Deepak Mohanty: Price stability and financial stability - an emerging market
perspective
Address by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, in the
2012 Central Bank of Nigeria (CBN) Board Retreat, Cape Town, South Africa, 27 June 2012.
* * *
The assistance provided by J.K. Khundrakpam and Rajeev Jain is acknowledged.
"A system of credit which has slowly grown up as years went on, which has suited itself to
the course of business, which has forced itself on the habits of men, will not be altered
because theorists disapprove of it, or because books are written against it." Walter Bagehot,
Lombard Street,1873.
It is indeed an honour for me to be addressing the distinguished members of the Board of
Directors and Senior Management of the Central Bank of Nigeria. I thank Governor Sanusi
Lamido Sanusi for this opportunity. The recent global financial crisis has generated an
intense debate on the role and responsibility of central banks in maintaining financial stability.
Over the centuries, the world has experienced periodic financial crises, prompting changes in
the way we think about monetary and financial stability. Yet, we are not immune from crisis.
In the present context, several questions arise. What ought to be the objectives of central
banks or more specifically that of monetary policy? Is there a trade-off between price stability
and financial stability? Were central banks blindsided by the success of price stability to the
neglect of financial stability? Do central banks have the necessary mandate and instruments
to handle multiple objectives and at the same time maintain credibility? How does one
ensure accountability with multiple objectives? Is there a need to revisit the best practice in
monetary policy? While we currently grapple with these issues, they are by no means new.
Against this background, I sequence my presentation as follows. First, I briefly trace the
evolution of central bank objectives over the centuries. Second, I review central bank
objectives and practices in emerging market economies (EMEs). Third, I highlight our
experience in India in the conduct of monetary policy and how we have combined it with
financial stability. Finally, I conclude by drawing three practical lessons in central banking in
terms of monetary policy framework, institutional design and communication in pursuit of
both monetary and financial stability.
Evolution of central bank objectives
Let me first turn to central banking history for some insights. What was the motivation for
setting up central banks in the 17th century? While the early central banks were set up for
issuance of currency and financing governments, financial stability considerations got
embedded as trade expanded and the banking and financial sectors developed. For
instance, the Swedish Riksbank, the first central bank, was set up in 1668 as a joint-stock
bank to lend funds to the government and to act as a clearing house for commerce. The
Bank of England (BoE) was set up in 1694 to act as the government's banker and
debt-manager.
How did central bank objectives change in the 19th century? Most central banks began
assuming financial stability function though it was not articulated the way we understand it
now. Drawing from the criticism on its functioning during the panics in 1825, 1837, 1847, and
1857, the BoE adopted the "responsibility doctrine" proposed by Walter Bagehot. The
doctrine required the BoE to subsume its private interest to that of public interest of the
banking system as a whole. As per the Bagehot's rule, the BoE was to lend freely on the
basis of any sound collateral offered, but at a penal rate to prevent moral hazard. Thus, the
role of the central bank as the lender of last resort (LOLR) as espoused by Bagehot remains
the cornerstone of financial stability function even today.1
How did central banks change in the 20th Century? The functions of central banks came to
be further aligned with public policy objectives. Frequent bank panics in the US led to the
creation of the Federal Reserve in 1913 with LOLR as one of its main functions. However,
the Fed could not prevent the Great Depression as monetary policy followed the "Principle of
Real Bills Doctrine".2 After the Great Depression, central banks transformed themselves as
growth and employment facilitators and put in place deposit insurance. This kept the world
economy insulated from any major banking crisis from the late 1930s until the mid-1970s.
But fiscal activism and the belief that employment can be permanently increased at the cost
of inflation, supported by the early version of the Phillips Curve,3 led to accommodative
monetary policy. This manifested in high inflation in the 1970s.
In order to address the inflation surge and the accompanying economic stagnation,
intellectual opinion swung in favour of price stability supported by the work of economists like
Milton Friedman, which advocated a dominant role for monetary policy.4 Thus, price stability
emerged as a primary objective of most central banks during the 1980s. How did financial
stability fit into this framework? The understanding around that time was that monetary policy
directed at maintaining price stability would lessen both the incidence and the severity of
financial instability. The argument was that price stability obviates the information problems
for both borrowers and lenders and ensures financial stability through efficient allocation of
resources. Studies based on the experience of advanced countries such as the US, the UK,
Canada and Japan also concurred with the view that price instability contributed to financial
instability (Bordo and Wheelock, 1998).5
Did the financial crisis of the 21st century with its epicenter in the advanced countries change
the world view of central bank objectives? The dominant view, particularly among the
advanced economies, was that monetary policy should ideally have a single objective, a
corresponding single tool, and an operationally independent and accountable central bank. In
fact, following this wisdom, many countries, both advanced and emerging markets, set
explicit inflation targets and mandated inflation control as the paramount objective of
monetary policy since the 1990s. Explicit emphasis on price stability often came with certain
legislative changes in central banks and emphasis on fiscal rules in many countries.
