Jean-Pierre Danthine: Reconciling price and financial stability
Speech by Mr Jean-Pierre Danthine, Member of the Governing Board of the Swiss National
Bank, at the University of Zurich, Zurich, 24 January 2012.
* * *
I would like to thank Pierre Monnin, Anna Faber and Adriel Jost for their invaluable support in drafting
this paper. I also thank Rita Kobel, Peter Kuster, Reto Nyfeller, Dewet Moser and Angelo Ranaldo for
their insightful comments.
It is a great pleasure for me to be with you today at the University of Zurich to discuss an
issue that the recent financial crisis has exposed as a major challenge to central banks;
namely how they can best contribute to ensuring financial stability while pursuing price
stability as a primary mandate.1 Before I do this, however, let me say a few words on another
dimension of stability: institutional stability. As you are all aware, the Swiss National Bank
(SNB) recently experienced an unfortunate event which has few, if any, historical precedents.
On a personal level, I deeply regret the resignation of Philipp Hildebrand, under whose
leadership the SNB steered Swiss monetary policy over the last two years. On an
institutional level, however, I would like to stress that the SNB's institutional strength is the
result of teamwork, not only between the board members, but across the Bank as a whole.
The SNB's culture is one of excellence and of service. It is the product of a long history and
many generations of leaders. It remains as strong as ever. Despite the difficult conditions
and the unusual challenges that have characterized the last two years, all important
monetary policy decisions have been reached by consensus, a consensus which emerged
from in-depth and intensive analyses and discussions. The current course of Swiss monetary
policy, particularly the decision to introduce a minimum exchange rate, is the result of a
deep-rooted consensus of this kind. The SNB will thus continue to enforce the minimum rate
with the utmost determination and remains prepared to buy foreign currency in unlimited
quantities. The Swiss franc is still highly valued, but it should depreciate further in the future.
Let me now return to my topic. I will start by presenting general pre-crisis assessments of the
state of monetary policy and will then examine how central banks' policies may have
contributed to the financial crisis. After considering these issues, I will be in position to
assess the alternative courses of action available to central banks in general, and the SNB in
particular, to derive principles for a future in which financial and price stability are better
reconciled with one another.
I. The Great Moderation: a success of monetary policy?
Let me start by considering the state of many developed economies, to include Switzerland,
before the onset of the crisis. In contrast with the episodes of high inflation which prevailed in
the 1970's, rates of inflation were subsequently stable and low for some twenty years. This
period, which is commonly referred to as the "Great Moderation", was also characterized by
low real GDP volatility and low interest rates. Slide 1 illustrates these developments in the
cases of the United States and Switzerland in this period.
Though there is no definitive analysis of the causes of the "Great Moderation", monetary
policy is regularly cited as a contributing factor.2 This accords well with observations that
major progress had been made in identifying the determinants of inflation, understanding the
importance of central bank independence and therefore in improving the conduct of
monetary policy. At the methodological level, these developments are generally linked to the
concept of "inflation-targeting"3 and summarized in a class of macroeconomic models, which
Marvin Goodfriend and Robert King4 have named "the New Neoclassical Synthesis". This
label tells of an approach that combined key elements of Keynesian and classical thinking.
While the new models made conditional forecasting possible and permitted scientifically
appropriate policy evaluations, they only included primitive financial sectors. In their current
state, they therefore cannot address issues of financial stability or the link between low
interest rates and financial excesses.
II. The recent financial crisis: are central banks the culprits?
The recent financial crisis has thrown the positive pre-crisis perceptions of modern monetary
policy into question. Indeed, many analysts now attribute a certain degree of responsibility for
the financial crisis to central banks, in sharp contrast with the typically benevolent
assessment of their contributions to the "Great Moderation". Two main lines of argument
support claims that central banks were contributed to the crisis, as Slide 2 illustrates. The
first is that the precepts of the "inflation-targeting" paradigm were misapplied and that these
policy errors have contributed to, or have directly caused, the crisis. The second is that the
paradigm itself is deficient, or at least incomplete. Indeed, even when central banks conduct
monetary policy optimally, according to the "inflation-targeting" mantra, it is a mistake for
them not to recognise that a long period of low interest rates may encourage financial
intermediaries to take increased risks with negative consequences for systemic stability.
