Bernanke stresses importance of financial stability

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This post is a guest contribution by Asha Bangalore, vice president and economist of The Northern Trust  Company.

Chairman Bernanke’s remarks yesterday focused on how the Great Recession has modified “doctrine and practice” of central banking. Bernanke summarized the recent transformation that has taken place in central banking practice as follows: “The basic principles of flexible inflation targeting–the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency–seem destined to survive. However, following a much older tradition of central banking, the crisis has forcefully reminded us that the responsibility of central banks to protect financial stability is at least as important as the responsibility to use monetary policy effectively in the pursuit of macroeconomic objectives.” Bernanke’s concern about financial stability was further reinforced in his observation that “one of the most important legacies of the crisis will be the restoration of financial stability policy to co-equal status with monetary policy.”

A more interesting aspect of the speech pertains to whether central bankers should step in and act against asset and credit bubbles. The conclusion one draws from the excerpt below is that Bernanke is suggesting that financial imbalances should be prevented by policy action.

In practice, the distinction between macroeconomic and financial stability objectives will always be blurred to some extent, given the powerful interactions between financial and economic conditions. For example, monetary policy actions that improve the economic outlook also tend to improve the conditions of financial firms; likewise, actions to support the normal functioning of financial institutions and markets can help achieve the central bank’s monetary policy objectives by improving credit flows and enhancing monetary policy transmission. Still, the debate about whether it is possible to dedicate specific policy tools to the macroeconomic and financial stability objectives is a useful one that raises some important practical questions. A leading example is the question of whether monetary policy should “lean against” movements in asset prices or credit aggregates in an effort to promote financial stability. In my view, the issue is not whether central bankers should ignore possible financial imbalances–they should not–but, rather, what “the right tool for the job” is to respond to such imbalances

He also pointed out that monetary policy is “too blunt a tool to be routinely used to address possible financial imbalances.” He continued to note that monetary policy will be used at the margin until appropriate policy tools evolve.

Bernanke also discussed the importance of transparency of monetary policy and noted that the Fed introduced the “extended period” concept in March 2009 and also for the first time attached a timeline to federal funds rate target in August 2011 by indicating that the FOMC would maintain the current policy target until mid-2013.

Source: Asha Bangalore, Northern Trust – Daily Economic Commentary, October 18, 2011.

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