In the wake of the global financial crisis, there is an emerging consensus that the framework underpinning modern central banking – known as flexible inflation targeting – needs to be rethought.
* A monetary policy framework focusing on price stability and output growth will also affect financial stability through its impact on asset valuations, commodity prices, credit, leverage, capital flows, and exchange rates.
* One country’s monetary policy can spill over to other countries, especially when central banks follow inconsistent frameworks, with cross-border capital flows serving as the transmission channel.
All this suggests that the conventional framework for central banking is inadequate (eg Dalla Pellegrina et al 2010). It is too narrow to meet domestic and global needs, as we argue in Eichengreen et al (2011).
Consensus on dissatisfaction; disagreement on solutions
There may now be broad consensus on this general point, but there is still little agreement about the particulars of the new framework. It is time to move beyond dissatisfaction with the prevailing framework and properly flesh out an alternative. In our view and that of our colleagues (listed below), that alternative should have the following elements:
* Financial stability should be an explicit mandate of central banks.
Other micro- and macroprudential policies should be deployed first, wherever possible, in the pursuit of financial stability, but monetary policy should be regarded a legitimate part of the macroprudential supervisors’ toolkit.
* When rapid credit growth or other indicators of financial excess accompany asset price increases, the authorities should employ stress tests to measure the effects of changes in credit conditions on asset prices, economic activity, and financial stability.
Instead of seeking to identify bubbles, the authorities should simply ask whether current financing conditions are raising the likelihood of sharp reversals in asset prices that are disruptive to economic activity.