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JEM027 Monetary Economics Monetary policy, asset prices and financial stability Tomáš Holub [email protected] December 14, 2015 Partly based on presentation of K. Šmídková from 2013 Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague Monetary policy: the pre-crisis view 1 Central banks should take care of the economic welfare, together with other institutions 2 Welfare is a too complex concept, so central bank is attributed one specific role related to what it can really achieve in the long term: protect price stability by using monetary policy 3 Price stability is too abstract concept, monetary policy is given explicit target (2% CPI inflation) 4 Consensus about policy tool: short-term rates only 5 Consensus about forecasting tool: high-tech model such as DSGE (real economy only, no financial sector) combined with expert judgment JEM027 – Monetary Economics 1 Our basic model corresponds to this view The loss function (strict IT) The model Inflation is the only target Forecasting model is consensual Experts judge the size of shocks ... where εt+1 and ηt+1 are white noise random shocks Optimization problem Interest rate the only tool JEM027 – Monetary Economics 2 Monetary policy in this set-up Optimal reaction function Interest rates react only to variables in the model Actual inflation in time t+2 Success is measured by deviation of inflation from the target in a given time horizon JEM027 – Monetary Economics 3 Inflation was stabilized: all was sunny Bernanke (2004) in “Reflections on Monetary Policy 25 Years after October 1979” “ The low-inflation era of the past two decades has seen not only significant improvements in economic growth but also a marked reduction in economic volatility, a phenomenon that has been dubbed "the Great Moderation" is due to good monetary policy. Greenspan (2005) in “Greenspan Era – Lessons for the Future” “ US economy has prospered notably, inflation remains low, resilience to shocks and flexibility enhanced. Gaspar, Kashyap (2006) in “ECB colloquium held in honour of Otmar Issing” “ ” ” The stability-oriented monetary policy clearly worked, the HICP inflation during the first 7 years of the single monetary policy was very close, but not below 2%. JEM027 – Monetary Economics ” 4 Criticism when IT was being introduced The loss function (flexible IT) Under flexible IT, some weight is put on output stability. ▪ When inflation targeting was being introduced, it was typically criticised for leading to too restrictive policy (”inflation freaks“). ▪ Central bank put a lot of effort into explaining that in reality they were doing flexible inflation targeting, contributing to stability of output. ▪ Empirical analyses suggest that they were successful in achieving this before the crisis. JEM027 – Monetary Economics 5 The impact of the crisis: the prosperity is gone UK GDP growth US economic growth Percent Percentage change in GDP, annualised Source: US Department of Commerce JEM027 – Monetary Economics 6 IT and the crisis ▪ Even before the crisis, some people were saying that the IT alone is not ▪ ▪ enough and that central banks should also take care of financial stability (e.g. W. White, BIS) The crisis has challenged the prevailing policy paradigm, including the IT strategy. The IT framework is now criticised for leading to too loose monetary policy, that contributed to the emergence of bubbles! 10 9 Euro area - actual rate Euro area - Taylor rule 8 7 6 5 4 3 2 1 0 I/99 I/00 I/01 I/02 I/03 I/04 I/05 I/06 I/07 I/08 JEM027 – Monetary Economics 7 Deviations from Taylor Rule and Housing Booms Source: Ahrend, et al. (2008) JEM027 – Monetary Economics 8 Some post-crisis quotes ▪ Greenspan (October 2008): he admitted that he was in a state of shocked disbelief, because the whole intellectual edifice had collapsed ▪ Krugman (2009): last year everything came apart – There is no convergence of vision, as claimed by Lucas in 2003 (and also Blanchard in 2008, see next slide) – The problem of depression-prevention has not been solved, as claimed by Bernanke in 2004 JEM027 – Monetary Economics 9 About models: prior and after crisis Blanchard (2008) “ The state of macro is good... The battles of yesterday were over...There is a broad convergence of vision. ” Krugman (2009) “ Comments from Chicago economists are the product of a Dark Age of macroeconomics ... Hard-won knowledge (...how to prevent depression) has been forgotten. JEM027 – Monetary Economics ” 10 Monetary policy: the post-crisis debate 1 Central banks should take care of the economic welfare, together with other institutions 2 Welfare is a too complex concept, so central bank is attributed one specific role related to what it can really achieve in the long term : protect price stability by using monetary policy 3 Price stability is too abstract concept, monetary policy is given explicit target (2% CPI inflation) 4 Consensus about policy tool: short-term rates only 5 Consensus about forecasting tool: high-tech model such as DSGE (real economy only, no financial sector) combined with expert judgment JEM027 – Monetary Economics 11 Should we really