Rethinking Macroeconomic Policy

Olivier BlanchardGiovanni Dell’AricciaPaolo Mauro

Stockholm, November 21st , 2011

The views in this presentation are those of the authors and do not necessarily represent those of the IMF

Pre-Crisis Consensus

One target for monetary policy: Low and stable inflation

One main monetary policy instrument: The policy interest rate

A limited role for fiscal policy

No cyclical role for prudential regulation

The proof of the pudding: The Great Moderation

Caveat: Differences between and among academics, central banks, politicians

2

Monetary Policy: One Target/One Instrument

Stable inflation (backed by theory and politics)

Low inflation (low prob. of Zero bound, but Japan…)

Connected markets and arbitrage (one rate does it all)

Expectation channel: Rule based policy

Financial intermediation largely ignored (with exceptions)

3

Asset prices a concern only through their impact on GDP and inflation

Bubbles difficult to identify

Ex-post policies effective and costs of clean up limited

Better clean up than prevent

Benign Neglect Approach to Boom/Busts

Financial Regulation Not a Cyclical Tool

Macro dimension of regulation largely ignored:

Focus on soundness of individual institutions Some exceptions in EMs

Cyclical use of prudential policies discouraged:

Seen as mingling with proper market functioning Little thought given to cyclical rules on capital ratios,

LTV ratios (exceptions: Spain, Colombia)

The Great Moderation

Steady decrease in the variability of output and inflation in advanced countries

Sources? Luck, structural changes, improved monetary policy?

Successful responses to the financial scares. 1987 stock market crash, LTCM, Tech bubble burst

6

Bust had enormous consequences

Standard policies rapidly hit their limits

Limited effectiveness of less traditional policies

Large fiscal and output costs

Then the Crisis Came …

Reflections on the Crisis

Stable inflation: Necessary but not sufficient

Limits of very low inflation

Reconsider “benign neglect”

Financial intermediation is macro relevant

8

Before Crisis Inflation and Growth Looked OK

-3

-2

-1

0

1

2

2000 02 04 06 08:Q4

Output Gap2Core CPI Inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2000 02 04 06 08:Q4

Euro area United States Average of other economies1

1 Japan omitted.2 Estimate of output gap using rolling Hodrick-Prescott filter.

-40

-20

0

20

40

60

80

JP

N

DE

U

AU

T

PR

T

CH

E

NL

D

GR

C

US

A

ITA

NO

R

FIN

AU

S

CA

N

SW

E

DE

N

GB

R

FR

A

IRL

NZ

L

ES

P

Change in real house prices (2001:Q4-2006:Q3)

Real house price falls from recent peak

But Houses Prices Were Rising Rapidly

Note: Real house price falls from recent peaks not shown for Germany and Japan as real price declined through the 2001:Q4-2006:Q3 period.

11

R2 = 0.60

-0.05

0

0.05

0.1

0.15

0.2

-5 0 5 10 15

And Credit Booms Fueled Vulnerabilities

JPN

DEU

FIN

GBR

NLD

CHE

ITA

USACAN

NOR

IRL

ESP

DEN

FRA

SWE

Growth Rate of Nominal Credit relative to GDP and Household Quick Ratio(percent)

Average growth rate of nominal credit relative to GDP (2002:1-2006:3)

Av

era

ge

an

nu

al

pe

rce

nta

ge

po

int

ch

an

ge

in

ho

us

eh

old

q

uic

k r

ati

o (

lia

bil

itie

s/l

iqu

id a

ss

ets

)

GRC

BEL

AUT

PRT

12

0

1

2

3

4

5

6

7

Jan-07 Jan-08 Jan-09

United States

United Kingdom

Euro area

Limited Monetary Policy Room (policy rates in percent)

Jun-09

Financial Intermediation Matters

When normal investors exit, markets become segmented

Arbitrage fails, and prices can deviate far from fundamentals

Policy rate no longer a sufficient instrument for policy

Credit easing and quantitative easing can affect rates and asset prices, given policy rate

13

What We Should Explore Going Forward

If low/stable inflation not enough, what should monetary policy target?

If benign neglect is dead, then what?

More targets means more tools: what role for macroprudential policies?

14

Monetary Policy Many targets:

Inflation/output gap Exchange rate Asset prices: Housing, stocks, etc

But also many instruments:

Policy interest rate Reserve accumulation Macro prudential instruments

Cyclical capital/liquidity ratios Loan to value ratios, margin requirements

15

Problems and trade offs with more interventionist strategy remain:

Bubbles difficult to detect in real time (China real estate)

Risks with pricking bubbles (including for policy makers)

Traditional policies may be ineffective (speculative demand))

And have large costs

Benign neglect approach may be dead, but…

Not all asset-price booms should be target of policy But how to choose?

