Stephen S Poloz: Integrating financial stability into monetary policy
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the National Association
for Business Economics, Washington, DC, 12 October 2015.
* * *
I would like to thank Don Coletti and Stephen Murchison for their help in preparing this speech.
Introduction
I appreciate the opportunity to be part of this event. As usual, NABE is confronting some of the
most important and difficult issues in economics at this meeting. For central bankers, as we
work to understand and react to the aftermath of the global financial crisis, the key question is
how we should integrate financial stability concerns into the conduct of monetary policy.
Over the weekend, I attended the annual meetings of the International Monetary Fund and the
World Bank, where this question was a topic of discussion. There is some urgency to this issue,
given the way the crisis highlighted how much we have yet to learn about the linkages between
the financial system and the real economy. If you think back to the pre-crisis period, nobody
gave much credence to the idea that focusing on price stability could somehow contribute to
the buildup of dangerous imbalances. Central bankers now know that we must consider
financial stability as we set policy. The idea that central bankers should pay little heed to
financial stability issues and simply "stick to our knitting" of inflation control - a position once
advocated by many - seems quaintly naïve.
Fortunately, the profession appears to be up to the challenge. Understanding real-financial
linkages is a research priority at the Bank of Canada and elsewhere. After all, we've seen how
financial imbalances in one sector of one economy can be amplified and propagated across
the entire financial system, leading to the worst global downturn since the Great Depression.
So what I will do today is share our perspective on how we integrate financial stability concerns
into the pursuit of our goals of price stability and macroeconomic stabilization. This exercise is
fraught with risks and uncertainties, and it is complicated by the fact that macroeconomic and
financial stability objectives are not always consistent with each other. Coping with this
becomes a problem, not of policy optimization, but of risk management. In other words, we put
aside the idea of engineering the perfect policy and focus instead on the more realistic goal of
finding an appropriate policy setting, given the risks and uncertainties.
Monetary policy and financial imbalances
The debate about using monetary policy to respond to financial imbalances has evolved rapidly
since the pre-crisis era. A decade or so ago, the discussion was essentially between those
who argued that monetary authorities should lean against imbalances such as asset-price
bubbles and those who said that monetary policy should be reserved for cleaning up the mess
after the bubble popped.
Before the financial crisis, the Bank of Canada basically straddled the two camps. On the one
hand, we argued that it's very difficult to identify an asset-price bubble, and central bankers
have no comparative advantage in making this determination. Like many, we questioned the
wisdom of using the blunt instrument of interest rates on a bubble that could be confined to
one asset class. Indeed, if a bubble was particularly large and persistent, a central bank that
used the cure of higher interest rates could end up causing the very economic damage it was
trying to prevent.
On the other hand, the Bank recognized that price stability was a necessary, but not sufficient,
condition for financial stability. Given our keen interest in a well-functioning financial system
and our macro perspective, we worked to raise awareness of stability threats. Our decision to
begin publishing our Financial System Review (FSR) in 2002 showed our early commitment
to promoting financial stability. We used the phrase "global imbalances" a lot in speeches
leading up to the crisis. In other words, we weren't content to just stand on the sidelines and
wait to clean up messes.
The widespread and extremely high cost of the Great Recession made it clear just how difficult
the clean-up job can be. It has been roughly seven years since the crisis, and the damage
done to the global economy has left many central banks still struggling with weak growth and
inflation.
However, the more fundamental lesson we learned is that "lean versus clean" is a false
dichotomy. It's far too simplistic to say that financial stability threats compel central banks to
choose between leaning and cleaning. In a perfect world, we would have a macroeconomic
model sophisticated enough to capture the emergence and resolution of financial imbalances,
along with their related impacts on the real economy. With such a model, we would be able to
incorporate financial stability threats into our reaction function, if not with absolute precision,
then at least as well as we incorporate other economic variables.
Unfortunately, we don't live in that perfect world. A general-equilibrium model containing a
grand synthesis of real and financial variables doesn't exist and isn't likely to. I don't mean to
downplay the importance of research and the development of stylized models, which are
crucial in helping us understand aspects of the relationship between the real economy and
financial stability. But the reality is that central banks have to cope with tremendous uncertainty
regarding financial stability issues, and this is layered on top of the regular uncertainties of
monetary policy concerning unobservable variables such as potential output.
Given all of the uncertainty, it seems to me the proper response of the monetary authority is to
acknowledge and accept all the things we don't know, gauge the risks facing the economy as
best we can, and manage those risks as we conduct monetary policy. I'll describe our
riskmanagement framework in detail later on. But we still have the question of how policy-makers
should respond to financial imbalances, particularly those that are concentrated in a specific
sector or asset class.
