Speech by Bank of Greece Deputy Governor John (Iannis) Mourmouras in Kuala Lumpur (Malaysia): “On monetary policy and financial stability: a European perspective”
23/11/2016 - Speeches
“On monetary policy and financial stability: a European perspective”*
Speech by Professor John (Iannis) Mourmouras
Deputy Governor, Bank of Greece
Former Deputy Finance Minister
I. Do policymakers have sufficient procedures and protocols to address multiple objectives?
The 2007-2009 global financial crisis has changed our understanding of the interactions between the real economy, the monetary policy objectives and the financial system. In fact, the crisis did not only require a major monetary policy response, but also triggered a re-design of the monetary policy framework to safeguard financial stability in the future. In other words, the global financial crisis raised the question if central banks should have one single or multiple objectives in order to avoid financial instability. Prior to the crisis, many major central banks focused on price stability and adopted inflation targeting.
Indeed, over the past decade, central banks acted aggressively to counter the adverse effects of the global financial crisis and its aftermath, operating in uncharted waters as they implemented “unconventional monetary policies” (UMPs) such as quantitative easing (QE) and, more recently, negative policy interest rates. While these interventions, along with many others that were introduced since the 2007-2009 global financial crisis were initially thought to be temporary, they are expected to remain partly in place for longer than expected. The unconventional is increasingly becoming conventional and UMPs have become established as part of any modern central bank’s toolkit. The experience which was very stressful for the global financial system has shown that unconventional tools were essential in order to ease financing conditions. Central banks have introduced a wide range of these measures that have evolved over time. In any event, the measures were tailored in their nature, size and extent to conditions specific to the country in which they are being implemented. Recently, monetary policy stances have begun to diverge: policy normalisation has started in the United States when the Federal Reserve raised its policy rate towards the end of last year and a further Fed rate hike is expected next month, as the implied volatility is around 81% today. On the other hand, after the Brexit vote the Bank of England cut its benchmark rate to the historic low of 0.25% and relaunched its QE programme with £60 billion over six months and up to £10 billion of corporate bonds over the next 18 months. Also, in the last GC meeting the ECB said that it will extend its QE programme beyond March 2017, if needed. Focusing on the ECB’s case, expansionary monetary policy is needed as part of the current ‘optimal policy mix’ for the Eurozone, as the core inflation rate remains below its target level of 2% for more than 5 years. Furthermore, even if there is ample evidence that the ECB’s QE helps banks by raising credit volumes and future growth, there are also negative effects as many banks are negatively impacted by low interest rates in an environment characterised by slow nominal GDP growth (and high non-performing loans), post-crisis banking overcapacity, higher capital requirements and technological challenges (digitalisation). Hence, monetary policy cannot be the ‘only game in town’. It is necessary to also ‘protect’ monetary policy by avoiding financial instability. There are two different reasons why monetary policy cannot, and should not, be used to deal with financial instability in asset markets. The first relates to the fact that the priority goals of monetary policy may require an expansionary (restrictive) stance when asset markets would require restrictive (expansionary) measures. Monetary policy cannot abandon its priorities as clearly stated in the mandate of central banks. More generally, as Mervyn King once stated, it would be highly controversial if a restrictive central bank policy adopted for reasons of asset market risks would create “mini-recessions” in real activity and unemployment, when the level of inflation would be compliant with the defined and publicly-known target. The second argument questions whether monetary policy, through its main policy instrument – short-term interest rates – can effectively target asset market prices. There is no theory or model establishing a reliable relationship between interest rates and asset price targets. Therefore, many central banks strengthened or were given financial stability and financial regulation roles. The first line of defence should be macroprudential policy, in particular in the face of asset price bubbles but especially to increase bank resilience as the business and financial cycles are not synchronised. Especially in a monetary union where vulnerabilities in each country can be addressed with macroprudential policy tools, which allow for the appropriate heterogeneity, countries remain subject to a single monetary policy.
Ultimately, striking the right balance between multiple objectives and the effectiveness of monetary policy is tricky, as there may be unintended impacts on central bank independence. A multiple-objective mechanism indeed poses some potential challenges. The first one is whether the mechanism can be expressed as a multi-objective function that can be optimised. From a theoretical point of view, it can be expressed in linear or log-linear multi-objective function, and it also formulates a duality relationship with a general equilibrium, which can be proven if weights on various objectives are appropriately determined by market prices. Besides, there may be some overlap of objectives. For instance, if monetary policy objectives are growth and employment simultaneously, there is some overlap between these objectives. There could be a conflict of objectives. We are all faced with dilemmas and trilemmas when making decisions on economic issues, which requires a trade-off and balancing act. Mathematically, this is unavoidable but normal. Objectives in conflict will cancel each other out during optimisation. Another challenge posed by multiple objectives is complicated models and communication difficulties. It is certainly desirable to have simple models and a single objective. Yet central banks are faced with a complicated world and have in many cases mandates that are far from simple. Many central banks are assigned more responsibilities after the global financial crisis. For instance, the Federal Reserve now needs to supervise systemically important financial institutions in addition to its mandates of maximum employment and stable prices. The ECB has been tasked to lead the Single Supervisory Mechanism (SSM) for systemic banks in the EU as part of the creation of a European Banking Union. The Bank of England has resumed the role of prudential regulator. Therefore complication and complexity are unavoidable, and the difficulty in communication is in essence a reflection of the complexity of reality.
