The lean or clean controversy: should financial stability considerations be part of monetary policy?

Author:Engelen, Klaus C.

Some have lauded the U.S. Federal Reserve's first interest rate hike after seven years as a beginning step toward the normalization of monetary policy. In recent remarks at the Bank for International Settlements' Farewell Symposium in honor of outgoing Chairman Christian Noyer, the Fed's vice chairman, Stanley Fischer, addressed the issue that has been raised by the BIS for years but ignored by the major central banks: That central banks should incorporate financial stability considerations in the conduct of monetary policy.

In 2003, then-BIS General Manager Andrew Crockett argued, "In a monetary regime in which the central bank's operational objective is expressed exclusively in terms of short-term inflation, there may be insufficient protection against the build-up of financial imbalances that lies at the root of much of the financial instability we observe. This could be so if the focus on short-term inflation control meant that the authorities did not tighten monetary policy sufficiently preemptively to lean against excessive credit expansion and asset price increases. In jargon, if the monetary policy reaction function does not incorporate financial imbalances, the monetary anchor may fail to deliver financial stability."

The key BIS economists in the long-running "lean or clean" controversy in monetary policy--especially present and former BIS chief economists Claudio Borio and William White--remain skeptical. "As regards the latest speeches by Stan Fischer," says Borio, "some observers have interpreted them as pointing to a more sympathetic attitude towards the 'lean against financial imbalances' view. Personally, I would be more cautious. As we say in Italian, una rondine non fa primavera, meaning one swallow does not make a spring." And White echoes: "Not a great deal has changed in the last while, aside from the fact that the global economy looks weaker and the previous financial excesses (that is, narrow high risk spreads) are beginning to get unstuck. The Fed's stimulus worked initially by exporting imbalances into emerging markets, but these are now set to feed back negatively on the United States and others. If so, the contention of the BIS (and mine) that the stimulus of 'ultra-easy monetary policy' would not work to stimulate global demand and would have undesired financial consequences seems increasingly to be supported by the facts. However, the former development seems to imply lower rates and latter higher rates. The Fed then has a problem, which they will likely resolve by either cutting rates again or raising them much more slowly than they currently forecast. As the BIS might put it, the jaws of the 'debt trap' are closing. The only way out is government (not central bank) action as 1 described in the G30 report."


This magazine's publisher, David Smick, recently made the point, "It seems to me, stated very simply, that the world's central bankers have based policy on the theory that money is the central, highly predictable driver of all economic motivation, when it is clear the issue of money is a lot more complicated. This is why the central banker's tools have been less effective than anticipated."

This is what the BIS for years has been asserting. Since--in terms of forward-looking monetary policy orientation, independence from political influence, and quality economic research--this observer asserted "The BIS was right" (TIE, Summer 2015), the TIE publisher wanted to know more about how the economists from the "central banks' bank" in Basel look at the world of quantitative easing, zero-bound interest rates, growing imbalances, currency wars, and not enough economic growth and employment.

After the "Great Moderation" with low inflation that came to an end with the financial crisis of 2007-2010, followed by years of anemic economic growth, record high unemployment, and financial instability, there's a new conventional wisdom for central banks. It says that when all else fails to make economies grow, central banks can use balance sheet expansion to step up liquidity provision and increase their intermediation role. Central banks can act as a backstop to banks and financial markets when they see the functioning of interbank and broader financial markets impaired. Liquidity provision to the economy can take the form of temporary lending or outright purchases. This process of expanding a central bank balance sheet through asset purchases, financed by central bank money, is widely called quantitative easing.

In the definition of the Bank of England, quantitative easing is "an unconventional form of monetary policy where a central bank creates new money electronically to buy financial assets, like government bonds. This process aims directly to increase private sector spending in the economy and return inflation to target."

Most economists, policymakers, and market actors think that quantitative easing worked in the United States and other advanced market economies such as the United Kingdom and Japan, preventing their economies from tumbling into depression. The U.S. Federal...

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