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The roles of monetary and macroprudential policy in macroeconomic management
Microprudential policies such as banking regulation and supervision are still necessary in safeguarding the soundness of individual institutions. But as it turns out, they are not enough when it comes to safeguarding the financial system as a whole. For the management of systemic financial stability risks we need an additional toolkit – macroprudential policies. And it seems to me that this assessment is by now widely shared.
The role of monetary policy in this context is, however, still being debated. While macroprudential policy frameworks are still under development, we need to take a stand on whether and how monetary policy should play a supporting role without undermining its pursuit of price stability.
Some observers argue that price stability and financial stability are so closely intertwined that, in the case of both upturns and downturns, monetary policy has to play an active role in stabilising the financial system. Some even call for a dual mandate for central banks, with financial stability on a par with price stability. But in my view, even if monetary policy instruments were an efficient tool to influence financial stability – a premise which I would still doubt – an important argument against the comprehensive involvement of monetary policy in financial stability lies in the risk of losing credibility with regard to the pursuit of price stability.
To put it succinctly: when it comes to handling financial stability risks, monetary policy is a sledgehammer rather than a scalpel. So, the latter should be the preferred choice of tool, and getting it ready for use has to be a political top priority.
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When it comes to financial stability, monetary policy has a role to play – insofar as price stability is at risk as well. But macroprudential policies, with their more versatile and precise instruments, should provide the first line of defence against financial instability. In many cases, the interest rate will prove too crude an instrument with which, for instance, to prick asset bubbles.
Micro- and macroprudential regulation
It is not only the macroeconomic toolbox that needs an overhaul. The crisis has laid bare structural shortcomings of the financial system. These structural flaws demand a structural – that is, a regulatory – answer. Market failures and regulatory blind spots have tilted the playing field, hampered competition, and over-stimulated the risk appetite of investors. As you all know, much effort has already been taken to address the fault lines revealed by the global financial crisis and to move towards a more resilient global financial system.
At its meeting in Sydney last weekend the G20 agreed, to focus its current work programme on
In Europe, one major bit of progress is undoubtedly the agreement on the Bank Recovery and Resolution Directive. The directive sets forth resolution instruments and the sequence of liability for failing banks. And the new Basel III international capital rules increase the loss absorbing capacity of banks because they now have to hold more and better capital than before. But to some, the risk-weighted approach of the Basel rules is fundamentally flawed.
And there is a major aspect of interconnectedness that regulators have not taken into account up to now: the link between banks' balance sheets and public finances. The financial crisis has shown that if a systemically relevant bank or many banks simultaneously run into financial difficulties, the stability of the financial system is put at risk as a result. Given the deficiencies of previous resolution regimes, governments often had no option but to step in and bail out banks to prevent the financial system from collapsing.
From a financial stability viewpoint this vicious circle has to be broken. As I discussed earlier, resolution regimes for banks are important in this regard. Having credible resolution frameworks in place with clear bail-in rules of shareholders and creditors would help to shield the government from having to rescue banks with taxpayers' money.
Without addressing the regulatory treatment of sovereign exposures, I see no reliable way of breaking the sovereign-banking nexus. In my view, such regulations are an indispensable prerequisite for a healthy financial system in the longer run.
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Monetary policy can influence financial conditions. Notably, it can, to a certain extent, influence the risk-taking behaviour of the financial sector. A more symmetric monetary policy that looks through the financial cycle therefore seems appropriate. Monetary policy has to counter financial imbalances inasmuch as they endanger price stability.
But adopting financial stability as an additional monetary policy objective on a par with price stability overstates the accuracy and the effectiveness with which monetary policy can contribute to financial stability. And ultimately it runs the risk of harming credibility with regard to the pursuit of price stability, as this depends on both monetary policy clarity regarding its objectives and transparency regarding its limitations.
This implies, however, that we must continue in our efforts to fully develop macroprudential policy as soon as possible; and that the international recommendations on financial regulation have to be transposed quickly and consistently into national law.
See also Dombret’s Concluding Remarks at the Bundesbank Symposium on Financial Stability and the Role of Central Banks, 28.2.14
Fed governor Daniel Tarullo suggested earlier this week that monetary policy can't be ruled out as a response to systemic risk. "Clearly, time-varying macroprudential policies could not be viewed as a substitute for monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of transactions and, as such, would not "get in all the cracks" of the financial system", he said in a speech." "But", he continued "...they could potentially provide something of a speed bump, while not producing the much broader effect on the economy that a federal funds rate increase would. Moreover, time-varying macroprudential policies may also give monetary policymakers more of an opportunity to assess whether the asset inflation is generalised and sustained enough to warrant a change in monetary policy."