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By Nick Mickshik
Until around a decade ago, central bankers tended to operate with the assumption that, if they deployed the various tools of monetary policy at their disposal effectively, they could ensure low and stable inflation, manage economic fluctuations, and ensure favourable domestic macroeconomic conditions. Of course, it was widely accepted that exogenous shocks to an economy might have a significant impact domestically – hence the truism that when the United States sneezes the rest of the world catches a cold – but this was largely taken to be a symptom of the outsize influence of the US economic performance on global affairs.
Then, in a paper presented to the prestigious Jackson Hole Symposium in August 2013, LBS Professor of Economics Hélène Rey unveiled the concept of a global financial cycle. It was an idea that, as it gained currency, not merely challenged conventional thinking on monetary policy, but obliged economists, policymakers and even politicians to fundamentally rewrite the handbook of central banking.
In simple terms, the old orthodoxy (captured in the ‘Mundellian trilemma’) held that, in making decisions about managing international monetary policy, a country had three mutually exclusive options: set a fixed currency exchange rate; allow capital to flow freely (with no fixed currency exchange-rate agreement); or pursue autonomous monetary policy. According to this view, countries who allowed free mobility of capital across their borders could only pursue an independent monetary policy if they allowed the value of their currency to rise and fall relative to others.
By analysing how international bond, equity and bank-lending flows; risky asset prices; and credit growth tended to move together globally, Professor Rey first identified a global financial cycle, then studied how this global trend impacted financial conditions within countries as capital flowed in and out, further demonstrating that it impacted national financial conditions irrespective of the prevailing exchange-rate regime.
Using newly developed econometric methods to identify causal links between variables, Professor Rey produced hard evidence to show that the monetary policy of the Federal Reserve was an important driver of this global cycle. In other words, shocks to US monetary policy had spillover effects on the financial conditions of other countries – advanced economies and emerging markets alike – whether or not they operated a flexible exchange rate.
The finding that decisions made about US interest rates could alter the flow of investment into and out of countries across the world challenged standard thinking about the relationship between exchange-rate regimes, monetary policy and financial stability; such that what was a hitherto unknown feature of the global economic system has since dominated economic and financial discussions on the world stage, leading to a new orthodoxy: if a country wants to determine its own monetary and financial conditions, it must put robust macroprudential policies in place to regulate the financial sector – which may mean it sometimes has to restrict international capital flows.
Following the high-profile launch of her idea, Professor Rey endeavoured to develop and share her findings widely among economists; an undertaking that not only saw her idea placed firmly at the top of the global economic agenda, but also saw her given a place at the top table of global policymakers.
Landmarks included being invited to give prestigious lectures on the research (fittingly enough, she was the first woman to give the International Monetary Fund’s Mundell-Fleming Lecture in 2014), while the IMF based its entire 2017 Annual Research Conference on the concept of the global financial cycle.
The impact of the research is clearly evident in the pronouncements of the global financial policymakers – particularly in the US, Europe and the UK – who have acted on its findings. Janet Yellen, for example, who was Chair of the US Federal Reserve from 2014-2018, said: “Hélène Rey’s research on the global financial cycle and the trilemma has been important in informing Federal Open Market Committee discussions especially about the effect of US monetary policy on the rest of the world. It has also influenced our thinking about the effect of monetary policy in risk-taking in international financial markets.”
Janet Yellen’s predecessor as Chair of the Federal Reserve, Ben Bernanke, put his finger on why the research was so important, observing that the impact of the global financial cycle had to be taken very seriously “given the sometimes severe consequences of financial instability.”
In Europe, Benoît Cœuré, former member of the Executive Board of the European Central Bank, said Professor Rey’s work had helped transform central bank thinking on the international transmission of monetary policy, obliging central bankers “to qualify their traditional views about monetary policy independence and flexible exchange rates”, and revealed that the ECB had even used the research to “understand the international consequences of our conventional and non-conventional monetary policy measures”.
In the UK, former Governor of the Bank of England Mark Carney said: “Hélène Rey has been a key proponent of the importance of the [multiple channels through which developments in financial conditions can be transmitted across countries]”, and that her research had made “an influential contribution to the discussions at the Bank of England’s Monetary Policy Committee”.
Central bank policy and the concentration of risk
Hélène Rey’s latest research measured banks’ risk-taking behaviours and aggregate systemic risk from banks’ balance sheets. Before the 2008 financial crisis, macro risk tended to concentrate in the balance sheets of large banks. The paper, ‘Central Bank Policy and the Concentration of Risk: Empirical Estimates’ extracted the distribution of banks’ risk-taking parameters from balance-sheet data to understand systemic risk and its concentration in the banking sector over time. The research generated three main findings:
Perhaps most significantly, the research has changed how the IMF itself operates. Cross-border capital flows can provide large benefits to economies, but can also cause and amplify shocks – and the smaller and more open economies are more vulnerable to shifts in international capital flows. The traditional response was to use flexible exchange rates as a “shock absorber” to minimise impact, but this does not give full insulation from external shocks – and can be particularly ineffective when financial markets do not work perfectly.
Policymakers therefore frequently resort to intervening in the currency market and putting macroprudential and capital flow management measures in search of domestic economic stability; but this, in the words of the IMF, is an eclectic approach that suffers from “the significant shortcoming” of the lack of a clear framework.
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"Professor Rey’s insights have been incorporated into the new analytical Integrated Policy Framework of the IMF"
In 2019 and 2020, the IMF embarked on a major initiative “to develop conceptual and quantitative models taking greater account of real-life frictions and vulnerabilities to guide how these tools should be used”.
Professor Rey’s paper was fundamental to that effort and underpinned the IMF’s new approach. IMF Chief Economist Gita Gopinath commented: “Professor Rey’s research has been very useful for us. So much so that her insights have been incorporated in the new analytical Integrated Policy Framework of the Fund [published in 2020]. We highlight in this new conceptual model the possible role of foreign exchange intervention and capital flow measures to improve monetary autonomy following shocks to international risk appetite. This is in accordance with Professor Rey’s work. This new conceptual framework will […] be gradually rolled out to help our policy advice to emerging markets and advanced economies.”