Jens Weidmann: The relationship between monetary and
macroprudential policies - black and white or shades of grey?
Dinner speech by Dr Jens Weidmann, President of the Deutsche Bundesbank and Chairman of
the Board of Directors of the Bank for International Settlements, at the Annual Meeting of the
Central Bank Research Association, Frankfurt am Main, 20 August 2018.
* * *
1 Introduction
Ladies and gentlemen
The Bundesbank is honoured to have organised this evening's dinner. And for me, it's a great
pleasure to be here with you at the Annual Meeting of the Central Bank Research Association, or
CEBRA for short.
CEBRA is a fine example of the art of the acronym. If you think about central bankers, I dare say
creativity won't exactly be the first quality that springs to mind. But coining new acronyms does
appear to be one discipline that really gets central bankers' creative juices flowing. We also
came up with CAMELS, which stands for capital adequacy, asset quality, management,
earnings, liquidity, and sensitivity to market risk. However, our acronyms are not just confined to
hoofed animals. There is TARGET, of course. And we have ART, for alternative risk transfer;
CAR, for capital adequacy ratio; and CEIOPS, which is short for Committee of European
Insurance and Occupational Pensions Supervisors and has a certain pyramid ring to it.
Examples of contrived acronyms abound: they have been intentionally designed to convey a
positive connotation or double meaning. In the case of CEBRA, one naturally thinks of those wild
animals that are closely related to horses and populate Africa's grasslands and savannahs. With
their distinctive black and white stripes, zebra are a snappy image for the academic dialogue and
discourse which we cherish at conferences such as this. But zebra are also known for forming
large herds and intermingling with other mammals, especially with wildebeest, which are also
known as gnus. Both species subsist on grasses, and you might think that they compete for
food. So how come they graze peacefully in mixed herds? What's behind their special
relationship?
This was a long run-up, but it does lead to one of the key issues addressed at this year's
meeting: What's behind the special relationship between monetary and macroprudential
policies? What are the linkages between monetary policy and financial stability, and what follows
from there?
2 Monetary policy and financial stability
Questions like these are a focal point of the Bundesbank's research. Under the patronage of
Markus Brunnermeier and Eric Leeper, and in tandem with Sweden's Riksbank, the Bank of
Canada and the Federal Reserve Bank of New York, the Bundesbank established the Trinity
research network, as it is known, to investigate issues surrounding the interplay between
macroeconomic policies.
When it comes to monetary policy and financial stability, there is now a substantial body of
evidence which suggests that monetary policy affects economic agents' willingness to take on
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risk. By lowering risk-free interest rates, monetary policymakers raise the attractiveness of
riskier financial assets. With investors searching for yield or simply rebalancing their portfolios,
prices of risky assets then also increase.
This shows up in the data on investment decisions. Even German households - typically rather
conservative in their choice of financial assets - have been seeking out potentially more lucrative,
but also riskier options such as shares and mutual funds. According to Bundesbank data, equity
and investment fund purchases by households made up more than 25% of all their financial
investments in 2017; four years earlier, this share had been a meagre 6%.
Equities and investment fund shares did indeed still contribute to a positive real portfolio return for
German households in recent years. However, due to the weak performance of capital markets
in the first quarter of this year, their contribution has virtually vanished. Consequently, the total
real return of households turned negative, as the Bundesbank has just highlighted in its August
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Monthly Report published today.
Moreover, mutual fund managers have been increasing the duration and credit risk of their bond
portfolios in response to low rates. In a recent paper, Emanuel Mönch and his co-authors
examine bond holdings of more than 4,500 German retail and institutional investment funds. They
find reach for yield in response to low rates to be pervasive and also document a persistent
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feedback of funds' buying pressures to bond prices.
Given such evidence, it seems plausible that the comparatively high valuations in some asset
markets in the euro area are being driven, in part, by the low level of policy rates.
To some extent, the impact of monetary policy on risk taking is not a mere side-effect. In their
efforts to stimulate the economy, central bankers are also pinning their hopes on the portfolio
rebalancing channel.
But monetary policy also affects the propensity of banks to assume risks in another, unintended
way: the more protection is provided against potential risks, and the clearer the prospect of easy
funding if push comes to shove, the less wary banks might be of taking on excessive risk.
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Economists like Raghuram Rajan and Jean Tirole, to name but two, argue compellingly that the
prospect of readily provided central bank funding in case of a financial downturn constitutes a
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powerful incentive for banks to take on greater risks.