One clear proponent of the first argument is John B. Taylor. Taylor has argued that the Federal
Reserve contributed to the crisis by setting interest rates too low prior to 2007. Although price
stability was achieved, monetary policy in the United States was, in his view, inappropriately
conducted, given the level of inflation and the size of the output gap, as attested by significant
deviations from the "Taylor rule", a benchmark he first proposed in 1993.5
The "Taylor rule" recommends that central banks systematically adjust nominal interest rates
in response to macroeconomic developments and inflation movements, but, between 2002
and 2005, they were lower than the "Taylor rule" advised, as Slide 3 illustrates. According to
Taylor,6 monetary policy may have been too expansionary, certainly in the United States and
the Euro area. Taylor even suggests that, if central banks had set higher interest rates in this
period, the subsequent housing bubble and the global financial crisis might have been
avoided.7 According to this view, the crisis stemmed from a misapplication of the
"inflationtargeting" precept. The underlying models may be unable to explain why an excessively
accommodative policy would lead to a financial crisis. The episode does not, however, imply
that the entire monetary policy paradigm has to be revisited, nor that financial stability is
incompatible with price stability.
Slide 4 illustrates the "supply shock" hypothesis. Here, the crux of the argument is that
monetary policy was too expansionary because the impact of supply shocks on prices was
underestimated. This, in turn, prompted miscalculations of the output gap. As one can see, in
the United Kingdom and in Switzerland, the prices of those goods which were most
influenced by imports increased far more slowly than those of services, which were less
import-dependent. One plausible explanation for this is that the availability of cheap imports
from Asia (or Eastern Europe) acted as a positive supply shock, thus reducing the relative
price of imports. If the supply shock had been temporary, it would have provoked lower
transitory inflation and the optimal monetary policy response would have been to do nothing,
except to let the economic forces at play re-establish an equilibrium and normal inflation
levels.8 In recent decades, however, the pressures associated with globalization have borne
greater resemblance to a permanent series of shocks. As these shocks were interpreted as
temporary, they were disregarded from a policy perspective, which, it is argued, caused
monetary policies to be excessively expansionary.
Both of these views suggest that central banks could have potentially helped prevent the
crisis by setting higher interest rates and that they should have done so if the
"inflationtargeting" precepts had been fully understood and optimally followed. In both cases,
however, the underlying models would have predicted that such policy failures would have
prompted overproduction and excessive rates of inflation, rather than a financial crisis.
The third hypothesis I would like to discuss is the theory of the "risk-taking channel". This
newer line of argument is that, even if monetary policy was optimally conducted before the
crisis, the prevailing low interest rates provided fertile ground for miscalculation and
excessive risk-taking by financial intermediaries, thus contributing to the crisis. According to
this view, the "inflation-targeting" paradigm itself is deficient in the sense that it does not take
into account the negative externality of a policy exclusively aimed at price stability imposes
on financial stability. In Claudio Borio and Haibin Zhu's9 terms, "changes in policy rates have
an impact on either risk perception or risk-tolerance and hence on the degree of risk in
portfolios, on the pricing of assets, and on the price and the non-price terms of the extension
of funding". In other words, a long period of low interest rates drives financial intermediaries
to take increased risks. Empirically, there is a growing body of evidence to indicate that a
channel of this kind exists.10
There are three main versions of the "risk-taking channel". Every one of them suggests that,
while low interest rates might be the natural consequence of price stability, they may
ultimately compromise financial stability. The first hypothesis, is that hedge-fund and wealth
managers, who tend to be paid according to the nominal returns on their investments, might
be prone to taking additional, possibly excessive, risks when interest rates are low and, as a
result, they might receive lower levels of compensation.11 To the best of my knowledge,
empirical studies which support or dismiss this claim have been yet to be carried out.
The second hypothesis12 is that low interest rates increase the value of the collateral backing
up loans. Banks thus have less incentive to monitor their clients' loans.13 This view is
empirically better documented, but the supporting evidence is ambiguous.14
Finally, the third hypothesis is that banks with access to cheaper external funding increase
their leverage to achieve higher returns on equity. This change in banks' balance sheet
structure tends to make the banking sector more fragile. There is some evidence to support
this argument. For example, Slide 5 reports the results of simulating how banks in the United
States adjust their external funding to changes in monetary policy. It suggests that when
central banks increase interest rates, banks significantly decrease their external funding for
the next two years or so.15
The "Taylor rule", the "supply shock" hypothesis and the "risk-taking channel" theory all have
one common feature. Every one of them acknowledges the possibility that interest rates may
have been too low prior to the crisis, though their proponents may disagree as to whether, or
to what extent, this was the result of a policy or paradigm failure. There is also consensus
that this may have contributed to the financial instability that followed, although only the
theory of the "risk-taking channel" clearly suggests how this would have come about.
