Mark Carney: Some considerations on using monetary policy to stabilize
economic activity
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to a symposium sponsored
by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009.
* * *
It is an honour to provide a few comments on Carl Walsh's excellent paper, which revisits
some fundamental monetary policy issues. Walsh's paper highlights many useful lessons
that can be learned from the conventional framework and its various extensions. However,
the financial crisis provides a stark and costly reminder of just how incomplete the standard
model is. I will concentrate on the future of monetary policy in light of both the lessons of the
crisis and the prospect of some central banks having more formal responsibility to promote
financial stability. I will take as my starting point Walsh's observation that: "distortions in
financial markets that generate real effects of monetary policy also imply that financial
stability may require making trade-offs with the goals of inflation stability and stability of real
economic activity."1
There is an emerging consensus that price stability does not guarantee financial stability and
is, in fact, often associated with excess credit growth and emerging asset bubbles.2 There is
also general agreement that the first line of defence should be better regulation, including
new macroprudential tools. However, it is less widely recognized that this will mean it is not
"business as usual" for monetary policy. At a minimum, the regulatory response will change
the transmission mechanism and, consequently, the implementation of monetary policy.
A more fundamental policy question - one that has not yet been fully thought through - is
whether the policy rate itself should lean into the wind for financial stability purposes. If so,
how will central banks retain accountability and credibility, and their associated benefits for
inflation expectations? Could it be advantageous to amend the price stability mandate? I
would like to undertake an initial exploration of these issues today.
What follows is a discussion of ideas worthy of consideration. It should not be seen as having
any bearing on the current conduct of monetary policy or the prospective management of
financial stability in Canada. The Bank of Canada's current inflation-control agreement with
the Government of Canada will remain in effect until the end of 2011. Any changes to our
agreement with the Government, if desired by both parties, would only come into effect
thereafter. Changes to financial stability regulation are generally the purview of the
Government of Canada.
Is price stability enough?
While most central banks have added a financial stability objective in recent years, the
monetary policy and financial stability wings of many of our institutions have operated as two
solitudes.3 For example, the standard New Keynesian transmission channels featured in
workhorse monetary policy models and described in Walsh's paper ignore not only the
financial accelerator but also broader procyclical dynamics in modern money and credit
markets. Importantly, these dynamics could be triggered by the attainment of price stability
itself. Such downplaying of real-financial linkages obscured the scale of emerging
vulnerabilities and challenged the initial crisis response.
The experience of the past two years is quickly changing these attitudes. Central banks are
recognizing that they need a deeper understanding of financial system dynamics in order to
better understand the relationship between price and financial stability and, ultimately, the
contribution of both to the stabilization of economic activity.
The variable transmission mechanism
Central banks have effectively treated the transmission mechanism as uncertain but fixed (or
at best only mildly variable) when it is in fact highly variable and procyclical. The transmission
mechanism is a function of, among other factors, (i) regulation, which changes over time; (ii)
financial innovation, which often evolves to circumvent regulation; and (iii) confidence, which
is influenced by monetary policy in ways not commonly acknowledged.4
Consider three states of the world. In the normal state, financial agents balance
macroeconomic and idiosyncratic risks in their investing, lending, and financing decisions. In
the exuberant state, agents become complacent about macroeconomic risks and seek to
exploit more idiosyncratic or obscure opportunities.5 In the panicked state, macroeconomic
risks dominate and all idiosyncratic risks are shunned. The normal state is just that, normal.
The other two extremes are the tails that we have just lived through.
A prolonged, benign macroeconomic environment can encourage the transition from normal
to exuberant states. As we have all just been reminded at great cost, low, stable, and
predictable inflation and low variability in activity - especially when associated with
exceptionally low and stable interest rates - can breed complacency among financial market
participants as risk taking adapts to the perceived new equilibrium.6 Indeed, risk appears to
be at its greatest when measures of it are at their lowest. Low variability of inflation and
output (reduces current financial VaR and) encourages greater risk taking (on a forward VaR
basis). Investors stretch from liquid to less-liquid markets. In parallel, low and stable interest
rates promote larger asset-liability mismatches across credit and currency markets. These
tendencies are particularly marked if there is a perceived certainty about the stability of low
7
interest rates.
