Media Briefings

COMBINING MONETARY AND MACROPRUDENTIAL POLICIES FOR GREATER STABILITY

  • Published Date: February 2018

Better economic outcomes can be achieved by complementing an inflation targeting policy with a macroprudential policy that leans against excessive credit growth. However, absent macroprudential policy, clear and consistent communication by central banks that they intend to lean against financial excesses will help to reduce the associated misallocation of resources and excessive business cycle fluctuations.

These are among the conclusions of new research by Sylvain Leduc of the Bank of Canada and Jean-Marc Natal of the International Monetary Fund. Their study of the potential of combining monetary and macroprudential policies to achieve greater financial and economic stability is published in the March 2018 Economic Journal.

The authors note that the great financial crisis of 2009 has led the economic profession and policy-makers to reconsider the role of financial stability in the conduct of monetary policy. With hindsight, stabilising inflation may not be sufficient to bring about overall macroeconomic stability, and central banks may need to pay greater attention to financial stability issues when deciding on monetary policy.

The new study shows that there is indeed value in monetary authorities reacting to developments in asset prices, financial leverage, credit growth or other measures of financial excesses. This is the case even if inflation is otherwise well behaved and under control. Importantly, a clear and consistent communication by central banks that they intend to lean against financial excesses will help to reduce the associated misallocation of resources and excessive business cycle fluctuations.

Two objections have traditionally been directed at proposals to extend the role of monetary policy to include stabilisation of asset prices. The first and most common objection is that monetary policy is too blunt an instrument to tackle different and potentially conflicting goals, and central banks should concentrate on stabilising prices.

The second objection is that central banks are not better equipped than market participants to assess the fundamental or fair value of a given asset. So why should authorities interfere in the normal price discovery process?

These are legitimate concerns that the new study tackles in turn. It is true that the first-best theoretical arrangement is to delegate the responsibility for financial stability to a macroprudential authority and to let monetary policy-makers focus on price stability – on the principle of ‘one instrument, one goal’.

But this conclusion rests on untested assumptions about the effectiveness of macroprudential policy. It remains empirically unclear whether macroprudential policy can be relied on to contain financial excesses, especially system-wide excesses.

Because monetary policy ‘gets in all the cracks’, as famously argued by Jeremy Stein, the new analysis demonstrates that central bank can approximate the first-best allocation by leaning against asset prices when macroprudential policies are unavailable.

Doing so does not require central banks to take a stand on the right, equilibrium, level of asset prices – the second objection. All they need to do is to allow monetary policy to react to both goods and asset price changes, and systematically to communicate their willingness to adjust policy along these two dimensions.

By choice, the authors of the new study rely on a widely used macroeconomic model to show that optimal policy dampens both goods and asset price fluctuations. In the absence of a systematic policy reaction to asset price fluctuations, the economy periodically enters cyclical feedback loops whereby higher asset prices stimulate investment.

This itself boosts asset prices further to the point where potentially important resources are misallocated due to excessive business cycle fluctuations. Optimal monetary policy trades off some volatility in the inflation rate for a more efficient allocation of production by leaning against excessive changes in key asset prices.

The new study also shows that better economic outcomes can be achieved by complementing an inflation targeting policy with a macroprudential policy that leans against excessive credit growth. Specifically, the authors look at a policy that raises banks’ reserve requirements when credit growth is above its historical average, a policy often used in emerging markets economies with a history of financial crises.

All told, the analysis suggests important interactions between monetary and macroprudential policies. This issue will gain in relevance as unconventional policies are increasingly used by central banks to overcome the zero lower bound constraint on interest rates, with potentially negative side effects on financial stability. In such cases, macroprudential policies will need to be deployed and their interactions with monetary policy understood.

ENDS


Notes for editors: ‘Monetary and Macroprudential Policies in a Leveraged Economy’ by Sylvain Leduc and Jean-Marc Natal is published in the March 2018 issue of the Economic Journal.

Sylvain Leduc is Deputy Governor of the Bank of Canada. Jean-Marc Natal is at the International Monetary Fund.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); Sylvain Leduc via email: SLeduc@bank-banque-canada.ca; or Jean-Marc Natal via email: JNatal@imf.org