The response of central banks to financial instability was front and center of global monetary policy last week, with Sweden’s rate cut underscoring how the topic of financial stability has become an integral part of monetary policy since the global financial crises.
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Measures of credit and property prices are likely to become even more central to policy-making in coming years as threats to financial stability worldwide continues to grow unless policy makers start to tackle the ever-growing mountain of debt.
The Bank for International Settlements (BIS) threw down the gauntlet to central banks on Sunday, calling on monetary policy to be reoriented toward the slow-moving financial cycle and away from reacting to short-term fluctuations in inflation and economic output.
One of the consequences of the BIS view is that central banks should be ready to tighten monetary policy when financial imbalances start building up, even if inflation appears to be under control. The BIS has for years pointed to the dangers from the growing reliance on debt as an engine of economic growth along with ultra-low interest rates and most observers saw the BIS’ annual report as a direct challenge to the current policy stance of major central banks.
The speech by Janet Yellen, chair of the U.S. Federal Reserve, only three days after the BIS annual meeting in Basel, Switzerland, therefore took on added significance.
Most observers heard Yellen’s speech as a rejection of the BIS view, referring to her statements that “monetary policy faces significant limitations as a tool to promote financial stability,” and there is no need for “monetary policy to deviate from a primary focus on attaining price stability and maxiumum employment.“
But on a closer reading, Yellen agrees with many of the points argued by the BIS, an illustration of how the BIS annual report reflects much of the thinking in central banks worldwide. Monetary policy has changed since the 2007-2009 financial crises and the belief that central banks should focus narrowly on inflation and then clean up any mess from a financial crises is dead and buried.