put the blame on IT? ▪ Deviation from Taylor rule means that the policy was too loose compared to the inflation targeting standard (not that IT is too loose in itself) ▪ The subprime mortgage bubble that led to the global financial crisis originated in the US, which was not pursuing inflation targeting, but following its ”just-do-it strategy“ with the dual objective (and focus put on core rather than headline inflation) ▪ In Europe, the problem of too loose policy related to countries that had surrendered their monetary policy either due to euro adoption, or due to a currency board regime; it was not a problem of IT countries; ▪ IT performed quite well empirically during the crisis, relative to other MP regimes. The debate should not be about replacing inflation with another known MP regime, but about adding the MP-FS nexus. JEM027 – Monetary Economics 12 Post-crisis issues ▪ How to link monetary policy, financial stability and regulation/supervision? ▪ MP response to asset prices: Greenspan‘s ”cleaning“ view challenged; should monetary policy ”lean against the wind“? ▪ Inclusion of the asset prices into the targeted index: e.g. imputed rents? ▪ Inclusion of financial imperfections into macro models (for sure, but how?) ▪ Number of objectives vs. number of tools: active counter-cyclical use of regulatory powers as well (i.e. macro-prudential tools)? JEM027 – Monetary Economics 13 Monetary policy – financial stability nexus (i) Is it possible / optimal to have a Chinese wall in between? ? Price stability Financial stability Financial developments Interest rates Macro-prudential tools JEM027 – Monetary Economics 14 Two (separate) targets and models? The loss function (pure IT) The loss function (FS targeting) What we need to know The model The model Optimization problem for year t Optimization problem for year t JEM027 – Monetary Economics 15 Leaning against the wind? Shall monetary policy sometimes be more restrictive than needed to for achievement of the inflation target in order to reduce the risk of bubbles? Price stability Financial stability Financial developments Interest rates Macro-prudential tools JEM027 – Monetary Economics 16 Leaning against the wind – arguments in favour ▪ Bubbles have high (first-order) social costs. ▪ Once bubbles burst, it affects adversely achievement of MP objectives – trying to avoid them is in line with these objectives, you just need to take a longer-term view. ▪ Pre-emptive reaction is less harsh than a postponed one. ▪ Reacting only when bubble bursts leads to asymmetry (the „Greenspan put“ resulting in excessive risk-taking). ▪ If macro-prudential tools are not developed, using monetary policy may be a second-best option. ▪ Pre-emptive reaction to bubbles and imbalances advocated by various studies (e.g. Cecchetti et al, 2000) JEM027 – Monetary Economics 17 Leaning against the wind – arguments against ▪ Bubbles are hard to detect, there are many false alarms. ▪ Responding to these false alarms imposes unnecessary costs on the economy. ▪ Having two objectives with one instrument only runs against the Tinbergen principle: trying to chase two rabbits, you may lose both of them, and undermine the credibility of your policy framework. ▪ Interest rates are too blunt a tool to prick the financial bubbles. ▪ The first best is to develop macro-prudential tools. JEM027 – Monetary Economics 18 Leaning against the wind – Swedish experiment ▪ Sweden was leaning against the wind in 2011-2013. ▪ Lars Svensson, Riskbank‘s Board member, has criticised this heavily. ▪ In December 2013, Riksbanks started to move away from this policy: – Riskbank‘s December 2013 policy decision: ”Deputy Governor Per Jansson began by saying that this was probably the most difficult repo-rate decision he had been involved in during his time as a member of the Riksbank's Executive Board.“ – Centralbanking.com (8 January 2014): Riksbank board grappling with ‘genuine policy dilemma: ”The Riksbank cut its repo rate by 25 basis points to 0.75% last month in a bid to bring "unexpectedly low" inflation back towards its 2% target…The move marked a departure from the bank's previous policy of using interest rates to curb Sweden's large and growing household debt stock (known as ‘leaning against the wind'), which currently stands at about 170% of average disposable income.“ JEM027 – Monetary Economics 19 Leaning against the wind – Swedish experiment JEM027 – Monetary Economics 20 Leaning against the wind – Norway Interest rate trajectory according to different monetary policy criteria Source: Norges Bank 7 6 Historical interest rate Actual interest rate Criterion 1 (March 2012 forecast) Criteria 1&2 (March 2012 forecast) Criteria 1,2&3 (March 2012 forecast) 5 4 3 2 1 0 3/08 9/08 3/09 9/09 3/10 9/10 3/11 9/11 3/12 9/12 3/13 9/13 3/14 9/14 3/15 9/15 ▪ Criterion 1 = strict IT; Criterion 1&2 = flexible IT; Criterion 1,2&3 = flexible ▪ IT with leaning. It seems that the Norges Bank was leaning in 2012-2013, but the fall in oil prices and deteriorating macro situation have enforced rate cuts. JEM027 – Monetary Economics 21 Debate about the targeted index ▪ Inflation target is based on