The IMF says central banks’ mandates may need to be expanded to include explicit concerns for macrofinancial stability and they could usefully place greater emphasis on avoiding asset price busts. But policymakers working under a broader approach to monetary policy would need to explain very carefully why actions are being taken, what the immediate objective is, and how actions are consistent with longer-term objectives of macroeconomic and financial stability.
The Fund today released two chapters of the forthcoming World Economic Outlook (WEO), the twice-yearly report on the global economy, and said expectations should be realistic about what can be achieved with such broader approaches. Credit and asset price surges can sometimes be justified by positive productivity developments, and it is hard to tell ex ante whether booms are driven by benign or malign circumstances. It said empirical evidence confirms that even the best indicators of financial vulnerability are noisy, sometimes sending false signals and raising the risk of policy errors. Inflexible use of macroprudential policy tools could lead to policy mistakes, so some discretion is needed.
Chapter 3 seeks lessons for monetary policy from recent experiences of asset price busts. It studies historical evidence to see whether there are consistent macroeconomic patterns leading up to asset price busts, examines the role of monetary policy in the build-up to such busts, including the latest crisis, and asks whether monetary policy should be responsible for more than just the stability of goods price inflation, how this could be done, and what the potential trade-offs are.
It finds that monetary policy was not the smoking gun behind the current crisis. There is some evidence for loose monetary policy in the years leading up to the current crisis in some countries, but it says it is not likely to have been the main systematic cause of the booms and consequent busts across the global economy. Differences in monetary policy settings across countries do not correlate well with differences in house and stock price growth.
The IMF says, however, there were warning signs ahead of the current crisis that monetary policymakers could have heeded. Central banks fulfilled their mandates - - inflation in advanced economies stayed within a narrow range in the lead-up to the current crisis. But central banks accommodated the relaxation in financial conditions, raising the risk of a damaging bust. Credit, shares of investment in GDP, current account deficits, and asset prices typically rise ahead of asset price busts, providing useful leading indicators of asset price busts. By contrast, inflation and output do not typically display unusual behavior.
It says monetary policymakers could usefully place greater emphasis on avoiding asset price busts. Model-based analysis suggests that stronger-than-usual monetary reactions to signs of overheating or of a credit or asset price bubble could be warranted to reduce macroeconomic volatility. This would imply tightening monetary conditions earlier and more vigorously to try to prevent dangerous excesses from building up, even if inflation appears to be under control. Introducing time-varying “macroprudential” instruments designed specifically to dampen credit market cycles could help monetary policy. Some proposals include so-called “dynamic provisioning”, in which financial institutions automatically set aside more capital as leverage rises, or for policymakers to have discretion over required reserves. For best effect, the setting of monetary policy and macroprudential instruments should be tightly coordinated.
The WEO says in economies with common nominal monetary policy rates, looser real rates in recent years were associated with larger rises in real house prices. Across advanced economies as a whole, there was little significant correlation in recent years between real policy rates and real house prices - -and several countries experienced large house price rises despite tight monetary conditions.
