Our Policy Lab was held on 11 March, the day that the Bank of England cut the interest rate to 0.25 per cent (and then to 0.1 per cent a few days later) as part of the response to the Covid-19 outbreak and the US Federal Reserve pledged to pump more than $1 trillion into the system over the following days. The fiscal authorities in many countries have subsequently unveiled very large measures to shore up the economy.
The capacity and limits of central banks’ monetary policy tools in providing further stimulus to the economy will be tested in the days and months to come. The other big challenge central banks will face is related to coordination with the fiscal authorities and the consequences of those fiscal measures for inflation and interest rates. All of this has substantial implications for financial stability, so understanding the links and interactions between monetary policy and financial stability remains crucial.
Macroprudential policy in the New Normal
The last decade has been characterised by historically low real interest rates, resulting from demographic, technological, and other forces that raised desired global saving relative to desired investment. Coupled with low actual and expected inflation, these have translated into persistently low nominal interest rates throughout the yield curve. Persistently low interest rates pose a challenge for the traditional approach to monetary policymaking, based on the management of a short-term policy interest rate. They also affect financial stability through 3 main channels:
- Bank profitability: Low interest rates mean that banks, especially those that are very reliant on retail deposits, including many Japanese and European banks, see their profits and ability to generate capital eroded over time. This forces them closer to their capital constraints and makes them less willing to lend, but perhaps more inclined to take other risks.
- Risk-taking: With interest rates low, pension funds, insurers and other intermediaries who have promised their clients returns seek those returns in higher risk assets.
- Less policy space: There is less room for monetary policy to stabilise the economy using either conventional or unconventional tools.
If monetary policy is less able to cushion the economy from shocks, banks should assume bigger shocks in their stress tests and therefore have bigger capital buffers, but issues around bank profitability and risk-taking work against this. Moreover, banks may struggle to raise the additional capital given that the long squeeze on their margins means the sector as a whole is already struggling to earn its cost of equity (the amount of return shareholders expect in compensation for the risk of ownership).
The counter-cyclical buffer and other macroprudential measures
The counter-cyclical capital buffer (CCyB) is a macroprudential tool used by some central banks. It requires private sector banks to accumulate capital at points in the economic cycle where lending activity is expanding, so that they are better able to cope when losses materialise. The aim is to dampen the impact of economic downswings, and to slow credit growth during the upswing.
While most countries now have frameworks in place for using the CCyB, there remain challenges with its deployment. Basel III guidelines which stipulate that when the gap between current credit to GDP ratio and its long-term trend become positive, counter cyclical buffers should be introduced on a graduated scale. Some interpreted this as the only potential trigger and have allowed a build-up of other mildly related potential vulnerabilities without introducing a buffer. More sophisticated authorities have looked at a broader range of indicators: of the 15 countries that have raised countercyclical buffers, the vast majority have a negative credit gap. This raises the challenge of how to weight information in different indicators. For example, in recent years the UK has experienced elevated asset prices, a substantial current account deficit but weak credit growth.
The signal sent to banks by raising or releasing the counter cyclical buffer may be more important than the economic mechanism of the buffer itself, but so far historical evidence is sparse. Another issue that might hamper the effectiveness of counter-cyclical buffers is uncertainty around the subsequent response of the microprudential regulators, which might require to rebuild the buffers quickly. This would suggest some degree of coordination between the macro- and the micro-prudential regulators.
Many countries have focussed on borrower-based measures as a means to improve financial stability. South Korea was among the first to introduce borrower-based measures, such as Loan to Value and Loan to Income limits – and most recently added a debt service ratio. Similar patterns have been followed across East Asia and in Central and Eastern Europe, and there is evidence of impact on ‘intermediate’ policy goals such as slower credit growth and curbs on house prices.
However, borrower-based measures like these can have unintended consequences. If you create a constraint on lending with down payments, individuals may seek unsecured credit at more punitive rates instead. Loan-to-Value restrictions mostly bite first-time buyers, and there is evidence that this can push them to more marginal locations, raising prices in areas that have less strong fundamentals, such as poorer access to public transport. This may reduce their labour market flexibility and also leave them doubly exposed in a downturn. It is necessary to understand more of the macro implications of these kinds of measures.
There remains a broader debate about the appropriate tools to use to regulate banks. Contingent capital or “cocos” remain untested and may behave procyclically in a stress. Some economists also favour greater emphasis on liquidity regulation, reflecting the fact that banks fail when they run out of liquidity.
Policy making structures
Monetary policy decisions and macroprudential policy making decisions interact, but there are strong arguments in favour of retaining two separate decision-making bodies. Retaining separate structures ensures a depth in specialist skills so that an economy is better prepared to deal with a range of different kinds of shocks and also prevents an exclusive focus on those measures which are easiest to measure and track, such as inflation targeting.
Evidence around the world shows that delegating macroprudential policy to a separate decision-making body tends to result in better responses to shocks to the financial system. There may also be an impact on monetary policy: where monetary and financial policy are separate, monetary policy-makers tend to be more conservative, focussing on price stability.
Where a model with two separate authorities is chosen, there still needs to be a level of coordination. The experience in emerging markets in the 1990s shows that macroprudential policy is more effective when it is supported by monetary policy.
Regular joint committees may be a structural solution to achieve coordination, but this may result in an agenda that prioritises areas that the two committees have in common, rather than those which should be the top priority for either body. An alternative approach is to design an overlap in membership so that a few key individuals can update both bodies on the other committee’s concerns and perspectives.
Scaling up finance to macrofinance?
How do we scale up finance to be a macro discipline? Until the 1930s, most economic analysis did not separate out individual behaviour from aggregate behaviour. With the Great Depression of the 1930s and the development of the concept of national income and product statistics, the field of macroeconomics began to expand and the term ``macroeconomics’’ was coined by Ragnar Frisch in 1933. In a parallel to macroeconomics, it would be desirable for finance to become a truly macro discipline. And in a parallel to monetary policy, it would be desirable to find measures for assessing macro risk and financial stability that are widely understood, and that central banks can be held accountable for. This can coordinate and anchor expectations and pave the way for more systematic macroprudential policymaking.