The Bank of Canada's view is that monetary policy should be the last line of defence against
threats to financial stability, behind the joint responsibility of borrowers and lenders,
appropriate regulatory oversight within the financial sector, and sound macroprudential
policies. Let me say a little bit about each of these.
Financial stability threats - lines of defence
Borrowers and lenders are the first line of defence. They bear the ultimate responsibility for
their own decisions at the individual and firm level. It is not the role of monetary policy to protect
individuals from making bad choices. It is possible that the sum of those bad decisions could
threaten financial stability or the economy as a whole, and so we monitor the situation as a
matter of course. But there is no reason to assume that, in all circumstances, equilibrium will
devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis.
Indeed, market discipline enhanced by appropriate transparency can be very helpful in this
regard.
That's not to say policy-makers have no role in enhancing this line of defence. Financial
education and efforts to improve financial literacy can help consumers better understand the
important decisions they make.
In Canada, we have seen increasing levels of household debt that represent a key vulnerability
for the financial system. The main driver behind this rise has been an increase in home-backed
debt against a backdrop of rising house prices, particularly in two of Canada's largest cities -
Toronto and Vancouver. Among other factors, this was due to low interest rates that resulted
in the ratio of debt service to income, including principal repayment, remaining roughly
unchanged since 2008. Given this, the increase in household debt levels is no surprise. Rather,
this rational response by consumers to easy monetary policy is a sign that the transmission
mechanism has been working.
I'm not trying to diminish the threat posed by elevated household debt. We are continuing to
watch this closely. The point is that there is more to the story than the debt-to-income ratio.
Because house prices have generally been rising faster than incomes, we have seen increases
in the size of a first-time mortgage that a new borrower might take out. Mathematically, the
total debt-to-income ratio rises as a result. But it doesn't necessarily mean an increase in the
vulnerability of the economy or the financial system.
The second line of defence is sound regulatory oversight of the financial sector. This oversight
has been significantly strengthened since the financial crisis. Basel III has made the world a
safer place; there can be no doubt about that. But even before the crisis, Canada's banking
system was well served by its strong regulatory environment and prudent culture, which
allowed our institutions to avoid the worst of the turmoil.
Given the scale of the damage caused by the financial crisis, it's not surprising that authorities
devised a reform agenda of corresponding proportions. The G20 pledged to do everything
necessary to address the weaknesses exposed by the crisis.
The proper implementation of the Basel rules will go a long way to preventing certain threats
to financial stability from forming in the first place. It will also reduce the potential consequences
of those threats by making the financial system much more resilient.
Nonetheless, Basel III can't prevent the formation of all financial imbalances, such as those in
housing markets. Elevated house prices can become a concern for central bankers,
particularly if they are associated with higher levels of household indebtedness and leverage.
And we know that house prices can deviate in a meaningful way from underlying fundamentals,
especially if expectations of price gains are based on simple extrapolations and become
disconnected from economic fundamentals. A sudden reversal of such misalignments can
cause significant stress in the financial system and the economy as a whole.
That is where the third line of defence - macroprudential policy - comes into play.
Macroprudential policies have a relatively short history, and there isn't a lot of empirical
evidence yet. But one set of tools that has been used more frequently and studied more
extensively consists of those that deal with housing. The International Monetary Fund and
several central banks - including the Bank of Canada - have looked at this area. They've found
that some macroprudential policies, such as limits on mortgage loan-to-value ratios and
increased capital weight on bank holdings of mortgages - can moderate the growth of credit
and house prices as well as improve the average creditworthiness of borrowers. The impact
of recent macroprudential tightening in Canada, which was aimed primarily at rules for insured
mortgages, appears to support these findings.
If we accept that properly implemented macroprudential policies can help to effectively combat
financial vulnerabilities by strengthening resilience in the financial system and reducing
systemic risk, this supports the view that authorities should look to these policies first when
imbalances arise, before turning to monetary policy.
Across the advanced economies, there is a wide variety of governance models for
macroprudential policy-making. In many cases, the mandate is centralized - sometimes within
the central bank, as is the case at the Bank of England, or outside the central bank, as in the
United States. Some macroprudential bodies have the power to write regulations; others are
limited to monitoring and making recommendations.
