Rethinking Macroeconomic Policy II: Getting Granular

SYstemic Risk TOmography:Signals, Measurements, Transmission Channels, and Policy Interventions

Giovanni Dell’AricciaInternational Monetary Fund (IMF)Centre for Economic Policy Research (CEPR)

Brescia, 25 June 2013The views expressed here are those of the authors and do notnecessarily represent those of the IMF or the IMF Board

How the crisis challenged the macro policy consensus

Take stock of post-crisis debate so far

Focus on relationship between monetary and regulatory (macro-prudential) policies

Leave fiscal policy and other issues (ZLB, LOLR, UMP etc.) aside for today

For more: “Rethinking Macro policy II. Getting granular” (Blanchard/Dell’Ariccia/Mauro)

“Rethinking Macro policy II”. April conference webcast. IMF website

Plan for this talk

Monetary policy to focus on inflation (and output gap): “divine coincidence”

Little attention to asset prices and credit aggregates: A concern only through their impact on GDP and inflation (exceptions RBA, Riksbank, some EMs)

Benign neglect approach to boom/busts: Bubbles difficult to identify Costs of clean up limited and policy effective Better clean up than prevent Bank risk taking important, but job of regulators

ZLB considered as an interesting theoretical concept, but unlikely in practice

Before the crisis …A policy gap

Regulatory policy focused on individual institutions

Limited attention to credit aggregates or asset price dynamics

Ill equipped to deal with booms:

Correlated risk taking

Fire sales and other externalities

Few regulators had necessary tools (exceptions: Spain/Colombia)

Before the crisis … A policy gap

Macro literature: Financial intermediation seen as macro neutral

Asset prices (including property prices) did matter. They could accentuate the cycle through financial accelerators (BGG etc.)

But macro model largely ignored their impact on bank risk taking. In equilibrium, no bank defaults

Banking literature Focused on excessive risk taking by intermediaries operating under limited liability

and asymmetric information

Defaults/crises in equilibrium

But there was little attention to macro and monetary policy conditions

Before the crisis … A theory gap

Before crisis … Macro 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.

LVA

EST

LTU

IRL

UKR

JPN

RUS

DNK

HKG

SWE

SVN

GBRNLD

SVK

ESP

BGR

MYS

BOL

THAPHL

AUS

IND

KAZ

PAN

URY

DOM

NPL

VNM

BGD

MOZCHLMAR

SURIDN

CHN

y = -1.2852x + 12.969R² = 0.14

-50

-25

0

25

50

75

100

-30 -20 -10 0 10 20 30

Cha

nge

in c

redi

t-to-

GD

P ra

tio fr

om 2

000

to 2

006

Change in GDP from 2007 to 2009

Credit Growth and Depth of Great Recession

Bubble size shows the level of credit-to-GDP ratio in 2006.

House boom/busts and great recession

AKALAR

AZ CA

CO

CT DCDE

FL

GA

HI

IA

ID

IL

INKSKY

LA

MA

MD

MEMI

MN

MO

MS

MT

NCND

NE

NH

NJ

NM

NV

NY

OH OK

OR

PA

RI

SCSDTN

TX

UTVA

VT

WA

WI

WV

WY

y = 1.1159x + 20.457R² = 0.5501

-50

0

50

100

150

200

250

0 20 40 60 80 100 120 140 160

Cha

nge

in m

ortg

age

delin

quen

cy ra

te, 2

007-

09

House price appreciation, 2000-06

Subprime Boom and Defaults

Bubble size shows the percentage point change in the ratio of mortgage credit outstanding to household income from 2000 to 2006.

Monetary policy and risk taking Is the “divine coincidence” dead?

We already knew short-term trade-off inflation/output Is there also one between output/inflation eqlb and financial stability? Financial frictions imply that low/stable inflation is not enough any longer

(assuming systemic risk taking is excessive)

Other tools? Macroprudential (LTVs, DTIs, dynamic provisioning, cyclical CARs) But unlikely to work perfectly Potential need to lean against the wind

Many questions: What metrics (leverage, asset-prices, credit growth,…) Rules versus discretion General overhaul of IT and Taylor rules or case-by-case practical approach?

Definition? Financial regulation with a cyclical (macro) twist Objective: Contain “excessive” risk/imbalances associated with cycle

Standard macro policy works rather poorly: for instance: Housing booms: MoP a blunt tool Capital inflows: Lower or higher interest rates?

Macroprudential instruments can be more targeted: LTV ratios, DTI ratios Cyclical capital ratios FX borrowing/lending restrictions Taxes on short term inflows

A Role for Macro-prudential policy ?

13

If macro prudential tools worked perfectly → Monetary policy could focus on inflation (output).

How well do they work (useful to thin about K-controls)? Evidence: Perhaps not well enough.

LTVs/DTIs in Korea and Hong Kong Dynamic Provisioning in Spain

Many issues. Some transitory, some permanent: Hard to calibrate. Hard to aim: Many forms of risk taking. Circumvention Political economy issues

But there are several unresolved issues

14

Relationship with other policies How many agencies in charge of MoP/MaP?

Two instruments (Policy rate, MaP)/ Two objectives (Inflation/output, Stability) Each instrument affects both objectives If perfectly functioning, design does not matter

But, if not, separation improves credibility

Especially if CB’s mandate very clear Similar to fiscal/monetary policy divorce (think Barro/Gordon) At potential cost of second-best policy mix

Example, in a recession: CB cuts rate aggressively to stimulate demand FA reacts by tightening macro-prudential regulation to reduce risk-taking → CB eases even

more → FA …. Result: a policy mix with too low interest rates and too tight macro-prudential measures

Governance issues Outsourcing monetary policy to independent CBs was “easy”

A clear and measurable objective: low and stable inflation (sometimes with some attention to short-term output)

A clearly understood (almost mono-dimensional tool): the policy rate Accountability led to properly designed incentives for central bankers

But financial stability much more complicated

Is there a too stable banking system? Multiple objectives, difficult to measure Nobody sees the crises that do not happen Accountability complicated, potential for poor incentives Systemic nature makes problem worse than for MiP (no yardstick)

Implications for regulatory design How many agencies in charge of MaP/MiP?

Is it conceivable to keep macroprudential and microprudential regulators separate? MaP could set level of certain ratios over the cycle MiP enforcement and bank level variations

Yet, things are more multidimensional and there can be conflicts Set P(X)=probability that bank X fails Then probability of joint failures: P(X∩Y)=P(Y|X)P(X)=P(X|Y)P(Y) So you could have measures that lower P(X), P(Y), but increase P(X∩Y)

Think about completely separated versus integrated systems (Allen/Gale) Hedging across banks/Cross-border links What kind of strategic game can emerge between MiP and MaP agencies?

Cross-border issues Macroprudential policy with open k-accounts?

Cyclical CARs vs Basel I Borrower or activity based measures Risk of circumvention Especially an issues within currency areas

Interaction with CA balance Spillovers through capital flows Not a major issue if ER not a target; but problem if ER volatility is an issue Incentives of national regulators?

Is there room for greater coordination of MaP?

Conclusions Contours of new macro policy consensus still evolving

Flexible inflation targeting “plus”? Same basic framework But with attention to credit aggregates and other imbalances Discretionary/limited use of MaP tools

More ambitious redesign? Broader mandates for CBs Difficult political economy issues Do not throw the baby away with the bathwater

This project is funded by the European Union under the

7th Framework Programme (FP7-SSH/2007-2013) Grant Agreement n°320270

!!!!!!!

www.syrtoproject.eu

This document reflects only the author’s views. The European Union is not liable for any use that may be made of the information contained therein.