Lars E O Svensson: Inflation targeting after the financial crisis
Speech by Prof Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at the
International Research Conference "Challenges to Central Banking in the Context of
Financial Crisis", Mumbai, 12 February 2010.
* * *
I thank Charles Bean, Claes Berg, Alan Blinder, Stephen Cecchetti, Chuck Freedman, Charles Goodhart, Lars
Nyberg, Irma Rosenberg, Hyun Shin, Frank Smets and Staffan Viotti for discussions of these issues. The views
expressed here are my own and not necessarily those of other members of the Riksbank's executive board or of
the Riksbank's staff. Hanna Armelius and Hans Dellmo of the Riksbank's staff contributed to this speech.
As the world economy begins to recover from the financial crisis and the resulting deep
recession of the global economy, there is a lively debate about what caused the crisis and
how the risks of future crises can be reduced. Some blame loose monetary policy for laying
the foundation for the crisis and there is a lively debate about the future of monetary policy
and its relation to financial stability. Here I will discuss the lessons for inflation targeting after
the crisis. My view is that the crisis was not caused by monetary policy but mainly by
regulatory and supervisory failures in combination with some special circumstances.
Ultimately, my main conclusion for monetary policy from the crisis so far is that flexible
inflation targeting, applied in the right way and using all the information about financial factors
that is relevant for the forecast of inflation and resource utilization at any horizon, remains the
best-practice monetary policy before, during, and after the financial crisis. But a better
theoretical, empirical and operational understanding of the role of financial factors in the
transmission mechanism is urgently required and needs much work, work that is already
underway in academia and in central banks.
So I will focus on two particular issues: whether monetary policy caused the crisis and what
the possible lessons for future monetary policy are.1
Best practice before the crisis: Flexible inflation targeting
It is probably not a surprise to hear that I consider flexible inflation targeting the best-practice
monetary policy. The Riksbank and all the other inflation-targeting central banks conduct
flexible inflation targeting rather than strict inflation targeting. Flexible inflation targeting
means that monetary policy aims at stabilizing both inflation around the inflation target and
the real economy, whereas strict inflation targeting aims at stabilizing inflation only, without
regard to the stability of the real economy, what Mervyn King (1997) has described as being
an "inflation nutter". By stabilizing the real economy I mean stabilizing resource utilization
around a normal level, keeping in mind that monetary policy cannot affect the long-term level
of resource utilization.2
Because of the time lags between monetary-policy actions and their effect on inflation and
the real economy, flexible inflation targeting is more effective if it relies on forecasts of
inflation and the real economy. Therefore, flexible inflation targeting can be described as
"forecast targeting": the central bank chooses a policy-rate path so that the forecast of
inflation and resource utilization "looks good." By a forecast that looks good I mean a
forecast for inflation and resource utilization that effectively stabilizes both inflation around
the inflation target and resource utilization around a normal level. In the event of conflicting
objectives, it achieves a reasonable compromise between the stability of inflation and the
stability of resource utilization. Different central banks express this in slightly different words.
The Riksbank has often used the term "well-balanced" monetary policy.3
The forecasts of inflation and the real economy are then conditional on the central bank's
view of the transmission mechanism, an estimate of the current state of the economy and a
forecast of important exogenous variables. The central bank uses all relevant information
that has an impact on the forecast of inflation and the real economy. In this framework, the
central bank takes financial conditions such as credit growth, asset prices, imbalances,
potential asset price bubbles and so on into account only to the extent that they have an
impact on the forecast of inflation and resource utilization. Inflation and resource utilization
are target variables, that is, variables that the central bank tries to stabilize. Financial
conditions are not target variables. Instead, they are only indicators, as they provide
information to the central bank about the state of the economy, the transmission mechanism
and exogenous shocks. Financial conditions then affect policy rates only to the extent that
they have an impact on the forecast of inflation and resource utilization.4
Now, is there any reason to modify this view of monetary policy given the experience of the
financial crisis so far? Let me approach this question by first asking what the causes of the
financial crisis were, whether monetary policy contributed to the crisis, and whether a
different monetary policy was warranted and could have prevented or reduced the size of the
crisis.
