Central bank independence is essential for maintaining price stability and effective monetary policy, as it protects policymakers from short-term political pressures that could lead to inflationary bias. Research presented at the 32nd Dubrovnik Economic Conference demonstrates that monetary policy transmission varies across inflation regimes, with policy being less effective at affecting real variables during high inflation periods. The conference panelists emphasized that while legal independence provides the foundation, actual effectiveness depends on credibility, accountability, and a broader stability culture that includes politicians, markets, and the public.
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32nd Dubrovnik Economic Conference Day 1Hinzugefügt:
So it's u it's the 32nd uh record conference. There are lots of you who are old-timers. Some who have been here but have not been here. We just discussed that Helen was here with with her contribution but not in in in presence. And those who are here know how how fun it can be. I don't have to encourage you to be active. you always are. Newcomers are encouraged to be uh both very active in the in this room and and outside in the in the social program. Um the program this year is uh you will see that there's a lot on the on the payment systems which have due to the technology developments now moved into the center stage of our discussions both on the on the on the payments and on the on the monetary policy implications for the monetary policy. We have um two very good keynote speakers Helen who will speak at lunch today. Uh it's going to be fine. It's going to be 25° so not too warm. We will not be able to present the slides in the sun but you'll get something printed out if I understand well. And she'll talk about the internationalization and digitalization of currencies. And then Katherine Shank who will speak tomorrow about public and private interests in the architecture of global payments.
Then in in addition we have tomorrow a panel that I chair which will uh be on the stable coins and monetary policy very very topical thing. Uh there are papers being written right now about it and we still don't know exactly know what the what the uh growth of stable coins might mean for the monetary pol.
So it's going to be very interesting to discuss that tomorrow. Of course, we have not forgotten the bread and butter topics uh for central bankers. We have the four academic papers. One on the transmission of monetary policy shocks when the inflation is high after a long time. It was high this time. Uh the safety net aspects of central bank balance sheets in times of financial crisis and then two topics which are particularly important I would say for my future employer. One is on the exchange rate pass through in the Euro area and the other one on the sovereign debt and financial integration in the European Union.
And then we have another I think three uh uh topics that are very much discussed also these days. One is central bank independence whether it's under threat or not. Uh very nice panel there. I'm looking at Jacob. Uh and then we have one on the housing affordability. Some will say what settle banks can do about the housing affordability. Well, we'll see. We'll hear from the panel if there is anything that they can do. I'm sure that Yiannis already has an idea what we can do a little bit at least. Uh and the third is on the private credit and then private equity. Another another worry these days uh particularly in the in the terms of the financial stability.
So, I think it's a it's a it's a good program. Again it's my last conference as you know uh and in this capacity I have been together with Thomas love running this conference for the last 30 years uh but I hope I'll be invited again uh with a different badge.
Uh when we started to run this conference 30 years ago phones had a wire and the best ones had antenna. Yeah. And uh and the stable coins was basically the the the money that you had to have in your pocket to pay the parking meter at PL. Yeah. The the the parking. Uh today it's very different.
That's why we discuss this new landscape of a of a payment system. So the world has became better and I'm sure that in next 30 years uh at this conference they will discuss even better world than it is today. We had a lots of fun here. uh as you know songs were one of the uh great things in in this conference. Uh we even have an anthem which we will sing uh tomorrow at the at the at the boat and we sang many of them invented here. Uh I I remember some from the Eurosan crisis when Lucas Papados my predecessor was here. Papadeos tell me the truth.
Papa Deos, you and I cry.
Or the one for for Angula. Oh wie, don't you weep. All your bo still taste sweet.
I hated this in your eyes. Uh but but but today but by but today although I'm departing uh for a new professional destination on Monday in Frankfurt uh I can assure you that the dubonic economic conference will will stay for next 30 or or more years.
So I'd just like to paraphrase a great Gershin classic uh as another song. Now the Dromnik Economic Conference is here to stay.
Together we're going a long long way. In time that rockies may crumble, Gibbral may tumble, they're only made of clay, but the death is here to stay. So thank you again for coming here and have a good conference.
So where are the presenters?
I've already seen phone like that. Okay. Okay. So again, good morning everyone. So it is my great privilege to open the working part of the conference with uh two excellent papers. Actually both papers will hit the very core of the central banker's business. The one is dealing with the exchange rate pass through and the other with the monetary policy transmission.
So first uh f first paper and first presenter is Mr. Fabio Kenova Fabio Kenova uh from uh Norwegian Business School and uh he uh he will present the paper co-authored by uh Mr. Fernando Perez Ferrero from Central Reserve Bank of Peru. Uh unfortunately Mr. Perez Ferrero is not here with us but he will be uh well represented by Mr. Kenova.
And the second paper is the one uh written by my colleagues.
Uh and uh the paper will be presented by Evo. So uh without further ado uh I will let Mr. Canova to present uh the first paper which will will be discuss discussed by Mr. Vber. uh and uh after serious negotiations uh all the both uh the presenters will uh get 18 minutes from me and the discussion Mr. Weber Mr. uh will have like six seven minutes for their their discussion.
Uh >> after each paper we will give the possibility to the audience also to do discuss further the papers and uh to ask questions. So let me start by Mr. Canova. Yes. Yes. The floor is yours and you will get your 18 minutes.
>> Okay. Thanks very much for inviting me here. Um it's always a pleasure to be in this beautiful city in this fantastic coast. So thanks. Uh since I have 18 minutes, no further ado and I get into the paper. This is joint work with Fernando Perez Ferrero which is the the research bank of uh reserve bank of Peru and obviously the view do not reflect uh uh the the the position of the bank you go forward I the one so I don't think I need to explain to this audience what is inflation and why is inflation becoming important again we have seen after covid uh this burst of inflation in most of the industrialized world and also in developing country and there is an an expectation if if it's not already realized that the recent uh war in Iran will bring back inflation to some uh high level again. Uh there's been quite a lot of uh academic work trying to understand the causes of the inflation burst after COVID. Um basically um after the initial burst of uh or initial problem with supply chains, it looks like uh expansionary fiscal policy which were unfounded caused uh the the burst of inflation.
I'm not going to talk about uh sources of uh of fluctuation. So I'm not going to talk about what causes inflation to burst. Instead, I'm going to ask a more basic question which is should central bank try to use different tools when inflation is high versus when inflation is low. By now we have uh understood pretty well what central banks should do when inflation is more or less under control. What should the uh central bank do when inflation is not under control or is getting out of control?
Um the question that I'm going to ask is quantitative. So I'm going to ask if there is a change in the transmission of monetary policy uh shocks across regimes. The regimes are going to be low inflation versus high inflation. And I'm going to look especially at the question whether monetary policy is more or less effective when inflation is high. And the background for this investigation basically comes from some theoretical work which are listed in this uh slide.
Um basically there are different theories menu cost rational in attention and what I call slantedell uh models of inflation which all predict then in high inflation regime monetary policy should be less effective uh uh to less powerful to affect real variable and should have a direct inflation direct effect on inflation. Okay. So there should be some changes that I should be able to measure. uh different theories tells you the transmission is going to be different or the mechanics is going to be different but more or less the answer is going to be the same.
So what I'm going to use is a structural VR like the one that you will see next.
The only difference is that since I'm looking at the regime, I'm going to use a regime dependent structural VR and it's going to be a basian uh model because uh as you will see I don't have a lot of uh information about high states and I need to put some prior information to be able to estimate.
Uh I'm going to focus on the US data.
I'm sorry. Uh but uh that's the the best that we could find. All the other data are not very friendly. We tried different data sets and basically what what we're going to do as I said we're going to uh compare the transmission of monetary policy shock in high and infl and low inflation regime and I'm going to look at uh if the evidence is consistent with what the theories uh about inflation output tradeoff tell us.
So very quickly uh the results. So it looks like statistically there are not very many difference between low inflation regime and high inflation regime. There are qualitative differences and in particular if you look at conventional shock they look like they predict they produce a weaker effect but more persistent and long run effects in uh high inflation regime.
uh the evidence I'm going to show you seems to be consistent with what uh recent theory of theformational content of monetary policy shock emphasize.
Um I'm also going to look at what I call liquidity shocks which are basically a broad aggregate of of shocks which should capture for guidance uh quantitative easing and or quantitative reducing um uh policies and they look like more or less they have similar results meaning that they have uh quantitatively not very big difference qualitatively some differences and they're they look like they are going to be for expansion in the short run in the high inflation regime and again I'm going to try to explain to you the mechanism through thisformational uh uh content and these evidence as I'm going to emphasize if I have time is not very much consistent with any of the three theory I've talked about at the beginning I'm going to skip the literature there is a lot of paper nowadays that look at the regime dependent uh transmission Um please take a look at the paper.
So here is the US inflation in case uh you don't know about it which I doubt.
Uh anyway as you can see there are three burst of inflation. 19 beginning of the 70s, the end of the 70s and the 20s. Uh the data here stops at 23 which is basically when we started doing this project. There was no other data and we haven't updated it. But as you can see there's a quite a lot of difference between uh the two uh the three peaks and the rest of the sample.
Um if you plot the distribution of inflation rates you see very clearly that is not a normal distribution. The normal distribution is the red line that you see there and the histogram shows you that there is uh quite a lot of skewess meaning there are inflation quite a lot of inflation rates in the samples which are close to uh the lower part but there are there is a very long tail upper tail uh in the distribution.
So the idea is to try to split this distribution of inflation rate into two parts say the lower part and the upper part and try to infer if uh there are differences in the transmission uh across these two regime. I want to make sure you understand everything is going to be endogenous. So I'm not going to use any indicator to tell me when the inflation is high when inflation is low.
I'm going to let the data tell me when these regimes will prevail.
Just for fun, last night I also plotted the Croatian inflation rate. Um, Croatian inflation rate as you all know except me had a burst of influ.
But he has stayed quite high since then at about four or five% which is above uh what you see in the in the in the euro era.
uh and uh as in in most of the country there is a long period from the uh in the 2010s when the inflation rate was basically very close to to zero.
Okay. So very briefly uh one technical detail which is the the model I'm going to estimate as I said is a structural VR uh which switches with the regime. The regime is characterized by this variable I call S. S could be zero if you are in one regime or one if you are in the other regime. So it's a binary uh uh and if you are in one regime the intercept the slope and the variance may change uh relative to the uh other regime. So everything is allowed to switch here with the regimes not only the intercept not only the slope everything um the variable and the VR is are going to be this Z which are output inflation the unemployment rate short-term interest rate the slope of the yield curve 10 years minus 3 months uh a monetary aggregate uh commodity prices and standard and poor 500 index and the S indicator is a latent variable which is going to be estimated together with the model which can take two values I said zero or one and it's going to take value one when the inflation rate uh passes some threshold P star okay and P star was going to be estimated in the sum okay that's everything I want to say about the technicalities here how do I identify I'm going to identify two uh shocks I'm going to say call it a conventional monetary shock which is basically an interest rate uh uh surprise interest rate increase and I'm going to identify also what I call a liquidity shock which is a surprise increase in uh in money which is engineered through a change in the slope of the term structure. This way I kind of capture both uh uh unconventional monetary policy and older time uh open market operation shocks which were popular in the se 60 and the 70 in the in the US. The identification restriction are pretty standard for the conventional monetary policy shock. Uh you will see you see them listed there contemporaneously. It's not going to have any effect on out on output and unemployment. It may have an effect on inflation and it is going to have an effect on interest rate and money growth. And the other the liquidity shock is identified by uh as I said a decrease in the yield curve and an increase in the money growth.
So I'm going to show you since I don't think I have a lot of time, let me show you uh the the results. So I plot on top again the inflation rate for the US and down the regime indicator. So when you see blue bar it means that's regime number one which means the high inflation regime.
Perhaps unsurprisingly it fits pretty much with the conventional wisdom. So it picks the beginning of the 70s, the end of the 70s and the 220s as the period of inflation. I want to emphasize that the number of observation in these three periods is pretty small. That's why I need we need to go basian here to estimate.
If you want to know what is the threshold that you need to switch uh this is the distribution the posterior distribution of the threshold u is center around by uh 5.3%.
Uh so when inflation reaches about 5.3% you switch from one regime to the next and this is surprising similar to the number that some people have estimating using survey data for uh for uh for this quantity in term of delay parameter I forgot to mention there is also delay parameter it looks like you need two quarters of inflation rate above 5.3% to convince agents that you are in in the high regime or vice versa two quarters below the threshold to convince uh agents that you are below uh in the low inflation regimes.
So uh in for the sake of time I'm going to just focus in the discussion about the transmission of conventional monetary policy shock.
uh I'm going to very briefly talk about the transmission of uh liquidity shock but I'm going to focus on this. So what you see here are the structural impulse responses then going to obtain from this structural VR. In blue you have the responses uh the 68 95% credible sets for the low inflation regime. In red you have the 95% credible sets for the high inflation regime. And I'm going to focus on the first row which reports industrial production, inflation and unemployment rate. So as I told you statistically there is not a big difference between the two regime meaning monetary policy seems to have similar effect. There is some qualitative difference and you see for example in the low inflation regime the uh output growth is uh the trout of output growth is larger in the medium than in the high inflation regime but overall there are not big differences and if you look at the other variable it doesn't seems like there is a huge difference except for one variable which is the slope of the yield curve. So as you can see there is an clear switch here between uh low inflation regime and high inflation regime. When you are in a low inflation regime the uh uh 10-year rate seems to react more than the three-month rate while in the high inflation regime the opposite seems to be the case. Okay. So the question is what is it that causes this difference?
So I'm going to do two exercise. One I'm going to do a counterfactual as you will see counterfactual in the next paper. Uh I don't have to explain what the counterfactual are. But basically what I'm going to force is what if the slope of the term structure will not change across the regime. What would be the effect on output inflation and the unemployment rate?
And the second exercise I'm going to do is if there is a change in the way 10 years rate react in the two regime it must be driven by inflation expectation.
So I'm going to look how inflation expectation react in the two regimes.
So here is the counterfactual. Look at the central box in the second row. I'm forcing the response of the yield curve to be the same across the regime and then I'm calculating what's going to be the effect on industrial production PCE inflation and the unemployment rate. As you can see there is very little difference.
So if there is any difference between the two regime in the two uh um in this variable it must be due to this effect on the slope of the yield curve.
And to give you some more evidence, I'm going to look at the dynamics of inflation expectation. These are 10 years inflation expectations. My discussant will be uh will have probably something to say about this since is a super expert about inflation expectations. But as you can see there is a difference in low inflation regime expectation seems to react more than in high inflation regime. uh the difference is not huge as I told you standard errors are pretty large but there seems to be evidence that in low uh expect in low inflation regime expectation seems to react more to monetary policy shocks than in high inflation regime um similar picture for uh liquidity shock I don't want to talk about too much about I only want to focus attention on the last box of the which is the response of standard and poor 500. Overall there are some difference across variable but the main difference is in the response of stock prices and the response of stock prices seems to be again a source of informationational effect and indeed if I try to see uh what happen if I fix the response of the standard 500 to the shock I get that there is no difference.
So it looks like the effect if there's any difference the effect seems to be going through the stock market and basically it looks like is an expectation of future profitability um that the liquidity shocks generate very briefly uh what do these result tell us in term of theory? Well, most of the theory the the three theory I mentioned can be represented in term of the slope of the Philips curve. Meaning that when uh inflation is higher, the slope of the Philips curve should be flat flatter.
One final point um we have estimated a model under two regimes. Some people tell me well but there is at least three regimes. There is also a zero lower bound regime in the US and in many countries. So maybe you are misspecifying here. Maybe we have a high inflation regime, a normal inflation regime and a very low inflation regime. So I estimated we estimated a four- state model. That's the last one before the last bullet. We found that there are thresholds which are consistent with what we would expect. However, the impulse responses do not change very much across these uh lower two lower regimes, which means that probably it's a good idea to put them together.
I'm going to end up here since the chair is uh showing me.
So thank you very much for this very distilled version of the paper and uh now Mr. Michael Vber from the University of Chicago.
>> My affiliation has changed but >> okay changes it's great as always. So like I'm very happy to be back like just a brief anecdote. So yesterday afternoon I walk down to the beach to quickly jump into the water and I run into Boris who comes back and I ask him you know how is the water? and he says it's pretty chilly but for you as a German it should be fine to which of course I said you better get used to it soon because you know Frankffort especially in fall and winter can be pretty bad so like you know hopefully you have time to come back to Croatia frequently so like >> you know there is a difference between water and the sea >> Okay, fair enough. Okay, perfect. So like you know I really like the paper and so what I'm trying to do in the next seven minutes that I have also is just pretty much contextualize it to hopefully also help you appreciate that paper and so like you know what's the starting point of the paper. So if you think about kind of like you know kind of the big picture we want to understand how monetary policy should react to different types of shocks and the nature of the shocks and you know a textbook conventional prescription would tell us you know we should maybe respond more than one for one to demand driven inflation instead like if it's a temporary it's a bad word maybe to some of you in the room or transitory supply shock maybe we can watch through and you know if you think a little bit about kind of the theoretical underpinning if you a two sector lucensson model where you differ across sectors in terms of maybe price stickiness. Aoki tells us, you know, stabilize the sticky price sector and then kind of like you get what you want. Now you know this paper says well actually let's better understand how we should actually or whether the transmission of monetary policy stay dependent. You know Fabio gave you like a pretty good summary of kind of the key findings of the paper.
So let's like let me directly step back for a second and discuss a few reasons why we might actually expect that monetary policy transmits differently in states of high versus low inflation.
Okay. It's like you know the first B the first assumption we typically make in a standard textbook nucson model is like you know inflation expectations are well anchored and then you can of course look at the data and get an idea you know is that something that's true empirically that's from some work we've done among 25,000 Americans in 2018 inflation was pretty well behaved at the time we asked them you know what do you kind of think the Federal Reserve that is in charge of monetary policy in the US tries to achieve in terms of inflation outcomes over longer periods of time. Our attempt to elicit an inflation target. And what you see here is, you know, maybe 20% have an idea what the Fed tries to do, but among 25,000 representative Americans, you see also maybe as high as 40% that told us a number that is actually higher than 10%. Now, you could say, well, no, those are households have no clue. But actually if you were to reach them to send them communication via the Fed let's say you do see that their inflation expectations do react meaningfully and crucially in actual consumption data they update in line with economic theory it's not that it's all noise they do react to signals we just have to better understand what those signals are similarly like you know if you look at any point in time this is data from the New York Fed you know there's huge dispersion across individuals when inflation is 2% you see some people telling telling you 20%, other people tell you minus 5%.
Certainly like that's also maybe not consistent with agents potentially having full information and rational expectations. Now another reason why potentially we might have a deviation from the textbook prescription is that maybe high inflation undermines the credibility of our monetary policy makers. Maybe because of that households react differently to monetary policy.
This is now across different institutions in the US from um kind of public research data. what is the trust in institutions and you see actually like know across institutions in the US there's kind of a downward trajectory in trust also like you know for the fed but it doesn't seem like you know with a surge in inflation there has been a peculiar decrease and if anything like for the fed it was similar in the early 2020s as it was kind of like in 2014 when inflation was maybe not on top of our minds. You could also maybe be concerned that you know when we have potentially high unfunded fiscal transfer we might enter a fiscally led regime. This is from some work of Bian coers and you do see like you know indeed when inflation is high you also see unfunded transfers and that could potentially also contribute why inflation or why monetary policy transmit differently in time of high versus low inflation.
Now, as Fabio alluded to, maybe if you have a menu cost model in mind, you have big shocks that ultimately, you know, that's why we have high inflation.
That's why maybe firms than actually are more likely to hit their SS bands and because of that, they're more likely to adjust and indeed like Avanier and among many I think 20 co-authors from like different Euro area central banks, they do document of course you see cyclicality, more price adjustments in January. But if you look at the trend when inflation goes up the frequency of price adjustment goes up. So indeed a reason why potentially you might see differential transmission. And of course like you know maybe different from a key you know where you just have two sectors that operate next to each other potentially the flex price sector produces stuff that is used as an intermediate input to the sticky price sector. So that could you you could have transmission through production networks and indeed like if you have heterogeneity in input output linkages paired with heterogeneity in price thickness that indeed potentially can matter for the transmission. Finally like you know one more thing and this is like also something that was alluded to by Fabio maybe households and firms indogenously become more attentive to monetary policy when inflation is high.
And in fact, you know, generically, if you look at kind of like Euro area data, if you look at US data, where inflation is low and stable, maybe it's not too costly to be uninformed. So, typically on average, consumers relative to prevailing inflation are upward bias in their perception of uh inflation. But then when inflation kind of goes up, you do see like, you know, the gap between the two lines become smaller, at least consistent with this idea that agents become indulgently better informed when inflation is high. Let me just uh skip that for a second. Now go directly come to the results like you know Fabio showed that you know when you look at conventional monetary policy shocks you get like you know higher kind of peak response in low inflation times but a bit more persistence in high inflation times. If you look at the middle middle panel in there, you see like the yield curve really seems to make the difference and particularly you see that inflation expectations react quite differently in high versus low inflation time. So like you know one thing potentially Fabio that I would encourage to do is you know you could potentially directly add inflation expectations in your bever to get a better idea how they behave. Now if you look at the sample period like you know many many things in addition to the conduct of monetary policy has changed we saw that what really matters is the slope of the yield curve. So like you know given that the financial markets if you think about 1980 you had like you know us as individual investors maybe making up 30% 40% of kind of all the holdings in financial markets whereas now individual investors make more like 15 20%. Clearly like the industrial organization has changed a lot. So potentially it would be really crucial to look at subsamples.
Now of course I'm pretty sure like Fabio they have thought a lot about that and they look at one subsample 84 till 2019 but in that subsample of course naturally not much happens to inflation and indeed you do not see any differences. Now what I would maybe encourage the authors to do given that by now we have a bit more data in particular the full cycle of the recent inflation surge. maybe don't end in 2019 but maybe update the data and end more recently like uh you know Fabio didn't discuss much about the model so let me also skip that given that I'm also kind of almost running out of time I'm personally not really sure what the liquidity shock is and you know Fabio is pretty upfront in the paper sense of a mixture of different shocks in different time periods so it's a little bit hard to to digest like just one thing you know that's Coming back to why I really like the paper like very different methods very different kind of approach like you know Fabio and his structural beaver they identified this threshold during which maybe we have a high inflation regime around 5%. If you do something very different in a very kind of shorter sample period, this is from a paper by Coron address that what they do, they look at Google searches when do consumers wake up and care about inflation and what you see there, you know, you get a threshold of a little bit more than 4%. So like very similar to what Fabio finds like you know if you had Google searches in the 1970s the threshold might be higher unfortunately like you know maybe we can do soon maybe some time travel and introduce Google at the time but anyway so like you know all I wanted to say is like you know it's a great paper like many things to think about and kind of like you know great uh uh contribution. Thank you.
Oh, thank you very much and I hope that the audience have uh prepared their questions and uh so we will continue the discussion with your questions. So anything from the audience? Yes, please.
>> Thank you. This is Can you hear me?
Thank you very much for that paper. you know um for me I I wonder what sort of lesson a monetary policy maker should take from this analysis. Um the monetary policy shock is by definition uh a movement in the policy rate that's not systematic to the rule that the policy maker is taking. Right?
Um I think the question isn't it should the systematic component of monetary policy vary with regime and I'm not sure if your analysis is able to address that question and I think that that's the uh or can you speak to that >> I collect >> okay okay so uh we agreed to collect the the questions and uh uh professor Kenova will uh answer in a bulk please.
>> Okay. Let let me add to the bulk.
>> So um so another question is how long do these regime changes last? Right. So you said it Fabio you said two quarters before the switch comes. How long does it last? There's a very old survey based literature that says well it's a generational effect. Once I have experienced sort of you know your case plus 5.3% inflation this will stick with me for life. So uh could we use the data to learn about the persistence of Latin?
>> Thank you. And uh I will pick another question. Yeah.
>> Thank you very much. Uh Thomas Bank of Austria. Could you repeat again maybe for uh for a dummy like me uh how you distinguish between demand and supply uh side shocks and especially uh regarding the supply side shocks whether these are domestic or global and does your framework allow to know in advance or at least in real time if I look at your Z uh vector then I have some doubts right so when do we know as uh monetary policy makers uh which regime we are in thank Thank you.
>> Thank you very much. So I think it it was enough three questions.
>> Okay.
>> Well, thanks very much to the discussion. I think uh I agree on uh 99.999% of the points. Uh we we already tried many of the stuff that he suggested. We are in the process of revising the paper. So some of the stuff that he mentioned are going to be in the next version. So regarding the the lesson for monetary policy so we are talking here about shocks we're not talking about systematic component if you think about a tailor rule a shock to a tailor rule is basically a shift in the intercept not a shift in the slope. So there is some role also to think about shifts in the uh in the reaction function which is the old literature about uh whether the Fed was you know ahead or below one uh in the in responding to inflation in the 70 and in the 80s. Um so we are not addressing that type of question. We are simply asking if monetary policy changes will would make a difference in the tour. that's and is changing us in a way that is not predictable. If it's predictable, we have basically nothing to say in this paper.
Um a generational effect um I think this is an interesting question and I think it should be answered through the type of work that uh Michael is doing inflation expectations.
uh we are not going I can tell you what's the persistence here of the shock of the regimes because we have an a regime indicator and we can calculate the persistence but probably that's not going to answer your question. It's probably a question about more about how different people in different generation react to changes in inflation. If you are old guys like me probably you have seen the 70s and then you know the 20s are going to be different than what younger people may perceive. But uh I don't have really uh any evidence in in that sense. Uh regarding demand and supply, we are not identifying the demand and supply. We're simply saying what will be the changes that monetary policy will make in the two regimes. So we are simply identifying monetary policy. We are not distinguishing whether the source of the changes is demand versus supply. We could potentially we have a bunch of variables in there which would could allow us to identify demand and supply. What you probably think are real time evaluation we have no variable that allow us to do that. We need some now casting variable here. Um just to put this in perspective this the estimation of this model is pretty complex. It takes about a week on a computer which has 64 cores uh to estimate. So um addition of variables modification takes some time. So we'll probably implement them but it will take time. Thank you.
