The Fall of Bagehot – Monetary policy implementation during the financial crisis

The purpose of this article is to provide an introduction to monetary policy implementation and the challenges posed by the financial crisis. Monetary policy implementation is normally about setting a short-term interest rate. This apparently simple task is complicated by additional objectives, e.g. in relation to the development of a money market, as well as the necessity to decide on a number of parameters, such as collateral, timing, counterparties and quantitative restrictions on the supply of liquidity. The apparent attempt to both control quantities (liquidity) and prices (interest rates) is one of the more mind bugling aspects of monetary policy implementation. The financial crisis has demanded great flexibility in relation to the setting of parameters, and one of the consequences has been that the distinction between monetary policy lending and the lender of last resort role of central banks in the spirit of Bagehot has become blurred. Central banks have also moved beyond setting a short-term rate as financial markets became disconnected. As central banks wisely opted for influencing prices (interest rates), the attempt at also controlling quantities was set aside and central bank balance sheets ballooned. However, this proved insufficient and central banks first loosened virtually all other parameters related to their lending operations and subsequently went beyond traditional short term lending, only to discover that even more was needed.