Financial stability and monetary policy

Financial stability and monetary policy are two central themes in the work of LSE professor, Financial Markets Group co-founder and former Bank of England official Charles Goodhart. At a recent conference held in his honour, discussions explored the interaction of these two areas, which has once again become topical in the wake of rising inflation and higher interest rates, which have severely affected bank balance sheets, triggering a flight of deposits and government intervention.

By Romesh Vaitilingam

‘… my own conclusion has been that the authorities should intervene in exchange markets, but that their concern should not be to pick and to defend any particular level of rates, but to control the rate of change of parities, managing this rate of change to see that it never becomes too large to become a disruptive force.’

Ricardo said that while exchange rate pegs usually fail, sometimes they work. He demonstrated this by looking at the peculiar peg between onshore and offshore renminbi – deposits of the Chinese currency in Shenzhen and Hong Kong – concluding that this is ‘the first successful test of the monetary theory of exchange rates’.

In the next presentation, Hyun Song Shin (Bank for International Settlements, BIS) went back to a financial institution whose money was the first global currency for trade and finance. As Claire Jones once wrote in the Financial Times, ‘The Bank of Amsterdam is to central banking history what Little Richard is to rock ‘n’ roll.’ And as Hyun and colleagues have shown in a series of studies, much can be learned from its rise and fall about the payments system, financial crises, the monetary-fiscal nexus and how far a central bank can push monetary financing (Schnabel and Shin, 2004; Frost et al, 2020; Bolt et al, 2023).

The Bank of Amsterdam started life in the form of a rigid ‘stablecoin’, where holders of silver and gold coins delivered them to the Bank, in return for deposits. These deposits were used for wholesale payments – for settlement of financial instruments like bills of exchange, where a payment was settled by debiting the account of the payer and crediting the account of the receiver, much like the modern wholesale payment system.

As a public institution owned by the City of Amsterdam, the Bank found itself increasingly thrust into a public policy role, fine-tuning financial conditions through its market operations, much like a modern central bank. But it lacked the fiscal backing of a modern central bank, and found itself in the awkward halfway house between a rigid stablecoin and a central bank without full fiscal backing: this position ultimately proved untenable.

The final presentation was by Isabel Schnabel (executive board member of the European Central Bank, ECB) and it explored whether monetary and financial stability can be separated – the ‘separation principle’, an application of the Tinbergen rule, which suggests that multiple policy targets require at least an equal number of policy instruments, In particular, she discussed what financial stability risks imply for central banks’ policy choices at a time when inflation remains stubbornly high, indicating the need for further policy tightening (Schnabel, 2023).

Isabel stated that central banks have an important role to play as lenders of last resort to tackle liquidity crises. Even in periods of high inflation, separation can be ensured if tools are targeted and temporary, and the underlying issue is one of liquidity rather than solvency. But monetary policy-makers cannot address solvency issues. A sound financial regulation and supervision are the best protection against financial dominance, just as a functioning fiscal framework is needed to protect against fiscal dominance.

Taking financial stability into account is not just about market stabilisation, Isabel went on. Central banks need to consider the side-effects of monetary policy measures. They need to reflect on how their own actions may have contributed to the build-up of financial fragilities.

Given the resilience of euro area banks, Isabel reiterated the message from ECB president Christine Lagarde that there is currently no trade-off between price stability and financial stability. The Bank can continue to do whatever is needed to bring inflation back to its 2% target in a timely manner. Over the longer run, she added, weakened bank profitability may expose the persisting problem of overbanking in the euro area coupled with a lack of pan-European bank mergers, providing a new impulse for completing European banking union.

The conference concluded with a policy panel on financial stability and monetary policy moderated by Sebastian Mallaby (Council on Foreign Relations) and where Hyun and Isabel were joined by former Bank of England governor Mervyn King (LSE).

Hyun noted that while inflation is moderating, the low hanging fruit of addressing supply-side shocks have already been taken. Dealing with the demand-side issues will be a much tougher task going forward, notably tackling rising wages in the services sector and the understandable desire of workers to recoup labour’s share of income, which has borne the burden of inflation to date, particularly in the euro area.

Isabel also spoke about the drivers of today’s inflation moving from the supply-side to the demand-side, with workers trying to keep up, especially in services, and firms trying to protect their margins. Expectations are anchored but at a stubbornly high level, currently implying four years of above target inflation, which will play an important role in wage negotiations and price-setting, and may erode public trust. What’s more, monetary transmission lags could be longer and weaker because of labour market strength, implying potentially higher rates and for longer.

The former Bank governor called for greater analysis of the monetary transmission mechanism and the need to put measures of money back on monetary policy-makers’ dashboard of indicators. He also outlined his proposal for a systematic way of agreeing central banks’ liquidity provision to banks in advance, explained in more detail in the Financial Times. And he made some observations about diversity and groupthink, which provoked a backlash on Twitter and in the Times.

One recurring theme in the final discussion was what Ricardo described as Charles’s meticulous study of how banks actually work and how the plumbing of liquidity facilities affects monetary policy, inflation and financial stability. As former Bank of England official Huw van Steenis commented in a Financial Times piece to mark Charles’s 80^th birthday in 2016, ‘every Monetary Policy Committee should have members who have a real world understanding of the plumbing of financial intermediaries.’ And Kathleen Tyson, co-author with Charles of the history of FMG (Goodhart and Tyson, 2018), added: ‘thanks again for the call to bring more plumbers into policy’.

References

Bolt, Wilko, Jon Frost, Hyun Song Shin and Peter Wierts (2023) ‘The Bank of Amsterdam and the limits of fiat money’, Bank for International Settlements Working Paper No. 1065.

Frost, Jon, Hyun Song Shin and Peter Wierts (2020) ‘An early stablecoin? The Bank of Amsterdam and the governance of money’, Bank for International Settlements Working Paper No. 902.

Goodhart, Charles (1989) Money, Information and Uncertainty, second edition, Palgrave.

Goodhart, Charles, and Kathleen Tyson (2018) A Brief Affectionate History of the Financial Markets Group, CreateSpace Independent Publishing Platform.

Schnabel, Isabel (2023) ‘Monetary and financial stability – can they be separated?’, speech in London, May 2023.

Schnabel, Isabel, and Hyun Song Shin (2004) ‘Liquidity and contagion: the crisis of 1763’, Journal of the European Economic Association 2(6): 929-68, earlier version entitled ‘Foreshadowing LTCM: the crisis of 1763’, summarised in CentrePiece magazine, Autumn 2003.