Leaning against persistent financial cycles with occasional crises

We investigate the conditions under which a leaning against the wind (LAW)-type monetary policy is advisable to address risks to financial stability stemming from housing credit imbalances. We do so within an endogenous regime-switching dynamic stochastic general equilibrium (DSGE) model with occasional crises, effective lower bound (ELB) on interest rates, and intrinsically persistent financial cycles driven by partly backward-looking house price expectations. Under empirically plausible financial cycles, LAW amplifies the transmission of supply shocks to inflation by strengthening the countercyclical response of collateral values and domestic demand. This results in heightened inflation volatility and a lower average inflation rate, thereby increasing the frequency of ELB episodes. In our baseline estimated model, we find that these costs far outweigh the benefits of a less likely and less severe crisis. However, we also show that LAW may become advisable, depending on specific conditions, including (i) if the central bank focuses less on near-term output stabilization but more on medium-term growth stability by counteracting financial imbalances, or (ii) if the expectations-driven financial cycles are intrinsically less persistent or more policy-responsive than currently observed. Higher long-run capital regulation is better suited to addressing risks to financial stability as it significantly reduces the fluctuations in inflation and output by reducing both the frequency of ELB and the severity of crises.