Many of these positions are funded on a collateralized basis. Such asset-based financing
creates intensely procyclical liquidity cycles. In these cycles, rising asset prices increase
funding liquidity, which finances further purchases and prompts additional price increases.
Over time, haircuts are relaxed, further intensifying the cycle.8,9
It is important to recognize that expectations about monetary policy can feed these
dynamics. It would appear that the so-called "Clean" doctrine reinforces the risk-taking
behaviour of agents. This is a strategy that advocates using monetary policy to "clean up," or
respond to, the consequences of a burst asset bubble rather than "leaning into the wind,"
4
Other factors include where the economy is in the cycle and the state of household and corporate balance
sheets.
5
They do so within a perceived risk budget. The actual risk budget has, of course, grown.
6
Either perceptions of risk or risk preferences could change. In the former case, complacency about actual
risks can mean taking greater risks within the same risk budget.
7
See Diamond and Rajan (2005).
8
See Gorton and Metrick (2009), Fisher (2008), and Adrian and Shin (2008) for comprehensive descriptions of
these dynamics.
9
Ways to limit such procyclicality include enforcing through-the-cycle margins in repo markets and limiting
rehypothecation margins in securities lending to 100 per cent.
BIS Review 98/2009
which would limit the progression of excess credit creation.10 The combination of the central
bank's silence over the existence of a possible bubble, the certainty that it would not respond
to emerging financial pressures unless they affect price dynamics over the monetary policy
horizon, and the expectation that it would mop up if the bubble bursts all conspire to sow the
seeds of the next crisis.11
Though they are far from the whole story, such dynamics are central to the understanding of
the current financial crisis.12
The first line of defence is better regulation
While misery loves company, we must be careful not to generalize recent failings. The
foregoing description of liquidity cycles assumes that agents can extend mismatches,
increase leverage, and boost collateral-based finance if conditions appear favourable. In
other words, regulatory quiescence or arbitrage is also required.
Neither has been universal. The oft-derided existing regulatory tool kit has been deployed
more effectively in some jurisdictions than in others. Indeed, many Inflation Targeters
achieved their price stability objectives and retained well-functioning, appropriately exuberant
financial systems (including Canada, Australia, and New Zealand). This advantage is easily
replicated and could be further enhanced if an effective macroprudential approach were
developed.13
The implementation of monetary policy will have to change
New macroprudential tools will change the transmission mechanism, potentially in real time if
discretion is used in their application. As a result, central banks will need to coordinate
across conventional monetary policy tools and those emerging financial stability tools that
have monetary policy implications. This could prove challenging.
Fortunately, we are already on the learning curve. Strains in the interbank, repo, and credit
markets dramatically tightened the effective stance of monetary policy. In response,
extraordinary liquidity facilities were deployed. The effectiveness of these facilities varied
across jurisdictions with the health of core financial institutions and the scale of shadow
banking systems.
A common lesson is that current market infrastructure does not ensure continuously
available core funding markets. A wholesale restructuring of funding markets is thus
required. Promising avenues to break such liquidity spirals include introducing clearing
houses, standardizing products, implementing through-the-cycle margining, and ensuring
more effective netting. As the ultimate provider of liquidity to the system, central banks
should consider whether to adapt our facilities to support continuous private liquidity creation.
Through such measures, we can reduce the procyclicality of the transmission mechanism.
How other emerging macroprudential tools are implemented also matters. If these new tools,
such as time-varying capital buffers, are purely rules based, perhaps linked to aggregate
credit growth, their impact on the transmission mechanism may be determined with
experience. Unfortunately, it is unlikely that we can get the rules right ex ante and, in any
event, private innovation may change their impact over time. If there is an element of
discretion in their application, it may be less certain that such dynamic management of the
transmission mechanism for financial stability purposes will be both timely and effective. This
could place greater pressure on monetary policy to act. For this reason, there is likely value
in either coordinating such decisions in the same authority or determining some other
mechanism for joint optimization.
The basic point is that in order to maximize the probability of achieving both price and
financial stability objectives, one objective of macroprudential tools should be to dampen the
procyclicality of the transmission mechanism. This will take the weight off monetary policy to
act for financial stability purposes and allow its use to be concentrated on the pursuit of price
stability.
