Download Financial Cycle, Financial Stability and Monetary Policy

Monetary Policy, Asset Prices
and Financial Stability:
A New Consensus on the Horizon?
Jan Frait
Executive Director
Financial Stability Department
November 2012
This lecture represents my own views and not necessarily these of the
Czech National Bank.
At the same time, the lecture is focused on the general aspects of a
monetary policy framework and its content has no connections to the
current monetary policy stance of any central bank.
This presentation is based on
FRAIT, J., KOMÁREK, L., KOMÁRKOVÁ, Z. (2011): Monetary Policy in
a Small Economy after the Tsunami: A New Consensus on the Horizon?
Czech Journal of Economics and Finance 61, No. 1, pp. 5-33.
http://journal.fsv.cuni.cz/mag/article/show/id/1202
FRAIT, J., KOMÁRKOVÁ, Z. (2011): Financial stability, systemic risk and
macroprudential policy. Financial Stability Report 2010/2011, Czech
National Bank, pp. 96-111.
http://www.cnb.cz/miranda2/export/sites/www.cnb.cz/en/financial
_stability/fs_reports/fsr_2010-2011/fsr_2010-2011_article_1.pdf
What Is This Presentation Focusing On?
• The prevailing views on monetary policy-making reflect the experience of
the Fed and other central banks in major advanced economies.
• The theoretical framework of flexible inflation targeting is strongly
influenced by U.S. academia.
• Central bankers in small and emerging economies:
• being event-takers (or price-takers) often do not have a chance to opt for
the first-best policies owing to external conditions set by the macroeconomic
policies of major advanced economies,
• must therefore be less orthodox, more flexible and exceptionally smart to
succeed,
• the optimal way of making monetary policy may vary over time as external
conditions and macroeconomic policies in large economies change,
• occasionally, steps that do not look intuitive may constitute the best reaction
(though still being only second best).
• This view reflects the experience of the Czech National Bank (CNB) as a
central bank operating in a flexible exchange rate framework.
3
I.
Monetary Policy Framework in the Pre-Crisis Times?
Price Stability, Decline of Interest Rates and the Great Moderation
• In the second half of the 1980s, in response to the high inflation of the
previous two decades, central banks focused on achieving price
stability, i.e. low and stable inflation, as their primary objective.
• In most countries, price stability was achieved quickly – in advanced
countries by the early 1990s and in emerging and developing ones
in the second half of the 1990s.
• Inflation expectations in many countries started to be strongly and
successfully anchored by explicit or implicit inflation targets.
• The restoration of price stability led to a considerable and sustained
decline in nominal interest rates.
• In this environment central banks did not have to respond to the
economic recovery by rapidly tightening monetary policy as in
previous boom and bust cycles which fostered a reduction in the
short- to medium-term volatility of real economic activity.
• The view started to prevail that a “Great Moderation” had occurred in
the world economy and that a long period of low and stable inflation
and high and stable economic growth lay ahead.
Price Stability, Decline of Interest Rates and the Great Moderation
• The onset of the Great Moderation coincided with the development of
the theory and models of inflation targeting.
• In the years before the crisis, a consensus reflecting the theoretical and
empirical studies published over the previous two decades completely
prevailed among mainstream theoreticians and policy-makers.
• Bean et al. (2010) talk about the “Jackson Hole“ consensus as a
synthesis of the rigour of dynamic general equilibrium modelling with
the empirical realism of sticky-price Keynesian thinking.
• Mishkin (2010) refers to it as the “science of monetary policy” based on
the new neoclassical synthesis (as defined by Clarida, Gali and Gertler,
1999) and transformed into a system of flexible inflation targeting.
• One of the major effects of the strength of this consensus was a strong
belief in the potential of monetary policy and in central banks’ ability to
leverage this potential.
The Great Moderation versus the Asset Markets‘ Wilderness
• The expected stabilisation of financial markets did not take place, on
the contrary, fluctuations in asset markets increased and were
accompanied by sharp changes in credit dynamics.
• Economists responded in the late 1990s by opening a major debate on
whether monetary policy should actively seek to encourage asset price
stability, or even whether it should attempt to prevent or at least reduce
asset price bubbles.
• Central banks have always been taking the asset price developments
into account when setting monetary policy:
• asset price movements impact on CPI inflation via demand for goods and
services used to create assets, and also through spending via the "wealth“
effect.
• The debate always was not whether a central bank should respond at
all, but whether it should respond over and above the response
associated with the objectives to stabilise inflation and output.