Although central banks were cognisant of the importance of financial stability for conduct of
monetary policy, a distinction between monetary policy and financial stability policy was
generally maintained.
The current global crisis seems to have undermined the view that monetary policy should
only have a single objective of price stability. The pre-crisis view, also called the "Jackson
Hole Consensus", was that central banks should respond to asset prices and financial
imbalances only to the extent that they affect the shorter term inflation forecast. However,
1
The term was first used by Francis Baring (1797) but systematically explained by Thornton (1802) who first
identified it as a function of Bank of England. Thornton, H. (1802), An Inquiry into the Nature and Effects of the
Paper Credit of Great Britain, edited with an Introduction by F.A. von Hayek. New York: Rinehart and Co.,
1939.
2
If only real bills are discounted by banks, the expansion of bank money will be in proportion to the needs of
trade. It was assumed that monetary system will be self regulating.
3
Phillips, A. W. (1958). "The Relationship Between Unemployment and the Rate of Change of Money Wages in
the United Kingdom 1861-1957", Economica, 25 (100): 283-299.
4
Milton Friedman (1968), "The Role of Monetary Policy", AEA Presidential Speech, Amercian Economic
Review, Vol LVIII, No.1.
5
Bordo, Michael D. and David C. Wheelock (1998), "Price Stability and Financial Stability: The Historical
Record", Federal Reserve Bank of St. Louis Review, September/October.
such perception was belied by the recent crisis (Gali, 2011).6 It became clear that financial
stability can be jeopardised even if there is price stability and macroeconomic stability
(Subbarao, 2009).7 Consequently, post-crisis assessment increasingly veered towards
explicit recognition of the financial stability objective. But there are unsettled issues and the
jury is still out.
First, should financial stability be considered as an explicit objective of the central bank or,
more specifically, as an additional objective of monetary policy? It has been argued that
central banks are not only the lenders of last resort, but also better equipped to look at both
financial system and economic cycles. In this context, Eichengreen, Prasad and Rajan
(2011) suggest a dual mandate of price stability and financial stability so that "monetary
policy is recognised as a legitimate element of the macroprudential supervisor's toolkit."8
Similarly, Woodford (2012) argued that monetary policy might indeed lessen the severity of
risks to financial stability.9 Gokarn (2010) was of the view that broader mandates for central
banks will need to be made explicit and conditional on the priority of the core mandates.10 In
contrast, Svensson (2010) argued that it was important to distinguish financial stability policy
from monetary policy to avoid conceptual and practical confusion between the two policies.
Using monetary policy for the financial stability objective can lead to poor outcomes.11
Second, how compatible is inflation targeting framework with financial stability as an
additional objective? The views are quite diverse. While some recommend eschewing of
inflation targeting altogether, Woodford (2012) suggested modifying inflation-targeting
practice for making interest rate policy a more effective tool for financial stability.12 In
contrast, Svensson (2010) opined that flexible inflation targeting remains the best-practice
monetary policy before, during, and after the financial crisis.13
Third, should financial stability be the sole or shared responsibility of the central bank? A BIS
survey shows that in practice an overwhelming majority of central banks have either full or
shared responsibility for financial stability, but the mandates are rarely explicit.14 Similarly,
Čihák (2010) found that the remit for central bank's role in financial stability was weaker than
in the case of price stability.15 The dominant view, however, seems to be that financial
stability should be a shared responsibility, as monetary policy instruments of central banks
can only have a partial impact on the ultimate objective of financial stability.
Fourth, do central banks have the instruments to ensure both price stability and financial
stability? Central banks functioning with a single instrument of short-term interest rate,
6
Gali, Jordi (2011), "Monetary Policy and Rational Asset Price Bubbles", Barcelona GSE Working Papers
Series No.592.
7
Subbarao, D. (2009), "Financial Stability: Issues and Challenges", RBI Bulletin, October.
