Leaning Against Persistent Financial Cycles with Occasional Crises

We provide a theory of persistent financial cycles based on partly backward looking house price beliefs, endogenous crises and conditions under which leaning against the wind (LAW)-type monetary policy is advisable to address risks to financial stability. Under empirically plausible financial cycles, LAW increases inflation volatility significantly as it amplifies the effects of supply shocks on inflation over the business cycle. It also leads to a lower average inflation rate resulting in more frequent episodes of a binding effective lower bound. LAW is only advisable if central bank cares more about output stability relative to inflation or if financial cycles are less persistent