Monetary Policy Beyond Connecting Dots and Parsing Words
Janet Yellen’s congressional testimony today drew more than the usual attention because of growing expectations that the Federal Open Market Committee will soon raise the federal funds interest rate for the first time in almost a decade. Such attention is obviously warranted given continuing doubts about the strength of the U.S. economy and the global economy more generally. Nevertheless, the fixation of market participants and others on the so-called “dots,” indicating where decision makers see future interest rates, as well as the parsing of words in FOMC statements, is missing a new policy feature that is likely to become significantly intertwined with monetary policy. This new element is macroprudential policy.
Although macroprudential policy is not new to those steeped in the intricacies of policy influences on the financial sector and the real economy, it is gaining visibility in the wake of the global financial crisis. The realization that traditional monetary measures cannot adequately ensure financial stability has led policymakers and regulators to look for alternative policies that can complement and supplement monetary policy in dealing with macroeconomic as well as stability issues. The interaction of these issues and the interplay of policies associated with them is likely to receive increasing attention from market participants as they discover that the traditional ways of interpreting the influence of monetary policy on asset prices will no longer be sufficient.
The recently released Milken Institute research paper, “Macroprudential Policy: Silver Bullet or Refighting the Last War?” aims to clarify the concept of macroprudential policy for a broader audience, cultivating a better understanding of these tools and their implications for broader monetary policy. Subsequent blogs by co-authors of this report will focus on several key points in the paper. For now, it is important to note that the authors realized that the potential impact of macroprudential policy on financial markets and the real economy could not possibly be captured in a single paper.
What has been learned from our research to date and from interacting with participants at this year’s Global Conference is that the nature of financial stability is not well understood – and that efforts to maintain it are fraught with difficulties. Early-warning systems designed to signal the onset of potential problems have proved largely inadequate. This will hamper efforts to devise appropriate timing rules for the adoption of macroprudential measures, which is addressed in our report. This also begs the question of what type of measures to implement.
Beyond dealing with the timing and type of macroprudential measures, there is also the issue, particularly in the United States, of who is going to oversee and be responsible for carrying out macroprudential policy. The IMF in its latest comprehensive assessment of the U.S. financial system notes that the institutional structure for implementing macroprudential policy needs significant improvement. During her testimony, Yellen was asked when someone would be nominated to take charge of macroprudential policy. An entire chapter in the MI research paper is devoted to the interaction with the political economy.
While this blog offers only a brief introduction to macroprudential policy, it nevertheless makes clear that much more work will need to be done if this policy is to be effective in helping to promote financial stability in the United States and elsewhere. One area in which the Milken Institute can play an important role is facilitating a dialogue between policymakers/regulators and market participants. Policies, especially financial policies, generally work best when they are transparent, predictable, and establish traditions and limitations. A regular dialogue can help promote such attributes.
Given the wide range of macroprudential measures that could be employed along with their potential intrusiveness in various sectors of the economy, it would not be hard to imagine a situation where the Federal Reserve could induce instability as market participants guess the next “anti-bubble” decree.