Timothy Lane: Monetary policy and financial stability - looking for the
right tools
Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to HEC Montreal,
Montreal, Quebec, 8 February 2016.
* * *
The charts can be found at the http://www.bankofcanada.ca/wp-content/uploads/2016/02/remarks-080216.pdf
website.
I would like to thank Don Coletti and Oleksiy Kryvtsov for their help in preparing this speech.
Introduction
Thank you for the opportunity to speak here today. My remarks will focus on the following
question: Should a central bank's decisions on monetary policy account for the stability of the
financial system and, if so, how? We at the Bank of Canada are grappling with this question,
and it is being debated by economists and policy-makers around the world.
This topic is not new, but finding the right answer now seems more urgent than ever. The
global financial crisis that began eight years ago has taken an enormous toll, both economic
and, more important, human. Around the world, including in Canada, the crisis ushered in a
period of subpar economic growth and inflation, which continues to the present day.
So it's easy to see why promoting financial stability - and preventing crises in the future - is
such a high priority for world leaders and all those involved in the financial system. This priority
has given rise to an ambitious and comprehensive agenda of reforms to make the global
financial system more resilient.
But, in thinking about how to prevent financial crises, it's also natural to look at monetary policy.
After all, when a central bank influences the cost of financing through changes in the policy
interest rate, its actions affect the economy by changing asset prices, encouraging or
discouraging risk taking, and influencing credit flows. This suggests that monetary policy has
the ability to influence financial stability, for good or ill.
If a central bank eases monetary policy, it stimulates the economy, largely by encouraging
households and companies to borrow more and pushing up the prices of many types of
financial assets. The increased borrowing, together with the greater wealth that comes with
higher asset prices, encourages households to spend more, generating income for other
households and creating opportunities for companies. But, at the same time, more debt and
higher asset prices may create vulnerabilities in the financial system.
In Canada in the period since the global financial crisis, the most concerning vulnerabilities
have been in the household sector - notably the combination of rising indebtedness and
elevated house prices. But a wider set of vulnerabilities, in more than one sector, was important
in setting the stage for previous crises. For example, heightened risk taking by investors and
elevated leverage in large financial institutions and in shadow banking activities were among
the factors that turned a downturn in the U.S. subprime mortgage market into a global financial
crisis.
While increasing such vulnerabilities at the margin is a normal consequence of an easing of
monetary policy, they may become of particular concern if interest rates stay low for an
unusually long time. In the presence of such vulnerabilities, an event such as an adverse
macroeconomic shock can stress the financial system or even trigger a crisis.
Since monetary policy can contribute to financial vulnerabilities, it could also be argued that it
can be adjusted to limit them. But whether and how to do that can't be considered in isolation
from the central bank's mandate. For the past quarter century, the Bank of Canada has had
the responsibility of using monetary policy to achieve low, stable and predictable inflation, a
goal cemented in our 2 per cent inflation target. This is our primary mission, which guides our
setting of the policy interest rate. While a failure to maintain financial stability would ultimately
impair our ability to achieve the inflation target, it is generally understood that we should aim
to get inflation sustainably back to target within about two years.
Within this framework, financial system developments are always part of monetary policy
discussions, because of their importance for the real economy and especially because of the
transmission of the effects of monetary policy.
We have some flexibility within our inflation-targeting framework: we might accept a slower
return of inflation to target, if necessary, to avoid adverse effects on financial stability. But the
expectation has been that we would only rarely, if ever, use the framework's flexibility in this
way.
This is not to say that our framework is immutable. The law governing the Bank since 1935
says we should "regulate credit and currency in the best interests of the economic life of the
nation." How we fulfill that requirement has evolved over the years. Inflation targeting was
established in Canada in 1991 under an agreement with the federal government, which we
renew every five years. We are currently working toward the next renewal, which takes place
later this year. This process gives us an opportunity to re-examine our mandate and consider
other ways of doing things. Financial stability, and its relationship to monetary policy, figures
prominently in our current research agenda.
