Paradigm Shift on Part of Central Banks? (fg)

Please find an enlightening speech of L. Bini-Smaghi, member of the exectutive board of the ECB, on monetary policy, the setting of interest rates, financial stability concerns and linkages to macroprudential regulation.

It is not asset prices per se that a central bank should incorporate in its policy framework. After all, the equilibrium value of assets – particularly real assets, such as claims on companies and houses – is difficult to compute and is certainly state-contingent. So, there is little merit in an unconditional monetary policy response to asset price changes. The policy response should be conditional.[...] This being said, monetary policy needs support in its ex ante action to resist the formation and build-up of toxic financial imbalances. There is a clear need for a corresponding policy framework to foster financial stability; we need to understand how it interacts with monetary policy in order to minimise frictions between the two and exploit possible synergies.[...]Could there be consequences for the setting of monetary policy? It is too early to tell, but given the various levels of interplay with macro-prudential policies that I have described, and the need to coordinate the latter, we need to think more about the international dimension of monetary policy, which may be driven by financial stability concerns. This will be on our agenda for the coming years.

For a related discussion on monetary policy and asset price dynamics see the work of Fahr et al (2011) In particular, asset price busts are induced by market participants’ choice of an increasingly fragile balance sheet structure during good times. Their vulnerability is inevitably revealed by some small, randomly occurring shocks which cause the need for sharp deleveraging - which even triggers defaults and macroeconomic contractions. Some recent work and simulation results on this issue can be found here or here.