Monetary policy at the crossroads

How to clean up after the global financial crisis

Ravi Menon | May 28, 2021

Sections Economics Public Policy

Collections Monetary Policy

Chicago Booth Review’s From the Archives series features notable past work by University of Chicago faculty and other business leaders. This essay is an edited excerpt of a speech given in 2014 at the Asian Monetary Policy Forum, which is organized by the Asian Bureau of Finance and Economic Research, Chicago Booth, the Monetary Authority of Singapore, and the National University of Singapore Business School.

One of the most pressing questions facing central bankers today concerns the role of monetary policy in helping to secure financial stability. For two decades before the 2008–09 global financial crisis, central bankers thought they had found the secret sauce of monetary policy. The recipe was simple: an independent central bank, a single target (price stability), and a single instrument (the interest rate). Monetary policy was directed at achieving price and output stability, with the central bank’s reaction function well characterized by the Taylor rule [a relationship linking interest rates to inflation and unemployment, used to guide monetary policy] on an ex post basis. 

The recipe worked brilliantly. Sustained price stability and steady economic growth were the order of the day. The result was the Great Moderation. Indeed, monetary policy was getting boring. During this period, monetary policy was unencumbered by financial stability considerations. To be fair, central bankers were not unconcerned about financial stability. But it was seen as the preserve of prudential regulation and supervision. Academic thinking reinforced policy practice: the macroeconomic models central banks relied on did not map clear linkages between financial and real variables.

 Another constraint may have been the perceived difficulty in identifying a financial bubble ex ante. How does one tell if the value of an asset reflected economic fundamentals or speculative fever? So when faced with potential financial vulnerabilities, it was deemed better to clean up after a bubble had actually burst than to try to lean against suspected bubbles.

 But beneath the still waters of macroeconomic stability, deadly financial whirlpools were forming. Financial imbalances built up steadily in the advanced economies from the mid-1990s to the mid-’00s and culminated in the global financial crisis. The crisis sent financial systems spinning and plunged economies into recession. The cost of cleaning up proved extremely high. All this reignited debate about how to proceed, and monetary policy became interesting again.

Financial stability: What we know and what we don’t 

Following the crisis, there has been growing consensus that it is important for central banks to pay more attention to financial stability. We know now that macroeconomic stability does not guarantee financial stability, nor does prudential supervision of individual institutions guarantee financial stability at the systemic level.

We also have a much better appreciation of how credit cycles have strong implications for financial stability, which helps us better understand the conditions that led to the global financial crisis. The concerns remain valid in the postcrisis environment. There are signs of growing risk-taking in the form of leveraged loans, covenant-lite corporate bonds, and narrowing spreads on subinvestment-grade paper. The risks to financial stability are nowhere near precrisis levels, but they bear close watching. We must not repeat the mistakes of the past.

But there is as yet no consensus on how to secure financial stability and, in particular, what role, if any, should be played by monetary policy.

When economic agents are determined to take risks, they will find ways to circumvent measures that central banks and regulators have put in place.

There are three broad approaches to these questions. The first is to stick to the status quo. Monetary policy remains focused on price stability, with macroprudential policies limited to the use of capital buffers to preempt insolvencies. In the second approach, monetary policy explicitly takes account of financial stability in addition to price stability. Under the third approach, monetary policy remains focused on price stability, while financial stability is secured with the help of a more active macroprudential policy.

The first approach is well known and still the dominant practice in most central banks today, especially in the advanced economies. Under this inflation-targeting approach, monetary policy will not try to respond to credit-cycle movements or asset bubbles unless they have a demonstrable impact on inflation outcomes. The success of inflation-targeting regimes in central banks around the world has provided ample evidence of the efficacy of this approach. As Lars Svensson of the Stockholm School of Economics put it in a 2010 speech while deputy governor of Sweden’s central bank, flexible inflation targeting “remains the best-practice monetary policy before, during, and after the financial crisis.”

