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The increase in the Monetary Policy Rate (MPR) by the Central Bank of Nigeria (CBN) is aimed at achieving price stability through curbing inflation. But manufacturers will have to contend with the attendant high cost of production due to increased lending rates, which will then be passed on to consumers by raising prices, COLLINS NWEZE writes.

In recent months, the Central Bank of Nigeria (CBN) has taken some policy decisions aimed at tightening liquidity and achieving price stability. Over a week ago, the Monetary Policy Rate (MPR), rate at which banks borrow from the CBN was raised by 275 basis points (bps) to 12 per cent at extraordinary Monetary Policy Committee meeting. The increase, was sixth in a series by the apex bank this year.

The Cash Reserve Ratio (CRR), a proportion of banks deposit liabilities with the CBN, was doubled from four per cent. Also, reserve averaging method for computing CRR was suspended in favour of daily maintenance even as banks net open positions was reduced to one per cent of shareholder funds, from five per cent.

The apex bank, however, kept its 200 basis point corridor around the benchmark rate; its recommended deposit rate is 10 per cent and lending rate, 14 per cent.

Currently, average lending rate for prime customers, which is expected to go up is 17.79 per cent per annum, while that of those who are not prime customer is 20.40 per cent. But when other costs are added, the average lending rates for prime customers will hover between 25 and 27 per cent, while those who are not prime customers will be over 30 per cent. Also, interest rate on savings account, which is currently 2.27 per cent per annum is expected to rise to about 3.5 per cent. Interbank rates rates at which banks borrow from one another to cover their positions has since risen. Commenting on the monetary tightening, Managing Director, Financial Derivatives Company Limited, Mr. Bismarck Rewane, described it as a big pill to swallow.

Noting that the development has very wide implications, he said it would have been easier for the MPC to adjust the exchange rate. This will tighten liquidity so much and make banks to liquefy their Asset Management Corporation of Nigeria (AMCON) bonds. The cost would be passed on to corporate borrowers, who will also pass it on to consumers by raising the prices of their jobs.

These measures can also be of benefit to the naira, but it could be distruptive to corporate borrowers. I am not sure that the naira can be protected, but lets see what happens to the forex market in the future, he said.

The CBN Governor, Sanusi Lamido Sanusi said the actions were informed by the decision to control excess liquidity in the system and sustain inflation at single digit.

While some market participants had expected the apex bank to announce a devaluation of the naira at the special meeting, the decisiveness of the policy moves, and the dramatic tightening they represent, leaves little doubt about the apex banks overall policy intent.

Experts perspectives

Head, Market Risk, Greenwich Trust Limited Babatunde Obaniyi, said by raising the MPR, the CBN may be able to curb inflation. He said there was high demand pressure on the naira, which can only be controlled by mopping liquidity in the system.

Obaniyi said payment of the minimum wage would add to excess liquidity in the system, adding that the best option is to raise the MPR.

He said the apex bank has moved decisively to underscore its price stability credentials. According to the firm, in response to increased global uncertainty, capital outflows, and speculation over waning official commitment to foreign exchange stability, the CBN tightened policy much more than expected at an extraordinary MPC meeting, which was called in response to new all-time lows in the naira.

An analyst at Standard Bank, Razia Khan, explained the implication of these adjustments. He said it is the increased cost of funds that deters borrowing for reckless purposes, but which also shortchanges the real sector that engages on productive activities. By raising the base rate at which banks borrow from the CBN, the banks have no choice but to raise interest rates, thereby increasing the cost of loans. It also implies that funds available for lending by banks would reduce since a larger cash proportion is expected to be held with the CBN.

Analysts at Renaissance Capital insist that the rate, which was raised last month from 8.50 to 9.25 per cent, has failed to reduce the volume of money in circulation, thereby putting pressure on the naira against other global currencies, especially, the dollar.

