EU - In a weak macroeconomic framework, the central bank will not just have to “lean against the wind” – it will be forced to “lean against a storm” that will inevitably put strains on – and ultimately overburden – any type of monetary policy strategy. ..- Peter Praet - ECB

Press Release -  Financial cycles and monetary policy

Speech by Peter Praet, Member of the Executive Board of the ECB, in the context of a panel on “International Monetary Policy”,  - Beijing, 31 August 2016

Financial asset prices and credit creation in the global economy are characterised by pronounced and recurrent ebbs and flows – a pattern we have come to refer to as the financial cycle.

[1] In my remarks today, I will discuss the role of monetary policy and other policy domains in steering this cycle.[2]

Financial cycles derive from two closely related factors. The first is a natural tendency towards occasional bouts of “irrational exuberance” – for instance in response to promising scientific discoveries or technological advances – that lead investors to radically upgrade their future income expectations. The second factor is the capacity of financial intermediaries to transfer this expected increase in future income into the present through credit creation, thus establishing a financial upswing that constitutes the real-world counterpart to the upswing in economic optimism.

But when some of the expected benefits that investors ascribed to the new discoveries or technologies do not come to pass, this process goes in reverse. A period of collective retrenchment ensues and the financial cycle enters into a downswing.

Such cycles, while certainly painful for individual investors, are not necessarily harmful for the economy as a whole: productivity growth and technological progress rely on investments in promising but risky ventures, which are driven by entrepreneurial zeal and often financed by credit. As such, financial exuberance often acts as a by-product of economic progress.[3] But this is not always the case: some asset price bubbles, for example in housing markets, may go along with a misallocation of resources and lower productivity growth. And in all instances the flip-side of financial exuberance is an increased risk of regular, and potentially violent, reversals[4] – a pattern we have seen repeatedly in history, going back at least to the Dutch Tulip Mania in 1636.[5]

Hence, for policymakers concerned with financial stability, financial cycles present two related questions. First, how should they identify when it is justified to intervene in the cycle? And second, if intervention is justified, which policy domain should act?

Criteria for policy intervention

A key criterion to identify the case for pre-emptive policy intervention is the presence of systemic negative externalities. In the most general terms, such externalities arise whenever the costs of failed endeavours are not only borne by those who stood to benefit from the initial risk-taking activity, but also spill over to the wider financial sector and economy. Though they have macroeconomic consequences, these externalities typically originate from misaligned incentives at a microeconomic level – for instance pervasive moral hazard that induces agents into excessive risk-taking in their contractual relations. Not all such market failures are relevant for financial stability, but insofar as they aggregate up to a systemic level they may become relevant.

There is one specific embodiment of such externalities that has proven in the past to be particularly deleterious. This relates to the tendency for financial intermediaries to adopt unstable and run-prone funding patterns – a tendency that was particularly pronounced in the run-up to the last financial crisis when financial intermediaries, including depository but also non-depository institutions that operate in non-bank forms of intermediation such as the repo market, increasingly funded their exposures in the wholesale market.

These intermediaries had an incentive to reap liquidity premia that other investors were willing to pay for short-term assets that could be readily converted into currency and thus to finance long-term asset exposures with very short-term funding. This pattern of funding, however, exposes the system to fire-sale damage in case of a run on such short-term funding instruments. The externality, in turn, resides in the failure of financial intermediaries to internalise this fire sale damage, which affects the broader economy and not just the institutions engaging in such funding patterns.

Accordingly, when assessing the implications of swings in the financial cycle, the key issue for policymakers is not so much to diagnose irrational exuberance as to identify its funding patterns – namely, whether rising asset prices are being fuelled by excessive leverage and maturity transformation which will have systemic consequences when the cycle turns.

When such risks to financial stability are identified, however, the second question becomes salient: which policy domain should act to quell financial exuberance?

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