Monetary policy and banking supervision: coordination instead of separation. CEPS Policy Brief No. 286, 12 December 2012

Introduction. Following the June 2012 European Council decision to place the ‘Single Supervisory Mechanism’ (SSM) within the European Central Bank, the general presumption in the policy discussions has been that there should be ‘Chinese walls’ between the supervisory and monetary policy arms of the ECB. The current legislative proposal, in fact, is explicit on this account. On the contrary, however, this paper finds that there is no need to impose a strict separation between these two functions. The authors argue, in fact, that a strict separation of supervision and monetary policy is not even desirable during a financial crisis when the systemic stability of the financial system represents the biggest threat to a monetary policy that aims at price stability. In their view, the key problem hampering the ECB today is that it lacks detailed information on the state of health of the banking system, which is often highly confidential. Chinese walls would not solve this problem. Moreover, in light of the fact that the new, proposed Supervisory Board will be composed to a large extent of representatives of the same institutions that also dominate the Governing Council, the paper finds that it does not make sense to have Chinese walls between two boards with largely overlapping memberships. In addition, it recommends that some members of the Supervisory Boards should be “independents” in order to reduce the tendency of supervisors to unduly delay the recognition of losses.

Flexible rules cum constrained discretion: a new consensus in monetary policy

This paper demonstrates that recent influential contributions to monetary policy imply an emerging consensus whereby neither rigid rules nor complete discretion are found optimal. Instead, middle-ground monetary regimes based on rules (operative under 'normal' circumstances) to anchor inflation expectations over the long run, but designed with enough flexibility to mitigate the short-run effect of shocks (with communicated discretion in 'exceptional' circumstances temporarily overriding these rules), are gaining support in theoretical models and policy formulation and implementation. The opposition of 'rules versus discretion' has, thus, reappeared as the synthesis of 'rules cum discretion', in essence as inflation-forecast targeting. But such synthesis is not without major theoretical problems, as we argue in this contribution. Furthermore, the very recent real-world events have made it obvious that the inflation targeting strategy of monetary policy, which rests upon the new consensus paradigm in modern macroeconomics is at best a 'fair weather' model. In the turbulent economic climate of highly unstable inflation, deep financial crisis and world-wide, abrupt economic slowdown nowadays this approach needs serious rethinking to say the least, if not abandoning it altogether

The housing market channel of monetary policy transmission in the Euro area

Purpose – The purpose of this paper is to explore the role of the housing market in the monetary policy transmission to consumption among euro area member states. It has been argued that the housing market in one country is then important when its mortgage market is well developed. The countries in the euro area follow unitary monetary policy, however, their housing and mortgage markets show some heterogeneity, which may lead to different policy effects on aggregate consumption through the housing market. Design/methodology/approach – The housing market can act as a channel of monetary policy shocks to household consumption through changes in house prices and residential investment – the housing market channel. We estimate vector autoregressive models for each country and conduct a counterfactual analysis in order to disentangle the housing market channel and assess its importance across the euro area member states. Findings – We find little evidence for heterogeneity of the monetary policy transmission through house prices across the euro area countries. Housing market variations in the euro area seem to be better captured by changes in residential investment rather than by changes in house prices. As a result we do not find significantly large house price channels. For some of the countries however, we observe a monetary policy channel through residential investment. The existence of a housing channel may depend on institutional features of both the labour market or with institutional factors capturing the degree of household debt as is the LTV ratio. Originality/value – The study contributes to the existing literature by assessing whether a unitary monetary policy has a different impact on consumption across the euro area countries through their housing and mortgage markets. We disentangle monetary-policy-induced effects on consumption associated with variations on the housing markets due to either house price variations or residential investment changes. We show that the housing market can play a role in the monetary transmission mechanism even in countries with less developed mortgage markets through variations in residential investment.

Some benefits of cyclical monetary policy

In this paper, we present a simple random-matching model of seasons, where di§erent seasons translate into di§erent propensities to consume and produce. We Önd that the cyclical creation and destruction of money is beneÖcial for welfare under a wide variety of circumstances. Our model of seasons can be interpreted as providing support for the creation of the Federal Reserve System, with its mandate of supplying an elastic currency for the nation.

The contagion effect of public debt on monetary policy: the brazilian experience

This paper attempts to explain why the Brazilian inter-bank interest rate is so high compared with rates practiced by other emerging economies. The interplay between the markets for bank reserves and government securities feeds into the inter-bank rate the risk premium of the Brazilian public debt.

Monetary policy and country risk

This article develops an econometric model in order to study country risk behavior for six emerging economies (Argentina, Mexico, Russia, Thailand, Korea and Indonesia), by expanding the Country Beta Risk Model of Harvey and Zhou (1993), Erb et. al. (1996a, 1996b) and Gangemi et. al. (2000). Toward this end, we have analyzed the impact of macroeconomic variables, especially monetary policy, upon country risk, by way of a time varying parameter approach. The results indicate an inefficient and unstable effect of monetary policy upon country risk in periods of crisis. However, this effect is stable in other periods, and the Favero-Giavazzi effect is not verified for all economies, with an opposite effect being observed in many cases.