Some consensus emerging that culprit is leverage (Nasdaq crash was fine)

Housing markets are special: Leverage (link to crises) Large storage of wealth Major supply-side effects Network externalities

Booms in Housing Markets Are Particularly Dangerous

Boom, Leverage, and Defaults

AUS

AUT

BGR

CAN

CHN

HRV

CYP

CZEDNK

EST

FIN

FRA

GRC

HUN

ISL

IND

IRL

ITA

KOR

LVALTU

NLD

NZL

NOR

POL

PRT

SVN

ZAFESP

SWE

CHE

UKR

GBR

USA

y = -0.0416x - 4.1152R² = 0.1496

-30

-20

-10

0

10

-20 0 20 40 60 80 100 120 140 160 180 200 220 240

Cum

ulat

ive

dec

line

in G

DP

fro

m s

tart

to e

nd o

f re

cess

ion

Change in house prices f rom 2000 to 2006

Figure 2. House Price Run-Up and Severity of Crisis

Source: Claessens et al (2010).

Bubble size shows the change in bankcredit f rom 2000 to 2006.

Real Effects of House Busts

Make borrowing more expensive and may limit leverage and risk taking

But: Too blunt: costly for the entire economy (unless in

context of general overheating) Issues for small open economies Effect on speculative component may be limited

Panel VAR suggests impact on house prices at considerable cost to GDP growth 100 basis points reduce house price appreciation by 1

but also lead to a decline of 0.3 in GDP growth

The Policy Rate and House Price Bubbles

Most ‘experiments’ in emerging markets, particularly Asia

Common tools: Maximum LTV/DTI limits Differentiated risk weights on high-LTV loans Dynamic provisioning

Discretion rather than rule-based

Mixed evidence on effectiveness

Macro-Prudential Tools

Hong Kong: Limited Effectiveness of LTV Limits

110

120

130

140

150

160

70

90

110

130

150

170

2009 - Mar 2009 - May 2009 - Jul 2009 - Sep 2009 - Nov 2010 - Jan 2010 - Mar 2010 - May 2010 - Jul

New loans approved Prices

October 2009:Maximum LTV for properties over HK$20 million lowered to 60 percent, maximum loan size for mortgage insurance eligibility reduced and non-owner-occupied properties disqualified.

August 2010:LTV for properties over HK$12 million lowered to 60 percent, applications for mortgage insurance exceeding 90% LTV and 50% DTI suspended, maximum loan size for mortgage insurance eligibility if LTV>90%.

Korea: Effective LTV Limits, but Difficult Calibration?

0

1

2

3

4

5

6

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2000 - Jan 2001 - Apr 2002 - Jul 2003 - Oct 2005 - Jan 2006 - Apr 2007 - Jul 2008 - Oct 2010 - Jan

September 2002:Introduced LTV limits

June 2003:Lowered LTV in speculative areas

October 2003:Lowered LTV in speculative areas

July 2009:Lowered LTV in non-speculative areas

February 2007:Tightened DTI

August 2005:Introduced DTI limits

September 2009:Tightened DTI

Month-on-month house price changes in 'speculation zones' (LHS)

Policy rate (RHS)

Pragmatic and discretionary, mobilized within existing institutional frameworks, targeted at specific markets

Some evidence of temporary cooling effect on markets and building of buffers for bad times

Too early to judge impact on aggregate cycles and interaction with other policies

Macro-prudential policy still in its infancy

Macro-prudential tools first line of defense Target leverage Strengthen balance sheets

Monetary policy definitely to be involved when there are other signs of overheating

But may have to come into play anyway if macroprudential tools are ineffective

Tentative Policy Taxonomy for Real-Estate Booms

Who does what? Where should macro-prudential authority reside?

Relationship among policies? To what extent are these independent tools?

Rules versus discretion? Far away from IT standards Risks associated with excessively interventionist policy

Important Open Questions

Conclusions: An evolution, not a revolution

Low (but how low?) and stable inflation still essential

Low deficits and fiscal room even more needed than before

Monetary policy: Many targets and instruments

New macroprudential tools/ Coordination with monetary policy

Important questions of institutional design27

Thank You

28

29

Widespread Declines in Output Volatility

Emerging Markets and Developing Countries

Asia

Latin America

Africa and the Middle East

2

2.5

3

3.5

4

4.5

5

5.5

6

6.5

7

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Selected Advanced Economies

US

EU15

1

1.5

2

2.5

3

3.5

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006