Monetary Policy and Financial Stability: Never Say Never

Last week, in her most important speech since becoming Fed Chair in February, Janet Yellen articulated the emerging policy consensus about the relationship between monetary policy and financial stability. What is that consensus? How confident should we be about its precepts? How will it influence Fed monetary policy over the medium term?

Three principles form the basis of the consensus: (1) the primary policy tools for addressing systemic risks are regulatory (now called macroprudential tools); (2) interest rate policy has only limited effects on systemic risks and comes with potentially costly side effects; and (3) policymakers may wish to use interest rates to address systemic risks, but only when the primary tools are not working.

The first two principles pre-date the emerging consensus and remain undisputed. Regulatory tools – ranging from capital and liquidity requirements for intermediaries to margin and collateral requirements for systemic financial markets – can be tailored to address systemic risk. In contrast, interest rate policy affects many aspects of economic behavior beyond the financial system. So, adjusting interest rates to secure financial stability can put at risk the central bank’s conventional goals of price stability and stable economic growth. [Indeed, one recent simulation by Fed staffers showed that the economic costs of using interest rate policy to prevent a crisis can exceed the benefits.]

Prior to the financial crisis, policymakers treated these first two principles as sufficient to warrant a complete separation between monetary policy (setting interest rates) and regulatory policy. The former would be used exclusively for conventional stabilization, the latter exclusively for financial stability. And never the twain shall meet.

As Chair Yellen’s speech highlights, that separation principle is dead. The key challenges for policymakers today are: (1) to identify the circumstances when the high hurdle for using monetary policy to address systemic risks should be crossed; and (2) to explain publicly the financial stability factors that can influence interest-rate setting today and in the future.

Ideally, there would be no surprises: we could all anticipate how interest-rate policy would react to different kinds of systemic threats, in addition to changes in inflation and economic growth. Yet, as Chair Yellen emphasized, “there is no simple rule than can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability.” Put differently, there is no Taylor rule for systemic risk.

So, how will Chair Yellen address the two big challenges? When might it be appropriate to use monetary policy to “get in the cracks” (the phrase comes from a 2013 speech by former Federal Reserve Governor Jeremy Stein) left by the regulatory framework?

In her speech, the Chair focused on private balance sheets and the well-being of intermediaries, noting that: (1) financial conditions have “contributed to balance sheet repair” while “nonfinancial credit growth remains moderate”; (2) “leverage in the financial system … is much reduced”; and (3) “short-term wholesale funding is also significantly lower than immediately before the crisis.” In short, there is no present need for “monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns.”

We also doubt that monetary policy should deviate now from its primary focus. The single biggest source of risk in the financial system ahead of the crisis – the bloated level of house prices – has corrected sharply (see figure). In addition, the ratio of household debt to GDP has declined since the crisis, despite sluggish growth; and, with interest rates so low, debt-service to income ratios are back to their 1995-2007 average.

United States: Real House Prices (1991=100) and the Ratio of Private Debt to GDP

Sources: Shiller data set for Irrational Exuberance 2e (real house price), FRB Z.1 household and nonfinancial firm liabilities (FRED codes: CMDEBT and TBSDODNS), and BEA (GDP).

Sources: Shiller data set for Irrational Exuberance 2e (real house price), FRB Z.1 household and nonfinancial firm liabilities (FRED codes: CMDEBT and TBSDODNS), and BEA (GDP).

However, there also is scope to be less sanguine about financial stability than the Fed seems to be. The private debt/GDP ratio (including households and nonfinancial businesses) is now similar to the level in 2006, shortly before the crisis. So, when interest rates start to rise, debt service will become a burden. Similarly, while leverage among U.S. intermediaries is far lower than during the crisis, it is not lower than in the run-up to the crisis: based on data from the Stern Volatility Lab, the ratio of book assets to market capital for the 10 most systemic U.S. intermediaries (weighted by their shares in total systemic risk) was 14.7 at the end of June, down from a whopping 52.1 in September 2008, but up from 13.4 at the end of 2006. The same conclusion arises from the V-Lab’s historical estimate of aggregate systemic risk among U.S. financials (see next chart).

Source: Stern Volatility Lab.

Source: Stern Volatility Lab.

So, what to conclude? If Chair Yellen wishes to make the financial system “resilient,” there remains considerable scope for tightening and broadening prudential policies, including both higher bank capital requirements and stricter oversight of systemic funding markets (like those for repurchase agreements and securities lending) and shadow banks (such as money market mutual funds).

Chair Yellen didn’t rule out the use of interest rate policy for the purpose of securing financial stability at some point in the future, but she set the bar very high. The risk is that the message will be viewed as a policy commitment beyond that warranted by our limited knowledge. As a counterweight, perhaps the Fed should publish its own Financial Stability Report that regularly (semi-annually?) assesses the drivers that could prompt a deviation of interest rate policy from conventional goals. Doing so would highlight the inevitable uncertainties arising from limited experience with macroprudential tools and still-sizable holes in the regulatory framework. It might also help limit the complacency of observers who view the Fed as pre-committed not to raise interest rates to address financial instability.