77453 MAY 2013 • Number 116 Asset Prices, Macroprudential Regulation, and Monetary Policy Otaviano Canuto and Matheus Cavallari Confidence in combining inflation-targeting-cum-flexible-exchange-rate regimes with isolated microprudential regulation as a means to guarantee both macroeconomic and financial stability has been shattered by the scale and synchronization of the asset price booms and busts that preceded the global financial crisis. It has now become clear that if monetary policy makers and prudential regulators are to succeed in achieving stability, there can be no complacency regarding asset price cycles. This note explores some of the ways in which monetary policy can address asset price booms and busts through its integration with macroprudential regulation. Until the onset of the global financial crisis, economists were ensure smoother balance-of-payment adjustments. Micropru- close to a consensus on a set of blueprints for monetary and dential regulation of bank capital and banking supervision exchange rate regimes. An increasing number of central would, in turn, prevent excessive risk taking. banks, both in advanced and emerging markets, had adopted However, confidence in the combination of an inflation- a combination of inflation-targeting regimes and exchange targeting-cum-flexible-exchange-rate regime and indepen- rate flexibility. Alternatively, small, integrated economies had dent financial regulation and supervision has been shattered the option of virtually abdicating the exercise of monetary by the scale and synchronization of the asset price booms and policy by fixing their exchange rates. There was rising confi- busts that led to the 2008 global financial crisis. It is now in- dence in the effectiveness of this approach to deliver macro- creasingly accepted that, to some extent, the interdependence economic stability, and implicitly, to achieve smooth interna- of macroeconomic and financial stability calls for coordina- tional monetary cooperation, provided that there was no tion between monetary policy and macroprudential regula- major fiscal imbalance in national economies (Canuto and tion (Canuto 2011a). Additionally, the magnitude of cross- Cavallari 2013). border spillovers of asset price booms and busts, as well as The close relationship between inflation targeting and corresponding country policy responses in the cases of large macroeconomic stability led to the belief that financial stabil- countries, has undermined the belief in the sufficiency of ity should be pursued solely by microprudential regulatory flexible exchange rates as a shock absorber. and supervisory measures. Monetary policy would take care Drawing on Canuto and Cavallari (2013), this note ap- of inflation by acting upon short-term interest rates and ex- proaches some of the ways in which monetary policy can pectations of future interest rates and, thus, the yield curve tackle the asset price booms and busts through its integration that affects aggregate demand. Flexible exchange rates would with macroprudential regulation. After addressing the impli- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise cations of asset price booms and busts, as well as of corre- and financial stability to the extent that sponding cross-border spillovers, on monetary policy, this they unwind in a disruptive way. By finan- note outlines the challenges of integrating asset prices into cial imbalances we mean overextensions in private sector balance sheets, characterized monetary policy reaction functions, as well as those of inte- by joint credit and asset price booms that grating macroprudential regulation and monetary policy ‘go too far,’ sowing the seeds of the subse- while maintaining a balance between discretion and rules. quent bust. In other words, changes in the economic environment may have increased Asset Prices and Monetary Policy the ‘elasticity’ of the economy or, put dif- ferently, its potential procyclicality. The blueprint of basic principles for an inflation-targeting- cum-flexible-exchange-rate regime did not give due attention The pervasiveness and magnitude of asset price booms to how financial markets and their channels of interconnec- and busts led to acknowledgement of a distinction between tivity are relevant for macroeconomic stability (Canuto and microfinancial risks, which arise due to specific problems in Cavallari 2013). It had been commonly accepted that asym- individual financial institutions, and macrofinancial risks, metric information and market failures played a significant which affect the financial system as a whole because of the role in financial systems and in business cycles. Nonetheless, interconnectedness of the institutions within the system. The mainstream views maintained that markets and private insti- conceptual innovation from the last few years is that micro- tutions could self-adjust in an efficient way, and manage their prudential tools—concerned with ensuring the soundness of own market and liquidity risks properly. Microregulation and individual institutions and the protection of depositors—are supervision of individual entities would sufficiently disci- not sufficient for financial