Randal K Quarles: Monetary policy and financial stability
Speech by Mr Randal K Quarles, Vice Chair for Supervision of the Board of Governors of the
Federal Reserve System, at &quot;Developments in Empirical Macroeconomics&quot;, a
research conference sponsored by the Federal Reserve Board and the Federal Reserve Bank of
New York, Washington DC, 30 May 2019.
* * *
Thank you for the opportunity to take part in today's "Developments in Empirical
Macroeconomics" conference. I would like to use my time here to talk about a topic of interest to
many central bankers and macroeconomists: the interaction of monetary policy and financial
stability. As you well know, monetary policy has powerful effects on financial markets, the
financial system, and the broader economy. Conversely, financial instability, by impairing the
provision of credit and other financial services, can depress economic growth, cause job losses,
and push inflation too low. Accordingly, financial stability, through its effects on the Federal
Reserve's dual-mandate goals of maximum employment and stable prices, must be a
consideration in the setting of monetary policy.
Against this backdrop, a natural-yet quite complex-question is whether monetary policy should
be used to promote financial stability. This question is hotly debated in a large and growing
academic literature, and any serious answer has to be subject to considerable nuance. At the
same time, my sense is that the balance is clearly tilted toward the conclusion that
macroprudential policies-through-the-cycle resilience, stress tests, and the countercyclical
capital buffer (CCyB)-may be better targeted to promoting financial stability than monetary
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policy.
Before I wade into the lessons from past research and experience, I would like to highlight that
this question is not just academic. As you know, the economy, monetary policy, and financial
stability are intertwined. For example, the past three recessions were preceded by some
combination of elevated asset prices, rapid increases in borrowing by businesses and
households, and excessive risk-taking in the financial sector. These financial vulnerabilities have
amplified adverse shocks to the overall economy time and again. Such concerns have
resurfaced among some observers, as the current long expansion has brought business
borrowing to new heights. My own assessment is that even though business debt is elevated, at
least by some measures, overall financial stability risks are not, as the financial sector has
substantial loss-absorbing capacity and is not overly reliant on unstable short-term funding. Yet,
even if the risk of financial system disruption does not seem high, it well remain true that if the
economy weakens, some businesses may default on this debt, potentially leading to a
contraction in investment, a slow-down in hiring, and possibly to an unusual tightening in financial
conditions. These concerns highlight how cyclical factors influencing monetary policy borrowers
may overlap with financial stability considerations.
How Monetary Policy Can Influence Financial Stability
Let me begin by laying out how monetary policy can influence financial stability. Monetary policy,
operating primarily through adjustments in the level of short-term interest rates, has powerful
effects on the entire financial system. A more accommodative monetary policy lowers interest
rates across the maturity spectrum. The textbook result is that mortgage rates and corporate
borrowing rates, among others, decline; equity prices rise; and the dollar exchange rate
depreciates. In other words, financial conditions broadly ease, spurring households to buy more
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and businesses to invest and hire, thereby supporting economic growth and price stability.
Monetary policy, however, if too accommodative, may lead to a buildup of financial vulnerabilities.
These incentives arrive through a number of channels. For instance, low interest rates reduce
the cost of borrowing, and so may prompt businesses and households to overborrow. Low rates
may lead to a speculative bubble by compressing risk premiums for assets-such as equity,
corporate bonds, and housing-and potentially leading investors to extrapolate price gains into
the future in a bout of irrational exuberance. Low rates may also squeeze the profitability of
financial intermediaries through narrow interest margins and other factors. In turn, these
intermediaries as well as investors that had promised fixed nominal rates of return-such as
insurance companies and pension funds-may "reach for yield," or take on more credit or
duration risk in their portfolios in order to maintain high returns. Taken to extremes, this story
often does not end well. Periods of excessive leverage, rapid credit growth, or buoyant credit
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market sentiment increase the risk to economic growth.
These dynamics point to the possibility that accommodative monetary policy, while necessary to
support activity during the early stages of an economic expansion, may also increase
vulnerabilities in the financial system, especially if maintained for too long. These vulnerabilities
weaken the financial system's ability to absorb negative shocks, and so when a shock arrives,
losses mount, the financial system weakens, lending slows, and economic activity slows by
more than it would have otherwise, potentially leading to an economic downturn or a more severe
recession.
