I have long stated that targets of “financial stability” and “price stability” (monetary policy) were important – but should be performed in separate, yet independent, operational terms (here and here). Namely, keep the central bank focused on monetary policy while another organisation/operational entity solely focuses on the more long term goal of financial stability.
In my view separation is important for communication – by separating the two people can tell when actions are framed towards certain goals. By having one organisation/entity trying to attempt both, you risk muddying the waters – which in turn will lead to worse outcomes.
Interestingly, empirics tells us that bank risk not only responds to a rate cut, but that it also matters how long rates are kept low (Maddaloni and Peydro forthcoming, Altunbas et al. 2010). This relates to the argument that in the years leading up to the crisis rates were kept low for too long. Our model can provide some reasoning for why this can be damaging. We make the model dynamic and add a crucial feature, maturity mismatch.
In contrast to their short-term liabilities, banks’ assets are long-term. Because of this, banks will only adjust their portfolios if they foresee that a change to their environment is of long duration. A short-rate cut will not push them to take more risk. But a long lasting cut will. A monetary authority that considers financial imbalances therefore has a different timing of policy than an authority that cares only about inflation and output gap stabilisation.
This argument is compelling, and if you have a central bank with only one tool (the cash rate) I think I would be convinced.
However, if central banks are also willing to put in place measures to try and reduce maturity mismatch, and adjust the cyclical nature of banks reserves – then I believe we have multiple instruments. In this case, the use of each individual instrument should still be directed at a specific target – to make communication clear.
Yes, these instruments are related, and the choice of a financial stability institution will influence the choice of a monetary institution. But this is already the case with fiscal and monetary policy – and yet we believe we can keep monetary policy independent.
The fact is that the balancing of expectations, and the ability to communicate policy to manage these expectations, is the key part of monetary – and even financial stability – policy. As this is the case, I continue to find it important to keep these two policy targets operationally separate.
This is an issue I find fascinating, and I’m looking forward to seeing how things develop over the next decade – and why.