Pitfalls for Monetary Policy

Revised draft Ensuring Financial Stability: Financial Structure and the Impact of Monetary Policy on Asset Prices Katrin Assenmacher-Wesche∗ Research Department Swiss National Bank Stefan Gerlach Institute for Monetary and Financial Stability Johann Wolfgang Goethe University, Frankfurt March 26, 2008 Abstract This paper studies the responses of residential property and equity prices, inflation and economic activity to monetary policy shocks in 17 countries, using data spanning 1986-2006. We estimate VARs for individual economies and panel VARs in which we distinguish between groups of countries on the basis of the characteristics of their financial systems. The results suggest that using monetary policy to offset asset price movements in order to guard against financial instability may have large effects on economic activity. Furthermore, while financial structure influences the impact of policy on asset prices, its importance appears limited. Keywords: asset prices, monetary policy, panel VAR. JEL Number: C23, E52 ∗ The views expressed are solely our own and are not necessarily shared by the SNB. We are grateful to seminar participants at the SNB and Petra Gerlach for helpful comments. Contact information: Katrin Assenmacher-Wesche (corresponding author): SNB, Börsenstrasse 15, Postfach 2800, CH-8022 Zürich, Switzerland, Tel +41 44 631 3824, email: Katrin.Assenmacher-Wesche@snb.ch; Stefan Gerlach: IMFS, Room 101D, Mertonstrasse 17, D-60325 Frankfurt/Main, Germany, email: Stefan.Gerlach@wiwi.uni-frankfurt.de. 11. Introduction There is much agreement that asset prices, in particular residential property prices, provide a crucial link through which adverse macroeconomic developments can cause financial instability.1 Episodes of asset price “booms” are seen as raising the risk of a sharp correction of prices, which could have immediate repercussions on the stability of financial institutions. Indeed, many observers have argued that property-price collapses have historically played an important role in episodes of financial instability at the level of individual financial institutions and the macro economy (e.g. Ahearne et al. 2005, Goodhart and Hofmann 2007a). Not surprisingly, this view has led to calls for central banks to react to movements in asset prices “over and beyond” what such changes imply for the path of aggregate demand and inflation (Borio and Lowe 2002, Cecchetti et al. 2000). Proponents of this policy emphasise that episodes of financial instability could depress inflation and economic activity below their desired levels. Consequently, they argue, central banks that seek to stabilise the economy over a sufficiently long time horizon may need to react to current asset price movements (Bean 2004, Ahearne et al. 2005). Importantly, they do not argue that asset prices should be targeted, only that central banks should be willing to tighten policy at the margin in order to slow down increases in asset prices that are viewed as being excessively rapid in order to reduce the likelihood of a future crash that could trigger financial instability and adverse macroeconomic outcomes. While seemingly attractive, this proposed policy has implications for central banks' understanding of Pitfalls for Monetary Policy Pitfalls for Monetary Policy By: OpenStaxCollege In the real world, effective monetary policy faces a number of significant hurdles Monetary policy affects the economy only after a time lag that is typically long and of variable length Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars Then it takes time for these changes to filter through the rest of the economy As a result of this chain of events, monetary policy has little effect in the immediate future; instead, its primary effects are felt perhaps one to three years in the future The reality of long and variable time lags does not mean that a central bank should refuse to make decisions It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve Excess Reserves Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves above the legally mandated limit For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession, because they recognize that firms’ sales and employees’ jobs are more insecure in a recession, and they not want to face the need to make interest payments The result 1/11 Pitfalls for Monetary Policy is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP Japan experienced this situation in the 1990s and early 2000s Japan’s economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0% It kept it there most of the time through 2003 Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the money supply of the country by about 50%—an enormous increase Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand Japan’s economy continued to experience extremely slow growth into the mid-2000s Should monetary policy decisions be made more democratically? Should monetary policy be conducted by a nation’s Congress or legislature comprised of elected representatives? Or should it be conducted by a politically appointed central bank that is more independent