05/26/2023 | News release | Distributed by Public on 05/25/2023 22:33
Professor Bernard Yeung, National University of Singapore Business School, and President of the Asian Bureau of Finance and Economic Research (ABFER)
Professor Steven J Davis, University of Chicago, Hoover Institution, and EXCO Member of ABFER
Distinguished speakers and guests, ladies and gentlemen
GETTING IN ALL THE CRACKS OR TARGETING THE CRACKS?
At the inaugural Asian Monetary Policy Forum in 2014, I spoke about the challenge of securing both price stability and financial stability.Menon (2014), "Getting in all the cracks or targeting the cracks? Securing financial stability in the post-crisis era," Speech at the 2014 Asian Monetary Policy Forum. Now, nearly ten years later, we know a lot more about this issue,yet there is still much we do not know. Let me take stock of where we are.
To achieve both the objectives of price stability and financial stability, I described in 2014 three possible approaches for monetary policy.
The first approach is to keep monetary policy focused on price stability and leave financial stability to microprudential regulation and supervision. Most advanced economies have stuck to this approach in the last ten years, with adjustments to counter-cyclical capital buffers as the sole macroprudential policy innovation.
The second approach is to include financial stability in addition to price stability as an objective of monetary policy. This is motivated by what Jeremy Stein had characterised as the unique ability of monetary policy to "get in all of the cracks".Stein (2013), "Overheating in credit markets: Origins, measurements, and policy responses", Speech at the 2013 "Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter" Research Symposium. No central bank has formally adopted this approach though it would appear that some central banks do at least indirectly consider financial stability implications in their monetary policy decisions.
The third approach is to keep monetary policy focused on price stability and use macroprudential policies to secure financial stability. This is what I had painted in 2014 as "targeting the cracks" through macroprudential policies instead of getting into all the cracks through monetary policy. A growing number of emerging market economies has been taking this approach, prompted by increased capital flow volatility, exchange rate fluctuations, and asset price bubbles, in the wake of spillovers from unprecedented loose monetary policies in the advanced economies.
The experience of the last decade has, if anything, underscored the importance of the nexus between monetary policy and financial stability.
To borrow a phrase from a recent award-winning movie, everything seems to be related; there are financial vulnerabilities everywhere; and economic and financial shocks seem to happen all at once. Okay, that sounds exaggerated, but I think you get my drift.
As with the multiverse, there is much that we do not know about the complex interactions between the real economy and the financial system and their implications for price and financial stability. But policymakers are not entirely clueless. Let me set out four key propositions based on the experience of the last decade:
Let me elaborate on each of these.
AN INTEGRATED POLICY FRAMEWORK
First, securing both monetary and financial stability requires an integrated framework, combining monetary policy, fiscal policy, and macro-financial policies.
Macro-financial policies include macroprudential measures, foreign exchange intervention, and capital flow management measures.
There are three reasons why we need an integrated policy framework.
One, there are important interactions between monetary policy and the financial system. In the last decade, policymakers around the world have gained better appreciation of the increasingly important role that the financial system plays in the transmission of monetary policy. As Jeremy Stein puts it, "monetary policy is fundamentally in the business of altering risk premiums."Stein (2014), "Comments on market tantrums and monetary policy", Speech at the 2014 US Monetary Policy Forum, New York. Accommodative monetary policy reduces risk premiums and can lead to unsustainable credit growth and asset price increases. Correspondingly, monetary policy tightening can trigger a sharp reversal in sentiments and risk premiums, which can impair credit supply and trigger financial failures.
Two, capital flows and exchange rates cannot be ignored in macro policy settings, especially in emerging market economies. In advanced economies, capital flows and exchange rate movements are generally viewed as equilibrating mechanisms outside the remit of macro polices. But for emerging market economies, they can spell serious macroeconomic and macro-financial trouble.
Three, there appears to be a short-term trade-off between price stability and financial stability.
Combining the use of monetary policy and macro-financial policies can mitigate trade-offs between objectives. Studies by both the BIS and IMF have found that policy combinations can be more effective than using a single instrument.
The fundamental premise of an integrated policy framework is the recognition that policies that are independent in execution are often interdependent in their effects.
Specifically, an integrated policy framework must seek to avoid the unsustainable build-up of debt which is the root cause of much financial instability.
MACRO-FINANCIAL POLICIES
The second key proposition: financial sector vulnerabilities are best addressed using a variety of macro-financial policies in a coherent manner.
Ensuring financial stability requires a multi-dimensional approach. There is no single instrument that has a stable and reliable relationship with financial stability or asset price stability. This is because financial risks emanate from multiple sources and manifest in multiple ways. We need to adopt a range of macro-financial tools to address the spectrum of potential financial vulnerabilities. As mentioned earlier, the macro-financial policy toolkit contains three broad categories.