Benign Neglect View
• The predominant “benign neglect” view in the literature prior to the
current crisis was that a central bank should pay attention to asset
market developments, but cannot and should not try to constrain asset
price bubbles on their own.
• The classical and influential contributions justifying this particular view
were provided by Bernanke and Gertler (1999, 2001):
• central banks should focus primarily on underlying inflationary pressures
and that asset prices can become relevant only to the extent that they may
signal potential inflationary or deflationary forces;
• policy rules responding directly to asset prices would provide little if any
additional gains.
• These contributions strongly influenced „global monetary policy view“
even though the Fed (US) is more specific than a general case.
Ben Bernanke – Use the Right Tool for the Job!
• Bernanke (2002) suggested a very simple rule for central bank policy
regarding asset market instability defined in line with the Tinbergen
separation principle:
• Use the right tool for the job!
• Fed has two sets of responsibilities:
• maximum sustainable employment, stable prices, and moderate long-term
interest rates,
• the stability of the financial system.
• Fed has two sets of policy tools:
• policy interest rates,
• range of powers with respect to financial institutions.
• Fed should focus its monetary policy instruments on achieving its
macro goals, while using its regulatory, supervisory, and lender-of-last
resort powers to help ensure financial stability.
• This particular rule subsequently gained a very strong position in the
deliberations of the central banking community.
Lean-Against-the-Bubble View
• There was a second stream developing alongside the predominant
view favouring a more active monetary policy approach to asset price
swings - a special subgroup consisted of the writings of BIS economists
(see the next section).
• The proponents of leaning against the bubble assert that a central bank
should take account of, and respond to, the implications of asset-price
changes for its macro-goal variables.
• A well-known example of the “leaners” approach is Cecchetti et al.
(2000), who applied the classic Poole (1970) analysis:
• a central bank should “lean against the wind” of significant asset price
movements if these disturbances originate in the asset markets
themselves, if a disturbance originates in the real sector, asset prices
should be allowed to change in order to absorb part of the required
adjustment.
• an inflation-targeting central bank is likely to succeed by adjusting its policy
rates not only in response to its forecast of the inflation and output gap, but
also in response to asset prices.
Lean-Against-the-Bubble View
• They believe that such an approach could also reduce output volatility.
• This conclusion is based on the view that reaction to asset prices in
the normal course of policy making will reduce the likelihood of
asset price misalignments arising in the first place.
• On the other hand, the authors are not recommending that central
banks either seek to burst bubbles currently perceived to exist, or
target specific levels of asset prices.
• Furthermore, they do not recommend responding to all changes in
asset prices in the same way or including asset prices directly in
measures of inflation.
• They just say that it is important for central bankers to develop a
framework for policy making that accounts for the various sources of
uncertainty that they face in meeting their objectives.
Lean-Against-the-Bubble View
• While confirming their previous stand, Cecchetti et al. (2002) admit that
setting policy rates on the basis of conscious deviations of expected
inflation from the target could hurt credibility.
• The outcome could be that policy becomes less predictable and
less transparent.
• In practice, attempts to set interest rates at a level different from
what is necessary to achieve the target level must be accompanied
by a justification that is explained simply and that commands broad
agreement.
Lean-Against-the-Bubble View
• The lean-against-the-bubble strategy has always been acknowledged
as not without merit even by supporters of the predominant view - they
have nevertheless believed that leaning against the bubble was unlikely
to be productive in practice.
• It is difficult to identify a bubble, once a central bank becomes certain that
a bubble has emerged, it will probably be too late to act with interest rate
hikes.
• Pursuing a separate asset price objective could mean having to
compromise on the inflation objective. A central bank’s focus on assets
could lead to public confusion about its policy objectives (Giavazzi and
Mishkin, 2006).
• It is unlikely that a small increase in short-term interest rates,
unaccompanied by a significant slowdown of the economy, will induce
speculators to modify their equity or real estate investment plans.
• To materially affect some asset prices, such as housing, interest rates
would probably need to move by much more than would be required just to
keep CPI inflation comfortably within the target range.
II.
