While the U.S. economy registered rather strong growth from mid-2003 through mid-2006, core inflation edged up slowly from 1.5% to 2.5%. Then, in the second half of 2006, economic activity took a downturn on a sharp pullback in housing activity. What at the time appeared to many Fed officials as nothing more than an adjustment in the pace of economic expansion proved to be the early signs of the worst financial crisis in 60 years. According to IMF estimates, financial sector losses in the advanced economies could attain $4.1 trillion and the output gap is expected to reach 6% of GDP in 2010. Given the magnitude of the financial costs and the human hardship brought on by the crisis, it is not surprising that financial stability has become a key objective for governments. Financial markets are likely to see new regulations implemented and, as Bank of Canada Governor Mark Carney mentioned in Jackson Hole on August 22, the response to the crisis means it will no longer be business as usual as far as monetary policy goes. Indeed, achieving financial stability objectives may require deviating temporarily from the inflation target.
How did we get there?
Some people might wonder whether proposals to broaden the central bank’s mandate and to extend the powers of the regulators are not overkill. After all, was the crisis not triggered by defaults in the subprime mortgage market? Conventional wisdom has it that at the heart of an efficient financial market lie institutions that exercise caution when extending credit, all the while seeking out innovative ways to improve efficiency. It could easily be said that, to some extent, the U.S. mortgage market proved deficient in this regard. Indeed, in the thick of the housing boom, loans were granted to borrowers based on limited or no proof of income. This certainly does not qualify as a prudent lending practice.