8
Eichengreen, Barry, Eswar Prasad and Raghuram Rajan (2011), "Central Banks Need a Bigger and Bolder
Mandate", Opinion, Brookings Institution, October.
9
Woodford, Michael (2012), "Inflation Targeting and Financial Stability', NBER Working Paper 17967, National
Bureau of Economic Research.
10
Gokarn, Subir (2011), "Monetary Policy Considerations After the Crisis: Practitioners' Perspectives", RBI
Bulletin, January.
11
Svensson, Lars E O (2010), "Monetary Policy After the Financial Crisis", Speech at the Second International
Journal of Central Banking (IJCB) Fall Conference, Tokyo, September.
12
As in footnote 9.
13
As in footnote 11.
14
Bank for International Settlements (2009), Issues in the Governance of Central Banks, A Report from the
Central Bank Governance Group, www.bis.org/publ/othp04.htm.
15
Čihák, Martin (2010), "Price Stability, Financial Stability, and Central Bank Independence" 38th Economics
Conference at the Oesterreichische Nationalbank, Vienna.
particularly those with inflation targeting framework may not be equipped to achieve multiple
objectives following Tinbergen's assignment rule.16 In this context, many have argued that
interest rate is too blunt an instrument for dealing with overall financial stability issues (for
example, Bernanke, 2011).17 Goodhart (2008) opined that many central banks with only one
instrument of monetary policy may find these two objectives often conflicting with each
other.18 In contrast, it is argued that though identifying the bubble is difficult, and therefore a
risky strategy, the cleaning up cost after the bubble burst may be costlier than leaning
against the bubble (Stark, 2010).19
Finally, there are additional complexities in the context of EMEs as asset price bubbles are
often accompanied by exchange rate appreciation emanating from large capital inflows or
trade surplus. Therefore, raising interest rate in an attempt to burst asset bubble may
engender further capital inflows aggravating the bubble itself. Thus, it has been emphasised
that even if monetary policy is used to lean against the wind, it needs to be supplemented by
counter-cyclical instruments. Some economists believe that combining financial supervision
with monetary policy tasks, as indeed the case in many EMEs, can lead to synergies and a
more effective conduct of monetary policy (Borio, 2009),20 and it can be usefully connected to
the central banks' lender-of-last-resort function (Blinder, 2010).21 Danthine (2012) suggested
that central banks should be endowed with macroprudential instruments that directly target
the root causes of the problems generated by excessive risk taking in times of low interest
rates.22
In this regard, Mohanty (2011) argued that while interest rate continues to be the dominant
instrument for implementing monetary policy, supplementing it by other quantity or
macroprudential instruments even in normal times will enhance the flexibility of monetary
policy to attain multiple objectives.23 Therefore, post-crisis, there has been greater emphasis
on introducing additional instruments for central banks to deal with aspects of financial
stability. In short, the role of central banks in ensuring overall stability of the financial sector
has now got a fresh impetus. Against this background, I turn to the experience of EMEs.
Central bank objectives in emerging markets
How have the central bank objectives in EMEs been different? Historically, price stability has
been a key objective for central banks in EMEs as in the case of advanced economies.
However, given the level of financial market development and institutional structure, financial
16
Tinbergen, J. (1952), On the Theory of Economic Policy, 2nd Edition, North-Holland, Amsterdam.
17
Bernanke, B. (2011), "The Effects of the Great Recession on Central Bank Doctrine and Practice," Speech at
the Federal Reserve of Boston 56th Economic Conference.
18
Goodhart, Charles A.E. (2008), "Central Banks' Function to Maintain Financial Stability: An Uncompleted
Task", http://www.voxeu.org/index.php?q=node/1263.
19
Stark, Jürgen (2010), "In Search of a Robust Monetary Policy Framework", Keynote Speech at the
6th ECB Central Banking Conference "Approaches to Monetary Policy Revisited - Lessons from the Crisis",
Frankfurt am Main, November 19.
20
Borio, C. (2009), "Implementing the Macroprudential Approach to Financial Regulation and Supervision",
Banque de France Financial Stability Review No. 13, 31-41.
21
Blinder, A. (2010), "How Central Should the Central Bank Be?", Journal of Economic Literature, 48(1),
123-133.
22
Danthine Jean-Pierre (2012), "Reconciling Price and Financial Stability", Speech at the University of Zurich,
Zurich, January 24.
