Securing sustainable price stability: should credit come back from the wilderness? - July 2004

We argue that in order to achieve price stability in a sustainable way, central banks should consider paying greater attention to credit in their monetary policy strategies than is generally the case at present. Specifically, simply setting monetary policy so that a two-year inflation forecast is at the central bank’s target may, on occasions, be less than optimal. In particular, the central bank may wish to deviate from such a strategy when developments in the financial system are exposing the macroeconomy to materially increased risk. Doing so calls for longer policy horizons together with an explicit incorporation into policy decisions of the balance of risks in the outlook. One important indicator that risk is building up is unusually sustained and rapid credit growth occurring alongside unusually sustained and large increases in asset prices (“financial imbalances”). Building on previous work, we show that empirical proxies for financial imbalances contain useful information about subsequent banking crises, output and inflation beyond traditional two-year policy horizons. On the basis of Taylor rule-type descriptions of policy, we also investigate the response of central banks to financial imbalances. We find evidence that, at least until recently, central banks generally either have not responded to imbalances systematically or, to the extent that they have, have done so asymmetrically, loosening policy further than normal in the face of their unwinding but not tightening it beyond normal as they build up.