Chapter

Chapter 6. Monetary Policy and Financial Stability

Author(s):
Tobias Adrian, Douglas Laxton, and Maurice Obstfeld
Published Date:
April 2018
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Author(s)
Tobias Adrian Giovanni Dell’Ariccia Vikram Haksar and Tommaso Mancini-Griffoli

Monetary policy faces significant limitations as a tool to promote financial stability . . . [However,] it may be appropriate to adjust monetary policy to “get in the cracks” that persist in the macroprudential framework —J. Yellen (2014)

Should monetary policy have an objective besides price and output stability—namely, to minimize the risks of costly financial crises? Although such crises are rare events, the fact that they bring significant economic hardship means that preventing or minimizing the potential damage should be a first-order policy priority. Micro- and macroprudential policies would seem the most appropriate tools because they are designed to tackle specific financial vulnerabilities and thereby mitigate the probability of financial crises. However, their effectiveness remains somewhat uncertain, as does the willingness of politicians to adopt them. As a result, the spotlight turns naturally to monetary policy.

Weighing the possible role of monetary policy in reducing the risk of crises involves assessing whether interest rates should be raised more than required by medium-term price stability and full employment mandates. This involves three broad steps: first, estimating the link between policy rates and crisis probabilities; second, gauging the potential trade-off between meeting traditional policy mandates and containing the risks of a crisis; and third, determining whether the trade-off is worth it—namely, whether the welfare benefits are higher than costs.

To preview our results: First, interest-rate hikes during phases of economic expansion seem to reduce the probability of severe crises by influencing key macroeconomic variables such as credit growth. But the estimated effects tend to be small and to occur with a lag, after initially weakening private sector balance sheets. Second, the trade-off between financial stability and medium-term price and output stability objectives does not always seem severe. Most often, crisis risks build as economies grow strongly; higher interest rates are therefore warranted solely on the basis of traditional monetary policy objectives. As the 2008 global financial crisis showed, however, risks can still accumulate when inflation is close to target and the output gap appears to be closed.1 Finally, based on historical data, it appears that raising interest rates more than warranted by the price stability mandate in an attempt to preempt risks of occasional major crises generally implies costs that outweigh the potential benefits.2 Hence, adding financial stability as a separate objective for monetary policy besides inflation and output goals seems ill-advised.

However, that is not to say that monetary policymakers should remain oblivious to financial sector frictions and vulnerabilities. As argued in Chapter 7, these are particularly important in determining continuously evolving downside risks to economic activity, which should be distinguished from risks of devastating one-off crises (the focus of this chapter). Adrian, Boyarchenko, and Giannone (2016) suggest that financial conditions—an aggregate index of market prices such as credit spreads, loosely capturing the price of risk—provide policymakers with insights into how these continuously evolving downside risks to growth are likely to evolve. Responding to financial conditions when setting monetary policy is welfare-improving over the short to medium term for optimally behaving inflation-targeting central banks, even if doing so may involve some trade-off with current economic conditions (Adrian and Duarte 2016). This approach is consistent with “flexible inflation targeting” (Svensson 1997a, 1997b).

Macroprudential Policy, an Effective Way to Tackle Vulnerabilities?

Financial crises are typically deeper and more persistent than normal recessions. In advanced and emerging market economies after World War II, real GDP per capita following financial crises has lagged behind its average recovery path after normal recessions by about 4 to 5 percent after five years.3 Moreover, crises typically undermine countries’ fiscal positions, as well as social and political stability and cohesion.

Emphasis has therefore shifted to containing systemic risks, as opposed to waiting to clean up after a crisis hits, by complementing traditional microprudential policies aimed at individual institutions with macroprudential policy frameworks, as recommended in IMF (2013, 2014). Examples of the latter include both cyclical instruments such as countercyclical capital buffers, loan-to-value limits, or dynamic loss provisioning, and permanent measures to strengthen the structural resilience of the financial system (for example, minimum capital and liquidity ratios and improvements in supervision and financial infrastructures). A distinction can also be made between demand-side policies limiting risks taken by borrowers and those supply-side policies that aim to restrain lenders’ exposures.