The financial crisis was not caused by monetary policy
Many have claimed that excessively easy monetary policy by the Federal Reserve after 2001
helped cause a bubble in house prices in the U.S., a bubble whose inevitable bursting
proved to be a major source of the financial crisis.5 However, as I see it, the crisis was mainly
caused by factors that had very little to do with monetary policy and were mostly due to
background macro conditions, distorted incentives in financial markets, regulatory and
supervisory failures (also when central banks have been responsible for regulation and
supervision), information problems and some specific circumstances, including the U.S.
housing policy to support home ownership for low-income households.6
The macro conditions preceding the crisis included low world real interest rates associated
with global imbalances, as well as the Great Moderation, with a long period of very stable
growth and stable low inflation, which led to a systematic underestimation of risk and very
low risk premia in financial markets. There were distorted incentives for commercial and
investment banks to increase leverage that were made possible by lax regulation and
supervision and the lack of an appropriate bank resolution regime. There were also distorted
3
The idea that inflation targeting implies that the inflation forecast can be seen as an intermediate target was
introduced in King (1994). The term "inflation-forecast targeting" was introduced in Svensson (1997), and the
term "forecast targeting" in Svensson (2005). See Woodford (2007a, b) for more discussion and analysis of
forecast targeting.
4
Several central banks that do not call themselves inflation targeters effectively do conduct flexible inflation
targeting, although they may not be quite as transparent about their inflation target, the role of stability of the
real economy, etc.
5
See, for instance, Taylor (2007).
6
See Bean (2009) for an extensive and excellent discussion of the crisis, including the credit expansion and
housing boom, the macroeconomic antecedents, the distorted incentives, the information problems, the
amplification and propagation of the crisis into the real economy, the policy responses and the lessons for
monetary policy and economics generally. The Bank for International Settlements (2009) provides a more
detailed account of the possible macro- and microeconomic causes of the crisis.
BIS Review 16/2010
incentives to exercise less due diligence in loan origination because of securitisation and to
conduct regulatory arbitrage by setting up off-balance-sheet entities, which for various
specific reasons ended up still effectively remaining on the balance sheet. There were also
distorted incentives for traders and fund managers to take excessive risks because of myopic
and asymmetric remuneration contracts. There were eventually enormous information
problems
in assessing the risks of extremely complex asset-backed securities, and there was
a huge underestimation of the potential for correlated systemic risks. None of these causes
had anything to do with monetary policy, except that monetary policy may have contributed
to the Great Moderation.
Regarding the role of Federal Reserve monetary policy in the crisis, there are two relevant
questions. First, was the low interest rate reasonable given the information available at the
time? Second, could a different monetary policy with higher interest rates have prevented the
crisis? The first question, whether the low interest rate was reasonable given the available
information, is the relevant one when evaluating monetary policy. It is more relevant to
evaluate policy taking into account the information available ex ante to the policymaker rather
than information ex post that was unknown to the policymaker at the time (see Svensson,
2009a, on evaluating monetary policy ex ante and ex post).7 During the period in question,
given the information available, there was a genuine and well-motivated fear of the U.S.
