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«I. Introduction The Institute for Monetary and Economic Studies (IMES) of the Bank of Japan (BOJ) held the 2014 BOJ-IMES Conference, entitled ...»

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D. Monetary Policy, Financial Conditions, and Financial Stability9 Adrian discussed the roles of monetary and macroprudential policies by reviewing the literature on the monetary policy transmission channel and macroprudential policy tools. First, he reviewed the literature regarding the risk-taking channel of monetary policy through which expansionary monetary policy could lead to a buildup of financial vulnerabilities such as compressed risk premiums, excessive leverage, and excessive maturity transformation. This channel gave rise to a risk-return tradeoff between financial conditions and financial stability, which complemented the traditional tradeoff of monetary policy between inflation and real activity via a potential impact of financial vulnerabilities on future real activity. Next, he discussed the extent to which macroprudential policy could mitigate monetary policy’s risk-return tradeoff by reviewing the literature on the usage of monetary and macroprudential policies to address financial vulnerabilities in asset markets, the banking sector, the shadow banking sector, and the nonfinancial sector. He argued that while countercyclical macroprudential policies were the first-order defense against buildups of vulnerabilities, monetary policy might also be a useful tool for addressing vulnerabilities when macroprudential policies were insufficient due to their limited impacts on the shadow banking and nonfinancial sectors, their limited international reach, and long lags in their effects. He also pointed out that countercyclical macroprudential policies would also influence financial conditions and thus the stance of monetary policy, and argued that monetary and macroprudential policies should be jointly determined. Finally, Adrian noted that although monetary and macroprudential policies could be aligned in many instances, there might be potential conflicts when monetary policy tried to be accommodative based on the current output gap and inflation while vulnerabilities were accumulated. In this case, he argued that future tail risk due to the potential of a financial crisis must be weighed against current conditions.

The discussant, Frank Packer (Bank for International Settlements), praised the presented paper for attempting a deeper consideration of the interaction between monetary and macroprudential policies. Then he pointed out that monetary and macroprudential policies could work in different dimensions and thus their interaction could differ from the authors’ expectations. As an example, he mentioned the limits on real

9. For details, see Adrian and Liang (2014).

9 estate lending by banks imposed in 1990 in Japan. One of the outcomes of the limits was a shift in bank lending to housing finance companies, which arguably exacerbated problems after the bursting of the bubble. He also mentioned the issue of the composite financial conditions index used in the paper and argued that due attention should be paid to the features of individual variables in constructing the composite index. Regarding topics on macroprudential policy, he referred to recent research at the Bank for International Settlements on the effectiveness of macroprudential policies that showed the ratio of debt service to income was one of the most robust instruments in terms of significantly affecting the growth of credit to the housing sector. Finally, he pointed out that cross-border credit growth could exacerbate domestic credit booms and stressed the importance of policies to ameliorate the buildup of cross-border debt.

From the floor, Kocherlakota asked if there was a good historical example of conflicts between monetary and macroprudential policies such that central banks conducted accommodative monetary policy under a negative output gap, low inflation, and a buildup of financial vulnerabilities. He also asked if there was cross-border evidence that monetary policy easing in a large country led to the buildup of vulnerabilities in other countries. In reply, Adrian remarked that it was difficult to pin down the period of the conflict because it depended on how long it took for vulnerabilities to build up and for the policy effects to last, and mentioned that the United States tended to give crossborder issues little attention because it had been a relatively closed economy. Jordan asked about the relationship between structural and cyclical macroprudential policies.

Adrian replied that cyclical policies had to take structural policies into account as given and structural problems were expected to be fixed in the long run. Ito raised the question of whether indifference curves could be drawn in the chart of monetary policy’s risk-return tradeoff to find an optimal point in the balance between financial conditions and vulnerabilities. Snorre Evjen (Norges Bank) asked about the kind of financial stability indicators that central banks should monitor and target. Goodfriend proposed that financial vulnerabilities related to a short-term credit boom be distinguished from others, since the impact of vulnerabilities would be only second order without shortterm credit boom. Liew Yin Sze (Monetary Authority of Singapore) pointed out that since exchange rates had a significant impact both on output and inflation outcomes in Asian economies, policymakers had to adopt a multi-pronged approach to reduce exchange rate volatility and maintain domestic macroeconomic and financial stability at the same time; in this regard, calibrating macroprudential policy measures in real time amid volatile cross-border capital flows could be challenging.

E. Post-Crisis Slow Recovery and Monetary Policy10 In the aftermath of the recent financial crisis and subsequent recession, slow recoveries have been observed in many countries. Takushi Kurozumi (Bank of Japan) presented a model that was able to describe such slow recoveries resulting from an adverse financial shock in the presence of endogenous growth in total factor productivity (TFP), and reported an analysis of optimal monetary policy in the face of the financial shock. If a negative financial shock hit the economy, firms’ borrowing capacity shrank and the

10. For details, see Ikeda and Kurozumi (2014).

10 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014 Monetary Policy in a Post-Financial Crisis Era demand for investment and labor dropped. A decrease in demand caused a drop in supply in the long run, as the low demand discouraged investment in technology adoption as well as research and development (R&D) and thereby decreased TFP. In such an environment, the optimal monetary policy rule that maximized social welfare featured a strong response to output, as opposed to optimal monetary policy rules in a standard model that featured no response to output. A strong and timely monetary easing mitigated not only a decrease in demand in the short run but also a drop in TFP in the long run. Kurozumi showed that a nominal GDP growth or level targeting rule performed well because it reacted to output, while a strict inflation or price-level targeting rule induced a sizable welfare loss because it had no response to output. Comparing the optimal monetary policy rule with a discretional monetary policy in a simulated crisis scenario, he mentioned that a regime shift to the optimal monetary policy rule was desirable, since the discretional monetary policy could suffer from the zero interest lower bound. Finally, he emphasized that to obtain these results it was crucial to take into account the welfare loss resulting from a permanent decline in consumption caused by a drop in TFP.

