Monetary policy in the grip of a pincer movement

BIS Working Papers

No 706

 

Monetary policy in the grip of a pincer movement

by Claudio Borio, Piti Disyatat, Mikael Juselius and Phurichai Rungcharoenkitkul

 

Monetary and Economic Department

March 2018

 

JEL classification: E32, E40, E44, E50, E52

Keywords: monetary policy, financial stability, financial cycle, natural interest rate, inflation

 

This publication is available on the BIS website (www.bis.org).

 

© Bank for International Settlements 2017. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISSN 1020-0959 (print)

ISSN 1682-7678 (online)

 

Monetary policy in the grip of a pincer movement

Claudio Borio, Piti Disyatat, Mikael Juselius and Phurichai Rungcharoenkitkul

 

Abstract

Monetary policy has been in the grip of a pincer movement, caught between growing financial cycles, on the one hand, and an inflation process that has become quite insensitive to domestic slack, on the other. This two-pronged attack has laid bare some of the limitations of prevailing monetary policy frameworks, particularly in the analytical notions that have guided much of its practice. We argue that the natural rate of interest as a guidepost for monetary policy has a couple of limitations: the concept, as traditionally conceived, neglects the state of the financial cycle in the definition of equilibrium; in addition, it underestimates the role that monetary policy regimes may play in persistent real interest rate movements. These limitations may expose monetary policy to blindsiding by the collateral damage that comes from an unhinged financial cycle. We propose a more balanced approach that recognises the difficulties monetary policy has in fine-tuning inflation and responds more systematically to the financial cycle.

JEL classification: E32, E40, E44, E50, E52.

Keywords: monetary policy, financial stability, financial cycle, natural interest rate, inflation.


This paper was prepared for the 21th Annual Conference of the Central Bank of Chile on Monetary policy and financial stability: transmission mechanisms and policy implications, Santiago, Chile, 16–17 November 2017. We would like to thank our many colleagues for helpful comments and discussions on the studies on which this paper is based. All remaining errors are ours. The views expressed are those of the authors and do not necessarily represent those of the Bank for International Settlements, the Bank of Finland or the Bank of Thailand.

Rungcharoenkitkul (corresponding author), Senior Economist, Bank for International Settlements, phurichai.rungcharoenkitkul@bis.org; Juselius: Senior Research Economist, Bank of Finland, mikael.juselius@bof.fi; Borio: Head of Monetary and Economic Department, Bank for International Settlements, claudio.borio@bis.org; Disyatat: Executive Director, Puey Ungphakorn Institute for Economic Research, Bank of Thailand, pitid@bot.or.th.

 

Introduction

Monetary policy has come under strain since the Great Financial Crisis (GFC) of 2007-09. Once the GFC broke out, central banks' swift and determined response was essential to stabilise markets and to avoid a self-reinforcing downward spiral between the financial system and the real economy. But putting the economy back onto a robust, balanced and sustainable path has proved much harder than expected. This has been so despite the adoption of extraordinary measures which would have been simply unthinkable just a few years back.

The GFC has raised some tough questions for monetary policy. The pre-crisis experience has shown that, in contrast to common belief, disruptive financial imbalances could build up even alongside low and stable, or even falling, inflation. Granted, anyone who had looked at the historical record would not have been surprised: just think of the banking crises in Japan, the Asian economies and, going further back in time, the US experience in the run-up to the Great Depression. But somehow the lessons had got lost in translation during the inebriating enthusiasm of the Great Moderation. And post-crisis, the performance of inflation has repeatedly surprised. Inflation was higher than expected during the Great Recession, given the depth of the slump, and lower than expected during the recovery. And it has been puzzlingly low especially more recently, as a number of economies have been reaching or even exceeding previous estimates of full employment. Again, this is not entirely new: even well before the GFC central banks had been voicing questions about the sensitivity of inflation to domestic slack. But the recent experience has hammered the point home, raising nagging doubts about a key pillar of monetary policymaking.

This essay explores the implications for monetary policy of the conjunction of these two developments - the emergence of disruptive financial cycles and the limited sensitivity of inflation to domestic economic slack. It is as if monetary policy was in the grip of a pincer movement that threatened to upend the current regime, just as many of its predecessors have been upended in the past. We largely draw on our previous work, although we also provide a preview of some research under way.

Our conclusion is that adjustments to current monetary policy frameworks may indeed be desirable, particularly in the analytical underpinnings that guide their implementation. We argue that the natural rate of interest, as traditionally conceived, is not a particularly useful guidepost. And we suggest that responding systematically to the financial cycle need not imply abandoning price stability-oriented frameworks but simply adopting a more flexible interpretation in their application than is often the case. This could be done within current mandates. While amending mandates to explicitly include financial stability concerns may be appropriate in some circumstances, this should be done with great caution, mainly for institutional considerations.

The paper is organised as follows. The first section briefly describes the nature of the challenge: the pincer movement and its causes and consequences. The second draws implications for the natural rate of interest as a guidepost for policy. It explains why the pincer movement means that monetary policy may have a longer-lasting impact on real rates than commonly assumed; why it may not be helpful to think of market rates as tracking natural rates that are independent of monetary policy; and why, if the concept is used at all, it would be useful to extend it to include also a reference to financial equilibrium. The third section discusses possible adjustments to policy frameworks. Drawing on the previous analysis, and based on a simple counterfactual exercise, it illustrates how policy might respond to the financial cycle and, in the process, improve macroeconomic outcomes. It then considers practical adjustments to monetary policy frameworks to allow for the necessary room for policy manoeuvre to respond to the financial cycle.

1. The pincer movement: the financial cycle and inflation

The emergence of disruptive financial cycles and the limited sensitivity of inflation to domestic slack may at first sight seem to be unrelated. In fact, there may be a common thread: the behaviour of monetary policy. Consider each in turn.

