1. Monetary Policy, Asset Prices and Financial Stability: A Small Economy Approach.
Jan Frait
Executive Director
Financial Stability Department

2. This lecture represents my own views and not necessarily these of the Czech National Bank.
At the same time, the lecture is focused on the general aspects of a monetary policy framework and its content has no connections to the current monetary policy stance of any central bank.
This presentation is based on
FRAIT, J., KOMÁREK, L., KOMÁRKOVÁ, Z. (2011): Monetary Policy in a Small Economy after the Tsunami: A New Consensus on the Horizon? Czech Journal of Economics and Finance 61, No. 1, pp
FRAIT, J., KOMÁRKOVÁ, Z. (2011): Financial stability, systemic risk and macroprudential policy. Financial Stability Report 2010/2011, Czech National Bank, pp

3. What Is This Presentation Focusing On?
The prevailing views on monetary policy-making reflect the experience of the Fed and other central banks in major advanced economies.
The theoretical framework of flexible inflation targeting is strongly influenced by U.S. academia.
Monetary policy in a small open economy is a different discipline.
less autonomy (strong impact of external environment),
significant role of exchange rate in determination of monetary conditions,
impact of global financial cycle on credit dynamics,
need for broadly defined flexibility.
This presentation therefore reflects the experience of the Czech National Bank (CNB) as a central bank operating in a flexible exchange rate framework. 3

4. What Is This Presentation Focusing On?
Potentially adverse impact of major central banks‘ monetary policies on small and emerging economies gained plenty of attention following policy move by the Fed in summer of 2013*.
this was not a new phenomenon, it was just more apparent than before,
the impacts of pre-crisis policies were equally difficult to cope with.
Central bankers in small and emerging economies:
being event-takers (or price-takers) often do not have a chance to opt for the first-best policies owing to external conditions set by the macroeconomic policies in major advanced economies,
must therefore be less orthodox, more flexible and rather smart to succeed,
the optimal way of making monetary and macroprudential policies may vary over time as external conditions set by policies in large economies change,
occasionally, steps that do not look intuitive may constitute the best reaction (though still being only second best).
* Shin, H.S. (2013): The Second Phase of Global Liquidity and Its Impact on Emerging Economies, remarks at 2013 Federal Reserve Bank of San Francisco Asia Economic Policy Conference. 4

5. I. Monetary Policy Framework in the Pre-Crisis Times?

6. Price Stability, Decline of Interest Rates and the Great Moderation
In the second half of the 1980s, in response to the high inflation of the previous two decades, central banks focused on achieving price stability, i.e. low and stable inflation, as their primary objective.
In most countries, price stability was achieved quickly – in advanced countries by the early 1990s and in emerging and developing ones in the second half of the 1990s.
Inflation expectations in many countries started to be strongly and successfully anchored by explicit or implicit inflation targets.
The restoration of price stability led to a considerable and sustained decline in nominal interest rates.
In this environment central banks did not have to respond to the economic recovery by rapidly tightening monetary policy as in previous boom and bust cycles which fostered a reduction in the short- to medium-term volatility of real economic activity.
The view started to prevail that a “Great Moderation” had occurred in the world economy and that a long period of low and stable inflation and high and stable economic growth lay ahead.

7. Price Stability, Decline of Interest Rates and the Great Moderation
The onset of the Great Moderation coincided with the development of the theory and models of inflation targeting.
In the years before the crisis, a consensus reflecting the theoretical and empirical studies published over the previous two decades completely prevailed among mainstream theoreticians and policy-makers.
Bean et al. (2010) talk about the “Jackson Hole“ consensus as a synthesis of the rigour of dynamic general equilibrium modelling with the empirical realism of sticky-price Keynesian thinking.
Mishkin (2010) refers to it as the “science of monetary policy” based on the new neoclassical synthesis (as defined by Clarida, Gali and Gertler, 1999) and transformed into a system of flexible inflation targeting.
One of the major effects of the strength of this consensus was a strong belief in the potential of monetary policy and in central banks’ ability to leverage this potential.

8. Asset price fluctuations in 1990s
Borio et al. (1994):
Asset prices have undergone major fluctuations since the early 1980s, sometimes ending in downward corrections.
Such fluctuations are not new, yet the recent cases had strong impact on economic activity and on the soundness of financial institutions ...
… and the disruptions caused to balance sheets of economic agents, notably banks, has threatened or resulted in widespread financial distress.
And the prolonged upswings, in contrast to the 1970s, occurred against the backdrop of generally moderate and declining inflation and positive real interest rates …

9. The Great Moderation versus the Asset Markets‘ Wilderness
The expected stabilisation of financial markets did not take place, on the contrary, fluctuations in asset markets increased and were accompanied by sharp changes in credit dynamics.
Economists responded in the late 1990s by opening a major debate on whether monetary policy should actively seek to encourage asset price stability, or even whether it should attempt to prevent or at least reduce asset price bubbles.
Central banks have always been taking the asset price developments into account when setting monetary policy:
asset price movements impact on CPI inflation via demand for goods and services used to create assets, and also through spending via the "wealth“ effect.
The debate always was not whether a central bank should respond at all, but whether it should respond over and above the response associated with the objectives to stabilise inflation and output.

