José De Gregorio: Monetary policy and financial stability - an emerging markets perspective

1. The causes of the crisis: was it monetary policy or was it financial fragility? The argument blaming monetary policy for the current crisis claims that low interest rates combined with large current account surpluses in emerging economies, particularly Asian and oil-exporting ones, created an abundance of liquidity that triggered excessive increases in asset prices (bubbles). This was particularly acute in the housing market. When the bubble burst, the crisis erupted. Then, this argument claims that the housing bubble was caused by monetary policy, which failed to act opportunely and permitted severe imbalances to accumulate. Nonetheless, one must bear in mind that soaring asset prices do not necessarily end up in a crisis like this one. Closer attention must be paid to the financial fragility that accompanied this process, whose main culprit was the unrestrained financial innovation that generated deep distortions that neither markets nor regulators were able to predict. An expansionary monetary policy can undoubtedly induce an excessive increase in the prices of assets and credit. The ultimate role of monetary policy is to smooth the business cycle and control inflation. 1 Therefore, it is possible to think that a very expansionary monetary policy, more so than that needed to reach the inflation target, can exacerbate an economic boom. Moreover, such a policy will have serious consequences on output once the monetary impulse is withdrawn. However, an expansionary monetary policy could not explain by itself the severity of the financial collapse and the global recession the world is seeing today. There are countries where monetary policy was expansionary, with interest rates at their minimum, and no housing bubble nor financial collapses occurred. A couple of examples are Canada and Chile, two inflation targeters where, consistently with this policy framework, interest rates hit very low levels not so different from the Fed Funds rate (Figure 1). Still, housing prices generally did not experience increases comparable with those of other economies, and their financial systems have remained sound.