Should monetary policy ever lean against the wind? Panel - - PDF document

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Department of Economics, Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden, www.sse.edu

Lars E.O. Svensson

Stockholm School of Economics Web: larseosvensson.se The ECB and Its Watchers XVII Frankfurt, April 7, 2016

Should monetary policy ever lean against the wind?

Panel introduction

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Outline § Should monetary policy take into account financial stability risks explicitly? § Should monetary policy “lean against the wind”? § Background: The Riksbank’s policy dramatic tightening 2010-2011… § ... despite an inflation forecast below the inflation target and an unemployment forecast above a long-run sustainable rate § Cost-benefit analysis of leaning against the wind

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Background: Large and rapid increase in Riksbank policy rate 2010-2011

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1 2 3 4 5 6 7

• 1

1 2 3 4 5 6 7 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Interest rates

SE EA UK US 4

Swedish inflation fell rapidly

• 1

1 2 3 4 5 6

• 1

1 2 3 4 5 6 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Inflation rates

SE HICP EA HICP UK HICP US Core PCE

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Riksbank real policy rates increased even more, causing large real interest gap to Eurozone, UK, and US

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• 4
• 2

2 4 6

• 6
• 4
• 2

2 4 6 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Real interest rates

SE-HICP EA-HICP UK-HICP US-CPCE

+ 3.5 pp !

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Swedish Krona appreciated dramatically

80 90 100 110 120 80 90 100 110 120 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Nominal and Real SEK Exchange Rate

Real Effective Exchange Rate, Based on Consumer Prices, Index Nominal Effective Exchange Rate, Index

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Swedish unemployment stayed high

2 4 6 8 10 12 14 2 4 6 8 10 12 14 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Unemployment rate

Sweden US Germany UK Canada 8

Swedish unemployment rate more than 1 pp higher than counterfactual with no policy-rate increase

2 4 6 8 10 12 14 2 4 6 8 10 12 14 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Unemployment rate

Sweden Low policy rate US Germany UK Canada

Counterfactual w/o policy-rate increase

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§ If inflation forecast below target & unemployment forecast above long-run sustainable rate, then policy easing is the right thing § Bernanke (2010): Given these [June 2010] forecasts and FOMC objectives, “there would appear to be a case for further action” [, prepare QE2] § Or does anyone wish that the Fed would have followed the Riksbank example?

Fed and Riksbank June 2010 forecasts of inflation and unemployment very similar; policies very different

Svensson (2011), “Practical Monetary Policy: Examples from Sweden and the United States,” Brookings Papers on Economic Activity, Fall 2011, 289-332. 10

Riksbank tightening 2010-11 § Large costs of Riksbank tightening § Including making the economy more vulnerable to any negative shock (such as the Eurozone crisis) § Could there have been any benefits? § Cost-benefit analysis of leaning against the wind § Numbers and estimates are needed

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Cost-benefit analysis of “leaning against the wind” (LAW) for financial-stability purposes

§ LAW: Tighter policy than justified by normal flexible inflation targeting § Instead undershooting the inflation target and/or

• vershooting the long-run sustainable unemployment rate

§ Costs: Higher unemployment, lower inflation § Possible benefits: Lower probability or severity of a financial crisis § Forgotten additional cost in previous literature: Higher cost

• f a crisis if economy initially weaker because of LAW

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• 0.5

0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

• 0.5

0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

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• 24
• 16
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8 16 24 32 40

• Loss Quarter

Policy rate, pp Non-crisis unemployment gap Crisis unemployment increase Crisis unemployment gap

• (Loss = Squared gap)

Unemployment gap

Unemployment gap in non-crisis and in crisis, for 1 pp higher policy rate for 4 quarters (Riksbank estimates)

§ Noncrisis: Unemployment gap: From 0 to 0.5 pp Loss: From 0 to 0.25 Loss increase: 0.25 − Loss

Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.

§ Additional cost of LAW: Crisis loss increase is 11 times non-crisis loss increase § Crisis: Unemployment gap: From 5 to 5.5 pp Loss: From 25 to 30.25 Loss increase: 5.25 Loss = Squared unemployment gap

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Benefit: Lower probability? Household debt, debt growth, probability of crisis start, and probability of crisis from 1 pp higher policy rate (Riksbank, Schularick and Taylor 2012)

Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3. 14

Marginal cost much larger than marginal benefit of policy-rate increase; net marginal cost large

• 0.1

0.1 0.2 0.3

• 0.1

0.1 0.2 0.3 4 8 12 16 20 24 28 32 36 40 Quarter Marginal cost, pp Marginal benefit, pp Net marginal cost = MC - MB, pp Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.

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Cost-benefit analysis of “leaning against the wind” (LAW)

§ Given existing empirical estimates, the cost is larger than the benefit by a substantial margin § Empirically, the possible effect of the policy rate on the probability or severity of a crisis is too small § The main component of the cost is the additional crisis cost (the higher cost of a crisis because the economy is weaker due to LAW) § Ineffective macroprudential policy may increase the probability or severity of a crisis § Higher probability of a crisis gives more weight to the additional cost; larger severity increases additional crisis cost § Ineffective macroprudential policy therefore increases the cost of LAW more than the benefit, makes the cost exceed the benefit by an even larger margin

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Extra slides

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Was the tightening justified given the info at the time? § What did the Riksbank know?

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CPI inflation below target

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2 4 6

• 2

2 4 6 03 04 05 06 07 08 09 10 11 12

What the Riksbank knew in June 2010

CPI inflation CPI inflation target CPIF inflation

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GDP 5% below peak, 10% below trend; export 13% below peak

70 80 90 100 110 70 80 90 100 110 03 04 05 06 07 08 09 10 11 12

What the Riksbank knew in June 2010

GDP Real Time GDP trend Export

Svensson (2016), “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy,” Blog post, January 22, www.larseosvensson.se.

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Unemployment close to 9%, at peak; far above Riksbank’s “long-term” unemployment rate

5 6 7 8 9 10 5 6 7 8 9 10 03 04 05 06 07 08 09 10 11 12

What the Riksbank knew in June 2010

Unemployment rate, % Riksbank "long-term" unemployment rate

Svensson (2016), “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy,” Blog post, January 22, www.larseosvensson.se. 22

Cost-benefit analysis of “leaning against the wind” (LAW) § LAW: Tighter policy than justified by normal inflation targeting § Costs: Higher unemployment, lower inflation § Possible benefits: Lower probability or severity of a financial crisis § Forgotten cost: Higher cost of a crisis if economy initially weaker because of LAW § What if macroprudential policy is less effective?

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Less effective macroprudential policy, higher debt growth, higher probability of a crisis

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6 7 8 9 10 Annual real debt growth, %

A B

Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.

Annual probability of a crisis start, %

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Less effective macroprudential policy increases marginal cost more than benefit

• 0.1

0.1 0.2 0.3 0.4

• 0.1

0.1 0.2 0.3 0.4 4 8 12 16 20 24 28 32 36 40 Quarter Marginal cost, pp Marginal benefit, pp Net marginal cost = MC - MB, pp Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.

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Benchmark probability of crisis start and crisis in given quarter

Svensson (2016), “Cost-Benefit Analysis of Leaning Against the Wind : Are Costs Larger Also with Less Effective Macroprudential Policy?” IMF Working Paper WP/16/3.