The BIS Approach,
or the Austrian Business Cycle Revisited
Endogenous Financial Cycles Is What Matters
• An alternative approach to the predominant view was presented by
economists around the Bank for International Settlements (Borio, White,
Lowe,...):
• achieving both price and output stability still does not automatically
guarantee financial stability;
• the behaviour of globalised, liberalised financial markets can cause radical
changes in macroeconomic dynamics leading to financial instability;
• despite the fact that more efficient monetary policies helped to reduce shortterm output volatility and prolong expansions at the expense of recessions,
liberalised financial markets have created favourable environment for
endogenous “boom and bust” cycles;
• in periods characterized by low volatility of inflation and stable economic
growth market participants may start underestimating the level of risk …
Endogenous Financial Cycles Is What Matters
• ....
• so, during good times when cyclical improvements are confused with longterm boosts in productivity, endogenous virtuous circles can evolve, initiated
by the higher readiness of firms and households to take on debt and use it
for buying risky assets.
• these virtuous circles are characterised by higher asset prices, dampened
risk perceptions on the side of both banks and their clients, lower external
financing constraints, softer lending standards, accumulation of debt;
• against the background of this virtuous circle, sources of systemic risks build
up - they often show up after a long lag, when economic activity weakens as
a result of some kind of stimulus;
• when a contraction occurs, opposite processes take place, vicious circle sets
in, leading potentially to financial crisis with large negative impact on
economic activity.
Minsky revisited
• The idea that periods of economic stability encourage exuberance in
credit markets, thus sowing the seeds of their own destruction, is a key
part of Minsky’s theory of recurring financial crises or financial instability
hypothesis (Minsky, 1982).
• Minsky described a process in which endogenous speculative bubbles
emerge over the cycle due to the behaviour of financial markets:
• In good times the incomes grow well above levels required for stable servicing
of debts which may over time help to set debt-driven „leveraged“ investment
euphoria (or euro-phoria?).
• Initially predominant “hedge financiers“ or conservative debtors (who redeem
both principal and interest from standard incoming revenues from the
investment) are being joined by speculative debtors (able to serve only interest
from standard income, but they have to regularly roll over the principal) and
finally by Ponzi debtors (fully bet on the growth of the asset price only, not able
to service even interest from current incomes).
Minsky revisited
• If this credit cycle becomes too strong, it will end up in a Ponzi game.
• Accumulated debts exceed the level at which speculative debtors are able
to service debts from current incomes, they become Ponzi debtors and all
start selling their assets.
• A Minsky moment follows – market participants realize the overvaluation
of assets and excess level of their debts, start selling assets on a mass
scale, liquidity crisis starts transforming itself into solvency crisis.
• Banks increase risk margins and tighten lending standards even for
financially sound conservative debtors who can subsequently default as
well.
• Minsky‘s financial instability hypothesis can be well applied not only to the
US subprime crisis or to Spanish real estate crisis, but also to global
economy generally – conservative debtors like many traditional nonfinancial firms can go bust once the economic activity goes down due to
synchronized decline of demand.
Lean Against the Wind, Anchor Liquidity!
• The BIS economists decisively challenged the traditional objections to the
leaning-against-the wind strategy
• as to the bubble identification, they say that it is simply a wrong focus - the
proper one should be placed on financial imbalances and not so much on asset
price bubbles;
• even though identifying financial imbalances ex ante is not easy, it is certain
that sustained rapid credit growth combined with large drifts in asset prices
increases the probability of a future episode of financial instability;
• BIS economists suggest that the role of monetary policy would be to anchor the
liquidity creation process and, hence, the availability of external finance, since
lending plays a key role in determining money and macroeconomic dynamics.
• it is crucial to lean against the build-up of financial imbalances by tightening
policy, when necessary, even if near-term inflation pressures are not apparent;
• monetary policy oriented towards price stability has to be combined with
macroprudential policy oriented towards financial stability.
Lean Against the Wind
• BIS economists (mainly W. White) strongly argued against “can’t lean, but can
clean” policy asymmetry advocated, for example, by Alan Greenspan.
• many in the central banking community subscribed to the view that
monetary policy would not be effective in “leaning” against the upswing of a
credit cycle but that lower interest rates would be effective in “cleaning” up
afterwards;
• W. White finds the “can’t lean, but can clean” propositions seriously
deficient, since monetary policies designed solely to deal with short-term
problems of insufficient demand could make medium-term problems worse
by encouraging a build-up of debt to unsustainable levels;
• instead, monetary policy should be focused more on “pre-emptive
tightening” to moderate credit booms than on “pre-emptive easing” to deal
with the after-effects.
Great Moderation and Risk Disappearance
• Although the financial
markets did not
experienced stabilisation,
financial institutions
gradually started believing
that the Great Moderation,
would lead to a fall in credit
and market risk.
