Financial markets and monetary policy in Europe
Speech by Lucas Papademos, Vice President of the ECB,
at Wharton Business School, University of Pennsylvania,
Philadelphia, 18 November 2005
While I was travelling yesterday from Europe to the United States, I discovered that – allegedly – on this day, November 18, back in 1307, William Tell shot the apple off his son’s head. Why am I mentioning this? Because one might think that this was easy in comparison with trying to get into the Wharton Business School? No! I mention it because it is a story about excellence, courage and extraordinary skill. And, if my perception is right, these are also characteristics which are held dearly at this School, by students and faculty. I would like to thank you for inviting me to the Wharton European Business Conference. I understand this conference forms part of a wider forum with a global focus, which reflects Wharton’s dynamism, resourcefulness and international orientation. It is a pleasure to be here and take part in the School’s efforts to discuss global challenges in new and innovative ways, transcending geographical and political frontiers and cutting across different academic disciplines.
In such a setting, my presentation about “Financial markets and monetary policy in Europe” should fit in. After all, financial markets have been at the forefront of globalisation for a long time, and monetary policy in Europe has become supranational with the advent of the euro. It is also appropriate for me, as a central banker, to address these issues, because the financial system plays a key role in the conduct and transmission of monetary policy. Developments in financial markets are also key for assessing the stability of the financial system. Moreover, well-developed and forward-looking financial markets can provide us with timely information about the markets’ expectations of future economic developments and policies. This information is very useful in assessing the outlook for economic growth and inflation and determining the appropriate monetary policy stance.
All this is true of any national economy. For a monetary union like the euro area, which comprises twelve individual countries, the matter is somewhat more complex. The introduction of the euro in 1999 and the conduct of the single European monetary policy for the euro area as a whole by the European Central Bank (ECB) made it necessary for the financial systems of twelve euro area countries to become more integrated. Indeed, a fully integrated money market and a sufficiently high degree of integration of other financial markets is a prerequisite – a conditio sine qua non – for the smooth and effective implementation of monetary policy and for its balanced transmission across national boundaries. For this reason, the interrelationship between financial markets and monetary policy is particularly important in Europe, but it also holds more general lessons. In my presentation, I intend to concentrate on four questions:
First, how well are European financial markets integrated at present?
Second, what are the implications of financial market integration for the stability of the European financial system?
Third, what information can we extract from financial markets to help us assess the medium-term economic prospects, particularly the outlook for price stability?
And, finally, how can such information be usefully and effectively employed in formulating the appropriate stance of monetary policy?
II. Financial markets in the euro area: the process and current state of integration
Here in the United States, the notion that the various parts of the financial system – that is, financial institutions, markets and infrastructures – need to be fully integrated might sound like a truism, something self-evident. Here, there are only a few – if any – restrictions on conducting business, or offering financial services, across State boundaries. In Europe, we are only gradually approaching similar conditions in which we could speak of a single, fully integrated European financial market. As I said before, such an integrated market is not only necessary for the single monetary policy, it is also desirable because it facilitates the efficient allocation of capital and contributes to growth and employment.
It is for these reasons that the ECB continuously monitors and seeks to foster the process of financial integration in the euro area. Before going into the details, it is useful to explain what we mean by the term “financial integration”. For us, the market for a given set of financial instruments and/or services is fully integrated if all potential market participants with the same relevant characteristics (i) face a single set of rules when dealing with those financial instruments or services, (ii) have equal access to the previously mentioned set of financial instruments or services and (iii) are treated equally when they are active in the market. The evolution towards this “ideal” state of full integration affects financial markets, infrastructures and institutions simultaneously, as well as their functioning and interaction.
Having clarified the terminology, where do we stand in terms of financial integration in Europe? Because the relevant arguments in discussions on this topic are often of a qualitative nature, we sought to devise a way to capture, in quantitative terms, the various dimensions of financial integration, in the form of statistical indicators. So far, we only have integration indicators for financial markets, and these have been published in a report by the ECB (available on our website); we are working on those for financial infrastructures and institutions.
