Independent Does Not Mean Unaccountable

As you might guess given my recent posts defending Fed independence, I agree with this:  The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating… Understandably, many people are calling for change. … As a nation, our challenge is […]

British Regulators Disclose Terms of Emergency Aid During Panic of 2008

The Financial Times reports that British regulators have now opened up to reveal more of the details surrounding the emergency aid banks received during the most acute periods of stress to date in the financial crisis.  Meanwhile, in the U.S., the Federal Reserve continues to resist providing greater details. The sum some of Britain’s largest […]

The Fed is Already Transparent

Anil Kashyap and Frederic Mishkin are worried that the Ron Paul proposal to audit the Fed will “cripple policy making”:  The Fed Is Already Transparent, by Anil Kashyap and Frederic Mishkin: Under the banner of increasing Federal Reserve transparency, Congressman Ron Paul has sponsored a bill that would subject the Fed’s monetary policies to an […]

The Arrival of Asset Prices in Monetary Policy

Once upon a (not long ago) time, there was a widely established set of blueprints for regimes of monetary and exchange rate policies, one expected to fit not only the full range of economies in the global arena, but also to serve as a guide for international monetary cooperation. Confidence in the effectiveness of those blueprints has been shattered by the scale and simultaneity of asset price booms and busts that led to the current global economic crisis. A reshuffle of views on monetary and exchange rate policies may turn out to be a companion to the revision of financial regulation.

It is now increasingly accepted that, to some degree and width, mainstreaming reactions to asset price moves in monetary policy is to become a new norm. It is also becoming clear that the previous world of theoretical determinacy and optimum rules of conduct is to give place to less-obvious policy choices and more discretion.

The purpose of this note is to highlight how the special complexity and indeterminacy intrinsic to international monetary-financial relations will deepen under the new regime. In the case of financial transactions between advanced financial systems and emerging markets, there is in addition an asymmetrical impact in terms of higher foreign reserve requirements on the latter.

The determinate world of inflation targeting and exchange-rate corner solutions

“The past 10 years have been the decade of inflation targeting. (…) Narrowly defined, inflation targeting commits central banks to annual inflation goals, invariably measured by the consumer price index (CPI), and to being judged on their ability to hit those targets. Flexible inflation targeting allows central banks to aim at both output and inflation, as enshrined in the famous Taylor Rule. The orthodoxy says that central banks should essentially pay no attention to asset prices, the exchange rate, or export prices, except to the extent that they are harbingers of inflation”(Frankel. 2009).

Asset price cycles were seen as basically harmless – or non-significant as a channel of transmission of monetary policy, as in the case of developing economies without financial depth. Even when the frequent appearance of bubbles started to be acknowledged, the belief – “the Greenspan doctrine” – was that attempts to detect and prick them at an early stage would be impossible to accomplish and potentially harmful. If necessary, resorting to interest rate cuts to safeguard the economy after bubble bursts would be a safer procedure.

Low and stable inflation could then be attained through a forecast-oriented, anticipatory manipulation of basic interest rates, as the single focus for monetary authorities. Movements of floating nominal exchange rates would reinforce the effectiveness of interest rates set to target inflation. Stable inflation would also lead to low risk premiums and higher financial stability.

In the case of small countries, fixing the nominal exchange rate and abdicating of monetary policy would import stability from inflation-targeting countries. The “Great Moderation” period, with developed economies exhibiting relatively low inflation rates and output fluctuations from mid-80s onward, seemed to vindicate that confidence.

This world of presumed stable and stabilizing monetary and financial spheres was shaken by the global financial crisis. With hindsight, asset price booms and busts became acknowledged as both increasingly pervasive and harmful: real-estate and stock-market booms leading to excess US household debt and to fragile asset-liability structures; a generalized bubble burst pushing the global economy to a quasi-collapse.

Endogenous creation of liquidity and the “sea of bubbles”

Chapter 3 of the latest IMF’s “World Economic Outlook” brings evidence on the presence of real-estate and stock-market asset price busts over the past 40 years (WEO – ch.3). The recent experience with widespread busts of both house and stock prices is singular in the last 40 years (Chart 1). However, one can observe not only the frequency of previous episodes, but also that those “asset price busts are relatively evenly distributed before and after 1985 – a year that broadly marks the beginning of the ‘Great Moderation’” (p.95).


Besides noting the typical economic costs associated with asset price busts, the IMF study detects and points out some leading indicators of busts, namely, “rapidly expanding credit, deteriorating current account balances, and large shifts into residential investment”. As one might nowadays easily expect, with the benefit of hindsight, “inflation and output do not typically display unusual behavior ahead of asset price busts” (p.93). In other words, well behaved inflation and output performance is no guarantee against asset prices acquiring a cyclical life of their own, with potentially dire consequences. The even distribution of episodes of stock market and housing busts before and during the “Great Moderation” (Chart 1) is an illustration of that.

The Scope of Central Bank Independence, and the Accountability Mechanisms that go with This

From Financial Express The rationale for central bank independence The starting point of modern thinking on monetary policy is the issue of central bank independence. Watching the world across the centuries, a pattern has been found that non-independent central banks distort monetary policy to support the incumbent political party. When elections are approaching, rates tend […]

The Importance of ECB Wording on Inflation – Euro Thoughts Sep 7-11 2009 – UniCredit Group

Last Thursday my boss, Marco Annunziata, did not hesitate to define President Trichet a true statesman for his wise and transparent conduct of the ECB September press conference. In the last few weeks, with his intervention in Jackson Hole, the Sep 4 presser, and the op-ed in the Financial Times the following day, Mr. Trichet […]