1. The Optimal Monetary Policy Instrument versus Asset Price Targeting, and Financial Stability by CAE Goodhart, C Osorio and DP Tsomocos Discussant Mike Wickens Universities of York and Cardiff Sixth Norges Bank Monetary Policy Conference, June 2009

2. Aim of the paper Present an alternative theoretical framework for analysing monetary policy to the standard DSGE model

3. Main conclusions Monetary policy need more instruments than just the repo rate MP should deliver targeted assistance via the discount window (to avoid non-clearing money market due to liquidity shortages?) There should be tighter regulation of investment banks as they bear most mortgage risk Inflation target should include a measure of house prices

4. Key features of the alternative model The model is conventional in assuming that all agents rationally maximise inter- temporally subject their budget constraints and all markets clear Unconventional in including banks (central, commercial and investment), hedge funds and wholesale and inter-bank markets

5. The market clearing conditions (no- arbitrage conditions and budget constraints) are satisfied in good times In bad times they may not hold and default may occur - mortgages: due to value of collateral <mortgage - wholesale and inter-bank market: when penalty for bankruptcy is too low

6. What happens in bad times? Households default on mortgages Hedge funds pay collateral to the investment banks Investment banks transfer mortgages to the hedge funds and sell collateral on the market Neither the hedge funds not the investment banks can repay their loans to the commercial banks and so default Commercial banks borrowing on the inter-bank market also default

7. Can conventional monetary policy help? 1. Inflation targeting via repo rate cut - all interest rates fall which reduces default - maintains money market equilibrium - portfolio adjustment by banks to riskier assets 2. Money base expansion - similar except portfolio adjustment by banks to less risky assets - households are still credit constrained Note: In good times expansionary monetary policy increases default

8. Improve financial stability by raising the cost of default - The idea is to include in the profit function an extra cost to default 1. Commercial banks - higher penalties raises borrowing rate, reduces CB default and raises default premia 2. Investment banks - reduces MBS and reduces CB borrowing

9. Comments Basic proposition is that the price system can provide greater financial stability if risks are priced correctly (aided by default penalties) and MP avoids non-market clearing

10. Interest rates Recent experience has shown that at near zero rates markets don’t clear – quantitative easing Higher repo rate would probably imply lower default premia The high leverage ratios of some households, investment banks and hedge funds suggest interest rates were too low

11. Financial sector Clearly failed to correctly price risk Even worse, they thought that creating CDO’s from MBS’s and insuring them with CDS’s reduced risk Problem was that greater opacity made it hard to evaluate the risk and international diversification spread the problem across the world Default could have been avoided if banks held high capital reserves and mortgages required larger deposits In practice banks were allowed to reduce capital requirements by moving assets off- balance sheet through the use of SIV’s

12. Higher capital requirements Can show using a standard DSGE model that when there is a non-zero probability of a shock that affects income precautionary asset holdings are required The larger the probability of a shock and the size of the shock, the greater must be the precautionary assets In the absence of a shock, the higher precautionary assets must still be held A default penalty could be based on the equivalent loss of earnings due to holding precautionary assets This is an alternative to government intervention

13. A simple DSGE model with borrowing a constraint

18. My own view 1.Financial crisis has shown that MP carried out by inflation targeting via the repo rate is not sufficient 2.Too low real interest rates partly caused by loose MP (especially in US) caused over borrowing 3.Countries in euro-zone have suffered from one-size-fits-all MP 4.MP shouldn’t target asset prices but needs an inflation target that includes house prices

19. 5. Need to reconsider treatment of off- balance sheet items 6. Need greater transparency in pricing CDS’s by having a centralised exchange or market 7. Need joined-up monitoring of financial stability 8. Future tax payers shouldn’t foot the bill 9. If this is not enough then the CB must act as lender of last resort by removing the quantity constraint

20. Conclusion Strict inflation targeting conducted via interest rates alone is not sufficient