The rising role of central banks in monetary policies

Crises are challenging times, but they also provide an opportunity to learn lessons that can lead to positive changes. Paying close attention to current debates should not be confused with allowing economic policy to be dictated by passing fads. Instead, the global financial crisis presents us with the task of understanding its origins, improving traditional policy tools, and developing new, preventive policies.

A central issue underlined by the crisis is the complex relationship between price and financial stability. Successfully achieving the former proved insufficient to ensure the latter. With that in mind, how should monetary and prudential policies be conducted? How can we best use the various instruments available in the central bank’s toolbox?

Consensus reached

In the years before the global financial crisis, central bankers and academics had reached a practical consensus that keeping inflation low and stable was, to a large extent, all that was needed to ensure macroeconomic stability. It was an elegant formulation that largely left out movements in asset prices. Issues related to financial stability, the health of the banking system, risk-taking, and developments in credit and capital markets were the object of prudential and regulatory policy. The apparent success of this policy approach in the period of the 'great moderation', marked by low inflation, strong economic growth and limited volatility, contributed to strengthening the view that financial supervision and macroeconomic policy could be kept entirely separate.

There was also an understanding, especially in the advanced economies, that prudential regulation wasn’t a macroeconomic policy tool. Regulation focused almost exclusively on micro-prudential rules, based on the assumption that the solvency of individual financial institutions was sufficient to safeguard the stability of the entire financial system. And the macroeconomic models that guided monetary policy did not fully take into account the systemic and macroeconomic implications of financial intermediation and financial market dynamics in general.

It is true that there was an intense debate in the pre-crisis period as to whether monetary policy should counteract the build-up of asset-price bubbles ('lean against') or wait until after the bubble bursts and then react to its effects ('clean after'). But the 'clean after' approach held greater sway due to the perceived difficulty in correctly identifying a bubble, the apparent success of its approach after the bursting of the dotcom bubble, and the view that interest rates were too blunt a tool to use against asset price bubbles. The costs of cleaning up after a crisis were seen as small compared to the macroeconomic costs of attempting to smooth the asset price or credit cycle. Therefore, the prevailing view was that preventive action was unnecessary.

All of this led to the conclusion that monetary policy and financial stability policy should be kept separate and independent. In some countries, financial system regulation and supervision were moved from the central bank to a separate entity. In other countries, the financial stability mission remained within the central bank, but was accorded a lesser degree of institutional relevance.

Four conclusions

The financial crisis showed that the separation of monetary and financial stability policies had to be, at the very least, qualified. The view that price stability would almost automatically guarantee macroeconomic stability was called into question. Four conclusions can already be drawn.

The first conclusion is that price stability is a necessary, but not a sufficient condition for macroeconomic stability.

There is a lively debate on the role that the low and stable inflation, steady economic growth and low interest rates of the 'great moderation' played in encouraging economic agents to take excessive risk. We do know that financial decisions tend to be excessively procyclical. During an economic expansion, banks loosen their lending standards, generating even more growth, while often ignoring the accumulation of risk. During a retraction, on the other hand, lending standards become excessively rigid, making economic recovery even more difficult.

The second conclusion follows from the first: the procyclicality of financial intermediation can affect macroeconomic stability.

Excessive exuberance is followed by panic, which depresses economic activity. In the crisis, sudden changes in asset prices had an immediate impact on the balance sheets of financial institutions, firms and households. The disorderly deleveraging that resulted affected confidence, with further repercussions for macroeconomic stability.

The third conclusion is that financial and prudential regulation can smooth the procyclicality of the financial sector and help maintain macroeconomic stability.

The crisis demonstrated that microprudential rules, which focus on the stability of individual firms, do not necessarily have systemic reach. And systemic shocks can lead to negative feedback loops that can drive financial institutions and even the financial system to insolvency, with severe macroeconomic implications. Therefore, financial regulation has to be macroprudential in order to help smoothen the credit cycle. For example, regulation should encourage financial institutions to create capital and liquidity buffers during the boom for use in periods of retraction.

Finally, the fourth conclusion is not new, but the crisis has rekindled the debate on the necessity of coordinating fiscal, monetary and prudential regulatory policy in order to preserve stability.

These conclusions on the interactions between financial stability policy and macroeconomic policy more generally call into question institutional arrangements that minimise or eliminate the central bank's responsibility for financial stability policy. Furthermore, the crisis demonstrated the difficulties associated with policy coordination when responsibility for financial stability is split between autonomous agencies, especially in the most critical moments, which demand fast decision making and timely implementation.

Bigger central bank role

Post-crisis, the trend seems to be towards once again giving the central bank a leading role in financial stability policy, or at the very least, strengthening the coordination between the central bank and other agencies involved in financial stability policy.

In Brazil, the central bank has always had the mission of assuring both price stability and financial stability. This proved effective in coordinating policy and taking timely action at the height of the financial crisis, allowing Brazil to resume growth more quickly than many of our peers. Even so, in 2011 we created the Financial Stability Committee in order to coordinate financial stability assessment and strategy within the central bank.

The post-crisis recognition of the central bank’s leading role in financial stability has led to an intense debate in academic and policy circles on the interaction between monetary policy and prudential regulation and between their respective policy tools. While there is still no consensus, a pragmatic position is taking shape that is aligned with the Tinbergen principle: two instruments for two objectives.

My view is that monetary policy should focus on assuring price stability. And micro and macro prudential policies should aim to maintain financial stability. However, their actions, their objectives and their results are interconnected. This fact, one of the clearest lessons from the crisis, has to be taken into account in the policy-making process.

Therefore, even though conducted with distinct objectives, monetary and prudential policies are complementary. The actions of the former affect the results of the latter in the short and in the long run, and vice versa. It is hard to imagine a stable financial system in a highly volatile macroeconomic environment. It is equally hard to imagine that an unstable financial system would not have an effect on the macroeconomy.

The complementarities, however, go deeper than that. The main monetary policy tool, short-term interest rates, influences asset prices and credit markets, and can have implications for financial stability. On the other hand, micro and macro prudential rules affect financial institutions’ credit policies which are a driver of economic growth.

Complementarities also permeate the work of the teams directly responsible for monetary policy and prudential regulation. Macroeconomic information, including the likelihood of different scenarios, is used in the financial system stress-tests which shape prudential policy. Also, supervisory information on credit market conditions and outlook are an input of the macroeconometric models that guide monetary policy.

Inflation targeting

Although the crisis has forced us to reevaluate many of our beliefs and practices, inflation-targeting continues to be widely viewed as the best framework for monetary policy. This is due to its simplicity, accountability and transparency. Inflation targeting combines a clear commitment to price stability with sufficient flexibility to absorb economic shocks and keep the economy operating close to its potential.

In fact, inflation targeting gained new adherents since the financial crisis, with central banks such as the Federal Reserve in the US and the Bank of Japan adopting elements of the framework.

However, the crisis has posed new challenges for inflation-targeting central banks. First, we need to improve our theoretical, empirical and operational understanding of how developments in financial markets influence the transmission channels of monetary policy, particularly the credit channel. Today, more than ever, it is necessary to include asset prices and other financial sector information in our macroeconomic models. Second, the interactions between fiscal sustainability issues and monetary and financial policy need to be modelled more explicitly. Research in central banks and in academia is already making progress on these issues. 

Alexandre Tombini is the governor of Banco Central do Brasil.