23
Mohanty Deepak (2011), "Lessons for Monetary Policy from Global Financial Crisis: An Emerging Market
Perspective", Paper Presented in the Central Banks Conference of the Bank of Israel, Jerusalem, RBI Bulletin,
April.
stability has been important to policymaking, considering the greater incidence of financial
crises in EMEs in the 20th century. Moreover, many of them were also responsible for
macroprudential regulation even though only a few of them directly derive it from the explicit
mandate (Table 1).
Indeed, the resilience of the financial systems in the emerging markets during the recent
global financial crisis owes to financial stability already being an important monetary policy
objective (De Gregorio, 2011).24 Even as many EMEs formally adopted inflation targeting
(e.g., Chile, Brazil, South Africa, Indonesia, Thailand and Mexico), in practice they followed a
"flexible inflation targeting" framework, as discretion was used to respond to shocks and also
to pursue other objectives.25 EMEs which did not formally adopt inflation targeting (e.g.
China, Nigeria, Malaysia and India) have price stability as one of the key objectives of
monetary policy (Table 2).
Multiple instruments, including quantitative tools such as the cash reserve ratio, were used to
moderate the pace of domestic credit growth as well as monetary impact of large capital
inflows in China, India and Russia. In the East Asian EMEs, the importance of financial
stability and the need to prevent financial imbalances by active use of macroprudential policy
measures was emphasised after the Asian crisis. Accordingly, central banks were given
either the sole or shared responsibility in pursuing financial stability in addition to the
traditional mandate of monetary stability (Watanagase, 2012).26 In South Africa, the
prudential regulation and supervision of banks assisted and complemented the central bank
in its pursuit of financial system stability. Similarly, the Central Bank of Brazil actively used
macroprudential measures to deal with emerging financial risks, particularly from excess
capital flows in the economy. According to a BIS survey (2010), EMEs significantly
outnumbered advanced economies as users of some type of macroprudential instrument.27
Global financial crisis highlighted the importance of using a broader set of instruments for
financial stability. In this regard, most central banks in EMEs where monetary policy and
prudential supervision were within their purview seem to have been better equipped to
address financial stability issues as compared to advanced economies. Now, I turn
specifically to our experience in India.
Financial stability: Indian framework
The core functions of the Reserve Bank of India (RBI) are enshrined in the preamble to the
Reserve Bank of India Act, 1934 as, "to regulate the issue of bank notes and keeping of
reserves with a view to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage". In addition, the RBI is also
microprudential regulator as the Banking Regulation Act, 1949 entrusts it with the power to
regulate and supervise commercial banks and co-operative banks. The RBI also regulates
24
De Gregorio, José (2011), "Price and Financial Stability in Modern Central Banking", Keynote Speech,
Governor of the Central Bank of Chile, at the joint Latin American and Caribbean Economic Association
(LACEA)-Latin American Chapter of the Econometric Society (LAMES) Conference 2011, University Adolfo
Ibáñez, Santiago, November 11.
25
Flexible inflation targeting (IT) framework which requires achievement of the desired inflation target over the
medium-term makes it easier for central banks to look not only for price stability, but also consider other
variables, such as the output gap or the exchange rate. In a sense, flexible IT also implies a departure from
the corner solutions of the 'Impossibility Trinity' of fixed exchange rates, independent monetary policy and
perfect capital mobility.
26
Watanagase Tarisa (2012), Remarks at Monetary Policy Workshop on Strengthening Macroprudential
Frameworks organised by IMF Regional Office for Asia and Pacific (OAP) March 22-23, Tokyo, Japan.
27
Bank for International Settlements (2010), "Macroprudential Instruments and Frameworks: a Stocktaking of
Issues and Experiences", CGFS Papers, No. 38.
and supervises non-banking financial companies (NBFCs) under the Reserve Bank of India
Act, 1934. Similarly, the Foreign Exchange Management Act, 1999 empowers it to regulate
the foreign exchange market and the oversight of the payment systems is derived from the
Payment and Settlement Systems Act, 2007.