10. Benign Neglect View
The predominant “benign neglect” view in the literature prior to the current crisis was that a central bank should pay attention to asset market developments, but cannot and should not try to constrain asset price bubbles on their own.
The classical and influential contributions justifying this particular view were provided by Bernanke and Gertler (1999, 2001):
central banks should focus primarily on underlying inflationary pressures and that asset prices can become relevant only to the extent that they may signal potential inflationary or deflationary forces;
policy rules responding directly to asset prices would provide little if any additional gains.
These contributions strongly influenced „global monetary policy view“ even though the Fed (US) is more specific than a general case.

11. Ben Bernanke – Use the Right Tool for the Job!
Bernanke (2002) suggested a very simple rule for central bank policy regarding asset market instability defined in line with the Tinbergen separation principle:
Use the right tool for the job!
Fed has two sets of responsibilities:
maximum sustainable employment, stable prices, and moderate long-term interest rates,
the stability of the financial system.
Fed has two sets of policy tools:
policy interest rates,
range of powers with respect to financial institutions.
Fed should focus its monetary policy instruments on achieving its macro goals, while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.
This particular rule subsequently gained a very strong position in the deliberations of the central banking community.

12. Lean-Against-the-Bubble View
There was a second stream developing alongside the predominant view favouring a more active monetary policy approach to asset price swings - a special subgroup consisted of the writings of BIS economists (see the next section).
The proponents of leaning against the bubble assert that a central bank should take account of, and respond to, the implications of asset-price changes for its macro-goal variables.
A well-known example of the “leaners” approach is Cecchetti et al. (2000), who applied the classic Poole (1970) analysis:
a central bank should “lean against the wind” of significant asset price movements if these disturbances originate in the asset markets themselves, if a disturbance originates in the real sector, asset prices should be allowed to change in order to absorb part of the required adjustment.
an inflation-targeting central bank is likely to succeed by adjusting its policy rates not only in response to its forecast of the inflation and output gap, but also in response to asset prices.

13. Lean-Against-the-Bubble View
They believe that such an approach could also reduce output volatility.
This conclusion is based on the view that reaction to asset prices in the normal course of policy making will reduce the likelihood of asset price misalignments arising in the first place.
On the other hand, the authors are not recommending that central banks either seek to burst bubbles currently perceived to exist, or target specific levels of asset prices.
Furthermore, they do not recommend responding to all changes in asset prices in the same way or including asset prices directly in measures of inflation.
They just say that it is important for central bankers to develop a framework for policy making that accounts for the various sources of uncertainty that they face in meeting their objectives.

14. Lean-Against-the-Bubble View
While confirming their previous stand, Cecchetti et al. (2002) admit that setting policy rates on the basis of conscious deviations of expected inflation from the target could hurt credibility.
The outcome could be that policy becomes less predictable and less transparent.
In practice, attempts to set interest rates at a level different from what is necessary to achieve the target level must be accompanied by a justification that is explained simply and that commands broad agreement.

15. Lean-Against-the-Bubble View
The lean-against-the-bubble strategy has always been acknowledged as not without merit even by supporters of the predominant view - they have nevertheless believed that leaning against the bubble was unlikely to be productive in practice.
It is difficult to identify a bubble, once a central bank becomes certain that a bubble has emerged, it will probably be too late to act with interest rate hikes.
Pursuing a separate asset price objective could mean having to compromise on the inflation objective. A central bank’s focus on assets could lead to public confusion about its policy objectives (Giavazzi and Mishkin, 2006).
It is unlikely that a small increase in short-term interest rates, unaccompanied by a significant slowdown of the economy, will induce speculators to modify their equity or real estate investment plans.
To materially affect some asset prices, such as housing, interest rates would probably need to move by much more than would be required just to keep CPI inflation comfortably within the target range.

16. II. The BIS Approach, or the Austrian Business Cycle Revisited

17. Endogenous Financial Cycles Is What Matters
An alternative approach to the predominant view was presented by economists around the Bank for International Settlements (Borio, White, Lowe,...):
achieving both price and output stability still does not automatically guarantee financial stability;
the behaviour of globalised, liberalised financial markets can cause radical changes in macroeconomic dynamics leading to financial instability;
despite the fact that more efficient monetary policies helped to reduce short-term output volatility and prolong expansions at the expense of recessions, liberalised financial markets have created favourable environment for endogenous “boom and bust” cycles;
in periods characterized by low volatility of inflation and stable economic growth market participants may start underestimating the level of risk …

18. Endogenous Financial Cycles Is What Matters
....
so, during good times when cyclical improvements are confused with long-term boosts in productivity, endogenous virtuous circles can evolve, initiated by the higher readiness of firms and households to take on debt and use it for buying risky assets.
these virtuous circles are characterised by higher asset prices, dampened risk perceptions on the side of both banks and their clients, lower external financing constraints, softer lending standards, accumulation of debt;
against the background of this virtuous circle, sources of systemic risks build up - they often show up after a long lag, when economic activity weakens as a result of some kind of stimulus;
when a contraction occurs, opposite processes take place, vicious circle sets in, leading potentially to financial crisis with large negative impact on economic activity.

