Monetary policy in an environment of global financial markets
Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002
Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.
In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.
Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.
In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.
We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.
To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.
Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.
Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises  that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:
"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."
Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so: "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."
It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.
It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB.  Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.
Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.
Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.
Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.
This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.
No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.
I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.
 Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.
 Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.
 Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).
 Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20