January 28, 2008
Abstract: Events in 2007 raised a fundamental question: should central banks take asset price movements into consideration. Proponents argue that if financial turbulence threatens the macroeconomic stability, central banks must respond, while opponents contend that central bank intervention aggravates moral hazard and sets the stage for future problems.
The author’s view is that intervention is warranted if the fundamental objects of the central bank namely, inflation and growth are threatened, and that consequences such as moral hazard can be dealt with by other instruments like prudential norms. Within this framework, to decide whether a rate cut is warranted, all possible factors that are currently influencing growth and inflation need to be considered: domestic or international. Analysis shows that domestic factors have caused the current growth rate to remain below trend and that inflation is within the comfort zone. The global financial situation also requires that domestic growth should be supported. Clearly, there is a case for immediate rate cut.
Keywords: global financial volatility; central bank; macroeconomic stability; growth; inflation; rate cut