Monetary policy and financial stability: what role in prevention and recovery?

Working Papers No 440
January 2014

If the criteria for an institution's success are diffusion and longevity, then central banking has been hugely successful. But if the criterion is the degree to which it has achieved its goals, then the evaluation has to be more nuanced. Historically, those goals have included a changing mix of financial and monetary stability. Attaining monetary and financial stability simultaneously has proved elusive across regimes. Edging closer towards that goal calls for incorporating systematically long-duration and disruptive financial booms and busts - financial cycles - in policy frameworks. For monetary policy, this means leaning more deliberately against booms and easing less aggressively and persistently during busts. What is ultimately at stake is the credibility of central banking - its ability to retain trust and legitimacy.

JEL classification: E30, E44, E50, G10, G20, G28, H30, H50

Keywords: financial cycle, balance sheet recessions, expectations gap, time inconsistency, regime shifts