The U.S. Federal Reserve: many have argued central banks should raise interest rates to help contain financial stability risks (photo: Joseph Sohm/Corbis)
MONETARY POLICY
Based on current knowledge, the case for using monetary policy to contain risks to financial stability—commonly referred to as leaning against the wind—appears weak in most circumstances, according to the IMF. However, 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.
In the wake of the U.S. Fed’s decision to postpone a rate hike, and as interest rates remain low in advanced economies, some observers are concerned with mounting financial stability risks, such as corporate leverage in emerging market economies, and calling for monetary policy to respond. The IMF’s study provides central bankers with a framework, new results, and initial policy recommendations to help them decide whether and when to lean against the wind.
Crises are costly
The IMF study says crises are costly and persistent, and policymakers cannot rely on simply dealing with their repercussions—mopping-up—once they occur.
“Crises must be pre-empted: their probability reduced and their severity curtailed,” says Karl Habermeier, Assistant Director in the IMF’s Monetary and Capital Markets Department. “However doing so is not easy; price stability alone does not guarantee financial stability.”
Prudential policies, such as capital and liquidity ratios, are the natural response. Policymakers should pursue micro and macroprudential policies, as well as regulation, to support the resilience of the financial system.
“The only problem is that we don’t know how well these policies work; the grand experiment is just beginning,” says Habermeier.
From opinions to facts
Many have argued that monetary policy should lend a hand to maintain financial stability, and argue that on occasion policymakers should raise interest rates more than warranted by price and output stability in order to contain financial stability risks.
However, views on the role for monetary policy differ considerably, and are hotly contested.
“We engaged in this study so we could have an informed discussion, as opposed to a clash of opinions,” says Giovanni Dell’Ariccia, Deputy Director in the IMF’s Research Department. “Our goal was to advance the debate by offering a framework of analysis, new results and a stake in the ground in terms of policy recommendations based on what we know, and not provide rigid, conclusive, one-size-fits-all policy prescriptions.”
The framework offered by the IMF study has three steps: (i) understanding and quantifying the transmission mechanism going from interest rates to financial stability; (ii) gauging the tradeoffs between price and financial stability; and (iii) weighing the benefits and costs to the economy of leaning against the wind.
Monetary policy can help, but at considerable cost
According to the study, there is a meaningful, though not especially powerful link between interest rates and the probability of crises—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. Interest rates affect crisis probabilities through a variety of financial variables, related to quantities (leverage of financial firms, bank credit, and bank risk-taking behavior) as well as prices (of assets, especially real estate and credit spreads).
But the tradeoff policymakers face between price and financial stability is not always severe. Often, financial risks develop in periods of economic expansion that would require raising interest rates on the basis of price and output stability alone.
In most of the cases where tradeoffs arise, the costs of a temporary rate hike outweigh the benefits. This is because higher rates significantly raise unemployment in the short to medium term, and increase financial stability risks due to lower growth, net worth, and higher debt servicing costs. In addition, there may be costs to the credibility of central banks as they undershoot inflation. The benefits only come in the longer term, as higher rates eventually decrease the probability of crises.
“Based on what we know, we would generally say that monetary policy should stick to its guns, and not lean against the wind,” suggests Tommaso Mancini-Griffoli, Senior Financial Sector Expert in the IMF’s Monetary and Capital Markets Department. “However, never say never.”
Never say never
The IMF said based on current knowledge there are some circumstances in which central banks may want to lean against mounting financial stability risks; for instance, when the consequences of a crisis are expected to be especially severe.
“Our current understanding of the channels through which monetary policy affect financial stability domestically, across borders, and over the business cycle is rapidly evolving,” says Vikram Haksar, Division Chief in the IMF’s Strategy Planning and Review Department. “More circumstances may be uncovered in which deviations from a traditional policy response are warranted, such as when investors are likely to curtail their risk exposure in anticipation of policy action. Future research in this area is a key priority.”
According to the IMF, the final verdict will only come after an examination of the complete policy set. More efforts should be devoted to understanding the benefits and costs of prudential policies, as well as their interaction with monetary policy. Until then, monetary policy will remain more art than science.
