Monetary Policy, Financial Conditions, and …

1 Monetary policy , Financial Conditions, and Financial Stability Tobias Adrianaand Nellie LiangbaInternational Monetary FundbBrookings InstitutionWe review a growing literature that incorporates endoge-nous risk premiums and risk-taking in the conduct of mon-etary policy . Accommodative policy can create an intertem-poral tradeoff between improving current Financial conditionsat a cost of increasing future Financial vulnerabilities. In theUnited States, structural and cyclical macroprudential toolsto reduce vulnerabilities at banks are being implemented, butmay not be sufficient because activities can migrate and thereare limited tools for non-bank intermediaries or for Monetary policy itself can influence vulnerabilities, itsefficacy as a tool will depend on the costs of tighter policy onactivity and inflation.

2 We highlight how adding a risk-takingchannel to traditional transmission channels could significantlyalter a cost-benefit calculation for using Monetary policy , andthat considering risks to Financial stability as downside risksto employment is consistent with the dual Codes: E44, E52, E58, G21, G28. We thank Raymond Lee and Benjamin Mills for excellent research assis-tance and Stijn Claessens, Fernando Duarte, Rochelle Edge, Thomas Eisenbach,William English, Simon Gilchrist, Luca Guerrieri, Harrison Hong, Michael Kiley,Andreas Lehnert, Jamie McAndrews, Frank Packer, Jeremy Stein, Lars Svens-son, Skander Van den Heuvel, Michael Woodford, and an anonymous refereefor helpful comments.

3 The views expressed in this paper represent those of theauthors and not necessarily those of the International Monetary Fund, its Man-agement, or its Executive Directors; or those of the Federal Reserve Bank of NewYork, or the Board of Governors of the Federal Reserve System. This paper waswritten when Adrian was at the Federal Reserve Bank of New York and Liangwas at the Federal Reserve Board. Author contact: Adrian: Monetary and Cap-ital Markets, International Monetary Fund, Liang: BrookingsInstitution, Journal of Central BankingJanuary 20181.

4 IntroductionMonetary policy works by affecting Financial conditions . This paperaddresses how Monetary policy also affects Financial stability, andthe roles for macroprudential and Monetary policies for reducingrisks to Financial stability. A growing body of research indicatesthat accommodative Monetary policy given Financial frictions canincrease risks to Financial stability by leading to buildups of finan-cial vulnerabilities, which can increase future downside risks to thereal particular, recent research is advancing on howaccommodative Monetary policy and compressed risk premiums onassets affect Financial vulnerabilities, such as excess credit of house-holds and businesses, and high leverage or maturity transformationat Financial intermediaries.

5 In addition, because accommodative pol-icy can create an intertemporal tradeoff between improving currentfinancial conditions and increasing future Financial vulnerabilities,consideration should be given to risks to Financial stability in thesetting of Monetary policy . How it should be considered will dependon its relative effectiveness and interactions with this paper, we provide a broad review of transmission chan-nels of Monetary policy through Financial conditions and financialvulnerabilities, and document a significant role for Monetary policyin the buildup of Financial vulnerabilities.

6 Financial frictions such asasymmetric information have been foundational for macro modelsthat include credit cycles and the effects of asset prices on collateralvalues and borrowing constraints. Other Financial frictions that couldresult in vulnerabilities include agency costs, institutional investorsticky nominal return targets, and Financial firms risk models andlimited liability. Moreover, individual borrowers and lenders mightnot have incentives to take into account their effects on aggregatedebt when they make their own private decisions.

7 These financialfrictions can lead to an intertemporal tradeoff between financial1 Financial conditions refer to broad funding conditions , including risk pre-mia for risky assets above the risk-free term structure. When Financial frictionsare present, policy may need to be set tighter or easier than neutral to achievean optimal policy outcome. Accommodative policy refers to a stance of mone-tary policy that is more expansionary than would be the case in the absence offinancial 14 No. 1 Monetary policy , Financial Conditions75conditions and Financial stability for setting Monetary policy , whereloose Financial conditions based on time-varying risk premia in assetprices and risk-taking by borrowers and lenders could lead to higherfuture vulnerabilities that make the system more prone to amplifynegative policies both structural through the cycle andcyclical time varying are usually viewed as the primary tools tomitigate vulnerabilities and promote Financial stability.

8 These regu-latory and supervisory tools, such as bank capital requirements orsector-specific loan-to-value ratios, may be used to lean against thewind by tightening Financial conditions in a targeted way, and toshore up the resilience of the Financial system to possible adverseshocks, such as the bursting of an asset policy works similarly to lean against the wind, thoughit is not targeted. It may be less efficient than macroprudentialpolicy if the Financial vulnerability is narrow. In addition, it doesnot directly increase resilience in the same way that higher capitalat banks can.

9 These considerations support the current prevailingapproach of a clear separation in responsibilities: Monetary policyshould focus on the inflation real activity tradeoff, and, conditionalon the stance of Monetary policy , macroprudential policy shouldbe used to mitigate vulnerabilities to achieve an acceptable level ofsystemic of an alternative non-separable approach point tothe effects that Monetary policy has on Financial vulnerabilities inaddition to Financial conditions . They also would point out thatmacroprudential policies may have limited reach to regulated finan-cial firms, and restricting their activities may simply push the activ-ities into a non-prudentially regulated sector.

10 In the United States,this sector is extensive: non- Financial credit market debt held by non-bank Financial firms greatly exceeds debt held by banks (figure 1 andAdrian, Covitz, and Liang 2015). Debt held by non-banks, whichincludes securitizations and entities funded by short-term liabilities,hit a peak in 2008 at over 100 percent of GDP, larger than the debtheld by contrast to macroprudential policies, Monetary policy willaffect costs for all borrowers and lenders it gets in all the cracks (Stein 2014). Moreover, Monetary policy is less subject to thecriticism that regulators are making non-market credit-allocation76 International Journal of Central BankingJanuary 2018 Figure 1.