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If the global financial crisis -- and the events that led up to it -- have taught us anything, it is, "No complacency with asset price booms." We know firsthand the dire consequences of bubbles, so it is clear monetary policy makers can no longer passively observe the evolution of asset prices. If an economy is to pursue macroeconomic and financial stability, they should coordinate with financial supervisors -- in an economic marriage of convenience -- to ensure financial regulation and monetary policies are complementary, and implemented in an articulated way.

Let's approach here three questions often made on how to go about reviving that policy marriage. They refer to the post-unconventional monetary policy world, yet it is time already to dedicate some reflections to them. A fuller treatment can be found here: papers.ssrn.com/sol3/papers.cfm

First, should monetary policy makers consider asset prices, together with output and inflation trends, when making decisions about interest rates? Should they use interest rate hikes to burst bubbles before they inflate fully? The emerging consensus is that credit-fueled bubbles (e.g., real estate) should be differentiated from equity-type bubbles. While the former frequently carry with them the seeds of systemic crises, the latter often has more bounded adjustment corrections.

Second, what is macroprudential regulation, and why should it be coordinated with monetary policy? Macroprudential regulation corresponds to rules that make the incentive structure for individual firms coherent and consistent, so externalities -- effects of one's decisions on others -- are internalized. The idea is to design a set of principles and rules that can reduce each institution's contribution to systemic risk. Thus, this set would smooth the financial cycle, i.e., reducing the systemic risk that inherently builds up in booms, and has damaging consequences in slumps, since leverage, risk taking, credit, and asset prices are pro-cyclical and crises typically follow booms.

Reflecting the two types of macrofinancial risks, macroprudential instruments can either assume a time series or a cross-section dimension. When systemic behavior over time is considered, the key issue is how risks can be amplified by interactions within the financial system and between the financial system and the real economy. On the other hand, the cross-section dimension relates to the common exposure of institutions at each point in time. Correlated assets, or even counterparty interrelations, create such a link among financial institutions.

In the time series dimension of macroprudential issues, monetary policy and macroprudential tools can clearly be complementary in reducing pro-cyclicality. However, the scope for joint calibration may be less obvious in the case of cross-sectional macroprudential regulation, in which the calibration must be conducted using a top down approach.

A rule of thumb for integrating monetary policy and macroprudential regulation may be to retain some division of labor, even if a more direct combination is considered the best way to go. Fine-tuning via monetary policy should be favored when stability issues are of a homogeneous and reversible nature. Moreover, macroprudential instruments tend to be more demanding in terms of implementation lags and transaction costs to financial institutions, whereas movements in short-term interest rates are faster, simpler to carry out and easier to communicate to the general public.

Third, compared to purely domestic asset price cycles, do cross-border capital flows and the potential transmission of asset price booms and busts impose additional layers of complexity? The answer is yes based on overwhelming evidence. Capital flow management policies can be an item for regulators to use in their toolkit when looking to address macroeconomic and financial instability risks. This is particularly the case in economies subject to significant spillovers from asset price cycles and policies from abroad, and in which the macroprudential and monetary policies are insufficient to ring-fence the economy. However, given the short life and usually low effectiveness of capital controls, more conventional policies should be explored first before considering this remedy.

The global financial crisis has shattered the confidence of many established principles of monetary policy and financial supervision, including the idea the two must be separate forces. But for a marriage to succeed, their union must be subject to constant calibration and elaboration.

Source: Marrying Monetary Policy And Macroprudential Regulation