Financial stability policy is generally associated with regulatory and supervisory measures, so the exercise of financial stability policy is often seen as being independent from the stance of monetary and fiscal policy. However, I am going to suggest that policymakers should view financial stability tools more holistically. Indeed, I would like to suggest that the ability to appropriately set financial stability tools is integrally related to the ability to fully utilize fiscal, monetary, and financial stability policy tools to respond to a large adverse financial shock.
The use of financial stability tools is generally seen as being conditioned on and calibrated to the severity of likely economic stresses – but I would argue that it is also critically important to take into account the extent to which monetary and fiscal policy are equipped to respond to an adverse financial shock, so that policymakers can best coordinate the response to a crisis across all available tools. Much of what I have in mind has to do with assessing each policy tool’s capacity to respond.
For example, suppose that a country’s government-debt-to-GDP ratio is high, limiting the ability or willingness to use fiscal tools to offset financial and other shocks. If that country has also not developed sufficient financial stability response tools, then most of the countercyclical policy response will likely fall to monetary policy. Alternatively, if the government-debt-to- GDP ratio is extremely high and interest rates are already at or near the effective lower bound, and the country is unable or unwilling to use less-conventional monetary tools like quantitative easing, then financial stability tools are likely to be more important. In sum, it is important to consider whether there is sufficient capacity in the toolkit for policymakers to adequately (let alone optimally) respond to severe financial shocks.