Download Financial Imbalances in Monetary Policy Decision

Financial
imbalances in the
monetary policy
decision
David Vestin
Trinity Workshop, Nov 7, Princeton
Disclaimer: The views expressed here are my own and should not be
interpreted as reflecting the views of Sveriges Riksbank.
Issues

Swedish policy-debate: sado-monetarism or normal IT
with an imbalance flirt?

How can financial imbalances quantitatively be factored
into the monetary policy decision?
The Swedish
policy debate
Sado-monetarism?
Because of debt-concerns?
Percent of disposable income
Note. The dashed line represents the Riksbank's forecast.
Sources: Statistics Sweden and the Riksbank
CPI: User cost+variable rates, tail-chase
Some role for leaning – but CPIF
higher and similar to other countries
Mostly here!
Inflation forecast, July 2010
5
5
CPI
4
4
CPIF
3
3
2
2
1
1
0
0
-1
-1
-2
-2
00
01
02
03
04
05
06
07
08
Annual percentage change
09
10
11
12
13
Sources: Statistics Sweden and the Riksbank
Factoring in
residual financial
imbalances in the
MP decision
Why should MP be concerned with
financial imbalances?

Imbalances can lead to low inflation, high unemployment

Macro-pru not in place – MP provides temporary bridge

Macro-pru instruments too weak, can be circumvented…

Possible narrow aim of macro-pru: only ”systemic” risk

Similar transmission channels, co-ordination needed?
Policy problem

How to weigh risks to households balance sheet with
”normal” monetary policy considerations

We illustrate a simple example:

Extend policy horizon

Model ”bad scenario”

Model how monetary policy affect p(bad scenario)
Foundation

Svensson (1997)
𝑳 = 𝝅 − 𝝅∗

𝟐
+ 𝝀 𝒖 − 𝒖∗
𝟐
Schularick and Taylor (2012):
p(crisis) = f(real credit growth)

BVAR: real credit groth = f(interest rate)

Alternative interest rate paths: through MP shocks
Pragmatic inflation targeting

Forecasting period of 3 years
Loss =
𝟑
𝟏
𝝅 − 𝝅∗
𝟐
+ 𝝀 𝒖 − 𝒖∗
𝟐

Construct a main forecast, based on models, judgement

Policy options: consider higher/lower rate path

Use unanticipated monetary policy shocks

Reasonable if temporary deviation
Lengthen forecast horison

Risks can build, even if inflation forecast on ”target”

Risks ”beyond the forecasting horison”
Loss =
𝟏𝟎
𝟏
𝝅 − 𝝅∗
𝟐
+ 𝝀 𝒖 − 𝒖∗
𝟐

I.e. same targets for monetary policy, but now T=10

Two alternative interest rate paths, High and Low
Lenghten forecast horison
Unemployment
12
12
10
L
10
H
8
8
6
6
4
4
2
2
0
0
13
14
15
16
17
18
19
20
21
22
15
Model ”Bad scenario”. Based on IMF
(2012)
Unemployment
12
12
10
L
10
Crisis,
with
prob p
H
8
8
6
6
4
4
2
2
0
0
13
14
15
16
17
18
19
20
21
22
16
Short-run vs. longer-run risks
E(Loss) = 𝑬
𝑬
𝟑
𝟏
𝝅 − 𝝅∗
𝟐
𝟏𝟎
𝟏
+ 𝝀 𝒖 − 𝒖∗
𝟐
𝝅 − 𝝅∗
+
shortrun(x)
x: path for interest rate

𝟐
+ 𝝀 𝒖 − 𝒖∗
𝟐
𝒑 ∗ 𝑪𝒓𝒊𝒔𝒊𝒔 + 𝟏 − 𝒑 ∗ 𝟎
+
p(x) Crisis
Crisis: loss during crisis
Comparing two alternatives, High and Low:
Diff = shortrun(H) – shortrun(L)
+
(P(H)-P(L)) Crisis
Quantifying the probability of a crisis:
Schularick and Taylor:

p(crisis) linked to growth in real debt, 𝑆𝑡
𝑝𝑡 =
exp(𝑋𝑡 )
1+exp(𝑋𝑡 )
𝑋𝑡 = −3.89 − 0.40𝑆𝑡−1 + 7.14𝑆𝑡−2 + 0.89𝑆𝑡−3 + 0.20𝑆𝑡−4 + 1.87𝑆𝑡−5