of voters? Here are some of the arguments made by each side The Case for Greater Democratic Control of Monetary Policy Elected representatives conduct fiscal policy by passing tax and spending bills They could handle monetary policy in the same way Sure, they will sometimes make mistakes, but in a democracy, it is better to have mistakes made by elected officials accountable to voters than by political appointees After all, the people appointed to the top governing positions at the Federal Reserve—and to most central banks around the world—are typically bankers and economists They are not representatives of borrowers like small businesses or farmers nor are they representatives of labor unions Central banks might not be so quick to raise interest rates if they had to pay more attention to firms and people in the real economy The Case for an Independent Central Bank Because the central bank has some insulation from day-to-day politics, its members can take a nonpartisan look at specific economic situations and make tough, immediate decisions when necessary The idea of giving a legislature the ability to create money and hand out loans is likely to end up badly, sooner or later It is simply too tempting for lawmakers to expand the money supply to fund their projects The long term result will be rampant inflation Also, a central bank, acting according to the laws passed by elected officials, can respond far more quickly than a legislature For example, the U.S budget takes months to debate, pass, and be signed into law, but monetary policy ... ADAM S. POSEN EXTERNAL MEMBER, MONETARY POLICY COMMITTEE, BANK OF ENGLAND AND SENIOR FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS WHEN CENTRAL BANKS BUY BONDS INDEPENDENCE AND THE POWER TO SAY NO Barclays Capital 14th Annual Global Inflation-Linked Conference, New York 14 June 2010   2 WHEN CENTRAL BANKS BUY BONDS INDEPENDENCE AND THE POWER TO SAY NO Adam S. Posen 1 Since the global financial crisis began in 2007, there has been a lot of hand-wringing about the independence of central banks. Some commentators today would suggest that the recent large scale purchases of government bonds by central banks inherently represent a compromise of their independence from elected officials. Others will assert that the central banks which purchased private-sector securities, thereby jeopardizing their balance sheets and supposedly making political asset allocations, are the ones which have put their independence at risk. The recent emergency actions of the European Central Bank [ECB] as part of the European Union’s response to the Greek financial crisis have prompted a whole new round of recrimination and worry on the continent. An unfortunately sizable number of people seem to believe that central bank independence is largely a matter of reputation, and that any apparent fraternization with or accommodation of debt issuers imperils that reputation. That supposed reputational damage is then presumed to have significant costs for central banks’ counter-inflationary credibility. I am not one of those people, and I will try with my brief remarks today to persuade you that this set of beliefs is wrong on all counts. Central bank independence is not primarily a matter of reputation, but of reality – what matters is what central banks do, not whether they maintain an appearance of public disdain towards the messy realities of economic life. The substance of central bank independence is giving monetary policy setting committees the legal autonomy to refuse demands to purchase debt instruments - even when demands come at moments when  1 This speech draws in part on research in progress with Kenneth Kuttner. The views expressed here, however, are solely my own, and not necessarily those of the MPC, of the Bank of England, or of PIIE.   3 politicians are very anxious that those bonds be bought. The desirable reduction of average inflation outcomes associated with central bank independence thus comes from saying no at critical moments, not from ongoing deterrence effects on expectations. 2 As a result, the counter- inflationary credibility of central banks is not fragile to voluntary purchases of bonds, public or private, made with reference to clear economic (as opposed to political) justification. 3 In contrast, always refusing to intervene in debt markets for appearance’s sake alone, regardless of the economic circumstances, is a sign of immaturity or insecurity, not independence. Some adolescents define their autonomy by being resolutely contrary, and often do damage to themselves (and others) by being deaf to common sense or to appeals to common standards just to stay contrary. Independent central banks can and should behave more like responsible adults than that. Therefore, it is my contention that by acting responsibly to respond to FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy Paolo Gelain Norges Bank Kevin J. Lansing Federal Reserve Bank of San Francisco and Norges Bank Caterina Mendicino Bank of Portugal August 2012 The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Working Paper 2012-11 