While their precise roles may differ, it's crucial that central banks be involved, because we
bring a unique, system-wide perspective that can help identify and assess systemic
vulnerabilities and risks. Further, our interests in financial stability cut across the Bank of
Canada's functions - not only do we need a well-functioning financial system to transmit our
monetary policy, but we also have oversight of systemically important financial market
infrastructures and, of course, we are the lender of last resort to the system.
When more than one body is involved in macroprudential policy, there needs to be a
mechanism to discuss and coordinate responses and to provide checks and balances within
the regulatory system. In Canada, the Senior Advisory Committee fulfills this role. The
committee is chaired by the Deputy Minister of Finance and includes the Bank of Canada, the
Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance
Corporation and the Financial Consumer Agency of Canada. It is an informal forum where
members can share information and perspectives on their own policies as well as on the overall
regulatory environment. The committee's strength lies in the way it allows members to
understand the views of other members and to coordinate macroprudential policies, which is
essential, given the potential side effects that macroprudential and monetary policies can have
on each other.
The last line of defence is monetary policy, and this is the context in which we think of leaning
against imbalances. To be clear, I'm defining leaning as choosing a different path for interest
rates than would be optimal for the inflation target in order to mitigate risks to financial stability.
This could mean, for example, accepting a significant delay in getting inflation back to target
so as not to exacerbate financial vulnerabilities along the way.
Understanding the links
At this point, let me remind you of a complicating factor for policy-makers that I mentioned
earlier - the fact that macroeconomic and financial objectives aren't always consistent. It's
clear that financial system policies - including global frameworks such as Basel III and
countryspecific macroprudential policies - can reduce the likelihood of financial imbalances and crises
by reducing tail risks. However, it is also clear that these policies, and the state of the financial
system in general, can also influence the effectiveness of monetary policy. So we need to
deepen our understanding of the links and potential trade-offs between monetary and financial
system policies.
Let me explain. Sometimes the economic and financial cycles move in tandem. Consider a
demand shock where excess demand and upward inflationary pressure lead the central bank
to raise interest rates. Here, monetary policy can restrain both demand and credit growth. Now
consider a different scenario, where a central bank is running easy monetary policy to try to
encourage borrowing and spending. Over time, the increased borrowing could potentially lead
to imbalances, in the housing market for example. In this case, you could have macroprudential
policy tightening that's working in the opposite direction of monetary policy.
It's therefore crucial to deepen our understanding of how the various transmission channels
for monetary policy can be affected by variables that could be targets for financial system
policies.
These types of questions are urgent research priorities for the Bank of Canada as we work
toward renewing our inflation- targeting agreement with the federal government next year.
Indeed, assessing the costs and benefits of possible monetary policy interventions to address
financial stability concerns continues to be a priority in the lead-up to the renewal. Let me give
you a taste of some of the specific areas the Bank is looking at in terms of the relationship
between financial stability and monetary policy.
We are gathering empirical evidence about the effects of household debt levels on monetary
policy. We are conducting research specifically on financial imbalances in the household sector
to determine the best way to minimize the risk of future crises. We are developing models that
will do a better job of quantifying the costs and benefits of using monetary policy to combat the
build-up of imbalances. We are drawing lessons from the experiences of other central banks
and the different ways they have reacted to financial stability developments. And we are
looking at ways of measuring how much safer the financial system has become following
regulatory reform in Canada and elsewhere. You can monitor the results of these efforts on
our website, where we have a section dedicated to the research that is informing the renewal
of the inflation-control target.
Central banks, including the Bank of Canada, have made progress in developing new
economic models and adapting existing ones to integrate financial system variables and
stresses as we conduct monetary policy. We've added potential sources of vulnerability, such
as the balance sheets of households, companies and banks, to our macroeconomic models.
We are using enhanced frameworks, fuelled by more and better data, to help monitor the
financial system and make more informed judgments about stability risks and how they might
interact with each other. We have boosted the profile of our semi-annual FSR publication.
We will continue to strive for a better understanding of the interactions between monetary
policy and financial stability, and I expect to see a large amount of groundbreaking research
that will shed light on various aspects of this relationship. However, there is a fundamental
problem - policy-makers need models that analyze a wide variety of variables and shocks in
order to do their projections, but it is enormously difficult to capture bubble-related behaviour
within a typical general-equilibrium model. So we have to rely on our regular models and
supplement them with stylized models that give us insights into specific financial stability
issues. These models show us a view of certain parts of the economic picture, but we will never
have a single tool that can provide the complete picture by itself.
Risk management in monetary policy
So, given that we're working with an incomplete picture of the economy, what is a central bank
to do? At the Bank of Canada we take a risk-management approach to monetary policy. Let
me explain what that means, and what it doesn't mean.
