iifl-logo

Invest wise with Expert advice

By continuing, I accept the T&C and agree to receive communication on Whatsapp

sidebar image

How should monetary policy be related to financial stability?

19 Jun 2023 , 07:37 AM

There is a certain context to it. During the pandemic, the Fed had gone out of the way to cut interest rates and loosen the monetary purse strings. The idea was to ensure sufficient helicopter money was available for the public to spend even when the economy was contracting. In a sense, that brought about financial stability as people could endure the economic ill-effects of the pandemic. However, the very same argument had a converse side to it. In the last few months, there have been concerns that the very same monetary policy had created financial instability and triggered off the banking crisis in the last three months. We will look at the merits of this argument later.

There are few central banks better equipped to speak on this subject than the US Federal Reserve and that was exactly the focus at a recent conference organized by Norges Bank. Speaking at the conference on “Future of Macroeconomic Policy” at Oslo, Norway; the Fed governor Christopher Waller strongly expressed his view point that the Fed policy was predominantly based on engendering and ensuring financial stability. However, he was quick to point out that in the process of financial stability, the Fed could create interest rate risk in the economy. The onus of managing the interest rate risk was on the banks and not on the Federal Reserve. That was the gist of Waller’s address at Oslo.

Did the Fed go wrong twice?

A general allegation against the US Federal Reserve in the last 2 years has been that it delayed monetary decision making twice, at fairly steep costs. The first case was when inflation had started rising sharply around mid-2021. The markets were expecting the Fed to start hiking rates by the third quarter of 2021. However, the Fed did not do so on two grounds. Firstly, it felt that the inflation triggered by supply side constraints would automatically disappear. However, that did not happen and inflation stayed sticky for much longer. Eventually, the Fed started hiking rates only in March 2022, a full 9 months after inflation first manifested itself. The market view is that in its obsession to not hamper growth, the central bank missed the bus on inflation control.

The second part of the criticism is that post March 2022, the Fed became ultra aggressive in hiking rates. For example, between March 2022 and May 2023, the Fed hiked rates by 500 basis points from the range of 0.00%-0.25% to 5.00%-5.25%. One of the casualties of this move was bank balance sheets. Most banks hold large quantities of bonds in their portfolio. Typically, the bond prices move inversely with interest rates, so when interest rates rise, the bond prices will fall. That is what happened in the case of Silicon Valley Bank, which had to sell these depreciated bonds at a multi-billion dollar loss to bridge its liquidity gap. That forced SVB into bankruptcy. The gist of the speech by Waller at the conference addresses exactly this aspect of Fed policy.

Financial stability and monetary policy related, yet independent

In his speech at Oslo, Christopher Waller had made a very interesting observation. According to Waller, while monetary policy and financial stability are generally independent variables, they are related. He also underlined that this linkage has come into the limelight largely due to the recent stress in the US banking system. According to Waller, financial stability was essential for monetary policy to achieve the goals of maximum employment and price stability. However, stable financial markets and institutions allow changes in the policy stance to transmit in a smooth and predictable manner to the financial conditions that households and businesses face in making spending and production decisions. 

According to Waller, the reason the Fed is obsessed with financial stability is because instability in the financial system hinders economic activities of households and businesses. One of the basic things that the Fed does is to ensure that the banks, nonbank financial institutions, and the financial markets continue channelling credit to households and businesses. This is like the lubricant that keeps economic spending and economic activity ticking smoothly. However, Waller also adds that the monetary policy is generally a smooth mechanism when the overall economy is stable. When there are cataclysmic changes in the macroeconomy, that is when the monetary policy adjustment tends to acquire sharp edges. That is what happened during the banking crisis triggered in March 2023.

In March, when Silicon Valley Bank crumbled and was followed by Signature Bank and First Republican Bank; it was like all hell had broken loose. The rapid, sizable increase in interest rates as an outcome of persistently elevated inflation resulted in stresses in the banking system. According to Waller, it is not that monetary policy is not in consonance with financial stability, but the tools tend to create violent adjustments. The banking crisis was one such example of a violent adjustment to a new order. 