II. Are existing policy instruments and policy strategies sufficient to handle extensions of central bank responsibilities?
Focusing on the euro area, since late-2011, the euro area inflation rate has fallen gradually. Bearing in mind that the ECB’s primary goal is to maintain price stability and closely monitor the risks to the outlook for price developments, the fragile euro area recovery and downward inflationary pressures necessitated a more expansionary monetary policy stance. To this end, the ECB further lowered overnight interest rates all the way to their effective lower bound – including below zero for the deposit facility. In addition, the ECB introduced, in July 2013, a policy of forward guidance, indicating its intention to keep interest rates at prevailing or lower levels “for an extended period of time”. The following step was to introduce two purchase programmes, for asset-backed securities (ABS) and covered bonds, and a programme to provide longer-term funding to banks in order to spur new loans. This latter programme is known under the term targeted longer-term refinancing operations (TLTRO), by providing term funding over up to four years at a very low fixed rate (June 2014). The negative developments after the December 2014 Eurosystem staff projections, the continuing downward trend of inflation mainly due to the recent fall in oil prices, the relatively weak use by the banks of the TLTROs, led the ECB in January of 2015 to expand its Asset Purchase Programme (APP) to include purchases of sovereign bonds, boosting its total monthly purchases of the three types of assets to €60 billion, starting in March 2015. This amount of purchases was “intended to be carried out until end-September 2016 and will in any case be conducted until a sustained adjustment is seen in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium-term”. One year later, on 10 March 2016, the ECB lowered the interest rate on Eurosystem main refinancing operations by 5 basis points to 0.00%, the interest rate on the marginal lending facility by 5 basis points to 0.25%, and the interest rate on the deposit facility has been decreased by 10 basis points to -0.40%. The monthly purchases under the asset purchase programme have been expanded to €80 billion per month, starting in April from €60 billion currently, taking the total size of the asset purchase programme to €1,740 billion by March 2017 or 15% of euro area GDP (from €1.14trn/11% of GDP previously). The result of the above non-standard measures was the impressive expansion of the ECB’s balance sheet. Indeed, in 2008 the ECB’s balance sheet was just under €1.5 trillion, reaching the highest level in June 2012 to €3.1 trillion and now it stands around €3.5 trillion. For the time being, the Eurosystem has already purchased € 1,306 billion of assets under the expanded APP, including € 1,149 billion under the Public Sector Purchase Programme (PSPP), and still has to buy €434 billion of assets until March 2017.
Such an accommodative monetary policy environment with negative interest rates, which foster search for yield and froth in asset markets, makes the use of macroprudential policy to tame the financial cycle and to pre-empt asset bubbles even more necessary.
Major institutional changes have been made to enhance financial stability in Europe, notably the establishment of a Single Supervisory Mechanism (SSM). In 2013, the European Council established a set of regulations, including a revised Capital Requirements Directive (CRD IV), the Capital Requirements Regulation (CRR) and the SSM Regulation, that all form the framework for a harmonised bank micro-prudential and macroprudential oversight in Europe. Implementation is ongoing and expected to be completed by 2019.
Based on these regulations, the ECB conducted a comprehensive assessment that was a health check of 130 banks’ balance sheets, including a stress test exercise using, inter alia, its own stress testing modelling framework. On 4 November 2014, the SSM became operative and now houses bank supervision in a single European institution. An agreement has also been reached among Member States to establish another key element of the Banking Union – the Single Resolution Mechanism. The SSM Regulation also confers the ECB with macroprudential powers. The ECB may top-up specific macroprudential measures if it considers actions by national designated authorities as insufficient to mitigate systemic risks. As in the past, the ECB will also continue to detect and assess systemic risks at the euro area level. However, in view of the new macroprudential mandate, this task is now also being enhanced by a more granular, country-level approach.
