PARIS (MNI) – A key lesson of the latest crisis is the importance
for central banks to preserve the credibility that allows them to
respond flexibly to new challenges, European Central Bank Governing
Council member Athanasios Orphanides said Friday.

“I think the crisis has reaffirmed the benefits of having the
central bank focus on maintaining price stability, safeguarding well
anchored inflation expectations in line with price stability,”
Orphanides, who heads the Bank of Cyprus, told a financial conference
here.

“The focus on price stability brings gains in credibility that
allow central banks to act decisively” when unconventional measures are
called for, he said, citing the various liquidity measures introduced
during the crisis. This “could not have been done if the central bank
was not credibly committed — and understood by everyone to be committed
— to maintaining price stability.”

At a time when spiraling energy prices reminds again of “the
specter of stagflation” this ability to act decisively must be
preserved, he argued.

As a consequence, the “stability-oriented approach” to monetary
policy has gained ground over the “activist view,” Orphanides asserted.
The first seeks to promote stable economic growth subordinate to the
goal of price stability.

The second aims to actively guide the economy toward obtaining its
full potential by setting out additional policy goals, for example
reducing the output gap. This creates the dangerous “temptation to
fine-tune the economy in addition to maintaining price stability,” he
said.

“Trying too hard to close the output gap can lead to worse results”
for both price stability and the economy, Orphanides warned.

“Distracting attention away from price stability by attention to
fine-tuning the economy threatens to lead the central bank to remain too
accommodative for too long,” he said. “Nothing should distract the
central bank from preserving price stability.”

International organizations like the IMF and the European
Commission have a tendency to overestimate the size of the output gap,
Orphanides noted. Indeed, the warnings to policymakers in the run-up to
the latest crisis might have received more attention without these
errors.

–Paris Newsroom, +331-42-71-55-40; stephen@marketnews.com

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