Central Bank Challenges after the Financial Crisis

Abstract

This paper challenges monetary policy after the financial crisis. The discussion shows that forward guidance of theinterest rate and Quantitative Easing (QE) may give monetary policy more power when the short term nominalinterest rate is close to zero lower bound. The current recession is a consequence of excessive debt in private andpublic sector, and since both public and household sector need time to pay down debts and rebuild savings, standardmonetary policy as well as non-standard monetary policy (QE) will have limited effects on the present recession. Animportant lesson from financial crisis is that imbalances in the financial sector and high debt in private and publicsector may fly under the inflation radar screen in conventional monetary policy and undermine the economy.Monetary policy in future should therefore target also financial stability. Taylor’s rule affords a monetary policy withmaximum of transparency, but it is unlikely to perform better than a central bank’s carefully judgment of inflation,production gap, other possible targets, and the means that the bank has available (the interest rate). The Tinbergenrule tells us that we need one instrument for every independent target, and monetary policy therefore needs help fromother economic policy areas. Even if we need an independent central bank, the central bank must also communicateand cooperate with government. Finely, the paper suggests that one should use market mechanisms to a higherdegree in the bank market to make clear to lending institutions that they are responsible and must consider the risk inrelation to their investments.