Central Bank Independence and Macro-Prudential Regulation

1. Central Bank Independence and Macro-Prudential Regulation Kenichi Ueda and Fabián Valencia IMF FinLawMetrics Conference, Bocconi University, June 21-22, 2012

2. Motivation • A growing literature of macro models with financial frictions advocates the use of macro-prudential regulation (e.g. Bianchi (2010), Jeanne and Korinek (2010), etc). • Implementing macro-prudential policy requires, among others, the optimal institutional design. • There is an intense debate about the desirability of formally assigning the central bank with the responsibility of financial stability.

3. This paper • We extend the central bank independence literature pioneered by Kydland and Prescott (1977) and Barro and Gordon (1983). • Output stability and price stability • Time-inconsistency problem and political pressures • Independence of monetary authority from the rest of the government • This paper adds financial stability. • Output stability, price stability, and financial stability • New time inconsistency problem • Separation of monetary authority and financial stability authority from each other • Independence of monetary authority and financial stability authority from the rest of the government

4. Main features • Regulation cannot change frequently, whereas monetary policy can. New time inconsistency problem in a simple two stage setup. • First stage: the policymakers make monetary policy and macro-prudential regulation decisions. • Second stage: monetary policy decisions can be “fine-tuned” after the realization of a credit shock, but the regulation cannot.

5. Main finding • A dual-mandate (price and financial stability) central bank is not optimal because of the new time inconsistency problem. • In the second stage, the dual-mandate central bank has only one tool, monetary policy, to achieve financial and price stability. • This central bank has the ex post incentive to reduce the real burden of private debt through inflation. • Separation of two authorities isbetter.

6. Modeling Linkages • Credit growth • Inflation • Output • Nominal debt • Debt / GDP ratio

7. Loss Function • Similar to conventional loss function in the literature (Carlstrom et al., 2010, Curdia and Woodford, 2010). • Frictionless economy  only output matters • With price stickiness  even with the same outputs, welfare varies with inflation • With financial friction  even with the same outputs and inflation, available credit matters.

8. Loss Function (technical) • Second order Taylor expansion at the steady state • First derivative terms equal to zero b/c FOC • Only second derivative terms remain • Cross derivative terms are zero due to conventional assumptions • Carlstrom et al: separable utility in credit goods and non-credit goods • Curdia and Woodford: Credit constraint independent from inflation

9. Social Planner • Minimize the loss function with three terms • Controlling expectations a priori: SP cannot generate “unexpected” inflation • First stage: choose zero (expected) inflation • Second stage: choose zero inflation by monetary policy to offset unexpected credit growth.

10. Dual Mandate Central Bank • Minimize loss function with two terms • Given people’s expectations on inflation, outputs, and credit growth. • In the first stage, two tools for two objectives: zero expected inflation, the same as the SP. • In the second stage, one tool for two objectives (not considering effects on outputs): less than fully offsetting the effect of credit growth on inflation. • CB tries to make unexpected inflation. • Unexpected positive credit growth  positive inflation

11. Private Debt Monetization • The level of equilibrium inflation depends on the relative importance of the price and financial stability objectives. • The overall welfare lossstems fromthe variance of credit shocks because the expected inflation is still zero. • In environments where credit growth is highly volatile, our result is particularly relevant.

12. Separate Authorities • Monetary authority minimizes • Financial stability authority minimizes • One tool for one objective.  Optimum • SP’s loss function does not include the cross derivatives (additively separable over three objectives).  Separate maximization gives the same outcome.

13. Sub finding • We also consider political pressures, as in Barro and Gordon (1983)  the same result • Monetary authority that is not independent from the rest of the government will use the monetary policy tool to generate too much expansions. • Macro-prudential authority that is not independent form the rest of the government will use the regulation to generate too much growth. • Independence from the rest of the government is as important as in Barro and Gordon.

14. Conclusions • A dual mandate central bank has a distorted incentive to lower the real burden of private sector debt.  Separation of monetary authority and financial stability authority delivers the social optimum. • If the central bankandthe macro-prudential regulator are not politically independent, they would not achieve the optimum.  Independence of monetary authority and financial stability authority from the rest of the government. • Caveats: • synergies from combining expertise and improving information sharing • more complex loss function with large shocks (not around steady state) – this applies to almost all the existing models • better modeling of financial stability in macro models