Financial market participants pay considerable attention to the monetary policy decisions made by central banks, for these are, in a broad sense, the “guardians” of liquidity. Excessively expensive liquidity is likely to result in a suboptimal volume of investment and, in turn, in an inefficient under-use of society’s productive resources. Likewise, when monetary conditions are excessively lax, some liquidity may be directed to financing projects with poor returns. If this situation prevails for some time, inflation arises, the average productivity of investment declines, asset prices deviate from their normal or fundamental values and the economy as a whole loses its ability to maintain a sustained growth path. When deciding on monetary conditions, central banks must understand the mechanisms underlying the workings of the economy in order to react to potential dangers and opportunities in due manner and course. No diagnosis could ever be complete without a careful analysis of how the entire circulatory system is behaving. From that standpoint, central banks can then be thought as of being the heart, initially controlling the price of the transactions conducted in the money market. Commercial banks would naturally fit into this analogy as the veins and arteries, for they have the last word on the destination of the funds they are being endowed with, a decision that pertains greatly to the sphere of banks’ credit management.
Those dangers are often linked to excessive risk-taking in the credit or asset markets leading to episodes of financial instability. In that situation, it may be difficult for monetary policy to meet its objectives since the relationship between certain key variables and interest rates becomes unstable. Moreover, as market volatility increases, the ability of central banks to affect the relevant interest rates becomes more uncertain. The conduct of monetary policy then becomes much like steering a boat in the middle of a dark stormy night. Even if the likelihood of such episodes of macroeconomic distress is low, the considerable implications in the economy and in terms of welfare have led to increasing concern among central banks and much discussion and research on what the monetary policy response to this kind of underlying risk could and should be. There is now a broad consensus among central bankers that they should not directly target asset prices, and I must include myself among those who share this view. Detecting unsustainable patterns of asset prices or indebtedness ratios in real time is a complex task in practice. But even if central banks were able to do so, there would still be a lot of uncertainty as to how those financial imbalances would react to a specific change in monetary policy.