The first key finding deriving from these indicators is that the degree of integration varies greatly depending on the market segment, and that integration is most advanced in those segments that are closest to the single monetary policy. In the money market, integration is essentially complete. As Chart 1 shows, the overnight lending rates in the euro area countries have become virtually identical since the introduction of the euro. This is partly due to the establishment of a pan-European infrastructure for large-value cross-border payments (the so-called TARGET system). An integrated interbank money market ensures an even distribution of central bank liquidity and a homogeneous level of money market interest rates across the euro area. This is a prerequisite for a smooth implementation of the single monetary policy.
In the bond market, we have also achieved a very high degree of integration. This is mainly due to the disappearance of (intra-euro area) exchange rate risk and the convergence of long-term inflation expectations across countries achieved at the time of the introduction of the euro in 1999. Thus, national government bond yields have converged considerably – as Chart 2 shows. Yields are now mainly driven by euro area-wide shocks and news; they are to a lesser extent explained by national factors such as credit risk. Another notable feature – as presented in Chart 3 – is the emergence and rapid growth since 1999 of a single corporate bond market, which has allowed companies to issue debt on the capital market to a euro area-wide investor base. Our studies suggest that this market segment is fairly integrated, in the sense that the country of issuance is only of marginal importance in explaining yield differentials. Equity markets, by contrast, are still largely defined within national contexts, although a gradual process is underway to overcome the current fragmentation. There is already some evidence, however, that the elimination of (intra-euro area) currency risk has encouraged some degree of integration in the sense that the so-called “home bias” in the equity holdings of institutional investors has been reduced significantly since 1999. In addition, as Chart 4 shows, stock prices across the euro area also increasingly react to area-wide shocks and news.
In the banking sector, progress towards integrated markets has been uneven. While there has been considerable consolidation among European banks in recent decades, this has taken place mainly within national boundaries. As Chart 5 shows, the bulk of mergers and acquisitions in the banking sector in any given year pertained to domestic deals. That said, more recently we have seen renewed activity in cross-border mergers and acquisitions.
In addition, it is useful to differentiate between different segments of the banking market: measured according to bank activities, integration is rather advanced in wholesale and capital-related activities, while it is lagging behind in the retail markets. As Chart 6 displays, banks in the euro area are increasingly granting loans to foreign banks, located mainly in other euro area countries or the rest of the European Union. For retail markets, the story is altogether different: as Chart 7 shows, retail bank lending activity across borders remains very limited at less than 4% of the total. This partly reflects differences in the nature of competition in these segments. Proximity to clients, bank-customer relationships and access to information play a key role in retail banking, while they are less crucial for investment banking and for corporate banking aimed at large companies. Moreover, Europe is faced with differing national regulatory arrangements, practices and product characteristics. To illustrate this lack of integration, take the European mortgage market: as Chart 8 shows, mortgage rates vary much more from country to country in the euro area than they do across States in the US.
This is where we stand today. A lot has been achieved. But further progress is still needed, at least in some market segments. What are the prospects for the further integration of European financial markets? I should start by stating that we see financial integration as being essentially market-driven; it is for financial institutions themselves to reap the benefits of open markets and a single currency, by offering their services beyond the borders of the national economy.
That said, there is clearly a role for public institutions in promoting financial integration: first, integrating financial markets obviously pose challenges for the regulatory and supervisory environment, which need to be addressed by the relevant national and European authorities in close cooperation with each other. Specifically, the consolidation, simplification and streamlining of existing regulatory and supervisory requirements (and arrangements) would certainly facilitate the cross-border business of financial institutions. In order to remove remaining obstacles to a single European market in financial services, the European Commission has devised a strategy for the coming five years, which has our full support, and which points very clearly to what still needs to be done. Second, public authorities have a role in promoting – or being a catalyst for – collective action in the private sector, for instance in the areas of payment and securities clearing and settlement systems, where common infrastructures would make cross-border transactions easier and cheaper. The initiative for a Single Euro Payments Area is a case in point, where the ECB and the European Commission, together with financial institutions, are working towards the goal that, by 2008, European citizens will be able to make payments in the euro area as securely, quickly and efficiently as payments within national borders.