>> Thank you. So we were very disciplined with the time. So you have uh abundant time to ask uh additional questions. So are there any? Yeah.
>> Hi Chris Waller Federal Reserve. So the interesting part of your uh V that you ran was always the yield curve. That was the main thing. There were magnitude differences, but the directions were all kind of the same. The one that was really different was yield curve. And this maps into something I've said for a long time. There are bad yield curve inversions and there are good yield curve inversions. If you think about a low and stable inflation regime, expectation theory is the future path of in expected inflation, the future path of real rates, short-term real rates.
Low and stable inflation regime, if it inverts, it's got to be because real rates are going to go down, which usually corresponds to recessions or bad economic growth. So, those are bad ones because it's telling you the economy is not going to do well. But in a high inflation regime, if you think the central bank's going to do their job and bring inflation down, expectations are going to come down and you get a good yield curve inversion. So it's it's interesting that your your your data mapped right into that kind of story. So it's more of a comment than a question, but I thought that was the most interesting part of the results you had.
>> Um I entirely agreed. I mean this this is a our in uh way of explaining the results meaning that there is some information uh in low inflation regimes that is not there in high inflation regime and it seems to go exactly in the direction that you mentioned.
>> So anything else >> if not then thank you very much for breaking the ice. Thank you.
>> Now, uh we'll continue with uh the the exchange rate pass through and Evo, the floor is yours.
>> Thank you.
>> Uh uh thanks for uh to everyone for being here. Thank you for including the paper.
Uh so uh my name is Zivo and today I'm going to present to you uh our current uh work and joint work with my colleagues from the Croatian National Bank Daw and Domago titled exchange rate pass through a counter fretual esvar approach.
So the standard disclaimer applies these are our own views not necessarily those of the bank. Here's the brief uh outline of the talk.
So in very general terms uh what are we trying to uh answer uh in this paper? So we want to know what is the effect of the exchange rate movements on uh prices or inflation and this is called the exchange rate pass through.
Uh so the exchange rate pass through is known to be incomplete. So after some shock the prices and exchange rate don't really move one for one. So prices move less. Um so one of the recent examples are these huge swings in the uh US dollar and euro exchange rate in 2025 that you probably all still uh remember.
There was a lot of talk about this uh uh uh tariffs.
So uh the euro appreciated a lot against the dollar but also this change happened very rapidly very suddenly for historical uh standards and still we didn't really feel uh uh these cheaper imports as uh this huge move would uh suggest.
So there's this prevailing view that these effects are rather small on macro level. uh and if you look at the economic theory uh there are many reasons for this. So uh there's market power pricing to market transportation costs or generally share of domestic uh products in the consumer prices uh currency pricing so a lot of products are invoiced uh in stable world currencies like the euro or US dollar.
So they're sticky in that currency.
Uh so what do we do? We revisit this uh existing estimates of the exchange rate pass through uh for the euro area and study whether this benign view of rather small macro effects uh holds or is it at least partially affected by this uh uh under quotation marks flow the methods that are being uh used in the current literature.
So before getting into our method uh I just want to try to explain why is it so hard to measure this exchange rate pass through. Uh so ideally in the data you would have some exogenous movements in the exchange rate and you would study its effect on inflation or prices. Um but however uh the exchange the the exogenous effects uh on exchange rate uh are not that common. So mostly the exchange rate responds to the standard macroeconomic disturbances. such as aggregate supply, demand shocks, monetary policy shocks, etc. Uh so on the left graph here you see the US dollar and euro exchange rate uh as well as the euro area uh inflation. So you would expect this these two move in the opposite direction. So when you have a stronger euro that you have uh lower inflation and vice versa because you have cheaper or more expensive imports.
uh and indeed uh sometimes you see that they move in different direction but sometimes uh they also move uh in the same direction. Yeah, which is u interesting. And on the right graph you see the moving uh correlation. So you see that sometimes this correlation is negative as this like naive kind of the theory or thinking would suggest uh but sometimes they are positive.
uh and this is precisely because uh as I mentioned the exchange rate is often uh being driven by some external macroeconomic shocks that also influence the inflation directly. So not only through the exchange rate. So sometimes they can move uh in the same direction.
So how has this been measured in the literature? So uh yeah the starting point was the uh simple uh single equation uh framework. So you would simply run the OS uh of inflation on the exchange rate and some controls. But as you see because you you have this positive correlation you can't really uh solve that in a single equation network because you have a serious uh problem of endogenity.
So to give you a clear example of this adjenative problem, you can think of uh demand shock. Let's say domestic demand shock. Uh so it does appreciate the exchange rate. So you do have some deflationary effects uh uh of that. Uh but even more importantly it uh increases inflation directly.
So yeah people spend more uh there's a pressure on prices uh and this letter effect will dominate. So you would have appreciated exchange rate and you would have uh higher inflation and then you would get this positive uh correlation.
So the literature then moved of course to address this and addressed it. It addressed it with vector auto reggressive models. Uh first by uh using recursive chilleski identification which addresses the doenity but in introduces another problem and that is uh that this approach attributes most of the movements uh in the exchange rate to the shocks to the exchange rate itself. And this is simply hard to believe. So these models attribute something like 90% to the exogenous exchange rate shocks. Um uh and then uh the literature moved to this structural uh VS using zero and sign identification uh to identify uh the shocks uh and this does clearly separate these causes of uh uh the exchange rate movement. So it attributes only 10% to the exogenous uh exchange rate shocks and the rest is uh demand shock, supply shock, monetary policy shocks, domestic and global etc. But still even in this state-of-the-art literature the exchange rate pass through is measured uh by co- movement we claim and the measures are mainly capturing the co- movement. So the main measure is this price to exchange rate ratio abbreviated pair. Uh so it's simply an impulse response of inflation after a shock divided by simple impulse response of uh exchange rate. And again because of this problem that I mentioned before you can get this perverse positive sign that that the strong currency can imply higher inflation. So we want to uh address this.
Uh so how do we do it? uh we do it uh by having uh relative uh Euro area US structural VR with sign restriction identification. So this part has been done before but then the uh part that we add uh is uh that we shut down the exchange rate channel uh in this uh uh structural VR model and we do it uh for each shock uh and we do it uh in two ways. So the benchmark way is to come up and construct this offsetting shocks. So these are these hypothetical shocks that offset or negate uh the effect of the original shock that we study for example demand shock on the uh exchange rate and then we can separate the world uh with the exchange rate channel and uh without. So constructing such shocks is of course somewhat arbitrary. So we run some robustness checks and we use also an auxiliary method when you run an auxiliary VA where you impose this zero restrictions uh of the shock on the exchange rate directly also as a robustness check and then we take the difference between these two worlds uh with the exchange and without the exchange rate uh effect uh and we call this uh uh uh the causal exchange rate pass through it its effects. So just to give you uh preview of the results. So we estimate that uh pass through to the consumer prices is 5 to 10% and to import prices 35 to uh 45%.
Uh so this is a key slide where I try to capture the intuition of of our approach. So if you look at the left we have this baseline case. So this a standard uh structural V. uh what you would u estimate uh so you have some structural shocks demand supply monetary policy sentiments etc. Then uh these shocks influence uh exchange rate but also inflation and also other variables in the model. Uh so what the u papers in the current lit literature would do is to take this overall effect on inflation and divide it by the overall effect on the exchange rate and call this a pass through.
Uh we say this uh would be a good measure of pass through uh if most of these arrows uh would be zero or close to zero uh or somehow somehow they would cancel each other out. So you would only have an effect on the exchange rate and then the exchange rate would influence inflation. But you have many of these other errors. Uh so for example for the demand shock you would have uh positive uh effect on inflation and appreciated exchange rate. So we try to think about this uh uh differently. Uh we want to construct a counterfactual where this exchange rate channel is uh shut down.
So as I said we do it by this offsetting uh uh shocks. So you can maybe imagine another cloud here uh negating this uh uh effect of the structural shocks on the exchange rate. And then we just compare these two worlds and call this the exchange rate pass through. So we kind of ask a sharper question uh uh compared to the state-of-the-art literature. So we don't ask how do inflation and exchange rate move after a shock. We ask uh does the exchange rate channel amplify or dampen the original shocks effect on inflation?
Uh so this is our model. Uh so I want to stress that our counterfactual approach does not necessarily depend on this particular model. We we just take it from the literature because it's parsimonious uh and should be largely uncontroversial.
I hope. Um so we have four variables. We have a GDP, we have consumer price index or alternatively import price index if you want to concentrate studying that uh interest rates and exchange rate. So the first three variables as said we have a relative model. So the values are uh computed by having the value for the euro area minus the value for the US. So here maybe the interesting shock is this sentiment shock uh and it's supposed to capture the uh for example this riskoff episodes when investors switch their uh holdings of in one country or in one currency to another because of changing perception of the risk.
Uh so let me get to the results. So here you have a full set of impulse response functions for all the variables in the rows on all the shocks in the columns.
Uh so let's look at this interesting case this uh demand shock uh because it illustrates most clearly these uh uh problems that we are trying to address.
So here again uh we are try we are showing the uh impulse response functions for the baseline case. This is in the blue line and for the counterfactual case. So this is this right graph that I showed and this is in the red color. So if you look uh yeah at the inflation after a positive demand shock you have higher inflation but you also have an appreciated exchange rate.
So with thinking in terms of pair you get this perverse situation. But uh if you uh consider a counterfactual as we do, you will notice that uh with the inflation uh graph uh this red line is above the blue line. So it means that if the exchange rate channel was not operating the exchange rate would have been even higher. So it means that the this appreciation of the currency does have a disinflationary effect because it reduced the the inflation. So this is just showing the same thing but the distribution of the difference between the blue and the red. So the difference between the baseline and counterfactual case and we see that uh they are negative and significant. Uh for the supply shock it's not significant because supply shocks don't tend to move the exchange rate uh much.
Uh but yeah we can uh go one step further. We can look at all of these uh three things jointly. So we can look at the jointly the distribution of the difference between the uh uh baseline and counterfactual inflation and the change in the exchange rate.
Uh so this is uh what we call uh uh the exchange rate posture in the counterfactual uh sense. So we plot it with the red line and we compare it to pair this standard measure that we claim is mostly capturing the co- movement.
Uh so I like this graph uh because uh it uh shows several attractive features of our approach. So the first one as I mentioned if you look at the demand shock uh we get the right sign right uh uh of the exchange rate pass through. So second you see that the heterogeneity between the shocks uh is greatly reduced. So before you had this huge swings of I don't know 20% for some shocks minus 10 for some uh we get it very stable. Uh third uh if you look at the confidence bands uh across these shocks you can see that it's uh much narrower. they are much narrower for our case and this is again kind of intuitive because we are capturing this particular channel or mechanism. Uh so the variation is much lower than if you are capturing more of them across different shocks. Uh so uh uh uh that that's also a kind of a nice uh uh nice feature. And finally if you look when are these two measures uh most similar? they are most similar for the sentiment shock. Uh you can see on the yaxis that this is the one with the most zoomed in uh y-axis.
So they are very similar. U so this is attractive because uh uh the sentiment shock is the closest thing we have in our framework to a pure exogenous shock to the exchange rate. uh so in that case this pair should be tainted the least by these other mechanisms. So it is exactly the case where you would expect that these two are uh most similar.
Uh so this uh makes reassures us that we are capturing something real that that uh our approach is um uh makes sense. Uh so uh what we can also do we can do some historical decomposition which shows uh how did uh exchange rate movements in a causal sense uh affect inflation. So if you look at the 2025 you can see uh yeah here at the end of the graph you can see it was mostly the sentiment shocks driving uh the effect on inflation and the inflation in the euro area was almost 0.4 four percentage points uh lower because of the changes in the exchange rate and some of our other specifications have even larger uh results. So this is a a bit different uh graph uh to uh what you're probably used to seeing uh when talking about historical decomposition. So the standard decomposition decomposition would tell you how much did shocks influence uh the inflation.
But our graph uh uh our decomposition answers maybe yeah slightly different question. It answers uh which shocks influenced the inflation but through the exchange rate and sometimes they can go these uh two can go in different directions. uh as as you can see here and it happens mostly uh when these demand shocks are uh uh driving uh uh the exchange rate.
Uh also I think you can notice that after 2020 you have a large uh effects of supply shocks on inflation.
Uh but you can barely uh see them on our graph because the supply shocks don't tend to move the exchange rate. they affect the inflation more directly or through other channels.
Uh so uh just to conclude so uh we revisit this exchange rate pass through literature using a counterfactual approach. Um so we resolve some of the things that the literature was struggling with like this like wrong sign when it comes to demand shock. uh the heterogeneity of the estimates across the shock decreases a lot. Uh and um we estimate the pass through to be 5 to 10% for consumer prices and 35 to 45% for uh import prices.
Uh so that's all from me. Thank you for your attention and I'm looking forward to the discussion and your questions later.
is inflation I take out energy component. So this is non- energyindustrial goods and you know if you have poor eyesight like I do then you would sort of conclude probably there is at least not a very strong correlation there but that's too easy because you are not able to to deduce shocks from this and this is so that's the the whole exercise that EVO is all about. Now I have a few mostly technical comments because it's a highly technical paper. Um and so the main challenge here is that I mean you have on the one hand this very theoretical concept which is sort of really unobservable the of the aggregate exchange rate pass through. Um and then you have in the end it's still sort of a reduced for microlevel elasticity that's being estimated and by construction there's a bit of a disconnect between these two and you do a lot of work in trying to connect them.
Um but that's very challenging because this exchange rate variables in the end an endogenous variable where you aggregate a lot of underlying primitive mechanisms and so in this chart where you say okay I'm now going to take out various of these errors and shutting down the channel in a reduced form estimation um that becomes um really hard to do because essentially um the exclusion restrictions that you assume they may be violated and so what you also acknowledge in the papers you may be subject to the Lucas critique now so ideally what you would want at that point in time in the papers to say okay here are my sufficient conditions under which this approach is valid I can connect these two bits and pieces um and I think that you go some way um and I would like to help you to make an additional step which is the following.
Um so you have this very nice timeline of how this literature evolved and you're sort of at the state-ofthe-art now but there are I think two more papers that you don't use very recent papers that I think can help you to really nail this thing.
Um so the first is a recent Jamie paper the other is an econometrica paper. So the first one will help you to assess the possibility of your scenario because now you know we have to take it sort of for granted. Um and the second one because you work off these counterfactuals with this impulse response functions the way you build them is with a series of MIT shocks but I find this problematic because I'm not so sure you can treat them really as exogenous once they are really a series.
So this is where you have the lucrris critique and this mai wolf which is highly highly technical paper is um an approach that I think you could use to improve on the counterfactual analysis that you now do that would make it invariant of the Lucas critique where you are basically using only information that is available at the point in time in which you do the analysis. So at a minimum I think you should cite this papers and uh related work uh to speak to you know some of the caveats to the analysis you have now but I I do think you could use this to kind of get to even the next generation maybe in the next paper.
Now the third one is on the four shock.
So here the novelty that Evo emphasized also is the sentiment shock. So there they're basically just four shocks. The monetary policy, demand, supply, they're really standard, conventional, no issues. The sentiment shock is really important and I mean it does behave very nicely, but it's a bit less compelling in a sense that I mean the key assumption here is that you can distinguish it from a negative demand shock basically because that's the opposite sign on the exchange rate response. But what I'm missing here is foreign shocks. Um so now an easy way to maybe address that would be to include some foreign variables. I would at least include the you know any change in mon policy by the fat maybe captured by the US interest rate that seems to be an omitted variable in the identification that would be an easy fix. So takeaway I think it's a really important and policy relevant question. It's really state-of-the-art what you're doing. It's a very promising approach. I have some little nit bit some quibbles on or and some suggestions on how to further solidify your identification and I look forward to the next version. Thank you.
So thank you very much. I hope that uh both the presentation and the discussion has have uh inspired you and maybe there okay great from the question from the panel no >> okay it's just a clarifying question so if I understood correctly basically you are measuring this counterfactual by assuming that the exchange rate is constant in response to this shock so basically you are measuring this as the difference between a fixed versus a flexible exchange rate.
And the second thing is exactly what kind of shocks do you use to construct this counterfactual to go along the lines that look mentioning.
>> Um yeah, first of all, thanks a lot to look for great discussion. I think the comments will be super helpful. Uh and and thanks for giving us points. Yeah.
where to how to continue. Um yeah, so first uh I I can briefly just just comment uh uh uh your uh uh your main points. Uh so I agree yeah uh uh it's uh uh kind of challenging right to make uh uh everything consistent yeah with the theory and the reduced form. So that was also something that we were yeah scratching our heads a lot and thinking about it. So I think there um yeah it would be good uh to continue by thinking in terms of maybe this simple new Kenian model like Clarida and GI with four equation shocks and then uh uh yeah make the counterpart of what we have there that that's in the yeah counterpart of the reduced form model uh uh with the theory uh with this theoretical simple model. So, so yeah, that's really helpful uh with the uh shocks and the choice of scenarios. Uh it's true. Yeah, we have this uh lot of the uh we assume this MIT shocks, right? So they are unexpected.
The the agents are continually surprised uh by these shocks. So yeah, of course you can say that that's not uh yeah very realistic assumption.
uh we are doing this analysis not necessarily to think uh of a world uh where this would actually happen but more as a method to isolate this uh exchange rate. So uh and of course yeah we are all all aware of the uh Lucas uh critique u uh but I would just yeah like to point that out. Uh when it comes to the global shocks uh yeah I agree uh I think uh yeah it would improve the paper to make those distinctions very clearly. Um there I want to say uh since we have this relative model so so all of our variables for example for interest rate uh our variable for interest rate is the uh ECB or Euro area interest rate minus the US uh interest rate. So it is already uh in the model. Uh but uh you are right in a way that uh this relationship might not be uh symmetric.
It's probably not uh symmetric. So because of just the role that US dollar has on the economy. So uh uh we should yeah maybe work to to maybe disentangle uh those nonlinearities that we currently uh don't have.
Uh so uh yeah just to uh answer yeah further questions. So um so I would not uh frame uh what we do uh to be a difference between the fixed and the flexible uh exchange rate uh because that would be several severely impacted by this by the Lucas critique of course.
Um so as I said here the agents always think uh that uh the exchange is flexible. Yeah. Right. But they are continuously surprised by this MIT shocks. Uh and we do that as I said.
Yeah. To try to isolate this uh uh uh this channel and uh how do we uh construct the shocks? Uh so so this is a really good point. Yeah. That's where it's kind of arbitrary uh in in arbitrariness comes uh when constructing those and that's why it's really helpful to to get the reference from Luke on how uh uh to maybe uh choose them uh without us deciding uh how to do it uh but uh the methodology telling us and u what we use uh currently uh so we run several uh different uh kind of versions. So one is just to use this uh sentiment shock because that's the one that's uh as I said most close to the pure exchange rate shock. Uh the second one for example is to use all of the shocks but have different weights uh on them. So one kind of naive approach uh that we do is uh simply to uh give same weight for all of the shocks but again that's kind of maybe too naive. So then we uh run uh some kind of decomposition and see which shocks moved the exchange rate the most and then give those shocks the the highest uh weights. Yeah. Uh uh and we also try to offset yeah with the monetary policy shocks but that's yeah that's the one with the biggest Lucas critique weaknesses. Uh so yeah that's what we done so far. We done we have done many things but yeah with Luke's comments I think we can go step further and yeah >> so thank you Evo I have seen some hands raised already. Yeah please.
>> Right. Um Katherine man from the Bank of England. Um I'm looking forward to reading the paper since there's clearly an awful lot in there that you were not able to completely address. Um but um my two uh questions are um with respect to uh the other shocks that might be dampening your the impact of an exchange rate pass through. Uh the one that is most notable is the monetary policy response because after all if it's an inflation targeting central bank and the pass through would be inflationary the immediate response of the monetary authority is to lean against that and I did notice in your blue and red uh set of charts the monetary policy shock which was on the left hand side in the middle uh did have a difference between the two lines and it'd be interesting to to see to kind of focus on that. Um the second uh comment I guess uh from the relevance of of a country that is um not the US and not the Euro area but a smaller one um is the extent to which the results that you have um would be affected by the size of the economy um and its relative importance in international capital markets.
So would you like to answer already because that was a rich set of questions.
>> We can also more >> I'll take one more. Yeah, maybe. Yeah.
>> Thank you very much. Uh yeah, I'm sorry.
I don't want to steal the show and take the spotlight away from the others but I would like to follow up with another question that I had uh and a comment actually I was wondering uh whether you have done this exercise also on the individual country level because it would be very interesting to see uh whether there are differences uh between a country say like Slovakia which has uh a rather large exposure to the US through its automotive industry and a country like uh Croatia which might be open but does not really have an exposure a large exposure to the US right this is at least my my my guess and uh uh then I would have a comment which I I will only sketch out uh because it would go beyond uh the the scope of of the two minutes that I have here but I would like to uh go into detail over coffee uh I've done uh some work on exchange rate pass through myself uh in the past in the context of the question uh to what extent uh does euro adoption affect inflation? uh and I think it was it would be very interesting to apply your uh tool your exercise uh to uh this kind of question also retrospectively uh because I think it's highly topical still and uh for instance the ECB in each convergence report writes uh that uh in those countries which have not adopted the euro yet uh inflation is uh likely to go up in the wake of euro adoption uh which I seriously doubt but I haven't uh really succeeded yet to change the sentence in each of those chapters in the convergence uh report.
So I would really encourage you to do this exercise even retrospectively uh in that context. Thank you.
>> Yeah, Evo like >> uh yeah uh uh thank you. Uh yeah uh so to answer your uh questions so when it comes to other countries uh yeah of course uh uh I think the the size and the structure of the economy uh will will matter a lot and as I said also the the composition yeah how much you uh import uh what uh kind of pro uh products does the country u import and these might also differ across the shocks, right? So maybe if there's an energy shock, what kind of imports do you have? Um so for sure this this would influence the results and then we would have to estimate it using yeah different data. Um uh when it comes to yeah monetary policy uh right so we have the interest rate uh as one of our variables. So we do have in there the response of the uh monetary authority, right? So if you so the sign restrictions so so it is kind of baked in in there. Um uh yeah and of course yeah the uh monetary policy uh will uh respond differently. There there are some differences between the blue and the red line because yeah the the inflation that that's happening between uh the two cases uh is uh um uh different but uh yeah we don't uh really go into uh the monetary policy uh stances or maybe differences uh in the stances too much because we do have reduced form. So we want to be careful not to yeah say there uh too much given given our framework uh uh so when it comes to individual countries so in short we haven't done it um uh but I agree that would be interesting right uh uh and especially in the context that um uh for example Slovakia or Croatia now have a shared the monetary policy with the euro area, right? So, um in a sense these monetary responses uh are not reflecting only in the shocks to those countries but also uh to the other and uh yeah so I think there the estimation or maybe even the framework would have to change uh somewhat to to really uh capture uh those realities.
uh and in this case I think actually the just knowing the pass through really the the in a causal sense not just the com movement is uh important because uh if uh you have a joint monetary policy actually this exchange rate pass through is would be important to know because it would be different for different countries but you have only yeah uh one interest rate uh when it comes to euro adoption uh Yeah. Um we would need to think about that. Uh maybe maybe you can uh use this uh approach. Maybe it will help you. Uh yeah, I I would uh need to think into that deeper to give you some more substantial answer. But the methodology is what it is, right? If you can construct a credible counterfactual, it might help you. But uh we were not thinking about this so far.
>> Thank you very much. Any other comments?
Yes, please. And maybe uh our colleagues from Croatian National Bank would have some questions for for the colleague.
>> Andre Maya from Tuda Capital. I'll ask two questions if I may. The first one is did you make any attempt to distinguish between positive and negative shocks or small and large shocks to get at these nonlinearities? I know there's a notion that weakness in the exchange rate has bigger effects than strength. M and second if I look at the relatively low estimate for this pass through 5 to 10% what does it tell you about the competitive structure of the economy in a way I've asked myself the same question in the context of the relatively moderate tariff pass through in the US last year so are there more margins that can be compressed for a significant amount of time um and therefore we have this relatively low pass through or how how do we reconcile it with the idea of a competitive if economy where basically cost shocks needs to be rolled over. Thank you.
>> Some other questions from the audience.
>> If not, please.
>> Uh yes. So, uh regarding the nonlinearities, that's a great point. Uh so, we were thinking about that. So especially in the context of if you see uh the heterogeneity between the estimates across the shocks uh when using our method basically collapsed uh so the differences were very uh small.
uh and uh we were thinking that maybe that is uh uh that they could be a bit different not not as drastic of course as in the current literature with the current methods but u as you said there is this uh for example downward price rigidities. So it's important whether the shock is positive, negative uh and especially big or small especially after yeah uh hearing the first presentation.
Um uh so that is something that we were uh thinking about uh and that we might pursue uh in the future but uh we still haven't done it and there uh it would be first good to know even given the shock uh what are the nonline nonlinearities uh but also these nonlinearities uh might uh give you some information on the through true heterogenity across the shocks as well. So I think that is important but we still haven't done those exercises because yeah as al so as you heard these computations can be quite uh uh difficult to do. Uh yeah sure can I add something to that? So >> this is already like really complicated and what I the homework I gave on doing the M wolf >> um which gives sufficient conditions to get the counterfactual analysis right I mean one of the key assumptions there is linearity so you would I mean you need another econometric paper first to develop the techniques to implement what so I think it's we're just not there yet but we should at some point Yeah.
Uh yeah. And then with the competitive structure uh yeah that's an very interesting uh question. So we were not thinking about that in in too much detail but uh maybe we should look more into that micro data and and and look at the margins and and and uh uh there could be a uh something uh uh new there and see exactly what really adjusts uh when the exchange rate uh uh changes but price is not. So so what really gives uh in there uh but we haven't done uh yeah we haven't gone that direction yet.
Thank you very much. So even with the very complex papers, we're never sat satisfied satisfied. We always would like to have more and more >> more research is needed.