Let me briefly describe how each of these components work.
Macroprudential policy tools include counter-cyclical capital buffers and sector-specific measures. The latter, often targeted at the property sector, include loan-to-value limits and debt service limits. A few countries have introduced counter-cyclical capital buffers, but it is too early to judge their effectiveness. Targeted macroprudential tools work better than counter-cyclical capital buffers to address financial risks emanating from specific sectors like real estate.
Macroprudential policy measures are most effective when used pre-emptively and in a coherent manner.
Foreign exchange interventions serve to limit exchange rate volatility and thereby mitigate financial market stresses arising from such volatility. They have been a useful tool for many emerging market economies to reduce unduly sharp swings in exchange rates as well as misalignment of the exchange rate with underlying fundamentals. But three caveats are in order.
Capital flow management measures are used to directly curb capital inflows and outflows. While capital flow measures have distortionary effects and long-term costs, they have been deployed as useful complements to safeguard financial stability.
MONETARY POLICY
Third proposition: monetary policy should remain focused on inflation control but its implications for financial stability must be taken into account.
Including financial stability as an additional objective of monetary policy seems attractive but may not be a good idea.
Monetary policy needs to remain focused on price stability but should seek to minimise the risk of financial dominance. The concern here is two-fold.
A practical way monetary policy could minimise the risk of financial dominance is to use inflation targeting more flexibly. A criticism of inflation targeting is that it has been too much of a straitjacket on monetary policies: for example, keeping interest rates low for long to get inflation up to the target of 2% led to a build-up of financial vulnerabilities. I think the problem is not with inflation targeting per se but with not using it flexibly enough.
There are two ways in which inflation targeting can be pursued more flexibly to minimise financial vulnerabilities.
However, a more flexible approach to implementing inflation targeting can potentially be misinterpreted as reducing the commitment to price stability. It therefore needs to be accompanied by clear communication on the consistency between taking financial stability into account while pursuing price stability as the primary objective.
FISCAL POLICY
Fourth and final proposition: fiscal policy plays an important role in helping to secure both price stability and financial stability.
The best contribution that fiscal policy can make to both price stability and financial stability is to ensure the sustainability of public debt. The role of fiscal policy in an integrated policy framework has not received as much attention as it probably deserves. Let me offer two reasons why it should.
Sound public finances reduce the risk of fiscal dominance, enabling monetary policy to operate more freely to pursue its price stability mandate.
Targeted fiscal policy measures can support monetary policy and macroprudential policy in achieving their objectives. Tax or expenditure measures have the advantage of being able to either alleviate or accentuate the effects of monetary and macroprudential policies on specific groups of people or sectors of the economy.
INTEGRATED POLICIES AS APPLIED IN SINGAPORE
Before I conclude, let me say a few words about the Singapore experience.
Singapore does not have a formal integrated policy framework but there has been an intuitive coherence across monetary, fiscal, and macro-financial policies. This has helped to secure both price stability and financial stability through various crises. Close consultations on the state of the economy across the respective policy-making bodies and a common ethos of prudence has helped to achieve this policy coherence without resorting to formal policy co-ordination.
Monetary policy is centred on managing the exchange rate to ensure price stability over the medium-term. It is set by the Monetary Authority of Singapore (MAS). Foreign exchange intervention is carried out in support of the monetary policy objective of price stability and not for any macro-financial purposes. There is no explicit inflation target but the track record of keeping core inflation relatively stable and, on average, just below 2% over the last thirty years has underpinned the MAS' policy credibility.
Fiscal policy seeks to promote macroeconomic stability, sustained economic growth, and social equity while maintaining a balanced budget. It is set by the Ministry of Finance (MOF). The Constitution prohibits the use of public debt for government expenditure except for a narrow class of long-term infrastructure projects.
Macro-financial policy comprises essentially of macroprudential measures aimed at promoting a sustainable property market. These measures are co-ordinated across the MAS, MOF, and Ministry of National Development (MND). The macroprudential toolkit comprises loan-to-value limits, debt servicing limits, buyers' and sellers' stamp duties, and adjustments in land supply.
In the movie "Everything, Everywhere, All at Once", we are told that parallel universes exist because every life choice creates a new alternative universe. Thankfully, the global economy and financial system are not as complicated as the multiverse. But the real economy and the financial economy are like parallel universes with many transmission channels across these two universes that we are only beginning to understand. Achieving coherence across policies through an integrated framework is key to minimising the risk of repeated bouts of financial and economic crises feeding on each other. It is not easy but probably not as difficult as jumping across the multiverse.