Perspectives on “marginal crisis risk” and “leaning against the wind” from the capital structure of housing investments

The purpose of this paper is to relate the marginal crisis risk of Woodford to a number of financial fragility indicators. The paper expands the interest rate gap approach by considering the capital structure of investments and systemic risk, dating back to Modigliani‐Miller. The model allows for distinct impacts from asset inflation, leverage as well as incentives for speculative investments for a central bank that aims to lean against the wind.

Framed in terms of the housing market and household behaviour, the paper sets out an augmented loss function which takes a number of financial fragility indicators into account. By moving beyond the case where all risk increasing mechanisms are driven by external monetary policy shocks, the approach shows why a central bank should be inclined to lean against the wind even in the absence of interest rate gaps.

Taking the return to equity into account, and moving beyond the case where all risk increasing mechanisms are related to external monetary policy shocks, the paper shows why a central bank might be inclined to lean against the wind even in the absence of interest rate gaps. The context‐specific nature of the monetary transmission mechanism in general, and the structure of the risk taking channel more specifically, calls for both internal financial market features as well as the link between financial markets and the real economy to impact on how and when to lean.

There seems to be increased awareness of the need to take financial stability considerations in monetary policy. In fact, Woodford argues that the balance between financial stability objectives and price and output stability is part of the choice when choosing between alternative short run paths for monetary policy. By taking a conventional approach to the capital structure of investments, this paper integrates asset inflation, leverage and incentives for speculation into a central bank's loss function in a way that to the best of the author's knowledge is novel.