A financial analyst, also predicted a hike in MPR. He said the exchange rate is bad as oil price is going down at a time the United States and Europe are economically challenged. We are in a box and need a bit of brainwave. The Federal Government has to step in as cost is likely to go up. I think labour will oppose removal of subsidy because government is not cutting its costs, he said.

He said the reduction in the price of oil means that Nigeria will earn less dollars, adding that the banking watchdog may not be able to meet the dollar demand meant for the importation of petrol and other consumables.

The Monetary Policy Committee is about liquidity and price stability. It is difficult to have price stability when three months to the end of the year, removal of oil subsidy looms, knowing that it will have a negative impact on inflation, he said, arguing that such an act will affect prices of products, goods and services.

He said where the naira is facing a challenge; the best thing to do is to increase the cost of money. If you increase what it costs to buy foreign exchange (forex), then the naira will firm up. The CBN has to look at the cost of money again. He said when there is too much money in circulation; the CBN may do well to obstruct it a little.

Managing Director, Financial Nigeria International, Jide Akintunde, said the policy is an attempt to consolidate on the gains of the past monetary policy which had helped to bring inflation to single digit from around 23 per cent in 2004. He said the increase was normal for the economy and would help to control inflations but admitted that high rates of this nature affect productive activities needed for the growth of domestic market economy. Others insist the CBN is only carrying out its constitutional duties by upwardly adjusting the rates, but needs to be cautious about it.

CBNs measures to stabilise Naira

The CBN has said it will restrict the sale of dollars at its auctions to foreign companies taking the currency offshore, in a further measure to limit local foreign exchange demand and support the weakening naira. The regulator said foreign investors were guaranteed to repatriate their earnings and proceeds of investments offshore but they could only seek dollars for such purposes from the open market, limiting forex demand at its auction. All remittances in respect of dividends, capital and proceeds of investments shall be through the use of autonomous funds (interbank), CBN Director, Trade and Exchange, Batari Musa said in a circular to banks.

For the avoidance of doubts, foreign investors are guaranteed repatriation of their earnings and or proceeds of investments through the use of autonomous funds, he said. The CBN has in its continued effort to consolidate on the policy measures taken on foreign exchange utilisation, coupled with the need to streamline petroleum products importers, authorised dealers are to forward copies of the Form lsquo;M proceeds and other relevant documents to the CBN for consideration. Also, request for purchase of foreign exchange shall be made within 48 hours to the bidding or auction day, failing which the bid shall be considered for the next auction session.

The apex bank said that after negotiation of the transaction, and within 30 days of arrival of the cargo, authorised dealers shall provide the final shipping documents including product certification report issued by the Department of Petroleum Resources (DPR) among other measures.

In the face of the spectre of declining oil prices, declining foreign reserves, increased demand for foreign exchange, fiscal dominance and capital flow reversals, monetary policy must bear a larger burden of economic adjustment. The MPC has, therefore, to make difficult choices, each of which has clear costs and benefits.

Presure on Naira

The pressure on the local currency intensified after the CBN, on September 26, sold naira outside the weakest edge of its target.

Inflation rises to 10.3 per cent

Nigerias headline inflation rose to 10.3 per cent in September, beating the CBN single-digit target. The rise in inflation came to many as a surprise because of six official interest rate rises by the apex bank this year. The inflation was 9.3 per cent in August, snapping three straight months of declines, the National Bureau of Statistics (NBS) said.

Food prices, the largest contributor to the consumer index, rose by 9.5 per cent year-on-year in September after 8.7 per cent the previous month. The biggest contributors to the consumer inflation were the high prices of electricity and food items even as the rise in food prices was mainly due to the increasing costs of yam, cooking oil and fish, the NBS document said.

The CBN has been raising interest rates for more than a year to help curb high inflation and support the naira, which plunged to an all-time low this week. CBN hiked its benchmark interest rate by a much bigger-than-expected 275 basis points to 12 per cent and implemented several other tightening measures at an emergency meeting on October 10.

