WORKING PAPER SERIES
Monetary Policy Lessons from the Crisis
Athanasios Orphanides
May 2010
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Monetary Policy Lessons from the Crisis
Athanasios
Orphanides∗
Central Bank of Cyprus
May 2010
Abstract
This paper provides a policymaker's perspective on some lessons from the recent financial
crisis. It focuses on questions in three areas. First, what lessons can be drawn regarding
the institutional framework for monetary policy? Has the experience changed the pre-crisis
consensus that monetary policy is best performed by an independent central bank focused on
achieving and maintaining price stability? Second, what lessons can be drawn regarding the
monetary policy strategy that should be followed by a central bank? How activist should a
central bank be in dampening macroeconomic fluctuations? Should the "output gap" serve
as an important policy guide? Are there lessons regarding the stability-oriented approach
followed by the ECB? How activist should a central bank be in tackling perceived asset price
misalignments? Does the ECB's monetary analysis pillar help incorporate the pertinent
information in formulating policy? Third, is monetary policy pursuing price stability enough
to ensure overall stability in the economy? Or is there room for improvement regarding how
central banks can contribute to financial stability? Should the role of monetary policy be
seen as completely separate from the broader institutional environment governing financial
markets and institutions in our economy? Or would greater central bank involvement in
regulation and supervision pertaining to credit and finance allow better management of
overall economic stability?
Keywords: Great financial crisis, activist stabilisation policy, real-time output gap, robust
simple rules, stability-oriented monetary policy, asset prices, macro-prudential supervision,
financial stability, ECB.
JEL Classification: E50, E52, E58.
1 Introduction
The assignment I accepted for this paper is not straightforward. The task is to provide
a policymaker's perspective on some lessons from the great financial crisis for monetary
policy. Having studied earlier challenging episodes in monetary history, I am well aware
of the pitfalls of attempting to draw lessons from a crisis while the experience is still raw.
Better to wait a decade or more, to have time to evaluate with greater clarity whether, how
and under what conditions things could have evolved differently. On the other hand, there
is no time to waste on suggested improvements in the policy framework if the objective is
to improve the odds of better outcomes for the future. What better opportunity to offer
some early thoughts on the lessons, then, than the occasion presented by this colloquium
honouring Lucas Papademos, taking place right after the last meeting of the Governing
Council of the European Central Bank (ECB), before the end of his tenure as Vice-President
of this institution.
I focus on questions in three areas. First, what lessons can be drawn regarding the
institutional framework for monetary policy? Has the experience changed the pre-crisis
consensus that monetary policy is best performed by an independent central bank focused
on achieving and maintaining price stability? Should central banks be more or less inde-
pendent? Should their aim be higher inflation instead of price stability, as some suggest?
Second, what lessons can be drawn regarding the monetary policy strategy that should
be followed by a central bank? A perennial debate in monetary economics has raged over
how ambitious monetary policy should be, how activist it should be in dampening fluc-
tuations and tackling perceived disequilibria and imbalances. Where does the historical
behaviour place the ECB in this debate? In the history of central banking, one can identify
shifts in the consensus from waves of optimism that policies could be fined-tuned to achieve
more to waves of caution when the limits of our knowledge are reconfirmed by reality. Has
the recent experience shifted the centre of gravity in this continuing debate?
Third, is monetary policy pursuing price stability enough to ensure overall stability in
the economy? Or is there room for improvement regarding how central banks can contribute
to greater stability? Would greater central bank involvement in regulation and supervision
pertaining to credit and finance allow better management of overall economic stability?
Or should the role of monetary policy be seen as completely separate from the broader
institutional environment governing financial markets and institutions in our economy?
It is not necessary to elaborate on the consequences of what became "the great financial
crisis". Its severity is evident in the evolution of euro area real GDP (Figure 1). Suffices to
note that the level of real GDP fell by nearly 5 percent from its peak in 2008Q1 to its trough
in 2009Q2. Events during the crisis, the decisive policy responses, and implications for the
future of macro-prudential supervision, were analysed by Lucas Papademos in a number of
timely and insightful speeches (Papademos, 2007, 2008, 2009a,b,c,d, 2010). As the person
responsible for both financial stability and economic research at the ECB during the crisis,
Lucas has been in a unique position to provide insights into the events and guidance on the
appropriate policy responses.
