Abstract
Clear rules have their advantages. But the enthusiasm for simple inflation targets as the main principle of monetary policy has waned after the crisis, as various central banks consistently missed their targets despite ultra-expansive policies. Meanwhile, the crisis once again supplied evidence of the painful consequences that financial market instability can have for economic growth and social stability. Central banks, including the ECB, should take the side-effects of their policies on financial stability more explicitly into account. Globalization and technological change have affected the way prices and wages are determined. The ensuing uncertainty has strengthened the case for a more adaptable strategy of inflation targeting. Such a strategy should leave room for central banks to systematically smooth the financial cycle, leaning against the wind in times of financial booms and loosening financial conditions in times of volatility. Such a policy would improve the long-term performance of the economy.
One cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of relative calm lulled investors, financial firms, and financial regulators into paying insufficient attention to risks that were accumulating must have some truth in it. I don’t think we should conclude, though, that we therefore should not strive to achieve economic stability. Rather, the right conclusion is that, even in (or perhaps, especially in) stable and prosperous times, monetary policymakers and financial regulators should regard safeguarding financial stability to be of equal importance as—indeed, a necessary prerequisite for—maintaining macroeconomic stability.
(Bernanke 2013, p. 10)
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Notes
- 1.
These and other practical issues of inflation targeting have been discussed since the early days of inflation targeting. See: Bernanke et al. (1999).
- 2.
The paradigm of inflation targeting has changed over time: “At the time targeting was developed, it was seen as a way to bring inflation down. 25 years ago, it was difficult to imagine an environment in which the price level would remain so subdued for so long. But that is where we are today, and the situation is stressing the architecture of monetary policy”, Tannenbaum (2018, p. 7).
- 3.
McKibbin and Panton (2018).
- 4.
Weber (2015).
- 5.
Rising real estate prices take time to translate into higher rents. Therefore, the difference in calculations with and without owner occupied housing is not as big as one might expect. The German Consumer Price Index (Preisindex der Lebenshaltung), for example, includes a pro-forma proxy for the rents of owner-occupied housing. Its rate of increase (1.6% in March 2018) is not significantly different from the Harmonized Consumer Price Index (HCPI) used by the ECB, which neglects owner occupied housing.
- 6.
For a recent discussion of these issues see Lautenschläger (2018).
- 7.
IMF (2018, p. 1).
- 8.
Praet (2017).
- 9.
IMF (2018).
- 10.
The Taylor rule relates the central banks’ interest rate to a long-term equilibrium rate, the output gap and the deviation of inflation from the target rate. It can be used as model explaining central banks rate setting behaviour.
- 11.
Praet (2017).
- 12.
Juselius et al. (2016, p. 3).
- 13.
Already in 2013 Ben Bernanke made the point for the Fed: “Financial stability is also linked to monetary policy, though these links are not yet fully understood. Here the Fed’s evolving strategy is to make monitoring, supervision, and regulation the first line of defense against systemic risks; to the extent that risks remain, however, the Federal Open Market Committee strives to incorporate these risks in the cost–benefit analysis applied to all monetary policy actions” (Bernanke 2013, p. 12).
- 14.
The distinction between monetary and financial variables is not clear-cut. I prefer to speak of financial conditions as it has a broader connotation than monetary conditions, which may be associated more with control or target variables of monetary policy, such as interest rates, the yield curve or money and credit growth. Financial conditions would also encompass variables that indicate behavioral changes and sentiment changes on financial markets.
- 15.
Blanchard et al. (2015).
- 16.
Bernanke (2013).
- 17.
Reinhart and Rogoff (2013).
- 18.
For a more general discussion of the overburdening of central banks see Issing (2016).
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Heise, M. (2019). Towards a Monetary Policy Fit for the Future. In: Inflation Targeting and Financial Stability. Springer, Cham. https://doi.org/10.1007/978-3-030-05078-8_5
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