falling into a Japanese-style deflationary liquidity trap, and the optimal policy in such a
situation is a very expansionary monetary policy.8 It may be that, in retrospect, the risk of
deflation was exaggerated, but there was no way to know this ex ante. Hence, I consider the
expansionary policy very appropriate. Adding some ex post evaluation, one can note that it
did not lead ex post to very high inflation or an overheated economy.9
The second question, whether a different monetary policy could have prevented the crisis, is
relevant when assessing to what extent monetary policy can be blamed for causing the
crisis, notwithstanding if it was reasonable from an ex ante perspective. The credit growth
and the housing boom in the U.S. and elsewhere were very powerful. Real interest rates
were low to a large extent because of global imbalances, the global saving glut and
investment shortage. I believe that somewhat higher interest rates would have made little or
no difference. Empirical evidence indicates that only a small portion of house-price increases
can be attributed to monetary policy.10 Bernanke (2010) shows that the recent phenomenon
of a higher share of adjustable-rate mortgages was unlikely to have significantly increased
the sensitivity of house prices to monetary policy. The availability of new, more exotic
mortgage types mattered much more for initial mortgage payments than the level of
shortterm interest rates. In my view, interest rates would probably have had to be raised very high
so as to cause considerable damage to the real economy in order to stop the credit growth
and housing boom.11 That could have thrown the U.S. right into Japanese-style deflation and
eventually a liquidity trap. Certainly, higher interest rates would have had no impact on the
regulatory problems, distorted incentives and information problems mentioned above
(although they could have ended the Great Moderation with a deep recession and
deflation).12
However, going beyond the Fed's actual monetary policy, perhaps it is possible that the
Fed's emphasis on its readiness to relax monetary policy aggressively in the wake of a sharp
fall in asset prices, as expressed by Greenspan (2002) for example, may have induced
expectations of a floor under future asset prices and contributed to the asset-price boom, the
so-called Greenspan put (Miller, Weller and Zhang, 2002). Arguably, this is more of a
communication issue than one of actual policy, and less emphasis on the readiness to clean
up after a sharp fall in asset prices might have been a preferable alternative.
The International Monetary Fund (2009, Chapter 3) has investigated the role of monetary
policy in causing financial crises. A large number of countries and financial crises were
included in the sample. The conclusion is that "the stance of monetary policy has not
generally been a good leading indicator of future house price busts... There is some
association between loose monetary policy and house price rises in the years leading up to
the current crisis in some countries, but loose monetary policy was not the main, systematic
cause of the boom and consequent bust." Further-more, the overall relationship between the
stance of monetary policy and house-price appreciation across countries in the years before
the current crisis is statistically insignificant and economically weak, and monetary policy
differences explain only about 5 percent of the variability in house price appreciation across
countries.13
Lessons for flexible inflation targeting
What conclusions can we draw so far from the financial crisis about the conduct of monetary
policy and any need to modify the framework of flexible inflation targeting? One obvious
conclusion is that price stability is not enough to achieve financial stability (Carney 2009,
White 2006). Good flexible inflation targeting by itself does not achieve financial stability, if
anyone ever believed that. Specific policies and instruments are needed to ensure financial
stability.
Another conclusion is that interest-rate policy is not enough to achieve financial stability.
Other instruments like supervision and regulation, including appropriate bank resolution
regimes, should be the first choice for financial stability. In many countries, the responsibility
for these instruments rests on authorities other than the central bank. Generally, to the extent
financial instability depends on specific distortions, good regulation should aim to attack
these distortions as close to the source as possible. To counter the observed procyclicality of
existing regulation, macro-prudential regulation that is contingent on the business cycle and
financial indicators may need to be introduced to induce better financial stability. Possible
macro-prudential regulation includes variable capital, margin, and equity/loan requirements.
As expressed by Bean (2009), "the best approach is likely to involve a portfolio of
instruments".14
More generally, what is the relation between financial stability and monetary policy? Financial
stability is an important objective of economic policy. A possible definition of financial stability
is a situation when the financial system can fulfil its main functions (of submitting payments,
channelling saving into investment and providing risk sharing) without disturbances that have
significant social costs. I find it helpful to conceptually distinguish financial-stability policy
from monetary policy. Different economic policies and policy areas, such as fiscal policy,
labor market policy, structural policies to improve competition, etc., can be distinguished
according to their objectives, the policy instruments that are suitable for achieving the
objectives, and the authority or authorities controlling the instruments and responsible for
achieving the objectives. Monetary policy in the form of flexible inflation targeting has the
objective of stabilizing both inflation around the inflation target and resource utilization
around a normal level. The suitable instruments are under normal circumstances the policy
rate and communication, including possibly a published policy-rate path and a forecast of
inflation and the real economy. In times of crisis, as we have seen during the current crisis,
other more unconventional instruments can be used, such as fixed-rate lending at longer
maturities, asset purchases and foreign-exchange intervention to prevent currency
appreciation. The authority responsible for monetary policy is typically the central bank.
