The Financial and Economic Crisis

Lecture Three: The implications for monetary policy

Mike Kennedy

The current US recession in perspective

Output gap in Canada: A comparison

Output gaps in problem euro area countries

Output gaps in the major euro area countries

The response of monetary policy in the three major economies has been sharp, pushing rates close to the

“zero bound”

The big questions • What can monetary policy do

at the zero bound? • Could something different have

been done? • What are the implications for

monetary policy going forward?

The status quo prior to the crisis

• Inflation was low and economies were doing well – called the “great moderation” which had followed the “great inflation” that started in the late ‘60s.

• Policy objectives: keep inflation low (and predictably low) and keep output close to potential (Taylor rule).

• An independent central bank was deemed best to achieve this.

• Monetary policy assigned the role of stabilising demand, not fiscal policy.

A digression on the Taylor rule• The idea is to have interest rates respond to both inflation and activity:

it = i* + (1+α)(πt – π*) + βGapt

where it is the nominal short-term interest rate; i* is the equilibrium nominal interest rate; π is inflation; π* is the inflation target; and Gap is the output gap. The “α” and “β” are positive coefficients with values less than one.

• In real terms the rule is:

rt = r* + α(πt – π*) + βGapt

Note that r* is the equilibrium real interest rate and that α and β could sum to one

The status quo prior to the crisis (con’t)

• Financial stability was taken as a given – crises occurred in history books or emerging markets.

• But as well, if price stability was achieved then financial stability would follow, in part because markets were thought to be efficient. New financial products were thought to be welfare enhancing.

• If a bubble burst, monetary policy could clean up the mess but should not try to prevent it – the collateral costs of bursting an asset bubble were thought to be high.

• Financial market frictions were recognised but were not felt to be overly important for policy design.

The status quo prior to the crisis (con’t)

• Forecasts were a critical input to making policy.• The policy framework was referred to as flexible

inflation targeting: • Keeping inflation low is the primary objective of

monetary policy but: – Central banks recognised that there is a short-run

trade-off between inflation and activity – focusing solely on inflation would be too costly in terms of activity lost.

– Implication, move to offset inflation shock but somewhat gradually.

The status quo prior to the crisis (con’t)

• The basic framework assumes that there are imperfections in the economy (sticky prices and monopolistic competition).

• Without these there would be no role for monetary policy other that to completely stabilise inflation.

• Of note was an absence of a well developed financial sector in macro models.

Canada is a successful inflation targeting country

Underlying inflation in the three major economies

Using models with forward looking agents: escaping the zero lower bound

• In these models what matters in the future path of real interest rates – policy is effective by changing the nominal rate of interest, which, since prices are sticky, changes the real interest rate.

• Because the future path is so important, economist point to the need for central bankers to be very transparent.

• In these frameworks, this recommendation forms the basis for escaping the liquidity trap.

Using these models to examine the zero lower bound (con’t)

• Note that policy must be credible otherwise it cannot influence expectations.

• As well there are no credit markets or asset prices in these frameworks.

• Faced with a shock, the authorities must act quickly. • This is even more important if expectations are

partly backward looking (which they likely are) as the longer the central bank waits the more likely that the negative shock gets embedded into these backward looking expectations.

Using these models to examine the zero lower bound (con’t)

• If agents know that the central will respond aggressively then this will help in exiting the zero lower bound. Note that policy rates fell faster than what would have been suggested by a Taylor rule.

• The cost of being at the zero lower bound depends on the central banks credibility – if credibility is high then the cost is low as the central bank can influence expectations.

• The idea is that the expected future real interest rate will be lowered if expected inflation is raised.

• All this puts central bankers in a tough position. They commit to higher inflation but are unlikely to let it happen.

• Price level targeting is a potential way out.

Other channels of monetary policy transmission

The exchange rate channel• This is an important channel for many

economies and the central bank can easily lower the value of its exchange rate.

• However this is not an option in a global crisis. In such circumstances the exchange rate will be influenced by risk preference (the initial rise in the US dollar) and circumstances particular to countries (Canada and oil prices).

Other channels of monetary policy transmission (con’t)

Liquidity channel• The role of the central bank as a lender of last resort has

been around since the time of Walter Bagehot in the 1800s. • Banks finance their long-term assets by issuing short-term

liabilities, which can be withdrawn at any time or on short notice leaving banks subject to runs even if assets backing the deposits are sound.