http://www.frbsf.org/publications/economics/papers/2012/wp12-11bk.pdf H ouse P rices, C redit G ro w th, and E xcess Volatility: Implications for M onetary and M acropruden tial P olicy ∗ Paolo Gelain † Norges Bank Kevin J . Lansing ‡ FRB San Francisco an d N org es B ank Caterina M endicino § Bank of Portugal August 10, 2012 Abstract Progress on the question of whether policymakers should respond directly to financial variables requires a realistic economic model that captures the links between asset prices, credit expansion, and real economic activity. Standard DSGE models with fully-rational expectations have difficulty producing large swings in house prices and household debt that resemble the patt erns observed in many developed countries over the past decade. We in- troduce excess volatility into an otherwise standard DSGE model by allowing a fraction of households to depart from fully-rational expectations. Specifically, we show that t he in troduction of simple moving-average forecast rules for a subset of households can signif- ican tly magnify the volatility and persistence of house prices and household debt relative to otherwise similar model with fully-rational expectations. We evaluate various policy actions that might be used to dampen the resulting excess volatility, including a direct response to house price growth or credit growth in the central bank’s interest rate rule, the imposition of m ore restrictive loan-to-value ratios, and the use of a modified collateral constrain t that takes into account the borrower’s loan-to-income ratio. Of these, we find that a loan-to-income constraint is the most effective tool for dampening overall excess volatility in the model economy. We find that while an interest-rate response to house price growth or credit growth can stabilize some economic variables, it can significantly magnify the volatility of others, particularly inflation. Keywords: Asset Pricing, Excess Volatility, Credit Cycles, Housing Bubbles, Monetary policy, Macroprudential policy. JEL Classification: E32, E44, G12, O40. ∗ This paper has b een prepared for presentation at the Fourth Annual Fall Conference of the International Journal of Central Banking hosted by the Central Bank of Chile, September 27-28, 2012. For helpful comments and suggestions, we would like to thank Kjetil Olsen, Øistein Røisland, A nde rs Vredin, seminar participants at the Norges Bank Macro-Finance Forum, the 2012 Meeting of the International Finance and Banking So ciety, and the 2012 Meeting of the Society for Computational Economics. † Norges Bank, P.O. Box 1179, Sentrum, 0107 Oslo, email: paolo.gelain@norges-bank.no ‡ Corresponding author. Federal Reserve Bank of S an Francisco, P.O. Box 7702, San Francisco, CA 94120- 7702, email: kevin.j.lansing@sf.frb.org or kevin.lansin g@norges-bank.no § Bank of Portugal, Department of Economic Studies, em ail: cmendicino@bportugal.pt 1Introduction Household leverage in many industrial countries increased dramatically in the years prior to 2007. Countries with the largest increases in household debt relative to income tended EUROPEAN CENTRAL BANK WORKING PAPER SERIES ECB EZB EKT BCE EKP WORKING PAPER NO. 218 THE ZERO-INTEREST-RATE BOUND AND THE ROLE OF THE EXCHANGE RATE FOR MONETARY POLICY IN JAPAN BY GÜNTER COENEN AND VOLKER WIELAND MARCH 2003 * Prepared for the “Conference on the tenth anniversary of the Taylor rule” in the Carnegie-Rochester Conference Series on Public Policy, November 22-23, 2002.We are grateful for helpful comments by Ignazio Angeloni, Chris Erceg, Chris Gust, Bennett McCallum, Fernando Restoy, Lars Svensson, Carl Walsh as well as seminar participants at the Carnegie- Rochester conference, the Bank of Canada, the London School of Economics and the European Central Bank. The opinions expressed are those of the authors and do not necessarily reflect views of the European Central Bank.Volker Wieland served as a consultant in the Directorate General Research at the European Central Bank while preparing this paper.Any errors are of course the sole responsibility of the authors. ** Correspondence: Coenen: Directorate General Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany, tel.: +49 69 1344-7887, e-mail: gunter.coenen@ecb.int;Wieland: Professur für Geldtheorie und -politik, Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany, tel.: +49 69 798-25288, e-mail: wieland@wiwi.uni-frankfurt.de, homepage: http://www.volkerwieland.com. WORKING PAPER NO. 218 THE ZERO-INTEREST-RATE BOUND AND THE ROLE OF THE EXCHANGE RATE FOR MONETARY POLICY IN JAPAN ** BY GÜNTER COENEN AND VOLKER WIELAND MARCH 2003 EUROPEAN CENTRAL BANK WORKING PAPER SERIES * © European Central Bank, 2003 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 D-60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. The views expressed in this paper do not necessarily reflect those of the European Central Bank. ISSN 1561-0810 (print) ISSN 1725-2806 (online) ECB • Working Paper No 218 • March 2003 3 Contents Abstract 4 Non-technical summary 5 1 Introduction 6 2 The model 9 3 Recession, deflation and the zero-interest-rate