Monetary policy has long been seen as too blunt a tool to use to prevent a buildup of financial imbalances by leaning against movements in asset prices or credit aggregates. By focusing on price stability, this approach did help foster a long period of macro-economic moderation. But the global financial crisis that began in 2007 demonstrated that the approach could not avert worldwide turmoil.
Reflecting on the lessons from the crisis, participants in the IMF’s 12th Jacques Polak Annual Research Conference on November 10 and 11 discussed the state of knowledge on the relationship between monetary policies and so-called macro-prudential policies—which seek to assure the safety and soundness of the financial system as a whole, rather than that of individual institutions, the traditional focus of regulatory and supervisory activity.
No consensus
There is no consensus yet on how exactly monetary policy should be coordinated with macro-prudential and other policies. The conference contributed to an evolving policy debate in this area. “The conference was both illuminating and depressing. We have a long way to go on these issues. They are essentially the other side of marrying standard macro with finance. I was surprised how much I learned from papers that were fundamentally technical”, said Ted Truman of the Peterson Institute for International Economics and a former top official of the US Federal Reserve, the nation’s central bank.
As Lipton noted in his opening remarks, the conference had three broad themes:
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evaluating the effectiveness of monetary policy in achieving financial stability objectives;
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looking at challenges in designing macroprudential policies;
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assessing the global dimension of monetary and macro-prudential policies.
Achieving financial stability objectives
The limited effectiveness of monetary policy in achieving financial stability objectives suggests that authorities must rely heavily on macro-prudential policy. An example of the difficulties monetary policy poses to stability is the impact of interest rate changes on the incentives financial institutions have for taking risk. Although keeping interest rates low for a prolonged period may encourage financial institutions to take on excessive risks, tightening monetary policy may also have an adverse effect on risk-taking. It may push some financial institutions closer to distress and encourage them to “gamble for resurrection”, by taking on excessive risk.
Using monetary policy to address financial stability objectives in a currency union has further limitations. Monetary policy cannot mitigate country- and sector-specific booms and busts in a currency union because monetary policy reacts to the state of the economy at the level of the union and not at the level of its individual states.
Designing effective macroprudential policies
Yet macro-prudential policy is not a silver bullet for achieving financial stability objectives either, and monetary policy may have to help in mitigating credit and asset price booms in some circumstances. For example, if financial regulators from different sectors and countries fail to coordinate changes in capital requirements, limits on lending, and other macro-prudential policies to prevent regulatory arbitrage, macro-prudential policies may “leak” as unregulated entities, including so-called shadow banks, may substitute for regulated bank lending. Another challenge to the effectiveness of macro-prudential policies is financial innovation. If the government does not understand well the riskiness of new financial instruments, the benefits of the macro-prudential policy it designs are likely to be limited.
Press release
© International Monetary Fund
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