>> More research is needed. More data is needed. More research is needed. Yeah.
Any other questions from the audience?
Yeah, please.
Thank you. Uh Yarish Den from Goldman Sachs. Uh two related questions. One is you're using the Euro dollar exchange rate rather than the broad exchange rate. Um where of course a lot of the evidence suggests that the pass through comes through the broad exchange rate.
And so any thoughts on how your results might be different when you do that? Um and then related to it, you focus on headline inflation, I think. Um and so how much of the pass through effects might really come through commodity prices which are priced to a large extent uh in dollars. So how different could it look if you focused on on core inflation and maybe the broad exchange rate.
>> Yeah.
>> Uh uh yeah. So, so again you are really yeah asking kind of the uh questions about yeah this important choices of of of the data set that we use. Um so I think uh uh this uh of course is important especially if we think in terms of this huge u uh energy uh shocks that we observed in the recent years. So you you might uh uh expect that uh the pass through would be somewhere higher given yeah the huge amount of energy imports that the Euro area uh u uh is importing but uh as I also mentioned during the presentation uh these supply shocks don't tend to move the uh the exchange rate much so they seem to operate through uh other channels.
uh there maybe more important thing would be uh to consider yeah the imports from China and from the Asian uh economies.
Uh so it's hard to yeah it's hard to me to speculate before yeah actually doing doing the exercises.
uh we could do it. Uh uh so for the exchange rate uh it would not be a problem but uh since we have a relative uh model we would need to construct all of these uh other variables uh to be relative uh which u yeah probably in theory at least should be doable but uh >> thank you very much. So I think that we have exhausted our time. Uh and if you agree I would invite Joseph a round of applause FOR >> YEAH. Just start. Okay, perfect.
>> Um, my name is Zoe Schneas. I lead a European Central Bank coverage and and economic coverage for Bloomberg in Frankfurt. And I'm delighted to be here today with a very illustrious panel. Um, we have right to my right we to my left we have Bhut Baltz who's a member of the Bundes Bank um managing um executive board. He there he oversees payments, settlement systems, cash management and um work on the digital euro. Next to him we have um professor Ian Beg. He's the professorial research fellow at the European Institute at the London School of Economics. He specializes in European in integration and EU economic um governance. Then to his left we have Helga who's a deputy director for the IMF's European Department. He's also an adjunct professor for monetary economics at the Fryon Vesitates Berlin. Um then next to him we have um Jacob um Frankl who as we all know served um for two terms as governor of the bank of Israel and in his illustrious career he's also served as the chairman of JP Morgan Chase International and as the chairman and CEO of the G30. And finally, we have Katherine Man, who's an external policy, external member of the EC of of the BOE's monetary policy committee. Um, we all also know her from her previous roles as chief economist at the OECD in Paris and at Cityroup. Um, we're going to kick off with um with Ian. Um, we all know the premise of this panel. We are all very much aware that central bank independence that we've all been taking for granted since the great moderation is increasingly under attack. Um you're here not to hear me but to hear um the panel. So Ian, over to you.
>> Right. Thank you Zoe. I hope we change.
Yes.
I'm going to try to be just a touch academic. It's part of my mitier in in thinking about what central banks are subject to and how fiscal policy is evolving. So to start with, we all know the core mission price stability and the price stability is what you think about this influencing policy decisions. It's clearly monetary dominance. But you also have solvency.
Financial stability can be a form of of dominance in its own right. And quite recently, some of you may know that Andrew Bailey of the Bank of England has given a thoughtful speech at Colombia in the US talking about whether financial stability arguments undermine to some extent the accepted case for independence. And the tricky one, the sovereigns, sovereign debt could lead to a sense that fiscal dominance may occur in central banking.
probably most of the people in this room would reject the idea. So I'm here to try to give it some some legs and think about whether it has credibility. Now think of some episodes. Price stability probably associated most closely with JeanClotrice, the early years of the euro, but also the inflation surge from 2122 onwards, a return to price stability as the dominant narrative. But you had the little local difficulties of Silicon Valley Bank and Khadis Swiss also around that time suggesting at some points that financial stability should be paramount. But then when you turn to the the the fiscal dominance, you might say a period like the debt crisis of the late late 20s and early 2010s again with COVID and again possibly now could become a far more significant narrative.
And there's one last consideration maybe there's no dominance. We don't know what dominates central bank policym and therefore we need to have some regard to all of these in thinking about independence.
Now on the fiscal side it's pretty clear that the challenges are intensifying.
Think about what we know very well. Most member states of the EU, the most countries in NATO and others ramping up defense spending. Two, three percentage points increase as a share of GDP.
Demographics like me, we're all aging, me probably more than most. We have high debt in se in several countries and reluctance to take the example of France, complete reluctance to address the scale of the debt problem. But it's not unique in that we have the huge difficulty that many governments find in trying to curb welfare spending. And you can see this articulation between welfare spending and spending more in defense. And if you look across the Euro zone in particular, look at the differences in the scale of fiscal challenges.
All of this made worse by the fact that growth rates have been so low. You could solve many of these problems if growth rates were higher. The trouble is they aren't. And this leads to questions I think we need to address in the context of central bank independence about the policy mix. Remember the heady days when you had Reagan Vulkar tight monetary policy loose fiscal policy or in this the following decade Clinton Greenspan Clinton perhaps paradoxically for a Democrat president being quite tight on fiscal policy greenspan very loose.
Those were the old days. So where where might we go next? Well, the first is is to reconsider something that I'm sure Bhart knows very well. The favorite expression of Otar ising Ohio own house in order. The central bank does what it should do according to its mandate and the fiscal authorities do something different. But we do have a trade-off that we need to consider. And that trade-off is is sometimes as in Clinton, Greenspan, etc. that one offsets the other. You have one tight, one loose. But is it still a contest of equals? That would be my rhetorical question here. Or are the fiscal authorities now in such a awkward and more powerful position that you don't get that same contest? The ECB arguably has something of a different approach to all of this simply because of the way it's set up. EU or at least Euro zone level monetary policy and national fiscal policy. So it's fiscal is fragmented but in some ways that is a major challenge in its own right because it doesn't add up necessarily to a coherent fiscal aggregate and we have to pose the question of whether this is still accurate I wonder so I tried to come up with a an alternative US state I tried Florida and couldn't get it to work so I came up with the one of the founders of the atomic bomb which may be quite quite German here in Nikopery fiscal excesses require monetary indulgence and if that's the case you'd argue that it is at least difficult to reconcile with full central bank independence. So my two con two initial provocations fiscal for the foreseeable future is going to be much more dominant and the second provocation central bank independence will not only be compromised but it's going to be more highly politicized and if that's the case the whole edifice of central bank independence is going to be under challenge. So, thank you.
>> Um, excellent. Um, Helga, you Oh, no, sorry, Bukat you are next.
>> Yeah.
>> Well, thank you. So, and first of all, thank you to Boris and the Croatian National Bank for having me here and uh for hosting again for the 32nd time this great uh conference here in Dub. I want to start with a simple point. Um central bank independence is not a privilege for central bankers. It's a safeguard for citizens. Um it is purpose to protect price stability uh the purchasing power and of course the trust uh in our money and uh central bank independence is in many ways uh a form of uh institutional uh infrastructure often taken for granted uh when it works but difficult to rebuild um once uh it has been damaged. matched. So this is uh not an abstract issue in my home country in Germany. Our institutional memory is shaped by the hyperinflation of the uh 1920s and the currency reform after the second world war. Both experience showed how deeply monetary uh instali can damage the society. It destroys savings.
It undermines trust and hits vulnerable groups particular heart. So one lesson from this history was uh the establishment of the Deutsche Bundes Bank in 1957 as an independent central bank with a clear focus on monetary stability. This helped to anchor confidence in the Deutsche mark. And uh when our common currency the euro was uh created uh I would say the bundesbang tradition became also an well more or less important reference point for the institutional design of the euro system.
But the case for independence is not only a historical one. It is also supported by economic theory and also empirical uh evidence. The core insight is clear. A monetary policy needs protection from short-term political incentives if it's to deliver uh price stability uh credibly. And uh research over several decades supports this link between central bank independence and a lower most stable inflation.
And at the same time legal independence is necessary but not sufficient. It provides the the foundation a clear mandate protection from political institutions uh institutional safeguards and in the euro system the provision of monetary financing but independence has also to work in practice. uh it requires credibility, institutional uh culture, uh accountability and a broad support for the price stability.
And again, Ian already mentioned Otma is and I will do the same. It shouldn't be too surprising for you. Um Otma ising has often stressed this point.
Independence needs to be embedded in a wider stability culture.
This also means um that independence and accountability belong together.
Independent central banks must explain their decisions, their analysis and the limits of their mandate. So accountability uh is not the opposite of independence.
It is what gives independence its democratic leg legitimacy.
So coming to the end um legal independence actual independence and also stability culture belong together. Each is necessary from my point of view. None is sufficient on its own. Thank you.
>> Perfect. Thanks so much, Burkart. Um, Helga, over to you. I know you were keen to highlight differences between Oh, I'll leave it to you.
>> I feel manipulated only slightly. Um, so um so thanks uh fantastic conference. I note that Boris was the last to come into the session. So um nothing has changed. Um um so I'm glad I finally made it here. Um central bank independence. So I think it's clear that the pressure is up but I think one needs to be very careful um to distinguish between two different sorts of um uh pressure on central bank independence and it's clear we're talking about you know de facto independence. I know Katherine will come back to this so I will not talk about this much. One aspect is what I would call political misuse. um think about uh the central bank being asked to help finance um you know climate uh other goals uh that are outside the traditional uh realm of of monetary policy and then there's the other aspect which is what the bread and butter political adversity around price stability and you know there's pressure and and along both dimensions um depending on what kind of central bank we're looking at sort of inside uh you know within the European uh context text. So, um let's talk um a little bit about um you know how this looks and what to do about it. So, let's start with what I said could be political misuse. Um it's clear that um often um these are small things. Um a central bank may be asked to support um um political interventions around industrial policy, fund a particular um um policy goal that the government has at the moment. Um you know there are questions around the central bank's budget that that can be leveraged.
That's something we see not every day but we see it sort of quite frequently uh in the central eastern southern eastern and eastern European region without going into details. So I think this is absolutely unacceptable right.
This is a intervention that may not have um or these kind of interventions or challenges may not have immediate macroeconomic impact but they will impact ultimately credibility which will then you know um be very detrimental to monetary uh transmission and the effectiveness of the proper um goals of the central bank. Um now what do we do about this? Um it's helpful that European institutions step up. The EU is very engaged. The ECB is very engaged and I think that is very important. Um it's also clear that we are doing whatever we can um to support sort of good governance um um across the region wherever central banks are under pressure. But there may be some sort of more medium-term questions that we as a profession sort of could ask ourselves in some of this. Ian um already um alluded to one may be ga um goal overload. I mean we may be burdening central banks with more than one target around in ex in addition to price stability that could create vulnerabilities. Um then there's the question of the direct um call it budgetary day-to-day uh linkages between central banks and the fiscal authorities. Settle banks need a working budget. Um they do have balance sheets.
They're not commercial banks. So the usual economic and accounting pressures don't apply yet. You know, you have to have rules and you have to decide how to deal with large losses, large gains that come from balance sheet operations. So I think these are good questions. We don't have all the answers, but we should be discussing some of this. Now on the political adversity around breadandbut monetary policy, um it's easy to be an independent central banker when inflation is low. I I mean I could do it. Um it's much more complicated uh when inflation is up and you have to do things that people do not like. Um it's particularly difficult right now. We have an adverse supply shock. So you got to dampen domestic demand uh at a time where demand is or aggregate incomes are already under pressure um where inflation expectations are sort of um wobbly and maybe taking off. So these are important challenges. So that is borat right this is hand-to-hand combat.
I don't think it's agreeing exanti among society and we will and make the bundesbank independent. I think the bundesbank's history was one of active discussions uh controversial uh discussions both with the government and parts of the public out of which the Bundesbank ultimately emerged with a sound reputation which later helped uh the institution but it has to be earned and it's not easy. So we need to get the current situation right sort of to all the active central bankers in the room um and on the podium. It's difficult. I don't envy you um you know for the reasons that we're all very familiar with. Um but I'm comfortable assuming that the banks um that operate in regions that have inflation close to the target that started out in a position of broad macro balance sort of will have a relatively easier time handling this then other central banks that operate with too high inflation may have been coming down but you're far away from the target. Inflation expectations are backward-looking. uh there's a dynamic that uh that is difficult um to uh um to be sure of and so I think um uh that's where the challenge is that that we see right now and clearly getting today right will help you uh with the um with with the future here two you know two um pieces of two questions that I think worthwhile for us to consider as a um as a profession. One is um you know do all the central banks have the right set of targets? Is it good to have a wide inflation target range rather than um a just a narrow range or a single inflation point as a target. There are some advanced in economy infla um settle banks that that should be thinking about this because it has to do with um it can impact the way we are um uh get to manage inflation expectations.
Communication um is another uh important question. uh we have come across many advanced economy central banks to a point where the um exchange of views within the MPCs or the larger um decision-making bodies have become quite likely um you know this is a change for many institutions from the past there are many benefits to this transparency is helpful markets get to decide um or know more and more information is generally good but there's also um a slight downside um how do you guide expectations when you have so many different views and I'm looking very much forward to Katherine's point of view on this matter. Thank you.
>> Perfect.
You've already introduced Katherine. So, here you go.
>> So, uh thanks again for the invitation to Croatia. It's a lovely um view out my window and uh it's unfortunate that we were stuck in here. Uh so, so we should finish quickly. Um so uh for me I I will get to Helga's point in the second round but um in in my introductory remarks um what does central bank independence mean to me. Uh there are two elements one is the what are we supposed to do in other words the remmit. Uh the second point is in the face of what pressures or the environment. So those are two different points and I want to develop each one of them and then bring them together at the end. Uh we have to remember that there's a long history of uh research on the importance of central bank independence and the implementation of inflation targeting. Uh there's the the sort of the research implies that it was a combination of those two things working together that um supported the period of the great moderation. Um in November uh 24 I gave a speech uh titled uh great moderation 20 years on and beyond. And at that point I said uh yeah that was good policy but there's also a lot of good luck and that's going to be an important uh bringing together of those two points my first two points remitt and pressures uh in the historical context and how things have changed where we are now. Um so on the remmit uh point number one when I was growing up at the Federal Reserve working with uh Alan Greenspan um we didn't talk about uh a dual mandate. We had a single vocabulary for what we were supposed to be doing. It was sustainable long-term growth and that embodied what ultimately has become uh the dual mandate of price stability and uh maximum employment. And that's even changed a bit over time. Um, but there were never any specific weights of what it meant to be uh on the price inflation versus the activity inflation uh point um under the rubric of sustainable long-term growth. But it's very clear that you can't have one without the other in terms of price stability and maximum employment or uh stable uh uh supply side economics. So where is it you know what about the BOE?
What is our remitt? Um well, it's price stability which is defined as inflation headline inflation at two 2% at all times. At all times uh and then it says subject to that subject to that support economic policy of government including growth and employment. Okay.
So there's a lot of wiggle room in there both with regard to the primary objective of price stability at all times headline um and subject to that this uh second set of things growth and employment which in itself are two different things. Um so over time there's been um and and within the committee it's fair to say uh they're changing weights on all those things and an important question is how do those weights change um by um the state of the economy and the kinds of pressures that we're under. So let me move then to the the second point which is what are you know in the face of what uh pressures or the environment um should we be con considering the the remitt um so there of course there are direct influences and those were brought up in um Ian's opening remarks there can be fiscal pressures um and so forth uh financial stability issues um which uh my governor has also brought forward which I would also agree are an important factor that one has to consider. Um, we could talk about job boning um as a as a as a direct pressure on um the independence uh uh of the central bank. But they're also very important indirect influences which are relevant for the state of the economy and therefore relevant for my price stability subject to etc um objective. Um and that's that is the fiscal that is the fiscal side. we can't kind of ignore that when when there's when there's uh fiscal spending um or fiscal retrenchment it becomes an important ingredient in the overall economic environment and that does affect my decisions. Um we could also talk about productivity enhancements and how that is relevant for my finan uh my monetary policy decisions. So there are kind of two ways in which we can bring together this um what do I do? what's my remitt telling me to do and what is the in face of what economic environment or other pressures well the first one as I say is the state of the economy and and and uh Helga did bring that up already in his introductory remarks um how are my decisions affected by um five years above in my inflation target of of 2% it's it's never been at 2% since in my five years I think it was maybe once um it was a touchandgo experience Um that means inflation expectations are elevated. That means inflation volatility and and volatility of inflation volatility of inflation expectations are both elevated. Uh and this of course uh generates precautionary savings buffers um on the part of consumers and households because of their concern about what the value of their purchasing power is at the end of each paycheck. um and so we end up with a consequence of slower growth uh coming or slower consumption coming through that channel. So I can't achieve my objectives uh unless I pay attention to the state of the economy. Um now the second point though that affects my uh environment in which case in which I have to make decisions is is a is uh another state of the economy and that is spillovers. Um I'm a small open economy with a large financial sector. Crossber spillovers in terms of financial conditions which means the macroeconomic environment and the monetary policy decisions being made by my neighbors as well as in Asia now people are paying a lot more attention to that uh that econ that set of economies and the uh monetary policy authorities there. um those spillovers into my financial conditions are incredibly important for my decisions and they cannot be ignored.
There are sometimes when uh we can uh and I can sort of say hm financial markets are doing my work for me. I can wait a little longer for doing what's appropriate for uh my underlying economic conditions at home.
And there are other times when the financial market conditions are inappropriate for my uh economic conditions at home and I have to communicate that to financial markets.
So how do I uh kind of uh bring that together with with sort of the doue versus de facto uh state of central bank independence? Um obviously the better are the doue foundations of central bank independence whether that be um governance whether that be clear remitt uh the better are those foundations of doue independence uh the better I can anchor my inflation expectations which I've said are very important for um the underlying economic environment um that means I can whether shocks better uh whether for whichever wherever they come from. Um and last year I gave a a a speech in New Zealand on the on the 25th anniversary of inflation targeting uh there at the new at the Reserve Bank of New Zealand calleding called holding anchor in turbulent waters and that addresses these two issues of how to bring together the remitt uh what we are supposed to do uh what do we are guided to do and what are the pressures that make it very difficult for us to do that.
Excellent. Thank you, Katherine.
Um, Jacob. Oh dear. Okay. We still know who you are even without a name tag. I think um you've you experienced a huge um development in central banking in your whole career. Why don't but why don't you >> Thank you. Thank you very much. And so please because I have probably the most number of years of dealing with these topics uh not because of talent but because of demography. So please stop me when you feel that I've extended my time. Um let me start only by saying how thrilled I am to be here today. And uh one of the reasons is that uh 31 or 32 years ago when we were meeting for the first time, we realized how poor forecasters central bankers are. When I asked Boris, the young assistant at the time where where will he be? Somebody joked and said, "Well, even may become the governor."
Nobody spoke about the ECB only for one reason. The ECB did not exist. which means that part of our challenge is not to deal with the existing situation and the existing questions but to anticipate another situation in other institutional settings that we are not familiar even with. So uh again I'll take you 31 years ago my paper was titled the role of central bank independence.
31 years later, the panel is about the role of central bank independence. Are we stupid or do we have amnesia and the answer is neither of the above. The questions will remain but the circumstances change to such an extent that these questions remain and will remain uh relevant for a long time. What are the main differences that have taken place since that time? I would say that there are two major issues. Number one, the role of financial markets has become clear and much wider than before. And it's not just a matter of identifying who are the players, but it's a very different rhythm.
In the old days, in order to transmit information from one place to the other and in order to have economic effect, the boat had to carry the cargo from one continent to the other to unload it and then you know something has happened.
And today it's just a finger.
Which means when we speak today about fragmentation, let's not be confused. Fragmentation does not reduce or eliminate interdependence. The interdependence is there. What fragmentation does, it destroys the machinery that allows the system to internalize externalities from that interdependence. So it makes life more difficult. But the reality is that the challenges are there and probably very big.
The second issue is of course the role of the private sector. So when we speak about central banks being the only game in town, we normally meant to say because fiscal authorities were paralyzed or impotent or whatever reasons. But that's not the game. The game is happening in the private sector and they have never been paralyzed. They have been maybe distorted because of the paral paralysis of somebody else but they are there. So the only game in town is not actually a compliment to central bank. It's a reflection of a sad state of affairs that the orchestra that has a lot of musicians is playing only with one violin. Don't be surprised that the coinally there are no harmony in this orchestra especially when the conductor forgets his music at home because the conductor has forgotten his music at home of the international financial system. So we'll now enough for generalities and I will only come back to the substance. We spoke about terminology. In the old days if we if we are talking here 30 40 years ago probably the speaker here would have been Fritz Mloop and Fritz Mloop would have never started the discussion in a panel without having the terminology what are the meaning of words. So when you go and discuss with politicians about central bank independence, there is nothing that makes them more angry.
We have campaigned and raised money for so much time in order to be elected and suddenly you has been appointed to tell us what to do and for the masses it sounds such a reasonable argument.
So I think that one of the tasks that has not changed over the past 30 years is still an educational task of what is the meaning of externalities? What's the meaning of a public good? Why is it in the interest of the system as a whole to delegate and relegate authority to an independent agency called the central bank? Why is it coming and to be ensuring a kind of time consistency by doing all of that? That's the kind of things that we understand but the public it's very difficult difficult to explain.
So we do have and this was mentioned time and again an inflation bias in our in our democratic system because the democratic system by necessity has to be led by elected politicians good people but they have to be elected in a given time horizon which is typically shorter than the horizon the economy needs.
That's all. And what we need in as a central bankers is to calibrate and say you are too short-termistic. So let me appoint a governor or a central bank that is much more conservative to the other direction so that the average outcome will be socially optimal. This is the essence of the rogue of paper in the Qj years ago called the conservative central banker. Conservatism is not a political stance. It's an inclination for the longer term. Longer term means responsibility, means accountability, means memory, means investment and growth, means sustainability. All of the kind of things that in the short term are out of the discussion and they are out of the discussion because when you have a fire, you have to worry about extinguishing it. And when you extinguish the fire, you put a lot of water. When you put a lot of water, you don't worry about the carpets. you worry about extinguishing the fire. Which brings me to the next question, which is what is the definition of success? In a short-term mystic perspective, the definition of success is did the firefighter extinguish the fire? That's a terrible definition because you are always coming from behind. The next question is how do I prevent the next fire and moral difficulty? How do I make sure that when I do a policy today in order to extinguish a fire, I do not basically plant the seeds for the next file.
Those are the kind of things that are relevant for for this discussion. And that's why the word every word that start with a C is relevant.
communication, uh, consistency, credibility, etc. There are a lot of C's in the language.
>> CEOs.
>> CEO means chief entertainment officer.
Uh, let me now that we spoke about short-term, long-term and terminology etc. I want to come to the more the more important thing which is tell me when to stop. I did not start yet. uh which is uh one of the reasons why central banks all over the world including the Fed uh have been criticized and in a way have been challenged and lost credibility is that during the last large crisis they quote came from the bea from behind and we need to understand why the economists are first rate nobody has better data nobody has better analysts so the question is why did they come from behind? One of the reasons I think is our inclination and fixation to be what is called data dependent because data dependent is saying until I see this happening I'm not going to respond and I remember the days when Janet the time Janet Yellen said I need to see the unemployment reaching that number before I respond.
By definition when things are already there you are coming from behind. So that's not don't it's not a criticism it's a built-in but I think that what we should do is replace the word data dependence with the word anticipatory data dependence and if it is anticipatory data dependence then I need to have a model another victim of the GFC has been discreditation of models but coming back we cannot operate without models and that's why we need to have strong research department that's for you and uh so when I so when I say anticipatory is important means in a way if I'm too much attached to to the legacy of the past it's a burden it's not an advantage now let me uh in the >> give you one more minute >> one more minute fine when the question was per permanent versus transitory uh we had a big discussion on this and I think this is also misplaced It's not the question for the observer after the effect to tell me this was permanent, this was transitory. Let's see who won.
That's not the issue. The role of the central bank and of policy maker in general is to make sure that transitory shocks be remain transitory before they become permanent.
deal with them as they happen or prevent them to make sure that no shock becomes permanent. In fact, when a shock becomes permanent, you failed. And this is really one of the issues. A central banker or a policy maker is not an observer of an observer seeing the car race who comes first and who is transitory and who is not. His role is to make sure to insist who is there. So I spoke about And by definition, volatility is the name of the game because we are now in a world in which capital markets are the key game. In capital markets, the key word is risk management. When you have risk management, it means that results happen. when results happen and you want to minimize their impact on you excantante make sure that the strategy is building resilience. So building resilience is not only because in the past I er but rather to prevent the future to have large damage. So volatility is the name of the game in financial markets. And why? Because all the past is translated into current pricing. All expected future is translated into current pricing. So the current pricing, this dot of today's number reflects the entire path of the history, entire path of expected future.
It's enough that the tiny element of the expected futures changes only expected futures without even seeing the policy itself that the results in the market will move immediately. In fact, it's healthy that the results in the market move immediately because it takes out the steam otherwise it accumulates the steam and when the policy takes place that's where all the pressure will come up. So volatility is not something that we say I don't like it. It's part of the reality and in fact if you don't see it it means that somebody else holds the valve and does not allow the full manifestation of the information to show itself in the marketplace.
>> Jacob redefining what one minute is.
>> Yes.
>> Definition of one minute. So one more sentence >> one more sentence only related to the dual mandate. When I spoke to Paul Vulkar about the dual mandate if I wanted to make him angry, I mentioned the dual mandate. He really blew his head off which was tall anyhow because he said there is no way that with a single instrument that I have I can play this Mickey Mouse between output and employment. This is the Philips curve era and we failed dramatically because nobody guided me how to find the balance between the two and therefore the only way I can achieve and I don't refute the law but the only way in which I can achieve long-term growth and price stability is to focusing on as if I only have one single target. So this terminology matters and that's where where I started started.
