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, often 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.

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 of altering risk premiums.” [3] 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. Studies by both the IMF and BIS find that exchange rate movements have perverse, destabilising macroeconomic and financial effects in emerging market economies, in contrast with their stabilising effect in most advanced economies. [4] 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.