How can we rearrange the pre-crisis monetary policy to guard financial stability as well as price stability?

My recent commentaries about monetary policy concluded on the pressing need for a new institutional regulation. For instance, my last commentary concluded, “We had better return to the inflation targeting regime. Also, it is possible to strengthen this regime in a way that it also safeguards financial stability. To this end, we need to consider options to transfer certain powers of the Banking Regulation and Supervision Agency to the Central Bank of Turkey (CBT).” I also explained why I have reached such conclusion. I want to summarize these neatly. Starting with today, I will talk about “the search for a new monetary policy.” 

Price stability is the priority
This is how the debate starts in my consideration: is the main objective for most central banks operating in open market economies. This does not imply that central banks do not regard financial stability. On the contrary, as the CBT Law also suggests, central banks have duties with respect to financial stability, as well. Some countries, including Turkey, have established separate institutions responsible mainly for regulating and supervising financial stability while some others delegated this power to the central bank. What is important here is not related to the authority responsible for protecting financial stability: Before the global crisis, theory of monetary economics and monetary policy was built upon the main objective of maintaining price stability. It was assumed that monetary policy contributes to financial stability indirectly via maintaining price stability.

Inflation rates have been standing at significantly low levels in many countries since the late 1990s. Table 1 shows the change in inflation rate by country groups and world average since 1980. According to this, the highest average consumer price inflation throughout the world was recorded in the 1990-94 period since 1980. After this period, price stability has been secured in developed countries and inflation rates tended down remarkably in developed ones. Albeit, global financial crisis has erupted: price stability does not necessarily guarantee financial stability. 

How to devise a new policy?
This brought about a critical question about how to rearrange the pre-crisis monetary policy to guard financial stability as well as price stability. The question is not as to whether to delegate the authority to regulate and supervise the financial system back to central banks. Then, the problem would not be interesting at all. There is no harm in exaggerating the situation: How many branches Bank X has or whether Bank Y can take a foreign partner is of importance for financial stability. But these have nothing to do with monetary policy. It is clear that, even if regulating these were among the powers of central banks, the decisions to be taken in this context would be out of the scope of monetary policy. Therefore, the matter of debate here is not whether or not central banks shall have such powers. It is how to design a monetary policy perspective which will safeguard financial stability.

* Turkey is involved in the Central and Eastern Europe region.

Source: IMF World Economic Outlook database

This commentary was published in Radikal daily on 21.01.2012