Monetary policy: Getting in all the cracks 

The intellectual underpinning for the second approach is based on the insight that monetary policy has the potential to affect financial stability through several channels, one of the most important of which is the risk-taking channel. US Federal Reserve governor Jeremy C. Stein puts it succinctly: “Monetary policy is fundamentally in the business of altering risk premiums.” 

Loose monetary policy can heighten vulnerabilities in the financial system by altering both the perception of risk and the tolerance for risk. In conventional monetary policy, lower policy rates boost incomes and profits and enhance asset and collateral values. This reduces the incidence of default in banks’ asset portfolios, leading to greater leveraging and risk-taking. In unconventional monetary policy, large-scale asset purchases by central banks depress returns along the entire yield curve. This provides asset managers the incentive to take on more risk, often in a herdlike fashion.

When interest rates are below the natural rate at which desired investment and savings reach equilibrium, banks will continue to expand credit. When economic agents are determined to take risks, they will find ways to circumvent measures that central banks and regulators have put in place. Nonmonetary tools such as macroprudential policy will therefore not adequately address the root problem caused by interest rates that are too low.

Under these circumstances, arguably only monetary policy can “get in all of the cracks” to plug the vulnerabilities. An increase in short-term interest rates will trigger a more realistic evaluation of asset and collateral values, income flows, and, thus, risks. This will curtail the extent of leverage created by banks and capital markets and keep asset managers from crowding into risky assets. The effects of monetary policy are all-pervasive and cannot be easily circumvented.

 This approach, if formalized, amounts to augmenting the Taylor rule with an additional term to capture deviations in financial variables from their equilibrium levels. If financial-market imbalances are growing, ceteris paribus, monetary policy should be tightened, even if it causes further deviations in actual output from potential output in the short run. This approach does not preclude the need for robust financial regulation and supervision. But the key is to get the price of money right, and to encourage a more realistic perception and tolerance of risks.

While no central bank currently implements monetary policy in this way, the concept behind the approach may not be as abstract as it seems. In practice, central bankers do not ignore financial-stability considerations when setting monetary policy.

Why getting in all of the cracks may not always work 

Relying solely on monetary policy to secure financial stability may not always be sufficient, for at least three reasons. First, monetary policy could be constrained by its traditional mandate: price and output stability. Second, monetary policy could be constrained by global financial factors. Third, monetary policy may get in all the cracks, but it may not be able to fill some of them.

It is useful to illustrate these considerations by drawing on the Asian experience in recent years. First, it is possible that there is a conflict between the objectives of price stability and financial stability in the short run. Financial and business cycles are not synchronized. The interest rate appropriate for price and output stability may therefore not be consistent with financial stability.

This has been the case. When Asian economies recovered fairly quickly from the global financial crisis, their central banks raised interest rates. This was, by a happy coincidence, congruent with the need to stem the rapid credit growth that was being fueled by improved economic prospects domestically and easy monetary conditions globally. However, following the eurozone debt crisis and other domestic shocks, economic activity in Asia slowed, and it became untenable for Asian central banks to raise interest rates further. At the same time, risk-seeking capital continued flowing into the region, inducing further increases in credit and asset prices. The business cycle and financial cycle began to diverge.

In thinking about the so-called new normal, we should pay equal heed to what is new and what remains normal.

A second constraint on the effectiveness of monetary policy in dealing with domestic financial stresses is the prominent role played by international liquidity in fueling these stresses. The exuberance in Asian asset markets and consequent buildup of financial risk in recent years has been exacerbated by the global search for yield in a zero-interest-rate environment. Raising policy rates may not sufficiently alter the extent of risk-taking in these economies. In fact, paradoxically, a central bank that tightens monetary policy to stem domestic borrowing could perversely attract more capital flows into the economy, resulting in stronger credit growth and rising asset prices.

