Navigating Monetary Policy in the New Normal, Monetary Policy in a Changing Financial Landscape, Speech by Christine Lagarde at the ECB Forum on Central Banking

IMF News, May 25, 2014

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Speech delivered at the first ECB Forum on Central Banking; date: May 25, 2014.
Core aim: assess how the remit, independence, and operating environment of monetary policy should evolve in a post-crisis “new normal.”
Three main themes addressed:
- (i) The evolving mandate of monetary policy;
- (ii) Monetary policy independence, given a possibly wider mandate for central banks; and
- (iii) The impact of growing financial interlinkages and challenges for monetary policy in emerging market and small open economies.

Findings and observations:

Pre-crisis consensus: monetary policy focused on price stability (low and stable inflation) with “light touch” microprudential regulation expected to deliver financial stability.
The 2008 global financial crisis demonstrated that financial crashes can be extremely costly and that price stability alone is not always sufficient for output stability.
Financial stability is now widely seen as an essential policy objective, but whether it should be part of monetary policy’s mandate is contested.

Empirical examples and exact figures preserved:

Korea reduced banks’ short term external debt by half—to 27 percent—between 2008 and 2013.
Hong Kong recently saw property prices level off and loan-to-value ratios decline (qualitative observation retained).
In some countries (Israel, Switzerland, Turkey), credit growth and house price inflation remained high despite macroprudential measures.

Key practical questions and challenges:

Transmission uncertainty: e.g., how much does a 100 basis points increase in interest rates deliver in terms of financial stability?
Measurement ambiguity: how to define and measure financial stability—credit growth, asset price growth, leverage?
Trade-offs in operating framework: raising rates to address financial imbalances versus lowering rates to support growth and inflation (example: Sweden shows less tendency to lower rates despite very low inflation because of rising financial stability risks).

Policy implication:

Primary objective should be to strengthen prudential frameworks (macro- and micro-prudential tools such as loan-to-value limits, countercyclical capital buffers) to avoid overburdening monetary policy.
Where macroprudential measures fall short, monetary policy may need a larger role to maintain financial stability.

Findings and reasoning:

Central bank independence historically associated with better inflation performance; foundations are credibility and accountability built on three pillars:
- Clear mandate;
- Consistent performance;
- Consensus on objective.
A wider financial stability objective challenges these pillars because:
- Objectives, targets, and instruments for financial stability are ill-defined.
- Performance is hard to measure and often revealed only after crises.
- Consensus may be fragile as some groups may lose from measures that enhance financial stability.

Institutional approaches and examples:

Separate institutions for monetary and macroprudential policy (examples: Australia, Chile, Mexico) — use of committees for information sharing and coordination.
Single-institution approach with safeguards (examples: ECB, Bank of England) — both monetary and macroprudential responsibilities with distinct governance structures to protect independence.

Policy implication:

Institutional structures must protect the achievement of price stability while enabling macroprudential action; safeguards and clear governance are required if responsibilities are combined.

Findings and empirical evidence:

Growing financial interlinkages and volatile capital flows pose challenges to monetary independence.
Examples of exchange rate and capital flow volatility:
- Strong appreciation between January 2009 and May 2013: nearly 50 percent in New Zealand and Australia, and 30 percent in Chile.
- Reversal between May and August 2013: currency depreciations of nearly 15 percent in Brazil, India and Uruguay.
- Non-resident holdings of domestic currency government bonds in Uruguay surged from 2 percent to 45 percent of the outstanding stock in May 2013 (increase occurred in a little over a year).

Three-pronged policy response framework (not mutually exclusive):

Resilience:
- Enhance resilience to shocks via sound macroeconomic fundamentals and reinforced macroeconomic and financial frameworks.
- Advanced economies can reduce volatility by communicating clearly about their monetary policy.
Response:
- Use the full policy toolkit: monetary policy, exchange rate policy, macroprudential policy, fiscal policy.
- Consider targeted, temporary capital flow management measures and foreign exchange intervention where appropriate.
- Empirical examples: Brazil, Uruguay and Indonesia used some form of capital controls; India and Peru intervened in foreign exchange markets.
Cooperation:
- International monetary policy cooperation can reduce the risk of tail events and large international feedback effects (examples: coordinated policy rate cuts during the crisis; Fed swap arrangements; G-20 agreement on expanding IMF resources).
- As conditions normalize, the urgency and clarity of cooperative gains may diminish, but uncertainties argue for continued evaluation of cooperative policies’ effectiveness and spillovers.

Policy implication:

National policies alone risk ad hoc intervention and exported financial instability; international cooperation and careful evaluation of spillovers and “spillbacks” are important to limit global welfare losses.

Several pre-crisis principles remain useful; others must be revisited in light of crisis lessons.
The IMF commits to advancing analysis and debate on the contours of monetary policy in the post-crisis world, including through surveillance, cross-country analysis, and collaborative projects.
Announcement: a new IMF lecture series on monetary policy in honor of Michel Camdessus; inaugural lecture by Janet Yellen on July 2 (as stated in the speech).

Speech by Christine Lagarde at the ECB Forum on Central Banking, May 25, 2014.