CPI that includes prices of consumed goods ▪ Missing from the index are: prices of commodities (gold, silver, etc.) and assets (equities, houses, etc.) ▪ This omission would not matter if both – consumer and asset – prices developed similarly ▪ However, asset prices are more volatile and this volatility can make the whole economy volatile ▪ Since low CPI inflation does not guarantee stable asset prices, question follows: is it enough to target CPI inflation? JEM027 – Monetary Economics 22 The view that targeted index must change ▪ Targeting CPI not enough, extend the index (Filardo, 2000 explored how much it would help) ▪ The crisis partially caused by neglecting asset price booms, specially on housing market (USA, UK, Spain) ▪ With extended new index, monetary policy would have been tighter, ceteris paribus ▪ Monetary policy strategy as a such would remain unchanged ▪ Volatility would be smaller, so would economic costs ▪ ESCB discussed incorporating housing prices into HICP via owner occupied housing JEM027 – Monetary Economics 23 The new index and the model The loss function (pure IT) Change index The model ... where εt+1 and ηt+1 are white noise random shocks Optimization problem JEM027 – Monetary Economics 24 Question: which is which? ▪ Assume I want to combine two indices into one to get the new target index for Spain Which is which (CPI, housing, new index)? What will new index imply for policy rates? JEM027 – Monetary Economics 25 Answer: new index ▪ The new index is black ▪ Housing more volatile ▪ New index will lead to more volatile rates JEM027 – Monetary Economics 26 Modelling financial imperfections (seminar topic) ▪ External finance premium (fin. accelerator; credit channel) – The price of credit depends on net worth – Bernanke, Gertler (1989); Bernanke, Gertler, Gilchrist (1999); Christiano, et al. (2003); Beneš, Kumhof (2011) ▪ Collateral constraints (balance sheet channel) – Volume limits on borrowing – Hart, Moore (1994); Kiyotaki, Moore (1997); Kocherlakota (2000); Iacoviello (2005); Iacoviello, Neri (2010) ▪ Models with banks – Bank lending channel as well as balance sheet channel; existence of multiple interest rates – Goodfriend, McCallum (2007); Cúrdia, Woodford (2009); Christiano, Trabandt, Walentin (2007); Gerali et al. (2009; 2010) JEM027 – Monetary Economics 27 Macro-prudential policy: How to define the target? ▪ How exactly should the explicit target for macro-prudential policy be defined is not clear yet ▪ Hans Gersbach 2009: equity capital requirements (minimum level) ▪ Claudio Borio and Mathias Drehmann 2009: operational framework difficult, take the measurement challenge seriously, find barometer of distress (EWI) ▪ Gabriele Galati and Richhild Moessner 2010 and 2011: set limit to systemic risk ▪ IMF 2011: set limit to a range of systemic risk indicators JEM027 – Monetary Economics 28 Two mandates under one roof ? ▪ Carmine Di Noia et al (1999): Inflation rate higher where two mandates in one institution (credibility loss), based on 12 countries with 2-2 and 12 countries with 2 in 1 institutional set-ups ▪ C.A.E. Goodhart (2000): Arguments for 2 in 1 alternative (transmission of information, payment system) as well as against it (the balance of power important, conflicts of interest) ▪ 2013: BoE, CNB, ECB... many central banks have two mandates now JEM027 – Monetary Economics 29 Macroprudential tools: examples ▪ The idea that interest rates alone cannot prevent various asset bubbles and their costly consequences leads also to the proposal that we need a set of macroprudential tools ▪ Examples of macro-prudential tools: counter-cyclical capital buffer, discretionary capital ratios to different classes of assets, extensive stress testing of portfolios to force macro risk internalization, credit growth ceilings, LTVs, removal of tax policies that encourage excessive risk taking (mortgage subsidies) JEM027 – Monetary Economics 30 Actual use of macro-prudential tools (i) JEM027 – Monetary Economics 31 Actual use of macro-prudential tools (ii) JEM027 – Monetary Economics 32 Summary: to great moderation and beyond 1980s ▪ Inflation, lost credibility 1900s ▪ Emergence of inflation targeting, consensus on explicit target, policy tool and forecasting model 2000s ▪ Great Moderation: Romer re-writes textbooks (How LM Curve Disappeared), new generation of forecasting models (DSGE without financial variables) 2010s ▪ Financial crisis challenged nearly everything; financial stability is becoming a new objective, macro-prudential tools are being developed… JEM027 – Monetary Economics 33 Summary: the post-crisis situation 1 Economic welfare: still desirable, but cannot be linked only to price stability and output gap stabilisation 2 Central banks: many were attributed with another role (financial stability) 3 Explicit target: CPI may be modified to better include housing prices 4 Instruments: macro-prudential tools are being developed and employed in practice 5 Forecasting tools: macro models being extended to include a financial part (so far as simulation rather than forecasting tools); better EWS needed, also work in progress JEM027 – Monetary Economics 34