Third, it is not clear that monetary policy can fill all the cracks. Undoubtedly, monetary policy flows into all the cracks by influencing all interest rates in the economy, but some cracks are just too big to fill. Financial vulnerabilities are not evenly spread across the economy, and tend to be concentrated in specific sectors and segments. Even when monetary policy has configured aggregate liquidity and risk-taking settings appropriately, specific pockets of financial-market vulnerabilities could remain, for example, property bubbles. Monetary policy is too blunt an instrument for addressing such specific risks to financial stability.

Macroprudential policy: Targeting the cracks 

This brings us to the third approach: using macroprudential policy to secure financial stability while monetary policy continues to focus on price and output stability. Macroprudential policies can be more effective for targeting the cracks where specific vulnerabilities are concentrated. 

But what exactly are macroprudential policies? Some have called them “old wine in new bottles,” as many macroprudential tools are the same as the microprudential limits familiar to regulators: loan-to-value ratios, debt-to-income ratios, debt service ratios, and so on.

However, there are some key differences. Unlike microprudential policy, which typically involves the adjustment of individual levers, or monetary policy, which has a single instrument, macroprudential policy requires a multidimensional approach. There is no single instrument that has a stable and reliable relationship with financial stability or asset-price stability.

Macroprudential policies encompass more than loan-to-value ratios for borrowers and countercyclical capital buffers for lenders. Adjusting capital requirements in a countercyclical fashion or increasing the risk weights for loans to vulnerable sectors cannot fill the cracks completely. 

A synthesis? 

The view that central banks ought to pay due consideration to financial stability is gathering momentum. The discussion above has described two alternative approaches to the status quo to achieving this: incorporating financial-stability considerations in the setting of monetary policy, or actively using macroprudential policy to help secure financial stability. 

Perhaps the differences between the two approaches are exaggerated. Both require the central bank to integrate monetary-policy functions with prudential policies. In one, strong supervisory and regulatory policies have to be in place even as monetary policy adjusts the level of risk-taking in the economy. In the other, monetary policy must be appropriately calibrated to the economy for macroprudential measures to target specific areas of imbalances effectively. 

In practice, the difference between the two approaches is likely to be one of degree and emphasis rather than of fundamental principle. Central banks will choose the most appropriate combination, taking into account the structure of their economies and the nature of the threats to financial stability existing at any point in time. 

And let us not forget the continued relevance of the traditional approach. Just because central bankers had previously ignored financial-stability considerations—with costly consequences—we must not overcompensate now by placing such an undue burden on monetary policy to secure financial stability that it becomes detrimental to price and output stability. 

We do not need to reinvent macroeconomics, nor do we need to discard most of what we know about monetary policy, built from decades of rigorous research and painful experience. Much of that knowledge remains relevant. In thinking about the so-called new normal, we should pay equal heed to what is new and what remains normal. No doubt, we need to update our paradigms to meet new realities. But we do not need to overhaul them. 

The current situation is highly unusual. We must not fall into the trap of believing that the innovative policy measures being taken now in response to these unusual conditions represent the basis for a new paradigm in the future. 

I suspect that when the dust has settled and more normal conditions return, monetary-policy regimes will not look drastically different from the days before the crisis. More central banks will have an eye to financial-stability considerations—at least informally—when setting monetary policy. More central banks are also likely to have macroprudential-policy tool kits at their disposal, which they will use from time to time, although perhaps not on the scale that has been seen in Asia in recent years. But in essence, monetary policy will remain largely focused on price and output stability—as it should be. 

Perhaps, as T. S. Eliot put it, the end of all our exploring is to arrive where we started and know the place for the first time.

This essay is adapted from a speech given by Ravi Menon, managing director of the Monetary Authority of Singapore, at the first annual Asian Monetary Policy Forum in May 2014. It is included in Asian Monetary Policy Forum, 2014–20: Insights for Central Bankers, edited by Chicago Booth’s Steven J. Davis, the Monetary Authority of Singapore’s Edward Robinson, and National University of Singapore’s Bernard Yeung, from World Scientific Publishing.