19. Minsky revisited
The idea that periods of economic stability encourage exuberance in credit markets, thus sowing the seeds of their own destruction, is a key part of Minsky’s theory of recurring financial crises or financial instability hypothesis (Minsky, 1982).
Minsky described a process in which endogenous speculative bubbles emerge over the cycle due to the behaviour of financial markets:
In good times the incomes grow well above levels required for stable servicing of debts which may over time help to set debt-driven „leveraged“ investment euphoria (or euro-phoria?).
Initially predominant “hedge financiers“ or conservative debtors (who redeem both principal and interest from standard incoming revenues from the investment) are being joined by speculative debtors (able to serve only interest from standard income, but they have to regularly roll over the principal) and finally by Ponzi debtors (fully bet on the growth of the asset price only, not able to service even interest from current incomes).

20. Minsky revisited
If this credit cycle becomes too strong, it will end up in a Ponzi game.
accumulated debts exceed the level at which speculative debtors are able to service debts from current incomes, they become Ponzi debtors and all start selling their assets.
a Minsky moment follows – market participants realize the overvaluation of assets and excess level of their debts, start selling assets on a mass scale, liquidity crisis starts transforming itself into solvency crisis.
banks increase risk margins and tighten lending standards even for financially sound conservative debtors who can subsequently default as well.
Minsky‘s financial instability hypothesis can be well applied not only to the US subprime crisis or to Spanish real estate crisis, but also to global economy generally – conservative debtors like many traditional non-financial firms can go bust once the economic activity goes down due to synchronized decline of demand.

21. Lean Against the Wind, Anchor Liquidity!
The BIS economists decisively challenged the traditional objections to the leaning-against-the wind strategy
as to the bubble identification, they say that it is simply a wrong focus - the proper one should be placed on financial imbalances and not so much on asset price bubbles;
even though identifying financial imbalances ex ante is not easy, it is certain that sustained rapid credit growth combined with large drifts in asset prices increases the probability of a future episode of financial instability;
BIS economists suggest that the role of monetary policy would be to anchor the liquidity creation process and, hence, the availability of external finance, since lending plays a key role in determining money and macroeconomic dynamics.
it is crucial to lean against the build-up of financial imbalances by tightening policy, when necessary, even if near-term inflation pressures are not apparent;
monetary policy oriented towards price stability has to be combined with macroprudential policy oriented towards financial stability.

22. Lean Against the Wind
BIS economists (mainly W. White) strongly argued against “can’t lean, but can clean” policy asymmetry advocated, for example, by Alan Greenspan.
many in the central banking community subscribed to the view that monetary policy would not be effective in “leaning” against the upswing of a credit cycle but that lower interest rates would be effective in “cleaning” up afterwards;
W. White finds the “can’t lean, but can clean” propositions seriously deficient, since monetary policies designed solely to deal with short-term problems of insufficient demand could make medium-term problems worse by encouraging a build-up of debt to unsustainable levels;
instead, monetary policy should be focused more on “pre-emptive tightening” to moderate credit booms than on “pre-emptive easing” to deal with the after-effects.

23. Great Moderation and Risk Disappearance
Although the financial markets did not experienced stabilisation, financial institutions gradually started believing that the Great Moderation, would lead to a fall in credit and market risk.
This resulted in a gradual decline in risk premia (credit spreads, interest rate margins) as a measure of the price of risk of loans and other debt products. The biggest decline in spreads occurred in the middle of the last decade.

24. Great Moderation and Tsunami
Even though this decline was explained at the time by the effects of the Great Moderation and financial institutions’ improved ability to manage risks:
In reality financial markets lost part of their capacity to value risk;
This was fully revealed following the onset of the crisis in 2007 and 2008, when spreads conversely increased dramatically.
In the last decade, therefore, financial markets experienced a tsunami effect, as risk first disappeared from the markets like water from the oceans only to return with a vengeance at the start of the crisis in the form of a destructive tidal wave.
the comparison of the financial crisis with a tsunami was first used by Alan Greenspan on 23 October 2008 in his Congressional testimony - he had in mind the shocking deterioration of credit markets that occurred after the Lehman Brothers failure;
the more important tsunami-like aspect was the near disappearance of credit risk margins from markets in the mid-2000s;
the correct description of the credit tsunami has to take into account both periods of risk motion, i.e. full financial cycle and the movement of systemic risk (its cyclical or time dimension) in the course of it.

25. III. Boom and Bust: Were Small Economies Different?

26. Not Leaning Against the Wind
Economic community in general was aware that the pre-crisis decade was a period of rapid global economic growth on the one hand and the build-up of significant risks due to financial market developments on the other, but there was not much open debate in central banks about making fundamental changes to the existing monetary policy paradigm.
One reason was that financial sector developments played a relatively small role in the prevailing models and the economy was almost always close to equilibrium in them.
And if it did deviate from equilibrium, it was supposed to return quickly to it in a model economy.
As a result, the possibility that the actual economy might in reality have been facing an “original sin” problem was not conceded.
“Original sin” refers to the situation where an economy – owing to endogenous or exogenous events
undergoes a large deviation from equilibrium which can then be maintained in the medium run, for example through monetary policy.
desired elimination of the intertemporal imbalances can be delayed for some time by continuing or accelerating supportive economic policies.

27. Not Leaning Against the Wind
From the current perspective it is quite clear that Western economies were much more overheated before the crisis than indicated by the output gap estimates of that time.
The underestimation of the overheating and its impacts on systemic risk was probably also due to an extraordinary combination of temporary positive technological shocks, the involvement of a whole range of new countries in international trade, and market reforms in the former communist countries. These factors led to a seemingly permanent and pronounced increase in productivity.
The low inflationary pressures observed despite fast economic growth were also due to huge inflows of labour into the world labour market as a result of globalisation (the opening up of China, India and the countries of the former Soviet bloc doubled the global labour supply), which dampened wage costs.
Another important factor in the pre-crisis years was the rapidly rising private sector and government debt levels in a large number of countries.
Monetary approach to balance-of-payments unfortunatelly forgotten even though globalization made it relevant for large economies too.