• The current situation is a bit like this in that banks did need lots of injections of liquidity.

• However, there is also a problem of asymmetric information in which it is impossible to value assets properly.

Other channels of monetary policy transmission (con’t)

Imperfect substitution of assets• Policy is thought to work because of this feature. In this view,

open market operations require that agents adjust their portfolios and this changes relative rates of returns until equilibrium is restored.

• An increase in the money supply (which the public holds) leaves their portfolios unbalanced, causing them to buy other assets, bidding up their prices and lowering their rates of return. This starts by affecting short rates and then moving to longer-term interest rates.

Other channels of monetary policy transmission (con’t)

Imperfect substitution of assets (con’t)• When we are at the zero bound, riskless securities (which now

have zero interest rates) and money are perfect substitutes – the implication is that there is no portfolio adjustment.

• The central bank could undertake open market operation in private sector assets and in fact the Fed and the Bank of Japan have done so.

• The real effects rest on the fact that risk is being transferred from the private sector to the central bank.

• The central bank can purchase longer-term government is an effort “to twist” the yield curve. – The evidence is mixed here but it seems that it would take a lot to do

it. Bean et al. (2010) provide some evidence that this had strong effects.

A more detailed look at US actions

Other channels of monetary policy transmission (con’t)

Agency costs and finance premium effects• These models deal with how the transmission mechanism

works. Because of asymmetric information lenders charge a premium to borrowers creating a wedge between the return on a project and the cost of financing.

• The wedge would be influenced by the balance sheet of the borrower. A shock like the current one has an adverse impact on balance sheets, lowering their ability to borrow.

• These models have been used to study the transmission mechanism not the causes of fluctuations.

• As well it is not sure that the central bank can influence these wedges.

Other channels of monetary policy transmission (con’t)

Collateral constraints and credit rationing• If there is credit rationing then it is hard to judge the effect of

monetary policy by looking at just interest rates. Central banks do surveys of bank lending attitudes and these definitely became more restrictive.

• These credit constraints can be important and some empirical studies have measured their effects.

• The only way that the central bank can lower these effects is by taking on the risky assets.

Macro-prudential policies• Want to change how banks behave, in particular have them hold

more capital as well as have them increase reserves as credit rises.

Exiting the current situation

• There are some issues here related to timing of the withdrawal of the huge amount of liquidity. Have to be reasonably sure about the timing.

• At this point, err on the side of caution.• In the event that the central bank is committed to

getting inflation higher then not all will be unwound.• Communications will be key. The models suggest

that rates be kept low until activity is firmly re-established and then policy rates need to be raised rapidly.

Future policy design • Certainly cannot focus on just activity.• The role of asset prices is posing challenges:– Pre-crisis view was that asset price changes are only useful

to the extent that they say something about the inflation forecast.

– One could use or respond to asset prices if: 1) they affect either the output gap; or 2) they affect the real rate of interest that is relevant for monetary

policy.

• The evidence is that the asset price developments are not much help in forecasting although they can help in analysing short-term developments.

Future policy design (con’t)

• There is the question of asset price bubbles. Here the issue is that:

1) they are hard to identify (models not helpful in this sense) and 2) monetary policy is a particularly blunt instrument to use.

• The status quo view was to clean up after they burst. At the same time the cost of letting the bubbles burst were certainly under-appreciated – a blotted financial and construction sector which is currently adjusting back to something like normal.

• This was a policy failure.

Inflation targeting re-visited

• It seems that inflation targeting has done well. There is no sense in which these regimes either created the bubble (it was in the US a non-inflation-targeting country) nor excessive volatility in output by focussing excessively on inflation.

• Should the inflation target be raised?• There is a very strict limit here and it is price level

targeting.• The idea is to set policy such that the price level is

maintained over time.

Inflation targeting re-visited (con’t)

• Such a policy can be stabilising provided that the central bank is credibly committed to maintaining the level of prices.– A shock that lowers the price level should set in

motion expectations that price will rise to restore the price level, e.g., there will be short run period of inflation which lowers the real rate of interest.

– This type of policy could also reduce one of the risks associated with nominal contracts like bonds. The inflation risk is removed.

Inflation targeting re-visited (con’t)

• Introducing such a system at this time would be difficult given a lack of experience with it.

• It would be very hard to communicate this to the public.

• The stabilising aspects depend on the speed at which the price level is restored or at which the public expects it to be restored.

• There is as well the question of which price index to use.