Same day, the naira recovered from the record low of 167.8 to the dollar, after the CBN sold around $1 billion into the market in the space of a week, traders said. But trading on the local currency remains volatile and further weakness would add to inflation pressures.

Implications to private sector, others

The President, National Association of Small Scale Industrialists (NASSI) said the result of these moves has raised the cost of getting loans from banks for commercial and manufacturing purposes. For the MPR, it means that if banks were before now, lending at N25 per cent per annum, then their lending rate will go up by at least two per cent. It also means that interest on saving will rise, making it more attractive for people to keep more money in the banks.

It is expected that interest on savings, which many banks used to pay about one per cent per annum, may move to between 1.5 per cent and two per cent. For Primary Mortgage Institutions (PMIs), the interest may move to between three and four per cent, depending on individuals bargain power, said Chukwumah Chukwu, Treasury Manager, UniTrust Savings amp; Loans Limited.

He explained that the cost of foodstuffs and other goods and services, which had gone up by at least 13 per cent in recent months, will climb even higher in the months ahead due to increase cost of funds to borrowers. The poverty level in the country will ascend within or above similar trajectory.

According to him, the effects of the latest tightening on the real economy are likely to be fairly limited, raising the risk of further rate hikes if they are deemed necessary. The transmission effect of monetary policy is still problematic. For structural reasons, very little bank lending in the economy is channelled to the real sector. Weighing up the policy costs and benefits, the authorities will feel vindicated by their decisions, ultimately, price stability results in greater benefits to more Nigerians than lower interest rates and a more volatile foreign exchange rate, he said.

Global implications

While the CBN has long supported the exchange rate through regular dollar sales at its official Wholesale Dutch Auction System (WDAS) auctions, market nervousness over the sustainability of foreign exchange stability is rooted in several key factors. First, despite rising oil output, higher oil prices, and a comfortable current account surplus, Nigerias reserves have been under pressure, falling to a recent low of $30 billion from a peak of over $60 billion before the global crisis.

According to Khan, this was partly due to expansionary fiscal policy and excessive liquidity growth, which raised demand for forex, much of which had been largely met by the CBN until recently. In the last three trading sessions, the authorities have not fully met demand at the WDAS auctions. Dollar to naira has traded outside of its theoretical +/-3 per cent trading band around 150, prompting speculation of a policy shift. The authorities had already stated that they would not defend the naira at all costs, if fundamentals deteriorated as in 2008, fuelling higher demand for forex on the interbank market.

The increasingly uncertain global economic outlook, doubts about the sustainability of current oil prices despite a tight market, and Nigerias significant overdependence on oil for its foreign exchange earnings have also weighed on sentiment. These factors have added to fears that the authorities would be forced to take a more flexible approach to currency management in the event of a more severe global economic slowdown.

Budget 2012 assumptions

Budget 2012 assumptions show little evidence of fiscal consolidation. The MPC said the 2012 budget is more expansionary than that of this year. The 2012 budget assumes a budget deficit of 2.69 per cent of Gross Domestic Product (GDP), which is marginally smaller than the target for the 2011 budget, of 2.97 per cent. Moreover, the government plans to increase fiscal spending to N4.8 trillion in 2012, from the N4.4 trillion planned for 2011. This explains Sanusis view that the proposed 2012 budget suggests a loose fiscal policy. The proposed increase in fiscal expenditure presents an inflationary risk for 2012.

It is expected that private sector credit growth in Nigeria is unlikely to increase beyond the mid-teens, given the higher-interest-rate environment. Moreover, the appeal of local-currency debt for banks and investors is likely to increase, as real yields rise.

