## EXECUTIVE SUMMARY (_082815a) ## Source details **Canonical URL:** [EXECUTIVE SUMMARY (_082815a)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2015/_082815a.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2015/_082815a.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2015/_082815a.pdf.json) --- ### Context and motivation - Prior to the global financial crisis, monetary policy focused on price stability and largely ignored asset prices and credit aggregates except when they affected inflation and output. - Financial stability responsibilities were assigned primarily to prudential regulation and supervision, with relatively little attention to systemic risk. - In the run-up to the crisis there was a sharp increase in credit-to-GDP ratios and real estate prices despite close-to-target inflation and small output gaps. - Financial crises are costly: - on average, after World War II financial crises have led to negative GDP growth for two years, with a peak loss of GDP per capita of about 1.5 percent; - GDP has lagged behind its average recovery path after normal recessions by about 4 to 5 percent after five years. - Extraordinary monetary accommodation was required during the crisis as short-term nominal rates hit the effective lower bound; large-scale Unconventional Monetary Policies (UMP) were deployed. - Analysis focus: advanced and emerging economies with freely floating exchange rates; empirical estimates are representative of advanced and emerging market economies. ### Core question and high-level conclusion - Central question: Should monetary policy be altered to contain financial stability risks—i.e., should it “lean against the wind” by raising interest rates temporarily more than warranted by price and output stability objectives (or by keeping rates persistently higher)? - High-level finding: Based on current knowledge and present circumstances, the answer is generally no; the door should remain open as understanding evolves and circumstances change. - Key principle: Monetary policy should deviate from its traditional response only if costs are smaller than benefits (the principle of doing no harm on net). Costs arise in the short term (lower output and inflation); benefits materialize mainly in the medium term via mitigated financial risks, but are more uncertain. ### Policy guidance and interim actions - Prudential policies (micro- and macroprudential regulation and supervision) should be pursued actively to attenuate the buildup of financial risks. - Central banks should monitor and openly discuss financial stability risks, and carefully consider costs and benefits of potential actions. - Leaning against the wind should not be the default; consider only when a clear net benefit is evident based on the “do no harm on net” criterion. *Italic: Source: EXECUTIVE SUMMARY (August 28, 2015).* --- ### Two approaches to using monetary policy for financial stability - Approach 1 — Persistently higher rates: - Keep nominal interest rates persistently higher than implied by a traditional reaction function focused only on inflation and output. - Drawback: Higher rates create persistently lower inflation, eventually decrease inflation expectations, leave real rates—and thus financial risks—unchanged, and aggravate risks of hitting the zero lower bound. - Approach 2 — Occasional “leaning against the wind”: - Respond occasionally to evolving financial risks (e.g., hiking more, cutting less, or hiking earlier than warranted by price stability alone). - Could be operationalized as a state-contingent, rule-based approach using identified financial indicators (credit growth, leverage, etc.). - Paper focuses on the second approach as more promising. --- ### Transmission and tradeoffs ### Transmission framework - Two-step relation: - Interest rates → financial variables. - Financial variables → probability of large disturbances to macroeconomic conditions. - Five financial variables of focus: - Quantities: leverage of financial firms, household debt, bank risk taking. - Prices: asset prices (especially real estate), credit spreads. - Other important variables noted with weaker data/literature: loss absorption capacity, liquidity, maturity, FX balance sheet mismatches. ### Horizon-dependent effects of interest rate changes - Short term (before balance-sheet adjustment): higher interest rates likely weaken financial stability because: - Reduced aggregate demand lowers household earnings and firms’ profitability. - Increased interest burden if liabilities are variable-rate and short-maturity. - Reduced asset prices and reduced value of legacy assets held by financial institutions. - Possible temporary increase in delinquencies and defaults, especially if balance sheets are weak. - Medium term (after balance-sheet adjustment): effects likely to reverse as agents rebalance: - Higher borrowing costs should induce households and firms to gradually reduce leverage through intertemporal substitution. - Tighter monetary conditions likely to gradually reduce banking sector leverage. - Effects on risk taking are ambiguous (insurers/pension funds vs. banks). ### Practical implementation challenges - Long and variable policy lags and communication difficulties. - Detection problem: distinguishing “good” credit expansions from “bad” ones in real time is difficult. - Timing: acting when vulnerabilities are already very large may worsen vulnerabilities; leaning should be early in the buildup. - Complementarity: monetary and prudential policies should be systematically compared and jointly optimized given practical constraints. --- ### Empirical findings on monetary policy → financial variables ### Key empirical effects and magnitudes - Real debt levels following a temporary monetary policy tightening of 100 basis points: - generally decrease by up to 0.3 percent and 2 percent after 4 to 16 quarters, depending on model. - Short-term: real debt to GDP seems to rise due to nominal GDP responding faster than nominal debt. - Default/delinquency effects: - Example (Box 3): household loan delinquency rates increase by 126 bps for the U.S. and 25 bps for Spain in the first 15 and 7 quarters, respectively, following a 100 bps unexpected hike to interest rates. - U.S. VAR (1988Q1–2015Q1): default rates on residential loans initially increase, peaking at 0.37 percent after 14 quarters; delinquency rates decline to 0.31 percent after 36 quarters. - Spain VAR (1999Q1–2014Q4): residential NPLs peak after 6 quarters at 0.08 percent. - Leverage and risk-taking: - Banks and nonbanks generally reduce leverage after 1–2 quarters, though leverage tends to rise in the initial quarters. - Cecchetti, Mancini-Griffoli and Narita (2015) full sample medians (1998–2014): leverage changes reported as 10.7 to 11.2 for banks, 7.0 to 7.3 for insurance companies, and 4.7 to 5.0 for investment banks. - Bruno and Shin (2015): a 90 bps hike decreases leverage of U.S. broker dealers from 22 to 21.5 (after initial increase). - Asset prices and spreads: - Real estate prices decrease on average of the order of 2 percent following a 100 bps interest rate shock, with a lag between 10 to 16 quarters. - Credit spreads tend to increase following an interest rate hike; a surprise decrease in one-year bond yields by 20 bps reduces the non-default component of corporate bond credit spreads by about 8 bps for eight months (Gertler and Karadi, 2013). - Crisis probability: - Higher interest rates reduce the probability of crises over the medium term, provided borrowers and the financial system can withstand the initial shock. - Quantified effect: probability is reduced by 0.04 to 0.3 percentage points following a 100 basis point interest rate hike for a year (illustrated for a middle-of-the-road response where real credit growth decreases by one percentage point for one year from historical average of 5.4 percent). - Average probability reduction per year across models over first four years ranges from 0 to 0.05 percentage points; cumulated reduction over four years is 0 to 0.2 percentage points. - If credit growth declines for one year from 20 to 19 percent, crisis probability would decline by about 0.4 percent after three years. ### Caveats and limitations - Estimates may be biased downwards because most data are from periods when higher rates coincided with good times. - Results about credit effects are sensitive to specification assumptions; credits may or may not return to steady state after a shock. - Empirical emphasis to date has been on costs to unemployment; other costs exist (inflation, public finances, social and political cohesion). *Italic: Source: _082815a - 24. Empirical results broadly support these theoretical predictions.