Long term perspectives on central banking
6. Sticking to the Rules
The history of central banking just surveyed teaches us that the first responsi-bility of a central bank is to maintain price staresponsi-bility. If the central bank is suc-cessful in maintaining a stable and credible nominal anchor then real economic stability should obtain although in the event of adverse shocks central banks should follow short-run stabilization policies consistent with their objective of price stability.
History also suggests that central banks should serve as lenders of last resort to the money market in the face of liquidity shocks. Lender of last resort policy involves temporarily expanding liquidity and then returning to the path consis-tent with price stability. The central bank should preferably do this by open market operations rather by discount window lending to individual banks, to let market forces chose the recipients of funds rather than relying on discretion (Goodfriend and King 1988). But if the discount window is to be used, loans should be made only to solvent institutions. Bailouts should be avoided.
The historical examples of 1929 and Japan suggests that the tools of monetary policy should not be used to head off asset price booms—following stable monetary policy should avoid bubbles. In the event of a bubble however, whose bursting would greatly impact the real economy, non monetary tools should be used to deflate it (Bordo and Jeanne 2002). The comparative advan-tage of the policy rate is to influence the money market and not asset prices (Bean et al 2010). Using the tools of monetary policy to achieve financial sta-bility (other than LLR) would reduce the effectiveness of monetary policy for its primary role.
History also suggests that the central bank should protect the payments me-chanism and be ready to provide liquidity assistance only to institutions which provide means of payment. The role of a central bank is not to protect non bank financial institutions which do not provide means of payment. The su-pervision and regulation of these institutions should be handled by other regu-latory authorities. Finally the history of inflations past and the recent financial crisis teaches us that central banks should be independent of the fiscal authori-ties.
In sum the events of the recent crisis leads to the conclusion that central banks should stick to following the rules to maintain price stability. Flexible inflation targeting as practiced by the Norges Bank and by the Riksbank seems to be a reasonable way to go forward and should be adopted by other central banks.
Flexible inflation targeting aims both at stabilizing inflation around the infla-tion target and resource utilizainfla-tion around a normal level. The central bank should then choose the policy rate and policy-rate path so the forecast inflation and resource utilization best stabilizes inflation and resource utilization. The central bank can incorporate financial conditions and other shocks into its forecasts (Svensson 2010). Finally, a lesson from the recent crisis is that fi-nancial regulation (by agencies other than the central bank) should be based on providing incentives for private financial agents to take prudent actions (“to have skin in the game”). Had this been the case the financial collapse would have been greatly attenuated.
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