Hutchins Roundup: Predicting financial crises, targeting inflation, and more – Brookings Institution

Studies in this week’s Hutchins Roundup find that the official CPI might be understating inflation, expectations of lower demand are driving small businesses to delay reopening, and more.

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Are economic crises predictable? Robin Greenwood, Samuel Hanson, and Andrei Shleifer from Harvard and Jakob Ahm Sorensen from the Copenhagen Business School argue that they can be predicted with data on credit and assets. The authors build a dataset that includes financial crisis indicators, household and nonfinancial business credit growth, home prices, and equity prices for 42 countries between 1950 and 2016. Using these data, they identify periods of credit-market “overheating” when credit growth and asset price growth are both high. The authors find that when household or non-financial business credit markets overheat, the probability of a financial crisis over the next three years is roughly 40%. Despite the modest rate of false positives from this predictive mechanism, the authors argue that crises are sufficiently predictable to warrant early action from central banks when warning indicators arise. Moreover, given that financial crises can lead to a permanent loss of real output, the authors advocate that precautionary macro-financial policies, such as tightening monetary policy or raising bank capital requirements, should be used much more frequently.

Persistently low inflation leads to lower nominal interest rates and limits the monetary space—how
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