* --- ### Welfare implications and cost–benefit analysis ### Modeling and welfare intuition - Models are needed to account for endogenous responses to structural policy changes; empirical relationships based on historical data are limited. - New-model findings: a class of models suggests leaning against the wind, absent other tools, can be welfare improving, but: - models do not yet generate crises of major proportions and model imbalances as small fluctuations around steady state; - welfare improvements are generally fairly small and state (or shock) dependent. - Simple rules that mechanically react to observable variables can lead to policy mistakes; judgment is necessary. ### IMF illustrative cost–benefit calculations (Table 1 scenarios) - Building blocks and outcomes (columns: Average | High (Peak) Probability | High (Peak) Probability, Severe Crisis) - Lower crisis probability, pp: 0.02 | 0.3 | 0.3 - Duration of crisis, years: 4.5-6 | 4.5-6 | 6-8 - Unemployment gap in crisis, %: 5 | 5 | 7 - Higher unemployment, pp (from the initial rate hike): 0.5 | 0.5 | 0.5 - Benefits: 0.008 | 0.113 | 0.294 - Costs: 0.25 | 0.25 | 0.25 - Ratio (B:C): 0.03 | 0.45 | 1.18 - Interpretation: - In the first two scenarios costs of leaning against the wind are notably higher than benefits. - Only in the third (severe crisis) scenario does leaning against the wind appear to pay off. - To justify leaning against the wind, parameters need to be near the upper range of empirical estimates. ### Key parameters and sensitivity - IMF’s GIMF model implies: unemployment would rise by somewhat less than ½ percentage point as a result of a 100 basis point increase in short-term interest rates for a year; effects peak after 1 to 2 years and unemployment returns to steady state after 3 to 4 years. - Benefits are sensitive to: - strength of linkage between policy rate and crisis risk; - assumed severity and duration of crisis; - whether credit returns to steady state or stabilizes at a lower steady state (hysteresis). --- ### Implementation, credibility, and open-economy considerations ### Credibility and communication - Leaning against the wind may undermine central bank credibility, predictability, and transparency, and could de-anchor inflation expectations. - Credibility depends on consistently satisfying the inflation target; evidence from Norway and Sweden shows inflation expectations dropped below target when central banks highlighted financial stability worries. - Central banks with financial stability mandates often separate decision-making bodies for financial stability and price stability to shield monetary policy independence. ### Cross-border spillovers and country size - Large economies with strong cross-border financial links: - benefits and costs of leaning against the wind may be larger once spillovers are considered; avoiding a crisis in a large country can yield large domestic and international gains. - higher interest rates in the large country could have negative effects on smaller countries via trade and currency channels. - Small open economies: - case for leaning against the wind may be weaker. - financial stability concerns often stem from strong capital inflows driving asset prices and compressing spreads. - raising domestic rates can attract further inflows and appreciate the currency; may be counterproductive. - exchange rate flexibility and other policies may be more appropriate. ### Timing, detection, and coordination with macroprudential policy - Acting early in the development of vulnerabilities is crucial; acting late can worsen vulnerabilities. - Policymakers face longer forecast horizons for crises than for price stability. - Monetary and prudential policies are complementary; well-targeted macroprudential measures should shoulder most of the burden. - Policy mix should be determined by joint maximization of social welfare, accounting for political and practical constraints. --- ### Box highlights and select empirical boxes ### Box 1 — Financial cycles: concepts and measurement - “Financial cycle” denotes “self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts (Borio 2014).” - Measurement approach: turning point algorithm (Harding and Pagan, 2002) and band-pass filter (Christiano and Fitzgerald, 1999). - Policy relevance: consider a range of indicators and be alert to early signs of pickup in trends and widening gaps in financial variables. ### Box 2 — How severe are tradeoffs? - Analysis for AEs with systemic banking crises in 2007–08 shows economic and financial variables tend to grow above normal values in three years prior to crisis, implying monetary tightening would have been warranted on simple economic-stabilization grounds. - Once a crisis begins, economic conditions deteriorate quickly while financial conditions adjust more gradually; this constellation typically does not justify monetary tightening. ### Box 3 — The Effect of Monetary Policy on Default Rates - Main takeaway: higher interest rates worsen financial stability in the short run (higher delinquencies) but may improve it in the long run (reduced household leverage and lower default rates eventually). - U.S. VAR (1988Q1–2015Q1): residential loan default rates peak at 0.37 percent after 14 quarters and decline to 0.31 percent after 36 quarters. - Spain VAR (1999Q1–2014Q4): residential NPLs peak after 6 quarters at 0.08 percent. - Institutional features (variable-rate mortgages, non-recourse mortgages) shape transmission speed and magnitude. ### Box 8 — Cross-Border Spillovers from U.S. Monetary Policy - Sample: 20 economies (advanced and emerging) between 1969Q3 and 2008Q4. - An exogenous increase of 100 basis points in the U.S. monetary policy rate typically contracts the level of real credit by about 1 percent after 12 quarters. - Heterogeneity: - Emerging market economies: about 1.3 percent contraction. - Advanced economies: about 0.8 percent contraction. - Pegged exchange rate regimes: 1 percent contraction; floaters: 0.4 percent contraction. - Higher capital account openness: 0.8 percent contraction. --- ### Selected emerging market country notes (excerpt) ### China - Output growth and inflation moderated; credit growth including shadow banking slowed considerably. - Fund advice: maintain a neutral monetary stance to allow deleveraging and structural adjustment. ### Peru - Sharp output growth slowdown in 2014–15; negative output gap expected to close only in 2018. - Credit growth decelerated and inflation expectations well anchored. - Key vulnerability: financial dollarization constrains further easing. - Emphasis: exchange rate flexibility as main defense; de-dollarization measures and prudential requirements recommended. ### Thailand - Tentative growth recovery; sizeable negative output gap closing gradually; headline inflation turned negative. - Fund view: recent monetary easing not seen as exacerbating financial stability risks. - Recommendation: strengthen regulation of non-commercial banks and credit cooperatives exposed to household sector. --- ### Concluding assessment (policy-relevant conditions) ### On balance - Based on current understanding and circumstances, the case for leaning against the wind is limited: - with substantial slack, transmission from interest rates to financial risks seems weak; - costs often appear greater than benefits; - implementation hurdles are substantial; - macroprudential policies remain key and, when well targeted, can address imbalances closer to the source than monetary policy. - Further research is warranted on transmission mechanisms and state-dependent effects; benefits can outweigh costs in particular circumstances. ### Conditions that increase the likelihood benefits > costs - Initial conditions: - low unemployment (so rate hikes have smaller macro costs); - rapid credit growth (so rate hikes have stronger effects on credit and crisis probability); - strong borrower and bank balance sheets (so the system can withstand the initial shock). - Structural conditions: - crises likely to be particularly severe (large, interconnected financial system and lack of effective macroprudential measures); - large cross-border spillovers (systemically important countries with open capital accounts); - reliable early identification of future financial risks (allowing early, preemptive rate increases). *Italic: Source: IMF staff content from the provided PDF excerpt (_082815a).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Context and motivation - Before the global financial crisis, monetary policy focused on price stability and largely ignored asset prices and credit aggregates except when they affected inflation and output. - Financial stability responsibilities were assigned primarily to prudential regulation and supervision, which concentrated on individual institutions and gave relatively little attention to systemic risk. - In the run-up to the crisis there was a sharp increase in credit-to-GDP ratios and real estate prices despite close-to-target inflation and small output gaps. - Financial crises are costly: on average, after World War II financial crises have led to negative GDP growth for two years, with a peak loss of GDP per capita of about 1.5 percent; GDP has lagged behind its average recovery path after normal recessions by about 4 to 5 percent after five years. - Extraordinary monetary accommodation was required during the crisis as short-term nominal rates hit the effective lower bound; large-scale Unconventional Monetary Policies (UMP) were deployed, but their fine-tuning, future financial-stability implications, and cross-border spillovers remain imperfectly understood. - The analysis is most applicable to advanced and emerging economies with freely floating exchange rates; empirical estimates are representative of advanced and emerging market economies. ### Core question and high-level conclusion - Central question: Should monetary policy be altered to contain financial stability risks—i.e., should it “lean against the wind” by raising interest rates temporarily more than warranted by price and output stability objectives (or by keeping rates persistently higher)? - High-level finding: Based on current knowledge and present circumstances, the answer is generally no; the door should remain open as understanding evolves and circumstances change. - Key principle: Monetary policy should deviate from its traditional response only if costs are smaller than benefits (the principle of doing no harm on net). Costs arise in the short term (lower output and inflation); benefits materialize mainly in the medium term via mitigated financial risks, but are more uncertain. ### Two approaches to using monetary policy for financial stability - Approach 1 — Persistently higher rates: - Keep nominal interest rates persistently higher than implied by a traditional reaction function focused only on inflation and output. - Drawback highlighted: Higher rates would create persistently lower inflation, eventually decrease inflation expectations, and leave real rates—and thus financial risks—unchanged, while aggravating risks of hitting the zero lower bound. - Approach 2 — Occasional “leaning against the wind”: - Respond occasionally to counter evolving financial risks (e.g., hiking more, cutting less, or hiking earlier than warranted by price stability alone). - Could be operationalized as a state-contingent, rule-based approach using identified financial indicators (credit growth, leverage, etc.). - This paper focuses on the second approach