Policy rules

Monetary economists like rules. Traditionally, they worry that policymakers will sacrifice the long-term benefits of price stability for the more immediate gratification of higher growth. Realizing how hard it is to resist temptation, politicians have delegated monetary policy to a central bank that is independent, but subject to a mandate that constrains their discretion. This institutional setup helped lower inflation in the advanced economies from a median exceeding 10 percent in the late 1970s and early 1980s to about 2 percent by the late 1990s.

But, convinced that overly accommodative financial conditions in the first few years of the century spurred the credit accumulation that fed the 2007-09 financial crisis, there is a push to constrain central banks further by requiring that they publish and account for their actions with reference to a simple policy rule...

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Monetary Policy and Financial Stability

In June 2015, a committee of Federal Reserve Bank Presidents conducted a “macroprudential tabletop exercise”—a kind of wargame—to determine what tools to use should risks to financial stability arise in an environment when growth and inflation are stable. The conventional wisdom—widely supported in policy pronouncements and in a range of academic studies—is that the appropriate tools are prudential (capital and liquidity requirements, stress tests, margin requirements, supervisory guidance and the like). Yet, in the exercise, the policymakers found these tools more unwieldy and less effective than anticipated. As a result, “monetary policy came more quickly to the fore as a financial stability tool than might have been thought.”

This naturally leads us to ask whether there are circumstances when central bankers should employ monetary policy tools to address financial stability concerns. Making the case for or against use of monetary policy to secure financial stability is usually based on assessing the costs and benefits of a policy that "leans against the wind" (LAW) of financial imbalances...

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