>> Thank you Jacob.
Okay, we've touched on a lot of topics in that. Um, >> we already have questions from the audience.
>> So, should we go for that? Yes. Okay.
>> Hi. Um, this >> we comment on each other's >> Sorry, would we let them be? We weren't going to do questions yet, but >> may may I may I actually ask my question now because um Marcel Deon from the Institute of International Finance, this was interesting discussion, but I don't think you delivered on the question. I mean, I don't think this is the audience that you need to convince the central bank independence is important and the import of doing maybe an anticipatory action to be more active. The question is why central bank independence under attack? I think that's the question.
It's almost like you guys are practicing to talk to politicians with us, which I think is fine. But the issue is why is institutional uh there's this institutional deterioration in western democracies.
That's what it is. If you have a talk like like maybe because there has been a while since there has been a real crisis where central bank needs to be tough.
The vocage inflation was in the 80s.
people lost memory of that. So I think the question is why there is this stronger pressure on central banking is really in the US. If you go to some emerging markets and you go to parliament and say the president is trying to undermine central bank independence the president would fall. So take the example of Brazil now interest rates in Brazil now real rates in Brazil now at 10%.
and the president tried to discredit the central bank. Nobody paid attention. So why? Because Brazil had a history of hyperinflation and of institutional u mediocrity that was solved and people don't want to go back. So I think that's the question why central bank independence under attack not the importance of central bank independence.
We know that we are in the private sector.
>> Okay. So before we get more audience questions, we will let the panel itself um focus on um respond to the questions that's been raised here. We can include that. And also we're particularly interested in what can we do right now with populist um politicians attacking central banks across the world. Um Katherine, do you want to start?
So um just in you know commenting on a couple of other uh a couple of points that that uh uh my fellow panelists made um so uh Ian on on financial stability and how you're you kind of put it in a separate corner that that somehow it um it tempers the direction or the the emphasis on on central bank independence on monetary policy. I think the two of them go hand in hand. um you really you the the they they may not go hand inand in terms of a time dimension but you can't have one without the other um and that you know be they become important u um importantly related because of the role of the financial markets um playing uh kind of both uh both sides of that um on um on uh Birkhart on you know uh the cost of living you you were mentioning you know you were noting the long legacy of the hyperinflation in Germany um being played out now and that's perhaps relevant for Marcelo's um comment as well is that most people have not had any most people in the advanced economies have not had experience of double digit inflation. Um and that's that's what was supposed to be the great moderation. It was supposed to be the successful outcome of central bank uh independence and inflation targeting was the great moderation. didn't have any didn't have any inflation and people didn't have to worry about it. They weren't attentive. Um times changed because the good luck of the great moderation has run out and we have to re we have to address the fact that the good luck ran out at the same time as the financial markets have become a much more important discipliner of of the behavior of uh economies and and of of central bankers. Um and and Jacob you know the data dependence I think we have to be a little careful um and talking about what data do we look at a lot of it is forwardlooking um the in at uh the bank of England we have the one year ahead pricing expectations of firms and the distribution of those pricing expectations and that is a look into the crystal ball because those companies are pretty good at uh and we can evaluate that research wise we can evaluate how good uh companies are at their for their forward-looking pricing strategies and and they're pretty good. So, we can use that as an indication of of whether we are um doing the right thing or not.
Inflation expectations. There was a presentation earlier today about that.
Um, but the thing that you did not address and I wonder if you would like to comment on it is how much policymakers continue to believe uh that the channel of transmission of monetary policy has to go through aggregate demand before it impacts inflation. I do not believe that. But a surprising number of ESRs continue to have a assumption included in their, you know, in their columns that there is no immediate effect on inflation. And increasingly the research at least at the Bank of England is very clear that my decisions have immediate effect on inflation. I do not have to wait for 18 to 24 months to have an impact. And yet a lot of decision-m is continuing to be on the assumption that it takes has to go through aggregate demand before we see an effect.
>> Hey Ian, do you want to respond right away?
>> Will you allow me a very quick poll of the audience? Does anybody in the room disagree with central bank independence?
Put your hand up.
So we are preaching to the converted populists.
Let's consider in my very limited knowledge of Latin what the word populist derives from which is populist which is the people. The people do not like what economic policy makers have been inflicting on them. So it's no great surprise that populists are doing doing better than other mainstream than mainstream parties at the moment.
I'll try to be a devil's advocate on this. Why? First reason is the there's a big chunk of the population, the people who feel left behind. They don't think economic policym has served their interests. And they're probably right.
Second, many see banks as the perpetrators of crisis and yet they see banks rescued but to take one extreme example, Greek pensioners penalized.
That feeds populism.
You also have distributive effects. And here I think there's there is a question that's raised in Andrew Bailey's speech about whether financial stability has greater distributive effects than mainstream monetary policy aimed at the interest rate. because there's a sense in which if you get stability wrong, it's the small savers who may well will suffer from it and the big banks and others who will who will benefit from it. There's also a perception that quantitative easing in whatever form you want to nominate it benefited asset holders, rich asset holders and didn't do much for the poor segments of the population. I'm sounding very convincing to myself at the moment.
And then you have the fact that high interest rates as we've seen them in the last well at least in the immediate response to 2122 inflation did seem to go into higher profits for banks. Yet again an argument that might be made. So I I I come up with a three or four questions. One is we all know the tying of hands argument for independence.
We're perfectly familiar with it. Is it still fully justified? Is it still making a strong case for full independence?
Burkart, you mentioned accountability.
How how accountable really are central banks? They have to appear before in the case of the the European Central Bank, the monetary policy committee of of the European Parliament. They sit on the platform and the members of parliament are below them and nothing happens.
>> Well, I had the same level because I quite quite poor. So, >> but you're cheating.
>> When I said uh not >> just just because you're 2 m 50, you you don't get a special place.
>> Then consider what accountability might mean to the people, the populace. I think it would be that they get to vote on it at some stage, but you cannot vote in independent central banks by definition. So there's a there is a gap in accountability there where I do not think what we stylize as the the median voter has any genuine input into monetary policy and yet they're affected by it.
So let let me conclude by what what might be the most basic test.
The era of strong central bank independence started as Katherine just mentioned 25 maybe 35 years ago with New Zealand despite the fact that the Bundes Bank and the Feder had already been independent and the Swiss National Bank.
basic test. Has economic performance in this era been better than what came before or worse?
And is the fact that economic performance generally has seemed to be on a downward trend orthogonal to central bank independence or related to it? I'll leave that question floating to see and I s I stress that I am being a devil's advocate.
>> Okay. Um just because you mentioned New Zealand, one of the things that we did find interesting was when there was a global push at the beginning of the year, a joint letter from central banks supporting Jerome Powell and is the attack on Jerome Powell. The New Zealand finance minister new RBNZ, the New Zealand central bank signed the letter and then the finance minister publicly scolded um Anna Breman for signing this because she got involved. They felt he she overstepped here. So even sort of the paragon here of C of independ central bank independence was then criticized by his own government.
>> He was probably trying to be careful not to offend Trump.
>> But is that not an issue here? Okay.
Helga that question you hand to me. Um so I we we are discussing central bank independence not because we don't agree it's important right now. um but because it's at stake because inflation is up and central banks need to do what they need to do. So that's the answer. This is why you know I I that's the real answer why um it's under pressure at least for the advanced world I think. Um and I um and that's normal, right? And so we we I'm we shouldn't be surprised as students of history of central banking as everybody on this panel left and right of me um is. But it's also clear that Marcelo right that learning how to talk to politicians and in turn to to everybody right the medium voter that allegedly has nothing to do with central bank independence and I disagree right is important because ultimately these debates or these these these fist fights around you know do we dampen demand at a time when it's not convenient to dampen demand sort of are decided in the court of public opinion that is the secret of the bundes success um you're not made in dependent and stay independent because there's a law that says so. You you you need the law. It's a necessary condition but you know a sufficient condition it is not. So so you have to win these public debates and we have to continuously learn how to make our point. Just pointing at the interest rate you know will not do it.
Uh telling people we want you to have less wage growth because that will fuel consumption that will push up inflation also not a good idea. Maybe correct. So what is it that we do? We speak about sort of the benefits in the short and the medium and long term of price stability and how on balance this is helpful. We have to find examples. We have to convince people um um of our arguments. And so it's good that we practice, you know, together in this room and look for and you know I'm looking forward to your good ideas, Marcelo, um on this issue. Um I I think a complexity and I I love your point to research departments in central banks and at the IMF. Um um thank you. Um is that the economy is constantly changing that financial sector that today Katherine you said I can sit back and let the financial markets do my work for me sort of um under certain conditions um is you know wasn't there for the Bundes Bank when it made its way they just had to pick up the phone and tell the banks how much credit how much credit to issue. So it's a completely different world. These financial markets as you explained are forwardlooking.
What is it that we do to help them amplify our policy intentions? And that's where the the current debate is.
And there I get a little nervous when people interpret data dependency literally. Data dependency cannot mean that we wake up in the morning with a green slate and decide what we do given the data. That's not what people mean.
That's also not what large advanced economy central banks mean when they say it. Right? It's it's you know if I'm data dependent I'm I'm dependent on what the forecast will do with the new data as I get together and decide about the future of the economy by setting monetary conditions now that must be the meaning and so communication about how I do this right how what is the framework in which I operate are essential and sometimes forward guidance can be helpful depends on the circumstances but you know making it up up as we go along is not the meaning of data dependence and I'm sure we can also agree on that.
>> Thank you. So um I I want to to take up two uh other points but of course here also in the core of our discussion. The one is the mission creep of uh central banks because for me it's centered in these of course discussion of the independence of central banks. um our central banks, modern central banks operated in a more uh much complex environment obviously than in the past.
Jacob uh of course told us that this is of course one of the big challenges. So we have to deal now not only with financial stability also digitalization, climate related, financial risk, cyber risk, uh the transformation of payments um and all affect the environment in which uh our monetary policy operates.
So, so um we as central bank makers cannot uh simply ignore those kind of issues and if a development is relevant for price stability, financial stability or the functioning of the monetary system, we have definitely the responsibility to analyze it and also to explain its implications.
But analyzing risk is definitely not the same as taking political decisions.
Central banks of course can access uh the macroeconomic and financial implications of fiscal policy of climate risk of the digitalization and also the financial stability. But the political choices uh and themselves belong to elected governments and elected parliaments. Um well the the latest example I would say in the last couple of years was uh when central banks uh started to look at the climate related financial risks. They do so because uh the these risks can affect the price and uh financial stability. For me it was always obvious but this is a mandate uh related risk analysis and it's definitely not climate policy. I'm by the way also not eager to do anything in climate policy because it's up to the politicians. It's not up to us as central bankers. Uh the same applies to uh to digital payments, a world where I'm focusing on since a couple of years.
Um in an increasingly digital economy, of course, central bank money must remain available and also usable.
What kind of uh of course uh digital money we will see. We have different passes and different uh jurisdictions.
But at the end this is uh relevant for the trust of money for the resilience of the overall payment system and also for monetary sovereignty. Uh but here I'm I'm absolutely clear uh the central bank's role must be clearly uh defined.
So I would not say that central banks should be silent on new challenge but uh they must be how should I describe it?
they must be disciplined in how they address those kind of new challenges.
The second uh point I wanted to to address is also then the political stance of central banks or central bank board members. Um because some central bankers in my point of view have become very vocal on political or also societal issues. Um the the the question I would have here um is uh of course what does it mean for the institutional levels? Of course central banks should not be politically partisan. At the same time independence does not mean silence. I've already said that. But if uh the developments are becoming relevant to our mandate and also our statutory tasks for example uh price stability uh we have to uh response uh and to explain our analysis.
So um if pressed for example here on specific uh uh interventions um on fiscal growth or also gross policy debates uh we have for example an own part in our bundesbank act um where we have to advise the federal government in Germany on questions of monetary significance. So that means sound public finances are for us uh of course precondition for price stability and speaking up for uh the conditions for monetary policy to succeed is definitely part of our mandate. So it's not the same thing I would say as telling the government what to do. uh as we are pretty disciplined about that line. But at the end political decisions belong to elected uh governments and parliaments.
And the important distinction and I will uh close with that is between uh being mandate relevant and then being partisan and uh of course central banks must be the former.
>> Okay. Fabulous. Um what um Booker here of course did not mention is that two of his fellow board members did actively participate in anti- AFD demonstrations in Germany. I'm aware you have a policy of not commenting on that and that it's minus f height and all that but it is one that one then notices that if you as a central banker go out and set a political act wouldn't it been then be expected that there's a reaction from those politicians or those politicians then take you into the crossfire and say we've seen this at the in the UK now with um you reform targets saying they might put a Treasury official there if they win power or they don't like the way QT is being done. Ian, I can see >> but al also is the case of Mark Carney being visibly against Brexit.
>> Yes, we we do see that. And I lived in Switzerland for six years where central banks even when there were these referendums about central bank policy.
They were that affected them quite actively. They did try to stay back as much as possible. I'm aware we're running out of time. We want we had one question from the audience and at Hawkwan. We have a lot more. I see Jiannis.
Shall we collect some quick questions over here on the side over here? We'll take Giannis then we'll take the lady over there and then we'll take the first row please. Uh thank you. Thank you Zoe.
Uh that was a very lively discussion. Um thank you. It's very close to the heart of every central banker in this room or anywhere else. Um I just want to ask you uh more professor beg but also everybody will be uh welcome to reply. Don't we perhaps overestimate the risk of fiscal dominance these days that as Jacob said that financial markets prevail bond markets are huge governments know very well that uh when inflation is low 10-year bond yields are going to be low so with the interest rates as a percent of GDP the order of 3% now worldwide what is the interest of of governments to want to to dominate fiscally uh central bank independence do perhaps overestimate this risk at least from the country that I know best and believe me we have passed through the crisis Greece it's much better to have low inflation that helps the government to keep the deficit low as well >> thank you >> and it was your turn over there >> thank you uh Dublin Norris the IMF so I'm going to go back to the point on fiscal uh dominance. I mean one you could think about the the government putting direct pressure in terms of interest rate policy. We're sort of seeing whiffs of that in the US uh already. Um there's there's other ways you can you can see uh the government putting pressure but your colleague Ian uh Ricardo Raj has talked about financial repression is another way out because you know we are in a world with very very high levels of debt. So in a sense it's sort of the view is it would perhaps anything goes um and it may not just be direct inter interest rate intervention but it could be something else. I'd be curious to hear your views on that.
>> Thank you. And here first row please university of Miamiisin the first chief economist of the European Central Bank was um very strong on being proactive to prevent asset bubbles and he mentioned that in many many speeches. I was a student of Armen Alchan and Ben Klene and in the 60 in the 70s they wrote this paper on the correct measurement of inflation that you should include asset prices.
uh so I would like the panel to comment on this and very quickly I have another question the target two balances at 1.5 trillion and growing uh is at some point the European central bank going to discuss and perhaps propose something like the interd district the settlement account of the 12 districts of the federal reserve. Thanks.
>> Okay. Who wants to start?
>> Ian.
>> Gh. Yanni.
I think it's a difficult question because if you look around the countries which are most exposed to fiscal risks France clearly finding it so difficult to curb public expenditure and the deficit still from memory five five six% of GDP debt around 120%. That is a heavy fiscal burden all the time. Even though France benefits hugely from being inside the the protection of the Euro zone in contrast to the UK where the the level of debt service expenditure now greatly exceeds the expenditure on health and education put together. So there's a a problem there that the politicians don't seem to be able to resolve. And the question for central bankers to me then becomes if it reaches the point where there is maybe not quite as severe as happened in Greece in the period between 2010 and 2015 but a risk of default or rising interest rates which add to the burden on the fiscal authorities and crowd out other public expenditure. What then happens? Do the central bankers say it's your fault we're going to raise interest rates anyway or will there be a sense of caution that says if we do this we are going to collapse the economy in much the same way it's happened to Greece I think that's where the tension lies and where ties in with your point about financial repression this is the big risk because of the proflegate nature of the fiscal authorities their hands are not tied and they don't seem likely to be tied in the near future And as for what's happening in the US, well, who knows where another two years of Trump will lead the public finances of the US. Maybe a weakening of the dollar's credibility, but I suspect Ellen will deal with this at lunchtime.
>> Okay. H guys. His already you.
>> Yeah. So I thank you. Um I think in that game between the fiscal authority and the central bank, it's very very difficult if not impossible for the central bank to be the Stuckleberg leader.
you know, the government moves more slowly and you know there's there's dynamics you described some of them one step is high interest rate payments high so they they just are where they are so I think it's an illusion to think that by promising being tough at the end and raising interest rates you're going to make the government um uh do your bidding I think you have to argue along the lines of what is good fiscal policy you have to convince um both the the population and the politicians to you know that high debt ultimately um is detrimental to growth and you have to you have to try to to convince um in the domain of fiscal policy itself I think that's essential and as era said um you know there are many ways in which this problem can be solved that are not good right so um in just one highlight uh we are thinking about the debt that is currently visible but the expendure pressures that are coming our way in Europe from defense spending from energy security policies and uh infrastructure a lot of things are very high for some countries up to 5% of GDP sort of in the medium-term additional spending pressures this is a real problem and you know the way central banks should engage on the substance of it which is a fiscal policy one >> okay Katherine I can see you >> so um um the point on sort of fiscal dominance I think uh the I think we have to kind of recognize that financial markets can play a very important role and disciplining the fiscal authorities.
Um maybe not in every country. Uh but um the lessons from that kind came from emerging markets that from which all the central bank independence and inflation targeting uh lessons came from was in if without those two things um the head of state, finance minister, usually central bank governor uh were all we're all turfed out. Now um fast forward to an advanced country uh where um fiscal uh uh fiscal issues uh generated a certain degree of financial market discipline and a prime minister a finance minister but not the central bank governor were turfed out. So financial markets can play a very important role in disciplining um the the fiscal the fiscal authorities as I say not in every country but there is experience in advanced countries where that's true. Um the Ian you you were talking about a a doom loop basically uh higher interest rates um uh inflationary effects um and it doesn't happen in France. Well, there are two reasons. One, financial markets are not disciplining France because they don't get at France directly. And number two, there's no exchange rate for France specifically. So for any country that does have international exposure and an exchange rate, that is an avenue for a doom loop.
So you were obviously referencing the trust moment, which we keep hearing again whenever anything whenever there any weird demands in the UK. Um, Jacob, I've seen you've taken a ton of notes without dominating the rest of the time.
Do you want to give us a quick answer?
>> Well, I know that I start with a deficit of time. So, uh, but since we live with deficits and we want to show the deficits are survival uh we will continue in carrying deficits which means that we are optimistic because it means the future is long otherwise we would not have been able to do it. Erh, I want to come for one minute to Marcelo's uh I would say passionate question. Um, of course the idea is not to educate the central bankers but the idea is to recruit the central bankers. If you are so convinced that you are doing the right thing but the problem is elsewhere, what do you do if you somehow decided by convention or by law that you are not allowed to speak? Uh in Israel the law of the bank of Israel says that the governor wears two hats. One is a governor like any governor and second he's also the chief economic adviser of the government which is a challenge because on the one hand for relevance you need to be to have proximity and for independence you need to have distance so the question is how do you balance it and that's why it is very much individually dependent in my case I served six prime ministers from right or left but there was no budget discussion that came to a vote before the Governor expressed his view about the budget, not always successfully, but it was part of the understanding that monetary policy is part of an orchestra. An orchestra includes the budget and decisions in the budget have profound implications to what we do in monetary policy. If there is a wage negotiations that the government is involved in, it's only natural that the that the central bank will express his view about it because that's what we are talking about. That's the subject. and to pretend that somehow this is belonging to somebody else's territory is really a very bureaucratic way to think about a system. So I'm not shy or afraid about it. But I can say that one of the challenges that we have is that blaming the firefighters for the fire. your central bankers came to the saving of the of the crisis and they found themselves therefore being responsible for it without having the tools to address it and the question was when I was asking Jacqu when I asked Jean Clrice why did you enter into this his answer was because I'm also a citizen in addition to being a head of a financial institution well it's It's very respectable answer but it means that we are in in a problem. I remember I was sitting in V Paul Vulkar's office when the decision was announced that the Fed is going into the market to buy to buy assets in order to clean the kind of the housing crisis that were there and he told me I understand what they are doing but this is a slippery slope that will bring about challenges to to the Fed's independence because you are send entering into area in which there will be fiscal consequences. So those are issues that therefore the answer cannot be black or white but that's why judgment is important and uh that's what I would say about about this I think that about the the interaction with other authorities in the government is depending on the culture and on the experience of the country. I remember the picture of Alan Greenspan being pictured in the inauguration ceremony of Clinton sitting next to Hillary and there was a big scandal that he's destroying the independence of the Fed because he's sitting next to the executive arm. So those are issues that at the end of the day you cannot take a snapshot and say this is the situation.
You need to have a time series say where are we, what's the culture and all of that. That's basically what I say.
>> Okay, we are end nearing the end. Are there any more urgent questions from the audience? Oh, sorry. No one of you answered target two was ignored. This >> We're all waiting for Luke to answer that question.
Are there any more questions from the Yes, back here in the middle we have one. Let's collect another three. I think we can squeeze that in.
>> Acid buzzwell. Sorry, you also didn't.
>> Yeah, thank you. I think that this topic is sufficiently uh uh important or or or actually constitutes a ground of the central banking operations and central banking role in the society so that I can also deliver a somewhat heretic thought on this. Okay. Uh very interesting discussions but I have not heard apart from uh uh Mr. Mr. Mr. uh bolts about uh the actual legal and that I would say constitutional foundations of the central bank independence. I mean this whole discussion took more than an hour but I have only I think twice heard the word legal and I have never heard the issue of uh the constitutional guarantees of the central banks and all of the laws of the countries basically with constitutional significance do guarantee this uh independence. Now I I just wonder whether in our and something of the discussion we haven't found a a a ground to address this sufficiently. Uh Mr. Balt said yeah yeah there is a legal foundation for this but that's not sufficient. I think that this is the root or this is the avenues that should be explored in order to achieve a better general understanding and apprehension of the central bank uh uh independence and it should not be instituted necessarily by central banks. There are also other players in the market in the society who may eventually understand that central bank independence is something that is also very very important for the general society. So thanks.
>> Okay, we had first row here as well.
>> Okay, this is a question for Yan. Uh going back to the populist uh story uh would that uh the shifting of the focus from uh uh say average inflation to distributional effect of inflation change the picture and the reason why I'm asking is because it looks like when you look at distributions the fact of monetary policy seems to occur only in the very very low part of the income distribution and a very very high part of the income distribution. So it doesn't seem to be room for improvement along those dimension.
>> Do we have a third question or should we answer those two given that we still need to answer acid bubbles from the previous round? Oh yes yes yes here sorry left hand sorry here first front row front row second row sorry lady in green took >> thank you one question which is about a prediction and I know we have some skepticism about economic forecasts but if it's true that artificial intelligence will lead to considerable increases in unemployment will central banks such as the Fed and Bank of England that have some sort of a dual mandate and issue about employment. Be it a disadvantage when trying to control inflation in the future and is the dual mandate a threat embedded in the mandates of those banks?
Okay, perfect. Um, we have just because I know Katherine wanted to be out in the sun the whole time. Um, so we have about four minutes left which means let's start with Katherine and let's try to make try to answer as much as possible in a short amount of time. I know impossible. What's the dual mandate?
>> So, so uh I'll I'll leave the dual mandate um question, but um the asset bubble question because I think that is an important one. Uh there so there's a fair amount of research that u makes it uh makes it clear it's hard to identify um when there is an asset bubble and when you should prick it, right? Yeah, there is. Um because I think it's uh uh um Luke who I think all research kind of goes back to Luke one way or another. Um several years ago uh conference sort of like saying well five of the uh three asset bubbles would have been pricricked right and and what do you lose? What do you lose when you prick an asset bubble too soon? There's a lot of conclusion that you lose innovation at the top.
Yes, you do. I know you're shaking your head, but but you lose innovation.
However, however, I can remember from my G7 work when I was at the Federal Reserve that there's also a a uh an issue that some central banks can clean.
Some central banks and other authorities uh working together can clean up which with a much greater capacity to clean up a mess than others. And so the decision about whether or not to break a bubble, prick a bubble is is partly endogenous to the capacity of an economy to uh and their authorities to respond. The problem is is that most bubbles are global because again it's a financial market and it's a global financial market. So you have a disconnect between what the consequences are of bubble breaking for individual economies. But to argue that you should break all bubbles when you don't know what the consequences on the innovation side should be, I think is something we have to be very careful of uh when we make decisions about whether or not to enter in to a bubble breaking exercise.
>> This is a very tough question, Ricardo.
So I'm not going to resolve it completely. But on the one hand, you cannot argue much against what Katin was saying. It's it's a tough game and a cost of a mistake is not low. By the same token, I remember 31 years ago here actually in hotel Argentina when Mandel was asked about the same question about bubble he said how do I know what is a bubble before it bursts? Which means for him a bubble is something that burst.
which means coming behind the curve.
Very unsatisfactory situation needless to say. So if you there is also a saying that uh some of the problems arose because they were too big to fail and some became too big to fail because they were too small to be bothered with when they were small. So the art is really to find the middle ground and that's why I will ask Ricardo to find and identify it for us.
I think we can agree that a bubble that finances a boom in residential real estate is different from a bubble that uh defines the evolution of the internet or potentially I. So I think that at least is something you need to consider before you can answer that question. Um on the legal independence I think I think the consensus also in terms of how does it matter empirically is legal independence is a necessary condition right to for a central bank to do what it needs to to do it's not sufficient so the proof of the padding is doing something with a with a legal independence that that ultimately keeps inflation low >> kat I know you had followup on the legal >> yeah I was directly asked by by the colleague for me of course legal independence is abs absolutely indispensable and without a clear legal framework.