stability and the avoidance of fi- pline the behavior of private agents. nancial crises. Sound risk management of individual financial Even when the frequent appearance of bubbles could not institutions is not enough to guarantee sound management of be overlooked, economists still believed that attempts to de- systemwide risk (see several examples in Canuto and Cavallari tect and prick them at an early stage would be impossible to [2013, 9–11]). accomplish and be potentially harmful. Conventional wis- With the benefit of hindsight, it has become clear that dom was that, if necessary, resorting to interest rate cuts to “inflation and output do not typically display unusual behav- safeguard the economy after bubble bursts would be the opti- ior ahead of asset price busts� (IMF 2009, 93). In other words, mum procedure, conditional to subsequent impacts on infla- well-behaved inflation and output performance provide few, tion and output gap (Bernanke and Gertler 2000). if any, assurances that asset prices will not acquire a life of In fact, the issue was the object of an intensive debate for their own, with potentially high costs in terms of output fore- some time before the crisis—the so-called “lean versus clean gone during the moments of bust. Besides noting the typical debate� (Mishkin 2009). While many argued in favor of mon- economic costs associated with asset price busts, IMF (2009) etary policy “leaning against the wind� from financial devel- detects and points out some leading indicators of busts, opments, the prevalent opinion was that difficulties in detect- namely, rapidly expanding credit, deteriorating current ac- ing bubbles would outweigh the advantages of doing so. count balances, and large shifts into residential investment. Furthermore, monetary policy tools would be too blunt to Therefore, the framework of a flexible inflation-targeting curb the rise of bubbles, and correspondingly sharp interest regime and microprudential regulation is not sufficient to rate hikes would have harmful unintended consequences on avoid asset price booms and busts because of macrofinancial output growth and volatility. The best approach would then risks that may develop beyond the scope of the framework. be to have monetary policy reacting only if and when neces- Given the high costs associated with asset price busts—includ- sary to “clean up� the financial mess resulting from the bub- ing the possibility of protracted negative feedback loops be- ble bursts. tween unsound private balance sheets, public sector imbal- However, it has now become clear that if monetary poli- ances and/or foregone employments, and gross domestic cy makers and prudential regulators are to succeed in achiev- product (GDP)—the negligence must be addressed. ing stability, there can be no complacency regarding asset price cycles. As Borio and Shim (2007, 7) have stated: Cross-Border Spillovers The establishment of credible anti-infla- In the case of capital-receiving countries—like most emerging tion regimes and the globalization of the markets—the neglect of asset price booms and busts by the ac- real-side of the economy may have been to cepted wisdom regarding inflation targeting and micropru- make it more likely that, occasionally, fi- dential regulation can be particularly severe. Even if these nancial imbalances build up against the countries succeed in avoiding domestic generation of macrofi- background of low and stable inflation. These imbalances can have potentially seri- nancial risks, they may experience asset price booms and busts ous implications for the macroeconomy caused by net capital flows from asset price cycles abroad. As 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise capital-receiving countries are integrated into the network of distinction should be drawn between credit-fueled bubbles interlinked balance sheets of international financial institu- (such as the house price bubble) and equity-type bubbles in tions, they are vulnerable to spillovers and externalities, in- which credit plays only a minor role (such as the tech stock cluding contagion in terms of confidence, as risks pro-cyclical- bubble).� In this view, the mop-up-afterward approach would ly taken in large countries end up affecting the entire global still be appropriate for equity bubbles not fueled by borrow- system. Similarly, policy responses in countries with asset ing, but the central bank should try to limit credit-based bub- price booms and busts affect capital-receiving countries as bles—probably through combining regulatory instruments well. and interest rates. This view may eventually become the new The framework of flexible inflation targeting and micro- consensus on how to deal with asset price bubbles—for exam- prudential regulation does not address cross-border spillovers ple, Bernanke (2010) came close to endorsing it. of asset price booms and busts and policy responses, although Yet it remains advisable not to treat asset prices on the these are often of first-order relevance. The neglect of asset same footing as the common components of “Taylor rules.