Wednesday, June 10, 2009

‘leaning against the wind’ when an asset or credit bubble is inflating by operating a tighter monetary policy

From Alphaville:

The need for greater realism in monetary policy

Is it ironic that the following conclusion is coming out of the Bank of England?

(Emphasis FT Alphaville’s):
. . . What lessons might be drawn for the operation of monetary policy? As we have argued, monetary policy can play a role in bringing credit booms to an end. But deploying monetary policy is much easier when credit growth is also accompanied by strong output growth and inflationary pressures. For a combination of reasons, this was not the case in many countries in the late 1990s and early 2000s. Some have argued that this means that the objectives of monetary policy should be changed — with a greater focus on ‘leaning against the wind’ when an asset or credit bubble is inflating by operating a tighter monetary policy than a conventional focus on price stability — such as an inflation target — would imply.

However, we see three problems with this approach. First, it is very difficult to operate because it is not always clear at what point in the growth of a credit cycle the monetary policy-maker should intervene. Second, it potentially creates confusion about the objectives of monetary policy by shifting the focus away from price stability as experienced by the general public towards a more complex set of objectives. This may undermine the credibility of monetary policy and its ability to anchor inflation expectations at a low and stable level. Third, and most crucially, however, this ‘leaning against the wind’ approach takes no account of the globalised nature of the financial system.

In the recent episode, the global financial crisis has been driven primarily by developments in the US mortgage market and within global financial markets and institutions. It is hard to see that a different course for monetary policy in other countries – such as the UK, the euro area or Japan — could have made much difference on either front. Within such a globalised fnancial system, a policy which sought to ‘lean against the wind’ risks having a deflationary bias at the national level - growth is held back in the upswing to head off a national credit bubble and yet the economy concerned is still at risk from a recession generated by a global financial crisis. The fact External MPC Unit Discussion Paper No. 27 June 2009 38 that Germany and Japan did not participate in the credit boom has not shielded them from the effects of the current global recession. Indeed, the export and manufacturing orientation of their economies means they have been among the hardest hit, in the short term at least.

Could better global coordination of monetary policies have helped in these circumstances? It could certainly be argued that while monetary policy seemed appropriate for many countries individually, at the global level it was too loose. The global credit boom was a symptom of this, as was the inflationary pressure which emerged in energy and other commodity markets in the mid-2000s. But effective coordination is likely to be very difficult to achieve when it is most needed. It is true that the current recession, along with an increased recognition of global interdependencies, has led to a renewed interest in policy coordination. But this has been against a background of strong mutual interest in the common goal of lifting the world economy out of recession. It would be much harder to achieve an appropriately coordinated monetary response when the world economy was growing healthily and the sense of common purpose was absent.

Maybe a more appropriate conclusion for monetary policy is the need for greater realism about what it can and cannot achieve. Monetary policy can deliver price stability over the medium term. But it cannot also single-handedly maintain the broader stability of the financial system or avoid all recessions. Economies experienced cycles and recessions going back to biblical times — long before inflation became a problem in the 1970s. Financial instability was an important driver of cycles before the Second World War. And the recent crisis provides a reminder that the instabilities of the earlier historical experience can re-emerge.

Another important conclusion for policy is that long expansions eventually come to an end. And they can be brought to an end by behaviours which are themselves encouraged by the experience of a long period of growth. The long expansion we saw in the 1950s and 1960s resulted in a sustained build-up in inflationary pressures which was responsible for at least two of the previous three UK post-war recessions. And we now recognise the financial excesses which built up in the recent period of sustained global economic growth ultimately sowed the seeds of the current recession. In a long period of economic expansion, policy-makers need to be alert to the imbalances and vulnerabilities which might bring a period of stability to an end. Even in a world in which inflation is generally low and stable recent experience suggests that financial instability is another powerful mechanism which can bring a long expansion to an end.

You can read the full BoE discussion paper — which focuses on the credit boom and the challenges it poses for macroeconomics and policy — here.

Related links:
Thinking anew on UK monetary policy - Martin Wolf, FT
Success and failure of monetary policy since the 1950s - Speech by Donald Kohn, BIS


Don the libertarian Democrat Jun 10 20:46
I never get irony. Sorry. However, the policy of a Central Bank leaning against the wind should be called "P---ing Against The Wind. In the same way that a Central Bank is a Lender Of Last Resort, it's a Leaner Of Last Resort. The Central Bank will always lag a bubble because it has to slow the entire economy to act against the bubble. It will not do that until the bubble is about the size of one's face and about to burst. **** this idea out before someone begins to take it seriously.

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