28. Not Leaning Against the Wind
The debate about the excess global liquidity, that was going on around the middle of the last decade demonstrates that the risks associated with financial market developments were not ignored.
The mix of low nominal and real interest rates, high credit growth and a real estate price boom was observed with remarkable apprehension.

29. „Benign Neglect“ vs. small economies
In the discussions of central bankers in small open economies, different and more structured views could be found - extension of the orthodox work on the small open economy case is Cecchetti et al. (2000, 2002).
Cecchetti et al. (2000) re-examined the issue in the context of a small-scale macroeconomic model in which these two aspects of exchange rate determination were present. The results showed that, on average, the degree of inflation and output volatility was really diminished by directly reacting to the exchange rate misalignment.
Cecchetti et al. (2002), while generally confirming their previous view, admit that the result is model-specific and that monetary policy reactions to the exchange rate should also be conditioned by the underlying sources of these movements.

30. What Benign Neglect Seemed to Ignore
Central banks in small and emerging economies were much more supportive of the views of the leaners/BIS in the pre-crisis boom accompanied by appreciation pressures (2005 example*):
What if a bubble emerges without any signs of inflationary pressures?
inflation measured in terms of consumer prices has not always signalled that imbalances have been building up in the economy.
Scenario for a small open economy:
high economic growth → excessively optimistic expectations → nominal appreciation of the domestic currency → very low inflation can prevail even under rapid credit growth and asset price acceleration for rather a long time → when open inflation pressures finally appear, it may be too late for monetary policy to react.
* Frait, J.-Komárek, L. (2005): Monetary Policy and Asset Prices: What Role for Central Banks in New EU Member States? Conference paper, published in Prague Economic Papers, Vol. XVI, No. 1, 2007.

31. Benign Neglect vs. Small Economies in Practice
With hindsight, both pre-crisis developments and post-crisis experience confirmed the importance of exchange rate movements as a crucial component of both monetary and financial conditions.
The countries in which central banks responded to exchange rate pressures broadly and pragmatically in a flexible inflation-targeting logic that were performing quite well in terms of price and financial stability*.
Such response to appreciation pressures in a booming economy consisted in cutting policy rates a bit, allowing simultaneously for some appreciation of the domestic currency.
How did it work?
* Woodford, M. (2012): Inflation Targeting and Financial Stability. Riksbank Economic Review, 2012:1. 31

32. Currency Appreciation in the IT Economies
Some tough inflation targeters (Sweden, Switzerland and Norway) as well as some other central banks were not fully resisting the appreciation pressures in the pre-crisis boom.
The best examples in this part of the world were the Czechs and Slovaks. 32

33. Currency Appreciation as a Way to Tougher Money
The willingness to allow the value of their currencies adjust made the overall monetary conditions in these economies relatively tough despite the low level of interest rates during the global boom.
by doing so, these countries to some extent avoided the adverse effects of the general asymmetry of pre-crisis monetary policies, focusing on actual or near-term inflation only, no matter how the business and financial cycle evolved.
they applied, albeit sometimes unwittingly, the prescription of the BIS economists, in which a successful leaning against a credit boom requires the central bank to tighten the monetary conditions above the level consistent with fulfilment of the inflation target and reduce inflation below the inflation target.
allowing for appreciation was a textbook response to widening positive output gap – after all, it is measured nominal appreciation of the currency that represents a direct and effective mechanism for achieving the desired counter-cyclical monetary tightening in small open economies. 33

34. The CNB Experience with Pre-Crisis Appreciation Pressures I
An exemplary case of an economy with sustained appreciation pressures was that of the Czech Republic.
the nominal exchange rate appreciation was certainly initially quite unpleasant and for some rather painful.
however, exporters soon learned how to live with the tough exchange rate conditions and factored in the future evolution of these conditions into their expectations.
labour unions realised that currency appreciation improves the purchasing power of workers’ wages; this helped to discipline wage dynamics.
As a consequence of the appreciation pressures, Czech inflation often undershot the inflation target.
In such a situation, the CNB naturally had to keep its policy rate at a similar or even lower level relative to the key central banks in order to avoid a protracted and even deeper undershooting of its target.
in reality this policy served more as a shield against risks from the external environment.
how could that be? 34

35. Strong Currency and Low Policy Rates as a Financial Stability Tool? I
In a booming economy, currency appreciation can contribute to financial stability especially via reducing risk-taking through a “favourable” nominal illusion:
an appreciating currency will decrease the growth rate of nominal income, which may restrict over-optimism regarding its future trend, which can, in turn, slow growth in demand for credit.
under such an “illusion” households will compare low interest rates with slow growth in nominal income, all expressed in the domestic currency.
Seemingly, sustained currency appreciation should create an incentive to borrow in a currency that is becoming cheaper over time, i.e. in foreign currency.
nevertheless, the people are not that rational, they “suffer” from nominal illusions: the share of foreign currency loans provided to households has been lowest in two countries with a history of profound and sustained nominal currency appreciation – the Czech Republic and Slovakia. 35

