Pursuit of Financial Stability: Monetary Policy or the Macro Prudential Measures Route

Central Bank Watch                                                                                                  

The financial crisis of 2008 has brought to the fore the use of macro prudential measures in promoting financial stability, especially in the developed world.  An intriguing question that now is being debated is should monetary policy be used to solve financial stability issues.

First, is the view from the U.S.A. On July 2, Federal Reserve’s Chair Janet Yellen gave a speech at the IMF on “Monetary Policy and Financial Stability”, where she stated clearly that “macroprudential approach to supervision and regulation needs to play the primary role” in promoting financial stability and that “monetary policy faces significant limitations as a tool to promote financial stability” (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm).

Next, on May 1, is a recent blog in the Financial Times by Gavyn Davies, the highly respected economist. He presents in his usual lucid and balanced style the case for both macro prudential policy and monetary policy in dealing with financial stability issues, and ends by asserting that “as risks continue to build throughout the financial system, it would be foolhardy to assume that macro prudential measures could or should be used as an excuse to postpone interest rate rises indefinitely” (http://blogs.ft.com/gavyndavies/2014/05/11/macro-pru-is-no-panacea/ ).

Finally, the Indian experience and here we have the recently retired Deputy Governor of RBI Dr. K .C. Chakrabarty covering India’s experience in the April Issue of Financial Stability Review (see RBI website) where he states that “there are strong complementarities between macro prudential policy and monetary policy. Measures aimed at strengthening the resilience of the financial system buttress monetary policy by potentially preventing sharp financial disruptions”.

In India and some other emerging markets macro prudential policies has been part of the policy framework for long, although the term macro prudential has come into existence in recent years and replaces what used to be simply called administrative/regulatory measures.  One thing is clear. As India has not been faced with a serious financial stability issue, it has been sufficient solely for macro prudential measures to focus on financial stability. It is only when India is faced with a crisis will the question arise on whether monetary policy should also be used as a tool to actively solve a financial stability crisis. That time does not appear to be near.