Monetary policy and financial stability: the end of benign neglect?

Transcription

1 Monetary policy and financial stability: the end of benign neglect? Claudio Borio* Bank for International Settlements, Basel Financial stability and the role of central banks Deutsche Bundesbank Symposium Frankfurt, February 2014 * Head of the Monetary and Economic Department. The views expressed are those of the author and not necessarily those of the BIS.

2 Introduction Thesis It is time we took out the question mark from benign neglect Role of monetary in preventing financial instability calls for a mix of ambition and humility - Ambition: be more proactive in restraining financial booms to avoid financial distress (systemic banking crises) - Humility: recognise its limitations in fostering recovery following financial busts (balance sheet recessions) End-result: more symmetric policy over financial cycle (FC) avoid downward bias - FC: Financial booms and busts that can cause serious financial crises and macroeconomic dislocations (credit and property prices) At stake: central bank s credibility in pursuing its mission Structure I Nature of financial instability and link to financial cycle II Role of MP during booms and busts III Risks of failing to adjust policy frameworks 2

3 I The nature of financial instability We care about financial instability because of its major macroeconomic costs Not care about volatility in asset prices or failures per se In this sense, it is a sort of intermediate target rather than independent goal Systemic crises are not like meteorite strikes, but reflect the slow build up of risk Balance sheets become progressively overstretched on the back of aggressive risk-taking financial imbalances (FIs) Financial booms sow the seeds of cause subsequent busts - Busts are endogenous, triggered by typically small events In this sense, crises are inextricably linked to financial cycles (FCs) Main force behind the FC is the self-reinforcing interaction between - Loosely anchored risk perceptions/attitudes - and liquidity (financing) constraints Evidence indicates that FCs have a number of properties Have often taken place alongside low and stable inflation Best captured by the joint behaviour of (private sector) credit and property prices Are much longer than the traditional business cycle (Graph 1) Busts are associated with costly balance sheet recessions - Permanent output losses; slow recoveries 3

4 Graph 1: The financial cycle is longer than the business cycle the United States example Note: Pink and green bars indicate peaks and troughs of the combined cycle using the turning-point (TP) method. The frequencybased cycle (blue line) is the average of the medium-term cycle in credit, the credit to GDP ratio and house prices (frequencybased filters). The short-term GDP cycle (red line) is the cycle identified by the short-term frequency filter. Source: Drehmann et al (2012). 4

5 II. What should MP do during financial booms? Implement the lean option Tighten MP even if near-term inflation is under control - Lengthen horizon and pay more attention to balance of risks FC is much longer than the traditional business cycle - Key concept: sustainable price stability Objection 1: FIs cannot be identified in real time.but Evidence suggests otherwise: leading indicators based on FC - Credit-to-GDP and asset prices (property) jointly above thresholds Worked well also ahead of GFC and out of sample (Graph 2) Potential output just as hard to measure in real time - and proxies for the FC can help address that (Graph 3) Objection 2: MP is ineffective and blunt but MP operates by boosting credit, asset prices and risk-taking Even traditional link output gap/inflation has proved elusive! Not subject to regulatory arbitrage Objection 3: Better tools available -- (macro-)prudential policy but Subject to regulatory arbitrage Major macroeconomic dislocations can occur even if banks are safe Bottom line: MP useful but needs support of other policies! (prudential, fiscal) 5

6 Graph 2: Financial imbalances can be identified in real time The US example The shaded areas refer to the threshold values for the indicators: 2 6 percentage points for credit-to-gdp gap; 15 25% for real property price gap. The estimates for 2008 are based on partial data (up to the third quarter). 1 Weighted average of residential and commercial property prices with weights corresponding to estimates of their share in overall property wealth. The legend refers to the residential property price component. Source: Borio and Drehmann (2009). 6

7 Graph 3 US output gaps: ex-post and real-time estimates In per cent of potential output Source: Borio et al (2013). 7

8 II. What should MP do during financial busts? Key issue Prevent a major stock problem from becoming a major and persistent flow problem (weak expenditures and output) Distinguish two analytical phases in a balance-sheet recession Crisis management - Objective: prevent implosion of system - Priority: shore up confidence Natural to use MP aggressively (extension LoLR policies) Crisis resolution: - Objective: establish basis for self-sustained recovery - Priority: balance-sheet repair (debt overhang/asset quality nexus) MP less effective than in normal recessions Why less effective? Operates against its grain: debt, asset prices and risk-taking already high! Transmission mechanism is impaired - Not just credit-supply constraints; but especially credit-demand constraints - No-one wishes to borrow: agents give priority to debt reduction Recent empirical evidence consistent with this 8

9 II. MP during financial busts: limitations Risk: as press on MP accelerator, exacerbate its side effects (interest-rate and balance-sheet policy) Side effects well-known by now: prolonged and aggressive easing can Mask underling balance-sheet weaknesses/delay loss recognition Numb incentives to reduce excess supply in financial sector and encourage wrong risk-taking Undermine earnings capacity of financial sector Atrophy financial markets as central bank takes over intermediation Raise political economy concerns - Especially balance-sheet policy (quasi-fiscal nature) MP can easily become overburdened MP can gain time but not address the underlying problems May generate incentives to waste that time Other policies need to take over! - Otherwise recovery delayed and weaker Paradox Concern with overburdening MP during boom ends up overburdening MP during bust Adjustments in MP frameworks do not require changes in mandates Usefulness is country-specific 9

