Central Banks Should Move Beyond Price Stability

September 22, 2009

• Monetary policymakers should consider leaning against credit market cycles
• Central banks’ mandates and tools may need to be expanded
• But broader approach would be challenging to implement

Monetary policymakers should consider doing more to counter credit market cycles to reduce risks of damaging asset price busts, according to a new IMF study after the worst financial market slump since the Great Depression.

The study—based on house and stock price busts over the past 40 years—shows that previous asset price busts were often foreshadowed by rapidly expanding credit, deteriorating current account balances, and large shifts into residential investment. This is also true of the buildup to the current crisis. With inflation typically under control, central banks effectively accommodated these growing imbalances, raising the risk of damaging busts.

Monetary policymakers should therefore consider putting more emphasis on broader macrofinancial risks. This could imply tightening monetary conditions earlier and more vigorously to try to prevent dangerous excesses from building up in asset and credit markets, even if inflation appears to be largely under control, according to the study, published as part of the IMF’s October World Economic Outlook (WEO).

The chapter in the WEO, “Lessons from Asset Price Fluctuations for Monetary Policy,” prepared by Antonio Fatas, Prakash Kannan, Pau Rabanal, and Alasdair Scott, says that taking a broader approach to monetary policy will be challenging. Expanded mandates and new sets of policy tools may be required. Policymakers will need to employ judgment to look at what is driving asset price movements and discretion to avoid costly policy mistakes. Crucially, expectations will need to be realistic, as it is inherently difficult to distinguish between unsustainable and sustainable asset price movements.

Studying the historical record

The chapter seeks lessons for monetary policy from recent experiences of asset price busts. It studies historical evidence to see whether there are consistent macroeconomic patterns leading up to asset price busts, examines the role of monetary policy in the buildup to such busts, including the latest crisis, and asks whether monetary policy should be responsible for more than just the stability of goods price inflation, how this could be done, and what the potential tradeoffs are.

It finds that monetary policy was not the smoking gun behind the current crisis. There is some evidence for loose monetary policy in the years leading up to the current crisis in some countries, but it is not likely to have been the main systematic cause of the booms and consequent busts across the global economy. For example, differences in monetary policy settings across countries do not correlate well with differences in house and stock price growth.

However, there were warning signs ahead of the current crisis that monetary policymakers could have heeded. Central banks fulfilled their mandates—inflation in advanced economies stayed within a narrow range in the leadup to the current crisis. But central banks accommodated the relaxation in financial conditions, raising the risk of a damaging bust.

Acting forcefully

Model-based analysis suggests that stronger-than-usual monetary reactions to signs of overheating or of a credit or asset price bubble could be warranted to reduce macroeconomic volatility. This would imply tightening monetary conditions earlier and more vigorously to try to prevent dangerous excesses from building up, even if inflation appears to be under control.

Introducing time-varying “macroprudential” instruments designed specifically to dampen credit market cycles could help monetary policy. Some proposals include so-called “dynamic provisioning,” in which financial institutions automatically set aside more capital as leverage rises, or for policymakers to have discretion over required reserves. For best effect, the setting of monetary policy and macroprudential instruments should be tightly coordinated.

Expanded mandates

Central banks’ mandates may need to be expanded to include explicit concerns for macrofinancial stability. But policymakers working under a broader approach to monetary policy would need to explain very carefully why actions are being taken, what the immediate objective is, and how actions are consistent with longer-term objectives of macroeconomic and financial stability.

But expectations should be realistic about what can be achieved with such broader approaches, the study says. Credit and asset price surges can sometimes be justified by positive productivity developments, and it is hard to tell ex ante whether booms are driven by benign or malign circumstances.

Empirical evidence confirms that even the best indicators of financial vulnerability are not always reliable, sometimes sending false signals and raising the risk of policy errors. Inflexible use of macroprudential policy tools could lead to policy mistakes, so some discretion is needed.