158 Finance – Challenges of the Future

Monetary Policy under the Border between Price Stability

and Financial Stability

Irina-Raluca BADEA1
1
PhD Student, Faculty of Economics and Business Administration, University of
Craiova
badea_irina_raluca@yahoo.com

Abstract: The international financial crisis drew the line for the international and
national authorities that conducted and implemented faulty monetary and financial
policies, regardless the potential risks that might arise. It was only after the crisis burst
when everyone realized the impact the systemic risk can have on the global financial
system and, consequently, on every national economy. The conventional point of view
is that inflation is the main source of financial instability, but recent evidence points out
the fact that reaching the inflation target does not necessarily mean that the financial
system is stable. What is the most important is that any source of financial instability
should be diminished if not erased, hence preserving financial stability has become an
important goal for the authorities, who dispute whether to include it on the objectives
list of central banks or authorize another institution to achieve it. Therefore, the main
goal of this paper is framing the present monetary policy framework with respect to its
objectives and strategies and the necessity to reconsider it in a realistic manner in
order to prevent another collapse in case of an economic downturn.

Keywords: financial crisis, central banks, financial stability, price stability,

inflation targeting

JEL Classification: E31, E44, E58, G01

1. Introduction

To begin with, everything in economy is related to the notion of

stability/instability since the international financial crisis, that turned upside down every
theory and economic model regarded as optimal for macroeconomic stability. Needless
to say that in order to become resilient to this kind of shocks, authorities should rethink
their policies. Therefore, preserving the financial stability has become a systemic
objective, a ‘bet’ as important as the monetary stability, both pillars for a sustainable
economic growth. The analysis of financial stability as a goal for the monetary policy
stands out as a challenge in the context of the multiple interlinkages among markets
and financial institutions and international capital flows.
This paper briefly presents the state of the monetary policy and the general
thinking about it, its objectives, strategies, instruments embedded in different theories
before the crisis, emphasizing the fundamental objective of price stability and the
inflation targeting strategy. The second and most important paragraph represents a
comparison between different views on how a sound monetary policy should be
conducted. On the one hand, there are economists who claim that central banks
should not include financial stability in their monetary policy; on the other hand, a more
popular view admits the importance of the macroprudential regulation and central
banks’ contribution to a stable financial system. Do price stability and financial stability
converge or are they divergent in terms of monetary policy and central banks’
authority?
159 Finance – Challenges of the Future

2. Objectives of the monetary policy promoted in the Pre-Crisis years

First of all, the period before the crisis was dominated by excessive confidence
in the ‘too big to fail’ welfare goals of both the population and financial institutions.
Moreover, the central banks developed strategies relying on a well defined “science of
monetary policy” and monetary policy was perceived as being successful in OECD
countries, with not only low inflation, but also low variability of inflation. In addition,
these countries faced a substantial decline in macroeconomic volatility, development
known as the Great Moderation. (Bernanke 2004). Some theoreticians claim that the
Great Moderation did not result primarily from changes in the structure of the economy
or improvements in policymaking and it occurred due to smaller and more rare shocks
hitting the economy . Whether the great reduction of macroeconomic volatility is a
result of efficient policies or it is a matter of good luck, this should be a lesson for policy
makers, in order to promote a resilient and sound monetary regime.

