1. Inflation Targeting and Financial Stability
Scott Roger, IMF
IMF - CAPTAC-DR
2-11 November 2010
Scott Roger

2. Overview and Issues
financial crisis has raised significant concerns about monetary policy frameworks, including IT:
Should financial stability be made an explicit objective of monetary policy?
How can monetary policy take better account of financial developments and vulnerabilities?
What should be the relationship between monetary policy, macro-prudential, and micro-prudential policies?
All 3 issues are active areas of research and debate.

3. IT and financial stability
Should financial stability be an explicit objective of monetary policy? General consensus is no:
Adding additional objective would compromise commitment to price stability, weakening credibility.
Macro-prudential policies are likely to be more efficient in addressing financial vulnerabilities and imbalances.
Monetary policy can still take financial stability concerns into account, even if not an explicit objective (like growth or exchange rate)

4. Taking financial stability into account in IT
Monetary policy needs to take better account of financial developments and vulnerabilities. First priorities:
Need to strengthen understanding and modeling of financial transmission and effects of prudential measures
Standard monetary policy models do not include financial sectors and have very simplified representation of financial transmission.
Limited understanding of behavior of financial firms and interactions between them.

5. Taking financial stability into account in IT
Need to strengthen modeling and analysis of housing market and business finance-production link.
Need to strengthen monitoring of financial developments and vulnerabilities, and bring systematically into policy decision making and communications.
Both areas are current priorities for central banks and financial supervision agencies.

6. Taking financial stability into account in IT
Issue of how to factor financial stability into monetary policy. Different views:
Discretionary approach. Reflects difficulty in defining financial stability, uncertain financial transmission, need for flexibility in handling policy trade-offs. Flexible, but not very transparent. May also be biased toward no action.
Lengthen policy horizon. This brings gradually emerging financial imbalances into the relevant policy horizon. More gradual response to inflation developments also gives more room to respond to financial imbalances or risks.

7. Taking financial stability into account in IT
Rules-based approach. Reflects concern for policy transparency, and accountability, as well as potential policy inertia.
Approach adds financial stability indicator to policy reaction function. Need to determine:
Appropriate indicator, trend value, and whether level or changes matter;
Appropriate weight to place on indicator;
Relevant policy horizon (use forecast, current, or lagged indicator).
Rule needs to be supplemented with discretion, and reviewed as knowledge is gained.

8. Financial stability policies
Recognition that financial stability policies need to have a more macro perspective:
More systemic focus (not institution by institution)
More attention to procyclicality (problem with Basel II)
Design of macroprudential “tools” still need to be worked out as well as appropriate institutional arrangements. But central bank will need to be closely involved in both, and use of policies taken into account in monetary policy.

9. Policy coordination and cooperation
Monetary and financial stability policies overlap and are interdependent. Need for coordination and cooperation. How?
Need for information sharing arrangements among financial supervisors to get overall picture;
Need for decision-making process that includes all relevant players, but that is accountable;
Need decision making body that has an important degree of autonomy from political and monetary policy decision making.

10. Policy coordination and cooperation
Europe and US opting for financial stability councils including central bank, but not part of central bank. In other cases, body may well be in the central bank (financial stability department?), but location is less important than effectiveness.