Lessons from the crisis : Monetary policy and financial stability

The article examines the link between monetary policy and financial stability in the context of the recent financial and economic crisis. It aims to draw lessons from those recent events and to examine the implications for monetary policy. More specifically, it asks whether, apart from its price stability mandate, monetary policy should play a more significant and pro-active role in safeguarding financial stability. The first section reviews the pre-crisis consensus on monetary policy. Economic developments in recent decades had shifted the focus of monetary policy to the link between price stability and economic growth, while the issue of financial stability had taken a back seat. In the prevailing macroeconomic context, known as “the Great Moderation”, a clear consensus on monetary policy emerged in terms of objectives, strategies and the institutional framework. Moreover, the dominant view was that monetary policy makers should take account of asset prices and other financial variables only in so far as they have implications for the future trend in activity and inflation over a period of approximately two years, typically taken as the relevant period for monetary policy. The monetary policy strategy of the Eurosystem is largely in line with this pre-crisis consensus. Unlike most other central banks, however, the Eurosystem has a unique two-pillar strategy in which the monetary pillar pays explicit attention to financial developments. Although initially aimed at identifying risks to price stability, it gradually focused more on aspects of financial stability. The second section draws a number of provisional lessons from the crisis. First, the recent crisis has provided evidence that price stability is not sufficient to maintain financial stability and macroeconomic stability in general. Second, not only has the continued firm anchoring of inflation expectations enabled monetary policy-makers to respond appropriately during the crisis, but it is also destined to remain one of the key elements of future monetary policy. Furthermore, recent research has revealed recurrent patterns which may help to identify financial vulnerabilities in the run-up to a serious financial crisis. However, it is still hard to identify financial imbalances in real time, and further research in this field is desirable. The debate on whether, in the future, monetary policy should make a greater contribution to financial stability and perhaps be given a broader mandate is still ongoing. However, some key points are already becoming clear. Financial stability should in the first place benefit from a strengthening of prudential policy, and particularly from the conduct of a macro-prudential policy. Moreover, a successful macro-prudential policy makes it easier to conduct monetary policy ; it prevents monetary policy from being over-burdened or confronted by serious policy dilemmas, so that it can continue to focus on the primary goal of price stability. In principle, this does not imply any significant modification of the existing monetary policy frameworks. Nevertheless, it is necessary that monetary policy takes full account of its impact on the risk-taking behaviour of the various economic agents. In addition, greater importance should be attributed to analysis of the formation of financial imbalances. That is not at odds with the priority of the price stability mandate, because the crisis clearly showed that risks to financial stability in the longer term also imply risks to price stability. However, it does assume an extension of the monetary policy horizon. If that horizon is actually extended, that should preferably be made explicit, as it would clarify the monetary policy strategy and increase accountability.