Financial-stability policy has the objective of maintaining or promoting financial stability. The
available instruments are under normal circumstances supervision, regulation and
financialstability reports with analyses and leading indicators that may provide early warnings of
stability threats. In times of crisis, there are instruments such as lending of last resort,
variable-rate lending at longer maturities, special resolution regimes for financial firms in
trouble, government capital injections and so forth. The responsible authority or authorities
vary across countries. In some countries it is the central bank, in other countries there is a
separate financial supervisory authority, sometimes the responsibility is shared between
different institutions. In Sweden, the Financial Supervisory Authority is responsible for
supervision and regulation, the Riksbank is responsible for lending of last resort to solvent
banks and for promoting a safe and efficient payment system, while the National Debt Office
is responsible for the resolution of failed banks. During times of crisis, these authorities
cooperate closely with the Ministry of Finance.
My point here is that financial-stability policy and monetary policy are quite different, with
different objectives, instruments and responsible authorities, the latter with considerable
differences across countries. This does not mean that there is no inter-action between them.
Financial stability directly affects the financial markets, and financial conditions affect the
transmission mechanism of monetary policy. Problems in financial markets may have a
drastic effect on the real economy, as the current financial crisis has shown. Monetary policy
affects asset prices and balance sheets and can thereby affect financial stability. But the fact
that financial-stability policy and monetary policy are conceptually distinct, with distinct
objectives and distinct suitable instruments, has to be taken into account when considering
the lessons of the financial crisis for monetary policy. In particular, it makes little sense to
extend the mandate of monetary policy to include financial stability.15
What are the specific conclusions for flexible inflation targeting? One important lesson from
the financial crisis is that financial factors may have a very strong and deteriorating effect on
the transmission mechanism, making standard interest-rate policy much less effective. This
motivates more research on how to incorporate financial factors into the standard models of
the transmission mechanism used by central banks. A rapidly-increasing volume of such
research is now being produced by academic and central-bank researchers and presented at
an increasing number of conferences on financial factors and monetary policy. Important and
challenging questions include how potential output and neutral real interest rates are affected
by financial factors and financial distortions (Curdia and Woodford 2009, Walsh 2009), and
what impact financial factors have on the general equilibrium effects of alternative policy-rate
paths on inflation and resource utilization forecasts.16
Even with much better analytical foundations concerning the role of financial factors in the
transmission mechanism, there will of course, as always, be considerable scope for the
application of good judgment in monetary policy.
Another conclusion, which is not new, is that consideration of the impact of financial factors
on the forecast of inflation and resource utilization may require longer forecast horizons.
Several inflation-targeting central banks (including the Bank of England, Norges Bank and
the Riksbank) have for other reasons already extended their forecast horizon from the
previously common two years to three years. There is nothing that in principle prevents an
inflation targeter from considering forecasts beyond a three-year horizon, but in practice
there is usually little information about anything at longer horizons except the tendency to
revert to the long-term average.