The price stability objective was set as the major objective of the central banks
as a result of the ideological debates of two schools of economics. Thus, the
Monetarist School or Currency School, which had as an influential figure Milton
Friedman, claimed that “Inflation is always and everywhere a monetary phenomenon”
(Friedman); on the other hand, the Keynesian School or Banking School attributed the
main causes of inflation to supply shocks. We could say that there was a general
agreement with Friedman’s arguments regarding the fact that the expansionary
monetary policy will eventually lead to high inflation. Therefore, the policy makers put
an emphasis on monetary aggregates targeting, in order to prevent the price raising.
The comparison Henry Wallich (ex-governor of FED) made on this respect
meant that the monetary approach lacked some important and relevant aspects:
„inflation is a monetary phenomenon, just like shooting at people if ballistic one”.
Given the fact that a monetary policy that complies with the traditional objective
is credible, there is a high risk for inflationary pressures to accumulate for longer
periods of time without being reflected in the prices of goods and services.
Consequently, the financial system deals with a shortcoming of an anti-inflationary
policy, which is the gap between the imbalances produce and their perceptible effects,
that are more likely to have a negative impact on the system as a whole.
The monetary authorities tackle with the paradox of a credible monetary policy, since
having price stability as the fundamental objective can lead to both stability and
instability, the latter consisting of uncontrolled financial imbalances.
The Pre-Crisis period identifies itself with‘ certainties’ and favourable
macroeconomic trends, which cemented a few monetary policy related concepts
(Mishkin,2011): the key for macroeconomic stability is stabilizing the inflation; a low
level of inflation is the proof of the financial system’s soundness, therefore the self-
adjustment mechanism exists within the system; price stability is a warrant for
sustainable development; the transmission mechanism of the monetary policy consists
of the interest rate channel; monetary policy operating through the control of a short-
term interest rate is sufficient to capture the impact of monetary policy on the economy.
Although short-term interest rates independent of other financial factors have only a
modest influence on economic activity, their transmission affects medium- and long-
term interest rates, which do have a substantial role in the economy. It is argued that
the future path of a short term interest rate is able to affect the entire range of interest
rates and their impact on the economy.
Year XV, No. 17/2015 160

As a long-term objective, price stability is the adequate fundamental objective

of the monetary policy. Price stability represents a goal itself and the means for it, as it
is a major contribution to a sustainable economic development and to macroeconomic
stability.(Bernanke, 2006). Moreover, promoting price stability is not only the most
efficient action to take by the policy makers, but a contribution to social welfare.
According to the Founding Treaty of the European Community, “the main objective of
the Central Banks European System is maintaining price stability”.
As I mentioned above, the so called Science of the Monetary Policy guided the
central banks’ actions with the help of some scientific principles, highlighted by Mishkin
in his papers. These principles sum up the ideology and the empirical evidence that led
the economic thinking up until 2007, as it follows:” inflation is always and everywhere a
monetary phenomenon”; price stability has important benefits; there is no long-run
trade-off between unemployment and inflation; expectations play a significant role in
the determination of inflation and in the transmission of monetary policy to the
macroeconomy; real interest rates need to rise with higher inflation, i.e., the Taylor
Principle; monetary policy is subject to the time-inconsistency problem, which means
that, in time, policies that were considered to be optimal at one moment in time are no
longer perceived to be optimal at some point in the future and are not implemented;
central bank independence is crucial for the enhancement of the monetary policy
efficiency; “in order to receive good outcomes of the monetary policy a strong nominal
anchor is required; financial frictions are an important determinant in business cycles”
(Mishkin, 2011).
The inflation targeting strategy of the central banks involves a strong, credible
commitment of the central bank to stabilize inflation in the long run, but also allows the
central bank to implement and promote policies designed to stabilize output around its
natural rate level in the short run.
The type of inflation targeting which is commonly applied is called “flexible” as
it does not pursue price stability as a sole target, though in connection with the real
economy performance. As such it aims at stabilizing inflation around the inflation target
and resource utilization around desirable output-gap. The concept of flexible inflation
targeting thus means that a trade-off between inflation stabilization and output
stabilization is built into monetary policy making. The policy implementation then aims
at a reasonable compromise between the two.

3. Reassessing the objectives of the monetary policy after the crisis

Traditionally, central banks focus their policy on obtaining and maintaining

price stability, as their status stipulates clear responsibilities regarding the fundamental
objective. Considering financial stability as a second priority objective of central banks
generates a reassessment of the banking regulation in terms of macroeconomic
stability and monetary policy.
Even before the crisis, central bankers were aware that financial disruptions
could have a serious negative impact on the economy, so their overall surveillance is
necessary when coping with a vulnerable financial system. This is why many central
banks not only carried out reports on monetary policy, but also published Financial
Stability Reports that provide an assessment of the financial conditions and the
systemic ones that engage potential threats to the financial system. I have previously
mentioned a notable principle for Mishkin’s monetary policy theory, which is the one
that refers to the financial frictions as a determinant of business cycles. In a Basel
161 Finance – Challenges of the Future

