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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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This paper was shortlisted for the Ieke van den Burg Prize 2019 by the Advisory Scientific Committee of the ESRB.


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”.