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Symposium 2012

Proposal - Presumptive Indicators should be used to drive Macro-Prudential Regulation

The Challenge

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which cent ...

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which central banks focus on maintaining price stability and stabilizing the output gap—was an appropriate and sufficient mandate for conducting monetary policy. Key assumptions underlying the consensus were that this mandate would automatically lead to financial stability and that the framework of monetary policy could deal with cross-border capital flows.

Central banks are now being given the task of maintaining financial stability as well as hitting inflation targets.  With two objectives there needs to be, optimally, two instruments that can be used separately for those purposes.  It remains essential for central banks to predicate interest rates primarily for the achievement of stable prices, i.e. hitting the inflation target.  The need is to find an additional set of instrument(s) that can allow them simultaneously to maintain financial stability.  Such instruments have been identified, and include such measures as state-varying capital and liquidity ratios, loan-to-value and loan-to-income ratios in the property market, and state-varying margins.  While these instruments affect the cost of borrowing, and so interact with the use of more general interest rates, they do have differing and more specific effects, and therefore can be used independently of, though interacting with, interest rate setting for the achievement of price stability.  The problem of using such macro-prudential instruments for achieving price stability is rather different.  They should be tightened in booms and relaxed in busts.  But the natural instinct of almost everyone involved is absolutely the reverse.  Although after the event the fact that a prior boom was unsustainable becomes patently obvious, during the boom it is not so; indeed if it was, the boom could not go on.  Booms are enormously popular, with politicians, borrowers, lenders and the media.  It takes enormous courage for a regulator/Central Banker to stand up and state that, ‘not only is the boom unsustainable, i.e. the market has got it wrong, but that the regulator will take steps to damage the interests of almost all those involved by tightening regulation’.  By exactly the same token, during busts, all borrowing counterparties, including banks, look much more fragile and the inevitable tendency is to require higher margins and tougher ratios, in order to protect against counterparty risk; exactly as is happening now.  Again it takes enormous courage and foresight for a regulator/Central Banker to cut margins/ratios just at the time when it seems more naturally sensible to raise them.

In short, the problem is not designing the appropriate instruments, but getting them used in a countercyclical fashion.  The only way to do this is to apply ex ante rules, but rules are a strait jacket and are frequently in practice inappropriate, so a better procedure is ‘comply or explain’.

The idea is as follows:-  Each regulator/Central Banker should designate a small number of indicators which have preceded and accompanied booms and busts in the past.  They could choose whichever seems historically appropriate.  These could include, for example, increases in credit expansion, both above the norm and above the average credit/GDP ratio; increases in household indebtedness above the norm and above the average debt GDP ratio; increases in housing prices above the norm and above the average ratio of house prices to the general level of prices.  Then, whenever a majority of these indicators are flashing red, the regulator/Central Banker should be required either to take countervailing macro-prudential steps to counteract that phase in the cycle, or explain in public why they did not do so.  The purpose is to make some degree of countercyclical action into the default option, rather than having inertia as the default option, which is normally the case now.

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