Monetary policy and financial stability

With very low (near zero) interest rate setting in many of the advanced economies, there have been many discussions recently (check this link) on if monetary policy should even be used as a tool to maintain financial stability? Many experts argue that any risks to financial stability is better handled through macro-prudential tools (such as regulations, oversight, capital reserve requirements etc.) and the monetary policy of setting interest rates and controlling money supply in the economy should be used only to achieve price stability and full employment.  They argue that any meager benefit one would get by using monetary policy tools to address the risks to financial stability (such as asset bubbles) is not worth the cost of losing price stability and/or full employment.

Now, in my view, there is partial truth to this, but only partial. There are lots academic papers that dwell into this, but we don’t have to go that far. Just by looking at our own bank statements, we could come to the conclusion that holding money in the bank today in, say for example, US, is guaranteed to give us a return that doesn't even exceed the inflation rate. In essence, this means that we are in a negative real interest rate setting. To put it in other words, holding money in a savings account today that barely gives 1% return annually is equivalent to losing the value of that money to inflation. So naturally, every individual is forced to chase assets that would give them a better yield. And how do they do it? More importantly what vehicles they have to do this? – stocks, bonds and real estate are the most commonly used vehicles by an average investor to make some returns on their capital a.k.a savings!

Now what is the basic definition of price inflation? – too many people chasing too few goods. So again, too many individual investors (a.ka. retail investors) chasing too few high performing assets inflates the price of these assets, thereby forming an asset bubble. And when asset bubbles form, many individual investors who were forced to invest in these assets, have a false sense of economic security – they see their net worth going up every day (not knowing why and not understanding the fundamentals) and start to take a lot of risk to further improve their net worth. It gives them a sense of comfort to take out loans (with the assets as the collateral and note: no amount of financial supervision can determine the "real" value of an asset other than the market value of the asset itself) and misallocate capital. This was one of the main reasons for the 2008 financial crisis (albeit that crisis had more to do with failure of regulators and financial supervisors to prevent banks from taking excessive risks where people who shouldn't have been given a loan were given a loan). But as you can see, monetary policy mistakes can also lead us to the same situation as monetary policy affects short term rates, which have an impact on your bank rates. In essence, a monetary policy that punishes savers is never a prudent policy in the long run. No nation or individual can survive indefinitely without adequate savings. And without a proper rate of return on savings for individuals, the misallocation of capital will continue to occur.

The problem currently is that monetary policy is in itself is seen as a solution to a financial crisis. It never should be that way. Monetary policy should only act as a cushion until fiscal policy catches up to recover the economy. The current zero interest rate environment should be seen as just that – a cushion and not a solution.

So to conclude, in my view, it is not whether monetary policy tools or macro-prudential tools should be used to address risks to financial stability, but rather both these tools should work in tandem to achieve an overall stable financial system.