How central banks contributed to the financial crisis

As numerous studies over the last two decades have shown, interest rate policies of a large number of central banks can be explained by the so-called Taylor Rule. According to this rule, which is consistent with inflation targeting, the policy rate is determined by a neutral real rate, the target inflation rate, the output gap, and the deviation of inflation from the target (or expected) rate. In this formula, the output gap can be interpreted as a leading indicator for inflation, as suggested by an augmented Phillips-curve inflation model, where the deviation of actual inflation from the target has the character of an error-correction term.
There is no room for financial variables, such as money, credit, or asset prices, in this policy rule.

• Leading economists and central bankers have indeed suggested that monetary policy should abstain from trying to prick asset price bubbles, but stand ready to support banks and financial markets when the bubbles burst (Bernanke and Gertler 2001).
• Only a minority have seen this differently and argued that monetary policy should lean against asset price inflation and monitor credit developments closely to this effect (ECB 2005).

As technical progress and global trade integration depressed prices in the 1990s and 2000s the Taylor Rule suggested that policy rates be kept low over an extended period of time despite strong credit growth and asset price increases. In this column we show how the policy of inflation targeting, which essentially implies that the central bank minimise the output gap, has led to excessive credit growth that eventually bred financial instability.

Read more: http://www.voxeu.org/article/how-central-banks-contributed-financial-crisis