José De Gregorio: Inflation targeting and financial crises
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the seminar on
financial crises Seminario Internacional de Crisis Financieras, organized by Banco de la
Fondo de Garantías de Instituciones Financieras de
República de Colombia and the
Colombia, Bogota, 28 May 2009.
I thank the valuable comments and insights of Luis Felipe Céspedes, Pablo García, Luis Opazo and Enrique
Orellana.
* * *
Thank you so much for this invitation. It is an honor to return after so many years to speak at
a conference organized by Banco de la República and FOGAFIN. The subject this time
Financial
around, Crises, is particularly timely, with the world struggling through a crisis
whose effects are still difficult to predict and that has propagated through the world with
unprecedented strength and synchrony (Figure 1).
Macroeconomic policies face major challenges in trying to cushion the effects of a crisis. Its
origin, magnitude and degree of propagation make stabilizing the economy a particularly
complex task. High uncertainty and, in some cases, poor functioning of key aspects such as
credit markets, have affected the monetary policy transmission channels in a number of
countries.
The current crisis is providing a unique opportunity to continue fostering the design of
economic policy frameworks that permit us to react to different shocks in the best way
possible while at the same time reducing the vulnerability of our economies.
The current situation raises many questions, some of which we had already been discussing
at the theoretical level. Meanwhile, it contributes the necessary evidence to dig into such
questions more deeply. Although we must detect the flaws and fix them to prevent episodes
like this to happen again, we must also identify what has operated properly and should
continue to be part of our macroeconomic and financial policies. In particular, a proposition
that permeates my presentation today is that the current turmoils have shown the
advantages of inflation targeting regimes committed credibly with an inflation anchor.
As the crisis we are going through keeps reminding us, price-level stability must occur hand
in hand with proper regulation of the financial system. Our region has learned these lessons
the hard way, after severe crises that were created when we lost sight of macroeconomic
and financial stability.
In this juncture, the region has withstood like never before the effects of the international
crisis. In the past, when the world got a cold, the region got pneumonia; today it is the other
way around, our countries suffering just a cold while the developed world is with pneumonia
(Figure 2). This comparatively good performance is no reason for complacency, as in our
countries it is more urgent to avoid large cycles that affect disproportionately the poorest
members of society, especially those most detached from the social safety nets.
Today, I intend to address two very important aspects of the discussion about monetary and
financial policy making. First I want to refer to the origin of this financial crisis and its linkage
with monetary policy. Some arguments point out that the current crisis was originated by
monetary policy mistakes, particularly in the United States, where low interest rates are
blamed for the housing bubble and subsequent financial meltdown. Some have even claimed
that inflation targeting regimes are inadequate, because monetary policy should also aim at
controlling asset price inflation. And this is precisely the second point in my presentation, that
is, whether interest rates should react to asset price movements or not, and what is the role
played by the exchange rate.
To sum up, and insisting on a point I have made before, there are many cases of countries
that lowered their interest rates substantially without triggering any housing bubbles. There
are also cases of countries with very low interest rates where home prices soared, but still
their financial systems did not end up in a financial disaster like they did in some developed
economies.
This crisis, or at least the magnitude it has reached, is the result of financial fragility and we,
in Latin America, are well aware that when a cyclical downturn is combined with a financial
crisis, the impact is magnified. Central banks generally have two objectives: price-level
stability and financial stability. Recent history reminds us that we cannot pursue both with
one single instrument, the interest rate. We also need a regulatory framework that ensures
financial stability, a feature that countries like Chile and Colombia have succeeded in
preserving in the actual juncture.
The causes of the crisis: was it monetary policy or was it financial fragility?
The argument attributing a leading role in the current crisis to monetary policy claims that low
interest rates combined with large current account surpluses in emerging economies,
particularly Asian and oil-exporting ones, created an abundance of liquidity that triggered
excessive increases in asset prices (bubbles). This was particularly important in the value of
real estate assets. When the bubble burst, the crisis erupted. Then, this argument claims that
the housing bubble was caused by monetary policy, which failed to act opportunely and
permitted severe imbalances to accumulate. Nonetheless, one must bear in mind that
soaring asset prices do not necessarily end up in a crisis like this one. Closer attention must
be paid to the financial fragility that accompanied this process, whose main culprit was the
unrestrained financial innovation that generated deep distortions that neither markets nor
regulators were able to predict.
