Issues in Monetary Policy: The Relationship Between Money and the Financial Markets

Monetary Policy
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These financial innovations — notably the acceleration of asset securitisation and credit derivatives markets — created an environment where credit was cheaper and more readily available, but at the same time a situation where the structure of the credit system became more complex. Against this background, the recent turmoil appears closely related to the complex nature of certain securities which have been issued in significant amounts during the rapid expansion of asset securitisation.

These involve instruments such as asset-backed securities ABS and various so-called structured finance products, such as collateralised debt obligations CDO. In addition, banks have increasingly used so-called conduits and structured investment vehicles SIVs to transfer a portion of their investments in structured products off their balance sheet. Starting initially with the mortgage markets, these securitisation operations have been extended to many other types of credit. Needless to say, such financial innovation has greatly increased the complexity — some would say opacity — of financial instruments, which serves to explain, at least in part, the current uncertainties that banks face about the quality of the product they have purchased and, by implication, the quality of their balance sheet and those of their counterparts.

The current turmoil began in mid-June when investors became increasingly concerned about the state of the US mortgage markets, in particular the so-called sub-prime segment.

Money and Finance: Crash Course Economics #11

Growing concern among investors, reinforced by further negative news about the US real estate market, initially affected the capital markets rather than the money markets. However, tensions were soon to surface in the money market as problems emerged in the refinancing of US-dollar denominated investment programs in asset-backed securities.

These programmes operated via the off-balance sheet conduits. Such conduits typically invest in longer-term asset-backed securities or CDOs some with exposures to US sub-prime mortgages. These investments are refinanced on a revolving basis through short-term borrowing by means of the issuance of so-called asset-backed commercial paper ABCP. With the emergence of problems in the sub-prime sector, investors suddenly refrained from buying such ABCP, treating it as too risky, especially as the quality of the underlying loans behind the securities purchased by the conduit was often uncertain.

Given the maturity mismatch between their assets and liabilities, conduits therefore started to draw on the credit lines they had originally been granted by their sponsoring banks, in particular banks resident in the euro area. This ultimately gave rise to liquidity shortages in the inter-bank money markets around the world, including in the euro area. Between the end of June and early August, it became clear that a number of European financial institutions needed liquidity to provide credit to their conduits that had invested in the US sub-prime market.

In the end, the demand for liquidity, in combination with a loss in confidence among banks, resulted in a hoarding of cash and the interest rate in the overnight segment of the money market in the euro area increased significantly, trading up to 70 basis points above its normal level.

Recognising these tensions, the ECB reacted immediately.

Specifically, it undertook a special liquidity providing operation a so-called fine tuning operation on 9 August in an attempt to reduce the overnight interest rate to more normal levels more consistent with key ECB interest rates and thus the monetary policy stance decided by the Governing Council. As regards monetary policy , the ECB response was governed by the likelihood that the turmoil in financial markets would have probably some implications for the outlook for price developments and thus for the course of a monetary policy resolutely focused on the maintenance of price stability.

Consistent with its monetary policy strategy, the Governing Council conducted a comprehensive assessment of all factors that impinge upon the prospects for price stability and acted in a manner that best serves its primary objective.

Since a major financial event such as the August money market turmoil has the potential to change the assessment of the prospects for price stability, monetary policy had to respond. Explaining the need for a liquidity policy response is more complex. As we have seen, the ECB has a clear interest in contributing to the functioning of the euro area money market. It was apparent that the tensions in the money market that emerged on 9 August represented significant dislocations to the functioning of the money market, which were likely to interfere with the transmission of monetary policy.

By providing a well-designed and transparent operational framework within which liquidity against adequate collateral could be provided to the market in a clear and transparent way, the ECB had from the outset made an important contribution to maintaining confidence and market trading. However, at the same time, the ECB recognised — again in line with the principles sketched earlier — that its ability to re-establish the pre-9 August situation in the money market by its own actions alone was limited. By its nature, trading in the money market relies on the existence of confidence among market participants.

Through its liquidity policy, the ECB attempted to support the smooth functioning of the money markets by bolstering the confidence of market participants in the system as a whole. The ECB eschewed providing support to individual institutions that had run into specific problems as a result of their own actions, for fear of creating moral hazard. Monetary policy decisions made since early August can only be understood against the backdrop of the progressive increase in key ECB interest rates since December , in the face of the emergence of upside risks to price stability, in a context of strong money and credit growth, a recovery in economic activity and, latterly, a tightening of capacity constraints.