Stochastic growth and monetary policy: the impacts on the term structure of interest rates

This paper builds a simple, empirically-verifiable rational expectations model for term structure of nominal interest rates analysis. It solves an stochastic growth model with investment costs and sticky inflation, susceptible to the intervention of the monetary authority following a policy rule. The model predicts several patterns of the term structure which are in accordance to observed empirical facts: (i) pro-cyclical pattern of the level of nominal interest rates; (ii) countercyclical pattern of the term spread; (iii) pro-cyclical pattern of the curvature of the yield curve; (iv) lower predictability of the slope of the middle of the term structure; and (v) negative correlation of changes in real rates and expected inflation at short horizons.

Tayloring Brazil: a system dynamics model for monetary policy feedback

The thesis introduces a system dynamics Taylor rule model of new Keynesian nature for monetary policy feedback in Brazil. The nonlinear Taylor rule for interest rate changes con-siders gaps and dynamics of GDP growth and inflation. The model closely tracks the 2004 to 2011 business cycle and outlines the endogenous feedback between the real interest rate, GDP growth and inflation. The model identifies a high degree of endogenous feedback for monetary policy and inflation, while GDP growth remains highly exposed to exogenous eco-nomic conditions. The results also show that the majority of the monetary policy moves during the sample period was related to GDP growth, despite higher coefficients of inflation parameters in the Taylor rule. This observation challenges the intuition that inflation target-ing leads to a dominance of monetary policy moves with respect to inflation. Furthermore, the results suggest that backward looking price-setting with respect to GDP growth has been the dominant driver of inflation. Moreover, simulation exercises highlight the effects of the new BCB strategy initiated in August 2011 and also consider recession and inflation avoid-ance versions of the Taylor rule. In methodological terms, the Taylor rule model highlights the advantages of system dynamics with respect to nonlinear policies and to the stock-and-flow approach. In total, the strong historical fit and some counterintuitive observations of the Taylor rule model call for an application of the model to other economies.

Monetary policy and the cross-section of stock returns: a FAVAR approach

We use a factor-augmented vector autoregression (FAVAR) to estimate the impact of monetary policy shocks on the cross-section of stock returns. Our FAVAR combines unobserved factors extracted from a large set of nancial and macroeconomic indicators with the Federal Funds rate. We nd that monetary policy shocks have heterogeneous e ects on the crosssection of stock returns. These e ects are very well explained by the degree of external nance dependence, as well as by other sectoral characteristics.

Credit shocks and monetary policy in Brazil: a structural FAVAR approach

This paper investigates the implications of the credit channel of the monetary policy transmission mechanism in the case of Brazil, using a structural FAVAR (SFAVAR) approach. The term structural comes from the estimation strategy, which generates factors that have a clear economic interpretation. The results show that unexpected shocks in the proxies for the external nance premium and the bank balance sheet channel produce large and persistent uctuations in in ation and economic activity accounting for more than 30% of the error forecast variance of the latter in a three-year horizon. The central bank seems to incorporate developments in credit markets especially variations in credit spreads into its reaction function, as impulse-response exercises show the Selic rate is declining in response to wider credit spreads and a contraction in the volume of new loans. Counterfactual simulations also demonstrate that the credit channel ampli ed the economic contraction in Brazil during the acute phase of the global nancial crisis in the last quarter of 2008, thus gave an important impulse to the recovery period that followed.

Essays on the credit channel of monetary policy: a case study for Brazil

The onset of the financial crisis in 2008 and the European sovereign crisis in 2010 renewed the interest of macroeconomists on the role played by credit in business cycle fluctuations. The purpose of the present work is to present empirical evidence on the monetary policy transmission mechanism in Brazil with a special eye on the role played by the credit channel, using different econometric techniques. It is comprised by three articles. The first one presents a review of the literature of financial frictions, with a focus on the overlaps between credit activity and the monetary policy. It highlights how the sharp disruptions in the financial markets spurred central banks in developed and emerging nations to deploy of a broad set of non conventional tools to overcome the damage on financial intermediation. A chapter is dedicated to the challenge face by the policymaking in emerging markets and Brazil in particular in the highly integrated global capital market. This second article investigates the implications of the credit channel of the monetary policy transmission mechanism in the case of Brazil, using a structural FAVAR (SFAVAR) approach. The term “structural” comes from the estimation strategy, which generates factors that have a clear economic interpretation. The results show that unexpected shocks in the proxies for the external finance premium and the credit volume produce large and persistent fluctuations in inflation and economic activity – accounting for more than 30% of the error forecast variance of the latter in a three-year horizon. Counterfactual simulations demonstrate that the credit channel amplified the economic contraction in Brazil during the acute phase of the global financial crisis in the last quarter of 2008, thus gave an important impulse to the recovery period that followed. In the third articles, I make use of Bayesian estimation of a classical neo-Keynesian DSGE model, incorporating the financial accelerator channel developed by Bernanke, Gertler and Gilchrist (1999). The results present evidences in line to those already seen in the previous article: disturbances on the external finance premium – represented here by credit spreads – trigger significant responses on the aggregate demand and inflation and monetary policy shocks are amplified by the financial accelerator mechanism. Keywords: Macroeconomics, Monetary Policy, Credit Channel, Financial Accelerator, FAVAR, DSGE, Bayesian Econometrics