world, these frictions are the subject of macroprudential regulation, as a necessary

pillar for financial stability and implementing a ‘new order’ in the financial system is a
step forward and against potential distresses. Nonetheless, Basel III represents a
toolkit for the banking system in terms of macroprudential regulation, creating a solid
framework for the implementation of a successful monetary policy. However, it is still
debated whether the financial stability and price stability goals converge into a unitary
monetary policy or not. “This naturally led to a dichotomy between monetary policy and
financial stability policy in which these two types of policies are conducted separately.
Monetary policy instruments would focus on minimizing inflation and output gaps
whereas it would then be up to prudential regulation and supervision to prevent
excessive risk taking that could promote financial instability.”(Mishkin, 2011)
It is considered that a central bank is responsible for payment systems
functioning efficiently. The turbulences that the financial systems have undergone
recently usually have changed the perception and extended the field of responsibilities
of a central bank, and its independence is considered a main factor in conducting an
efficient monetary policy. (Jacobson, 2001).
The financial fragility that describes the financial systems nowadays and the
contagion that could affect all the linked financial institutions in case of a disrupture
give us a different perspective of what the role of central banks is, the tools and the
authority they have to promote and ensure macroeconomic stability. Beyond the
traditional core functions of the central banks such as monitoring the banking system,
the payment systems and acting as a lender of last resort(microeconomic functions),
and price stability(macroeconomic function), there is macroprudential dimension that
introduces another macroeconomic function, dubbed as financial stability. Central
banks have the responsibility not only to maintain price stability, but the financial
system’s stability; the macroprudential regulation outlines the central banks’
responsibilities with regard to the financial stability as it follows: evaluating potential
risks that may affect the financial system stability; evaluating the solidity of the financial
system and its resilience to shocks. From this point of view, we cannot refer to these
main objectives as dichotomic.
“The global financial crisis of 2007-2009 was not only a tsunami that flattened
the economy, but in the eyes of some commentators it has flattened the science of
monetary policy, requiring a total rethink.”(Mishkin, 2011).
The financial system was the subject of a collapse during the global crisis,
comparable to the shock resulting from the calamities of the Great Depression.
However, “the economic contraction turned out to be far less severe”.(Mishkin, 2011)
Despite the similarities between the two severe crises, the current financial crisis was
managed with an aggressive monetary policy, effectively reassessed in terms of
prudential regulation and countercyclical measures in order to diminish the downturn
caused by the cyclical behaviour of banks.
On the other hand, central banks were forced resort to unconventional
monetary policies (policies that operate on balance sheets), beyond the standard
interest rate policy in order to influence longer term interest rates and general financial
conditions. Central banks engaged in supporting the banking sector from bankruptcy
and managed to ‘bail-out’ systemic financial institutions; the support the central banks
gave firstly consisted of massive assets purchases and secondly of capital injection in
order to solve the liquidity issues. As a consequence of these balance-sheet
operations, there was a high increase in the public debt and sovereign risk as well.
In my opinion, nonconventional monetary policy consists in the actions central
banks took in their struggle to counterbalance the impact of the crisis and represent
monetary stimuli that are difficult to withdraw from the economy: liquidity provisions;
Year XV, No. 17/2015 162