An expansionary monetary policy can undoubtedly induce an excessive increase in the
prices of assets and credit. The role of monetary policy, in our case carried out through an
inflation targeting regime, is to smooth the business cycle. Therefore, it is possible to think
that a very expansionary monetary policy can exacerbate an economic boom. Likewise, such
a policy will have serious consequences on output once the monetary impulse is withdrawn.
However, an expansionary monetary policy could not explain by itself the severity of the
financial collapse the world is seeing today.
There are countries where the monetary policy was expansionary, with interest rates at their
minimum, and no housing bubble occurred. A couple of examples are Canada and Chile, two
inflation targeters where, consistently with this policy framework, interest rates hit very low
levels not so different from the Fed Funds rate (Figure 3). Still, housing prices generally did
not experience increases comparable with those of other economies, and their financial
systems have remained sound.
Furthermore, in some cases housing prices did go up high, with clear signals of a bubble
being formed. However, their financial systems made it through and remained stable and,
despite the current difficulties including very recessive episodes, have avoided acute
financial crisis. This is the case with, for example, Australia and Spain.
Naturally, when facing disproportionate increases in the price of housing, both the level of
borrowing and the building boom associated with it are symptoms that the downturn that
comes with the cycle will be severe. This is because of the deleveraging that households will
have to undertake and the contraction of the building activity. Still, this need not result in a
systemic financial crisis.
In any case, monetary policy can and does help in the creation of bubbles, although not so
much by the level of the interest rate but by the monetary policy strategy with which financial
turmoil is dealt with. In the United States, the strategy of turning a blind eye to the period of
soaring asset prices and then cleaning the mess when it was already there used to be long
considered appropriate (Blinder and Reis, 2005). The cleansing consisted in cutting the
interest rates and granting all the necessary liquidity for the market to continue operating.
This approach was first used on the "Black Monday" of October 1987, then with the
breakdown of Long-Term Capital Management (LTCM) and later with the bursting of the
high-tech bubble. In all these occasions, once the asset prices reversed down, there was an
abrupt relaxation of the monetary policy.1 This implicit insurance, popularly known as the
Greenspan put, certainly makes the creation of bubbles more likely. Sadly, having worked for
some earlier episodes, it lost its power with the biggest collapse in decades. A monetary
policy strategy that used to provide insurance to speculation in episodes of limited financial
turbulence proved incapable of confronting a systemic financial crisis. And it is possible that
the very "risk management" strategy had as a consequence that a great collapse was bound
to happen sooner or later.
The final verdict is yet to be seen. This strategy certainly contributed to increase liquidity, but
low interest rates need not result in a financial crisis as I have illustrated with these few
examples. An inflation-targeting policy that in some circumstances determines an
extraordinary monetary impulse is perfectly compatible with preserving financial stability.
An overview to the experience of several economies suggests that the culprit of the current
crisis was related more closely with the functioning of financial systems than with monetary
policy. One issue that will have to be carefully examined in the future is the cause of the real
estate boom and the housing crisis, and why it occurred in the United States. At this point it
is clear that lending standards were excessively lowered. Ellis (2008) shows that in the U.S.,
households had strong motivation to increase their leverage through tax, legal and regulatory
incentives.
One key element of financial innovation was the creation of structured instruments. With
them, banks could reduce their individual risk levels and expand their operations into
formerly unexplored market segments. Recent evidence proves that the risk of these
instruments was wrongly evaluated by rating agencies and by credit originators. Credit
structuring also debilitated the central role of banks in the selection of their clients.2
Securitization did not maintain the incentives for banks to properly screen their customers or
for them to meet payments. The compensation structure was based on the number of
operations rather than on their quality.
This is a clear example that, if not accompanied by credit risk management measures at the
individual level and proper systemic prudential regulation and supervision, encouraging
access to mortgage loans by formerly excluded sectors, a praiseworthy goal without a doubt,
may end up substantially weakening the financial positions of not only the ones being
intended to help in the first place but also the financial system at large.