2 The Institutional Framework of Monetary Policy
The founders of the European Union ensured that the ECB, more than any other central
bank that has ever existed, would be an independent institution fully committed to ensuring
price stability.
The independence of the ECB as well as its clear mandate are enshrined in the Treaty
on the Functioning of the European Union. According to the Treaty, the primary objective
of the ECB "shall be to maintain price stability". In light of this mandate, the Governing
Council of the ECB aims to maintain inflation rates at levels below, but close to, 2 percent
over the medium term. Inflation is measured by the year-on-year rate of increase in the
Harmonised Index of Consumer Prices (HICP).
It should not be necessary to remind ourselves why price stability is so important. The
economic costs of inflation are well known.1 High and variable inflation is detrimental
to productivity and growth; uncertainty and unpredictability about future prices leads to
inefficient decisions. The social costs of failing to preserve price stability can be far reaching.
Inflation is one of the most virulent and corrosive forces in a democratic society, eroding
the functioning of a market economy.
The key to securing price stability is to ensure that businesses and households do not
need to worry about protecting themselves from the inflationary disease. Temporary up-
ward and downward fluctuations in inflation may occur but they must not be embedded
permanently in high inflation or deflation. This result is assured only when inflation expec-
tations over suitably long horizons are well anchored at levels of inflation sufficiently low
to constitute effective price stability. The ECB's definition of price stability, that is a rate
of increase of the HICP close but below 2 percent a year, meets this criterion. Delivering
on this goal of price stability is the best way monetary policy can contribute to economic
welfare over time.
Since the birth of the euro, the ECB has been successful in delivering on this task.
Figure 2 plots HICP inflation as well as the long-term expectations regarding inflation
from the ECB's quarterly Survey of Professional Forecasters (SPF).2 As can be seen, the
average of the SPF responses (the blue dashed line) has consistently been in line with the
ECB's price stability mandate despite fluctuations in actual inflation which, over the past
three years, have been relatively large. There are differences of opinion among the survey
respondents that are also informative. The thin red lines in the figure show the 25th and
75th percentiles of the cross-sectional distribution of responses in each quarter. As can
be seen by the fairly narrow width of the shaded area, disagreement, as measured by the
interquartile range of responses, has been limited. This speaks volumes for the credibility
of the ECB.
But price stability cannot be assured by a central bank unless it enjoys absolute political
independence that can be used to shield it from short-sighted political inflationary pressures
that harm the common good over the long haul. The temptations are asymmetric and well
known. Inflationary policies can temporarily ease budgetary pressures, buying time for
profligate governments. Necessary adjustments may be delayed. A democratically elected
government facing an unfriendly electorate, could be tempted to pursue inflationary policies
that might temporarily raise employment and income and its electoral prospects. The
detrimental effects of inflation, which far exceed any temporary gains for society, would
only appear later on. An unavoidable social cost of a democratic society is that the damage
from irresponsible government policies sometimes can be hidden from the electorate until
after the next election.
The problem, and its obvious solution, have been recognised for a very long time. Early
in the 19th century, English economist and member of Parliament David Ricardo explained
the main concern that led him to the conclusion that a central bank responsible for the
issuance of paper money should be independent as follows:
"It is said that Government could not be safely entrusted with the power of
issuing paper money; that it would most certainly abuse it; and that, on any
occasion when it was pressed for money to carry on a war, it would cease to
pay coin, on demand, for its notes; and from that moment the currency would
become a forced Government paper. There would, I confess, be great dangers
of this, if Government-that is to say, the Ministers-were themselves to be
entrusted with the power of issuing paper money" (Ricardo, 1824).
Ricardo thought it critical for the bank to be governed by individuals who, in his words,
would be "entirely independent" of the government's ministers and stressed that the indi-
viduals governing the bank "should never, on any pretence, lend money to Government, nor
be in the slightest degree under its control or influence." The object of Ricardo's inquiry
was the Bank of England, but his analysis has had lasting appeal and was adopted when the
ECB was created. By the end of the twentieth century, the need for an independent central
bank to ensure price stability became the consensus view. Increasingly, independence was
granted to more and more central banks (including the Bank of England in 1997). Today
virtually all of the world's major central banks enjoy a substantial degree of independence.
