1. Financial imbalances in the monetary policy decision David Vestin
Trinity Workshop, Nov 7, Princeton
Disclaimer: The views expressed here are my own and should not be interpreted as reflecting the views of Sveriges Riksbank.

2. Issues
Swedish policy-debate: sado-monetarism or normal IT with an imbalance flirt?
How can financial imbalances quantitatively be factored into the monetary policy decision?

3. The Swedish policy debate

4. Sado-monetarism?

5. Because of debt-concerns?
Percent of disposable income
Note. The dashed line represents the Riksbank's forecast.
Sources: Statistics Sweden and the Riksbank

6. CPI: User cost+variable rates, tail-chase

7. Some role for leaning – but CPIF higher and similar to other countries
Mostly here!

8. Inflation forecast, July 2010
Even if we can see strong economic development ahead, cost pressure will be fairly low. This is primarily due to…
However, we believe that inflation will approach the target of 2 per cent.
Annual percentage change
Sources: Statistics Sweden and the Riksbank

9. Factoring in residual financial imbalances in the MP decision

10. Why should MP be concerned with financial imbalances?
Imbalances can lead to low inflation, high unemployment
Macro-pru not in place – MP provides temporary bridge
Macro-pru instruments too weak, can be circumvented…
Possible narrow aim of macro-pru: only ”systemic” risk
Similar transmission channels, co-ordination needed?

11. Policy problem
How to weigh risks to households balance sheet with ”normal” monetary policy considerations
We illustrate a simple example:
Extend policy horizon
Model ”bad scenario”
Model how monetary policy affect p(bad scenario)

12. Foundation Svensson (1997)
𝑳= 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐
Schularick and Taylor (2012): p(crisis) = f(real credit growth)
BVAR: real credit groth = f(interest rate)
Alternative interest rate paths: through MP shocks

13. Pragmatic inflation targeting
Forecasting period of 3 years
Loss = 𝟏 𝟑 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐
Construct a main forecast, based on models, judgement
Policy options: consider higher/lower rate path
Use unanticipated monetary policy shocks
Reasonable if temporary deviation

14. Lengthen forecast horison
Risks can build, even if inflation forecast on ”target”
Risks ”beyond the forecasting horison”
Loss = 𝟏 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐
I.e. same targets for monetary policy, but now T=10
Two alternative interest rate paths, High and Low

15. Lenghten forecast horison Unemployment

16. Model ”Bad scenario”. Based on IMF (2012) Unemployment

17. Short-run vs. longer-run risks
E(Loss) =𝑬 𝟏 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐
𝑬 𝟏 𝟑 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐 𝒑∗𝑪𝒓𝒊𝒔𝒊𝒔 + 𝟏−𝒑 ∗𝟎
shortrun(x) p(x) Crisis
x: path for interest rate Crisis: loss during crisis
Comparing two alternatives, High and Low:
Diff = shortrun(H) – shortrun(L) (P(H)-P(L)) Crisis

18. Quantifying the probability of a crisis: Schularick and Taylor:
p(crisis) linked to growth in real debt, 𝑆 𝑡
𝑝 𝑡 = exp⁡( 𝑋 𝑡 ) 1+exp⁡( 𝑋 𝑡 )
𝑋 𝑡 =−3.89−0.40 𝑆 𝑡− 𝑆 𝑡− 𝑆 𝑡− 𝑆 𝑡− 𝑆 𝑡−5
Average value of S is 4.4% -> average p is 3%
BVAR-model: real debt for alternative interest rate paths

19. Another way to illustrate…
Crisis = 𝟒 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐 +𝝀 𝒖− 𝒖 ∗ 𝟐
(x) = 𝐄 𝟏 𝟑 𝝅− 𝝅 ∗ 𝟐 +𝒑(𝒙) 𝟒 𝟏𝟎 𝝅− 𝝅 ∗ 𝟐
U(x) similarly…
_diff = (H) - (L)

20. Difference in squared losses, CPIF
Difference between High and Low Negative value = good for low-interest rate alt
Bad for lower path
Main scenario
P constant
P depends on MP
Higher impact rate->debt
Higher impact debt -> risk
Higher impact on both
Unemployment
Difference in squared losses, CPIF
Good for lower path

21. Conclusions
Room for concern for imbalances within standard flexible inflation targeting
Concern for imbalances aims at achieving sustainable economic developments
Benchmark calibration and example of an economy in recession: short run cost of leaning higher than long-term benefit

22. Pescatori, Laséen and Vestin (2015): Crisis in near term
A crisis can be triggered every period, Markov chain
If crisis hits, inflation = non-crisis inflation – delta (like in Svensson, 2015)
New dimension:
Presense of risk LOWERS the main inflation forecast
Current state interacts with crisis size to determine Loss
If p does not depend on MP, leaning WITH the wind
If p depends on MP, less leaning than when crisis can only occur from steady state

23. Example
Example calibration: IRFS for inflation and unemployment from Ramses, credit from BVAR
If we start from a case where E(pi)=2 and E(u)=u*, then about 6 bps leaning is ”optimal”
What matters is RELATIVE effect of i on pi,u and p
Doubling the ST-coefficients leads to more leaning

24. Interest rate

25. Inflation an unemployment

26. Real credit growth

27. Probability of crisis

28. Alternative versions
Crisis state as in Ajello et. al; if crisis occurs, inflation = constant
Crisis-profile: An n-state Markov chain where the different crisis stages have different delta
Prel. result: Slightly stronger case for leaning, as interaction of short-run cost and crisis decreases
Estimate BVAR-models for large number of countries

29. Effects from interest rates to debt can be larger if misperceptions… Debt/disposable income, Walentin (2013)

30. Issues Systematic leaning -> expectational effects
Need dynamic DSGE version, extend Woodford (2011)?
Work in Gerali et.al. model, effects of macro pru?
Allows analysis of steady-state issues like Barro-Gordon etc.
Financial crisis can lead to permanent LEVEL effects?
GDP, unemployment
Much more costly than fluctuations (Lucas…)
Non-linearities in MP->Credit, Credit->p
Disaggregated credit analysis focusing on ”bad” credit growth
Leeper suggest analog to fiscal-limit: house-hold limit…