NEW YORK – One lesson of the 2008-2009 financial crisis is that protecting financial stability is “is at least as important as” effective monetary policy use ‘in the pursuit of macroeconomic objectives,” according to Federal Reserve Board Chairman Ben S. Bernanke.
Bernanke added that he expects forward guidance and other policy communicatons to be used increasingly in the future.
“With respect to monetary policy, the basic principles of flexible inflation targeting--the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency--seem destined to survive,” he told a Federal Reserve Bank of Boston conference Tuesday.
“An evolving consensus holds that central banks can dedicate separate toolkits to achieving their financial stability and macroeconomic objectives, but this consensus must be viewed as provisional,” he said. “Certainly, those toolkits appear to be much better stocked today than before the crisis: monetary policy tools that can be brought to bear if necessary include the management of the central bank’s balance sheet and, to a greater extent than in the past, communication about future policies. Financial stability policy encompasses, as the first line of defense at least, a range of microprudential and macroprudential tools, both structural and varying over the cycle, supported by enhanced monitoring and analysis of potential risks to systemic stability. Clearly, understanding and applying the lessons of the crisis will take some time yet; both theorists and practitioners of central banking have their work cut out for them.”
He called the crisis “historic,” “its severity and economic consequences … enormous,” with “profound and long-lasting effects on our economy, our society, and our politics. More subtle, but of possibly great importance in the long run, will be the effects of the crisis on intellectual frameworks, including the ways in which economists analyze macroeconomic and financial phenomena.”
Prior to the crisis, monetary policy was committed to “medium-term price stability and a high degree of transparency about central banks’ policy objectives and economic forecasts. The adoption of this approach helped central banks anchor longer-term inflation expectations, which in turn increased the effective scope of monetary policy to stabilize output and employment in the short run. This broad framework is often called flexible inflation targeting, as it combines commitment to a medium-run inflation objective with the flexibility to respond to economic shocks as needed to moderate deviations of output from its potential, or ‘full employment,’ level.”
The pre-crisis consensus framework generally proved effective during the crisis, according to Bernanke. “Notably, well-anchored longer-term inflation expectations moderated both inflation and deflation risks, as price-setters and market participants remained confident in the ability of central banks to keep inflation near target in the medium term. The medium-term focus of flexible inflation targeting also offered central banks latitude to cushion the effects of the financial shocks on output and employment in the face of transitory swings in inflation.”
Transparency made “monetary policy both more predictable and more effective during the past few years than it might otherwise have been,” he added, but despite the framework’s beneficial aspects, “it ultimately, by itself, was not enough to ensure financial stability.”
Critics want this framework modified or replaced. “My guess is that the current framework for monetary policy--with innovations, no doubt, to further improve the ability of central banks to communicate with the public-- will remain the standard approach, as its benefits in terms of macroeconomic stabilization have been demonstrated. However, central banks are also heeding the broader lesson, that the maintenance of financial stability is an equally critical responsibility,” Bernanke said. “Central banks certainly did not ignore issues of financial stability in the decades before the recent crisis, but financial stability policy was often viewed as the junior partner to monetary policy. One of the most important legacies of the crisis will be the restoration of financial stability policy to co-equal status with monetary policy.”
The use of balance sheet policies during this crisis showed the “constraints” of “more-conventional policies as short-term nominal interest rates reach very low levels. In more normal times, when short-term policy rates are not constrained, I expect that balance sheet policies will be rarely used. By contrast, forward guidance and other forms of communication about policy can be valuable even when the zero bound is not relevant, and I expect to see increasing use of such tools in the future.”
Another lesson of the recent crisis is that financial markets are so globalized central banks may need to offer liquidity in a variety of currencies, which led to the Fed creating bilateral currency swap agreements with 14 foreign central banks.
