Should Central Banks Lean Against the Wind?

by Andreas Hoffmann

The pre-crisis Jackson Hole Consensus view on how to take asset market developments into account in monetary policy can be summarized as follows: Because it is hard to spot bubbles in asset markets with certainty ex-ante, central bankers should not lean against the wind when there seems to be a boom in financial markets (as long as the inflation rate does not pick up). However, as a rapid fall in asset prices can pull the real economy into the maelstrom of crisis, monetary policy should react decisively when a bubble bursts and “clean up the mess” to  prevent spillovers to the real economy.

Because there is empirical evidence that countries with greater credit and asset market booms in the 2000s experienced more severe financial crises in 2007-9, the pre-crisis consensus view has lost popularity. Policymakers and academics have started to think of ways to curb financial booms and lower the probability of crisis using macroprudential regulation or leaning-against-the-wind monetary policy.

In particular, the economists at the Bank for International Settlements (BIS) suggest that central banks should consider using the policy interest rate to lean against the building of asset and credit market (financial) bubbles. According to the BIS view, the costs and risks of a financial crisis are endogenous to the financial boom. Financial booms build gradually and tend to unload rapidly. In a thought-provoking paper, A. Filardo and P. Rungcharoenkitkul, therefore, make a “case for a systematic leaning-against-the-wind policy in an environment where there is a recurring financial cycle with costly crises.” The authors propose to include financial cycle variables directly in monetary policy rules.

I find the BIS view of financial booms and busts appealing. The BIS’s explanation of the cycle is reminiscent of Hayek’s in the “Monetary Theory and the Trade Cycle”. Both, the BIS view and Hayek’s work, emphasize that the endogenous increase in leverage during the upswing of a cycle is the fundamental cause of the recurrence of credit cycles. Because the elasticity of the financial system is necessary to finance innovations and technological advances, Hayek considered recurring financial cycles the price for progress.[i] Unless central banks dramatically restrict the creation of credit, hampering economic development, central banks cannot prevent the credit cycle altogether. The modern BIS view as well as Hayek’s work from the 1920’s suggest that policymakers might at best help dampen the cycle.

However, there are issues with the BIS-proposal

Knowing that in theory a policy can be improved upon, does not mean that it is possible to reach better results in the real world by adding a financial cycle variable to the monetary policy rule. This policy implication reminds me of the fallacy to believe that just because conditions of the first welfare theorem are not fulfilled, the market outcome can be improved by well-designed policy.

More specifically, improvements in terms of welfare as shown in economic analysis hardly materialize in the real world because they depend much on timing and knowledge about the underlying variables as well as the sensitivities of these variables to policy changes. First, it is unclear ex-ante if a rise in a financial variable like an asset price is always and everywhere a negative thing. The old consensus view got that right. Second, the financial cycle is a result of people’s decisions. They are not ants under a magnifying glass but creative and may change behavior with changes in policies in unexpected ways.

Beyond the knowledge problem…

Including a financial cycle variable in the monetary policy rule as suggested by the BIS also adds complexity to monetary policy decisions. It would mean an increase in the number of objectives to trade-off with just one policy instrument. Richard Epstein emphasizes the need for simple rules in a complex world to not undermine the rule of law. The danger is real. If central banks trade-off more and more objectives, it will become difficult to hold them accountable for their actions. Central bank independence may be threatened and even turn out to be a problem. From this perspective, having one target only (an inflation, credit growth or nominal GDP growth target) might be preferable.


[i] “So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them. And even if it is a mistake — as the recurrence of crises would demonstrate — to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge, are thereby benefited in a way which we should be reluctant to forgo.” See Hayek (MT&TC, pp. 189–190).


6 thoughts on “Should Central Banks Lean Against the Wind?

  1. Imagine the trouble if hot dog sellers tried to lean against the wind, cooking fewer hot dogs when people are hungry, and more when people aren’t hungry. For centuries, banks relied on the real bills doctrine to automatically provide an elastic currency. Economists who criticize the RBD are like doctors who criticize the appendix: They can’t see its purpose, so they conclude it is a mistake. But just as the appendix is the product of millions of years of evolution, the RBD is the product of centuries of evolution in the banking industry. Bankers that followed the RBD survived and prospered and did not exaggerate natural booms and busts. On the other hand, bankers that did not follow the RBD tended to crash and burn.

  2. “ inflation, credit growth or nominal GDP growth target”

    Credit growth seems like a good target. The problems with inflation and NGDP targeting are with the accuracy of forecasts; they don’t have any. Scott Sumner has suggested an NGDP futures market, but has Ludwig Lachmann never tired of pointing out we already have that in the stock market, so it would make a good target. The benefit of the stock market is that it responds almost instantly to policy changes, as do the bond markets. Also, stock markets do a better job than any economic model of predicting recessions.

    Clearly, the Fed is as useless as the nipples on a boar, when it comes to rescuing the economy from a recession, but it does seem to have some value in leaning against the tendency that Hayek described for banks to expand credit too much in an expansion.

  3. In the post-Keynesian macroeconomic analysis, the central bank’s money supply equals the demand for money. The demand for money comes from the residents, businesses, governments, and commercial banks. Each sector has its own money demand function, depending on liquidity preferences and the portfolio management. At the same time, the central bank can adjust the benchmark interest rate and influence the demand for money by changing liquidity preferences, but demand depends not only on borrowing costs but also on expectations. It can be seen that endogenous currency means that money is created endogenously in the course of economic operation rather than controlled by the central bank, but we must admit that the central bank is the ultimate provider of liquidity. In shortages of liquidity, you still have to rely on the central bank.

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