How banks failed in risk management

Waller disagrees with the market criticism that policy tightening caused the bankruptcy of banks. According to Waller, the rate tightening was the best thing to do to curb inflation as well as inflation expectations. If these had not been controlled, the impact on household finances and individual purchasing power would have been immensely negative. In the process, if it did create an interest rate risk for the banks, it was the job of the bank management to handle such risks. According to Waller, just a handful of banks failed because they did not spruce up their risk management skills in sync with their business growth. There may have been gaps in regulation, but the onus was always on the banks. They were just not equipped or willing to handle these risks. 

Waller goes on to add that these financial stability tools had a good track record of promoting financial stability in the US. For instance, at the peak of the pandemic driven crisis in 2020, the Fed set up numerous lending facilities to limit strains that the pandemic put on the financial system. He also adds that during the failure of SVB and Signature Bank, the Fed had once again made the discount window and a new special facility available to banks to ensure banks have the ability to meet the needs of all their depositors. According to Waller, what was really gratifying for him was that the Fed could actually continue to pursue its monetary policy objectives even through the banking crisis. 

Will the banking stress impact monetary policy? According to Waller, it indirectly had impacted monetary policy. For instance, since the onset of the banking crisis in mid-sized banks, the lending conditions imposed by banks had tightened substantially. That had impacted consumer credit creation to a large extent. In short, Waller’s view is that the banking crisis supplemented the monetary policy efforts of the US Fed by reducing the need to hike rates further. That also brought down the consensus terminal rates of interest to the range of 5.5% to 5.7% by the end of the year. 

Real answer to banking crisis is elsewhere

Waller thinks it would be erroneous to call the failure of a handful of banks an outcome of Fed tightening. Hence, saying that the Fed’s tightening of monetary policy was significantly responsible for the failures and stress in the banking system was itself wrong. Responding to the argument that the Fed should have accounted for bank stress in its monetary policy, Waller again stressed that the fault lines were in the risk management practices. The focus of the Fed would now be on tightening supervision and risk management for the smaller sized banks too. 

To sum it up, the Fed uses monetary policy to achieve its dual mandate of price stability and maximum employment. For now, the focus is on hawkishness. Heads of banks have to deal with interest rate risk, and nearly all bank heads have done that fairly well. Bad banking cannot justify shift in monetary policy stance. The best the Fed can do here is to continue to pursue monetary policy goals; but also use financial stability tools to prevent spillovers.

Related Tags

  • FED
  • monetary policy
sidebar mobile

BLOGS AND PERSONAL FINANCE

Read More

Invest Right News

BSE: Firing on all cylinders
9 Apr 2024|10:33 AM
Read More
Knowledge Center
Logo

Logo IIFL Customer Care Number
(Gold/NCD/NBFC/Insurance/NPS)
1860-267-3000 / 7039-050-000

Logo IIFL Capital Services Support WhatsApp Number
+91 9892691696

Download The App Now

appapp
Loading...

Follow us on

facebooktwitterrssyoutubeinstagramlinkedintelegram

2025, IIFL Capital Services Ltd. All Rights Reserved

ATTENTION INVESTORS

RISK DISCLOSURE ON DERIVATIVES

Copyright © IIFL Capital Services Limited (Formerly known as IIFL Securities Ltd). All rights Reserved.

IIFL Capital Services Limited - Stock Broker SEBI Regn. No: INZ000164132, PMS SEBI Regn. No: INP000002213,IA SEBI Regn. No: INA000000623, SEBI RA Regn. No: INH000000248
ARN NO : 47791 (AMFI Registered Mutual Fund Distributor)

ISO certification icon
We are ISO 27001:2013 Certified.

This Certificate Demonstrates That IIFL As An Organization Has Defined And Put In Place Best-Practice Information Security Processes.