Friday, December 4, 2009

The Stance of Monetary Policy Via the "Risk-Taking Channel"

There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.

Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn't been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:
We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.
While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed's low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn's work. Here are some key excerpts:

Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.

For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.

The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."[emphasis added]

His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.

No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.

I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won't repeat the same mistakes after all.


  1. I don't think the Fed should "use" (manipulate) interest rates for any purpose, including controlling the risks taken by investment banks--and their apparently passive creditors.

    I don't doubt that changing the monetary base can impact interest rates, but the monetary base should be aimed at keeping nominal expenditure on target.

    Forcing nominal expenditure below target in order to create a short run liquidity impact on interest rates to deter speculation seems like a bad idea to me.

    If the speculation causes increase in nominal expenditures,then of course the quantity of base money needs to be changed to offset that effect.

    But since it is never a good idea to reduce nominal expenditure to choke of asset market speculation, what does all of this add?

  2. I agree with Bill Woolsey: using interest rates to control risk is uncalled for. We need to be getting through the message that banking is about screening,making loans and monitoring those loans, not playing at hedge funds. Nothing makes more sense to me than John Cochrane's call for the ending of deposit insurance for institutions that wish to be a hedge fund. Let them choose what they want to be. The website "Economics of Contempt" tried to paint economists calling for smaller banks as "naive". You need huge amounts of capital to be a market maker in derivatives etc said this gent. But what does market making have to do with banking? Nothing.

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  4. Although this comment by Shin suggests that the Fed does think that it might have to use interest rates to manage risk:
    "Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper"
    I think the new BIS paper by Andrew Haldane is excellent (Banking on the State). He argues that massive institutional reform is the best way to resolve the time inconsistency problem that lies at the heart of our ongoing economic and financial debacle.

  5. Bill, ECB:

    The take-away for me from this "risk-taking" channel is not so much that the Fed should manage interest rates to manage risk, but the following:

    (1) This channel provides further evidence the Fed was excessively loose in the early-to-mid 2000s.

    (2) It speaks to my concern that the "Great Moderation" in nominal spending was not enough for macroeconmic stability. Or, stated differently, the 5% average nominal spending growth rate was not enough for macroeconomic stability. If returning to 5% trend nominal expenditure growth required interest rates to be so low in 2002-2004 that as result banks took on excessive risk then this 5% is an inappropriate goal. Hello productivity norm.

    (More generally, as I have argued in recent posts I am not a big fan of the "Great Moderation" in the sense that it created a false sense of security about aggregate risk and lead to folks to take on more debt. These were all conditions contributing to current crisis. To the extent a 5% average nominal spending growth rate contributed to this complaceny it was inappropriate.)

  6. ECB:

    You probably know this already, but the good folks at the BIS also have a new article up on the risk-taking channel:

  7. I think that the BIS have this the wrong way round. Interest rates were low in the early 2000s BECAUSE of risk taken (earlier). From the mid-1990s, every time risks threatened to be realised, the Fed and other central banks erred on the easy side. However, to the extent that this encouraged investors to take more risk, I would not be surprised if it led to more trouble later. And we have already repeated the mistake big time - near zero policy rates, with even more far-fetched ideas such as negative interest on reserves and a debt jubilee getting a hearing. Similarly, I suspect that targeting nominal GDP will seem a lot less appealing during the next boom when it would involve very low inflation - remember "opportunistic disinflation"?