Journal Issue

Appendix II. Unconventional Tools and Financial Stability Concerns in Central Bank Responses to the Crisis

Simon Gray, and Philippe Karam
Published Date:
May 2013
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Monetary policy and financial stability frameworks before the crisis—main features

Maintaining low and stable inflation was thought to be the main contribution monetary policy could make to financial stability. Policy objectives other than price stability—notably output or exchange rate stability—were taken into account in policy, but financial stability was often not a major consideration. This reflected a number of factors, among them (i) the conventional policy framework focused on relatively rapid channels of policy transmission to inflation and the implications of financial market vulnerabilities for the conventional policy framework were not well understood; and (ii) there was a broadly accepted view that different policy instruments are needed to successfully attain different policy objectives.

CBs were meant to fulfill their role in financial stability by providing an overview of risks to the financial system, often using stress tests to gauge solvency risks in recession scenarios, and promulgating results in financial stability reports. However, the techniques used were not sufficiently advanced to take account of the endogenous interaction between solvency and liquidity pressures, while published financial stability reports often stopped short of mapping vulnerabilities to concrete policy actions.

While CBs recognized potential risks associated with asset price bubbles, these were not seen, in general, as justifying monetary policy responses. It was argued that CBs did not have reliable means of identifying asset bubbles, and that, even if they could, using interest rate policy to prick bubbles was likely to involve high costs in terms of output foregone. A bias towards inaction was reinforced by the view that monetary policy could cushion the impact on the economy when bubbles burst.84 Furthermore, market excesses, reflecting a number of factors left unaddressed by regulatory measures played a major role in setting the stage for the crisis. With inflation expectations well-anchored and inflation subdued by virtue of global supply factors, many advanced economy (AE) CBs kept policy rates low during the early 2000s in support of price stability. Low global interest rates and expectations of continued macroeconomic stability may have led market participants to underestimate risks in many asset classes.

Response of central banks to the crisis—unconventional tools, financial stability concerns

The crisis made it necessary for CBs to take a range of exceptional policy actions beyond cutting interest rates to historical lows, including:

  • AE CBs greatly expanded the reserve money base. This reflected the need for them to substitute for wholesale bank and shadow bank funding markets when they dried up. New facilities were established to alleviate liquidity shortfalls in specific markets that were spreading to the system as a whole and cutting off credit flows.
  • in some countries, a considerable amount of FX liquidity was injected into local markets to ease tensions in global funding markets after the collapse of Lehman in September 2008. AE CBs took prompt action to provide FX liquidity across borders, as facilitated by a number of CB swap facilities.
  • a few AE CBs purchased private and public long-term securities and took other measures after their policy interest rates hit the effective lower bound. These purchases were mainly intended to lower long-term interest rates, primarily for the purchased securities, but also were aimed at improving overall credit conditions.
  • CBs intervened in their function as a LOLR and were intimately involved in the resolution of large systemically-important institutions (SIFIs).

On the use of unconventional monetary policy tools, experience so far suggests elements of good practice which are summarized in Box 8.

Box 8.Best Practices Using Unconventional Monetary Policy Tools1

Policy objective—The overarching objective of the tool should be defined clearly at the outset to facilitate understanding of the measure and minimize the possibility of overlap across policy areas, including between monetary and fiscal policies. This will help stabilize expectations.

Transmission—A communication of the transmission of unconventional measures enhances understanding of how the policy is likely to work and helps underpin its effectiveness.

Transparency—A clear initial explanation, regular updates including balance sheet data, and formulation of an exit strategy should enhance effectiveness and accountability.

Balance sheet protection—Risks taken on by the CB should be managed. Ideally, any substantial credit risk should be transferred to the government.