� price booms and busts, in particular, has a counterpart in the After all: neglect of cross-border capital flows and macroeconomic pol- Even the best leading indicators of asset icy spillovers. Both types of overflows and spillovers bring im- price busts are imperfect—in the process of plications in terms of higher volatility of activity on the real trying to reduce the probability of a dan- side, more complicated monetary policy management, and gerous bust, central banks may raise costly false alarms. Also, rigid reactions to indica- augmented financial sector risks (CIEPR 2011). Positive or tors and inflexible use of policy tools will negative feedback loops between domestic balance sheets and likely lead to policy mistakes. Discretion is liquidity in other countries may by far outweigh the mitigat- required [authors’ emphasis] (IMF 2009, ing effects coming from exchange rate fluctuations in such 116). situations. Furthermore, flexible exchange rates lose their Such a cautious approach does not mean complacency. ability to smooth balance-of-payment adjustments under pro- On the contrary, signs of rising macrofinancial risks may de- longed situations of extraordinary liquidity inflows or out- mand a response from monetary policy makers. But first it is flows, because their persistent disequilibrium may have long- necessary to properly identify the reasons behind the evolu- lasting effects on the domestic allocation of resources. tion of rising asset prices and credit—a task that is far from The following sections sketch some of the frontiers along simple, as one can conclude after examining the challenges to which the flexible inflation-targeting regime will need to integrate financial frictions into forecast models and to iden- evolve to integrate the neglected macrofinancial risks. tify financial instability risks.1 Integration of Asset Prices into Monetary Integration with Macroprudential Regulation Policy Reaction Functions One take away from the previous discussion is the relevance Asset price booms and busts are now considered too impor- of macroprudential regulation commensurate with acknowl- tant to be left only in financial supervisors’ hands. And as edged macrofinancial risks, to both macroeconomic and fi- mentioned, the pendulum of opinions has moved in favor of nancial stability. As a complement to microprudential regula- those arguing for some monetary policy “leaning against the tion, macroprudential regulation should be concerned with wind� to prevent asset price bubbles, rather than the mop-up- the stability of the financial system as a whole and the mitiga- afterward approach. While most financial upturns do not tion of risks to the real economy, that is, strengthening finan- lead to crashes, large-scale financial booms are a meaningful cial stability in relation to endogenous propagation and exog- predictor of crises. Also, because synchronization of econom- enous shocks. Macroprudential regulation should aim to ic activity, credit growth and asset prices are material (and real make the overall incentive structure for individual firms co- economic losses are usually higher), it is even more important herent and consistent so that externalities are internalized. that these aspects are monitored by monetary policy makers. The idea is to design a set of principles and rules that can re- One question comes to the fore: Should central banks in- duce each institution’s contribution to systemic risk and thus corporate indicators of financial stability into their reaction smooth the financial cycle, that is, reducing the systemic risk function in a kind of “augmented Taylor rule�? Should they that inherently builds up in booms and has damaging conse- react automatically to variations in asset prices—or some as- quences in slumps, since leverage, risk taking, credit, and asset sociated variable, such as credit expansion—as they do under prices are pro-cyclical and crises typically follow booms. inflation-targeting regimes in the case of variations in output The objective of macroprudential regulation is not to gaps and inflation? eliminate the financial cycle, but to reduce its amplitude and An intermediary position in the lean versus clean spec- associated systemic risk. Pro-cyclicality is linked to all busi- trum has been offered by Blinder (2010), who argues that “a ness cycles and goes hand in hand with most fundamentals 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise and behaviors—for example, investments and “animal spirits.