Way out

Faced with these developments, the authorities could have made one of two policy choices. According to the MPC statement, they might have succumbed to market pressure and announced a one-off devaluation of the naira. However, in their view, this would not have ended pressure on the currency and would have achieved little. The demand for foreign exchange would have increased further had they given the market a reason to doubt their future commitment to currency stability, risking an even greater drawdown of reserves. Moreover, there is little evidence that Nigerias import demand is sensitive to the exchange rate. Price stability would have been compromised, with little to show for it. In economic terms, this would not have represented a stable equilibrium, and the benefits of such action would have been questionable, Khan said.

She said instead, the preferred approach was to tighten significantly, underscoring the authorities commitment to price stability and dealing with the causes of excessive demand for foreign exchange in the official, interbank and parallel markets at their source. However, the expected payment of debt owed by the Nigeria National Petroleum Corporation (NNPC) to the Federation Account this quarter is likely to add further to near-term liquidity pressures.

In the near term, the knee-jerk market reaction to unexpectedly aggressive tightening is expected to drive a significant downward retracement in the dollar to naira foreign exchange rate.

Each one per cent increase in the CRR is estimated to remove at least N100 billion from the economy. The higher CRR of eight per cent should result in the immediate withdrawal of N400 billion from the banking system.

With banks paying a higher rate to borrow via the CBNs standing lending facility, overall tightening is significant. Until recently, there was little competition for funds in the banking system. The availability of official guarantees on interbank deposits in the aftermath of the banking-sector crisis shielded banks, especially weaker institutions, from competing for liability growth. In fact, low deposit rates, largely unresponsive to the resumption of CBN tightening in September 2010, had caused larger cash balances to remain outside the banking system. Apparently, this may change now, with more aggressive competition for liabilities raising banking-sector deposit rates far more than in the past.

Unlike in previous instances of CBN tightening earlier this year, the return on naira deposits, and the opportunity cost of holding foreign exchange, should finally respond to policy action. Even if earlier tightening had little impact on demand for forex, this will not necessarily hold true in the future. Should the authorities be dissatisfied with the results, more tightening, either through policy measures on higher MPR or more frequent Open Market Operations (OMOs) cannot be ruled out

Tags: Monetary

The Effects of the Great Recession on Central Bank Doctrine and Practice

The financial crisis of 2008 and 2009, together with the associated deep recession, was a historic event–historic in the sense that its severity and economic consequences were enormous, but also in the sense that, as the papers at this conference document, the crisis seems certain to have profound and long-lasting effects on our economy, our society, and our politics. More subtle, but of possibly great importance in the long run, will be the effects of the crisis on intellectual frameworks, including the ways in which economists analyze macroeconomic and financial phenomena.

In particular, the crisis has already influenced the theory and practice of modern central banking and no doubt will continue to do so. Although it is too early to know the full implications of recent events for central bank doctrine and operations, I thought it would be worthwhile today to highlight and put into context some of the changes, as well as the continuities, that are already evident. My remarks will focus on how central banks responded to recent challenges related to the conduct of both monetary policy and the promotion of financial stability and how, as a result of that experience, the analysis and execution of these two key functions may change.

The Monetary Policy Framework
During the two decades preceding the crisis, central bankers and academics achieved a substantial degree of consensus on the intellectual and institutional framework for monetary policy. This consensus policy framework was characterized by a strong commitment to medium-term price stability and a high degree of transparency about central banks policy objectives and economic forecasts. The adoption of this approach helped central banks anchor longer-term inflation expectations, which in turn increased the effective scope of monetary policy to stabilize output and employment in the short run. This broad framework is often called flexible inflation targeting, as it combines commitment to a medium-run inflation objective with the flexibility to respond to economic shocks as needed to moderate deviations of output from its potential, or full employment, level. The combination of short-run policy flexibility with the discipline imposed by the medium-term inflation target has also been characterized as a framework of constrained discretion.

