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Symposium 2015

Virtual Library File - Monetary Policy and Financial Stability

The Challenge

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Ba ...

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Bank of England, quickly reached the zero-lower-bound on nominal interest rates; these central banks then started conducting extraordinary measures like quantitative easing and forward guidance. There is some consensus that this massive monetary stimulus in the first, ‘acute’, phase of the crisis was largely appropriate, preventing a second Great Depression. However, since then, discussion has turned toward how long monetary policy should remain highly expansionary, because of doubts about the effectiveness of expansionary monetary policy in the aftermath of banking crises. Moreover, expansionary monetary policy over a long period of time might be associated with adverse side effects such as financial instability, asset price bubbles, slower structural adjustment, distorted investment decisions, and inflation.

In this speech, Janet Yellen shares her views on monetary policy and financial stability. She argues that monetary policy faces significant limitations in promoting financial stability. Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, she concludes that a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. However, there may also be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. Because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policy-makers clearly communicate their views on the risks to financial stability and how such risks influence the appropriate monetary policy stance.