Following a recent conference on Rethinking Macropolicy at the IMF, last week’s post focused on some of the new areas that economists are working on. These included the real-time measurement of financial cycles, the addition of financial sector considerations to the monetary policy trade-offs, and the effectiveness of macroprudential policy tools to address these concerns. So, assuming for a moment that we’re confident in real-time measurement of financial imbalances and we have the tools to deploy, who should be making these decisions and deploying these tools?
This was the final area considered by Blanchard in his contribution to the conference – how to combine macroprudential and monetary policy? Blanchard considers a coordination approach between two separate institutions with distinct responsibilities. He believes that the likely outcome is less than ideal solution. Consider the following example: in a recession, the monetary authority will cut rates, but the macroprudential authority may tighten policy if concerned about low rates encouraging risk taking. If the monetary authority anticipates this, they will cut further than necessary, resulting in an interest rate that is too low and macroprudential measures that are too tight.
For Blanchard, the solution worth exploring is having these bodies under the one roof. As he notes, however, this is still far from an easy solution to the problem. Firstly, he recognises the concerns this may have for central banks credibility with inflation expectations, as a more diverse remit may be perceived to lessen the banks resolve on inflation. Secondly, and more troublesome, are the political economy issues.
With inflation targeting and the interest rate tool, the remit and measurement of monetary policy was relatively straightforward. With the consolidation of monetary and macroprudential measures, these are a lot murkier and harder to define. Blanchard cites several difficulties that would need to be addressed for consolidation to work:
- There are multidimensional targets, such as credit growth, leverage, asset price growth
- Understanding the relationship of the macroprudential objectives with the financial stability objective
- The difficulty in defining financial stability and its desired level. A move that tightens macroprudential policy that avoids a financial crisis may still be attacked because people will never know the counter-factual.
- The fact that macroprudential policies are targeted implies that they will face strong, organised opposition, in a way that the blunter instrument of the interest rate does not.
The UK is leading the way with the Financial Policy Committee: One institution, two committees
Opponents of a one institution setting, like Axel Weber, are concerned that these political economy issues will endanger the independence of a central bank, in that political interference in macroprudential measures will undermine monetary policy. For Blanchard, this points to a possible ideal set-up like that of the UK, which has a monetary policy committee and financial policy committee(FPC) both within the Bank of England.
What is the FPC and what is it designed to do? Attempting to manage the financial cycle
For those interested, I would recommend a good read of the draft policy statement from the Financial Policy Committee. The statement outlines the FPC’s responsibility:
“The responsibility of the Committee relates primarily to the identification of, monitoring of, and taking of action to remove, or reduce, systemic risks with a view to protecting and enhancing the resilience of the UK financial system, and, subject to that, supporting the economic policy of Her Majesty’s Government, including its objectives for growth and employment”
To achieve this resilience, the proposal is for the FPC to have control of two tools: the counter-cyclical capital buffer (CCB) and sectoral capital requirements (SCR). These tools are intended to deal with cyclical risks to reduce the likelihood and severity of financial crises. The CCB requires banks to build up capital when the FPC judges that this is needed to head off threats to stability. An increase in the CCB provides an additional buffer to cushion losses in a shock, while also providing an incentive for banks to rein in excessive or underpriced exposures during a boom.
The SCR, on the other hand, allows the FPC to temporarily increase capital requirements in certain sectors. For example, if it was judged that the mortgage sector was experiencing ‘exuberance’, the FPC could apply the SCR to mortgages with a high loan to value. Moreover, it could apply the SCR in intra-financial areas. For example, capital requirements could be raised on repurchase agreements (repos) if there are concerns about low quality collateral being used – the SCR may build resilience if shocks occur in these areas.
What indicators will the FPC consider to make their judgements?
The draft policy statement has done a great job of articulating the core indicators that the FPC will monitor. I will not cover all of them here, but a few of interest are as follows:
1. For the CCB, the credit-to-gdp gap is given particular importance. This ‘gap’ refers to the difference between the credit-to-gdp ratio and its long run trend. There is growing evidence that this is a useful leading indicator of a crisis. The FPC will compliment this indicator with other credit measures like the level of credit-to-gdp and nominal credit growth (shown below).
2. A natural indicator of banking system resilience is the leverage ratio. Whereas capital ratios tend to use risk-weighted measures, leverage ratios assign all on balance sheet assets the same weight. At the individual bank level, they were a better predictor of which banks got into trouble than the risk weighted capital measures. The chart below shows the falling ratio – or increased leverage – of UK banks before the crisis.
3. There are also core bank-balance sheet stretch indicators that assist in the judgement of the SCR. For example, intra-financial system lending was particularly pronounced in the UK before the crisis, suggesting that sectoral credit growth may be useful.
4. Intra-financial system lending may be more serious when the real sector is also taking on more debt. Therefore, the FPC will also watch household debt-to-income ratios.
5. In a similar vein to point 4, concern around increased bank lending may be heightened when accompanied by exuberance in property markets. Rapidly rising property prices have signalled impending stress in many countries.
While only a snapshot of the indicators have been shown here, as Blanchard says, the FPC is leading the world in this area. At this stage, they seem to have the most appropriate institutional set-up to confront macroprudential policy – one roof, two committees. As a final point, I also wonder if this set-up will have ‘expectational’ effects like that of the inflation-targeting regime of central banks. The implementation of these tools will not be as clear-cut as moving the interest rate, but if the financial market comes to believe that these measures will be used in periods of ‘exuberance’, then it’s possible that those expectations may also lead to increased financial market stability.
 The Financial Policy Committee’s powers to supplement capital requirements. A draft policy statement, Bank of England. January 2013.