In the time I have, I will discuss how our thinking on the interactions between monetary policy
and financial stability has been evolving, tell you about some interesting recent research by
our staff and touch on some questions that have yet to be resolved.
Financial Stability, then and now
Let me start by saying that central banks have always had a role in providing stability to
financial systems. Some of our tools are in the category of crisis management; others for crisis
prevention.
When the financial system comes under stress, a central bank may need to calm financial
markets through open market operations or act as the lender of last resort to financial
institutions to forestall bank runs. These tools were used effectively by many central banks
during the global financial crisis of 2007-09.
Some of the Bank of Canada's financial system activities are also designed, in part, to make
the system less prone to crisis. An example is the oversight of key financial market
infrastructures, such as payment systems and central counterparties. Such oversight is
intended to bolster their risk management so that they can support the continued functioning
of financial markets in times of stress.
More broadly, central banks are well placed to analyze systemic vulnerabilities and how they
might play out. In this vein, in 2002, the Bank of Canada began publishing a semi-annual
Financial System Review to raise awareness of the most important risks to Canada's financial
system.
But the Bank of Canada is only one of several official bodies whose policies have an influence
on financial stability. Others control many of the relevant tools - such as capital requirements,
the regulation of housing finance, the regulation of financial market conduct and the framework
for resolution of financial institutions. The Bank's analysis of emerging risks and vulnerabilities
can contribute to informing decisions by those other bodies.
It is in this context that we consider the question I raised at the beginning of this speech: the
possible role of monetary policy in underpinning financial stability.
While maintaining stable financial conditions was once understood to be part of the purview of
monetary policy, that changed in the wake of the period of high inflation in Canada and many
other advanced economies during the 1970s and 1980s. That experience, together with
influential research on monetary policy, convinced the economics profession that maintaining
price stability is the best - or even the only - contribution monetary policy can make to
promoting a country's economic and financial well-being.
The inflation-targeting regime we have today is an outgrowth of that experience. Inflation
targets have been very successful at maintaining price stability because they give everyone
an easy way to understand monetary policy and, over time, create a virtuous circle in which
realized inflation and expectations reinforce each other.
A central tenet of the framework is that a central bank uses the policy interest rate solely to
counter risks to inflation. If it tried to do other potentially conflicting things, such as keeping
unemployment artificially low or containing volatility in the financial markets, its credibility could
erode, the virtuous circle could break down and inflation could go back to being unpredictable.
The question of whether central banks can use monetary policy to promote financial stability
as well as price stability has re-emerged from time to time. It has often been couched in terms
of using monetary policy to prevent or deflate asset-price bubbles - perhaps to dampen
irrational exuberance in stock markets. But the question is really more general, related to the
use of monetary policy in countering an excessive buildup of leverage in the economy.
Identifying such financial imbalances is not as straightforward as it sounds, and using monetary
policy to address them was seen as a potential distraction from the task of targeting inflation.
Moreover, during the Great Moderation, such imbalances were not seen as a serious obstacle
to stabilizing the economy. Confronted with the choice of whether to "lean" or to "clean" -
leaning against emerging financial imbalances by keeping interest rates higher than they
otherwise would be or cleaning up in the event the risks they create are realized by providing
stimulus - central bankers at that time generally agreed that cleaning would be best.
That consensus was shattered by the global financial crisis. Unlike past episodes in recent
history, the crisis began in the world's most sophisticated financial systems, causing
widespread economic devastation. It stirred up persistent and formidable headwinds to
economic growth, also making it very difficult for central banks to bring inflation back to target.
After this brutal wakeup call, economists went back and re-examined the possible role
monetary policy plays in setting the stage for crises.