36. Strong Currency and Low Policy Rates as a Financial Stability Tool? II
There may be other factors specific to a small open economy at play too:
first, if the economy is export-oriented, sustained exchange rate appreciation may work against the formation of overly optimistic expectations in the corporate sector, which tames the potential for credit-enabled excessive investment and creation of unprofitable capacities.
it may also shift part of the existing domestic demand from nontradables to tradables along a long-term trend towards higher consumption of nontradables, thus contributing to more balanced macroeconomic and structural dynamics.
Of course, the idea of using a policy of low interest rates in a small or emerging economy to shield the country from risks stemming from developed countries’ policies may sound strange.
This was not a strategy for any central bank any time, just a specific strategy of some central banks for strange times.
The “global monetary” scene in the pre-crisis years was strange indeed. 36

37. IV. The New Consensus after Tsunami

38. Science of MP – Mishkin (2010) - pre-crisis basic principles
Neoclassical synthesis view (science of MP):
1. Inflation is Always and Everywhere a Monetary Phenomenon.
2. Price Stability Has Important Benefits.
3. There is No Long-Run Tradeoff Between Unemployment and Inflation.
4. Expectations Play a Crucial Role in the Macro Economy.
5. The Taylor Principle is Necessary for Price Stability.
6. The Time-Inconsistency Problem is Relevant to Monetary Policy.
7. Central Bank Independence Improves Macroeconomic Performance.
8. Credible Commitment to a Nominal Anchor Promotes Price and Output Stability

39. Science of MP – Mishkin (2010) - cont.
The objective function and the model (constraints) used by central banks before the crisis reflected all eight principles of the neoclassical synthesis.
However, the approach had an additional important features:
a linear quadratic (LQ) framework in which the equations describing the dynamic behavior of the economy are linear, a basic feature of DSGE models, and the objective function specifying the goals of policy is quadratic.
a representative-agent framework in which all agents are alike so that financial frictions are not present because they require that agents differ
The macroeconomic models used for forecasting and policy analysis did not allow for the impact of financial frictions (efficient markets assumed, no room for a BIS-style credit boom) and disruptions on financial intermediation and economic activity.
With asymmetric information and other sources of inefficiencies ruled out, the financial sector has no special role to play in economic fluctuations.
This naturally led to a dichotomy between monetary policy and financial stability policy in which these two types of policies should be conducted separately.

40. Science of MP – Mishkin (2010) - cont.
Mishkin‘s after-crisis lessons:
Developments in financial sector have a far greater impact on economic activity than we earlier realized.
The macro economy is highly nonlinear.
The zero lower bound is more problematic than we realized.
The cost of cleaning up after financial crises is very high.
Price and output stability does not ensure financial stability

41. Risk-Taking Channel Was a Missing Point
The lessons from the last financial crisis significantly changed the views concerning the relationship between monetary policy, asset prices and financial stability.
Following the lessons from the crisis, both academic economists and central bankers discuss a chance for reaching a new consensus.
The first and apparently most extensive subject of corrections of the “old” framework is the way how the financial sector is covered in existing models.
the changes in the financial sector may have a strong impact on economic activity;
it is necessary to rework fundamentally the way how monetary policy transmission is described in macroeconomic models;
it is crucial to concentrate on the „credit supply channel“ or the „risk taking channel“ which differ from broad credit channel in focusing on credit amplifications due to financing frictions in the lending sector, not in the borrowing sector;
the other important mechanism related to credit supply channel is “bank capital channel” in which monetary policy affects bank lending through its impact on bank equity capital.

42. Preemptive Action Expected Now
The New Consensus is an amended model of flexible inflation targeting (or price-level targeting) in which the central bank “should sometimes lean and can clean”.
financial stability becomes a separate objective of the central bank, affecting its short-term behaviour without changing its long-term commitment to price stability;
the key source of potential financial instability (source of systemic risk) is credit/financial cycle and one of the key concerns of policy has to be containment of procyclicality;
the primary instruments for safeguarding financial stability are still financial market regulation, supervision of financial institutions focusing on sufficient capitalisation and liquidity, and macroprudential policy measures;
monetary policy cannot ignore financial stability and acts preemptively when financial imbalances occur - central banks start to lean against the wind – monetary policy will support macroprudential policy.

43. Missing Channels
Treatment of transmission was clearly oversimplified, especially as regards various channels related to financial institutions’ activities and the tendency to behave pro--cyclically.
Carney (2009) admits that central banks have effectively treated the transmission mechanism as uncertain but fixed when it is in fact highly variable and procyclical – it is a function of regulation, which changes over time; financial innovations, which often evolve to circumvent regulation; and confidence, which is influenced by monetary policy in ways not commonly acknowledged.
Even the models that did encompass financial intermediation usually worked only with a simple “bank lending channel” or “broad credit channel” (Bernanke and Gertler, 1995) containing a financial accelerator mechanism in which interest rate changes affected the credit market through changes in asset and collateral values.

44. Missing Channels
“Credit supply channel” or “risk taking channel” differs from the broad credit channel in focusing on credit amplifications due to financing frictions in the lending sector, not in the sector of non-financial borrowers.
This channel considers the link between monetary policy, the perception and pricing of risk by economic agents, and credit provision.
It provides an explanation of how monetary policy in a booming economy may promote excessive risk taking leading to higher leverage, maturity- and other asset-liability mismatches which make the financial system more fragile.
There are basically three forces behind the channel. First, low returns on investments, such as government bonds, may increase incentives for banks, asset managers and insurance companies to take on more risk, for example to meet a target nominal return. This is the search-for-yield mechanism defined by Rajan (2006).

