Should monetary policy be used to target financial stability?

This issue is also very important for India. Price stability is a serious concern in the case of India. CPI inflation has been above the RBI’s target level of 4% for some time now and in particular, core inflation has been remarkably stubborn at 6% for a long time.

Therefore, as the RBI prepares to announce its monetary policy decision on April 6, it needs to maintain its focus on bringing down CPI inflation to the target level. The Fed may have slowed down the pace of rate hikes amid turmoil in financial markets, but this should not deter the RBI from prioritizing domestic macroeconomic stability and inflation control.

It is less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework. Under this, the primary goal of monetary policy is to achieve price stability. Expecting monetary policy to also track financial stability would distract from the legally mandated objective of the central bank and could lead to destabilizing consequences for the economy in general.

There are some practical and conceptual problems with making financial stability an objective of monetary policy.

First, financial stability is hard to define. We can only see volatility in the financial sector when it manifests itself, for example, in the failure of a systemically important bank or the bursting of an asset price bubble. But in the absence of such an event, it is difficult to say what is the stability of the financial sector.

The financial system is comprised of a large number of participants that interact with each other, forming a complex, interconnected network. Within this system, the sources of financial instability can be diverse. We have seen financial instability due to failure of banks, insurance companies, pension funds or mutual funds and we have seen crises in stock and bond markets. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where the risk is increasing.

Furthermore, once instability occurs in any part of this network, given the interconnectedness, it can spread throughout the system, commonly known as ‘contagion’. It is difficult to predict whether a financial instability event will actually trigger a transition, how fast the transition will spread through the system, and what effect it will have on different parts of the network.

Second, given that financial stability is difficult to define, it is also difficult to measure. Often financial sector regulators use “stress tests” to assess the resilience of systems to various possible scenarios. The problem is that they only test for the risks they are concerned about. There are many other risks beyond the obvious, and they are usually what get financial institutions into trouble.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of definition and measurement, it is more difficult for monetary policy to target financial stability than price stability, which can be clearly defined and measured.

In India, for example, the inflation targeting framework clearly sets the goal of the RBI’s monetary policy as achieving the 4% CPI target. Such a clear, quantifiable goal is unimaginable when it comes to financial stability.

Finally, and most importantly, policy making should be guided by Tinbergen theory which views economic policy as a relationship between instruments and goals. It postulates that the number of achievable goals is limited by the number of policy instruments available. Under the inflation targeting framework, the repo rate in India (or the fed funds rate in the US) should be used to target inflation. Therefore it is best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, what can be done to address financial instability?

Some have argued that central banks can inject liquidity to hedge against financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, eg an irrational move against a bank with a safe but illiquid asset (such as a loan to a profitable factory).

But this rarely happens. Typically, as is the case with SVBs, runs occur because banks are insolvent (i.e. the value of their assets has fallen below the value of their liabilities). In such a situation, the only solution is to invest capital. Injecting liquidity may actually make matters worse as it enables more people to flee the sick bank(s), thereby increasing – not reducing – panic.

Second, in situations involving a credit freeze, liquidity can be a temporary solution and help restore confidence in the system. But it is like calling the fire brigade in case of fire. This is necessary to extinguish the fire but does not help prevent future fires.

Third, using liquidity to address volatility may also mean keeping the system flush with excess liquidity for a longer period of time which may in turn affect price stability.

Broad-based financial stability can only be achieved by improving governance standards and establishing stronger supervisory oversight over relevant institutions to help avoid risk build-up. The collapse of the SVB, like the global financial crisis of 2008, reflected a colossal failure of governance and supervision.

In short, in the short term, the solution to financial instability is capital; In the long run, it is better governance and supervision. Monetary policy would then be free to pursue its ‘natural goal’ – price stability.

Dr. Rajeshwari Sengupta is Associate Professor of Economics at Indira Gandhi Institute of Development Research (IGIDR), Mumbai

Harshvardhan is a management consultant and researcher based in Mumbai