The global financial crisis showed that asset price bubbles can occur even when inflation and the output gap are in equilibrium and that accumulated risks in financial markets stemming from asset prices cannot be offset only with inflation targeting and micro-prudential measures and thus, the view suggesting that central banks should intervene by using interest rates and tools other than interest rates has been gaining more supporters (Borio, 2014).
In this period, a new academic literature has emerged regarding the design of macroprudential policies and the interaction between monetary policy and financial stability. This literature underlines that credit booms may mostly result in financial crises and dwells on how monetary policy should be designed. While one group of economists defend the “lean” strategy, which means keeping monetary policy tighter than what the price stability objective necessitates in periods of a boom, another group defends the “clean strategy” arguing that monetary policy should not try to take measures against financial risks, but instead adopt a “clean up” strategy at times of crisis.
The most important view of Stein (2013), who is an avid supporter of the “Lean” approach, is that monetary policy instruments should have a nature that penetrates the entire financial system, directly affects risk appetite and can be easily observed by anyone as it gets in all the cracks. Stein states that taking into account the complicated structure of financial systems, regulatory and supervisory measures cannot be successful in fighting all kinds of risks, that it will take time and it is difficult to track and measure the effectiveness of such measures. Meanwhile, Svensson (2018) claims that monetary policy is not a very appropriate tool (it is rather a blunt instrument) for combatting financial risks, given its effects on the real economy. Svensson argues that implementing a monetary policy tighter than required by the price stability target to mitigate financial risks may have higher costs than benefits given its side effects such as higher unemployment and below-target inflation. While some authors, such as Blinder (2010), defend the “lean approach” during credit-driven financial expansion periods, they argue that introducing monetary policy with a time lag during asset price-driven expansion periods will be the optimal strategy.
Particularly in the context of advanced economies, in periods of financial expansion, opting for the lean approach stands out as the optimal monetary policy strategy due to financial stability concerns; whereas in periods of contraction, it does not seem reasonable to adopt a monetary stance that is looser than required by the price stability target. In these periods, there are drawbacks with implementing a rapid and strong policy rate cut or keeping interest rates at low levels for a long period of time. First of all, low interest rates may disguise weak balance sheets and make them harder to detect. They can weaken the incentive to reduce excess capacity in the financial sector. They can also reduce financial intermediaries' returns by lowering interest rate spreads, thereby prolonging the tightness in credit markets (Borio, 2014). During times of balance sheet crises, efforts to overcome the crisis by implementing micro-prudential measures and designs towards recovering balance sheets are often cited as the most important parts of the optimal policy mix.
These arguments apply to both advanced and emerging economies. However, the fact that financial conditions in emerging economies are closely linked to capital flows and high foreign currency indebtedness makes it more difficult to determine the optimal policy mix in the presence of financial stability concerns. Monetary transmission through the credit and balance sheet channel generally works through changes in the value of firms, risk premia, cash flows and nominal debt burden. Therefore, the transmission mechanism in these countries can become more complicated due to the sensitivity of the financial system to capital flows.
In an economy where credit growth is influenced by capital flows, an interest rate hike may slow down the effectiveness of the policy rate by attracting more capital flow and increasing credit supply. Therefore, under free capital flows, the ability of monetary policy to smooth financial cycles may weaken (Fendoğlu and Gülşen, 2019). This implies that monetary policy easing steps should remain cautious even in periods of weak credits and economic contraction (Menna and Tobal, 2018).
In other words, implementing an easing monetary policy in response to a tightening in financial conditions independent of the monetary policy may lead to a decline in international capital inflows and a depreciation in exchange rates, ceteris paribus. Thus, credit and balance sheet channels may tighten financial conditions and limit the targeted easing effect of the monetary policy.
Let us clarify this issue with a more concrete example. In the aftermath of the global financial crisis, many financial intermediaries in emerging market economies borrowed large amounts of foreign currency denominated debt at low interest rates from abroad and lent in local currency at home. This led to currency mismatches on balance sheets of firms. In such a case, a monetary easing amid tight global financial conditions may lead to further depreciation of the local currency, which could have a contractionary impact on economic activity by reducing banks' equity capital and tightening leverage constraints. Cavallino and Sandri (2018) analyze the concept of the “expansionary lower bound" on the policy rate using a macro model with similar channels. They show that, in small open economies, the contractionary outcome of expansionary monetary policy can be driven by banks' capital constraints (the amount of domestic lending cannot exceed a certain ratio of equity capital) and currency mismatches on bank balance sheets.
In sum, due to the close relationship between capital flows and credits in open emerging economies, the argument favoring the lean strategy for advanced economies grows weaker, while there is more reason for monetary policy to adopt a cautious stance in times of financial contraction. It should also be noted that financial deepening is yet to be completed in emerging economies and country-specific factors should not be ignored in assessing the riskiness of the financial system. In economies with high foreign currency indebtedness, the relationship between the monetary policy and financial conditions is more complex due to balance sheet effects, and different strategies may be required in different periods depending on the economic outlook and the type of shocks encountered.
References
Borio, C. (2014). “The financial cycle and macroeconomics: What have we learnt?“ Journal of Banking & Finance, 45, 182-198.
Blinder, A. S. (2010). “How central should the central bank be?“ Journal of Economic Literature, 48(1), 123-133.
Cavallino, P., & Sandri, D. (2018). “The Expansionary Lower Bound: Contractionary Monetary Easing and the Trilemma.” IMF Working Paper No: 18/236.
Fendoğlu, S., Gülşen, E., & Peydro, J. L. (2019). “Global Liquidity and the Impairment of Local Monetary Policy Transmission.“ CBRT Working Paper No. 19/13.
Menna, L., & Tobal, M. (2018). “Financial and price stability in emerging markets: the role of the interest rate“. Forthcoming.
Stein, J. C. (2013) “Overheating in credit markets: Origins, measurement, and policy responses” speech in St. Louis, Missouri, February 7, federalreserve.gov/newsevents/speech/stein20130207a.htm
Svensson, L. E. (2018). Monetary policy and macroprudential policy: Different and separate? Canadian Journal of Economics/Revue canadienne d'économique, 51(3), 802-827.