Academic journal article Federal Reserve Bank of St. Louis Review

Challenges for Monetary Policy in the European Monetary Union

Academic journal article Federal Reserve Bank of St. Louis Review

Challenges for Monetary Policy in the European Monetary Union

Article excerpt

This article was originally presented as the Homer Jones Memorial Lecture, organized by the Federal Reserve Bank of St. Louis, St. Louis, Missouri, April 13, 2011.

Federal Reserve Bank of St. Louis Review, July/August 2011, 93(4), pp. 235-42.

Four years ago, I was invited to give a speech in Paris. Its title--"From Academic to Policy Maker"--referred to the fact that I started out as an academic (Weber, 2007). I began that speech by mentioning a number of other academics who went on to become central bankers: Mervyn King, Ben Bernanke, Janet Yellen, Bill Poole, and Otmar Issing, to name but a few.

I continued by analyzing why there are so many academics in monetary policy. James Bullard, by the way, is another case in point, whom I did not mention at the time because he was not yet in his current position. One of the main reasons why, over the past years, academic researchers have been taking up leading positions at central banks is that monetary policy itself has been heavily influenced by the findings of academic research. During the financial crisis, monetary policy and economies across the world have benefited significantly from these insights since they have helped us to swiftly apply the appropriate policy responses to contain the crisis. Conversely, the crisis has also raised important issues for academic research in monetary economics as well as in other fields.

As of next month [May 2011], after seven years as a policymaker, I shall be taking up the position of a faculty member of the University of Chicago Booth School of Business. In spite of this upcoming transition "from policymaker to academic," my remarks on the challenges for monetary policy in the European Monetary Union (EMU) are from the policymaker's perspective.

THE FINANCIAL CRISIS AND ITS LESSONS FOR MONETARY POLICY

The financial crisis has brought the "monetary policy consensus" formed in the years prior to the crisis under scrutiny (Bean et al., 2010). The framework of monetary policy differed significantly from one central bank to another. Nevertheless, across the board their primary objective was price stability--defined as a stabilization of the inflation rate at around 2 percent across a horizon of approximately two years. Steering short-term interest rates was considered a sufficient means of achieving this target. Central bank forecasts played a key role in monetary policy decisionmaking, with monetary aggregates increasingly taking a backseat in many forecast models.

Furthermore, capital markets were mostly assumed to be efficient, meaning that financial imperfections and their potential macroeconomic

effects were not taken into account. Temporary inefficiencies, such as asset price bubbles, were considered possible, but the majority view was that monetary policy could do little to counteract such developments.

Microprudential supervision was regarded as a sufficient means of containing risks in the financial sector. Monetary policymakers should intervene only after a financial crisis had occurred, minimizing the macroeconomic damage through resolute interest rate cuts.

Even though monetary policy proved indispensable and highly successful in containing the crisis and preventing a meltdown of the financial system, events have cast doubt on this consensus. The question now is whether and to what extent monetary policy should take account of financial market developments before a crisis occurs (Deutsche Bundesbank, 2011c; also see the following section). Let me elaborate on some aspects of this in greater depth.

A Stronger Role for Financial Markets in Monetary Policy Analysis ...

Given the genesis of the crisis, it is undeniable that monetary policy with too short a policy horizon can fail to take account of financial imbalances that eventually spill over to the real economy, thus jeopardizing price stability. So, how should monetary policy incorporate the experience of the crisis into its decisionmaking process? …

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