Here are some initial thoughts reading Michael Woodford’s new NBER paper. The paper addresses the following question. Should our current monetary policy framework, which involves ‘flexible inflation targeting’ (more on what this means below), be modified in an attempt to avoid a financial crisis of the type experienced in 2008? We can put the same question in a more specific way – should the Fed or Bank of England have raised interest rates by more in the years before the crisis in an effort to avoid the build up of excess leverage, even if movements in output and inflation indicated otherwise? The paper suggests the answer to both questions is yes. Although the paper contains plenty of maths, it is reasonably reader friendly, so I hope reading this will encourage you to read it.
First, what is flexible inflation targeting? Both inflation and the output gap influence welfare, so policy is always about getting the right balance between them. In a simple set-up, when a ‘cost push’ shock (like an increase in VAT) raises inflation for a given output gap, then creating a negative output gap so as to moderate the rise in inflation is sensible. The optimal policy can be expressed as a relationship (a ‘target criterion’) between deviations in the price level from some target value (the ‘price gap’) and the output gap. In the case of the cost-push shock, policy ensures that the output gap gradually narrows as the price level gradually convergences back to its original level. This is not quite the same as ‘hitting the inflation target in two years’, which is sometimes how the Bank of England describes its policy. It is, however, how most economists would describe optimal policy (assuming the central bank has the credibility to commit).
This ignores credit risk. In an earlier paper, Curdia and Woodford (2009) introduced a credit friction distortion (CFD) variable, which is related to the risk premium between lending rates to risky individuals/firms compared to the return on safe assets. This variable matters, because it can influence how consumption (demand) evolves, and it can influence the (New Keynesian) Phillips curve. It also influences social welfare itself. In the original paper CFD is treated as exogenous. Here it is allowed to take two values: a crisis value, and a normal value, but crucially the chance that it will move to the crisis value depends on leverage, which in turn depends on the output gap. It is this last link that is crucial. Without it a financial crisis would just be treated like any other shock: monetary policy would respond to it, but the relationship between prices and the output gap after the shock would remain the one described above.
If leverage depends on output, this is no longer the case. The relationship between the output gap and the price gap now depends on what Woodford calls the ‘marginal crisis risk’. If the risk of a damaging financial crisis is particularly high, then it is optimal to reduce output in an effort to reduce leverage even if prices are at their target. In a way this is just commonsense when you have only one instrument (monetary policy) and many targets. Without this link, optimal policy was a matter of getting the right balance between output and inflation, and the maths tells you the form that balance takes. Add a third target (the chance of a crisis) that can be influenced by monetary policy, and that has to be balanced against the other two.
What the maths tells you is the following. Suppose the optimal policy when a financial crisis is endogenous is expressed in the form of a modified price target like the one I have just described. Suppose also that policy did tighten to head off the possibility of a crisis, and this led to lower output and inflation than would otherwise have occurred. To quote Woodford: “Under the criterion proposed above, any departure of the price level from its long-run target path that is justified by an assessment of variations in the projected marginal crisis risk will subsequently have to be reversed.” In other words, a fear that central banks would constantly undershoot the inflation target because they were cautious about financial conditions does not follow under this policy, because in this case prices would move further and further away from their target path, and this would not be optimal.
None of this reduces the desirability of finding other ‘macro-prudential’ financial instruments that could also mitigate the chances of a financial crisis. The better those instruments are, the less need there is to modify standard monetary policy to take account of that risk.
What this analysis suggests is that the possibility of a financial crisis leads to a modification of optimal monetary policy as we now understand it, but not its complete overthrow. Woodford argues that flexible inflation targeting has served us well. To quote:
“Despite a serious disruption of the world financial system, that some have compared in magnitude to that suffered in the 1930s, this time none of the major economies fell into deflationary spirals. And despite large swings in oil prices, the effects on the dynamics of wages and prices this time have been modest. These comparatively benign outcomes are surely due in large part to the fact that inflation expectations in most of the major economies have remained quite well anchored in the face of these substantial disturbances. And it is arguable that the credibility with regard to control of the rate of inflation that the leading central banks have achieved over the past twenty years deserves a great deal of the credit for this stability.”
On that I have to agree.
I would like to make one final, somewhat tangential, observation. This paper seems to be a clear example of what I have called elsewhere (see this post and the paper referenced at its end) a ‘pragmatic microfoundations’ approach. Woodford’s endogenisation of the impact of policy on leverage and crisis is ad hoc (he describes it as ‘reduced form’), and he stresses repeatedly the need to do further work on modelling these links in a more structural manner. Nevertheless it would seem to me strange to dismiss what he does as ‘not proper macroeconomics’, as a microfoundations purist might do.