as more promising. ### Transmission and tradeoffs (summary) - The case for leaning against the wind is limited in most circumstances because: - Costs (short-term losses in output and inflation) often outweigh uncertain medium-term benefits from reduced financial risks. - Empirical evidence and theoretical frameworks are limited; channels through which monetary policy affects financial stability domestically, across borders, and over the business cycle are still being established. - Implementation is challenging due to long and variable policy lags and communication difficulties; yet in some cases price and financial stability may require similar policy reactions. ### Policy guidance and interim actions - Given current knowledge: - Prudential policies (micro- and macroprudential regulation and supervision) should be pursued actively to attenuate the buildup of financial risks. - Central banks should monitor and openly discuss financial stability risks, and carefully consider costs and benefits of potential actions. - Leaning against the wind should not be the default; it should be considered only when a clear net benefit is evident based on the “do no harm on net” criterion. ### Research and future priorities - Future research on the channels linking monetary policy and financial stability is a key priority. - As understanding evolves, additional circumstances may be identified in which deviations from traditional monetary policy responses are warranted. ### Notable contextual points and quotations - The paper reopens the “lean versus clean” debate and stresses sensitivity for policy frameworks and institutional mandates. - Representative views quoted in the paper: - John Williams: “monetary policy is poorly suited for dealing with financial stability concerns, even as a last resort.” - Oystein Olsen: “we have been leaning against the wind.” - Janet Yellen: “Monetary policy faces significant limitations as a tool to promote financial stability... [However,] it may be appropriate to adjust monetary policy to ‘get in the cracks’ that persist in the macroprudential framework.” *Source: EXECUTIVE SUMMARY (August 28, 2015).* ### 11. The Bank for International Settlements (BIS) has also been a prominent contributor to ### 11. The Bank for International Settlements (BIS) has also been a prominent contributor to ### BIS view and implications - The BIS expresses support for a stronger role for monetary policy in maintaining financial stability: “Financial stability is too large a task for prudential [...] frameworks alone. Monetary policy strategies also need to [...] lean against the build-up of financial imbalances even if near-term inflation remains low and stable.” - BIS advocates for higher interest rates for extended periods because “financial imbalances can build up gradually, over many years [...]. If central banks are to counteract such build-ups, they will need longer policy horizons.” - BIS frames these horizons as growing over a “financial cycle,” lasting longer than the business cycle (Caruana 2011, and Box 1). ### Current economic environment and cross-country patterns - Tensions between price and financial stability mandates have emerged in several advanced economies (AEs) that still face considerable slack in the economy and low inflation. - Country-pattern observations: - Sweden, Switzerland, and the United Kingdom (U.K.): house prices and credit growth are either accelerating or still increasing, sometimes from already elevated levels. - Australia and Canada: house prices are rising despite moderate credit growth. - The Netherlands and Norway: house prices and credit have decreased, but are recently recovering. - United States (U.S.): after a sharp correction in house prices and subdued credit growth, a range of asset markets other than housing show signs of stretched valuations. - Note: in some countries inflation has been pushed down by external factors, such as lower oil prices and domestic currency appreciation; in these cases, policy does not necessarily have to be especially accommodative and the tradeoff with financial stability may be less stark, at least over a temporary period. ### Paper objectives and approach - Aim: to help policymakers assess the value and implications of using monetary policy to support financial stability by: - providing a framework to conceptualize and clarify channels of transmission and policy tradeoffs; - advancing initial policy guidance based on the most recent empirical findings; - emphasizing the gaps that still need to be filled before more definitive policy advice can be formulated. - Guiding question: “what do we know and can be quantified, what should we do based on what we know, and how much do we really know?” - Structure: the paper is divided into five sections (first: policy context, conceptual underpinnings and definitions; second: empirical estimates; third: tradeoffs between price and financial stability; fourth: welfare implications; fifth: additional discussion including open economy implications; sixth: implementation issues; final: concluding thoughts). ### Policy context, dimensions, and role of structural policies - Two policy dimensions: - Cyclical: adapts to conjuncture and may target a specific source of risk. - Structural: remains unchanged over time, aims to support resilience of the financial system to a wide set of shocks (capital and liquidity requirements, limits on exposure to foreign exchange, redemption risks). - Recent work suggests strong structural policies can materially improve systemic resilience. - If structural policies are effective, the burden on cyclical policies—including monetary policy—could be lighter; however, the paper emphasizes cyclical policies given focus on monetary policy. ### Decision framework for cyclical dimension (stylized) - Key sequential questions (decision tree): 1. Are financial risks excessive? - Financial risks capture the likelihood of large disturbances to future macroeconomic conditions originating in financial variables. - Determining whether risks are excessive must rest on a socially agreed maximum for the probability and severity of large disturbances—analogous to defining an inflation target. 2. Are macroprudential policies effective in addressing these risks? - Macroprudential policies can target specific vulnerabilities; empirical evidence on their effectiveness is slim but growing. - Other policies (e.g., fiscal) should be considered for their interactions with financial stability and monetary policy. 3. Are there tradeoffs with traditional monetary policy (price stability)? - If tighter monetary policy warranted by price stability is also sufficient for financial stability, there are “no tradeoffs.” - If tradeoffs exist and prudential policy is not sufficiently effective, the remaining question is whether monetary policy should “lean against the wind.” ### Evaluating “leaning against the wind”: three broad steps - First: describe transmission channels—estimate links between policy interest rates and financial risks. - Second: establish the nature and size of the tradeoff between stabilizing inflation and financial risks. - Third: assess welfare implications of leaning against the wind in a clear cost-benefit framework. ### Transmission from interest rates to macroeconomic conditions - Two-step relation: - Interest rates → financial variables. - Financial variables → probability of large disturbances to macroeconomic conditions. - Focus on five financial variables: - Quantities: leverage of financial firms, household debt, bank risk taking. - Prices: asset prices (especially real estate), credit spreads. - Other potentially important variables noted but with weaker data/literature: loss absorption capacity, liquidity, maturity, FX balance sheet mismatches. ### Effects of interest rates on financial variables: horizon-dependent - General: effects can change or reverse depending on time horizon and initial conditions. - Short term (before balance-sheet adjustment): higher interest rates likely weaken financial stability because: - Reduced aggregate demand lowers household earnings and firms’ profitability. - Increased interest burden if liabilities are variable-rate and short-maturity. - Reduced asset prices and value of legacy assets held by financial institutions. - Possible temporary increase in delinquencies and defaults, especially if balance sheets are weak. - Medium term (after balance-sheet adjustment): effects likely to reverse as agents rebalance: - Higher borrowing costs should induce households and firms to gradually reduce leverage through intertemporal substitution. - Tighter monetary conditions likely to gradually reduce banking sector leverage (Dell’Ariccia, Laeven and Marquez (2014)). - Effects on risk taking are ambiguous: - For insurers and pension funds with fixed long-term liabilities, higher rates reduce search-for-yield motives and should reduce risk taking. - For banks, higher funding costs compress intermediation margins which could lower monitoring incentives, but lower leverage could induce more prudent bank behavior. *Italic source: Content from the provided IMF PDF chapter/section.