In terms of the toolkit, the ECB may use all macroprudential instruments laid down in the Union acts. It covers capital instruments, such as the counter-cyclical capital buffer, the systemic risk buffer, capital surcharges of systemically important institutions as well as liquidity instruments, such as the liquidity coverage ratio. In addition, the ECB can also increase risk weights on real estate exposures or set higher limits on large exposures. More precisely, from January 2016, the countercyclical capital buffer (CCB), the systemic risk buffer (SRB) and the other systemically important institutions (OSII) buffer, three important macroprudential tools, have been operational. However, given the need to diversify the available tools beyond regulations based on capital, tools based on liquidity, leverage and funding sources are also being introduced. With regard to the borrower’s side, instruments such as the loan-to-value (LTV), loan-to-income (LTI) and debt-service-to-income (DSTI) limits are considered to be among the most effective macroprudential instruments in curtailing excessive credit growth and the build-up of unsustainable debt positions. In order to effectively moderate the financial cycle, a time-varying dimension is crucial in the design of the various ratios. For example, the loan-to-value ratio should be lowered during the expansionary phase of a financial cycle and raised during the contractionary phase, while respecting the mandate of financial stability and avoiding the build-up of systemic risk. Otherwise, there is a risk of pro-cyclicality since leverage constraints decline as asset prices rise.
It is imperative, however, that the macroprudential toolbox be further enhanced with innovative tools beyond those outlined above. Cyclical systemic risk can arise not only as a result of excessive credit expansion (an issue that can be addressed with the countercyclical capital buffer along with limits on borrowing) but also because of inadequate channelling of credit that keeps the real economy under-financed for extended periods. A lesson drawn from the crisis is that we have focused on rather narrow areas of financial activity. Nowadays, it is important that we focus on the risks that might have been missed such as the interlinkages between sectors, and thus explore how the financial system can influence, and be influenced, by the wider economy. In the euro area, there is evidence of limited financing of the real economy, with the consequence that euro-area investment has not recovered to pre-2008 levels despite ECB policies directly aimed at increasing the lending of the banking sector.
III. Assessment of successes & shortcomings of macroprudential policies & their interaction with monetary policy
Before the recent financial crisis, the common view, both in academia and in central banks, was that achieving price and output stability would promote financial stability. This was supported by research findings (Bernanke, Gertler and Gilchrist (1999) and Bernanke and Gertler (2001)) indicating that monetary policy which optimally stabilises inflation and output is likely to stabilise asset prices, making asset price bubbles less likely. Indeed, central banks’ success in stabilising inflation and the decreased volatility of business cycle fluctuations, which became known as the Great Moderation, made policy-makers complacent about the risks from financial disruptions. The benign economic environment leading up to 2007, however, surely did not protect the economy from financial instability. Indeed, it may have promoted it. The low volatility of both inflation and output fluctuations may have lulled market participants into thinking there was less risk in the economic system than was really the case. Credit risk premiums fell to very low levels and underwriting standards for loans dropped considerably. As a result, the lesson learned from the financial crisis is that monetary policy and financial stability policy are intrinsically linked to one another, and so the dichotomy between them is a false one. Monetary policy can affect financial stability, while macroprudential policies to promote financial stability can have an impact on monetary policy. For instance, if macroprudential policies are implemented to restrain a credit bubble, they will slow the growth of aggregate demand. In this case, monetary policy may need to be easier in order to offset weaker aggregate demand. Alternatively, if policy rates are kept low to stimulate the economy, as is true currently, there is a greater risk that a credit bubble might occur. This may require tighter macroprudential policies to ensure that a credit bubble does not develop.
At a theoretical level, economists have lately developed DSGE models incorporating the banking sector whose presence allows for financial crises (see e.g. Gertler et al., 2012 and Boissay et al., 2013). At a policy level, the crisis has been followed by renewed interest in sound, comprehensive macroprudential frameworks which, coupled with micro-regulation, aim at minimising systemic risks and delivering financial stability (see Brunnermeier et al., 2009). An important difference between price and financial stability is that the former can be defined in a much more precise way than the latter, as financial stability presupposes the lack of market failures and externalities that are often difficult to identify (see Claessens, 2014). Ferguson (2002) defines financial stability in contrast to financial instability, described as a situation in which financial assets seem to have diverged sharply from fundamentals; and/or market functioning and credit availability, domestically and perhaps internationally, have been significantly distorted; with the result that aggregate spending deviates (or is likely to deviate) significantly from the economy’s ability to produce. From the above, it follows that unlike conditions of price stability, it is difficult to quantify conditions referring to financial stability. Having said that, a common feature of previous financial crises, including the one of 2008, is a run-up period characterised by fast credit growth causing bubbles in asset prices (see Borio and Lowe, 2002). Based on this experience, macroprudential policies are primarily set to have an ex ante effect, i.e. prevent excessive credit growth and asset price increases; but also, and given that a crisis has occurred, restore normal credit conditions and equilibrium asset prices (see Kindleberger and Aliber, 2005 and Brunnermeir et al., 2009).