1.1 The financial cycle

The first major development is that, since around the early 1980s, financial cycles appear to have grown in amplitude and length (eg Borio and Lowe (2002), Drehmann et al (2012), Claessens et al (2011), Borio (2014a)). There is no unique definition of the financial cycle. A useful one refers to the self-reinforcing processes between funding conditions, asset prices and risk-taking that generate expansions followed by contractions. These processes operate at different frequencies. But if one is especially interested in those that cause major macroeconomic costs and banking crises, probably the most parsimonious description is in terms of credit and property prices. Graph 1 illustrates the phenomenon for the United States using some simple statistical filters, although the picture would not be that different for many other countries or using other techniques (eg peak-trough analysis). The graph shows that the amplitude and length of the fluctuations has been increasing, that the length of the financial cycle is considerably longer than that of the traditional business cycle (blue versus red line) and that banking crises, or serious banking strains, tend to occur close to the peak of financial cycle.

Another key feature of financial cycles is that the bust phase tends to generate deeper recessions. Indeed, if the bust coincides with a banking crisis, it causes very long-lasting damage to the economy. There is evidence of permanent output losses, so that output may regain its pre-crisis long-term growth trend while evolving along a lower path. There is also evidence that recoveries are slower and more protracted. And in some cases, growth itself may also be seriously damaged for a long time.

Some recent work with colleagues sheds further light on some of the possible mechanisms at work (Borio et al (2016)). Drawing on a sample of over 40 countries spanning over 40 years, we find that credit booms misallocate resources towards lower-productivity

growth sectors, notably construction, and that the impact of the misallocations that occur during the boom is twice as large in the wake of a subsequent banking crisis (Graph 2). The reasons are unclear, but may reflect, at least in part, the fact that overindebtedness and a broken banking system make it harder to reallocate resources away from bloated sectors during the bust. This amounts to a neglected form of hysteresis. The impact can be sizeable, equivalent cumulatively to several percentage points of GDP over a number of years.

Why should financial cycles have grown in intensity and disruptiveness? Part of the answer lies in changes in financial and monetary regimes. On the one hand, financial liberalisation back in the 1980s weakened financing constraints and made funding easier and cheaper to obtain. Meanwhile, prudential safeguards lagged behind. On the other hand, the emergence of monetary policy regimes focused on near-term inflation control meant that policy would be tightened during financial booms only if inflation increased but would then be loosened aggressively and persistently during busts. And, as we shall see below, inflation often remained low and stable during the booms. Moreover, downplaying the role of monetary and credit aggregates also worked in the same direction.

1.2 Inflation

The second major development is that inflation has generally been quiescent, at times surprisingly so. Indeed, from a longer-term perspective, the response of both price and wage inflation to domestic measures of slack has been quite muted and appears to have declined over time (Graph 3).4 Why?

One possible explanation is that central banks have been very successful in bringing inflation down and keeping it there. Heightened anti-inflation credibility could also help explain why inflation has proved rather insensitive to domestic slack: that credibility means wages and prices are less likely to respond to tight conditions as economic agents anticipate the central bank's response. Indeed, proxies of inflation expectations have tended to be generally well anchored around inflation objectives. This general narrative is the most popular, especially within the central banking community. No doubt, it is part of the answer. To that extent, it may also mean that central banks have been partly the victim of their own success: their heightened credibility, by keeping inflation low and avoiding the need to tighten, has added fuel to the financial cycle - the "paradox of credibility" (Borio and Lowe (2002)).

But this explanation is probably incomplete. After all, post-GFC, central banks have toiled to push inflation back to target, with disappointing results overall; and the Bank of Japan has had huge difficulties for almost two decades. If credibility was the only factor, and if inflation expectations exerted such a powerful sway over inflation, surely the mechanisms should have worked symmetrically.

Another possible explanation is that some deeper forces have been at work, acting as tailwinds pre-crisis and turning into headwinds post-crisis. A likely candidate is globalisation, particularly the entry into the trading system of former communist countries and many emerging market economies that liberalised their markets - countries that, in addition, tended to resist exchange rate appreciation. As argued and documented in more detail elsewhere (Borio (2017a)), the entry and greater prominence of such producers are likely to have weakened the pricing power of firms and, above all, of labour, making markets more contestable. During the cost-convergence process, this would result in persistent disinflationary winds, especially in advanced economies, where wages are higher. If so, on balance, developments in the real economy may have exerted persistent downward pressure on inflation, possibly outweighing the cyclical influence of aggregate demand.

1.3 Monetary policy challenges

Larger and more virulent financial cycles have emerged in conjunction with a subdued and less responsive inflation process, the two factors interacting in important ways to give rise to the pincer movement.

In particular, globalisation amounts to a string of positive supply side "shocks" that may well have added fuel to financial cycles. Not only may it have put persistent downward pressure on inflation, allowing monetary policy to be easier than otherwise; it may also have fostered expectations of stronger growth and thus provided fertile ground for asset price booms.

Supply side-driven disinflation can also help explain another development that has been quite prominent since the 1990s: disinflations, and at times outright deflations, have often coincided with par or strong growth, rapid credit expansion and asset price increases. Just looking at the more recent period, countries such as China, the Nordic economies and Switzerland, to name but a few, have been experiencing such a combination.

Nor is this combination so exceptional: historical experience tends to indicate that it may be more the rule than the exception. In recent work with colleagues, we examined deflations using a newly constructed data set that spans more than 140 years (1870-2013), and covers up to 38 economies and includes equity and house prices as well as debt (Borio et al (2015)). We come up with three findings. First, before controlling for the behaviour of asset prices, we find only a weak association between deflation and growth; the Great Depression is the main exception. Second, we find a stronger link with asset price declines, and controlling for them further weakens the link between deflations and growth. In fact, the link disappears even in the Great Depression (Graph 4). Finally, we find no evidence of a damaging interplay between deflation and debt (Fisher's "debt deflation"; Fisher (1932)). By contrast, we do find evidence of a damaging interplay between private sector debt and property (house) prices, especially in the postwar period. These results are consistent with the prevalence of supply-induced deflations.