III. Financial market integration and financial system stability
What is the impact of financial market integration on the stability of the European financial system? There are two dimensions to this question: the longer-term, structural implications and the conjunctural aspects of the financial stability outlook at present. With regard to the former, the overall impact of integration on financial stability seems, prima facie, ambiguous. On the one hand, cross-border financial linkages broaden and deepen markets, and increase liquidity and risk sharing, thus strengthening the overall resilience and shock-absorption capacity of the European financial system. On the other hand, national financial systems may be increasingly exposed to common risks, and financial disturbances may be transmitted more easily across borders. That said, we expect the overall effects of financial integration on the stability of the financial sector to be positive in the long run. What we need, however, is a better understanding of the effects of cross-border linkages and of the propagation of shocks across borders. The links between financial integration and stability are complex and multifaceted. The one thing we know for certain is that we need to learn more about these links.
With regard to the outlook for financial stability in the euro area, our assessment is that it remains positive, although some potential risks have increased. Factors favourably influencing the outlook for financial stability include the robust pace of global economic activity, the expected further gradual recovery of the euro area economy, the improved balance sheets of non-financial corporations, and the increased profitability and strengthened balance sheets of financial institutions in the euro area. As Chart 9 shows, the profitability of the vast majority of euro area banks has improved significantly.
This overall positive picture notwithstanding, a number of imbalances in the financial system represent potential risks to this stability assessment. External imbalances, notably current account positions, have continued to grow and a further widening of global imbalances would give rise to medium-term risks of an abrupt unwinding. As experience has shown, financial crises often assume a global character owing to close international links between the financial markets and the financial institutions in different countries. Therefore, it is unlikely that the euro area financial system would be entirely shielded from financial disturbances originating abroad. At the same time, some internal imbalances have been building up, in particular in the household sectors in a number of euro area countries. As in the United States, the rapid increase in household sector indebtedness has gone hand in hand with significant rises in house prices in several countries in Europe. The growing popularity of variable rate mortgages means that households would become more vulnerable if interest rates were to go up. Nevertheless, we consider that euro area households would be able to withstand shocks to income for the time being. In addition, the rather conservative loan-to-value ratios applied by mortgage lenders should soften the impact of a potential house price drop.
All in all, the strength and resilience of the euro area financial system have improved over the past year, contributing to a positive outlook for financial stability. Nevertheless, financial imbalances have grown larger and they seem likely to increase further, primarily at the global, but also at the euro area, level. With shock-absorption capacities improving, but risks and vulnerabilities rising, the financial stability outlook continues to rest upon a delicate balance.
IV. Financial market prices and monetary policy
So far, I have focused my remarks on the state of integration and the stability of financial markets in Europe. Let me now come to the second part of my presentation: the links between financial markets and monetary policy. More specifically, what information can financial markets provide about the economic outlook and how can monetary policy-makers use this information to assess the outlook for price stability? And in what manner can such information be effectively employed and incorporated into our deliberations on the appropriate monetary policy stance? The primary objective – and responsibility – of the single European monetary policy is the preservation of price stability in the euro area as a whole. This objective has been quantitatively defined and the ECB aims at maintaining inflation at close to but below 2% over the medium term. To this end, the ECB continuously assesses the outlook for and the risks to price stability so as to set the policy interest rate at a level appropriate for attaining this goal. The assessment is based on a comprehensive conceptual framework that includes and combines both economic analysis and monetary analysis. Financial markets – that is, money markets, bond markets and credit markets – provide a lot of information that can help us assess the medium and long-term inflation trends as well as market expectations of future inflation. The extraction from financial market data of useful and pertinent information for monetary policy requires careful analysis and sound judgement. For example, while it is true that financial markets, and asset prices in particular, can provide some of the most “forward-looking” indicators available to central banks, we have to carefully analyse their information content. Let me illustrate this by first looking at recent, and somewhat puzzling, developments in bond and stock markets.
