US monetary policy drives global risk appetite

LBS academic links global financial cycles to credit creation and risk 

US monetary policy is a key driver of global financial cycles and risk appetite, according to Hélène Rey, Lord Bagri Professor of Economics at London Business School. 

“It affects the leverage of US banks but also of the Euro area and UK banks,” she said. “It drives credit creation inside and outside US borders as well as flows across borders.” 

Professor Rey was one of six world experts discussing global financial issues at the eighth High Level Conference on the International Monetary System, jointly organised by the International Monetary Fund (IMF) and the Swiss National Bank. 

Tobias Adrian, Financial Counsellor and Director of the Monetary and Capital Markets Department at the IMF, opened the session by stating:
“Financial conditions are heavily impacted by the global financial cycle. The question arises to what extent domestic policymakers still have control of their own financial conditions.”

Professor Rey spoke about the growing body of evidence on the importance of global financial cycles, which by her own 2013 definition means fluctuations in financial activity (measured by risk-taking, credit creation, asset prices, capital flows, spreads and leverage) on a global scale. 

“Macroeconomic data shows that one global factor in asset prices explains about 25% of the fluctuations in risky asset prices around the globe,” she said. She also pointed to microeconomic data supporting this: Yusuf Soner Baskaya and colleagues at the Central Bank of Turkey found that 43% of credit growth in Turkey is explained by foreign capital flows. 

She also mentioned the Research Network of Central Banks’ meta-analysis of the impact of foreign monetary policy on domestic lending. Most teams identified significant effects of US monetary policy and some teams found effects from the Euro area, UK and Japanese policy, she explained. “This is not surprising given the size of these currency areas,” she added. 

Professor Rey also addressed the likelihood of another global financial crisis. “Flexible exchange rates do tend to decrease the probability of a crisis but they are just not enough to lift the constraints that the global financial cycle put on domestic policy,” she said. 

Crises are very often booms gone bust, she reminded the audience. “We have to be careful in boom times. Do we have the right models to identify early enough the bad booms – the ones that are going to end up in crisis?”

She identified two promising future directions for research. “One is to use more micro-level data, look at intermediaries, track better on which balance sheets the risk concentrates during boom times – that’s where we can do a lot better. The other is to use more robust techniques for these early warning models, in particular using learning algorithms.”

Professor Rey concluded that the global appetite for risk may decrease – and this is likely to affect risk premiums, volatility and credit creation. When that happens, in an environment of high debt, risk could materialise, she said – especially in countries without countercyclical buffers and with depleted public finances. 

There was some good news: “Macroeconomic policies and instruments do make a difference,” Professor Rey said. “And we should not forget that fiscal policy can dampen the booms and help in busts. That’s highly desirable.”

The other participants were Agustín Carstens, General Manager at the Bank for International Settlements, Philip Lane, Governor at the Central Bank of Ireland, Mario Marcel, Governor, Central Bank of Chile) Jerome Powell, Chairman, US Federal Reserve.