Axel A Weber: Lessons for monetary policy from the financial crisis
Keynote speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
XII Annual Inflation Targeting seminar of the Central Bank of Brasil, Rio de Janeiro,
14 May 2010.
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1. Introduction
Ladies and gentlemen,
Due to the worldwide financial crisis a number of conceptual issues have been raised. This
also applies to the conduct of monetary policy. I would like to focus on three key aspects of
the ongoing debate on what lessons are to be learned from the crisis. The first question is
whether central banks should raise their inflation target in order to gain more leeway in times
of financial and economic distress. The second question is whether moving to a price-level
target would facilitate the conduct of monetary policy. And the third question concerns the
role of asset prices and the importance of financial stability for monetary policy in general.
In discussing these issues, however, it is important not to underestimate the dangers to
financial stability that still exist. Although it is now in its third year, the financial crisis
continues to present us with new challenges, as the focus of markets has shifted in recent
months towards concerns about the situation of public finances in a number of countries
across the globe.
Public debt has risen sharply not just in Europe but worldwide. In almost all industrialised
countries this has been a consequence of the support measures needed to stabilise not only
the financial sector but also the economy as a whole against the backdrop of the sharp
economic downturn. Today, there is no alternative to the rapid and credible consolidation of
public finances. A lack of confidence would undermine current fiscal stimulation, and
correspondingly higher financing costs would make consolidation even more difficult.
Furthermore, confidence in the soundness of public finances is a major prerequisite for both
the stability of financial markets and the anchoring of moderate inflation expectations. Fiscal
policy has to deliver sustainable public debt levels as a key policy priority at the current
juncture. Reducing deficits is vital in this context, and a frontloaded credible consolidation
strategy is thus of key importance. Given the danger of contagion, safeguarding the stability
of the monetary and financial system should be seen as the rationale behind some of the
recent liquidity support measures adopted by the Eurosystem. Any such measures have to
be implemented in a way that respects the appropriate division of responsibilities between
fiscal and monetary policy in the euro area: Providing liquidity and supporting malfunctioning
markets essential to ensure a proper conduct of monetary policy is the central bank's
contribution to achieving stability. Ensuring sustainable public finances is a fiscal policy
issue. For the remainder of my speech, however, I shall be discussing the three issues I
have already mentioned concerning the optimal strategy for monetary policy.
2. Lessons for monetary policy?
2.1 Increasing the inflation target?
Starting with the first question: Should we add a safety margin to the inflation target or the
quantitative definition of price stability - as we call it in the Eurosystem? Some prominent
economists argue in favour of a somewhat higher figure. For advanced economies with an
inflation target of around 2%, the proponents of a higher figure suggest an increase of
another 2 percentage points to 4%. The idea behind this is quite straightforward: Increasing
the distance from the zero interest rate bound by means of a higher average inflation rate
might supposedly create more room for an expansionary monetary policy.
However, enthusiasm for this proposal seems to be fading. One explanation for this might be
that recent developments have provided reassurance that the zero interest bound does not
constitute a restriction on monetary policy. In our case, the flexibility of monetary policy in
Economic and Monetary Union has not been limited during the crisis despite very low interest
rates. The success of unconventional monetary policy measures has shown that central
banks have more instruments at their disposal than just the short-term interest rate. In the
Eurosystem, unconventional measures have allowed us to provide liquidity to market
participants and thereby deter deflationary expectations.
Moreover, the costs of higher inflation should in no way be underestimated. Apart from menu
costs, these include - as you are all well aware - redistribution effects between, say,
borrowers and creditors, as well as the loss of allocative efficiency once the transparency of
relative prices has been hampered by the resulting higher volatility of inflation. In addition,
most tax systems are far from neutral with respect to the level of inflation.