Macroprudential policies offer the hope of targeting specific sources of vulnerability or financial frictions that affect one or more sectors at a lower cost than would be incurred using monetary policy. Such distortions include, for instance, the relationship between asset prices and credit growth, where higher asset prices allow borrowers to pledge more collateral and thus increase debt, until a shock forces them to deleverage rapidly, with potential externalities on other debtors.4

As discussed in IMF (2013) and Blanchard, Dell’Ariccia, and Mauro (2010, 2013), the policy burden of minimizing crisis risks should fall primarily on macroprudential policies, should they prove well targeted and effective. For now, empirical evidence on the effectiveness of macroprudential policies remains relatively thin and scattered, although it is growing quickly and, in areas, is encouraging.5

In addition, macroprudential policy has several advantages over monetary policy for containing financial stability risks (as discussed in Adrian 2017). First, monetary policy may be less effective in building a resilient financial sector because it would be used only occasionally, in response to mounting, observable risks to financial stability.6 In contrast. macroprudential policy, such as countercyclical capital requirements, can be made to bind for extended periods and, once implemented, can operate without any transmission lag. Second, monetary policy is not targeted enough to address differential financial vulnerabilities across various sectors of the economy and may constrain growth in all sectors—in that sense it is a “blunt” instrument. For instance, a residential or commercial real estate boom may develop because of the behavior of lenders and borrowers active in that particular sector and occur at times when financial conditions are not particularly easy across the whole economy.

However, even the stronger combination of micro- and macroprudential policies that is emerging may not suffice to contain financial stability risks. Viñals (2013), for instance, points to a strong bias toward inaction in the implementation of macroprudential policies due to political constraints and the fact that policy objectives are difficult to gauge in real time until a crisis actually materializes. Adrian and others (2017) report that US policymakers are hesitant to resort to macroprudential policies due to implementation lags and limited scope. Moreover, the well-targeted nature of prudential policies, even if effective, could be a detriment to countering unknown risks. As Stein (2014) points out, monetary policy “gets into all cracks,” whereas macroprudential policy can be arbitraged across jurisdictions, markets, and institutions.

The Link Between Interest Rates and Crisis Risk

Interest rates can affect key macroeconomic and financial variables that in turn affect the probability of crises. But these effects tend to be small, and estimates of them greatly depend on the time horizon and the state of the financial system.

In the short to medium term, before agents are able to adjust their balance sheets, theory suggests that higher interest rates work against financial stability, although the extent is likely contingent on existing conditions and thus remains an empirical question. First, by reducing aggregate demand, monetary tightening reduces household earnings and firms’ profitability. Second, monetary tightening leads to an increase in the interest rate burden, especially if liabilities are at variable rates and have short maturities. Third, higher interest rates tend to reduce asset prices and the value of legacy assets held by financial institutions. Finally, higher policy rates typically flatten the yield curve and—to the extent that they compress term premiums—tend to reduce bank profits at the outset.

In theory, the effects should reverse over the medium to longer term, as households, firms, and financial institutions readjust their balance sheets and adapt their behavior. In particular, higher borrowing costs should induce households and firms to gradually reduce leverage through the conventional intertemporal substitution effect. Tighter monetary conditions are also likely to gradually reduce leverage in the banking sector—as shown in Dell’Ariccia, Laeven, and Marquez (2014)—due to stronger monitoring incentives. By reducing the motivation to search for yield, higher rates should reduce risk-taking by financial intermediaries that have fixed long-term liabilities, such as insurers and pension funds.

Empirical results broadly support these theoretical predictions. In the short term, the ratio of real debt to GDP seems to rise, because nominal GDP responds faster than nominal debt to an interest rate hike, especially with lengthy loan amortization periods (Alpanda and Zubairy 2014; Gelain, Lansing, and Natvik 2015). Because real debt and debt-servicing costs increase with higher interest rates, default rates rise in the quarters following an interest rate shock (IMF 2015a). In the longer term, real debt levels tend to decrease, though the magnitude of the change varies across estimation methods and samples.7

Banks and nonbanks generally respond to higher interest rates by reducing their leverage.8 In the initial quarters, however, leverage tends to rise across financial firms. Banks typically tighten their lending standards, grant fewer loans to risky firms, and extend fewer risky new loans.9 Some research indicates that distance to default—a measure of banks’ riskiness—eventually increases (indicating lower risk) following rate hikes, even though it initially drops (see IMF [2015a] for a discussion).