Inflation targeting and asset prices
A corollary of those blaming monetary policy is that, apart from focusing on the variation of
the prices of goods and services, it should also have asset prices in mind.
Under inflation targeting regime, increased lending and asset prices can generate demand
increases with repercussions on inflationary perspectives. This would require a monetary
policy adjustment to prevent a persistent rise in inflation. Hence, in an inflation targeting
regime, asset prices and the level of credit aggregates affect the monetary policy decision to
the extent that they affect the inflation perspectives (Bernanke and Gertler, 1999).
However, some argue that monetary policy should react directly to asset prices, for example
by including them in the Taylor rule. Cecchetti et al. (2000) are perhaps the best
representatives of this position, claiming that any inflation-targeting central bank should react
beyond
to asset price misalignments their implications on expected inflation over the policy
horizon.
In my view, there are three reasons why monetary policy, in general, should not react to
asset prices beyond their impact on projected inflation. First, it is not clear that an increase in
interest rates will be capable of stopping an increase in asset prices. The required
adjustments might be so large that they could end up unnecessarily generating high
unemployment and an unwelcome drop in inflation. Second, what matters here is to
safeguard the stability of the financial system. An excessive interest rate aiming at controlling
asset prices could even trigger financial instability, which is precisely what it is meant to
avoid, especially if the increase in asset prices is accompanied by higher financial fragility.
Finally, under inflation targeting, any interest rate movements that are inconsistent with
inflation converging to the target may undermine the credibility of monetary policy, and we
know inflation expectations are critical in the functioning of the regime. To apply a policy that
is inconsistent with the inflation target would end up weakening it as the inflation anchor. This
is particularly important in the case of emerging economies with a shorter record of monetary
stability.
Another reason that has been put forward to not try to affect asset prices through monetary
policy is simply that it is impossible to determine when prices are significantly misaligned with
their fundamentals. Cecchetti et al. (2000) point out that asset price misalignment with their
equilibrium level is what must be incorporated in the monetary policy rule. However, it is
difficult to know with precision the precise level, so it may be impossible to manage the
degree of uncertainty. Still, I believe it is possible to know when asset prices are
fundamentally misaligned in specific episodes. This takes me to the role played by the
exchange rate in monetary policy, something as important as or more important than asset
prices in emerging economies.
An inflation-targeting regime, where the policy instrument is the interest rate, must operate
within a context of a flexible exchange rate. This solves efficiently and unambiguously the
well-known impossible trinity problem and allows the control of interest rates at a level
consistent with the inflationary objective. Adding an exchange rate objective weakens the
capacity to manage the interest rate and affects the ability to meet the inflation target.
This is no hindrance for the exchange rate to generally have a significant effect on monetary
policy decisions, if persistent movements of this variable do affect inflation. In this case, the
natural result is a leaning against the wind behavior. When the interest rate appreciates
substantially, it prompts a fall in inflation, which will result in a reduction in the interest rate
with subsequent pressures to depreciate. However, one must recognize that these are not
very significant effects because, in a floating regime, the pass-through coefficient from the
exchange rate to inflation is limited. It occurs primarily because of the usual transitory nature
of exchange rate fluctuations, due to changes in their fundamentals and their relationship
with the stage of the cycle.
Emerging economies may feel tempted, after a long history of crises caused by exchange
fear of floating
rate lags, to handle it to keep it depreciated, due to (Calvo and Reinhart,
2002). Handling the exchange rate is, apart from hardly feasible in the medium to long term,
risky. In the first place, in less flexible exchange rate regimes, the transmission coefficient to
inflation increases, because the level of the exchange rate may become a coordinator of
price expectations, given the policymakers' commitment to price stability. This, in turn, feeds
back to increased pressures to keep the exchange rate stable, thus aggravating the problem.
Secondly, a commitment of the authority to exchange rate stability may create perverse
incentives to take financial risks, by artificially lowering the cost of external borrowing. This
reinforces fear of floating, creating a spiral towards exchange rate rigidity, and deriving in the
much feared currency mismatches and exchange rate delays that were intended to prevent
in the first place.
