07 September 2021

SUERF: Central banks as bank supervisors: how does this double role affect their inflation outcomes?

Once we appropriately control for relevant policy and institutional factors, we show that the institutional settings of prudential policy and monetary policy do not have a significant effect on inflation outcomes

This policy brief note is based on a study that revisits an old debate about the way the institutional settings that determine the conduct of monetary policy and prudential regulation and supervision of the banking system influence policymakers’ actions in pursuing their designated mandates. We assess whether the allocation of policy mandates affects central banks’ primary objective of inflation stabilization by employing dynamic heterogeneous panel methods, using data for 25 industrialised countries from 1960 to 2018.

In its recent monetary policy strategy review, the European Central Bank acknowledges the importance of taking into account financial stability considerations in its monetary policy decision processes, calling for an enhanced role of the monetary analysis pillar.1^,2 It stresses that financial stability is a precondition for price stability and vice versa. Although microprudential and macroprudential policies should be considered the first line of defence against the build up of financial stability risks, the review emphasises that the monetary policy strategy of the ECB should retain and follow a flexible approach to deal with financial stability concerns. This conclusion strongly expresses the importance given to financial stability and its interlinkages with monetary policy, despite the existence of an effective macroprudential framework.

The macroprudential oversight of the financial system was introduced as a response to the Global Financial Crisis in 2008. In some countries, the financial stability mandate was explicitly assigned to macroprudential authorities that were endowed with proper instruments to deal with financial imbalances, while monetary authorities remained responsible for price stability. Such institutional arrangements in which stability mandates are assigned to separate policymakers with different instruments improve policy outcomes and therefore welfare according to the Tinbergen rule, provided that the policies have complementary effects on the two objectives. In contrast, when the effects from policy interplay are conflicting and coordination between policymakers is limited, internalising negative externalities by assigning both mandates to a central bank reduces the possible welfare losses.

The interaction between macroeconomic policies occurs because both macroprudential and monetary policy share the same transmission channels. Under specific economic circumstances, price and financial stability policy goals may conflict with one another, with policy actions potentially offsetting each other. First, although largely pro-cyclical, financial cycles tend to be longer than business cycles, which may lead to a decoupling between financial circumstances and economic fundamentals. Second, and perhaps more importantly, several propagation channels of monetary policy transmission are likely to interact with bank stability and ultimately with the stability of the financial system, in an asymmetric fashion. Policy rate adjustments influence asset and collateral prices which, through the financial accelerator mechanism (see Bernanke and Gertler, 1995), may encourage excessive risk-taking behaviour, undermining the goal of financial stability. Asset and collateral prices respond positively to a policy rate cut, especially when perceived to be prolonged, leading to an ease of credit standards, which stimulates credit provision and encourages banks and borrowers to take on greater risks. As such, monetary policy transmission via the asset pricing and risk-taking channels may sow the seeds for financial instability (see Borio and Zhu, 2012).

In this brief, we revisit an old debate regarding the separation of the two policy mandates, taking also into consideration the new institutional arrangements encompassing macroprudential policy. We examine whether the institutional structure of policymaking affects macroeconomic outcomes by influencing the monetary and prudential policies interaction and the central banks’ primary objective of inflation stabilisation.

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