From my point of view, we as central bankers are are really vulnerable to short-term political pressure and this is of course becoming more and more obvious in these times. So the legal foundation must include a clear mandate protection from uh instructions also operational autonomy and safeguards against monetary financing. Uh with us in the euro systems I would say these kind of safeguards are are relatively strong. uh the primary objective here if the price stability is laid down in the European treaties as you know and the ECB and the national central banks are uh pro protected from uh political instructions and also as I said which is for me personally a key point that monetary financing is prohibited but from my point of view also legal safeguards are not uh enough. Um, de facto independence depends on whether institutions respect these safeguards and practice and it also depends on whether central banks have the creditability and determination to act according to their mandate even when decisions are unpopular. So this is why and again I come back to accountability for me is that so key so important if central banks really can uh interact independent of course they must explain also themselves they need to show how their decisions are consistent with their mandate and of course they also need to communicate clearly and transparently. And finally, um, independence rest, uh, on a on a broad stability culture. Uh, politicians, markets, uh, and the public do not agree or have to agree with every decision, but there must be a shared understanding that price tability is a common good. Thank you.
>> Excellent. Ian, we'll let you have you had you kicked us off. We'll let you have the final word. fing I'll try to answer Fabio's question there are populists of the left there are populists of the right flat dital italia alternative for Deutsland and about six different variations in the UK they agree on one thing that there's a problem it doesn't mean that their diagnosis is correct from the distributive point of view which I think is is your point so it's simply answering it with with science. So this this question maybe the experiment we should try for next year. I know bodies will no longer be organizing the conference but is to to give a mandate to claude or chat gpt to run a monetary policy simulation and see if they do it better than the central bankers.
And the last point is I wrote down earlier and showed to Helga a comment group think and he said that doesn't begin with C. says okay we'll call it collective think collective think is the trap >> and we need to avoid it >> okay on that word I know we still have a lot of ideas here we'll be able to look at those over lunch thank you all so much for your attention and thank all the panelists Good afternoon.
Thank you for coming to the session right after lunch. It's usually the most difficult one but I hope we will be so um interesting in our deliberations that everybody will wake up. Um my name is Dra Kumihayak. I am external associate of Croatian National Bank, former BIS and IMF economist. Um and um I will make a few introductory remarks but let me first introduce this distinguished panel. Um we have Mr. Ben Broadband uh uh with Balashni Asset Management, former deputy governor of Bank of England. We have Mr. Gerine Click, executive director at DIMF for Dutch Belgian constituency, which is also a Croatian uh home at at the IMF.
We have Mr. Christian Keller, chief economist of Barclays. Uh we have uh uh Mr. Janis Tunaras, Governor of the Bank of Greece and very shortly I'm sure Mr. Radawanic will also appear uh CEO of Erst Bank Hungary and uh former governor of uh National Bank of Serbia. So uh since we are starting late and since some people will need to leave early um in the next panel, let's uh immediately start. So what is this panel about? It is about um what central banks can do on the topic of housing affordability.
If you read uh and everybody reads newspapers and and other media, a sense of housing crisis is omnipresent in media. Um but the concept of affordable housing which is intuitively uh appealing is difficult to get a catch on. It cannot be distilled into a single reliable indicator and this leaves a lot of room for interpreting what type of housing is unaffordable and and where.
uh for the EU standard affordability indicators provide the mixed picture. Um at the aggregate level um some indicators have even improved over the 10 years but the more you disagregate the more affordability issues emerge. Um the problem is that we don't have good disagregated data data at the level of cities data at the level of uh regions smaller than nuts three and we don't have a good breakdown by household uh uh situation.
So what we can read from u the data that are available is that socially most vulnerable the homeless uh the the very low income families they are the ones who are really struggling the most. Then there is also a middle inome uh population uh that is struggling with housing and these are uh renters at market rent. I will show some graphs later on. You can also identify few groups like um young people living with their parents, internationally mobile workforce and international students.
They they are affected by shortage of urban housing.
The issue um that is of concern uh from the economic point of view is that these are highly productive uh labor force participants and they would enhance the economy's potential if they took up jobs that are available in urban centers. But because of high cost of housing they may be discouraged from doing so and therefore the whole economy uh loses on on on a potential growth. This is the competitiveness issue associated with housing affordability.
Um as I mentioned one group struggling the most are tenants uh renting at market prices. The bars show long-term average of a ratio of uh people who are renting at uh market prices and who are facing um very high uh cost of housing burdens.
And these uh blue uh short uh bars are the latest observations. And and you can see that in many European countries, latest observations for these groups are above the long-term average, meaning that a lot more people are suffering now than they used to in in the long run. Uh if you try to explain uh what's behind this um of affordability crisis. First thing you look at is house prices. Uh on the left hand side you see nominal house price growth between 2015 and 24.
In EU nominal house prices increased by around 55%.
And then you look at standard determinants. These green bars are gross disposable income 45% not far behind house price growth. Then you look at household financial assets 50% household net financial worth 60%. So a lot of house price growth can be explained by fundamentals on the demand side. Then you look look further to the right you you see this uh uh tall red bar. These are construction costs 48%. So this also explains pretty much uh pretty well the the rise in in in house prices and we have few few other factors. Demographic factors are also important. Europe is about to reach its peak population this year at around 440 million people and decline from there on. But what's happening is that um household structure is changing. Single uh uh family households are single person households are increasing fast and that's where demand for for additional housing is coming from. immigration also.
Um for us as central bankers, what's important is um what is on this um uh brown uh penultimate bar. These are housing loans. You see, cumulative growth of housing loans in in the past decade has been around 30%.
Almost half the growth of nominal house prices. So just eyeballing it you would say um loans are are not pushing the the growth in in house prices. And then when you look further uh you start asking additional questions. The blue uh line in the left hand panel are um currency and deposits of households. You see that they have increased from around seven to around 11 trillion in the euro area.
Um you look at the right hand panel these are real uh mortgage rates the green line and real deposit rates the orange line. So clearly during this period of uh pandemic when real rates were deeply negative. There was an incentive for households with liquid assets to invest in in housing and that's indeed what what we have seen. Uh what's uh really interesting is that um share of housing purchases without bank credit is currently at 30 to 40% in many countries uh that are represented here. Um and then uh 50% in in France, Italy and Ireland, 70% in Hungary from uh available data. So this is where the purchasing power comes from and this is why it's difficult for monetary policy to do something about um housing market because at the moment uh it's not coming from uh the cost of credit. Uh people already have funds available to buy housing. Um there are also important reasons on the supply side. Um, in Europe, housing stock is relatively high, about 240 million dwellings or 1.2 dwellings per household. This is fairly high. In some countries, it's it's 1.6 or or or more. Uh, and number of dwellings is rising faster than population, but not fast enough. New construction is very slow. It takes about 56 year years to replace half of the housing stock. And after the second world war, for example, Germany replaced half of its housing stock in 20 years.
Croatia replaced half of its housing stock in 30 years. US also has experienced a huge decline in um building uh productivity since the 1970s. Two factors were highlighted.
uh high uh regulatory barriers, building u regulations and then low productivity in in in the construction sector. So this gives us a broad picture of demand supply and who is suffering the most and now we would like to discuss what central banks can do about this. I suggest that we go first with Mr. click to give us a broad uh glo perspective from the IMF point of view.
>> Perfect. Thank you very much, Drafco.
And you said it actually very well in your introductory remarks that Croatia is home in our constituency and it feels always when I'm here, it feels like home. So, thank you very much for that.
And I would also like to take a moment to thank the Central Bank of Croatia for all what you're doing for our constituency and our other 15 countries in the constituency. So having said that also to say the usual disclaimer of course the views that I express they can of course not be attributed to the board and uh of the IMF but um this panel is actually raising a very important issue uh because housing affordability it has actually real consequences for efficiency, mobility and growth and as you all know the fund is absolutely not a housing institution but we we are always concerned when issu come up that affect macroeconomic stability, growth and the allocation of resources and housing and housing affordability that sits a little bit at that intersection and at IMF we see actually three channels uh very clearly. First housing affects microeconomic dynamics. I think I don't need to convince anybody of that. That's we see through consumptions, savings, credit and inflation and inflation is especially through the rents. Second, the housing affordability affects also economic efficiency. When we have facing high housing cost, if that is preventing actually people from moving to the productive regions, we are just not facing an social issue but we are also facing an issue of misallocation of labor. And then third it also affect financial stability that is given the concentration of bank exposures to real estate and the role of housing in credit cycle. So the answer to the question is should the IMF actually engage in housing is actually very simple. Yes, and we already do because it has become a macrocritical topic and in fact this links to what I would say we have a broader discussion for the moment in the IMF and especially in the board as what counts now as macrocitical and that has become a central question in in our work and including in what we are discussing right now in the fund that is actually our comprehensive surveillance review that is the set to set and decide on our policy how we actually how our surveillance work should function and I have to be honest with you we it's a very vivid discussion that we are having in the board on is there merit to work on issues beyond the what I would say traditional or core variables uh such as fiscal monetary but do we need also to work on climate demographics gender and housing and housing is certainly not one of the traditional policy domain for the fund and probably also Alo not for central bankers as housing is primarily I would say a structural policy issue but when housing starts to affect inflation, financial stability and the allocation of resources across the economy it clearly enters what I would say the macrocritical space and then we must better understand the drivers and the dynamics of it and an obs important observation what we see in our recent article 4 uh discussions at the board for those who are not familiar article four that are the reports that every year our teams did prepare for each of our 191 member countries that is that housing what we see there is housing affordability is no longer treated as a single issue concern but it becomes more and more what I would say recurring theme appro uh that is approached from different angles thanks and I will give you a couple of examples for example in the report on Canada There our staff framed the deterioration of affordability basically as a result of strong demand interacting with persistent supply constraints. And the strong demand there also was indicated by immigration and in Canada they said well there are clear implications for productivity and microeconomic stability. In the report on Spain, uh the staff put the emphasis more on uh the rising house prices driven by credit excesses and structural supply and demand imbalances. There the staff was pointing that there is a need for a broad policy response and also expanding supply. And then the third example I want to give is Austria. In Austria, the discussion took a totally different angle because what we see there was a sustained increase in house prices and rents over the past decades. But we had more and more concerns about the declining affordability and that could become a potential source of macro financial vulnerabilities. So these examples illustrate a little bit how the fund starts increasingly to analyze housing affordability depending as you also said on the country circumstances.
So if I now turn to the role of monetary policy uh my point would be that monetary policy clearly matters but it cannot solve housing affordability challenges by itself and there is no doubt that financial conditions influence housing cycles. Interest rates affect borrowing cost, credit supply and expectations and they transmit to housing through multiple channels being mortgage affordability, house prices and wealth effects. So central banks cannot ignore housing because it has become an central part of the monetary policy transmission mechanism. But there again influence is not the same as control and interest rates. They affect always the entire economy. They're not just affecting housing. Um and their impact on affordability is I would say also a little bit ambitious ambiguous because tightening might actually slow house prices but it can also raise borrowing cost and for many households affordability does actually not improve and may actually worsen and a significant share and I think that's a very important one that we need to bring up in the discussion of the housing demand is relatively insensitive to interest rates that are the cash buyers, the investors and the wealthdriven demand. And that I think is particularly valid here for this very nice area of Dub Bronovnik and Croatia at in at a larger stage as well. So the there are the limits the degree of freedom and effectiveness of monetary policy as a targeted instrument. So affordability challenges that we see today are primarily uh driven by structural factors. So supply constraints, regulatory bottlenecks, market inefficiencies and demographic pressures. So what I think what housing affordability requires that is a coordinated policy approach and I think there are three elements here. Uh first and I think that's the most important one that are the supply side policies.
Uh the issue that is the issue is supply and we need to increase housing construction, reduce the bottlenecks and better use the existing housing stock including the vacant properties also something very relevant for Croatia. Uh that's that's going to be one part of the solution. Second, we can exploit macro credential policies. They offer of course more targeted tools I think to loan to value depth to income limited capital buffers and they can help to contain a little bit the the credit driven price dynamics without tightening actually the entire economy but they also involve tradeoffs and that is in particular access and especially for the younger and the first time buyers and then third uh fiscal and structural measures. These are measures that need to be targeted to social housing, support for vulnerable household groups and uh forms to actually also reduce speculative investments. And then I think about property taxation and their policy design is actually very critical and we also should not ignore targeted subsidies. They risk fueling demand and worsening affordability. So what I think is very important is that it is a combination of measures and not one individual measures but it's that combination of indiv measures that will deliver results. So where does it leave a little bit for central banks? Uh I think there are three uh roles and I I will finish with that. First uh and for all that's the most important thing is safeguarding financial stability ensuring that the housing cycles do not turn into systemic risk. Second is safeguarding effective transmission. So central banks need to understand how housing markets shape inflation dynamics and how it impact actually monetary policy on households. And then third, central banks they need to recognize that the root causes of housing affordability lie largely in structural and fiscal domains and that central banks can only I would say complement but certainly not substitute these policies. So I would like to conclude um that if housing affordability challenges are not addressed there is becoming a structural constraint on growth and on social cohesion. They can limit mobility. They can reduce productivity and they entrench inequality. And we have also new research that actually indicate negative effects of housing affordability issues on fertility rates.
And that compounds already also what you said the negative democratic trends. And so lastly, and that's probably a very important one, that housing affordability also increasingly shape political dynamics. And this is precisely why the IMF is giving it a a growing prominence both in its surveillance work and both in its analytical work because recognizing that housing affordability is no longer a sectoral concern but also a macrocitical driver of economic and social outcomes and I will stop here. Thank you.
>> Okay. Thank you very much Mr. Click. I suggest that we go to Mr. Mr. Nanis to give us a Greek perspective. Central Bank.
>> Thank you. It's uh both an honor and a pleasure to be here invited by my good friend and colleague uh Boris um uh at this panel as part of uh the Dubronik Economic Conference. Actually, housing affordability has become one of the uh defining economic and social challenges of our time. And I'm afraid we have underestimated it both in our research and in policym across advanced and emerging economies alike. Uh the cost of housing has risen faster than incomes.
Uh placing increasing pressure on households and threatening both social cohesion and economic efficiency.
Um at least in Greece uh it is also behind the very negative demographic trends. At the core of this issue lie two fundamental questions. First, what determines the appropriate level of house prices and rents and how adequate is current housing supply? Second, what are the wider implications of housing unaffordability on the broader economy, particularly in urban centers that act as hubs for economic activity, innovation, and talent attraction? How does this issue affect labor markets, productivity, and long-term economic growth? Let us begin with the first question. The long-term increase in house prices is not a mystery. It's largely explained by demand and supply fundamentals. Rising household income and accumulated wealth have increased purchasing power.
Demographic changes such as smaller household sizes and urbanization have intensified demand in cities. At the same time, supply has often struggled to keep pace due to construction costs, land scarcity, zoning regulations, and other building restrictions.
Monetary policy has also played a role.
A prolonged period of low interest rates has enhanced the attractiveness of real estate as an investment. Although low rates offer favorable conditions for businesses and households, they may also contribute to increased investment in the housing market while simultaneously reducing the incentives for saving in low yield environment. Indeed, in many European countries, a large share of property purchases is not financed through mortgages. This suggests that housing demand is increasingly driven by accumulated wealth and investment motives. As a result, higher income households are able to outbid others, crowding out less affluent households from housing markets. This brings us to the second question. The efficiency losses associated with unaffordable housing. When workers cannot afford to live near centers of economic activity, labor mobility is reduced, vacancies remain unfilled, and productivity growth is constrained. Housing affordability therefore is not only a social concern but also a macroeconomic one. At this point it's useful to briefly consider the case of Greece which clearly illustrates many of these developments.
Greece definitely has been a success story but there are still legacy issues and this is one of them. In recent years, the Greek housing market has shown an imbalance between supply and demand, especially in metropolitan areas such as the capital, Athens. Prices and trends have increased significantly even though the pace of growth has moderated somewhat. At the same time, housing affordability has deteriorated with household facing one of the highest housing cost burdens in the Euro area.
You saw it in in the first diagram shown. Uh it was Greece an outlier here.
It's about uh the um uh the highest uh housing cost burden was about uh 30% 29 compared to about 7.7% in the rest of Europe. What makes this particularly striking is that high albe declining home ownership rates have not translated into affordability. A key reason is that incomes remain relatively low while housing related costs including energy maintenance and renovation have risen substantially.
In addition, a large share of the housing stock is relatively old and energy inefficient which further increases the cost of living. On the supply side, the legacy of the past decade is still visible. Construction activity has only partially recovered from the sharp contraction during the economic crisis and investment in a residential property remains well below precrisis levels in the euro euro area average. At the same time, higher construction costs, regulatory complexity and delays in permitting continue to constrain new supplies.
Demand however remains strong. It is supported not only by domestic factors such as the gradual increase of depos of disposable income in recent years, improved economic expectations and targeted government support schemes, but also I would say mostly by foreign investment, higher tourist flows in urban centers and the perception of real estate as relatively safe assets.
Importantly, a significant share of transactions is financed through household savings rather than bank credit, reinforcing the idea that housing demand is not highly sensitive to interest rates, as many buyers are using their own accumulated wealth to purchase properties rather than relying on mortgages. Government policies have increasingly aimed to address these challenges. measures such as subsidized mortgage programs, rent support schemes, temporary tax incentives for renting out vacant properties, and incentives for innovation or utilization of vacant properties are steps in the right direction. There are also initiatives to increase social housing by leveraging public assets in partnerships with the private sector. However, these policies take time to bear fruit and affordability pressures are likely to persist in the near term. At this point, it is important to recognize that housing affordability is not only a social and macroeconomic challenge, but also reflects much deeper structural features of European financial markets and household investment patterns. In the case of Greece, housing insecurity has increasingly emerged as a factor affecting long-term demographic trends.
Limited access to affordable housing delays household formation, particularly among younger generations.
Many young adults end up remaining in the parental home for longer than they would uh otherwise choose while others postpone or reconsider decisions related to family formation altogether.
This has broader macroeconomic implications. A shrinking and aging population reduces the size of the labor force weighs on long-term growth potential and increases pressure on public finances. In this sense, housing affordability interacts directly with demographic sustainability and economic resilience. Returning now to the broader question, what can central banks do in such an environment? Well, traditionally, central banks have not been directly responsible for managing housing affordability. Their primary mandate has been to maintain price stability while also contributing to financial stability and the resilience of the financial system. However, as housing increasingly impacts the broader economy, central banks can no longer afford to remain entirely passive. One key challenge is uh that when housing demand is driven by cash buyers and investment motives, conventional monetary policy becomes less effective.
Raising interest rates may have only a limited impact on such demand while potentially slowing down the broader economy. This raises important questions about policy transmission. If interest rate changes do not significantly influence housing demand, additional tools or complimentary policies may need to be considered from a financial stability perspective. Microcredential policy can play an important role. While its primary objective is to mitigate systemic risks and strengthen the resilience of the banking sector, the design of such measures may also support housing affordability in a socially balanced manner. In particular, borrower based measures such as loan to value and debt service to income limits are intended to preserve prudent lending standards and prevent excessive household ineptness. At the same time, however, the calibration can take broader social considerations into account. More accommodative conditions for firsttime buyers may support access to home ownership, while stricter limits for so second or investment properties may help contain speculative demand and buy tolet activity. There is also scope for targeted flexibility. Carefully designed exemptions for specific categories such as social housing schemes or energy efficiency renovations can help align macro credential policy with broader public policy objectives without undermining financial stability.
In addition, capital-based measures, including the counter cyclical capital buffer or sectoral systemic risk buffers may help moderate housing related credit cycles when property price increases are increasingly driven by leverage. By strengthening banking sector resilience and discouraging excessive risk takingaking, such tools can contribute to a more sustainable evolution of housing markets over time.
Beyond macrocredential policy, promoting the savings and investment union is of utmost importance. By deepening European capital markets and broadening alternative investment opportunities, Europe could gradually reduce the structural preference for real estate as a store of wealth, thereby alleviating persistent demand pressures in housing markets.
Finally, enhanced transparency and stronger safeguards against the use of undeclared funds in real estate transactions can contribute to healthier market functioning and help limit non-funddamental demand pressures. At the same time, it must be emphasized that central banks cannot solve this problem alone. Housing affordability is fundamentally shaped by supply side conditions, fiscal policy and structural factors. Increasing housing supply, improving the efficiency of planning systems, and better utilizing existing housing stock are all essential components of the solution. Ultimately, the question of housing is not only about prices, markets, or policy instruments. It's about whether our economies provide a credible path forward for the next generation. If access to affordable housing becomes increasingly uncertain, the consequences extend far beyond the housing market.
They affect productivity, social cohesion, and economic growth prospects.
For this reason, the role of policy makers, including central banks, is not to solve the housing problem in isolation, but to ensure that their policies do not inadvertently reinforce these imbalances and wherever feasible contribute to a more balanced distribution of resources. Ultimately, a sustainable economy relies not just on stable prices, but on creating a sense of stability and opportunity for those who will shape its future. Thank you.
>> Thank you, Mr. Saras. Uh so a great deal of agreement so far. Uh could we hear from the private sector a bit more uh on uh what how you look at these issues? Mi Mr. Broadband. Um >> thank you very much. Do I just press this button?
>> Yeah. Um thank you very much. Um it's a pleasure to be on this panel and at this conference.
uh if I have any qualifications for for being on the panel other than having worked in a central bank for a long time is that I come from a country that in a rather unhealthy way has been obsessed um about house prices and before I went to the Bank of England I was also in the private sector and I would go round with a pack of slides about the European economies maybe about less than 10% of which was about housing but whenever I was in London it would take up half the discussion and people would ask me about you know whether they should buy in Chisik or Kensington or get what kind of mortgage they would get and at that time we'd been through a period in the I'm talking about the middle of the first decade of this millennium so 20045 of enormous growth in house prices um which as it happened coincided also with a time of pretty low inflation on average below target inflation thanks in the main to you know big improvements in the UK's terms of trade with China renting the world trading system and I completely agree with the other panelists there's very little that monetary policy can do about uh housing affordability it's not simply um that you know interest rates don't do that much directly I would say that the simple way viewing the determination certainly of purchase prices. You've got the flow cost of housing which is supply demand and then the relevant discount rate. If you view the purchase price as some capitalized value of rents is actually a long-term interest rate and certainly empirically that seems to work the best in um in the UK. It's an empirical model and monetary policy can't do that much and I'd go further. I think it would be pretty damaging if it were asked to do anything about housing affordability. We've got essentially one instrument.
Um if you introduce another target, you're going to compromise the achievement of the first. Um particularly if you don't have much influence over it, you're going to have to you know comp big big compromise.
There's big variability in inflation to have any real bearing at least if there are any independent disturbances to the two and there certainly are all the time. And that period is an illustration of that. Um some people said, well, you know, you should stop house prices rising so quickly by tightening monetary policy and that would have pushed out inflation even further.
Um more recently, people have said, well, maybe because QE affects long-term interest rates, maybe you had sort of a second instrument of policy. I'm not sure that that either had much bearing on house prices. The fact is that during the whole period of QE, rental yields in the UK didn't fall at all. Government bond yields did, but rental yields did not. So, I'd be pretty wary um if I was still in the central bank if anyone suggested that this should be added to our list of objectives because I think it would threaten compromising our principal objective with inflation.
And to be honest, the the main thing and I'll be very brief here that central banks can do is to list all the things that government should be aware of. They were asked by a government minister, you know, you should do something about housing affordability. Frankly, the answer should be well, you should do something about construction costs, about regulation, um about in the UK, for example, a huge tax on moving called stamp duty, which has significantly reduced mobility and labor mobility and to remind governments that um you know, they may do things that have unintended consequences on on the affordability of housing. I'll stop there. Thank you.
>> Thank you very much. These are good insights. Uh um Christian, what would be your take on these uh range of questions?
>> Yeah, thank you. First of all, also you know happy to be here. It's it's a fantastic conference also always a challenge. I think I spoke on panels on private credit on private non-bank lending and so today it's housing affordability and frankly when I read the question what can central banks do about housing affordability my instinct was very little and beyond that they better stay out of it and and my thinking was look we had a panel on central bank independence earlier today now the challenge for central banks at the moment is on the one hand fisc dominance. That's clearly there. And then the other one is that we're moving in a world where we're no longer living that much with demand cycles, but more more supply shocks. You know that there's there's tariff wars, there is a pandemic, there's another war, oil typically gets involved or gas. And so that's already put central banks in a very uncomfortable spot because in this dilemma that you're dealing with a supply shock which you know you cannot directly address with your monetary policy instruments but you somehow think about the secondary second round effects and and you know typically that's already a a more difficult situation than a classic demand cycle. Now when I conceptually think about housing the first thing that comes to my mind that it is a supply issue. So why in the world would you put on yourself another you know another burden of dealing with a supply issue which again you cannot directly deal with and I think you know we all agree here we all agreed that obviously a central bank cannot and should not build houses or do any cannot do anything that really directly um relates to this but I think you know we have to think political economy here once the perception is created that you have talk shows where people you know ask central bank governors you know why are they not doing anything about the house prices in London etc. when that perception is created, you suddenly have another problem at your hands. And I and I that was really the first thing that came to my mind. Now um so conceptually I think about this in um in three ways. So one which I think is the biggest issue really is is supply which central banks has nothing to do with.