However, the issue that remains pending is the level of the relationship between monetary policy and financial stability. Views on the topic range: from a categorical separation between the two and the need to take greater account of financial market developments in future monetary policy, all the way to the proposal that monetary policy should explicitly put the objective of financial stability next to that of price stability.
Macroprudential policy’s primary responsibility is counteracting the emergence of financial imbalances, and contributing to the stability of the financial system. Put simply, macroprudential policy has two primary tasks. First, it must strengthen the resilience of the financial system, such as through measures ensuring that banks have sufficient capital to absorb credit losses. Second, it must counteract financial imbalances, which in practice is about preventing credit and debt from increasing too rapidly. Risks in the financial system are usually divided into cyclical and structural risks. This is also a common way of dividing up the various tools of macroprudential policy. The cyclical tools are intended to change over time, and according to the financial imbalances that may arise. The countercyclical buffer is an example of such a tool. When banks’ household and corporate lending rises rapidly, the buffer requirement is higher. When the banks then exercise more restraint on their lending, it can be reduced. The structural tools, on the other hand, are intended to be implemented “once and for all” to create sound, long-term conditions for a stable financial situation. In practice, however, it is not easy to make a clear distinction between these tools. A certain tool may, under some conditions, be used to counteract both cyclical and structural risks.
On the other hand, monetary policy works by means of, for instance, influencing the volume of credit in the economy. There may thus be a reason for the central bank to attempt to counteract the emergence of financial imbalances, because they can ultimately affect inflation and resource utilisation. However, a well-functioning macroprudential policy should reduce the need to employ monetary policy in such situations, because the various macroprudential tools are normally more effective in managing financial imbalances than monetary policy. Various macroprudential tools also affect lending in the economy, and can therefore affect resource utilisation. High resource utilisation leading to overheating of the economy may threaten financial stability. The supervisory authority may therefore wish to work towards resource utilisation not being too high. In terms of both objectives and means the two policy areas are thus interlinked. In closing, coordination of monetary and macroprudential policies is important and becomes of greater value when all three objectives of price stability, output stability and financial stability are pursued at once.
As far as the empirical evidence on the matter is concerned, in a recent, comprehensive and highly-cited study, Cerutti et al. (2016) document policies and present evidence relating to their effectiveness in a sample of 119 countries, classified as advanced, emerging and developing, over the period 2000-2013. The authors undertake an extensive international survey, documenting the use of twelve macroprudential tools including: a general countercyclical capital buffer/requirement, the leverage ratio for banks, time-varying/dynamic loan-loss provisioning, the loan-to-value ratio, the debt-to-income ratio, limits on domestic currency loans, limits on foreign currency loans, reserve requirement ratios, levy/tax on financial institutions,: capital surcharges on SIFIs, limits on interbank exposures, and concentration limits. Namely, loan-to-value ratios and debt-to-income ratios are classified as borrower-oriented tools, while the remaining ten tools are classified as financial-institution oriented tools.
The reported evidence suggests that over the sample period, countries generally increased the use of macroprudential tools, with emerging and developing economies typically using more tools than advanced economies. With regard to effectiveness, tools are found to affect credit growth more than asset price inflation. Furthermore, the effect of tools on credit conditions shows considerable variation across a number of dimensions. Tools appear to be more effective in emerging/developing countries rather than advanced economies, relatively closed rather than relatively open economies, and also when the finance cycle is more intense, when credit growth is significantly higher or lower than normal. Finally, different tools appear to have different degrees of effectiveness in different environments, with borrower-oriented tools being more effective in advanced economies while financial institution-oriented tools are more effective in emerging and developing economies. This last set of findings may reflect the adverse effects on overall financial and economic stability of real estate developments in advanced countries and of international capital flows on emerging markets.
The findings by Cerutti et al. (2016) justify the use of countercyclical buffer tools such as loan-to-value and debt-to-income ratios in advanced economies, as instruments of an effective policy aimed to deliver financial stability. Nevertheless, more extensive research on the subject is necessary. The literature on the optimal macro-prudential framework is new and still evolving; whereas on the balance of evidence reported in previous literature, the precise policy mix to achieve the objective financial stability under different set-ups is at present rather inconclusive (see, for instance, Claessens, 2014, Akinci and Olmsted-Rumsey, 2015, and IMF-FSB-BIS, 2016).
*Panel intervention at the Central Bank of Malaysia-OMFIF Joint Policy Summit “Financial stability in an uncertain global environment” held in Kuala Lumpur (Malaysia) on Wednesday, 23 November 2016 in Session II entitled: “Financial stability and monetary stability – balancing central bank objectives”. An earlier version of this speech was presented at the Bank of Albania & SEESOX High-Level Conference in Tirana on 27 October 2016.