� practices as well as distortions in the microprudential incen- What macroprudential rules can do is reduce pro-cyclicality tives for individual firms. and control the externalities that amplify fluctuations. By do- There is a concern that risk-sensitive minimum capital ing this, they can ensure that the financial system operates requirements embedded in Basel II could lead to excessive with less systemic risk and can enhance the resilience of the pro-cyclicality.3 Other economists have argued that by raising system in downturns. capital requirements in a countercyclical way, regulators Potential gains from macroprudential policy were being could help choke off asset price bubbles—such as the one that discussed long before the recent financial crisis. However, de- developed in the U.S. housing market—before a crisis devel- spite an overall convergence on a definition, there is still no ops. The “Turner Review� (Financial Services Authority consensus about which macroprudential policy targets and 2009), for instance, favored countercyclical capital require- instruments should be prioritized. Specific targets for macro- ments, as did Brunnermeier and Sannikov (2009), who pro- prudential policies may include countervailing measured pose to adjust capital adequacy requirements over the cycle by risks during business cycles; stabilizing the provision of finan- two multiples—the first related to above-average growth of cial intermediation services; or avoiding bubble creation pro- credit expansion and leverage, and the second related to the cesses. Other potential targets could be limiting macroeco- mismatch in the maturity of assets and liabilities. nomic costs of system distress; addressing links and exposure At the international level, there has been significant prog- of financial institutions and the pro-cyclicality of the system; ress in establishing new standards in this area: the BCBS de- discouraging individual institutions from generating system- veloped a countercyclical framework that involves adjusting ic risk and negative externalities; controlling social costs of a bank capital in response to excess growth in credit to the pri- generalized drop in asset prices caused by credit crunches vate sector, which it views as a good indicator of systemic risk. and/or fire-sales; or enhancing financial system resilience. In a proposal released in September 2010, the BCBS suggest- There are many ways to approach the objective, and policy ed the implementation of a countercyclical capital buffer makers have a range of macroprudential tools to cope with ranging from 0 to 2.5 percent of risk-weighted assets. Overall, each one. total capital requirements would rise from a minimum of 8 One of the main ideas that emerged from the 2008 crisis percent of risk-weighted assets today, under Basel II, up to 13 was to improve capital and liquidity regulations, since inade- percent, when accounting for the maximum value of the quacies in these areas were partially the root of the quasi-melt- countercyclical capital buffer (BCBS 2011). down of the global financial system after the Lehman col- Macroprudential instruments can be discussed in a time lapse. A more robust banking system—in terms of capital and series dimension or in a cross-section (Borio 2010), mirroring liquidity—would be less vulnerable to crises, or at least would two different types of macrofinancial risks. When systemic not require the magnitude of taxpayer transfers required to behavior over time is considered, the key issue is how risks can address the recent financial crisis. Tighter regulatory stan- be amplified by interactions within the financial system and dards might also contribute to smaller output fluctuations between the financial system and the real economy. Such and to higher welfare gains even apart from banking crises. feedback loops are a crucial component of endogenously gen- There are a number of studies (for example, BCBS [2010]) erated business cycles. In turn, the cross-section dimension that point out that better capitalization and higher liquidity relates to the common exposure of institutions at each point of banks reduce the likelihood and the severity of crises and in time. Correlated assets, or even counterparty interrela- that regulatory reforms can reduce the amplitude of business tions, create such a link among financial institutions. cycles, especially using countercyclical capital buffers. Can financial instability be reduced without using mon- The Bank of International Settlements (BIS) and the Ba- etary policy, relying only on prudential and regulatory rules sel Committee on Banking Supervision (BCBS) have been incorporating macrofinancial risks? Would this method guar- advocating the adoption of countercyclical capital standards. antee both financial and macroeconomic stability? Most prac- Buffers need not be part of the prudential minimum capital titioners believe that a combined (articulate) use of both requirement and would be capital in excess of that mini- monetary and macroprudential policies and rules is superior mum, so that they are available to absorb losses in bad times. to a stand-alone implementation of either (Canuto 2011a). Countercyclical capital buffers would limit both the risk of Instead of “a corner solution, where one instrument is devot- large-scale accidents in the banking system and the amplifi- ed entirely to one objective, the macrostabilization exercise cation of macroeconomic fluctuations during crises.2 The must be viewed as a joint optimization problem, where mon- macroprudential rationale is the time-inconsistency argu- etary and regulatory policies are used in concert in pursuit of ment that risks tend to build up in good times, but their both objectives� (CIEPR 2011, 7). Prudential rules and mon- negative consequences materialize only with a lag. The lag etary policy are parameters to each other, because their stand- feature reveals the limitations of current