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05 June 2012

Seppo Honkapohja: How has the crisis challenged central banking as we know it?


Mr Honkapohja, Member of the Board of the Bank of Finland, said that new frameworks and tools for macro-prudential supervision and new regulations on the financial system have taken a central position on current policy and research agendas.

Looking at the current mix of policies, the general picture is that central banks in many advanced market economies continue to have policy interest rates near or at the effective risk to falter. In contrast, fiscal stimulus is no longer applied or its scale has been reduced in most countries. This state of affairs has two consequences for the changing role of central banking.

First, the mix of macro-economic policies is placing the main responsibility on central banks for achieving more satisfactory macro-economic developments. This situation and the use of unconventional policies are straining the conventional boundary between monetary and fiscal policy. Large-scale asset purchases and liquidity provision to banks in the euro area have clear fiscal consequences and there have recently been several political calls for more action from the central banks.

Second, one can ask whether this kind of policy mix can lead the economy back to the “normal regime”, where inflation is near the targeted level and the economy grows near its potential. The traditional answer is due to Pigou and Patinkin, who argued that wealth effects at very low inflation levels eventually lead to increased consumer spending and recovery of the economy to the normal regime. It should be noted that efficacy of the Pigou-Patinkin mechanism depends on the degree of private-sector indebtedness – high debts weaken the mechanism.

Price stability as the macro-economic objective continues to play an important part in central banking. Inflation targeting with a credible and independent central bank may well survive as the framework for monetary policy. However, interconnections between financial and macro-economic stability are one topic that needs more attention in the future. Redrawing the boundaries between fiscal and monetary policy is a second topic that needs attention in the future. There are two reasons for this. First, the roles of fiscal and monetary policy in the Great Recession and in exit from the current stagnation need further assessment. Second, the sovereign debt crisis and the rising debt levels in many advanced market economies may well influence the boundaries between monetary and fiscal policy in the coming years.

Full speech



© BIS - Bank for International Settlements


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