Monetary policy and
financial imbalances
David Vestin, 2015-11-30
Purpouse

Discuss the ”nexus” of monetary policy and financial
stability/imbalances

Main reference: Smets (2013) ”Financial stability and
Monetary Policy: How Closely Interlinked?”

”Monetary Policy and Financial Stability” (IMF)
Why does the monetary policy
mandate focus on price stability?


High and volatile inflation 1960-80
Back then, belief in long-run trade-off : pi = … - u


Revolution: Insight that



Conclusion: unemployment can be permanetly reduced if
inflation is kept high
Monetary policy lacks long-run real effects
Political business-cycles creates short-run losses
Conclusion: delegate monetary policy to independent
central bank


Nominal anchor
Sticky prices and wages -> monetary policy can influence real
interest rates and thereby economic activity and prices
Pre-crisis monetary policy framework

Flexible inflation targeting (Svensson 2007, EER)
𝐿 = (𝜋 − 𝜋 ∗ )2 +(𝑥 − 𝑥 ∗ )2

𝜋 inflation, x resource utilisation, e.g. unemployment
𝑥 = −𝑎(𝑖 − 𝐸(𝜋))
𝜋 = 𝑥

Conclusion: MP balances inflation and Resource Utilisation
Financial stability problems

Throughout history (Reinhart-Rogoff, ”This time is
different”)
Recent reminder: financial crisis 2008-2009

Definition of financial stability

Narrow: ”Banking system reasonably robust”

Broad: ”Financial system reasonably robust”

Financial crisis: US background

Long-standing policy to promote home ownership

”Underwriting”: banks originates loans to households,
then transfers the loans to state-owned enterprises

Banks also packaged loans and sold them to investors

Loans without interest and amortization

Assumption: house prices would continue to rise
House-prices turned down
Phases of crisis
Bear-Stearns, AIG, Lehman Brothers
 No confidence in banking sector – important
fundingmarkets closed
 Massive intervention of FED
 Contagion to rest of world, also to Sweden, Swedish banks
had exposures to Estonia and Latvia.
 Large macroeconomic downturn, trade collapsed,
uncertainty increased
 Banking crisis transformed into government debt crisis for
countries that needed to inject capital into banks

Lessons from the crisis

”The great moderation” did not prevent build-up of
financial imbalances

Imbalances can be hard to ”clean”

Ensuring sustainable economic development needs
further policy intervention
Strong credit growth to households in
Sweden
MFI lending, annual change
Note: Last observation october 2013.
Source: Statistics Sweden
Big questions after the financial crisis
1. Rethinking the monetary policy framework

Goals for monetary policy
2. Introduction of a new policy area

Macroprudential policy (BIS)
3. Challenges (finacial trilemma*) with achieving financial
stability in a world with cross-border banking


Banking union
BIS
The financial trilemma states that (1) financial stability, (2) financial integration and (3) national financial policies are incompatible.
Monetary policy effects on imbalances
Low interest rates might

stimulate (unsustainable?) debt growth

Induce ”search-for-yield” behavior

Possible first-best: other tools added to deal with
unwarranted side-effects of monetary policy
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?
Rethinking the monetary policy
framework - Smets (2013)

Modified Jackson Hole consensus

Leaning agains the wind vindicated

Financial stability is price stability
Smets (2013)
Smets three questions
1. How effective is macropru to ensure financial stability?
2. How significant is the effects of monetary policy on
financial stability?
3. What is the risk of ”financial dominance” - risk of losing
the nominal anchor…
Schematic outline: concern for
imbalances
• Inflation
• Resource utilisation
Monetary policy
deliberations
Repo-rate path
Macro-pru
Target attainment
during the forecast
period
Probability of the
scenario
Debt
Consequences of the
scenario:
• inflation
• resource utilisation
Expected target
attainment beyond
the forecast horizon
Risk-taking
Source: The Riksbank
Schematic outline: concern for
imbalances
• Inflation
• Resource utilisation
Monetary policy
deliberations
Repo-rate path
Macro-pru
Target attainment
during the forecast
period
Probability of the
scenario
Debt
Consequences of the
scenario:
• inflation
• resource utilisation
Expected target
attainment beyond
the forecast horizon
Risk-taking
Source: The Riksbank
Smets: Leaning against the wind
• Inflation
• Resource utilisation
Monetary policy
deliberations
Repo-rate path
Macro-pru
Target attainment
during the forecast
period
Probability of the
scenario
Debt
Consequences of the
scenario:
• inflation
• resource utilisation
Expected target
attainment beyond
the forecast horizon
Risk-taking
Source: The Riksbank
Smets: financial stability is price
stability

Brunnemeier and Sannikov: I-theory of money

Focus on financial intermediation

Financial intermediation can be impeded


Monetary policy works through banks


Bank capital losses
Lower interest rates raises bond prices, recapitalizes banks
In this setting, monetary policy works by stabilizing banks
IMF 2015: Monetar Policy and
Financial Stability

Monetary policy should deviate from its traditional
response only if costs are smaller than benefits …

Costs arise in the short term, from lower output and
inflation.

