Why financial stability is a necessary prerequisite for an effective monetary policy??

Not a long time ago, we were lectured on how mon stability is all that matters to financial stability. It was seen as a necessary and sufficient condition for some and necessary condition for most. The logic was not difficult to beat as it took a while for central bankers to tame the inflation beast and hence they kept emphasizing on the idea. And then things like great moderation etc made them overconfident and stretched the idea even more.

Now, the tide has turned. So much so, the speech titles have just become reverse like this one from NY Fed chief – Bill Dudley. He titles it as  – Why financial stability is a necessary prerequisite for an effective monetary policy? The speech is given during Andrew Crockett First Memorial Lecture given by Prof. Rajan.

So why do we need to have Fin Stab is necessary for effective mon policy?

In my mind, the biggest lesson of the financial crisis has been that monetary policy cannot work properly when there is financial instability. When financial instability occurs, it disturbs market functioning and can also impair bank balance sheets. The result can be disruption to the financial intermediation function with resulting constraints on the availability of credit for households and businesses. This, in turn, can lead to further reductions in aggregate demand that put additional stress on the weakened financial system. Obviously, this is not a favorable dynamic.

Financial instability can impact the conduct of monetary policy via three major channels. First, financial instability can generate a sufficiently large shock to aggregate demand that the central bank may encounter the zero lower bound constraint – the constraint that the monetary policy instrument, for example, the federal funds rate – cannot easily be pushed below zero. In such circumstances, it may not be easy to fully offset the shock through the pursuit of a more stimulative monetary policy..

Second, financial instability can impair the linkage between monetary policy and financial conditions. The central bank may move to a much more accommodative monetary policystance, but this may not lead to much improvement in financial conditions. We see this clearly in spreads and risk premia during periods of financial stress. Depletion of capital in the banking system or the interaction of frictions and market failures may also lead to constraints on the availability of credit following a financial shock.

Third, the linkage between financial conditions and aggregate demand may also be impaired. For example, if an asset bubble has caused a buildup of debt that now needs to be reduced significantly, then lower interest rates that ease financial conditions may not stimulate aggregate demand very much. Separately, in a protracted zero bound episode, the monetary policy impulse may become attenuated over time. Lower interest rates may make financial conditions easier, lifting wealth, and encouraging households to shift spending from the future to the present. But when the future arrives, spending may then be lower as a consequence. The linkage between financial conditions and economic activity may varydepending on how long the accommodative monetary policy regime has been in place.

The implication is that c-banks need to focus more on financial stability and it should be a primary goal..

So what are the implications that stem from the fact that financial instability can impair the efficacy of monetary policy? I think there are at least three major implications:

  •  The central bank has a strong stake in preventing financial instability.
  • When financial instability occurs, the central bank has an important role in taking steps to mitigate that financial instability. This includes ensuring that credible liquidity backstops are available and forcing banks to strengthen themselves, for instance by raising additional capital.
  • The stance of monetary policy needs to be judged in light of how well the transmission channels of monetary policy are operating. When financial instability has disrupted the monetary policy transmission channels, following simple rules based on long-term historical relationships can lead to an inappropriately tight monetary policy.

He says there are issues over whether c-banks should be appointed guardians of financial stabilfinanciity and risk giving them too many things to handle. The bigger risk is central banks unable to figure financial risks and unable to do mon pol properly..

Fed was actually started for financial stability and went off to do other functions along the years..Interesting times..



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