Much ink has been expended in discussions of the US yield curve and also on the reluctance of the country’s lower money aggregates to grow as rapidly as previously, despite the veritable explosion in credit instruments issued and traded and the unmistakable signs of renewed finanical market euphoria evident everywhere.
Perhaps this is an occasion when we would do well to remind ourselves that we should not be too wedded to historical empiricals, but rather we should remain alert to the possibility that the workings of undoubted and unalterable economic verities may be being expressed differently in today’s distinct institutional setting.
As we know, the vast majority of players in the game - be they professors or private equity pirates - constantly searches for two data sets which typically used to run in some sort of synch (often without asking exactly why or inquiring too closely into cause and effect) and then extrapolates this relationship confidently out into the future.
It is arguable that this sort of approach is even more dangerous than normal in a rapidly changing world where both the real side relations are in rapid flux (thanks in no small part to ‘globalization’) and where the monetary/financial matrix displays an instability which is an order of magnitude greater, thanks to the hyperspeed at which the electronic global casino is mutating.
The following extract from an address given by ECB VP Lucas Papademos highlights some aspects of this:-
Structural changes and associated uncertainty about the stability of structural and behavioural relationships are not confined to the real economy. Financial markets and institutions have been undergoing a remarkable transformation over the past 20 years as a result of deregulation, advances in information technology and financial innovation. The pace of financial development and innovation has markedly increased in recent years.
Let me just give you one figure that exemplifies the dimensions of this phenomenon: in the first six months of this year, the global derivatives market (according to the Bank for International Settlements) increased by almost 25%, reaching 370,000 billion US dollars. That’s 370 and twelve zeros! New financial instruments are continuously being introduced, and non-bank financial institutions are playing a more prominent role in the intermediation process than in the past.
There are various consequences of these developments for economic efficiency, financial stability and monetary developments. Let me focus on the latter which are pertinent for the conduct of monetary policy.
As a result of financial innovation and the introduction of new financial products, coupled with changes in payment technologies and practices (e.g. internet banking), the demand for monetary and financial assets as well as the characteristics of available financing instruments have been affected. Consequently, the interpretation of developments in monetary and credit aggregates and the extraction of information for the assessment of the risks to price stability require more detailed analysis.
Let me give an example. How do we ascertain the effects of the development of deeper and more liquid securities markets and the increasing importance of non-monetary financial intermediaries, other than insurance corporations and pension funds (other financial institutions, or OFIs), on monetary developments?
The OFI sector comprises a variety of financial firms, such as investment funds, corporations engaged in securitisation, lending and factoring, or clearing houses, which maintain specialised relationships with banks and whose operations may affect monetary developments in several ways. For instance, if changes in the money holdings of clearing houses reflect a shift in former interbank business to electronic trading platforms, this could affect the indicator properties of M3 for future price developments.
However, discarding money holdings of OFIs altogether when assessing the information content of M3 — on the grounds that these holdings reflect portfolio considerations and are not directly related to the demand for goods and services — would be premature. After all, OFIs’ money holdings are likely to mirror to a very large extent developments in private sector wealth, and may thus help explain the more complex relationship between monetary growth and future developments in economic activity and prices.
This is just one example of how financial innovation can influence the information content of monetary aggregates — and I could mention others — but it points to the need for a deeper and more refined monetary analysis that separates the “noise” from the “signals” in monetary aggregates which contain relevant information with regard to risks to price stability.
This example also suggests that it may be intrinsically difficult to determine the extent to which the observed monetary developments reflect the effects of financial innovation that can be characterised as noise — that is, shocks that may “distort” money demand. In a low interest rate environment, the fast pace of financial innovation and the increased importance of OFIs might also reflect the so-called search for yield rather than a structural change in fundamental market relationships.
Moreover, another pertinent issue is the extent to which new innovative derivative products held by households and non-financial firms have liquidity and risk characteristics that would justify their inclusion in a broad monetary aggregate, such as M3. These observations underscore the importance of further research to enhance our understanding of the implications of ongoing financial innovation for the analysis of monetary developments and the signals they provide about the risks to price stability.
