Over the long weekend, I had an opportunity to read the financial stability review reports by the U. S. Fed, the Bank of Canada and the European Central Bank. These reports were issued to the public in the middle of May by the central banks. Financial stability became one of the key elements for the century banks after 2007/2008 financial crisis, in supporting them to achieve their mandate of keeping price stability and/or maximizing employment.
Stability is an important concept in control system theory, specifically for potential behavioural evolutions of any system. In brief, a stable evolution is one that after initial deviation due to external disturbances, can return to its original course. Stability can sometime be changed by control mechanisms that are properly designed. In designing control strategies, the system has to be defined in a context which is more broad outside its boundary. The control strategies are often unable to be effective for the factors that are outside the boundaries of the system under consideration.
Central banks are established within their respective national or economic boundaries. However, their policies affect and are affected by other countries. This is especially true when the economic and financial activities have become globalized. The three financial stability review reports all addressed the challenges of spillover effect arisen from policies by other central banks. Noticeably
- Spillover effect by rising yield on U. S. Treasuries, leading to rising of yields on other government bonds, such as euro zone where they are not ready for any high yield.
- rising yield in the U. S. leading to large capital movement from emerging markets to the U. S. in anticipation of strengthening dollar, posing economic risk and equity market risk for the emerging market.
- rising rate causing volatility of the U. S. equity market. The ECB report indicated that “…a 10% correction in US equity prices that is associated with a US monetary policy tightening shock might lead to a fall of around 9% in euro area equity prices”.
Economic globalization calls for a central bank of central banks, which will be able to coordinate the monetary policies that are at national levels. This was partially achieved by G20 during the financial crisis in 2008 at a global setting, and late by the ECB during euro zone sovereign crisis at a regional level. This time when the global economies start to reopen when COVID-19 under control, I think there will be some coordinations among the central banks, though might be limited to G7 countries. The implication is that though the U. S. economy appears to be recovering earlier and faster, the Fed alone might not be able to go too early, too fast and too far in monetary tightening.