A Marriage Made in Heaven or Hell: Monetary and Financial Stability

IMF Blog, July 20, 2010

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Canonical URL: A Marriage Made in Heaven or Hell: Monetary and Financial Stability

Author: José Viñals
Date: July 20, 2010
Setting: Reflection on monetary policy evolution over the past three decades and interactions with financial stability.
Institutional note: The IMF is based in Washington D.C. and is an organization of 191 countries.

Over the past three decades, better monetary frameworks reduced the level and volatility of inflation by enshrining price stability as the main monetary policy objective, providing independence and constrained discretion through formal inflation targets.
These frameworks left a gap: weak attention to financial stability allowed credit-fueled asset price bubbles to build without necessarily affecting consumer price inflation.
Asset bubbles can feed unsustainable booms in consumption and investment; when bubbles burst they threaten the financial system, the real economy, and price stability.
Globalization effects over the past two decades complicate monetary-financial interactions:
- Domestic long-term rates in many economies are increasingly determined by international demand for domestic financial assets, limiting central banks’ ability to move them.
- Foreign-financed consumption can be released through current account deficits rather than inflation.
- Global, rather than local, liquidity was a major driver of financial imbalances; differences between local and global rates enticed capital inflows and fueled booms, particularly in smaller countries.

Prudential policies should be the first line of defense against credit-fueled asset booms; they are effective regardless of whether booms are driven by capital inflows or domestic funding.
Monetary policy can contribute by non-mechanistically “leaning” against the build-up of financial imbalances (for example, credit booms or asset bubbles), while ensuring actions remain consistent with price stability.
The appropriate policy mix is context-dependent and requires judgment using all available information rather than rigid mechanical rules.
Paying closer attention to financial stability in pursuit of price stability over the medium term can make monetary policy more symmetric during the cycle: more “leaning” in good times and less “cleaning” in bad times when bubbles burst.

Sharpen and link prudential tools to macrofinancial developments as part of a macroprudential policy approach; use these tools to counter the root build-up of financial imbalances.
Maintain monetary policy’s primary focus on price stability, but allow monetary authorities to support financial stability when consistent with price objectives.
Develop a new, enduring policy framework that better integrates monetary and prudential policies while respecting their distinct roles: monetary policy aiming mainly at price stability and prudential policy aiming mainly at financial stability.
Recognize the role of global financial conditions in domestic imbalances and adapt policy frameworks accordingly.

Further analysis is needed to understand fully how monetary policy affects output and inflation in the presence of changing financial developments, both domestically and globally.
Building effective institutions, tools, and judgment-based frameworks to align monetary and financial stability will be a major ongoing challenge going forward.

Views expressed are those of the author and do not necessarily represent the views of the IMF and its Executive Board.

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