“To Lean or Not to Lean?” That is the Question

IMF Blog, July 1, 2015

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Authors: Stefan Laseen, Andrea Pescatori, Jarkko Turunen
Date: July 1, 2015
Central question: Whether monetary policy should be used to dampen asset price booms (to “lean against the wind”) versus relying on other tools to safeguard financial stability.
Context: The question has become more prominent after the global financial crisis, which was preceded by an unsustainable boom in sub-prime mortgage lending and housing prices, and in the face of over six years of near zero policy interest rates.

The authors argue the answer is “no” to using standard monetary policy (policy interest rates) as the primary tool to lean against asset price booms.
Instead, priority should be on strengthening macroprudential policy and addressing gaps in regulation and supervision.

An unexpected increase of policy interest rates (for example to prick an emerging asset price bubble) does not reduce risks to the financial system.
- Such a policy reduces output, inflation, and asset prices without fundamentally mitigating financial risks.
Systematic use of monetary policy that reacts to financial risks as they build could, in theory, be worthwhile.
- Financial market participants respond to the expectation of future monetary policy actions by taking fewer risks ex ante.
- A simple policy rule that responds to higher financial sector “leverage” (using borrowed funds to finance investments) could improve economic outcomes (see figure).
- Sacrificing a modest amount of growth today could reduce the risk of economically costly financial crises in the future.

For monetary policy that leans against the wind to work in practice, several conditions must hold:
- Financial sector leverage needs to be pro-cyclical. Evidence is mixed: leverage tends to move with the economic cycle during some periods and for some types of intermediation, but not always or everywhere.
- Diagnostics must identify why leverage is increasing, with sufficient foresight to head problems off early. Misreading causes of leverage increases can lead to costly policy mistakes.
- Targeted macroprudential policy appears to generate better results than using policy interest rates, largely because macroprudential tools do not have to simultaneously achieve inflation and output objectives.
- A systematic leaning-against-the-wind policy requires a credible policy framework and clear communication from the central bank about its willingness and ability to react to perceived financial excesses.

Primary policy direction:
- Deploy supervisory and regulatory tools to build financial resilience and manage risks to the financial system (macroprudential policy).
- Address gaps in regulation and supervision.
Research and implementation priorities:
- Accelerate research on the theoretical and empirical nexus between interest rate changes and financial vulnerabilities.
- Work to identify appropriate measures of the financial cycle.
- Expand understanding of how and when monetary policy might best be used to tackle financial stability risks.
Interim stance:
- Given current limitations, give priority to strengthening the network of policies, rules and regulations that make the financial system safer, rather than relying on policy interest rates to lean against financial stability risks.

Stefan Laseen, Andrea Pescatori, Jarkko Turunen — July 1, 2015