In the middle of , the Governing Council considered that upside risks to price stability continued to prevail.

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In the absence of financial turmoil, this would have pointed to a need for further increases in key ECB interest rates, as was then anticipated by the financial markets. However, uncertainties surrounding the monetary policy transmission mechanism increased with the emergence of the turbulence in the money market. Moreover, the implications of the — possibly temporarily — high market interest rates as spreads between market and policy rates emerged on spending and pricing decisions was unclear.

Characterising the monetary policy stance in this context was particularly complicated and caution was needed when assessing the potential impact of the financial market developments on the real economy and the outlook for price stability. Overall, this uncertain situation called for prudence when assessing the monetary policy stance on the basis of the available data.

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It is important to recognise that this approach did not imply a fundamental reassessment of the prospects for the euro area economy or the outlook price developments. Indeed, the Governing Council re-emphasised the soundness of underlying economic fundamentals in the euro area, at the same times as highlighting the continued prevalence of upside risks to price stability.

Rather the Governing Council recognised that the uncertainties created by the emergence of financial turmoil increased the value of collecting and analysing new information before taking monetary policy actions.

Monetary policy and the money market: key principles and recent experience

This stance has been maintained through to mid-November, although the accumulation of information thus far points to a relatively limited impact of the turmoil on the real economy, no significant impairment in the supply of credit by banks and, if anything, intensifying risks to price stability as commodity prices rise.

On 9 August, in view of the strong demand for liquidity in the overnight market that had caused the substantial rise in very short-term market interest rates, the ECB provided a significant injection of liquidity for that day through an overnight refinancing operation. In the days that followed, tensions in the money markets remained intense.

This seemed to reflect a persistent distortion in the distribution of liquidity within the money market, caused by the lack of confidence among market participants. Moreover, given the persistence of the market tensions, interest rates in the term segments of the unsecured money market i. In order to facilitate a better distribution of liquidity, the ECB launched further liquidity providing fine-tuning operations as well as provided additional liquidity through its main refinancing operations. The purpose of all these operations should be made clear.

First, these operations did not add to the overall stock of liquidity provided by the ECB over the maintenance period within which banks have to meet their reserve requirements. Third, the longer term operations were not intended to directly steer interest rates at longer maturities, such as three months. Largely on account of these measures, the situation in the overnight money market has improved, with the overnight interest rate being both more stable and closer to the minimum bid rate determined by the Governing Council in recent weeks.

Improvements in the term unsecured money market have been more modest, although conditions have improved throughout October. The pragmatic reaction of the ECB regarding the liquidity policy decisions at early stage of the turbulences had the goal to reassure the market, to reduce the deviation of the overnight interest rate from the minimum bid rate and to build up confidence of market participants.

There was a need to contribute to the continuation of the trading in the money market, which is the kernel of the banking system through which financial institutions find in first instance their liquidity needs. While it is premature to form a final judgement, in the context of recent experience, the operational framework of the Eurosystem has proved to be resilient and effective in these exceptional circumstances. From this perspective, no innovation seems to be needed at this stage given the broad range of instruments already existing in the operational framework.

In particular, we have seen the benefit of having a large set of financial institutions i. At a time when banks were reluctant to trade with each other, providing many banks access to the ECB operations and facilities has given them a reliable source of liquidity to meet their needs. In the same vein, the wide definition of financial assets that can be pledged as security for borrowing in such operations i. Banks have not suffered from a shortage of collateral that has hindered their ability to bid at the ECB operations.

Finally, the option to have supplementary longer-term refinancing operations was available as part of the regular operational framework. Launching such operations was therefore straightforward and apparently helped to support market confidence. Money market conditions in the euro area have improved. We should nonetheless guard against complacency and recognise that the process of normalisation is likely to be drawn out. Further action on the part of the private sector is necessary to build confidence and improve transparency. The end of the year, which is typically a period of some tension in the money market, is set to be an important test of the resilience of the gradual improvement in money market conditions we have seen in recent weeks.

