Whether and should we include financial stability in monetary policy? Three views…

Peter Praet of ECB has this useful summary of thinking about including financial stability in mon policy:

To prevent the emergence of such bad outcomes, a sound, system-wide approach to financial regulation is of the essence. But what is the role of monetary policy? Can monetary policy be conducted in a way that reduces the likelihood of financial instability? The long-running debate on these issues within academic and policy-making circles can be broadly broken down into three different viewpoints.[3]

  • The first is the “pre-crisis consensus” view, which argues that monetary policy should maintain a relatively narrow mandate of price stability, leaving financial stability to prudential authorities. Under this view, the monetary authority should only take financial stability concerns into account in so far as they affect the outlook for price stability and economic activity.
  • The second view is to “lean–against–the–wind”, i.e. that as price stability may not be sufficient for financial stability, central banks should lean against the emergence of financial imbalances by tightening the monetary policy stance over and above the level necessary to bring inflation back to target over a policy horizon that is generally understood to be around two years.
  • The third view is that “financial stability is price stability”. Proponents of this view advocate a more radical change in the objective of monetary policy, arguing that financial stability and price stability are so intertwined that one cannot distinguish between the two.[4]Under this view, both standard and non-standard monetary policies are in the first place attempts at stabilizing the financial system, addressing malfunctioning financial markets and smoothing the monetary transmission process.

Hmm…Nice way to summarise the many views on the contentious issue.

He then says these interplays depend on the following:

While all these viewpoints recognise the important interplay between financial stability and monetary policy in pursuit of price stability, their relevance ultimately depends on (i) the weight to be attached to the “risk-taking” channel of monetary policy, (ii) the strength of the macroprudential framework and (iii) the policy strategy of the monetary authority, especially as regards its policy horizon.

He discusses all these and then looks at how ECB fares on this front:

Our monetary policy measures have proven effective in sustaining a resilient recovery and addressing the risks to price stability. This in turn provides a strong contribution to financial sector resilience. Looking ahead, significant monetary policy stimulus is still needed to support the gradual build-up of price pressures for inflation to return to levels below, but close to, 2% in a durable fashion.

At this stage of the cycle, careful monitoring of the risk-taking channel of monetary policy is important. While there is no evidence of excessive misalignment across asset classes in the euro area right now, there are signs that valuations are stretched in specific market segments. Macroprudential instruments are best placed to counteract the emergence of specific financial imbalances in an efficient and targeted manner. Macroprudential policy and monetary policy thus complement one another in pursuit of their respective objectives.

 

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