Can raising interest rates aid financial stability?

Mix of policies could more effectively prevent excessive risk-taking

BORROWERS have enjoyed an unprecedented period of low interest rates as global central banks try to spur spending and investment amid sluggish economic growth.

The move has largely worked, but not without costs. Ultra-low rates over the past five years have come at the expense of lenders and savers, who have suffered pitiful returns on their excess cash.

This has in turn encouraged some investors to take greater risks in search of higher yields, which market watchers warn may be sowing new seeds of instability just as the last recollections of the global financial crisis are fading.

Talk is rife of stock market bubbles - United States markets have been on a five-year bull run, culminating in record highs this year. Last Thursday, the Dow Jones Industrial Average crossed the 17,000 level for the first time.

Investors are also lending to companies, even those assessed as not being particularly financially strong, at unusually low rates.

This "reach for yield" was flagged last week by Dr Janet Yellen, the chairman of the US Federal Reserve - probably the institution most responsible for keeping global interest rates depressed.

At a lecture organised by the International Monetary Fund, Dr Yellen said she has noticed "pockets of increased risk-taking across the financial system", although this has not yet built up into a "systemic threat".

But notably, she added that though low interest rates may spur investors to take on more risk, raising interest rates is too blunt a tool to address vulnerabilities in the financial system.

Citing past crises, she argued that while higher rates might have slowed increases in house prices in the US prior to the global financial crisis, any hike in rates sharp enough to arrest the market's momentum would have led to large job losses and hurt home owners paying off their mortgages.

Higher rates would also not have strengthened regulators' supervision of big banks or made exotic financial products more transparent, she said.

So while changes to interest rates and monetary policy may eventually be necessary, the central tool for financial stability should be macroprudential policies, Dr Yellen concluded. These include better regulatory oversight of banks and financial instruments or caps on borrowing.

That is an attitude that will be familiar to observers of Singapore's economy. A few months ago, Monetary Authority of Singapore (MAS) managing director Ravi Menon made a similar argument in his speech at the inaugural Asian Monetary Policy Forum.

He said traditional monetary policy measures, such as tweaking interest rates, would have had a limited effect in dealing with the aftermath of the global financial crisis, when markets were flush with easy liquidity. In Singapore, this liquidity translated into a surge in property prices.

The Republic had maintained a tight monetary policy stance since 2012, but Mr Menon said that any further tightening to cool the property market could have backfired by attracting more capital into Singapore, driving up prices more.

The argument is appealing, at least in theory. But in practice, macroprudential policies have not always been enough to close the disconnect between economic fundamentals and exuberance in the property or stock markets.

The Economist magazine recently raised the example of Spain, where macroprudential tools such as forcing banks to build up reserves against losses were no match for a simultaneous rise in household debt.

In Singapore's case, several rounds of macroprudential measures, including mortgage caps and lower loan-to-value ratios, failed to stem the swelling tide of home demand for several years.

The most recent and sweeping new rule - capping a borrower's total debt relative to income - has had some effect on home prices, but buying remains strong.

Up to 10 per cent of borrowers are probably already overstretched on their mortgages, according to the MAS.

Intuitively, property players are agreed on the one thing that will finally cool the ardour for housing: higher interest rates.

Capping loans makes home buyers itch to spend more, but higher out-of-pocket payments monthly will pinch where it really hurts.

Relying too much on macroprudential policy, ironically, could also have the same counterproductive effect as monetary policy. Judicious, targeted loan curbs such as those in Singapore may help stabilise markets, only to find that stability attracts even more investors and borrowers.

Rather than place the main burden on macroprudential policy to ensure financial stability, perhaps an interplay of both monetary and macroprudential policy could more effectively prevent excessive risk-taking.