 

All this, in turn, raises tough questions about the analytical framework that underlies policy. We next turn more specifically to the implications for a popular policy guidepost: the natural interest rate.

2. Implications for monetary policy: the natural interest rate

In recent years, with the advent of dynamic stochastic general equilibrium (DSGE) models in the New Keynesian tradition (Woodford (2003)), economists and policymakers have rediscovered the concept of the natural interest rate, initially developed in the late 19th century by Wicksell (1898). The pincer movement from the financial cycle and inflation has significant implications for the usefulness of the concept. We next consider, sequentially, the implications for the concept's analytics and some new empirical evidence.

2.1 The natural rate of interest: analytical and empirical limitations​​​​​

The natural interest rate is defined as the real (inflation-adjusted) rate that prevails when the economy is at full employment (output at potential). In a closed economy, this amounts to equilibrating desired saving and investment at that point.

The natural rate is generally assumed to depend only on real factors. This perspective derives from the notion that money (monetary policy) is neutral in the long run, ie that it can only have a transitory impact on real variables. The notion of the "long run" is purely an analytical concept, the result of a thought experiment: what would occur once all the variables in the system, including prices, were allowed to adjust in the absence of shocks? In practice, when translated into calendar time - the only form of time relevant for policy - this is taken to mean something like a decade, if not considerably less. Put differently, the idea is that, over time, market rates will tend to gravitate towards the natural rate.

This gravitational pull is important and non-trivial, for we all know that market rates are not determined by anonymous forces. Rather, they are determined by a combination of central banks' and market participants' actions. Central banks set the nominal short-term rate and they influence the nominal long-term rate through their signals of future policy rates and their asset purchases. Market participants, in turn, adjust their portfolios based on their expectations of central bank policy, their views about the other factors driving long-term rates, their attitude towards risk and various balance sheet constraints. Given nominal interest rates, actual inflation - which is given in the short run - determines ex post real rates, and expected inflation determines ex ante real rates.

How, then, can we tell whether market rates are indeed close to the natural rate - an inherently unobservable, model-dependent concept? And what forces guide central banks and market participants to get them there?

The answer to the first question is "with great difficulty". The two main approaches used to provide evidence for the claim that the two interest rates are, on average, close to each other over long horizons rely heavily on maintained hypotheses. They allow the data to speak, but only within quite tight constraints.

The first approach simply assumes that, over the relevant sample, the market rate tracks the natural rate. In the process, it abstracts entirely from the behaviour of inflation. It then proceeds to do a couple of things. The less formal variant is to tell plausible stories based on visual inspection of graphs; the more formal one is to use more articulated models and calibrate parameters to see whether they can produce results roughly consistent with the data.

The second approach seeks to filter out the unobservable natural rates from market rates. Since the natural rate is defined as the real interest rate that prevails at full employment, or when output equals potential output, the behaviour of inflation provides a key signal. After all, the Phillips curve tells us that when output is above potential (the output gap is positive), inflation rises; when it is below, inflation falls. So, one infers that whenever inflation rises, the market rate is below the natural rate, and vice versa when inflation falls. This is because the real interest rate is assumed to be the key variable influencing aggregate demand, via the investment/saving (IS) curve.

The drawbacks of the first approach are apparent. Neither of its two variants provides independent evidence that the market rate has actually tracked the natural rate. Moreover, upon closer reflection, neither really tests the underlying IS framework of interest rate determination. The approach's less formal variant takes it as the starting point to see whether some factors might provide reasonable explanations. Its more formal variant at best tells us whether the stylised model can in principle describe some features of the data, but not whether the model is true or not: the behaviour of the interest rate is not actually used to test it - the bar would be too low. Moreover, the numerous degrees of freedom mean that it may typically be not that hard to reproduce qualitatively the behaviour of the interest rate.

The drawbacks of the second approach concern, in particular, the role of inflation and the Phillips curve. If one takes the model as true, it becomes almost a tautology to say that, since inflation is not rising and economies are close to estimates of full employment, the natural rate must have fallen. And yet, as discussed above, the Phillips curve is precisely the relationship that has proved so elusive. Recall, for instance, how inflation has remained remarkably subdued recently even though economies seem to be close to full employment or beyond it using benchmarks other than inflation itself or how inflation remained quiescent in the run-up to the crisis.

Indeed, recent research has found that information about the state of the financial cycle, excluded from the standard procedure, outperforms inflation in a straight horse race to identify potential output and output gaps in real time, ie as events unfold. Specifically, we have found that while traditional approaches indicate that pre-crisis output was above potential only with the benefit of hindsight, using financial cycle proxies this would have been apparent in real time (Borio et al (2014, 2017b) and Graph 5)).

All this has significant implications for how to think of natural or equilibrium interest rates and for the persistence of monetary policy's impact on real interest rates.

For one, defining an equilibrium or natural interest purely in terms of inflation is arguably too restrictive. Inflation need not be the only signal of disequilibrium; financial imbalances can also serve that purpose. If low interest rates can contribute to financial instability by encouraging booms and busts and if financial instability has long-lasting, but not permanent, effects on output and employment, then it is hard to regard a given interest rate as an equilibrium or natural rate if it generates financial instability, even if inflation is low and stable. The notion needs to be broadened to encompass some form of financial equilibrium (see below).

