Should central banks incorporate financial stability considerations in reaching monetary policy decisions? : the case for the central bank of Malta

Abstract

In recent years, the issue whether financial stability concerns should be given an enhanced role in the operations of central banks has become widely debated among central bankers. It has been recognised that financial instability, especially that involving the banking sector may hinder the achievement of monetary policy objectives. Hence, there may be two-way causation between monetary policy objectives and financial stability considerations. This has stimulated much of the debate on the relationship that the two functions must occupy within central banks. These ongoing debates have inspired this dissertation. The main role of monetary policy and financial stability within the central banks has been assessed in great detail. Also, the implications of the absence of stable prices or financial instability on the other counterpart have been examined. The research highlighted that if the central bank tackles the two objectives concurrently in its monetary policy stance, the bank may be faced with a conflict of interest between achieving price stability and mitigating financial instabilities. Practical examples where such situations can occur have also been discussed. Moreover, the paper discusses the limited effect that monetary policy under inflation targeting may have in mitigating financial imbalances. International evidence on the level of integration of financial stability considerations when designing monetary policy decisions has been compiled. The research methodology focused on two parts, with the most important being the survey conducted among six national central banks. The results of the research have been used to allocate the national central banks along a continuum, depending on the respective levels of integration of financial stability considerations in monetary policy decisions. The Bank of England resulted as the topmost central bank which incorporates most financial stability considerations in monetary policy decisions. The study also focused on the case of the Central Bank of Malta. Assessment of the current state of play on the matter has been undertaken. Furthermore, ample discussion focused on the evolvement of the two functions within the Bank once Malta joins the euro area. The research also highlighted the fact that the Maltese financial service sector, in particular the banking sector, is in synchronisation with that of the euro area. This implies that any future monetary policy decisions taken by the European Central Bank will have similar impact on the financial stability in Malta as those observed in the euro area. The study concluded by emphasising that although it would be unwise for central banks to ignore financial stability considerations, monetary policy should still maintain its focus on the achievement of price stability. However, the modification of the time horizon for inflation forecasting over the medium to longer-term could ensure that threats of financial imbalances are addressed in a timely manner.