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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 Pre-Crisis Consensus n One target for monetary policy: Low and stable inflation n One main monetary policy instrument: The policy interest rate n A limited role for fiscal policy n No cyclical role for prudential regulation n The proof of the pudding: The Great Moderation n Caveat: Differences between and among academics, central banks, politicians 2 Monetary Policy: One Target/One Instrument n Stable inflation (backed by theory and politics) n Low inflation (low prob. of Zero bound, but Japan…) n Connected markets and arbitrage (one rate does it all) n Expectation channel: Rule based policy n Financial intermediation largely ignored (with exceptions) 3 Benign Neglect Approach to Boom/Busts n Asset prices a concern only through their impact on GDP and inflation n Bubbles difficult to identify n Ex-post policies effective and costs of clean up limited n Better clean up than prevent Financial Regulation Not a Cyclical Tool n Macro dimension of regulation largely ignored: n Focus on soundness of individual institutions n Some exceptions in EMs n Cyclical use of prudential policies discouraged: n Seen as mingling with proper market functioning n Little thought given to cyclical rules on capital ratios, LTV ratios (exceptions: Spain, Colombia) The Great Moderation n Steady decrease in the variability of output and inflation in advanced countries n Sources? Luck, structural changes, improved monetary policy? n Successful responses to the financial scares. 1987 stock market crash, LTCM, Tech bubble burst 6 Then the Crisis Came … n Bust had enormous consequences n Standard policies rapidly hit their limits n Limited effectiveness of less traditional policies n Large fiscal and output costs Reflections on the Crisis n Stable inflation: Necessary but not sufficient n Limits of very low inflation n Reconsider “benign neglect” n Financial intermediation is macro relevant 8 Before Crisis Inflation and Growth Looked OK Euro area United States Average of other economies1 Core CPI Inflation Output Gap2 1 Japan omitted. 2 Estimate of output gap using rolling Hodrick-Prescott filter. 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. And Credit Booms Fueled Vulnerabilities Growth Rate of Nominal Credit relative to GDP and Household Quick Ratio (percent) Average annual percentage point change in household IRL quick ratio (liabilities/liquid assets) NOR FIN ESP PRT NLD GRC SWE USA CAN FRA GBR ITA AUT BEL DEN JPN CHE DEU Average growth rate of nominal credit relative to GDP (2002:1-2006:3) 11 Limited Monetary Policy Room (policy rates in percent) Jun-09 12 Financial Intermediation Matters n When normal investors exit, markets become segmented n Arbitrage fails, and prices can deviate far from fundamentals n Policy rate no longer a sufficient instrument for policy n Credit easing and quantitative easing can affect rates and asset prices, given policy rate 13 What We Should Explore Going Forward n If low/stable inflation not enough, what should monetary policy target? n If benign neglect is dead, then what? n More targets means more tools: what role for macroprudential policies? 14 Monetary Policy n Many targets: n Inflation/output gap n Exchange rate n Asset prices: Housing, stocks, etc n But also many instruments: n Policy interest rate n Reserve accumulation n Macro prudential instruments n Cyclical capital/liquidity ratios n Loan to value ratios, margin requirements 15 Benign neglect approach may be dead, but… n Problems and trade offs with more interventionist strategy remain: n Bubbles difficult to detect in real time (China real estate) n Risks with pricking bubbles (including for policy makers) n Traditional policies may be ineffective (speculative demand)) n And have large costs Booms in Housing Markets Are Particularly Dangerous n Not all asset-price booms should be target of policy n But how to choose? n Some consensus emerging that culprit is leverage (Nasdaq crash was fine) n Housing markets are special: n Leverage (link to crises) n Large storage of wealth n Major supply-side effects n Network externalities Boom, Leverage, and Defaults Real Effects of House Busts The Policy Rate and House Price Bubbles n Make borrowing more expensive and may limit leverage and risk taking n But: n Too blunt: costly for the entire economy (unless in context of general overheating) n Issues for small open economies n Effect on speculative component may be limited n Panel VAR suggests impact on house prices at considerable cost to GDP growth n 100 basis points reduce house price appreciation by 1 but also lead to a decline of 0.3 in GDP growth Macro-Prudential Tools n Most ‘experiments’ in emerging markets, particularly Asia n Common tools: n Maximum LTV/DTI limits n Differentiated risk weights on high-LTV loans n Dynamic provisioning n Discretion rather than rule-based n Mixed evidence on effectiveness Hong Kong: Limited Effectiveness of LTV Limits Korea: Effective LTV Limits, but Difficult Calibration? Macro-prudential policy still in its infancy n Pragmatic and discretionary, mobilized within existing institutional frameworks, targeted at specific markets n Some evidence of temporary cooling effect on markets and building of buffers for bad times n Too early to judge impact on aggregate cycles and interaction with other policies Tentative Policy Taxonomy for Real-Estate Booms n Macro-prudential tools first line of defense n Target leverage n Strengthen balance sheets n Monetary policy definitely to be involved when there are other signs of overheating n But may have to come into play anyway if macroprudential tools are ineffective Important Open Questions n Who does what? n Where should macro-prudential authority reside? n Relationship among policies? n To what extent are these independent tools? n Rules versus discretion? n Far away from IT standards n Risks associated with excessively interventionist policy Conclusions: An evolution, not a revolution n Low (but how low?) and stable inflation still essential n Low deficits and fiscal room even more needed than before n Monetary policy: Many targets and instruments n New macroprudential tools/ Coordination with monetary policy n Important questions of institutional design 27 Thank You 28 Widespread Declines in Output Volatility 29
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