SNS - Ricerca di base - Programma Manuela Moschella

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1 SNS - Ricerca di base - Programma Manuela Moschella Summary of the planned research activities My research activity for 2017 will focus on two main projects: the political-economic determinants of central banks behavior and the role of central banks in financial regulatory frameworks. In particular, I am interested in investigated two puzzles: 1) How did central banks in the advanced economies prioritize among price stability and output/employment and among price and financial stability during the crisis period ( )? 2) Why do policymakers delegate macroprudential responsibilities to central banks across countries? In addition to these main two research strands, I also plan to start an exploratory project on Italian financial regulatory policies, with a particular focus on decisions relating to banking regulation and bank resolution. In doing so, I will focus on decision-making processes both at the domestic level and at the EU-level (i.e. interaction between Italian policymakers and EU institutions involved in bank regulation and resolution). This exploratory research activity will be developed to ascertain the feasibility a larger comparative project that might include other European countries in addition to Italy. State of the art Monetary policy trade-offs and financial regulatory frameworks Monetary policymakers are usually assigned responsibility for pursuing a number of objectives, including low inflation, low unemployment, financial stability and maintaining external balance. Under these circumstances, the central bank is forced to face up to various trade-offs (Blinder 1999, 3). Two trade-offs became particularly problematic for central banks since the start of the global financial crisis in : the trade-off between price stability and real economic objectives; and between price and financial stability. Inflation and unemployment The task of balancing inflation and unemployment stands at the core of central banking. When inflation is high, the central bank may tighten monetary policy by inducing a rise in interest rates; this, in turn, causes firms and household to reduce their demand for money, leading to a contraction in economic activity and higher unemployment rates. Alternatively, when the central bank loosens monetary policy, investment and borrowing increase due to lower interest rates; the consequence is a boost to economic activity and a reduction in unemployment, but also an increase in inflationary pressures. The trade-off between inflation and unemployment, originally captured by the Phillips Curve in 1958, suggested that policy-makers can, in principle, obtain permanently higher levels of economic output and employment in exchange for higher inflation. The oil crisis of the early 1970s and changes in expectations concerning inflation gave rise to the popularity of the Monetarist school of thought, which brought the trade-off between inflation and unemployment under a different light. The monetarist theory of interest rates was pioneered by Milton Friedman (1968) and Edmund Phelps (1968) and asserted that inflation would continue to increase

2 if unemployment remained below a minimum level, initially identified as the natural unemployment rate and later modeled as the non-accelerating inflation rate of unemployment (NAIRU). The theory suggests that when the unemployment rate was equal to the NAIRU, inflation will remain stable. The logic is that if price inflation continues to increase, workers rational expectations would adjust accordingly leading them to demand higher nominal wages in order to maintain the same purchasing power of their wages. Once nominal wages rise at the same pace as the prices of goods and inputs of production, firm would no longer have any incentives to create new jobs. The economy would then end up with higher inflation but unemployment would return to its natural rate. The intellectual debate of the 1970s coupled with the experience of stagflation simultaneous occurrence of high inflation and high unemployment rate thus convinced many economists that high inflation did not bring benefits in the form of higher growth or lower unemployment. The conclusion that the trade-off between inflation and unemployment is short-lived has provided the intellectual foundations upon which the quest for price stability has been given pride of place among the goals of monetary policy.indeed, a broad consensus had emerged in the two decades before the crisis that the primary objective of central banks should be to maintain price stability (Goodfriend 2007). The consensus also preached that anchoring longer-term inflation expectations would be instrumental in stabilizing output and employment (Fischer 1996; Orphandies 2006). As such, price stability was incorporated into the mandates of numerous central banks, and a numerical inflation target has also been widely adopted. By the new millennium, the majority of central banks had established monetary stability as an explicit objective (Mahadeva and Sterne 2000). Despite complementarities of price and output stability in the long-run, central banks still face a trade-off in the short run. Specifically, when faced with inflationary pressures, the central banks action to tighten its policy stance (by raising interest rates) has a negative impact on real economic activity and is received as publically and politically unpopular. In the words of one of the most-well known inflation-fighters of recent times, It s much easier to lower interest rates than it is to raise interest rates (Volcker and Feldstein 2013, 109). Furthermore, in spite of the narrow focus on price stability, no central bank can simply focus on inflation and ignore what happens to economic activity. To highlight the absurdity of such a policy approach Blanchard and Giavazzi (2005) suggest thinking of a situation where stabilizing prices came at the cost of a 30% unemployment rate an outcome that certainly nobody would support. These dilemmas were particularly acute at the start of the global financial crisis. Throughout the crisis, central banks were left with the challenge to implement policies that balanced price stability and the urgent need to support output and employment. The expansion of the monetary policy toolkit beyond short-term interest rates was associated with significant uncertainty over the impact of new policies on both objectives. The uncertainty goes in both directions. On the one hand, too much accommodation could significantly boost real economic activity while at the same time increasing longerterm

