The global trend toward flexible monetary policy and away from a singular focus on inflation accelerated this week as the Bank of Japan doubled its inflation target, the Bank of Canada delayed an rise in interest rates, the Bank of England governor said it was time to review the policy framework and a Riksbank board member called for a macroprudential framework that would help ensure financial stability.
Two forces are driving this change in monetary policy. Firstly, in the wake of the global financial crises, central bankers have become de facto responsible for financial stability along with price stability. Secondly, economic growth is inadequate in advanced economies despite central banks’ ultra-low interest rates and creative use of their balance sheets.
What we are now witnessing is a change to central banks’ operational framework that reflects the lessons of the global financial crises.
The 2007-2009 financial crises showed that low inflation does not prevent economic crises and may in fact contribute to the build-up of financial imbalances. If central bankers don’t pay close attention to credit and debt, which can accumulate without causing inflation, it poses a systemic risk that can destroy the livelihood of millions of people and wreck havoc on societies.
Central bankers no longer believe it makes sense to deal with the aftermath of financial crises - as former Federal Reserve Chairman Alan Greenspan suggested - because cleaning up after a crises is a complicated, costly and lengthy affair. Society is far better served if financial crises can be prevented.
Crises prevention has thus moved to the forefront of central bankers’ agenda. Financial regulation is increasingly focused on protecting the entire financial system, rather than just individual institutions, and the implementation of monetary policy must take financial stability into account, not just inflation.
Much was said in the press about the Japanese government’s pressure on the Bank of Japan to double its inflation target to 2 percent and its adoption of a Federal Reserve-style open-ended asset purchases, though first in 2014.
But little attention was paid to the fact that the BOJ never had an inflation target before – it was a goal – and the BOJ went to great lengths to stress that it was not adopting a rigid target, but rather a flexible UK-style target.
“Switching from a "goal" to a "target" reflects an increasing awareness regarding the importance of flexibility in the conduct of monetary policy in Japan,” the BOJ said, adding that monetary policy can’t just automatically react to price shocks in order to achieve a certain inflation target.
“It is not appropriate to run monetary policy mechanically aiming to achieve a certain inflation rate within a certain period of time in order to achieve sustainable growth with price stability,” the BOJ said, adding:
“Moreover, reflecting the recent experiences at home and abroad, many credit bubbles emerged under the recognition that prices were stable on a real-time basis, but they created large fluctuations in economic activity and prices after the bursting of the bubbles,” BOJ said, putting another nail in the coffin of strict inflation-targeters.
In Canada, where the Bank of Canada (BOC) two years ago first acknowledged that financial imbalances affect the inflationary target, the explicit reference to household debt in the same sentence as inflation was another reminder of the changes in the conduct of monetary policy.
In the U.K., Mervyn King, the outgoing governor of the Bank of England (BOE), said the UK’s focus on price stability remains essential but acknowledged there are times when inflation targets should be set aside due to concern over financial stability.
And with the U.K.’s inflation target almost 21 years old and coming of age, “it would be sensible to review the arrangements for setting monetary policy,” King said in Belfast.
In Sweden, Riksbank First Deputy Governor Kerstin af Jochnick said monetary policy was now taking household debt into account when setting interest rates because the financial crises had demonstrated that it poses a macro economic risk.
The reason for broadening the bank’s policy framework was simple: Sweden has no macroprudential framework to tackle household debt so by default the Riksbank has to take action.
The Riksbank's position is symptomatic of the change in central banks.
Interest rates are a blunt instrument to manage household debt, a fact that Kerstin af Jochnick readily acknowledges. In the past, this argument was used by central banks to abdicate responsibility for pricking asset price booms.
Now, however, the Riksbank steps up to the plate and says it, just like the BOE, welcomes the added responsibility of overseeing financial stability.
“It is desirable that the Riksbank should be able to use the policy rate to an even greater extent to stabilise inflation and the real economy in the future, and that more appropriate tools than the repo rate can be used to reduce the risks of financial imbalances.
“A functioning framework for macroprudential policy can improve the conditions for ensuring that the Riksbank attains its two main objectives: price stability and financial stability,” Kerstin af Jochnick said in Stockholm.
Returning to this week’s policy decisions, 10 central banks met to decide on their policy stance with only the National Bank of Denmark adjusting rates upward in response to easing pressure on the krone from euro-zone investors seeking a safe haven.
Although Turkey held its benchmark rate steady, it continued to adjust its rate corridor, cutting both the floor and ceiling rates. As with other major central banks in advanced economies with rates effectively at the zero bound, the Bank of Japan should be counted in the easing camp due to further quantitative easing measures.
Through the first four weeks of 2013, 28 central banks have decided on monetary policy with 24, or 86 percent, keeping rates steady, two cutting rates and two raising rates.
LAST WEEK’S (WEEK 4) MONETARY POLICY DECISIONS:
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|TRINIDAD & TOBAGO||2.75%||2.75%||3.00%|
Next week (week 5) eight central banks will be deciding on monetary policy, including Israel, Colombia, India, Hungary, the United States, Malaysia and New Zealand. Angola’s central bank will issue its decision on Monday as the bank’s policy committee did not finish its deliberations last week.
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