* ### 24. Empirical results broadly support these theoretical predictions. ### _082815a - 24. Empirical results broadly support these theoretical predictions. ### Empirical findings on how monetary policy affects financial variables - Real debt levels generally decrease following a temporary monetary policy tightening of 100 basis points, by up to 0.3 percent and 2 percent, after 4 to 16 quarters, depending on the model. - In the short term, real debt to GDP seems to rise. - Intuition: nominal GDP responds faster than nominal debt to an interest rate hike, especially with lengthy loan amortization periods. - Because real debt and debt servicing costs increase with higher interest rates, default rates rise in the quarters following an interest rate shock. - Example from Box 3: household loan delinquency rates increase by 126 bps for the U.S. and 25 bps for Spain in the first 15 and 7 quarters, respectively, following a 100 bps unexpected hike to interest rates. - Banks and nonbanks generally respond to higher interest rates by reducing their leverage, though after 1–2 quarters. - In the initial quarters, leverage tends to rise across financial firms. - Cecchetti, Mancini-Griffoli and Narita (2015) find changes in leverage (full sample medians between 1998 and 2014): 10.7 to 11.2 for banks, 7.0 to 7.3 for insurance companies, and 4.7 to 5.0 for investment banks. - Bruno and Shin (2015) find that a 90 bps hike in rates decreases leverage of U.S. broker dealers from 22 to 21.5 (after increasing leverage initially). - Higher interest rates seem to induce banks to tighten lending standards, grant fewer loans to risky firms, and extend less risky new loans. - Sharpe ratios of financial firms—both banks and nonbanks—decrease somewhat following protracted rate cuts; implication: Sharpe ratios would increase (lower financial risks) following interest rate hikes. - Cecchetti, Mancini-Griffoli and Narita (2015): Sharpe ratios decrease (implying greater volatility or risk of assets) from (full sample medians between 1998 and 2014): 6.1 to 5.4 for banks, 4.0 to 3.5 for insurance companies, and 2.6 to 2.1 for investment banks (implying the converse effect for hikes). - Market-based measures (distance to default) show banks are perceived to hold a less risky portfolio after an interest rate hike in the medium term, but in the short term distance to default decreases (higher riskiness). - Distance to default is based on Merton (1974); it increases with asset growth, and decreases with leverage and equity price volatility. - Threshold-VAR (TVAR) results: after a positive interest rate shock (taken to be a flattening of the yield curve), distance to default decreases on impact, especially in periods of high financial stress; it then rises again, though only back to levels existing before the interest rate shock. - Real estate prices decrease on average following a hike in interest rates. - Effect: of the order of 2 percent, following a 100 bps interest rate shock, though after a lag of between 10 to 16 quarters. - Credit spreads tend to increase following an interest rate hike. - Evidence: a surprise decrease in one-year bond yields by 20 bps reduces the non-default component of corporate bond credit spreads by about 8 bps for eight months (Gertler and Karadi, 2013). ### Caveats and limitations of empirical estimates - Estimates of the effect of interest rates on financial variables may be biased downwards because relationships are mostly estimated over periods of relative stability when higher rates were associated with good times and growing vulnerabilities. - Analysis to date emphasized costs to unemployment, but other costs exist: inflation, public finances, social and political stability and cohesion. - Results about credit effects are sensitive to specification assumptions; credits may or may not return to steady state following a monetary policy shock, and focusing on peak effects may overstate effects on credit. ### Financial variables and macroeconomic conditions: crises and setbacks - Two types of disturbances distinguished: - Crises: infrequent, but very substantial drops in output and increases in unemployment. - Setbacks: more frequent, smaller, akin to mild recessions with financial roots. - Historical frequency: crises have on average struck every 15 to 20 years (Taylor, 2015). - Link between bank credit and crises: - Schularick and Taylor (2012) (annual data 1870–2008 for 14 advanced economies) document that faster credit growth over the previous five years is associated with a higher probability of a financial crisis. - IMF staff obtained similar results using a larger set of 35 advanced countries and quarterly data post 1960. - Higher interest rates reduce the probability of crises over the medium term, provided borrowers and the financial system can withstand the initial rate shock. - Reduced-form estimates suggest the probability of crises first increases, then decreases to its trough after 3 to 5 years. - Quantified effect: probability is reduced by 0.04 to 0.3 percentage points following a 100 basis point interest rate hike for a year, given the range of effects found in the literature (illustrated for a middle-of-the-road response where real credit growth decreases by one percentage point for one year from its historical average of 5.4 percent). - Important nuances: - Average reduction in crisis probability is lower than the maximum effect at the trough because crisis risk initially spikes following an interest rate hike (stock effects). - The average probability reduction per year across the full set of models over the first four years ranges from 0 to 0.05 percentage points; cumulated reduction over the four years is 0 to 0.2 percentage points. - The path of crisis probability depends strongly on credit behavior: - If credit returns to steady state, credit growth may need to overshoot after the trough, potentially causing crisis probability to overshoot initial levels. - If credit stabilizes at a lower steady state after the rate hike (hysteresis), crisis probability returns to initial level more smoothly. - An interest rate hike reduces crisis probability more if it occurs during a credit boom. - Example: if credit growth declines for one year from 20 to 19 percent, the probability of a crisis would decline by about 0.4 percent after three years. - Other financial variables matter for crisis risk: - Early warning indicator and logit regression approaches indicate equity and house prices, credit growth, and the output gap may be useful indicators for monitoring stability risks and monetary policy scope. - Considering additional intermediating channels (leverage, risk-taking, asset prices, credit spreads) likely increases the estimated effect of higher interest rates on lowering crisis probability. ### Tradeoffs for monetary policy - Tradeoffs between stabilizing inflation (or output) and financial risks should be evaluated by magnitude and direction of effects. - Key questions: - Do periods requiring rate tightening for price stability coincide with periods where financial stability also calls for higher rates? - Should interest rates be raised by the same magnitude to accomplish both objectives? - Practical considerations: - A 100 basis point rise in interest rates is large for price stability purposes in tranquil times; central banks rarely lift rates by more than 25 or 50 basis points on any given announcement date (cumulative examples exist, e.g., the U.S. Federal Reserve raised rates by about 200 basis points per year in the 2004–06 tightening cycle). - Earlier analysis suggests a 100 basis point increase in rates is associated with a small decrease in the probability of a crisis. *Italic: Source: _082815a - 24. Empirical results broadly support these theoretical predictions.* ### 34. However, tradeoffs may not always be severe, at least on the basis of the direction of ### _082815a - 34. However, tradeoffs may not always be severe, at least on the basis of the direction of ### Tradeoffs between monetary policy and financial stability: historical dynamics - Financial risks often develop during economic expansion, which also warrant higher interest rates for price stability. - Figure 6 evidence (advanced economies with systemic banking crises in 2007–08): - Inflation: "inflation was running slightly above target prior to the crisis, thus calling for a somewhat tighter monetary stance from a pure inflation-targeting perspective." - Output gaps: real-time estimates (WEO April 2007) showed "no sign of economic overheating" pre-crisis; revised estimates (WEO October 2015, based on revised data and the realization of the crisis) reveal "large positive output gaps that would have warranted considerable monetary tightening." - Implication: tradeoffs may have been small in these cases both in sign and size of interest rate responses. - Policy lesson: "policy makers should seek to improve real-time estimates of potential output, possibly using financial variables, as well as external balances—this remains a key and difficult challenge." ### Comparing output gaps and financial gaps - Box 2: a similar analysis comparing output gaps with financial gaps (a measure of financial stability risks) "also suggests that tradeoffs between stabilizing inflation and financial risks may not always be severe." ### Welfare implications of "leaning against the wind" - Need for models: - Empirical relationships from past data are limited because agents would have adapted if policy had systematically leaned against the wind. - "Only models can account for the endogenous response of households and firms to a structural change in policy." - Models require micro-foundations linking agents’ risk-taking behavior with financial and macro variables. - New-model findings: - "A new class of models suggests that leaning against the wind, absent other tools, can be welfare improving." These models incorporate some financial distortions and heterogeneous agents. - Limitations: these models "do not as yet generate crises of major proportions" and model financial imbalances as small fluctuations around steady state, excluding large nonlinearities (e.g., default states). - Result: "reacting systematically to swings in financial variables (asset prices, leverage, and risk premia) reduces inefficient fluctuations in output." - Magnitude and state dependence: - Welfare improvements in current models are "generally fairly small and state (or shock) dependent." - "Simple rules that react to observable variables may lead to policy mistakes—emphasizing the need for judgment in actual policy decisions." - Welfare gains from leaning against the wind are small relative to complete macroprudential policies (though macroprudential policy is highly stylized in models). ### Model limitations and research needs - Stylized models miss important features: - Do not fully capture foundations of financial distortions or specific dynamics of risk-taking behavior. - Unclear how much monetary policy can affect root causes such as incentive structures