• This resulted in a gradual
decline in risk premia
(credit spreads, interest
rate margins) as a measure
of the price of risk of loans
and other debt products. Note: As from December 1997, s imple average of US and euro area high-yield Merril
Lynch indic es; Monthly average of BBB-rated Merrill Lynch bond index yields against
The biggest decline in
10-year government bond yields for US, EMU (10Y German), JP and UK, simple
average; option adjusted spreads; JP Morgan Emerging Markets Bond Index Plus .
spreads occurred in the
middle of the last decade.
2100
basis points
High-yield corporate spreads
1800
EMBI+ spread
1, 3
4
Corporate bonds spreads
2, 3
1500
1200
900
600
300
0
1997
1999
2001
2002
2004
1
2
3
4
2005
2007
2009
2010
Great Moderation and Tsunami
• Even though this decline was explained at the time by the effects of
the Great Moderation and financial institutions’ improved ability to
manage risks:
• In reality financial markets lost part of their capacity to value risk;
• This was fully revealed following the onset of the crisis in 2007 and 2008,
when spreads conversely increased dramatically.
• In the last decade, therefore, financial markets experienced a tsunami
effect, as risk first disappeared from the markets like water from the
oceans only to return with a vengeance at the start of the crisis in the
form of a destructive tidal wave.
• the comparison of the financial crisis with a tsunami was first used by
Alan Greenspan on 23 October 2008 in his Congressional testimony - he
had in mind the shocking deterioration of credit markets that occurred
after the Lehman Brothers failure;
• the more important tsunami-like aspect was the near disappearance of
credit risk margins from markets in the mid-2000s;
• the correct description of the credit tsunami has to take into account both
periods of risk motion, i.e. full financial cycle and the movement of
systemic risk (its cyclical or time dimension) in the course of it.
III.
Boom and Bust: Were Small Economies Different?
Not Leaning Against the Wind
• Economic community in general was aware that the pre-crisis decade was a
period of rapid global economic growth on the one hand and the build-up of
significant risks due to financial market developments on the other, but there
was not much open debate in central banks about making fundamental changes
to the existing monetary policy paradigm.
• One reason was that financial sector developments played a relatively small
role in the prevailing models and the economy was almost always close to
equilibrium in them.
• And if it did deviate from equilibrium, it was supposed to return quickly to it in a
model economy.
• As a result, the possibility that the actual economy might in reality have been
facing an “original sin” problem was not conceded.
• “Original sin” refers to the situation where an economy – owing to endogenous
or exogenous events
• undergoes a large deviation from equilibrium which can then be maintained in the
medium run, for example through monetary policy.
• desired elimination of the intertemporal imbalances can be delayed for some time
by continuing or accelerating supportive economic policies.
Not Leaning Against the Wind
• From the current perspective it is quite clear that Western economies were
much more overheated before the crisis than indicated by the output gap
estimates of that time.
• The underestimation of the overheating and its impacts on systemic risk was
probably also due to an extraordinary combination of temporary positive
technological shocks, the involvement of a whole range of new countries in
international trade, and market reforms in the former communist countries.
These factors led to a seemingly permanent and pronounced increase in
productivity.
• Another important factor in the pre-crisis years was the rapidly rising private
sector and government debt levels in a large number of countries.
• The low inflationary pressures observed despite fast economic growth were also
due to huge inflows of labour into the world labour market as a result of
globalisation (the opening up of China, India and the countries of the former
Soviet bloc doubled the global labour supply), which dampened wage costs.
• Monetary approach to balance-of-payments unfortunatelly forgotten even
though globalization made it relevant for large economies too.
Not Leaning Against the Wind
Figure 2 Correlation Between Credit Growth and Real Estate Prices
400
350
ZA
house prices increase (1997-2007)
• The debate about the
excess global liquidity, that
was going on around the
middle of the last decade
demonstrates that the risks
associated with financial
market developments were
not ignored.
• The mix of low nominal and
real interest rates, high
credit growth and a real
estate price boom was
observed with remarkable
apprehension.
300
250
200
150
100
IE
ES
UK
FR*
DK
NL
IT
US NZ
BE
AU
SE
CA*
50
CH
0
DE
JP*
-50
domestic credit increase (1997-2007)
-100
-50
0
50
100
150
200
250
300
350
400
450
500
Source: authors’ calculations based on data from BIS, IMF and Economic Intelligence Unit
„Benign Neglect“ vs. small economies
• In the discussions of central bankers in small open economies,
different and more structured views could be found - extension of
the orthodox work on the small open economy case is Cecchetti et
al. (2000, 2002).
