Price and Financial Stability in Modern Central Banking

Although the first central banks were created more than three hundred years ago, it was not until the mid-nineteenth century that central banks were given the monopoly power to issue banknotes and to act as lender of last resort. Thereafter, central banks played the role of liquidity provider and lender of last resort. These tasks were intended to allow a proper functioning of the payment system, so financial stability was implicitly a major concern for central banks. Over time, central banks moved toward achieving price stability, from monetary stability to controlling inflation. Financial stability became a secondary goal, if a goal at all.

This has not been the case in emerging market economies, which have been affected by recurrent financial crises. Indeed, financial crises like those of Chile in the early 1980s or in Mexico and Asian countries in the 1990s are not radically different from the recent crisis in advanced economies. The complexity may have changed, but the original causes had many similarities.¹ Some years ago it was much more frequent to find central bankers concerned about financial stability in emerging countries than in advanced ones. However, as a consequence of the global financial crisis, the issue of financial stability has reemerged as a top priority for policymakers.

In this paper, I discuss the issue of price and financial stability in central banking. I first explore the conduct of central banks in achieving price stability, in particular in the context of inflation targeting, and then move on to how the financial stability mandate has to be included as a key component of modern central banking. I end with a few concluding remarks.

Central Banks and Price Stability

As mentioned above, central banks in advanced economies have long been focused mainly on ensuring low inflation. Moreover, some scholars and practitioners argued that price stability should be the only objective of central banks, so that the goal would be more credible and monetary policy more effective in achieving stability. How exactly or operationally to achieve this target was an open question, however. Some central banks tried to target monetary aggregates, others to peg nominal exchange rates, and others to use an eclectic mix of indicators. Two decades ago, some central banks started conducting monetary policy targeting a specific value or range for the inflation rate. This trend started with New Zealand in 1990 and was followed by Canada, the United Kingdom, Australia, and Sweden in the early 1990s. This is a case in which policy development led academic advances. Progress on the academic front provided further impetus to the adoption of inflation targets as new models were developed to provide the theoretical underpinnings of inflation targets and the basis to conduct empirical work.²

This view was further justified by the success of monetary policy around the world in providing stability, not only on the inflation front, but also in activity and employment. The evidence that output volatility declined significantly in the United States after the mid-1980s was first reported by Kim and Nelson and later called the Great Moderation by Stock and Watson.³ Several factors could be behind this trend, such as technical progress, better policies, deeper financial markets, and sheer good luck. Although there is no final verdict, evidence points to the role of better macroeconomic policies.⁴ Emerging market economies also enjoyed a Great Moderation, but it came in the second half of the 1990s, much later than in developed economies. This coincided with the time in which inflation was conquered, supporting the hypothesis that it was good policies rather than good luck.⁵ It is easy to discredit the Great Moderation in the current juncture. However, the resilience of emerging market economies to the global crisis was impressive. Indeed, emerging markets had a recession, but much milder than in the past and with a remarkable recovery. This was, of course, the consequence of much better macroeconomic management.

The case of Chile illustrates this point. The economy did suffer a recession, but the size of the initial impact and the speed of the recovery were quite...