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Rethinking Macroeconomic Policy

Rethinking Macroeconomic Policy. Olivier Blanchard Giovanni Dell’Ariccia Paolo Mauro . Stockholm , November 21 st , 2011 . The views in this presentation are those of the authors and do not necessarily represent those of the IMF. Pre-Crisis Consensus.

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Rethinking Macroeconomic Policy

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  1. Rethinking Macroeconomic Policy Olivier Blanchard Giovanni Dell’Ariccia Paolo Mauro Stockholm, November 21st , 2011 The views in this presentation are those of the authors and do not necessarily represent those of the IMF

  2. 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

  3. 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)

  4. Benign Neglect Approach to Boom/Busts • 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

  5. 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)

  6. 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

  7. Then the Crisis Came … Bust had enormous consequences Standard policies rapidly hit their limits Limited effectiveness of less traditional policies Large fiscal and output costs

  8. Reflections on the Crisis Stable inflation: Necessary but not sufficient Limits of very low inflation Reconsider “benign neglect” Financial intermediation is macro relevant

  9. Before Crisis Inflation and Growth Looked OK United States Euro area Average of other economies1 Core CPI Inflation Output Gap2 1 Japan omitted. 2 Estimate of output gap using rolling Hodrick-Prescott filter.

  10. 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. And Credit Booms Fueled Vulnerabilities Growth Rate of Nominal Credit relative to GDP and Household Quick Ratio (percent) IRL NOR FIN ESP Average annual percentage point change inhousehold quick ratio (liabilities/liquid assets) PRT NLD GRC SWE USA CAN GBR FRA ITA AUT BEL DEN JPN CHE DEU Average growth rate of nominal credit relative to GDP (2002:1-2006:3)

  12. Limited Monetary Policy Room (policy rates in percent) Jun-09

  13. 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

  14. 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?

  15. 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

  16. Benign neglect approach may be dead, but… • 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

  17. Booms in Housing Markets Are Particularly Dangerous • 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

  18. Boom, Leverage, and Defaults

  19. Real Effects of House Busts

  20. The Policy Rate and House Price Bubbles • 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

  21. Macro-Prudential Tools • 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

  22. Hong Kong: Limited Effectiveness of LTV Limits

  23. Korea: Effective LTV Limits, but Difficult Calibration?

  24. Macro-prudential policy still in its infancy • 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

  25. Tentative Policy Taxonomy for Real-Estate Booms • 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

  26. Important Open Questions • 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

  27. 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 design

  28. Thank You

  29. Widespread Declines in Output Volatility

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