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Symposium 2012

Proposal - The Future of Central Banking: Inflation Targeting versus Financial Stability

The Challenge

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which cent ...

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which central banks focus on maintaining price stability and stabilizing the output gap—was an appropriate and sufficient mandate for conducting monetary policy. Key assumptions underlying the consensus were that this mandate would automatically lead to financial stability and that the framework of monetary policy could deal with cross-border capital flows.

Central Banks have to further develop a fully-flexed framework of macroprudential surveillance. This framework has to allow for a broad assessment for the build-up of financial imbalances even if inflation and inflation expectations remain subdued. This monetary policymaking strategy should also include a profound surveillance of money and credit developments and crosscheck the results against other analyses. This guarantees the symmetry of policy in expansions and contractions. ”Ultimately, this cross-check leads to a better assessment of the correctness of the policy stance. Early indications that a process of surging equity or house prices in the euro area might be interacting with conditions of abundant liquidity would lead to heightened vigilance” (ECB (2005, p 60)). There are many examples of the application of “vigilance”. “Monetary developments, therefore, require careful monitoring, especially in the light of the strengthening of economic activity and, in particular, of strong asset price dynamics, especially in housing markets” (ECB, Introductory Statement of 6 June 2006).

In times of crises central banks can act as a “fire service” through its tools of liquidity management and unconventional monetary instruments. However, in the medium and long term they should stick to the successful model developed in the 1980s that led the Great Moderation, and should attach ultimate importance to maintaining credibility for low inflation. Financial stability and systemic misallocations should be treated separately by a Financial Stability Authority (Svensson 2010).

Although central banks may be charged with additional tasks in the aftermath of the crisis, their primary objective must remain the maintenance of price stability. We cannot allow any conflicts of interest to arise. The high-level expert group headed by Jacques de Larosière, former Governor of the Bank of France and Managing Director of the IMF, has identified a number of weaknesses in the supervisory framework both inside and outside Europe that contributed to the build-up of the current crisis. One of the group’s proposals is to give the ECB more responsibility for so-called macro-prudential supervision. This means supervision that aims to limit the risk of distress in the financial system as a whole, but does not extend to supervision of individual financial institutions (See Stark 2010).

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