IMF Survey : Monetary Policy Should Focus on Price Stability

IMF News, September 21, 2015

Source details

Publication date: September 21, 2015
Core message: Monetary policy should stick to its core mandate of price stability and deviate from that role only when benefits to the economy outweigh the costs.
Context: Study from the International Monetary Fund responding to concerns about mounting financial stability risks amid low interest rates and delayed policy tightening in advanced economies.

Three-step analytical framework:
- (i) understanding and quantifying the transmission mechanism from interest rates to financial stability;
- (ii) gauging the tradeoffs between price and financial stability;
- (iii) weighing the benefits and costs to the economy of leaning against the wind.

Link between interest rates and crisis probability:
- Hiking rates by 100 basis points for a year will eventually reduce the probability of crises by 0.04 to 0.3 percentage points at most.
Transmission channels:
- Interest rates affect crisis probabilities through quantities (leverage of financial firms, bank credit, bank risk-taking behavior) and prices (asset prices, especially real estate, and credit spreads).
Tradeoffs and costs:
- In many cases, the costs of a temporary rate hike outweigh the benefits because:
- Higher rates significantly raise unemployment in the short to medium term;
- Higher rates increase financial stability risks through lower growth, reduced net worth, and higher debt servicing costs;
- There may be costs to central bank credibility if inflation is undershot.
- Often financial risks develop during economic expansions when higher rates would already be justified by price and output stability.

Primary prescription:
- Monetary policy should generally stick to its core mandate of price stability and not lean against the wind based on current knowledge.
Prudential measures:
- Microprudential and macroprudential policies, capital and liquidity ratios, and regulation are the natural tools to prevent crises and support financial system resilience.
Monitoring and conditional deviations:
- Policymakers should closely monitor financial stability risks and not rule out higher interest rates while knowledge of the relationship between monetary policy and financial risks evolves.
- Deviations from traditional policy may be warranted in some circumstances, for example when the consequences of a crisis are expected to be especially severe.

General assessment:
- Based on current evidence, the case for using monetary policy to contain risks to financial stability (leaning against the wind) appears weak in most circumstances.
Exceptions and evolving understanding:
- There are circumstances in which central banks may want to lean against mounting financial stability risks.
- The IMF stresses that more research is needed; the understanding of domestic, cross-border, and business-cycle channels is rapidly evolving.
- Future work should examine the complete policy set, including the benefits and costs of prudential policies and their interaction with monetary policy.

Improve understanding of:
- How well microprudential and macroprudential policies work in practice;
- The full interaction between monetary policy and prudential regulation;
- Circumstances where monetary policy deviations produce beneficial anticipatory responses by investors.
The final verdict on the appropriate role for monetary policy in containing financial stability risks requires further empirical and policy analysis.

Source: IMF Survey : Monetary Policy Should Focus on Price Stability (September 21, 2015).