Many central banks in both advanced and emerging market economies consider themselves to be inflation targeters, prominent examples including those in Australia, Brazil, Canada, Mexico, New Zealand, Norway, Sweden, and the United Kingdom. Although they differ somewhat in the details of their policy strategies, policy tools, and communication practices, today virtually all inflation-targeting central banks interpret their mandate flexibly–that is, they treat the stabilization of employment and output in the short term as an important policy objective even as they seek to hit their inflation targets over the medium term. Several other major central banks, such as the European Central Bank (ECB) and the Swiss National Bank, do not label themselves as inflation targeters; however, they have incorporated key features of that framework, including a numerical definition of price stability, a central role for communications about the economic outlook, and a willingness to accommodate short-run economic stabilization objectives so long as these objectives do not jeopardize the primary goal of price stability.

How does the Federal Reserve fit into this range of policy frameworks? The Federal Reserve is accountable to the Congress for two objectives–maximum employment and price stability, on an equal footing–and it does not have a formal, numerical inflation target. But, as a practical matter, the Federal Reserves policy framework has many of the elements of flexible inflation targeting. In particular, like flexible inflation targeters, the Federal Open Market Committee (FOMC) is committed to stabilizing inflation over the medium run while retaining the flexibility to help offset cyclical fluctuations in economic activity and employment.

Also, like the formal inflation targeters, over time the Federal Reserve has become much more transparent about its outlook, objectives, and policy strategy. For example, since early 2009, the Federal Reserves Summary of Economic Projections has included the FOMCs longer-run projections, which represent Committee participants assessments of the rates to which economic growth, unemployment, and inflation will converge over time. These projections are conditioned on the assumptions of appropriate monetary policy and no further shocks to the economy; consequently, the longer-run projections for inflation in particular can be interpreted as indicating the rate of inflation that FOMC participants judge to be most consistent, over time, with the Federal Reserves mandate to foster maximum employment and stable prices. These longer-run inflation projections are thus analogous to targets although, importantly, they represent the Committee participants individual assessments of the mandate-consistent inflation rate, not a formal inflation goal of the Committee as a whole.

To what extent, if at all, has the pre-crisis consensus framework for monetary policy been changed by recent events? In part because they recognized the benefits of continuity and familiarity during a period of upheaval, central banks generally retained their established approaches to monetary policy during the crisis; and, in many respects, the existing frameworks proved effective. Notably, well-anchored longer-term inflation expectations moderated both inflation and deflation risks, as price-setters and market participants remained confident in the ability of central banks to keep inflation near target in the medium term. The medium-term focus of flexible inflation targeting also offered central banks latitude to cushion the effects of the financial shocks on output and employment in the face of transitory swings in inflation. In particular, they were able to avoid significant policy tightening in mid-2008 and early 2011, when sharp increases in commodity prices temporarily drove headline inflation rates above target levels. Finally, for central banks with policy rates near the zero lower bound, influencing the publics expectations about future policy actions became a critical tool, as I will discuss further shortly. The commitment to a policy framework that is transparent about objectives and forecasts was helpful, in many instances, in managing those expectations and thus in making monetary policy both more predictable and more effective during the past few years than it might otherwise have been.

However, the recent experience did raise at least one important question about the flexible inflation-targeting framework–namely, that although that framework had helped produce a long period of macroeconomic stability, it ultimately, by itself, was not enough to ensure financial stability. Some observers have argued that this failure should lead to modifications, or even a replacement, of the inflation targeting approach. For example, since financial excesses tend to develop over a relatively longer time frame and can have significant effects on inflation when they ultimately unwind, it has been suggested that monetary policy should be conducted with reference to a longer horizon to take appropriate account of financial stability concerns.

My guess is that the current framework for monetary policy–with innovations, no doubt, to further improve the ability of central banks to communicate with the public–will remain the standard approach, as its benefits in terms of macroeconomic stabilization have been demonstrated. However, central banks are also heeding the broader lesson, that the maintenance of financial stability is an equally critical responsibility. Central banks certainly did not ignore issues of financial stability in the decades before the recent crisis, but financial stability policy was often viewed as the junior partner to monetary policy. One of the most important legacies of the crisis will be the restoration of financial stability policy to co-equal status with monetary policy.