Broadening the notion of equilibrium would avoid an apparent paradox. It is not uncommon to hear supporters of the "saving glut" and "secular stagnation" hypotheses say that the equilibrium or natural rate is very low, even negative, and that this very rate generates financial instability. Seen from this angle, such a statement is somewhat misleading. It is more a reflection of the incompleteness of the analytical frameworks used to define and measure the natural rate concept - frameworks that rule out financial instability - than a reflection of an inherent tension between natural rates and financial stability.

More generally, if inflation is not as responsive to economic slack as once thought, the impact of changes in nominal (policy) rates on the real rate may be correspondingly larger and longer-lasting. To fix ideas: at the limit, if inflation was entirely exogenous and trendless, the trend in the real interest rate would simply depend on whether inflation was below or above target. For instance, the real rate would tend to fall continuously if inflation started below target, as the central bank cut nominal interest rates repeatedly in the vain attempt to boost inflation towards target. More realistically, imagine that inflation is below target and that headwinds make it hard to generate the second-round effects whereby wages chase prices.

Then, easing policy would have a permanent impact on the price level - say, through a currency

 

More generally, if inflation is not as responsive to economic slack as once thought, the impact of changes in nominal (policy) rates on the real rate may be correspondingly larger and longer-lasting. To fix ideas: at the limit, if inflation was entirely exogenous and trendless, the trend in the real interest rate would simply depend on whether inflation was below or above target. For instance, the real rate would tend to fall continuously if inflation started below target, as the central bank cut nominal interest rates repeatedly in the vain attempt to boost inflation towards target. More realistically, imagine that inflation is below target and that headwinds make it hard to generate the second-round effects whereby wages chase prices.

The general point is that what happens to the real interest rate depends on the reaction function of the central bank (ie the monetary regime in place) and the behaviour of inflation. One can get persistent effects when inflation is unresponsive and the central bank seeks to influence it. This is the unfamiliar case, not discussed much in the literature. But one can equally get persistent effects if inflation takes off and the central bank does not respond. This is a more familiar case, and often aptly used to describe the experience of the Great Inflation in the 1970s.

The two cases, however, differ substantially in terms of the role of the natural rate. In the standard framework, changes in real rates that reflect a persistent rise in inflation coupled with a passive monetary policy would be interpreted as a persistent deviation of market rates from the (Wicksellian) natural rate. By contrast, changes in real rates that reflect a limited influence of monetary policy on inflation would cast doubt on the usefulness of the very concept of a natural rate. This is because they would undermine the presumption that real interest rates have a tendency to revert to a given equilibrium level and that the resulting gap between actual rates and this equilibrium level drives inflation.

2.2 The natural rate of interest: new empirical evidence and interpretation

The previous analysis suggests that the impact of purely real factors on real interest rates may be overestimated and that of monetary factors correspondingly underestimated. How can one try to break out of the grip of maintained hypotheses in current tests in order to explore this possibility further?

One option is to let the data speak a bit more. Crucially, this also requires going beyond the traditional period used to discuss the decline in real interest rates - from the early 1990s or, in some cases, early 1980s. During that period, one can indeed observe some similarity in the trends between real interest rates and the IS factors emphasised by, say, the popular "saving glut" (Bernanke (2005, 2015)) and secular stagnation (Summers (2014)) hypotheses. But these trends may simply be coincidental. Do they survive over longer periods?

This is what we have explored in some recent work (Borio et al (2017b)). In it, we go back to the 1870s for 19 countries, and we examine the relationship between real interest rates and the "usual suspects": growth, productivity, demographics, income distribution, the relative price of capital and the marginal product of capital. We do this for both real long-term interest rates and the most popular filtered estimate of the short-term natural rate, based on the behaviour of inflation. We then compare the role of these factors with that of monetary policy. The advantage of going that far back is that we cover different monetary policy regimes.

We come up with two key findings. First, while the usual suspects appear to work reasonably well over the often cited, more recent sample, the relationships break down when going back in history: no consistent pattern emerges - a sign that the relationships may be spurious. Even a simple visual inspection of the data suggests that this is likely to be the case (Graph 6). The finding is confirmed by more formal testing, when one allows the various real sector determinants to interact (see Table 1, where statistically significant and correctly signed coefficients are in green while statistically significant and wrongly signed ones are in red). And it appears robust to the use of different interest rates - long and short; market or traditional estimates of natural rates - as well as measures of inflation expectations. Second, there are generally economically and statistically significant differences in the level of interest rates across monetary policy regimes; moreover, their trends also differ. This is so even when one controls for the usual suspects (see Graph 7, left-hand panel, for an illustration).

It is then possible to provide an interpretation of the historical evolution of real interest rates in which monetary policy regimes figure more prominently than in the prevailing narrative. Consider, in particular, two periods: the experience over the sample since the 1980s- 90s, and that during the classical gold standard.

The decline in real rates over the recent standard sample could be attributed to the combination of three factors. The first factor is the gradual normalisation of interest rates after the Volcker shock that ended the Great Inflation (Graph 6), which saw interest rates rising from peacetime troughs. This suggests that the starting point is rather unrepresentative and already embeds a key monetary policy imprint.

The second factor is an asymmetrical policy response to successive financial and business cycles in a context of prevailing disinflationary tailwinds linked to globalisation (eg Borio (2014a,b, 2017b)). In particular, asymmetrical responses were in evidence around the financial boom and bust of the 1980s-90s and the one that surrounded the GFC. As long as inflation remained low and stable, there was no incentive for central banks to tighten policy during the financial booms that preceded financial strains in both cases. But there was a strong incentive to respond aggressively and persistently to fight the bust and stave off any deflation threat.

The third factor, especially post-GFC, is the strenuous central bank efforts to push a stubbornly low inflation rate towards target as the disinflationary tailwinds before the crisis turned into unwelcome headwinds after it. Difficulties in generating second-round effects, with wages chasing prices, would imply that reductions in interest rates have a largely temporary effect on inflation. Thus, repeated cuts would end up reducing real interest rates further and further even as inflation remained persistently below target.