Since the early 1990s, inflation targeting has become increasingly popular among central
banks, and Canada was an early adopter. Under our current agreement, we aim to keep
inflation around a target of 2 per cent, and we usually try to accomplish this over six to eight
quarters.
Even in the absence of financial stability threats, the practice of monetary policy requires the
central banker to deal with vast amounts of uncertainty. Think of the most important aspects
of a macroeconomic model - the level and growth rate of potential output, the real neutral
interest rate, and the transmission of terms-of-trade shocks. None of these can be observed;
they all must be estimated. The assumptions that we make in running our models inject
uncertainty throughout the policy-making process. And, since the crisis, we have also been
confronted with the risk that our models have been distorted because of fundamental shifts in
economic behaviour.
Now, on top of all this uncertainty, we have to add the uncertainty represented by risks to financial
stability, a concept that is difficult to quantify. Adding this whole other dimension of uncertainty
complicates the practice of monetary policy by forcing us to weigh both sets of risks, the
probabilities that they will be realized and the potential consequences of a policy error.
So how do we manage the risks? At the Bank of Canada, we try to be realistic about the things
we don't know and do a thorough examination of the related risks. Every time we come to a
decision, there are a number of potential paths for policy that could be consistent with the
inflation goal. In the process of formulating policy, we weigh these possibilities and focus on
those that fall into a zone where the range of likely outcomes makes us reasonably certain that
we'll achieve the inflation target over an acceptable time frame and that financial stability risks
will evolve in a constructive way.
Still, we know there can be times when setting policy to achieve the inflation target within the
usual time frame can increase the level of financial stability risk to an unacceptable level. This
would take us out of the zone where the risks are essentially balanced. Because the flexibility
in our framework allows it, we reserve the right to choose our policy tactics so that our actions
don't significantly worsen financial stability concerns by opting for a policy path that aims to
return inflation to target over a longer time frame than normal.
Risk management, then, does not mean that the central bank will adjust policy to try to lean
against every emerging financial imbalance. Since we are an inflation- targeting central bank,
our policy tool must always be directed first at our inflation target. Even in extreme conditions,
when financial stability risks constrain monetary policy from achieving the inflation target over
a reasonable time frame, a central bank would want to ensure that all macroprudential options
were exhausted before trying to address those risks with monetary policy.
Let me give a real-life example to illustrate how we put our risk-management approach into
practice. Last year, before the oil price shock hit the Canadian economy, our policy was in the
zone I just described, with inflation on course to return to target in a reasonable time frame
and vulnerabilities in the household sector looking as if they would evolve constructively.
The oil price shock changed the outlook dramatically. It represented a potentially sizable
reduction of our national income and threatened to drive inflation below target for an
unacceptably long time. The expected sharp decline in economic activity and employment also
represented a possible trigger for Canadian financial stability risks related to elevated
household debt. Our monetary policy was knocked out of the zone, and the downside risk to
future inflation was material. So, in January, we lowered our policy interest rate, and we did so
again six months later as the impact of the shock became clearer.
We knew that easing policy would have implications for financial stability. However, we also
knew that those concerns had to remain subordinate to the primary mission of achieving our
inflation target and getting our policy back in the zone where the risks are balanced. Our
riskmanagement approach implied that, in the absence of any additional macroprudential
measures, our actions would affect the balance of risks in opposite directions. Lowering
interest rates could worsen vulnerabilities related to household debt at the margin, but it would
also lessen the chances of the oil price shock triggering financial stability risks. In the current
context, getting the economy back to full capacity with inflation on target is central to promoting
financial stability over the longer term.
Conclusion
It's time to conclude. The dramatic events of the financial crisis required a dramatic reaction.
New financial sector rules are being implemented to make the global economy safer.
Policymakers are working hard to understand the impact of new regulations and to develop effective
frameworks and best practices for implementing macroprudential policies.
For central banks, we know that financial stability has now become a permanent
preoccupation. We can't have a firm grasp on the economy and its outlook without also having
a good understanding of the links between financial stability and monetary policy. This is a
critical area of research for central bankers everywhere, and we look forward to the
contributions that economists will make in the months and years ahead.]
At the Bank of Canada, we will remain committed to delivering on our mandated inflation goal.
We will continue to strive toward improving our understanding of how monetary policy and
financial stability influence each other. And we will continue to use the flexibility in our inflation
targeting framework as needed to integrate financial stability concerns into the conduct of
monetary policy, while always keeping inflation control as our primary mission.