Adherence to these practices would help preserve the high degree of CB independence that has proven crucial for maintaining price stability. Quasi-fiscal roles taken on by CBs in the past undermined their credibility. Any losses from long-term security holdings that threaten the financial integrity of CBs should be met by government financing. The expanded post-crisis balance sheets make even more important effective collaboration between the CB and government in macro-policy coordination, cash management, and broader asset and liquidity management.

1IMF (2010).

In further promoting financial stability, financial system developments and vulnerabilities need to be more fully taken into account. A priority is to strengthen CBs’ monitoring and analysis of macroprudential imbalances and risks whereby incorporating features of financial balance sheets, financial intermediation, and asset prices into more elaborate macroeconomic models will be essential for monetary policy makers to assess the consistency of financial sector developments with price and output stability.85

It is also argued that CBs may need to adopt longer planning horizons if they are to bring financial stability concerns into their decision making (see Borio and White, 2004, and Gerlach and others, 2009). The financial and asset price imbalances that can magnify risks to financial stability tend to develop gradually, and therefore generally lie beyond the conventional planning horizon for monetary policy of two-three years. But a concern in this context is that tolerating more persistent deviations of inflation would both dilute policy accountability and fuel uncertainty about the CB’s long-term commitment to price stability.

A remaining open question is whether monetary policy should go beyond these measures and add financial stability as a distinct policy objective. In this regard, more relevant instruments (beyond policy interest rates) rooted in the macroprudential framework need to be elaborated to meet the financial stability objective.

Box 9 addresses a pertinent question as to whether CBs should “lean against” emerging financial imbalances or “bubbles” or wait to clean up after a bubble had burst. Three views are briefly posited. A common view has been that leaning mechanistically against financial imbalances could increase inflation volatility, require strong interest rate responses to be effective (thus imposing high output costs), and may be counterproductive in small open economies where high interest rates can attract capital inflows. Nevertheless, the high costs of systemic financial instability shown by the crisis can be seen as strengthening the case for using monetary policy to lean against asset price bubbles. Until financial developments are better structurally incorporated in monetary policy decision making, CBs should utilize judgment in deciding whether to maintain interest rates somewhat higher than otherwise in order to avoid imbalances from undermining financial stability, which would endanger longer-term price stability. For example, a combination of rising asset prices and rapid credit growth may warrant a higher policy rate, even if inflation projections for the normal policy horizon are benign.

Box 9.Central Banks’ Reaction to Asset Price Imbalances: Lean or Clean?

“Reactive” view

  • ✓ Changes in asset prices should influence monetary policy only insofar as they influence the expected inflation and the output gap.
  • ✓ Monetary policy would not be effective in “leaning” against the upswing of a credit cycle (the boom).
  • ✓ CBs should only address the fallout from an eventual crisis (the “Greenspan Put”).

“Proactive” view

  • ✓ If advanced country CBs had reacted more forcefully to the sharply rising asset prices between 2003–07, the bubble on equity and real estate markets would not have been as large, and the crisis may have been averted.
  • ✓ This does not necessarily mean that CB should “target” a certain level of asset prices (or asset price inflation), nor that policy rules need to be modified to include asset prices.
  • ✓ Policy reactions to asset price misalignments must be qualitatively different from reactions to asset price changes driven by fundamentals (Cecchetti and others, 2002).

Preconditions for proactive approach

  • ✓ Policymakers must be able to identify bubbles in a timely fashion and with reasonable confidence.
  • ✓ Monetary policy must have a high probability of being able to check some of the speculative activity.
  • ✓ Expected improvement in economic performance from pricking the bubble must be large enough to justify preemptive action.

“Intermediate” view

  • ✓ Form views about risks to macroeconomic and financial stability, including risks arising from asset price bubbles.
  • ✓ Devise contingency plan.
  • ✓ Strengthen prudential and supervisory policies: monetary policy is not the only instrument to curb or curtail asset price bubbles.

Box 9 describes the “clean versus lean” debate.


Kohn (2009), among others, noted that standard macroeconomic models used for monetary policy had largely ignored those features.

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