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The Evolution of Monetary Policy: More Art and Less Science

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The global financial crisis shook monetary policy in advanced economies out of the almost complacent routine into which it had settled since Paul Volcker’s Fed beat inflation in the United States in the early 1980s.

Simply keep inflation low and stable, target a short-term interest rate, and regulate and supervise financial institutions, the mantra went, and all will be well.

Of course many scholars and policymakers, especially in emerging markets, were skeptical of this simple creed. But they did not make much headway against a doctrine seemingly well-buttressed by sophisticated theoretical models, voluminous empirical research, and over 20 years of “Great Moderation” —low inflation and output volatility. All of that has changed since the crisis, and ideas that were once marginal have now moved to center stage.

We don’t yet know where this debate will eventually lead. In some respects, the monetary policy of tomorrow may well look familiar, but in other respects, it is likely to be very different.

Our new paper, co-authored with other IMF staff, takes stock of where the debate stands, and provides a launching pad for further research and reflection. While not the first effort of its kind, this latest work shows just how much momentum the rethinking has gained, with a vast volume of new work by academics and central banks in just the last two or three years. We’ve invited policymakers, academics, and media from around the world to a high- level conference on April 13 during the Spring Meetings of the World Bank and IMF to give this broad group of stakeholders a further opportunity for discussion.

While our paper covers a broader set of issues, here we want to focus on three critical questions on the role of monetary policy and its relationship to financial stability and the economy: Should monetary policy target more than just price stability? Should current policy decision rules be reconsidered? And, finally, what are the challenges for central bank independence under a potentially expanded mandate?


Long-term price stability has been a primary objective of monetary policy for many years, and our review found no good reason why this should change. Low and stable inflation makes it easier for households and businesses to plan, and allows the economy to operate efficiently. But the crisis has shown that this is not enough: dangerous financial imbalances can brew under the apparently tranquil surface of low and stable inflation. And traditional prudential policy, which focused primarily on the stability of individual banks, proved inadequate to deal with the type of system-wide risks that led to the crisis.

So macroeconomic policy needs to pay greater attention to financial stability. However, the interest rate will often be a blunt and costly instrument to deal with financial imbalances. Would you put two million people out of work because banks are too leveraged or house prices are rising too fast? Instead, the first line of defense should be instruments that can target financial stability more directly and efficiently, including macroprudential tools, such as loan-to-value and debt-to-income limits, and capital flow management measures. Yet, when these tools prove insufficient, we may have to accept a new tradeoff for monetary policy, and the interest rate may have to lend a hand to maintain financial stability.

Policy decision rules

During the crisis, there were tectonic shifts in the structure and regulation of the financial sector. These have affected the impact of monetary policy on the broader economy. Moreover, the short-run relationship between inflation and unemployment seems to have changed.

The bottom line is that the details of how the central bank can best achieve its objectives are probably not the same as before the crisis. We still have a lot to learn about how things have changed and by how much, but it is already clear that for some time to come, monetary policy will involve more art and less science. This in itself will pose new challenges, including from a political economy standpoint. A less mechanical and predictable monetary policy may be more exposed to political interference, as we explain below.

Central bank independence

Central bank independence has been helpful to maintain price stability. Ulysses had himself tied to the mast to resist the sirens, and governments tie their monetary policy to an independent central bank to resist the short-term temptation to inflate away fiscal constraints. A simple and measurable mandate allows for effective accountability and makes independence politically feasible.

But is it possible to extend independence to also cover financial stability? And critically, can central banks retain independence for price stability if they allow greater government oversight over financial stability?

The answer to the first question is not clear. Financial stability is far more difficult to measure than inflation, and policy actions would often have clearer winners and losers than interest rate policy. This complicates accountability and could bring political challenges. As for the second question, countries have chosen a wide range of institutional arrangements to deal with the challenge. In some countries, the central bank leads financial stability policies (Singapore, United Kingdom); elsewhere, the ministry of finance is ultimately in charge (United States). So far, there are no final answers on what works best.

Parting thoughts 

What can we expect in the future? Only some of the questions raised here will be settled one way or the other in the short term. Many will require years of new experience and observation. In the meantime, policymakers will have to take decisions on new policies and institutional arrangements, often under great uncertainty. The art of central banking is alive and well.