Monetary Policy and Financial Stability G I O VAN N I D E L L’ A R I C C I A I M F – R E S E A R C H D E PAR T M E N T

ECB Watchers Conference – Frankfurt, April 2016 The views expressed here are those of the authors and do not necessarily represent those of the IMF or the IMF Board

Talk Plan Review debate on monetary policy and financial stability

• Cost benefit analysis • Role of financial variables in estimating potential output • Governance challenges when MP has multiple targets

Pre-crisis Consensus: No leaning against the wind “I find it difficult to conceive the degree of central bank certainty to justify the scale of preemptive tightening that would likely be necessary to neutralize a bubble.” Alan Greenspan, 2002. “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” Ben Bernanke, 2002. “…monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements…attempting to "prick" an asset price bubble, should be avoided.” Rick Mishkin, 2008

Pre-crisis: Macro ok, but risks were growing Figure 1. Output Gap, Core Inflation, and Financial Indicators Before the Crisis Output Gap (In percent of potential output)

Core Inflation (In percent, y/y)

8

8

7

Ireland Spain United States United Kingdom

6 5

4

7 6 5

3

4

2

3

1

2

0

1

-1

0

-2 2000

2001

2002

2003

2004

2005

2006

2007

Credit-to-GDP (2000Q1=100)

2001

260

220

2002

2003

2004

2005

2006

2007

Residential Real Estate Prices, (2000Q1=100)

240

200

220

180

200

160

180 160

140

140 120

120

100 2000Q1

100 2000Q1

2001Q3

2003Q1

2004Q3

2006Q1

2007Q3

2001Q3

2003Q1

2004Q3

2006Q1

Source: World Economic Outlook (September 2007 vintage for the output gap) and Haver Analytics.

2007Q3

Subprime Boom and Defaults

Credit Growth and Depth of Great Recession

100

y = -1.2852x + 12.969 R² = 0.14 IRL

75

ESP

LVA

50

DNK

EST LTU

GBR NLD BGR SVN

UKR

25

RUS

KAZ VNM AUS

SWE

IND

0

Bubble size shows the level of credit-to-GDP ratio in 2006.

-25

SVK HKG JPN

THAPHL BOL

SUR NPLBGD MAR CHL MOZ DOM PAN

IDN CHN

URY

Change in mortgage delinquency rate, 2007-09

Change in credit-to-GDP ratio from 2000 to 2006

Crisis: severity in line with magnitude of credit booms

250 AZ NV

y = 1.1159x + 20.457 R² = 0.5501

CA

200 VT HI 150

FL MD

OR ID 100

IL WI MN GA NC SC AL IACO TN MO AR KY KS SD ND OH OK MS NE WV LA

MI IN 50

MYS

UT MA

WA

CTNY MT NM NH ME WY

DE VA NJ RI

DC

Bubble size shows the percentage point change in the ratio of mortgage credit outstanding to household income from 2000 to 2006.

AKPA

0

-50 -30

-20

-10

0

10

20

0

30

20

40

60

80

100

TX

Change in GDP from 2007 to 2009 -50

House price appreciation, 2000-06

120

140

160

2.4

7.5

2.6

2.8

3

Risk of loans (detrended)

Capital-to-asset ratio (detrended) (in %) 8 8.5 9

3.2

9.5

3.4

Monetary policy and risk taking

-2

0 2 4 Real federal funds rate (detrended) (in %)

6

-2

0 2 4 Real Federal Funds Rate (detrended) (in %)

6

Dell’Ariccia, Laeven, Suarez, 2016, (JF, forthcoming)

Today’s views are more diverse “Monetary policy is poorly suited for dealing with financial stability concerns, even as a last resort.” John Williams, 2015 “For existing empirical estimates and reasonable assumptions, the marginal cost of leaning against the wind is much higher than the marginal benefits. Thus, leaning against the wind is not justified. Lars Svensson, 2015

“Monetary policy faces significant limitations as a tool to promote financial stability… [But] it may be appropriate to adjust monetary policy to ‘get in the cracks’ that persist in the macroprudential framework.” Janet Yellen, 2014 “It would make sense not to rule out the possible use of the interest rate for this purpose, particularly when other tools appear to be lacking.” Stan Fischer, 2015

“In other words, we have been leaning against the wind.” Oystein Olsen, 2015 “Financial stability is too large a task for prudential… frameworks alone. Monetary policy strategies also need to… lean against the build-up of financial imbalances even if near-term inflation remains low and stable.” Jaime Caruana, 2011

To lean or not to lean? A three step approach 1

Transmission • •

2

Tradeoffs • •

3

How does monetary policy affect financial variables? What are the effects on financial stability?

Is policy tightening for inflation purposes sufficient? How often do we see a conflict between price and financial stability objectives?

