The less sloped straight line is an iso-loss line that corresponds to equal weight on inflation and output-gap stabilization, that is to a “lambda” equal to one. 4 With such equal weight, the high policy-rate path is preferred. The steeper straight line corresponds to lambda equal to 0.3, that is, with a weight on output-gap stabilization equal to 0.3 relative to the weight on inflation stabilization. With such a weight, the main policy-rate path is about as good as the higher and clearly better than the lower policy-rate path. At the time, Norges Bank had announced that its decisions were consistent with a relative weight on output-gap stabilization equal to 0.3 and a relative weight on interest-rate smoothing of 0.2 (Bergo 2007 and Holmsen, Qvigstad, and Røisland 2007). With some weight also on interest-rate smoothing, the main policy rate is best. The use of the mean squared gaps is one more step towards more systematic and transparent inflation targeting, in which central banks can be evaluated and held responsible for their decisions with even greater accuracy than before, following the introduction of numerical inflation targets, published forecasts of inflation and the real economy, published policy-rate paths and other important steps taken in the development of a systematic and transparent monetary policy. References Adrian, Tobias, and Hyun Song Shin (2010a), “Financial Intermediaries and Monetary Economics,” in Friedman, Benjamin M., and Michael Woodford (eds. ), Handbook of Monetary Economics, Volume 3, Elsevier, forthcoming.
However, let us suppose that the appropriate and effective instruments for ensuring financial stability are not available, for instance because of serious problems with the regulatory and supervisory framework that cannot be remedied in the short run. In such a second-best situation, if there is a threat to financial stability, one may argue that, to the extent that policy rates do have an impact on financial stability, this impact should be taken into consideration when choosing the policy-rate path to best stabilise inflation and resource utilisation. Such considerations could result in a lower or higher policy-rate path than otherwise, in order to trade off less effective stabilisation of inflation and resource utilisation for more financial stability. 2 To the best of my knowledge, the evidence so far indicates that in normal times such a trade-off is very unfavourable, in the sense that the impact of policy rates on financial stability is quite small and the impact on inflation and resource utilisation is significantly greater. Then, in normal times an optimal trade-off would still result in policy rates directed towards stabilizing inflation and resource utilization with little impact on financial stability. In particular, it seems clear that monetary policy should not be used to target housing prices. A considerable amount of research has concluded that policy rates have a modest impact on housing prices but a substantial impact on output, implying high real costs for using the policy rate for this purpose (Assenmacher-Wesche and Gerlach 2010).