Monetary policy in the grip of a pincer movement

BIS Working Papers  |  No 706  | 
01 March 2018



Since well before the Great Financial Crisis, monetary policy has been grappling with two major forces. On the one hand, the inflation process has proved rather insensitive to economic activity. On the other hand, financial cycles have become larger and more disruptive. This has made it much harder for policy to reconcile price stability with financial, and hence macroeconomic, stability. For instance, easy monetary policy designed to bring a stubborn inflation rate back to target can fuel financial booms and heighten economic risks down the road. The current analytical paradigm underplays the interaction of these two deep-seated forces.


We explore the interaction of these two forces and their policy implications. To do so, we bring together recent research. We question the usefulness of the natural interest rate as a monetary policy benchmark. We present empirical evidence on the determination of the real interest rate that supports this conclusion. We then lay out a framework that assigns monetary policy a greater role in mitigating the financial cycle as part of a multi-pronged approach.


The financial cycle has a large and persistent impact on the economy, including by misallocating resources. Monetary policy regimes appear to influence long-term movements in real interest rates more than saving and investment. That influence operates in part through the long-lasting scars that financial cycles leave on the economy. A more balanced monetary policy framework would place less emphasis on near-term inflation and more on the financial cycle.



Monetary policy has been in the grip of a pincer movement, caught between growing financial cycles, on the one hand, and an inflation process that has become quite insensitive to domestic slack, on the other. This two-pronged attack has laid bare some of the limitations of prevailing monetary policy frameworks, particularly in the analytical notions that have guided much of its practice. We argue that the natural rate of interest as a guidepost for monetary policy has a couple of limitations: the concept, as traditionally conceived, neglects the state of the financial cycle in the definition of equilibrium; in addition, it underestimates the role that monetary policy regimes may play in persistent real interest rate movements. These limitations may expose monetary policy to blindsiding by the collateral damage that comes from an unhinged financial cycle. We propose a more balanced approach that recognises the difficulties monetary policy has in fine-tuning inflation and responds more systematically to the financial cycle.

JEL classification: E32, E40, E44, E50, E52

Keywords: monetary policy, financial stability, financial cycle, natural interest rate, inflation