What about "leaning against the wind" (as advocated by, for instance, Borio and White, 2003,
and Cecchetti, Genberg and Wadhwani, 2002), the idea that central banks should raise the
interest rate more than what appears to be warranted by inflation and resource utilization to
counter rapid credit growth and rising asset prices? It has sometimes not been quite clear
whether advocates of leaning against the wind mean that credit growth and asset prices
should be considered targets and enter the explicit or implicit loss functions alongside
inflation and resource utilization, or whether they mean that credit growth and asset prices
should still be considered just indicators and are emphasized only because credit growth and
asset prices may have potential negative effects on inflation and resource utilization at a
longer horizon. In the latter case, leaning against the wind is a way to improve the stability of
inflation and resource utilization in the longer run. Then it is completely consistent with
flexible inflation targeting.17
However, in line with the previous discussion, instruments other than interest rates are likely
to be much more effective in avoiding excessive credit growth and asset-price booms, and
should thus be used as a first best alternative. Interest rates that are high enough to have a
noticeable effect on credit growth and asset prices may have strong negative effects on
inflation and resource utilization, and a central bank will probably rarely have sufficient
information about the likely beneficial longer-horizon effects on inflation and resource
utilization for the trade-off to be worthwhile and motivated.18
16
Walsh (2009) points out that when financial factors cause distortions, these distortions will in general introduce
corresponding terms in a loss function for monetary policy that is a second-order approximation to household
welfare. Curdia and Woodford (2009) present a model where the second-order welfare approximation is a
standard quadratic loss function of inflation and the output gap between output and potential output, but where
potential output is affected by financial factors. Then inflation and the output gap remain the target variables,
with and without financial factors. The neutral rate in the model, that is, the real rate consistent with output
equal to potential output, is then also affected by financial factors.
17
Adrian and Shin (2007, 2009) argue, in a model with a risk-taking channel as in Borio and Zhu (2008), that
short interest-rate movements may have considerable effects on the leverage of securities broker-dealers in
the market-based financial sector outside the commercial-banking sector. However, new regulation may affect
the magnitude of these affects, and the size of the market-based financial sector may end up being smaller
after the crisis. In Europe, the commercial banks dominate the financial sector.
18
Kohn (2006, 2008) specifies three conditions that should be fulfilled for central banks to take "extra action" to
deal with a possible asset-price bubble: "First, policymakers must be able to identify bubbles in a timely
fashion with reasonable confidence. Second, a somewhat tighter monetary policy must have a high probability
that it will help to check at least some of the speculative activity. And third, the expected improvement in future
economic performance that would result from the curtailment of the bubble must be sufficiently great." He
concludes, also in 2008 and after thorough considerations, that those conditions would rarely be met. See also
Kohn (2009).
BIS Review 16/2010
In particular, if there is evidence of rapidly-rising house prices and mortgage loans, and these
developments are deemed to be unsustainable and a possible bubble, there are much more
effective instruments than policy rates. Restrictions on loan-to-value ratios and minimum
mortgages and requirements of realistic cash-flow calculations for house buyers with realistic
interest rates are much more effective in putting a break on possible unsustainable
developments than a rise in the policy rates. In particular, more transparency about future
policy rates, in the form a policy-rate path published by the central bank, may help in
providing realistic information about future interest rates.
Ultimately, my main conclusion from the crisis so far is that flexible inflation targeting, applied
in the right way and using all the information about financial factors that is relevant for the
forecast of inflation and resource utilization at any horizon, remains the best-practice
monetary policy before, during, and after the financial crisis. But a better theoretical,
empirical and operational understanding of the role of financial factors in the transmission
mechanism is urgently required and needs much work, work that is already underway in
academia and in central banks.
The outcome might very well be that financial factors are considered to have a larger role in
affecting the transmission mechanism and as indicators of future inflation and resource
utilization. If so, central banks would end up responding more to financial indicators, in the
sense of adjusting the policy rate and policy-rate path more to a given change in a financial
indicator. However, this would not mean that financial factors and indicators have become
independent targets besides inflation and resource utilization in the explicit or implicit
centralbank loss function. Instead, it would be a matter of responding appropriately to financial
indicators in order to achieve the best possible stabilization of inflation around the inflation
target and resource utilization around a normal level over time.
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