Comments on
“Flexible Inflation Targeting & Financial Stability:
Is It Enough to Stabilise Inflation and Output?”
Andrew Filardo
Bank for International Settlements
The Architecture of Financial System Stability:
From Market Micro Structure to Monetary Policy
24-26 May 2006, Capri, Italy
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Related Policy Issues
• Asset prices and monetary policy
• Monetary stability and financial stability
• Very important policy issues that demand greater
research efforts – not just a Norwegian problem
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Related Policy Issues
Emerging market economies
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The Pros
Making progress
• Explicit consideration of financial stability and
monetary stability considerations for central
banks
• Larger set of equations – more realistic policy model!
• “Calibrated” model of the Norwegian economy
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The Cons
Making progress???
• What should policymakers make of these results?
• My remaining comments raise doubts about whether
policymakers can rely with confidence on the
“themes” coming from this analysis
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Modeling Approach
Monetary policy loss function
Macro-financial set of 8 equations:
output, inflation, housing, shares, FX, Unemp,
wages, credit
Monetary policy – augmented Taylor rules
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If it were only that easy!
Deep modeling issues: CB loss function
“Second generation” loss function – is it enough?
 First generation - var(r)?
Second generation V(f)
rL
f 
PY
Not clear that this is exactly
what we mean by financial stability
Not exactly sure what is going on with f in the model
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If it were only that easy!
Deep modeling issues: CB loss function
• What do we mean by financial stability for CBs?
 Low probability meltdowns
 Japan-like situation where system short-circuits
 The nonlinear interactions are surely the key ones
• What is the ultimate source of externality or market
failure? What justifies government intervention?
And, is the central bank the obvious “stabiliser of
first resort”?
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If it were only that easy!
Deep modeling issues: “Calibrated” models
• Macro-financial model – is it that easy?
• Asset prices – misspecification or bubbles?
• Should CBs respond? Should CBs prick? Can
CBs encourage/discourage bubbles by holding R
too low for too long? [Filardo 2004, 2005]
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If it were only that easy!
Deep modeling issues: “Calibrated” models
• Macro-financial model – is it that easy?
• Asset prices – misspecification or bubbles?
• Should CBs respond? Should CBs prick? Can
CBs encourage/discourage bubbles by holding R
too low for too long? [Filardo 2004, 2005]
• Credit growth – monetary or real phenomenon?
• Intrinsic shocks & linear stochastic control are key!!!
Cannot simply estimate a set of regression equations
to draw robust policy implications!!!
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If it were only that easy!
Deep modeling issues: Ad hoc MP rules
• Ad hoc monetary policy – is it sufficient?
• Yes, if start with a realistic policy rule. Then, can
ask: “Can the central bank do better?”
• No, if comparing two non-optimal rules. They do
not reveal much
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Results for Optimal Policy
Variance of inflation
Optimal Monetary Policy Frontiers
?
Variance of output
12
If it were only that easy!
Deep modeling issues: Ad hoc MP rules
• Ad hoc monetary policy – is it sufficient?
• Yes, if start with a realistic policy rule. Then, can ask:
“Can the central bank do better”
• No, if comparing two non-optimal rules. They do not
reveal much
Other possible issues • Where is the role for monetary aggregates? thresholds?
• Considerations of deflation and ZLB should be added
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Bottom Line
I like the paper
 It makes some progress in thinking about key
policy issues …
 … but I am not sure that such modeling efforts
are ready for prime time … yet!
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Where Do We Go From Here?
Need to backwards before moving forwards!
• “Optimal” monetary policy
• How do we add financial stability concerns in the
“welfare” function of the central bank?
• Shock identification and modeling – intrinsic and
non-linear aspects
• Policy responses – game theoretic aspects
 amongst domestic policymakers (eg RBNZ)
 multilateral considerations
• Decision making under uncertainty – interim solution
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Thank you!
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Results for Optimal Policy
Variance of inflation
Optimal Monetary Policy Frontiers
*
rt  a*y yt  a
t
Variance of output
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Results for Optimal Policy
Variance of inflation
Optimal Monetary Policy Frontiers
*
rt  a*y yt  a
t
Superior policy
Variance of output
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Modeling a Bubble
Time-Varying Transition Probability Model
Sample Path of a Bubble
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10
5
0
-5
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
-10
-15
-20
Time periods
Not a CAPM model!
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Results for Optimal Policy
Variance of inflation
Optimal Monetary Policy Frontiers
r  a*yy  a*ππ  other
t
t
t
Variance of output
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