The financial stability-monetary policy nexus

Central bankers around the world agree that they should concern themselves with financial stability. They know that accommodative monetary policy aimed at bolstering growth and employment acts in part by encouraging borrowing, driving up asset prices and boosting risk taking.  They also know it can go too far. And, when it does, credit booms turn into busts.  Asset prices rise and then crash.  Credit spreads narrow and then balloon.  The result is defaults by households, firms, and intermediaries. On all of this everyone agrees.

In a recent speech, Federal Reserve Board Governor Jeremy Stein discussed the connections between monetary and financial stability policy.  Most importantly, he emphasized that the first line of defense has been and should remain prudential tools, both micro and macro. Monetary policy is for the residual risks these traditional tools cannot offset.

But policymaking is a practical pursuit. It is about taking specific actions on particular dates.  It is about answering questions like: Should the target interest rate be set at 1%, 2% or 0.5%?  Should the central bank buy sovereign or privately-issued securities?

So, in asking whether monetary policymakers should concern themselves with financial stability, the tough question is what should they do and when should they do it?  Surely, macroeconomic stabilization today can create financial stability risks tomorrow. But how big are these risks? To answer this question, we need a measure of financial sector vulnerability and then some sense of the extent to which it is influenced by monetary policy.

Yet, five years after the financial crisis, empirical investigations of these connections remain at a very early stage. We don’t even share a working definition of systemic risk: One recent paper explores 17 different U.S. measures and 10 measures for Europe and the United Kingdom.

It’s also not clear how monetary policy affects systemic risk. When we looked at SRISK, the systemic risk measure computed by the Volatility Lab of NYU Stern, we find measurable, but small, effects in the largest countries. A rise of 100 basis points in either the level or the slope of the yield curve led to an increase in systemic risk on the order of US$50 billion – quite modest when compared with the current SRISK level of US$300 billion for France, the United Kingdom, or the United States; or the $500 billion for Japan.

So far, no analysis focused on systemic risks has made a quantitative case to alter the current stance of monetary policy. The recent USMPF paper on market tantrums – which focuses on the links between monetary policy and non-leveraged sources of instability – does not question the familiar arguments for accommodative monetary policy based on low inflation and economic slack.  In his talk, Governor Stein emphasized that empirical work is far from demonstrating the need for a different policy setting than conventional models imply. Similarly, a recent Brookings paper finds only a modest financial stability cost from unconventional monetary policy in the United States over the past few years.

So, does monetary policy create financial stability risks?  In theory, yes.  In practice, the case for changing monetary policy today to address these risks remains difficult to make. Following Governor Stein’s lead, we expect that micro- and macro-prudential regulation will remain the principal tools to contain systemic risk. We also expect that central banks will not alter monetary policy any time soon to in response to future financial stability risks that are so tough to quantify.