bound 14 3.1 The zero-interest-rate bound 14 3.2 A severe recession and deflation scenario 16 3.3 The importance of the zero bound in Japan 19 4 Exploiting the exchange rate channel of monetary policy to evade the liquidity trap 23 4.1 A proposal by Orphanides and Wieland (2000) 23 4.2 A proposal by McCallum (2000, 2001) 31 4.3 A proposal by Svensson (2001) 33 4.4 Beggar-thy-neighbor effects and international co-operation 39 5 Conclusion 42 References 43 Appendix: Simulation techniques 46 European Central Bank working paper series 47 ECB • Working Paper No 218 • March 2003 4 Abstract In this paper we study the role of the exchange rate in conducting monetary policy in an economy with near-zero nominal interest rates as experienced in Japan since the mid-1990s. Our analysis is based on an estimated model of Japan, the United States and the euro area with rational expectations and nominal rigidities. First, we provide a quantitative 27BANK OF CANADA REVIEW • WINTER 2007–2008 The Zero Bound on Nominal Interest Rates: Implications for Monetary Policy Claude Lavoie and Stephen Murchison, Research Department • The lower bound on nominal interest rates is typically close to zero, since households can earn a zero rate of return by holding bank notes. • The average inflation rate, the size of the shocks hitting an economy, the formation of inflation expectations, and the conduct of monetary policy itself all influence the risk of hitting the zero bound. The balance of evidence suggests a small risk of encountering the zero bound when average inflation is at least 2 per cent. • Central banks considering an inflation target much below 2 per cent must factor in possible difficulties that the zero bound on nominal interest rates might present for the conduct of monetary policy. rice stability is generally viewed among both academics and practitioners as the most appropriate long-run objective for monetary policy. In Canada, the benefits of low, stable, and predictable inflation are clear. Since the Bank of Canada adopted an explicit inflation target in 1991, both the level and volatility of short- and long-maturity interest rates have declined. In addition, real growth has been higher and more stable than in previous dec- ades (Longworth 2002). Monetary policy aimed at achieving low and stable inflation, in conjunction with sound fiscal policy, has resulted in a stronger, more resilient economy that is better equipped to weather shocks. Canada’s strong economic performance since the adoption of a 2 per cent inflation target raises the question of whether the Bank of Canada should lower the target further. Even when measurement error is factored into the consumer price index (CPI) (see Rossiter 2005), 2 per cent inflation does not corre- spond to true price stability. Targeting a rate of inflation closer to zero may further reduce resource misallo- cations resulting from inflation uncertainty and reduce the frequency of price changes, thereby lowering menu costs. 1 In addition to the possible transition costs associated with a reduction in the target, how- ever, two main arguments have traditionally been advanced against the idea of targeting a very low rate of inflation. The first stems from the concern that it may be more difficult to adjust real wages downwards when inflation is low because this would also entail a 1. Interpreted literally, the term menu costs refers to the costs associated with having to reprint menus each time a restaurant updates its prices. The term is typically used more broadly to describe costs associated with changing prices in general. P 28 BANK OF CANADA REVIEW • WINTER 2007–2008 reduction in the nominal wage, and workers may be reluctant to accept such reductions (Akerlof, Dickens, and Perry 1996; Fortin 1996; and Fortin et al. 2002). 2 The second argument is that central banks could encounter difficulties conducting monetary policy in a very low-inflation environment because nominal interest rates cannot go below zero (Summers 1991). Canada’s strong economic performance since the adoption of a 2 per cent inflation target raises the question of whether the Bank should lower the target further. Recent experience in Japan, in which nominal short- term interest rates remained close to zero for more than seven years and real annual growth in gross domestic product (GDP) averaged just 1.7 per cent over the same period, suggests that the zero interest rate bound remains a significant and relevant practi- cal issue for monetary policy. In ... growth 6/11 Pitfalls for Monetary Policy Monetary Policy in a Neoclassical Model In a neoclassical view, monetary policy affects only the price level, not the level of output in the economy For example,... best monetary policy was for the central bank to increase the money supply at a constant growth rate These economists argued that with the long and variable lags of monetary 5/11 Pitfalls for Monetary. .. does a monetary policy of inflation targeting work? Critical Thinking Questions How does rule-based monetary policy differ from discretionary monetary policy (that is, monetary policy not based