A staff report from the New York Federal Reserve Bank makes the case for using monetary policy to address vulnerabilities in the financial system, but draws the same conclusion as Fed Chair Janet Yellen that financial stability does not need to be an explicit mandate of the central bank.
The newly-updated staff report on financial stability monitoring concedes “the degree of monetary accommodation has a direct impact on the risk taking of financial institutions.”
And while monetary policy “does not have an explicit financial stability objective,” the authors of the paper conclude that “to the extent that assessments of tail risks change the expected outlook for inflation or real activity, financial stability considerations could indirectly enter into monetary policy decisions.”
The staff report, which focuses on programs to identify and track the sources of systemic risk over time, finds “the best path forward for promoting financial stability is a program for monitoring systemic risks.”
This program should be “based on improved data collections and enhanced disclosure, and the implementation of meaningful pre-emptive regulatory and supervisory policies to address specific risks.”
But “when excesses appear to be broad, monetary policy also may be appropriate,” suggest the authors of the paper highlighted on the New York Fed’s Liberty Street Economics blog Monday.
This is largely in line with the view outlined by Chair Yellen in a speech to the International Monetary Fund in July, when she said she did not see “a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns.”
Conceding she did see “pockets of increased risk-taking across the financial system,” Yellen said “an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach.”
The New York Fed staff report also reiterates concerns expressed by Yellen and others that “the blunt nature of monetary policy may make it a poor tool for targeting tail outcomes, whereas regulatory and supervisory tools may be able to more directly address some financial vulnerabilities, particularly when vulnerabilities emanate from specific markets or institutions.”
Former Fed Governor Jeremy Stein, who left earlier this year to return to academia, made the argument that policymakers should keep an open mind to the idea of using monetary policy to address instability issues.
His argument was that supervisory and regulatory tools, due to their narrow focus, may simply end up pushing vulnerabilities into other parts of the financial system where only monetary policy could reach.
The paper’s authors, Tobias Adrian of the New York Fed, and Daniel Covitz and Nellie Liang, economists with the Federal Reserve Board, agreed saying “monetary policy also would affect the rates for all financial institutions, even the ones in the shadow banking system that cannot be targeted via typical supervisory or regulatory actions.”
But, in practice, the paper said “it may be difficult to aggregate risks to financial stability by embedding them into a dual mandate framework.”
To do so “would require monetary policy makers to assess not only expected output and inflation, but to make determinations about the tails of the outcome distributions,” they said.
In addition, policy makers would “need to be able to evaluate which distributions are optimal,” the staff paper said. For example, policy makers would need to assess “whether higher expected employment and higher downside risk would be preferred to lower expected employment and lower downside risk.”
In the end, the paper said, “the question of the effectiveness of monetary policy relative to more targeted policies remains.”