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Unformatted text preview: European Central Bank Approaches to monetary policy revisited – lessons from the crisis A p p ro a c h e s to m o n e ta ry p o l i c y r e v i s i t e d – l e s s o n s f ro m t h e c r i s i s Sixth ECB Central Banking Conference 18-19 NOvember 2010 EDitors Marek Jarociński, Frank Smets and Christian Thimann A p p ro a c h es to m o n e ta ry p o l i c y r e v i s i t e d – l ess o n s f ro m t h e c r i s i s Sixth ECB Central Banking Conference 18-19 NOvember 2010 EDitors Marek Jarociński, Frank Smets and Christian Thimann © European Central Bank, 2011 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 D-60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet Fax +49 69 1344 6000 All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. ISBN 978-92-899-0333-2 (print) ISBN 978-92-899-0334-9 (online) CONTENTS INTRODUCTION by Marek Jarociński, Frank Smets and Christian Thimann..........................  6 INTRODUCTORY SPEECH Reflections on the nature of monetary policy non-standard measures and finance theory by Jean-Claude Trichet . ...............................................................................  12 S ession 1 MONETARY POLICY STRATEGIES – EXPERIENCES DURING THE CRISIS AND LESSONS LEARNT Lessons for monetary policy strategies from the recent past by Stephan Fahr, Roberto Motto, Massimo Rostagno, Frank Smets, and Oreste Tristani .......................................................................................  26 Monetary Policy Strategy: Lessons from the crisis by Frederic S. Mishkin .................................................................................  67 Comments Guido Tabellini . ...........................................................................................  1 1 9 William R. White...........................................................................................  1 2 4 General Discussion . .....................................................................................  1 3 3 S ession 2 PANEL THE FINANCIAL CRISIS – WHAT DID CENTRAL BANKERS FORGET AND WHAT DID THEY LEARN? A HISTORICAL PERsPECTIVE PANEL STATEMENTs Marc Flandreau . ...........................................................................................  1 3 8 Carl-Ludwig Holtfrerich . .............................................................................  1 4 3 Harold James..................................................................................................  1 5 3 Comment Lorenzo Bini Smaghi.....................................................................................  1 6 0 General Discussion........................................................................................  1 6 4 D inner A ddres s by Alexandre Lamfalussy..............................................................................  1 6 8 keynote address In search of a robust monetary policy framework by Jürgen Stark .............................................................................................  1 7 6 3 SESSION 3 PANEL WHAT SHORTCOMINGS IN MACROECONOMIC AND FINANCE THEORY HAS THE FINANCIAL CRISIS REVEALED, AND HOW SHOULD THEY BE ADDRESSED? PANEL STATEMENTS Jean-Philippe Bouchaud ...............................................................................  1 9 0 Martin Eichenbaum ......................................................................................  2 1 3 John Geanakoplos..........................................................................................  2 2 0 General Discussion........................................................................................  2 3 9 KEYNOTE ADDRESS Rebalancing the global recovery by Ben S. Bernanke.......................................................................................  2 4 4 SESSION 4 POLICY PANEL EMERGING FROM THE CRISIS – WHERE DO WE STAND? PANEL STATEMENTS Jean-Claude Trichet.......................................................................................  Dominique Strauss-Kahn...............................................................................  Henrique Meirelles........................................................................................  Ben S. Bernanke............................................................................................  260 263 267 270 General Discussion........................................................................................  2 7 4 SESSION 5 MONETARY POLICY OPERATIONS – EXPERIENCES DURING THE CRISIS AND LESSONS LEARNT Implementing monetary policy in crisis times – the case o f t h e ecb by Nuno Cassola, Alain Durré, and Cornelia Holthausen............................  2 8 0 Challenges and lessons of the federal reserve’s monetary policy operations during the financial crisis by Spence Hilton and James McAndrews.....................................................  