The classical gold standard is also quite revealing. During this regime, central banks did not respond systematically with changes in interest rates to output and inflation as they do now. They simply tended to keep nominal interest rates constant unless the (internal or external) convertibility-into-gold constraint came under threat (eg Flandreau (2008)). Gold acted as a monetary anchor, but only over very long horizons. Still, inflation remained very much range-bound, with the price level gradually falling or rising over long periods. As a result, nominal and real interest rates were remarkably stable and did not deviate much from each other (Graph 7, centre and right-hand panels). Given the behaviour of inflation, the standard approach would infer that the market rate tracked the natural rate quite closely. And yet the usual suspects tended to vary just as much as they have in the recent sample (Graph 6). Another possible interpretation is that monetary policy had a persistent impact on the real interest rate without exerting a strong influence on inflation. Indeed, the classical gold standard era coincided with a major globalisation wave, saw rapid technological change and featured a labour force with limited pricing power. The resemblance with the experience since the 1980s-90s is striking (eg Obstfeld and Taylor (2003), BIS (2017)).

 

3. Implications for monetary policy: adjusting frameworks

The previous analysis suggests that there is a prima facie case for monetary policy to pay closer attention to the financial cycle than in the past. We may have been underestimating the influence of benign disinflationary forces and overestimating the ability of monetary policy to fine-tune inflation, especially to push it up towards targets in the face of powerful headwinds. If so, we may also have been underestimating the collateral damage that such strategies may generate in terms of financial and macroeconomic stability over longer horizons, especially by amplifying the financial cycle.

This combination of factors could even give rise to a debt trap (Borio and Disyatat (2014), Borio (2017b))). Such a trap could result from asymmetrical policies over successive business and financial cycles, failing to tighten during expansions but easing aggressively and, above all, persistently during contractions. Over time, policy could run out of ammunition, and it could become harder to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates. Such a risk can be amplified by the transmission of monetary policy across countries, to the extent that the very low rates in the economies that issue international currencies tend to support the build­up of financial imbalances elsewhere. And, as discussed further below, it is also amplified by the substantial impact that debt service burdens appear to have on aggregate expenditures: if debt-to-GDP ratios continued to rise along this path, the level of interest rates an economy is able to withstand would decline. From this perspective, the continued increase in indebtedness alongside the shrinking room for manoeuvre does not bode well (Graph 8).

Note also the twist that such a scenario implies for the interpretation of any natural or equilibrium interest rate. Seen through the lens of the standard approach, the contraction in aggregate demand in a debt trap would be interpreted as a sign that the natural rate has fallen, driven exclusively by some deep underlying factors. Seen through the lens of an approach that attaches importance to the financial cycle and growing indebtedness, it would be seen as a sign that the economy has been following a disequilibrium path. And what policymakers would take as given (exogenous) at that point would be, at least in part, the result of a sequence of past policy decisions. This points to a new form of time inconsistency, which is arguably more insidious than the familiar one in the context of inflation (Borio (2014a)). Policies that are too timid in leaning against financial booms, but then too aggressive and persistent in leaning against financial busts, may end up leaving the authorities with no ammunition over successive financial and business cycles.

One possible objection to this analysis is that, rather than adjusting monetary policy frameworks, it would be better simply to enlist another instrument to target the financial cycle - prudential, and more specifically macroprudential frameworks, based on solid microprudential foundations. If successful, such an approach would have additional benefits. It would allow monetary policy to continue to focus exclusively on price stability and short­term output stabilisation, reducing the risk of overburdening it. It would make it easier to ensure accountability wherever the objective is set in terms of an inflation target. And it would prevent monetary policy from actually damaging the economy. This is generally the conclusion reached by those who argue that "leaning" against financial imbalances is harmful (eg Svensson (2014), (2017)).

These objections clearly have force. But, in our view, they are not compelling enough to rule out adjustments to the frameworks.

First, it is debatable whether prudential measures alone can be sufficient to prevent the build-up of financial imbalances (Borio (2014d)). Indeed, even in countries that have used macroprudential tools aggressively, there have been signs of the emergence of such imbalances. These are captured by standard indicators such as increases in the private credit- to-GDP ratio and property prices in excess of critical thresholds (BIS (2017)). Of course, there is little doubt that prudential measures have strengthened the resilience of the financial system. Even so, only once the expansions turn into contractions will one find out by how much. Moreover, even if the financial system is able to withstand the shock, the macroeconomic implications could be severe. For instance, the turn in the recent financial cycle in Brazil coincided with one of the deepest recessions on record, although the country avoided a full-blown crisis. And, more generally, there is a tension in employing macroprudential measures and monetary policy in opposite directions, as when seeking to offset any undesired impact of a very easy monetary policy stance: this is a bit like driving by pressing on the accelerator and brake simultaneously - not exactly what is normally recommended (Borio (2014a)).

Second, it is not clear how macroprudential measures can address the risk of a debt trap following a financial bust. The measures are designed to address signs of exuberance in credit and asset markets, but that is not quite what a debt trap is about. To be sure, asset prices may appear high measured on their own terms (eg historical price-to-rent ratios), but valuations may not be unusual compared with bond yields. Similarly, private credit may be expanding, but its pace need not be cause for alarm, especially given the post-bust adjustment. And public sector debt is also an integral part of the picture. The debt trap is not a financial imbalance in the usual sense of the term: it is the result of a cumulative and gradual process over successive business and financial cycles. It is not synonymous with hot credit and asset markets; it is more like a cold "cul de sac". As a result, the literature that defines the response to the financial cycle exclusively as "leaning against the wind" of financial excesses does not do full justice to the nature of the problem - and this quite apart from calibration questions (Annex 1).

