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Assessment of Key Issues

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Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: International Experience
Asset Prices, Financial Stability and Monetary Policy

In the context of the involvement of central banks with financial stability, a widely discussed issue has been the 'degree of activism' that central banks should adopt in pursuing this objective. The conventional view is that (i) monetary stability contributes to financial stability as high inflation is one of the main factors creating financial instability in the first place and (ii) monetary and financial stability reinforce each other. Nonetheless, as recent developments suggest, monetary stability need not necessarily lead to financial stability in the short-run although, in the long-run, monetary and financial stability reinforce each other.

In an era of price stability and well-anchored inflation expectations, imbalances in the economy need not show up immediately in overt inflation. Increased central bank credibility is a double-edged sword as it makes it more likely that unsustainable booms could take longer to show up in overt inflation. For instance, unsustainable asset prices artificially boost accounting profits of corporates and thereby mitigate the need for price increases; similarly, large financial gains by employees can partly substitute for higher wage claims. In an upturn of the business cycle, self-reinforcing processes develop, characterised by rising asset prices and loosening external financial constraints. 'Irrational exuberance' can drive asset prices to unrealistic levels, even as the prices of currently traded goods and services exhibit few signs of inflation. These forces operate in reverse in the contraction phase. In the upswing of the business cycle, financial imbalances, therefore, get built-up. There is, thus, a 'paradox of credibility'. The role of financial imbalances was brought out strikingly by the recent global slowdown of 2000 which reflected the interplay of unwinding of such financial imbalances in contrast to earlier episodes of slowdowns which were induced by monetary tightening. Of course, financial crises during the 1990s were also partly a reflection of shortcomings of the reform agenda pursued by many developing economies. Issues such as institutional and governance reforms, and macroeconomic fragilities arising from the financial system and capital account of the balance of payments were not fully addressed.

For all the above reasons, central banks are now simultaneously preoccupied with both monetary and financial stability. Historically, however, central banks have typically been concerned with one of the two objectives at a point of time but not both together. Given the possibility that monetary stability itself can induce financial instability, a key question is: should monetary policy respond to asset price misalignments so as to contribute more directly to financial stability? While the debate on the issue is yet unresolved, an emerging consensus is that lengthening of monetary policy horizons beyond the usual two-year period, developing early warning indicators of financial imbalances and prudent regulation will be a more appropriate monetary policy response to tackle asset price bubbles and achieve financial stability (Box VIII.2).

In case of extreme misalignments in asset prices, the central bank could also consider communicating its views to the public which, in turn, could lead market participants to increase their own doubts about the sustainability of asset price bubbles. Capital requirements on banks could be increased in line with credit extensions collateralised by assets whose prices have increased. Finally, a central bank, in case of need, should ensure the integrity of the financial infrastructure - the payments and settlements system - and provide adequate liquidity. Central banks, therefore, need to pursue a multi- faceted approach towards ensuring financial stability. Illustratively, following the global financial turmoil set off by the Russian debt default in August 1998 and exacerbated by the failure of the hedge-fund LTCM, risk spreads widened sharply, stock prices fell, and liquidity conditions tightened. The US Fed responded by cutting policy interest rates by 75 basis points in three steps. In part, this response was necessitated by a change in economic forecasts but "part of this cautious behaviour reflected the FOMC's concerns about financial instabilities and associated downside risks to the economic forecast". Similarly, in the aftermath of September 11, 2001, the U.S. Fed was concerned about maintaining stability in the financial system and it undertook a number of steps to provide adequate liquidity through discount window lending, open market operations (OMOs), waiving of normal overdraft fees on daylight overdrafts and a 50 basis points reduction in the Fed Funds rate.

At the same time, in view of the growing integration of financial markets around the world, the pursuit of financial stability requires structural changes in the world economic order, beyond national central bank policy-making. In particular, a need has been felt for refinements in international financial architecture. At the global level, crisis prevention initiatives have prominently centred around strengthened IMF surveillance and include a number of aspects: data dissemination, greater transparency, development of standards and codes, constructive involvement of the private sector, Sovereign Debt Restructuring Mechanism (SDRM) and introduction of facilities like Contingent Credit Line (CCL).

While the debate on the appropriate monetary policy response to asset prices is still evolving, a number of studies have attempted to examine as to whether central banks, in practice, display any systematic response to asset prices. The Bank of Canada reduces policy rates significantly in response to an appreciation of trade weighted exchange rate, whereas the Reserve Bank of Australia does not respond to changes in any of the asset prices. Evidence for the US indicates that monetary policy responds significantly to stock market movements. A five per cent rise in the S&P 500 index, over a day, increases the likelihood of a 25 basis point tightening by about a half. The magnitude of this response is consistent with rough calculations of the impact of stock prices on aggregate demand. Therefore, it appears that the US Fed systematically responds to stock price movements to the extent warranted by their impact on the economy. Per contra, estimates for the US show that 25 basis points increase in short-term interest rates leads to a decline of about two per cent in stock prices. Ehrmann and Fratzscher (2004) report qualitatively similar results: an unexpected 50basis point increase in the policy rate reduces S&P index by about three per cent on the day of the monetary policy announcement. Individual stocks react in quite a heterogeneous manner. In particular, stocks offinancially constrained firms - those with low cash flows, poor credit ratings - show a higher order of decline, a result consistent with the credit channel of transmission. Overall, the response of equity prices to interest rates appears to be fairly modest and the estimates confirm the earlier observation that monetary policy response would have to be quite aggressive to have any significant effect on asset prices.


