The role of financial imbalances in monetary policy

Ágnes Csermely () and Zoltán Szalai ()
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Ágnes Csermely: Magyar Nemzeti Bank (central bank of Hungary)
Zoltán Szalai: Magyar Nemzeti Bank (central bank of Hungary)

MNB Bulletin (discontinued), 2010, vol. 5, issue 2, 6-12

Abstract: One fundamental lesson of the financial crisis is that the evolution of financial imbalances may suggest overheating in the economy, which does not necessarily entail a rise in inflation. The bursting of these bubbles may result in an abrupt overshooting of the positive output gap in the opposite direction, in other words, it can lead to a severe recession. Thus, in addition to inflation and growth forecasts, central banks endeavouring to stabilise income fluctuations need to develop new indicators which are suitable for grasping the output gaps which evolve during the development of financial imbalances. This would require models that capture shocks in the banking systems and financial frictions in an endogenous way, but such models are still in their infancy. Over the short run, the only feasible opportunity is to derive indicators with good forecasting qualities directly from the indicators that characterise the imbalance, which are then considered by the Monetary Council in the form of expert information during the decision-making process. There is no need to change the framework of inflation targeting. However, in the future greater emphasis should be laid on the fact that anchoring inflationary expectations is a necessary, but not sufficient prerequisite to creating macro-economic stability, and that measures taken to avoid financial imbalances help to dampen income fluctuations. As the usual instruments are highly inefficient for stabilising the output gap caused by financial imbalances, the occasional application of macro-prudential instruments needs to be considered.

Keywords: monetary strategy; boom bust; asset prices; regulation; central banking. (search for similar items in EconPapers)
JEL-codes: E30 E44 G10 G20 G28 (search for similar items in EconPapers)
Date: 2010
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