Published Date: 26 May 2023
"Everything, Everywhere, All at Once: Securing
Monetary and Financial Stability in an
Interconnected World" - Opening Remarks by Mr
Ravi Menon, Managing Director, Monetary
Authority of Singapore, at the 10th Asian
Monetary Policy Forum on 26 May 2023
Professor Bernard Yeung, National University of Singapore Business School, and President of
the Asian Bureau of Finance and Economic Research (ABFER)
Professor Steven J Davis, University of Chicago, Hoover Institution, and EXCO Member of
ABFER
Distinguished speakers and guests, ladies and gentlemen
GETTING IN ALL THE CRACKS OR TARGETING THE CRACKS?
At the inaugural Asian Monetary Policy Forum in 2014, I spoke about the challenge of
[1]
securing both price stability and financial stability. Now, nearly ten years later, we know a
lot more about this issue,yet there is still much we do not know. Let me take stock of where
we are.
To achieve both the objectives of price stability and financial stability, I described in 2014
three possible approaches for monetary policy.
The first approach is to keep monetary policy focused on price stability and leave
financial stability to microprudential regulation and supervision. Most advanced
economies have stuck to this approach in the last ten years, with adjustments to
countercyclical capital buffers as the sole macroprudential policy innovation.
the unique ability of monetary policy to get in all of the cracks . No central bank has
formally adopted this approach though it would appear that some central banks do at least
indirectly consider financial stability implications in their monetary policy decisions.
The third approach is to keep monetary policy focused on price stability and use
macroprudential policies to secure financial stability. This is what I had painted in 2014
as "targeting the cracks" through macroprudential policies instead of getting into all the
cracks through monetary policy. A growing number of emerging market economies has
been taking this approach, prompted by increased capital flow volatility, exchange rate
fluctuations, and asset price bubbles, in the wake of spillovers from unprecedented loose
monetary policies in the advanced economies.
The experience of the last decade has, if anything, underscored the importance of the
nexus between monetary policy and financial stability.
The era of ultra-easy monetary policy has heightened risk-taking, far more in the financial
sector than in the real economy.
The financial system itself has become more complex, with a wide variety of players and
activities, many of them unregulated. The migration of financial risks across these
players and activities has made it difficult to discern how shocks are transmitted across
the system and how they affect financial stability.
Then there are feedback loops from the financial system to the real economy, with
implications for price and output stability.
Most worryingly, we seem to be confronted with a trade-off between price stability and
financial stability, at least in the short term.
To borrow a phrase from a recent award-winning movie, everything seems to be related;
there are financial vulnerabilities everywhere; and economic and financial shocks seem to
happen all at once. Okay, that sounds exaggerated, but I think you get my dri.
As with the multiverse, there is much that we do not know about the complex interactions
between the real economy and the financial system and their implications for price and
financial stability. But policymakers are not entirely clueless. Let me set out four key
propositions based on the experience of the last decade:
securing both monetary and financial stability requires an integrated framework,
combining monetary policy, fiscal policy, and macro-financial policies;
financial sector vulnerabilities are best addressed using a variety of macro-financial
policy tools in a coherent manner;
monetary policy should remain focused on inflation control but its implications for
financial stability must be taken into account;
fiscal policy plays an important role in helping to secure both price stability and financial
stability;
Let me elaborate on each of these.
AN INTEGRATED POLICY FRAMEWORK
First, securing both monetary and financial stability requires an integrated framework,
combining monetary policy, fiscal policy, and macro-financial policies.
Macro-financial policies include macroprudential measures, foreign exchange
intervention, and capital flow management measures.
There are three reasons why we need an integrated policy framework.
One, there are important interactions between monetary policy and the financial
system. In the last decade, policymakers around the world have gained better appreciation
of the increasingly important role that the financial system plays in the transmission of
monetary policy. As Jeremy Stein puts it, "monetary policy is fundamentally in the business
[3]
of altering risk premiums." Accommodative monetary policy reduces risk premiums and
can lead to unsustainable credit growth and asset price increases. Correspondingly,
monetary policy tightening can trigger a sharp reversal in sentiments and risk premiums,
which can impair credit supply and trigger financial failures.
Two, capital flows and exchange rates cannot be ignored in macro policy settings,
especially in emerging market economies. In advanced economies, capital flows and
exchange rate movements are generally viewed as equilibrating mechanisms outside the
remit of macro polices. But for emerging market economies, they can spell serious
macroeconomic and macro-financial trouble.
Capital flows can fuel domestic credit and asset price bubbles.
Capital flows can induce exchange rate fluctuations that are disconnected from
macroeconomic fundamentals. In the face of large and volatile capital flows, a freely
floating exchange rate can become a shock amplifier rather than a shock absorber.
in contrast with their stabilising effect in most advanced economies.
