21 January 2014

BIS/Borio: Monetary policy and financial stability - What role in prevention and recovery?

Borio addressed the question of success and credibility of central banking. Attaining monetary and financial stability simultaneously has proved elusive - that goal calls for incorporating systematically long-duration and disruptive financial cycles in policy frameworks.

"Insofar as instability is the key defect of the market-led system, it will very shortly be impossible to avoid facing the problem that tormented scholars at the time bank money was being introduced: how to exploit the ‘magic of credit’ for growth without inciting banks to imprudent lending practices." We now know all too well that the system proved unstable, just as it had so often in the past.

In this essay Borio argues that edging closer towards lasting monetary and financial stability calls for adjustments to policy frameworks. While he focused on monetary policy, those adjustments go well beyond it, and involve both prudential and fiscal policy. Their common element is to take financial booms and busts – financial cycles – more systematically into account. The task of ensuring financial stability is far too big to rest on the shoulders of monetary policy alone, or even a combination of monetary and prudential policies. Because of their role, however, central banks are inevitably in the midst of the battle.

The basic idea is for policies to be more symmetric across the boom and bust phases of financial cycles – cycles which, given current regimes, have been much longer than the more familiar business cycles, at least longer than business cycles as we traditionally think of and measure them. Policies would lean more deliberately against booms and ease less aggressively and persistently during busts. And during busts they would tackle the debt-asset quality problems head-on. By so doing, they would build up buffers that could help soften the blow once the bust occurred. They might also help constrain the build-up of the boom in the first place, thereby reducing the likelihood and intensity of the subsequent bust. And they would then use the scarce ammunition more effectively to hasten the recovery.

If the analysis is correct, the risks of failing to make the necessary adjustments should not be underestimated. First, there is a risk that central banks will lose their credibility as the body politic and public at large lose confidence in their ability to fulfil their mission. Failing to acknowledge the limitations of what monetary policy can do to foster a solid recovery following a balance sheet recession risks opening up a dangerous expectations gap, between what central banks are expected to deliver and what they can actually deliver.

Second, there is a risk that, over time, instability will become entrenched in the system. An asymmetric response may end up leaving policymakers bereft of ammunition over successive financial and business cycles. This is all the more so once the global implications of national policies are taken into account. All this amounts to a new form of time inconsistency, less apparent but more damaging than the much more familiar one in the context of inflation control.

Finally, there is a risk of yet another epoch-defining and disruptive seismic shift in the underlying economic regimes. This would usher in an era of financial and trade protectionism and, possibly, inflation, as policymakers struggled to come to terms with private and public sector debt burdens. It has happened before, and it could happen again. Such a world would be extremely hostile to the institution of central banking. 

Full Working Paper

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