10 III Risks of failing to adjust frameworks Risk 1: loss of credibility an expectations gap Gap develops between what MP is expected to deliver and it can deliver Vicious circle: failure to produce results leads to more pressure to act - Normalisation becomes harder and harder - Central bank loses legitimacy and public support Risk 2: Entrenching instability A new form of time inconsistency (not just MP) Policy remains asymmetric and generates bias over time - Erodes economy s defences, exhausts policy ammunition, entrench FC Evidence - MP is testing its outer limits (interest rates and balance sheets) - For world as a whole interest rates look unusually low regardless of the benchmark used (Graph 4) Small open economies find it hard to operate with interest rates considerably higher than thse in core jurisdictions Concerns with exchange rate overshooting - Signs of build-up of FIs in countries less affected by GFC (Graph 5) Yet another round of crises ahead? 10

11 Graph 4: unusually accommodative monetary conditions Inflation and real policy gap 1 Interest rates and trend growth 3 Global Taylor rule 7 1 G20 countries; weighted averages based on 2005 GDP and PPP exchange rates. 2 Real policy rate minus natural rate. The real rate is the nominal rate adjusted for four-quarter consumer price inflation. The natural rate is defined as the average real rate (for Japan, ; for Brazil, China, India, Indonesia, Korea, Mexico, Russia, Saudi Arabia and South Africa, ; for Argentina and Turkey, ) plus the four-quarter growth in potential output less its long-term average. 3 In per cent. 4 From 1998; simple average of Australia, France, the United Kingdom and the United States; otherwise only Australia and the United Kingdom. 5 Trend world real GDP growth as estimated by the IMF in WEO 2009 April. 6 Relative to nominal GDP; 1995 = The Taylor rates are calculated as i = r*+p* + 1.5(p p*) + 1.0y, where p is a measure of inflation, y is a measure of the output gap, p* is the inflation target and r* is the long-run level of the real interest rate. For explanation on how this Taylor rule is calculated see Hoffmann and Bogdanova (2012). Sources: Borio (2011); Hoffmann and Bogdanova, BIS Quarterly Review, September

12 Conclusion It is time for MP to abandon its benign neglect of financial instability In prevention, from a macroeconomic perspective Requires incorporating FCs systematically into current policy frameworks Key: more symmetric policy across boom and bust phases Ambition: lean more deliberately against booms Humility: ease less aggressively and persistently during busts - Addressing debt/asset quality problem head on Bearing in mind that FCs are much longer than business cycles - Medium-term policy horizons are essential Does not require changes in current mandates Risks should not be underestimated Central banks loss of credibility (expectations gap) Entrenching instability (time inconsistency) Not just MP! Also need adjustments in prudential and fiscal policy FCs are simply too powerful to be left to one or two policies alone 12

13 References (to BIS work only) Bech, M, L Gambacorta and E Kharroubi (2012): Monetary policy in a downturn: are financial crises special?, BIS Working Papers, no 388, September. Borio, C (2011): Central banking post-crisis: what compass for unchartered waters?, in C Jones and R Pringle (eds) The future of central banking, London: Central Banking Publications. Also available as (updated) BIS Working Papers, no 353, October. (2012a): On time, stocks and flows: understanding the global challenges, lecture at the Munich Seminar series, CESIfo-Group and Sueddeutsche Zeitung, 15 October, BIS Speeches. Also available in National Institute Economic Review, August (2012b): The financial cycle and macroeconomics: what have we learnt?, BIS Working Papers, no 395, December. Forthcoming in the Journal of Banking & Finance (already available in electronic form). (2014): Monetary policy and financial stability: what role in prevention and recovery?, BIS Working Papers, no 440, January. Forthcoming in Capitalism and Society. Borio, C, P Disyatat and M Juselius (2013): Rethinking potential output: embedding information about the financial cycle, BIS Working Papers, no 404, February. (2014): A parsimonious approach to incorporating economic information in measures of potential output, BIS Working Papers, no 442, February. Borio, C and P Disyatat (2010): Unconventional monetary policies: an appraisal, The Manchester School, Vol. 78, Issue s1, pp , September. Also available as BIS Working Papers, no 292, 2009, November. (2011): Global imbalances and the financial crisis: link or no link?, BIS Working Papers, no 346, May. Borio, C and M Drehmann (2009): Assessing the risk of banking crises revisited, BIS Quarterly Review, March, pp Borio, C, R McCauley and P McGuire (2011): Global credit and domestic credit booms, BIS Quarterly Review, September, pp Borio, C, B Vale and G von Peter (2010): Resolving the financial crisis: are we heeding the lessons from the Nordics?, Moneda y Crédito, 230, pp Also available as BIS Working Papers, no 311, July. Borio, C and H Zhu (2011): Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?, Journal of Financial Stability, December. Also available as BIS Working papers, no 268, December Caruana, J (2010): Macroprudential policy: could it have been different this time?, speech at the People's Bank of China seminar on macroprudential policy, in cooperation with the International Monetary Fund, Shanghai, 18 October, BIS Speeches (2012): International monetary policy interactions: challenges and prospects, Speech at the CEMLA-SEACEN conference on "The role of central banks in macroeconomic and financial stability: the challenges in an uncertain and volatile world", Punta del Este, Uruguay, 16 November. Drehmann, M, C Borio and K Tsatsaronis (2012): Characterising the financial cycle: don t lose sight of the medium term!, BIS Working Papers, no 355, November. Hofmann, B and B Bogdanova (2012)): Taylor rules and monetary policy: a Global Great Deviation?, BIS Quarterly Review, September, pp