First, bond markets. The behaviour of long-term bond yields in major markets across the globe has received a lot of attention over the last year or so. As Chart 10 shows, in the euro area, long-term bond yields have been at very low levels in recent months, lower than in the US. This is broadly in line with lower expected long-term growth and inflation for the euro area, although special factors – like unusually strong demand for bonds – have also contributed to depressing euro area bond yields to some extent. It is in the United States, however, where we are observing a conundrum, namely that bond yields have remained at surprisingly low levels over the past year, despite robust economic growth and the gradual tightening of monetary policy. It seems that strong foreign demand for US fixed-income instruments has been holding bond yields down and we cannot rule out the possibility that long-term interest rates may deviate at times from what market expectations for growth and inflation would suggest.
If this is the case, how could a central bank extract information about market participants’ inflation expectations? We could, for example, look at the difference between the nominal yields of bonds and the real yields of inflation-linked bonds. This difference measures what the markets consider to be “break-even inflation rates”. It should be noted, however, that a break-even inflation rate also contains a premium demanded by investors for incurring inflation risk, which is the reason why the Federal Reserve refers to this yield difference as “inflation compensation”. Long-term break-even inflation rates can be regarded as indicators of the credibility which the market attaches to a central bank’s commitment to price stability. These indicators are therefore very closely monitored by monetary policy-makers in general and the ECB in particular. In Europe, we have today a fair number of index-linked bonds with maturities ranging from 3 years up to nearly 30 years. This in turn enables us to extract break-even inflation rates over various time horizons.
To illustrate this point, Chart 11 shows that short-term break-even inflation rates have fluctuated and increased somewhat in recent months in the euro area. This indicates that the markets have revised near-term inflation expectations upwards, taking into account the foreseeable temporary inflationary pressures stemming from the recent oil price increases. However, the long-term break-even inflation rate has been relatively stable and is only slightly above 2%, which is very close to the ECB’s definition of price stability. As you can see from Chart 12, survey-based measures of long-term inflation expectations provide a very similar picture. The anchoring of long-term inflation expectations to price stability confirms the credibility of the ECB’s monetary policy. Taking into account the increase in current inflation rates, stemming mainly from energy price developments, and several upside inflation risks, strong vigilance on the part of the ECB is warranted so as to ensure that medium-term inflationary pressures remain contained and inflation expectations continue to be firmly anchored to price stability. Monetary policy credibility is maintained through the effective implementation of the appropriate policy to preserve price stability.
What about stock prices? Stock prices incorporate market expectations of future earnings growth of listed firms and may therefore provide advance information about the general economic outlook as perceived by stock market investors. For Europe, this raises some interesting questions: how can it be explained that euro area stock prices have risen relatively strongly throughout 2005, by around 15%, and thus much more than in the US? How does this square with the general environment of more subdued economic growth in the euro area than in the United States and the still very high oil prices? The answers to these questions can partly be found in the significant improvement in the profitability of euro area firms, reflecting efficiency gains, restructuring of balance sheets and good export performance. Moreover, as the aggregate profitability figures may hide differences at the sectoral level, it is informative to look more closely at sectoral stock market developments. As Chart 13 shows, stock prices of the oil and gas sector, supported by strong oil price developments, have outperformed the rest of the market in the euro area. In contrast, the retail sector has performed less well, not least due to modest consumption by euro area households. In addition, as previously noted, many large euro area corporations tend to earn a substantial part of their profits from business abroad where growth has been more dynamic than in the euro area.
The lessons from these two examples are clear: even though the information emanating from financial markets is very useful, we need to interpret asset price developments with caution. Asset prices are not only driven by changes in macroeconomic fundamentals and the market expectations of such changes, but also by variations in risk premia and technical factors which are difficult to single out. Moreover, we all know that financial markets occasionally overreact to news and display herd behaviour. As a result, we might be confronted with situations of temporary over- or undervaluation of financial assets. In sum, sound judgement is warranted in drawing policy conclusions based on the information emanating from financial markets. After all, to paraphrase a little what a well-known investor once remarked: “Financial markets cannot always discount the future correctly because they do not merely discount the future; they help to shape it.”
