Before the 2008 financial crisis, most governments lacked an adequate institutional framework for discussing financial policies. While central banks focused on monetary policy, generally using interest rates to influence inflation and output, believing that such an approach guaranteed economic stability, when it came to financial policy, there was a tendency to rely on the invisible hand of the free market.
The financial crisis put an end to this approach. After all, the 2008 crisis was not a monetary policy crisis but a financial policy crisis. In other words, it was a crisis of easy credit, highly leveraged institutions and a general lack of supervision and regulation in the banking and financial sectors.
Assignment of responsibilities
As a result, governments, together with their central banks, began to rethink their approach to financial policy. In some cases, this led to the allocation of responsibility for monetary and financial policy to different authorities. It was also necessary to ensure that each authority had different instruments to provide stability in their respective jurisdictions. Currently, the Board of Governors of the US Federal Reserve System aims to achieve its monetary policy objectives – stable prices and full employment – through its use of the interest rate. However, another institution, known as the Financial Stability Oversight Council, deals with financial policy. Other countries, including Chile, Mexico and Japan, have established similar systems.
Meanwhile, the United Kingdom and the European Union have created a separate committee within their central banks to deal with financial policy issues. And Korea, Norway and Sweden, among others, have made explicit commitments to manage financial stability through their central banks.
A key point is that while monetary policy influences financial policy and vice versa, policymakers should have the same objective – monetary and financial stability – but different instruments at their disposal in each area. This means that monetary policy should focus on dealing with inflation through interest rates. And financial policy should concentrate, among other things, on ensuring that banks can provide credit when the financial system faces a negative shock and lacks liquidity.
The worst systems use only the interest rate
In a recent paper, we show the advantages and potential problems of each of the three approaches currently in use. We show that the worst systems are those that use the interest rate as their only instrument, while focusing exclusively on inflation. This is because using only the interest rate can have unintended consequences for the financial system. And when these consequences are not taken into account, the vulnerabilities of an already fragile financial system are more likely to be exacerbated.
An intermediate scenario takes into account both inflation and financial aspects, but still uses only the interest rate as its sole instrument. This is an improvement over the previous scenario because it takes into account the impact of the interest rate on the financial system. However, by limiting itself to that single instrument, policymakers risk negative repercussions on monetary and financial policy. For example, they may lower interest rates to stimulate the economy but, in the process, create a credit boom that leads to a dangerous bubble.
The ideal scenario
The ideal scenario requires using different instruments for monetary and financial policy in order to control the impact of one on the other. It also means ensuring that different authorities share the same objective. What should be avoided is a situation where the Central Bank tries to minimize variations in inflation and the interest rate, while the financial authority tries to minimize variations in the interest rate spread and its financial instruments. On the contrary, the different authorities should work towards the common goal of minimizing variations in both areas.
The financial crisis taught us many lessons, including the vitally important lesson of paying close attention to the financial system. This means using different instruments, beyond the interest rate, to address financial policy issues. And it means ensuring that different authorities, with different instruments, work together to achieve common goals.
By: Victoria Nuguer, Research Economist in the Research Department of the Inter-American Development Bank.
Aduana News is the first Argentine customs newspaper to launch its digital version. With 20 years of experience, its publications and initiatives aim to provide the most relevant knowledge on customs issues in order to contribute to safe trade in the region.
