To sum up, financial innovation is on the whole expected to have facilitated the job of monetary policymakers by accelerating the transmission of monetary impulses to the economy. However, in times of stress, when financial sophistication may have gone further and quicker than risk-management practice, the confidence crunch that may ensue paves the way to non-linear responses of the economy that seriously challenge our common understanding of how monetary policy impulses are transmitted to the economy. Challenges for our reliance on monetary indicators As you know, the Eurosystem’s monetary policy strategy assigns an important role to money, which is based on the premise that monetary developments provide valuable information on future inflation in the longer run. I would like to ground this with two reasons, a well-known stylised fact and a conjecture. The stylised fact first: there is ample statistical evidence, in the euro area and elsewhere, that low frequency movements in money growth are closely correlated with trend inflation, e.g. for frequencies corresponding to cycles of eight to ten years. The conjecture, then, brings us to an issue that will be tackled this afternoon, namely the flattening of the Phillips curve: changing inflation dynamics, which can partly be viewed as a consequence of a successful anchoring by credible monetary policies, tend to reduce the sensitivity of inflation to incipient imbalances in the economy.
In contrast to the enhancement of the interest rate channel, at least in normal times, financial innovation is traditionally expected to have weakened significantly the so-called bank lending channel. Financial innovation gives firms broader access to securities markets and, as such, makes them less dependent on bank funding. Similarly, banks may be more able to issue debt securities and less dependent on the constraint of funding themselves with secured deposits. Moreover, securitisation by banks was expected to alleviate their liquidity constraints and thus to further weaken the credit channel. Indeed, previous research has generally found that banks have used credit market innovations such as loan sales and securitisation to diversify credit risk exposures and increase lending. However, recent research has highlighted the potential for bank capital regulation and market discipline to shape a bank capital channel of monetary transmission. Viewed as an extension of the standard bank-firms agency problem to the relationship between banks and their creditors, this capital channel could reinforce the standard financial accelerator mechanism. This last concern is closely related to the fears of a credit crunch that have been voiced in the last six months. Current events show that the tide of financial innovation may recede and the future of the originate-and-distribute model of banking is a topic of renewed work. What we see now suggests that an unprecedented reintermediation process is underway, which might imply in the end a strengthening of the credit channel.