do with present attitudes towards monetary policy. After all, in a world growing at 4%-5%, where labour costs are restrained because of low wages in emerging economies, and where technological changes and productivity gains are strong, a 2% rate of inflation should not be seen as an absolute minimum (strong growth and declining prices were often combined in Europe in the 19th century).

Risks and crises

Securitisation and leveraging mechanisms are flourishing. The explosion of private equity leveraged buyouts – in particular those concerning non-investment grade corporates – is a case in point: the acquisitions at high prices made by these funds are involving more and more layers of debt at the expense of equity. Risk has been spread out, which strengthens the banking system but raises uncertainties about the behaviour of market players in case of crises. High-asset valuations and low-risk pricing are, as they have always been, a source of vulnerability because they can well be reversed. The boom in property valuations has been used and abused to ‘extract cash’; this has favoured consumption and additional borrowing by households.

Meanwhile, as consumption was expanding, particularly in the US, corporate profits have tended to be returned to shareholders through share buybacks and the distribution of additional dividends (thus sustaining consumption and asset valuations) to the detriment of investment. Indeed, advanced economies have been investing (in terms of fixed capital formation) relatively poorly in the past few years. Emerging markets are the net savers of the world but also the most dynamic investors (thanks, in part, to capital flows from advanced countries).

Massive US current account deficits (6.6% of gross domestic product) are mirrored by huge surpluses and accumulated foreign reserves in emerging countries, which often choose to peg their currencies to preserve a strong competitive advantage. This is an unsustainable and dangerous situation that makes the dollar and the system at large more vulnerable. The necessary resumption of savings by US households and the declining value of the dollar – two facets of the US adjustment process – could, if they were to be excessive or precipitous, lead to significant financial disturbances, in particular via the housing market.

In such an unbalanced but globalised world, where emerging growth-oriented economies are not endowed with developed financial markets, the challenges are huge. Credit defaults and insolvency issues may be more difficult to cope with than in a more traditional and less cross-border-intensive setting.

Is global financial integration really achieved? Are systemic crises prevention and treatment mechanisms in place between large and increasingly consolidated lenders, investors and borrowers and are they solid enough? Is IMF surveillance on countries that are at the centre of large imbalances up to the challenge? The IMF’s articles call for “multilateral surveillance” and give it the mission to assess the appropriateness of the underlying policies and of the exchange rate behaviour of the “unbalanced” countries. But that mission is far from being fulfilled.

Policy considerations

Therefore, my conclusion is that monetary policy makers who have less influence on credit creation (for the reasons explained above) need to take into consideration – in addition to inflation, with all its uncertainties and variations – money aggregates and credit expansion, asset prices, global imbalances, exchange rate trends, potential growth evolution, financial innovation, the possible ‘crisis behaviour’ of non-banks and its impact on banks and the increased vulnerability of over-leveraged corporates to adverse cyclical developments.

Central banks are developing their analysis of these risks and are conducting stress tests. This is to be welcomed as would be the setting of a new checklist of various indicators to cover the broad concept of financial stability in a changing and globalised world. It might also be timely to consider asking high leveraged funds to disclose their liabilities, as well as their value at risk, on a regular basis so as to provide the full picture of their exposure.

As economist Henry Kaufman stated in one of his recent illuminating speeches: “We have moved well beyond the point where we can navigate the financial markets with the single compass of the Fed funds rates. The compass served early navigators well, but today we need guidance mechanisms every bit as precise and sophisticated as the markets in which we journey.”

Jacques de Larosiére is chairman of the strategic committee at Agence France Trésor and an adviser to BNP Paribas. He is a former managing director of the IMF, president of the EBRD and governer of the Banque de France.

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