Monetary policy flexibility, risk management, and financial disruptions

This paper argues that the monetary policy that is appropriate during an episode of financial market disruption is likely to be quite different than in times of normal market functioning. When financial markets experience a significant disruption, a systematic approach to risk management requires policymakers to be preemptive in responding to the macroeconomic implications of incoming financial market information, and decisive actions may be required to reduce the likelihood of an adverse feedback loop. The central bank also needs to exhibit flexibility-that is, less inertia and gradualism than would otherwise be typical-not only in moving decisively to reduce downside risks arising from a financial market disruption, but also in being prepared to take back some of that insurance in response to a recovery in financial markets or an upward shift in inflation risks. (C) 2009 Elsevier Inc. All rights reserved.