Monetary policy and asset prices
A narrow path
Central banks around the world are struggling to promote growth without fomenting worrisome risk-taking
Jun 21st 2014
Washington, DC
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UNTIL the global financial crisis, central banks treated bubbles with benign neglect: they were hard to detect and harder to deflate, so best left alone; the mess could be mopped up after they burst. No self-respecting central bank admits to benign neglect any longer. “No one wants to live through another financial crisis,” Janet Yellen, then a candidate to head the Federal Reserve, said last year. “I would not rule out using monetary policy as a tool to address asset-price misalignments.”
After six years of interest rates near zero the tension between central banks’ responsibility for output and inflation on one hand and financial stability on the other is growing. On June 12th the Bank of England hinted it would pursue new measures to curb ever-climbing property prices. Shortly afterwards Ms Yellen fretted about the “reach for yield” and subdued volatility, a sign of investors’ complacency.
For Britain and America, the prospect of using interest rates to tackle financial imbalances remains hypothetical. Not so in Norway and Sweden, where central banks have been stingy with rate cuts for fear of inflating home prices and household debt. That has come at a cost: inflation is below target in both countries; in Sweden it is negative. This could become entrenched: Andy Levin, an economist at the IMF, recently noted that long-run inflation expectations in both countries have also dropped below target.
In Sweden, the Riksbank’s stance has been deeply divisive. Two of the six members of its executive board voted in April to cut the repo rate, which is now 0.75%.
Lars Svensson, an academic economist who left the board last year, calculates that unnecessarily tight monetary policy since 1997 has raised unemployment by 0.8 percentage points. He believes it has also worsened Sweden’s imbalances by slowing the growth of incomes more than the growth of debt, thereby raising the household-debt ratio, now 174%.
Sweden’s parliament recently instigated an independent review of the Riksbank’s policy. The central bank’s defenders argue that the consequences of a household-debt bust require pre-emptive action, and that tightening rules, such as tougher underwriting standards for mortgages, while essential, is not enough. A Riksbank staff study contradicts Mr Svensson’s findings, concluding that it is lower rates, if perceived to be long-lasting, that would in fact raise debt ratios. Nonetheless, a rate cut is widely expected next month.
Sweden’s experience is a cautionary tale for other central banks. In Britain, house prices have risen by 10% in the past year, and household debt, though down relative to income since the recession, still exceeds 140% of income. Mark Carney, the governor of the Bank of England, complains this has “unbalanced” Britain’s recovery. He has hinted at countermeasures such as higher capital charges for mortgages and limits on high loan-to-value or debt-to-income ratios. He also warned that interest rates could rise sooner than markets expect, although this was motivated more by the surprising pace of recovery than by fears of financial instability.
Ms Yellen’s challenge is different. America’s economy, in contrast to Britain’s, continues to disappoint: on June 18th policymakers lowered their projection for economic growth this year, to 2.2% from 2.9% in March, the latest in a series of downgrades. They also reaffirmed their expectation that rates would stay near zero through the middle of next year, though the projected pace of tightening thereafter rose slightly.
Two things could prompt an earlier move. One is prices. The trend of falling inflation that had alarmed Fed officials is now over: consumer prices were up by 2.1% in May, the fastest in 20 months. But that is hardly unnerving; according to the Fed’s preferred index inflation is closer to 1.6%, well below the 2% target, and it is expected to stay below target through 2016. Moreover, Fed officials have recently hinted that they would prefer to let inflation rise above 2% briefly than strangle the recovery with premature tightening.
Before the meeting the IMF, in an unusually public and explicit fashion, urged the Fed to keep rates near zero for even longer than now planned and to let inflation exceed its target. But the dilemma this creates is well illustrated by the IMF’s indecision on the issue. In April it cautioned that “undue delay” in raising interest rates “could lead to a further build-up of financial stability risks”.
American homes are reasonably valued and household debt is just 109% of income, and falling. But fixed-income markets exhibit euphoria reminiscent of 2007. A record $94 billion of junk bonds was issued in the second quarter, and leveraged loans are on track to match last year’s record $1.1 trillion, according to Thomson Reuters. A third of those loans lack the standard covenants that limit how much debt the borrower can carry.
Ms Yellen said such trends are not troubling enough to affect the course of monetary policy for now; she prefers that they be dealt with through “macroprudential” policy, meaning regulations designed to address specific imbalances in the financial system. The Fed has already urged tougher underwriting standards on leveraged loans. But some of her colleagues want higher interest rates to play a part as well.
Esther George, president of the Federal Reserve Bank of Kansas City, recently warned that the Fed’s commitment to keep interest rates low has encouraged small banks to raise the share of their bondholdings and loans that mature in more than three years to 53%, up from 37% in 2005. That exposes them to “heavy losses” if rates rise suddenly. Jeremy Stein, a Fed governor until last month, has noted that moneymen can find ways around macroprudential controls, whereas tighter monetary policy “gets in all of the cracks”.
Most officials at the Fed, however, worry more about an aborted recovery than financial instability. Three Fed economists helpfully quantified this trade-off last year by simulating two responses to a financial crisis.
In one, rates fall to zero, and another crisis, 60% as bad as the first, erupts ten years later. In the other, rates are not allowed to fall below 1.5%, and the second crisis is avoided. Their conclusion: even with the second crisis, the cumulative loss of income and employment is far smaller in the first scenario. The ironic and unsettling upshot is that, sometimes, chancing another crisis is the optimal policy.
