Build-up Of Financial Imbalances Research Articles

The Role of Financial Stability Considerations in Monetary Policy and the Interaction with Macroprudential Policy in the Euro Area

Since the European Central Bank’s (ECB’s) 2003 strategy review, the importance of macro-financial amplification channels for monetary policy has increasingly gained recognition. This paper takes stock of this evolution and discusses the desirability of further incremental enhancements in the role of financial stability considerations in the ECB’s monetary policy strategy. The paper starts with the premise that macroprudential policy, along with microprudential supervision, is the first line of defence against the build-up of financial imbalances. It also recognises that the pursuit of price stability through monetary policy, and of financial stability through macroprudential policy, are to a large extent complementary. Nevertheless, macroprudential policy may not be able to ensure financial stability independently of monetary policy, because of spillovers originating from the common transmission channels through which the two policies produce their effects. For example, a low interest rate environment can create incentives to engage in more risk-taking, or can adversely impact the profitability of financial intermediaries and hence their capacity to absorb shocks. The paper argues that the existence of such spillovers creates a conceptual case for monetary policy to take financial stability considerations into account. It then goes on to discuss what this conclusion might imply in practice for the ECB. One option would be to exploit the flexible length of the medium-term horizon over which price stability is to be achieved. Longer deviations from price stability could occasionally be tolerated, if they resulted in materially lower risks for financial stability and, ultimately, for future price stability. ...

Sowing the seeds of financial imbalances: The role of macroeconomic performance

The seeds of financial imbalances are sown in times of buoyant economic growth. We study the link between macroeconomic performance and financial imbalances, focusing on the experience of the United States since the 1960s. We first follow a narrative approach to review historical episodes of significant financial imbalances and find that the onset of financial disturbances typically occurs when the economy is running hot. We then look for evidence of a statistical link between measures of macroeconomic conditions and financial imbalances. In our in-sample analysis, we find that strong economic growth is followed by a buildup of financial imbalances across all dimensions of the National Financial Conditions Index. In our out-of-sample analysis, we find that the link between strong economic performance and increases in nonfinancial leverage is particularly strong and robust. Using a structural VAR identified with narrative sign restrictions, we also demonstrate that business cycle shocks are important drivers of nonfinancial leverage.

Sowing the Seeds of Financial Imbalances: The Role of Macroeconomic Performance

The seeds of financial imbalances are sown in times of buoyant economic growth. We study the link between macroeconomic performance and financial imbalances, focusing on the experience of the United States since the 1960s. We first follow a narrative approach to review historical episodes of significant financial imbalances and find that the onset of financial disturbances typically occurs when the economy is running hot. We then look for evidence of a statistical link between measures of macroeconomic conditions and financial imbalances. In our in-sample analysis, we find that strong economic growth is followed by a build-up of financial imbalances across all dimensions of the National Financial Conditions Index. In our out-of-sample analysis, we find that the link between strong economic performance and increases in nonfinancial leverage is particularly strong and robust. Using a structural VAR identified with narrative sign restrictions, we also demonstrate that business cycle shocks are important drivers of non financial leverage.

Sowing the Seeds of Financial Imbalances: The Role of Macroeconomic Performance

The seeds of financial imbalances are sown in times of buoyant economic growth. We study the link between macroeconomic performance and financial imbalances, focusing on the experience of the United States since the 1960s. We first follow a narrative approach to review historical episodes of significant financial imbalances and find that the onset of financial disturbances typically occurs when the economy is running hot. We then look for evidence of a statistical link between measures of macroeconomic conditions and financial imbalances. In our in-sample analysis, we find that strong economic growth is followed by a build-up of financial imbalances across all dimensions of the National Financial Conditions Index. In our out-of-sample analysis, we find that the link between strong economic performance and increases in nonfinancial leverage is particularly strong and robust. Using a structural VAR identified with narrative sign restrictions, we also demonstrate that business cycle shocks are important drivers of non financial leverage.

To What Extent did Monetary Policy Contribute Towards the Recent Financial Crisis and Subsequent Recession in the US and UK?

This essay researches the question, “To what extent did monetary policy contribute towards the recent financial crisis and subsequent recession in the US and UK?” This article begins by demonstrating monetary policy’s role in guiding the economy’s development under different economic fundamentals. Then the essay puts forward the existence of possibility that monetary policy may cause potential dangers for the economy. In the next chapter, the essay illustrates the guideline for monetary policy namely Taylor rule and economists’ arguments and explanations for the US monetary policy in the past decade. In chapter 3, this article estimates the nominal interest rates for both the US and the UK based on Taylor rule for different periods and illustrates influences of monetary policy actually taken for each country in different periods. In chapter 4, the article tests the relationship between monetary policy’s deviations from Taylor rule and financial imbalances by using the OLS method and explains results. Finally, in chapter 5, the article concludes that in some degree monetary policy’s deviations from Taylor rule prescriptions contribute to a build-up of financial imbalances.