Capital flows can compromise the monetary policy latitude of emerging market
economies.
Studies show that their monetary policies respond to movements in US interest
rates and exchange rates, besides their own domestic macroeconomic conditions.
[5]
Helene Rey and Silvia Miranda-Agrippino find that US monetary policy moves can
induce changes in risk premiums across countries, move the global financial cycle,
[6]
and challenge the monetary policy autonomy of emerging market economies.
Three, there appears to be a short-term trade-off between price stability and financial
stability.
Macroeconomic theory and empirical evidence tell us that although there is no long-run
trade-off between price stability and employment, there is a short-term trade-off. This is
expressed as a "sacrifice ratio", or the increase in the unemployment rate necessary to
achieve a given reduction in the inflation rate.
Likewise, could it be that while there is no long-term trade-off between price stability and
financial stability, there is a short-term trade-off? In the current conjuncture, for example,
there are concerns that monetary policy tightening to bring down inflation could trigger
contagious financial failures. Is there an analogous "sacrifice ratio" between price
stability and financial stability?
These short-term trade-offs call for a mix of monetary and macro-financial policies to
meet the twin goals of financial stability and price stability.
Combining the use of monetary policy and macro-financial policies can mitigate
tradeoffs between objectives. Studies by both the BIS and IMF have found that policy
combinations can be more effective than using a single instrument.
Claudio Borio and colleagues at the BIS find that when low inflation in advanced
economies required loose monetary policies, tightening macroprudential measures
through strengthening capital buffers helped mitigate risks to financial stability from
[7]
increased risk taking and indebtedness.
Tobias Adrian and colleagues at the IMF find that augmenting conventional monetary
policy with foreign exchange interventions and capital flow measures in emerging market
[8]
economies may improve their monetary policy trade-offs.
The fundamental premise of an integrated policy framework is the recognition that
policies that are independent in execution are oen interdependent in their effects.
If fiscal policy is not sound, fiscal dominance concerns will undermine monetary policy
credibility.
If the financial system is not sound, financial dominance concerns may compromise
monetary policy. Fiscal stability may also be put at risk.
In an integrated policy framework, the objectives of monetary, macro-financial, and fiscal
policies do not need to change. But the way these objectives are pursued cannot ignore
their implications for financial stability and price stability.
Specifically, an integrated policy framework must seek to avoid the unsustainable
build-up of debt which is the root cause of much financial instability.
For monetary policy, it means providing a credible anchor for price stability in a way that
does not lead to an unsustainable increase in leverage in the economy.
For macroprudential policies, it means leaning against an unsustainable expansion of
credit, inflation in asset prices, and the excessive build-up of debt in the economy.
For fiscal policy, it means ensuring that public debt is sustainable and does not become a
source of financial vulnerability in the economy.
MACRO-FINANCIAL POLICIES
The second key proposition: financial sector vulnerabilities are best addressed using a
variety of macro-financial policies in a coherent manner.
Ensuring financial stability requires a multi-dimensional approach. There is no single
instrument that has a stable and reliable relationship with financial stability or asset price
stability. This is because financial risks emanate from multiple sources and manifest in
multiple ways. We need to adopt a range of macro-financial tools to address the spectrum
of potential financial vulnerabilities. As mentioned earlier, the macro-financial policy toolkit
contains three broad categories.
macroprudential measures to moderate credit demand and asset price inflation
foreign exchange interventions to dampen exchange rate volatility
capital flow management measures to directly curb capital inflows and outflows
Let me briefly describe how each of these components work.
Macroprudential policy tools include counter-cyclical capital buffers and sector-specific
measures. The latter, oen targeted at the property sector, include loan-to-value limits and
debt service limits. A few countries have introduced counter-cyclical capital buffers, but it is
too early to judge their effectiveness. Targeted macroprudential tools work better than
counter-cyclical capital buffers to address financial risks emanating from specific sectors like
real estate.
Macroprudential policy measures are most effective when used pre-emptively and in a
coherent manner.
A forward-looking or pre-emptive approach is appropriate given the long lags between
policy actions and macroeconomic effects. An added reason is that financial cycles are
viewed as being longer than standard business cycles.
Both the IMF and BIS support the use of macroprudential measures in a pre-emptive
manner, rather than in response to shocks.
Stephen Cecchetti and colleagues at the IMF find that preventive macro-financial
measures are much more effective than reactive measures in limiting the build-up
[9]
of financial leverage in response to US monetary policy spillovers.
