Stephen S Poloz: Integrating financial stability into monetary policy
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, at the 2015 Institute of
International Finance Annual Membership Meeting, Lima, 10 October 2015.
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I would like to thank Don Coletti and Stephen Murchison for their help in preparing this speech.
Introduction
The experience of the global financial crisis and subsequent Great Recession has led
policymakers to question some basic assumptions. Long-held beliefs about monetary policy no
longer apply in today's global environment. Ten years ago, the idea that focusing on price
stability could actually contribute to the buildup of dangerous imbalances was very much a
minority view. Central bankers now understand that financial stability issues must somehow
be integrated into the conduct of monetary policy. And both central bankers and leaders of
financial institutions are working to understand the impact of the sweeping regulatory reform
agenda that is being implemented.
Around the world, researchers are looking at the issues from several angles. How are
financial system reforms affecting monetary policy? How can different monetary policy
choices affect financial stability? Today, the idea that central bankers should pay little heed
to stability issues and simply "stick to our knitting" of inflation control, a position once
advocated by many, seems quaintly naïve.
Through painful experience, we have been reminded that a well-functioning financial system
is critical for economic activity and the transmission of monetary policy. We saw the
emergence of excessive risk taking, aided by financial engineering and shortcomings of
oversight, during an extended period of low and stable inflation and low volatility. The crisis
showed us how financial imbalances in one sector of one economy could be amplified and
propagated across the entire financial system, leading to the worst global downturn since the
Great Depression. So what I will discuss today is how central banks 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
assetprice 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
risk-management framework in detail later on. But we still have the question of how
policymakers 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.
With Basel III, we gave ourselves an ambitious task. We aimed for a financial reform
package that would be implemented consistently across jurisdictions and would not impede
the ability of financial institutions to innovate, intermediate and foster economic growth. The
road to implementation hasn't been as smooth as one would like. But that's hardly surprising,
given the political processes and trade-offs required to put the reforms in place and the many
differences among the jurisdictions involved.
What's important now is that we finish the job. Ensuring the safety of the global financial
system is in all of our interests. We can't be distracted and lose sight of this objective. For
financial institutions, that means meeting both the letter and the spirit of the new capital and
liquidity regulations. And policy-makers should expect institutions to respond to the new
regulatory regime. We are seeing competitive forces leading to innovation, in market-based
finance, for example. To be clear, such innovation is a good thing. Even as we implement the
new rules, we need to be cognizant of their full impact and ensure that we don't stifle
competition and innovation.
That said, the scars of the financial crisis will not fade quickly, and we are determined not to
let another such crisis occur. 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
country-specific 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.
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. For
financial institutions, this is a long and difficult path, but the stakes are too high to
contemplate leaving the job incomplete. Policy-makers 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.
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.