V. The role of money and credit in the monetary policy framework
Nevertheless, and bearing in mind these qualifications, central banks can extract useful information from bond yields and asset prices for their monitoring of inflation expectations and the assessment of the outlook for price stability. In addition, the ECB places special emphasis on the analysis of developments in the money and credit markets for the assessment of future inflation trends and the associated medium and longer-term risks to price stability. Monetary analysis complements economic analysis and provides a means of cross-checking the assessment obtained on the basis of the economic analysis over a longer time horizon. This strategy reflects the consensus view that inflation is ultimately a monetary phenomenon.
The analysis of the information provided by developments in the money and credit markets has progressively become more comprehensive and sophisticated, so as to identify risks to price stability using a variety of data, models and methods of analysis. One point to keep in mind when analysing developments in money markets is that potential risks have to be recognised in real time. For instance, over longer horizons the evidence of a positive relationship between monetary growth and inflation is widespread and robust – as Chart 14 shows. However, in the short run, transitory shocks to monetary aggregates – such as portfolio shifts – can obscure the signals concerning future price developments stemming from the money market – as Chart 15 shows. From a monetary policy perspective, it is therefore important to identify those movements in monetary aggregates that are associated with longer-term inflationary pressures and to discard other movements which constitute “noise”.
In order to accomplish this, the ECB monitors a variety of monetary and credit indicators, also taking into account institutional factors and financial innovation. In addition, a number of measures of the liquidity situation in the economy have been constructed and are regularly analysed in order to assess the level of liquidity relative to estimated equilibrium values consistent with the objective of price stability. Moreover, we always analyse developments in monetary variables in conjunction with other economic indicators so as to understand better the causes and effects of monetary developments and thereby to identify the underlying monetary dynamics which drive price trends. All plausible measures of liquidity indicate that there is ample liquidity in the euro area. Our monetary analysis points to increased upside risks to price stability over the medium and longer term. The acceleration of monetary growth since mid-2004 and robust credit expansion support this assessment.
Finally – and this may be of particular relevance also here in the United States – we analyse money and credit dynamics also in connection with asset price developments. Research has shown that “extraordinary” increases in asset prices in various periods and countries have typically been accompanied by strong monetary and/or credit growth. Chart 16 shows, for example, a discernible positive correlation, for a number of euro area countries, between substantial house price increases and significant credit growth. Of course, correlation does not imply causality. However, the identified empirical relationships suggest that monetary and credit aggregates can be important indicators of the possible emergence of asset price “bubbles”. Therefore, we consider such indicators to be very useful in the context of our policy framework for maintaining price stability and safeguarding financial stability.
VI. Concluding remarks
Ladies and gentlemen,
I could elaborate further, and for some time, on other matters concerning the links and interactions between financial markets and monetary policy. But I should stop. In the Old Testament writings of the Apocrypha, I have found a useful piece of advice: “Let thy speech be short, comprehending much in a few words.” I know that I have said more than just “a few words”, but there is “much to comprehend” regarding a number of important and topical issues relating to financial markets and monetary policy.
Thank you very much for your attention.
 See L. Baele, A. Ferrando, P. Hördahl, E. Krylova and C. Monnet, “Measuring financial integration in the euro area”, ECB Occasional Paper No 14, April 2004.
 For a more thorough discussion, see the article entitled “Extracting information from financial asset prices”, ECB Monthly Bulletin, November 2004.
 See, for instance, C. Borio and P. Lowe, “Asset prices, financial and monetary stability: exploring the nexus”, BIS Working Paper No 114, 2002, or C. Detken and F. Smets, “Asset price booms and monetary policy”, ECB Working Paper No 364, published in Horst Siebert (ed.), Macroeconomic Policies in the World Economy, Springer, Berlin, 2004.