The credibility that an independent central bank can establish with its actions over time
does not only facilitate the success of monetary policy in normal times. It can be invaluable
during critical times when unusual actions may be required that might otherwise risk raising
questions regarding the central bank's continued commitment to price stability.
A complicating factor, especially since the last quarter of 2008, has been that numerous
central banks around the world, including the ECB, the Federal Reserve and the Bank of
England, have reduced interest rates to or near historical lows and, as a result, consider-
ations regarding the zero bound on nominal interest rates have become pertinent. When
policy operates very close to the zero bound, unconventional policy measures may be under-
taken for engineering additional monetary policy easing.3 These measures operate through
expanding or changing the composition of the balance sheet of the central bank. At times,
monetary policy and fiscal policy may blur as some monetary policy decisions may unavoid-
ably have a temporary fiscal dimension.4 Under such circumstances, an independent central
bank that is credibly committed to ensuring that inflation remains low in line with price
stability, can have much greater flexibility to take actions that would otherwise risk stoking
inflationary fears.
Events during the past three years have provided practical demonstrations of these
points. One example has been the massive provision of liquidity by the ECB and other
central banks, first when money markets malfunctioned in August 2007 and then during
subsequent periods of stress. Were it not for the independence of the central banks in
question, and the credibility earned by their earlier success in maintaining price stability,
the ensuing rapid increases in the monetary base could have raised the spectre of inflation
in the public's conscience.
Some purchases of assets by central banks over the past two years may also be seen
as examples of such unusual actions. These actions were taken either to repair market
functioning or, in light of the zero bound, to engineer further monetary policy easing and
defend against deflation, or both. In the United States, for example, the Federal Reserve
bought large quantities of asset-backed securities to prop up an ailing financial sector and
the housing market and to stimulate economic activity. In the United Kingdom, the Bank
of England engaged in quantitative easing by purchasing UK government bonds. And
very recently, the ECB decided to conduct targeted interventions in some euro area public
and private debt securities markets to address their dysfunction. In each of these cases,
the unusual central bank interventions could potentially have been questioned if the central
banks undertaking these interventions were not seen as independent, credible and committed
to safeguarding price stability.
One lesson I draw from this experience is that the greater the independence and cred-
ibility enjoyed by a central bank in ordinary times, the greater the flexibility to engage in
unusual and forceful corrective policy measures during times of crisis. Independence and
credibility cannot be taken for granted, however, and must be continuously defended, es-
pecially in jurisdictions where the independence of the central bank is not enshrined in a
constitutional treaty. The risk that the corrective actions taken by a central bank during a
crisis become part of a short-sighted political agenda cannot be ruled out.
Another issue that has surfaced in academic debates concerns the appropriateness of
price stability as the primary objective of a central bank. The zero bound on nominal
interest rates suggests that if interest rates are already low under normal circumstances,
the scope of engineering a conventional monetary policy easing by cutting rates is limited.
In light of the recent experience, when several central banks cut short-term nominal interest
rates close to zero, it has been suggested that the price stability objective should be replaced
with the objective of aiming for a stable higher rate of inflation, say 4 percent. This, it is
argued, would provide flexibility for greater policy easing, if needed in the future.
Such proposals to abandon price stability seem to be the unfortunate consequence of a
fundamental misconception about monetary policy. They seem to draw on the false premise
that the zero lower bound on nominal interest rates poses a limit on the effectiveness of
monetary policy to protect against deflation. But when policy rates are close to the zero
lower bound, they no longer suffice as indicators of the monetary policy stance and of how
expansionary monetary policy may be. In these circumstances, unconventional policy mea-
sures acquire an elevated role. To evaluate policy, it is important to look at the complete
policy package, accounting both for conventional and unconventional policy easing. In fact,
monetary policy can continue to engage in unconventional policy easing even without chang-
ing very short-term interest rates near the zero bound. The room for conventional easing
may be limited but the ammunition for unconventional policy easing is unlimited. A more
legitimate concern is that we have much less experience with unconventional policy-easing
measures and face greater uncertainty in calibrating their impact. But this uncertainty is
only a matter of degree. Policymakers also face considerable dynamic multiplier uncertainty
with respect to conventional policy changes.
