On financial stability targeting

The case for targeting financial stability

In this paper, Ricardo J. Caballero, Tomas E. Caravello, and Alp Simsek explore how noisy financial flows impact financial conditions and macroeconomic activity, and how monetary policy should respond to this noise. Here are the main findings:

• Noisy Financial Flows: The authors present evidence that financial flows, which are not always related to economic fundamentals, significantly influence financial conditions and macroeconomic activity. These flows introduce noise that complicates the task of monetary policy.
• Monetary Policy Response: The paper proposes that central banks should target financial conditions indices (FCI) as part of their policy strategy. This approach involves announcing a soft target for the FCI and striving to maintain it close to the target. This strategy is suggested to be optimal because it helps stabilize financial conditions beyond their direct impact on output gaps.
• Benefits of FCI Targeting: FCI targeting is shown to create a feedback loop that reduces endogenous return volatility, thereby stabilizing the output gap. This policy allows arbitrageurs to better absorb noise, which enhances market stability. The authors argue that FCI targeting is superior to traditional interest rate forward guidance, as it could reduce the variance of the output gap, inflation, and interest rates significantly.
• Empirical Findings: The paper applies its model to U.S. data, estimating that FCI targeting could have reduced the variance of the output gap by 36%, inflation by 2%, and interest rates by 6%. It also suggests that FCI targeting would have been particularly effective during periods dominated by financial noise shocks, such as from 2000Q1 to 2007Q4.

Figure 10 shows the results [of FCI targeting during the 2000-2007]. First, the initial part of the recession appears unavoidable. However, thanks to FCI targeting, the recession is less deep, with the output gap plateauing between 2001Q4 and 2003Q2 instead of falling. During this period, FCI targeting makes financial conditions less restrictive than in the data. Interestingly, this is not due to extra interest rates cuts in that period; if anything, interest rates are higher than in the data starting on 2001Q4. Thus, we can attribute these looser financial conditions to the positive effects of announcing the FCI target.

Financial Conditions Targeting
Authors: Ricardo J. Caballero, Tomás E. Caravello, and Alp Simsek
From: MIT, Yale University

Trading -off inflation and financial instability costs

In this paper, Franklin Allen, Jae Hyoung Kim, and Ansgar Walther address the complex relationship between monetary policy, specifically inflation targeting, and financial stability. Here is a summary of the key findings from the paper:

• Critique of Traditional Monetary Policy: The authors critique the traditional view that monetary policy should focus solely on inflation targeting, suggesting that this approach may not adequately address financial stability concerns. They argue that the regulation of individual banks, which was previously thought to prevent systemic risk, is insufficient on its own.
• Leaning Against the Wind: The paper discusses the concept of “leaning against the wind,” which involves raising interest rates to curb asset price booms and prevent financial instability. However, the authors note that this approach has been criticized, particularly by Svensson (2017), who argues that the economic costs of raising interest rates often outweigh the benefits of reducing financial instability risks.
• Macroprudential Tools: The authors explore the use of macroprudential tools to control asset prices and maintain financial stability. However, they find that these tools have not been very effective in practice.
• Alternative Monetary Policy: The paper proposes an alternative approach to addressing financial instability, which involves pursuing an accommodative monetary policy. The authors use the Allen, Carletti, and Gale (2014) model to suggest that such a policy can be optimal by balancing the costs associated with both inflation and financial instability.
• Case Study of China: The authors highlight the case of China, where real estate prices have surged due to the lack of attractive investment alternatives in the stock market. This underscores the importance of considering the entire financial system when addressing real estate price increases.

Inflation Targeting and Financial Stability
Authors: Franklin Allen, Jae Hyoung Kim, Ansgar Walther
From: Imperial College London