Average value of S is 4.4% -> average p is 3%

BVAR-model: real debt for alternative interest rate paths
Another way to illustrate…
Crisis =
(x) = 𝐄
𝟑
𝟏
𝟏𝟎
𝟒
𝝅 − 𝝅∗
𝝅 − 𝝅∗
𝟐
𝟐
+ 𝝀 𝒖 − 𝒖∗
+ 𝒑(𝒙)
𝟏𝟎
𝟒
U(x) similarly…
_diff = (H) - (L)
𝟐
𝝅 − 𝝅∗
𝟐
Difference between High and Low
Negative value = good for low-interest rate alt
Skillnad i kvadrerade förluster för arbetslöshet
1,4
Bad for lower path
1,2
Huvudscenario
Main scenario
1,0
P constant
utan
risk
0,8
P depends on MP
med risk
0,6
Unemployment
0,4
0,2
0,0
-0,2
högre
utväxling
-> skuld
Higher
impact repo
rate->debt
Higher
impact skuld
debt ->
->risk
risk
högre
utväxling
Higher impact on both
högre utväxling på både skuld och
risk
-0,4
-0,6
Good for lower path
-0,4
-0,2
0,0
0,2
Skillnad i kvadrerade förluster för KPIF
Difference in squared losses, CPIF
0,4
0,6
Conclusions

Room for concern for imbalances within standard
flexible inflation targeting

Concern for imbalances aims at achieving sustainable
economic developments

Benchmark calibration and example of an economy in
recession: short run cost of leaning higher than longterm benefit
Pescatori, Laséen and Vestin (2015):
Crisis in near term

A crisis can be triggered every period, Markov chain

If crisis hits, inflation = non-crisis inflation – delta (like in
Svensson, 2015)

New dimension:




Presense of risk LOWERS the main inflation forecast
Current state interacts with crisis size to determine Loss
If p does not depend on MP, leaning WITH the wind
If p depends on MP, less leaning than when crisis can
only occur from steady state
Example

Example calibration: IRFS for inflation and
unemployment from Ramses, credit from BVAR

If we start from a case where E(pi)=2 and E(u)=u*, then
about 6 bps leaning is ”optimal”

What matters is RELATIVE effect of i on pi,u and p

Doubling the ST-coefficients leads to more leaning
Interest rate
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
-0.1
0
5
10
15
20
25
30
35
40
Inflation an unemployment
Expected inflation
0.4
0.2
0
-0.2
-0.4
0
5
10
15
20
25
30
35
40
30
35
40
Expected unemployment
0.3
0.2
0.1
0
-0.1
0
5
10
15
20
25
Real credit growth
1.15
1.1
1.05
1
0.95
0.9
0
5
10
15
20
25
30
35
40
Probability of crisis
0.11
0.109
0.108
0.107
0.106
0.105
0.104
0.103
5
10
15
20
25
30
35
40
Alternative versions

Crisis state as in Ajello et. al; if crisis occurs,
inflation = constant

Crisis-profile: An n-state Markov chain where the
different crisis stages have different delta

Prel. result: Slightly stronger case for leaning, as
interaction of short-run cost and crisis decreases

Estimate BVAR-models for large number of countries
Effects from interest rates to debt can
be larger if misperceptions…
Debt/disposable income, Walentin (2013)
Skuld/disponibel inkomst
240
220
200
180
160
140
2,25% resp. 145%
120
100
0
1
2
3
realränta
4
5
Issues

Systematic leaning -> expectational effects




Financial crisis can lead to permanent LEVEL effects?



Need dynamic DSGE version, extend Woodford (2011)?
Work in Gerali et.al. model, effects of macro pru?
Allows analysis of steady-state issues like Barro-Gordon etc.
GDP, unemployment
Much more costly than fluctuations (Lucas…)
Non-linearities in MP->Credit, Credit->p


Disaggregated credit analysis focusing on ”bad” credit growth
Leeper suggest analog to fiscal-limit: house-hold limit…