Should Financial Vulnerabilities Affect the Stance of Monetary Policy?
These observations lead to the important question of whether and how financial vulnerabilities
should affect the setting of monetary policy. One simple framework for evaluating the tradeoffs
associated with actively setting monetary policy to lean against the buildup of financial
vulnerabilities is to examine the costs and benefits of such a policy in terms of unemployment
and inflation. In this approach, the costs of tightening monetary policy in response to a buildup of
financial vulnerabilities are lower employment and potentially below target inflation in the near
term. The benefits are possibly reducing the risk of a future financial crisis, an event likely
associated with a much larger fall in employment and inflation.
One view is that monetary policy curbs household and business borrowing only modestly but can
boost the unemployment rate notably. And so using monetary policy to damp borrowing does
more harm than good. According to this view, using monetary policy to lean against financial
vulnerabilities does not generate significant net benefits and may be counterproductive-
increasing unemployment and decreasing inflation below a desired level with little reduction in
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risks to financial stability.
At the same time, some research has identified circumstances under which the benefits of using
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monetary policy to lean against financial vulnerabilities could outweigh the costs. A key
consideration is the estimated amount of economic activity lost in a financial crisis-and some
research suggests such losses may be quite large, which raises the benefits of leaning against
imbalances. Similarly, monetary policy may affect a broad range of financial imbalances-
excessively high house or equity prices and leverage within the financial sector-and the full set
of these effects could shift the risk of financial instability sufficiently, at least under some
circumstances, to make leaning against financial vulnerabilities with monetary policy desirable.
The broader point is that we do not fully understand the cost-benefit tradeoff and whether
monetary policy adjustments for financial stability reasons may be appropriate at some times.
Whither Macroprudential Policy?
Of course, there is one additional and critical factor to consider when weighing adjustments to
the stance of monetary policy for financial stability reasons: the availability and efficacy of other
instruments to promote financial stability. After all, the pursuit of multiple goals-full employment,
price stability, and financial stability, for example-likely requires multiple tools. This is just
common sense. Economists have a name for this common-sense notion: the Tinbergen
principle.
Effective supervisory, regulatory, and macroprudential policy tools appear to be well placed to
address financial vulnerabilities. In particular, these tools may be used to increase the resilience
of the financial sector against a broad range of adverse shocks and, perhaps, lean against the
buildup of specific financial vulnerabilities. At the Federal Reserve, we have emphasized a set of
structural, or through-the-cycle, regulatory and supervisory policies as our primary
macroprudential tools to promote financial stability. These measures include strong capital and
liquidity requirements for banks, especially the largest and most systemic institutions. In addition,
our supervisory stress tests evaluate the ability of large banks to weather severe economic
stress and the failure of their largest counterparty as well as examining the risk management
practices of the firms. Moreover, the stress-test scenarios are designed to generally be more
severe during buoyant economic periods when vulnerabilities may build. Furthermore, our stress
tests consider the potential effects of specific risks we have identified in our financial stability
monitoring work. For example, the tests in recent years have included hypothetical severe strains
in corporate debt markets, exploring the resilience of the participating banks to the risks
associated with the increase in business borrowing.
In addition, the Federal Reserve monitors a wide range of indicators for signs of potential risks to
financial stability that may merit a policy response, and we now publish a summary of this
monitoring in our semiannual Financial Stability Report. If vulnerabilities are identified as being
meaningfully above normal, the Federal Reserve can require large banks to increase their
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lossabsorbing capacity through increases in the CCyB.
Despite all of these efforts, we understand that these tools have limitations. First, central
bankers' experience with macroprudential tools, including the CCyB, is limited. Second,
regulation and macropudential tools can reduce economic efficiency and hamper economic
growth by limiting the ability of the market to allocate financial resources. For this reason, the
Federal Reserve has been evaluating ways in which our supervisory and financial stability goals
can be achieved more efficiently, and it has been participating in global efforts to evaluate the
effects of reforms under the auspices of the Financial Stability Board. Third, macroprudential
policies that are targeted to banks may create an incentive for financial intermediation to migrate
outside of the regulated banking system. The vulnerabilities may still emerge, albeit elsewhere in
the financial system-perhaps in institutions or structures that are less stable and resilient than
our banks. In part reflecting these incentives, we regularly monitor financial intermediation both
inside and outside of the banking system.