But then there's clearly aspects I think you you all have mentioned that is this asset pricing and then there is also the monetary transmission that is influenced by how house prices uh uh behave and also who buys houses and whether it's credit finance etc. Now given that it's about monetary policy I shouldn't talk too much about supply but I think given that we all talk about affordability being a huge issue just very quickly in a way what what my perception is and I'm not an expert but what the issue is that the elasticity of supply and housing is almost zero in many areas so in particular when you talk about these high productive areas you know of of you know be it Athens be it London you know all the centers where the density is high you know typically it's it's very difficult to build so you have If you increase demand by losing regulation or so typically that that goes into price not in quantity and um you know that we have to address through you know land restrictions uh the the speed as which things can be planned and also regulations about you know how you want to build and we have to really think about is that by accident so have we just like you know gotten into this overregulated environment or is that by design does it reflect actually preferences you know probably people if you say London if I take the last parks that are left and build on them. I could increase supply but probably people don't want that. The same thing you mentioned that old housing you know means that people have to because of bad insulation people have to pay more for heating. Well that's why we have the regulation that new housing has to have all these insulations. Well that costs money though that makes housing more expensive. So what I'm seeing here is um you know there may be some regulations which are clearly just superfluous or or the planning needs to be accelerated but some of this stuff is probably you know we have to think about whether you know we are own enemies here. we want this actually and it's a re you know revealed preference um then I would also say one thing about you know the highest productivity areas that is true but there are also many other reasons I mean mukonos I think is a is a is a housing affordability problem but it's not because it's a very productive area but because every Hollywood star and wants to have a house in Mukonos by now so you know there's also a little bit of of preferences of wealthy people wanting to live in certain areas so it's not I don't think it's not only a productivity driven There's also, you know, issues, you know, as I said, on the side, nothing to do with monetary policy, but very interesting. My colleagues at at Barclays, and by the way, I'm not speaking here for Barclays. I should say this. Um, they did some interesting story um research, you know, together with a survey about right sizing. Fact is a lot of people live in those centers in apartments that are way too big for them. You know, several rooms they don't use, etc. because they don't move, right? So you know it suffices to say very very a difficult issue migration plays a big role something for example um you just said you know Europe will peak in population and then you know it's going down I once talked to someone in Berlin and asked you know how could Germany misplan this so much of like letting infrastructure decay etc and I mean there was a lot of wrong fiscal policy but part of it was that in the beginning of the 2000s they thought Germany by now had a population of 78 million you know so what is it 84 because they just did the you know which is easy demographics fertility rates and then you can extrapolate but you know there was migration and we see in the US right now I don't know whether whether governor Waller is here but you know in the US we clearly saw that what was good for the labor market over several years uh uh you know during the pandemic hund you know millions of of migrants that that fed the US labor supply was an issue on housing because now that that is being suppressed, we suddenly see a lot of easing on on rental inflation.
So, you know, there are choices and I think all of this is important and um but it's outside the realm of of monetary policy. Now, there are two other issues. I said, you know, it's asset pricing and and monetary transformation transmission. Um let me quickly say a few things about this. Um you know, obviously central banks are not neutral here. I my impression is that QE the way it was done beyond just dealing with acute you know market stress or market dysfunction when it was done really to explicitly bring down term premier lowering long and yields I have to think that it has an infect impact on on on on real asset prices. I mean you know during that time there was a run on housing on vintage cars Rolex watches you know somehow if you artificially press the discount factor the 10ear year or whatever I think that has an impact I I would think that going forward whenever central banks consider QE for that purpose they got to think strongly about the the implications has for non-productive assets and and the and the distributional consequences microcredential regulation I mean that was tightened everywhere after the global financial crisis for good reasons. There's now a lot of talk in particular in the UK. I think the previous prime minister's always said it had gone too far. We need to change it.
Again, I have um I read a little story um a little research here by the resolution foundation. They looked into this. Apparently, the biggest issue for firsttime home buyers in in the UK is now coming up with a deposit. And so that is a problem. and and and you know some people have access to not not to bark but they're going to the uh uh Bulma bank of mom and dad that is you know they have inheritance and they get their deposit from them uh and you know there's now thoughts about whether one could replace this by very targeted help to firsttime buyers to give them you know some subsidy for the for the deposit that they need to put down. It's not the income typically uh to serve the interest rate. Uh it's it's really the the the first time deposit. We can go into this but all kinds of ramification around that one and potential you know kind of misuse etc. But um I think this is uh this is for the for the for the part of the asset pricing. And then last monetary transmission I think you know central banks do have to be very cognizant about this because obviously it it affects monetary policy. I mean, the way I think about it, if there's more people buying cash, that means more of your monetary policy goes through the portfolio subsidy channel, portfolio channel rather than through the mortgage credit channel. Uh, and and that is a fact. Um, you know, it's a bigger societal question, frankly. I mean, maybe in a world now where the, you know, the share of income is probably shifting more towards capital away from labor, we're going to have a lot of bigquest, a lot of inheritance. Maybe we need to redesign tax systems away from taxing labor more towards taxing capital and taxing inheritance also. And maybe there's a lot of resistance against inheritance tax, death tax. But you know, if one does it in a way that one reduces some other taxes on on on income, maybe then there's a little greater willingness and one suggests to introduce it or increase it just for the sake of getting additional additional revenue. Um there's foreign buyers.
That's a huge issue, right? So, so they often buying cash in London. I think most of the houses bought by cash are by foreign buyers. Yeah, you can do something about it if you want to, including maybe checking where the money is coming from, etc. This is all being discussed, but it's not for central banks. And and last but not least, when I look at the market of housing, it's extremely heterogeneous. Extremely heterogeneous. If you think the two typical characteristics, you know, housing ownership, my own country, I wrote it down here, I think Germany has like, you know, 50% or so ownership.
Romania and and this entire region has 90% or so. So, in a way, you would have to then, you know, design it maybe even in different ways. Um, housing as a share of total wealth has a lot to do with what alternatives people have. If you go to Sophia, Bulgaria, it's not like, you know, there are no Middle Eastern wealthy people want to buy an apartment in Sophia at all. Bulgarians who buy if they have a little bit of saving, they buy one apartment in Sophia because they don't believe in the stock market was I lived in Turkey was the same thing. You know, you buy a piece of concrete because that's what you believe in. So, you know, we have to develop financial markets, give people that opportunity to to save in in more productive ways. And um you know, there are also different mortgage systems. You know, for example, if you have a flexible mortgage rates as you have in the Baltics, I think often it's a much quicker transmission than when you have a 10-year or in the US even 30-year mortgages, you know. So, that makes the market very complicated. And I think, you know, if I if I summarize, you know, um central banks can do very little about it. They should be very wary, I think, to be getting drawn into it. Um they probably should consider when deploying QE the next time about the distributional consequences it has. and and you know as I said impact on on non-productive assets um and financial regulation you know can do something on the margin but you know it's I think it's it's marginal and uh um you know let's um let's address affordability but let's not be seen that central banks are at the center of it thank you >> um so we have um um really continued convergence of views. Radawan uh could you please let us know what uh what's on on your on your mind when you think about affordability issues.
>> Thank you very much once for for inviting me and would like to congratulate to Boris and want to remind him that he can maybe a little bit represent us as well meaning Hungary, Serbia and many other countries from the region when he's going to sit in Frankfurt and not forget about us. Uh maybe I will actually a little bit contradict to uh uh Christian and uh maybe just u come up with a couple of very concrete examples that's actually did take place uh um in Hungary. Uh of course this is not what will change the world but I think it's a very very good uh uh way of fine-tuning what central banks can do. Um financial stability is not sustainable.
social stability. We all know that. Um I we put together here in couple of neighboring countries how many uh uh months of salaries you need in order to buy a home in in certain countries. But I guess this is the same challenge basically all over and and and also uh uh which percentage of the salary to be spent in order to uh uh pay uh um so to say uh rent. There is one thing that's definitely happened in Hungary. uh we had a hyperactive government and a hyperactive central bank coming up with a lot of lot of lot of lot of measures in order to help basically uh uh everybody with almost uh any problems they had and um um I think we do have to try not to throw out the child with the bath water because at the end um there are a couple of good things that has happened as well but before I go to that one uh unfortunately I just want to warn everybody if governments and also central banks work exclusively on the uh um on the demand side then this is basically what will happen. So uh thanks to all of these uh uh great programs basically the real estate prices exploded in Hungary during the last 15 years. There was more and more and more and more and even more demand.
And uh if you are not financing so to say the construction of new dwellings that's the way how we have learned that's in economics 101. them. Yeah. Um what were the unwanted effects? Um definitely uh um they were not made concrete differences between so to say who makes u€,000 a month, 5,000 and€10,000.
um lot of lot of housing speculations and of course if you're very very generous uh at the end you'll find out uh paying a lot of money for um the different subsidies.
Now let me go to a very very concrete things um where actually even banks were uh we were actually very skeptic and it was you know lower the LTVs for first home buyers. Um first it was only for people who are younger than 41.
um only day uh if the mom in the bank of mom and dad doesn't provide you even enough deposit um basically it was lower from 20 to 10%. Uh it's very interesting for a couple of years it was only for people below 41 then they lifted it up and I can tell you from own experience it works yeah so again this was one of the things that central banks told you know uh we don't know what will happen a lot of commercial banks actually are thinking three times should they do that immediately but after a couple of years uh uh uh uh we did realize that actually especially among younger people it is it does help a lot that second thing which was very very helpful to the commercial banks. Um you know we always have this issue people come variable interest is usually majority of the time lower than the fixed interest rate. Basically the central bank helped us a lot by uh increasing uh substantially uh the debt to income ratio uh for fixed rate compared to the variable rate. So in practice is this meant the client came you know of course all of them want to go for a lower variable rate but then when we told them you know but listen at this rate you can go only up to 30% your income if you get a fixed one you can go up to 50 555 it was much easier to spin them over to go to the fixed one and of course once the inflation came u especially in 22 and 23 it uh so to say also helped so to say financial uh uh stability Um one more thing which was very interesting and um of course it can be discussed you know to which extent central bank should do that it is the central bank in order to develop the mortgage bond market they decided to buy up to 50% of the mortgage bonds that were issued by commercial banks at the price which was approximately 40 to 50 basis points before the uh uh u the market level So actually it was even lower than uh so to say the yield of the government buds then um on one hand it u definitely made us much more interest in order to pry that loans on the other hand it also contributed to the development of the secondary market and um uh similar thing actually also happened uh with the issue of of of um uh of the houses that were um uh built up um so to say in uh uh uh um so they fulfilled so to say the the green mortgage bonds uh uh requirements meaning substantially lower uh uh consumption.
Um there was one which is actually not a central bank issue but one thing that's uh happened actually before the recent elections. Um you know lots of smart politicians thinking you know how they can even increase even more people buying uh uh real estate that's the government decided you know let's for one year allow people to use their third pillar private voluntary pension fund in order to buy real estate. Yeah. Of course all the um uh fund managers were very upset about that fund. But at the end uh a very limited number used that. But what was also very interesting that actually right now they go back to the government and they say actually this is maybe a good way uh because there is tax benefits in order to put it into the third pillar and actually the person who buy an apartment and he doesn't have uh probably he doesn't need to pay the rental income once he's retiring. Um so I think it was also a very very uh uh um interesting experience that we have seen and last but not least uh um I think it's also important to mention that you should not work only on the demand side you should only you should also work on the supply side meaning that there were some not central bank but government programs in order to provide some cheaper financing to real estate developers uh of course capping the prices to make sure that uh uh uh they are also uh uh providing cheaper uh uh real estate in order for the banks to uh um uh um to provide as loans. Uh what we did not try out uh is definitely a risk weighted asset discount for certain groups. Um um again no completing experience about this one you can go to that's fine tuning as well but I just want to come up with some concrete examples what was done what could be done and um um yes um you can say Christian and probably also Jiannis you know that this is not the part the mandate of the central bank but you've seen so many other things for central banks who have told you in the last 20 30 years this is not your job, somebody else should do that. At the end, it ended up so to say at our court and usually if there is a will, there is a way as well. What can be done then?
Yeah, thank you for your attention.
>> Um, very good. So, some some ideas uh things can be done from uh the central bank side. Um, you didn't tell us if what were the the costs of all all of these actions.
Are there any issues that um um panelists would like any reactions to each other's remarks? Uh otherwise we can go to the floor. Yeah, please.
>> Just one question. What I thought was very interesting on the slide there.
Central bank buying mortgage bonds. Uh in other countries, would that be acceptable? I think that is a question also to the audience that I would like to know. or is that because it was Hungary where you said it well you had a very active government and you had a very active central bank so I I'm not so sure about that so I think that is an important one uh but I liked it very much because we heard from different perspectives from different country uh perspective and I think it converge a little bit and I think there uh one final thing I want to add and I think that's also very important to know that uh in December last year the European Commission actually issued a very first time an uh first affordable housing plan and I think that is also a very interesting development because this is a purely local national issue but that shows that yeah there are broader and wider economic implications and that the challenge actually requires coordination exchanging best practices what works well what doesn't work well and I think that also the IMF with its work can can really add value so let me stop here and looking forward to the the the questions from the audience.
>> Okay, if there are no more um reactions from the panel, let's uh turn to questions.
Yeah.
Well, a provocative question.
What if this is it is not uh supply problem but an excess demand problem?
which is a result of the asset bubble.
asset bubble that all central banks even the bank of England recently the deputy governor came with a statement that careful there is an asset bubble talks about now in support of this uh question the world population is going to start declining in 30 years this is the estimate of professor Fernande via the UN is 20 years so that means means that the number of um housing units per capita um is going to to increase. So housing is going to become relatively less scarce and and and and and dropping in the scarcity.
Um in uh the year 2007 uh the US housing starts um uh reach 2.1 million units.
Uh in Spain my country it peak at 700,000 corrected by population the the bubble and the over construction was three times bigger than than in the United States. it brought down all the savings banks of the of the country and we know that. So my my point is there was a housing af affordability issue in the '9s and the the early 2000s and it was tackled with the supreme mortgages that were securitized sold everywhere.
And then we have a huge financial crisis that uh took the prices to the level they should be on trend or perhaps with a little bit of undershooting but made affordability worse. So my question to you is this not a transitory excess demand problem recognizing the issues of the constraints in the inelasticity of the supply rather than a supply issue.
>> Um I don't think it is. No. Um I mean I'll come back to a point I made earlier.
A bubble in an asset is characterized usually by, you know, falling yields sustained by people believing that the capital gain will will go on. That's not what happened in the UK certainly. And it may seem perverse and maybe one would have expected all sorts of asset prices to go up relative to their earnings um during QE, but it it didn't. I mean basically the ratio of house prices to incomes at the end of QE say in 2020 was exactly the same as it had been in 2009.
The real decline in yields was before the financial crisis. So there's no evidence to me that QE fed some bubble in house prices. Certainly not in the UK. That's just not true. The the strong period was sort of 95 to 2005.
And as it happens the financial crisis or the bank the huge problem the banking crisis in the UK in 20089 was not was nothing to do with domestic mortgage debt. I mean the vast majority of losses for British banks were on overseas assets and US mortgages in particular.
So the losses on US mortgages for British banks were about 15 times what they lost on domestic mortgages. So I don't think there's you know the the real issue is is supply and demand. The real issue is that you know all cost of housing whether purchase prices or rents uh went up over that period and and it's you know the population rose 20% and the housing stock didn't and these supply and demand are pretty inelastic um particularly in the crowded southern half of the UK. So you increase the population by 20%, you're going to have a much bigger than 20% increase in in cost of housing whether rented or purchased.
So I I I don't think that um there was any evidence of a bubble whether fueled by QE or or not. I think it was pretty directly in the in the UK at least supply and demand.
just just bend just yeah just just we could I wouldn't challenge you on on the on the UK I think what's interesting is how different uh uh markets behaved I mean for example the German market you can clearly see that nothing happened the German housing market when everything was booming before the global financial crisis and the German market took off when suddenly you could get a 10-year fixed mortgage at you know 0.5% or so so you know so it's um it is very interesting that it doesn't happen all synchronous and on the quickly on this transitory um access whether it's an excess demand that is transitory I don't know how long transitory is in your view I mean but I would say again one thing is also you know people also you know over time they actually ask for bigger houses you know a lot of these things are not fixed as I said the study our barkness policy group that you know people now sit often in places with you know several extra bedrooms And when you ask them, do you feel you have too many bedrooms? No. No. The one is my gym, the other one is. So, you know, when you ask about excess demand, it depends how you define. Is it one unit or is it people actually, you know, wanting to live in much bigger places now than before when they get wealthier?
>> Uh well, um with the formation of the euro as we know uh there was some kind of uh imbalances uh but now the situation is completely different. Yeah. Okay. In that case you could say that there were transfer of capital from one country to another uh not in in the traded good sectors but in the non-traded good sectors including including housing. So in that case you can say that uh um it it there was some some kind of bubble in in certain countries in in certain but definitely not today definitely not through QE uh I I don't think that QE created a bubble in uh in housing now whether excess demand overall you know it's very difficult to say definitely in countries like Greece Croatia that are tourist with tourist flows etc in Greece the demand for housing does come from the domestic population does not come from from credit it's it's only now the last mark that after many years uh net credit expansion for mortgages was made positive in Greece so the demand comes from abroad from um um from Americans from Saudis from Turks uh from everybody uh so they they beat prices up everybody wants to buy a house in Mkonos I cannot afford to buy housing.
Um so that that crowds out the domestic population. So it's very difficult to say it's maybe it's definitely excess demand in Greece definitely uh but not throughout the planet. Uh nobody can say whether there is an excess demand for housing on planet earth uh in Greece.
Now you know as uh there was in the diagrams the number of dwellings per head are very is is very high. So why do we have a problem? Because they're closed. They're closed because uh of the crisis people don't have enough money to renovate uh uh to satisfy regulation, energy regulation. So some people don't want because they're afraid of taxation.
I'm telling the government is not enough to have I mean it's good to have both a stick and a carrot policy. Now I think I'm afraid we only have carrot that is incentives to open them but not penalties. If why do you keep your house such closed I I think uh we need to exchange information I mean countries that have this problem to see exactly definitely it is not a central bank problem. multi I mean um macro u is I think the the right kind of policy here as I said we can uh calibrate macro credential poly especially borrowed based measures to to help the vulnerable definitely here uh but not overall definitely I mean uh will not say that we need uh to adjust monetary policy only for for for the housing market but uh we need a combination of policies macro approved from uh central banks and then supply side um everything another side of the coin that we tend to forget in Europe home ownership is close to 70%.
Increase it used to be very high 85 but uh after the the crisis it fell also to the European average. Now with this increase in prices, household wealth for those that have houses has gone up, very few governments will dare to tax the um excess value, I'm afraid, in order to to subsidize the poor. I mean that in in terms of piggovian uh taxes, that would be perhaps a solution. Uh but it's very difficult. I mean in practice it's extremely difficult to do that.
Oops. Yeah. I just wanted to come back on on on you what you said there on 30 years from now. I I I like these kind of questions because that is how how will the world look like 30 years from now?
Nobody knows. Uh but I think immediately about climate change. What is the effect of climate change? uh water access that is going to change that certain territory might probably not be able or livable anymore. Also, if you have topical storms that destroy uh every five years your housing stock, you will have a change in the dynamic in the market that is one. And then not only climate change, but if you start to think a little bit, I think also about all the conflicts that there are in the world right now. We live in a very geopolitical difficult situation. You have to hope not that it's going not to affect so much the land use but that's what I see also in my countries especially in Ukraine and Ukraine is in our constituency the territory that is now occupied it's basically useless for the next 100 years because the land is as toxic as possible so if we would have moved uh to a situation let's hope not of course but to more wars more conflict and so on so all this could impact how much territory you have combined with climate change and so on. So I think it's something to to brainstorm on but you need to take everything into account.
>> So we had one question over there and then we will turn to the front.
>> Yeah. It occurs to me that in answer to the what can central banks do, there is one instrument that I didn't really hear discussed.
A little over a month ago, Fed Vice Chairwoman uh Bowman gave a speech to the American Bankers Association that addressed that issue and called for a serious re-examination of the structure of capital requirements on mortgages.
And I remember seeing a research paper from a couple of years ago using UK data that a 1% reduction in the capital requirement on a mortgage led to about a 15 basis point reduction in the mortgage rate. So would you care to talk a little bit about whether central banks in their regulatory role have room to relax capital requirements and lower mortgage rates?
I mean, that may well be true, but my guess is in the UK that would just push up the price of housing, right? I mean, you know, for someone who's an existing owner, it would be good, but what you're basically doing would be to transfer money from people who already towards people who already own houses and away from those who don't. Uh the the stock is essentially fixed over short periods of time. So I, you know, would it would I think it would actually worsen affordability problems for young people hoping to get on the housing ladder. Um, so I I I fundamentally think it would be mis from all sorts of points of view to ask central banks to think about this question and you have to think about things as economists say in sort of general equilibrium before before thinking what it would do. So it would just be yet another transfer of which we've had many in my country certainly from from young to old.
>> Yes. U here we had the question M re >> so I think it was related actually to the last intervention of Yianis as well.
So we are talking about housing affordability but there is also potentially quite an important link with financial stability and so in the financial policy committees or macro financial policy committees which are often kind of close to central banks sometimes hosted even within the same institution. I think it's worth thinking about um in a disagregated way when we have a a kind of bubble phenomenon taking hold. We usually have a lot of second houses, third houses being bought, buy to let kind of getting a bit crazy. And these are movements that both kind of beat up the price of housing and at the same time threaten financial stability. And so there is there a kind of double you know uh element that can be tackled by very targeted macro potential tools for financial stability purposes because these are as we know very important the the leverage element the dynamics also of recovery after a crisis depending on the indebtedness of various um players is it's it's very much determined by by the degree of leverage and how much over exposure there is to the housing market.
So in the you know for financial stability purposes I think there there can be an aggregate effect also on the price dynamics and so I'm not saying that you know central bank should target housing affordability but I think as a side product of financial stability that may be actually material and I think we don't know enough about this aggregation and and the price dynamics across using very micro data some central banks do have and some macro financial authority do have a lot of disagregated data on this others don't and and and I think that's that's you know that's why some very targeted tools are used in some jurisdictions and in other not and I think that's very important >> just to to add to what what Helena say I agree what with what she said we can have a macro proof tailored to this kind of problems but uh we might also think about taxes because Um if you for example in Croatia we have a lots of uh uninhabited housing units which people bought just for to accumulate to put savings into into basically something of a speculative nature. So they they the taxes are very low, capital gain is high in the real estate market and it just builds over time a bubble where people put more money because the capital gains are going they go up until they don't and then it's going to come down and if you have no taxes if you have very low taxes on the real estates you're bas basically encouraging that that type of the the the behavior. So we have to think to have a kind of a level playing field also of taxes on on on any other types of investments and and and the real estate. Of course the texts are very different in different countries but in mine for example it's a problem and why you you have to address it through the taxing policy because much majority of the house purchases are non-leveraged.
So they are not people don't go through the banks they just come they pay they buy. So, so micro doesn't work there. It has to be tax policy.
>> Yeah. Mr. >> Thank you. I found the the presentation by Radavan on the sort of unorthodox policies of the central bank of Hungary very very interesting. Um but even though uh Hungary is not part of the euro because uh it's part of the master treaty, the European Central Bank probably had to pass judgment on many of these either through legal opinions or through the annual uh monetary financing report which is not public but I'd be curious if Janice or others can tell us whether there has been some discussions internally on on how uh the ECD appraises these sorts of policies undertaken by uh by the central bank of Hungary and and I would imagine the IMF also by way of its article 4 has probably passed judgment on that as well. So be curious to see what what other institutions think of what has happened in Hungary.
>> Um if we can take uh there was one more question here and then we will have to stop otherwise uh we will not have >> coffee. This is a fascinating discussion and it seems like it's very clear that there's very little the central bank can do and when when central bank try to do something you talk about financial stability I think about exactly the the downside of it. I mean I remember a time when I used to go to meetings at the Fed in 2005 and had Fed staff defending the way you know markets are going to you know take care of what was happening in the housing market there through the through the supervision of loan origination I guess central banks can do something by just keeping stability in the market not having bubbles and that could be something but given that we are kind of I think there's kind of a concern there's very little that the central bank can do the question is clearly uh is a structural issue. I mean there was a point about temporary demand but it's clearly the housing price is a structural issue. You talk about London.
I mean if you go through San Francisco there's no question the housing price there are high structurally because of regulations. The regulations are massive. You cannot build above a particular height and you cannot have uh too too much space if you build a building. There is also depth and I would say that in some sense the answer is easy to give but very hard to implement is almost all about regulation almost all the markets that you can think of that there's a darth of housing is because there's a even rich people like us like our city very nice with low houses or uh gentrification of some areas. So, so the question is really how do you see the role of regulation? All your variables demographical that you showed can just be explained by regulations in particular u countries and and regions.
>> Yeah, there is some discussion in the literature. Some are saying all is all about regulations. Some are saying no no it's all about demand. But but I I would agree that a lot of it is about uh uh regulation. Uh if we can have um >> maybe just u very shortly um just one thing what Jiannis and also Boris mentioned >> I'm convinced that's with one measure we can solve the entire housing problem in the in European Union especially yeah and this is just tax empty apartments the number of empty apartments is just amazing we just moved kids left us downtown Budapest. Yeah. I mean, you just go there, look up in the evening, you know, if in one/ird there is a light. Yeah. Probably 15 20% are offices. The rest is all empty. And everybody is just waiting for the real estate prices to go up and up and up and up. So again, just tax. I'm emphasizing empty. Yeah. Not where people live, not which is rented, which own, but just just tax empty apartment. That's can make miracles.
>> But but just to add but the interesting >> Germany too.
>> Yeah. in Germany too, in Berlin, everyone talks about it. I'm not even sure it's just about speculation for prices to go up. It's also because they use it, they rent them out for for tourism, etc., right? And I I mean, but one comment to Helen, I mean, I think for financial stability, we solved this issue that was solved after the global financial crisis. I mean, and then now the question is, have we solved this so much that there's an issue, right?
Because I mean, American households now are, you know, they're no longer as indebted as they were before. Um so exactly I clearly agree what the pendulum swings out the other day now in the in the other way and then you know 10 years later five years later we goes so I agree with you but but the fact is that's why I think one shouldn't deregulate and there was a question about 30-year mortgages in the US I mean 30-year mortgages are priced off 30-year rates in the US and 30-year rates in the US are not only high because of regulation that's the mortgage part but but you know 30-year treasuries are high because of term premium inflation expectations etc. So in a way there we're back to central banks. The best thing central banks can do is you know have a stable inflation expectations low inflation risk premier and then hopefully the government may do something about fiscal sustainability.
That takes a little bit of fiscal risk premier away and then you have a lower long-term yield and your mortgage rate gets gets uh gets lower. It's a bit simplistic but I think that's is still the the crux of the issue and about the rest is yeah it's not financial stability. These people often buy with cash, so they're not leveraged. That was global financial crisis. You know, people who have a, you know, low-inccome jobs having three apartments and and then waiting for them to, you know, to flip them after two months. But that's I don't think is a reality now.
