Lessons from the Financial Crisis for Monetary Policy
October 3, 2013
Aloisio Araújo and Susan Schommer, IMPA, and Michael Woodford, Columbia University and NBER
Araújo, Schommer, and Woodford consider the effects of central bank purchases of a risky asset, financed by issuing riskless nominal liabilities (reserves), as an additional dimension of policy alongside "conventional" monetary policy (central bank control of the riskless nominal interest rate), in a general equilibrium model of asset pricing and risk sharing with endogenous collateral constraints of the kind proposed by Geanakoplos (1997). When sufficient collateral exists for collateral constraints not to bind for any agents, the authors show that central bank asset purchases have no effects on either real or nominal variables, despite the differing risk characteristics of the assets purchased and the ones issued to finance these purchases. At the same time, the existence of collateral constraints allows their model to capture the common view that sufficiently large central bank purchases would eventually have to affect asset prices. But even when central bank purchases raise the price of the asset, because of binding collateral constraints, the effects need not be the ones commonly assumed. The authors show that under some circumstances central bank purchases relax financial constraints, increase aggregate demand, and may even achieve a Pareto improvement, but in other cases they may tighten financial constraints, reduce aggregate demand, and lower welfare. The latter case is almost certainly the one that arises if central bank purchases are sufficiently large.
Mark Gertler and Peter Karadi, European Central Bank
Gertler and Karadi provide evidence on the nature of the monetary policy transmission mechanism by combining traditional monetary vector autoregression (VAR) analysis with high frequency identification (HFI) of monetary policy shocks. They show that the shocks identified using HFI surprises as external instruments produce responses in output and inflation consistent with those obtained in the standard monetary VAR analysis. They also find, however, that monetary policy responses typically produce "modest" movements in short rates that led to "large" movements in credit costs and economic activity. The large movements in credit costs are mainly the result of the reaction of both term premia and credit spreads that are typically absent from the baseline model of monetary transmission. Finally, the authors show that forward guidance is important to the overall strength of policy transmission.
Simon Gilchrist, Boston University and NBER, and David López-Salido and Egon Zakrajšek, Federal Reserve Board
Gilchrist, López-Salido, and Zakrajšek investigate the effect of monetary policy surprises on Treasury yields and borrowing costs of businesses and households, as measured by interest rates on corporate bonds and mortgage-related instruments. They compare the effects of policy surprises on market interest rates during the period of conventional policy actions and during the period in which the target federal funds rate is at the zero lower bound. In the conventional policy regime, a policy surprise that reduces the two-year nominal Treasury yield ten basis points induces a five basis point decline in longer-term nominal Treasury yields and a four basis point decline in the comparable-maturity Treasury inflation-protected securities (TIPS) yield. In the unconventional policy period, by contrast, an unanticipated easing that has the same effect on the two-year yield causes a 20 basis point decline in long-term nominal Treasury yields and an 18 basis point decline in TIPS yields - that is, expansionary monetary policy flattens the nominal yield curve. The authors also document that expansionary monetary policy significantly reduces real borrowing costs for investment-grade firms and that policy easing during the unconventional policy period implies an effect on real corporate borrowing costs that is three times as large as during the unconventional policy regime for a commensurate movement in the two-year Treasury yield. Monetary policy also reduces the real cost of household finance, as measured by movements in the real yields on mortgage-related instruments. While the pass-through from Treasury yields to real corporate yields is roughly one-for-one, the pass-through to household borrowing costs is substantially lower - on the order of five basis points for a ten basis point decline in a comparable-maturity Treasury yield.
Lawrence Christiano and Martin Eichenbaum, Northwestern University and NBER, and Mathias Trabandt, Board of Governors
Christiano, Eichenbaum, and Trabandt argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were the result of financial frictions interacting with the zero lower bound. The authors reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidity and no nominal rigidity in the wage setting process. Their model does a very good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the presence of a working capital channel played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.
Lars Svensson, Stockholm University and NBER
Svensson examines the Swedish experience of forward guidance in the form of a published policy-rate path, focusing on the big discrepancy between the Riksbank's policy-rate path and market expectations of the future policy rate in September 2011, its causes and its consequences. The main reason suggested for the discrepancy is that the Riksbank had gradually come to conduct a "leaning-against-the wind" policy because of concerns about housing prices and household indebtedness. This apparently led the Riksbank to publish a high policy-rate path that was deemed unrealistic and irrelevant by the market. As a forecaster of the policy rate, ex post the market was right and the Riksbank was wrong. The author discusses alternatives for handling and possibly avoiding such situations. The Riksbank's leaning-against-the-wind policy has led to lower inflation than the target, higher unemployment than a long-run sustainable rate and, ironically, to a higher household real debt and debt-to-income ratio than if average inflation had been equal to the inflation target. The author examines ways to avoid such outcomes.
Olivier Coibion, University of Texas, Austin and NBER, and Yuriy Gorodnichenko, University of California at Berkeley and NBER
Coibion and Gorodnichenko evaluate possible explanations for the absence of a persistent decline in inflation during the Great Recession and find commonly suggested explanations to be insufficient. They propose a new explanation for this puzzle within the context of a standard Phillips curve. If firms' inflation expectations track those of households, then the missing disinflation can be explained by the rise in their inflation expectations between 2009 and 2011. The authors present new econometric and survey evidence consistent with firms having similar expectations as households. The rise in household inflation expectations from 2009 to 2011 can be explained by the increase in oil prices over this time period.
Jordi Gali, CREI and NBER, and Luca Gambetti, Universitat Autonoma de Barcelona
Gali and Gambetti estimate the response of stock prices to exogenous monetary policy shocks using vector-autoregressive models with time-varying parameters. Under their baseline identifi cation scheme, the evidence cannot be easily reconciled with conventional views on the effects of interest rate changes on asset price bubbles.
Markus Brunnermeier, Princeton University and NBER and Yuliy Sannikov, Princeton University
Brunnermeier and Sannikov provide a unified theoretical framework to analyze the macroeconomic consequences of capital account liberalizations and capital controls, like capital inflow taxes. They identify two pecuniary externalities that lead to inefficient outcomes in terms of welfare and to financial instability. The first externality undermines the "terms-of-trade hedge" while the second leads to excessive liquidity mismatch and leverage. Short-term debt flows, or "hot money," stabilize the economy up to a certain level of global imbalance, but expose the system to sudden stops and financial instability.