I am not saying that attention must not be paid to the exchange rate beyond its effects on
inflation. Excessive deviation from its long-term fundamentals may create problems in terms
of resource allocation and the business cycle. The exchange rate should be influenced
through accumulating or reducing reserves. Some conditions must be met, however, in order
for this to be effective and convenient. In the first place, it must be consistent with the
inflation target, in order for the intervention not to threaten the credibility of the monetary
policy. Secondly, to safeguard monetary policy independence, once the intervention is
announced it must be implemented mechanically. All this shields the conduct of monetary
policy, typically carried out in regular pre-established meetings, from the extraordinary
decision of buying or not buying foreign currency. In particular, the sterilization of intervention
decisions permits to preserve both the credibility and the independent management of
monetary policy. Finally, and because of this sterilization requisite, the cost of intervention
must be properly considered, because it entails a quasi-fiscal component that could be
significant.
In any case, to the extent that the decision to intervene is taken because of evident real
exchange rate misalignments, the risk of suffering quasi-fiscal costs should be limited.
Intervention would occur within the context of an extraordinary episode where the central
bank would estimate that there are sufficient elements to evaluate that the current exchange
rate dynamics are unsustainable and the market is not properly internalizing the long-term
prospects of the real exchange rate. If there is no evidence of misalignment, and the issue is
simply about hoarding reserves, the probability of the intervention having any effects on the
exchange rate is smaller, while the possibility of incurring in quasi-fiscal costs increases.
The Chilean experience last year was in line with the aforesaid principles. It was done in a
moment where there was clear evidence of misalignment with respect to the levels
consistent with long-term fundamentals. It was also totally consistent with the inflation
objective, and started at a moment - April 2008 - in which there were rather benign inflation
figures that revealed a smaller risk of unwanted inflationary propagation. Towards midyear it
was even possible to raise the interest rate substantially to tackle an inflation rate that was
much deviated from the target. This was thanks to the fact that the purchase of dollars was
being carried out mechanically and despite a significantly depreciated exchange rate after
the intervention. The purchase of foreign currency was concluded prematurely due to global
tensions in global liquidity in dollars in September of last year. The capacity of the Chilean
economy to subsequently deal with a significant exchange rate depreciation scenario, with
monetary easing prospects and reduced inflationary pressures is proof that there was no
inconsistency between the decision to intervene and the conduct of monetary policy (Figure
4).
Intervention can occur only under special circumstances, because it is not easy to assess
whether the prices of domestic assets are really in a bubble. If the slightest exchange rate
movement will prompt an intervention persistently, the market's perception of this greater
stability of the exchange rate may limit the power of monetary policy. For example, fighting
an asset price bubble, by raising the interest rate while intervening at the same time to
prevent a larger appreciation, may be counterproductive, because the incentives for carry
trade positions may exacerbate the bubble and the exchange rate appreciation itself.3
Final remarks
Financial stability must be preserved with an adequate regulatory system. Agencies must
analyze the strength of institutions, while central banks must evaluate the system's overall
stability. Regulators and central banks must closely cooperate and work in the effort of
maintaining the integrity of the financial system.
Regulating specific institutions is not enough, because interconnections exist that could
derive in a systemic crisis. The current crisis proves that the regulatory scope must
encompass every agent with a systemic importance. So a proper macro-prudential regulatory
system is needed. This is a system still in debate, particularly regarding the instruments that
must be applied to achieve this function.
A first set of instruments has to do with capital adequacy. However, this is not enough, and it
is no trivial to judge the soundness of the financial system by its capital and leverage levels.
Higher levels of capital will certainly have to be required in the future, particularly as banks
gradually assume higher levels of risk. Such is the spirit of the Basel II standards, but this
crisis has proved they do are not enough. It will be necessary to examine how capital
requirements and accounting norms may have amplified the financial crisis, and what must
be done to avoid the excessive procyclicality of the banking activity. Fortunately this has not
been a problem in the financial systems of Colombia, Chile and the rest of the region, where
regulatory schemes worked. Banks are adequately matched in terms of currencies, an
aspect that used to be the Achilles heel of our banks.
