Economics Working Paper 19113
Abstract: The Bank of Canada has been considering whether to focus on financial stability (defined as responding to the build -up of financial imbalances) in addition to its mandate of a two per cent inflation target. In this paper we marshal historical and empirical evidence to make the case that the BoC should “stick to its knitting” and focus on price stability. A major impediment to burdening the BoC with additional responsibilities to maintain financial stability is that there is disagreement not only about when financial instability erupts, not to mention the form this instability can take, but also about its overall economic impact. Although calls to increase the burdens placed on central banks have become more widespread in recent years at the international level, policymakers also need to be made aware that such views are sometimes based on erroneous assumptions. These include: (i) All financial crises are the same. They are not; (ii) We know the size, timing and spillovers from financial crises. There is no one-size-fits-all response to financial crises; (iii) Financial stability policy is capable of being forward-looking. Unlike monetary policy, which has been forward-looking for more than two decades, there is little evidence yet that the same is currently feasible to maintain future financial stability. Any renewal of the Bank of Canada’s inflation target, while explicitly acknowledging the bank’s role as one of several agencies responsible for the maintenance of financial stability, should not confuse the public by adding the burden of meeting a goal it cannot reasonably achieve on its own. Unlike inflation, which, as discussed below, inflation-targeting central banks have managed to control within tolerance ranges for more than two decades, financial stability requires a much wider set of tools. If the central bank were to become responsible for these tools, this would bring the institution dangerously close to making political-style decisions.