or funding liquidity constraints. - Distortions are multiple, interrelated, and time varying; models often miss cross-effects (e.g., on financial intermediaries vs. household delinquencies). - Crises are typically modeled as small steady-state fluctuations; models largely exclude multiple equilibria and large nonlinearities observed in real crises. - Need for richer analysis of non-linearities with potentially sizable implications for monetary policy. ### Cost–benefit intuition and illustrative calculations - A simpler cost–benefit framework (inspired by Svensson (2014)) can guide intuition: - Leaning against the wind involves paying a short-term cost (lower output or higher unemployment) in exchange for medium-term benefit (lower expected costs from a financial crisis). - There is less inter-temporal tradeoff between monetary policy’s role in stabilizing inflation and output over short horizons because of their strong correlation. - Key parameter: short-run unemployment loss from higher interest rates. - IMF’s GIMF model implies "unemployment would rise by somewhat less than ½ percentage point as a result of a 100 basis point increase in short-term interest rates for a year." - Effects peak after 1 to 2 years; unemployment returns to steady state after 3 to 4 years. - Empirical consistency: this estimate is "broadly consistent with those obtained using vector auto-regression (VAR) models." ### Illustrative scenarios and numerical results (Table 1) - The cost–benefit conclusion is sensitive to: - strength of linkage between policy rate and crisis risk; - assumed severity of crisis. - Three illustrative scenarios reported (building blocks and outcomes): - Building blocks and outcomes (columns: Average | High (Peak) Probability | High (Peak) Probability, Severe Crisis) - Lower crisis probability, pp: 0.02 | 0.3 | 0.3 - Duration of crisis, years: 4.5-6 | 4.5-6 | 6-8 - Unemployment gap in crisis, %: 5 | 5 | 7 - Higher unemployment, pp (from the initial rate hike): 0.5 | 0.5 | 0.5 - Benefits: 0.008 | 0.113 | 0.294 - Costs: 0.25 | 0.25 | 0.25 - Ratio (B:C): 0.03 | 0.45 | 1.18 - Interpretation: - In the first two scenarios, "the costs of leaning against the wind are notably higher than benefits." - Only in the third (severe crisis) scenario does leaning against the wind appear to pay off. - To justify leaning against the wind, parameters need to be near the upper range of empirical estimates. ### Refinements, state contingency, and alternative analyses - A more detailed alternative (Bayesian VAR analysis) reaches similar conclusions and provides refinements. - Key points: - Tradeoffs differ by country circumstances; benefits may exceed costs in some cases but only modestly and over medium to long term. - Costs are short-run and benefits materialize slowly and with uncertainty. - Benefits are sensitive to assumptions, including the return of real credits to steady state and initial unemployment conditions. - Policy responses must be state contingent; a fixed-coefficient addition to a Taylor rule is inadequate. ### Further considerations - Three relevant considerations: effects on the probability of setbacks (not only crises), central bank credibility, and open-economy implications. - Setbacks vs. binary crises: - Current analysis uses a "zero-one" crisis definition (full-fledged crisis only). - If leaning against the wind also reduces severity/incidence of "non-crisis" recessions with financial roots, expected benefits could increase. - This would require assessing effects on the entire distribution of future unemployment, not just the crisis tail. - Empirical results on this additional benefit are "still scarce and inconclusive." - Evidence on credit spreads and activity: - Compressed spreads today often forecast future widening, lower credit supply to lower credit-quality firms, and an economic contraction. - Reference: an increase of 100 basis points in spreads predicts "a drop in real GDP growth of more than 1.5 percentage points over the subsequent 4 quarters." - Credit growth leads to a future expansion and then contraction of GDP according to staff estimates, but "GDP never substantially falls back below its initial level," weakening the case to lean against credit growth specifically. - Credibility risks: - Leaning against the wind might undermine central bank credibility, predictability, and transparency, and could de-anchor inflation expectations. - Crises may still occur despite leaning, and central banks may "under deliver on inflation, at least at times," destabilizing inflation expectations. - If central banks under-delivered on their inflation mandates, real debt and... [text truncated in source] *Italicized source: IMF staff content from the provided PDF excerpt.* ### 4.2 percentage points over the subsequent two years. Other papers have also documented a correlation between ### _082815a - 4.2 percentage points over the subsequent two years. Other papers have also documented a correlation between ### Transmission, evidence, and credibility - Evidence links shocks to financial stress indices with output, both domestic and foreign; examples cited include Metiu and others (2014), and Alessandri and Mumtaz (2014). - The link between monetary policy and credit spreads is mixed: - Gertler and Karadi (2013) find easier monetary policy reduces spreads. - Gilchrist and others (2015) do not find any impact of monetary policy on credit spreads. - Communication of monetary policy aimed at financial stability improves as the central bank learns the transmission mechanism to financial stability and refines crisis-probability forecasting models. - Central banks that are responsible for financial stability and control macroprudential policy often separate decision-making bodies for financial stability and price stability to shield the independence and credibility of monetary policy. - Credibility is not exogenous and depends on consistently satisfying the inflation target; evidence from Norway and Sweden is noted where inflation expectations dropped below target when central banks highlighted financial stability worries. ### Cross-border spillovers and country size considerations - For large economies with strong cross-border financial links: - Benefits and costs of leaning against the wind may be larger once spillovers are considered. - Monetary policy that decreases crisis probability in a large country avoids higher domestic and international costs, potentially tipping cost-benefit analysis toward leaning against the wind. - Higher interest rates in the large country could have negative effects on smaller countries through trade linkages (more sluggish demand, partially compensated by a stronger currency). - Central banks primarily focus on domestic mandates unless spillovers spill back to the domestic economy or mitigating cross-border spillovers does not affect achieving domestic objectives. - For small open economies: - The case for leaning against the wind may be weaker. - Financial stability concerns often stem from strong capital inflows that drive up asset prices and compress credit spreads (see Sahay and others, 2014). - Increasing domestic interest rates (or cutting rates by less than warranted) may be counterproductive by attracting further capital inflows. - Higher rates tend to appreciate the domestic currency, strengthening balance sheets for those with foreign currency debts; higher rates could even increase the share of foreign currency debt in highly dollarized economies. - Other policies may be more appropriate to manage financial stability risks stemming from capital inflows. ### Implementation issues - Timing of action: - Acting when vulnerabilities are already very large may worsen vulnerabilities because the immediate effect of higher interest rates is to worsen, not improve, vulnerabilities. - Leaning against the wind should be done early in the development of financial vulnerabilities and should not be done after a crisis when unemployment is already very high. - Detection and real-time prediction: - It is difficult to distinguish between “good” credit expansions (driven by productivity) and “bad” ones (driven by consumption and expectations of capital gains) in early phases of expansion. - Policymakers face longer forecast horizons for crises than for price stability, augmenting difficulty under uncertainty. - Historical example: in 2002 U.S. house prices and household debt were growing rapidly; had policymakers expected a large increase in crisis probability and severity (a rise in the unemployment rate of 4 percent on average for 6 years, starting in 2007), they may have leaned against the wind. However, in 2002 most forecasts did not foresee such a surge. - The hope is for better frameworks and better estimates linking interest rates to financial stability and the dynamics of financial variables to crisis probability; judgment remains necessary. - Combining monetary and prudential policies: - Monetary and prudential policies must be considered together; well-targeted macroprudential (and micro-) policies should shoulder most of the burden to contain financial instabilities. - Macroprudential and monetary policy appear strongly complementary: - An early interest rate hike that contains a possible spike in asset prices would facilitate prudential policies later. - Monetary and prudential policies should be systematically compared on: - relative uncertainty, - expected effects, - expected costs (prudential policies also give rise to distortions while correcting others). - The policy mix should be determined by joint maximization of social welfare, taking into account practical constraints on each policy (e.g., political pressures can hinder both prudential and monetary policy focus on financial stability). ### Concluding assessment and when benefits may outweigh costs - On balance, based on current understanding and circumstances, the case for leaning against the wind is limited: - With substantial slack in the macroeconomy, transmission from interest rates to financial risks seems weak. - Costs often appear greater than benefits. - Implementation