Adding financial stability as an objective of monetary policy: Relevant or irrelevant? (Note)

Usefulness of the article: This article offers a better understanding of how central banks could reduce the risk of financial instability by using their main monetary policy instrument: key interest rates. The questions and limitations surrounding this strategy, as well as possible new developments, are also presented.

Summary:

• The monetary policy approach of focusing on price stability did not prevent the 2008 financial crisis, prompting a rethink of monetary policy objectives.
• By adopting a « Leaning Against the Wind » strategy, central banks could theoretically reduce financial vulnerabilities. However, this strategy has been criticized and its relevance remains to be determined given the difficulty of estimating its effectiveness.  

The mandate of many central banks follows the principle of « separation, » whereby they must separate the objectives of price stability and financial stability by focusing solely on the former. This principle has long been supported by the assumption that maintaining price stability was a sufficient condition for ensuring financial stability.

In the 2000s, this price stability-focused strategy may have fostered a sustainable environment of low interest rates, contributing to excessive risk-taking. The outbreak of the 2008 financial crisis called this paradigm into question and prompted a debate on monetary policy objectives. In particular, to reduce the likelihood of another financial crisis, monetary policy could openly target financial stability as well as price stability.

1) How to target financial stability

Under the principle of « separation, » monetary policy is designed to respond to financial instability only when financial crises erupt, in order to limit their adverse effects on economic activity. This « cleaning up afterwards« strategy was observed after the 2008 crisis with ultra-accommodative and unconventional monetary policies.

Adding financial stability as an objective of monetary policy implies a different view of the role of monetary policy. From this perspective, monetary policy would respond systematically to identified financial imbalances in order to prevent the risk of financial crisis. In other words, as opposed to the principle of « cleaning up afterwards, » monetary policy would act on financial instability even outside periods of financial crisis while continuing to aim for price stability. More specifically, the objective of monetary policy would be to « smooth » the financial cycle by limiting, for example, excessive credit growth or asset price growth, two factors that often precede a financial crisis.

In more concrete terms, the central bank would systematically respond to upward phases of the financial cycle by raising interest rates even if there were no inflationary pressures. In principle, the adoption of a higher interest rate should lead to a reduction in credit growth and asset prices, which would reduce the risk of excessive debt and financial bubbles. On the other hand, this increase in interest rates could lead to a reduction in inflation and growth. This monetary policy strategy aimed at preventing financial risks is called « Leaning Against the Wind« (LAW). However, it is not unanimously supported by economists.

2) Uncertainties surrounding this strategy

The benefits of this strategy remain mainly theoretical and are subject to criticism. Borio and Lowe (2002), Levieuge (2018), and Woodford (2012) summarize these criticisms:

• There is no simple, consensus indicator for estimating a financial stability target. This makes it difficult to identify when financial imbalances arise. It is therefore possible to adopt a LAW strategy too early or too late.
• The effectiveness of interest rates in smoothing the financial cycle is difficult to estimate. An increase in interest rates could be too small to really limit financial instability, or too large, which would disproportionately reduce inflation and growth.
• Politically, an interest rate hike could be criticized and misunderstood by the general public, especially if it reduces economic growth in the absence of inflationary risk.

Furthermore, academic studies aimed at estimating the effectiveness of the « LAW » have produced mixed results. Svensson (2016) analyzes the case of the Bank of Sweden, which implemented this strategy to reduce debt in the summer of 2010 by raising the interest rate from 0.25% to 2% at the end of 2011. These estimates show that the costs outweigh the benefits. Indeed, if the interest rate had remained at 0.25% until 2014, unemployment would have been 1.7 percentage points lower and the 2% inflation target would have been almost achieved. At the same time, raising interest rates does not appear to be effective in improving financial stability, with little effect on debt levels. However, there is no consensus on the ineffectiveness of LAW.  Woodford (2012) concludes that even if inflation and growth temporarily deviate from their targets, it is still appropriate to use a LAW policy when the risk of financial crisis is considered high.

Ultimately, it is clear that adding a financial stability objective to monetary policy involves complex trade-offs. Further research is needed to determine how this strategy could be used optimally.

Conclusion: towards other alternatives?

In conclusion, two key points emerge from this summary. Macroprudential policies also help to limit the accumulation of financial imbalances with various tools aimed at reducing the vulnerability of borrowers or strengthening the capital base of financial institutions. Cerutti et al (2017) show that the adoption of these measures can reduce credit growth, particularly in the upward phase of the financial cycle. The combined use of some of these tools with a « LAW » policy could be beneficial to financial stability (Aspergis 2017). However, the coordination of monetary and macroprudential policies is not straightforward. While the two policies may be complementary, they may also conflict (Beau et al 2012), reducing the effectiveness of each[vi].

Finally, even if the current trend is not towards a change in monetary policy objectives, monetary policy could consider financial stability differently. While we know that there is no ideal indicator of financial stability, Villeroy de Galhau (2021) suggests that the ECB should monitor several indicators to achieve its price stability objective: corporate and household debt, information in bank balance sheets, stock prices, etc.