Financial Stability Takes on Growing Policy Importance

Monetary Policy Week in Review: 30 June to 04 July 2014

by Peter Nielsen, Central Bank News

The response of central banks to financial instability was front and center of global monetary policy last week, with Sweden’s rate cut underscoring how the topic of financial stability has become an integral part of monetary policy since the global financial crises.

Measures of credit and property prices are likely to become even more central to policy-making in coming years as threats to financial stability worldwide continues to grow unless policy makers start to tackle the ever-growing mountain of debt.

The Bank for International Settlements (BIS) threw down the gauntlet to central banks on Sunday, calling on monetary policy to be reoriented toward the slow-moving financial cycle and away from reacting to short-term fluctuations in inflation and economic output.

One of the consequences of the BIS view is that central banks should be ready to tighten monetary policy when financial imbalances start building up, even if inflation appears to be under control. The BIS has for years pointed to the dangers from the growing reliance on debt as an engine of economic growth along with ultra-low interest rates and most observers saw the BIS’ annual report as a direct challenge to the current policy stance of major central banks.

The speech by Janet Yellen, chair of the U.S. Federal Reserve, only three days after the BIS annual meeting in Basel, Switzerland, therefore took on added significance.

Most observers heard Yellen’s speech as a rejection of the BIS view, referring to her statements that “monetary policy faces significant limitations as a tool to promote financial stability,” and there is no need for “monetary policy to deviate from a primary focus on attaining price stability and maxiumum employment.”

But on a closer reading, Yellen agrees with many of the points argued by the BIS, an illustration of how the BIS annual report reflects much of the thinking in central banks worldwide. Monetary policy has changed since the 2007-2009 financial crises and the belief that central banks should focus narrowly on inflation and then clean up any mess from a financial crises is dead and buried.

Tackling the threat to a country’s financial stability, whether from domestic or global sources, is now an integral part of monetary policy discussions worldwide, including at the Fed, with central banks using a host of macroprudential measures as the first line of defense.

But expanding the framework for taking policy decisions to include financial stability in addition to inflation and output takes time.

Yellen said:

“We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions”

The question is not whether monetary policy should respond to treats to financial stability, the issue that faces policy makers is how to gauge these threats and what the optimal policy tool is. As Yellen said, “adjustments in monetary policy may, at times, be needed to curb risks to financial stability.”

Her current diagnosis is that the threat from growth in nonfinancial credit and leverage in the financial system is much reduced from past years and the reliance on short-term wholesale funding is significantly lower than before the crises.

That said, Yellen acknowledged increased risk-taking across the financial system that could trigger more macroprudential measures and the importance of keeping an eye on credit creation,losses by borrowers and a worsening of leverage and liquidity.

Yellen said:

“It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways” .

Sweden’s Riksbank has been one of the most active central banks in integrating financial stability and monetary policy decisions, with Yellen pointing to the fact that the Riksbank has acknowledged keeping its policy rate “slightly higher” due to financial stability concerns. But last week the Riksbank concluded that inflation had now fallen so much that it outweighed the threat from rising household debt and cut its rate by 50 basis points – twice the expected amount.

As the Riksbank is no longer in charge of overall financial supervision and regulation, all it could do was to appeal to other policy makers to take steps to dampen households’ demand for credit. LIST OF LAST WEEK’S CENTRAL BANK DECISIONS:

• Australia holds rate, still sees period of stable rates
• Romania holds rate, cuts RRR on foreign FX deposits
• Poland holds rate, says next move to depend on data
• Sweden slashes rate 50 bps on lower inflation forecast
• ECB maintains key rates, including negative deposit rate
• ECB to publish details of meetings from Jan. 2015

TABLE WITH LAST WEEK’S MONETARY POLICY DECISIONS:

This week (Week 28) 10 central banks will decide on monetary policy, comprising the countries of Ghana, Croatia, Indonesia, Malaysia, South Korea, United Kingdom, Serbia, Peru, Mexico and Mozambique. TABLE WITH THIS WEEK’S MONETARY POLICY DECISIONS:

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