Benefits materialize mainly in the medium term, as
financial risks are mitigated, though uncertain effects

Current knowledge – limited case for leaning, as in most
circumstances costs outweigh benefits.
Decision-tree
IMF: Three questions
1.
Are financial risks excessive?
2.
Are macro-pru instruments effective?
3.
Whether tighter monetary policy warranted by pricestability is also sufficient for financial stability?
Strategy

Identify channels from monetary policy to financial
stability

Establish trade-offs between price stability and financial
stability

Do empirical cost-benefit analysis
IMF: comparable calculations
Example: Trying
to quantify the
trade-off
k
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
Schematic outline: concern for
imbalances
• Inflation
• Resource utilisation
Target attainment
during the forecast
period
Monetary policy
deliberations
Repo-rate path
Probability of the
scenario
Debt
Consequences of the
scenario:
• inflation
• resource utilisation
Expected target
attainment beyond
the forecast horizon
Source: The Riksbank
Effects of policy on likelihood of bad
scenario
Monetary
policy
Real debt
accumulation
Quantified
via VAR
model
Likelihood of
crisis
Quantified
via
Schularick
and Taylor,
AER 2012
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
33
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
34
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…
Conclusion

Small effects of policy on real debt accumulation and
probability of bad scenario in mean estimates

But uncertainty; if willing to ”tails”, effects are larger

In the latter case, concern for debt contributes to explain
why rate is not lowered
Discussion
Non-linearities
 Expectation formation: if households perception of
normal rate is affected by low rates for a long period,
effects can be larger
 Small effects stand in contrast to studies of procyclicality of banks balance sheets
 Analog to Leepers ”fiscal-limit” for households
 Distributional effects
 Assets

The Swedish policy-debate

Some leaning 2010, 2013, but how much?

Recent experience, inflation gradually lower, no room for
concerns for debt growth

Important that the FSA deals with the potential
imbalances
Alternative take: adding financial
stability as a separate objective

The authorities have three objectives:




E(𝜋𝑡 − 𝜋 ∗ )2
E(𝑦𝑡 − 𝑦 ∗ )2
E 𝑓𝑡 − 𝑓 ∗ 2
The authorities have two instruments:



Price stability:
Real stability:
Financial stability:
Monetary policy:
Macroprudential:
r
c
(interest rate)
(capital requirement)
Two alternative strategies:


A: coordination (centralization)
B: no coordination (decentralization)
52
Two alternative strategies

A: set r and c to minimize
E
∞ 𝑡
𝑡 𝛽 [(𝜋𝑡
− 𝜋 ∗ )2 + 𝜆1 (𝑦𝑡 − 𝑦 ∗ )2 + 𝜆2 𝑓𝑡 − 𝑓 ∗ 2 ]
B: set r to
minimize
E
and set c to
minimize
E

∞ 𝑡
𝑡 𝛽 [(𝜋𝑡
− 𝜋 ∗ )2 + 𝜆1 (𝑦𝑡 − 𝑦 ∗ )2 ]
∞ 𝑡
𝑡 𝛽 [ 𝜆2
𝑓𝑡 − 𝑓 ∗ 2 ]
53
Two alternative strategies

A: CB uses both MP and macro-pru to stabilize inflation,
economic activity and financial development

B: The central bank uses different instruments for
different purposes, or


central bank has responsibility for monetary policy
financial stability is delegated to another authority (e.g. an FSA)
54
Suggested answers:

In this setting, coordination is at least as good

But perhaps easier to evaluate cb if fewver objectives?
 Decentralisation offers higher transparency,
credibility and legitimacy, and allows independence

The disadvantages of the second strategy are small if
 r has large effects on 𝜋 and y, but small effects on f
 c has large effects on f, but small effects on 𝜋 and y
 there are strong correlations between 𝜋 and y, but
not between f and y or f and 𝜋
55
Suggested answers, cont.

There is a ”risk-taking channel” which implies that



r can have large effects on f
there is a strong correlation between f and y
r and c can be close substitutes (have similar effects)
56