Does Easing Monetary Policy Increase Financial Instability? Ambrogio Cesa-Bianchi1 2 Johns
Alessandro Rebucci2
1 Bank of England Hopkins Carey Business School
“IFABS 2016”
1
Disclaimer
The views expressed in this paper are solely those of the authors and should not be taken to represent those of the Bank of England.
2
Financial crises, Monetary policy & Financial stability
I
The global financial crisis has ignited a debate on the role of ”policies for the stability of the financial system or the economy as a whole”, or macro-prudential policies
I
In advanced economies, this debate is revolving around the role of monetary and regulatory policies (or the lack of thereof) in causing the crisis
Introduction
3
U.S. monetary policy in the run up to the Great Recession Figure Policy rate as implied by a standard interest rule (Taylor, 2007) 9 8 7
Percent
6 5 4 3 2 1 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Actual Fed Funds Rate
Introduction
4
U.S. monetary policy in the run up to the Great Recession - Too loose? Figure Policy rate as implied by a standard interest rule (Taylor, 2007) 9 8 7
Percent
6 5 4 3 2 1 0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Actual Fed Funds Rate
Introduction
Taylor Implied Fed Funds Rate
5
This paper Key questions I
I
I
Can monetary policy address both macroeconomic and financial frictions? Is there a trade off between macroeconomic and financial stability in the conduct of monetary policy? Was US monetary policy too loose in the run up to the Great Recession?
Contribution I
Address these questions in a model with two sets of frictions: Macroeconomic - Monopolistic banking - Real rigidities (int. rates) ⇓
Financial - Occasionally binding collateral constraint ⇓
Policy has macroeconomic and financial stability objectives! Introduction
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Related literature (subset!)
I
New Keynesian DSGE models with interest rate rules “augmented” with macroprudential arguments: Kannan et al. (IMF, 2009), Bean et al. (BoE, 2010), Angelini et al. (BI, 2011), Beau et al. (BdF, 2012)
I
Neo-Fisherian models where macro-prudential policies address a well defined market failure (pecuniary externality): Jeanne and Korinek (AER P&P, 2010), Bianchi (AER, 2011), Bianchi and Mendoza (IMF, 2011), Benigno et al (JIE, 2012)
I
Two other papers address same key question: Kashyap and Stein (AEJ Macro, 2012), Woodford (2012)
Introduction
7
Key findings Positive perspective I
Real rigidities have an asymmetric impact on financial stability depending on the sign of the shock hitting the economy
Normative perspective I
When the policy interest rate is the only available instrument, a (constrained) policy authority may face a trade-off between macro and financial stability
Implication for U.S. monetary policy I
The weak link in the US policy framework was not an excessively lax monetary policy, but rather the absence of an effective second policy instrument aimed at preserving financial stability
Introduction
8
Outline
I
Model
I
Decentralized equilibrium
I
Restoring the efficient allocation
I
Implications for monetary policy and financial stability
Model
9
Model
I
The model embeds a monopolistic banking sector with interest rate rigidities in the pecuniary externality framework of Jeanne and Korinek (AER P&P, 2010)
I
Three time periods t = 0, 1, 2
I
Two sets of agents plus government: 1. Consumers: own one unit of an asset, can borrow from banks to smooth their consumption, receive a stochastic endowment in t = 1 2. Monopolistic banks: collect deposits at rate R and extend loans at rate RL
Model
10
Consumers I
The optimization problem of consumer i is n o max u(ci,0 ) + u(ci,1 ) + ci,2 c0 ,c1 ,c2 ,θ1 ,θ2
ci,0 = bi,1 + (1 − θi,1 )p0 , ci,1 + bi,1 RL1 = e¯ + ˜ε + bi,2 + (θi,1 − θi,2 )p1 + π i,1 , ci,2 + bi,2 RL2 = θi,2 y + π i,2 . with ˜ε ∼ U [−ε, +ε] I
In period 1, consumers are subject to a collateral constraint which takes the form bi,2 ≤ θi,1 p1 and binds only occasionally
Model
11
Banks I
The optimization problem of bank j is max bj,t RLj,t − dj,t Rt ,
RLj,t ,bj,t
s.t. bj,t = dj,t I
Market power leads to pricing-above-marginal cost RLt = MRt =
I
Model
1 Rt 1−ζ
One-period real rigidity: following a shock to Rt , only a fraction µ of the banks can update the lending rate, while the remaining 1 − µ cannot 12
Outline
I
Model
I
Decentralized equilibrium
I
Restoring the efficient allocation
I
Implications for monetary policy and financial stability
Restoring Efficiency
13
Addressing the macro friction Interest Rate Rigidity
I
Conditional on deposit rate shock, the average lending rate is different from its frictionless counterpart µ · M(R + υ) + (1 − µ) · M(R) 6= {z } | RL with sticky rates
I
M(R + υ) | {z }
RL with flex rates
Policy maker can restore efficiency by affecting the funding cost of banks R + υ + ψ ψ=
1−µ υ µ | {z }
Int. Rate Wedge ≷0 if υ≷0
Restoring Efficiency
14
Addressing the financial friction Pecuniary externality I
Unlike individual consumers, the social planner internalizes that atomistic decisions affect market asset prices p1 (c1 ) =
I
y u0 (c1 )
(Asset pricing equation)
The social planner increases precautionary savings in period 0if constraint is expected to bind in period 1 u0 (c0 ) = RL1 E u0 (c1 ) + λp0 (c1 ) | {z } Pecuniary Externality
I
Policy maker can achieve efficiency by imposing a Pigouvian tax on borrowing (1 − τ )b1 E [λp0 (c1 )] τ= E [u0 (c1 )]
Restoring Efficiency
15
Addressing the financial friction Pecuniary externality
I
An isomorphic allocation can be achieved by increasing lending rates RL1 = M (R + ψ) E [λp0 (c1 )] R ψ= E [u0 (c1 )]
I
Or alternatively imposing bank reserve or capital requirements
Restoring Efficiency
15
Interest rate as the only policy instrument I
Policy rate can be used to address either the macro or the financial friction
I
But when it is used to achieve both objectives ... Financial Friction ψ=E
I
h
λp0 (c1 ) u0 (c1 )
i
R
Real Friction ψ=
1−µ µ υ
Conditional on a negative shock =⇒ the macroeconomic friction and the financial friction require opposite action on the interest rate (ψ ↑↓) =⇒ There is a policy trade-off!
