Since the financial crisis, there has been an active debate about whether and how monetary policy frameworks should incorporate risks to financial stability. The debate has moved beyond the pre-crisis focus on the ability of policymakers to identify asset bubbles and whether monetary policy can stop asset prices from continuing to rise. Research has advanced on adding financial intermediary frictions into monetary policy models. Woodford (2010, 2012) proposes incorporating a credit spread as a third variable in an optimal monetary policy rule with flexible inflation targeting. Christiano et al. (2010) show that stock market booms tend to be accompanied by low inflation, suggesting that policy rules that focus narrowly on inflation targets will destabilise asset markets and the broader economy. Interest rate rules should thus allow an independent role for credit growth to reduce the volatility of output and asset prices.
In a recent paper, we review the growing research on the transmission channels of monetary policy through both financial conditions and financial vulnerabilities (Adrian and Liang 2016). Financial conditions refer to borrowing costs determined by the policy rate, including risk premia for risky assets above the risk-free term structure. Financial vulnerabilities, in contrast, refer to features of the financial sector that would amplify, rather than dampen, the effects of an adverse shock on the economy, and include compressed risk premiums for asset prices, excess credit of households and businesses, and high leverage or maturity transformation at financial intermediaries (Adrian et al. 2015 present a monitoring framework for financial vulnerabilities).
Monetary policy not only affects financial conditions but can lead to build-ups of financial vulnerabilities, and increase future downside risks to the real economy, given the presence of financial frictions. Recent research provides strong evidence of a risk-taking channel.
We argue that policymakers face an intertemporal trade-off between financial conditions and vulnerabilities. Looser monetary policy improves financial conditions, but can in some situations worsen vulnerabilities, making the financial system less resilient to negative shocks. Such situations can arise when risk premiums are already tight and credit is expanding.
Macroprudential policies can mitigate this trade-off. Structural through-the-cycle and cyclical time-varying macroprudential policies are both primary tools to act on vulnerabilities. In contrast, monetary policy acts primarily on financial conditions. Furthermore, regulatory and supervisory tools, such as bank capital requirements or sector-specific loan-to-value ratios, may be used to 'lean against the wind' by tightening financial conditions in a targeted way. Monetary policy can also lean against the wind, but it is not targeted.
Monetary policy may be less efficient than macroprudential policies if a financial vulnerability is narrow, and it does not directly increase resilience in the same way that higher capital at banks can. These considerations support the current prevailing approach of separating responsibilities: in most countries, monetary policy focuses on the inflation-real activity trade-off, while macroprudential policy is mandated to mitigate vulnerabilities to achieve an acceptable level of systemic risk.
Macroprudential policies, however, may not be effective if activities can migrate from a highly regulated sector to a less-regulated sector. US non-financial credit market debt held by non-bank financial firms, which includes securitisations and entities funded by short-term liabilities, hit a peak in 2008 at more than 100% of GDP. It currently exceeds debt held by banks (Figure 1). The use of monetary policy which applies to all market participants can avoid potential arbitrage, especially in periods of rising asset prices and credit growth, because it can “get in all the cracks” (Stein 2014). On the other hand, Svensson (2014) argues that the financial crisis was a failure of regulatory policies, and that monetary policy should focus solely on inflation because it cannot effectively affect financial intermediaries or asset bubbles.
Svensson (2016) offers a framework to evaluate the costs of monetary policy as a pre-emptive tool to reduce risks to financial stability (his spreadsheet is available here). The framework allows for traditional monetary policy mechanisms by reducing credit and increasing unemployment. High policy rates lead to a higher unemployment rate in the current period, and the benefits are lower credit to households, reducing the probability of a financial crisis in the future. The framework thus explicitly recognises the intertemporal trade-off between financial conditions and vulnerabilities. Svensson argues that the costs of tighter policy to reduce the probability of a crisis exceed the benefits, using parameters from a model of the Swedish economy.
Svensson's model has no asset prices or a financial sector, so tighter monetary policy does not work by raising risk premiums or reining in risk-taking. As a result, the model implies that pre-emptive monetary policy does not reduce the severity of a subsequent crisis – as measured by the size of the unemployment increase in the crisis state – and reduces the probability of a crisis by a minimal amount. That is, the gain is not a less severe recession, but just a reduction in the probability of a crisis, which is already quite small.
We provide sensitivity analysis to illustrate how adding the risk-taking channel through asset prices and borrower leverage could significantly change the cost-benefit calculation for the use of monetary policy (Adrian and Liang 2016). In particular, the conclusion that costs exceed benefits is very sensitive to reasonable alternative assumptions about three key parameters: the severity of a crisis; the probability of a crisis; and the sensitivity of the probability of a crisis to monetary policy, when monetary policy is used pre-emptively. For example, for a higher likelihood of one severe recession in 20 years rather than one in 30 years, and if the increase in unemployment were 4.6% in the recession if monetary policy had been tightened pre-emptively rather than an increase of 5.0% when monetary policy had not been tightened, there would be a positive net benefit from using monetary policy. These modest adjustments to the parameters indicate that more research is needed to quantify the potential benefits of using monetary policy pre-emptively before drawing firm conclusions.
So recent research suggests that monetary policy not only affects financial conditions, but also vulnerabilities. The stance of monetary policy thus potentially impacts risks to financial stability, through incentives for financial sector risk-taking and nonfinancial sector borrowing when asset prices are rising and volatility is low. Importantly, the explicit consideration of risks to financial stability in the conduct of monetary policy may reduce volatility of real activity. More empirical research is needed to determine the magnitude of the risk-taking channel of monetary policy for credit cycles. Given the limitations of macroprudential policies in advanced financial systems with substantial market-based intermediation, policymakers should consider monetary policy, which is more broad-based when more targeted regulatory and supervisory policies are not sufficient.
Adrian, Tobias, Daniel Covitz, J. Nellie Liang (2015). “Financial Stability Monitoring,” Annual Review of Financial Economics 7, 357-395.
Adrian, Tobias and J. Nellie Liang (2016). “Monetary Policy, Financial Conditions, and Financial Stability,” Federal Reserve Bank of New York Staff Report 690.
Christiano, Lawrence, Cosmin Ilut, Roberto Motto, Massimo Rostagno (2010). “Monetary Policy and Stock Market Booms,” Federal Reserve Bank of Kansas City Jackson Hole Symposium.
Stein, Jeremy (2014). “Incorporating Financial Stability Considerations into a Monetary Policy Framework,” Speech delivered at the International Research Forum on Monetary Policy, Washington, D.C., March 21, 2014.
Svensson, Lars (2014) "Inflation Targeting and Leaning Against the Wind" International Journal of Central Banking 10(2) pp. 103-114.
Svensson, Lars (2016) "Cost-Benefit Analysis of Leaning Against the Wind: Are Costs Larger Also with Less Effective Macroprudential Policy?" National Bureau of Economic Research Working Paper 21902.
Woodford, Michael (2010). “Financial Intermediation and Macroeconomic Analysis,” Journal of Economic Perspectives 24(4), 21-44.
Woodford, Michael (2011). “Monetary Policy and Financial Stability,” Columbia University working paper.