Journal of Political Economy 85: 473–492. 2  The advantage of tying oneself to economic policy objectives does not conflict with the ability of economic policy to stabilise the economy at the same time. On the contrary, a credible commitment to objectives can provide greater leeway for stabilising the economy. See, for example, Michael Woodford (2003) “Interest and Prices”, Princeton University Press. BIS central bankers’ speeches  3  The clearest expression of this lesson was found in monetary policy. In Norway, the authorities set an objective for the value of the krone, but devalued when the krone came under pressure. The devaluations were over time incorporated into expectations and inflation surged. It is tempting to quote Hermod Skånland, who stated that Norway “early and with great perspicacity” charted a course for economic policy – and thereafter promptly embarked on a different path. 3 During the upturn in the mid-1980s, the interest rate was held low and public spending was high. The economy became vulnerable. When oil prices fell in 1986, a change of course became imperative. All efforts were concentrated on bringing public spending under control. Interest rate setting was geared towards maintaining a steady krone exchange rate. The aim was to bring down inflation close to the level prevailing in other countries. The banking crisis and the downturn in the early 1990s led to renewed recognition that market forces had to be controlled and banks regulated. An approach based on broad economic policy cooperation was pursued.

This narrow view is unlikely to survive a broader analysis that takes into account all the interactions between financial markets and real economic activity. If more restrictive monetary policies were pursued to generate higher interest rates, they would likely result in higher unemployment and a sharp decline in asset prices, choking the moderate recovery. Such an adverse economic outcome is unlikely to set a favorable foundation for financial stability. Moreover, our short-term interest rate tools are too blunt to have a significant effect only on those pockets of the financial system that are most prone to inappropriate risk-taking. At the same time, these blunt tools could significantly damage other markets, as well as the growth prospects for the economy as a whole. Therefore, stepping away from otherwise appropriate monetary policy to address potential financial instability risks would degrade progress toward maximum employment and price stability. This approach would be a particularly poor choice when other tools are available, at lower social costs, to address the risk of financial instability. Let me be clear. I am not saying that financial stability concerns are not relevant for the economy or that policymakers should not take decisive action against developments that threaten financial stability. Rather, I am saying that the macroprudential tools available to policymakers are better-suited safeguards to addressing financial risks directly. These macroprudential actions can be dialed up or down given the appropriate setting of monetary policy tools; so, undesirable macroeconomic outcomes are less likely than if we were to resort to premature monetary tightening.