Christian Noyer: Monetary policy and macroprudential policy
Speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of the Board
of Directors of the Bank for International Settlements, at the conference on "The future of
Monetary Policy", Rome, 1 October 2010.
* * *
Ladies and Gentlemen,
It is a great pleasure for me to be here today at this joint Banca d'Italia, Einaudi Institute and
Banque de France conference, which has provided a lot of stimulating ideas on the future of
monetary policy frameworks. In my intervention, I will start with some reflections on the
relationship between the objectives of price stability and financial stability, and I will then
proceed to discuss several issues concerning the joint implementation of, and the interaction
between, monetary and macroprudential policies.
I. General considerations on the relationship between financial stability and
price stability
Both the experience of the last decades and, looking much further back, economic history
provides a useful perspective on the relationship between price and financial stability:
first, price stability is not a sufficient condition for financial stability but second is necessary;
third, a key reason why the authorities in charge of monetary policy have a stake in
maintaining financial stability is that financial instability may give rise to "tail risks" to price
stability.
Let me elaborate on these two issues in turn.
A. Price stability is not sufficient for financial stability
The two decades leading up to the financial crisis had been characterized, across the
developed world, by low and stable inflation, and, by historical standards, by exceptionally
stable output growth. It is not by chance, indeed, that macroeconomists labeled those years
as the "Great Moderation" era. At the same time, however, as extensively documented in
particular by the BIS in several perceptive, early papers,1 those years had been also
characterized, compared with the previous portion of the post-WWII era, by a significantly
more frequent occurrence of asset price bubbles and subsequent crashes.
A longer-term perspective clearly shows that the occurrence of asset prices booms and
busts under conditions of price stability, far from being a "fluke" of the Great Moderation era,
had been, in fact, quite common. Until the outbreak of World War I, indeed, metallic
standards had dominated for centuries, guaranteeing an extent of price stability which is, by
today's standards, virtually unimaginable. Just to mention a single example, the price level in
England in 1661, five years before the Great Fire of London, had been virtually the same as
that prevailing in 1913, one year before the collapse of the international Gold Standard. In
spite of such remarkable price stability, however, metallic standards had been recurrently
plagued by financial crises and asset prices booms and busts, from the South Sea bubble of
17202 to the "Panic of 1907", which was only solved by the forceful intervention of John
Pierpont Morgan, and which ultimately convinced U.S. policymakers of the necessity to
establish a central bank.
But why should monetary regimes delivering strong price stability be vulnerable to asset
price bubbles and financial crashes? A long term perspective suggests that banking systems
tend to periodically generate asset price bubbles even under radically different monetary
regimes. Having an outburst of several years of excessive credit growth, or for the old days
financial crisis, the rising exposure of some financial institutions to asset price volatility has
repeatedly led to financial crises. Historical experience before world war I, where price
stability has been unmatched ever since, should have reminded all of us, financial market
participants and policy makers alike, that price stability is no blanket insurance against
financial instability.
B. Price stability is necessary for financial stability
The most obvious case in which price instability automatically leads to financial instability is
that of deflation, via the "debt deflation" mechanism originally identified by Irving Fisher with
reference to the Great Depression.3 A more recent example of this phenomenon is provided
by Japan, where the persistent deflation which has gripped the country since the early 1990s
has consistently led, ceteris paribus, to a heavier debt burden for households that had
contracted mortgages in the boom phase of the late 1980s and deterioration of banks'
balance sheets. In a symmetric fashion, high inflation - which, historically has also
consistently meant volatile inflation - threatens the very foundations of the financial system
because of the resulting capricious and unpredictable redistribution of wealth between debtor
and creditor institutions. The most glaring example of such a phenomenon is provided by
episodes of very high, or hyper-inflation, such as those plaguing a significant fraction of
belligerent nations in the aftermath of World War I. Evidence from the Great Inflation episode
of the 1970s is, although less dramatic, equally telling.