>> A few things. Um first of all on uh I I I I watched very carefully um what Hungary Hungary's central bank is doing.
I I don't think we can do it in the ECB or um in the national central banks.
It's very uh off um by construction. I think we cannot do it. Uh but even that you can somebody could could say uh what do you do this the state uh could have done it. It's a question of of seniors.
I mean you you you make some expenditure so you less you you pay uh less dividend to the government. Um so it's a question of who is doing that. So it's a it's a fiscal if I can say it's a fiscal activity more or less. It's not a a monetary activity. Now on financial stability as um Helen as you know all microcredential and other useful instruments um have been devised during the crisis. That's why I call Greece uh the midwife of history to use Karl Mar's term here. It's because of of Greece's crisis that we we now have all these uh useful instruments of of course um we cannot use them for micro uh for micro purposes. This is for aggregate um financial stability uh issues.
Unless we can calibrate as as I said the I I gave the example of the borrowed based measures who can calibrate the the borrowed based measures for the vulnerable for for the poor um for for uh to address demographic issues for instance but not um in general we cannot use financial this kind of instruments uh only when uh there is I mean the these are used when um there is as you know um a problem of a of a potential bubble along with other metrics um current account nominal GDP uh as a percent of or sorry uh credit expansion as a percent of GDP growth so we make an assessment of uh of all this but yes uh we can have some calibration of macro measures Yeah, >> last word Mr. Click.
>> Yes, very very brief just to confirm in fact that in our article 4 reports on Hungary, you will read very critical lines from the IMF on the interventions uh in the housing and in the credit market. So, and that makes a little bit of publicity for our surveillance products. So, continue to read our article for reports. Thank you.
>> Okay.
Thank you. We have a coffee break.
Good afternoon everyone. Can you please please sit down?
Um we are going to start and and finish with the last uh uh panel of the of the day.
uh we have to be uh punctual because some of you really have begged me that there is enough time for a swim before the the bus. So I I will honor that and also because Tobias has a has a flight to to catch. Um so without further ado, I wanted to introduce this uh panel on uh mostly revolving around the question of private credit which uh has been talked about a lot over the last year.
For some uh private credit is uh the next uh sub subprime uh and maybe the um vehicle by which the next financial crisis will come. for others uh it's been a very useful way of disseminating and distributing uh risks but also a key engine of financing the AI capex boom uh in in the US uh so we'll have a lively uh discussion but before we do that uh I want to give the floor to Toby Sadrien the financial counselor of of of of the IMF who will give us an introductory presentation and then we'll have a discussion with the panel to the floor is is yours All right. So, let me also thank um the Bank of Croatia and Boris in particular for having me at this panel. Um so, I'm going to do a little bit of a deep dive into private credit. Um and hopefully that's going to be a good backdrop uh for the discussion. Much of what I'm going to talk about is from the global financial stability report which we put out uh twice a year and we have been reporting on private credit over the past two and a half or so years. Um so um you know some of the material is so like background for the GFSR but it's really GFSR based. What I'm what I'm doing are three segments. First um you know what is private credit and what are so like the variance of private credit.
Uh secondly, I'm going to go deeper into direct lending, which is the most important segment of private credit that has been in the news. And then thirdly, I'm going to go into interconnectivity uh with the financial sector. Um each uh chart is or each slide is is somewhat intricate. Um and so I'm going to give you some highlevel messages in terms of uh what are the economic frictions and what are uh the policy issues. So let me start um first uh by um thinking a little bit about um uh magnitudes. Uh so when we look on insurance companies in particular, this has been one focus and I'm going to talk a lot about banks as well at the end. Um so I'm going to start here with insurance companies. So when you look at a broad definition of private credit okay uh so that includes commercial real estate private placements residential mortgages infrastructure money market lending and asset based finance um you know in the US and Canada about 35% uh of uh insurance company assets are in private credit uh using this broad definition in the UK it's about 25% Europe Asia Pacific a little bit less um and you know they're sort like many variants of private credit. There are middle market collateralized loan obligations, commercial real estate collateralized loan obligations, fund financing through feeders, collateral fund obligations, etc. It gets you know so like very intricate very very quickly. So I'm going to try to sort through uh these issues a little bit.
You know, one of the um notable uh developments uh is shown on the right chart, which is that um you know, we all know the big three rating agencies um but the share uh of those big three in uh credit ratings is collapsing right so you can see so like the total ratings by the big three is about a thousand um in in the U we have this number only for the US unfortunately we don't have globally. Um you know the vast majority of ratings are uh what are called um private letter ratings and we don't have full visibility into uh into so like um you know uh the rating quality relative to the big three. Uh you know some research you know uh um analysts um are suggesting that there could be some inflation in that could be up to three to five notches. Um so it could be somewhat significant. So what are the economic frictions here? The first economic friction is so like you know do insurance companies understand um what they are holding on the balance sheet and then the policy issue is you know do supervisors that are supervising those insurance companies understand what the insurance companies hold and what the risk is. So there is um a concern about opacity though I would note that the industry is moving you know very quickly towards resolving this opacity challenge. So this is um um uh challenge number one. Let me turn next to assetbased finance. So assetbased finance has been in the news recently.
Um so there have been highprofile default cases. You all heard and read about tririccolar and first brand and uh so here again so assetbased finance are basically um special purpose vehicles that are collecting um uh uh credit securities and when you look on the left chart here you know uh this is growing very quickly. So uh for 27 28 29 these are estimates of the top five uh private credit asset managers. So the estim the the expectation is that this goes from 300 to 900 billion uh in between uh 23 and 29. Uh so it's very very active. Uh when you talk to market participants they are you know actively wanting to get into this. Now the vast majority of this asset based finance is actually underwritten by banks. So more than half um in particular in the specialty finance market. So this is one the very high yielding uh uh uh segment of asset based finance uh is uh the specialty finance banks are very predominant but the non-banks so the private credit uh asset managers uh do want to get uh into this um and um you know the economic frictions here again opacity um you know some sort of lack of understanding of borrower risk um But you know at the same time we don't think that so like these failures of triricolor and first brand is representative for the broader universe right because there was fraud involved there was a lack of due diligence we don't think that this is so like representative more broadly but these are certainly risks uh to look at.
Um turning next to uh direct lending.
Okay, so this is the high yield debt of um investment fund private credit. So this is really the heart of the current policy debate and uh the um magnitude is about $2 trillion globally. Um so this is roughly the size of the US high yield corporate bond market right so high yield corporate bond market about two trillion direct lending about two trillion. Now know note that there's a you know very quick growth. Uh there is some sort of um leveling off in the past couple of years and what is very important is that the dry powder is very large. So when you when you so like think about um uh this market you know um um it is you know funding sort of like midsized companies um that are risky. So it's high yield. Uh but there's quite a bit of try powder in the private uh private credit companies. Uh so that's a kind of like a buffer. It's similar to a to a capital buffer or so.
Uh and that is some protection against any uh any potential losses. Um now when you look at uh the breakdown of private credits, so these are investment funds uh private credits. So this is basically these are investment funds that are sold to you know high net worth individuals um and um you know the vast majority there about 50% or so is this direct lending segment um now um you know what are what are the frictions here so I think our main challenge from the policy point of view is understanding the underwriting standards when we talk to sort of like industry participants that are in the space they say they understand very well what's going on. Uh but you know as a as a policy maker it's a little bit harder to understand um you know what what is going on here with the underwriting standard. So I'm not um I will get to to more of that later on in in the in the presentation. So let me uh dig deeper into some of the uh frictions and financial stability issues in direct lending. So again what has been in the news what you have certainly read about is the exposure of those direct lending private credit funds to software. So a number of the major uh private credit funds have have had you know quite targeted um exposures to software you know which seemed like a good idea a couple of years ago but of course AI has changed that so there's a repricing of future cash flow expectations in the software industry also when you look at multiples you know prior to the selloff earlier this year you know these multiples were pretty stretched in for many the public companies. Um so that's a repricing. It's basically a shock uh to um future expected earnings and you know capital markets are there uh to provide an insurance mechanism. So the repricing uh of of this debt seems like exactly what capital markets should be doing. Um now of course there is an issue in terms of the maturity wall uh coming uh in the future. This is shown on the right side.
Um so basically uh you can see that um there is sort of like uh quite a bit of exposure to AI disruption that is still coming uh to roll over and um you know that's that's a concern and um that is also somewhat concentrated uh in uh in uh in the um you know more high yielding or lower rated spectrum.
Um so you know what is the economic friction here you know um it's a repricing basically um there is a rollover risk uh so there is um uh you know a maturity risk um but um again I think fundamentally it's a repricing relative to expectations that have shifted um it seems like um you know that is that is what should have happened now turning to overall credit quality.
So what are the kind of default rates and there are two ways to look at that.
Um so um uh one uh question is what are actual defaults you know as in bankruptcy. So this is the purple line on the left chart. Um and you can see that this is hovering in a in in a range uh between one and one and a half%.
there's a little bit of a recent uptick, but most recently it's actually going down a little bit as um interest rate expectations have come down. Um there's also quite a bit of selected defaults.
So many of those are sort of like payment in kind. So these are kind of like restructurings that are ongoing as part of this private credit deal. So it's kind of like arms length credit.
And you can see that that is very similar in terms of magnitude to the high yield credit market. So, you know, when we're looking at these numbers, we think it's similar to high yield corporate bonds. It's also similar in magnitudes to what you see in a loan book. Um um so it's not necessarily so it's certainly something to watch very closely. Uh but you know, the overall magnitudes are somewhat similar to other asset classes. Uh in the GFSR, we're reporting on a kind of you know, stress test of those default rates. And of course if you go into a boro stress scenario um you know similar to um you know a sharp slowdown of aggregate economic activity of course you do see multiples going uh going up. So stressed earnings are going down stressed uh default rates are going up roughly two uh to two and a half times in a reasonably uh stressed scenario. again very comparable to what would be happening in a banking loan book or a high yield uh loan book. So there are risks we need to monitor but um it seems uh somewhat proportionate to other asset classes.
Now um you know a particular concern has been around liquidity pressures. Um so you can see on the left chart that um you have these semi-liquid funds and those have gone from about 10% to about 20% of total outstanding uh private credit right uh so about 20% are semilquid. So um u you know you u you don't you're not fully locked in right.
So say you're a private net worth individual, you're allocating part of your savings um uh in private credit or it's your pension. Uh your pension might be invested in private credit. Uh your insurance company may be invested in private credit. So some of those are semilquid and the middle chart shows you that basically those redemptions are um kicking in whenever there's concern about credit quality. Back in um late 2022, early 2023, there was um quite a bit of likelihood of a recession that was talked about by analysts and you can see that a lot more redemptions came in and most recently with this software repricing the redemptions have gone up.
Now having said that uh those funds have sort of like a 5% redemption limit, right? So they're constructed to limit the amount of maturity transformation and liquidity transformation. So the economic friction here is of course you know these are very long-term investments. Part of them are redeemable but they are typically locked in. So many funds have hit the 5% uh lock in rate. you know, if there were, you know, more redemptions, uh, you would the funds would lock in and then I told you there's this dry powder and so the number of quarters it would take under a stress scenario for them to run out of the dry powder is something between five and and eight or nine uh quarters, right? I mean, so it's a fairly long time. So you would have to see you know of course they can run out of cash but you know it's something like three years or so down the line. So it's not something that is extremely immediate and you would have to be under stress for a couple of years. So again the economic friction you know um is liquidity transformation and of course you want to have lockins to solve that.
Now perhaps the biggest concern from a financial stability point of view is the interconnectivity with the rest of the financial system. I already talked about the insurance companies. Um and I'm going to go a little bit deeper uh in in some other interconnectivity issues. So the first way uh that interconnectivity is increasing is that you know the US is the by far the largest um um u h home for private credit uh funds and uh um you know the median fund is investing about 10% around the world right um perhaps in Croatia or so um uh and you know some funds are investing something like 25% um of uh of their funding around the world and in reverse uh say pension funds or insurance companies here I'm showing this for pension funds pension funds from around the world we are here showing for example Australian pension funds Scandinavian pension funds they are investing in private credit funds all over the world US UK Hong Kong and domestic and the US pension funds are not only investing in US private credit but also in private credit in Canada, the UK and Hong Kong. Um so this is interconnectivity across uh the globe.
The next level of interconnectivity here I cannot unfortunately sort out what is private credit relative to other NBFI exposure. So what I'm showing you here is so so like the total exposure of banks to non-bank financial institutions and we can do this neatly for the US and for Europe. So the left chart shows you that basically over the past 20 years the you know bank C1 exposure to non-banks went from something like 2% to over 20%. So that's like a 10x you know relative to CCT1 right? So um clearly non-banks are more important and banks are the intermediaries for non-banks and the policy issue here is clearly for bank supervisors to understand what these exposures are and think about stresses and I'm going to say a little bit more about that in a moment. Now, when you look at the cross-section of banks, and this is done for both the US and the Euro area, you can see that there's sort of like a tail of banks that have exposure to non-banks that is well above 100% of their C-1 ratio, right? So, it goes up to five, four, five, 600%. And that's true both in Europe and the US. So you know there's certainly a tale where you know as a as a bank supervisor you really want to make sure that you understand this exposure and of course you know the banks as you know some of the recent failures illustrate the banks also may have difficulty understanding some of the exposure that they are taking on.
>> This could be sec lending brokerage it could be >> this is yeah exactly so this is everything. So this is so the main clients of banks bes besides the private funds. So there's you know private credit, private equity and the hedge funds of course um and then there are other buy institutions but in terms of leverage you know what we worry about is private credit and so like trading and yes so sec lending repo would be part of that and that's quantitatively larger.
We can't break it down. Um, you know, if we had access to supervisory data, we could do more. But I will show you a little bit more. So again, for the US, we can break out how much goes to private equity funds versus consumer, versus business, versus mortgages. Um, in terms of undrawn commitments, right?
And you do see that um you know some of the banks um you know do have fairly sizable exposures to private uh equity and um and other funds. Um and um you know the revolving debt um is is fairly large. Um um so you know the typical business development corporation so these are public firms where we have better data uh that are doing private credit um origination and then they they're managing the private credit portfolio.
um you know new deals typically have like um 30% leverage uh so one/ird above the initial lending through uh either drawn or undrawn commitments and you can see that um you know the the the commitments are are going up um in terms of commitments to those uh BDC's um so it is certainly a fast growing segment and that's reflective of opportunities um you So again, this is ultimately funding, you know, um, midsize corporates, you know, so we certainly want to see mid-size corporates get credit, right? There's no question. I think the question is, is the risk managed appropriately? Is there enough data by the banks and then by the supervisors of the banks to understand so like what the risk is and is there enough market discipline to understand all of that.
Now um we try to do some stress testing here. So um you know basically asking what is um what is the potential decline in CT1 ratios when we have a stressed event. Again we do this for the NVFI sector overall. We can't really sort it out in between uh private credit and private equity. Uh but you know if you go far enough into the tail you do get sort of like losses that are worrisome.
Um you know I again I think bank supervisors could do you know much more here. You know our role is to sort of like look at the global picture and try to gauge um you know some magnitudes.
So I think um you know the punchline of all of this is that um um private credit plays an important role. It's funding midsized risky firms. Um it's you know you know smaller size than high yield corporate bonds. We all are used to think about high yield corporate bonds.
So this is perhaps half or a third of the size in terms of any one deal. Um and you know there is opacity, there is liquidity transformation.
Um there are defaults you know um we do think more data would be better. Um and this is good for market discipline. It's good for interconnectivity um for people to understand. We talked to many people that are saying they understand but from a policy point of view for us it is somewhat challenging to understand exactly what the underwriting standards are how they are evolving who is folding what risk etc. But in terms of sort of like the spectrum of being very alarmist or being completely reassured, we're somewhere in the middle, right? We do think there are risks that warrant monitoring. Um we are not saying, you know, this is the next systemic crisis, but we do think it's something that needs monitoring in particular the interconnectivity across institutions and across countries. With that, thank you. Thank you very much for this um uh very good scene setter. I suggest we turn to Andre from Tutor who is a chief European economist but who's also done some work on on private credit and yeah >> I can I can also go over there whatever >> podium or >> yeah yeah >> thank you >> thanks very much I'm speaking in a personal capacity and my views are not necessarily those of TUDA capital needless to say so as to be has already suggested this segment of the market has grown really fast at an annualized rate of 15% or so since 2010 and this has helped to offset to some extent not fully the deleveraging we've seen in other parts of the loan business in the US. So overall leverage of US non-financial businesses actually hasn't gone up over the last five, six, seven years but private credit certainly has contributed positively while other things have detracted. What I think this points to is that private credit is meeting a genuine demand both from borrowers and from investors. But as tends to be the case when something grows very fast, there's a bit of a gold rush. And maybe some practices emerge that aren't quite as sound as the original idea of the business. And that has given rise to commentary like this from some of the greats in the industry. There's an asset bubble. There are cockroaches. And where there's one, there are more. and some have even drawn a comparison to subprime. So let's think about this in the briefness of time a little systematically.
Um the worst combination you can have is unexpectedly shoddy assets in highly leveraged structures financed very short term. Those are exactly the ingredients we had for the subprime crisis in 2008.
You can add opacity interconnectedness and it makes it worse. So let's look at private credit through this lens of I would say five dimensions of financial vulnerability and I would start from observing that there are some important built-in safeguards in this industry starting with funding structure. So the typical private credit fund collects money for 7 8 9 10 years and invests in bonds with a maturity of 7 8 9 10 years.
So there is no maturity mismatch which prevents exactly the run risk that we had in 2008.
There is also relatively limited leverage typically and to be showed some stats on this no more than a factor of two which of course compares to leverage in bank balance sheets on the order of 10 and talking here about simple leverage not risk weighted.
Another factor one can say in support of underwriting quality being relatively good in private credit is that these are very private bilateral relationships where a lot more information can be shared than perhaps with a public deal where there are some sensitivities about what information goes out. So you can actually have pretty tight covenants pretty tight monitoring of your of your borrowers and that should ensure sufficient underwriting standards. But as I already said, whenever something looks very attractive, generates high yields, high returns, maybe some entrance that have somewhat laxive standards come into the business and some people don't ask all the the right questions and then fierce competition that emerges can weaken some of these underwriting practices and I think the primma facial evidence we have for that is exactly what to be showed in terms of the high share of software exposure.
Just to give a comparison here in BDC funds or in these business development corporations the share of software is now in the order of 20 to 25% whereas in the high yield market it's below five.
So you have to ask yourself why is it that suddenly all these software companies threatened with the AI revolution get money from these funds and do the lenders really know in all cases that the risk is is manageable. So some question marks certainly around asset quality. And the other important point I pick here from this list is the the third one where what used to be originally an investor base of very sophisticated entities, pension funds, insurers, sovereign wealth funds, family offices has become more diverse. They are now retail investors. Maybe not you and me, but very high netw worth um individuals who see an attractive option and they have been offered something that looks like the holy grail, access to a high yielding, very illquid set of assets like a long-term loan in a speculative grade market and yet they perceive there is liquidity because they can redeem. Now what some people have learned um in a somewhat painful way is that there are some some footnotes and the footnote says you can only redeem up to an aggregate 5% every quarter and guess what if a fund comes into disrepute or under a cloud of uncertainty because there was some default then suddenly everyone wants to come the usual run dynamics now they cannot run here because there is the 5% constraint on overall redemptions and that means there is no fire sale of assets that's good for financial stability, but as an individual investor in this fund, I'm a little miffed because I thought I could get my money back at will and I can't. So, I'd say this is actually an okay outcome for financial stability, but obviously sub-optimal if an investor didn't understand that they were actually buying an illquid product. I'm going to wrap up here and summarize in some sense the answer to my upfront question. Is this an industry built on solid foundations or is it a house of cards? I look at it not like an insider who knows everything about this industry, more like a macroeconomist that tries to understand is this subprime 2.0. My takeaway is it is not. There are generally solid foundations but also in this in this house in this edifice of private credit there are a few dark corners that we should shine more of a light on not only and mainly regulators.
I think market discipline can actually go a long way and I would say even the headline grabbing experiences of the last nine months have probably had the positive effect of inoculating the market a bit alerting people to the the risks looming in some corners and that should allow the market to grow perhaps a bit less fast but in a more mature fashion. I'll end there.
Thank you. Uh I suggest we turn to Jillian Edworth for a more macro perspective on on this. Even more macro perspective on this.
>> Thanks, Jean. Um I just want to start by thanking a couple of my colleagues.
Emily Banister leads our private credit business and Short Fakil is our financials analyst and does a lot of work in BDC. So they they took the time to try and get me up to speed here. So appreciate that. I just want to make three broad points today. First on private markets and um the likelihood of continued growth and and innovation ahead when you take a multi-year horizon. The second is just risks emanating from some of the stress that we're seeing in private credit markets right now. And just a final point then on on asset prices more globally and what they could or could not mean for for the global cycle. So just to start with you private markets more broadly and what is the case for for continued growth potentially including in um private credit not just private markets more broadly you know if let's start with maybe um private equity. So private equity transactions last year were 2% of what they were in public equity markets.
So it's obviously a a much smaller market. Um why go to private equity markets? The upsides are one um greater longerterm capital alignment. So as you're building a business, you don't need to report quarterly. You can invest for the medium to long-term and be less near-term focused. Lower go governance and regulatory costs in terms of issuing. And then if um reduced exposure to competitive information. So if you're growing a business and would prefer to make some things non-public to maintain an edge, um private markets allow you to do that.
private credit, depending on how you measure it, it's a market of two to3 trillion dollars and it's one that as as we've learned here already today, it has grown quickly. Um, we think that much of what you're seeing in private credit is essentially mirroring a lot of what's already happening in public fixed income markets. Um, so we've talked a lot today about BDC and direct lending. Um, but it is a market that starts with um low low spread low-risk investment grade lending. There's issuance there of about 100 billion a year. Um and overlap with um public fixed income market issuers there is only about 10 to 15%. So you do see higher quality smaller issuers gaining access to funding there. Other safer parts of the market or lower yielding parts of the market, infrastructure and real estate that are also present in public fixed income markets. And then you go the whole way up the credit spectrum or down the credit spectrum if you wish to say to venture lending and distress debt. So again, why go to private credit rather than just issue a public bond? Um it can be done more quickly. Um the costs of it at times can be lower. Um in some cases covenants are stronger not weaker. Um you have flexibility over the time horizon over which you draw down the loans and how that is structured. Um and again issues around um disclosures. So let's say a sports team wants to keep salaries private or a private company doesn't want to issue a prospectus to keep an edge in some terms of their competitive information. Um it that all fits in with the trend where you're seeing companies come to IPO later stage as well in terms of their growth. Um so just just as with public companies my many private companies now are larger than what they were a decade ago. So if you think about OpenAI at 300 billion, Anthropic at 180, Stripe at almost 100, 10 years ago, the largest out there was probably going to be Uber at about um 50 billion. So as we look at this, we see quite a diverse um a diverse market that has developed um in parts quite rapidly over the last few years.
My second point is really stress in private markets of private credit markets in particular of late and and how to interpret that and what that means for for this part of the market going forward. Now, as we've discussed, private credit has grown rapidly. Um there are some areas of stress right now. Um we are reluctant to equate that with systemic risk. It's something that could rock the boat as we see it rather than sink the ship. um over the coming quarters, I think there's a couple of things that are going to be quite important in terms of um seeing whether this market um matures from here. Signs of stress at full employment, we're seeing defaults climb higher. Some of that is fraud. Um lending that was over collateralized or collateralized more than once. Um and and equally the market reaction if you look at things like equity prices for private asset managers was pretty indiscriminate in March. Um so um the sort of equity share price moves you were seeing in asset managers um was pretty similar irrespective of their exposure to BDC's and and and what rep what portion of their aum that represented. Um going forward we think that's going to see due diligence step up. um there are ways to access the sort of information that you need um to avoid these situations and that is more likely to happen going forward and the more often it happens um the more constructive that is um in areas of private credit there is also beginning to be a shift towards daily pricing. Now there's a limit to how much the market can do that um but that is probably going to help improve transparency um going forward in terms of leverage on these structures. If we think of the GFC and the banks running 20 to 30 times um right now this is equivalent to one to two times. So it's it's it's it's a very different type of leverage. Um a couple of final points in this one is just on the evergreen BDC's or or the type of private credit that's being discussed here quite a bit. Actually implementing those caps we think in the next few quarters is going to be quite important.
Um and making sure that there's as much education out there for investors who are investing in these products regularly to sure to ensure that they understand those caps is are is quite important. Um the average duration on some of these products is pretty low 5 to seven years. So, if you think of a cap that allows you withdraw 5% a quarter, which is where we are right now, um that that allows you to to to manage this product down um very smoothly over a 5 to sevenyear period if those caps are are kept in place. Um just one other last point. There's been um some discussion of the high yield market here and I think maybe one nuance that um isn't very visible is just how public high yield fixed income markets particularly in the US have improved in terms of credit quality. Um so the average rating within a high yield public fixed income product these days has moved up towards a double beast. um the amount of triple C's in that product has fallen out quite a bit and some of that has moved to the private credit market and that's where we're seeing some of the stresses now. So, not to say that there hasn't been new risk added to the market um but some of what we're seeing is just a shift in that risk to different parts um of the market. Just a final point on asset valuations and the cycle. Um there is a broader question around where asset valuations are right now and how they're going to impact macro outcomes going forward. private markets are part of that but far from the full story. And then how how resilient is the economy going to be if there is a turn in in asset prices. Um so private credit um rocks the boat doesn't sink the ship. Um private credit exposures in a standalone basis in our sense is manageable as well acknowledging um the interlap or the overlap of exposures between private equity and private credit. Um but this is happening at a time when US stock valuations are 250% of US GDP. Um spread levels on USIG markets, EM markets, high yield markets 10th percentile or tighter. Um and more and more people active in financial markets given given some of the tech and financial innovation that we've seen and that's generating a wealth effect that we haven't had to to measure um in the past the way we do today. Um and against this backdrop we have a cycle that is very AIdriven. Um it's not a cycle we've seen before.
