The final tool available to the central bank is monetary policy. This tool is not likely to work as well as macroprudential tools because it is too broad. Typically, monetary policy will not address specifically the sources of the changes in supply and demand that are driving the bubble and, obviously, monetary policy will have big effects elsewhere. Some argue that monetary policy should “lean against” incipient asset bubbles. The notion is that by pursuing a slightly tighter monetary policy, the central bank would take out insurance against the risk that the rise in asset prices is a bubble and that its busting would be disruptive. Although this sounds attractive, it critically depends on how expensive the insurance is relative to the losses that the insurance protects against. It is not clear to me that a modest tightening in monetary policy beyond that needed to achieve full employment and price stability in the absence of a bubble would represent a favorable cost-benefit tradeoff. The costs of the deviation from the optimal monetary policy in terms of lost output and  10  However, in the recent crisis, the different outcomes in the United States and Canada might be instructive. Canada had a tougher regime in terms of mortgage underwriting standards. Also, Canada had imposed an overall leverage limit on its banks, which helped to limit the amount of gearing in the financial system.
Timothy F Geithner: Change and challenges facing the US financial system Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, before the New York Bankers Association’s Annual Financial Services Forum, New York, 25 March 2004. *  *  *  It is a pleasure to join you at the New York Bankers Association Financial Services Forum. The institutions represented in this room, together with the rest of the New York financial community, remain at the center of the U.S. and global financial systems. Your meeting today takes place against the backdrop of a relatively favorable national and global economic outlook. The U.S. financial system is in reasonably strong shape. Financial innovation has enabled substantial improvements in the quality of risk management and in the capacity of the system to handle shocks. But the benefits of innovation have come with significant challenges to the people who run financial institutions and to those responsible for supervision and oversight. How effective we are in responding to these challenges will determine whether the U.S. financial system is as successful in the future as it has been in the past. The consensus forecast for the U.S. economy expects solid growth this year and next, somewhat above the upper bound of the range of most estimates of U.S. potential growth. Confidence in the sustainability of the U.S. expansion, as measured by changes in these forecasts, for example, seems to be increasing.