These effects underscore that there is a link between policy interest rates and the probability of crises. The most stable link hinges on credit growth. Using annual data from 1870 to 2008 for 14 advanced economies, Schularick and Taylor (2012) document that faster credit growth over the previous five years is associated with a higher probability of a financial crisis. IMF (2015a) finds similar results using a larger set of 35 advanced economies and quarterly data from 1960 onward.

According to this evidence, higher interest rates should reduce the probability of a crisis over the medium to long term. The probability of a crisis first increases, then decreases to its trough after three to five years following an interest rate increase. At that point, the probability has been reduced by between 0.04 and 0.3 percentage points following a 100-basis-point interest rate hike for a year, given the range of effects found in the literature.10 These are relatively small numbers and suggest that significantly reducing the probability of a crisis would likely require substantial hikes in interest rates since the nexus of credit growth and asset price spirals does not seem to be very sensitive to interest rates. However, Adrian and Liang (2018) argue that such estimates are subject to substantial uncertainty. In addition, much more research is needed to enable robust estimates of the linkages from monetary policy to household and business credit—and ultimately from credit growth—not only to the probability of a subsequent recession but also to its severity. Furthermore, there are channels besides credit growth that the literature is only starting to quantify.

The Costs of a Financial Stability Mandate Generally Outweigh the Benefits

The welfare effects from pursuing an additional financial stability mandate for monetary policy should be evaluated in a full-blown model because only a model that captures financial frictions and risk-taking behavior can account for the endogeneity of agents’ response to a change in the monetary policy rule. More concretely, if monetary policy were credibly and openly to pursue an additional financial stability mandate, households and firms might take fewer risks from the start. As a result, there may be less need to raise rates than if monetary policy were conducted in a more unpredictable and ad hoc fashion.

Modeling crises and risk-taking behavior is complex. Any such models need to incorporate heterogeneous agents to generate lending, as well as some form of financial friction so that shocks to financial variables have real consequences. In addition, such models need to allow for global nonlinearities, so that economies can fluctuate between a normal state and a crisis state. Ideally, the probability of changing states should depend on a state variable that is endogenous to the model, and risk-taking behavior, including relevant externalities, should be built on minimal assumptions and optimal—though not necessary fully rational—behavior.

There are some models that quantify the welfare effects of pursuing the additional goal of financial stability, but few exhibit all the features described above. Ajello and others (2016) develop a linearized New Keynesian model calibrated to match historical data in which the economy risks jumping from a normal state to a crisis state depending on credit growth. They find that even when crises have relatively large costs, optimal policy differs only very slightly from a traditional response that is oblivious to crisis risks. (Of course, the fact that the model itself is linearized does present problems for modeling crises.) Gourio, Kashyap, and Sim (2016) and Filardo and Rungcharoenkitkul (2016) study similar but somewhat richer frameworks and find more substantial gains from using monetary policy to contain crisis risks. The former assume that crises permanently depress productivity and that a relaxation of the financial constraint (positive financial shocks) increases the probability of crises while lowering inflation, thereby inducing a stark trade-off between managing crises and stabilizing prices (Gourio, Kashyap, and Sim 2016).

A more recent class of promising models features global nonlinearities; one of these is discussed and calibrated in Chapter 7. This literature is very young and it is premature to draw definitive conclusions,11 but results so far suggest that optimal monetary policy should take financial conditions into account, even without a separate objective related to financial stability or the prevention of financial crises. Intuitively, financial conditions provide information on risks to GDP growth and inflation, and so should enter the optimal monetary policy rule in a forward-looking, inflation-forecast-targeting framework.