asset purchases; “quantitative easing, in which central banks greatly expanded their
balance sheets”(Mishkin, 2011); long-term low rates of banking policy.
‘’The problem during the financial crisis episode with conventional monetary
policy is not that it was ineffective, but that the contractionary shock from the financial
crisis was so severe that it overwhelmed the ability of conventional monetary policy to
counteract it.’’(Mishkin, 2010)
The trade-off between the price stability and financial stability is similar to the
one between the monetary policy and the regulation and surveillance policy. This
conflict is the subject of overheated debates among authors, theorists, authorities and
other ‘stakeholders’ of financial systems and it has as main argument is missing the
inflation target as a consequence of the liquidity injections made by central banks in
order to bail-out some financial institutions at risk. Another argument is related to the
reputation of the central bank, which could be affected by its failure in ‘fostering’ the
banking system and which could compromise the credibility in its authority.
We have seen during the recent financial turmoil that the lendor of last
resort(LOLR) function is extremely important in avoiding an eventual collapse and
regaining trust in the financial system, and ensuring liquidity is an essential condition
for preserving stability.
Whereas the central banks seen as the systemic stabiliser are allocated a new
set of macroprudential instruments to operate, such as (possibly time- and state-
varying) capital, liquidity and leverage ratios in order to promote and preserve banks’
resilience to shocks, the traditional focus of stabilisation has been the central bank’s
“capacity to lend, and thus to create liquidity, either to an individual bank, as the lender
of last resort, or to the market as a whole, via open market operations.” (Goodhart,
2010)
Whether the dichotomy between the tradition monetary policy and the financial
stability goal means a short-term trade-off in literature (Goodhart 2010), there is
another view on this which claims that the mentioned above objectives converge to the
financial system’s stability.
In an open economic environment in which capital pressure generate adverse
economic conditions, the expansionary monetary policy used to balance the
contractionary phase of the business cycle and to stimulate the economy may also
alter the financial fragility of the system, because the liquidity injections can be used by
some banks in a wrong manner, causing distress in the financial system.
Moreover, this dichotomy is revealed if economy goes through a high inflation
period and banks are vulnerable. In order to counteract the inflation pressures, central
banks normally proceed to raising interest rates. Taking into account the fact that the
surveillance responsibilities give central banks information on system’s fragility and that
high interest rates might amplify this vulnerability, central banks give up raising interest
rates and so they miss the inflation target.
A short review of literature outlines multiple arguments for the consistency of a
monetary policy including the two interrelated goals, price stability and financial
stability. Mishkin asserts that “both a sustained increase of the price level and a
reduction under the level of expectations represent potential instability
sources.”(Mishkin, 2010)
In an economy with moderate or low inflation, banks normally give loans at a
fixed interest rate. A disinflation process would lead to higher real interest rates,
diminishing cash-flows and increasing financial instability. Nevertheless, when
monetary authorities conduct an abrupt disinflation policy, they have to pay attention to
the soundness of the financial system and its tolerance to changes.
163 Finance – Challenges of the Future

As far as the financial stability objective is concerned, there is historical

evidence that pleads for the importance of macroeconomic stabilization. Therefore, the
banking crises were caused by vicious macroeconomic policies, with flawed
fundamentals and applied principles.
Nevertheless, a price stability oriented policy reduces risks and has a toolkit for
achieving price stability and financial system’s stability. However, if we follow the
Tinbergen rule, a conflict between the two goals is relevant. Tinbergen’s study “On the
Theory of Economic Policy assumes that “policy designers have a relatively freehand
in selecting tools from a large toolbox of possibilities in order to address their policy
goals and attempts to discern the optimal arrangement f policy goals or “targets”, and
the means or ‘instruments’ available to resolve them.”(Del Rio&Howlett,2013) In his
work, Tinbergen analyzed what he termed the ‘normal’ case in which it was possible to
match one goal with one target so that one instrument could fully address its task and
accomplish the goal set out for it. In my opinion, Tinbergen rule could apply in some
cases, but definitely not in all cases.
The banking system is the transmission mechanism of the monetary policy,
thus the links among the central bank, the banking system and their objectives is
imminent. Arguments against their separation mainly rely on the necessarily intimate
connection between the two facets of monetary policy. “For example, once the zero
lower bound to interest rates is reached, then monetary policy, in the guise of inflation
targeting, and systemic stability issues become indistinguishable.” (Goodhart, 2010)
There are several arguments in favour of separating interest rate setting from central
banking, such as the conflict of interest that may arise in respect of independence and
growing responsibilities. Central banks’ failures as interest setters mainly resulted from
not taking into consideration the financial conditions and frictions and the monetary
policy in the context of a fragile financial system.
The recent international financial crisis demanded some unconventional
monetary policy that sacrificed inflation targeting in favour to numerous capital
injections, in order to preserve financial stability.
The recent evidence the ongoing financial crisis gives us is a contradiction to
the economic theories on which monetary authorities relied on when conducting the
monetary policy. On the one hand, there was a general outlook concerning the optimal
monetary policy according to which “a policy that stabilizes inflation and output is likely
to stabilize asset prices, making asset-price bubbles less likely to appear”(Mishkin,
2011). On the other hand, central banks succeeded in implementing a credible and
‘safe’ monetary policy from the end of the 80’s until the major financial crisis burst in
2007. Moreover, the stabilized inflation and the decreased volatility of business cycle
fluctuations, which were the features of the Great Moderation, made policymakers
complacent about the risks from financial disruptions and unaware of the fact that
everything in the financial world is prone to risk and should be treated accordingly.
The Great Moderation period surely did not protect the economy from financial
instability, but kept it from clearly signalizing it. The context of low inflation volatility and
not severe fluctuations of the output gave the false impression of stability, even though
it did not generate very good economic outcomes. Accordingly, this “benign economic
environment may have led market participants into thinking there was less risk in the
economic system than was really the case. Credit risk premiums fell to very low levels
and underwriting standards for loans dropped considerably”. (Gambacorta, 2009).
The aftermath of the financial crisis reveals different views on how central
banks should conduct their monetary policy and there is the view sticking to continuity
and the adjustment oriented view. The continuity view holds that “flexible inflation
targeting does not require any explicit addition of financial imbalances or asset prices
Year XV, No. 17/2015 164