Altogether, historical evidence therefore leads us to conclude that, although not sufficient,
price stability is indeed a necessary precondition for financial stability.
I now turn to a final point concerning the relationship between financial and price stability,
namely the need to preserve the stability of the financial system in order to prevent the
emergence of "tail risks" to price stability. I will start by discussing risks on the downside
- that is, the possibility that the economy falls into a deflationary spiral - and I will then turn
to those on the upside.
C. The need to preserve the stability of the financial system in order to prevent
to price stability
the emergence of "tail risks"
The best illustration of tail risks to price stability on the downside associated with financial
crises comes from the historical experience of the United States during the Great Depression
which followed the collapse of the stockmarket and housing bubbles of the second half of the
1920s, and by that of Japan following the collapse of the real estate bubble of the second
half of the 1980s. In both cases a dramatic expansion of credit fuelled bubbles which
pushed asset prices to dizzying heights. In the case of the 1920s United States, in particular,
such credit expansion was associated with a wave of euphoria caused by "new-era" thinking
which, in turn, had been ignited by the dramatic wave of technological innovation which
swept across the country during that decade.4
The attempt, on the part of young Federal Reserve, to gently deflate asset prices via interest
rates increases backfired, and the result was the 1929 crash, with the associated destruction
of a staggering amount of financial wealth, and the injection into the economy of a significant
extent of uncertainty. This, in turn, exerted a paralysing effect on a significant fraction of
spending decisions, thus playing a key role in triggering the 1930s Depression and the
resulting deflationary spiral.5
What should we conclude from this brief excursus? In launching the economic revolution
which unbound China and ultimately propelled it among the world powers, Deng Xiao-Ping
famously exhorted his countrymen to "Seek truth from facts",6 in stark opposition to the
ideological approach which had dominated up until then. Within the present context the facts
are clear: on the one hand, price stability is a necessary precondition for financial stability,
although it is by no means a sufficient one; on the other hand, a key reason for preserving
the stability of the financial system is in order to avoid potentially significant risks to price
stability, in one direction or the other. Let me now turn to discussing several issues
concerning the joint implementation of, and the interaction between, monetary and
macroprudential policies.
II. Issues concerning the joint implementation of, and the interaction between,
monetary and macroprudential policies
We are currently in uncharted waters. The new mix of macroeconomic policies, with the
setting up of macroprudential policies, is being developed as we speak. Some issues are
already clear: we have two objectives - price and financial stability - which, based on
standard economic analysis, means that we will need two separate instruments to achieve
them. Further, based again on standard analysis, the assignment of instruments to objectives
ought to be based on the principle of comparative efficiency. Monetary policy is the natural
instrument for pursuing price stability. Using again the prisma of Deng Xiaoping, the success
of central banks in stabilizing inflation since 1995 strongly supports this view. Macroprudential
policies - defined as a set of policies aimed at limiting both excessive credit growth and the
build-up of systemic risk within the financial system - will have to take care of preserving
financial stability. From here onwards, however, things become less clear-cut, and sometimes
positively complex.
First, the two objectives are qualitatively different. On the one hand, price stability is very
easy to define and to measure in terms of a specific price index. As a result, monetary policy
is comparatively easy to communicate, and its performance can be assessed in a relatively
straightforward way. Financial stability, on the other hand, is significantly fuzzier, as it deals
with preventing the accumulation of systemic risks, the build-up of asset price persistent
misalignments, that some call bubbles, etc.. As a result, it cannot be defined in a
straightforward fashion, with reference to, in the extreme case, a single indicator, and ought
therefore to be communicated and assessed in a more complex way.
