The role of financial stability in the ECB’s new monetary policy strategy

Published as part of the Financial Stability Review, November 2021.

Financial stability is a precondition for price stability and vice versa. In recognition of this fundamental tenet, the ECB’s recent strategy review included a thorough assessment of whether financial stability considerations should play a role in monetary policy decisions at all – and if yes, in what form.^[1] The analyses covered a wide range of relevant issues, including the side effects of monetary policy on financial stability, the interactions between monetary and macroprudential policies, whether the medium-term orientation of the ECB’s price stability objective can cater for financial stability considerations and how relevant financial stability analyses could be integrated into the analytical framework based on which monetary policy decisions are taken. This box summarises the most relevant aspects and their implications for monetary policy.

The pursuit of price stability through monetary policy, and of financial stability primarily through macroprudential policy, are to a large extent complementary. Financial crises tend to be associated with sharp de-risking and deleveraging, with negative repercussions for economic growth and the inflation outlook. The associated impairments in the transmission mechanism of monetary policy make it more difficult for central banks to maintain price stability. By preventing systemic crises and increasing the resilience of the financial sector, prudential policies (macroprudential, supervisory policies as well as a well-designed regulatory framework for financial institutions) safeguard smooth monetary policy transmission and support price stability. In a similar vein, monetary policy supports financial stability via a number of channels. During recessions, it stabilises the economy, thereby reducing the losses for the financial sector, as well as inflation, which mitigates the risk of debt-deflation spirals. Crucially, it also contains episodes of bank runs and fire sales in periods of outright financial stress. In the long run, and in most cases also over the short to medium term, the actions of the two policy domains are complementary.

Monetary policy needs to take the financial stability environment and the stance of macroprudential policy into account. Monetary policy and macroprudential policy operate through common transmission channels, meaning that the scope for interaction between the two policy spheres is wide. For example, an increase in macroprudential capital buffers may improve the resilience of the financial system and mitigate the consequences for inflation stemming from financial shocks. Yet, depending on the state of the economy, such a move may be associated with a lower supply of bank credit and create a disinflationary impulse. In an environment of buoyant economic activity and associated price pressure, the two policy domains would reinforce each other. By contrast, when the build-up of systemic risk occurs in the context of subdued inflation, some trade-offs may emerge. Irrespective of the actual constellation, information about the macroprudential stance is relevant for monetary policy.

It has been acknowledged that monetary policy, through both conventional and unconventional measures, can in principle also adversely influence financial stability. For instance, lower interest rates create incentives to engage in more risk-taking which could become excessive and lead to the build-up of systemic risk.^[2] It has been shown that the financial stability footprint of monetary policy can be minimised by adjusting the design of some of its instruments, as is the case with the ECB’s targeted longer-term refinancing operations (TLTROs, which entail a lending target that excludes housing loans, the aim being to avoid contributing to the possible formation of real estate bubbles under specific circumstances) or its tiered system for excess reserve remuneration.^[3] However, potential financial stability side effects cannot be completely ruled out. They can arise as financial intermediaries assume more credit, liquidity and duration risks in their search for yield, and due to the associated asset price misalignments. In addition, low interest rates affect the resilience of financial intermediaries. As regards banks, falling interest rates reduce net interest margins, yet at the same time they are associated with one-off valuation gains on securities and a brighter economic outlook, the latter boosting lending volumes and asset quality. While for now these effects have largely offset each other, the adverse effects of low interest rates could worsen over time. For some types of non-bank, low rates may be detrimental to their financial positions.

A systematic leaning against the wind^[4] is fraught with conceptual controversies and practical difficulties. It is widely accepted that an aggressive monetary policy response is necessary to restore the functioning of the monetary policy transmission mechanism in a financial crisis, as possible distortions in incentives can, in principle, be addressed by an effective macroprudential framework. By contrast, previous economic literature indicates that monetary policy is too blunt a tool to address sector or country-specific financial imbalances. This is particularly relevant in a monetary union where financial cycles are not fully synchronous across participating states.^[5] In addition, given the slow-moving nature of financial cycles, a systematic leaning against the wind may require relatively long periods of inflation undershooting, which are not compatible with price stability and risk destabilising inflation expectations. Importantly, monetary policy is not responsible for guaranteeing financial stability.

Instead, macroprudential policies are the first line of defence against the build-up of systemic risk. The adverse side effects described above should be addressed by appropriate micro- and macroprudential measures which are designed to target the affected subset of the financial system and address precisely the underlying vulnerability. In fact, the existing empirical evidence shows that – whenever available – macroprudential measures have proven to be effective in addressing systemic risk. Yet at present, the macroprudential framework does not adequately cover non-bank financial intermediaries. Moreover, the ability of macroprudential policies to affect bank lending countercyclically (by releasing macroprudential buffers) in a downturn is limited. Both aspects may increase the need for aggressive monetary policy accommodation in the face of adverse developments.

Against this background, the ECB’s new monetary policy strategy envisages a flexible approach in considering financial stability. The medium-term orientation of the ECB’s price stability objective allows the institution to consider financial stability in its monetary policy decisions, whenever this is relevant to the pursuit of price stability. Accordingly, an in-depth assessment of the interaction between monetary policy and financial stability will be conducted at regular intervals as part of monetary and financial analysis and considered at monetary policy meetings of the Governing Council. These assessments will provide a more systematic evaluation of the longer-term build-up of financial vulnerabilities and their implications for the tail risks to output and inflation. In addition, they will gauge the extent to which macroprudential policies can mitigate possible financial stability risks that are relevant from a monetary policy perspective.