One of the lessons that can be drawn from the experience with near-zero interest rates
over the past year or so is that, when needed, unconventional monetary policy measures
can be effectively deployed to engineer additional easing to prevent deflation. With this in
mind, I see absolutely no reason to tolerate corrosive higher inflation in order to reduce the
probability that policy rates may occasionally have to be very close to zero.
3 The Strategy of Monetary Policy
There are a number of areas of broad consensus regarding what constitutes good monetary
policy practice. Two such elements are common to the monetary policy strategy of numerous
central banks around the world today, including the ECB. The first is the usefulness of a
clear definition of the central bank's price stability objective, as discussed in the previous
section. The second is a forward-looking policy orientation and the associated monitoring of
economic projections and, in particular, close attention to inflation forecasts and inflation
expectations. Since long and variable lags are an inherent feature of monetary policy, a
forward-looking approach is a necessary part of policy stategy.
Monitoring short-term inflation expectations is valuable because expectations are im-
portant determinants of actual price and wage setting behaviour and thus actual inflation
over time. Monitoring the stability of inflation expectations is also important to gauge the
extent to which a central bank can respond to real economic disturbances without compro-
mising its price stability mandate. When private inflation expectations become unmoored
from the central bank's objectives, macroeconomic stabilisation can be considerably harder
to achieve. Well-anchored inflation expectations facilitate the monetary policy response
to adverse supply shocks, thereby enabling central banks to better stabilise economic fluc-
tuations. Indeed, one lesson from the crisis is the confirmation of this stabilising role of
well-anchored inflation expectations when the economy is under stress.
There is less agreement, however, about a third aspect of monetary policy strategy. This
aspect concerns the degree of policy activism that should be employed as a central bank seeks
to dampen economic fluctuations and address perceived disequilibria. We may distinguish
between two alternative views: the activist view and the stability-oriented view. The activist
view suggests that, in addition to price stability, an equally important goal of monetary
policy is to guide the economy towards attainment of its ideal "potential" level of activity.
That is, an important guide to policy is the "output gap", which measures how far GDP
deviates from its potential. In contrast to the activist view, the stability-oriented approach
could be characterised as attempting to dampen economic fluctuations by promoting stable
economic growth over time, subject to a primary focus on maintaining price stability. The
stability-oriented view more closely describes the monetary policy strategy of the ECB than
the activist view. A perennial debate in monetary economics has raged over how activist
policy should be in terms of closing output gaps. In the next two sections, I review in
greater detail some lessons that can be drawn from the experience of the ECB regarding
these two approaches.
4 Monetary Policy Activism
The activist view is motivated by the fact that the academic literature sometimes poses
the monetary policy problem as the solution to a maximisation problem with not one but
two main objectives: getting inflation as close to its assumed target, consistent with price
stability, and getting real economic activity close to its ideal "potential" level, defined as
the equilibrium or natural level of output that is consistent with price stability.5
Let p and q denote (the logarithms of) the price level and real output, respectively, and
define the rate of inflation π ∆p. Then, using "stars" to mark the ideal target values of
≡
respective variables, we can use to denote the numerical definition of price stability and
π∗
to denote the level of potential GDP.
q∗
The activist approach to monetary policy imparts greater symmetry on closing the
inflation gap (π and the output gap (q than alternative approaches. Thus, to
π∗) q∗)
- -
the extent that this is feasible, activist policies prescribe that monetary policy should not
only focus on achieving its price stability objective (that is closing the inflation gap) but
also on closing the output gap. A constraining factor to achieving both results is presented
in the form of a Phillips curve. A policy tightening can, by opening a negative gap, lead to
dampening inflation pressures and vice versa.
There are two types of activist policies: those that rely on a simple activist policy rule
and those that claim broader optimality properties. The latter can be seen as attempting to
devise a policy plan that balances the inflation and output gaps in the outlook, accounting
as precisely as possible for model dynamics.6,7 The alternative approach, that is relying on
an activist monetary policy rule to achieve an approximate balance, is simpler. A common
reference to the latter approach is the Taylor (1993) rule:
i = + π + + (1)
r∗ θπ(π π∗) θq(q q∗)
- -
where i is the policy rate and the natural or equilibrium rate of interest.8
r∗
5Equivalent definitions may also be expressed in terms of the natural rate of employment and
unemployment and are robust to alternative models of the process of inflation determination, as explained by
Modigliani and Papademos (1975) in the discussion that defined the NIRU (non-inflationary rate of
unemployment) concept.