Three Approaches to Macrofinance: Evidence from 140 Years of Data

We interrogate 140 years of macrofinancial data from three directions. The first approach pays attention to the slow buildup of financial imbalances that threaten financial stability and isolates medium-term movements in credit and property prices to identify national financial cycles. We show that the data reveals the reemergence of outsized financial cycles since the 1980s. In particular, we document the existence of an outsized financial cycle in the United States during the interwar period. We show that national financial cycles tend to move together and that their comovement has become particularly marked since the 1980s. Further, we show that virtually all financial booms are accompanied by housing-finance booms. The second approach pays attention to the predictive information in the consumption to wealth ratio. We show that the consumption to wealth ratio predicts not only global real rates (as has already been shown) but also property excess returns and the term spread although not stock excess returns. The third approach pays attention to the risk appetite of financial market intermediaries whose marginal value of wealth prices a broad class of financial assets. We create a metric for intermediary risk appetite for an earlier period not covered by the extant literature (1920-1970) and show that intermediary risk appetite predicts stock excess returns. We conclude with a discussion of our findings and the path forward for marcrofinance.

The Role of Financial Imbalances in Assessing the State of the Economy

The buildup of financial imbalances may provide a signal regarding the sustainable rate of resource utilization in the economy.

What Caused the Global Financial Crisis? Evidence on the Drivers of Financial Imbalances 1999-2007

This paper investigates empirically the drivers of financial imbalances ahead of the global financial crisis. Three factors may have contributed to the build-up of financial imbalances: (i) rising global imbalances (capital flows), (ii) monetary policy that might have been too loose, (iii) inadequate supervision and regulation. Panel data regressions are performed for OECD countries from 1999 to 2007, so as to shed light on the relative importance of these factors, as well as the extent to which these factors might have interacted in fuelling the build-up. We find that the build-up of financial imbalances was driven by capital inflows and an associated compression of the spread between long and short rates. The effect of capital inflows on the build-up is amplified where the supervisory and regulatory environment was relatively weak. We find that, by contrast, differences in monetary policy cannot account for differences across countries in the build-up of financial imbalances ahead of the crisis.

What Caused the Global Financial Crisis: Evidenceon the Drivers of Financial Imbalances 1999: 2007

This paper investigates empirically the drivers of financial imbalances ahead of the global financial crisis. Three factors may have contributed to the build-up of financial imbalances: (i) rising global imbalances (capital flows), (ii) monetary policy that might have been too loose, (iii) inadequate supervision and regulation. Panel data regressions are performed for OECD countries from 1999 to 2007, so as to shed light on the relative importance of these factors, as well as the extent to which these factors might have interacted in fuelling the build-up. We find that the build-up of financial imbalances was driven by capital inflows and an associated compression of the spread between long and short rates. The effect of capital inflows on the build-up is amplified where the supervisory and regulatory environment was relatively weak. We find that, by contrast, differences in monetary policy cannot account for differences across countries in the build-up of financial imbalances ahead of the crisis.

Inflation targeting, asset prices, and financial imbalances: Contextualizing the debate

This paper casts the debate regarding the role of asset prices and financial imbalances in the formulation of monetary policy from the perspective of theoretically optimal policy responses. Within the context of a standard model of the transmission mechanism, several possible motivations for responding to financial imbalances are highlighted. However, preventative policy actions against the build-up of financial imbalances cannot be easily understood within such a framework without fundamental modification to the underlying model. It is argued that a more practical way to evaluate such actions is through the inclusion of concerns for financial imbalances explicitly in the central bank's objective function.

Inflation Targeting, Asset Prices and Financial Imbalances: Conceptualizing the Debate

This paper attempts to conceptualize the debate regarding the role of asset prices and perceived financial imbalances in the formation of monetary policy from the perspective of theoretically optimal policy responses. While much of the disagreement can be reconciled within the framework of flexible inflation targeting, defined as a commitment to a targeting rule, preemptive policy actions against the build-up of financial imbalances cannot be motivated within such a framework without modification either to the targeting rule or the underlying model. Given standard forecasting models, such actions are shown to be operationally equivalent to targeting financial imbalances explicitly in the central bank loss function.

The Financial Turmoil of 2007-?: A Preliminary Assessment and Some Policy Considerations

The unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century. This essay seeks to provide a preliminary assessment of the events and to draw some lessons for policies designed to strengthen the financial system on a long-term basis. It argues that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the subprime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences that follows the build-up of financial imbalances in good times. The significant idiosyncratic elements, including the threat of an unprecedented involuntary reintermediation wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes. The policy response, while naturally taking into account the idiosyncratic weaknesses brought to light by the turmoil, should be firmly anchored to the more enduring factors that drive financial instability. This essay highlights possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.

Monetary and Financial Stability: So Close and Yet So Far?

This paper argues that changes in the financial and monetary regimes since the early 1980s may have made it more likely that financial factors in general, and the booms and busts in credit and asset prices in particular, act as drivers of economic fluctuations. As a result, the current environment may be more vulnerable to the occasional build-up of financial imbalances, ie. overextensions in (private sector) balance sheets that herald economic weakness and disinflation down the road, as they unwind, raising also the risk of financial strains and possibly even broader financial instability. Achieving simultaneously monetary and financial stability may call for some significant refinements to current policy frameworks, based on closer cooperation between prudential and monetary authorities. These refinements include a strengthening of the macroprudential orientation of regulatory and supervisory frameworks ensuring that monetary frameworks allow enough room for manoeuvre to lean pre-emptively against the build-up of the imbalances.