October 2015 newsletter – Money and Macro-prudential policy. What will be the new ‘normal’?

A panel session organised and chaired by Andy Mullineux (University of Birmingham) on behalf of the UK’s Money Macro and Finance Research Group (MMF) took place on Friday 12 June 2015 at the University of Nice Sophia Antipolis during the 32nd International Symposium on Money, Banking and Finance organised by the GdRE European Monnaie, Banque et Finance (EMBF).

The panellists were: James Talbot (Head of Money, Asset and Strategy Division, at the Bank of England); Benoît Mojon (Monetary Policy Research Division, Banque de France); Jérôme Henry (DG Macro-Prudential Policy and Financial Stability, European Central Bank) and Jagjit Chadha (Chair of the MMF, University of Kent).

Andy Mullineux introduced the session recalling that, when the topic was chosen a year ago, it had been anticipated that we would by now have a clearer picture of what ‘new normal’ monetary policy might look like.

James Talbot spoke first, asking: what level of ‘new normal’ interest rates we should expect; to what extent should monetary policy ‘lean against the wind’; and what role should macro-prudential policy play?

The Bank expects interest rates to be below pre-crisis levels for the foreseeable future, because of a combination of persistent post-crisis demand headwinds and structural factors which have been pushing down on real interest rate for some years. This meant that monetary normalisation would involve interest rate rises which were ‘gradual and limited’.

The Bank’s current view was that monetary policy was a ‘last line of defence’ against risks to financial stability. The institutional structure at the Bank allows the Monetary Policy Committee (MPC) and Financial Policy Committee (FPC) to set monetary and macro-prudential policy separately; with each committee having its own instruments and objectives (including a common secondary objective to support the government’s objectives for growth and employment). Having both committees in the central bank meant that they could share information and expertise (including by having overlapping membership and common chairmanship).

This framework had been used in 2014 to tackle emerging risks in the UK housing market. Whilst monetary policy was a blunt instrument to deal with such risks, and needed to focus at that time on ensuring the recovery in UK output, macro-prudential policy — via the implementation of a flow limit on high LTI mortgages and a solidification of underwriting standards — had taken action to guard against a further increase in riskier lending.

Benoît Mojon outlined the pre-crisis consensus, that central banks should focus on achieving low and stable inflation and this would contribute to minimising the ‘output gap’ and delivering financial stability. There was one instrument, the policy (interest) rate and, implicitly, three targets. Central banks adopted ‘benign neglect’ of asset price misalignments, arguing that they were impossible to identify, and chose not to contain the build-up of the financial imbalances that created financial fragility; in part due to a lack of policy instruments.

Benoît next drew the following lessons from the Great Financial Crisis (GFC): price stability is not a sufficient condition for financial stability; and financial instability can have negative effect on price stability and the real economy. Assuring the soundness of individual financial institutions is not sufficient to guarantee financial stability. Macro-prudential policy should be used to complement monetary (and fiscal) policy for countercyclical management. The new frontier was to establish, largely through trial and error, the best strategy for implementing macro-prudential policy.

Jérôme Henry focussed on the ECB’s role before and after the introduction of the Single Supervisory Mechanism (SSM) in November 2014; under which the ECB took on bank and prudential supervisory duties alongside its previous inflation targeting monetary policy. Prior to adapting its new supervisory role, a ‘Comprehensive Assessment’ of the Eurozone banking system had been undertaken. This involved an Asset Quality Review (AQR) of banks and ‘stress tests’ of their balance sheet risks. The capital shortfalls identified had been addressed. In addition progress had been made in defusing the ‘Doom Loop’ or ‘sovereign bank debts nexus’ identified in the MMF panel discussion at the 2012 symposium (with the exception of Greece!).

The three pillars of the Eurozone Banking Union (the SSM, the Single Resolution Mechanism (SRM) and the Deposit Guarantee Scheme (DGS)) were outlined and it was noted that SRM is close to completion (though Greece has not passed the enabling legislation), but the DGS is nowhere near finalised.

The SSM and the ECB would interact; with the SSM focusing on micro-prudential policy and the ECB on monetary policy, in accordance with the ‘separation principle’.
This would be challenging when macro-prudential stress testing is undertaken; for example, the effect of asset sales, as part of required deleveraging, on banking asset prices needed to be taken into account.

In addition, the resumed and accelerating growth of the shadow banking sector post GFC creates the need to consider the interaction between the more heavily regulated traditional banking sector and the much less regulated shadow banking sector.

Jérôme concluded by highlighting the significant data shortcomings that inhibited macroeconomic and microeconomic stress testing and analysis of cross country and within (traditional and shadow) banking system contagion.The accumulation of international supervisory data to complement existing time series will necessarily take time!

Jagjit Chada, reminded the audience of the ‘art of central banking’. Andrew Crockett (whilst General Manager of the Bank for International Settlements, BIS) had pointed out that risk is accumulated during upswings, as financial imbalances build up, and materialises in recessions. Further, Ralph George Hawtrey (HM Treasury, UK) had expressed the view in the 1930s that central banks should tighten ‘credit policy’ in the cyclical upswings and relax it in downswings. Post GFC interest rates policy had been constrained by the ‘zero-lower-bound’, which had led to the re-discovery of alternative instruments for credit control.

Jagjit explained that ‘one club’ monetary (interest rate) policy was not only insufficient to prevent boom and busts, but reliance on it to hit multiple targets may have played a role in ‘nurturing’ volatility. The FPC had asked for additional counter-cyclical, macro-prudential, instruments and has been granted some, but not others, as yet. Liquidity ratios are to be introduced as part of Basel III and the FPC may seek permission to adjust them anti-cyclically. Jagjit pointed out that macro-prudential instruments are as yet largely untried and untested and that established models are not well geared to analysing their effects, whilst data is seriously lacking.

Jagjit also considered the role that ‘forward guidance’, with regard to interest rates, might play. Its role in the UK and the US now seems largely to have been confined to indicating when the first rise in interest rates might occur; and assuring that rate rises will be ‘gradual’. Jagjit asked what the low expected long term interest rates might be signalling: success of monetary and micro-prudential policy, or ‘secular stagnation’.

Jagjit finally explored the role of fiscal policy in recapitalising banks and their effects on the recovery through the post crisis fiscal consolidation and also the role asset purchases by the Bank (QE) had played in stabilising monetary and financial conditions. The rate at which the Bank's assets balance sheet is reduced and the way it is reduced through changes in its maturity composition will have potentially far-reaching effects through impacts on market and bank liquidity and the shape of the yield curve.

Jagjit concluded inter alia that inflation targeting alone could not prevent ‘boom and bust’ and debt levels will take many years to get back to ‘normal’. Sensible application of liquidity and capital target ratios, used as counter-cyclical macro-prudential instruments, seemed likely to reduce business cycle variance; albeit at the potential cost of some reduction of 'trend' economic growth.

As a footnote, the 85th BIS Annual Report, published a couple of weeks after the panel session, challenged both the ‘separation principal’, and the view that ‘new normal’ interest rates would be significantly lower than pre-crisis levels and urged the major central banks to get on with ‘normalisation’ and not to undertake it too gradually!