These days central bankers seem more concerned about “financial stability” than ever before – and even more concerned about financial stability than nominal stability. These things go in cycles. After 1929 central bankers became terribly concerned about financial stability. Then again in the 1990s after the Mexican crisis in 1994 and the Asian crisis in 1997 and then after the bursting of the “IT bubble” in 2001.
But should central bankers really concern themselves with “financial stability” as a monetary policy goal? The great David Laidler gave the answer in a paper 10 years ago – This is from the abstract to “Sticking to its Knitting”:
It has become painfully evident that low inflation is not, in and of itself, sufficient to guarantee overall stability to the financial system. The bursting of the high-tech stock market bubble of the late 1990s in North America is sufficient evidence of this, but there were echoes here of the collapse of Japan’s bubble economy at the beginning of the decade, and even of the stock market crash of 1929 that marked the onset of the Great Depression of the 1930s. All of these episodes occurred at time when inflation was low and stable. At the same time, the Bank of Canada’s success in controlling inflation has been matched in many countries, to the point that monetary policy appears almost routine.
This combination of circumstances has led to a new interest in financial stability among central bankers, and a debate is beginning about what they might do to enhance it. No serious commentator is suggesting that inflation targeting should be abandoned for more ambitious goals, but there are those who suggest that existing regimes ought to be modified at least to the point of taking more notice of asset price behaviour, and others who argue that, sometimes it might be appropriate to trade off a little short term inflation stability in order to pre-empt financial market problems before they become acute.
This Commentary argues that monetary policy makers should think several times before becoming more ambitious in their goals. It notes that central banks already have all the powers they need to prevent financial market collapses getting out of hand in the wake of asset-price bubbles. In their role as lenders of last resort, they can and should be ready to provide ample liquidity to markets in such circumstances, measures which the Bank of Japan failed to take in the early 1990s. The Bank of Canada should stick to the single basic task of targeting inflation, while always holding lender-of-last-resort powers in reserve.
The Riksbank’s Stefan Ingves and the Bank of England’s Mark Carney should read David’s paper before talking more about macroprudential instruments and credit bubbles.
HT David Laidler
PS Tomorrow I will be speaking at the Financial Times’s CAMP Alphaville conference. See the programme here.