Drawing from a wider mandate, monetary policy in India has evolved to have multiple
objectives of price stability, financial stability and growth. These objectives are not inherently
contradictory, rather mutually reinforcing. The Reserve Bank's approach recognises that
price and financial stability are important for sustaining high levels of growth which is the
ultimate objective of public policy. The Reserve Bank's approach to financial stability has
been proactive and preventive rather than reactive. Its role as monetary policy authority, well
integrated with macroprudential regulation and microprudential supervision, with an implicit
mandate for systemic oversight has enabled the Reserve Bank to exploit the synergies
across various dimensions (Subbarao, 2011).28
Even before the crisis, the institutional arrangement in the financial sector was already in
place for inter-regulatory co-ordination to monitor financial stability in the economy. A High
Level Co-ordination Committee on Financial Markets (HLCCFM) was set up in 1992 with the
Governor of the Reserve Bank as Chairman, and the Chiefs of the Securities and Exchange
Board of India (SEBI), the Insurance Regulatory and Development Authority (IRDA) and the
Pension Fund Regulatory and Development Authority (PFRDA), and the Finance Secretary
to Government of India as members. However, post-crisis, the collegial approach to financial
stability has been further strengthened by constituting the Financial Stability and
Development Council (FSDC).
The FSDC, headed by the Finance Minister, was set up in December 2010 in the wake of the
global financial crisis with a specific mandate, inter alia, for systemic financial stability. The
FSDC is expected to deal with issues relating to financial stability, financial sector
development, inter-regulatory co-ordination and macroprudential supervision of the economy
including the functioning of large financial conglomerates. A Sub-Committee of the FSDC,
headed by the Governor of the Reserve Bank, replaced the HLCCFM and is the primary
operating arm of the FSDC. This Sub-Committee has also set up a dedicated Crisis
Management Framework.
In addition, various committees of the Reserve Bank's Central Board monitor financial
stability issues: the Board for Financial Supervision reviews the Reserve Bank's supervisory
and regulatory initiatives and the Board for Payment and Settlement Systems oversees the
overall functioning of the payment system.
Another development signifying the Reserve Bank's role in the context of financial stability is
the setting up of Financial Stability Unit in the Bank in July 2009 with a mandate to conduct
effective macroprudential surveillance of the financial system on an ongoing basis and
enable early detection of any incipient signs of instability. The Reserve Bank also brings out
biannual Financial Stability Reports. Incidentally, the IMF has just concluded a Financial
Sector Assessment Programme, which in fact comes close on the heels of a comprehensive
self assessment of financial sector carried out by the Reserve Bank. Thus, the RBI is one of
those central banks to recognise financial stability as one of the objectives of monetary policy
even before the crisis.
Lessons for central banks
In my opinion, the global financial crisis has fundamentally altered the way we used to view
monetary policy and financial stability and the interface between them. However, there are
issues which entail further work in three key areas. First, a relook at monetary policy
framework in terms of both objectives and instruments towards a clear recognition of
financial stability. Second, to put in place an appropriate institutional mechanism drawing
upon countries' own experience and history for better co-ordination among the concerned
regulatory entities to deliver on financial stability. Third, address the communication
challenge of multiple objectives to preserve central bank credibility to ensure price and
financial stability. Let me now elaborate on each of these three aspects.
(i) Monetary policy framework
The view that monetary policy framework should allow policymakers to lean against the
build-up of financial imbalances, even if near-term inflation expectations remain anchored, is
gaining importance. While there is little doubt that monetary policy framework of central
banks needs to change, the moot point is what should be the ideal monetary policy
framework for better analysis of the macroeconomic effects of financial imbalances? One
approach could be to formally broaden the set of information variables for monetary policy
decision making: in a way, for example, the two pillar approach of the ECB or the multiple
indicators approach of the Reserve Bank of India that factors in financial considerations into
monetary policy.29 The multiple indicators approach has the advantages of broad-basing
monetary policy operations on a large set of information such as money, credit, asset prices,
interest rates and exchange rate and providing flexibility in the conduct of monetary
management. Such approach, however, may involve a greater element of judgment.
At an operational level, the most widely accepted presentation of monetary policy reaction
function that combines both inflation and growth objectives is the "Taylor Rule". The Taylor
rule can be augmented by adding financial variables to the standard monetary reaction
function based on inflation and the output gap so as to enhance central banks' ability to react
to financial stability concerns. However, efficiency of such a formulation needs to be tested.
Whichever framework is adopted, there should be flexibility for the central bank to respond to
potential imbalances and the risks, apart from growth and inflation control.
(ii) Institutional design for better coordination
The recent crisis and the subsequent response have shed new light on the critical role of
central banks in promoting financial stability. However, it needs to be recognised that this
added responsibility should not come at the cost of their conventional role for price stability.
