It is an honor to deliver the inaugural Michel Camdessus Central Banking Lecture. Michel Camdessus served with distinction as governor of the Banque de
The recent crises have appropriately increased the focus on financial stability at central banks around the world. At the Federal Reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. There have also been calls, from some quarters, for a fundamental reconsideration of the goals and strategy of monetary policy. Today I will focus on a key question spurred by this debate: How should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability?
In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.
I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. Because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policymakers communicate their views clearly on the risks to financial stability and how such risks influence the appropriate monetary policy stance. I will conclude by briefly laying out how financial stability concerns affect my current assessment of the appropriate stance of monetary policy.
Balancing Financial Stability with Price Stability: Lessons from the Recent Past
When considering the connections between financial stability, price stability, and full employment, the discussion often focuses on the potential for conflicts among these objectives. Such situations are important, since it is only when conflicts arise that policymakers need to weigh the tradeoffs among multiple objectives. But it is important to note that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment. A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability.
Despite these complementarities, monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system.1 This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. I will highlight these potential costs and the clear need for a macroprudential policy approach by looking back at the vulnerabilities in the U.S. economy before the crisis. I will also discuss how these vulnerabilities might have been affected had the Federal Reserve tightened monetary policy in the mid-2000s to promote financial stability.
Looking Back at the Mid-2000s
Although it was not recognized at the time, risks to financial stability within
In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.
In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important financial institutions (SIFIs) and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.
It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.
Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained--or perhaps even prevented--the worst effects of the crisis.
A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble.2 Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly.3
Similar mixed results would have been likely with regard to the effects of tighter monetary policy on leverage and reliance on short-term financing within the financial sector. In particular, the evidence that low interest rates contribute to increased leverage and reliance on short-term funding points toward some ability of higher interest rates to lessen these vulnerabilities, but that evidence is typically consistent with a sizable range of quantitative effects or alternative views regarding the causal channels at work.4 Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.5
Recent International Experience
Turning to recent experience outside
In reviewing these experiences, it seems clear that monetary policymakers have perceived significant hurdles to using sizable adjustments in monetary policy to contain financial stability risks. Some proponents of a larger monetary policy response to financial stability concerns might argue that these perceived hurdles have been overblown and that financial stability concerns should be elevated significantly in monetary policy discussions. A more balanced assessment, in my view, would be that increased focus on financial stability risks is appropriate in monetary policy discussions, but the potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time.
If monetary policy is not to play a central role in addressing financial stability issues, this task must rely on macroprudential policies. In this regard, I would note that here, too, policymakers abroad have made important strides, and not just those in the advanced economies. Emerging market economies have in many ways been leaders in applying macroprudential policy tools, employing in recent years a variety of restrictions on real estate lending or other activities that were perceived to create vulnerabilities.10 Although it is probably too soon to draw clear conclusions, these experiences will help inform our understanding of these policies and their efficacy.
Promoting Financial Stability through a Macroprudential Approach
If macroprudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macroprudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to "get in the cracks" that persist in the macroprudential framework.11
In weighing these questions, I find it helpful to distinguish between tools that primarily build through-the-cycle resilience against adverse financial developments and those primarily intended to lean against financial excesses.12
Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses. Such requirements take on a macroprudential dimension when they are most stringent for the largest, most systemically important firms, thereby minimizing the risk that losses at such firms will reverberate through the financial system. Resilience against runs can be enhanced both by stronger capital positions and requirements for sufficient liquidity buffers among the most interconnected firms. An effective resolution regime for SIFIs can also enhance resilience by better protecting the financial system from contagion in the event of a SIFI collapse. Further, the stability of the financial system can be enhanced through measures that address interconnectedness between financial firms, such as margin and central clearing requirements for derivatives transactions. Finally, a regulatory umbrella wide enough to cover previous gaps in the regulation and supervision of systemically important firms and markets can help prevent risks from migrating to areas where they are difficult to detect or address.
Oversight of the U.S. shadow banking system also has been strengthened. The new
Additional measures should be taken to address residual risks in the short-term wholesale funding markets. Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex organizations. Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis. To the extent that minimum margin requirements lead to more conservative margin levels during normal and exuberant times, they could help avoid potentially destabilizing procyclical margin increases in short-term wholesale funding markets during times of stress.
Leaning Against the Wind
At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a "bubble" and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.
Nonetheless, some macroprudential tools can be adjusted in a manner that may further enhance resilience as risks emerge. In addition, macroprudential tools can, in some cases, be targeted at areas of concern. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses. The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions and incorporate the possibility of highlighting salient risk scenarios, both of which may contribute to increasing resilience during periods in which risks are rising.13 Similarly, minimum margin requirements for securities financing transactions could potentially vary on a countercyclical basis so that they are higher in normal times than in times of stress.
Implications for Monetary Policy, Now and in the Future
In light of the considerable efforts under way to implement a macroprudential approach to enhance financial stability and the increased focus of policymakers on monitoring emerging financial stability risks, I see three key principles that should guide the interaction of monetary policy and macroprudential policy in
First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment. Key steps along this path include completion of the transition to full implementation of Basel III, including new liquidity requirements; enhanced prudential standards for systemically important firms, including risk-based capital requirements, a leverage ratio, and tighter prudential buffers for firms heavily reliant on short-term wholesale funding; expansion of the regulatory umbrella to incorporate all systemically important firms; the institution of an effective, cross-border resolution regime for systemically important financial institutions; and consideration of regulations, such as minimum margin requirements for securities financing transactions, to limit leverage in sectors beyond the banking sector and SIFIs.
Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macroprudential tools to influence these developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support.14 Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability.15
These first two principles will be more effective in helping to address financial stability risks when the public understands how monetary policymakers are weighing such risks in the setting of monetary policy. Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.
To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in
Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates. The Federal Reserve, the
In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in
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