The most relevant argument against higher inflation targets is the implicit downside of higher
inflation expectations. Such expectations might become instable since the public might
expect further increases in the future. In light of the existing concerns that governments will
try to inflate away the huge increase in public debt caused by the crisis, the timing of this
proposal was particularly unfortunate. Actually, a recent study by Bundesbank staff analyses
the incentives that a government has to reduce its real debt burden by increasing inflation
temporarily. On the one hand, within their monetary DSGE model, the success of such a
policy depends crucially on the maturity structure of public debt. On the other hand, what
turns out to be essential is the extent to which monetary policy can use the credibility of its
inflation target to exploit expectations of low inflation1. Without allowing an un-anchoring of
inflation expectations, it is scarcely possible to let actual inflation rise sufficiently.
In this context, we should remind ourselves what efforts it took us to break persistent inflation
trends and to anchor long-term inflation expectations at low levels during the past decades.
In fact, we do not have to go back as far as the 1970s, the time known as the "Great
Inflation", to find inflation rates considerably higher than those today. In the late 1990s, some
Latin American countries, among them Brazil, introduced inflation targeting as a monetary
strategy and thereby succeeded in driving down inflation rates. Somewhat earlier, EU
member states started preparing for Economic and Monetary Union - a project that was
crowned by the introduction of the euro as a common currency. In Brazil, as well as in some
of the euro area member states, the efforts involved in bringing down inflation are well
remembered. In this sense, our two continents share the experience of building up a
successful disinflation record. We should not risk this success for the perceived benefits of
more flexibility in our monetary policy frameworks.
2.2 Price-level targeting
In my view, allowing inflation expectations to rise permanently is not an option. Against this
background, let me now turn to the second question: Should central banks switch to a
strategy in which inflation expectations are only temporarily raised when needed? In other
words, should central banks follow the advice given in the academic literature and think
seriously about defining the objective of monetary policy in terms of a target path for the
aggregate price level rather than a target for the rate of inflation?
In technical terms, the main difference between the two regimes is that under price-level
targeting, the central bank commits itself to correcting deviations of the price level from the
target path (over a given horizon), whereas under inflation targeting, the central bank
commits to correcting deviations of inflation from target (over a given horizon), but does not
respond to one-off shifts in the price level. As a consequence, under inflation targeting, there
will be price-level drift - the price level will be non-stationary - whereas under price-level
targeting, the rate of inflation will be stationary, and the price level will be trend stationary.
Hence, price-level targeting would limit uncertainty regarding the future price level and thus
facilitate the forecasting of the real value of future payment flows which are fixed in nominal
terms (as is the case in the majority of financial contracts). This would be beneficial because
it would tend to reduce the risk premiums demanded by risk-averse creditors and thus lower
the cost of capital. However, according to conventional wisdom, the potential benefits of the
reduction in uncertainty regarding the future price level must be weighed against the potential
cost of correcting shock-induced price-level shifts. Bringing the price level back onto the
target path may induce additional fluctuations in the inflation rate and real economic activity
compared with targeting the inflation rate.
Whereas this reasoning may persuade us to be sceptical, the recent academic literature has
stressed the potential benefits of price-level targeting which arise from the stabilising effect of
the price-level target on inflation expectations. In this respect, price-level targeting has
gained particular importance in the current period of extremely low policy rates since the
stabilising effects of the price-level target on inflation expectations have the added advantage
of reducing the probability of hitting the zero interest rate bound.
This argument is based on the following reasoning: A negative aggregate demand shock
leads to a drop in the price level to below the target path. If the central bank's commitment to
the price-level target is credible, the private sector anticipates that the price level will return to
its target. Hence, a drop in the price level will lead to an automatic rise in inflation
expectations. This movement of inflation expectations mitigates the effect of the original
shock on the inflation rate. Consequently, for a given nominal interest rate, the real interest
rate decreases. This stimulates aggregate demand and, in turn, keeps the required nominal
interest reduction to a minimum. Hence, a credible price-level targeting regime lowers the
risk of hitting the zero bound and falling into a deflationary trap following a negative goods
demand shock.
Given these stabilising attributes of price-level targeting, it is hardly surprising that price-level
targeting regularly performs well in simulation studies which compare price-level targeting
and inflation targeting under the assumption that the central bank is constrained to act under
discretion. It may be argued, however, that when considering a fundamental change in the
monetary policy regime, the relevant question is not whether the new strategy does better
than discretionary inflation targeting, but rather how the proposed strategy compares to the
optimal commitment solution which monetary policymakers strive to attain.
