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Liquidity is an elusive and challenging term with many uses and definitions, in terms of both quantities and prices. Mr Caruana defines it as the “ease of financing” in the global financial system. What determines “ease of financing”? To be sure, there is official liquidity created as a consequence of central bank actions. But more broadly, it is market participants’ perceptions and attitudes towards risk, valuations and cash flows that drive credit extension and liquidity. The important point here is that these shifts in risk-taking and credit creation can have monetary and financial stability consequences as well as real economy consequences.
Just in the last twenty years, a long list of advanced and emerging economies have experienced episodes where imbalances are accumulated for some time and a sudden shift in market sentiment leads to turbulence that disrupts the functioning of the financial system, ultimately leading to prolonged recessions and unemployment. Over the last several weeks, not to mention during the geopolitical tensions of the last few days, we’ve been reminded how quickly sentiment can change in financial markets. Periodic swings in risk sentiment are nothing new. But they always leave us somewhat puzzled – it’s never clear why a given piece of news sometimes causes radical shifts in market prices and financial flows, while at other times similar news leaves the markets unaffected.
The analysis of global liquidity is important for a number of reasons. First, the interaction between financial booms and busts – what is called the financial cycle – and the real economy deserves more attention than it has received in the past. Even today these implications are not fully understood and internalised in people thinking and models. Global liquidity excesses can contribute to the endogenous build-up of vulnerabilities, and liquidity shortages can have important implications for stability and growth.
A second underestimated factor is the growing impact of global conditions on domestic economies and financial systems. In an interconnected world, global conditions – the global financial cycle – have a growing economic impact on domestic economic conditions. Policymakers need to take these feedback effects into consideration. More work is needed to internalise all these interdependencies and spillovers in a consistent framework.
Mr Caruana said: “Moreover, financial structures and flows are evolving. We are entering a new phase of global liquidity. Shocks can cross borders even when cross-border capital flows do not seem unusually high. In this new phase, dynamism comes from capital markets and the search for yield more than from the leverage cycle of global banks. Global liquidity analysis is a vehicle to help us think about these factors.
“We need to understand, to monitor and to address global financial cycles and liquidity risks as we formulate domestic macroeconomic policies. Our objective is to ensure open and adequate financing of the global economy, while addressing financial excesses at an early stage, in order to lay the foundations for long-term, sustainable growth.”
In his remarks Mr Caruana tries to set out a framework that could be useful in thinking about these questions. He focuses on how financial risk-taking, asset prices and credit expansion tend to move together across countries, even when these countries are at different stages of the macro-economic business cycle. He first tries to set out what it is known about these patterns, including the indicators that BIS finds to be useful for tracking and analysing them in real time. Next he sets out where he thinks things stand right now in the global financial system in terms of risk-taking and global liquidity. He goes through some of the main features of the new phase of global liquidity. And Mr Caruana concludes with some implications for policymakers.
“The message is that, notwithstanding efforts in some parts of the world to begin normalising policy, global liquidity conditions remain accommodative. We need to be aware of the new risks in this new phase of global liquidity. At some point, more normal conditions will return and should be welcomed. But both policymakers and the private sector will need to be prepared for the adjustment.”
This means watching out for vulnerabilities that may have built up while conditions were accommodative. It also means taking action to build resilience in the financial system. All types of policies – not just monetary policy – need to play a part in striving for economic growth that is sustainable. With this longer-term view in mind, policymakers should stay the course despite the inevitable bumps in the road associated with policy normalisation, though they should of course also remain alert to unexpected events and circumstances.