Summary
To sum up, while there is evidence that financial vulnerabilities have the potential to translate into
macroeconomic risks, a general consensus has emerged that monetary policy should be guided
primarily by the outlook for unemployment and inflation and not by the state of financial
vulnerabilities. Financial system resilience, supported by strong through-the-cycle regulatory and
supervisory policies, remains a key defense against financial system and macroeconomic
shocks.
There is a clear need for new theory and empirics to address the questions about monetary
policy and financial stability I have posed today. I encourage you to continue to contribute to these
answers. By engaging the help of the wider academic community, conferences such as this one
provide an invaluable opportunity to make progress on issues of great importance for economic
policy.
References
Adrian, Tobias, Nina Boyarchenko, and Domenico Giannone (2019). "Vulnerable Growth,"
American Economic Review, vol. 109 (April), pp. 1263-89.
Adrian, Tobias, and Nellie Liang (2018). "Monetary Policy, Financial Conditions, and Financial
Stability," International Journal of Central Banking, vol. 14 (January), pp. 73-131.
Ajello, Andrea, Thomas Laubach, David López-Salido, and Taisuke Nakata (2019). "Financial
Stability and Optimal Interest Rate Policy," International Journal of Central Banking, vol. 15
(March), pp. 279-326.
Bernanke, Ben S., and Mark Gertler (1995). "Inside the Black Box: The Credit Channel of
Monetary Policy Transmission," Journal of Economic Perspectives, vol. 9 (Fall), pp. 27-48.
Boivin, Jean, Michael T. Kiley, and Frederic S. Mishkin (2010). "How Has the Monetary
Transmission Mechanism Evolved over Time?" in Benjamin M. Friedman and Michael Woodford,
eds., Handbook of Monetary Economics, 1st ed., vol. 3. Amsterdam: Elsevier, pp. 369-442.
Gourio, Francois, Jae W. Sim, and Anil K. Kashyap (2018). "The Trade Offs in Leaning against
the Wind," IMF Economic Review, vol. 66 (March), pp. 70-115.
Kiley, Michael T. (2018). " Unemployment Risk (PDF)," Finance and Economics Discussion
Series 2018-067. Washington: Board of Governors of the Federal Reserve System, September.
López-Salido, David, Jeremy C. Stein, and Egon Zakrajšek (2017). "Credit-Market Sentiment and
the Business Cycle," Quarterly Journal of Economics, vol. 132 (August), pp. 1373-1426.
Mian, Atif, Amir Sufi, and Emil Verner (2017). "Household Debt and Business Cycles Worldwide,"
Quarterly Journal of Economics, vol. 132 (November), pp. 1755-1817.
Schularick, Moritz, and Alan M. Taylor (2012). "Credit Booms Gone Bust: Monetary Policy,
Leverage Cycles, and Financial Crises, 1870-2008," American Economic Review, vol. 102
(April), pp. 1029-61.
Svensson, Lars E.O. (2014). "Inflation Targeting and 'Leaning against the Wind,'" International
Journal of Central Banking, vol. 10 (June), pp. 103-114.
--- (2017). "Cost-Benefit Analysis of Leaning against the Wind," Journal of Monetary
Economics, vol. 90 (October), pp. 193-213.
1
These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.
2
For reviews of the various monetary policy transmission channels to the real economy, see Bernanke and
Gertler (1995) and Boivin, Kiley, and Mishkin (2010).
3
See, among others, Schularick and Taylor (2012); López-Salido, Stein, and Zakrajsek (2017); Mian, Sufi, and
Verner (2017); Adrian, Boyarchenko, Giannone (2019); and Kiley (2018).
4
See, for instance, Svensson (2014, 2017).
5
See, for example, Ajello, Laubach, López-Salido, and Nakata (2018); Guorio, Sim, and Kashyap (2018); and
Adrian and Liang (2018).
6
CCyB also builds financial-sector resilience during periods when financial vulnerabilities are high and there is a
risk of potential losses within the banking sector that could strain the supply of credit. Furthermore, the CCyB
might be a more effective tool than monetary policy to mitigate financial vulnerabilities, as the benefits are
comparable to those of using monetary policy while the costs are an order of magnitude smaller.