Should monetary policy ever lean against the wind? Panel - PDF document

Should monetary policy ever lean against the wind? Panel introduction Lars E.O. Svensson Stockholm School of Economics Web: larseosvensson.se The ECB and Its Watchers XVII Frankfurt, April 7, 2016 1 Department of Economics, Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden, www.sse.edu Outline § Should monetary policy take into account financial stability risks explicitly? § Should monetary policy “lean against the wind”? § Background: The Riksbank’s policy dramatic tightening 2010-2011… § ... despite an inflation forecast below the inflation target and an unemployment forecast above a long-run sustainable rate § Cost-benefit analysis of leaning against the wind 2

Background: Large and rapid increase in Riksbank policy rate 2010-2011 7 7 Interest rates 6 6 SE EA 5 5 UK 4 4 US 3 3 2 2 1 1 0 0 -1 -1 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 3 Swedish inflation fell rapidly 6 6 Inflation rates SE HICP 5 5 EA HICP UK HICP 4 4 US Core PCE 3 3 2 2 1 1 0 0 -1 -1 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 4

Riksbank real policy rates increased even more, causing large real interest gap to Eurozone, UK, and US 6 6 Real interest rates 4 4 2 2 0 0 + 3.5 pp ! SE-HICP -2 -2 EA-HICP UK-HICP -4 -4 US-CPCE -6 -6 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 5 Swedish Krona appreciated dramatically 120 120 Nominal and Real SEK Exchange Rate 110 110 100 100 90 90 Real Effective Exchange Rate, Based on Consumer Prices, Index Nominal Effective Exchange Rate, Index 80 80 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 6

Swedish unemployment stayed high Unemployment rate 14 14 12 12 10 10 8 8 6 6 Sweden 4 4 US Germany 2 2 UK Canada 0 0 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 7 Swedish unemployment rate more than 1 pp higher than counterfactual with no policy-rate increase Unemployment rate 14 14 12 12 Counterfactual w/o policy-rate increase 10 10 8 8 6 6 Sweden Low policy rate 4 4 US Germany 2 2 UK Canada 0 0 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 8

Fed and Riksbank June 2010 forecasts of inflation and unemployment very similar; policies very different § If inflation forecast below target & unemployment forecast above long-run sustainable rate, then policy easing is the right thing § Bernanke (2010): Given these [June 2010] forecasts and FOMC objectives, “there would appear to be a case for further action” [, prepare QE2] § Or does anyone wish that the Fed would have followed the Riksbank example? Svensson (2011), “Practical Monetary Policy: Examples from Sweden and the United States,” Brookings Papers on Economic Activity , Fall 2011, 289-332. 9 Riksbank tightening 2010-11 § Large costs of Riksbank tightening § Including making the economy more vulnerable to any negative shock (such as the Eurozone crisis) § Could there have been any benefits? § Cost-benefit analysis of leaning against the wind § Numbers and estimates are needed 10

Cost-benefit analysis of “leaning against the wind” (LAW) for financial-stability purposes § LAW: Tighter policy than justified by normal flexible inflation targeting § Instead undershooting the inflation target and/or overshooting the long-run sustainable unemployment rate § Costs: Higher unemployment, lower inflation § Possible benefits: Lower probability or severity of a financial crisis § Forgotten additional cost in previous literature: Higher cost of a crisis if economy initially weaker because of LAW 11 Unemployment gap in non-crisis and in crisis, for 1 pp higher policy rate for 4 quarters (Riksbank estimates) § Noncrisis: Unemployment gap: Loss = Squared unemployment gap From 0 to 0.5 pp 6 6 Unemployment gap Loss: From 0 to 0.25 5.5 5.5 Loss increase: 0.25 5 5 § Crisis: 4.5 4.5 Unemployment gap: 4 4 From 5 to 5.5 pp 3.5 3.5 Loss: From 25 to 30.25 3 3 Policy rate, pp Non-crisis unemployment gap Loss increase: 5.25 2.5 2.5 Crisis unemployment increase 2 2 Crisis unemployment gap § Additional cost of LAW: 1.5 - (Loss = Squared gap) 1.5 Crisis loss increase is 11 times 1 1 non-crisis loss increase − Loss 0.5 0.5 0 0 -0.5 -0.5 -40 -32 -24 -16 -8 0 8 16 24 32 40 - Loss Quarter Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also 12 with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.

Benefit: Lower probability? Household debt, debt growth, probability of crisis start, and probability of crisis from 1 pp higher policy rate (Riksbank, Schularick and Taylor 2012) Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 13 Marginal cost much larger than marginal benefit of policy-rate increase; net marginal cost large 0.3 0.3 Marginal cost, pp Marginal benefit, pp Net marginal cost = MC - MB, pp 0.2 0.2 0.1 0.1 0 0 -0.1 -0.1 0 4 8 12 16 20 24 28 32 36 40 Quarter Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 14

Cost-benefit analysis of “leaning against the wind” (LAW) § Given existing empirical estimates, the cost is larger than the benefit by a substantial margin § Empirically, the possible effect of the policy rate on the probability or severity of a crisis is too small § The main component of the cost is the additional crisis cost (the higher cost of a crisis because the economy is weaker due to LAW) § Ineffective macroprudential policy may increase the probability or severity of a crisis § Higher probability of a crisis gives more weight to the additional cost; larger severity increases additional crisis cost § Ineffective macroprudential policy therefore increases the cost of LAW more than the benefit, makes the cost exceed the benefit by an even larger margin 15 16

Extra slides 17 Was the tightening justified given the info at the time? § What did the Riksbank know? 18

CPI inflation below target 6 6 What the Riksbank knew in June 2010 CPI inflation 4 4 CPI inflation target CPIF inflation 2 2 0 0 -2 -2 03 04 05 06 07 08 09 10 11 12 19 GDP 5% below peak, 10% below trend; export 13% below peak 110 110 What the Riksbank knew in June 2010 GDP Real Time 100 100 GDP trend Export 90 90 80 80 70 70 03 04 05 06 07 08 09 10 11 12 Svensson (2016), “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy,” Blog post, January 22, www.larseosvensson.se. 20

Unemployment close to 9%, at peak; far above Riksbank’s “long-term” unemployment rate 10 10 What the Riksbank knew in June 2010 9 9 8 8 7 7 6 6 Unemployment rate, % Riksbank "long-term" unemployment rate 5 5 03 04 05 06 07 08 09 10 11 12 Svensson (2016), “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy,” Blog post, January 22, www.larseosvensson.se. 21 Cost-benefit analysis of “leaning against the wind” (LAW) § LAW: Tighter policy than justified by normal inflation targeting § Costs: Higher unemployment, lower inflation § Possible benefits: Lower probability or severity of a financial crisis § Forgotten cost: Higher cost of a crisis if economy initially weaker because of LAW § What if macroprudential policy is less effective? 22

Less effective macroprudential policy, higher debt growth, higher probability of a crisis 6 6 Annual probability of a crisis start, % 5 5 B 4 4 A 3 3 2 2 1 1 0 1 2 3 4 5 6 7 8 9 10 Annual real debt growth, % Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 23 Less effective macroprudential policy increases marginal cost more than benefit 0.4 0.4 Marginal cost, pp Marginal benefit, pp 0.3 0.3 Net marginal cost = MC - MB, pp 0.2 0.2 0.1 0.1 0 0 -0.1 -0.1 0 4 8 12 16 20 24 28 32 36 40 Quarter Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 24

Benchmark probability of crisis start and crisis in given quarter Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 25