The ECB’s decision to inject E95 billion into the overnight interbank market in the second week of August 2007 was what finally made the world wake up to the severity of the unfolding liquidity squeeze.
Although it is too early to tell if the ECB’s decision was correct, or if it will lead to fresh inflationary pressures, former National Bank of Poland president Leszek Balcerowicz argues that the decision-making process certainly points in the right direction. “Keeping inflation low should remain the basic objective of central bankers, but at the same time the central banks should consider the developments in the financial markets.”
He recognizes that this is no easy task, and it would involve “putting an additional premium on considering monetary statistics”, which is already the ECB’s stance, and contrasts with some other leading central banks.
ECB executive board member Jurgen Stark agrees. “The ECB, with its monetary strategy based on two pillars, is well equipped to deal with the issues that came up in the current situation, which highlights the link between liquidity and asset price formation.” He says that the bank’s monetary analysis had signalled the build-up of potential risks well before they materialized, and the ECB had started work on enhancing these methods of analysis even before the crisis unfolded. In particular, the growing use of structured finance products has made it more difficult to assess credit growth and the likely response of credit markets to higher interest rates.
“This is a work in progress, to understand what influence financial innovations have on credit growth and the growth of monetary aggregates. We know that liquidity always finds its way into higher asset prices and HICP.”
But he adds that, in line with central banking consensus, the ECB does not aim to prick financial bubbles, but rather to communicate to the market that there are developments out of line with fundamentals that risk imbalances in the economy.
And financial innovation is only one fresh challenge facing monetary policy-makers, as the globalization of inflation and liquidity has created “a totally new environment for central banks and market participants alike”, Stark observes. The sharp decline in the dollar – and with it China’s renminbi – against the euro is another factor in the equation, prompting increasing anxiety among European exporters. ECB executive board members have traditionally maintained the line that the euro-dollar exchange rate is market-determined, but of course, this is not true of China’s managed exchange rate.
Balcerowicz expresses caution about allowing too much politics back into European monetary policy. “The word ‘coordination’ is much used, but it should not be understood to mean any reduction in the independence of the central bank,” he argues. —P.A.