David Vestin, Monetary policy and financial imbalances

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 Back then, belief in long-run trade-off : pi = … - u Conclusion: unemployment can be permanetly reduced if inflation is kept high Revolution: Insight that 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

Financial stability problems Throughout history (Reinhart-Rogoff, ”This time is different”) Recent reminder: financial crisis 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 Source: Statistics SwedenNote: Last observation october 2013.

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 Source: The Riksbank Macro-pru Risk-taking

Schematic outline: concern for imbalances Source: The Riksbank Macro-pru Risk-taking

Smets: Leaning against the wind Source: The Riksbank Macro-pru Risk-taking

Smets: financial stability is price stability Brunnemeier and Sannikov: I-theory of money Focus on financial intermediation Financial intermediation can be impeded Bank capital losses Monetary policy works through banks 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 price- stability 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

k Example: Trying to quantify the trade-off

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

Schematic outline: concern for imbalances Source: The Riksbank

Effects of policy on likelihood of bad scenario Monetary policy Real debt accumulation Likelihood of crisis Quantified via VAR model Quantified via Schularick and Taylor, AER 2012

Pragmatic inflation targeting

Lengthen forecast horison

Lenghten forecast horison Unemployment 33

Model ”Bad scenario”. Based on IMF (2012) Unemployment 34

Short-run vs. longer-run risks

Quantifying the probability of a crisis: Schularick and Taylor:

Another way to illustrate…

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

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…

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 pro- cyclicality 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 52

Two alternative strategies 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: 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