3 2 2 Comments Marvin Goodfriend........................................................................................  3 6 2 Rafael Repullo...............................................................................................  3 6 7 General Discussion........................................................................................  3 7 6 4 CONCLUDING REMARKS by Jean-Claude Trichet..................................................................................  3 8 0 R E V I E W O F T H E M E D I A C O V E R A G E ������������������������������������������ 3 8 4 P R O G R A M M E ................................................................................................  3 8 6 5 INTRODUCTION1 BY MAREK JAROCIŃSKI, ECB FRANK SMETS, ECB CHRISTIAN THIMANN, ECB Two years after the outbreak of the global financial crisis, the ECB considered it opportune to review the strategic and operational decisions that central banks had taken to combat the crisis, counter the fallout for real economies and stave off the worst economic scenarios. The sixth biennial ECB Central Banking Conference, organised under the auspices of the Executive Board, provided an opportunity to look back at the dramatic years following the Lehman bankruptcy and to reflect on the resulting lessons for central banking. The conference was titled “Approaches to monetary policy revisited – lessons from the crisis” and held on 18 and 19 November 2010 in Frankfurt am Main. This volume contains the papers presented at the conference, as well as the related discussions and speeches. The contributions are grouped around five broad topics: • monetary policy strategy, • lessons from historical experiences, • challenges for macroeconomic and finance theory, • the international dimension of the crisis, and • operational frameworks for monetary policy. The financial crisis and the deep recession that followed have, in the eyes of some, raised doubts about the appropriateness of what Mishkin calls “flexible inflation targeting” strategies, which until recently were credited with bringing about in many countries a long period of nominal and real stability, known as the “Great Moderation”. The first session of the conference, entitled “Monetary policy strategies: experiences during the crisis and lessons learnt”, raises a number of questions in this context, namely: what is and what should be the role of money, credit and other financial indicators in monetary policy frameworks? What is the appropriate horizon for the inflation target? Should central banks manage risk and act pre-emptively? Should they lean against asset price bubbles? 1 We would like to thank all participants of the 6th ECB Central Banking Conference for their contributions; the staff of the ECB’s Publishing, Events and Protocol Division for the conference organisation; and the staff of the ECB’s English Translation and Editing Section for the editing of this volume. 6 JAROCIŃSKI, SMETS, THIMANN In their paper Stephan Fahr, Roberto Motto, Massimo Rostagno, Frank Smets and Oreste Tristani (all from the ECB) discuss the ECB experience. Their simulations with a structural model show the importance of the ECB’s monetary pillar and the advantage of the ECB’s medium-term orientation. They also present evidence that the non-standard policy of “enhanced credit support” has been successful in overcoming financial market impairments. The paper by Rick Mishkin takes a broader view and discusses more generally the strategic monetary policy issues exposed by the crisis. He argues that “none of the lessons from the financial crisis in any way undermine or invalidate the nine basic principles of the science of monetary policy developed before the crisis”. However, the crisis experience does warrant a rethinking of inflation targeting strategies, especially with regard to managing tail risks and leaning against credit bubbles. Insightful and, at times, provocative discussions of both papers are provided by Guido Tabellini (Bocconi University) and William White (OECD).2 White questions some of the implicit complacency in Mishkin’s arguments, while Tabellini queries the motivation behind the ECB’s monetary pillar. They both agree, however, on the need to develop a framework in which financial stability is managed with policy tools other than the interest rate. The speeches by Jean-Claude Trichet (President of the ECB) and Jürgen Stark (Member of the Executive Board of the ECB) provide a policy-maker’s perspective with regard to the strategy of the ECB. Among other things, President Trichet stresses the role of the ECB’s quantitative definition of price stability in anchoring inflation expectations, which materially helps to avoid large fluctuations of inflation even in the most turbulent of times. Stark reiterates the key elements of the ECB’s monetary policy framework: “a quantitative definition of price stability, a medium-term orientation and a broad analytical framework, with money and credit playing an important role”. He also notes that