If the global crisis – and the events that led up to it – have taught us anything, it is that there should be ‘no complacency with asset price booms’. We know first-hand the dire consequences of significant and widespread bubbles, so clearly monetary policymakers can no longer passively observe the evolution of asset prices. If an economy is to pursue macroeconomic and financial stability, they should coordinate with financial supervisors to ensure financial regulation and monetary policies are complementary, credible, implemented in an articulated way and well communicated (Claessens and Valencia 2013).
The need to implement monetary policy not as a self-contained, isolated set of rules comes out clearly in a comprehensive ebook recently edited by Reichlin and Baldwin (2013), Is Inflation Targeting Dead? Central Banking After the Crisis. As they highlight in the introduction, the global crisis has proved wrong the assumption that ‘the goal of financial stability should be pursued with a set of microprudential rules (e.g., bank supervision and regulation), which would generally leave the central bank free to focus on inflation’.
The view that a combined (articulate) use of both prudential regulation and monetary policy tends to be more effective than a standalone implementation of either has gained ground (Canuto 2011). Nonetheless, how to go about adjusting the inflation-targeting framework to deal with asset prices and to articulate with macroprudential regulation is still a work in process.
We have recently made a first cursory attempt (Canuto and Cavallari 2013a, 2013b) to map out the challenges faced by complementary implementation of monetary policies and macroprudential regulation. A learning curve has yet to be traversed, but at least three broad questions now present themselves.
Asset prices and monetary policy
- First, should monetary policymakers consider asset prices, together with output and inflation trends, when taking decisions about interest rates? Should they use interest-rate hikes to burst bubbles before they fully inflate?
We must acknowledge that it is necessary to properly identify the reasons behind rising asset prices and credit – a task that is far from simple (see annexes I and II in Canuto and Cavallari 2013a).
Monetary policy tools may be too blunt to curb asset price bubbles, as correspondingly sharp interest rate hikes would have harmful unintended consequences on output growth and volatility. Prior to the crisis, the prevailing opinion became that the best approach would be to use monetary policy only to ‘clean up’ the financial mess after a bubble bursts. More recently, an intermediary position gained prominence: the ‘mop-up-afterwards’ approach would be appropriate for equity bubbles not fuelled by over-borrowing, whereas the central bank should try to limit credit-based bubbles – though probably combining micro-regulatory instruments and interest rates.
Macroprudential regulation and monetary policy
- Second, what is macroprudential regulation, and why should it be coordinated with monetary policy?
As a complement to microprudential tools, macroprudential regulation should be concerned with ensuring the stability of the financial system as a whole and the mitigation of risks to the real economy. Macroprudential regulation corresponds to rules that make the incentive structure for individual firms coherent and consistent, so externalities – effects of one’s decisions on others – are internalised. The idea is to design a set of principles and rules that can reduce each institution’s contribution to systemic risk. Thus, this set would smooth the financial cycle, i.e. reducing the systemic risk that inherently builds up in booms, and has damaging consequences in slumps, since leverage, risk taking, credit, and asset prices are procyclical and crises typically follow booms.
Reflecting the two types of macrofinancial risks, macroprudential instruments can either assume a time series or a cross-section dimension. When systemic behaviour over time is considered, the key issue is how risks can be amplified by interactions within the financial system and between the financial system and the real economy. On the other hand, the cross-section dimension relates to the common exposure of institutions at each point in time. Correlated assets, or even counterparty interrelations, create such a link among financial institutions.
Clearly, over time, monetary policy and macroprudential tools can be complementary in the pursuit of less procyclicality. For example, during simultaneous asset price and macroeconomic booms, one could combine higher contingent capital requirements and additional liquidity surcharges in an eventual specific sector with interest rate hikes. There is imperfect substitutability between these measures, so what can achieve the most effectiveness should be considered when jointly calibrating their intensities.
The scope for joint calibration may be less obvious in the case of cross-sectional macroprudential regulation, in which the calibration of the latter must be done ‘top down’. In this case, it is easier to deal with vulnerabilities through macroprudential tools than with short-term interest rate. Policymakers can focus directly on their concern, for example, real estate credit or leveraged loans or currency mismatches, and tighten or loosen the respective rules. One may wonder about the alternative of containing bubbling growth of real estate credit just by hiking interest rates, but this measure reaches all monetary-transmission channels and most often will not be the most efficient option when a confined distortion is identified.
The huge variety of macroprudential tools makes possible the design of tailored policy for specific purposes. But too much uncertainty may be counterproductive and costly if rules and regulations often change. There is thus a trade-off between, on the one hand, more discretionary, time-varying macroprudential policies, as more effective tools to deal with specific shocks and, on the other hand, less uncertainty associated with stable and general macroprudential rules. Moreover, too much activism makes it harder to assess interactions among different macroprudential tools, and between them and monetary transmission mechanism.
A rule of thumb for integrating monetary policy and macroprudential regulation may be to retain some division of labour, even if a more direct combination is considered the best way to go. Fine-tuning via monetary policy should be favoured when stability issues are of a homogeneous and reversible nature. Moreover, macroprudential instruments tend to be more demanding in terms of implementation lags and transaction costs to financial institutions, whereas movements in short-term interest rates are faster, simpler to carry out and easier to communicate to the public.
Likewise, managing expectations about policymakers’ intentions is essential to improving policy effectiveness. After the global crisis, the need for stimulus made central banks to undertake much experimentation, including balance-sheet operations, changing targets and forward guidance about monetary policy – as approached in Reichlin and Baldwin (2013). Accordingly, the integration of old and new instruments – the monetary and macroprudential tools – creates a critical pitfall about how to clearly communicate these varied decisions and to enhance overall credibility.
- Third, compared to purely domestic asset price cycles, do cross-border capital flows and the potential transmission of asset price booms and busts impose additional layers of complexity?
The answer is a ‘yes’, based on overwhelming evidence. Capital-flow management policies can be an item for regulators to use in their toolkit when looking to address macroeconomic and financial stability. This is particularly the case in economies subject to significant spillovers from asset-price cycles and policies from abroad, and in which the macroprudential and monetary policies are insufficient to ring-fence the economy. However, given the short life and usually low effectiveness of capital controls, more conventional policies should be explored first.
Three broad guidelines emerge from our analysis:
- First, as far as integrating asset prices into monetary policy reaction functions, credit-fuelled bubbles should be differentiated from equity-type bubbles.
- Second, retain some division of labour when combining macroprudential regulation and monetary policy.
- Third, when dealing with cross-border spillovers, the macroprudential toolkit often will be more efficient and should be used before capital controls.
The global financial crisis has shattered the confidence of many established principles of monetary policy and financial supervision, including the idea the two must be separate forces. However, one should keep in mind that policymakers need to better understand the interactions among all those instruments as well as the efficient way to benefit from transparent and credible communication to the politicians and the general public.
Canuto, Otaviano (2011), "How Complementary Are Monetary Policy and Prudential Regulation?", Economic Premise 60, World Bank.
Canuto, Otaviano and Matheus Cavallari (2013a), "Monetary Policy and Macroprudential Regulation: Whither Emerging Markets", World Bank Policy Working Research Paper 6310, Washington, DC.
Canuto, Otaviano and Matheus Cavallari (2013b), "Asset Prices, Macroprudential Regulation, and Monetary Policy", Economic Premise 116, World Bank.
Claessens, Sitjn and Fabian Valencia (2013), “The interaction between monetary and macroprudential policies”, VoxEU.org, 14 March.
Reichilin, Lucrezia and Richard Baldwin (2013), “Is Inflation Targeting Dead? Central Banking After the Crisis”, eBook, VoxEU.org.