Looking at the historical evidence, it would be fair to conclude that few, if any, crises have been
caused by monetary policy alone. The global financial crisis, like the Great Crash of 1929, also
reflected widespread regulatory shortcomings and other weaknesses in a number of
countries.1 But it is likely that monetary policy played at least a contributing role in encouraging
the buildup of leverage and asset prices in a fragile financial system. The nature and
importance of that role in the run-up to these and other crises is the subject of ongoing research
and debate.2
Trade-offs
So, can monetary policy target inflation and still promote financial stability? This question can
be addressed in two parts. First, let's consider a case in which monetary policy is the only tool
available to promote both macroeconomic and financial stability. Later, I'll consider how
monetary policy might complement other policies that work more directly on the financial
system.
Sometimes inflation targeting and financial stability are complementary. For example, if the
economy is running above potential, creating inflationary pressures, while financial
vulnerabilities are also building, then both considerations point to tighter monetary policy. In
retrospect, this appears to have been the case in many countries in the period leading up to
the 2007-09 global financial crisis (Chart 1, see "Case 1").
The chart shows estimates by the International Monetary Fund of output gaps and credit gaps
during that period; while such estimates are obviously imprecise, they suggest that in most of
those countries, inflation targeting and financial stability may have been complementary, rather
than conflicting goals.
A second example is one in which the economy is in recession, or operating below potential,
and the financial system is going through a phase of deleveraging and low asset prices (Chart
1, see "Case 2"). In this case, easing monetary policy is the right action for both inflation control
and financial stability purposes. An example is the United States after the 2007-09 crisis: easy
monetary policy cushioned the economy and also helped heal a broken financial system.
In both of these cases, there is no trade-off for monetary policy. There are other situations,
however, where there could be tension between the two objectives. One is when the economy
has been hit by a highly persistent adverse foreign demand shock - such as a recession in the
economy of a major trading partner - while the domestic financial system is unimpaired (Chart
1, see "Case 3").
In this case, inflation targeting calls for policy easing to support economic activity and return
inflation sustainably to target. But that easing would also disproportionately affect domestic
sectors that are highly sensitive to interest rates like housing and other consumer durable
goods, encouraging the buildup of financial vulnerabilities. This has been the situation in
Canada for the past seven years, as reflected in increasing levels of household indebtedness
and elevated house prices - although, as I'll discuss later, regulatory measures have been
used to mitigate the resulting financial system risks (Chart 2).3
What can monetary policy do?
Given the situation in Canada, we have focused our research on the low-demand, high-debt
scenario. Empirical research shows that a buildup of household debt in the economy makes a
financial crisis more probable, so we wanted to understand the costs and benefits of
leaning against financial imbalances through tighter monetary policy. Our researchers used
several of the Bank's economic models to examine these issues.4
On the benefits side, they estimated that increasing the Bank's policy rate by 1 percentage
point for one year would reduce real household debt by 2 per cent over five years.5 Everything
else being equal, less household debt reduces the vulnerability of the economy and the
financial system; the results, however, suggest that this difference may be very small. On the
cost side, the same increase in the policy rate might cut output by up to 1 per cent and push
inflation down by 0.5 percentage point relative to what it would have been otherwise. While,
like any empirical results, these findings are a product of the methodology used, it is noteworthy
that they are consistent across standard models - and indeed, similar results have been found
using broadly similar approaches in other countries.
These results suggest that, even though monetary policy could, in principle, be used to reduce
vulnerabilities in the financial system, it may be too costly in practice. Interest rates affect all
parts of the economy and are too blunt an instrument to address an imbalance in just one part
of the economy - household credit. If you have a specific imbalance, you need a specific tool
to address it.
The analysis relies on a number of assumptions about how monetary policy affects debt and
how debt affects financial stability. The relationship between monetary policy and financial
stability may depend on the specific economic conditions in which we find ourselves.6
Moreover, the processes resulting in financial cycles, with periods of unsustainable debt
buildup, occasional crises and periods of deleveraging, are not well captured by standard
models.7 We have more work to do before we can be fully confident about our conclusions.
