More frequent in theoretical work tend to be definitions of financial stability that are more directly observable (even though less conceptually convincing than the one mentioned above) which refer to situations with asset price stability, the absence of banking crises, and relative to some benchmark for the policy rate, interest rate smoothness. Nevertheless, an appropriate standard for even this style of definitions has not yet emerged.
If a definition of financial stability as interest rate smoothness is used, then following the result in Poole (1970) in the face of aggregate demand shocks there is a trade-off with price stability and, thus, the central bank needs to choose the degree of stabilisation of either interest rates or output and inflation. Therefore, a suitable
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As this definition focuses on the resilience of the financial system, it would not give proof of financial instability with each individual bank failure or each large shift in an asset price. Conversely, large asset price volatility that may lead to bank and financial institution failures after the realisation of a strong real or financial shock, may even prove the inherent stability or the self-purifying powers of the system, provided that there is no impairment on the efficient financial intermediation and financing process. Issing (2003), views this definition as having “little practical guidance for any institution trying to maintain or to contribute to the goal of financial stability” (Issing (2003), p. 16).
definition of financial stability is crucial with regard to the trade-off between monetary and financial stability (for a detailed discussion see Issing (2003)).
However, the existence of a trade-off between price and financial stability is not widely accepted, since the conventional view regards inflation as a major cause of financial instability. Inflation renders misperceptions about future return possibilities more likely and it can deteriorate the asymmetric information between lenders and borrowers. As high inflation tends to be related to high inflation volatility, the problems of accurately predicting real returns become worse. Traditionally, the presence of high inflation in addition to a business cycle boom has been thought to give rise to real overinvestment and asset price bubbles. Excess liquidity that is provided by the central bank gives rise to inappropriately lax lending standards. Excessive credit growth (in view of realistic return expectations) tends to be a main factor for the development of financial instability. Therefore, price stability and the focus of monetary policy on such an objective are crucial for the stability of the financial markets (Issing (2003), p. 17).
Proponents of the above, to one extreme, even view price stability as sufficient to guarantee financial stability (Schwartz (1995)), or from a less extreme perspective, they claim that financial stability tends to be promoted by price stability (Bordo and Wheelock (1998)). Issing (2003) finds it difficult to discredit the latter because, in the long run, price stability and financial stability reinforce each other, and also since there is sufficient empirical evidence that many financial crises were caused by major price-level shifts and since, historically, most banking crises occurred during the course of recessions that succeeded periods of high inflation (Issing (2003),
p.17). In this way, the approach to monetary policy that considers price stability as the principal objective is also appropriate for the maintenance of a stable financial system. Therefore, the conventional view does not accept the presence of a general trade-off between the achievement of monetary and financial stability.
Nevertheless, an environment of stable prices cannot always deter the build up of financial imbalances. The examples most commonly given are the United States during the 1920s and Japan during the late 1980s, which demonstrate that price stability cannot guarantee financial stability as well. At times, even when the only central bank objective is price stability (as defined over the relevant medium-term horizon), to consider financial imbalances while designing monetary policy may lead to a different stance than fixed-horizon inflation targeting (see footnote 78 for more on this point).
In fact, research has recently indicated that achieving and maintaining low inflation leads to the creation of a “new environment” (as mainly stated in the relevant Bank for International Settlements research papers, see eg. Borio, English and Filardo (2003)), that does not reflect a maintenance of financial stability through the safeguarding of price stability. Views have also been expressed as radical as advocating the reverse of the conventional approach mentioned above78. The focus
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Issing (2003) identifies initial signs of such a discussion can be found in the Federal Open Market Committee (FOMC) minutes of the 13.11.1996 meeting, a few weeks prior to Chairman Greenspan’s famous speech on “irrational exuberance”. During this FOMC meeting Governor Lindsay mentioned that he was preoccupied by the thought that central bank’s success in controlling inflation could produce an extremely optimistic outlook on the future course of the economy. People’s false sense of security could lead to asset valuations which could pose problems for the future. Additional arguments have been proposed since then trying to explain why low and stable inflation can increase the vulnerability of the financial system. The main reasons suggested are that “for quite some time inflationary pressure might not show upon inflation itself, due to (a) low pricing power of firms, (b) positive supply side developments and (c) well anchored low inflation expectations” (Issing (2003), p. 18).
that central banks tend to apply mainly on (consumer) price stability is claimed to be insufficient and the suggestion is to address the perceived financial imbalances directly. Such a direct response can be either in terms of prevention (or in the least control) of the building-up process or the smoothing of the adverse consequences when the imbalances are eventually unfolding. Still accepting that the central banks’ ultimate objective should be monetary stability, this “new environment” short-term conflict presents the build-up of financial imbalances as crucial enough, even constituting a potential, long-run threat to price stability (Issing (2003), p. 19).
A necessary condition for any central bank intervention is the ability of the central bank to identify in real time the presence of a bubble in asset prices. Varied evidence, though, demonstrates that the developments in the (US for example) stock market during the late 1990s were not related to fundamentals to a great extent. This kind of information is available both to the central banks, as well as the market participants, but as the actual timing of the bursting of the bubble is highly uncertain and extremely difficult to predict, market participants tend to find it more rewarding to exploit the upward trend of the bubble than to bet against it. Issing (2003) finds this view in line with the literature on market efficiency, “which finds that returns are to some degree predictable, but the horizon over which this would be exploitable is too long to be sustainable for individual market participants and, thus the central bank might have a role to play in providing a noisy but unbiased opinion about equilibrium prices to the public” (Issing (2003), p. 19).
If the financial market participants expect the central bank to support the stock market if it crashes, then relevant prices will most likely be increased, helping, thus,
the excessive valuation of assets and inflating a bubble that may crash later. Certainly such a series of outcomes is what the central bank would rather avoid. The question raised is whether central bank should try to prick an asset price bubble in the effort to avoid the eventual collapse of the pertinent asset prices, which tends to be highly damaging to the economy. Ceccheti, Genberg, Lipsky and Wadhwani (2000), for example, give an affirmative answer, yet Mishkin and White (2003) find serious flaws in the above argument. Their principal claim is that it is very hard for central banks to determine with precision if a bubble is actually underway. This implies that the monetary authorities have no informational advantage over the private sector. Therefore, if the monetary authorities know of the development of a bubble that will eventually crash, then market participants must be aware of that as well, positioning themselves accordingly restricting the growth of the bubble. If the central bank has no informational advantage then it may well falsely predict the presence of a bubble (as the market may as well), pursuing, thus, the wrong monetary policy (Mishkin and White (2003), p. 76).
By examining 15 episodes of stock market crashes in the US during the 20th century Mishkin and White (2003) basically conclude that “the key problem facing monetary policymakers is not stock market crashes and the possible bursting of a bubble, but rather whether serious financial instability is present” (Mishkin and White (2003), p. 76). In particular, they demonstrate that the US stock market crash during the years 1999-2000 affected interest-rate spreads to a minor extent, claiming, thus, that that episode of a stock market crash had not been related to financial instability. They further concluded that (at the time of publication) an ad hoc central bank response to the stock market decline was not warranted. They also finally advocated that a focus
of the monetary authorities on financial stability as opposed to the stock market could result in an optimal response to stock market fluctuations, reinforcing, thus, the independence of the central bank (Mishkin and White (2003), p. 76).
Chapter 2 discusses in some detail the transmission process which starts with a change in official interest rates. There still remains the issue at which level and how strongly a central bank should react to perceived misalignments in asset prices with respect to fundamental values. Accordingly, this issue is addressed in detail in the following two sections.