There can be little doubt, then, that monetary policy is able to influence financial stability. What
follows from that? Should financial stability become an additional objective of monetary policy?
Maybe even on a par with price stability? To me, this would be a perilous proposition. For one
thing, aiming for more than one objective risks complicating communication with the general
public, thereby jeopardising accountability.
Financial stability poses even greater challenges in this regard, as it is a multi-faceted concept.
Price stability is typically specified in terms of changes in a consumer price index and a time
frame. But financial stability cannot be boiled down into a single indicator in the same way.
Financial stability is therefore often described, very broadly, as a state in which the financial
system performs its functions for the real economy properly. As Otmar Issing once observed:
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"Defining financial stability is as difficult as it is important."
But if an objective cannot be effectively measured, confidence in actions taken towards this
objective will naturally be limited. In other words, the credibility of monetary policy could be
undermined if tasked with financial stability.
What is more, a multitude of objectives might force monetary policy into unfavourable trade-offs.
It risks exposing monetary policy to greater political pressure, and more besides.
By generating higher inflation, monetary policy could lower the real level of debt and thereby
mitigate financial imbalances after their build-up. Thus, if monetary policy has been tasked with
aiming for both price stability and financial stability, a time-inconsistency problem can arise. As
Kenichi Ueda and Fabían Valencia have highlighted, such a central bank may have an incentive
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to deviate from the socially optimal inflation ex post.
3 The role of macroprudential policy and monetary analysis
Taking on financial stability as an additional objective for monetary policy would likely do more
harm than good. Nevertheless, central banks can play a productive role in safeguarding financial
stability. It certainly makes sense to harness central banks' high level of expertise with regard to
financial stability risks. However, the "weapon of choice" for combatting these risks is not
monetary policy - it is macroprudential policy. In his first speech as a Governor at the Federal
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Reserve Board, Ben Bernanke demanded: "Use the right tool for the job."
To stretch the analogy with the African fauna further, this is something we could compare to the
feeding habits of zebra and wildebeest. They graze alongside each other, of course, but they
actually feed from different grass heights, with zebra preferring taller grass and wildebeest
focusing on short grass. Researchers have attributed this selection to anatomic differences in
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mouth dimensions.
In a similar vein, macroprudential instruments can be used in a far more targeted way than
monetary policy. They cut the grass at a different level, so to speak. This is of particular use with
respect to the euro area. Macroprudential tools can be employed at the level of member
countries to combat problematic developments in national financial systems - developments that
cannot be counteracted by the single monetary policy.
One of the instruments to address exuberance in the financial system are countercyclical capital
buffers. Moreover, as real estate markets have underscored their destabilising potential during
the last crisis, many tools are geared explicitly towards this market. Caps on the loan-to-value or
debt-to-income ratios are two examples of instruments that allow for a tempering of the demand
for mortgages.
However, if we are to deploy these new policy instruments, we need to gain a better
understanding of how they affect macroeconomic performance and interact with monetary
policy. A forthcoming Bundesbank discussion paper points out the danger of "financial
dominance". Within a DSGE model, Vivien Lewis and Markus Roth demonstrate that, if
macroprudential policy is too lax, monetary policy may be forced to do the job by driving inflation
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above its price stability target and reducing the real burden of private debt. Thus a stringent
macroprudential reaction to financial stability risks is also a means to protect monetary policy. To
ascertain when we should adjust macroprudential tools, and by how much, we need to know
how effective these tools are, and whether the transmission channel is subject to lags. So far,
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there is limited empirical evidence to guide us.
Although it is certainly reasonable to harness central bank information in assessing financial
stability risks, the final decision on the use of macroprudential instruments does not need to be
made by central banks as well. Germany is a case in point here. While the Bundesbank provides
an assessment, it is the government that ultimately decides whether and how macroprudential
measures are employed. Central bank analysis is brought to fruition, but a different
decisionmaking body provides an extra layer of insurance that monetary policy does not get mired in a
potential conflict between price stability and financial stability goals.
But given the uncertainty about the effectiveness of macroprudential tools, should monetary
policy remain completely passive if financial imbalances were to build up? In my view, this would
be a mistake. As we have witnessed, financial crises have a considerable impact on
macroeconomic outcomes and, ultimately, central banks' ability to guarantee price stability.
