## The Evolution of Monetary Policy: More Art and Less Science

_IMF Blog, April 7, 2014_

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## Bibliographic details
- Authors: Giovanni DellAriccia, Karl Habermeier
- Published: April 7, 2014

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### Overview
- Authors: Giovanni Dell’Ariccia, Karl Habermeier
- Date: April 7, 2014
- Context: Post-global financial crisis reassessment of monetary policy; conference on April 13 during the Spring Meetings of the World Bank and IMF.

### Key observations from the review
- The global financial crisis disrupted a long-standing monetary policy routine characterized by:
  - "Simply keep inflation low and stable, target a short-term interest rate, and regulate and supervise financial institutions."
  - Success attributed to Paul Volcker’s Fed beating inflation in the United States in the early 1980s and over 20 years of “Great Moderation” — low inflation and output volatility.
- Ideas once marginal before the crisis have moved to center stage, with a "vast volume of new work by academics and central banks in just the last two or three years."
- Monetary policy going forward: "more art and less science" — greater uncertainty about decision rules and transmission mechanisms.

### Objectives: price stability and financial stability
- Primary finding:
  - "Long-term price stability has been a primary objective of monetary policy" and the review "found no good reason why this should change."
  - Benefits: makes planning easier for households and businesses; allows the economy to operate efficiently.
- Crisis lesson:
  - "Dangerous financial imbalances can brew under the apparently tranquil surface of low and stable inflation."
  - Traditional prudential policy focusing on stability of individual banks proved inadequate for system-wide risks.
- Policy implications and recommendations:
  - "Macroeconomic policy needs to pay greater attention to financial stability."
  - First line of defense should be instruments targeting financial stability more directly and efficiently, including:
    - Macroprudential tools, such as loan-to-value and debt-to-income limits.
    - Capital flow management measures.
  - Acknowledge limits: "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."
  - Political tradeoff example highlighted rhetorically: "Would you put two million people out of work because banks are too leveraged or house prices are rising too fast?"

### Policy decision rules: changed structure and uncertainty
- Structural changes:
  - "Tectonic shifts in the structure and regulation of the financial sector" during the crisis have altered monetary policy transmission.
  - The short-run relationship between inflation and unemployment "seems to have changed."
- Consequences:
  - "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."
  - For the foreseeable future, monetary policy will require greater judgment: "more art and less science."
- Political economy risk:
  - "A less mechanical and predictable monetary policy may be more exposed to political interference."

### Central bank independence: challenges under an expanded mandate
- Historical role:
  - Independence has been helpful to maintain price stability; analogy: Ulysses tied to the mast to resist sirens.
  - A simple and measurable mandate enables accountability and makes independence politically feasible.
- Two central questions explored:
  - Can independence be extended to cover financial stability?
  - Can central banks retain independence for price stability if there is greater government oversight over financial stability?
- Assessment:
  - The answer to the first question "is not clear."
  - Financial stability is "far more difficult to measure than inflation," and actions would often have clearer winners and losers than interest rate policy, complicating accountability and creating political challenges.
  - Institutional arrangements vary across countries:
    - Central bank leads financial stability policies in some countries (Singapore, United Kingdom).
    - Ministry of finance is ultimately in charge in others (United States).
  - "So far, there are no final answers on what works best."

### Parting thoughts and outlook
- Near-term expectations:
  - Only some questions will be settled in the short term; many require years of experience and observation.
  - Policymakers will need to make decisions on new policies and institutional arrangements "often under great uncertainty."
- Bottom line: "The art of central banking is alive and well."

*The Evolution of Monetary Policy: More Art and Less Science — Giovanni Dell’Ariccia, Karl Habermeier, April 7, 2014.*

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## Content in this bundle

- **Staff Discussion Note**
  - [Staff Discussion Note (Markdown version)](/external/pubs/ft/sdn/2014/sdn1403.pdf.md){rel="alternate" type="text/markdown"}
  - [Staff Discussion Note (PDF)](/external/pubs/ft/sdn/2014/sdn1403.pdf){rel="external" type="application/pdf"}

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_Source: https://www.imf.org/en/blogs/articles/2014/04/07/the-evolution-of-monetary-policy-more-art-and-less-science_