• Cecchetti et al. (2000) re-examined the issue in the context of a
small-scale macroeconomic model in which these two aspects of
exchange rate determination were present. The results showed
that, on average, the degree of inflation and output volatility was
really diminished by directly reacting to the exchange rate
misalignment.
• Cecchetti et al. (2002), while generally confirming their previous
view, admit that the result is model-specific and that monetary policy
reactions to the exchange rate should also be conditioned by the
underlying sources of these movements.
What Benign Neglect Seemed to Ignore
• Central banks in small and emerging economies were much more
supportive of the views of the leaners/BIS in the pre-crisis boom – the
points below are taken from a 2005 CNB presentation:
• What if a bubble emerges without any signs of inflationary pressures?
• inflation measured in terms of consumer prices has not always signalled
that imbalances have been building up in the economy.
• “Dilemma” scenario (small open economy case):
• high economic growth → excessively optimistic expectations →
nominal appreciation of the domestic currency → very low inflation can
prevail even under rapid credit growth and asset price acceleration for
rather a long time → when open inflation pressures finally appear, it
may be too late for monetary policy to react.
28
Benign Neglect vs. Small Economies in Practice
• With hindsight, pre-crisis developments confirmed the importance of
analysing the underlying sources of exchange rate movements as a
component of the monetary conditions.
• Surprisingly (for some), these were countries in which central banks
responded to exchange rate pressures broadly and pragmatically in a
flexible inflation-targeting logic that were performing quite well in terms
of price and financial stability.
• Such response to appreciation pressures in a booming economy
consisted in cutting policy rates a bit, allowing simultaneously for some
appreciation of the domestic currency.
• How did it work?
29
Currency Appreciation in the IT Economies
• Some tough inflation targeters (Sweden, Switzerland and Norway) as well as
some other central banks were not fully resisting the appreciation pressures
in the pre-crisis boom.
• The best examples in this part of the world were the Czechs and Slovaks.
Currency Appreciation in Selected Economies
120
110
110
100
100
90
90
80
80
70
70
60
CZK/EUR
SKK/EUR
CAD/USD
MYR/USD
AUD/USD
1/10
1/09
1/08
1/07
1/06
1/05
1/04
1/03
1/02
50
1/01
1/10
1/09
1/08
1/07
1/06
1/05
1/04
1/03
1/02
1/01
60
KRW/USD
NZD/USD
30
Currency Appreciation as a Way to Tougher Money
• The willingness to allow the value of their currencies adjust made the
overall monetary conditions in these economies relatively tough despite
the low level of interest rates during the global boom.
• by doing so, these countries to some extent avoided the adverse effects of
the general asymmetry of pre-crisis monetary policies, which consisted of
a much greater readiness to accept some depreciation of the domestic
currency relative to appreciation no matter how the business and financial
cycle evolved.
• they applied, albeit sometimes unwittingly, the prescription of the BIS
economists, in which a successful leaning against a credit boom requires
the central bank to tighten the monetary conditions above the level
consistent with fulfilment of the inflation target and reduce inflation below
the inflation target.
• their reaction was a textbook one – after all, it is measured nominal
appreciation of the currency that represents a direct and effective
mechanism for achieving the desired monetary tightening in small open
economies.
31
The CNB Experience with Pre-Crisis Appreciation Pressures I
• An exemplary case of an economy with sustained appreciation pressures
was that of the Czech Republic.
• the nominal exchange rate appreciation was certainly initially quite unpleasant
and for some rather painful.
• however, exporters soon learned how to live with the tough exchange rate
conditions and factored in the future evolution of these conditions into their
expectations.
• labour unions realised that currency appreciation improves the purchasing
power of workers’ wages; this helped to discipline wage dynamics.
• As a consequence of the appreciation pressures, Czech inflation often
undershot the inflation target.
• In such a situation, the CNB naturally had to keep its policy rate at a
similar or even lower level relative to the key central banks in order to
avoid a protracted and even deeper undershooting of its target.
• in reality this policy served more as a shield against risks from the external
environment.
• how could that be?
32
Strong Currency and Low Policy Rates as a Financial Stability Tool? I
• In a booming economy, currency appreciation can contribute to financial
stability especially via reducing risk-taking through a “favourable” nominal
illusion:
• an appreciating currency will decrease the growth rate of nominal income, which
may restrict over-optimism regarding its future trend, which can, in turn, slow
growth in loan demand.