central bankers’ past scepticism towards “leaning against the wind” should be reassessed. Session 2, entitled “The financial crisis: what did central bankers forget and what did they learn? A historical perspective”, compares the current crisis with the 19th century banking crises and the Great Depression, drawing analogies and highlighting contrasts. Harold James (Princeton University) notes that history provides both constructive lessons, which were well learned (e.g. the need for monetary expansion in a crisis), and serious warnings (for example with regard to the large cost of banking crises, and the resurrection of economic nationalism). Carl-Ludwig Holtfrerich (Freie Universität Berlin) calls for more regulation of financial markets. Marc Flandreau (Graduate Institute Geneva) points out that, in contrast to the present practice, 19th century lending of last resort was extended at a high interest rate in order to avoid stifling the interbank market. He also contrasts the Bank of England’s insistence in the 19th century on only the best collateral in crisis periods with the widening of collateral eligibility by many central banks in recent years. 2 The third discussion presented at the conference, by Jean Pisani-Ferry (Bruegel), could not be included in this volume. INTRODUCTION 7 The panel discussion in Session 3 focuses on the following question: “what shortcomings in macroeconomic and finance theory has the crisis revealed, and how should they be addressed?” Jean-Philippe Bouchaud (Capital Fund Management and École Polytechnique) argues that fundamentals play a relatively small role in asset price dynamics. Instead, these dynamics are mostly endogenous, emerging from a chaotic interaction of uninformed heterogeneous agents. He advocates the use of physics models of complex systems in modelling financial markets. Martin Eichenbaum (Northwestern University) responds to the post-crisis criticism of macroeconomic theory. He points out that pre-crisis DSGE models did not include financial markets because these were not needed to explain the pre-crisis macro data of advanced economies. He calls for the use of more heterogeneous samples, including emerging markets data. John Geanakoplos (Yale University) characterises the crisis as an exceptionally pronounced leverage cycle. He argues that the analysis of leverage cycles should be a central element of macroeconomics and finance. The international dimension of the crisis is covered by Session 4’s policy panel – with contributions from Ben Bernanke (Chairman of the Board of Governors of the Federal Reserve), Henrique Meirelles (Governor of the Central Bank of Brazil), Dominique Strauss-Kahn (Managing Director of the International Monetary Fund) and President Trichet – and is also reflected in Ben Bernanke’s keynote speech. Global imbalances endangering the current recovery are the common theme. Bernanke rejects the view that the United States can tackle its current account deficit on its own and links the imbalances with sustained foreign exchange interventions in some emerging market economies. Finally, the focus of Session 5 is on monetary policy operations, although this topic arises frequently throughout the conference. The session is entitled “Monetary policy operations: experiences during the crisis and lessons learnt”. Operational matters used to be viewed as a mere technicality. However, the credit turmoil placed them at the heart of central banking and exposed many controversies. In their paper, Nuno Cassola, Alain Durré and Cornelia Holthausen (all from the ECB) model the central bank’s trade-off between providing liquidity and sustaining private intermediation in the money market. The paper by Spence Hilton and James McAndrews (Federal Reserve Bank of New York) explains the institutional and balance sheet constraints on the Federal Reserve’s response to the crisis. These papers reveal a contrast in policy frameworks before the crisis: while the ECB dealt with many counterparties and accepted a wide range of collateral, the opposite was true of the Federal Reserve. In the wake of the crisis a convergence in frameworks was observed, with both institutions dealing with many counterparties and collateral types. In his contribution Marvin Goodfriend (Carnegie Mellon University) classifies central bank operations into two groups: “monetary policy” and “credit policy”; and he points out that the latter has fiscal implications that can impact on central bank independence. Rafael Repullo (CEMFI) distinguishes between three ways of managing liquidity and money market interest rates: through a structural liquidity 8 JAROCIŃSKI, SMETS, THIMANN deficit (as with the ECB framework), where commercial banks constantly borrow from the central bank and the lending rate is the policy rate; with an approximate liquidity balance (as with the Federal Reserve prior to the crisis); and through a structural liquidity surplus, where the policy rate is the rate paid on