UNTIL the global financial crisis, central banks treated bubbles with benign neglect: they were hard to detect and harder to deflate, so best left alone; the mess could be mopped up after they burst. No self-respecting central bank admits to benign neglect any longer. “No one wants to live through another financial crisis,” Janet Yellen, then a candidate to head the Federal Reserve, said last year. “I would not rule out using monetary policy as a tool to address asset-price misalignments.”
After six years of interest rates near zero the tension between central banks’ responsibility for output and inflation on one hand and financial stability on the other is growing. On June 12th the Bank of England hinted it would pursue new measures to curb ever-climbing property prices. Shortly afterwards Ms Yellen fretted about the “reach for yield” and subdued volatility, a sign of investors’ complacency.
For Britain and America, the prospect of using interest rates to tackle financial imbalances remains hypothetical. Not so in Norway and Sweden, where central banks have been stingy with rate cuts for fear of inflating home prices and household debt. That has come at a cost: inflation is below target in both countries; in Sweden it is negative. This could become entrenched: Andy Levin, an economist at the IMF, recently noted that long-run inflation expectations in both countries have also dropped below target.
In Sweden, the Riksbank’s stance has been deeply divisive. Two of the six members of its executive board voted in April to cut the repo rate, which is now 0.75%.
Lars Svensson, an academic economist who left the board last year, calculates that unnecessarily tight monetary policy since 1997 has raised unemployment by 0.8 percentage points. He believes it has also worsened Sweden’s imbalances by slowing the growth of incomes more than the growth of debt, thereby raising the household-debt ratio, now 174%.
Sweden’s parliament recently instigated an independent review of the Riksbank’s policy. The central bank’s defenders argue that the consequences of a household-debt bust require pre-emptive action, and that tightening rules, such as tougher underwriting standards for mortgages, while essential, is not enough. A Riksbank staff study contradicts Mr Svensson’s findings, concluding that it is lower rates, if perceived to be long-lasting, that would in fact raise debt ratios. Nonetheless, a rate cut is widely expected next month.
Sweden’s experience is a cautionary tale for other central banks. In Britain, house prices have risen by 10% in the past year, and household debt, though down relative to income since the recession, still exceeds 140% of income. Mark Carney, the governor of the Bank of England, complains this has “unbalanced” Britain’s recovery. He has hinted at countermeasures such as higher capital charges for mortgages and limits on high loan-to-value or debt-to-income ratios. He also warned that interest rates could rise sooner than markets expect, although this was motivated more by the surprising pace of recovery than by fears of financial instability.
Ms Yellen’s challenge is different. America’s economy, in contrast to Britain’s, continues to disappoint: on June 18th policymakers lowered their projection for economic growth this year, to 2.2% from 2.9% in March, the latest in a series of downgrades. They also reaffirmed their expectation that rates would stay near zero through the middle of next year, though the projected pace of tightening thereafter rose slightly.
Two things could prompt an earlier move. One is prices. The trend of falling inflation that had alarmed Fed officials is now over: consumer prices were up by 2.1% in May, the fastest in 20 months. But that is hardly unnerving; according to the Fed’s preferred index inflation is closer to 1.6%, well below the 2% target, and it is expected to stay below target through 2016. Moreover, Fed officials have recently hinted that they would prefer to let inflation rise above 2% briefly than strangle the recovery with premature tightening.
Before the meeting the IMF, in an unusually public and explicit fashion, urged the Fed to keep rates near zero for even longer than now planned and to let inflation exceed its target. But the dilemma this creates is well illustrated by the IMF’s indecision on the issue. In April it cautioned that “undue delay” in raising interest rates “could lead to a further build-up of financial stability risks”.
American homes are reasonably valued and household debt is just 109% of income, and falling. But fixed-income markets exhibit euphoria reminiscent of 2007. A record $94 billion of junk bonds was issued in the second quarter, and leveraged loans are on track to match last year’s record $1.1 trillion, according to Thomson Reuters. A third of those loans lack the standard covenants that limit how much debt the borrower can carry.
Ms Yellen said such trends are not troubling enough to affect the course of monetary policy for now; she prefers that they be dealt with through “macroprudential” policy, meaning regulations designed to address specific imbalances in the financial system. The Fed has already urged tougher underwriting standards on leveraged loans. But some of her colleagues want higher interest rates to play a part as well.
Esther George, president of the Federal Reserve Bank of Kansas City, recently warned that the Fed’s commitment to keep interest rates low has encouraged small banks to raise the share of their bondholdings and loans that mature in more than three years to 53%, up from 37% in 2005. That exposes them to “heavy losses” if rates rise suddenly. Jeremy Stein, a Fed governor until last month, has noted that moneymen can find ways around macroprudential controls, whereas tighter monetary policy “gets in all of the cracks”.
Most officials at the Fed, however, worry more about an aborted recovery than financial instability. Three Fed economists helpfully quantified this trade-off last year by simulating two responses to a financial crisis.
In one, rates fall to zero, and another crisis, 60% as bad as the first, erupts ten years later. In the other, rates are not allowed to fall below 1.5%, and the second crisis is avoided. Their conclusion: even with the second crisis, the cumulative loss of income and employment is far smaller in the first scenario. The ironic and unsettling upshot is that, sometimes, chancing another crisis is the optimal policy.
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