• under such an “illusion” households will compare low interest rates with slow
growth in nominal income, all expressed in the domestic currency.
• Seemingly, sustained currency appreciation should create an incentive to
borrow in a currency that is becoming cheaper over time, i.e. in foreign
currency.
• nevertheless, the share of foreign currency loans provided to households has
been lowest in two countries with a history of profound and sustained nominal
currency appreciation – the Czech Republic and Slovakia.
33
Strong Currency and Low Policy Rates as a Financial Stability Tool? II
• There may be other factors specific to a small open economy at play too:
• first, if the economy is export-oriented, sustained exchange rate appreciation
may work against the formation of overly optimistic expectations in the
corporate sector, which tames the potential for credit-enabled excessive
investment and creation of unprofitable capacities.
• it may also shift part of the existing domestic demand from nontradables to
tradables along a long-term trend towards higher consumption of
nontradables, thus contributing to more balanced macroeconomic and
structural dynamics.
• Of course, the idea of using a policy of low interest rates in a small or
emerging economy to shield the country from risks stemming from
developed countries’ policies may sound strange.
• This was not a strategy for any central bank any time, just a specific
strategy of some central banks for strange times.
• The “global monetary” scene in the pre-crisis years was strange indeed.
34
IV.
The New Consensus after Tsunami
Science of MP – Mishkin (2010) - pre-crisis basic principles
Neoclassical synthesis view (science of MP):
1. Inflation is Always and Everywhere a Monetary Phenomenon.
2. Price Stability Has Important Benefits.
3. There is No Long-Run Tradeoff Between Unemployment and Inflation.
4. Expectations Play a Crucial Role in the Macro Economy.
5. The Taylor Principle is Necessary for Price Stability.
6. The Time-Inconsistency Problem is Relevant to Monetary Policy.
7. Central Bank Independence Improves Macroeconomic Performance.
8. Credible Commitment to a Nominal Anchor Promotes Price and Output
Stability
Science of MP – Mishkin (2010) - cont.
• The objective function and the model (constraints) used by central banks
before the crisis reflected all eight principles of the neoclassical synthesis.
• However, the approach had an additional important features:
– a linear quadratic (LQ) framework in which the equations describing the dynamic
behavior of the economy are linear, a basic feature of DSGE models, and the
objective function specifying the goals of policy is quadratic.
– a representative-agent framework in which all agents are alike so that financial
frictions are not present because they require that agents differ
• The macroeconomic models used for forecasting and policy analysis did not
allow for the impact of financial frictions (efficient markets assumed, no room
for a BIS-style credit boom) and disruptions on financial intermediation and
economic activity.
• With asymmetric information and other sources of inefficiencies ruled out, the
financial sector has no special role to play in economic fluctuations.
• This naturally led to a dichotomy between monetary policy and financial
stability policy in which these two types of policies should be conducted
separately.
Science of MP – Mishkin (2010) - cont.
•
Mishkin‘s after-crisis lessons:
1. Developments in financial sector have a far greater impact
on economic activity than we earlier realized.
2. The macro economy is highly nonlinear.
3. The zero lower bound is more problematic than we realized.
4. The cost of cleaning up after financial crises is very high.
5. Price and output stability does not ensure financial stability
Risk-Taking Channel Was a Missing Point
• The lessons from the last financial crisis significantly changed the
views concerning the relationship between monetary policy, asset
prices and financial stability.
• Following the lessons from the crisis, both academic economists and
central bankers discuss a chance for reaching a new consensus.
• The first and apparently most extensive subject of corrections of the
“old” framework is the way how the financial sector is covered in
existing models.
• the changes in the financial sector may have a strong impact on
economic activity;
• it is necessary to rework fundamentally the way how monetary policy
transmission is described in macroeconomic models;
• it is crucial to concentrate on the „credit supply channel“ or the „risk
taking channel“ which differ from broad credit channel in focusing on
credit amplifications due to financing frictions in the lending sector, not in
the borrowing sector;
• the other important mechanism related to credit supply channel is “bank
capital channel” in which monetary policy affects bank lending through its
impact on bank equity capital.
Preemptive Action Expected Now
• The New Consensus is an amended model of flexible inflation
targeting (or price-level targeting) in which the central bank “should
sometimes lean and can clean”.
