Carney reveals 5 monetary policy lessons

While countries continue to cope with the aftermath of the financial crisis, the scope and fury of events have left policymakers with important lessons about the functioning of monetary policy and its frameworks, says Bank of Canada Governor Mark Carney.

Read: Carney says deposits safe if big banks fail

“Globally, central banks are now being simultaneously accused of being ineffective and too powerful,” he says. “The goals of monetary policy are being called into question. It is also being recognised that how monetary policy interacts with other macro policies, including fiscal and macroprudential policies, can affect its independence and potentially its effectiveness.”

Read: BoC keeps 1% overnight rate, lowers outlook

Carney notes there have been several lessons learned.

1. Price stability does not guarantee financial stability. Price stability can be associated with excessive credit growth and emerging asset bubbles, which can ultimately compromise the achievement of price stability. Further, stability can encourage excessive optimism that can lead to overestimates of future growth in incomes and asset prices, creating for a time a self-reinforcing asset and credit boom.

Read: BoE to give Carney more power

2. Monetary policy is the last line of defence against financial vulnerabilities. The first lines of defence (responsible behaviour by individuals and institutions and micro- and macroprudential regulation and supervision) will go a long way to mitigate the risk of financial excesses. On the margin, monetary policy should be complementary to macroprudential efforts that have already been instituted. Whether it should actively lean depends on the severity of the imbalances and how effective the macroprudential measures are expected to be. In exceptional cases, monetary policy may be needed to support financial stability.

Read: It’s time to be more accountable: Carney

3. Central banks are not powerless at the zero lower bound. With the onset of the crisis, the zero lower bound went from remote possibility to reality with frightening speed. This led central banks to quickly develop unconventional measures to provide stimulus, including credit easing, quantitative easing and extraordinary forward guidance. “As with any policy action, the effectiveness of unconventional policies requires that they remain credible and consistent with well-anchored inflation expectations,” Carney says.

4. Communications matter. In April 2009, the Bank committed to hold rates at the zero lower bound, conditional on the outlook for inflation, through the second quarter of 2010. By increasing the expected duration of rates at the lower bound, guidance can lead to lower long-term nominal rates. The increased certainty regarding the path of rates reinforces this stimulative effect. “By outlining (and bounding) the consequences of its strategy for near-term inflation dynamics, the central bank can help anchor inflation expectations and retain credibility.”

Read: BoC names deputy governor

5. The limits of central banks’ discretionary authority need to be clarified. The time frame for returning inflation to target can be extended, but the credibility essential for the success of such a tactic could be undermined if such flexibility is taken too far, deployed too frequently or undertaken by stealth. Further, the flexibility that central banks may require, both to address the consequences of the crisis and to reduce the risk of a repeat, raises a fundamental question about the appropriate constraints on central banks’ delegated authority. “It is critical to have a clear framework. The better this framework is understood by the public, the greater the chance of success.”

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.