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Financial stability and monetary policy--theory and practice.

Article Excerpt
Both price stability and financial stability are important for achieving macroeconomic stability. It is not clear-cut, however, what weight should be attached to financial stability and price stability considerations, respectively, when making monetary policy decisions. Nevertheless, both the communication and the monetary policy decisions of central banks indicate that financial stability is in the process of acquiring a more distinct role in monetary policy. This can be ascribed to the recognition that financial stability has consequences for future developments in inflation and output. In Norway, financial stability assessments are incorporated in the monetary policy advisory process, as Norges Bank Financial Stability contributes information, forecasts and recommendations in the process leading to monetary policy decisions.

1 Introduction

Central banks aim to promote economic stability, usually by targeting price stability and financial stability. In monetary policy regimes that target low and stable inflation, the key interest rate is the main policy installment. However, the level of and the changes in this policy rate may also have an impact on financial stability. In some situations, the two objectives may be in conflict.

What weight should be attached to financial stability and price stability considerations, respectively, when making monetary policy decisions? Financial instability normally develops over a long period, and there are considerable problems associated with operationalising and measuring financial stability. The challenges linked to modelling the interplay with monetary policy are even greater. Flexible inflation targeting, where emphasis is placed on both variability in inflation and variability in output and employment, is a framework where the outlook for financial stability may have monetary policy consequences to the extent that it influences future inflation and output.

External communication and policy decisions in a number of central banks indicate that taking account of financial stability has consequences for practical monetary policy. At Norges Bank, financial stability assessments are part of the preparations leading up to monetary policy decisions. Norges Bank Financial Stability (2) contributes by compiling and evaluating information from the financial sector as well as information concerning the financial position of households and enterprises. In addition, it provides specific recommendations on the monetary policy strategy in the light of the financial stability outlook, where projections of macroeconomic variables of importance to financial stability figure prominently in the assessments.

Section 2 of the article discusses the relationship between price stability and financial stability, and its consequences for the conduct of monetary policy. Section 3 considers three aspects of Norges Bank's incorporation of financial stability in monetary policy: the underlying motivation; the specific contributions; and the basis for the assessments.

2 The link between price stability and financial stability

Both price stability and financial stability are important for achieving macroeconomic stability. When inflation is low and stable, economic agents are in a better position to distinguish relative price changes from changes in the general price level. A more reliable information set underlying decisions on resource allocation contributes to stability in credit and securities markets, and price stability thus contributes to financial stability. Similarly, financial stability is a prerequisite for macroeconomic stability. Instability in the financial system may lead to pronounced fluctuations in monetary variables and in the real economy. Hoggarth et al. (2001) showed that financial crises entail not only financial costs, but also costs in the form of lost output. A smoothly functioning financial system also contributes to promoting macroeconomic stability. Deeper financial markets have probably increased the capacity of the financial system to absorb adverse shocks to the economy. White (2002) points to the emergence of a steadily increasing diversity of credit channels. New instruments are better suited to transferring various types of risk to those best able to cope with it. In addition to banks, institutions that channel credit include securities markets, pension funds, insurance companies and mortgage companies that specialise in high risk projects. White (2002) also stresses that financial institutions now measure risk more accurately, and that it has become simpler and cheaper to access and to exchange information. This helps markets to function more efficiently during periods of turbulence.

Although the objectives of price and financial stability are compatible in many situations, this provides no guarantee of financial stability during periods of price stability. Since the episodes of high and unstable inflation in the 1970s, inflation has been reduced and become more stable in most countries. Nevertheless, there have been a number of incidents where the financial system has been under pressure, with large fluctuations in asset prices and debt levels. In the most serious cases, these have developed into financial crises.

Much of the explanation for the episodes of financial instability must be ascribed to problems associated with the transition from a regulated to a liberalised financial system (see Allen and Gale, 1999) (3). Financial liberalisation may to some extent have increased the volatility of the financial system, because inherent pro-cyclical forces in financial markets are subject to fewer restrictions than before (Borio et al. 2001). On the other hand, increased system volume and liquidity serves to create greater stability.

The recent relatively long period of low and stable inflation has shown that strong economic growth does not necessarily result in high inflation (see Chart 1).

If the cause of the strong growth is a positive supply side shock, for example in the form of stronger international competition or higher productivity, inflation will remain low. In such situations, it can therefore be argued that there is less of a case for tightening monetary policy. The combination of moderate interest rates and strong economic growth may then lead to an upswing in asset and property prices. This will tend to lead to an increase in bank lending, because economic agents need more capital to purchase assets. There is a risk of their becoming overly optimistic in their assessment of the future. A number of studies have shown that risk perceptions...

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