Central banks should consider financial vulnerability in monetary policy: BOK conference

Central banks should consider financial vulnerability alongside inflation and economic growth when setting monetary policy, according to arguments presented at the Bank of Korea's international conference.

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If financial conditions are eased, risk management by financial institutions may become lax, improving production and the economy in the short term, but at the same time, the risk of extreme economic recession may increase due to increased investment in risky assets and leverage by financial institutions.

Tobias Adrian, IMF's financial advisor and director of the Monetary and Capital Markets Department, presented a paper titled 'Financial Vulnerability and Monetary Policy.' He argued that while easing financial conditions can boost short-term economic performance, it may also increase risks of extreme downturns by encouraging financial institutions to take on more risk and leverage. Adrian emphasized that incorporating financial vulnerability into policy decisions can reduce economic volatility and enhance overall welfare, offering a different perspective from traditional monetary policy focused solely on inflation and economic output.

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Even if financial stability is not a direct policy objective of the central bank, financial vulnerability must be considered in the monetary policy operation process to mitigate medium- to long-term fluctuations in inflation and the output gap (the difference between actual and potential GDP).

In another session, Princeton University professor Markus Brunnermeier discussed the 'trilemma' of digital currencies, highlighting the inherent conflict between achieving efficient payment systems, credit provision, and privacy. He advised careful consideration of these trade-offs in designing central bank digital currencies (CBDCs) and regulating private payment services.

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The three core values that digital currency pursues – efficient payment, credit provision, and privacy – are conflicting values that are difficult to achieve simultaneously.

Michael Weber, a professor at Purdue University, presented findings from a survey on the US Federal Reserve's perceived political leanings. The study indicated that even if the Fed believes itself to be politically independent, public perception of bias can significantly undermine the effectiveness and credibility of its monetary policy. Weber suggested the Fed needs a new communication strategy to emphasize its non-partisanship and assure the public it does not favor specific interest groups.

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Even if the Fed believes it is a politically independent institution and communicates as such, the credibility and effectiveness of monetary policy are significantly reduced when the general public perceives the Fed as biased.