Monetary policy and financial instability

Abstract

This paper presents how monetary policy, restricted only by price stability, may easily become propitious to asset inflation and, eventually, to a financial crisis. This risk is particularly high when the financial system lacks proper regulation and effective supervision. Hasty liberalization, negligence of official oversight and Greenspan doctrine which refuted any activist policy promoting financial stability features former Fed’s monetary policy. The paper also analyzes monetary policy reaction to financial crises. It is not surprising that it consists of systemically cutting interest rates and bail-out of insolvent important financial institutions. Such policy, especially when run too long and changed too abruptly, not only creates moral hazards but it also sets the stage for another search for yield and build-up of another speculative bubble. As a result, monetary policy becomes asymmetric and pro-cyclical. Fed’s reaction to the recent crisis seems to be very much in line with typical Fed’s policy in the past. However, this time the scale of flooding the economy with liquidity and, and as a consequence, the risks of future major imbalances in the financial system are unprecedented. A general conclusion is that there can’t be a sound financial and economic system unless money itself is a scarce resource and monetary policy of some central banks seems to miss the point.