by Taeyoung Doh, Guangye Cao, and Daniel Molling – Economic Review, Federal Reserve Bank of Kansas City
The recent financial crisis has reignited interest in whether monetary policy should respond to financial stability concerns such as asset price bubbles. Before the crisis, many believed monetary policy should respond to these concerns only to the extent they significantly alter the future outlook for inflation or unemployment. Proponents of this view regarded promoting financial stability by raising the cost of borrowing more than the outlook for inflation or unemployment warranted as undesirable because it might conflict with macroeconomic stability. However, the severity of the 2007-08 financial crisis and subsequent slow recovery challenged this view.
Recently, some policymakers have argued that monetary policy can and should play a more active role in preventing financial instability. Adjusting interest rates in response to risk premiums in financial markets could be an effective way to mitigate financial instability and the resulting macroeconomic instability. For example, if investors are underpricing adverse future outcomes, central banks could raise interest rates to increase the cost of risk-taking. Despite the importance of this suggested policy change, thorough investigations of the idea remain scarce.