Afternoon Must-Read: Lars E. O. Svensson: Monetary Policy and Financial Stability
Monetary policy tradeoffs in CESEE###
Lars E.O. Svensson
http://larseosvensson.se
Department of Economics, Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden, www.sse.edu
Conference on European Economic Integration (CEEI) 2014 Vienna, November 24, 2014
Monetary policy’s best contribution to financial stability?
* Inflation on target and resource utilization at long-run sustainable rate
* Suppose 2% inflation and 3% real growth, nominal growth 5% of asset prices and disposable income, doubling every 14 years
* For any given nominal debt, LTV and DTI ratios halved in 14 years. Pretty good for repair of balance sheets.
* Monetary policy should only be the very last line of defense of financial stability, normally not to be used
Outline
* What can monetary policy achieve?
* Do not ask to much from monetary policy
* What is the relation between monetary policy and financial stability?
* Monetary policy and financial-stability policy are very different
* In normal times: Best conducted separately, also when conducted by the same institution
* But each policy should be fully informed about and take into account the conduct of the other policy
* In crisis times: Full cooperation between the relevant authorities
* Monetary policy should be the very last line of defense of financial stability, not to be used in normal times

What can – and cannot – monetary policy achieve?
* MP can stabilize inflation around a given inflation target
* MP can stabilize overall resource utilization around a long-run sustainable rate
* But the latter is determined by nonmonetary, structural factors
* MP cannot affect the long-run sustainable rate of resource utilization
* This requires structural policies
* MP cannot solve structural problems
* This requires structural policies
What can – and cannot – monetary policy achieve?
* MP cannot achieve financial stability
* This requires financial-stability policy (macroprudential policy)
* Leaning against the wind cannot solve debt problems
* See Riksbank bad example (FT Big Read Nov 20)
* In Swedish case, benefits of leaning are just around 0.4% of costs (should have be more than 100% of costs to justify policy)
* Inherent flaw in leaning
* Running inflation below a credible inflation target increases
households’ and other agents’ real debt burden
* It also increases unemployment
What can – and cannot – monetary policy achieve?
* Do not ask too much of monetary policy

What is the relation between monetary policy and financial stability?
* Distinguish economic policies according to:
* (1) objectives,
* (2) suitable instruments, and
* (3) responsible authorities
* MP and financial-stability policy (FSP) are clearly separate policies, with different objectives and different suitable instruments, regardless of whether they have the same or different responsible authorities
Monetary policy
* Objective
* Flexible inflation targeting: Price stability and real stability
* Instruments
* Normal times: Policy rate, communication
* Crisis times: Also unconventional measures, balance sheet policies, FX policy, …
* Responsible authority
* Centralbank

Financial-stability policy
* Objective
* Financial stability: Financial system fulfilling 3 main functions w/ sufficient resilience to disturbances that threaten those functions
* Instruments
* Normaltimes:Regulation,supervision,macroprudentialpolicy, buffers, capital requirements, LTV caps, LCRs, NSFRs, taxes, deposit insurance, …
* Crisis times: Lending of last resort, liquidity support, capital injections, guarantees, banking resolution, …
* Authority(ies)
* Varies across countries
* FSA, CB, banking-resolution authority, MoF, …

What is the relation between monetary policy and financial-stability policy?
* Very different policies
* In normal times: Conduct independently, also when conducted by the same authority
* Each policy should be fully informed about and take into account the conduct of the other’s policy
* Similar to MP and fiscal policy (Nash equilibrium rather than coordinated equilibrium (joint optimization)
* In crisis times: Full cooperation and joint policies by FSA, CB, MoF, banking-resolution authority…

Monetary policy’s best contribution to financial stability?
* Inflation on target and resource utilization at long-run sustainable rate
* Suppose 2% inflation and 3% real growth, nominal growth 5% of asset prices and disposable income, doubling every 14 years
* For any given nominal debt, LTV and DTI ratios halved in 14 years. Pretty good for repair of balance sheets.
* Monetary policy should only be the very last line of defense of financial stability, normally not to be used