Monetary Policy after theFinancial Crisis
Lars E.O. Svensson
IJCB Conference, Bank of Japan
September 17, 20101

Outline The causes of the financial crisis and the roleof monetary policy
 Lessons for monetary policy

 The relation between monetary policy (MP)and financial-stability policy (FSP)

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The financial crisis was notcaused by monetary policy
Main causes of the crisis:Macro conditions: Global imbalances, global saving glut andinvestment shortage, low world interest rates, underestimationof risks, very low risk premia
Distorted incentives to excessiv leverage and lack of due
diligens: lax regulation and supervision, securitization, myopic
and asymmetric remuneration contracts
Information problems: Hidden risk in complex securities,
underestimation of correlated systemic risks
These causes had little or nothing to do with monetary policy!

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The financial crisis was notcaused by monetary policy
 Loose Fed policy after 2001 justified by fearof Japanese-style deflation and liquidity trap
 Modest effects of policy rates on house prices
and credit growth; substantially higher interest
rates needed to stop house prices: recession,
deflation and eventually liquidity trap?
 No impact on problems of distorted incentives,
reg and sup, information4

Lessons for monetary policy?
Price stability not enough to achieve financialstability
 Interest rate not enough to achieve financial stability:
Separate financial-stability policy needed Let financial conditions and asset prices remainindicators, not targets, of monetary policy:
Incorporate effects in forecasts of inflation andresource utilization at any horizon

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Lessons for monetary policy?
Flexible inflation targeting, ”forecast targeting”:Set policy rate path so forecast of inflation and RU
best stabilizes inflation and RU, using all relevant
info, including financial conditions
 In 2nd best situation w/ imperfect financial-stability
policy, if policy-rate path affects financial stability,
take into account (probably very rare event) Normally policy-rate neglible impact on financialstability and strong impact on inflation and RU(unfavorable tradeoff!)6

Relation monetary policy andfinancial-stability policy?
 Distinguish economic policies acoording toObjectives
 Instruments
 Authority(ies) controlling instruments andresponsible for achieving objectives
 Fiscal policy and monetary policy distinct anddifferent, but interaction
 Financial-stability policy and monetary policy
distinct and different, but interaction
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Monetary policy (MP)Objective

Flexible inflation targeting:Stabilise inflation around inflation target and resource
utilisation around normal level

Instruments
Normal: Policy rate, policy-rate path, communication
 Crisis: Fixed-rate lending at longer maturities, asset
purchases (quantitative easing), …
AuthorityCentral bank8

Financial-stability policy (FSP)Objective

Financial stability (financial system fullfils main functions
w/o disturbances with significant social costs)

Instruments:
Normal: Supervision, regulation, FS reports
 Crisis: Lending of last resort, variable-rate lending longer
maturities (credit easing), guarantees, bank resolution,
capital injections, asset purchases,…


Authority(ies): FSA, CB, MoF, …(varies acrosscountries). Good case for CB for macroprudential
supervision and regulation
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MP and FSP different and distinct
 Interaction

FSP affects inflation and resource utilisation via
financial markets and transmission mechanisms(spreads, lending) MP affects resource utilisation, asset prices,balance sheets, leverage, credit losses Distinction and difference to be taken intoaccount10

Conclusions
Flexible inflation targeting remains best-practice MP(but take financial conditions into account!) If policy-rate path affects FS, take into account MP cannot ensure FS; a separate FSP is required FS as additional objective for monetary policy makes
no sense FS as additional objective for central bank makes
sense, if additional instruments
 Conduct MP taking effects of FSP into account Conduct FSP taking effects of MP into account11