Foreign exchange interventions serve to limit exchange rate volatility and thereby
mitigate financial market stresses arising from such volatility. They have been a useful
tool for many emerging market economies to reduce unduly sharp swings in exchange rates
as well as misalignment of the exchange rate with underlying fundamentals. But three
caveats are in order.
One, foreign exchange interventions tend to be more effective if they are large and in line
[10]
with fundamentals and the monetary policy stance.
Two, policy credibility for such interventions requires having deep foreign reserves,
which needs to be weighed against the cost of accumulating such reserves.
Three, there is the danger of slipping into an over-reliance on such interventions to
defend the level of the exchange rate.
Capital flow management measures are used to directly curb capital inflows and
outflows. While capital flow measures have distortionary effects and long-term costs, they
have been deployed as useful complements to safeguard financial stability.
Capital flow measures, more so than foreign exchange interventions, have been used in a
proactive manner to prevent large capital flows in the first place and thereby reduce the
risk of large and destabilising reversals of such flows.
Capital flow measures have also been used together with macroprudential measures to
moderate demand and asset price inflation in the property sector.
MONETARY POLICY
Third proposition: monetary policy should remain focused on inflation control but its
implications for financial stability must be taken into account.
Including financial stability as an additional objective of monetary policy seems
attractive but may not be a good idea.
In my 2014 AMPF speech, I argued that although monetary policy "flows into all the
cracks, some cracks may be just too big to fill". Today, I would add that some other
cracks may be over-filled. The point is that monetary policy is simply too blunt an
instrument to address excessive risk-taking and leverage at the sectoral level.
Research at the IMF suggests that the net benefits of leaning against asset price bubbles
[11]
using monetary policy are likely to be small, or even negative.
Country experience suggests caution. In 2010-2014, the Swedish Riksbank raised interest
rates roughly 2 percentage points to counter rising house prices. The strategy proved
unsustainable as inflation fell to zero and unemployment remained at high levels.
Monetary policy needs to remain focused on price stability but should seek to minimise
the risk of financial dominance. The concern here is two-fold.
The first is that highly expansionary monetary policy over a prolonged period could
contribute to a build-up of financial system vulnerabilities which is, in and of itself,
undesirable.
As pointed out by Markus Brunnermeier, the willingness of central banks to
continue making large purchases of private assets long aer the end of the Global
Financial Crisis has led to "a build-up of private debt, depressed credit spreads,
[12]
distorted price signals, and high house prices from increased mortgage lending."
The second concern is the feedback loop from these vulnerabilities constraining future
monetary policy options. If these vulnerabilities are significant, the central bank may be
concerned that the tightening of monetary policy necessary to bring down inflation to
target could trigger financial instability - in other words, financial dominance.
A practical way monetary policy could minimise the risk of financial dominance is to
use inflation targeting more flexibly. A criticism of inflation targeting is that it has been
too much of a straitjacket on monetary policies: for example, keeping interest rates low for
long to get inflation up to the target of 2% led to a build-up of financial vulnerabilities. I
think the problem is not with inflation targeting per se but with not using it flexibly enough.
There are two ways in which inflation targeting can be pursued more flexibly to
minimise financial vulnerabilities.
One, take time to bring inflation back to target. The BIS, for instance, advocates
lengthening the monetary policy horizon to take financial stability consequences of
[13]
monetary policy more fully into account. But allowing inflation to persist for too long
away from the target runs the risk of unhinging inflation expectations.
Two, be more tolerant of inflation outcomes close to zero. Masaaki Shirakawa draws on
Japan's experience to suggest that the risks to economic activity associated with very low
inflation did not warrant ultra loose monetary policy stances that undermine financial
[14]
stability.
However, a more flexible approach to implementing inflation targeting can potentially
be misinterpreted as reducing the commitment to price stability. It therefore needs to be
accompanied by clear communication on the consistency between taking financial stability
into account while pursuing price stability as the primary objective.
FISCAL POLICY
Fourth and final proposition: fiscal policy plays an important role in helping to secure
both price stability and financial stability.
The best contribution that fiscal policy can make to both price stability and financial
stability is to ensure the sustainability of public debt. The role of fiscal policy in an
integrated policy framework has not received as much attention as it probably deserves. Let
me offer two reasons why it should.
Sound public finances reduce the risk of fiscal dominance, enabling monetary policy to
operate more freely to pursue its price stability mandate.
Quantitative easing by major central banks through the purchase of massive amounts of
government debt was a necessary response to the strong deflationary pressures
unleashed by the Global Financial Crisis.
But as government spending continued to grow long aer the crisis and central banks
continued to purchase government debt, the risk of fiscal dominance grew: the concern
that normalising, let alone tightening, monetary policy would create fiscal problems.