• financial stability becomes a separate objective of the central bank,
affecting its short-term behaviour without changing its long-term
commitment to price stability;
• the key source of potential financial instability (source of systemic risk) is
credit/financial cycle and one of the key concerns of policy has to be
containment of procyclicality;
• the primary instruments for safeguarding financial stability are still
financial market regulation, supervision of financial institutions focusing
on sufficient capitalisation and liquidity, and macroprudential policy
measures;
• monetary policy cannot ignore financial stability and acts preemptively
when financial imbalances occur - central banks start to lean against the
wind – monetary policy will support macroprudential policy.
Risk of Financial Instability as MP Driver
• The object of reaction of monetary authority should be the growing
financial imbalances generated by an upswing in the credit cycle,
which may potentially result in strong macroeconomic fluctuations.
• The risk of financial instability (or the risk of a future crisis), assessed
and quantified in a certain way, rather than the level of credit or debt
(proxied by the credit-to-GDP ratio), should be the reaction criterion (a
reaction threshold for the level of financial sector vulnerability should
be set).
• Financial stability considerations will become a part of monetary policy
reaction only if concluded that certain threshold of financial
vulnerability is exceeded, leading to a high risk of financial instability.
• In such a situation policy makers will start respecting the need to restrain
lending growth and excessive risk taking (leaning phase).
• If crisis finally occurs, it will be necessary to offset the sharply increased
risk margins with a more pronounced fall in monetary policy rates
(monetary policy should clean to a certain extent).
Financial Cycle, Financial Stability and Monetary Policy
• The New Consensus in a highly stylized form:
Financial Cycle, Financial Stability and Monetary Policy
• Since debt (leverage) in the stock sense adjusts to changed
economic conditions with a significant lag, it cannot be a monetary
policy response variable. It is a backward-looking variable showing
only the average extent of risk for financial stability over cycle.
• Such a variable must be a forward-looking one that describes the
current level of risk for future financial stability (or the
instantaneous extent of risk taken by financial firms and their
clients).
• This variable is termed the (marginal) risk of financial instability.
• Marginal risk of financial instability is a strongly discontinuous
variable that increases in good times as leverage rises.
• A fundamental requirement for growth in this risk – in addition to the
availability of cheap credit – is the emergence of overly optimistic
expectations about future income and asset prices, which leads to
the development of a bubble.
• When the bubble bursts and the financial crisis becomes openly
visible, the level of this risk changes dramatically.
Financial Cycle, Financial Stability and Monetary Policy
• Discontinuity may lead to sharp shifts from leaning to cleaning
(the case of lack of success or policy failure).
Financial Cycle, Financial Stability and Monetary Policy
• Policy setting has to counter-balance false signals of
systemic risk materialization indicators.
Financial Cycle, Financial Stability and Monetary Policy
• The New Consensus in a highly stylized form – policy
should counter-balance risk perception.
Three Different Policy Stages
• Normal times
• policy rates evolve in line with the normal level consistent with “pure”
inflation targeting (i.e. the „Old Jackson Hole Consensus“ inflation
targeting ignoring the aspects of financial stabilitym but not credit
channels!).
• Leaning phase (financial exuberance period):
• central banks accepts and justifies via convincing communication the
desirability of setting interest rates at a level higher relative to the one
consistent with achieving the inflation target (higher relative to simple
Taylor rule) even at the expense of inflation sliding below the target for
some time.
• Cleaning phase (financial distress period, if leaning not successful):
• central bank is not following the simple Taylor Rule either, it acts to offset
the sharply increased risk margins with a pronounced fall in monetary
policy rates.
• Monetary policy will thus partly offset the underestimation and
subsequent overestimation of risk by banks and their clients over the
financial cycle.
Price of Risk Misalignment as a Policy Rate Driver
• In the risk build-up period - monetary policy rates rise above the pure inflation
targeting level.
• When the crisis breaks out - central bank responds with policy rate cuts below
the pure inflation targeting level.
• As the economy recovers and conditions set to normal - policy rates are
pushed back to their normal trajectory.
Build-up of risk
Financial
exuberance: risk
margins too low,
leverage
accumulation
Monetary policy reaction
Financial
distress: risk
margins too high,
deleveraging
phase
time
policy interest rates
Lean period:
policy rates above
simple Taylor rule
Clean period:
policy rates below
simple Taylor rule
time
normal contitions
marginal risk of
financial instability
policy rates relative to ”pure“
inflation targeting rates
Financial Cycle, Financial Stability and Monetary Policy
• The New Consensus: price-level vs. inflation targeting.