Can central banks achieve dual price and financial stability mandates?
With the advent of inflation targeting, price stability mandates for most central banks have
become increasingly well defined. Until recently, the vagueness of most financial stability
mandates and the assumption that price stability was consistent with financial stability meant
that there were few perceived conflicts. In the wake of the crisis, financial stability mandates
can be expected to harden and conflicts may become more apparent. Can central banks
jointly optimize these objectives? What are the implications for monetary policy of trying to do
so?
Price stability should be retained as the central objective of monetary policy, although its
definition may have to change. Price stability may not be enough to stabilize economic
activity in all states of the world, but neither is it undesirable. Indeed, the single most direct
contribution that monetary policy can make to sound economic performance is to provide our
citizens with confidence that their money will retain its purchasing power. That means
keeping inflation low, stable, and predictable. Price stability lowers uncertainty, minimizes the
costs of inflation, reduces the cost of capital, and creates an environment in which
households and firms can invest and plan for the future. It has generally been coincident with
sustainable growth in output and employment.
Having a credible price stability objective has also proven enormously helpful during the
crisis and should continue to be so during the eventual exit. The coherence of policy and the
message derived from one fixed objective provide greater certainty for financial markets in a
time of considerable turmoil. The ability to maintain inflation expectations has helped keep
real interest rates low and provide the necessary monetary stimulus. The inflation anchor
remains essential even when providing extraordinary guidance. This is why the Bank of
Canada's current commitment - that our target rate is projected to remain at its effective
lower bound through the end of the second quarter of 2010 - is explicitly conditional on the
outlook for inflation.
Different time horizons for price and financial stability require flexibility
The main challenge for joint optimization is that financial and price stability share common
determinants but have different time horizons. Price stability dynamics continuously reflect
real shocks and/or policy responses, while financial vulnerabilities are much less predictable.
They build over time and can persist for longer than expected. Because of this mismatch,
policy actions consistent with targeting one may undermine the other.14
This timing difference can be partially bridged in a couple of ways. First, housing prices can
be incorporated in the consumer price index, as they are in Canada. Second, monetary
policy communications could adapt to reflect the behavioural dynamics of financial systems.
An effective communications strategy for normal states may prove counterproductive in
exuberant states.
How central banks communicate can influence the degree to which low, stable, and
predictable inflation fosters excess credit growth. It is important that markets understand how
a central bank formulates policy, but that does not equate to perfect foresight. Differences in
judgment and the fundamental uncertainties surrounding the economic outlook should mean
occasional differences in view. These should be particularly marked during turning points in
the economic cycle. As the review of liquidity cycles suggests, wider "markets" in expected
economic outcomes (which would mean greater short-term volatility) could promote
longterm financial stability.15
The alternative would be to generate price instability to prevent financial instability. That is,
the price objective might have to become less stable in order to disrupt the endogenous
liquidity creation that comes from relatively stable, predictable rate paths.16 This, rather than
a higher inflation rate (if reliably achieved), would appear necessary to disrupt the dynamics
described earlier.
The trade-off between flexibility and credibility challenges joint optimization
Flexible inflation targeting is the standard approach to bridge the different time horizons for
financial and price stability. However, there are limits. The time frame for inflation targeting
can be stretched, but the credibility essential for its success may be undermined if such
flexibility is taken too far or deployed too frequently.17 Flexible inflation targeting works well
with temporary or one-off shocks. Whether it can adapt to address unique but longer-lived
shocks or different states of the financial economy, such as an asset boom, is the relevant
question.
The design of monetary policy frameworks depend in part on the trade-off between flexibility
and credibility. This, in turn, is a function of both the extent to which (inflexible) rules enhance
credibility and the ability of central banks to exercise the discretion required to deploy any
flexibility in a credible manner.
There is an important governance and accountability aspect to this, which the current debate
often ignores. Inflation-targeting regimes generally have fixed targets, with bands and tight
timelines for their achievement. This inflexibility sets clear objectives and helps hold central
bankers accountable. It also can create a virtuous circle. As the inflation target is achieved, it
enhances the central bank's credibility, which further anchors inflation expectations, which
then contribute to a more stable macroeconomic environment, and that, in turn, further builds
policy credibility.