During the recession of 2008-09, real GDP in the US decreased by 4%. The unemployment rate
peaked at 10% in October 2009 after a cyclical low of just 4.4% in May 2007. In other words, the
number of unemployed persons surged by 8.6 million to more than 15 million. Finally, annual
inflation, as measured by the PCE deflator (the Federal Reserve's preferred gauge), averaged
just 1.3% between 2009 and 2017, compared to 2.4% in the preceding nine years.
In the long term, price stability and financial stability can complement each other. Thus, taking a
longer-term perspective on inflation, central banks might be compelled to act on the build-up of
financial imbalances despite having a single objective.
Let us again consider the mixed herds of zebra and wildebeest in Africa. Their selection of
different grass heights may account for the lack of food competition, but it cannot explain their
intermingling. However, both species face common predators, especially lions. In this context,
evidence suggests that zebra benefit from the presence of wildebeest: they spend considerably
less time keeping watch for predators in a mixed herd than in a zebra-only herd of the same size.
This finding could be due to the wildebeest's superior ability to detect predators, as they may
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have better - and complementary - senses of smell and hearing.
In a similar vein, developments in the financial system can provide central banks with valuable
information. In general, there is ample evidence that financial conditions do contain information
about future economic activity. For instance, Tobias Adrian and his co-authors have shown that
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downside risks to GDP growth increase as financial conditions tighten. More to the point, the
source of financial crises is often related to excessive credit growth. Although not every
extraordinary credit boom results in a full-blown financial crisis, Moritz Schularick and Alan Taylor
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warn that policymakers ignore credit at their peril. This pattern held up in the last crisis as well.
In the euro area, growth of credit to the private non-financial sector surged from 6% in 2003 to
more than 11% in 2007. Broad money growth increased at a similar clip over this period.
The ability of credit quantity to help predict future crises therefore shows that the second,
monetary, pillar of the Eurosystem's monetary policy strategy is still very relevant today.
Moreover, as Volker Wieland and others have demonstrated, cross-checking economic analysis
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with monetary analysis can be helpful in the context of data uncertainty.
4 Microprudential supervision and regulation
A final lesson of the crisis should not be forgotten. Ten years ago almost to the day, and just a
few weeks before the collapse of Lehman Brothers, Chairman Ben Bernanke gave a speech at
the Federal Reserve Bank of Kansas City's Annual Economic Symposium in Jackson Hole. In
his comments, he explored ways to reduce systemic risk and suggested a broader, system-wide
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approach for supervisors and regulators. The establishment of such a macroprudential
approach in recent years is a major achievement. In interconnected systems, risks can be
propagated and amplified - this is the famous domino effect.
However, this does not mean that traditional microprudential regulation and supervision have lost
any of their importance. Quite the opposite is the case, in fact. As Edward Lazear has pointed
out, not only the domino effect was at work during the crisis, but also the "popcorn
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theory". When popcorn is heated in a pan, every kernel will eventually pop, irrespective of
whether the other kernels have already popped or not. The heat affects each kernel equally and
causes each of them to eventually pop. There is no chain reaction taking place. The reason they
pop can be found in the design of the popcorn kernel. The kernel is protected by a hard outer
shell or hull. Within, water is enclosed. Under sufficiently high heat, the water turns into steam,
raising the pressure inside the kernel. At a temperature of approximately 180 degrees Celsius,
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the pressure becomes strong enough to burst the shell.
We could compare the pressure inside the kernel to financial problems building up inside banks,
while banks' capital may be thought to resemble the protective hull. Undercapitalised banks were
a salient feature of the pre-crisis financial system. Ultimately, they were unable to sufficiently
withstand financial stress. Fortunately, much has already been done in this regard, thanks to
Basel III. A rollback of these reforms would therefore make the financial system decidedly less
safe, in my view.
Nevertheless, we should evaluate the measures agreed upon and consider how they interact if
we are to achieve the objective of financial stability as efficiently as possible. The G20
postimplementation evaluation, which is being discussed in a plenary session at this conference
tomorrow, is therefore a necessary exercise. Streamlining regulation is important. But at the
same time, we must not forget to examine the question of whether we are all the way there yet in
terms of financial stability, particularly with regard to the crucial issue of too-big-too-fail.
5 Conclusion
Ladies and gentlemen
Africa's large herds of wildebeest and zebra have been monitored for a considerable time. In the
late 1950s, the long-time director of Frankfurt Zoo, Bernhard Grzimek, and his son used a small
aircraft to follow and count the migrating animals in Serengeti. Fittingly, their plane was painted in
black and white stripes; it was called "Flying Zebra". To this day, the relationships within these
herds remain a subject of academic publications.