Second, and crucial, is the unchartered interaction between the two policies. On the one
hand, recent thinking has stressed how monetary policy can contribute to sowing the seeds
of future financial instability. Low interest rates, for example, can contribute to the build-up of
financial imbalances via the so-called "risktaking" channel.7 Simply put, very low interest
rates may create incentives for banks to take on more risks. Recent research has provided
empirical evidence compatible with such a notion. It has been documented,8 for example,
how market based measures of bank's risks as perceived by financial market participants
tend to react positively to changes in interest rates, so that a lower interest rate leads
investor to perceive banks as less risky. By the same token, several papers9 have shown
that credit standards are correlated with the level of interest rates: lower interest rates, in
particular, imply lower credit standards including to customers who are perceived as
Banque de
representing a higher credit risk. On the theoretical side, research done at the
France10 has shown that, when the regulatory environment is not transparent, a decrease in
the level of real interest rate increases banks' risk-taking behavior, in parts because it may
facilitate the under-pricing of risks typical when asset prices rise.
Another risk, spotted by Raguram Rajan11, is that low interest rates lead banks into a "search
for yield" strategy, in order to maintain a desired - or even institutionally mandated - rate of
return. A time-honored principle of finance is that, ceteris paribus, the only way to increase
the expected rate of return is to take more risk, and the result of such search for yield is
therefore that banks will increase their risk exposure.
An alternative channel through which excessively low rates may have contributed to the
building up of financial imbalances during the period leading up to the crisis originates from
central banks' ultimate focus on goods', rather than asset prices' inflation. During a period
characterized by large, benign supply shocks originating from the integration of large
developing countries into the global economy, the resulting disinflationary pressures induced
central banks to keep interest rates at comparatively low levels - in particular, levels which,
with the benefit of hindsight, may have contributed to excessive credit growth, with the
resulting creation of asset prices' bubbles.
Some commentators have henceforth suggested including asset prices into the index
targeted by the central bank. I see this as a distinctly sub-optimal solution, as it would
essentially amount, in practice, to moving to a situation with one instrument, monetary policy,
aiming at a combination of two objectives, price and financial stability. Economic theory
dictates that, in the presence of multiple objectives, policymakers ought to rely on a number
of instruments at least equal to the number of objectives. Combining multiple objectives into
a single one, on the other hand, would only apparently solve the problem by artificially
reducing the number of goals, but it would not change the fundamental nature of the control
problem facing the policymaker.
At the current juncture, only very little research is conducted on the interaction between
monetary and macroprudential policies within rigorously microfounded general equilibrium
models. The Banque de France staff and I are very admirative of the leadership of Banca
7
See Claudio Borio and Haibin Zhu (2008), "Capital Regulation, Risk-Taking, and Monetary Policy: A Missing
Link in the Transmission Mechanism?", BIS Working Paper n. 268, December 2008.
8
See Yener Altunbas, Leonardo Gambacorta, and David Marqués-Ibáñez (2010), "Does Monetary Policy Affect
Bank Risk-Taking?", ECB Working Paper n. 1166, March 2010.
9
See Vasso Ioannidou, Steven Ongena, and José-Luis Peydró (2008), "Monetary Policy, Risk-Taking and
Pricing: Evidence from a Quasi-Natural Experiment", ECB, mimeo; Matteo Ciccarelli, Angela Maddaloni, and
José-Luis Peydró (2009), "Trusting the Bankers: Another Look at the Credit Channel of Monetary Policy",
ECB, mimeo.
10
See Benoit Mojon, Simon Dubecq and Xavier Ragot (2010), "Fuzzy Capital Requirements, Risk Shifting and
the Risk Taking Channel of Monetary Policy", Banque de France mimeo.
11
See Raguram Rajan (2005), "Has Financial Development Made the World Riskier?", presented at: The
Greenspan Era: Lessons for the Future, a symposium sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming, August 25 - 27, 2005.
BIS Review 158/2010
d'Italia in this domain, as shown in the paper by Angelini, Neri, and Panetta12 which has been
presented at this conference. I look forward to further research on this new dimension of
macroeconomic policy. If research on new topics has some form of diminishing returns, the
first good papers in this area will have huge visibility and numerous citations.
I know that the brain power in this audience is first class. Let me tell you that if you ever
dreamt of having an impact on the design and the implementation of economic policy, this is
the time. Your inputs are badly needed !