We should be careful neither to underweight the value of resulting simple heuristics of
economic agents nor to minimize the risks of complicating them. If the central bank were to
lean for financial stability reasons and miss its inflation target as a consequence, its
accountability could be diminished, its credibility reduced, and potentially, inflation
expectations themselves could become unanchored.18
The key question is whether the financial stability benefit of greater flexibility is worth the
price stability risk of forfeited credibility.
Amending the price stability objective to promote financial stability
This all suggests that if monetary policy must lean into the wind for financial stability
purposes, then the price stability objective should change in a manner consistent with the
desired variability in the price path. This could be accomplished by combining flexible
inflation targeting and price-level targeting.
In general, policy-makers would rely on enhanced macroprudential regulatory frameworks to
curb the enthusiasm in the financial system.19 While the policy interest rate would not be the
primary tool for promoting financial stability, it occasionally might be used to support
macroprudential tools. Leaning into the wind for financial stability purposes could thus result
in temporary deviations from the inflation target. To avoid threatening the monetary policy
objective, these deviations could be recovered over time in order to keep the economy on a
predetermined path for the price level.
The prospect that the target rate could be deployed in this manner would help maintain a
balance between macro and idiosyncratic risk. The discipline of a transparent and
accountable price stability objective via the price-level target could maintain central bank
credibility.
However, authorities, if they are granted flexibility, must be sufficiently disciplined not to
decide that all shocks are uniquely virulent. This suggests that exercising any flexibility to
lean into the wind for financial stability purposes should be episodic, the product of
statedependent rules. That is, the central bank would need to make the judgment not only that an
exuberant state is developing, but also that macroprudential tools alone are insufficient to
possibility
counteract it. The that the central bank would make this judgment would rise with
the degree of excess credit creation, providing a partial check on emerging complacent
financial expectations.
A crucial motivation for this idea is that the balance of long-term price stability (i.e., achieving
a predetermined price path) with higher short-term variability (due to the occasional leaning)
is ultimately more consistent with achieving financial stability than conventional inflation
targeting.20 This reflects the relationship between price stability; low, relatively stable interest
rates; and the emergence of exuberant financial states of the world described earlier.
However, it also presumes that regulation is not up to the task. It is important to stress again
that the first line of defence against these dynamics must lie in improved regulation and
market structure.
It is also important to remember that there are concerns about macro stabilization under
price-level targeting. In particular, the performance of a price-level target may suffer if
inflation expectations are highly backward looking and/or if the economy is vulnerable to
shocks generating negative correlation between output and inflation.21 Highly persistent
relative price shocks may also pose a problem for macro stabilization under price-level
targeting.22 Any decision on the overall merits of price-level targeting must take all of these
considerations into account.
Conclusion
Experience has shown that monetary and financial stability are more tightly bound than had
been appreciated. Price stability is a necessary, but not sufficient, condition for the
stabilization of economic activity, and it must be supplemented by a robust macroprudential
regulatory framework. This, in turn, will have consequences for the implementation of
monetary policy. If these macroprudential tools prove insufficient to achieve financial stability,
monetary policy faces a difficult trade-off between flexibility and credibility. As a
consequence, authorities may wish to adjust the monetary policy objective to have the
credible
flexibility required to achieve both targets. Price-level targeting offers one potential
avenue for consideration.
A formal assessment of the merits of price-level targeting will require the development of a
framework that has a more realistic depiction of real-financial linkages than is embodied in
the standard financial accelerator model. These models are still in their infancy, and their use
to study the relative merits of inflation targeting and price-level targeting is the subject of
ongoing research at the Bank of Canada.
The financial stability aspect of the price-level versus inflation targeting debate is only one of
many relevant dimensions. The Bank has launched a multi-year research initiative that
includes a comprehensive examination of the possible advantages of moving to a price-level
target.23 Our efforts in this area are ongoing and we look forward to continuing to work with
monetary policy experts, academics, and central bankers from across the world. Carl Walsh
has made a valuable contribution to that debate today.
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