«Reconciling Price and Financial Stability Jean-Pierre Danthine 1 Member of the Governing Board Swiss National Bank University of Zurich Zurich, 24 ...»
Embargo: 24 January 2011, 5.15pm
Reconciling Price and Financial Stability
Jean-Pierre Danthine 1
Member of the Governing Board
Swiss National Bank
University of Zurich
Zurich, 24 January 2012
© Swiss National Bank, Zurich, 2012.
I would like to thank Pierre Monnin, Anna Faber and Adriel Jost for their invaluable support in drafting this
paper. I also thank Rita Kobel, Peter Kuster, Reto Nyfeller, Dewet Moser and Angelo Ranaldo for their
It is a great pleasure for me to be with you today at the University of Zurich to discuss an issue that the recent financial crisis has exposed as a major challenge to central banks;
namely how they can best contribute to ensuring financial stability while pursuing price stability as a primary mandate. 2 Before I do this, however, let me say a few words on another dimension of stability: institutional stability. As you are all aware, the Swiss National Bank (SNB) recently experienced an unfortunate event which has few, if any, historical precedents. On a personal level, I deeply regret the resignation of Philipp Hildebrand, under whose leadership the SNB steered Swiss monetary policy over the last two years. On an institutional level, however, I would like to stress that the SNB’s institutional strength is the result of teamwork, not only between the board members, but across the Bank as a whole. The SNB’s culture is one of excellence and of service. It is the product of a long history and many generations of leaders. It remains as strong as ever. Despite the difficult conditions and the unusual challenges that have characterized the last two years, all important monetary policy decisions have been reached by consensus, a consensus which emerged from in-depth and intensive analyses and discussions. The current course of Swiss monetary policy, particularly the decision to introduce a minimum exchange rate, is the result of a deep-rooted consensus of this kind. The SNB will thus continue to enforce the minimum rate with the utmost determination and remains prepared to buy foreign currency in unlimited quantities. The Swiss franc is still highly valued, but it should depreciate further in the future.
Let me now return to my topic. I will start by presenting general pre-crisis assessments of the state of monetary policy and will then examine how central banks’ policies may have contributed to the financial crisis. After considering these issues, I will be in position to assess the alternative courses of action available to central banks in general, and the SNB in particular, to derive principles for a future in which financial and price stability are better reconciled with one another.
2 This order of priorities is in line with the National Bank Act, article 5, which clearly states that “ensuring price stability” is the SNB’s primary goal while it should also “contribute to the stability of the financial system”.
Let me start by considering the state of many developed economies, to include Switzerland, before the onset of the crisis. In contrast with the episodes of high inflation which prevailed in the 1970’s, rates of inflation were subsequently stable and low for some twenty years. This period, which is commonly referred to as the ‘Great Moderation’, was also characterized by low real GDP volatility and low interest rates. Slide 1 illustrates these developments in the cases of the United States and Switzerland in this period.
Though there is no definitive analysis of the causes of the ‘Great Moderation’, monetary policy is regularly cited as a contributing factor. 3 This accords well with observations that major progress had been made in identifying the determinants of inflation, understanding the importance of central bank independence and therefore in improving the conduct of monetary policy. At the methodological level, these developments are generally linked to the concept of ‘inflation-targeting’ 4 and summarized in a class of macroeconomic models, which Marvin Goodfriend and Robert King5 have named ‘the New Neoclassical Synthesis’. This label tells of an approach that combined key elements of Keynesian and classical thinking.
While the new models made conditional forecasting possible and permitted scientifically appropriate policy evaluations, they only included primitive financial sectors. In their current state, they therefore cannot address issues of financial stability or the link between low interest rates and financial excesses.
II. The recent financial crisis: are central banks the culprits?
The recent financial crisis has thrown the positive pre-crisis perceptions of modern monetary policy into question. Indeed, many analysts now attribute a certain degree of responsibility for the financial crisis to central banks, in sharp contrast with the typically benevolent assessment of their contributions to the ‘Great Moderation’. Two main lines of argument support claims that central banks contributed to the crisis, as Slide 2 illustrates.
