lorenzo bini smaghi : lessons for monetary policy from the recent crisis speech by mr lorenzo bini smaghi, member of the executive board of the european central bank, at the roundtable “ l ’ euro e la crisi internazionale ”, milan, 19 january 2011. * * * introduction the financial crisis has been a very challenging period for policy - makers worldwide, not least for monetary authorities. central banks have lowered interest rates to levels close to zero and implemented a broad range of unprecedented non - standard policy measures. the recent experience offers, i think, five lessons from which monetary policy - makers can learn. let me list them upfront, before turning to each of them – in that order – in my remarks today. 1. central bank independence remains critical to delivering price stability, particularly during crises. 2. a clearly defined objective of price stability is essential to firmly anchor inflation expectations, which can act as an automatic stabiliser during a crisis. 3. monetary policy should be oriented to the medium term. trying to fine - tune monetary policy on the basis of indicators, such as output gaps and measures of core inflation, which are either subject to ex post revisions or are misleading, may – and often does – induce an excess short - termism and entail serious risks. 4. monetary and financial variables should be a key input in the assessment of medium to long - run risks to price stability, particularly during financial crises. 5. finally, price stability and financial stability are complementary. the new macroprudential function and monetary policy reinforce each other. 1. central bank independence remains critical the value of central bank independence is the first, lasting lesson. of course, central bank independence is a sine qua non of effective monetary policy, at all times and under all possible circumstances. if a central bank is not independent, policy - makers from other quarters have strong incentives to pass on to the bank problems and responsibilities for which they, in fact, are to be held accountable. this – always – leads to a blurring of responsibilities and potentially to a loss of trust, which ultimately undermines the effectiveness of monetary policy. 1 but in times of crisis the value of independence rises even further. in perturbed market conditions central banks may have to implement extraordinary measures, both in terms of reducing policy rates to unprecedented levels, and in terms of unconventional liquidity measures. if these measures – untested as they are – are to be expected to exert

. but as soon as monetary policy in the 1980s changed paths and embarked on decisive stabilisation, and inflation risks subsided, house prices started to plummet, making the disinflationary recession more painful. so, lack of price stability generates financial volatility and financial volatility aggravates macroeconomic uncertainty. a second channel through which monetary policy can contribute to financial stability is through its lender - of - last - resort function. when financial markets become dysfunctional and the monetary transmission channels are no longer working properly, monetary policy has a role to play in supporting the liquidity conditions of solvent and illiquid banks. i mentioned this before – when i described the ecb ’ s reaction to the crisis. third, more recent analysis has drawn attention to a channel through which monetary policy might also – unintentionally – influence the perception of risk by financial markets and thus, ultimately, the assumption of risk by financial agents : the so - called risk - taking channel. 14 financial institutions apparently increase their leverage during booms and reduce it during recessions. thus, contrary to common assumptions, financial institutions ’ leverage is procyclical ; the expansion and contraction of balance sheets amplifies, rather than counteracts, the credit cycle. protracted loose monetary conditions can foster excessive risk - taking and, consequentially, produce a build - up of financial imbalances. if not accurately controlled, this channel can add to the pro - cyclicality of financial markets. now, you have two ways to counter financial pro - cyclicality. the first is through a monetary policy regime that is not centred exclusively on inflation, but leans against the wind of financial imbalances. what does this mean? it means, for example, implementing a tighter policy in the face of financial exuberance than would be justified by the same inflation outlook in more tranquil market conditions. it means tolerating a downdrift in inflation in exchange for some more insurance against greater and more disruptive risks to price and financial stability in the longer run. the second way to counter financial pro - cyclicality is through macro - prudential supervision, a new perspective of macroeconomic control. macro - prudential supervision aims to support the stability of the financial system as such and seeks to dampen its pro - cyclicality by eliciting regulatory and supervisory instruments. from the central bank ’ s perspective, this implies that macro - prudential