This strategy of relaxing monetary policy once a bubble bursts certainly makes the creation of bubbles more likely. But while the mop-up strategy worked in some earlier episodes, it failed miserably during the biggest collapse in decades. I will return to this point below. In summary, financial fragility played a crucial role in explaining the origin and magnitude of the crisis. But financial fragility was related to poor regulation more than monetary policy. Having said this, it can be still argued that the original sin in this case was a “relaxation” (loosening) of their financial stability responsibilities by some central banks and the inability of the existing supervisory bodies to adequately monitor aggregate financial stability. 2  BIS Review 76/2010  The objectives of central banks Given the magnitude of the financial crisis we faced, there is always a discussion on whether the objectives of central banks were the right ones or if they should be changed. As I mentioned before, the financial crisis was mainly related to a poor implementation of a key task of central banking. Nevertheless, it will be useful for the ensuing discussion of the challenges of implementation of central bank tasks to evaluate first their current objectives. Should the objective of price stability be changed? Broadly speaking the answer is no. For a start, central banks need to retain a clear mandate for price stability. Inflation is costly and should be avoided, and this has to be done by the monetary authority.
In the first two cases (2001 and 2002) events in international financial markets led to rapid depreciations, unrelated to country fundamentals. In the last case – 2008 – we considered it prudent to build up reserves in a period in which the exchange rate was below fundamentals and global financial markets were under extreme stress. Let me now refer to the interaction between financial and price stability from an ex-post perspective, i.e. once a financial shock (crisis) has hit the economy. From an ex-ante point of view I discussed that there are occasions in which these two objectives may not be completely aligned. From an ex-post perspective, these objectives are in general consistent, which will reinforce the need for strengthening the ex-ante dimension of financial stability. Suppose that a shock in financial markets (of a domestic or external nature; based on fundamentals or simple contagion) hits the economy. This shock will result in an increase in the cost of capital, bringing down investment and aggregate demand. The reduction in aggregate demand reduces output and therefore also reduces inflationary pressures. This example shows that dealing with this “financial shock” is usually – and I will be explicit regarding this conditionality – consistent with pursuing price and output stability. From this ex-post perspective, financial and price stability can be addressed simultaneously. The instruments that monetary policy can use to deal with these financial shocks will depend on the nature of the financial shock.