Non-technical summary of ESM Working Paper 56 "Leaning against persistent financial cycles with occasional crises"

Should central banks take financial imbalances into account in their monetary policy decisions and raise interest rates above the levels implied by their flexible inflation-targeting frameworks, despite the likely ensuing economic costs? Proponents of such a leaning-against-the-wind (LAW) monetary policy emphasise the increased financial vulnerabilities following the ultra-loose monetary policy stance in most major economies in response to the Global Financial Crisis (GFC) and the Covid-19 pandemic, thereby sowing the seeds of the next financial crisis. On the other hand, LAW policies lead to lower economic activity in normal times.

In light of these considerations, this paper revisits LAW-type monetary policy by departing from the existing literature in several ways. First, we explicitly consider the role of persistent financial cycles in our analysis of LAW policy. We address this issue by incorporating households’ partially backward-looking expectations about house prices. In particular, these hybrid house price beliefs prolong the house price and household credit cycles, as in the data, and turn out to be crucial for whether LAW-type monetary policy is beneficial or not. Our framework also nests standard rational house price expectations, which lead to less persistence in house prices and household debt. We use this nested framework to assess the importance of house price expectations and the role of persistence for the desirability of LAW policy. Second, we evaluate LAW policy in a regime-switching macroeconomic model that explicitly incorporates the nonlinearities induced by occasional financial crises and the effective lower bound (ELB) on interest rates.

Our main findings do not support systematic LAW by monetary policy. Although systematic LAW reduces both the probability and the severity of crisis episodes, it significantly increases the volatility of inflation in normal times by amplifying the effects of supply shocks over the business cycle. This feature is mainly due to the strong countercyclical effect of systematic LAW on housing collateral, which restrains domestic demand, and leads to larger declines in inflation. It also induces a lower average inflation rate and increases the frequency of ELB periods.

We find that systematic LAW is advisable only when the policymaker places more emphasis on output stability relative to price stability, or when financial cycles are less persistent (or equivalently, under rational house price expectations). Our results depend on the interaction between the persistence of the financial cycle and whether the LAW policy is systematic or not. Although systematic policy is potentially more powerful than nonsystematic policy in taming the persistent financial cycle because it is incorporated into the agents’ future expectations, it also turns out to be more harmful because the higher policy is fed into inflation expectations, lowering the average inflation and making it more volatile.