MASSACHUSETTS — Following are remarks by US Federal Reserve chairman Ben S Bernanke at the Federal Reserve Bank of Boston 56th Economic Conference.
The financial crisis of 2008 and 2009, together with the associated deep recession, was a historic event — historic in the sense that its severity and economic consequences were enormous, but also in the sense that, as the papers at this conference document, the crisis seems certain to have profound and long-lasting effects on our economy, our society and our politics.
More subtle, but of possibly great importance in the long run, will be the effects of the crisis on intellectual frameworks, including the ways in which economists analyse macroeconomic and financial phenomena.
In particular, the crisis has already influenced the theory and practice of modern central banking and no doubt will continue to do so.
During the two decades preceding the crisis, central bankers and academics achieved a substantial degree of consensus on the intellectual and institutional framework for monetary policy.
This consensus policy framework was characterised by a strong commitment to medium-term price stability and a high degree of transparency about central banks’ policy objectives and economic forecasts.
The adoption of this approach helped central banks anchor longer-term inflation expectations, which in turn increased the effective scope of monetary policy to stabilise output and employment in the short run.
This broad framework is often called flexible inflation targeting, as it combines commitment to a medium-run inflation objective with the flexibility to respond to economic shocks as needed to moderate deviations of output from its potential, or “full employment”, level.
Many central banks in both advanced and emerging market economies consider themselves to be inflation targeters, prominent examples including those in Australia, Brazil, Canada, Mexico, New Zealand, Norway, Sweden and the United Kingdom.
Several other major central banks, such as the European Central Bank (ECB) and the Swiss National Bank, do not label themselves as inflation targeters.
However, they have incorporated key features of that framework, including a numerical definition of price stability, a central role for communications about the economic outlook and a willingness to accommodate short-run economic stabilisation objectives so long as these objectives do not jeopardise the primary goal of price stability.
Following the crisis and the downturn in the global economy that started in 2008, central banks responded with a forceful application of their usual policy tools, most prominently sharp reductions in short-term interest rates.
Then, as policy rates approached the zero lower bound, central banks began to employ an increasingly wide range of less conventional tools, including forward policy guidance and operations to alter the scale and composition of their balance sheets.
A prominent example was the Bank of Canada’s commitment in April 2009 to keep its policy rate unchanged at ¼% until the end of the second quarter of 2010, depending on the outlook for inflation.
This commitment was successful in clarifying for market participants the bank’s views on the likely path of policy rates and appears to have helped reduce longer-term interest rates, thus providing additional policy accommodation.
In 2010, the Bank of Japan, which faced ongoing deflation in consumer prices, also used conditional forward guidance, saying: “The Bank will maintain the virtually zero interest rate policy until it judges, on the basis of the ‘understanding of medium to long-term price stability,’ that price stability is in sight, on condition that no problem will be identified in examining risk factors, including the accumulation of financial imbalances.”
Some central banks provide forward guidance directly by releasing forecasts or projections of their policy rate. In addition to forward guidance about short-term rates, a number of central banks have also used changes in the size and composition of their balance sheets as tools of monetary policy.
In particular, the Federal Reserve has both greatly increased its holdings of longer-term Treasury securities and broadened its portfolio to include agency debt and agency mortgage-backed securities.
Its goal in doing so was to provide additional monetary accommodation by putting downward pressure on longer-term Treasury and agency yields while inducing investors to shift their portfolios toward alternative assets such as corporate bonds and equities.
These actions also served to improve the functioning of some stressed financial markets, especially in 2008 and 2009, through the provision of market liquidity.
Other central banks have also used their balance sheets more actively than before the crisis, with some differences in their motivations and emphasis, in part reflecting differing financial structures across countries.
One of the lessons of the crisis was that financial markets have become so globalised that it may no longer be sufficient for central banks to offer liquidity in their own currency, financial institutions may face liquidity shortages in other currencies as well.
The evolving consensus, which is by no means settled, is that monetary policy is too blunt a tool to be routinely used to address possible financial imbalances; instead, monetary policy should remain focused on macroeconomic objectives, while more-targeted microprudential and macroprudential tools should be used to address developing risks to financial stability, such as excessive credit growth.