3 Other commonly cited causes are: i) financial deepening resulting from developments in the financial markets in the 1980-90’s such as options, hedging tools, etc.; ii) less and more stable government regulation and taxation; iii) luck.
4 The SNB does not describe its approach as ‘inflation targeting’ as it differs somewhat from classic ‘inflation targeting’. See http://www.snb.ch/en/iabout/monpol for further details.
5 Goodfriend and King (1997).
3 The first is that the precepts of the ‘inflation-targeting’ paradigm were misapplied and that these policy errors have contributed to, or have directly caused, the crisis. The second is that the paradigm itself is deficient, or at least incomplete. Indeed, even when central banks conduct monetary policy optimally, according to the ‘inflation-targeting’ mantra, it is a mistake for them not to recognise that a long period of low interest rates may encourage financial intermediaries to take increased risks with negative consequences for systemic stability.
One clear proponent of the first argument is John B. Taylor. Taylor has argued that the Federal Reserve contributed to the crisis by setting interest rates too low prior to 2007.
Although price stability was achieved, monetary policy in the United States was, in his view, inappropriately conducted, given the level of inflation and the size of the output gap, as attested by significant deviations from the ‘Taylor rule’, a benchmark he first proposed in 1993. 6 The ‘Taylor rule’ recommends that central banks systematically adjust nominal interest rates in response to macroeconomic developments and inflation movements, but, between 2002 and 2005, they were lower than the ‘Taylor rule’ advised, as Slide 3 illustrates. According to Taylor,7 monetary policy may have been too expansionary, certainly in the United States and the Euro area. Taylor even suggests that, if central banks had set higher interest rates in this period, the subsequent housing bubble and the global financial crisis might have been avoided. 8 According to this view, the crisis stemmed from a misapplication of the ‘inflation-targeting’ precept. The underlying models may be unable to explain why an excessively accommodative policy would lead to a financial crisis. The episode does not, however, imply that the entire monetary policy paradigm has to be revisited, nor that financial stability is incompatible with price stability.
Slide 4 illustrates the ‘supply shock’ hypothesis. Here, the crux of the argument is that monetary policy was too expansionary because the impact of supply shocks on prices was underestimated. This, in turn, prompted miscalculations of the output gap. As one can see, 6 Taylor (1993).
7 Interpretations of the ‘Taylor rule’ can be ambiguous. Interestingly, the formula produces quite different results depending on whether it includes core or headline inflation and how the output gap is measured. It also omits factors such as widening credit spreads, the role of time-varying parameters and the risk of deflation, particularly between 2002 and 2004. See, for example, Bernanke (2010) and Kohn (2007).
8 Taylor (2009).
4 in the United Kingdom and in Switzerland, the prices of those goods which were most influenced by imports increased far more slowly than those of services, which were less import-dependent. One plausible explanation for this is that the availability of cheap imports from Asia (or Eastern Europe) acted as a positive supply shock, thus reducing the relative price of imports. If the supply shock had been temporary, it would have provoked lower transitory inflation and the optimal monetary policy response would have been to do nothing, except to let the economic forces at play re-establish an equilibrium and normal inflation levels. 9 In recent decades, however, the pressures associated with globalization have borne greater resemblance to a permanent series of shocks. As these shocks were interpreted as temporary, they were disregarded from a policy perspective, which, it is argued, caused monetary policies to be excessively expansionary.
Both of these views suggest that central banks could have potentially helped prevent the crisis by setting higher interest rates and that they should have done so if the ‘inflationtargeting’ precepts had been fully understood and optimally followed. In both cases, however, the underlying models would have predicted that such policy failures would have prompted overproduction and excessive rates of inflation, rather than a financial crisis.
