RDP 1999-05: Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy 2. Monetary Policy, Financial System Stability and Efficiency

Before discussing the linkages between monetary policy and the stability of the financial system, it is worthwhile to discuss what we mean by system stability.^[2]

We begin by acknowledging that policy-makers care about financial system disturbances because they result in macroeconomic losses. If there is a monotonic relationship between the size of the financial system disturbance and the macroeconomic loss, then system stability can be defined in terms of either concept. We choose to focus on macroeconomic losses, since minimising these is one of the ultimate objectives of policy. Also, to be a useful concept for policymakers, system stability needs to be cast in terms of expected outcomes, rather than as a statement of the size of past events. Combining these two ideas, we define system stability as the expected macroeconomic losses that arise from financial system disturbances. Thus in measuring the degree of stability it is necessary to consider both the probability of various financial disturbances, and the size of the macroeconomic costs arising from such disturbances. Both the probabilities and macroeconomic costs of financial disturbances are likely to change through time under the influence of ongoing developments in the financial system. A more formal definition of system stability is provided in Section 4.2 of this paper.

It is unlikely that a financial system can be perfectly stable, such that the probability of macroeconomic losses arising from financial system disturbances is reduced to zero. With sufficiently heavy-handed regulations in place, it may be possible to reduce this probability to very low levels. However, it is likely that this would be at the expense of reducing the efficiency of financial intermediation. In general, the objective of policy should be to enhance both the stability and efficiency of the financial system, recognising that in some cases there may be a trade-off between the two. An overly regulated financial system may be very stable, which itself is beneficial for growth, but this may be at the cost of inefficient intermediation which is detrimental to growth. In many cases, developments in the financial system are likely to increase both stability and efficiency.

2.1 The Interaction Between Monetary Policy and System Stability

The primary aim of monetary policy is to maintain the highest possible non-inflationary growth rate. Instability of the financial system can impinge on that goal both directly through a breakdown in financial intermediation, and indirectly through an interruption of the transmission mechanism.

Concerns about the stability of the financial sector have been paramount at various times in the first half of this century. In the late 1920s in the US, credit growth helped fuel the run-up in stock prices, and then the impact of the stockmarket crash was greatly amplified by subsequent bank failures. At the time, this influence of the intermediation process on monetary policy goals was emphasised by Irving Fisher (1933). More recently, there has been a growing literature on the ‘credit channel’ of monetary policy which, in part, builds on Fisher's debt-deflation model.^[3] However, that literature tends to emphasise the balance sheet positions of debtors. The experience of the past decade highlights the key role that the balance sheets of banks can play in the transmission process.

Over most of the postwar period, such concerns have been of second order in monetary policy deliberations. Shocks such as the OPEC oil price rises and increased inflationary pressure from an overheating real economy have been the focus of policy-makers' attention. However, financial shocks have increasingly been coming to the fore in the wake of the banking-sector problems in a number of OECD countries in the late 1980s and early 1990s, and particularly in light of the Japanese experience in the 1990s. The current crisis in Asia has highlighted the importance of the two-way interaction between financial system instability and macroeconomic instability, the speed at which crises can unfold and the impact of contagion, both within and across countries. The financial system has been of concern not only as a direct source of instability but also in worsening the impact of a real shock.

Because of these links between the real sector of the economy and the financial sector, monetary policy needs to be cognisant of the potential for financial system instability. One of the major threats to financial system stability has been the substantial and prolonged deviation of asset prices away from fundamental levels. Changes in the nature of intermediation can have implications for the behaviour of asset prices. This was particularly evident in the asset price bubbles that developed in a number of OECD countries (including Australia) in the late 1980s. These were, in large part, fuelled by the increase in intermediation following deregulation of the financial system in the first half of the 1980s (Section 3.2).

To emphasise this linkage between financial instability, asset prices and monetary policy, Kent and Lowe (1997) develop a Fisherian model which shows that monetary policy-makers may want to raise interest rates in response to an emerging asset price bubble with the intention of bursting this bubble before it becomes too large. This helps to reduce the possibility of an even larger bubble developing and the likely eventuality that its collapse would lead to significant financial instability and therefore a prolonged period of weak output performance and inflation below target. In this way, monetary policy, with the sole objective of stabilising inflation around a target, can act to help prevent major financial instability. However, Kent and Lowe emphasise the importance of adopting other policies to ensure financial system stability, to reduce the likelihood and the effect of asset price bubbles. Monetary policy may be a second-best method of dealing with such occurrences.

Alternatively, there may be circumstances where there is upward pressure on inflation in the short term, but at the same time the financial system may already be in a weak condition. In this case it may be inappropriate to tighten monetary policy in response to concerns about short-term inflation, since such a response would exacerbate the problems in the financial system and lead to a sustained downturn over the medium term.

This discussion suggests that monetary policy with a medium-term horizon needs to take account of the stability of the financial system in ways that may imply a non-standard response to short-term inflationary pressures.

The financial system also plays an integral role in the standard textbook description of the transmission mechanism of monetary policy. A critical process in the transmission mechanism is the increased use of bank-intermediated credit to fund consumption and investment spending following a decrease (say) in interest rates. It is generally implicitly assumed in such expositions that the financial sector is sufficiently stable to act as a reliable conduit of monetary policy actions. However, a breakdown in the process of intermediation will reduce the potency of monetary policy actions.

There are also important interactions that run in the opposite direction between monetary policy and financial system stability. High rates of inflation of goods and services prices are clearly bad for system stability. They distort the incentives of individuals to invest in worthwhile projects (in part through the interaction between inflation and the tax system). They can also lead to speculation in asset markets, funded through borrowing and growth in the value of collateral. Variable rates of inflation can also lead to unanticipated wealth transfers between debtors and creditors, which may jeopardise their financial situations.

On the other hand, while low inflation is beneficial for system stability, it does not guarantee it. This was demonstrated in Japan in the early 1990s. Further, the effectiveness of monetary policy in Japan has been significantly curtailed despite the presence of low inflation, because of the state of the financial system. Good monetary policy is necessary for system stability but it is not sufficient. Therefore, central banks (with standard monetary policy objectives in mind) need to devote considerable attention to issues relating to system stability.

Footnotes

For a recent discussion of the issues related to defining financial system stability see Crockett (1997). Mishkin (1997) describes financial instability as occurring when information flows are disrupted to such an extent that the financial system cannot channel funds to productive investment projects in an efficient manner. [2]

Bernanke and Gertler (1995) summarise this literature. [3]