6The so called "flexible" inflation targeting approach to monetary policy is sometimes presented in this
manner by some authors. See, among others, Svensson (2002) and McCallum and Nelson (2005).
7The intellectual underpinnings of the approach relate to the optimal control approach to monetary policy
that was developed in the 1970s. This was an active area of research to which Lucas Papademos, starting
with his Ph.D. thesis, contributed considerably (Athans et al (1977), Papademos (1977, 1981), Modigliani
and Papademos (1976, 1978).
8Taylor (1999), Orphanides (2003b) and Taylor and Williams (2010) review the development and rationale
for this and related simple monetary policy rules. The specification of such simple rules for a central
bank's policy rate abstracts from the zero-lower-bound problem. As mentioned earlier, unconventional
policy measures come into play when short-term rates approach zero.
Either approach to activism potentially suffers from a crucial practical pitfall: the need
of accurate measurements of the level of potential output to measure the output gap,
(q-q∗).
Output gaps are notoriously difficult to construct in real time, and without reliable estimates
these activist approaches can run into problems.9
Next, I review some illustrative evidence regarding the potential usefulness of the activist
approach drawing on the recent experience of the ECB. However, since the ECB's policy
cannot be characterised by this approach and the ECB does not even publish estimates of
the output gap for the euro area, this illustrative evidence must be based on other sources.
In what follows, I rely on the pertinent analysis presented by the International Monetary
Fund (IMF) in its World Economic Outlook (WEO) publications. The WEO is useful for
two reasons: First, it presents the necessary data and analysis either in the publication
or in the associated electronic databases. And second, in the years examined, the policy
recommendations appear to have been influenced by readings of the output gap and, in this
sense, they have had an activist bent.
Two specific episodes, when the ECB was concerned about inflation and was in a policy
tightening mode, present interesting case studies. They correspond to the Spring 2000
WEO and the Spring 2006 WEO. On both occasions, the economy was growing at a brisk
pace, but, according to the IMF analysis at the time, had not reached its potential. These
are occasions when the differences between the activist and stability-oriented approaches
become easier to isolate.
In the Spring of 2000 WEO, the IMF analysis suggested that the euro area suffered from
a significant output gap that was projected to persist into 2001. (The forecasts suggested
an output gap equal to percent for 2000 and percent for 2001.) This was a factor
-1.2 -0.5
in the assessment that inflation prospects appeared benign and a policy recommendation
that the ECB should hold back on a rapid tightening. Specifically, the IMF noted:
"Higher energy prices will temporarily affect headline inflation in the short term,
but inflationary pressures should remain subdued due to the large output gap
(projected at about 1 1/4 percent in 2000) and increased competitive pressures
caused by the deregulation and restructuring across the area. While the ECB
needs to maintain a strong anti-inflationary stance, and a gradual shift to a less
accommodative stance is to be expected as slack is absorbed, inflation prospects
remain benign and it is important currently to avoid holding back the ongoing
recovery through a rapid tightening of policy" (IMF, 2000, p. 18).
A similar analysis is present in the Spring 2006 WEO, and brings us closer to the crisis.
Again, the IMF projected a significant (negative) output gap for 2006 that was seen as
persisting into 2007. Specifically, the forecasts suggested a euro area output gap equal to
percent for 2006 and percent for 2007. Indeed, the significant negative output
-1.4 -1.3
gap on this occasion was seen as a global phenomenon. Drawing on these estimates, the
Spring WEO noted: "Quiescent inflation, partly because of a significant global output gap,
allowed monetary policy to be very accommodative. Now as the global output gap narrows,
monetary accommodation is being withdrawn" (IMF, 2006, p. xii). The IMF went on
to suggest that the ECB should hold back on its policy tightening: "[W]ith underlying
inflationary pressures contained and domestic demand still fragile, there appears to be no
need to rush to normalize rates" (IMF, 2006, p. 25-26).
