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 Even if we can see strong economic development ahead, cost pressure will be fairly low. This is primarily due to… However, we believe that inflation will approach the target of 2 per cent. Annual percentage change 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 = 𝟏 𝟑 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 = 𝟏 𝟏𝟎 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

Model ”Bad scenario”. Based on IMF (2012) Unemployment

Short-run vs. longer-run risks E(Loss) =𝑬 𝟏 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐 𝑬 𝟏 𝟑 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐 + 𝒑∗𝑪𝒓𝒊𝒔𝒊𝒔 + 𝟏−𝒑 ∗𝟎 shortrun(x) + p(x) Crisis x: path for interest rate 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, 𝑆 𝑡 𝑝 𝑡 = exp⁡( 𝑋 𝑡 ) 1+exp⁡( 𝑋 𝑡 ) 𝑋 𝑡 =−3.89−0.40 𝑆 𝑡−1 +7.14 𝑆 𝑡−2 +0.89 𝑆 𝑡−3 +0.20 𝑆 𝑡−4 +1.87 𝑆 𝑡−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 = 𝟒 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐 (x) = 𝐄 𝟏 𝟑 𝝅− 𝝅 ∗ 𝟐 +𝒑(𝒙) 𝟒 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 U(x) similarly… _diff = (H) - (L)

Difference in squared losses, CPIF Difference between High and Low Negative value = good for low-interest rate alt Bad for lower path Main scenario P constant P depends on MP Higher impact rate->debt Higher impact debt -> risk Higher impact on both Unemployment Difference in squared losses, CPIF Good for lower path

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 long-term 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

Inflation an unemployment

Real credit growth

Probability of crisis

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)

Issues Systematic leaning -> expectational 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. Financial crisis can lead to permanent LEVEL effects? 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…