Here, I would like to focus on one critical aspect of the discussion: that monetary policy can
affect financial stability only through its effects on household debt, even though it affects a wide
swath of the real economy. However, we also need to envisage a case where the effects of
monetary policy on financial stability are not limited to one sector, as in the case we just saw,
but spread across many different parts of the financial system. In that case, monetary policy's
ability to get in all the cracks of the financial system - to paraphrase former Federal Reserve
Governor Jeremy Stein - would give it a more powerful influence on financial stability.8
Another aspect to consider is that risks to financial stability have two elements: the underlying
vulnerability and the trigger that could cause a risk to materialize. Both elements are part of
our risk-management approach to monetary policy.
Over time, stimulative monetary policy may cause vulnerabilities to build up. That was part of
our thinking in late 2013, when inflation was running persistently below target: we were
concerned about the downside risks to inflation, but decided against easing policy further to
avoid exacerbating growing household indebtedness and elevated house prices.
Failing to ease monetary policy in an economic downturn could, however, worsen the
contraction and cause a crisis. This scenario was part of our thinking at the beginning of last
year, when Canada's economy was hit by the collapse in oil prices and we cut our policy
interest rate. Although we knew that lowering the policy rate could worsen vulnerabilities
related to household debt, we also knew that it would counter the risk that growth would crater
and lessen the probability that the oil price shock would trigger financial stability risks.
Two tools - or three?
This discussion suggests that any adaptation of monetary policy to financial stability objectives
is, to say the least, far from straightforward.
Fortunately, monetary policy is not the only game in town. There are also macroprudential
tools - regulatory measures that can be used to promote not just the safety of an individual
financial institution, but also that of the entire financial system.
Macroprudential tools can be used in two ways. One is to foster a more resilient financial
system on an ongoing basis. To give just one example, regulators can establish ceilings on
mortgage loan-to-value ratios on an ongoing basis, so that any correction in housing prices is
less likely to create stress for the financial system. With a more resilient system, all of the
financial stability concerns I have been discussing become more manageable.
Authorities could also, in principle, adjust macroprudential tools to dampen financial cycles -
tightening them when leverage is building up and risk taking is increasing, and easing those
requirements when that cycle turns. For example, regulators can lower loan-to-value ratios in
response to indications of rising household sector vulnerabilities. Another example is the
countercyclical capital buffer introduced as part of the Basel III reform of bank capital
requirements.
Such countercyclical measures are designed, in part, to weaken the feedback loop between
asset prices and credit growth that can lead to the kind of financial excesses that set the stage
for a crisis. The track record of countercyclical measures in leaning against a financial cycle is
not yet nearly sufficient to form a definite view of their practical effectiveness, however.
The changes in mortgage finance regulations that we have seen in the last eight years in
Canada include a combination of these elements. When the government successively
increased the required down payments and tightened other regulations, it was partly to reduce
the taxpayer's longer-term exposure to the housing market and partly to restrain the ongoing
buildup of financial system vulnerabilities associated with rising household indebtedness and
housing prices.
If the effectiveness of macroprudential policies could be relied on, would that mean that
monetary policy is off the hook, allowing the Bank to focus on its inflation target and leave
macroprudential policies to take care of financial stability?
Perhaps, but not necessarily. There might be significant spillovers between monetary policy
and macroprudential policies. When the government imposes tighter requirements on
mortgage insurance, for example, it likely reduces demand for housing, which may, in turn,
have a negative effect on growth and inflation. Household indebtedness may also affect the
transmission mechanism of monetary policy, for instance, by influencing households'
willingness to spend out of their disposable incomes. On the flip side, if prolonged low interest
rates encourage people to take on more debt, financial stability concerns grow. So we need a
better grasp of how monetary policy and macroprudential measures interact.