Central banks must strengthen and perfect the models with which they carry out their stress
tests. They should take into account the interconnections within the financial system and
detect vulnerabilities opportunely. We have seen how the U.S. investment banks, insurance
companies and other non-banking agents of the financial system played a leading role in the
origin and spread of the crisis, but were not at the heart of the banking supervision network.
Of the many aspects that may be debated with respect of the financial system, there is one
that should be singled out, especially to the extent that banking systems of emerging
economies continue along the lines of financial innovation. It is important to allow
securitization, but establishing incentives for both credit screening and monitoring of
payments to remain at the banks and that the process of transferring credit risk away from
individual institutions' balance sheets does not escape the authority's eye. The current crisis
should not become a hindrance to financial development, but a sign of alert in favor of
prudence and rigor when assessing the innovations.
Thank you very much.
References
Batini, N. and E. Nelson (2000), "When the Bubble Bursts: Monetary Policy Rules and
Foreign Exchange Market Behavior," mimeo, Bank of England.
Bernanke, B. and M. Gertler (1999), "Monetary Policy and Asset Price Volatility," in New
Challenges for Monetary Policy, Proceedings of the Jackson Hole Symposium 2005, Federal
Reserve Bank of Kansas City, pp. 77-128.
Blinder, A. and R. Reis (2005), "Understanding the Greenspan Standard," in The Greenspan
Era: Lessons for the Future, Proceedings of the Jackson Hole Symposium 2005, Federal
Reserve Bank of Kansas City, pp. 11-96.
Calvo, G. and C. Reinhart (2002), "Fear of Floating," Quarterly Journal of Economics, Vol.
107, No. 2, pp. 379-408.
Asset Prices and Central Bank
Cecchetti, S., H. Genberg, J. Lipsky y S. Wadhawani (2000),
Policy, Geneva Reports on the World Economy No, 2, ICMB and CEPR.
Ellis, L. (2008), "The Housing Meltdown: Why Did It Happen in the United States?," BIS
Working Paper No. 259.
Keys, B., T. Mukherjee, A. Seru and V. Vig (2009), "Did Securitization Lead to Lax
Screening? Evidence from Subprime Loans," Quarterly Journal of Economics, forthcoming in
Vol. 125, No. 1.
Loutskina, E. and P. Strahan (2006), "Securitization and the Declining Impact of Bank
Finance on Loan Supply: Evidence from Mortgage Acceptance Rates," mimeo, Darden
Graduate School, University of Virginia.
Figure 1
Countries experiencing drops in real GDP in the fourth quarter of 2008 (*)
(percentage of total sample)
100 100
90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
71 74 77 80 83 86 89 92 95 98 01 04 07
(*) Using the annualized quarterly GDP for a sample of 29 developed and emerging economies.
Source: Central Bank of Chile.
Figure 2
GDP
(annual change, percent)
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
70 75 80 85 90 95 00 05 10(f)
Latin America (*) World at PPP Developed ecoomies
(*) Simple average of annual GDP change in Argentina, Brazil, Colombia, Chile, Mexico, Peru and
Venezuela.
(f) Forecast.
Source: Central Bank of Chile based on data from investment banks, Consensus Forecasts, and IMF.
Figure 3
Monetary policy and housing prices
Monetary policy Housing prices
(percent) (nominal index, first quarter 2001=100)
10 10
250 250
8 8
200 200
6 6
150 150
4 4
100 100
2 2
50 50
0 0
0 0
00 01 02 03 04 05 06 07 08 09
01 02 03 04 05 06 07 08 09
U.S.A. Canada Australia U.S.A.
Chile (*) Chile Spain
Canada
(*) As from August 2001, the monetary policy interest rate is set in nominal terms. Before that, it was
indexed to the CPI.
Sources: Central Bank of Chile, Bank of Canada, Bloomberg and U.S. Federal Reserve.
Figure 4
Inflation
(percent)
1.5 15
1.0 10
0.5 5
0.0 0
-0.5 -5
-1.0 -10
-1.5 -15
04 05 06 07 08 09
CPI (monthly change) CPI (annual change)
CPI minus foods and energy (annual change)
Sources: Central Bank of Chile and National Statistics Bureau (INE).