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Andrew FilardoBank for International Settlements

Comments on

“Flexible Inflation Targeting & Financial Stability: Is It Enough to Stabilise Inflation and Output?”

The Architecture of Financial System Stability: From Market Micro Structure to Monetary Policy 24-26 May 2006, Capri, Italy

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Related Policy Issues

• Asset prices and monetary policy

• Monetary stability and financial stability

• Very important policy issues that demand greater research efforts – not just a Norwegian problem

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Related Policy Issues

Emerging market economies

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The Pros

Making progress

• Explicit consideration of financial stability and monetary stability considerations for central banks

• Larger set of equations – more realistic policy model!

• “Calibrated” model of the Norwegian economy

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The Cons

Making progress???

• What should policymakers make of these results?

• My remaining comments raise doubts about whether policymakers can rely with confidence on the “themes” coming from this analysis

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Modeling Approach

Monetary policy loss function

Macro-financial set of 8 equations:

output, inflation, housing, shares, FX, Unemp, wages, credit

Monetary policy – augmented Taylor rules

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If it were only that easy!

Deep modeling issues: CB loss function

“Second generation” loss function – is it enough?

First generation - var(r)?

PY

rLf

Second generation V(f)

Not clear that this is exactly what we mean by financial stability

Not exactly sure what is going on with f in the model

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If it were only that easy!

Deep modeling issues: CB loss function

• What do we mean by financial stability for CBs?

Low probability meltdowns

Japan-like situation where system short-circuits

The nonlinear interactions are surely the key ones

• What is the ultimate source of externality or market failure? What justifies government intervention? And, is the central bank the obvious “stabiliser of first resort”?

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If it were only that easy!

Deep modeling issues: “Calibrated” models• Macro-financial model – is it that easy?

• Asset prices – misspecification or bubbles?

• Should CBs respond? Should CBs prick? Can CBs encourage/discourage bubbles by holding R too low for too long? [Filardo 2004, 2005]

1010

If it were only that easy!

Deep modeling issues: “Calibrated” models• Macro-financial model – is it that easy?

• Asset prices – misspecification or bubbles?

• Should CBs respond? Should CBs prick? Can CBs encourage/discourage bubbles by holding R too low for too long? [Filardo 2004, 2005]

• Credit growth – monetary or real phenomenon?

• Intrinsic shocks & linear stochastic control are key!!!

Cannot simply estimate a set of regression equations to draw robust policy implications!!!

1111

If it were only that easy!

Deep modeling issues: Ad hoc MP rules

• Ad hoc monetary policy – is it sufficient?

• Yes, if start with a realistic policy rule. Then, can ask: “Can the central bank do better?”

• No, if comparing two non-optimal rules. They do not reveal much

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Results for Optimal PolicyV

ari

anc

e o

f in

fla

tio

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Variance of output

Optimal Monetary Policy Frontiers

?

1313

If it were only that easy!

Deep modeling issues: Ad hoc MP rules

• Ad hoc monetary policy – is it sufficient?

• Yes, if start with a realistic policy rule. Then, can ask: “Can the central bank do better”

• No, if comparing two non-optimal rules. They do not reveal much

Other possible issues -

• Where is the role for monetary aggregates? thresholds?

• Considerations of deflation and ZLB should be added

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Bottom Line

I like the paper

It makes some progress in thinking about key policy issues …

… but I am not sure that such modeling efforts are ready for prime time … yet!

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Where Do We Go From Here?

Need to backwards before moving forwards!

• “Optimal” monetary policy

• How do we add financial stability concerns in the “welfare” function of the central bank?

• Shock identification and modeling – intrinsic and non-linear aspects

• Policy responses – game theoretic aspects amongst domestic policymakers (eg RBNZ) multilateral considerations

• Decision making under uncertainty – interim solution

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Thank you!

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Results for Optimal PolicyV

ari

anc

e o

f in

fla

tio

n

Variance of output

Optimal Monetary Policy Frontiers

tatyyatr **

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Results for Optimal PolicyV

ari

anc

e o

f in

fla

tio

n

Variance of output

Optimal Monetary Policy Frontiers

Superior policy

tatyyatr **

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Modeling a Bubble

Time-Varying Transition Probability Model

Sample Path of a Bubble

-20

-15

-10

-5

0

5

10

15

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Time periods

Not a CAPM model!

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Results for Optimal PolicyV

ari

anc

e o

f in

fla

tio

n

Variance of output

Optimal Monetary Policy Frontiers

othertπ*πaty

*yatr