Vývoj inflace
lean period
clean period
post clean period
čas
Inflace v relaci s cílem
Why a cleaning phase – risk of balance sheet recession
• Koo (2011) shows that in some countries, after Lehman Brothers
failure, the increases in private savings (including debt repayments)
were higher than increases in government‘s demand for credit due to
higher budget deficits – this may initiate deflationary spiral.
Why a cleaning phase – risk of balance sheet recession
Finanční přebytky a deficity japonských sektorů, v % HDP
Pramen: převzato z Koo (2011)
V.
Conclusions
Lessons from the Crisis Learned
• The flexible inflation targeting concept still valid, but some corrections
are acknowledged:
• Model framework: representative-agent framework is clearly dead
and financial frictions are called for – monetary policy models should
be changed substantially,
• Operational framework: transmission mechanism is uncertain, highly
variable and procyclical - credit supply channel (risk taking channel)
focusing on credit amplifications in the lending sector has to be
added to the picture,
• Analyses: financial stability becomes a separate objective of the
central bank: but bubbles and their identification is not a proper focus
- the financial imbalances and systemic risk build-up is what matters,
• Decision-making: forget about “can’t lean, but can clean” policy
asymmetry: monetary policy should be focused more on “pre-emptive
tightening” during credit booms than on “pre-emptive easing” to deal
with their after-effects.
A New Consensus May Have Emerged…
• Financial stability analyses must be focused in good times on
assessing the risk of financial instability and in bad times on
measuring the magnitude of the problem related to the
materialisation of risks that were previously “allowed” to build up.
• Given the forward-looking nature of monetary policy, central banks’
staff in their financial stability analyses has to focus primarily on
the identification of the latent future risks brought about by current
developments in the financial sector.
• It is rather difficult since the contemporanous indicators talk about the
materialization of systemic risk, not about the probability of financial
instability in the future.
• What is needed is a set of forward-looking indicators providing the
insight into the potential for financial imbalances.
…Along with Some New Challenges Too
• We learned the hard way how to cope with the impacts of loose
monetary policies of large advanced economies in pre-crisis times.
• now we are learning how to do so in crisis and post-crisis times.
• Central banks of major economies (U.S., euro area, Japan, UK…) have
moved beyond traditional policy approaches:
• low short-term rates and low yields on governments bonds are reflected in
a search-for-yield resulting from efforts of international investors to harbour
liquidity in higher-yielding assets,
• currencies in other economies may come under appreciation pressure.
• Global monetary conditions may thus make the first-best monetary
policy outcome (policy rates reflecting the development of economic
activity and domestic inflation pressures with relative stability of the
exchange rate) not available again due to the policies of the key central
banks acting as price makers.
• it may become necessary to work hard and smart to achieve the secondbest result.
55
The Zero Lower Bound Is Reality
• The CNB policy rates have already hit the zero lower bound in coping
with volatile external conditions
• symmetrically to the pre-crisis times, the exchange rate factor should help
to set the overall monetary conditions right again, this time in the
depreciation direction,
• a readiness to intervene has been vigorously communicated.
• The authorities in countries with fixed exchange rates (or in currency
unions) may resort to monetary policy measures other than policy rates
and interventions, as well as to macroprudential policies if needed.
• the story of the euro area shows that having neither autonomous monetary
policy, nor national macroprudential policy is dangerous.
• Diverse states of business/financial cycles and financial market
structures make creative and specific approaches inherent:
• there is no room for one-size-fits-all models.
56
Are we going to succeed next time?
• No guarantee ..
• If the international economy in the future starts undergoing a dynamic drive
again like in a preceding decade, accompanied by credit and asset price
booms, the authorities will have to apply concerted set of macroprudential
and microprudential measures to tame the immoderate optimism.
• Factors mitigating procyclicality embodied in regulation will hopefully
ensure accumulation of buffers and more intrusive supervision may
prevent some bank managers from taking excessive risks.
• Monetary policies might need to step in directly via interest-rate channel
or indirectly via prudential tools changing its transmission.
• Still, plenty of courage, communication skills and luck would be needed
to succeed.
57
Thank You for Your Attention
Contact:
Financial Stability Department in the CNB:
financial.stability(at)cnb.cz
CNB: Financial Stability Reports, various issues available at http://www.cnb.cz/en/financial_stability/
Jan Frait
Financial Stability Dept.
Czech National Bank
Na Prikope 28
CZ-11503 Prague
E-mail: jan.frait(at)cnb.cz
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