The Implications of Evolving Policy Regimes”, presented at: Monetary Policy and Uncertainty: Adapting to a Changing Economy, a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 28 – 30, 2003. BIS Review 158/2010  1  1720 2 to the “Panic of 1907”, which was only solved by the forceful intervention of John Pierpont Morgan, and which ultimately convinced U.S. policymakers of the necessity to establish a central bank. But why should monetary regimes delivering strong price stability be vulnerable to asset price bubbles and financial crashes? A long term perspective suggests that banking systems tend to periodically generate asset price bubbles even under radically different monetary regimes. Having an outburst of several years of excessive credit growth, or for the old days financial crisis, the rising exposure of some financial institutions to asset price volatility has repeatedly led to financial crises. Historical experience before world war I, where price stability has been unmatched ever since, should have reminded all of us, financial market participants and policy makers alike, that price stability is no blanket insurance against financial instability. B. Price stability is necessary for financial stability  The most obvious case in which price instability automatically leads to financial instability is that of deflation, via the “debt deflation” mechanism originally identified by Irving Fisher with reference to the Great Depression.
This, in turn, exerted a paralysing effect on a significant fraction of spending decisions, thus playing a key role in triggering the 1930s Depression and the resulting deflationary spiral. 5 What should we conclude from this brief excursus? In launching the economic revolution which unbound China and ultimately propelled it among the world powers, Deng Xiao-Ping famously exhorted his countrymen to “Seek truth from facts”, 6 in stark opposition to the ideological approach which had dominated up until then. Within the present context the facts are clear: on the one hand, price stability is a necessary precondition for financial stability, although it is by no means a sufficient one; on the other hand, a key reason for preserving the stability of the financial system is in order to avoid potentially significant risks to price stability, in one direction or the other. Let me now turn to discussing several issues concerning the joint implementation of, and the interaction between, monetary and macroprudential policies. II. Issues concerning the joint implementation of, and the interaction between, monetary and macroprudential policies  We are currently in uncharted waters. The new mix of macroeconomic policies, with the setting up of macroprudential policies, is being developed as we speak. Some issues are already clear: we have two objectives – price and financial stability – which, based on standard economic analysis, means that we will need two separate instruments to achieve them.