3 inflationary pressures. On the other hand, too little stimulus or hesitation in taking a proactive monetary policy stance can cause longer-term inflation expectations to become unanchored through future expectations of very low inflation or even deflation. At several points during the crisis, uncertainty over the potential for lagged adjustment of inflation expectations to exceptional monetary accommodation has required policymakers to decide on how to balance the inflation and the unemployment objectives. Price stability and financial stability A second major trade-off that policymakers face is between macroeconomic stability and financial stability. While there are important synergies between the two objectives: price and output stability can help improve access and terms of finance for financial institutions, while more sound financial institutions can help stabilize the real economy by ensuring the smooth functioning of the transmission mechanism through improvements in the flow of credit to firms and households. Central banks efforts to stabilize the macroeconomic outlook can, however, come at the detriment of financial stability; and actions to stabilize financial markets and institutions can undermine macroeconomic stability. Monetary policy affects financial stability through a number of channels. To start with, monetary policy directly affects the incentives and ability of households and firms to borrow by changing current and future expected costs of borrowing. In this way, central bank s monetary policy acts as a direct accelerator or break on credit growth. In addition, monetary policy shapes risk-taking incentives of individual agents by affecting risk tolerance through wealth effects of interest rate changes and by inducing the search for yield when gains from sticky rates-of-return can be made (Borio and Zhu 2008). By tilting the yield curve upwards where short-term rates fall and long-term rates rise monetary policy can affect the term spread, which have a significant impact on the risktaking capacity of financial intermediaries by raising net interest margins and forward-looking capital (Adrian and Shin 2010). If risk-taking and credit growth have already increased, a tightening of monetary policy could exacerbate financial stability concerns in the short-run; however, in the medium-term tighter monetary policy should incentivize firms and households to consolidate their balance sheets and reduce risktaking incentives (IMF 2015). Finally, increased transparency or pre-commitment to monetary policy setting can directly compress risk premiums (Borio and Zhu 2008); this type of commitment is more likely to take place when rates are near their zero lower bound. Given modern understanding of the powerful interactions between monetary policy and financial stability, policymakers are now left to decide whether and to what the extent monetary policy should respond to financial stability concerns. This further complicates the central banks function as it must determine how to balance the three main objectives of price, output and financial stability that may at times require contradictory policies. For instance, policymakers might consider lower interest rates than it would otherwise be selected to protect the financial sector. They might also consider raising

4 interest rates to stem the buildup of financial imbalances. In the pre-crisis period, the consensus among policymakers and academics alike was that price stability should take precedence over all other objectives, including financial stability. In that environment, and based on empirical evidence pointing to the fact that several financial crises were often caused by large shifts in the price level (Bordo, Dueker and Wheelock, 2000), price stability was regarded as almost a sufficient condition for financial stability (see Schwartz 1995) or, at least, a necessary factor for financial stability (Bordo and Wheelock 1998). As Ben Bernanke (2011), then Chair of the US Federal Reserve system put it, Central banks certainly did not ignore issues of financial stability in the decades before the recent crisis, but financial stability policy was often viewed as a junior partner to monetary policy. The crisis that started in 2008 showed the limits of the no trade-off view. Indeed, the crisis vividly revealed the paradox of price stability (Shirakawa 2013, 380), as a stable price environment set the foundations for the buildup of financial imbalances. The argument that monetary policy should not be used to address financial stability concerns has since come under close scrutiny (see, e.g., Mishkin 2011, White 2009; Yellen 2014), as has the conclusion that price stability was sufficient, or at least the best contribution to be made, for financial stability (e.g., Bean et al. 2010; collection of works in Reichlin and Baldwin 2013) Acknowledging the interactions between macroeconomic and financial stability objectives inevitably complicates monetary policy-making. Furthermore, addressing financial stability requires access to several policy tools as vulnerability in the financial sector may arise in different markets, institutions and channels. This implies revising domestic financial regulatory frameworks also rethinking the role that central banks play in them (Bank for International Settlements et al, 2016) Aims Although the trade-offs between price stability and output/employment and financial stability have marked monetary policymaking even before the crisis, the pre-crisis intellectual and operational consensus had attenuated the dilemmas that policymakers confront by providing them a clear compass to guide their actions (Borio 2011). Central banks had dealt with conflicting goals by elevating price stability as the ultimate guide-post of monetary policy which was to be achieved by managing short-term interest rates. Circumscribing the scope of action of monetary policy was widely believed to be the best contribution that monetary policy could make to simultaneously achieving all three goals: monetary stability, economic growth and financial stability (e.g., Dodge 2002; Greenspan 1997). Since the start of the crisis, however, the tidy and cosy principles that had helped central banks navigate before the crisis have lost much of their guidance (Borio 2011, 1). In the face of new and pressing challenges, the science of managing conflict among multiple objectives has thus taken on different forms. My research is meant to investigate exactly these forms by shedding light on the

5 political-institutional factors that central banks to attach more weight to one objective over the others at least in the short-run. In order to investigate the puzzle of how central banks balance among competing objectives, I will compare the preferences articulated by the Chairs of the US Fed, the Bank of England and the ECB from 2008 till 2015 using automated text analysis. In addition to this task, my research is meant to investigate the changes in domestic financial regulatory frameworks since the start of the crisis with a focus on the changing role of central banks in them. To this end, I will undertake a large n quantitative analysis that will analyze the pattern of delegation of macroprudential regulatory responsibilities to central banks in 71 countries. Finally, during 2017 I plan starting an exploratory project on Italy and in particular Italian policymaker s decisions related to bank regulation and resolution. This study is meant to serve as a pilot project to assess the feasibility of larger comparison across EU countries. In this preliminary stage, my research activity will focus on assessing some of the most important regulatory changes that have taken place at the domestic level in the area on banking regulation over the past twenty years. At the same time, I will try to assess the evolution of Italian policymakers decisions also in light of the changes at the EU level, that is through the interaction with EU institutions charged with responsibility in banking supervision and resolution._