Third, at issue is not so much a change in monetary policy objectives, but in the time frame over which traditional objectives are pursued and in the underlying analytical framework. This would be a framework in which financial factors have a first-order and long- lasting impact on the economy, in which monetary policy has a sizeable impact on those factors, and in which inflation may be less responsive to monetary easing than traditionally assumed. Under those conditions, over horizons that go beyond the traditional business cycle, monetary and financial stability, broadly defined, are mutually supportive; short-run trade-offs tend to vanish.

3.1 Why respond to the financial cycle?​​​​​​​

One can illustrate these points with the results of a recent empirical study (Juselius et al (2017)). The analysis uses the United States as an example. It proceeds in three steps.

The first step is to decompose the financial cycle into two sets of variables that in the data are found to have very stable long-run relationships (Juselius and Drehmann (2015)). One is a proxy for the private sector (households and firms) debt service burden, ie the ratio of the sum of interest payments and amortisation to income (or GDP); the other is a proxy for "leverage", linking the debt-to-income ratio to property and equity prices. Deviations of these variables from their long-run (cointegrating) relationships ("gaps") interact and, when embedded in a richer econometric system, are found to have a sizeable impact on private sector expenditure and output fluctuations. This is intuitive. Heavier debt service burdens depress spending, not least as they squeeze cash flows. And higher asset prices in relation to credit can boost both spending and credit growth. There are many stories and simple models that capture these mechanisms, although none that as yet fully captures their interaction.

The system has a couple of interesting properties that set it apart from the previous studies. For one, it can result in financial busts with permanent output losses. In fact, the interaction between the two financial gaps can help trace the Great Recession quite well out of sample, though not quite its depth - the financial crisis still appears to have an additional effect (Juselius and Drehmann (2015)). The possibility of permanent losses does not depend on the GFC: it is a more general property. In addition, it does not rely on a separate crisis module (Annex 2): the financial cycle is fully integrated in the dynamics of the economy. The system gives rise to "endogenous" fluctuations in which the financial and real sectors interact, but not to crises as such.

The second step is to use the two financial gaps to derive estimates of the typical unobservable variables in any policy rule. These are economic slack (or the output gap) and the natural rate of interest. Estimates of the output gap and natural interest rate are derived by adding the two financial gaps to a very standard macroeconomic setup. Thus, the natural rate now requires not just output at potential and inflation on target, but also closure of the financial gaps - the concrete definition of "financial equilibrium" in this approach.

Importantly, the financial gaps are allowed to have an impact on the output gap and the natural rate, but it is the data that decide. This richer system nests the standard model (Laubach and Williams (2003)), and the data are allowed to tell us which one is a better characterisation of the economy.

The third step is to carry out a counterfactual experiment. This is done by adding the financial gaps to a traditional Taylor rule, whereby the interest rate is adjusted in response to the output gap and the deviation of inflation from target (Taylor (1993)), and then seeing how the economy would evolve under this different rule. Thus, the aim is not to respond only once the signs of an impending crisis emerge, which would be too late, but to steer the economy throughout the financial cycle. The financial gaps simply complement the variables traditionally included in the policy rules, which retain their role.

A number of findings emerge. First, responding systematically to the financial cycle proxies in addition to output and inflation can result in significant output gains (Graph 9). Second, there need not be much cost in terms of inflation. In fact, on average, inflation is effectively unchanged: it is a bit lower pre-crisis, reflecting the tightening phase, and higher post-crisis, as economic slack is smaller then. Third, leaning early is key, and this can gain considerable room for manoeuvre in the bust (Graph 10). In the counterfactual, the policy rate is some 1 percentage point higher until mid-2005; it can then afford to decline earlier, starting roughly when asset prices peak (not shown) and is normalised more quickly after the recession, as output recovers faster. Finally, the source of the gains is that the policy helps to smooth out the financial cycle (Graph 11): the amplitude in the cycle in asset prices, real credit and the credit-to-GDP ratio is clearly smaller in the counterfactual.


The results also shed light on the notion and usefulness of the natural rate of interest (Graph 12). Even with these minimal changes in its definition, the decline in the financial cycle- adjusted natural rate (red line), which includes information about the financial cycle, is smaller than the standard estimate (blue line) and it is even smaller in the counterfactual (dashed line). The smaller decline emerges even if the procedure by construction severely constrains the evolution of the natural rate to follow output growth, which, as we saw in the previous discussion, does not seem to have much explanatory power historically. In fact, once financial factors are allowed to play a bigger role, stabilising the economy sometimes requires sizeable deviations of the policy rate from the natural rate in response to the financial gaps. This is necessary so as to keep the economy close to financial equilibrium. The deviations tend to be larger than those under a standard Taylor rule. And they raise questions about the usefulness of the very concept of a natural rate for policy.

There are, of course, obvious limitations in this type of analysis. It is always hazardous to make counterfactual evaluations based on historical correlations. The exercise is quite stylised, and does not address explicitly the complications that arise in small open economies, notably the exchange rate and capital flows. Moreover, it does not fully characterise the uncertainty that plagues policymaking.

 

Even so, we would argue that the limitations are not show-stoppers. The Lucas critique can be overdone. Indeed, the public becoming aware of the central bank's reaction function could even enhance the policy's effectiveness, just as anti-inflation credibility reduces the likelihood of second-round effects in wages and prices. Including explicitly the impact of the policy on the exchange rate is bound to change the balance of the policy mix in favour of macroprudential measures. At the limit, for instance, if the exchange rate was pegged, these would be the only measures de facto available. And a richer characterisation of the uncertainty need not overturn the conclusion. The costs of a debt trap would be very large, and current frameworks exclude this possibility altogether.

