Abstract
IMF Research Bulletin summarizes some of the recent research activities of the IMF.
Giovanni Melina and Stefania Villa
In recent times credit booms and busts have dramatically affected business cycle fluctuations. This has called for a deeper understanding of credit market conditions and the role of central banks in ensuring financial stability. We examine whether, during the Great Moderation, interest-rate policy has reacted and whether it should have indeed reacted to bank lending growth in the U.S. economy. A narrative analysis of the minutes of the Federal Open Market Committee suggests a correlation between concerns on credit conditions and intended changes in the federal funds rate. This finding motivates a more structural investigation. Using an estimated macroeconomic model with banking, this paper first provides evidence that monetary policy did lean against the wind blowing from the loan market. It then shows that, although the estimated monetary policy feedback to bank credit growth yields a small welfare loss, the optimal interest-rate rule features almost no response to credit conditions. Counterfactual experiments unveil that the sources of business cycle fluctuations are crucial in determining whether a “leaning-against-the-wind” policy is optimal or not. In fact, the predominant role of estimated supply shocks in the medium run gives rise to a trade-off between inflation and financial stabilization.
The role of central banks in promoting financial stability, in addition to inflation stability, had been debated well before the Great Recession. The so-called “Greenspan doctrine,” which objects to the policy of leaning against the wind blowing from asset prices, greatly influenced the central banking world before the crisis. However, in the aftermath of the Great Recession, the need to protect the banking sector from periods of unduly high or excessively low credit growth has led to a renewed interest in the “lean” versus “clean” role for monetary policy, with an emphasis on credit conditions.
Indeed, the important role of credit markets in affecting business cycle fluctuations emerged also from the Basel III framework that aimed to protect the financial sector from periods of excessive credit growth, which is often associated with an increase in systemic risk. On this aspect, Jordà, Schularick, and Taylor (2013) document that, in a sample of 14 countries between 1870 and 2008, more credit-intensive expansions tended to be followed by deeper recessions and slower recoveries. In a recent contribution, Batini, Melina, and Villa (2016) find that higher levels of private leverage lead to more severe recessions, with serious consequences also for public finances. Furthermore, Bordo and Haubrich (2017) provide empirical evidence that bank lending significantly affects GDP fluctuations in the United States.
Our paper (Melina and Villa, 2017) focuses precisely on bank lending and it examines whether interest-rate policy has reacted and whether it should indeed react to bank lending growth in the U.S. economy.
A Narrative Analysis
Figure 1 illustrates the intended changes in the federal funds rate (FFR) around all meetings of the Federal Open Market Committee (FOMC) that occurred during the Great Moderation, and whether, in the minutes of each meeting, credit was (i) not a particular concern; (ii) judged to be expanding; or (iii) judged to be weak or tight. The series of intended changes in FFR is an extension of the Romer and Romer (2004) series. It ends in June 2008, before the zero lower bound became binding. To construct our narrative measure of concerns on credit conditions in U.S. monetary policy decisions, we read the statements released after each FOMC meeting and searched for sentences related to credit conditions in the minutes of the 196 meetings held between January 1984 and June 2008. We then constructed two variables. The first takes value 1 if, in the minutes, credit was judged to be expanding and zero otherwise. The second takes value 1 if credit was judged to be weak or tight and zero otherwise. If both variables take value zero, we conclude that credit was not a particular concern.
Intended Federal Funds Rate Changes around FOMC Meetings and Concerns on Credit Conditions Raised in FOMC Minutes
Citation: IMF Research Bulletin 2017, 003; 10.5089/9781484327234.026.A002
Note: Sample:1984Q1–2008Q2; shaded areas indicate NBER recessions.Source: Melina and Villa (2017)Intended Federal Funds Rate Changes around FOMC Meetings and Concerns on Credit Conditions Raised in FOMC Minutes
Citation: IMF Research Bulletin 2017, 003; 10.5089/9781484327234.026.A002
Note: Sample:1984Q1–2008Q2; shaded areas indicate NBER recessions.Source: Melina and Villa (2017)Intended Federal Funds Rate Changes around FOMC Meetings and Concerns on Credit Conditions Raised in FOMC Minutes
Citation: IMF Research Bulletin 2017, 003; 10.5089/9781484327234.026.A002
Note: Sample:1984Q1–2008Q2; shaded areas indicate NBER recessions.Source: Melina and Villa (2017)In most FOMC meetings (79 percent) in which the FFR was intended to be held constant, credit was not a particular concern. In most cases (79 percent) in which the FOMC intended to raise the FFR, an expansion in credit was mentioned; while in the greatest part of FOMC meetings (78 percent) in which the FFR was intended to be lowered, weak or tight credit was mentioned.
Empirical Evidence from a Structural Model
The narrative analysis motivates a more detailed empirical investigation on the extent to which monetary policy had a concern on credit conditions beyond their implications for inflation and economic activity. To this end, we build a structural dynamic stochastic general equilibrium (DSGE) model with frictions in the bank loan market, and a monetary policy whereby the short-term interest rate reacts, not only to inflation and the output gap, but also to nominal credit growth. The model is estimated with Bayesian methods over the Great Moderation period, 1984Q1–2008Q2, using a set of U.S. macroeconomic and financial variables.