Restoring Efficiency
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Outline
I
Model
I
Decentralized equilibrium
I
Restoring the efficient allocation
I
Implications for monetary policy and financial stability
Monetary Policy & Financial Stability
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Assessing Taylor’s argument through the lens of the model RL
Two policy instruments One policy instrument Negative shock
MR
M(R+ν)
2000 2004 2008
Monetary Policy & Financial Stability
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Assessing Taylor’s argument through the lens of the model
I
Our findings support Taylor’s argument only if we make the auxiliary assumption that the policy authority has just one instrument at its disposal, namely the policy rate
I
However, in the U.S., institutional responsibility for financial stability is shared among a multiplicity of agencies
I
What did these agencies do to contain the housing boom and indiscriminate mortgage lending between 2002 and 2007?
Monetary Policy & Financial Stability
19
4 facts about the U.S. housing sector in the run up to the crisis a) Prime and non-prime (Subprime, ALT-A, Home equity and FHA/VA) mortgage originations 7
3.0 SEC
FDIC 1
FDIC 2
6
2.0
4 1.5 3 1.0
2 1
0.5
0
0.0
Fed funds rate
Non Prime (right)
Trillion USD
Percent
I
2.5
5
Fact 1 While prime mortgage originations started to fall in 2003, non-prime mortgage originations continued to increase in 2004 and 2005
Prime (right)
Source. Inside Mortgage Finance, 2008 Mortgage Market Statistical Annual
Monetary Policy & Financial Stability
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4 facts about the U.S. housing sector in the run up to the crisis b) Share of private-label Mortgage Backed Securities (MBS) over total MBS issuance 7
60 SEC
FDIC 1
FDIC 2
6
40
4 30 3 20
2 1
10
0
0
Fed funds rate
Percent
Percent
I
50
5
Fact 2 A similar pattern emerges by looking at the share of private-label mortgage backed securities (MBS) over total MBS issuance
Private-label MBS (right)
Source. Bloomberg, Dealogic, Thomson Reuters
Monetary Policy & Financial Stability
21
4 facts about the U.S. housing sector in the run up to the crisis 7
c) Share of mortgage originations with LTV > 90% over total mortgage originations
6
7
1
FDIC 1
FDIC 2
6
30
5
25
4
20
3
15
2
10
1
5
0
0
0
Fed funds rate
I Percent
Percent Percent
2
Percent
4 3
35 SEC
5
Fact 3 The share of high LTV ratio mortgages in the U.S. spiked in 2005, two years after the beginning of the monetary policy tightening
LTV > 90% (right)
Source. Inside Mortgage Finance, 2008 Mortgage Market Statistical Annual.
Monetary Policy & Financial Stability
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4 facts about the U.S. housing sector in the run up to the crisis d) Changes in lending standards & perceived level of credit risk in residential real estate loan portfolios 7
30 SEC
FDIC 1
FDIC 2
6 5
10
4 0 3
Percent
Percent
I
20
-10
2 1
-20
0
-30
Fed funds rate
Lend. Stand. (right)
Fact 4 Level of perceived risk was sharply increasing from 2004 Banks were easing their lending standards from 2003
Credit Risk (right)
Source. Office of the Comptroller of the Currency, Survey of Credit Underwriting Practices
Monetary Policy & Financial Stability
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Conclusions Two results I
Sticky interest rates have an asymmetric impact on the probability of a financial crisis in the model depending on the sign of the shock hitting the economy
I
When only one instrument is available (namely the monetary policy rate) and the economy is hit by a negative shock to the interest rate, there is a trade–off between macroeconomic and financial stability
One policy implication I
The weak link in the U.S. policy framework in the run up to the great recession was not an excessively lax monetary policy stance after 2002, but rather the absence of a second policy instrument (effective regulation) aimed at preserving financial stability
Monetary Policy & Financial Stability
24
