After the Fall

• Author: Eswar Prasad
• Position: the Nandlal P. Tolani Senior Professor of Trade Policy at Cornell University, the New Century Chair in International Economics at the Brookings Institution, and a Research Associate at the National Bureau of Economic Research.

AS the world economy ponders the lessons from the receding global crisis, a fierce debate has erupted about central banking concepts thought to have been long settled (Goodfriend, 2007). The appropriate role and mandate of central banks has come under scrutiny around the world.

Globalization has made both advanced and emerging market economies more exposed to external shocks, as their rising openness to trade and financial flows creates wider channels for cross-country spillovers of shocks. These forces have also increased the burden on monetary policy. It is much harder now for a central bank to use instruments such as interest rate changes to attain domestic objectives; as capital sloshes around the globe it can create many difficulties in managing monetary policy, especially in economies with shallow financial systems. And yet, monetary policy is gaining importance as a first line of defense against external shocks and breakdowns in the financial system, because it can be far more nimble than other macroeconomic policy tools.

This has generated a rich debate: what the right framework is for monetary policy, what the scope of a central bank’s objectives should be, and what the optimal degree of central bank independence is. Even as clarity about optimal monetary frameworks has diminished, a remarkable outcome of the crisis has been a convergence in the nature of the debates about central banking in economies at different stages of economic and institutional development.

Emerging market central banks have been considered as lagging behind those in advanced economies—in terms of the rigor of their operating frameworks and also their sophistication and transparency. But central banks in emerging markets have come out of the crisis looking a lot better than their advanced economy counterparts. Less-sophisticated financial markets and much greater regulatory prudence proved to be an advantage. Consequently, some interesting twists have come up in the debates about suitable monetary and regulatory policies for emerging markets (Gill, Kanbur, and Prasad, 2009). At the outset, it is worth reviewing some general principles that are relevant for all types of economies.

Targeting inflation targeting

Over the past two decades, inflation targeting—in either explicit or implicit form—has become the monetary policy framework of choice for most advanced economies. A number of emerging market central banks have also adopted frameworks in which their priority is to maintain inflation at a target level or within a specified range. Many others had been moving toward such a system. Inflation targeting has had a good track record of delivering price stability and anchoring inflation expectations, which has proven valuable in emerging markets, where high inflation is especially pernicious because it hits the poor disproportionately hard.

But inflation targeting has come under sharp attack in the aftermath of the global financial crisis. Central bankers in developed economies are being pilloried for focusing too much on price stability, ignoring asset market bubbles, and failing to prevent the worst crisis seen for a generation.

Meanwhile, although many emerging markets weathered the crisis relatively well, central banks in that group that target inflation also face pressure to abandon the framework. Critics argue that targeting inflation could be damaging to these economies if it means disregarding sharp exchange rate fluctuations and boom-bust cycles in equity and housing markets.

Indeed, a more sweeping argument by some emerging market central bankers is that low inflation is neither necessary nor sufficient for financial stability. That enormous financial market stresses built up in many advanced economies during a time of low inflation and stable growth forces one to take this view seriously.

Asset market bubbles

Price bubbles in housing and equity markets can have destructive effects on financial markets and the economy when they pop, as they eventually do. This reality seems to legitimize the argument that central banks cannot ignore asset price bubbles and that a narrow framework that restricts central banks from taking preemptive actions against bubbles is doomed to failure. But there is a major problem—it is difficult to detect such bubbles in real time and far from...