commercial bank deposits with the central bank. He calls for a reconsideration of which is the best framework. A prominent issue throughout the conference is whether the non-standard monetary policy measures are complements to, or substitutes for, the standard interest rate decisions. In the introductory speech President Trichet reiterates the ECB’s view that non-standard measures are a complementary tool used to ensure the proper transmission of the standard measures. “We judged then – as we do now – that the level of our key rates was appropriate to serve the maintenance of price stability over the medium term. Rather, our view was that non-standard measures were required to ensure that the stance of monetary policy was effectively transmitted to the broader economy, notwithstanding the dysfunctional situation in some financial markets”. Chairman Bernanke views the Federal Reserve’s non‑standard measures, consisting mainly of securities purchases, as a substitute for the interest rate cuts that are used when the zero lower bound is encountered: “Although securities purchases are a different tool for conducting monetary policy from the more familiar approach of managing the overnight interest rate, the goals and transmission mechanisms are very similar”. In his concluding remarks President Trichet reiterates that the ECB’s medium-term inflation objective of “below, but close to, 2%” and its analysis of credit aggregates are increasingly recognised and adopted around the world. Yet, more research on nonlinearities and transitory dynamics is needed. The President concludes: “I was fascinated by the wealth of discussion that we have had here”. We trust that the reader of this volume will share this view. INTRODUCTION 9 Jean-Claude Trichet 10 introductory speech 11 Reflections on the nature of monetary policy non-standard measures and finance theory B y J ean - C laude T richet , P resident of the E C B 1 I ntroduction It is a great pleasure to open the ECB’s 2010 Central Banking Conference. As you know, we consider this event, which has been held every other year since 2000, as our institution’s flagship conference. I am therefore particularly pleased to see that so many central bank governors from around the world have taken up our invitation, as well as representatives from European institutions and governments, leading academics, financial market participants and many other friends of the ECB. This year, we also have about 30 graduate students from all over Europe with us. I would like to extend a very warm welcome to all of you, on behalf of the Executive Board and the Governing Council of the ECB. As ever, the goal of the conference is to bring together central bankers, policymakers, academics, market participants and other observers to exchange views on topics of crucial relevance to central banks. I am sure you will all agree that the theme of the conference – “Approaches to monetary policy revisited: lessons from the crisis” – is both relevant and timely. I think we have inspiring work ahead of us for these two days: the programme is packed with a combination of papers and panels, and I am very much looking forward to our discussions. In these opening remarks, I would like to do two things. First, I will present a “bird’s eye” view of the ECB’s conduct of monetary policy during the crisis, focusing in particular on the distinction between standard and non-standard policy measures. And second, I will identify some of the main lessons to be learned from the crisis regarding economic analysis. 2 T he role of standard and non - standard measures Let me start with monetary policy. The widespread introduction of non-standard monetary policy measures has been a defining characteristic of the global financial crisis. Across central banks, there has been no standardisation of non-standard measures: approaches are distinct, tailored to the respective economies and their structures. We have seen enhanced credit support, credit easing, quantitative easing, 12 TRICHET interventions in foreign exchange and securities markets, and the provision of liquidity in foreign currency – to name but a few of the measures taken.1 These tools have been used to support the functioning of the financial sector, to protect the real economy from the fallout of the financial crisis, and, ultimately, to preserve price stability over the medium term. There are two distinct views on non-standard measures. Some view them as the continuation of standard policy by other means. Once nominal interest rates cannot be lowered further, central banks use other tools to determine the monetary policy stance – that is, to contribute in the desired way to economic, financial and monetary developments in pursuit of price stability.2 Figuratively speaking, this can be compared to – once the end of the road has been reached – engaging the four-wheel drive. Central banks expand their balance...
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