Four Monetary Policy Strategies in Comparison: How to Deal with Financial Instability?

The article provides a review of the monetary policy strategies of four major central banks – the Eurosystem, the Federal Reserve, the Bank of Japan and the Bank of England – and investigates whether these strategies are modified in times of financial instability. The study finds a number of – statutory and actual – differences regarding the central banks’ objective(s), strategies and approaches to achieve the objective(s), and communication, including the publication of forecasts. While central bank laws are often not very explicit about financial stability, there is consensus that the latter is a major concern in practice. Many see the 2007/2008 financial crisis as yet another reminder that central banks in their monetary policy strategies need to take a longer-term and broader view than might have been suggested only a few years ago. All four central banks’ monetary policy strategies in principle allow for adequate incorporation of financial stability concerns. The lender of last resort function poses challenges for the operational implementation of monetary policy and their credibility as competent and reliable policy institutions. While central banks have been praised for their flexibility in dealing with the recent crisis, this very flexibility may also create moral hazard for the future. Empirical estimates of Taylor-type reaction functions, augmented for a measure of financial instability, confirm some relevant differences in the reaction elasticities to inflation and the output gap, as well as significant effects of financial instability on the interest rate setting behavior of the Bank of England, which are in line with the theoretical view that less inertia in monetary policy should be allowed for in times of financial market risks.