The estimated parameter representing the interest-rate response to nominal credit growth turns out to be statistically positive and economically important. This result is robust to various alternative specifications of the monetary policy rule. Therefore, estimates point to the evidence that, during the Great Moderation, monetary policy did lean against the wind blowing from the loan market beyond its concern for price and output stability. This is a novel result. In fact, Christiano, Motto, and Rostagno (2010) estimate a significant degree of “leaning against credit exuberance” in the euro area monetary policy framework, while Belke and Klose (2010) perform a similar analysis within a reduced-form GMM estimation. However, as far as estimated DSGE models for the U.S. economy are concerned, the literature has so far offered contributions focusing on the reaction of the monetary policy rate to stock prices (see, e.g., Castelnuovo and Nisticò, 2010, among others)—for which we also control—but not to credit conditions.
Normative Analysis
Is the estimated monetary policy response to credit growth the welfare-optimal policy? In our paper, we show that the answer to this question heavily depends on the sources of business cycle fluctuations. We perform a welfare comparison of alternative interest-rate rules, relative to the fully optimal policy, imposing an approximate zero-lower-bound constraint in a way similar to Levine, McAdam, and Pearlman (2008). The estimated response of monetary policy to credit growth delivers a small welfare loss compared to the optimum. Indeed, we find that optimal monetary policy features almost-zero responses both to the output gap and to credit growth. While the former result is in line with the findings of Schmitt-Grohe and Uribe (2007) in a model with perfect credit markets, the latter is a novel contribution. The explanation of such a finding lies in the fact that, in the estimated model, supply shocks–technology, price and wage mark-up–turn out to be the main drivers of output, lending and inflation fluctuations in the medium run. Unlike demand shocks, supply shocks move output and prices in opposite directions, implying a trade-off between inflation and output stabilization. In other words, there is no “divine coincidence” (Blanchard and Galí, 2007) for the two targets. Given the pro-cyclical behavior of lending, a monetary policy that responds also to financial variables should respond more aggressively to inflation. As a result, it turns out to be optimal for monetary policy to respond almost exclusively to inflation. This result is in line with Faia and Monacelli (2007), who show that the presence of only one policy instrument–the nominal interest rate–in a simpler calibrated model, cannot simultaneously neutralize both financial frictions and price stickiness, and that a strong anti-inflationary stance always leads to the highest level of welfare.
Counterfactual experiments highlight the importance of the sources of business cycle fluctuations. For instance, if we suppress wage mark-up shocks—prominent supply shocks in the estimated model—it would be indeed optimal to lean against windy bank lending. This exercise is important also because it allows reconciling our results with the literature. For instance, Aksoy, Basso, and Coto-Martinez (2013) and Gambacorta and Signoretti (2014), in similar but simpler calibrated models with no wage mark-up shocks, find a leaning-against-the-wind policy to be optimal.
The findings of this paper agree with the recent tendency in central banking to move toward macroprudential instruments as tools to promote financial stability. Indeed, a bolder research effort is necessary to identify effective instruments and design rules that achieve the goal of reducing financial instability without conflicting with the objective of inflation stabilization.
References
Aksoy, Y., H. Basso, and J. Coto-Martinez. 2013. “Lending Relationships and Monetary Policy.” Economic Inquiry, 51(1):368–393.
Batini, N., G. Melina, and S. Villa. 2016. “Fiscal Buffers, Private Debt and Stagnation: The Good, the Bad and the Ugly.” IMF Working Paper 16/104. Washington, DC: International Monetary Fund.
Belke, A. and J. Klose. 2010. “(How) Do the ECB and the Fed React to Financial Market Uncertainty?: The Taylor Rule in Times of Crisis.” Discussion Papers of DIW Berlin, 972.
Bordo, M. D. and J. G. Haubrich. 2017. “Deep Recessions, Fast Recoveries, and Financial Crises: Evidence from the American Record.” Economic Inquiry, 55(1):527–541.
Blanchard, O. and J. Galí (2007). “Real Wage Rigidities and the New Keynesian Model.” Journal of Money, Credit and Banking, 39(s1):35–65.
Castelnuovo, E. and S. Nisticò. 2010. “Stock Market Conditions and Monetary Policy in a DSGE Model for the U.S.” Journal of Economic Dynamics and Control, 34(9):1700–1731.
Christiano, L., R. Motto, and M. Rostagno. 2010. “Financial Factors in Economic Fluctuations.” ECB Working Paper Series, 1192.
Faia, E. and T. Monacelli. 2007. “Optimal Interest Rate Rules, Asset Prices, and Credit Frictions.” Journal of Economic Dynamics and Control, 31(10):3228–3254.
Gambacorta, L. and F. M. Signoretti. 2014. “Should Monetary Policy Lean Against the Wind?: An Analysis Based on a DSGE Model with Banking.” Journal of Economic Dynamics and Control, 43:146–174.
Jordà, O, M. H. Schularick and A. M. Taylor. 2013. “When Credit Bites Back.” Journal of Money, Credit and Banking, 45(2S):3–28.
Levine, P., P. McAdam and J. Pearlman. 2008. “Quantifying and Sustaining Welfare Gains from Monetary Commitment. Journal of Monetary Economics, 55(7):1253–1276.
Melina, G., and S. Villa. 2017. “Leaning Against Windy Bank Lending.” IMF Working Paper 17/179. Washington, DC: International Monetary Fund. (Also, forthcoming in Economic Inquiry.)
Romer, C. D. and D. H. Romer. 2004. “A New Measure of Monetary Shocks: Derivation and Implications.” American Economic Review, 94(4):1055–1084.
Schmitt-Grohe, S. and M. Uribe. 2007. “Optimal Simple and Implementable Monetary and Fiscal Rules.” Journal of Monetary Economics, 54(6):1702–1725.
