For example, if an asset bubble has caused a buildup of debt that now needs to be reduced significantly, then lower interest rates that ease financial conditions may not stimulate aggregate demand very much. Separately, in a protracted zero bound episode, the monetary policy impulse may become attenuated over time. Lower interest rates may make financial conditions easier, lifting wealth, and encouraging households to shift spending from the future to the present. But when the future arrives, spending may then be lower as a consequence. The linkage between financial conditions and economic activity may vary depending on how long the accommodative monetary policy regime has been in place. So what are the implications that stem from the fact that financial instability can impair the efficacy of monetary policy? I think there are at least three major implications:   The central bank has a strong stake in preventing financial instability.   When financial instability occurs, the central bank has an important role in taking steps to mitigate that financial instability. This includes ensuring that credible liquidity backstops are available and forcing banks to strengthen themselves, for instance by raising additional capital.   The stance of monetary policy needs to be judged in light of how well the transmission channels of monetary policy are operating. When financial instability has disrupted the monetary policy transmission channels, following simple rules based on long-term historical relationships can lead to an inappropriately tight monetary policy. Let me now consider each of these implications in turn.

Although the BoJ response was appropriate relative to the economic forecasts that prevailed at the time, those forecasts proved much too optimistic. Thus, policy was insufficiently accommodative with the benefit of hindsight. To a lesser degree, the same critique also applies to the United States. Despite an aggressive shift towards greater monetary policy accommodation in 2008 and 2009, and ongoing subsequent easing – which has supported a return to growth and helped to facilitate needed adjustments in housing and household balance sheets – the economic recovery has been consistently weaker than forecast. As a result, the Federal Reserve has fallen short of meeting its employment and inflation objectives. This suggests that with the benefit of hindsight, U.S. monetary policy, though aggressive by historic standards, was not sufficiently accommodative relative to the state of the economy. In this regard, I would caution against the mechanical use of monetary policy rules following a financial crisis. In the United States, the so-called Taylor Rule receives considerable attention as a guide to policy. But there are a number of reasons to believe that using it mechanically would result in too tight of a monetary policy setting. While discussing the shortcomings of the Taylor Rule is beyond the scope of my remarks today, let me make one simple point. If the transmission channels of monetary policy are impaired, then the equilibrium real rate associated with monetary policy neutrality is likely to be considerably lower than the 2.25 percent real rate assumption embodied in the typical Taylor Rule formulation.