45. Missing Channels
The second stream focuses on the impact of changes in policy rates on either risk perceptions or risk tolerance and hence on the degree of risk in portfolios, on the pricing of assets, and on the availability of credit.
Borio and Zhu (2008) and Adrian and Shin (2008) explain how low interest rates may affect asset prices, collateral valuations, incomes and cash flows, which in turn can modify how banks perceive and measure risk. The influence on risk perceptions is manifested through procyclical behavior of estimates of probabilities of default, loss given default, volatilities and correlations.
Third, as explained by Borio and Zhu (2008), risk-taking may be boosted by central bank communication, especially by the asymmetrical commitment of to clean in the risk-materialization phase of the financial cycle (the Greenspan put).
The existence of the risk-taking channel has been supported by the empirical findings. Gambacorta (2009) finds evidence of a significant link between the extended period of low interest rates prior to the crisis and banks’ risk-taking associated with the underestimation of the future default rates.

46. Missing Channels
There is another important mechanism interconnected to the credit supply channel – the “bank capital channel” (Van den Heuvel, 2009), in which monetary policy affects bank lending through its impact on bank equity capital. If monetary policy actions affect bank profits, then over time this will accumulate to changes in bank capital.
Starting from a position of a binding capital requirement, any change in bank capital can in turn have a potentially large effect on lending. This particular channel becomes rather important in times of stress, when it restricts lending activity by threatening banks to breach minimum capital requirements.

47. Maddaloni and Peydro (2013):
Missing Channels
Maddaloni and Peydro (2013):
Keeping monetary policy rates too low can increase banks' appetite for credit and liquidity risk due to banks’ moral hazard problems. This, in turn, increases the likelihood of a financial crisis originating by the accumulation of bank risk. But once the risk in the balance sheets of banks realizes and the crisis starts, the banking sector may then need low monetary policy rates to support credit supply for firms and households – especially for the banks with weaker balance sheets.
The paradox is that while low monetary policy rates may induce risk-taking by banks, increasing the probability that a banking crisis occurs, once the crisis starts, the central banks may need to lower the rates to support the weak banking system and avoid a credit crunch, in turn sowing the seeds for the next credit bubble.
We find robust evidence that – prior to the start of the 2008 crisis – low (monetary policy) short-term interest rates soften lending conditions and terms, for both firms and households.

48. Risk of Financial Instability as MP Driver
The object of reaction of monetary authority should be the growing financial imbalances generated by an upswing in the credit cycle, which may potentially result in strong macroeconomic fluctuations.
The risk of financial instability (or the risk of a future crisis), assessed and quantified in a certain way, rather than the level of credit or debt (proxied by the credit-to-GDP ratio), should be the reaction criterion (a reaction threshold for the level of financial sector vulnerability should be set).
Financial stability considerations will become a part of monetary policy reaction only if concluded that certain threshold of financial vulnerability is exceeded, leading to a high risk of financial instability.
In such a situation policy makers will start respecting the need to restrain lending growth and excessive risk taking (leaning phase).
If crisis finally occurs, it will be necessary to offset the sharply increased risk margins with a more pronounced fall in monetary policy rates (monetary policy should clean to a certain extent).

49. Conseptual approach to macroprudential policy
The key concept describing the time dimension of systemic risk over financial cycle is leverage (the indebtedness of economic agents, stocks of loans, the ease of obtaining of external financing, the size of interest rate margins and credit spreads, etc..).
The leverage can be approximated by credit-to-GDP ratio:
increases until the financial cycle turns over; normally the turnover happens in an orderly way (a case of cycle without a crisis in Chart) without a need for an extra policy action.
sometimes the turn is disorderly and presents itself as the eruption of financial crisis.
then leverage starts to decline, although in the early phase of the crisis remains high (given falling nominal GDP it can even rise in the initial post-crisis years).
The deleveraging phase can therefore last several years, and in the event of a deep crisis the leverage ratio can, after a time, fall below its long-term normal value.
consequently, the leverage ratio adjusts to economic conditions after a considerable lag, so stock measures have only a limited information value as a guide for the macroprudential policy response during the financial cycle.
for this reason, forward-looking variables are needed that can be used to identify situations where the tolerable limit for systemic risk has been exceeded.

