Cost-Benefit Analysis of Leaning Against the Wind: Are Costs Always Larger Than Benefits, and Even More So with a Less Effective Macroprudential Policy?∗

Leaning against the wind”(of asset prices and credit booms) (LAW), that is, a somewhat tighter monetary policy and a higher policy interest rate, has costs in terms of a weaker economy with higher unemployment and lower inflation. It has been justified by possible benefits in terms of a lower probability and severity of a future financial crisis. A worse macro outcome in the near future is then considered to be an acceptable tradeoff for a better expected macro outcome further into the future. But a crisis can come any time, and the cost of a crisis is higher if initially the economy is weaker due to previous leaning against the wind. LAW thus has an additional cost in the form of a higher cost of a crisis when a crisis occurs. With this additional cost, for existing empirical estimates, the costs of LAW exceed with a large margin the possible benefits from a lower probability of a crisis. Furthermore, empirically a lower probability of a crisis is associated with lower real debt growth. But if monetary policy is neutral in the long run, it cannot affect real debt in the long run. Then, if a higher policy rate would result in lower debt growth and a lower probability of a crisis for a few years, this is followed by higher debt growth and a higher probability of a crisis in the future. This implies that the accumulated benefits over time of LAW are close to zero. But even if monetary policy is assumed to be non-neutral and permanently affect real debt, empirically the benefits are still less than the costs. Finally, perhaps somewhat surprisingly, less effective macroprudential policy, with resulting higher probability, severity, or duration of a crisis, can be shown to increase the costs of LAW more than the benefits, thus further strengthening the strong case against LAW. JEL Codes: E52, E58, G21 ∗I thank Vivek Arora, Helge Berger, Olivier Blanchard, Lael Brainard, Giovanni Dell’Ariccia, Stanley Fischer, Dong He, Olivier Jeanne, Michael Kiley, Stefan Laséen, David López-Salido, Tommaso Mancini Griffoli, William Nelson, Bengt Petersson, Rafael Portillo, Damiano Sandri, David Vestin, José Viñals, and participants in seminars at the Federal Reserve Board and Bank of Canada for helpful discussions and comments. I also thank Nakul Kapoor for research and editorial assistance. The views expressed in this paper are those of the author and do not necessarily represent those of the IMF or IMF policy.