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Should Monetary Policy Lean Against the Wind?

Quasi-Experimental Evidence from Federal Reserve Policies in 1920-21.


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Are excessive credit booms and leverage in the financial sector better addressed by conventional monetary policy “leaning against the wind” (LAW) or by targeted macroprudential policies? In this paper, I use a natural experiment to answer this question. In 1920, when U.S. monetary policy was still decentralized, four Federal Reserve Banks implemented a conventional rate hike to address financial stability concerns. Another four Reserve Banks used macroprudential policy with the same goal. Regional financial segmentation enables me to exploit regression discontinuities at borders with the remaining four Federal Reserve districts which did not change policy stance. I present evidence that macroprudential policy caused both bank-level loan growth and leverage to fall significantly. Macroprudential policy also reduced the probability of bank failure. In contrast, LAW did not have a statistically significant effect on these bank-level outcomes. I simulate the impact of both policies on bank-level data in a stress-testing exercise to explain the channels at play. I show that macroprudential policy reined in over-extended banks more effectively than conventional monetary policy because it allowed Federal Reserve Banks to use price discrimination when lending to highly leveraged counterparties. Drawing on city-level data, I also find that the two policies triggered statistically identical real economic costs. Hence, although successful macroprudential policy had a price, it did not inflict greater economic losses than the less effective strategy of “leaning against the wind”.