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“Leaning Against the Wind” and the Timing of Monetary Policy

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“Leaning Against the Wind” and the Timing of Monetary Policy

IMF,

5 min read
5 take-aways
Audio & text

What's inside?

A short but sharp interest rate cut may be the best response to shocks.

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Editorial Rating

7

Qualities

  • Analytical
  • Innovative
  • Well Structured

Recommendation

As 2008 began, leverage ratios at many banks were north of 40 to 1, but financial engineering had dispersed risk, and risk models were giving executives minute-by-minute readings on the health of their institutions. Just nine months later, it was all in ruins. Banks have an interest in taking on more risk than may be prudent for society at large, and persistently low interest rates tilt the risk/reward equation dramatically. Central banks responding to economic shocks tend to be cautious when raising rates as an economy improves, thereby helping to drive bubbles. In this technical paper, economists Itai Agur and Maria Demertzis propose that central banks consider a new approach to financial stability. getAbstract suggests their innovative work to financial policy makers and to central and commercial bankers.

Summary

The low interest rate environment that followed the dot-com bubble in the early 2000s was a culprit in creating the financial excesses that preceded the 2008 financial crisis. Faced with low interest rates, banks seek higher returns through riskier activities. At the same time, low short-term financing costs make leverage more attractive. When a central bank keeps interest rates low while the economy recovers, banks tend to increase their risk profiles. That chain of events set the stage for the 2008 financial crisis.Currently, central banks’ main goal is to minimize...

About the Authors

Itai Agur is an economist at the IMF’s Singapore Regional Training Institute. Maria Demertzis, an economist at De Nederlandsche Bank, is on secondment to the European Commission.

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