3.3 How to adjust current frameworks? Practical considerations​​​​​​​

If this analysis is accepted, how could one adjust monetary policy frameworks? How can central banks gain the necessary room for manoeuvre to respond more systematically to the financial cycle?

The first point to note is that there is no one-size-fits-all. The analysis does not claim universality: some countries around the world are still struggling with the age-old problem of ensuring that inflation is brought down or does not get out of control. And initial conditions matter: the inherited regime constrains and helps shape the desirable and feasible adjustments. Even so, some general considerations are possible.

The smallest adjustment is to lengthen the horizon over which to achieve a given inflation objective. An obvious advantage of this approach is that a specific number, or narrow band, could help anchor expectations by acting as a focal point. In fact, to varying degrees, this is already how flexible inflation targeting is implemented. It has been widely recognised that the optimum horizon over which to guide inflation back to target depends on the nature of the "shocks". In principle, one could apply the same logic to the financial cycle. Indeed, some central banks that take account of financial stability/financial cycle considerations have done precisely this (eg the Central Bank of Norway and the Reserve Bank of Australia, to mention just two).

One issue with this approach is that the tolerance for inflation deviations from target may have to be quite high. How persistent and large can the deviations be before central bank credibility comes into question? This is likely to be country-specific and depend on history and institutional arrangements. Moreover, given the history of inflation targeting, inflation shortfalls arguably raise less reputational concerns than inflation above target. For instance, in a country like Switzerland, persistent deviations in the form of actually falling prices have been tolerated quite easily: the central bank has progressively de-emphasised the target while never officially renouncing it. Similarly, in Thailand, where financial stability considerations have played an important role in the decision to leave policy unchanged despite over two years of undershooting the inflation target band, the central bank's credibility does not appear to have been affected significantly.

A second option is to move from a point target to a band, or to widen a target band. In practice, there may not be that much difference between this and the previous approach. And the room for manoeuvre would be greater if one treated the edges of the band as soft, rather than hard, bounds. The disadvantage of this option is that it could weaken the target's anchoring role. How serious a problem this turns out to be would depend on one's views about the strength of the target's gravitational pull on expectations and about their influence on wage and pricing decisions. The advantage would be to dispel the notion that monetary policy can fine-tune inflation. For instance, the Riksbank has decided to reintroduce a (softer) target band for precisely these reasons.

A third option would be to reduce the point target or shift the band downwards in order to take into account the longer-term headwinds that may be reducing inflation. This option is trickier, since it may jeopardise more directly the central bank's credibility. And it raises tougher communication issues. But it may be viable in countries that have seen persistent shortfalls in inflation alongside obvious signs of the build-up of financial imbalances and good growth. The Bank of Korea, for instance, has decided to reduce its point target from 3% to 2% based on such considerations. No doubt, reducing the target to a standard figure internationally has facilitated the move.

A fourth option is to go one step further and change the mandate to, say, include financial stability as a separate consideration. The advantage of this approach is that it would definitely give the central bank ample room for manoeuvre. The disadvantage is that it explicitly introduces the notion of a trade-off that need not be there over a sufficiently long horizon.

Moreover, the political process of changing a mandate is unpredictable. While helpful under the right circumstances, the step may not be necessary. In fact, the mandates enshrined in the central bank law are typically written in very general terms and provide plenty of scope for interpretation. They tend to be the product of the time when they were written. For example, the Reserve Bank of Australia's actually refers also to the "welfare of the Australian people", which is clearly less constraining than the agreement the central bank has reached with the government concerning its objectives. In order to attach greater weight to financial stability considerations, the central bank has modified that agreement and used the mandate in its communication to avoid further easing in a context of very high and rising household debt and rich property prices. By contrast, the recently established independent commission in Norway has recommended explicitly adding financial stability to the central bank's mandate and setting up a joint policy committee for monetary and macroprudential policies. The objective is to strengthen the foundation for policies the Central Bank of Norway has already been following since 2012.

The key point is that, at the end of the day, mandates matter less than the analytical framework used to implement them. Many of the current arrangements already provide significant room for manoeuvre, as evidenced by the varying degree to which inflation targeting central banks take financial stability concerns into account. And one could imagine circumstances where changes in the mandate, if interpreted the wrong way, could actually be harmful. For instance, that would be the case if a financial stability objective was interpreted as keeping interest rates low because the banking system was weak even as inflation was threatening to increase out of control. Under those circumstances, the right policy would be to tackle the banking problems head-on with other instruments. Admittedly, including financial stability in central banks' mandates could help the institution resist political pressure when taking decisions that put long-term gains above short-term ones. That said, the unpredictability of the political process means that changes in mandates should be treated with great caution.

Conclusion

Paradigms die hard. This is entirely understandable. The hurdle should be set high. New evidence cannot be interpreted in isolation. It must be evaluated against the backdrop of the body that precedes it. What is true for intellectual disciplines is equally, if not more, true for policymaking. Innovation is risky, for those who carry it out and for society. The danger in all  this, however, is that change may come too late, only when damaging events make it unavoidable. And then the pendulum may swing too far.

This was clearly the case pre-crisis. The experience showed once more how some of the most serious risks do not arise from the mechanical repetition of errors in identical circumstances, but from the interaction between policy and changes in the economic environment. And they arguably reflect overconfidence in our ability to understand the economy, a sense that policy is finally on the right track. The belief in the Great Moderation in the run-up to the GFC was simply retracing an all too familiar historical pattern. In the 1960s, having "digested" the lessons of the Great Depression, policymakers thought they had discovered the secret of how to achieve full employment at the cost of moderate inflation. In the lead-up to the Asian crisis, fiscal probity and low inflation were seen as guaranteeing the sustainability of the Asian boom. Further back in history, in the lead-up to the Great Depression, the Roaring Twenties had held out the promise of permanent prosperity.

