Central Banks Should Move Beyond Price Stability

• Author: International Monetary Fund

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...