hurdles are substantial. - Macroprudential policies (cyclical and structural) remain key to defending against financial instability; when well targeted and effective they can address imbalances closer to the source than monetary policy and allow monetary policy to focus on price stability. - Further research is warranted: - Understanding of the transmission mechanism from monetary policy to financial stability is limited; new evidence could identify new channels and strengthen the case for leaning against the wind. - Benefits can plausibly outweigh costs in particular, albeit relatively unlikely, circumstances reflecting confluence of initial conditions and structural characteristics. - Examples of conditions increasing benefits relative to costs: - Initial conditions: - low unemployment (when rate hikes could lead to smaller macroeconomic costs); - rapid credit growth (when rate hikes could have a stronger effect on credit growth and crisis probability by discouraging exuberant, self-fulfilling behavior); - borrower and bank balance sheets are strong (and hence can withstand the initial interest rate shock). - Structural conditions: - crises likely to be particularly severe (large and interconnected financial system and absence of well-targeted macroprudential measures); - financial spillovers could be large (systemically important countries with open capital accounts); - future financial risks can be reliably identified early (so that early increases in interest rates may avoid a large buildup of risks). ### Box summaries - Box 1 — Cycles in Financial Variables: Concepts and Measurement - “Financial cycle” denotes “self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts (Borio 2014).” - Financial cycles generally include credit and property cycles; credit cycles tend to be highly correlated with GDP with similar durations of about five years, while property cycles tend to be shorter. - Measurement approach used in the paper: turning point algorithm (Harding and Pagan, 2002) to estimate average length of cycles, then a band-pass filter (Christiano and Fitzgerald, 1999) to estimate gaps (deviations from trend). - Policy relevance: given uncertainty in empirical features and stability of financial cycles, a prudent approach is to consider a range of indicators and be alert to early signs of pickup in trends and widening gaps in financial variables. - Box 2 — How Severe are the Tradeoffs Between Economic and Financial Stabilization? - Analysis for advanced economies that experienced a systemic banking crisis in 2007 and 2008 shows both economic and financial variables tend on average to grow above normal values in the three years prior to a banking crisis; monetary tightening would thus be warranted on simple economic-stabilization grounds. - Once a crisis begins, economic conditions deteriorate quickly while financial conditions adjust more gradually, which may lead to negative economic gaps and positive financial gaps; this constellation does not seem to justify monetary tightening since financial conditions tend to correct over time. - The analysis calls for improving quality of real-time estimates of potential output, possibly using financial variables, to better guide monetary policy. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2015/_082815a.pdf* ### Box 3. The Effect of Monetary Policy on Default Rates ### Box 3. The Effect of Monetary Policy on Default Rates ### Main takeaway - Higher interest rates have a negative effect on financial stability in the short run, but may have positive effects in the long run. - Loan delinquencies often increase shortly after a monetary contraction (consistent with lower economic activity, lower house prices, and higher interest payments), while household leverage ratios eventually improve after several quarters, reducing default rates in some cases. ### U.S. evidence (VAR results) - Model: standard VAR with real GDP, core PCE, the Federal Funds Rate, real house prices, household leverage, and delinquency rates; four lags; period 1988Q1 to 2015Q1. Monetary policy shock identified with a standard Cholesky ordering. - Short-term responses: - Real GDP and real house prices decline. - Core PCE response not significant. - Default rates on residential loans initially increase, peaking at 0.37 percent after 14 quarters. - Long-term responses: - Delinquency rates decline to 0.31 percent after 36 quarters. - Household leverage (Flow of Funds measure) is not significantly different from zero for the first 25 quarters and becomes negative afterwards. - Robustness: - Similar results when using commercial and industrial loans delinquency rates. - Results robust to different orderings of variables, to Bayesian VAR with a Minnesota prior, and to using the two-year rate instead of the Federal Funds rate to address the effective lower bound and unconventional policies. ### Spain evidence (VAR results) - Model: standard VAR with real GDP, HICP, the 12-month EURIBOR rate, real house prices, household leverage, and delinquency rates; one lag; period 1999Q1 to 2014Q4. - Responses: - An increase in the 12-month EURIBOR leads to an increase in residential loan default rates. - Household leverage first increases and then declines significantly. - Residential nonperforming loans (NPLs) increase faster but the response is smaller than in the U.S., peaking after 6 quarters at 0.08 percent. - Possible explanations for differences with the U.S.: - Larger share of variable-rate mortgages in Spain leads to faster transmission of interest-rate shocks. - Widespread use of non-recourse mortgages reduces the incentive to default. ### Interpretation and implications - Short vs. long-term tradeoff: - Short-term costs: higher delinquencies and weakened financial stability following tighter monetary policy. - Longer-term benefits: reduced household leverage and, in some cases (e.g., the U.S.), lower default rates. - Policy relevance: - Leaning against credit booms by raising rates can increase short-term defaults but may lower medium- to long-term default risk if household leverage declines persistently. - Cross-country institutional features (mortgage contract types, recourse rules) affect the speed and magnitude of transmission and should inform policy choices. ### Data and measurement notes - U.S. delinquency data: Federal Financial Institutions Examination Council, FRB Call Report, Board of Governors of the Federal Reserve System. Delinquent loans include those past due 30 days or more and still accruing interest, as well as those on nonaccrual status. - Spanish data: doubtful (nonperforming) loans over total loans for house purchase and renovation, from the Banco de España. - Robustness and alternative specifications noted above (different loan types, alternative rate measures, Bayesian estimation). *Author of the box: Pau Rabanal (RES). Sources: BEA, Federal Reserve, OECD, Banco de España, and IMF staff estimates.* ### Box 8. Cross-Border Spillovers from Monetary Policy on Financial Stability ### Box 8. Cross-Border Spillovers from Monetary Policy on Financial Stability ### Scope and motivation - Investigates effects of U.S. monetary policy on financial stability abroad, focusing on real credit growth as a measure of financial stability risk. - Sample: 20 economies (both advanced and emerging) between 1969Q3 and 2008Q4. - Motivated by documented spillover effects of U.S. monetary policy on foreign asset prices and capital flows and the variation of those effects with country-specific conditions. ### Empirical approach - Two specifications: - First specification assesses effect of U.S. monetary policy shocks on foreign real credit growth. U.S. exogenous monetary policy shocks are identified by Coibion (2012). - Second specification interacts monetary policy shocks with country characteristics, following the approach in Auerbach and Gorodnichecnko (2013). - Estimation includes country fixed-effects. ### Key empirical findings - Aggregate impact: - An exogenous increase of 100 basis points in the U.S. monetary policy rate typically contracts the level of real credit by about 1 percent after 12 quarters. - Heterogeneity by income group: - Emerging market economies: about 1.3 percent contraction in real credit. - Advanced economies: about 0.8 percent contraction in real credit. - Heterogeneity by country characteristics: - Fixed exchange rate regimes (pegged): 1 percent contraction. - Flexible exchange rate regimes (floaters): 0.4 percent contraction. - Higher capital account openness: 0.8 percent contraction. - Degree of market capitalization: impact is similar and not statistically different across low market value and high market value countries. - Temporal dynamics: - Effects are assessed up to at least 12 quarters after the shock (Figure 8, top panel shows impact on log level of real credit; dashed lines indicate the 90-percent confidence bars). ### Policy implications and open questions - Spillovers from U.S. monetary policy can affect credit dynamics and thus financial stability in other countries, with larger effects in emerging markets and in countries with pegged exchange rates or higher capital account openness. - Two pressing questions highlighted for further research: - To what extent do spillovers depend on the underlying drivers of policy normalization (better growth prospects vs. financial stability concerns)? - How do financial risks, and financial stress propagate across borders? *Author of this box: Aleksandra Zdzienicka (SPR) with assistance from Federico Diaz Kalan (SPR).