A separate literature assesses the costs and benefits of using interest rates to pursue the additional goal of financial stability using a simpler framework, following Svensson (2015) and IMF (2015a). The empirical relationships discussed previously offer a rough estimate of the effects of monetary policy, albeit in partial equilibrium.

Costs of raising rates more—or keeping rates higher—than warranted to satisfy medium-term price and output stability mandates are well understood. Output decreases while unemployment increases. And inflation remains below target for longer, possibly undermining the stability of inflation expectations and thereby raising the trade-off between price and output stability, as mentioned throughout this book.

The IMF’s Global Integrated Monetary and Fiscal model, which is also used by many central banks, implies that unemployment would rise by somewhat less than ½ percentage point because of a 100-basis-point increase in short-term interest rates for a year. This estimate is broadly consistent with those obtained using vector autoregression (VAR) models to estimate the transmission of monetary policy.12

Benefits instead usually seem smaller. To be comparable, these can be expressed as expected gains in employment—given the lower longer-term probability of a crisis—and assumed rises in unemployment if a crisis occurs. However, even if one overlooks the shorter-term increases in the probability of a crisis produced by the higher rates, the benefits seem relatively small. To justify using monetary policy to mitigate the risk of a crisis, the severity of the potential crisis and the link between interest rates and the crisis probability need to be at the upper range of existing empirical estimates. IMF (2015a) discusses these results in further detail, based on a simplified two-period model and a Bayesian VAR model responding to an interest rate shock. However, as discussed, these models do not fully capture all the channels through which interest rates impact the buildup of financial vulnerabilities.

Other Considerations

The above discussion offers a stake in the ground, largely defining what can be quantified. But other considerations are relevant, and these relate to the costs of clouded communications, spillovers, and effects specific to small open economies—typically emerging markets.

The use of policy rates to reduce the risks of a crisis could undermine the credibility and effectiveness of monetary policy, including by unanchoring inflation expectations. Credibility and policy effectiveness largely stem from transparency, predictability, and observable success, which are key underpinnings of the flexible-inflation-targeting framework. By contrast, pursuing the objective of financial stability requires policy action to be justified on the basis of distant events that are rarely observable, difficult to forecast, and even difficult to define precisely. What, for instance, is the socially acceptable level of financial stability? The IMF’s October 2017 Global Financial Stability Report proposes a new metric for financial stability, namely, growth at risk (GaR)—defined as the value at risk of future GDP growth as a function of financial vulnerability. Systematically evaluating GaR and reporting on GaR should help clarify central banks’ expectations for and communication about financial stability. The credibility of monetary policy can be put further at risk by the pursuit of a financial stability objective, both because crises are bound to still occur occasionally and because the central bank might at times underdeliver on the inflation objective.

For large economies with strong cross-border financial links, both the benefits and the costs of adding a financial stability objective to monetary policy may be larger because of the potential spillovers. Financial crises in large countries can have strong effects across borders due to financial linkages, as discussed in the IMF Spillover Report (IMF 2015c). Thus, if monetary policy in a large country were to decrease the probability of a crisis, it would avoid not only higher domestic costs but also higher international costs. This would be a positive effect from a global welfare perspective. However, higher interest rates in the large country could also have negative effects on smaller countries through trade linkages (more sluggish demand from the large country, compensated for in part by a stronger currency). So it seems that on balance global cost-benefit effects are ambiguous.

For small open economies, the case for pursuing an additional financial stability objective appears even weaker. First, financial stability concerns in such economies often stem from strong capital inflows that drive up asset prices and compress credit spreads (Sahay and others 2014). In such circumstances, increasing domestic interest rates by more than warranted to stabilize prices may be counterproductive and may actually exacerbate instability by attracting further capital inflows.13 Second, whatever the source of financial vulnerability, higher rates would tend to appreciate the domestic currency and strengthen balance sheets for those with debts in foreign currency. In this regard, the IMF’s October 2015 Global Financial Stability Report (IMF 2015b) highlights the extent to which firms in emerging markets are exposed to foreign currency debt. In fact, higher rates could even increase the share of foreign currency debt, a common problem in economies that are highly dollarized. As a result, debt levels may actually increase instead of decrease (Ozkan and Unsal 2014). Other policies may be more appropriate for managing the financial stability risks that stem from capital inflows (IMF 2012).