III. "Leaning against the wind": an unfavourable trade-off between financial
stability and output growth
If interest rates were indeed too low in the pre-crisis years, it would appear that by raising
them central banks could have helped avoid, or at least contain, the crisis. When this calls for
deviations from otherwise optimal policy, one talks of "leaning against the wind". In economic
upturns, this would involve central banks setting higher interest rates than would be
necessary to achieve price stability alone. The objective would be to avoid the overvaluation
of assets, to constrain excessively risky behaviour on the part of financial intermediaries and
hence to prevent bubbles from emerging, or at least to reduce their size.
In contrast, Alan Greenspan was widely credited for supporting a "clean up after bubbles"
approach. This basically involves central banks actively sustaining the economy after an
asset price bubble has burst, rather than using monetary policy to try to prevent the bubble
from developing in the first place. The rationale for this approach is that it is more
costeffective overall, as bubbles are very hard to identify. Erroneously implemented "leaning
against the wind" policies could well impose significant economic costs with no real
subsequent benefit.
The huge cost of the recent financial crisis has decreased the weight of such objections to
"leaning against the wind". It is therefore important to further examine the potential of a
preventive policy. Charles Bean et al16 strive to estimate the impact a "leaning against the
wind" would have had on asset prices and real output in the recent financial crisis. The charts
in Slide 6 show the simulated impact on credit, real estate prices and GDP growth of a policy
which would push US interest rates 200 basis points higher than were actually observed
between 2003 to 2006. The slide illustrates that the simulated policy would probably have
kept real house prices some 7.5 percent lower than they were at their peak. The simulated
policy would probably also have prompted a significant drop in cumulative real GDP growth,
estimated at about 3.3 percent. These higher interest rates would, however, only have had a
limited impact on credit growth, i.e. they would theoretically have reduced a 30 percent credit
growth to around 27 percent. As a result, it is not clear that the simulated policy could have
significantly reduced the probability of a real estate bubble developing. Another study of
OECD countries by Katrin Assenmacher-Wesche and Stefan Gerlach,17 estimates that, to
obtain a 10% decrease in property prices, central banks would have to sacrifice between
2.3 and 4.0 percentage points of real GDP growth. In turn, Christian Hott and Pierre Monnin18
estimate that house prices were overvalued by some 25 percentage points in the US in 2005
and by approximately 50 percentage points in the UK in 2006. Together, these two studies
suggest that a drop of between 9 and 10 percentage points of real GDP in the US and
between 11.5 and 20.0 percentage points in the UK would have been necessary to totally
erase the two countries real estate bubbles. These results highlight the unfavourable
tradeoff between financial stability and output growth when "leaning against the wind" is the only
instrument available to address the former. They also strongly suggest that, even if central
banks had optimally followed the "inflation-targeting" principles (or the "Taylor rule") ahead of
the crisis, the higher interest rates that would have resulted would not have been sufficient to
prevent the emergence of a bubble and the ensuing financial crisis.
IV. How might systemic risk be reduced?
The unfavourable trade-off I have just highlighted provides a powerful incentive to explore
the potential of alternative instruments. This is where "macro-prudential tools" come into play.
These tools focus on directly addressing the vulnerabilities to which the financial system as a
whole is exposed. Their strength is that they target the problem directly at the root. Slide 7
summarizes the two main dimensions of systemic risk: the "structural" dimension, which
covers the possible risks associated with individual institutions whose failure would endanger
the entire system; the "cyclical" dimension refers to systemic risks which are not directly
linked to an individual institution, but which stem from financial institutions' collective
responses to business or financial fluctuations and adverse shocks. "Structural tools" strive
to reduce the impact of institutional failure by strengthening individual institutions. Their
potential utility is often cited with regard to institutions which are considered "too big to fail" or
"too interconnected to be liquidated" and whose failure would impact the entire system.