Box VIII.2
Monetary Policy and Asset Prices

Asset price misalignments that typically precede and accompany financial instability can profoundly affect consumption and investment decisions, misallocating resources across sectors and over time. In the context of sharp movements in asset prices such as equity and property prices and exchange rates, a protracted debate has emerged on the appropriate response of monetary policy. A dominant view is that a central bank should not respond to changes in asset prices, except in so far as they signal changes in expected inflation. According to Woodford (2003), monetary policy should target only goods prices and not asset prices. Woodford's argument is based on the fact that goods prices are sticky while asset prices are flexible. It is the stickiness in the goods prices as well as wages that leads to deviation of actual output from its natural (potential) level of output. Therefore, monetary policy should aim to stabilise those prices that are infrequently adjusted. Large movements in frequently adjusted prices - such as stock prices - can be allowed and may be even desirable if such large movements make possible greater stability of the sticky prices.

According to the other view, an inflation-targeting central bank might improve macroeconomic performance by adopting a lean-against-the-wind. Having a transparent reaction function consisting not only of the inflation forecast but also an adjustment to asset price misalignment could potentially make bubbles less likely to occur. Cecchetti et al. (op cit.) emphasise that they do not advocate that asset prices should be targets for monetary policy, but rather that central banks should react systematically to misalignment. Similarly, Borio and White (op cit.) favour a pre-emptive monetary policy response against a build-up of financial imbalances, supported by improved financial regulation and supervision.

A usual argument against monetary policy response to asset price misalignments is that it is difficult to identify bubbles. Although true, same difficulties are inherent in estimation of potential output - a key variable in monetary policy decision-making. Notwithstanding claims of difficulties in identification, it is debatable that extreme cases of stock market bubbles cannot be detected in real time - for instance, the NASDAQ in early 2000. Moreover, available empirical evidence suggests that bubbles can be identified in real time if a central bank widens its information base to include indicators such as credit aggregates. According to Borio and White (op cit.), excessive increases in just two indicators - real asset prices and credit/GDP ratio - contain useful leading information about future systemic banking distress. Real asset prices (when 60 per cent or more above trend) and credit-GDP ratio (4 percentage points or more above trend) individually predict more than 70 per cent of episodes of banking distress. For emerging markets, real exchange rate appreciation is an additional leading indicator. In this context, the European Central Bank's two-pillar approach - where the second pillar is explicitly based on monetary and credit developments - takes into account build-up of financial imbalances. The two-pillar strategy provides warning signals in cases where inflation remains benign but monetary and credit aggregates rise strongly.

A related issue of the debate is: whether 25 or 50 basis point hikes in policy rates - the usual size of policy response - are sufficient to counter the sharp increases in stock prices? As Fed Chairman Greenspan has recently noted, a moderate monetary tightening has often been associated with subsequent increases in the level of stock prices. Moreover, the notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is "almost surely an illusion" and, therefore, the strategy of addressing the bubble's consequences rather than the bubble itself is appropriate. The prevention of bubble can be arrested only by a sharp increase in interest rates, with adverse implications for the real economy. Nonetheless, central banks are not oblivious of the need of a pre-emptive policy response against future bubbles. Illustratively, the recent tightening of monetary policy by the Bank of England has been partly in response to the movement in housing prices.

In the presence of subdued inflation, another criticism of pre-emptive monetary tightening is that it would be seen as the central bank exceeding its remit. However, as Borio and White (op cit.) argue, it was the recognition of the absence of a long-run inflation-output trade-off that has led to clear-cut price stability mandates for central banks. Likewise, a view of economic processes that stresses the role of financial imbalances could promote the necessary intellectual consensus for action.

In brief, although there are arguments against a pre-emptive monetary policy strike to asset price misalignments, there are strong counter arguments when faced with a suspected bubble. There are, of course, difficulties in implementing acceptable solutions. Lengthening of monetary policy horizons, developing early warning indicators of financial imbalances and prudent regulation are considered as apposite central bank responses to asset price bubbles. .

In sum, monetary stability is a necessary but not a sufficient condition for financial stability. Central banks are now therefore pursuing a more pro-active approach in maintaining financial stability. Two issues arise in this context: how does the financial stability objective affect central banks' other policy goals and how is the objective of financial stability perceived by the public? A financial stability objective that is accorded too much weight could, at the margin, impair the conduct of monetary policy. Monetary policy instruments are, therefore, required to be supplemented with other instruments as safeguarding financial stability is a multi-faceted task requiring action at micro as well as macro levels. For central banks, the macroeconomic levers are the instruments of monetary policy. The levers related to the micro area relate primarily to infrastructure and institutions. These include: the payment and settlement systems, the provision of a safety net for depositors and procedures for resolving crisis, the regulation and supervision of institutions and the formulation of accounting conventions. However, the provision of a safety net for depositors and prudential controls over banks may also have macroeconomic implications, as well as constituting a part of the central bank's armoury of micro levers. A cross-country survey of practices in these areas is discussed in the following paragraphs.


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