* ### 54. Discussions around financial stability objectives are also emerging in a few emerging ### _082815a - 54. Discussions around financial stability objectives are also emerging in a few emerging ### Overview: EM monetary easing and financial-stability tensions - Slower growth, tighter financial conditions, and lower commodity prices have reduced inflationary pressures in EMs since 2014, allowing some countries to ease monetary policy. - Despite deceleration in credit growth, financial stability risks remain in some EMs reflecting vulnerabilities built during the past rapid credit expansion fueled in part by buoyant capital inflows. - Spillovers from advanced economy monetary policy have complicated financial stability for smaller open economies, including many EMs (Box 8). ### Country cases and staff findings - China - Output growth and inflation have moderated, and credit growth (including shadow banking) has slowed considerably. - Fund advice: maintain a neutral monetary stance. - Rationale: reflects the structural nature of the growth slowdown and the need for deleveraging to bring the credit-to-GDP and private leverage ratios to more comfortable levels. - Peru - Experienced a sharp output growth slowdown in 2014–15, with the negative output gap expected to close only in 2018. - Credit growth has decelerated and inflation expectations are well anchored. - Key vulnerability: financial dollarization remains a major vulnerability and constrains the room for further monetary easing given pressure in the FX market in the context of the anticipated U.S. monetary policy normalization. - Fund emphasis: exchange rate flexibility should be the main line of defense, with de-dollarization measures, including prudential requirements, aimed at reducing currency-liquidity-maturity mismatches. - Thailand - Seeing a tentative growth recovery following political uncertainties during 2013–14, but the sizeable negative output gap is expected to close gradually; headline inflation has turned negative. - Fund view: recent monetary easing is not seen as exacerbating financial stability risks. - Policy recommendation: strengthen regulation of non-commercial banks, including specialized financial institutions and credit cooperatives, which are heavily exposed to the highly-indebted household sector. ### Policy advice and instruments emphasized - Exchange rate flexibility as the main line of defense (explicitly recommended for Peru). - De-dollarization measures, including prudential requirements, to reduce currency-liquidity-maturity mismatches (Peru). - Maintain neutral monetary stance where structural slowdown and deleveraging needs exist (China). - Strengthen regulation and supervision of non-bank financial institutions exposed to household debt (Thailand). - Recognize and manage spillovers from advanced economy monetary policy for smaller open economies. *Source: Excerpt from IMF chapter/section (pages excerpted: 54–52) in the provided PDF content.* ### References ### References (_082815a) ### Overview - Bibliographic listing of works cited in the chapter "MONETARY POLICY AND FINANCIAL STABILITY." - Entries cover topics including bank liquidity and risk-taking, procyclical leverage, global financial cycle, capital flows to Emerging Market Economies, macroprudential policy effectiveness, monetary policy transmission, credit cycles, and systemic risk monitoring. - Formats include CEPR Discussion Papers, NBER Working Papers, IMF Working Papers and Staff Notes, journal articles (Review of Financial Studies; Journal of Financial Stability; Journal of International Money and Finance; Journal of Monetary Economics), working papers from central banks and international organizations, and books. ### Monetary policy, risk-taking, and bank behavior - Acharya, Viral V., and Hassan Naqvi, 2012, "The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking Over the Business Cycle," CEPR Discussion Papers 8851. - Adrian, Tobias, and Hyun Song Shin, 2014, “Procyclical Leverage and Value-at-Risk,” Review of Financial Studies, 27(2), pp. 373–403. - Altunbas, Yener, Leonardo Gambacorta, and David Marques-Ibanez, 2010, "Bank Risk and Monetary Policy," Journal of Financial Stability, Elsevier, Vol. 6(3), pp. 121–129, September. - Angeloni, Ignazio, Ester Faia, and Marco Lo Duca, 2015, “Monetary Policy and Risk Taking,” Journal of Economic Dynamics and Control, 52(C), pp. 285–307. - Bernanke, Ben, and Mark Gertler, 1999a, "Monetary Policy and Asset Price Volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pp. 17–51. - ______, Mark Gertler, and Simon Gilchrist, 1999b, “The Financial Accelerator in a Quantitative Business Cycle Framework,” Handbook of Macroeconomics, in: J. B. Taylor and M. Woodford (ed.), Handbook of Macroeconomics, Edition 1, Vol. 1, Chapter 21, pp. 1341–1393, Elsevier. - Diamond, Douglas W., and Raghurarm G. Rajan, 2012, "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, Vol. 120(3), pp. 552–591. - Dell'Ariccia, Giovanni, Luc Laeven, and Gustavo Suarez, 2013, "Bank Leverage and Monetary Policy's Risk-Taking Channel; Evidence from the United States," IMF Working Paper WP/13/143 (Washington: International Monetary Fund). - Dell’Ariccia, Giovanni, Luc Laeven, and Robert Marquez, 2014, “Real Interest Rates, Leverage and Bank Risk-Taking,” Journal of Economic Theory, Vol. 149, pp. 65–99. ### Macroprudential policy design, use, and effectiveness - Akinci, Ozge, and Jane Olmstead-Rumsey, 2015, "How Effective are Macroprudential Policies? An Empirical Investigation," International Finance Discussion Papers 1136, Board of Governors of the Federal Reserve System (U.S.). - Arregui, Nicolas, Jarom r Bene , Ivo Krznar, Srobona Mitra, and Andre Oliveira Santos, 2013, “Evaluating the Net Benefits of Macroprudential Policy: A Cookbook,” IMF Working Paper WP/13/167 (Washington: International Monetary Fund). - Blancher, Nicolas, Srobona Mitra, Hanan Morsy, Akira Otani, Tiago Severo, and Laura Valderrama, 2013, “Systemic Risk Monitoring (“SysMo”) Toolkit—A User Guide,” IMF Working Paper WP/13/168 (Washington: International Monetary Fund). - Cerutti, Eugenio, Stijn Claessens, and Luc Laeven, 2015, "The Use and Effectiveness of Macroprudential Policies: New Evidence," IMF Working Paper WP/15/61 (Washington: International Monetary Fund). - Columba, Francesco, A. Costa, Piyabha Kongsamut, Chen Hoon Lim, A. Otani, Mustafa Sayid, Torsten Wezel, Xiaoyong Wu, “Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences,” IMF Working Paper WP/11/238 (Washington: International Monetary Fund). - Claessens, Stijn, Swati R. Ghosh, and Roxana Mihet, 2013, "Macro-Prudential Policies to Mitigate Financial System Vulnerabilities," Journal of International Money and Finance, Elsevier, Vol. 39(C), pp. 153–185. - Choi, Henry, Tom Fong, Ka-fai Li, and Eric Wong, 2011, "Loan-to-Value Ratio as a Macro-Prudential Tool—Hong Kong's Experience and Cross-Country Evidence," Working Papers 1101, Hong Kong Monetary Authority. - Dassatti Camors, Cecilia and Jose-Luis Peydro, 2014, “Macroprudential and Monetary Policy: Loan-Level Evidence from Reserve Requirements,” mimeo, Universitat Pompeu Fabra, Spain. - Crowe Christopher W., Giovanni Dell'Ariccia, Deniz Igan, and Pau Rabanal, 2011, "Policies for Macrofinancial Stability; Options to Deal with Real Estate Booms," IMF Staff Discussion Note, February. - Bakker, Bas B., Giovanni Dell'Ariccia, Deniz Igan, Luc Laeven, Hui Tong, and Jerome Vandenbussche, 2012, “Policies for Macrofinancial Stability: How to Deal with Credit Booms,” IMF Staff Discussion Note, June. ### Credit, leverage, financial cycles, and crises - Borio, Claudio, and Mathias Drehmann, 2009, “Assessing the Risk of Banking Crises—Revisited,” BIS Quarterly Review, March, pp. 29–44 (Basel: Bank for International Settlements). - Borio, Claudio, and Haibin Zhu, 2012, “Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?” Journal of Financial Stability, 8(4), pp. 236–251. - Borio, Claudio, Piti Disyatat, and Mikael Juselius, 2014, "A Parsimonious Approach to Incorporating Economic Information in Measures of Potential Output," BIS Working Papers 442, (Basel: Bank for International Settlements). - Brunnermeier, Markus K., Thomas M. Eisenbach, and Yuliy Sannikov, 2012, “Macroeconomics With Financial Frictions: A Survey,” NBER Working Papers 18102, National Bureau of Economic Research, Inc. - Calvo, Guillermo A., and Enrique G. Mendoza, 1996, "Mexico's Balance-of-Payments Crisis: A Chronicle of a Death Foretold," Journal of International Economics, Elsevier, Vol. 41(3-4), pp. 235–264, November. - Detragiache, Enrica, and Asli Demirguc-Kunt, 1998, "Financial Liberalization and Financial Fragility," IMF Working Paper WP/98/83, 238 (Washington: International Monetary Fund). - ______, 2005, "Cross-Country Empirical Studies of Systemic Bank Distress: A Survey," National Institute Economic Review, National Institute of Economic and Social Research, Vol. 192(1), pp. 68–83, April. - Freixas, Xavier, Luc Laeven, and Jose-Luis Peydró, 2015, “Systemic Risk, Crises and Macroprudential Policy”, Boston, Massachusetts: MIT Press. - Ghosh, Atish R., Jun Kim, Mahvash S. Qureshi, and Juan Zalduendo, 2012, “Surges,” IMF Working Paper 12/22238 (Washington: International Monetary Fund). ### Capital flows, spillovers, and international transmission - Ahmed, Shaghil, and Andrei Zlate, 2014, "Capital flows to Emerging Market Economies: A Brave New World?" Journal of International Money and Finance, Elsevier, Vol. 48(PB), pp. 221–248. - Avdjiev, Stefan and Zheng Zeng, 2014, “Credit Growth, Monetary Policy, and Economic Activity in a Three-Regime TVAR Model,” Applied Economics, 46(24), pp. 2936–2951. - Chen, Jiaqian, Tommaso Mancini-Griffoli, and Ratna Sahay, 2014, "Spillovers from United States Monetary Policy on Emerging Markets: Different This Time?," IMF Working Paper WP/14/240 (Washington: International Monetary Fund). - Chen, Qianying, Andrew Filardo, Dong He, and Feng Zhu, 2015, “Financial Crisis, U.S. Unconventional Monetary Policy and International Spillovers,” Journal of International Money and Finance, DOI: 10.1016/j.jimonfin.2015.06.011. - Forbes, Kristin J., and Francis E. Warnock, 2011, "Capital Flow Waves: Surges, Stops, Flight, and Retrenchment," NBER Chapters, in: Global Financial Crisis National Bureau of Economic Research, Inc. - Fratzscher, Marcel, 2011, "Capital Flows, Push Versus Pull Factors and the Global Financial Crisis," NBER Working Papers 17357, National Bureau of Economic Research, Inc. - Ghosh, Atish R., Jun Kim, Mahvash S. Qureshi, and Juan Zalduendo, 2012, “Surges,” IMF Working Paper 12/22238 (Washington: International Monetary Fund). - Bayoumi, Tamim, Giovanni