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ViewpointSeptember 2 2014

Monetary policy: caught between price stability and financial stability

The interest rate needed for low inflation and full employment is different from the interest rate needed for financial stability. How did this happen and what can be done about it?
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Monetary policy: caught between price stability and financial stability

A sub-par global economic recovery and low global inflationary pressure have enabled a very expansionary monetary policy stance in recent years. However, there are concerns that this policy is precipitating financial market imbalances that may lead to the next downturn. The great financial crisis of 2008/09 has clearly shown that financial markets matter for economic and price stability.

What is less clear, however, is whether, and how, central banks should take the financial cycle into account when setting monetary policy. In fact, a consensus seems more remote than ever. The debate has grown more pronounced, with two prominent opponents bringing their arguments to the point recently.

Caught in the crosswind

On the one hand, the Bank for International Settlements (BIS) has long argued that monetary policy should be leaning against the wind, i.e. using the interest rate instrument for the purpose of financial stability, even if this sometimes results in undershooting the inflation target. In its recent annual report, covering 2013/14, the BIS argued that the upturn in the global economy is a window of opportunity that should not be wasted, and postulated that monetary policy should normalise sooner rather than later.

Macroprudential instruments can complement the interest rate instrument, but on their own they cannot tame financial markets sufficiently, being vulnerable to regulatory arbitrage, while monetary policy sets the universal price of leverage and reaches into all of the cracks.

On the other hand, the US Federal Reserve is an outspoken opponent of leaning against the wind. Chair of the Fed, Janet Yellen, recently noted that she does 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".

Ms Yellen also commented that a "resilient financial system can withstand unexpected developments, therefore identification of bubbles and leaning against the wind is less critical", and that macroprudential policy should serve as the primary tool to pursue financial stability.

A step back

Before seeking an answer to the question of how to take the financial cycle into account in monetary policy, I would like to step back and circumscribe the problem at hand.

It seems increasingly the case that short-term consumer price stability and financial stability are, at times, incompatible with one another. On the one hand, terms such as 'the new normal' or the 'new neutral short-term interest rate' underline growing expectations that the equilibrium interest rate for the economy has come down and will stay low for a significant length of time.

On the other hand, buoyant financial markets could probably do with higher rates – in fact, they would probably require higher rates to avoid the build up of imbalances. Interest rates seem simultaneously too high for the economy and too low for financial markets. The equilibrium rate for the economy seems to be lower than the equilibrium rate for financial markets.

Unresolved questions

The apparent divergence between the rate that is consistent with low but positive inflation and full employment, and the rate that is consistent with financial stability raises a host of important questions:

  • When did the divergence begin? Interest rates were certainly not too high in regard to inflation in the 1970s or 1980s – on the contrary, loose monetary policy resulted in plenty of inflation. The disconnect is therefore probably a relatively recent phenomenon, which set in sometime in the past 20 years. This timeframe is also consistent with the observed growth acceleration of finance in the past 20 years. Many indicators, such as value added in finance relative to overall gross domestic product, financial market prices, market capitalisation and turnover, as well as many measures of credit and debt, show a clear acceleration during the 1990s.
  • What may be the cause of the divergence? In particular, is it possible that monetary policy itself has created this wedge? The BIS annual report seems to think so – it argues that asymmetric monetary policy is to blame for the decline in interest rates. "Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which, in turn, makes it hard to raise rates without damaging the economy – a debt trap," it says.
  • What are the costs and risks of the divergence? I would argue that any sustained divergence must imply intertemporal misallocation, probably involving excessive consumption, debt and malinvestment, and will eventually correct.
  • How will an eventual convergence look? Will it be benign and gradual, with rates gradually increasing, as the Fed seems to expect? Or will the eventual convergence turn out to be violent and abrupt, as the BIS seems to suspect? Note that the sluggish global economic rebound despite zero interest rates indicates that the gap may not be closing yet. In fact, it may be increasing. If asymmetric monetary policy was responsible for creating the gap in the first place, then more of the same will probably increase the divide, not decrease it.
  • Should central banks really give priority to a short-term inflation objective and set their policy rates accordingly, even if this may imply financial instability in the long term and an eventual financial crash? Or should central banks focus more on long-term stability and react to credit, money, investment and asset prices, including the exchange rate, even if this may not always be consistent with the typical 2% inflation target? Note that the monetary targeting frameworks of the Bundesbank and the Swiss National Bank in the previous millennium can be interpreted as targeting both price stability and financial stability over the longer term, resisting such attempts to finetune inflation and growth in the short term.

These and other important questions about how central banks should take the financial cycle into account remain, in my view, unresolved. However, the stakes are high and growing, and yet there is fundamental disagreement on these crucial issues. More research and discussion are needed, and central banks should tackle these questions with an open mind.

A new framework

In the meantime, monetary policy places high hopes on macroprudential measures to bridge the gap between the zero monetary policy rate and the higher rate which would be necessary to equilibrate financial markets. However, I would argue that macroprudential measures are no panacea.

Cyclical macroprudential measures such as the countercyclical capital buffer imply costs and risks. The success of cyclical macroprudential measures hinges on the assumption of an omniscient and benevolent regulator, which defends the public good against vested interests of all sorts and analyses, decides and adopts measures in real-time and without any delay. But, even in the presence of a superhuman regulator, cyclical macroprudential policy is only a second-best solution, as the price mechanism is suppressed by switching from a market-determined capital allocation to a command-and-control-determined capital allocation, which may cause significant efficiency losses.

Also note that some macroprudential measures are, in fact, equivalent to financial repression. Financial repression describes policies that allow governments to capture domestic savers, thus bringing down the cost of financing government debt. Zero interest rates are the most powerful instrument of financial repression.

In theory, financial repression is one of five options for reducing excessive debt, the others being unexpected inflation, economic growth, default or restructuring, and austerity. With both low inflation and growth prospects, and with policy-makers sensibly ruling out default and increasingly unwilling to adopt austerity, financial repression is basically the only instrument remaining for tackling excessive debt. However, policy-makers are playing a dangerous game by relying exclusively on zero rates and macroprudential measures.

Monetary policy frameworks have changed in the past, due to a changing environment. It is naive to think that the current paradigm of inflation targeting will stand the test of time. Rather, the past 10 to 20 years have shown weaknesses in the inflation-targeting policy framework.

Monetary policy-makers should continuously challenge their way of thinking and acting. One cannot assume that today’s predominant monetary policy framework of inflation targeting is also the optimal framework for the future. To my mind, the financial crisis has raised doubts about whether it was the adequate framework for the past in the first place. 

Axel Weber is the chairman of UBS and a former president of the Bundesbank.

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