This is more relevant particularly for central banks in EMEs which admittedly, are yet to
achieve that level of credibility as their advanced economy counterparts. For many EMEs,
exchange rate stability is an important objective, and without price stability it is not possible
to maintain exchange rate stability. Furthermore, the financial markets and institutions have
grown in complexity, the oversight and regulation of which could be beyond a single entity
such as the central bank. Hence, financial stability would have to be a joint responsibility,
though the central bank could have a dominant role by virtue of it being the natural lender of
last resort. However, there is a need to explicitly incorporate the financial stability role of the
central bank into its statute to establish an accountability framework.
The challenge for a central bank is to achieve multiple objectives without losing credibility as
a monetary authority solely responsible for price stability. This would be possible only if
policies implemented by various stakeholders in financial stability are coherent. Accordingly,
an appropriate design for co-ordination mechanism is required to derive synergies between
monetary policy and macroprudential policy and make more effective use of policy tools
available with multiple bodies having the mandate of financial stability.
The design of co-ordination mechanism may, however, vary across countries depending on
the nature and size of their financial systems and their own historical experience. In fact,
efforts towards greater institutionalisation of co-ordination mechanism have already begun.
Most prominent examples are the newly created bodies, both in advanced countries and
EMEs, like the Financial Stability Oversight Council in the US, the Financial Policy
Committee (Interim) in the UK, the European Systemic Risk Board for the European Union,
Financial Regulation and Systemic Risk Council in France, Financial Stability Council in
Chile, Council for the Stability of the Financial System in Mexico and Financial Stability and
Development Council in India (Table 3). In some other countries, financial stability framework
has been strengthened by setting up committees in central banks to gauge systemic risk
(e.g., Brazil in 2011).
Under the new institutional design, as shown in Table 3, though financial stability has been
recognised as a shared responsibility, central banks have been assigned the lead role in
most of the countries. Even as details of the newly created bodies differ, the thrust is the
same, i.e., better co-ordination to gauge systemic risks and plan an appropriate response.
Furthermore, with increasing sovereign risk concerns in a number of economies, particularly
the advanced economies, better policy response is expected as fiscal authorities are also a
part of the new institutional framework for financial stability. However, even under the more
collegial approach to financial stability, policy co-ordination is not going to be so easy,
especially when there is a problem of time-inconsistency and the objective functions of the
authorities may not always be the same (Praet, 2011).30 It is also important to guard against
the risk that active involvement of governments should not bring back fiscal dominance and
compromise the autonomy of each regulator and the central bank.
(iii) Central bank communication
In a market-determined system, central banks have placed a greater reliance on
transparency and communication to enhance monetary policy transmission and establish
accountability to the public for their decision-making. So far the experience shows that
communication on monetary policy issues has moved from complete secrecy, to constructive
ambiguity to transparency. For instance, the Fed and the ECB have in recent years
frequently provided fairly direct indications about future interest-rate decisions in their official
statements. We, in the RBI, have also started giving forward guidance since September
2010. However, there are several challenges.
It is not easy to communicate clearly on a single objective. Going forward, as central banks
broaden their mandates and institutional design grows in complexity, so also will the
communication challenges. For example, if a central bank were to ease monetary policy on
financial stability concerns even when inflation is high, it risks unhinging of inflation
expectations, which in turn could complicate financial stability.
During the recent crisis, there were many instances of communication challenges faced by
central banks. For instance, the US Fed faced communication challenge with regard to
quantitative easing and the exit policy of its unconventional measures. We, in the RBI, had to
face communication challenge when we reduced cash reserve ratio (CRR) of banks in
January and March 2012 on liquidity concerns even when inflation was above our tolerance
level. While some interpreted it as premature reversal of tight monetary policy stance, others
saw this as a pure liquidity action not inconsistent with our monetary stance.
If the policy measures are not properly guided and not understood as intended, they may not
transmit the right signal and eventually prove to be a noise to financial market entities.
Guidance by central banks, at best, could be conditional because of the provisional nature of
immediate available information set, limitations of macro models, incomplete knowledge and
uncertainties about the evolution of the economy and periodic unanticipated shocks. Thus,
transparency in communication is a double-edged sword which at times could produce
unintended consequences. As central banks broaden their objectives so also they have to
hone their communication skills.
Conclusion
To sum up: Financial stability as an objective of central banks has turned a full circle from
being the predominant objective, to a virtual neglect to being reinstated recently as an
important objective drawing on the lessons of global financial crisis. However, financial
markets and institutions have grown in complexity making it difficult for a single entity to
deliver on financial stability. Therefore, financial stability has to be a shared responsibility
wherein central ba