Federal Reserve Board Chairman Ben Bernanke on Tuesday emphasized the role of central banks in preserving financial stability, arguing it must have equal footing with their monetary policy responsibilities.
"In the decades prior to the crisis, monetary policy had come to be viewed as the principal function of central banks; their role in preserving financial stability was not ignored, but it was downplayed to some extent," said Bernanke in remarks before the Federal Reserve Bank of Boston's annual economic conference. "The financial crisis changed all that."
Today, financial stability and monetary policy are "co-equal responsibilities" of central banks and both functions, he said, are "highly complementary."
Under former Fed Chairman Alan Greenspan, critics accused the Fed of being relatively lax on its regulatory responsibilities as it tried not to interfere with market forces. But in the wake of the financial crisis, Bernanke said regulation and supervision of banks is a key part of the central bank's mission to preserve financial stability, while saying monetary policy can also be used for that purpose.
"The diverse tools of financial regulation and supervision, together with appropriate monitoring of the financial system, should be, I believe, the first line of defense against the threat of financial instability," said Bernanke. "Still, the effectiveness of such targeted policies in practice is not yet proven, so the possibility that monetary policy could be used directly to support financial stability goals, at least on the margin, should not be ruled out."
But he said efforts to draw distinctions between the two roles can be challenging. For example, the European Central Bank kept its "separation principle" throughout the recent crisis which it used to orient changes in its interest rates to achieve price stability and focused its unconventional liquidity and balance sheet measures toward addressing dysfunctional markets.
To some extent, Bernanke said, the distinctions between those two objectives "will always be blurred" because of the strong ties between financial and economic conditions.
Simply put, he said, economic outlook which improves because of monetary policy actions boosts conditions of financial firms. Likewise, actions taken by the Fed to support firms and markets also end up improving credit flow aiding the Fed in meeting its monetary policy objectives.
A prominent example used to illustrate the debate is the question of whether monetary policy should "lean against" movements in asset prices or credit aggregates to help promote financial stability.
For Bernanke, the issue is never whether central bankers should "ignore possible financial imbalances," because it never should. "But rather, what "the right tool for the job" is to respond to such imbalances, he said.
Bernanke added there is a growing consensus that monetary policy is "too blunt a tool to be routinely used to address possible financial imbalances; instead, monetary policy should remain focused on macroeconomic objectives, while more-targeted microprudential and macroprudential tools should be used to address developing risks to financial stability, such as excessive credit growth."