risk measurement alone stances affect the evolution of asset prices. Therefore, a 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise joint optimization pursuit is likely to be superior to isolated in mitigating systemic risk (Lim et al. 2011). Some instru- corner solutions. ments were shown to be particularly effective in reducing pro- In the time series dimension of macroprudential issues, cyclicality (for example, caps on loan-to-value ratios, debt-to- monetary policy and macroprudential tools can clearly be income ratio, ceilings on credit or credit growth, and reserve complementary in reducing pro-cyclicality. For example, dur- requirements). The evidence of effectiveness did not depend ing simultaneous asset price and macroeconomic booms, one on the exchange rate regime or the size of the financial sector, could combine higher contingent capital requirements and but differed according to types of shock. additional liquidity surcharges with interest rate hikes. Be- The huge variety of macroprudential tools makes it nec- cause of the imperfect substitutability between these mea- essary to tailor policy designs to specific purposes. However, sures, the greatest effectiveness should be considered when too much uncertainty regarding government-implemented jointly calibrating their intensities. changes may be counterproductive and costly in terms of less Additionally, when the short-term interest rate reaches a credit provided if rules and regulations change too often. The lower bound, macroprudential policies can be used to cope tradeoff is, on the one hand, more discretionary, time-varying with specific financial vulnerabilities, or even to increase the macroprudential policies, and on the other hand, less uncer- traction of monetary policy. As mentioned earlier, the nomi- tainty from stable and general macroprudential rules. More- nal zero bound is now taken more seriously as an issue than over, too many ad hoc changes make it harder to assess interac- before the crisis, as witnessed by the recent use of “quantita- tions among different macroprudential tools, and between tive easing� and other unconventional monetary policies them and monetary transmission mechanisms. (Brahmbhatt, Canuto, and Ghosh 2010). In such situations, The issue of how best to calibrate tools to avoid excessive Goodhart (2011) argued that the first macroprudential tool pro-cyclicality of the financial system involves a tradeoff be- to be used should be the central bank’s own balance sheet. tween discretion and rules (Borio and Shim 2007). Take, for This issue has not been as relevant for most emerging markets, instance, the case of dynamic provisioning rules (that is, capital because average inflation has been higher, the crisis’s collateral requirements of financial institutions that rise/fall faster than effects milder, and fiscal policy more available. leverage) versus a discretionary setting of required reserves, in In fact, major central banks have been using balance both cases reinforcing—and reducing the burden of—the di- sheets in the last few years when other tools—like lower capital rection taken by monetary policies. There is no consensus on requirements to alleviate banks’ capital burden and compress whether its calibration should be discretionary or in the form credit spreads to the final borrower—are out of reach because of built-in stabilizers, like reaction functions used in mone- of generalized fears of bank insolvency. As many emerging tary policy. Because imbalances are infrequent and specific to economies have held historically higher capital ratios, this in- each period, discretionary measures may be more useful to strument often can be used in parallel with interest rate cuts; fine-tune or target specificities. The system may also become China, Brazil, and Turkey are recent examples. too rigid regarding nonfinancial shocks—like real side produc- The scope for joint calibration may be less obvious in the tivity shocks—in the presence of automatic rules. As with dis- case of cross-sectional macroprudential regulation, in which cretionary monetary policy, discretionary calibration may be the calibration must be conducted top down. The calibration more subject to policy error or public/political pressures, in must also consider that diverse institutions have different con- addition to increasing regulatory uncertainty and encourag- tributions to systemic risk, with institutions with greater sys- ing financial disintermediation. In practice, a combination of temic relevance receiving tighter macroprudential require- both macroprudential built-in stabilizers and discretionary ments. Estimating institutions’ individual contributions to measures are used. systemic risk is always a challenge. In any case, from the cross- A rule of thumb for integrating monetary policy and section perspective, it is clearly easier to cope with vulnerabili- macroprudential regulation may be to retain some division of ties through macroprudential tools than with short-term in- labor, even if their combination is considered the best way to terest rate instruments. Policy makers can go directly to their go. Fine-tuning via monetary policy should be