Monetary Policy Should Focus on Price Stability

  • Policy should aim to decrease risk of costly crises
  • Generally more costs than benefits fixing crises with monetary policy
  • Micro, macroprudential policy, regulation best to prevent crises
  • Based on current knowledge, the case for using monetary policy to contain risks to financial stability—commonly referred to as leaning against the wind—appears weak in most circumstances, according to the IMF. However, policymakers should closely monitor financial stability risks, and not rule out higher interest rates, while knowledge of the relationship between monetary policy and financial risks evolves.

    In the wake of the U.S. Fed’s decision to postpone a rate hike, and as interest rates remain low in advanced economies, some observers are concerned with mounting financial stability risks, such as corporate leverage in emerging market economies, and calling for monetary policy to respond. The IMF’s study provides central bankers with a framework, new results, and initial policy recommendations to help them decide whether and when to lean against the wind.

    Crises are costly

    The IMF study says crises are costly and persistent, and policymakers cannot rely on simply dealing with their repercussions—mopping-up—once they occur.

    “Crises must be pre-empted: their probability reduced and their severity curtailed,” says Karl Habermeier, Assistant Director in the IMF’s Monetary and Capital Markets Department. “However doing so is not easy; price stability alone does not guarantee financial stability.”

    Prudential policies, such as capital and liquidity ratios, are the natural response. Policymakers should pursue micro and macroprudential policies, as well as regulation, to support the resilience of the financial system.

    “The only problem is that we don’t know how well these policies work; the grand experiment is just beginning,” says Habermeier.

    From opinions to facts

    Many have argued that monetary policy should lend a hand to maintain financial stability, and argue that on occasion policymakers should raise interest rates more than warranted by price and output stability in order to contain financial stability risks.

    However, views on the role for monetary policy differ considerably, and are hotly contested.

    “We engaged in this study so we could have an informed discussion, as opposed to a clash of opinions,” says Giovanni Dell’Ariccia, Deputy Director in the IMF’s Research Department. “Our goal was to advance the debate by offering a framework of...

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