The recent rise of the macroprudential policy domain only dates back to the crisis. Not
surprisingly, we have to learn more about the interactions with monetary policy. This relationship
is a natural topic for CEBRA - though it is certainly not a question of black and white. Between
acknowledging financial stability as an explicit objective of monetary policy and disregarding it
altogether, there is an intriguing range of shades of grey.
I have left plenty of other issues - and acronyms - for us to discuss this evening. For now, I
suggest we devote our undivided attention to "Document Encoding and Structuring Specification
for Electronic Recipe Transfer", otherwise known as DESSERT.
Thank you for your attention.
1
See, for example, C M Buch, S Eickmeier and E Prieto (2014), In search for yield? Survey-based evidence on
bank risk taking, Journal of Economic Dynamics and Control, 43, 12-30; and G Jiménez, S Ongena, J L Peydró
and J Saurina (2014), Hazardous times for monetary policy: what do twenty-three million bank loans say about
the effects of monetary policy on credit risk-taking?, Econometrica, 82, 463-505, for evidence on the effects of
monetary policy on risk taking.
2
Deutsche Bundesbank, Zur Entwicklung der realen Portfoliorenditen privater Haushalte in Deutschland,
Monatsbericht, August 2018.
3
A Barbu, C Fricke and E Moench (2017), Procyclical asset management, reach for yield, and bond risk premia,
mimeo.
4
D W Diamond and R G Rajan (2012), Illiquid banks, financial stability, and interest rate policy, Journal of Political
Economy, 120, 552-591; E Farhi and J Tirole (2012), Collective moral hazard, maturity mismatch, and systemic
bailouts, American Economic Review, 102, 60-93.
5
See also M Gertler, N Kiyotaki and A Queralto (2012), Financial crises, bank risk exposure and government
financial policy, Journal of Monetary Economics, 59,, 17-34, for a macroeconomic model in which the possibility
of asset purchases increases banks' incentives to take more risk.
6
O Issing (2003), Monetary and financial stability - is there a trade-off?, speech at the Conference on "Monetary
Stability, Financial Stability and the Business Cycle", Bank for International Settlements, Basel.
7
K Ueda and F Valencia (2014), Central bank independence and macro-prudential regulation,
Economics Letters, 125, 327-330.
8
B S Bernanke (2002), Asset-price "bubbles" and monetary policy, remarks before the New York Chapter of the
National Association for Business Economics, New York.
9
See R Arsenault and N Owen-Smith (2008), Resource partitioning by grass height among grazing ungulates
does not follow body size relation, Oikos, 117, 1711-1717.
10
V Lewis and M Roth (2018), Interest Rate Rules Under Financial Dominance, Deutsche Bundesbank,
Discussion Paper, forthcoming.
11
See R Bachmann and S Rüth (2018), Systematic monetary policy and the macroeconomic effects of shifts in
residential loan-to-value ratios, CEPR Discussion Paper, 12024; and S Eickmeier, B Kolb and E Prieto (2018),
The macroeconomic effects of bank capital requirement tightenings: evidence from a narrative approach,
mimeo, for recent attempts to quantify the macroeconomic effects of macroprudential policies, mimeo.
12
See M H Schmitt, K Stears, C C Wilmers and A M Shrader (2014), Determining the relative importance of dilution
and detection for zebra foraging in mixed-species herds, Animal Behaviour, 96, 151-158.
13
T Adrian, N Boyarchenko and D Giannone, Vulnerable growth, American Economic Review, forthcoming.
14
M Schularick and A M Taylor. (2012). Credit booms gone bust: monetary policy, leverage cycles, and financial
crises, 1870-2008. American Economic Review, 102, 1029-61.
15
G Coenen, A Levin and V Wieland (2005), Data uncertainty and the role of money as an information variable for
monetary policy, European Economic Review, 49, 975-1006.
16
B S Bernanke, Reducing systemic risk, speech given at the Federal Reserve Bank of Kansas City's Annual
Economic Symposium, Jackson Hole, 22 August 2008.
17
E Lazear (2011), www.chicagobooth.edu/news/2011-10-25-lazear.aspx
18
E Virot and A Ponomarenko (2015), Popcorn: critical temperature, jump and sound, Journal of the Royal Society
Interface, 12, 20141247.