favored when area of concern (for example, real estate credit, leveraged loans, stability issues are of a homogeneous and reversible nature, or currency mismatches) and tighten or loosen the respective like those associated with generalized waves of market eupho- rules, whereas the alternative of containing high growth of ria or panic. Changes in automatic macroprudential rules, in real estate credit just by hiking interest rates reaches every turn, are to be made in cases of permanent, structural shocks. credit line and probably will not be the most efficient option. More ad hoc discretionary prudential policies should be used for specific, but systemically significant, disturbances from a Discretion versus Rules cross-section perspective. Countercyclical tools should be How effective are macroprudential instruments? A recent used judiciously, because distinguishing between transitory study of country experiences found that they can be effective and permanent shocks in real time is always challenging. Divi- 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise sion of labor may also be justified by the fact that macropru- ary concern, policy makers should sterilize these interven- dential instruments tend to be more demanding in terms of tions. If inflation is under control, another option would be implementation lags and transaction costs to financial institu- simply to cut interest rates. Because there are costs incurred tions, whereas movements in short-term interest rates are by the sterilization process, there are limits beyond which it is faster, simpler to carry out, and easier to communicate to the no longer attractive to keep buying foreign currency. In this general public. case, fiscal tightening may be an option to attenuate the exter- nal stimulus. If the scope for fiscal contraction is limited, then Dealing with Cross-Border Spillovers capital controls could be useful to deal with the situation. Compared to purely domestic asset price cycles, cross-border In parallel, if capital inflows cause prudential concerns, capital flows and the potential transmission of asset price the macroprudential toolkit may be more efficient and should booms and busts through interconnected balance sheets add be used before capital controls. If policy makers are able to additional layers of complexity. As surges in capital inflows identify the source of concern, a macroprudential measure can have collateral macroeconomic effects, potentially in- could be better targeted than a broader restriction. As an il- creasing financial vulnerabilities, macroeconomic and/or lustration, if the concern is excessive borrowing from abroad macroprudential policies could be adopted to respond to or its impact on domestic credit growth, increasing capital re- those surges. As discussed, asset and credit bubbles may origi- quirements for these activities may be more transparent, effi- nate from abroad and overwhelm a prevailing macropruden- cient, and easier to implement than taxing all foreign sources tial regulation designed for purely domestic asset price booms. of funding. Additionally, if the country’s capital account is Furthermore, if capital inflow surges lead to prolonged far- too open and financial markets too deep, it could be very dif- from-equilibrium real exchange rates, they may have distor- ficult to implement effective capital controls, given circum- tive and long-lasting effects on the domestic allocation of re- vention strategies. sources.4 For the purpose of this note, capital controls and exchange Magud and Reinhart (2006) pointed out four fears that rate interventions can be seen as options to be combined with motivate policy makers to be proactive in managing capital monetary and macroprudential policies, options that can flows: (i) fear of exchange rate appreciation, (ii) of hot money, even increase, or at least help, the effectiveness of the latter. (iii) of large inflows, and (iv) of loss of monetary autonomy. Depending on the vulnerability identified, policy makers Higher levels of a country’s exchange rate could damage the could choose measures that are most efficient and appropri- competiveness of its domestic industries. Sudden inflows of ate for the circumstance. Consideration has to be given, hot money pose risks of sudden reversals, increasing the vola- though, to costs associated with curbing capital inflows in tility of exchange rates. countries with low saving rates. If capital controls and related macropru- In any case, it is important note the differences in manag- dential measures are seen not as instru- ing capital inflows that are expected to be temporary or perma- ments of exchange rate management but as nent. Temporary capital inflows call for policies to ring-fence part of a package of policies targeted at fi- the economy from volatility. However, even if inflow surges nancial stability, then it is the composition are permanent, some action may be implemented to postpone of capital flows that takes center stage rath- adjustments in the economy and/or smooth transitional ef- er than their volume (CIEPR 2011, 11). fects. For example, an important discovery of natural resourc- However, sometimes the