By Steven K. Beckner

CHATHAM, MASS. (MNI) - Eric Rosengren, president of the Federal Reserve Bank of Boston, stressed the importance of financial supervision for monetary policy and, conversely, the importance of monetary policy for financial supervision in a paper presented Thursday at a conference on Cape Cod sponsored by the Boston Fed.

Rosengren, in a paper co-authored with Boston Fed economist Geoffrey Tootell and University of Kentucky economist Joe Peek, said the financial crisis shows how financial conditions -- and not just the Fed's statutory dual mandate of price stability and full employment -- affect monetary policy. But he suggested that economic models and policies need to be refined to take fuller account of the interaction between monetary policy and the health of financial institutions.

They contend that the Fed can use information on financial stability from supervisors in deciding how to respond to asset price bubbles, but they suggest that supervisory policy, not monetary policy, is the best way to counter asset price bubbles.

Monetary policy is too much of a "blunt instrument" for dealing with bubbles, they argue.

The Fed has long maintained that it needs to play a key role in financial supervision to properly conduct monetary policy, and the Rosengren-Tootell-Peek paper serves to reinforce that message.

"The recent financial crisis has highlighted the nexus between banking, financial markets, and the real economy," the paper begins. "The complex interactions between the financial system and the real economy raise important questions about the role central banks should play in responding to episodes of financial instability."

"While many central banks have a mandate to focus on inflation, and the Federal Reserve has a dual mandate to focus on inflation while maintaining full employment, financial stability is not currently included directly in the mandate of major central banks, although it was the impetus for creating the Federal Reserve," it adds.

Rosengren and the two economists find, not surprisingly, that Federal Open Market Committee (FOMC) policy actions are affected by information on problem banks and problem assets "above and beyond its effect on the expected path of inflation and real output" and that "given the outlook for inflation and output, the FOMC reacts to a deterioration in the overall health of banks by lowering the federal funds rate."

They note that the Fed's credit easing became much more aggressive following the failure of Lehman Brothers last October.

Explaining the Fed's response to adverse financial stimuli, they write that, "traditional model-driven forecasts of inflation and real output growth may underestimate the impact of episodes of financial instability."

"However, even if the macroeconomic models used by the central bank and by private forecasters do not fully capture the effects of financial market frictions, FOMC reactions to changes in the risk of financial instability still might incorporate such effects," they continue. "In fact, we do find that macro models do not fully capture the effects of financial instability, and that their forecasts of real output growth can be improved by incorporating the information contained in bank supervisory data."

The FOMC also reacts to episodes of increased risk of financial instability because they "might also increase the probability of extreme adverse economic outcomes" and acts to take out "insurance" against those outcomes.

Rosengren et al emphasize that "the benefit of the interaction between supervision and monetary policy is not a one-way street."

"Not only is incorporating supervisory information into the production of the macroeconomic forecasts relevant for guiding monetary policy, but macroeconomic data are shown to be useful in forecasting problems in the banking sector," they write. "In particular, bank supervisory models based on banking data alone can be improved by incorporating macroeconomic data in the form of the macroeconomic forecasts used to guide the FOMC in their monetary policy deliberations."

"Thus, supervisory policy may be improved by utilizing the forecasts of the central bank. That is, the transfer of information between bank supervisors and monetary policy makers should be more than just a monologue," they add.

An example of this "symbiotic relationship" between monetary policy and supervisory policy was the way economic scenarios were incorporated a few months ago in bank stress tests. "Tools routinely used to reach the monetary policy goals of the Federal Reserve would certainly help determine how 'stressful' a stress test should be," write Rosengren and his co-authors. "Moreover, adequately incorporating the interactions between the financial and real sectors of the economy may require a more complete understanding of macroeconomic modeling than is typically required for a bank examination."

Rosengren and company apply their symbiotic approach to asset price bubbles.

"Better integrating monetary policy, supervisory policy, and financial stability policy may provide a useful instrument for monetary policy makers when addressing asset bubbles," they write. "For example, if the central bank observed a rapid increase in asset prices in combination with increased leverage by lenders and increased borrowing by purchasers of the assets in a particular sector of the economy, focusing on underwriting standards and the degree of leverage of lenders may be more effective than altering the cost of financing to all sectors of the economy."

"Emerging bubbles may be better addressed by targeted changes in supervisory policy rather than the more blunt instrument of monetary policy, although such a decision will be better informed if it is made by a regulator that also is familiar with how macroeconomic activity is evolving," they continue. "While monetary policy generally influences the cost of credit, the role of a macroprudential supervisor will be more focused on the availability of credit, especially insofar as that availability is affected by the health of the banking system and the stability of financial markets."

"In particular, a macroprudential supervisor should be interested in whether current underwriting standards and capital standards are consistent with a growth rate in asset prices that is sustainable," they go on. "Because financial intermediaries provide critical financing that enables the economy to grow, monetary policy makers need to understand emerging financial trends and how regulation and supervision are affecting those trends."

Commenting on the paper, Claudio Borio, head of research for the Bank for International Settlements, disagreed with the Rosengren paper, saying that both monetary policy and supervisory policy "have a mutually supporting role to play" in countering asset bubbles, because they "can have severe effects" on economic output.

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