"Countercyclical tools" aim to address the cyclical dimension of risk by reducing feedback
loops. As Slide 8 shows, these are designed to counter problems associated with the actions
of individual financial institutions, which can lead them all to act in the same way after an
initial shock, thus amplifying the initial movements of the markets and leading to a new wave
of similar reactions.19 This is because individual financial institutions tend to react to a shock
by shedding risks, either because it is rational to do so or because regulation oblige them to
do so. If the system is not designed with the explicit aim of stopping such movements, a
negative cycle can set in with dangerous consequences for individual institutions and the
system as a whole.
Countercyclical measures are intended to modulate, reduce and potentially prevent such
instability. The aim of "capital buffers" is to ensure that, in good times, banks acquire capital
base that is well above the minimum. The buffers can then be released in more difficult
times, allowing financial institutions to absorb substantial asset price falls before legal
constraints become binding. They should thus help avoid the mentioned pro-cyclical
behaviour that typically leads to so-called "fire sales".
What is appealing in theory is not necessarily easy to implement in practice. Few doubt that
there are challenges to defining and calibrating the indicators used to determine when capital
buffers should be triggered, and by how much. However, to quote Borio, "while calibration is
not straightforward, the difficulties can be overstated".20 To support his claim, Borio notes that
traditional monetary policy also confronts such challenges when interest rates are set on the
basis of indicators, such as output gaps or natural interest rates which are unobservable and
difficult to measure accurately. It is however commonly accepted that central banks have, to
a large extent, surmounted these difficulties.
Of course, countercyclical buffers cannot be implemented without inflicting some costs to the
economy, but the trade-off involved seems significantly more favourable than is the case with
"leaning against the wind" policies. A 2011 study by the Bank of International Settlements
estimates that, by reducing the probability of a severe crisis, the benefit of countercyclical
buffers is on average 10 times higher than their costs in terms of real output growth per year.
V. The Swiss case
Every central bank in the world faces its versions of the challenges I have mentioned. The
Swiss National Bank is no exception. Indeed, the SNB's position is particularly challenging as
the Swiss economy is small and open, which potentially makes it more vulnerable to any
negative fall-out which may stem from the trade-off associated with policies which
"leanagainst-the wind". As the current situation of the Swiss economy makes all too clear, the
impact of a high interest rate policy on the exchange rate would surely increase the
associated output loss. It is therefore crucial that the Swiss authorities implement the most
cost-effective measures to counter the financial excesses which may lead to a crisis.
Indeed, the Swiss authorities are currently pursuing a comprehensive agenda of
macroprudential measures. From a structural perspective, in 2011 the Swiss Parliament passed a
package of measures aimed at reducing the systemic impact of potential failure of those
institutions classed as "too big to fail". These banks will now be asked to retain extra capital
reserves. They will also be required to improve their liquidity positions, diversify their risks
and propose a scheme by which they will ensure the continuation of their systemically
important functions, should they find themselves in financial difficulty. This new regulatory
regime will come into force on 1st January 2013, pending approval of the associated
directives by Parliament. Second, after a round of consultations that just ended, the Federal
Council is soon expected to decide upon a proposal to introduce a new risk-weighting system
for mortgage-related assets. From a cyclical perspective, a proposal to ensure that banks
implement countercyclical capital buffers was part of the recent consultations and is also
pending approval by the Federal Council. The proposal foresees that the ultimate decision to
activate or modify the capital buffer requirement will lie with the Federal Council. This
decision will be made on the basis of the SNB's proposal and the FINMA's response to it.
Finally, in order to enhance the SNB's capacity to assess the stability of the financial system
and to take appropriate measures, the Bank has also called for improved access to
information on financial institutions.
VI. Conclusion
The preceding discussion has, I hope, clarified some of the complex interactions between
price and financial stability. Within the Swiss legal framework, I am convinced that the central
bank has been given an appropriate mandate. In order of priority, the SNB must ensure price
stability, while taking due account of the developments of the economy. It must also
contribute to the stability of the financial system. One important lesson to emerge from the
analysis of the recent crisis is that an interest rate policy cannot be the sole, or even the main
instrument, used to promote financial stability. It is imperative that central banks be endowed
with alternative "macro-prudential" instruments. This assessment is not only the product of
careful application of the "Tinbergen principle", according to which one needs as many
instruments as one has objectives. On a deeper level, this conclusion is based on the
recognition that, from a welfare perspective, a "leaning against the wind" policy would clearly
be dominated, by instruments which target the root causes of those problems generated by
excessive risk-taking in times of low interest rates.
