Should fears of financial instability raise interest rates?

Inflation is significantly below 2% almost everywhere. In the US, Japan and the UK (even though in the UK inflation is still just above 2%) central banks are doing a great deal to get inflation back to 2%. Maybe not enough, but their goal is clear. The ECB is belatedly following the same path (although it remains somewhat behind), but this has caused a very public split in its ranks. One reason given by those who have opposed the ECB’s latest rate cut is a risk to financial stability, and house price increases in certain Eurozone cities. [1] In the US some have raised concerns that continuing QE might generate financial instability. In the UK one of the three ‘knockouts’ to forward guidance, that could allow interest rates to rise even if unemployment remained above 7%, concerns financial stability.

And in one country, Sweden, the independent central bank has kept interest rates above the ZLB, even though prices have been literally falling. While the central bank cut short rates to 0.25 in 2009, during 2010 they were increased to 1%, and during 2011 to 2%. They have since been cut to 1%, but the central bank does not want to cut any further despite prices being flat or falling throughout 2013. Yet the central bank has a clear target for inflation of 2%.

The reason the Swedish central bank - the Riksbank - is overriding its inflation target were clearly set out in a speech given by Kerstin af Jochnick, First Deputy Governor of the Sveriges Riksbank, in January 2013. The Riksbank is concerned that low interest rates will exacerbate a housing bubble. The discussion is interesting for at least two reasons. The first is that the Riksbank is not primarily concerned about the impact of any bursting bubble on the financial sector itself. It is not worried about a second financial crisis. Instead it is worried about the impact a bursting bubble might have on households (creating another balance sheet recession) and overseas confidence.

The second is that the Governor is explicit that higher interest rates are a second best solution to this problem. The first best solution is macroprudential regulation. But, to quote the speech: “One reason why monetary policy in Sweden has needed to give consideration to financial imbalances is because there has been no framework for macroprudential policy.” The speech discusses the progress that the central bank has made in developing a framework for macroprudential regulation.

In passing I would want to add that interest rate policy is probably the third best solution to housing market concerns. The potential for using particular fiscal policy instruments is often overlooked. For example, just as the UK government has tried (somewhat opportunistically) to stimulate the housing market through fiscal means (Help to Buy), these means can also be used to dampen that market. Indeed Goodhart and Baker have argued that Help to Buy can be seen as a macroprudential instrument.

My more substantive point is that a monetary policy of the Swedish kind risks undermining the legitimacy of independent central banks. As regular readers will know, I believe strongly that there are areas of macroeconomics where delegation can be highly beneficial. You only need to look at the influence that misguided, and sometimes crazy, macroeconomic ideas can sometimes have among politicians to see why. On the other hand, delegation potentially undermines the democratic process. There is nothing which says that central bankers, or experts who sit on monetary policy committees, have any particular right to take decisions which can have a substantial impact on people’s lives.

That is one reason why Alesina and Tabellini [2], among others, stress that successful delegation happens when there is a broad consensus on what constitutes sound policy. I think one reason that delegation of monetary policy to central banks has been largely uncontested so far is that this consensus existed for monetary policy. Essentially the task of central banks was to keep inflation low. Of course there is plenty of scope to discuss the details of how this is done, which macroeconomists spend a great of time doing. But the primary task, and the proximate means by which it should be achieved, were clear and commanded near universal support.

For some time the only potentially competing goal was keeping unemployment low: hence the dual mandate in the US. However there was near universal agreement amongst economists that the only sustainable level of unemployment or output that monetary policy should try to achieve was precisely the level that kept inflation stable. If that level of unemployment was too high, then means other than monetary policy should be used to address that problem. Again there are disputes at the margins, particularly when supply or cost-push shocks hit, but little dispute about the basic idea.

The moment central banks start allowing inflation to be persistently below target (with the loss in output that this implies) because of concerns about housing bubbles, this consensus will evaporate. Again Sweden provides a clear example. Lars Svensson, a highly respected academic and a former Deputy Governor of the central bank, has strongly disputed that this policy will achieve the goals it is designed to achieve, and instead suggests that the central bank is violating its mandate. (A good summary is here.) On the more general issue of how much monetary policy should take account of financial risk or housing bubbles there is a wide spectrum of views among economists.   

It is also not difficult to see how reasoned debate could easily escalate into attacks on central bank independence itself. If the central bank begins to be perceived as protecting the interests of the financial sector rather than the public at large, then demands for the government to take back the control of interest rate setting could become difficult to resist (even if the government wanted to resist). I would have no difficulty writing the slogan myself. First the banks created the recession, and now (through the central bank) they want to take away the recovery.

One response to this argument might be that the public would not forgive a central bank that allowed a second financial crisis to develop. I would agree that in the absence of any other remedy interest rate policy should be influenced by the possibility of a financial crisis, as Michael Woodford has demonstrated formally (see this post). So how do you exercise this option of last resort, but still ensure the legitimacy of independent central banks by focusing on the control of inflation? I quite like the arrangement in the UK, where there is a separate Financial Policy Committee (FPC) that works with but is independent of the Monetary Policy Committee (MPC). The FPC, not the MPC, is in charge of macroprudential policy. The knockout to forward guidance that I mentioned above involving financial instability is called by the FPC, and the MPC can then decide whether to act on that call.

Such an arrangement works best if both committees are populated by experts from outside the central bank, and in the case of the FPC those experts are not just current or past bankers. It has the advantage that before the MPC can even begin to consider allowing fears of financial instability to influence its interest rate judgement, the FPC has to in effect say we have exhausted all the other means at our disposal. It would be also good if the FPC was explicit about any micro fiscal issues that might also be involved, just as Bernanke has been explicit about the problems macro fiscal policy has caused him in the last year or so. This institutional arrangement makes it clear that it is for others, and not those who set interest rates, to protect mortgage borrowers from their own potential folly.

[1] See this article by Hans-Werner Sinn for example. To be fair housing is only briefly mentioned there, and the main point seems to involve something else, although what exactly is less clear to me.

[2] Alesina, A. and Tabellini, G. (2007) “Bureaucrats or politicians? Part 1: A single policy task.” American Economic Review 97: 169–179.