Conclusions

Severe financial crises impose enormous costs on society. Their occurrence therefore must be preempted, but with which policy? The analysis in this chapter indicates monetary policy is generally not the appropriate tool. Raising interest rates more than warranted by medium-term price and output stability objectives seems to increase the overall costs to society by raising unemployment and lowering real activity. These generally exceed the gains achieved from reducing the risks of a financial crisis. Moreover, an additional financial stability objective may cloud communications and undermine the credibility, and therefore the effectiveness, of monetary policy.14

Micro- and macroprudential policies seem most appropriate for mitigating the risks of a financial crisis. These policies are designed to target risks at their source with minimal distortions on other sectors and to strengthen the resilience of the financial system to potential shocks. However, the effectiveness of macroprudential policy is not yet firmly established, though early evidence seems promising. And the ultimate effectiveness of such policies could suffer from inaction bias, implementation lags, and a scope that is too narrow to affect newly emerging risks. As a priority, prudential policies (both micro and macro) should be designed and improved to overcome, or at least minimize, these hurdles.

Even if the policy hurdles are minimized, there remains the question raised in Federal Reserve Chair Janet Yellen’s quote that tops this chapter: should monetary policy be used occasionally to complement prudential measures? More work is certainly needed to deepen the analysis summarized in this chapter. One need is for more accurate models of risk-taking behavior and its contribution to the risk of a financial crisis, as well as the behaviors taken in response to monetary policy. There is also a need to uncover the links between credit growth and the severity of a recession or crisis, not just the probability of such an event. Finally, exploration is needed of other channels that lead to systemic risks.

The message of this chapter—that inflation-forecast-targeting central banks should not generally pursue the additional mandate of mitigating the risks of major financial crises—should be distinguished from that of Chapter 7, which argues that monetary policy should respond to financial conditions. Monitoring financial conditions provides valuable information on the continuously evolving downside risks to inflation and growth over the short-to-medium-term policy horizon that stem from vulnerabilities in the financial sector. Responding to financial conditions thus improves welfare even with a monetary policy mandate that remains focused on medium-term price and output stability.

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1

See IMF (2015a) for a further discussion of trade-offs otherwise left out of this chapter.

2

See Smets (2014) for an overview of the literature weighing the costs and benefits of using monetary policy to support financial stability. Smets largely sides with resorting to prudential supervision and regulation, as opposed to monetary policy. IMF (2015a) takes a similar view after broadly surveying the literature and undertaking independent analysis, while Svensson (2017) argues that higher policy interest rates could actually undermine financial stability. Caruana (2011) and Borio (2014) instead suggest that monetary policy should on average be tighter to support financial stability. Model evidence, as discussed later in this chapter, is somewhat more mixed.

3

See Jordà, Schularick, and Taylor (2015). These are average numbers, and individual crises can lead to larger losses. See also Calvo and Mendoza (1996), Kaminsky and Reinhart (1999), Allen and Gale (2000), Cerra and Saxena (2008), Reinhart and Rogoff (2009), and more recently, Taylor (2015). Taylor suggests that evidence for advanced and emerging market economies is quite similar. Such works on crises were highly influential in emerging markets, even when published before the global financial crisis, but remained at the periphery of policymaking in most advanced economies. Blanchard, Cerutti, and Summers (2015) as well as Martin, Munyan, and Wilson (2015) document more persistent effects of financial crises on output, potentially affecting productivity growth.

4

As initially framed in Bernanke, Gertler, and Gilchrist (1999). See Brunnermeier, Eisenbach, and Sannikov (2012) and Leeper and Nason (2014) for a survey of financial frictions. Other distortions include incomplete or asymmetric information, liquidity constraints, funding constraints, moral hazard stemming from policy actions like bailouts, monitoring costs or costly state verification, incentives and principal-agent problems, and regulatory arbitrage.