Even if such spillovers are important, a clear assignment of policies could be effective in
achieving both objectives: monetary policy to target inflation, macroprudential measures to
target financial stability. Each could operate independently, focusing only on its own objective.9
The resulting combination of policies - a Nash equilibrium - could both achieve the inflation
target and ensure an acceptable degree of financial stability (Chart 3).
Under certain conditions, as long as monetary policy has a larger effect on inflation than it does
on financial stability risk and macroprudential policy has a larger effect on financial stability risk
than it does on inflation, there would be no need, in theory, for the agencies responsible to
coordinate their actions explicitly. They would need to share information with each other only
so that each could use its own policy tool to account for the spillovers from the other policy on
its own objective.
This might mean, for example, that the central bank would need to run a more stimulative
policy than it would have otherwise to offset the effect of macroprudential policies, and the
macroprudential authority would impose more stringent measures than it would have otherwise
to counteract the leverage and risk taking generated by looser monetary policy. In the end, we
could see an increase in the level of households' indebtedness without a significant
deterioration in their creditworthiness. This has been the situation in Canada over the past few
years.
This logic suggests that it is very important to have a public sector body with both the power
and the paramount responsibility to use macroprudential tools to promote financial stability.
This setup would leave monetary policy free to target inflation unfettered by possible financial
stability concerns. The appropriate body might be a committee, as is currently the case in
Canada, where the potentially relevant tools are shared among several public sector
institutions.
However, even with an ideal set of institutional arrangements, there may be limits to how
independently monetary policy and macroprudential policy can work. Regulatory measures
designed to contain risk might, if carried to extremes, distort incentives to allocate resources
to their most productive uses. For example, some financial institutions may reduce their lending
to riskier but innovative companies. It is also possible that, mindful of such adverse
consequences, regulators may refrain from going as far as would be needed to preserve
financial stability. And that, in turn, could inhibit the central bank from providing sufficient policy
easing to support the economy.
Thus, it is possible that, in a situation of sustained weak aggregate demand, relying primarily
on monetary policy to provide stimulus may lead to financial vulnerabilities that
macroprudential policy cannot, or should not, offset. In such circumstances, fiscal policy may
be called upon to provide stimulus, particularly since it is likely to be more effective at low
interest rates. Of course, fiscal policy also has its limits, since an excessive buildup of public
debt can create its own problems for both the economy and the financial system. We saw that
in Canada in the 1990s. But these costs need to be set against concerns that prolonged
monetary policy stimulus may result in an excessive buildup of private sector vulnerabilities.
These issues are relevant to the renewed discussion of fiscal policy that is now taking place in
Canada.
Conclusion
Allow me to conclude.
During the years since the global financial crisis, we have been doing a lot of thinking and
research to improve our understanding of the nexus between monetary policy and financial
stability. This is a key question in this year's renewal of our inflation-control agreement.
We will need to continue to examine these issues in the period ahead. Indeed, research on the
nexus between monetary policy and financial stability is an important element of the Bank of
Canada's 2016-18 medium-term plan.10
One thing is clear, though: monetary policy cannot take primary responsibility for maintaining
financial stability. Other, prudential, tools are required to build a resilient financial system and,
where needed, to address increasing vulnerabilities.
Questions remain, however, about the financial stability effects of monetary policy itself and
what, if anything, should be done to address them. Some of these questions pertain to how
aggressively a central bank should strive to return inflation sustainably to target in the face of
other economic forces. When the economy is hit by a large and persistent adverse shock,
should we accept greater downside risks to inflation to avoid exacerbating financial
imbalances? Or indeed, given such imbalances, should we tighten policy less aggressively as
the economy returns to potential to avoid triggering financial system risks?
For the foreseeable future, we are not likely to agree on a formula for addressing these issues.
We are inevitably in the realm of judgment informed by the available evidence and analysis.
That element of judgment in weighing financial stability considerations, including the
implications of our own actions, is central to our risk-management approach to monetary policy.