8 BIS central bankers' speeches
BIS central bankers' speeches 9

BIS central bankers' speeches 11
References
Altunbas, Yener, Leonardo Gambacorta and David Marqués-Ibáñez. 2010. Does monetary
policy affect risk-taking. European Central Bank Working Paper, No. 1166, 11 March 2010.
Angeloni, Ignazio, Ester Faia and Marco Lo Duca. Monetary policy and risk-taking. 2010.
Bruegel Working Paper 2010/00, February 2010.
Assenmacher-Wesche, Katrin and Stefan Gerlach. 2010. Monetary policy and financial
imbalances: facts and fiction. Economic Policy, Volume 25, Issue 63, Pages 437-482,
July 2010.
Bean, Charles, Matthias Paustian, Adrian Penalver and Tim Taylor. 2010. Monetary policy
after the fall. Paper presented by Mr. Charles Bean, Deputy Governor of the Bank of England
at the Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, Wyoming,
28 August 2010.
Bean, Charles. 2006. Impact of globalisation on monetary policy: commentary. Proceedings.
Federal Reserve Bank of Kansas City. pp. 307-313.
Bernanke, Ben. S. 2010. Monetary policy and the housing bubble. Speech at the Annual
Meeting of the American Economic Association, Atlanta, Georgia. 3 January 2010.
Borio, Claudio. 2011. Anchoring countercyclical buffers: the role of credit aggregates. Bank
for International Settlement Working Paper, No. 355, November 2011.
Borio, Claudio and Haibin Zhu. 2008. Capital regulation, risk-taking and monetary policy: a
missing link in the transmission mechanism? Bank for International Settlements. BIS Working
Papers. No. 268, December 2008.
Brunnermeier, Markus and Lasse Pedersen. 2009. Market liquidity and funding liquidity. The
Review of Financial Studies, 22, pp. 2201-2238.
Buch, Claudia M., Sandra Eickmeier and Esteban Prieto. 2011. In search for yield? Survey
based evidence on bank risk taking. Paper provided by the Deutsche Bundesbank Research
Centre. Discussion Paper Series I, Economic Studies, number 2011, 10.
Danielsson, Jon, Hyun Song Shin and Jean-Pierre Zigrand. 2011. Endogenous and systemic
risk. First version, July 2010. This version, August 2011.
Dell'Ariccia, Giovanni, Luc Laeven and Robert Marquez. 2010. Monetary policy, leverage and
bank risk-taking. IMF Working Papers 10/276, International Monetary Fund. 1 December 2010.
Hott, Christian and Pierre Monnin. 2008. Fundamental real estate prices: an empirical
estimation with international data. The Journal of Real Estate Finance and Economics.
Springer, vol. 36(4), pp. 427-450, May.
Goodfriend, Marvin and Robert G. King. 1997. The new neoclassical synthesis and the role
of monetary policy in Ben S. Bernanke and Julio J. Rotemberg, eds., NBER Macroeconomics
Annual 1997, Cambridge, Massachussetts, MIT Press, pp. 231-83.
Kohn, Donald L. 2007. Financial stability: preventing and managing crises. Speech by the
Vice Chairman of the Board of Governors of the Federal Reserve System at the Exchequer
Club Luncheon. Washington DC, 21 February, 2007.
Morris, Stephen and Hyun Song Shin. 2004. Coordination risk and the price of debt.
European Economic Review. Elsevier, vol. 48(1), pp. 133-153, February.
Rajan, Raguhuram G. 2005. Has financial development made the world riskier? NBER
Working Papers. No. 11728. National Bureau of Economics Research, Inc.
Taylor, John B. 1993. Discretion versus policy rules in practice. Carnegie-Rochester
Conference Series on Public Policy 39, pp. 195-214.
Taylor, John B. 2009. The financial crisis and the policy responses: an empirical analysis of
what went wrong. NBER Working Paper 14631, National Bureau of Economic Research,
Cambridge, MA, January 2009.