IMF’s Olivier Blanchard hosted Twelfth Jacques Polak Annual Research Conference, held at IMF in Washington, D.C. (photo: Stephen Jaffe/IMF)
ANNUAL RESEARCH CONFERENCE
“Many conceptional and operational issues remain unanswered,” said David Lipton, First Deputy Managing Director of the IMF.
Economists need to better understand how monetary and macroprudential policy can best be conducted to achieve the objective of overall stability, he said.
Monetary policy has long been seen as too blunt a tool to use to prevent a buildup of financial imbalances by leaning against movements in asset prices or credit aggregates. By focusing on price stability, this approach did help foster a long period of macroeconomic moderation. But the global financial crisis that began in 2007 demonstrated that the approach could not avert worldwide turmoil.
Reflecting on the lessons from the crisis, participants in the IMF’s Twelfth Jacques Polak Annual Research Conference on November 10 and 11 discussed the state of knowledge on the relationship between monetary policies and so-called macroprudential policies—which seek to assure the safety and soundness of the financial system as a whole, rather than that of individual institutions, the traditional focus of regulatory and supervisory activity.
No consensus
There is no consensus yet on how exactly monetary policy should be coordinated with macroprudential and other policies. The conference contributed to an evolving policy debate in this area.
“The conference was both illuminating and depressing. We have a long way to go on these issues. They are essentially the other side of marrying standard macro with finance. I was surprised how much I learned from papers that were fundamentally technical,” said Ted Truman of the Peterson Institute for International Economics and a former top official of the U.S. Federal Reserve, the nation’s central bank.
As Lipton noted in his opening remarks, the conference had three broad themes:
• Evaluating the effectiveness of monetary policy in achieving financial stability objectives;
• Looking at challenges in designing macroprudential policies;
• Assessing the global dimension of monetary and macroprudential policies.
Achieving financial stability objectives
The limited effectiveness of monetary policy in achieving financial stability objectives suggests that authorities must rely heavily on macroprudential policy.
An example of the difficulties monetary policy poses to stability is the impact of interest rate changes on the incentives financial institutions have for taking risk. Although keeping interest rates low for a prolonged period may encourage financial institutions to take on excessive risks, tightening monetary policy may also have an adverse effect on risk taking. It may push some financial institutions closer to distress and encourage them to “gamble for resurrection,” by taking on excessive risk.
Using monetary policy to address financial stability objectives in a currency union has further limitations. Monetary policy cannot mitigate country- and sector-specific booms and busts in a currency union because monetary policy reacts to the state of the economy at the level of the union and not at the level of its individual states.
Designing effective macroprudential policies
Yet macroprudential policy is not a silver bullet for achieving financial stability objectives either, and monetary policy may have to help in mitigating credit and asset price booms in some circumstances. For example, if financial regulators from different sectors and countries fail to coordinate changes in capital requirements, limits on lending, and other macroprudential policies to prevent regulatory arbitrage, macroprudential policies may “leak” as unregulated entities, including so-called shadow banks, may substitute for regulated bank lending. Another challenge to the effectiveness of macroprudential policies is financial innovation. If the government does not understand well the riskiness of new financial instruments, the benefits of the macroprudential policy it designs are likely to be limited.
Global dimension
Multilateral considerations are also key when designing both monetary and macroprudential policies. As Princeton Professor Hyun Song Shin emphasized in his Mundell-Fleming lecture (which you can watch), financial conditions, credit and asset price growth, and ultimately financial stability depend not only on domestic factors, such as monetary policy, but also international factors, particularly capital flows. Furthermore, some macroprudential tools—such as some types of capital controls—can have complex spillover effects across borders as investors respond to capital controls by changing the share of their portfolios allocated to other countries that do not have capital controls.
The conference’s Economic Forum (which you can watch) debated the challenges and solutions to the dilemma of how best to coordinate macroprudential and monetary policy. It was hosted by IMF Economic Counselor Olivier Blanchard and included Lewis Alexander (Nomura Securities), Joseph E. Gagnon (Peterson Institute of International Economics), Andrew Lo (MIT), and John Williams (Federal Reserve Bank of San Francisco).
In a luncheon speech, Jean-Pierre Landau, former Second Deputy Governor of Banque de France, stressed that central banks must pay attention to the way markets operate because it can affect both overall financial stability and the ability of authorities to conduct monetary policy. He cited the markets’ ability to convert short-term funds into long-term assets and to permit investors to use borrowed funds to control assets worth far more than their capital. He said there are at least two potential consequences. There may be no independent monetary and macroprudential instruments with which price and financial stability objectives can be achieved. The crisis, he said, showed the need to pay greater attention to some monetary and liquidity aggregates when implementing monetary policy.