>> The investment amounts involved are very large. Um and unlike say the internet or software cycle, this is really about hard assets. So it's impacting large parts of the global economy even if the US dominates the headlines at this point. Um so think about the need for commodities um boosting exports in many countries, infrastructure needs like data centers um and energy needs. Um put it another way, this is a high nominal GDP growth world that supports um high asset prices that again um feeds into high nominal GDP growth. I think we've learned today that returning inflation to target at this stage in the cycle is tricky. Um but at some s at some stage that that acceleration in investment that we're seeing that acceleration in asset prices that we're seeing right now um will slow and the cycle will turn um and and could put some pressure on on labor markets at the same time. Um so just you know as we try to think ahead about you know asset valuations and the cycle it's all moving in one direction right now. um and just being open to how to manage the interconnectedness between not only private markets, public markets and the AI cycle um going forward.
>> Uh thank you Jillian. I think the the link to to the AI capex cycle is very welcome given the importance that private credit has on on financing this cycle. I think we're like run through the phase where uh the capex boom was financed through um uh through cash flow. Now you know most of the max 7 max 7 companies are negative cash flow. So a lot of that is going to be financed going forward through credit and most most likely through private credit. So I think the link between everything we've said on private credit and this AI capex boom is is super important. Um Marcelo uh estab with a few slides as well. The floor is yours. Thank thanks so much. Um I'm struggling a little bit because we all saying the same thing in different ways.
So let let me try to I don't know skip some stuff and and how do I do this? It's not >> yeah the green one.
>> Yeah.
>> Just have to hit it hard.
>> Oh I see. I see. So, so let me maybe change a bit my notes and let's say that let me start from the obvious point that the micro that the micro environment the private markets and public markets face is the same. So debate the debate around private credit often begins with institution themselves but I would begin with the environment in which they operate. So a little bit of a macroeconomist try to understand if this matters and how it matters. And over the last few years we have seen a broad repricing of long-term interest rates across major economies, treasuries, guilts, bumps and increasingly even JGBs have all moved higher. Uh you know we talk about fiscal deficits, geopolitical fragmentation, energy uncertainty, the AI investment cycle. She she also I thought I had one thing this new to say.
She said uh they have all contributed to an environment in which long-term rates are higher and more volatile the investors had become accustomed uh to during the decade after the GFC. So the key point maybe that I can make is slightly different than what has been made before is that private markets are not operating outside that environment.
They are absorbing the same micro shocks as public markets. But the difference that they absorb it more slowly. So that's the message that I mean so public markets adjust continuously through prices. Private markets adjust episodically through transactions marks refinancing and negotiations and I think maybe that's a useful distinction to keep in mind and in this environment one of the conse one of the consequence that liquidity is being generated differently. uh these charts they captured the what I think is one of the most important developments in private markets. So on the left side I think um uh Tobias present a very similar chart.
So uh dry powder remains quite elevated is that the the black uh line and uh while IPO which is a way that you kind of recycle capital or you know uh um has been quite weak. So capital capital has accumulated faster than it has been recycled and as a result the system has increasingly relied on things like continuation vehicles. Uh secondar is net asset value financing when you basically use your your portfolio to borrow more. um there's an increase in payment in kind which you basically you you you instead of paying interest on your leverage you you you you ac you you basically add the interest to the total amount of loan that you have so there's all these different ways of attract liquid that we see in the market and u I do not see them as inheriting problematic these are kind of a rational responses to a world in which financial conditions change rapidly and exit opportunities like IPO become scarcer. Um but that does mean that there's a bit of I don't know I'll call engineered liquidity uh in a low rate environment. So this lower adjustment could like could look like some resilience but in a higher rate environment the same feature could look like delay and then I understand why the BIS the IMF that kind of concern about let's let's keep an eye on this because again the fox that I'm giving here is that it takes a while for this stress to show up in private uh credit.
Uh so yeah what I said public marks are repricing faster than uh private markets um high y spreads uh widen leverage low markets became more selective and listed alternative managers have underperformed uh we we've heard the the the stories private marks have moved less I mean many of these let's call funds or or uh vehicles do not have to mark to market and I would interpret that primarily as a difference in adjustment speed again rather than a difference in underlying economic recovery reality. Now I would avoid direct comparisons with 2008 which is another topic that I think maybe Tobias touch a little bit but we haven't focused as much. I mean private credit is funded differently from banking. uh we all know that use less maturity transformation and remains relatively small compared with broad uh credit system. I mean this chart show the estimated private credit lending. So that's basically uh as a percentage of households and business debt and loans.
So that's direct lending as a percentage of total debt and loans is about 4% now.
Yeah, surely it has grown pretty fast since 2010, but you know, in particular after uh Dodd and Frank passed and but it's still pretty small. Um so I and because of this difference, the challenge is not a classic deposit flight that you'd see in a in a in a financial crisis. It is that stress that increasingly moves through like a refinancing pressure. there's a valuation kind of a drift that is not quite value the the this this um this uh vehicles because they don't have to move as fast as as prices in public markets.
There's a lot of liability management exercises and Tobias presentation mentioned some of that and different financial structures that you do not quite uh understanding. Um now the chart bas show that this low credit cycle is becoming more visible. So BDC's no acrruels are rising uh deteration is a uneven I mean direct lending still carries a very large premium over syndicated loans that's the yellow uh area that you see on the right hand chart and the borrow quality and refinancing needs are increasingly driving outcomes. So there's something there but given uh the smallness of the market and u and the um and the fact that structured differently it makes me maybe less concerned and let's call it the official organizations.
Now this semiquid structure also reduce volatility and visibility which is a problem and that I can see that as being a source of worry a particular source of worry I think Gileia mentioned every green private creating flows have slowed sharply you see in the left hand side of of this exhibit uh redemptions pressure like I mentioned makes liquid assets harder to manage so um you can there's there's just so much you can you can uh impede need investors to get to the money. Um, and the fact that these gates have been brought up, of course, makes me concerned about particular uh parts of this market.
Now, Gileian also mentioned AI uh and I think that's maybe the most interesting development to me is is that borrow level uh dispersion is increasing. you see in the in the right hand chart uh um AI for instance which is a key sector to explain economic growth in the United States and many parts of the global economy is supporting growth while simultaneously differentiating winners and losers more aggressively particularly in software and in technology lending like Tobias mentioned so that creates a more selective credit environment than we have seen in many years so so there is some distribution effects. There is some uh um loan providers that may be doing worse than others and part of this mask by the way this industry works that is a slower price uh re uh price revealing process.
So my conclusion I I think is kind of clear in some sense to me at least is like I I'm not overly concerned private about private markets. They are not replacing quote unquote the credit cycle but they are changing the way the credit cycle moves through the financial system and I think the key question for investors regulators and policy makers I think it's increasingly about u visibility timing how fast this adjustment is again if if you are in a different situation with lower interest rates you could say oh you know private credit is doing well because you know you don't have prices adjusting as fast but that's just a characteristic of this sector um and uh and and I would say that just to finalize that why this sector grew so much and that's clear in one of the charts it grew so much because we regulated uh banking in a tougher way and we can have a whole discussion if it's too tough or it's not tough enough but then this risk is going to move somewhere else in the financial sector the only way for you to elimate this to be a bit ideological in some sense is to eliminate capitalism in some sense and you don't want to go that far. So that balance is something that one needs to be careful about it. So I would certainly not say this issue that you are bringing up I don't think are reasons to regulate more this sector.
>> Thank you very much. I we've talked a lot about the interaction with the banking system. So I I suggest that we end with a banker's perspective uh on this. Uh Bosian, the floor is yours.
>> Thank you. Thank you Hervatar Nabanka for inviting me again. I I don't know why I deserve to be invited every year, but but thank you very much. I really enjoy it. So uh much appreciation. Uh so uh what what what I'd like to to to present is uh the banking angle in uh in uh in the growth of private credit and then private credit ecosphere and how do banks deal with uh with uh u increased leverage transactions and then particularly supervisory pressure there and uh the way I'm not going to repeat the core risk uh private credit growth of course has shifted leverage and credit risk into less transparent less supervised channels. Uh but what is the role of the banks there? uh whenever you produce a new credit your RWAs increase uh your uh capital requirements increase and then then all of a sudden uh something called like synthetic risk transfers uh appeared and then banks are heavily getting engaged in synthetic risk transfers and it is even more u telling that uh nobody likes to to to call them synthetic risk transfers the semantics there really matters now we're talking about significant risk transfer because It's much more appealing that synthetic risk transfers. And what do we do? We're literally selling the part of of of our exposures to the same private credit ecosphere that is currently still being financed uh through other sources. But uh we are seeing that uh these the same guys that are buying synthetic risk transfers are also getting the loans from the banks.
And then all of a sudden the the the loop is closed. And then in this respect uh uh of course uh individual bank uh uh has uh offloaded risk but this risk has not disappeared from the system. this uh risk is accumulating somewhere in the system and then uh as individually indemnified uh it is growing somewhere else and then this is uh particularly in the in in in the case of Europe where there is very little crossborder uh crediting u the risk synthetic the the significant risk transfer or synthetic risk transfers are all of a sudden becoming the crossber because we don't know where where where they go and then then how how is that accumulating and aggregated in in the in in the system. Very telling story about Germany last year when V credit uh war cart uh was was finally coming to the news was the story of Deutsche and Commerce Bank. Deutsche was exposed to war crime much more than Kumar's bank but Kumar's bank was hid with the losses much more than than Deutsche and Deutsche literally publicly not confirmed that uh they uh uh they indemnified the losses through the SRTs >> and that was that that was a story in the financial times and it was like how how did how did they do it? I can tell you from the KBC perspective, we are midsize European bank uh and in last year the the story of the SRTs uh talking about one 2% of the the RWAS all of a sudden become 10% story in a in in a span of a year >> and this is for me uh uh adding the the angle to to what all of you said in how the banks are are getting into into the story and again European banks are in the lead there. European banks and then parallel to to CDS CDO story from 15 years ago, it's it's very telling again.
It is European banks that are leading.
Uh they're selling to the to the very small number of specialized funds uh and then institution investors. you both of you uh me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me me mentioned some of them Apollo, KKR, Blackstone uh they're all the same guys uh who are also uh uh buying the the SRTs and for me that uh that of course uh uh creates uh maybe too connected to fail risk uh that might uh uh we emerge uh opacity uh tends to increase uh and uh there's this crossborder market that uh that is very difficult to to to measure. There is this it should be not a bank leverage back leverage uh creates the process.
There's a typo there. Uh and then for me that is that is that is uh something that might still not be in in the volumes uh big enough to to to create uh um uh concern but uh it is as we discussed earlier uh there there is a bubble when there is a bubble. So uh you see it only when when it bursts. So so for me that is that is uh that is very uh significant development which is and that is that is for me uh the the irony uh somehow produced also by the supervisors. supervisors are literally by uh uh requesting uh more capital for uh more exposures also pushing us the banks into the SRTs. There is uh you SRTs for for for SSM are something that is highly appreciated and this is what banks start to do. If KBC uh not you know as I said midside bank it's doing it I would assume that that other banks are doing it even more and then that is something that uh that of course uh uh creates and it might create uh a problem and uh for me uh what is >> and the SSM is not imposing limits on the use of SRTs. No, no, though they're they're they're coming with uh through ABA uh uh guidelines uh in terms of the the the highly leverage transaction ratios uh putting the the constraints or or setting up the the the the ceilings where which of course banks are are trying to to overcome and then cut short and that's why we we started to use the SRTs. So I guess uh uh there is very recent uh uh very recent uh survey by by the FSB uh I just uh provided the summary but I I think uh the the bottom line there as an alternative to ambitious implications incentives for the shift should be reconsidered. It is incentive for the banks that is or let's put it differently supervisors are incentivizing banks to use the SRTS. So it is it is for me uh closing the the the the doom loop that that might uh uh have some similar similar uh implications and conclusions as uh as 15 16 years ago. Thank you.
>> Thank you.
Thank you to the whole panel for a very comprehensive discussion. With that I open the floor. I see a few uh the two questions here and then two questions uh here.
First a quick comment. I fully um would highlight what Boscham said. That's true. This SRT lending is very interesting. It's very capital efficient for banks and uh it's it you know it works as long as there's no correlation risks. Your bars are okay because you you know senior losses elsewhere and it's exactly I mean not saying exactly but it does remind of COS of you know global financial crisis because when something correlated happens that's when it it suddenly starts uh coming back. No that was just a comment. Two quick questions. One is um Adri um Tobias you said you don't seem to agree to the cockroaches you said we don't see it as systemic risk but if you see it in two instances why would you think that there's not more because I agree that in principle private credit is there you have a close relationship though that gives you more insight and that improves the relation but it also could lead to laziness so you know why would you why don't you agree with a cockroach statement made by by diamond and then the Second one is bit maybe a bit particular but are you concerned with regard to funds that the current situation in the Middle East which is a lot of the private credit funding is coming from sovereign wealth funds out of that region which maybe no longer have the appetite and capacity in a way to continue to to fund or maybe even to call back. Do do you consider that a potential particular risk emanating from the from the ongoing war?
Yeah, my question is um what is driving the growth of private credit? Um we heard a number of hypothesis um many of them from Jillian, many of them I found very you know agree with fully. One I'm not entirely sure about that was he said that there may be companies that don't want to see um the salaries of the management in the newspaper. So they prefer to do private credit instead of u doing a um bond perspectives. I mean that's possible but you know this sort of sudden longing for privacy this burst of shyness of decency as if they had all spent a summer in a Georgian monastery.
Yeah. Um I'm not entirely sure that's really the reason why we had this growth on private credit. If they don't want to see the newspaper the their salary in the newspaper they could have well could just get a bank loan. No. So I actually see two other reasons why uh private credit has grown. The first one is regulatory arbitrage. Yeah. uh and that to me seems to be the main reason. Uh and then if we do have stress in the private credit um sector now um because regulatory arbitrage is coming to an end well then we really shouldn't be moreing now. If the the whole thing is driven by regulatory arbitrage, then let them sort out sort out the problems. And the other reason why we've seen this massive growth in private credit could be that this is a um sort of a desired uh effect of ultralose monetary is that it's a desired effect of ultralose monetary policy. You do quantitative easing, you drive down long-term interest rates, you drive people into liquid, high yielding assets such as private credit because you want to ease financing conditions.
But this is a thing of the past. we don't want these very easy financial conditions anymore. So if that's the case, uh then stress in the private sector is something totally warranted.
It's what we want. We want tightening of financial conditions. Um and then we shouldn't be worrying about that. So my question is really what is driving private credit and the fact that we have issues now in private credit. Should we worry about it or is it actually an intended consequence?
>> Thank you. We take two more uh here and Yeah, I've been following this u uh private credit uh matter. But let me say something um on the on the history of this conference which is very relevant to the presentation that you've given.
I was in the first conference in 1995. I come to 31 out of 32 conferences.
In 2007, early July, there was a panel similar to this one on the housing bone and the supreme early July.
A few years later, there was a panel on the debt crisis in in Europe. sovereign day crisis and as we left the room it was the announcement by Drai of the what whatever it takes.
Now uh I work 20 years in three IFIs including the World Bank and the EVT and I work along the the IMF in missions.
And when I read the financial stability reports of the last uh two or three years and the presentation of toas uh not only do I have shivers, I have tremors because the way they present the downside risk, if you read between the lines and you have the skill of knowing how to translate that, it tells you something is I mean my my opinion something is about to to break. And I repeat, uh, I think this is a slowm moving crisis around the corner, not very far from now. And it really reminds me of this panel on the Supreme that took place in 2007, early July.
>> One last question for this round by >> Thank you very much. comment and um and a question. Um so it's what I've heard here now is kind of consistent what I've heard just a couple of days ago. So the FS there is FSB uh private credit report and I think there's also the ECB um financial stability reporter review there's also a uh a chapter on that and it kind of matches what what we've been hearing here. So that yes the the concerns the stability concerns are not as strong but a space to be watched. So kind of to uh to to borrow from oh who was it now I forgot to uh the dark corner so put some light in the dark corners please b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b b basically. No. Um and again as somebody else said I mean this is actually maybe a good outcome of the regulatory changes that this stuff is not on banks balance sheets but actually on outside. Of course it still raises the question of regulatory arbitrage.
Now the question I have and um I kind of I guess I'm going to put it in a provocative way. Some people on the other side of the Atlantic say, "Well, um uh we might have gone too far in the bank regulation and that's why this stuff goes outside the banking system.
Well, let's lower capital requirements.
Maybe it comes back and so we level the playing field." Now, I don't agree with that, but I'd like to hear the the the view of the the panelists on that.
Thanks.
>> Thank you. Um who wants to take what? Tobias, you start. Sure, happy to start. Um, so um there were many questions and um let me let me try uh to perhaps rank them by um what I found most striking.
Um so the first question is really about this banking regulation and the regulatory arbitrage issue. Um and I would point to two facts here. Um so the first one is that you know clearly banks have um provided credit lines to private credit right so the typical deal from what we can see is about 30% of of uh total credit is added on via bank credit um and so that's a profitable business for banks right there there's no question they don't do that they're not forced to do that they make money with that I mean the Second point I would make is that when I talk to to bankers that are running private credit businesses out of banks, what they are telling me is that so I typically ask them what is your cost of capital? Okay, how do you think about your cost of capital running private credit out of a banking organization?
And the answer I get is that it is the ROE of the firm i.e. they are using basically the capital of the firm or on the margin they would think about you know raising capital of the firm in order to private in order to run private credit so and they don't you know from what I understand they don't feel that they are at a cost disadvantage in the cost of raising equity capital relative to private credit firms so in that sense And that that is you know that has I think been true for a couple of years and in fact you see banks getting into private credit you know as as a proprietary business i.e using their own capital right and so I think both of these arguments for me question this story about regulatory arbitrage um you know and this is straight from you know market intel.
Um secondly the 2007 question right so um can you sleep at night or do you have um you know some sort of you know how how how uh worried are we um so as I as I said we are at the fund we're somewhere in the middle right so we don't think there are no risks we do think there are risks that uh warrant being monitored you know and that is underwriting standards i credit losses um exposures of banks, insurance companies, pension funds, exposures across borders, etc. And um you know we spend a lot of time doing stress testing of those things and we think the magnitudes are sort of reasonable relative to other credit classes, right?
So relative to what is on the loan book of banks or in high yield it seems of comparable magnitude from what we can see. Now the caveats are we can't see everything.
Um but on the other hand you know it's not obvious to us that there is you know this massive tail risk insurance the GFP kind of thing uh out there. you know we don't see the kind of you know drastic maturity transformation um where you know the these AAA tanches are funded in money markets right so you know I do I do think that the public sector including you know central banks IFIs like the FSB BIS IMF I do think we have put a lot more resources into financial stability assessments and you When I compare to what we do today relative to what I remember doing in 2004 2005 I do think we have a much better understanding just of the breadth of what's going on. I mean we just didn't have that magnitude of understanding of the interconnectivity how to think about you know all these issues. So I I would argue um that uh you can take some comfort because I do think we have put more resources into financial stability assessments and I would argue we're we're somewhat better.
Now the last question I will take is this question of question number two um uh about you know what is driving the growth. So why have we seen this massive growth of of private credit? And so I totally agree with Marello's point that you know this is all in the microeconomic environment right I mean um you know it's kind of like an equilibrium outcome I mean I think it's a kind of financial inclusion that is what is happening right so and you know these are you know fairly small firms um you know the the the b so there is a shift recently with the move to big tech right so you know nowadays through these asset based finance you know you know um technology firms AI firms are being funded and these are like multi-billion dollar deals right so so that I think is a little bit novel and I think there we can argue about the AI cycle that's a point that was made by several but I think the traditional private credit direct lending these are like fairly small firms so the deals will be like 100 million 200 million or so and it was just not a priority for the banks from my again talking to bankers they're like well we were chasing the four five six 700 million deals not the two 300 right but you know it clearly became visible that if you collect a lot of those one two 300 million deals you still have you know pretty high returns and you have sort of like a size of market share which is why the banks now are getting into it using their private you know their own capital to get into it so I think it's a kind of like a story of financial inclusion um of those midsized firms that were underserved, right? I just don't think it's a regulatory capital story. And you know, the Middle East question um you know, I'm I'm I'm not sure how much of a difference it makes, but um I don't have any particular insight there.
>> Um add a bit to No, I agree with with your answers, Tobias. Back to your question on compared to 2007. I bet in that seminar if someone had said you know I know the housing prices are going to come down everybody would agree there would be a catastrophe. I think there was a there was a a lack of appreciation for the fact that housing prices could fall nationally in the United States and we don't have anything like that here.
Everybody has mortgages. Everybody has said >> yeah no but but see what I'm saying is um I remember those discussion I was at the IMF and actually in 2008 I was the mission chief to the US so it's like so I remember those discussions so I I cannot claim it's my fault but I got the result um no I mean the people were that was the hu the biggest argument that is the underlying asset is housing mortgage and for this to be really systemic. You need housing price to decline and then if oh this is not going to happen never happen and then it did happen. So and then so the base of the of the of the risk is huge was huge there here is not as huge for the reasons that that Tobiios was mentioned I think there's less of a >> but here we have an underlying asset which is this AI capex >> yeah that's what say so my my my second thing my second what will make me lose sleep and have been writing about this on the micro side if there's a crash in AI valuations then I think I don't I I actually am not as concerned about public credit. I'm concerned about the growth in the US economy, unemployment rate and usual because the US growth right now is quite narrow is quite based on the strength of that sector. So then yes on the I would be a concern but that's I think it's a bigger shock than private credit but yeah >> why why why private credit I mean from from European perspective uh I usually unnerve my my new colleagues at the KBC by saying that banking is not rocket science you you produce credit if you have a good collateral and coming back to what said on software finance banks cannot do this I mean we we we cannot properly uh sells the collateral. So there we we're creating the room for somebody else to step in and is somebody else is coming from from private funds uh institutional investors and uh that is uh that is one side of the story. The other side of story is of course uh the the supervisory uh prudence and then uh and the strictness which uh for for whatever leverage transactions you do uh it dramatically increase your risk weight assets and then this affects the capital. So we are you know struggling there uh trying to be part of it but cannot. So there there are there are different ways of of how and then I said one way of of of of us getting in the market is through this SRTs that we we're trying to to reduce the risk weighted assets and that's it. But the the the there's very very very important thing or initiative that are and particularly in Europe where there is very little crossber crosser crediting.
If if any bank wants to do any crossber banking, they need to buy the subsidiary in the country that they want to do any crediting and then you do the the credit. But it is something I I think in in France I think there was this TB initiative uh which uh created this uh public private partnership where banks started to be part of the the initiative of financing uh the the technological uh uh sector and and that is something that that in Europe of course lags behind the US and that is where the the the private credit market is being created out of necessity to fill the the void that the banks particularly European banks cannot cannot step in.
>> Chillian.
>> So just to address I mean why is this happening? Part of it is bank regulation and and we saw another round of increase in private credit lending after SVP the regional banks um being increasingly regulated as well. And if you want to layer on top of that, I think there is a part of the market um associated with some of the direct lending that did see an increase in competition. So between private credit, private credit bank loans and and euro bond issuance. So you put some of those things together and you can call it growing pains. Um but but but we're already seeing at full employment some issues um come through and and I think that's partly um a market that is learning by doing at this point given how young the market is and the pace at which it's growing. Um, I think there is also a component to this which which is innovation. An ability to lend to meaningfully sized but but smaller than Eurobond level a eurobond sized companies to to allow them to to grow and and there are definitely parts of this market that are very well researched and and I think that that investment is is is only stepping up.
Um, yeah. What to say? I mean, why is this not 2008? I think it just comes back to some of the metrics we've been given in terms of leverage, in terms of the amount of dry powder. Will or will those 5% limits on withdrawals stay? If if they don't, that that's really tough. If they do, and we can educate folks on on what they're investing in, that's going to be a constructive um step forward.
Well, there's very little to add at this point, but maybe to Christian's question, I think there is the aspect of maybe financial inclusion, maybe regulatory arbitrage, and I don't consider regulatory arbitrage as a four-letter word. I might use a different word, you know, response to a regulatory environment. If regulators say we don't want banks to extend certain business or only if they have very strong capital underpinnings, then it's natural for other players to step in. So I think even if that may not be the whole story, uh I think it's a legitimate explanation. The other two that I've come across is first search for yield. Clearly we had a very long period after 2010 with very very low interest rates and people have been looking for other ways to earn interest.
Now that might make you concerned.
However, we've obviously seen since 2021 a very sharp interest hiking cycle in the US to 525 to 550 and yet the wheels didn't come off this industry. So I would say it has passed at least some measure of a stress test. The third reason that often comes up is the growth of private equity because private credit is often an annex to private equity. So private equity fund buys a company wants to lever it up gets private credit to get the leverage to the desired ratio and I think as private credit has clearly done very well partly for reasons that Marcelo explained they don't have to mark to market every day.
they mark to market every or mark to model even every quarter thereby creating maybe a mirage of a better sharp ratio on their returns whatever the case may be they've done very well and I think on the back of that private credit has also done quite well >> are there any burning questions otherwise I suggest we bring this to a close and offer everybody a short break before we meet at 7:30 for uh shuttle to dinner, right?
>> Can I just uh can I just have a can I just have a very private uh uh message for Boris? Uh I'm very proud to be your friend. Uh our friendship goes uh back uh 25 years if you remember in Rio. We uh I cannot tell much about it but happens in Rio stays in Rio. Uh you've done it. You've made it. You nailed it. not only for yourself, for for Croatia, for all transition economies, uh, but even more for the benefit of, uh, the ECB. So, I actually have a heartfelt congratulations.
>> I have a remarkable.
I I I think Bor showed awful judgment by accepting the ECB job because I think that means you're going to come here less often.
and uh and but anyway I'm happy for you for your professional uh growth if you want to call but I think show some lack of judgment what matters in life but anyway good luck
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