The third hypothesis I would like to discuss is the theory of the ‘risk-taking channel’. This newer line of argument is that, even if monetary policy was optimally conducted before the crisis, the prevailing low interest rates provided fertile ground for miscalculation and excessive risk-taking by financial intermediaries, thus contributing to the crisis. According to this view, the ‘inflation-targeting’ paradigm itself is deficient in the sense that it does not take into account the negative externality of a policy exclusively aimed at price stability imposes on financial stability. In Claudio Borio and Haibin Zhu’s 10 terms, “changes in policy rates have an impact on either risk perception or risk-tolerance and hence on the degree of risk in portfolios, on the pricing of assets, and on the price and the non-price terms of the extension of funding.” In other words, a long period of low interest rates drives financial intermediaries to take increased risks. Empirically, there is a growing body of evidence to indicate that a channel of this kind exists. 11 9 Bean (2006).
10 Borio and Zhu (2008).
11 See, for example, Altunbas, Gambacorta and Marqués-Ibáñez (2010).
5 There are three main versions of the ‘risk-taking channel’. Every one of them suggests that, while low interest rates might be the natural consequence of price stability, they may ultimately compromise financial stability. The first hypothesis, is that hedge-fund and wealth managers, who tend to be paid according to the nominal returns on their investments, might be prone to taking additional, possibly excessive, risks when interest rates are low and, as a result, they might receive lower levels of compensation. 12 To the best of my knowledge, empirical studies which support or dismiss this claim have been yet to be carried out.
The second hypothesis 13 is that low interest rates increase the value of the collateral backing up loans. Banks thus have less incentive to monitor their clients’ loans. 14 This view is empirically better documented, but the supporting evidence is ambiguous. 15 Finally, the third hypothesis is that banks with access to cheaper external funding increase their leverage to achieve higher returns on equity. This change in banks’ balance sheet structure tends to make the banking sector more fragile. There is some evidence to support this argument. For example, Slide 5 reports the results of simulating how banks in the United States adjust their external funding to changes in monetary policy. It suggests that when central banks increase interest rates, banks significantly decrease their external funding for the next two years or so. 16 The ‘Taylor rule’, the ‘supply shock’ hypothesis and the ‘risk-taking channel’ theory all have one common feature. Every one of them acknowledges the possibility that interest rates may have been too low prior to the crisis, though their proponents may disagree as to whether, or to what extent, this was the result of a policy or paradigm failure. There is also consensus that this may have contributed to the financial instability that followed, although only the theory of the ‘risk-taking channel’ clearly suggests how this would have come about.
12 Rajan (2005).
13 Dell’Ariccia, Laeven and Marquez (2010).
14 Note that this theory closely resembles Ben Bernanke and Mark Gertler’s ‘financial accelerator’ model.
However, in this model the increase in collateral value prompts investors to borrow more whereas in the model of the ‘risk-taking channel’, increased collateral value induces banks to monitor their existing loans less.
15 See, for example, Buch, Eickmeier and Prieto (2011). This study of the US market between 1997-2008 suggests that looser monetary policy or unexpected house price decreases prompt small domestic banks to increase their exposure to risk. The same conditions seemingly cause foreign banks to reduce their risk exposure, however, while large domestic banks retain the same levels.
16 Angeloni, Faia and Lo Duca (2010).
6 III. ‘Leaning against the wind’: an unfavourable trade-off between financial stability and output growth If interest rates were indeed too low in the pre-crisis years, it would appear that by raising them central banks could have helped avoid, or at least contain, the crisis. When this calls for deviations from otherwise optimal policy, one talks of ‘leaning against the wind’. In economic upturns, this would involve central banks setting higher interest rates than would be necessary to achieve price stability alone. The objective would be to avoid the overvaluation of assets, to constrain excessively risky behaviour on the part of financial intermediaries and hence to prevent bubbles from emerging, or at least to reduce their size.