5

Gaspar and others (2016) makes the same argument. See IMF (2014) for guidance on the use of macroprudential policy. For cross country analysis, see Altunbas, Binici, and Gambacorta (2017), Akinci and Olmstead-Rumsey (2015), Cerutti, Claessens, and Laeven (2015), Freixas, Laeven, and Peydró (2015), McDonald (2015), Claessens (2014), Galati and Moessner (2014), Bakker and others (2012), and Lim and others (2011). Zhang and Zoli (2014) and Bruno and Shin (2014) offer a review of macroprudential policies in Asia; Cerutti, Claessens, and Laeven (2015), Kuttner and Shim (2013), and Crowe and others (2011) focus on instruments geared toward the real estate market; He (2013) surveys Hong Kong SAR’s approach to financial stability; Tressel and Zhang (2016) review the euro area; Jacome and Mitra (2015) and Christensen (2011) review debt-to-income and loan-to-value (LTV) limits; Benes, Laxton, and Mongardini (2016) and Benes, Kumhof, and Lax-ton (2014a, 2014b) develop models to study the benefits of LTV limits and countercyclical buffers; Shin (2011) considers a levy on banks’ noncore liabilities; and Epure and others (2018), Dassatti Camors and Peydro (2014), Aiyar, Calomiris, and Wieladek (2012), Jimenez and others (2012), Igan and Kang (2011), Wong and others (2011), and Saurina (2009) study sectoral, firm-level, or credit registry data. The IMF’s Global Macroprudential Policy Index offers a database of macroprudential instruments for research purposes.

6

It is not plausible for monetary policy to keep interest rates persistently higher than warranted by price and output stability. Higher rates would create persistently lower inflation. This would eventually decrease inflation expectations and in the end leave real rates—and thus financial risks—unchanged, while aggravating risks of hitting the zero lower bound.

7

A temporary monetary policy tightening of 100 basis points is found to decrease real debt levels by up to 0.3 percent and 2 percent, after 4 to 16 quarters, depending on the model. See Sveriges Riksbank (2014) for a middle-of-the-road result, showing that debt contracts by 1 percent at the peak, after 8 quarters. IMF (2015a) surveys other related papers.

8

See Cecchetti, Mancini-Grifoli, and Narita (2017) and Bruno and Shin (2014). The first also finds that leverage decreases abroad when US monetary policy tightens, as does Miranda-Agrippino and Rey (2014).

9

See Maddaloni and Peydro (2011), Jimenez and others (2012), Dell’Ariccia, Laeven, and Suarez (2013), De Nicolo and others (2010), Adrian and Shin (2009), Freixas, Martin, and Skeie (2011), Diamond and Rajan (2012), Borio and Zhu (2012), and Acharya and Naqvi (2012). Most papers are based on survey data. Cecchetti, Mancini-Grifoli, and Narita (2017) find that Sharpe ratios decrease following protracted rate cuts. Demirgüç-Kunt and Detragiache (1998, 2005) find that bank profits drop due to higher real interest rates and undermine banking sector stability in the short to medium term.

10

See IMF (2015a) for a further discussion, including of somewhat larger effects when hikes coincide with periods of rapid credit growth, but also of the potential for credit growth to pick up more strongly after the initial rate hike, thereby reducing or reversing the drop in crisis probability, as in Svensson (2017).

11

For examples of models exhibiting global nonlinearities, see Benes, Kumhof, and Laxton (2014a, 2014b) and Benes, Laxton, and Mongardini (2016).

13

See Ahmed and Zlate (2014), Forbes and Warnock (2011), Fratzscher (2011), and Ghosh and others (2012) for a discussion of how interest rate differentials drive capital flows.

14

Similar arguments apply to the question of whether foreign exchange stability should be an additional objective of monetary policy. Chapter 10, for example, discusses the Czech experience, highlighting how the central bank was forced to abandon a pegged exchange rate in 1998 because it interfered with its ability to stabilize prices (Holub and Hurník 2008). However, the chapter also shows that foreign exchange interventions aiming to satisfy output and inflation objectives in an internally consistent framework can be powerful tools when central banks lose their interest rate instrument at the effective lower bound.

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