Monetary policy 'not way forward'

Financial markets across the world and espe¬cially in the United States have seen tremendous changes over the past couple of decades, according to a paper entitled "The Territory of Monetary Policy in the New Financial Environment".

Among the notable changes is a rapid growth in the size and the number of types of financial instruments as seen by the growing pool of acronyms such as ABS, MBS, CDOs and CDS.

More importantly, the advent of some of these instruments allows investors to "slice and dice" risk exposure to cater for particular needs, but in doing so adds com¬plexity to their evaluation and makes the structure more opaque. 

 In addition, the stable econom¬ic environment between 2003 and 2006, rising global financial imbal¬ances and reduced capital restric¬tions around the world have led to rising global liquidity and increas¬ing international portfolio diversi¬fication.

Thus, financial markets have become more integrated, both across asset classes and across countries. These developments have made financial institutions increasingly vulnerable to possible shocks in the system, as we have witnessed since the third quarter of 2007.

In response to the new financial environment, two challenging questions have arisen for mone¬tary policymakers. First, has the effectiveness of monetary policy in curbing inflation and helping to sustain economic growth altered? Second, apart from the main role of maintaining price stability, should the role of monetary poli¬cy be extended somewhat further to take care of financial stability, especially as asset prices can increase at a faster pace in the new financial environment?

The research findings indicate that the above financial environ¬ment factors have complexly altered the transmission mecha¬nism of monetary policy to the financial and the real sectors in terms of speed and magnitude.

For example, the rising liquidi¬ty and increasing importance and size of securitisation have resulted in the relatively weaker transmis¬sion through traditional bank lend¬ing channels.

Most importantly, the trans¬mission from the Fed funds rate to longterm interest rates - the key connecting variable between the financial sector and the real sector - has been less potent in the US.

The main agreement among central banks and the majority of academics is that rising financial instability should be addressed by prudential and supervision poli¬cies, not monetary policy.

However, it has been widely argued that the recent houseprice tumble and financial turbulence in the US could have been averted or better contained had the US Fed funds rate not been kept at a low level for such a lengthy period fol¬lowing the dotcom recession.

The challenge is, while price sta¬bility will rightly continue to be the most important goal for monetary policy, whether and to what extent the territory of monetary policy could be extended to take care of financial stability. \The most cru¬cial factor seems to be under¬standing the synchronisation pat¬tern among economic, price and assetprice cycles further down the road.

The paper was writ¬ten by two officials at the Bank of Thailand's Monetary Policy Group, Chaipat Poonpatpibul and Krittinun Wiangwangchai, and another two at the Financial Markets Operation Group, Vasuvirabhadra Ramdeja and Pawinee Chitmongkolsamur. The views expressed in the paper are those of the authors and do not necessarily represent the Bank of Thailand's policies.