Safeguarding currency value 

Goethe knew what money is to nations. As a privy counselor to the Grand Duke of Saxe-Weimar, he engaged in state duties as hyperinflation raged in America and then in France, in the wake of their revolutions. No wonder that, in Faust, the devil himself creates paper currency to expand the country's money supply. This makes him an authentic central banker, though a radically ill-considered one.

Whatever inspires man's monetary ingenuity, modern central banks are concerned with controlling its powerful inno­vations. If their missions have anything to do with the battle of good against evil, the latter certainly goes by the name of monetary instability.

Emperor:  I've heard enough of these endless how and when. We're short of money. Good: get money then. Mephistopheles: I will. A surplus too, you have my word. Easy enough, but easy things are hard. It's there already. The whole art is getting at it. Who knows where to start? ~Faust, Part II, Johann Wolfgang von Goethe

Indeed, price volatility blurs the signals required to make rational economic decisions, hinders efficient resource al­location and distorts competition. While monetary stability does not prevent financial crises, inflation shocks have di­rectly resulted from many (such as the Argentine peso and Thai baht collapses in the 1990s). Although conventional wisdom holds that financial stability depends on monetary stability, that view is increasingly facing skepticism. Most central banks target price stability as a primary, if not sole, goal. Despite this consensus, international central-bank coordination is a difficult political issue, especially when it comes to exchange rates, as illustrated by current tensions over dollar-yuan parity.

So, easy things are hard. Indeed, to formulate monetary policy and steer its instruments with reasonable accuracy in a changing global environment, central banks must weave a comprehensive economic intelligence capacity into their decisions.

Large bureaucratic structures must collect and process vast amounts of heterogeneous economic, financial and monetary data, then distill elaborate information, aggregated indicators, model-based projections and analyses that are the basis of risk assessments of price stability. Eventually, the governing body applies informed judgments to make its decisions.

All along this process, harmonized auditable data infuses communication, especially among stakeholders such as supervisors and regulators, peer central banks, international institutions or states. Economic and monetary statistics are essential because accountability to citizens is paramount.

Economic intelligence
Following standards from the International Monetary Fund and the Bank for International Settlements, central banks, regulators and nations have developed statistical frameworks together with analytical functions to guide their policies and disseminate information. While the relationships among these bodies vary within and across countries, they often achieve strong levels of cooperation, at least regarding economic and financial statistics production. At the international level, they maintain strong ties with supranational entities and with the academic community as informa­tion providers, contributors to theoretical frameworks, and employers.

The data sources, their cascades and their modes of processing are numerous and heterogeneous. Rather than attempt to describe them all, we provide this example from the European Central Bank (ECB) to shed light on the typical elements and their articulation.

With the ECB's federal structure, regular policy preparation is essentially fed by data from 16 member-nation central banks and their statistical ecosystems. This data is structured along two main threads: economic and the monetary analysis.

The economic indicators are output and its components, demand and labor market conditions, price and cost indicators, fiscal policies, asset prices and financial yields, sentiment indicators, and balance of payments. Note that, as a comprehensive statement that systematically summarizes economic transactions with the rest of the world, the latter is itself a critical, highly complex framework involving many aggregates as part of the compilation of national accounts.

The monetary indicators are monetary aggregates and their counterparts (ranging from notes and coins to saving deposits and money market funds in several standardized combinations), credit aggregates (assets of banks' balance sheets), loans to the private sector, money-based inflation-risk indicators, measures of excess liquidity, indicators of the monetary policy stance, and interest rates.

These two sets of indicators are jointly processed in model-based macroeconomic projections, quarterly monetary assessments, time series, factor and dynamic stochastic equilibrium models.

The resulting high-level analysis comes along the two threads again: an assessment of short-to-medium-term determinants of inflation on the economic analysis and an analysis of monetary trends on the other side. They are cross-checked and form the overall assessment of risks to price stability upon which the Governing Council makes its decisions.

The regulatory bodies are not formally accounted for in the above scheme. However, the risk information they con­trol plays an increasing role in central-bank decisions, especially when the systemic stability of the banking system is endangered. Recent crisis management has demonstrated that a strong organizational integration of central banking and regulatory functions brings the most acute analysis.

It would take a separate article to describe the vast amounts of data at stake, the quality and integrity issues, and the many layers of aggregation and computation involved.

As a whole, this endeavor to monitor economic activity represents a significant effort that can be viewed in terms of employees, budgets, data volumes, publications and more. But it might be more relevant to evaluate its worth relative to the value created or even to the value-destruction avoided or mitigated.

This is the realm of decision making and action.

The central banker's helm
It is with an eye on these parameters that policymakers take action. Conventional monetary policy instruments consist chiefly of open-market operations with the main refinancing operations playing a pivotal role in steering interest rates, managing liquidity and signaling policy stances. The two other instruments are the standing facilities that provide and absorb overnight liquidity and the minimum reserves requirements that credit institutions must meet to stabilize inter­est rates and adjust liquidity.

With recent short-term interest rates at or near zero, these instruments have been complemented everywhere by unconventional measures targeting the cost and availability of external finance to banks, households and nonfinancial companies. Whether it's a direct acquisition of financial assets (direct quantitative/credit easing) or loans with longer maturities against a wider range of eligible collateral (indirect quantitative/credit easing), these policies significantly affect the central bank balance sheet while amounting to a massive risk transfer to the lender of last resort, especially when it comes to highly illiquid assets, such as sovereign bonds whose markets are impaired (for example, Greek debt and the ECB's Securities Markets Programme).

While the infrastructures that control conventional instruments still require improvements such as indicators and models harmonization, with large discrepancies among established integrated economic zones and emerging coun­tries, unconventional measures require vast increases in analytic power.

For example, pricing the financial assets held by central banks has always been challenging. However, properly designed risk models that analyze illiquid complex products are a high priority today. (Consider that the 2008 sub-prime crisis was not foreseen by legacy risk models.) It will be even more urgent upon recovery when the special measures are unrolled and excess assets are exchanged. Given the hundreds of billions of dollars at stake, the infinite variety of papers, the speed and unpredictability of markets, and the shifting regulatory landscape, there is much work ahead for central banks.

More generally, the forces that shape central bankers' tools in the future include improved integration of the new sources of systemic and financial instability in the models, added data from private financial entities, and stronger institutional linkages as part of a more harmonized regulatory framework. Keeping up with globalization will increasingly require high-frequency or near-real-time information.

The known challenges are enough to focus energies on quickly improving the instruments. Some of the threats to monetary stability – aside from systemic financial risk – include the serious economic imbalances between the US and Asia, the risk that inflationary strategies come to the fore again, the hidden costs of very low interest rates, and the deflationary scenarios at the heart of collective predictive analysis. Addressing these will help the world weather further instability.

More than ever, smart and comprehensive open-analytical systems will be essential to support the changes and the innovations that will emerge from these troubled times.

Written by Jean-Loïc Berthet, Implementation Consultant, SAS France and Bertrand Cayzac, Account Manager covering Banque de France, SAS France.