Inflation Targeting After the Financial Crisis Lars E.O. Svensson Sveriges Riksbank Speech at Reserve Bank of India’s International Research Conference “Challenges to Central Banking in the Context of Financial Crisis”, Mumbai, February 12,

Introduction Questions after the financial crisis: Did monetary policy contribute to the crisis? Are any changes of best-practice monetary policy justified? Outline of speech: Best-practice monetary policy before the crisis The causes of the crisis and the role of monetary policy Does flexible inflation targeting need to be modified in light of the crisis? 2

Best-practice monetary policy: Flexible inflation targeting Stabilize both inflation around the inflation target and resource utilization around a normal level “Forecast targeting”: choose policy-rate path so that forecast of inflation and resource utilization “looks good” (Riksbank: “well-balanced policy”) The CB uses and responds to all info that affects forecast of inflation and resource utilization CB responds to financial conditions only to the extent they affect forecast of inflation and resource utiliz’n Financial conditions are only indicators, not targets 33

The financial crisis was not caused by monetary policy Main causes of the crisis (Bean 09): Macro conditions: Global imbalances, low world real interest rates, Great Moderation, underestimation of risk, very low risk premia Distorted incentives: Lax regulation and supervision, missing bank resolution, US housing policy, securitization, regulation arbitrage, increased leverage Information problems: Hidden risk in complex securities, underestimation of correlated systemic risks These causes had little or nothing to do with monetary policy! 44

Was US monetary policy too easy during ? Ex ante: Genuine threat of deflation and liquidity trap, expansionary policy right Given FOMC forecasts, policy rates not exceptional (Bernanke) Neutral real interest rates low because of global unbalances 55

Would tighter US monetary policy have prevented the crisis? Interest rates explain small portion of US house- price increases Initial payments on new exotic mortgage types not very sensitive to short interest rates (Bernanke) To affect boom and credit growth, substantially higher interest rates needed: recession, deflation, and eventually liquidity trap? No impact on regulatory problems, distorted incentives, information problems 6

Would tighter US monetary policy have prevented the crisis IMF WEO (Oct 09): Many countries and crises MP stance generally not leading indicator of future financial crises Current crisis: Statistically insignificant and economically weak association between loose monetary policy and house prices (5% of variation explained) Beyond actual monetary policy: “Greenspan put”? Floor for asset prices, reduce risk? Communication rather than policy, less emphasis had been better? 7

Lessons for flexible inflation targeting Price stability not enough to achieve financial stability Interest-rate policy not enough to achieve financial stability Regulation, supervision, bank resolution, macro- prudence, “a portfolio of instruments” (Bean 09) for financial stability 8

Relation monetary policy and financial-stability policy? Financial stability important objective for policy FS: Situation when the financial system can fulfil its main functions without disturbances that have significant social costs Policies (fiscal, labor market, structural…): Distinguish because differ regarding objectives, instruments, responsible authorities Monetary policy and financial-stability policy distinct and different policies 9

Monetary policy Objective: Stabilize inflation and resource utilization Instruments: Policy rate, policy-rate path, communication (fixed-rate lending, asset purchases) Responsible authority: CB 10

Financial-stability policy Objective: Financial stability Instruments: Supervision, regulation (lending of last resort, variable-rate lending, liquidity policy, bank resolution, capital injection, …) Authority: FSA, CB, …(Sweden: FSA regulation and supervision, Debt Office bank resolution, Riksbank lending of last resort) 11

MP and FSP different and distinct Interaction FSP affects inflation and resource utilization via financial markets and transmission mechanism MP affects asset prices and balance sheets Responsible authority(ies) for FSP open question (CB for macroprudential regulation?) Distinction and difference to be taken into account FS as additional objective for MP makes little sense 12

Necessary to modify flexible inflation targeting? Specific conclusions for flexible inflation targeting? Extend forecast horizon (old): No problem (BoE, NB, SR), but how much info? Leaning against the wind? If financial factors are indicators, not targets, completely consistent with flexible inflation targeting Instruments other than interest rates more effective (loan-to-value restrictions, minimum mortgages etc) More research warranted 13

Conclusions Flexible inflation targeting remains best practice monetary policy If done rightly, using all information in financial factors about future inflation and resource utilization However, a better theoretical, empirical and operational understanding of the role of financial factors in the transmission mechanism is required Financial factors still indicators, not targets CBs responding appropriately to financial factors in order to best stabilize inflation and resource utilization over time 14