The Promise and Peril of Macroprudential Policy

MONTEVIDEO – Central bankers continue to fret about frothy asset markets – as well they should, given the financial crisis of 2008-2009. Having been burned once, they are now doubly shy. And China’s recent stock-market plunge has certainly not eased their fears.

Securities prices are extraordinarily high, considering the backdrop of flaccid economic growth. Bond prices have soared on the back of quantitative easing by the Bank of Japan, the Federal Reserve, and the European Central Bank. Property prices from London to San Francisco have risen to nosebleed-inducing levels. What, if anything, should be done to minimize the risks of a rapid and sharp asset-price reversal?

For many years, this question was framed according to the “lean versus clean” debate: Should central banks “lean” against bubbles, damping down asset prices that create risks to financial stability, or just clean up the mess after bubbles burst? Proponents of the latter approach, such as former Fed Chair Alan Greenspan, express doubt that policymakers can reliably identify bubbles, and are generally uneasy about managing asset prices.

To be sure, central bankers cannot know for sure when asset prices have reached unsustainable heights. But they cannot know for sure when inflation is about to take off, either. Monetary policy is an art, not a science; it is the art of taking one’s best guess. And, as the 2008-2009 crisis demonstrated, merely cleaning up after the bubbles burst is very costly and inefficient.

So what should central bankers do instead? Ideally, they would develop a set of specially tailored financial tools. For example, raising banks’ capital requirements when credit is booming could restrain lending and strengthen banks’ cushion against losses, while setting ceilings on loan-to-value ratios could rein in exuberant property markets, thereby heading off excessive risks for borrowers and lenders.

Unlike such tools, interest-rate policy is a blunt instrument for dealing with financial imbalances. And using interest rates to address such concerns may interfere with the central bank’s primary objective of keeping inflation near target.

Unfortunately, the development and use of macroprudential tools faces considerable economic and political obstacles. The Bank of Spain’s attempt to implement adjustable capital requirements for banks, through its system of “dynamic provisioning,” did little to deter aggressive lending during the country’s property boom. Once a mania gets underway, the temptation to join is simply too strong.

Macroprudential policy may also fail when the regulatory perimeter is too narrow. In 1929, the Fed attempted to restrain Wall Street with a policy of “direct pressure,” coercing member banks not to lend to security brokers and dealers. In 2006, it encouraged its members not to lend to commercial property developers. In both cases, other lenders stepped in to meet the demand for credit, neutralizing the authorities’ macroprudential initiative.

And, while countries like the United Kingdom and New Zealand have experimented with giving central banks the power to place ceilings on loan-to-value ratios, this remains a bridge too far in the United States. In a country where homeownership is virtually an entitlement, measures making it more difficult would whip up a political firestorm.

Any attempt by the Fed to impose caps on loan-to-value ratios would also excite Americans’ fears of concentrated financial power – fears that have intensified since the crisis. By seeming to favor one segment of society, such an initiative would merely provide more fodder to those who argue for greater political oversight of the Fed.

Policymakers should respond to these challenges by working hard not only to develop effective macroprudential tools, but also to demonstrate that they can be deployed evenhandedly. But even with their best efforts, the process will take time.

In the meantime, situations may arise in which the interest rate is the only instrument available for limiting financial excesses. And, as the recent crisis demonstrated, there are circumstances when central bankers should use it. Sometimes, the costs of inaction – of permitting financial risks to develop – are simply too high.

There are two key conditions for using policy interest rates as a macroprudential tool. The first – and most obvious – is that risks to financial stability must be substantial. But the second condition is equally important: adjusting the interest rate should not jeopardize the central bank’s other key objective, namely achieving its inflation target.

The Swedish Riksbank provides a cautionary case in point. In 2010, when it began raising its policy rate to contain financial excesses, it put price stability at risk. Before long, Sweden had succumbed to deflation, from which it is still struggling to recover.

Similarly, after its policy of direct pressure failed in 1929, the Fed raised interest rates to rein in the stock market. Its attempt to prevent a bubble came at the cost of inducing a depression. The point of seeking more effective macroprudential policies is to avoid such tragic bargains.