Transcript Flexible Inflation Ta

Inflation Targeting After the
Financial Crisis
Lars E.O. Svensson
Sveriges Riksbank
Speech at Reserve Bank of India’s International Research
Conference “Challenges to Central Banking in the Context of
Financial Crisis”, Mumbai, February 12, 2010
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Introduction
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Questions after the financial crisis:
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Did monetary policy contribute to the crisis?
Are any changes of best-practice monetary policy
justified?
Outline of speech:
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Best-practice monetary policy before the crisis
The causes of the crisis and the role of monetary
policy
Does flexible inflation targeting need to be
modified in light of the crisis?
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Best-practice monetary policy:
Flexible inflation targeting
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Stabilize both inflation around the inflation target and
resource utilization around a normal level
“Forecast targeting”: choose policy-rate path so that
forecast of inflation and resource utilization “looks
good” (Riksbank: “well-balanced policy”)
The CB uses and responds to all info that affects
forecast of inflation and resource utilization
CB responds to financial conditions only to the extent
they affect forecast of inflation and resource utiliz’n
Financial conditions are only indicators, not targets
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The financial crisis was not
caused by monetary policy
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Main causes of the crisis (Bean 09):
Macro conditions: Global imbalances, low world real
interest rates, Great Moderation, underestimation of
risk, very low risk premia
Distorted incentives: Lax regulation and supervision,
missing bank resolution, US housing policy,
securitization, regulation arbitrage, increased leverage
Information problems: Hidden risk in complex
securities, underestimation of correlated systemic
risks
These causes had little or nothing to do with
monetary policy!
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Was US monetary policy too easy
during 2001-2004?
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Ex ante: Genuine threat of deflation and liquidity
trap, expansionary policy right
 Given FOMC forecasts, policy rates not exceptional
(Bernanke)
 Neutral real interest rates low because of global
unbalances
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Would tighter US monetary
policy have prevented the crisis?
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Interest rates explain small portion of US house- price
increases
 Initial payments on new exotic mortgage types not
very sensitive to short interest rates (Bernanke)
 To affect boom and credit growth, substantially
higher interest rates needed: recession, deflation, and
eventually liquidity trap?
 No impact on regulatory problems, distorted
incentives, information problems
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Would tighter US monetary
policy have prevented the crisis
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IMF WEO (Oct 09): Many countries and crises
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MP stance generally not leading indicator of future
financial crises
Current crisis: Statistically insignificant and economically
weak association between loose monetary policy and
house prices (5% of variation explained)
Beyond actual monetary policy:
“Greenspan put”? Floor for asset prices, reduce risk?
Communication rather than policy, less emphasis had
been better?
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Lessons for flexible inflation
targeting
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Price stability not enough to achieve financial
stability
 Interest-rate policy not enough to achieve financial
stability
 Regulation, supervision, bank resolution, macroprudence, “a portfolio of instruments” (Bean 09) for
financial stability
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Relation monetary policy and
financial-stability policy?
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Financial stability important objective for policy
 FS: Situation when the financial system can fulfil its
main functions without disturbances that have
significant social costs
 Policies (fiscal, labor market, structural…):
Distinguish because differ regarding objectives,
instruments, responsible authorities
 Monetary policy and financial-stability policy distinct
and different policies
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Monetary policy
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Objective: Stabilize inflation and resource utilization
 Instruments: Policy rate, policy-rate path,
communication (fixed-rate lending, asset purchases)
 Responsible authority: CB
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Financial-stability policy
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Objective: Financial stability
 Instruments: Supervision, regulation (lending of last
resort, variable-rate lending, liquidity policy, bank
resolution, capital injection, …)
 Authority: FSA, CB, …(Sweden: FSA regulation and
supervision, Debt Office bank resolution, Riksbank
lending of last resort)
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MP and FSP different and distinct
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Interaction
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FSP affects inflation and resource utilization via financial
markets and transmission mechanism
MP affects asset prices and balance sheets
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Responsible authority(ies) for FSP open question
(CB for macroprudential regulation?)
 Distinction and difference to be taken into account
 FS as additional objective for MP makes little sense
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Necessary to modify flexible
inflation targeting?
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Specific conclusions for flexible inflation targeting?
Extend forecast horizon (old): No problem (BoE, NB,
SR), but how much info?
Leaning against the wind?
If financial factors are indicators, not targets,
completely consistent with flexible inflation targeting
Instruments other than interest rates more effective
(loan-to-value restrictions, minimum mortgages etc)
More research warranted
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Conclusions
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Flexible inflation targeting remains best practice
monetary policy
If done rightly, using all information in financial
factors about future inflation and resource utilization
However, a better theoretical, empirical and
operational understanding of the role of financial
factors in the transmission mechanism is required
Financial factors still indicators, not targets
CBs responding appropriately to financial factors in
order to best stabilize inflation and resource
utilization over time
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