Learning from the Asian Financial Crisis and the Dot-Com Boom

The Asian Financial Crisis and the dot-com boom and bust ignited great debate on the conduct of monetary policy, with the prevailing inflation-targeting framework coming under review. While this common approach to central banking had worked effectively to support price stability in the preceding years, some commentators suggested that central banks might simultaneously play a more explicit and active role in promoting financial stability. One such commentator, Roger W. Ferguson, Vice Chairman of the US Federal Reserve Board of Governors from 2001 to 2006, posed a “deceptively simple question” that warrants repetition in the current economic climate: “Should financial stability be an explicit central bank objective on a par with other objectives such as price stability and sustainable economic growth?”

Many central banks already have an explicit responsibility for supporting financial stability through the maintenance of an effective and efficient payments system. In addition, central banks often have a role to play in supervising financial institutions and shaping the regulatory environment that underpins the financial system. In Australia, however, the Reserve Bank (RBA) for the most part works closely with other external institutions – APRA, for example – to achieve these ends. There are also several ways in which central banks can help to mitigate adverse impacts following a financial crisis (acting as lenders of last resort, for example).

However, Ferguson’s notion that the financial stability objective could be considered on par with macroeconomic objectives has more far-reaching implications for the conduct of monetary policy. It is already widely acknowledged that central banks play some role in supporting financial stability through their policy actions. For one thing, a stable macroeconomic environment is probably essential for a stable financial environment; the pursuit of price stability and sustainable growth by central banks is thus a contributing factor. Conversely, even in the current inflation-targeting framework, monetary policy would be formulated to directly combat financial imbalances in instances where instability threatens the more explicit macroeconomic objectives of the central bank.

Indeed to date, explicit financial stability considerations have generally only affected the formulation of monetary policy – in Australia and elsewhere – indirectly through their anticipated impact on the broader macroeconomy. Unfortunately this can lead to sub-optimal policy outcomes. In particular, it is possible for simultaneously rapid growth in asset prices and credit – conditions that tend to precede financial crises – to occur in a stable inflationary environment (as discussed by Borio and Lowe (2002)). Under a strict inflation-targeting regime, monetary policy makers would have no cause to react to these developments. However, the longer financial imbalances persist and intensify, the more likely there is to be a sharp unwinding of these trends – a burst bubble, a credit crunch – and severe negative impacts on growth and inflation in future. In these sorts of circumstances, a more explicit monetary policy objective to pursue financial stability alongside consumer price stability as means to achieving sustainable long-term growth could yield a superior policy outcome.

In Australia, the Reserve Bank Act 1959, the RBA’s “charter,” only explicitly refers to financial stability in the context of the Payments System Board; there is little to suggest that financial stability need be a direct concern in the conduct of monetary policy itself. Indeed, while the RBA’s website notes that “stability of the financial system is a long-standing responsibility of the Reserve Bank” and that it aims, where possible to prevent “financial disturbances with potentially systemic consequences”, it does not go so far as to suggest monetary policy itself may be directed towards such a purpose. The website does acknowledge that:

“There are several ways in which the Reserve Bank attempts to reduce the likelihood of financial instability. One is by laying the foundation for low and stable inflation and sustainable economic growth. Crises often have their origin in periods of rapid and prolonged credit growth, particularly when coupled with speculative activity and high asset price inflation.”

This statement is interesting, as it seems to imply that in merely “laying the foundation for low and stable inflation and sustainable economic growth” the RBA will also assuage “periods of rapid and prolonged credit growth…coupled with speculative activity and high asset price inflation”. This seems optimistic, particularly given that the RBA’s monetary policy objectives “have found practical expression in a target for consumer price inflation” and the fact that financial imbalances can occur in stable inflationary environments.

While financial stability considerations may be largely external to its conduct of monetary policy at present, the Reserve Bank is well-placed to incorporate an explicit financial stability objective going forward. For one thing, the RBA is already practiced and proficient in assessing the stability of the financial system, as evidenced in its bi-annual Financial Stability Review publication. In addition, the RBA is blessed with in-house expertise in this area. Specifically, Assistant Governor (Financial System) Philip Lowe, co-authored a seminal paper titled “Asset prices, financial and monetary stability: exploring the nexus” whilst on secondment at the Bank for International Settlements in 2002, concluding that “in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability”.

On the other hand, there could be some room for improvement in the ability of the central banks to think outside the mode: to seriously consider not just likely outturns, but possible, significant alternatives. It certainly appears that the RBA’s own inflation forecasts (which presumably form the core basis for the RBA’s policy recommendations each month), are of the modal variety, designating the most likely path for prices over the medium-term horizon, and abstracting away from outlier events. It is notoriously difficult to pick the timing and severity of turning points, and it would probably have been inappropriate for the RBA to incorporate the ex ante possibility of this current financial crisis in their central forecasts for the economy a year ago. However, regular stress testing and scenario modelling (as advocated by Ferguson (2002)) could prove particularly useful analytical tools for policy makers in future, particularly if financial stability were an objective of monetary policy in and of itself.

Conducting monetary policy with the dual objectives of promoting both price stability and stability of the financial system would obviously involve some challenges. In particular, financial stability is a difficult concept to define – policy makers will struggle to match the straightforward “practical expression” of the price stability objective (a targeted 2-3 per cent growth in consumer prices per annum in Australia). While central banks will be able to garner much useful information from monitoring rates of credit growth and asset price inflation, determining the point at which policy action is warranted will be difficult (as highlighted by Icard (2002)). At times, it will also be difficult to appropriately balance dual objectives of price stability and financial stability. Nonetheless, monetary policy has never been an exact science and given the potential for financial crises to yield devastating consequences, central banks should be inspired to rise to face these challenges. At the very least, further debate on these issues is imminent; as RBA Governor Glenn Stevens affirmed in a speech delivered in early 2009, “we cannot avoid another look at the question of monetary policy, asset prices and leverage”.

As a final note, it is worth mentioning that the RBA’s adoption of this approach to monetary policy would have done little to prevent the current financial crisis, nor have had much impact in mitigating its consequences in Australia. However, had the US Federal Reserve Bank employed monetary policy to moderate some of the financial imbalances in its financial system a few years ago – the rapid rates of credit growth and housing prices – the outlook for the global economy could look a little rosier today.

Bario, Claudio and Philip Lowe (2002), “Asset prices, financial and monetary stability: exploring the nexus”, BIS Working Papers (No 114).

Ferguson, Roger W. (2002), “Should Financial Stability be an Explicit Central Bank Objective?”, IMF Conference: Challenges to Central Banking From Globalized Financial Systems.

Icard, André (2002), Comments on Roger W Ferguson’s paper “Should Financial Stability be an Explicit Central Bank Objective?”, IMF Conference: Challenges to Central Banking From Globalized Financial Systems.

Stevens, Glenn (2009), “Financial System Developments and Their Implications for the Conduct of Monetary Policy”, Bank Negara Malaysia High Level Conference: Central Banking in the 21st Century: Implications of Economic and Financial Globalisation.

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