The crisis showed that irrespective of the degree of globalisation of a country and the soundness of its domestic policies, it cannot remain isolated due to the inter-linkages in the global economy.

The crisis has tested the mettle of central banks.

In the process, they reinvented themselves towards the unconventional and unprecedented role – shifting from the role as lender of last resort to lender of first resort.

While it might yet be early to draw precise lessons, I will highlight six broad lessons reflecting on the ongoing debate, especially from an EME perspective.

Lesson 1. Monetary Policy has Limits: Constrained by Zero bound

The dominant view during the pre-crisis period that one objective and one instrument as the best monetary policy framework has come under question during the crisis. Despite the success of this framework in achieving price stability, the crisis falsified the dominant view that price stability could simultaneously ensure financial stability. It can be observed from the sequencing of monetary policy responses in advanced countries that as policy rates gradually approached record lows or even near zero, central banks had to resort to unconventional measures such as credit and quantitative easing, which posed significant challenges to policy communication.

New Keynesian models generally agree that monetary policy can be effective even at zero lower bound, if policy can take the form of credible commitments to future interest rate paths. However, the risk is that such commitments could undermine central banks’ credibility if not communicated effectively. As solutions to zero bound constraint, other prescriptions (i) raising inflation targets by central banks (Blanchard et al., 2010) and (ii) making negative nominal interest rates a possibility (Mankiw, 2010) have been questioned on various grounds. While such measures may have a stimulating impact on the economy, they may come at the risk of undermining public confidence in the central bank’s willingness to resist further upward shifts in inflation.

Various alternative measures were undertaken in view of the constraint of zero lower bound. For instance, the US Fed expanded its balance sheet on the liability side through remuneration of reserves to pursue an expansionary monetary policy. However, this in itself did not constitute an expansionary policy stance due to lack of associated incentive to spend. The balance sheet expansion on the asset side through direct purchases of private securities, although considered to be more effective, had repercussions in terms of profits/loss with attendant fiscal implications. IMF (2010) points out that in case of severe crisis, increases in risk aversion may well override the stimulus to consumption and investment from low real interest rates.

The monetary policy frameworks in EMEs, mostly based on multiple indicators (e.g., in China, India and Russia) and multiple instruments were found to be more effective in responding to the crisis situation without being confronted with the zero lower bound. Liquidity management operations being an integral part of execution of monetary policy in EMEs, sequencing of policy measures in a combination of rate and quantity instruments proved to be more effective.

While interest rate continues to be the dominant instrument for implementing monetary policy, supplementing it by other quantity or macro-prudential instruments even in normal times will not only enhance the flexibility of monetary policy to attain multiple objectives but also could obviate the risk of hitting the zero lower bound. Concurrent deployment of multiple instruments also enhances the transmission of monetary policy which is impaired as policy rate moves close to the zero lower bound.

Lesson 2. Asset Prices and Monetary Policy: Leaning against the Wind

During the pre-crisis period, central banks’ monetary policy gained more credibility for achieving great moderation characterized by high growth and low inflation. With the adoption of inflation targeting increasing number of central banks had focused primarily on maintaining price stability. However, it needs to be recognized that globalization was another major factor contributing to the great moderation. Countries such as China and India with their abundant labour provided low cost substitutes and thereby helped contain both inflation and wage pressures in the advanced economies. Consequently, with explicit focus on price stability, central banks were able to anchor inflationary expectations and gain credibility.

On the back of robust growth, there was ‘benign neglect’ of credit market excesses and asset price booms. The pre-crisis view largely favoured that asset markets were efficient at distributing and pricing risk. Even though there could be some temporary bouts in asset prices due to “exuberance” on the part of investors, there was little that monetary policy could do about them (Bean et al., 2010). Moreover, many central banks had limited or no supervisory role and therefore ignored or failed to assess the systemic risk arising from credit and building up of asset price bubbles, partly fuelled by a low interest rate environment.

Post-crisis, it is increasingly recognised that the policy of benign neglect of asset price build-up did not succeed: price stability by itself cannot deliver financial stability. Accordingly, it is felt that the mandate of monetary policy should encompass macro-financial stability and not just price stability. The view that monetary policy frameworks should allow policymakers to lean against the buildup of financial imbalances, even if near-term inflation expectations remain anchored, appears to be gaining ground. The balance of views within the central banking community has been shifting in this direction (Carney, 2009; Shirakawa, 2009; Trichet, 2009; Cagliarini et al, 2010; Woodford, 2010 and Fischer, 2011).

It is argued that central banks must improve the underlying analytical framework of their monetary policy taking due cognisance of asset price movements, monetary and credit developments and the build-up of financial imbalances in order to identify potential risks and ensure more informed decision making. Given the likely synergy between macroprudential supervision and conduct of monetary policy, the perception has gained importance that central banks, entrusted with regulatory and supervisory functions, in addition to monetary policy functions, are better equipped to foster financial stability goals. In fact, many central banks have recently been assigned with new responsibilities for microprudential and macroprudential supervision - such as the Bank of England and the Federal Reserve.

Lessons 3. Financial Stability Objective: Instrumentality not Clear?

Post-crisis there is emerging consensus that financial stability should be an objective of central banks but opinion remains divided as to what extent it can be considered as an additional objective of monetary policy. It is argued that the monetary policy horizon for achieving the inflation target could be lengthened to facilitate taking financial stability concerns into account. IMF (2010) noted that in adopting such an approach, central banks need to guard against the persistent deviations of inflation which may otherwise dilute policy accountability and create uncertainty about the long-term commitment to price stability. The question is: should financial stability objectives be considered explicitly in the central bank’s reaction function? Svensson (2009) argues that it should be treated as a constraint to monetary policy rather than as a separate target. The rationale being that under normal circumstances financial stability does not impose any constraints on monetary policy, except in crisis when it undermines the effectiveness of transmission mechanism. Broader mandates for central banks will need to be made explicit and conditional on the priority of the core mandates (Gokarn, 2010).