Welfare analysis •

Costs and benefits of leaning against the wind

9

Costs/benefits analysis: Should monetary policy lean against the wind? In general, no. • •

Reasonable parameters suggest costs exceed benefits Other tools (macro- and micro-prudential)

Yet, benefits grow relative to costs when: •

Conjuncture: rapid credit growth, low unemployment, high probability of long-lasting and severe crisis,

•

Structure: large, interconnected economy (spillovers)

Prudential policies should be the first policy considered •

•

More targeted, probably less costly, Both micro- and macro-prudential can play a role

A Different Role for Financial Variables? Before the GFC: •

•

Real-time estimates of output gaps did not signal substantial overheating CPI inflation was below target in most advanced economies

After the GFC: • •

Large upward revisions to output gaps Greater awareness of the role of housing and credit booms

Use real-time financial data to reduce errors in potential output estimates

Potential output a bit of a moving target 4

Panel 2. United States, output gap (Percent)

Panel 1. Cross-country average, output gap (Percent)

4

2

2

0

0

-2

-2 April 2015 WEO

-4

April 2015 WEO

-4

Real-time WEO

Real-time WEO

-6

-6

2000

2007

2012

2000

Panel 3. Cross-country average, credit and house prices (Real indexes, 2000=100) 200

2007

2012

Panel 4. United States, credit and house prices (Real indexes, 2000=100) 160

Credit

180

Credit

House prices

House prices

140

160 140

120

120 100

100 2000

2007

2012

2000

2007

2012

Potential output a bit of a moving target Panel 1. Greece, output gap (Percent)

Panel 2. Spain, output gap (Percent)

15

4

10

2

5

0

0

-2

-5

2000

April 2015 WEO Real-time WEO

Real-time WEO

-10

320 300 280 260 240 220 200 180 160 140 120 100

-4

April 2015 WEO

-6

2007

2012

2000

2007

2012

Panel 4. Spain, credit and house prices (Real indexes, 2000=100)

Panel 3. Greece, credit and house prices (Real indexes, 2000=100)

260

Credit

Credit

240

House prices

House prices

220 200

180 160 140 120 100 2000

2007

2012

2000

2007

2012

Economic and financial overheating

Bank NPLs in crises 90

80

NPL ratio, percent

70 60 50

40 30 20 10 0 Non-OECD Countries

OECD Countries

Role of bank capital/loss absorption 1

Share of banking crises avoided

0.9 0.8

0.7 0.6 0.5 0.4 0.3 0.2

Risk-weighted bank capital ratio, percent

0.1 0 0

10

20 Loss given default = 50%

30

40 Loss given default = 75%

50

60

Governance issues with financial stability mandate Outsourcing price stability to independent CBs was “easy”: •

•

•

A clear and measurable objective: low and stable inflation (some attention to short-term output) Clearly understood (often mono-dimensional) tools: the policy rate Accountability led to properly designed incentives for central bankers

Outsourcing financial stability is much more complicated

Governance issues with financial stability mandate Paradox of success •

• •

Unlike monetary pol.: No easily measurable target (is there a too stable financial sector?) Unlike prudential supervision: No yardstick Nobody sees the crisis that did not happen

Politically charged (with or without MaP) • •

Hit most vulnerable Against increased credit access

Need for rule-based approach. But… • •

Measurability makes delegation challenging Far from calibration of DSGE standards

Risks to Central Bank Independence? Theoretical foundation for CB independence on price stability: •

• •

Inflation is an inferior tool to deal with fiscal constraints Time-inconsistency problem This clearly still desirable

Analogous arguments for financial stability? • •

Governments may be tempted to use regulation to distort incentives for banks to finance the treasury Politicians may be reluctant to tighten if this is politically costly

Legitimate concerns •

•

Democratic deficit if a central bank is endowed with powers ranging from setting interest rates to credit allocation and financial regulation Especially in the context of mandates with measurability issues

Evidence so far suggests no significant difference in inflation performance with multiple mandates Figure 7. Inflation Performance and Bank Supervision among Inflation Targeters 30

20 15 10

Note: Average inflation deviation from the target since the central bank introduced inflation targeting until 2006Q4. Difference in means is not statistically significant. Source: Central Banks' websites, Haver Analytics, and staff calculations.

Romania

Slovak Republic

Czech Republic

Albania

Ghana

Thailand

Philippines

Indonesia

Israel

Uruguay

Brazil

South Africa

New Zealand

Iceland

Turkey

Poland

Hungary

Korea

Peru

Guatemala

Colombia

Chile

-5

Sweden

0

Mexico

5

United Kingdom

inflation deviation from targets Percentage points

25

Central Banks in Charge of Bank Supervision average inflation deviation = 3.49

Central Banks not in Charge of Bank Supervision average inflation deviation = 3.16

Yet, important concerns remain So far, a financial stability mandate has meant to be in charge of relatively “a-cyclical” bank regulation and supervision Political pressures can intensify: • •

Tools with more targeted effects (with clearer winners and losers) Cyclical use of prudential tools

Communication/credibility challenges • •

One tool/two targets Conflicting mandates

Key challenge: •

Protecting MP independence (on price stability) if government/public chooses to exercise greater oversight on new central bank responsibilities