The discussant, Mark A. Wynne (Federal Reserve Bank of Dallas), mentioned that in the United States deep recessions tended to be followed by strong recoveries, in line with Milton Friedman’s “plucking theory” of business cycles. Wynne noted, however, that this theory did not apply to the recent recovery because economic activity had been weak, underperforming the pre-crisis growth trend. He commented that the presented paper was an important step toward understanding slow recoveries and the role of monetary policy, and made two suggestions to improve the model. First, he commented that the authors should use a more general borrowing constraint in their model because the borrowing constraint played an important role in propagating the effect of financial shock. Second, he suggested that an important next step would be to deal with the zero lower bound issue explicitly and try to model monetary policy as it had actually been conducted in the wake of the recent financial crisis. He concluded that addressing the next step would deepen understanding of the mechanism of slow recoveries and the effect of monetary policy during and after a crisis.

From the floor, Adrian asked about any direct evidence on the role of TFP in a financial crisis. In reply, the co-author, Daisuke Ikeda (Bank of Japan), mentioned the literature that empirically showed a drop in R&D in the manufacturing sector after the financial crisis in the late 1990s in Japan. Kurozumi added that after the recent financial crisis a slowdown in TFP had been observed particularly in the United Kingdom and the euro area. Goodfriend suggested that it would strengthen the authors’ argument on monetary policy if they could provide empirical evidence on the relationship between financial conditions and productivity growth. Kocherlakota mentioned a sharp decline in TFP in 1929–33 followed by a strong recovery in TFP in 1933–37, and commented that it would be interesting if the presented model could capture such a phenomenon. Ikeda answered that with some modifications to the modeling of R&D the model could explain such a decline and recovery in TFP. Finally, the session chair, Jun Il Kim (Bank of Korea), commented that the transmission mechanism of monetary policy presented in the paper was a large departure from conventional thinking in the sense that monetary policy in the presented model worked on not only the demand

–  –  –

VI. Policy Panel Discussion In the policy panel discussion moderated by Obstfeld, six panelists, Jordan, Mersch, Hiroshi Nakaso (Bank of Japan), Charles I. Plosser (Federal Reserve Bank of Philadelphia), Raghuram G. Rajan (Reserve Bank of India), and Tucker presented wide-ranging issues relevant to central banks’ policies during and after the recent financial crisis, and this was followed by a general discussion from the floor. Obstfeld began the panel discussion by posing several questions to panelists: how well could central banks conduct forward guidance policy; what did we know about the process of exiting from the current unconventional monetary policy; how did central banks deal with spillover effects from one country to another; how well had policymakers improved international coordination; and how should monetary policy deal with financial stability in relation to macroprudential policy.

A. Remarks by Panelists Jordan described the situation of the Swiss economy after the recent financial crisis, and discussed the policy reaction of the Swiss National Bank (SNB) against the impact of spillovers of accommodative monetary policy conducted in larger economies.

During and after the crisis, the Swiss franc had appreciated significantly against all major currencies due to its safe-haven characteristics and a shrinkage in the interest rate differentials. Because this appreciation put strong downward pressure on the Swiss consumer prices, in the end the SNB introduced a minimum exchange rate policy to prevent deflation. Although this policy was considered to be an emergency measure at the time it was introduced, it became the key policy measure due to the Swiss franc’s long-lasting strength. This was due not only to the weakness of the global economic recovery but also to the continuing highly accommodative monetary policies in major economies, which differed from the situation in the 1970s, when the SNB had introduced a similar measure for the first time. On top of this, he mentioned the concern that a prolonged period of very low interest rates could create financial stability problems. He noted that while monetary policy should be used mainly to achieve the goal of price stability to avoid deflation, macroprudential tools such as a countercyclical capital buffer should be used to achieve the goal of financial stability.

Mersch discussed the ECB’s forward guidance and the possibility of QE policy as a policy option in the future. Regarding the former, he first explained that the ECB’s forward guidance took the form of qualitative guidance conditional on the assessment of three areas: the inflation outlook, the real economy, and unutilized capacity. He stated that qualitative forward guidance worked well in the sense that it lowered the expected level of future interest rates and reduced market uncertainty surrounding this level by clarifying the ECB’s policy intentions. At the same time, he pointed out that date-based guidance could be misinterpreted as an unconditional commitment, and that outcome-based guidance might need to repeatedly communicate conditionality with increasingly complex systems of thresholds as targeted variables approached their 12 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014 Monetary Policy in a Post-Financial Crisis Era numerical thresholds. Regarding other policy options, he commented that QE seemed suited to cope with a significant fall in aggregate demand and the risk of falling inflation expectations. He noted, however, that the ECB should be mindful of the potential risks and side effects, such as financial stability concerns and moral hazard problems in private investment behavior. The side effects also included concerns regarding the independence of central banks, because some interaction with fiscal policy could occur under QE policies. He also commented on the possibility of international cooperation.

He mentioned that it was important to improve the analytical framework to gain a better understanding of the international propagation of shocks and prepare for rapid and coordinated action in exceptional circumstances. Having said this, he noted that each central bank had its own constitutional mandates and could not exceed them because of the need for democratic legitimacy.

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