BREAKING DOWN 'Monetary Policy'

As President Trichet announced on 8 November, the Governing Council has decided to roll-over the supplementary LTROs, such that this longer maturity liquidity extends across the end-year period, in the interests of providing continuity and reassurance to the markets that should support confidence. Looking further ahead, the lessons of the recent turmoil for the conduct of liquidity policy and the design of the operational framework have to be identified and their implications digested.

Nonetheless, I remain confident that our current framework and practice have performed well in the face of considerable challenges in recent months. From the macroeconomic and monetary policy perspective the current financial turmoil has had a limited impact on the expansion of economic activity in the euro area, at least so far.

Issues in Monetary Policy: The Relationship Between Money and the Financial Markets

However, the turmoil is not yet over. Through time, a higher degree of transparency in financial markets will both contribute to a better functioning of the money market and provide a richer picture of the impact of the turmoil on credit conditions and the real economy.

Thus far, the dynamism of the world economy has also proved to be resilient. However, regional patterns of growth have changed. The moderation of economic growth in the US economy has been at least partly compensated by sustained growth in emerging market economies. Whether economic and financial developments in the US will spill over to other regions in the world depends on the significance of the various potential transmission channels. In the US, concerns about housing market developments, and their potential consequences for consumer and investor confidence as well as for private consumption inter alia weigh heavily on growth prospects.

At the same, risks to price stability in the euro area continue to be on the upside and appear to have increased and intensified recently. Earlier this year, we had already expected that inflation would rise further towards the end of and early , reflecting base effects stemming from the third and the fourth quarter of We communicated to the public along these lines. Moreover, domestic price pressures remain strong in the euro area. Against this background it is very likely that headline inflation will remain elevated in the months to come.

In the context of continued capacity constraints, in particular in the labour market, there is a high risk that this might trigger high wage growth in the months to come. It is crucial that all parties concerned meet their responsibilities to avoid second-round effects. The Governing Council has explicitly clarified that it will monitor all developments very closely and stands ready to prevent any second-round effects in response to these pressures.

What is 'Monetary Policy'

While recognising that the interpretation of the monetary data is to some extent clouded by the possible impact of financial turmoil, the monetary analysis continues to support the view that upside risks to price stability prevail at medium to longer horizons. The need for a careful interpretation of the incoming data places a premium on the assessment of a broad range of monetary and financial data in coming to an overall assessment.

Such a broad-based analysis supports the view that the underlying rate of money and credit growth remains strong, even if M3 growth somewhat overstates this underlying strength as the flattening of the yield curve and the general rise in risk aversion may have increased the demand for M3 deposits. Bank loans continue to grow strongly, particularly to the non-financial corporate sector, which both underpins the view that the underlying pace of monetary expansion is strong and points against any significant impairment to bank credit supply stemming from the turmoil in money markets.

On the basis of its economic and monetary analyses, and by acting in a firm and timely manner, the ECB will ensure that upside risks to price stability over the medium term do not materialise and that medium and long-term inflation expectations remain firmly anchored in line with price stability. This will thereby favour an environment conducive to sustained economic growth, well-functioning markets and job creation. Providing such an anchor for medium and long-term inflation expectations is all the more important at times of financial market volatility and increased uncertainty.

As regards the financial markets, although improving, the situation in the money market is not yet back to normal. It thus appears necessary to pay great attention to developments over the period to come and to stand ready to act if needed, but of course without impinging on or prejudicing the delivery of price stability. How does a central bank deal with asset price deflation?

Should more account be taken of monetary aggregates? Should central banks target asset prices? What is the relationship between the money supply and asset price inflation?

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How should central banks ensure financial stability? The IEA was at the forefront of changing the parameters of the debate surrounding monetary policy in the s and s. This text, brings together some of the leading authors in the field, including the current Governor of the Bank of England, to discuss current issues in monetary policy and the relationship between monetary policy and financial markets. It is appropriate for undergraduates and postgraduates in economics and finance as well as for practitioners in financial markets.

He has previously worked as a special advisor on financial stability issues for the Bank of England. He teaches, researches and writes in the areas of finance, investment and social insurance. Request permission to reuse content from this site. Is Price Stability a Good Idea?

Pepper with Michael J. Issues in Monetary Policy: Added to Your Shopping Cart. Description Since the Bank of England was made independent in , the conduct of monetary policy has been relatively uncontroversial.