The Optimal Monetary Policy
Instrument versus Asset Price
Targeting, and Financial Stability
by
CAE Goodhart, C Osorio and DP Tsomocos
Discussant
Mike Wickens
Universities of York and Cardiff
Sixth Norges Bank Monetary Policy Conference, June 2009
Aim of the paper
• Present an alternative theoretical
framework for analysing monetary policy
to the standard DSGE model
Main conclusions
• Monetary policy need more instruments
than just the repo rate
• MP should deliver targeted assistance via
the discount window (to avoid non-clearing
money market due to liquidity shortages?)
• There should be tighter regulation of
investment banks as they bear most
mortgage risk
• Inflation target should include a measure
of house prices
Key features of the alternative model
• The model is conventional in assuming
that all agents rationally maximise intertemporally subject their budget constraints
and all markets clear
• Unconventional in including banks
(central, commercial and investment),
hedge funds and wholesale and inter-bank
markets
• The market clearing conditions (noarbitrage conditions and budget
constraints) are satisfied in good times
• In bad times they may not hold and default
may occur
- mortgages: due to value of collateral <mortgage
- wholesale and inter-bank market: when penalty for
bankruptcy is too low
What happens in bad times?
• Households default on mortgages
• Hedge funds pay collateral to the investment
banks
• Investment banks transfer mortgages to the
hedge funds and sell collateral on the market
• Neither the hedge funds not the investment
banks can repay their loans to the commercial
banks and so default
• Commercial banks borrowing on the inter-bank
market also default
Can conventional monetary policy help?
1. Inflation targeting via repo rate cut
- all interest rates fall which reduces default
- maintains money market equilibrium
- portfolio adjustment by banks to riskier
assets
2. Money base expansion
- similar except portfolio adjustment by
banks to less risky assets
- households are still credit constrained
Note: In good times expansionary monetary policy
increases default
Improve financial stability by raising the
cost of default
- The idea is to include in the profit function an
extra cost to default
1. Commercial banks
- higher penalties raises borrowing rate,
reduces CB default and raises default premia
2. Investment banks
- reduces MBS and reduces CB borrowing
Comments
• Basic proposition is that the price system
can provide greater financial stability if
risks are priced correctly (aided by default
penalties) and MP avoids non-market
clearing
Interest rates
•
•
•
Recent experience has shown that at
near zero rates markets don’t clear –
quantitative easing
Higher repo rate would probably imply
lower default premia
The high leverage ratios of some
households, investment banks and
hedge funds suggest interest rates were
too low
Financial sector
•
•
•
•
•
Clearly failed to correctly price risk
Even worse, they thought that creating CDO’s
from MBS’s and insuring them with CDS’s
reduced risk
Problem was that greater opacity made it hard
to evaluate the risk and international
diversification spread the problem across the
world
Default could have been avoided if banks held
high capital reserves and mortgages required
larger deposits
In practice banks were allowed to reduce
capital requirements by moving assets offbalance sheet through the use of SIV’s
Higher capital requirements
• Can show using a standard DSGE model that
when there is a non-zero probability of a shock
that affects income precautionary asset holdings
are required
• The larger the probability of a shock and the size
of the shock, the greater must be the
precautionary assets
• In the absence of a shock, the higher
precautionary assets must still be held
• A default penalty could be based on the
equivalent loss of earnings due to holding
precautionary assets
• This is an alternative to government intervention
A simple DSGE model with borrowing a constraint
My own view
1. Financial crisis has shown that MP
carried out by inflation targeting via the
repo rate is not sufficient
2. Too low real interest rates partly caused
by loose MP (especially in US) caused
over borrowing
3. Countries in euro-zone have suffered
from one-size-fits-all MP
4. MP shouldn’t target asset prices but
needs an inflation target that includes
house prices
5. Need to reconsider treatment of offbalance sheet items
6. Need greater transparency in pricing
CDS’s by having a centralised exchange
or market
7. Need joined-up monitoring of financial
stability
8. Future tax payers shouldn’t foot the bill
9. If this is not enough then the CB must act
as lender of last resort by removing the
quantity constraint
Conclusion
• Strict inflation targeting conducted via
interest rates alone is not sufficient