Monetary Policy Tools
While central banks may have left their monetary policy frameworks largely unchanged through the Great Recession, they have considerably widened their set of tools for implementing those frameworks. Following the crisis and the downturn in the global economy that started in 2008, central banks responded with a forceful application of their usual policy tools, most prominently sharp reductions in short-term interest rates. Then, as policy rates approached the zero lower bound, central banks began to employ an increasingly wide range of less conventional tools, including forward policy guidance and operations to alter the scale and composition of their balance sheets.

Forward guidance about the future path of policy rates, already used before the crisis, took on greater importance as policy rates neared zero. A prominent example was the Bank of Canadas commitment in April 2009 to keep its policy rate unchanged at 1/4percent until the end of the second quarter of 2010, depending on the outlook for inflation. This commitment was successful in clarifying for market participants the banks views on the likely path of policy rates and appears to have helped reduce longer-term interest rates, thus providing additional policy accommodation. In 2010, the Bank of Japan, which faced ongoing deflation in consumer prices, also used conditional forward guidance, saying that The Bank will maintain the virtually zero interest rate policy until it judges, on the basis of the ‘understanding of medium- to long-term price stability, that price stability is in sight, on condition that no problem will be identified in examining risk factors, including the accumulation of financial imbalances.

Some central banks provide forward guidance directly by releasing forecasts or projections of their policy rate. This practice had already been adopted by the Reserve Bank of New Zealand (in 1997), the Norges Bank (in 2005), and the Swedish Riksbank (in 2007). Each of these central banks used those projections during the financial crisis to indicate that they were likely to keep rates at low levels for at least a year.

In the United States, the FOMC introduced language in its March 2009 statement indicating that it anticipated rates to remain at low levels for an extended period, and at its August 2011 meeting the Committee elaborated by indicating that it anticipated rates would remain low at least through mid-2013.⁵ The FOMC continues to explore ways to further increase transparency about its forecasts and policy plans.

In addition to forward guidance about short-term rates, a number of central banks have also used changes in the size and composition of their balance sheets as tools of monetary policy. In particular, the Federal Reserve has both greatly increased its holdings of longer-term Treasury securities and broadened its portfolio to include agency debt and agency mortgage-backed securities. Its goal in doing so was to provide additional monetary accommodation by putting downward pressure on longer-term Treasury and agency yields while inducing investors to shift their portfolios toward alternative assets such as corporate bonds and equities. These actions also served to improve the functioning of some stressed financial markets, especially in 2008 and 2009, through the provision of market liquidity.

Other central banks have also used their balance sheets more actively than before the crisis, with some differences in their motivations and emphasis, in part reflecting differing financial structures across countries. For example, the Bank of England has used large-scale purchases of medium- and long-term government securities as its preferred tool for providing additional stimulus; it expanded the size of its asset purchase program earlier this month out of concern about possible slowing of domestic and global economic growth. The Bank of Japan has acquired a wide range of assets, including government and corporate bonds, commercial paper, exchange-traded equity funds, and equity issued by real estate investment corporations. The ECB purchased privately issued covered bonds between July 2009 and June 2010 to improve liquidity in a key market segment; it recently announced plans to resume such purchases in November. The ECB has also bought the sovereign bonds of some vulnerable euro-area countries, to ensure depth and liquidity in those market segments which are dysfunctional, although the monetary effects of these purchases have been sterilized through offsetting operations.

In most cases, the use of balance sheet policies for macroeconomic stabilization purposes has reflected the constraints on more-conventional policies as short-term nominal interest rates reach very low levels. In more normal times, when short-term policy rates are not constrained, I expect that balance sheet policies will be rarely used. By contrast, forward guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant, and I expect to see increasing use of such tools in the future.

