You are here: Home Knowledge Base Economy The Future of Central Banking: Inflation Targeting versus Financial Stability Solutions Central banks should adopt "default countercyclical policy," using the "comply or explain" approach.
Symposium 2012

Solution for 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 should adopt "default countercyclical policy," using the "comply or explain" approach.

Central banks should improve their monitoring of financial variables by designing a variety of presumptive macroprudential indicators. For example, they could increase their focus on credit aggregates and the growth of asset prices. In addition, they could rethink the concepts underlying their monetary analysis, particularly the role that monetary aggregates play in the emergence of financial imbalances.

Each central bank should designate a small number of indicators that have preceded and accompanied booms and busts in the past. They could choose whichever seems historically appropriate. These could include, for example, increases in credit expansion above the norm and above the average credit to GDP ratio; increases in household indebtedness above the norm and above the average debt to GDP ratio; and increases in housing prices above the norm and above the average ratio of house prices to the general level of prices.

Ultimately, if central banks detect the unsustainable build-up of financial balances, they should be required either to take countervailing "macroprudential" steps to counteract that phase in the cycle or to explain in public why they did not do so.

The problem is not designing the appropriate instruments but getting them used in a countercyclical fashion. The only way to do that is to apply exante rules. But rules are a straitjacket and are frequently in practice inappropriate, so a better procedure is "comply or explain." The purpose is to put some degree of countercyclical action into the default option rather than having inertia as the default option, which is normally the case now.

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