problem is not one of an unde- es could change the fundamentals of an economy toward sirable composition of inflows, but their size. A surge in for- higher current account surplus, which in turn would lead to eign capital poses risks of asset price or credit bubbles if the more appreciated exchange rates in the near future. Notwith- economy has limited capacity to absorb.5 At the same time, standing the fact that a resource reallocation is hard to avoid at cash-rich agents could be encouraged to take excessive risks or the end, or at least not without increasing difficulties, some exhibit herd behavior, which suggests that some restrictions measures could be in place to slow the pace of transfers. In the or taxes on capital flows could be useful—including as a way to same sense, a consolidation of better fundamentals in emerg- gain additional freedom in setting short-term interest rates. ing markets tends to attract abnormally high inflows of capital Ostry et al. (2010) offer a sequential approach to cope for some time during the transition, as investors adjust their with surges of capital inflows. As per macroeconomic con- portfolio (stock) exposure to the new reality. Furthermore, the cerns, policy makers should ask themselves whether the ex- inevitable sluggishness to adjust on the side of the supply of change rate is undervalued and should be allowed to float up- new assets may lead to a price overshooting of existing assets, ward, as a first step. If that is not the case, the country could with some negative side effects (Canuto 2011b). start with a policy of accumulation of reserves, provided that In sum, once asset price cycles and spillovers are acknowl- increasing their levels is desirable. But if there is an inflation- edged as a fact of life, capital flow management policies be- 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise come one—highly or lowly effective—item in the toolkit of price cycles and policies from abroad, and in which the mac- combined monetary-cum-macroprudential policies used to roprudential and monetary policies are insufficient to ring- address macroeconomic and financial instability risks. This is fence the economy. particularly the case in economies subject to significant spill- Three broad guidelines can be taken from this discus- overs from asset price cycles and policies from abroad, and in sion: first, as far as integrating asset prices into monetary poli- which the scale and duration of spillovers make a narrow set cy reaction functions, credit-fueled bubbles should be differ- of prudential and monetary policies insufficient to ring-fence entiated from equity-type bubbles. Second, retain some the economy. Nevertheless, one has to take into account the division of labor when combining macroprudential regula- shorter lifespan of capital-control effectiveness, because vola- tion and monetary policy. Third, when dealing with cross- tility will migrate and show up elsewhere, given the ultimate- border spillovers, the macroprudential toolkit often will be ly fungible character of capital flows and their creativity in more efficient and should be used before capital controls. designing circumvention strategies. About the Authors Conclusions Otaviano Canuto is the Senior Advisor on BRICS in the Devel- Given the implications of asset price cycles to achieving mon- opment Economics Department of the World Bank. He previ- etary policy objectives, the way to go seems to be to consider ously served as the Bank’s Vice President and Head of the Pov- asset prices in monetary policy decisions, as well as to use erty Reduction Network (PREM). Matheus Cavallari is a macroprudential regulation as a complement to monetary Consultant with the PREM Network. policy. Notes Macroprudential regulation should aim to make the in- centive structure for individual firms coherent and consistent 1. See annexes I and II of Canuto and Cavallari (2013). so that externalities are internalized. The idea is to design a set 2. As noted by Drehmann et al. (2010, 1): “Any effective of principles and rules that can reduce each institution’s con- scheme would need to have a number of features. First, it tribution to systemic risk. Thus, this set would smooth the fi- would identify the correct timing for the accumulation and nancial cycle, that is, reducing the systemic risk that inher- release of the capital buffer. This means correctly identify- ently builds up in booms and has damaging consequences in ing good and bad times. Second, it would ensure that the slumps, since leverage, risk taking, credit, and asset prices are size of the buffer built up in good times is sufficiently large pro-cyclical and crises typically follow booms. to absorb losses without triggering serious strains. Third, it In the time series dimension of macroprudential issues, would be robust to regulatory arbitrage, including manipu- monetary policy and macroprudential tools clearly can be lation. Fourth, it would be enforceable internationally. complementary in reducing pro-cyclicality. However, the Fifth, it would be as rule-based as possible, acting as an au- scope for joint calibration may be less obvious in the case of tomatic stabilizer. In particular, this would ease the pres- cross-sectional macroprudential regulation, in which the cali- sure on prudential authorities to refrain from taking re- bration must be conducted top down. strictive measures in good times. Sixth, it should have a low A rule of thumb for integrating monetary policy and cost of implementation. Finally, it would be simple and macroprudential regulation may be to retain some division of transparent.