to the formal structure of inflation targets”.(Svensson, 2010) This statement is clearly

asserted by L. Svensson, an expert on flexible inflation targeting, who has the belief
that the outbreak of the financial crisis was not entirely connected to monetary policy
and it was mainly due to “regulatory and supervisory failures, distorted incentives in
financial markets and mishandled macro conditions”.(Svensson, 2010)
Moreover, the outbreak of the crisis made an impact on the advocates of the
continuity of the existing monetary policy framework as well. They are striving to prove
that the applied regime of flexible inflation targeting has a potential to cope with the
risks for financial stability without any substantial change in its operational framework.
Personally, I consider that taking for granted the existing monetary policy framework
eventually means ignoring its flaws in terms of regulation, risk management, liquidity
management and the new requirements of the Basel III Accord.
Overall, central banks succeeded in stabilizing inflation, but a low and stable
inflation is not a guarantee for stability.
According to the continuity perspective, “the targets of monetary policy should
remain to be confined to price stability and resource utilization (output gap) and should
not be extended on financial conditions”.( Hrnčíř, 2012)
The advocates of this view have the following arguments for this approach:
• the two highly debated goals of monetary policy, financial stability and price
stability, though interrelated , are different goals. Accordingly, financial stability policy
and monetary policy are different, with different objectives, instruments and
responsibilities and should not be conducted similarly or simultaneously ;
• flexible inflation targeting is not sufficient for achieving financial stability and
there is recent evidence from the latest financial crisis to state that . In accordance
with Tinbergen’s principle, who claimed that each goal must have its own instrument,
interest rate policy is therefore not enough to achieve financial stability;
• there is a relatively wide range of instruments except the interest rate,(credit-
to-GDP ratio, capital standards, loan-to-value ratio) that are likely to be much more
effective in avoiding excessive credit growth and asset-price bubbles, and are
preferable to the interest rates in order to achieve the financial stability goal;
• the extension of the monetary policy targets to financial stability would cause
overburdening the monetary policy and it would question the achievement of the
fundamental goal of the monetary policy, price stability. Hence, a trade-off between
financial stability and price stability is undesirable from this point of view.
There are two principal arguments why it should be not only useful but also
desirable to effectively engage monetary policy in financial stabilization:
• the monetary policy framework undoubtedly affects the financial environment,
the degree of leverage of financial institutions and the probability of occurrence of a
crisis;
• the regulatory authorities develop a new range of regulation tools or
consolidate and put into practice the existent appropriate ones for both the individual
financial institutions and the system as a whole. The Basel Accords implemented and
the third one is still mplementing new requirements towards a more efficient and less
vulnerable financial system. Moreover, the new regulatory framework is supposed to
strengthen its macroprudential dimension and to change its character from a
procyclical to a more countercyclical one and to become consistent with the financial
stability goal.
Nevertheless, an extended engagement of monetary policy in financial
stabilization, though its milestone, is, however, exposed to several constraints, which
were logically and concisely summarized by the czech banker Miroslav Hrnčíř as it
follows:
165 Finance – Challenges of the Future