Financial Stability Policy
Even as central banks were innovative in the operation of their monetary policies, they were forced to be equally innovative in restoring and maintaining financial stability. Serving as a lender of last resort–standing ready in a crisis to lend to solvent but illiquid financial institutions that have adequate collateral–is, of course, a traditional function of central banks. Indeed, the need for an institution that could serve this function was a primary motivation for the creation of the Federal Reserve in 1913. The Federal Reserves discount window is an example of a facility that operates in normal times to provide very short-term liquidity to depository institutions. Most other central banks have facilities with similar features that are generally aimed at banks that find themselves with temporary liquidity needs. During the crisis, as short-term funding markets failed to function normally, central banks around the world acted forcefully to channel liquidity to institutions and markets by lengthening the terms of their lending, increasing the range of collateral accepted, and expanding the set of counterparties with which they would undertake operations.

To help stabilize the financial system and facilitate the flow of credit to households and businesses, the Federal Reserve responded to the dislocations in funding and securitization markets by dramatically increasing the amount of term funding that it provided to banks, establishing new lending facilities for nonbanks, and providing funding to support the operation of key markets. Elsewhere, including Canada, the euro area, and the United Kingdom, central banks introduced similar facilities or expanded existing facilities to boost the provision of liquidity in their local currencies. The types of facilities have varied across countries commensurate with differences in financial systems. In the euro area, where the banking sector plays a relatively large role in financial intermediation, the ECB focused on increasing liquidity to banks. Similarly, the Bank of England sought to improve banks liquidity positions by allowing them to exchange illiquid mortgage-backed securities for UK treasury bills for up to three years.

One of the lessons of the crisis was that financial markets have become so globalized that it may no longer be sufficient for central banks to offer liquidity in their own currency; financial institutions may face liquidity shortages in other currencies as well. For that reason, the Federal Reserve established bilateral currency swap agreements with 14 foreign central banks during the financial crisis. The swap facilities have allowed these central banks to borrow dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally. Similarly, the ECB established bilateral swap lines with several other central banks in Europe to exchange euros for their respective currencies.

As lender of last resort, a central bank works to contain episodes of financial instability; but recent events have shown the importance of anticipating and defusing threats to financial stability before they can inflict damage on the financial system and the economy. In particular, the crisis illustrated some important benefits of involving central banks in financial supervision. Among these benefits are the facilitation of close and effective information sharing between supervisors and the providers of backstop liquidity, especially during crises; the ability to exploit the substantial overlap of expertise in the making of monetary policy and financial stability policy; and the usefulness of the information supervisors gather about economic and financial conditions for monetary policy. Appreciation of these benefits is leading to larger roles for central banks in financial supervision. For example, the Bank of England received expanded powers and responsibilities for financial stability with the establishment of a prudential regulator as a subsidiary of the bank and the creation of a separate Financial Policy Committee within the bank that will identify, monitor, and take action to reduce systemic risks. In the euro area, the newly created European Systemic Risk Board, which is chaired by the president of the ECB and includes the governors of all European Union central banks, draws heavily on central bank expertise, including analytical, statistical, and administrative support from the ECB. In the United States, the Federal Reserve has reoriented its existing supervisory activities to incorporate a broader systemic focus; it also has been assigned new responsibilities for financial stability, including supervisory authority over nonbank financial institutions that are designated as systemically important by the Financial Stability Oversight Council and new backup authorities for systemically critical financial market utilities.

The Integration of Monetary Policy and Financial Stability Policies
As I noted earlier, in the decades prior to the crisis, monetary policy had come to be viewed as the principal function of central banks; their role in preserving financial stability was not ignored, but it was downplayed to some extent. The financial crisis has changed all that. Policies to enhance financial stability and monetary policy are now seen as co-equal responsibilities of central banks. How should these two critical functions fit together?