On both of these occasions, the ECB emphasised the risks to inflation and continued
its tightening. In retrospect, this proved to have been the right call. Retrospective analysis
using the IMF's subsequent estimates of the output gap can be read as confirmation of the
ECB's policy. How is this so? Simply, the large real-time negative output gap readings for
these two years were subsequently revised away, and eventually became positive estimates
of the output gap. The annual evolution of the estimates for the output gap for 2000,
from Spring 2000 to Spring 2004, and that for the output gap for 2006, from Spring 2006
to Spring 2010, are shown in Figure 3. As can be seen, on both occasions, the real-time
estimate proved to be of the wrong sign and was revised by more than 2 percentage points
over the subsequent four years. Such revisions are not specific to the IMF estimates of
the output gap. The pattern of revisions is rather typical of other estimates as well. For
comparison, the figure shows the evolution of corresponding estimates of the output gap
prepared by the European Commission (EC) each Spring.10
How much does this matter for policy? To get a sense, recall that Taylor (1999) suggested
considering 2 values for the output-gap response coefficient in rule (1), = 1/2 (the classic
θq
rule), and = 1 (the more activist revised rule). Thus, a 2 percentage point revision
θq
in the output gap corresponds to a 100 basis points difference in the classic rule and 200
basis points in the revised rule. Considering the size of typical policy changes, these are
remarkably large.
Figure 4 plots the time series of real-time estimates of the output gap from each Spring
WEO against the latest vintage (Spring 2010). Note also that the real-time estimates appear
to be systematically biased downward. Since the birth of the euro, the real-time estimate of
the euro area output gap in the Spring WEO has been negative every single year. Looking
at the first ten years of this sample (1999 - 2008), on seven of ten occasions, the sign of the
2010 estimate of potential output is the reverse of the sign of the real-time estimate.11 The
average bias for the first ten years is quite large, around 2.1 percentage points. The pattern
of revisions is consistent with a gradual downward update of the rate of growth of potential
GDP, which characterizes various estimates over the past decade.
One reason for the pronounced difference between the real-time and the recent estimates
of the output gap is the dramatic revisions in prospects regarding potential GDP, partly as
a result of the recent crisis. Figure 5 traces successive vintages of the output gap, starting
with Spring 2000 to show how large the revisions were in the early years of the euro area.
Figure 6 plots the successive vintages of the output gap from 2006 to the present. As can
be seen, these estimates vary rather little for the early part of the sample shown but are
drastically different for the past few years. The crisis has forced a reevaluation of the euro
area's productive capacity, as it has elsewhere in the world. According to the Spring 2010
IMF analysis, the output gap of all advanced economies for 2006 and 2007 is now estimated
to have been large and positive ( +0.9 and +1.5 percent, respectively) and not significantly
negative as was projected in 2006 ( and percent, respectively).
-0.6 -0.5
Thus, the crisis has reconfirmed the lesson that activist monetary policy cannot work,
simply because of our inability to possess reliable estimates of the output gap in real time.
All in all, the size of revisions in estimates of the output gap for the euro area, as shown in
the IMF analysis, suggests that the ECB is correct to eschew the activist approach to policy.
This lesson against activism in monetary policy is not new. It is just a reconfirmation of
earlier similar experiences, for example the disastrous experience of the Federal Reserve
during the 1970s when warnings against the activist approach were not heeded.12
5 The Stability-Oriented View and Robust Simple Rules
It is not necessary to rely on activist guidelines to formulate effective monetary policy.
The alternative, stability-oriented approach appears less ambitious. Its relative strength
is in consistently preserving price stability, stressing robustness over optimality. As an
illustration, in this section I provide an example of a simple policy rule along these lines
that I have found useful to monitor, among other things, over the past several years.13
The policy rule is a simple difference rule that can be thought of as providing prescrip-
tions for quarterly changes of the policy rate based on the evolution of inflation and real
GDP growth:
∆i = π∗) + ∆q∗). (2)
θπ(π θ∆q(∆q
- -
Rules of this type have been extensively investigated in quantitative evaluations and have
been found to be robust to various sources of misspecification and to the possibility (in
reality the certainty) of imperfect knowledge on the part of policymakers and of businesses
and households in the model economies.14
The intellectual underpinnings of this rule connect with the writings of Knut Wicksell
at the end of the 19th century and those of Milton Friedman in the middle of the 20th
century, as well as numerous other authors. The common thread is the desire to find a
simple monetary policy guide that can lead to reasonably robust p