Can LAW be justified to prevent financial instability? A cost-benefit analysis of leaning against the wind (LAW) in Norway : Evidence from a Bayesian VAR model

Abstract

Since the 2008 Global Financial Crisis, there has been an ongoing debate about how central banks can prevent future financial crises by mitigating the build-up of financial imbalances. We analyse the effect of incorporating financial stability considerations through monetary policy by "leaning against the wind" (LAW), which involves keeping a slightly tighter monetary policy for the purpose of mitigating financial instability. The benefits of LAW are lower probability and severity of a financial crisis in the future, while the cost is higher unemployment. We model LAW as a one-time monetary policy shock using a structural Bayesian VAR model on Norwegian data, inspired by Robstad (2018). Then, we analyse the cost-benefit trade-off of LAW in Norway using a modified version of the framework in Svensson (2017a), and contribute to the literature by including house price growth as an indicator explaining the probability of a crisis. We find that LAW is clearly unjustified when using household credit growth as an indicator of financial instability. This conclusion also is robust to any reasonable changes in the underlying estimates and assumptions. When using house price growth, we actually find that LAW is justified in the benchmark model, although only by a very small margin. However, this conclusion is not at all robust, as reasonable changes to the underlying estimates and assumptions easily change the conclusion, making LAW unjustified. Hence, we cannot use this result to conclude that LAW is an advisable policy in Norway. In sum, the numerical results do not find evidence that LAW is justified in Norway. Furthermore, Norway has a well-equipped macroprudential policy toolkit to counteract financial imbalances, arguably reducing the effect of and need for LAW. We therefore recommend that Norges Bank should not "lean against the wind", unless the Norwegian economy experiences extraordinary circumstances where the macroprudential policy tools clearly are insufficient to secure financial stability.