At an institutional level, as I have already suggested, the two functions are highly complementary. Monetary policy, financial supervision, and lender-of-last-resort policies all benefit from the sharing of information and expertise. At the Federal Reserve, for example, macroeconomists help design stress-test scenarios used by bank supervisors, while supervisors provide information about credit conditions to macroeconomic forecasters. Threats to financial stability, and their potential implications for the economy, are thoroughly discussed at meetings of the FOMC.

An important debate for the future concerns the extent to which it is useful for central banks to try to make a clear distinction between their monetary and financial stability responsibilities, including designating a separate set of policy tools for each objective. For example, throughout the crisis the ECB has maintained its separation principle under which it orients changes in its policy interest rate toward achieving price stability and focuses its unconventional liquidity and balance sheet measures toward addressing dysfunctional markets. The idea that policy is more effective when separate tools are dedicated to separate objectives is consistent with the principle known to economists as the Tinbergen rule.

In practice, the distinction between macroeconomic and financial stability objectives will always be blurred to some extent, given the powerful interactions between financial and economic conditions. For example, monetary policy actions that improve the economic outlook also tend to improve the conditions of financial firms; likewise, actions to support the normal functioning of financial institutions and markets can help achieve the central banks monetary policy objectives by improving credit flows and enhancing monetary policy transmission. Still, the debate about whether it is possible to dedicate specific policy tools to the macroeconomic and financial stability objectives is a useful one that raises some important practical questions. A leading example is the question of whether monetary policy should lean against movements in asset prices or credit aggregates in an effort to promote financial stability. In my view, the issue is not whether central bankers should ignore possible financial imbalances–they should not–but, rather, what the right tool for the job is to respond to such imbalances.

The evolving consensus, which is by no means settled, is that monetary policy is too blunt a tool to be routinely used to address possible financial imbalances; instead, monetary policy should remain focused on macroeconomic objectives, while more-targeted microprudential and macroprudential tools should be used to address developing risks to financial stability, such as excessive credit growth. Prudential tools can be structural or cyclical in nature. Examples of structural prudential tools are measures to ensure adequate levels of capital and liquidity in the banking sector or to increase the resiliency of the financial infrastructure. Examples of cyclical prudential tools include varying caps on loan-to-value ratios on mortgages, as Korea and Hong Kong have done; dynamic provisioning for losses by banks, as employed in Spain; time-varying margin and haircut rules; and countercyclical capital requirements, as have been set out in BaselIII. In principle, structural and cyclical prudential tools could both damp the buildup of imbalances and bolster the resilience of the financial sector to a decline in asset prices by increasing its capacity to absorb losses. The diverse tools of financial regulation and supervision, together with appropriate monitoring of the financial system, should be, I believe, the first line of defense against the threat of financial instability. However, the effectiveness of such targeted policies in practice is not yet proven, so the possibility that monetary policy could be used directly to support financial stability goals, at least on the margin, should not be ruled out.

Conclusion

The financial crisis of 2008 and 2009 will leave a lasting imprint on the theory and practice of central banking. With respect to monetary policy, the basic principles of flexible inflation targeting–the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency–seem destined to survive. However, following a much older tradition of central banking, the crisis has forcefully reminded us that the responsibility of central banks to protect financial stability is at least as important as the responsibility to use monetary policy effectively in the pursuit of macroeconomic objectives.

An evolving consensus holds that central banks can dedicate separate toolkits to achieving their financial stability and macroeconomic objectives, but this consensus must be viewed as provisional. Certainly, those toolkits appear to be much better stocked today than before the crisis: monetary policy tools that can be brought to bear if necessary include the management of the central banks balance sheet and, to a greater extent than in the past, communication about future policies. Financial stability policy encompasses, as the first line of defense at least, a range of microprudential and macroprudential tools, both structural and varying over the cycle, supported by enhanced monitoring and analysis of potential risks to systemic stability. Clearly, understanding and applying the lessons of the crisis will take some time yet; both theorists and practitioners of central banking have their work cut out for them.

Tags: Monetary