Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

The financial instability argument for raising rates

There is a nice juxtaposition of recent articles in the Economist. This one, by P.W. (it is weird this convention they have for signing with just their initials), puts the “case against maxing out monetary policy” (a.k.a. raise rates now). The Fed, Bank of England and ECB “argue that the priority is to restore growth and to do battle against low inflation. But [they] grievously misread the risks before the financial crisis, which weakens their claim to be reading them correctly now.” Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. In contrast Ryan Avent writes that there are two big problems with this argument. I want to expand on his discussion, and be a little less polite.

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. If you have just one instrument (interest rates) and two targets (inflation and preventing a crisis) you will be influenced by both targets. If you want this point expressed more formally, see this post and the paper by Mike Woodford it discusses. 

 

However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused.

This is not just what macroeconomic theory says. In mid-2010 the Swedish central bank started raising interest rates (from 0.25% to 2%), despite forecasts that inflation would stay below target and with unemployment well above its natural rate. They did this explicitly because they were worried about the build up of household debt and a possible housing bubble. Inflation began to fall, and since 2013 it has been at or below zero. As Lars Svensson has pointed out, even on its own terms this is not a very clever policy, because with lower inflation the real value of debt is higher than it would otherwise have been. But the key point for the current discussion is that now interest rates are coming down again (currently 0.75%), because you cannot ignore inflation being over 2% below target.

Some of those making the BIS case understand this. What they hope is that if interest rates are raised to, say, 2% and stay there, that will still give us enough monetary stimulus to eventually get inflation back up to target. It clearly was not correct in the Swedish case, and with Euro inflation still at 0.5% it looks pretty improbable there too. But maybe it could be correct for the US and UK. So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery.

I want to make two observations that follow from the BIS argument. The first is that they are in effect saying that the Zero Lower Bound (ZLB) constraint on monetary policy is even more severe than we thought, because if we leave interest rates at the ZLB for too long this generates an unacceptable risk of financial instability. That in turn must strengthen arguments (pdf) for raising inflation targets above 2%. Strangely, I do not hear advocates of the BIS case also arguing for higher inflation targets. The second is that, the more severe the ZLB constraint is in practice, the more compelling the case for using fiscal stimulus when we hit the ZLB. (Fiscal policy has become more expansionary in Sweden.) Again, this is something you do not hear BIS advocates argue for – in fact they often push austerity.

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. If parts of the financial system appear prone to instability because people are taking insufficient account of risks, bring in controls (or maybe taxes) of various kinds to stop this happening. Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.

John Williams on bubbles and monetary policy

I have always found what John Williams writes interesting, from long before he became president of the Federal Reserve Bank of San Francisco. So this post just reviews a speech he recently gave at the Bundesbank’s delightful conference centre on the banks of the Rhine. For me he said three interesting things.

1) He first emphasised the dangers of deviating from monetary policy’s primary goals because of a concern about financial stability. What was interesting for me is that he did this by example, looking at what had happened in Sweden and in Norway. Now my impression is that central bankers do not make a habit of publicly criticising their colleagues in other countries, but Williams’ verdict is hardly nuanced. He is particularly concerned that inflation expectations in those countries have fallen sharply away from the target. (I discussed the dangers that could arise from this here.) He concludes “If the anchor were to slip, it would wreak lasting damage to a central bank’s control over both inflation and economic activity, at considerable cost to the economy.” We are used to hearing this about positive deviations of inflation from target, so it’s nice to hear it applied equally to negative deviations (ECB please note).

2) He then talked about asset market bubbles. What he had to say was not too controversial, but it is of immediate relevance to the UK. After looking at some persuasive empirical evidence, he said:

“Low interest rates boost fundamental valuation of assets. In a world of rational expectations, asset prices adjust and that’s it. But, if one allows for limited information, the resulting bull market may cause investors to get “carried away” over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.”

Recently I talked about how expectations of a prolonged period of low real interest rates could lead to sharp increases in house prices, as we have recently observed in the UK and elsewhere. What Williams is suggesting is that this process can lead to overshooting, as the market gets carried away.

3) All this seems to be leading to the inevitable discussion of macroprudential controls rather than interest rates to deal with overshooting of this kind. He says “monetary policy actions should only be a last resort.” But then his discussion took an unexpected turn, for me at least.

“One of monetary policy’s most important lessons—borne out in both theory and practice—is that the framework for policy is more important than the details of the execution. In terms of price and economic stability, anchoring inflation expectations and responding in a systematic way to economic developments are by far the most important elements of good monetary policy.

 Instead of thinking about how monetary policy should respond to risks to financial stability, we should focus on studying ways to design policy frameworks that support financial stability with only a modest cost to macroeconomic goals and anchoring inflation expectations.”

What does this mean? He is careful to say “I am not personally advocating either of these proposals, but I do view them as creative ways to think of how to bend the curve in terms of macroeconomic and financial stability tradeoffs.” Well one of the two ideas he notes is that monetary policy should target nominal income rather than inflation. “The idea that nominal income targeting could be supportive of financial stability is relatively straightforward (Koenig 2013, Sheedy 2014).” The paper by Koenig [1] I did not know, but the paper by Kevin Sheedy [2] I discussed over a year ago in this post. You read it here first!

[1] Koenig, Evan F. 2013. “Like a Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk.” International Journal of Central Banking 9(2, June), pp. 57–82.

[2] Sheedy, Kevin D. 2014. “Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting.” Presented at Brookings Panel on Economic Activity, March 20–21.