By Angela Abbate and Dominik Thaler
Empirical research suggests that lower interest rates induce banks to take higher risks. We assess analytically what this risk-taking channel implies for optimal monetary policy in a tractable New Keynesian model. We show that this channel creates a motive for the planner to stabilize the real rate. This objective conflicts with the standard inflation stabilization objective. Optimal policy thus tolerates more inflation volatility. An inertial Taylor-type reaction function becomes optimal. We then quantify the significance of the risk-taking channel for monetary policy in an estimated medium-scale extension of the model. Ignoring the channel when designing policy entails non-negligible welfare costs (0.7% lifetime consumption equivalent).
Nobody said monetary policy was easy. Even when the central bank’s mandate has only one or two objectives, and thus one or two tools should be sufficient, it always turns out that there are implicitly more objectives. Or like in this case, tools are not narrowly focused and have other implications. Central banks really need more tools, call them unconventional if you want.
Or call them regulation. But as long as regulation remains imperfect, the (conventional) interest rate tool impacts risk taking and thus needs to be used with additional care.