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Securing sustainable price stability: should credit come back from the wilderness?

  • Claudio E. V. Borio
  • Philip Lowe

    (Reserve Bank of Australia)

We argue that in order to achieve price stability in a sustainable way, central banks should consider paying greater attention to credit in their monetary policy strategies than is generally the case at present. Specifically, simply setting monetary policy so that a two-year inflation forecast is at the central bank's target may, on occasions, be less than optimal. In particular, the central bank may wish to deviate from such a strategy when developments in the financial system are exposing the macroeconomy to materially increased risk. Doing so calls for longer policy horizons together with an explicit incorporation into policy decisions of the balance of risks in the outlook. One important indicator that risk is building up is unusually sustained and rapid credit growth occurring alongside unusually sustained and large increases in asset prices ("financial imbalances"). Building on previous work, we show that empirical proxies for financial imbalances contain useful information about subsequent banking crises, output and inflation beyond traditional two-year policy horizons. On the basis of Taylor rule-type descriptions of policy, we also investigate the response of central banks to financial imbalances. We find evidence that, at least until recently, central banks generally either have not responded to imbalances systematically or, to the extent that they have, have done so asymmetrically, loosening policy further than normal in the face of their unwinding but not tightening it beyond normal as they build up.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 157.

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Length: 51 pages
Date of creation: Jul 2004
Date of revision:
Handle: RePEc:bis:biswps:157
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  1. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
  2. Lawrence J. Christiano & Massimo Rostagno, 2001. "Money Growth Monitoring and the Taylor Rule," NBER Working Papers 8539, National Bureau of Economic Research, Inc.
  3. David Gruen & Michael Plumb & Andrew Stone, 2005. "How Should Monetary Policy Respond to Asset-Price Bubbles?," International Journal of Central Banking, International Journal of Central Banking, vol. 1(3), December.
  4. repec:cup:cbooks:9780521645966 is not listed on IDEAS
  5. Eichengreen, Barry & Arteta, Carlos, 2000. "Banking Crises in Emerging Markets: Presumptions and Evidence," Center for International and Development Economics Research, Working Paper Series qt3pk9t1h2, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  6. Michael D. Bordo & Olivier Jeanne, 2002. "Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy," NBER Working Papers 8966, National Bureau of Economic Research, Inc.
  7. David Gruen & Tim Robinson & Andrew Stone, 2002. "Output Gaps in Real Time: Are They Reliable Enough to Use for Monetary Policy?," RBA Research Discussion Papers rdp2002-06, Reserve Bank of Australia.
  8. Edwin M. Truman, 2003. "Inflation Targeting in the World Economy," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 346, May.
  9. Marc Zelmer & Andrea Schaechter, 2000. "Adopting Inflation Targeting: Practical Issues for Emerging Market Countries," IMF Occasional Papers 202, International Monetary Fund.
  10. Klaus Schmidt-Hebbel & Matías Tapia, 2002. "Monetary Policy Implementation and Results in Twenty Inflation-Targeting Countries," Working Papers Central Bank of Chile 166, Central Bank of Chile.
  11. Trautwein, Hans-Michael, 2000. " The Credit View, Old and New," Journal of Economic Surveys, Wiley Blackwell, vol. 14(2), pages 155-89, April.
  12. repec:cup:cbooks:9780521641739 is not listed on IDEAS
  13. Frederic S. Mishkin & Klaus Schmidt-Hebbel, 2001. "One Decade of Inflation Targeting in the World: What Do We Know and What Do We Need to Know?," NBER Working Papers 8397, National Bureau of Economic Research, Inc.
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