50. Leverage over credit cycle – a slow motion process
As I already said, our main focus is the time dimension of systemic risk – i.e. the goal is to understand the developments of leverage and its implications for policy throughout the financial cycle.
There are basically 3 analytical tasks: to identify that leverage gets too far in good times, sometimes conclude that serious systemic problems are setting on, and occasionally agree that systemic risks fell enough and policies should be normalized.
It is not easy. The graps basically says that in the accumulation phase of systemic risk, it will be essential to identify the breach of tolerance point and issue a signal for macroprudential tools activation. This is the most difficult task. The first graph on the next slide says that the forward-looking indicators like credit-to-GDP gap, real estate prices gap can be very useful.
If prevention fails in, different indicators have to be used to determine the inception of crisis, assess the seriousness of it and recommend the use of anti-crisis tools in the systemic risk materialization phase. It may not be so difficult, as the second graph on the next slide shows that financial market indicators like credit spreads signal rather clearly that crises comes in and out.
Finally, set of indicators should be used to detect the decline of systemic risk below a critical level and inform about the need to exist from supportive measures and policies. Third graph on the next slide suggests that besides forward looking indicators, the credit risk variables can serve the purpose well too thanks to the financial stability paradox (once they start improving, banks start to accept more risk).
Pozn. JF: těmi gapy vždy rozumíme procentní rozdíl příslušné veličiny oproti dlouhodobému průměru nebo trendu – takže např. credit-to-GDP gap je procentní rozdíl mezi podílem úvěrů na HDP v daném momentu a nějakou normální hodnotou danou např. historickým průměrem. Podobně je tomu u cen nemovitostí. V tom prvním grafu na dalším slidu jsem použil irská data, neboť Irsko zažívá skutečně vzorovou krizi.
Doporučuji přepínat postupně mezi tímto slidem a následujícím. 50

51. Financial Cycle, Financial Stability and Monetary Policy
The framework for New Consensus in a highly stylized form:

52. Financial Cycle, Financial Stability and Monetary Policy
Since debt (leverage) in the stock sense adjusts to changed economic conditions with a significant lag, it cannot be a monetary policy response variable.
It is a backward-looking variable showing only the average extent of risk for financial stability over cycle.
Such a variable must be a forward-looking one that describes the current level of risk for future financial stability (or the instantaneous extent of risk taken by financial firms and their clients).
This variable is termed the (marginal) risk of financial instability.
Marginal risk of financial instability is a strongly discontinuous variable that increases in good times as leverage rises.
A fundamental requirement for growth in this risk – in addition to the availability of cheap credit – is the emergence of overly optimistic expectations about future income and asset prices, which leads to the development of a bubble.
When the bubble bursts and the financial crisis becomes openly visible, the level of this risk changes dramatically.

53. Financial Cycle, Financial Stability and Monetary Policy
Discontinuity may lead to sharp shifts from leaning to cleaning (the case of lack of success or policy failure).

54. Financial Cycle, Financial Stability and Monetary Policy
Policy setting has to counter-balance false signals of systemic risk materialization indicators. 54

55. Global liquidity creation

56. Financial Cycle, Financial Stability and Monetary Policy
The New Consensus in a highly stylized form – policy should counter-balance risk perception.

57. Price of Risk Misalignment as a Policy Rate Driver
In the risk build-up period - monetary policy rates rise above the pure inflation targeting level.
When the crisis breaks out - central bank responds with policy rate cuts below the pure inflation targeting level.
As the economy recovers and conditions set to normal - policy rates are pushed back to their normal trajectory.
Financial exuberance: risk margins too low, leverage accumulation
time
Build-up of risk
Financial distress: risk margins too high, deleveraging phase
marginal risk of financial instability
Monetary policy reaction
policy rates relative to ”pure“ inflation targeting rates
Lean period: policy rates above simple Taylor rule
Clean period: policy rates below simple Taylor rule
policy interest rates
normal contitions

58. Inflation undershooting should be followed by overshooting
MP symmetry calls for compensating the undershooting by extra inflation for some time.
Inflation
Time
Inflation relative to target
In reality, it is not easy after the crisis (zero bound, excess debt, deleveraging, balance sheet recession …). 58

59. Three Different Policy Stages
Normal times
policy rates evolve in line with the normal level consistent with “pure” inflation targeting (i.e. the „Old Jackson Hole Consensus“ inflation targeting ignoring the aspects of financial stability, but not credit channels!).
Leaning phase (financial exuberance period):
central banks accepts and justifies via convincing communication the desirability of setting interest rates at a level higher relative to the one consistent with achieving the inflation target (higher relative to simple Taylor rule) even at the expense of inflation sliding below the target for some time.
Cleaning phase (financial distress period, if leaning not successful):
central bank is not following the simple Taylor Rule either, it acts to offset the sharply increased risk margins with a pronounced fall in monetary policy rates.
Monetary policy will thus partly offset the underestimation and subsequent overestimation of risk by banks and their clients over the financial cycle.

60. Lessons from the Crisis Learned
The flexible inflation targeting concept still valid, but some corrections are acknowledged:
Model framework: representative-agent framework is clearly dead and financial frictions are called for – monetary policy models should be changed substantially,
Operational framework: transmission mechanism is uncertain, highly variable and procyclical - credit supply channel (risk taking channel) focusing on credit amplifications in the lending sector has to be added to the picture,
Analyses: financial stability becomes a separate objective of the central bank: but bubbles and their identification is not a proper focus - the financial imbalances and systemic risk build-up is what matters,
Decision-making: forget about “can’t lean, but can clean” policy asymmetry: monetary policy should be focused more on “pre-emptive tightening” during credit booms than on “pre-emptive easing” to deal with their after-effects.