� labor, even if their combination is considered the best way to 3. BCBS conducted a series of quantitative exercises that, tak- go. Fine-tuning via monetary policy should be favored when ing risk-sensitivity into account, assessed the impact of the stability issues are of a homogeneous and reversible nature. cyclicality of capital requirement regimes. One of the meth- Moreover, macroprudential instruments tend to be more de- odologies used adjusted for the compression of probability of manding in terms of implementation lags and transaction default (PD) estimates in the internal ratings-based approach costs to financial institutions, whereas movements in short- during benign credit conditions by using PD estimates for a term interest rates are faster, simpler to carry out, and easier bank’s portfolios in downturns. Using higher PD (for risk) to communicate to the general public. during upturns would provide—by subtraction with actual Compared to purely domestic asset price cycles, cross- data—an estimate of cyclical effects. border capital flows and the potential transmission of asset 4. Asset price booms and busts may be transmitted without price booms and busts imposes additional layers of complexi- actual capital flows, not only indirectly through synthetic ty. Capital flow management policies become one—highly or operations that may not require cash transfers, but also lowly effective—item in the toolkit of combined monetary- through pure contagion of expectations and risk behavior. In cum-macroprudential policies used to address macroeco- the latter case, macro- and microprudential tools as well as nomic and financial instability risks. This is particularly the macroeconomic policies are the obvious means to deal with case in economies subject to significant spillovers from asset them. 7 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise 5. Recently, for example, “because the creation of new assets Brunnermeier, M., and Y. Sannikov. 2009. “A Macroeconomic in developing countries will be slower than the increase in de- Model with a Financial Sector.� Mimeo, Princeton University. Canuto, O. 2011a. “How Complementary Are Monetary Policy mand for them, the price of existing assets in those markets— and Prudential Regulation?� Economic Premise 60, World Bank, equities, bonds, real estate, and human capital—are likely to www.worldbank.org/economicpremise. overshoot their long-term equilibrium value. Recent history is Canuto, O. 2011b. “Risky Growth Engines.� Project Syndicate, full of examples of the negative side-effects that can arise� January 21. (Canuto 2011b, 1). Canuto, O., and M. Cavallari. 2013. “Monetary Policy and Mac- roprudential Regulation: Whither Emerging Markets.� World References Bank Research Paper 6310, Washington, DC. CIEPR (Committee on International Economic Policy and Reform). BCBS (Basel Committee on Banking Supervision). 2010. An 2011. Rethinking Central Banking. Brookings Institution, Assessment of the Long-Term Impact of Stronger Capital and Liquid- Washington, DC. ity Requirements. 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Gertler. 2000. “Monetary Policy and Asset Policy from Asset Price Fluctuations.� World Economic Outlook Price Volatility.� NBER Working Paper 7559, National Bureau October. of Economic Research, Cambridge, MA. Lim, C., F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Blinder, A., 2010. How Central Should the Central Bank Be? Journal Saiyid, T. Wezel, X. Wu. “Macroprudential Policy: What of Economic Literature 48 (1): 123–33. Instruments and How to Use Them? Lessons from Country Borio, C. 2010. Implementing a Macroprudential Framework: Blend- Experiences.� International Monetary Fund Working Paper ing Boldness and Realism. Keynote address for the BIS-HKMA No. 11/238. research conference, “Financial Stability: Towards a Macropru- Magud, N., and C. Reinhart. 2006. “Capital Controls: An Evalua- dential Approach,� Hong Kong SAR. tion.� NBER Working Paper No. 11973. Borio, C., and I. Shim. 2007. What Can (Macro-)Prudential Policy Mishkin, F. 2009. “Will Monetary Policy Become More of a Sci- Do to Support Monetary Policy? BIS Working Paper No. 242, ence?� In Monetary Policy Over Fifty Years: Experiences and Les- Basel, Switzerland. sons, ed. Deutsche Bundesbank, 81–107. London: Routledge. Brahmbhatt, M., O. Canuto, and S. Ghosh. 2010. “Currency Wars Ostry, J., A. Gosh, K. Habermeier, M. Chamon, M. Qureshi, and Yesterday and Today.� Economic Premise 43, World Bank, www. D. Reinhardt. 2010. “Capital Inflows: The Role of Controls.� worldbank.org/economicpremise. International Monetary Fund Staff Position Note No. 10/04. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 8 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise