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Should Monetary Policy Lean Against the Wind?

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

Download paper (last update: April 2019)


Are credit booms and high leverage in the financial sector better addressed by conventional monetary policy “leaning against the wind” (LAW) or by macroprudential policies? In this paper, I exploit 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. Due to regional financial segmentation and local continuity in baseline covariates, I can estimate a geographic regression discontinuity model using 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 had statistically identical real economic costs: although successful macroprudential policy may have come at a price, it did not inflict greater economic losses than the strategy of “leaning against the wind”.