Post-crisis, policymakers have made huge efforts to shore up the financial sector and strengthen financial regulation and supervision. As part of that, they have been implementing wholly new macroprudential frameworks, crystallising a concept that had been put forward a decade before and had remained largely ignored until the crisis (Crockett (2000), Borio (2003), Borio and Drehmann (2011)).37 These efforts are necessary and welcome. But they have also nurtured the expectation that they are sufficient to avoid financial instability, broadly defined, and its serious macroeconomic costs - that they can, on their own, avoid the disruptive financial booms and busts of the past (Borio (2014c)). As a result, monetary policy - and fiscal policy, for that matter - have by and large continued to operate as it if it was business as usual.

This may well be the right answer. But in this paper we have argued that it may not be prudent enough. Monetary policy has been in the grip of a pincer movement, caught between growing financial cycles, on the one hand, and an inflation process that has become quite insensitive to domestic slack, on the other. With inflation stubbornly unresponsive to attempts to push it back towards target, it may be imprudent to downplay the longer-term side effects of extraordinarily and persistently accommodative monetary policy for the financial side of the economy.

If so, a more balanced approach may be preferable. The approach would recognise the difficulties monetary policy has in fine-tuning inflation when the rate is already low, possibly owing to supportive real factors such as globalisation and technology. It would take into account the risks of conducting policy based on unobservables that do not consider its impact on the financial side of the economy, such as the Wicksellian or New Keynesian natural interest rate. And it would provide sufficient room for manoeuvre to respond more systematically to the financial cycle. This, too, may not be the full answer. But it may bring us closer to it.

Annex 1: Recent approaches to evaluating leaning strategies

This Annex reviews recent approaches to evaluate the desirability of "leaning against the wind" (LAW) of the financial cycle (a "stability-oriented monetary policy"). It examines key assumptions underlying these approaches and highlights features that deserve greater prominence in future research to fully capture potential gains from such a strategy.

What is the standard way of evaluating empirically the costs and benefits of a financial stability-oriented monetary policy? The basic idea is to trade off the output costs of leaning today against the possible output benefits that would arise tomorrow if leaning helps reduce the likelihood and/or the costs of future banking crises.

Implementing this thought experiment involves a number of steps. First, one takes a traditional model embedding relationships between the policy rate, output and inflation. Then one augments it with a "crisis module". The module describes the relationship between a financial variable and banking crises, links this variable to the policy rate and assumes something about the costs of banking crises. The variable most commonly used is the growth rate of (private sector) credit, which some work has found to be a reliable leading indicator of banking crises. Finally, one estimates the resulting net benefits in terms of output and (possibly) inflation by adjusting policy, either as a one-off deviation from traditional policy rules or as the optimal response given the model.

Analysis of this type tends to find that, for typical parameter values, a LAW strategy does not generate significant net benefits and may be counterproductive. Extending this basic analysis in certain directions can strengthen the case for leaning, but the typical conclusion drawn from it has been that the first-order benefits are, at best, small.

This type of analysis follows a clear logic, but there are a number of reasons why it may underestimate the potential net benefits of leaning. These have to do with the assumptions and with the calibration (Table A1).

In most studies, the crises do not result in permanent output losses, so that eventually output returns to its pre-crisis trend. But empirical evidence suggests that this is typically not the case. Output may indeed regain its previous long-term growth rate, but it typically ends up following a parallel and lower path. Thus, if one postulates, plausibly, that actual and potential output eventually converge, this means that potential output is also permanently lower.

 

​​​​​​​

In some cases, monetary policy can even "clean up" after a crisis hits, in the sense that the central bank can cut rates and make up for any demand shortfall as it would with any other normal recession. But the GFC experience clearly suggests otherwise: monetary policy has a harder time dealing with balance sheet recessions, as agents are overindebted and balance sheets impaired (eg Borio (2014a)). There is indeed a consensus that this is a lesson to be drawn from the crisis.

Leaning is often assumed to affect the probability of a crisis but not its severity once it occurs. Yet one might expect that the bigger the initial imbalance, the larger the costs will be. Indeed, the severity of a balance sheet recession depends on the extent of bad debt previously accumulated. If policy can help restrain the build-up, it would also limit the damage of any subsequent strains. Some studies have incorporated this endogenous crisis cost and found support for leaning (eg Adrian and Liang (2016), Gerdrup et al (2017)).

In most exercises, financial variables have no or limited impact on output other than through crises. And even if they do, this is not considered part of the analysis. But this means that benefits can only arise if crises are successfully averted, which is very restrictive. It couches the problem exclusively in terms of rare events rather than of the potential for financial fluctuations to damage the economy more generally.

Finally, another underappreciated key assumption concerns the evolution of financial risks. In prevailing approaches, risks are not expected to grow over time in the absence of leaning. By that we mean that if no action is taken, then any "shocks" that may occur in normal times will die away. This implies that there is little or no cost to waiting. Importantly, this encourages the view that a financial stability-oriented monetary policy is one that follows a traditional policy most of the time and then deviates from it only once the signs of financial imbalances become evident. But the risk of this strategy is obvious: it could end up doing too little too late or, worse, it could be seen as precipitating the very crisis it intends to prevent.

Some work at the BIS has relaxed most of these restrictive assumptions of the standard approach. As a result, it has found higher potential benefits from leaning (eg Juselius et al (2017), Filardo and Rungcharoenkitkul (2016)). While the specifics differ, this research strand shares two elements: it allows risks to build up over time as the economy evolves - and here the notion of the financial cycle is key - and it allows monetary policy to play a bigger role in influencing both the probability and costs of financial busts, even without crises. In other words, there is path dependence, so that once financial imbalances are allowed to build up, some losses down the road are inevitable. The benefits from leaning stem not only from averting full-blown crises, but also from tempering the financial cycle and its associated cost.

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