[7] Tobias Adrian and colleagues at the IMF find that augmenting conventional monetary policy with foreign exchange interventions and capital flow measures in emerging market economies may improve their monetary policy trade-offs. [8]  The fundamental premise of an integrated policy framework is the recognition that policies that are independent in execution are often interdependent in their effects. If fiscal policy is not sound, fiscal dominance concerns will undermine monetary policy credibility. If the financial system is not sound, financial dominance concerns may compromise monetary policy. Fiscal stability may also be put at risk. In an integrated policy framework, the objectives of monetary, macro-financial, and fiscal policies do not need to change. But the way these objectives are pursued cannot ignore their implications for financial stability and price stability. Specifically, an integrated policy framework must seek to avoid the unsustainable build-up of debt which is the root cause of much financial instability. For monetary policy, it means providing a credible anchor for price stability in a way that does not lead to an unsustainable increase in leverage in the economy. For macroprudential policies, it means leaning against an unsustainable expansion of credit, inflation in asset prices, and the excessive build-up of debt in the economy. For fiscal policy, it means ensuring that public debt is sustainable and does not become a source of financial vulnerability in the economy. MACRO-FINANCIAL POLICIES The second key proposition: financial sector vulnerabilities are best addressed using a variety of macro-financial policies in a coherent manner.

As pointed out by Markus Brunnermeier, the willingness of central banks to continue making large purchases of private assets long after the end of the Global Financial Crisis has led to “a build-up of private debt, depressed credit spreads, distorted price signals, and high house prices from increased mortgage lending.” [12] The second concern is the feedback loop from these vulnerabilities constraining future monetary policy options. If these vulnerabilities are significant, the central bank may be concerned that the tightening of monetary policy necessary to bring down inflation to target could trigger financial instability – in other words, financial dominance. A practical way monetary policy could minimise the risk of financial dominance is to use inflation targeting more flexibly. A criticism of inflation targeting is that it has been too much of a straitjacket on monetary policies: for example, keeping interest rates low for long to get inflation up to the target of 2% led to a build-up of financial vulnerabilities. I think the problem is not with inflation targeting per se but with not using it flexibly enough. There are two ways in which inflation targeting can be pursued more flexibly to minimise financial vulnerabilities. One, take time to bring inflation back to target. The BIS, for instance, advocates lengthening the monetary policy horizon to take financial stability consequences of monetary policy more fully into account. [13] But allowing inflation to persist for too long away from the target runs the risk of unhinging inflation expectations.