• there may be conflicts between the goals of price and financial stabilization.
These conflicts start where the responsibilities broaden for the regulators. Prior to the
global financial crisis it was well known that monetary policy safeguards price stability
and promotes it as its fundamental goal whilst the regulatory framework is in charge
with preserving financial stability. In the post-crisis world, we highlight the necessity of
a reassessment of this order and a consensus between the two goals in order to avoid
or minimize the effects of a potential financial disarray.
• “the extended policy framework should still provide a clear anchor for medium
term inflation expectations”( Hrnčíř, 2012)
• it is difficult to dispose of “the technical background and the practical
experience on how to implement “leaning against the wind””( Hrnčíř, 2012) is lacking to
a great extent; it is arguable if the regulators have the ability to extract the relevant
information from financial imbalances in a way that allows preemptive policy to be
implemented, so as to counteract the cylical damage or the necessary background is
lacking to a great extent. (Hrnčíř, 2012)
Personally, I consider that taking for granted the existing monetary policy
framework eventually means ignoring its flaws in terms of regulation , risk and liquidity
management.
To put it in a nutshell, the conflict between price stability and financial stability
lays not only in the activities central banks are engaged to, that have to ‘wear two hats’
simultaneously, but in choosing the right tools to achieve these interlinked major
objectives. The policy objectives, the strategies, the instruments to achieve the
objectives and the transmission channels of the monetary policy represent the
configuration of the monetary policy, in which all the elements presented are linked to
each other.
One of the most important lessons from the crisis is the fact that the inflation
targeting goal is necessary but not sufficient for preserving financial stability and there
should be taken into consideration both quantitative and qualitative aspects of the
targeting. The central banks do not have as main concern inflation targeting at any
horizon independent of the intermediate objectives, since they managed it during the
crisis, but every strategy is oriented towards financial stability.
Central banks need to reconsider their monetary policy frameworks with a view
to ensuring symmetry in the conduct of monetary policy over the financial cycle and to
better internalise the externalities associated with global monetary policy spillovers
(Borio 2011).

4. Conclusions

This paper aimed at identifying clear and valid “pros and cons” referring to the
current monetary policy framework and the need to reconsider central banks’
objectives. In the first paragraph there were mentioned some scientific principles that
guided thinking at almost all the central banks before the crisis outburst and it is clear
that the agenda of central banks has suffered and has to suffer serious changes in
terms of monetary policy.
The global financial crisis resulted in a trigger for the authorities that are
charged with implementing monetary policy, leading to the expansion of policy goals,
instruments, strategies, due to the failures of the narrow oriented policy conducted
before the crisis. Even though there is a divergence among the views on the role of the
monetary policy, we can appreciate that the adjustment view mentioned above is
Year XV, No. 17/2015 166

gaining ground ; the monetary policy disposes of a range of instruments that can
consolidate the financial system and preserve its soundness and stability. Hence, the
established consensus on the goals of monetary policy is likely to go through
reassessment and adjustment.
As a conflict is likely to exist between the requirements of price and financial
stability, such an extension of monetary policy targets implies that a trade-off between
them is faced. Given the fact that there was not adopted a practical model of the
monetary policy and no legislation amendment was made, we could assume a
temporary “switch” to the financial stability mode once a situation characterized by
substantial financial stability risks develops, while the commitment to the medium term
inflation target remains untouched.

Acknowledgement: This work was cofinanced from the European Social

Fund through Sectoral Operational Programme for Human Resources Development
2007-2013, under the project number POSDRU/159/1.5/S/140863 with the title
„ Competitive Researchers in Europe in the Field of Humanities and Socio –Economic
Sciences. A Multi-regional Research Network”.

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