In the first case, we have good tools with which to respond. As the economy moved closer to full employment, we could raise short-term interest rates and subsequently sell assets from our portfolio. By doing this, we would tighten financial conditions, slow the economy and ensure it remained on a path consistent with our dual mandate objectives. The losses to society from this scenario should not be very large, provided we act in a manner that keeps medium-term inflation expectations in check. But the losses to society may be very high in the second case. That is because – as Japan has discovered over the past two decades – once in a liquidity trap it is not easy to return to full employment and price stability. Pinned at the lower bound, we don’t have as good a set of tools as we would ordinarily have to push the economy back toward our dual mandate objectives. As a result of this asymmetry, we should give somewhat more weight to avoiding the liquidity trap outcome. Embedded within the traditional Taylor Rule formulations is the implicit return path back to full employment and price stability that the FOMC achieved in the past when faced with shocks that pushed economic activity below its potential level.14  14  Obviously, there is a cost to those who are unemployed longer than necessary with no offsetting gain in terms of greater price stability. But there also is another potential long-run cost.
The interest rate is a blunt and unsuitable instrument for achieving financial stability and it thus makes little sense to assign the objective of financial stability to monetary policy. However, it may make sense to assign the objective of financial stability to the central bank, if the central bank is given control of the appropriate supervisory and regulatory instruments. The fact that financial-stability policy and monetary policy are different does not mean that there is no interaction between them. Similarly, monetary policy and fiscal policy are distinct policies but both have an impact on inflation and resource utilisation. The interaction between monetary policy and financial-stability policy has to be considered. Monetary policy affects asset prices and balance sheets and can thereby affect financial stability. Financial-stability  being smaller after the crisis. In Europe, Canada and the Nordic countries, commercial banks dominate the financial sector. 4  BIS Review 118/2010  policy directly affects financial conditions, which affect the transmission mechanism of monetary policy. This motivates more research on how to incorporate financial conditions into the standard models of the transmission mechanism used by central banks. The outcome might very well be that financial conditions are considered to play a larger role in the transmission mechanism and as indicators of future inflation and resource utilisation. If so, central banks would end up responding more to financial indicators, in the sense of adjusting the policy rate and policy-rate path more to a given change in a financial indicator.