Many EMEs had financial stability as an additional objective of their monetary policy framework and therefore used multiple instruments, including quantitative tools such as the cash reserve ratio to moderate the pace of domestic credit growth as well as monetary impact of large capital flows (e.g., China, India and Russia). Macro-prudential measures in the form of loan loss provisioning requirements were used to target certain sectors in a number of EMEs (Moreno, 2011). Apart from raising provisioning requirements (on banks’ exposure to systemically important nonbank financial institutions), risk weights (for housing loans, consumer credit and commercial real estate) were also used to check unbridled credit growth in specific sectors. Several countries used credit ceilings (such as Indonesia) and window guidance (involving consultations between the authorities and the banks in China) to curtail lending, while Korea used aggregate credit ceiling to target credit to small and medium enterprises.

Even while the weight of arguments tilts towards acceptance of financial stability as an objective of central bank or monetary policy, there is little agreement about what should be the framework and how it should be implemented: First, even if central banks closely monitor developments in asset markets, how to calibrate the policy response remains an open-ended issue? Second, do central banks have a sufficient number of instruments to conduct both monetary and prudential policy to fulfill a dual mandate of price and financial stability? If both monetary policy and prudential policies are conducted by the central bank, dedicated governance arrangements are needed to ensure monetary policy independence (IMF, 2010).Third, how to coordinate macro-prudential tools with other supervisory and regulatory agencies? This issue becomes all the more important when regulatory and supervisory functions of financial system do not fall under central banks’ purview. Fourth, there are also risks that macro-prudential tools may under certain conditions act as substitutes to policy interest rates and thereby could undermine the effectiveness of monetary transmission mechanism.

Lesson 4. Financial Stability: A Shared Responsibility?

There is no denying that financial stability, by its nature, lacks precise specification and measurement unlike price stability. Even though greater role for central banks has been widely recognized for ensuring financial stability, unlike price stability, a formal institutional framework for better coordination with other regulatory agencies is yet to evolve. Caruana (2011) highlighted that determining the manner of interaction and ensuring central bank autonomy needed to achieve price stability, will not be easy.

Nonetheless, a number of countries, viz., the UK, the US and Euro area are gearing towards a new set of arrangements for better coordination between financial regulatory agencies. In particular, central banks are being assigned with an enhanced role for financial stability in view of their informational advantage with respect to the dynamics of the financial system. For instance, in the UK a Financial Policy Committee (FPC) has been set up under the Chairmanship of Governor of the Bank of England to promote financial stability objective. Within the Bank of England, a Prudential Regulation Authority (PRA) has been constituted to deal with issues related to macro-prudential regulation for reducing risks across the financial system. In this context, it may be noted that in many EMEs, including India, the responsibility for executing monetary policy and supervising the financial system rested with the central banks. This sort of arrangement proved to be more effective during the crisis, especially by enabling central banks to undertake macro-prudential measures.

In the recent years, the Reserve Bank conducted macro-prudential regulation being both the monetary authority and the regulator of banks and non-bank financial institutions. However, there are different regulators for the capital market, insurance and pension fund. In order to facilitate coordination amongst the various regulators of the financial system, recently a Financial Stability and Development Council (FSDC) has been set up with the Finance Minister as Chairman. While coordination mechanisms within the financial sector have been strengthened, it is yet early to assess their efficacy which will be tested by future developments.

Lesson 5. Need for Development of Local Bond Market

In the context of stability of the external sector, a key initiative could be to develop the local currency bond market. Experience shows that capital flows to emerging and developing countries take a sudden hit even if they are not the source of crisis. This can pose a number of challenges for policy makers in EMEs. First, financing of growth can be an issue with significant dependence on external resources. Second, domestic currencies tend to fall with reversal of capital flows. Third, bank-intermediation is also adversely affected as was observed during the recent crisis. Under such circumstances, countries with well functioning and liquid local bond markets cope better with shocks and the risks stemming from frozen credit markets. Since EMEs do not have reserve currency status, they need to keep adequate buffers of foreign exchange reserves to insure against sudden reversals in investor sentiment.

In India, the Reserve Bank and the Securities and Exchange Board of India (SEBI) have taken a number of steps to develop the market microstructure of the corporate bond market. Limits on foreign investment in local currency bonds have been progressively liberalised. It is expected that further reforms in insurance and pension segments of the financial sector alongside fiscal consolidation will spur demand for corporate bonds. As India has a huge need for infrastructure development, the expansion of corporate bond market becomes important.

Lesson 6. Exchange Rate Policy and Global Imbalances

It is argued that the coexistence of complementary growth models may have contributed to the crisis. While many EMEs followed export-oriented growth models, major advanced economies followed debt fueled growth models which were not bound by external current account constraints. This ultimately led to building up of global imbalances between current account deficits and surpluses as well as between savings and investment. The causation, however, is not very clear: whether it is excess savings in EMEs or excess consumption in the advanced countries that contributed to the crisis. Moreover, it is also not clear whether movement in exchange rates by itself could have prevented global imbalances without an adjustment in aggregate demand – lower consumption in the advanced countries and higher consumption in EMEs. On balance, there is broad agreement that greater flexibility in exchange rate could help moderate global imbalance.