61. A New Consensus May Have Emerged…
Financial stability analyses must be focused in good times on assessing the risk of financial instability and in bad times on measuring the magnitude of the problem related to the materialisation of risks that were previously “allowed” to build up.
Given the forward-looking nature of monetary policy, central banks’ staff in their financial stability analyses has to focus primarily on the identification of the latent future risks brought about by current developments in the financial sector.
It is rather difficult since the contemporanous indicators talk about the materialization of systemic risk, not about the probability of financial instability in the future.
What is needed is a set of forward-looking indicators providing the insight into the potential for financial imbalances. 61

62. … challenges remain
We learned the hard way how to cope with the impacts of loose monetary policies of major central banks in pre-crisis times.
now we are learning how to do so post-crisis times*.
Global monetary conditions may still make the first-best monetary policy outcome (policy rates reflecting the development of economic activity and domestic inflation pressures with relative stability of the exchange rate) not available.
it may become necessary to work hard and smart to achieve the second-best result,
swings in business and financial cycles plus “euro area policy-making” make creative and flexible approaches inherent.
Co-ordination of monetary and macroprudential policies could be necessary:
frequent switches in both policies may make the framework less efficient and not so predictable.  
* Filardo, A., Genberg, H., Hofmann, B. (2014): Monetary analysis and the global financial cycle: an Asian central bank perspective. BIS Working Papers No. 463. 62

63. The Zero Lower Bound Is Reality
Policy rates in number of economies hit the zero lower bound in coping with volatile external conditions
symmetrically to the pre-crisis times, in smalll economies, the exchange rate factor should help to set the overall monetary conditions right again, this time in the depreciation direction.
The authorities in countries with fixed exchange rates (or in currency unions) may resort to monetary policy measures other than policy rates and interventions, as well as to macroprudential policies if needed.
the story of some euro area economies shows that having neither autonomous monetary policy, nor effective national macroprudential policy is dangerous.
Diverse states of business/financial cycles and financial market structures make creative and specific approaches inherent:
there is no room for one-size-fits-all models. 63

64. References
Bean C, Paustian M, Penalver A, Taylor T (2010): Monetary Policy after the Fall. Federal Reserve Bank of Kansas Economic Policy Symposium, Jackson Hole, Wyoming, August 26–28.
Bernanke B, Gertler M (1999): Monetary Policy and Asset Price Volatility, Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter, pp. 17–51.
Bernanke B, Gertler M (2001): Should Central Banks Respond to Movements in Asset Prices? American Economic Review, Vol. 91, No. 2, May, pp. 253–257.
Bernanke B (2002): Asset-Price “Bubbles” and Monetary Policy. Remarks before the New York Chapter of the National Association for Business Economics, New York, October 15, 2002,
BORIO C., FURFINE C. AND LOWE, P. (2001): Procyclicality of the financial system and financial stability: issues and policy options”, in “Marrying the macro- and microprudential dimensions of financial stability”, BIS Papers, No. 1, March, pp. 1–57
BORIO, C – SHIM, I. (2007): “What can (macro)-prudential policy do to support monetary policy. BIS Working Papers, no 242, December.
BORIO, C. - P. LOWE, P. (2001): To provision or not to provision. BIS Quarterly Review, September 2001, pp
BORIO, C. - WHITE, W. (2004): Whither monetary and financial stability? The implications of evolving policy regimes. BIS Working Paper, No. 147, February 2004.
BORIO, C. (2003): Towards a macroprudential framework for financial supervision and regulation? BIS Working Paper, No. 128, February
BORIO, C. (2009), Implementing the macro-prudential approach to financial regulation and supervision, Banque de France Financial Stability Review, No. 13 — The Future of Financial Regulation, September 2009.

65. References
BORIO, C.-DREHMANN, M. (2009), Towards an operational framework for financial stability: fuzzy measurement and its consequences. BIS Working Paper, No. 284, June 2009.
BRUNNERMEIER, M. et al. (2009): The Fundamental Principles of Financial Regulation. Geneva Reports on the World Economy 11. International Center for Monetary and Banking Studies, January 2009
Cecchetti S, Genberg H, Wadhwani S (2002): Asset Prices in a Flexible Inflation Targeting Framework. NBER working paper series. National Bureau of Economic Research. No
Fahr S, Motto R, Rostagno M, Smets F, Tristani O (2010): Lessons for monetary policy strategy from the recent past, Paper presented at ECB Central Banking Conference Monetary Policy Revisited: Lessons from the Crisis, Frankfurt, 18–19 November
Mishkin F (2010): Monetary Policy Strategy: Lessons from the Crisis. Paper presented at ECB Central Banking Conference Monetary Policy Revisited: Lessons from the Crisis, Frankfurt, 18–19 November
Posen A (2006): Why Central Banks Should Not Burst Bubbles. International Finance 9:1, 2006: pp. 109–124.
Posen A (2009): Finding the Right Tool for Dealing with Asset Price Booms, Speech to the MPR Monetary Policy and the Economy Conference, London, December
White W (2002): Changing views on how best to conduct monetary policy, BIS Speeches, 18 October
WHITE, W. (2006): Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?, BIS Working Papers, no 193, January.
WHITE, W. (2009): Should Monetary Policy "Lean or Clean"? Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute, Working Paper No 34 (August 2009).

66. References
Woodford M (2010a): Financial Intermediation and Macroeconomic Analysis Journal of Economic Perspectives—Volume 24, Number 4—Fall 2010—Pages 21–44
WOODFORD, M. (2012): Inflation Targeting and Financial Stability. Riksbank Economic Review, 2012:1
WOODFORD, M. : “Monetary Policy and Financial Stability,” a presentation at the NBER Summer Institute, Cambridge, Massachusetts, July 15, 2011b.; NBER Working Paper 17967,