Just as central banks need to gradually unwind monetary accommodation when the
crisis has passed, so must fiscal policy return to a more sustainable trajectory.
Targeted fiscal policy measures can support monetary policy and macroprudential
policy in achieving their objectives. Tax or expenditure measures have the advantage of
being able to either alleviate or accentuate the effects of monetary and macroprudential
policies on specific groups of people or sectors of the economy.
To help cool an overheated property market, fiscal measures such as transaction taxes on
property purchases can be a useful complement to macroprudential measures to curb
excessive demand.
In the current conjuncture of high inflation, fiscal policy has the versatility of being
tighter overall to help ease demand pressures while providing targeted support for the
most vulnerable groups.
INTEGRATED POLICIES AS APPLIED IN SINGAPORE
Before I conclude, let me say a few words about the Singapore experience.
Singapore does not have a formal integrated policy framework but there has been an
intuitive coherence across monetary, fiscal, and macro-financial policies. This has
helped to secure both price stability and financial stability through various crises. Close
consultations on the state of the economy across the respective policy-making bodies and a
common ethos of prudence has helped to achieve this policy coherence without resorting to
formal policy co-ordination.
Monetary policy is centred on managing the exchange rate to ensure price stability over
the medium-term. It is set by the Monetary Authority of Singapore (MAS). Foreign
exchange intervention is carried out in support of the monetary policy objective of price
stability and not for any macro-financial purposes. There is no explicit inflation target but
the track record of keeping core inflation relatively stable and, on average, just below 2%
over the last thirty years has underpinned the MAS' policy credibility.
Fiscal policy seeks to promote macroeconomic stability, sustained economic growth,
and social equity while maintaining a balanced budget. It is set by the Ministry of Finance
(MOF). The Constitution prohibits the use of public debt for government expenditure except
for a narrow class of long-term infrastructure projects.
Macro-financial policy comprises essentially of macroprudential measures aimed at
promoting a sustainable property market. These measures are co-ordinated across the
MAS, MOF, and Ministry of National Development (MND). The macroprudential toolkit
comprises loan-to-value limits, debt servicing limits, buyers' and sellers' stamp duties, and
adjustments in land supply.
In the movie "Everything, Everywhere, All at Once", we are told that parallel universes exist
because every life choice creates a new alternative universe. Thankfully, the global economy
and financial system are not as complicated as the multiverse. But the real economy and the
financial economy are like parallel universes with many transmission channels across these
two universes that we are only beginning to understand. Achieving coherence across
policies through an integrated framework is key to minimising the risk of repeated bouts of
financial and economic crises feeding on each other. It is not easy but probably not as
difficult as jumping across the multiverse.
Stein (2013), Overheating in credit markets: Origins, measurements, and policy responses , Speech
at the 2013 "Restoring Household Financial Stability aer the Great Recession: Why Household Balance
Sheets Matter" Research Symposium.
[3]
Stein (2014), "Comments on market tantrums and monetary policy", Speech at the 2014 US
Monetary Policy Forum, New York.
[4]
IMF (2020) "Toward an integrated policy framework', and Borio, Shim, and Shin (2022), "Macro-
financial stability frameworks: experience and challenges", BIS Working Papers No. 1057
[5]
Ca'Zorzi, Dedola, Georgiadis, Jarocinski, Stracca and Strasser (2020), "Monetary policy and its
transmission in a globalised world", Discussion paper No 2407 in the European Central Bank Working
Paper Series.
[6]
Miranda-Agrippino and Rey (2020), "U.S. monetary policy and the global financial cycle", The Review
of Economic Studies, Volume 87, Issue 6.
[7]
Borio, Shim, and Shin (2022), "Macro-financial stability frameworks: experience and challenges", BIS
Working Papers No. 1057
[8]
Adrian, Erceg, Kolasa, Lindé, and Zabczyk (2021), "A quantitative micro-founded model for the
integrated policy framework", IMF Working Paper WP/21/292.
[9]
Cecchetti, Narita, Rawat, and Sahay (2021), "Addressing spillovers from prolonged US monetary
policy easing", IMF Working Paper WP/21/182
[10]
Fratzscher, Gloede, Menkhoff, Sarno and Stoehr (2018), "When is foreign exchange intervention
effective? Evidence from 33 countries", American Economic Journal: Macroeconomics
[11]
IMF (2015) "Monetary policy and financial stability".
[12]
Brunnermeier (2023), "Rethinking monetary policy in a changing world", in IMF Finance and
Development, March.
[13]
Borio and Disyatat (2021), "Integrated policy frameworks: the constraints of policy horizons and
adjustment frequencies", SUERF Policy note 246.
[14]
Shirakawa (2023), "Time for change", in IMF Finance and Development, March.