9 The second question, whether a different monetary policy could have prevented the crisis, is relevant when assessing to what extent monetary policy can be blamed for causing the crisis, notwithstanding if it was reasonable from an ex ante perspective. The credit growth and the housing boom in the U.S. and elsewhere were very powerful. Real interest rates were low to a large extent because of global imbalances, the global saving glut and investment shortage. I believe that somewhat higher interest rates would have made little or no difference. Empirical evidence indicates that only a small portion of house-price increases can be attributed to monetary policy. 10 Bernanke (2010) shows that the recent phenomenon of a higher share of adjustable-rate mortgages was unlikely to have significantly increased the sensitivity of house prices to monetary policy. The availability of new, more exotic mortgage types mattered much more for initial mortgage payments than the level of shortterm interest rates. In my view, interest rates would probably have had to be raised very high so as to cause considerable damage to the real economy in order to stop the credit growth and housing boom. 11 That could have thrown the U.S. right into Japanese-style deflation and eventually a liquidity trap.
4  BIS Review 16/2010  the inflation target and resource utilization around a normal level. In the event of conflicting objectives, it achieves a reasonable compromise between the stability of inflation and the stability of resource utilization. Different central banks express this in slightly different words. The Riksbank has often used the term “well-balanced” monetary policy. 3 The forecasts of inflation and the real economy are then conditional on the central bank’s view of the transmission mechanism, an estimate of the current state of the economy and a forecast of important exogenous variables. The central bank uses all relevant information that has an impact on the forecast of inflation and the real economy. In this framework, the central bank takes financial conditions such as credit growth, asset prices, imbalances, potential asset price bubbles and so on into account only to the extent that they have an impact on the forecast of inflation and resource utilization. Inflation and resource utilization are target variables, that is, variables that the central bank tries to stabilize. Financial conditions are not target variables. Instead, they are only indicators, as they provide information to the central bank about the state of the economy, the transmission mechanism and exogenous shocks. Financial conditions then affect policy rates only to the extent that they have an impact on the forecast of inflation and resource utilization. 4 Now, is there any reason to modify this view of monetary policy given the experience of the financial crisis so far?