A recent study by the Federal Reserve Board has shown that if explicit account is taken of
the zero interest rate bound, optimal monetary policy under commitment may involve
considerable price-level drift following a more substantial contractionary demand shock.
Consequently, returning the price level to its target path, as required under price-level
targeting, is associated with welfare losses. Based on an extension of the New Keynesian
model that allows for sector-specific shocks, a recent study by Bundesbank staff confirms the
welfare costs of eliminating an optimal price-level drift2.
It is not clear at present whether the costs associated with returning the price level onto the
target path would be outweighed by the benefits which accrue from the reduction in
longterm price-level uncertainty. Against this background, price-level targeting cannot be
regarded as a viable monetary policy strategy until we know much more about its potential
benefits and costs than we do at present. But it is definitely worth pursuing this line of
research further in the future.
2.3 Asset prices, financial stability and monetary policy
Another question that has been raised once again by the financial crisis concerns asset
prices and their relevance to monetary policy. First of all, the well known arguments against a
"leaning against the wind" strategy are still valid: Financial bubbles are difficult to identify and
difficult to moderate using monetary policy instruments.
Nevertheless, there is empirical evidence on the link between money and credit growth and
asset price booms. This suggests that monetary policymakers should take due account of
developments in the financial markets and in asset prices - as part of their price stability
mandate. One of the lessons of the recent crisis may be that the time horizon relevant to
monetary policy decisions should not be too short.
Looking beyond credit and monetary developments, there are more interdependencies
between monetary policy and the financial cycle. Therefore, we must improve our
understanding of the impact of monetary policy on banks' behaviour and vice versa. On the
one hand, recent experience has clearly shown that financial imbalances can trigger an
economic downturn and thereby endanger price stability as a result of deflationary risk. On
the other hand, the financial cycle is not exogenous to the strategic orientation of monetary
policy. Monetary policy has the potential to influence risk-taking behaviour, for example.
Thus, monetary policymakers taking these factors into account should respond symmetrically
to financial cycles. This will not prevent boom-bust cycles in asset prices, but might
contribute to somewhat less volatile financial cycles.
Does this imply that monetary policymakers should take responsibility for financial stability?
In my view, ensuring price stability over the medium term remains the appropriate objective
of monetary policy. In order to fulfil this task, monetary policy has basically one instrument at
its disposal, the short-term interest rate. Given that short-term interest rates are too blunt a
tool to safeguard financial stability, financial stability should not become an additional
independent objective of monetary policy.
Instead, financial stability is best ensured by macro-prudential policy with its own set of
instruments. However, this does not mean that macro-prudential policies cannot or should
not be carried out by central banks. On the contrary: The expertise already present in central
banks as well as the interactions between monetary policy and macro-prudential policy I
mentioned earlier are arguments that call for central banks to play a prominent role.
Central banks possess comparative advantages of information and action as they combine
complementary elements such as oversight of payment systems, their own refinancing
operations, their activities in the financial markets and their presence in international
committees. In addition, only central banks can perform the vital function of the lender of last
resort for the banking sector during financial crises. This, in turn, requires that central banks
constantly keep abreast of financial institutions' solvency situations and of liquidity conditions
in the money market. They are therefore able to assess possible domino effects. Central
banks' market proximity in the regulatory and supervisory process clearly enhances their
ability to identify disequilibria and proactively counter potential pockets of instability.
What is needed, however, is a clear distinction between central banks' responsibilities with
respect to monetary policy and their financial stability tasks. For example, at the level of the
EU, a separate European Systemic Risk Board will deal with macroprudential issues, but it
will be situated at the ECB, allowing it to draw on the central bank's resources and analytical
capacities. In a similar vein, the Bundesbank has created a new "Financial Stability"
department.
3. Conclusion
Ladies and gentlemen
The financial crisis has stimulated a number of discussions about the optimal conduct of
monetary policy. I have touched on only some of them, highlighting the key points. This
seminar has provided us with the opportunity to elaborate on the lessons to be learned by
monetary policy. And I have learned a lot in yesterday's and today's sessions!