For many advanced economies, the decade and a half leading up to the financial crisis was indeed a period of unusual macroeconomic stability, with low and stable inflation accompanied by steady growth – the Great Moderation. Inflation targeting and similar price-stability oriented monetary policies appeared to have delivered the goods. But in a number of countries – most obviously the United States, but also including Australia, Ireland, Spain and the United Kingdom – this period was also characterised by rapid credit growth and property price inflation, sowing the seeds of future problems (Chart 3). Now many factors contributed to the severity of the subsequent financial crisis. A non-exhaustive list includes: the development of complex securities which were impossible to value in stressed conditions and which connected financial institutions in unexpected ways; disguised leverage through the use of securitisation vehicles, whose real aim was regulatory arbitrage; remuneration packages encouraging positions that generated decent returns most of the time but high losses in some states of the world; excessive reliance on credit-rating agencies; defective risk management; and insufficient high-quality capital to absorb losses when they materialised. But macroeconomic conditions possibly also played a part2. Far from fostering financial stability, the Great Moderation may itself have contributed to the build-up of credit and the adoption of risky positions by leading investors to underestimate potential macroeconomic risks. And commentators, such as John Taylor (2009) and Bill White (2009) have blamed excessively loose monetary policy during the years leading up to the crisis.
The severity of the recession might appear to tilt the argument in favour of “leaning”, but the question still arises as to how effective such a policy would have been in restraining the boom in credit and property prices and at what cost to activity. Together with colleagues from the Bank (Bean et al, 2010), I recently attempted to investigate this question using simple vector autoregressive models of the US and UK economies. I will refer you to the paper for the details, but Table 1 shows the results of counterfactual simulations of a pretty aggressive “leaning against the wind” policy, in which the policy rate is held around 200 basis points higher over the 2003–2006 period. The simulations suggest that the peak in real house prices would have been about 7½% lower in the United States and some 20% lower in the United Kingdom. The impact on the stock of credit is, though, more modest: just 3–4% lower by the end of 2006. Moreover, the cumulative impact on activity is considerable, with output around 3% lower by the time the crisis begins. Clearly, then, the terms of trade for controlling the risks to financial stability through monetary policy alone do not look very favourable: even substantially higher interest rates over a sustained period would not have prevented the crisis. A similar conclusion is reached by Bernanke (2010) and Carmen Reinhart and Vince Reinhart (2011).