Bank of Canada Governor Mark Carney says a new age of central banking is being created out of the ruins of the recent financial crisis that if done correctly could help avert, mitigate or at least better manage future economic crashes.
One key lesson, he said Wednesday, is that central banks have learned they need a more flexible approach to conducting monetary policy.
In an example he has used before, Mr. Carney said the Bank of Canada now realizes that it may need to take an active role in preventing a housing bubble that could have an impact on the wider economy. Effectively, that means the bank is prepared to raise interest rates if necessary to slow down borrowing.
"The clear lesson is that a central bank pursuing price stability without due regard for financial stability risks achieving neither," he told students and academics at the University of Alberta.
Notes of the address were released in Ottawa.
The issue is particularly pertinent in Canada, where the bank's low interest rate policy has fuelled excessive consumer debt accumulation, particularly on mortgages, and a hot housing market.
Mr. Carney realizes the problem he has wrought, but defends it by saying without such a loose-money policy the economy most likely would be much weaker and unemployment higher.
He credits Ottawa with tightening mortgage rules and lending practices to discourage irresponsible borrowing and he says it is working. Growth in household credit has fallen to about 3 per cent, from six in 2011, and fixed mortgages now represent 90 per cent of new issuances, compared with about 50 per cent in 2011.
"The bank now recognized there may be some cases when monetary policy may still have to take financial stability considerations into account. This is most obviously the case when financial imbalances affect the near-term outlook for output and inflation."
The speech, advertised as a wide-ranging lecture on the conduct of monetary policy, was one of Mr. Carney's last major addresses in Canada before departing for the Bank of England next month.
While mostly scholarly in its approach, it will undoubtedly be closely read by policy-makers in England for clues on how their star catch is likely to conduct himself when he takes over the Bank of England on July 1.
Mr. Carney is clearly advocating that central banks in the future be much more involved in the financial stability issues and the real economy, although their prime concern should remain maintaining stable and predictable price inflation.
"Although it has not been the case in Canada where policy has remained conventional, globally, central banks are being asked to do more, in more ways, than ever before," he says. "All of these developments put a premium on clearly articulated monetary policy frameworks."
For instance, he says researchers at the Bank of Canada and other central banks are in the process of trying to determine what they could have done better to prevent the crisis in the first place, and the effectiveness of the measures they have taken to mitigate the fallout on the real economy.
One of the lessons he believed should be taken from the 2008-09 recession is that central banks did little to avert the crisis from happening or even appreciate its seriousness. While they sprang into action once the bottom fell, they did not appreciate that they could have tightened policy earlier to limit the damage.
One thing that appears clear, he says, a conventional policy of strictly targeting a set inflation marker such as 2 per cent is not adequate in all circumstances, particularly during exceptional economic times.
The success of the policy itself might have exacerbated the 2008-09 financial crisis by instilling a false sense of security among market players and consumers that led to greater risk-taking.
As well, he says central bankers have learned to use forward guidance, that is conditional pledges about policy direction, along with a longer horizon for achieving its inflation target, to try an influence how people borrow and spend.
But Mr. Carney says there are limits to flexibility in conducting monetary policy. He said if markets lost trust in central banks, their effectiveness will be greatly diminished.