Dell'Ariccia, Karl Habermeier, Tommaso Mancini-Griffoli, and Fabian Valencia, 2014, “Monetary Policy in the New Normal,” IMF Staff Discussion Note, April. ### Methods, models, and indicators used in the literature - Alessandri, Piergiorgio, and Haroon Mumtaz, 2014a, “Financial Indicators and Density Forecasts for U.S. Output and Inflation,” Temi di discussione 977, Bank of Italy. - ______, 2014b, “Financial Regimes and Uncertainty Shocks,” Working Papers 729, Queen Mary University of London, School of Economics and Finance. - Balke, Nathan, 2000, “Credit and Economic Activity: Credit Regimes and Nonlinear Propagation of Shocks,” Review of Economics and Statistics, 82(2), pp. 344–349. - Christiano, Lawrence J., and Terry J. Fitzgerald, 2003, "The Band Pass Filter," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Vol. 44(2), pp. 435–465, 05. - Christiano, Lawrence, Cosmin Ilut, Roberto Motto, and Massimo Rostagno, 2010, "Monetary Policy and Stock Market Booms," Proceedings—Economic Policy Symposium—Jackson Hole, Federal Reserve Bank of Kansas City, pp. 85–145. - Faust, Jon, Simon Gilchrist, Jonathan H. Wright, and Egon Zakrajsek, 2013, “Credit Spreads as Predictors of Real-Time Economic Activity: A Bayesian Model-Averaging Approach,” The Review of Economics and Statistics, 95(5): pp. 1501–1519. - Eickmeier, Sandra, Massimiliano Marcellino, and Esteban Prieto, 2013, “Time Variation in Macro-Financial Linkages,” CEPR Discussion Papers 9436. - Blancher, Nicolas, Srobona Mitra, Hanan Morsy, Akira Otani, Tiago Severo, and Laura Valderrama, 2013, “Systemic Risk Monitoring (“SysMo”) Toolkit—A User Guide,” IMF Working Paper WP/13/168 (Washington: International Monetary Fund). *References list as presented in the PDF file _082815a - References* ### 03. Washington: Board of Governors of the Federal Reserve System, December 2013. ### 03. Washington: Board of Governors of the Federal Reserve System, December 2013 ### Major thematic areas covered by the cited literature - Credit markets, credit shocks, and leverage cycles - Gilchrist, Simon, Vladimir Yankov, and Egon Zakrajšek, 2009, “Credit Market Shocks and Economic Fluctuations: Evidence From Corporate Bond and Stock Markets,” Journal of Monetary Economics, 56: pp. 471–493. - Schularick, Moritz, and Alan M. Taylor, 2012, "Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008," American Economic Review, Vol. 102(2), pages 1029–61, April. - Lopez-Salido, David, Jeremy C. Stein, and Egon Zakrajsek, 2015, “Credit-Market Sentiment and the Business Cycle,” Finance and Economic Discussion Series 2015–028. - Jordà, Òscar, Moritz Schularick, and Alan M. Taylor, 2015, "Betting the House," Journal of International Economics, Vol. 96(S1), pp. S2-S18. - Iacoviello, Matteo, and Raoul Minetti, 2008, "The Credit Channel of Monetary Policy: Evidence from the Housing Market," Journal of Macroeconomics, Vol. 30, No. 1, pp. 69–96. - Monetary policy (conventional and unconventional) and its international/asset-market effects - Glick, Reuven, and Sylvain Leduc, 2013, "The Effects of Unconventional and Conventional U.S. Monetary Policy on the Dollar," Working Paper Series 2013-11, Federal Reserve Bank of San Francisco. - Rogers, John H., Chiara Scotti, and Jonathan H. Wright, 2014, "Evaluating Asset-Market Effects of Unconventional Monetary Policy: A Cross-Country Comparison," International Finance Discussion Papers 1101, Board of Governors of the Federal Reserve System (U.S.). - Swanson, Eric T., and John C. Williams, 2014, "Measuring the Effect of the Zero Lower Bound on Medium- and Longer-Term Interest Rates," American Economic Review, vol. 104(10), pp. 3154–85, October. - Ozkan, Gulcin, and Filiz Unsal, 2014, “On the use of Monetary and Macroprudential Policies for Small Open Economies,” IMF Working Paper WP/14/112. - IMF 2013a, “Global Impact and Challenges of Unconventional Monetary Policies,” IMF Policy Paper, October. - IMF 2013c, “Unconventional Monetary Policies—Recent Experience and Prospects,” IMF Policy Paper, April. - Interaction of monetary policy and financial stability; integrating financial stability into policy frameworks - Goodfriend, Marvin, 2004, "Monetary Policy in the new Neoclassical Synthesis : A Primer," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pp. 21–45. - Leeper, Eric M., and James M. Nason, 2014, "Bringing Financial Stability into Monetary Policy," CAMA Working Papers 2014-72. - Smets, Frank , 2014, “Financial Stability and Monetary Policy: How Closely Interlinked?” International Journal of Central Banking, 10(2), pp. 263–300. - Stein, Jeremy C., 2014, “Incorporating Financial Stability Considerations into a Monetary Policy Framework,” speech, Washington, D.C., March 21, 2014. - Yellen, Janet L., 2014, “Monetary Policy and Financial Stability,” speech, July 2, 2014. - Williams, John C., 2015, “Macroprudential Policy in a Microprudential World,” speech, May 28, 2015. - Macroprudential policy design, tools, and evidence (LTV/DTI, countercyclical buffers, capital) - Igan, Deniz, and Heedon Lang, 2011, “Do Loan-to-Value and Debt-to-Income Limits Work? Evidence from Korea,” IMF Working Paper WP/11/297. - Jacome, Luis, and Mitra Srobona, 2015, “LTV and DTI Limits—Going Granular,” IMF Working Paper WP/15/154. - Jiménez, Gabriel, Steven Ongena, José-Luis Peydró, and Jesús Saurina, 2012, "Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the Spanish Dynamic Provisioning Experiments," Working Papers 628, Barcelona Graduate School of Economics. - IMF 2013e, “The Interaction of Monetary and Macroprudential Policies,” IMF Policy Paper, September. - IMF 2013f, “Key Aspects of Macroprudential Policies,” IMF Policy Paper, June. - IMF 2014c, “Staff Guidance Note on Macroprudential Policy,” IMF Policy Paper, November. - Miles, D., J. Yang, and G. Marcheggiano, 2013, “Optimal Bank Capital,” The Economic Journal, 123(567), pp. 1–37. - Jihad, Dagher, Giovanni Dell’Ariccia, Luc Laeven, Lev Ratnovski, and Hui Tong, 2015, “Bank Capital: How Much Is Enough?” IMF Staff Discussion Note (forthcoming). - Housing, household debt, and monetary transmission - Goodhart, Charles, and Boris Hofmann, 2008, "House Prices, Money, Credit, and the Macroeconomy," Oxford Review of Economic Policy, Vol. 24(1), pp. 180–205. - Musso, Alberto, Stefano Neri, and Livio Stracca, 2011, "Housing, Consumption and Monetary Policy: How Different are the US and the Euro Area?" Journal of Banking and Finance, vol. 35(11), pp. 3019-3041, November. - Walentin, Karl, 2014, "Housing Collateral and the Monetary Transmission Mechanism," Scandinavian Journal of Economics, Vol. 116(3), pp. 635–668, 07. - Riksbank, Sveriges, 2014, “The Effects of Monetary Policy on Household Debt,” Box in the Monetary Policy Report. - Kuttner, Kenneth N., and Ilhyock Shim, 2013, "Can Non-Interest Rate Policies Stabilise Housing Markets? Evidence from a panel of 57 economies," BIS Working Papers 433. - Financial stress, systemic risk, and crises databases - Hubrich, Kirstin, and Robert Tetlow, 2015, “Financial Stress and Economic Dynamics: The Transmission of Crises,” Journal of Monetary Economics, 70 (March), pp 100–115. - Laeven, Luc, and Fabian Fabian, 2012, “Systemic Banking Crises Database: An Update,” IMF Working Paper WP/12/163. - Valencia, Fabian and Luc Laeven, 2012, "Systemic Banking Crises Database: An Update," IMF Working Papers 12/163238. - Laeven, Luc., Lev Ratnovski, and Hui Tong, 2014, “Bank Size and Systemic Risk,” IMF Staff Discussion Note, May. - Hartmann, Philipp, Kirstin Hubrich, Manfred Kremer, and Robert Tetlow, 2015,”Melting Down: Systemic Financial Instability and the Macroeconomy,” Annual Conference 2013 (Duesseldorf). - Capital flows, spillovers, and the international dimension of policy - IMF 2012, “The Liberalization and Management of Capital Flows, an Institutional View,“ IMF Policy Paper, November. - IMF 2013d, “2013 Spillover Report,” July. - IMF 2014a, “2014 Spillover Report,” July. - Sahay, Ratna, Vivek B. Arora, Athanasios V. Arvanatis, Hamid Faruqee, Papa N’Diaye, and Tommaso Mancini-Griffoli, 2014, “Emerging Market Volatility: Lessons from The Taper Tantrum,” IMF Staff Discussion Note, October. - Rey, Hélène, 2015, “International Credit Channel and Monetary Policy Autonomy,” IMF Economic Policy Review (forthcoming). - Metiu, Norbert, Björn Hilberg, and Michael Grill, 2015, “Financial Frictions and Global Spillovers,” Discussion Papers 04/2015, Deutsche Bundesbank Research Centre. - Measurement, methodology, and theoretical foundations - Harding, Don, and Adrian Pagan, 2002, "Dissecting the cycle: a methodological investigation," Journal of Monetary Economics, Vol. 49(2), pp. 365–381, March. - Merton, Robert C., 1974, "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, Vol. 29(2), pp. 449–70, May. - Woodford, Michael, 2003, “Interest and Prices: Foundations of a Theory of Monetary Policy,” Princeton University Press. - Woodford, Michael, 2012, "Inflation Targeting and Financial Stability," NBER Working Papers 17967. ### Key policy- and research-oriented IMF documents cited - IMF 2002, “World Economic Outlook,” September. - IMF 2011, “Global Financial Stability Report,” September. - IMF 2013a, “Global Impact and Challenges of Unconventional Monetary Policies,” IMF Policy Paper, October. - IMF 2013b, “The Dog That Didn’t Bark: Has Inflation Been Muzzled or Was it Just Sleeping?,” World Economic Outlook, Chapter 3, April. - IMF 2013c, “Unconventional Monetary Policies—Recent Experience and Prospects,” IMF Policy Paper, April. - IMF 2013d, “2013 Spillover Report,” July. - IMF 2013e, “The Interaction of Monetary and Macroprudential Policies,” IMF Policy Paper, September. - IMF 2013f, “Key Aspects of Macroprudential Policies,” IMF Policy Paper, June. - IMF 2014a, “2014 Spillover Report,” July. - IMF 2014b, "Global Financial Stability Report," October. - IMF 2014c, “Staff Guidance Note on Macroprudential Policy,” IMF Policy Paper, November. - IMF 2015, "Global Financial Stability Report," April. *Source: 03. Washington: Board of Governors of the Federal Reserve System, December 2013.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2015/_082815a.pdf_