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Seeing Double at Central Banks

OXFORD – Central banks are now targeting liquidity, not just inflation. The credit boom of the past decade highlighted the inadequacy of focusing only on prices, and underscored the need for the monetary authority of a country (or group of countries in the case of the European Central Bank and the eurozone) to monitor the financial sector. Macroprudential regulation is the new term of art among central bankers, supplementing their well-established inflation-targeting regimes.

This shift in focus could radically change monetary policy, but for better or worse? The Bank of England may be blazing the way in this transition, but the ECB and the United States Federal Reserve Board are taking on more financial regulation as well. Indeed, the ECB’s European Systemic Risk Board serves a function that is similar to the United Kingdom’s new Financial Policy Committee (FPC).

At the end of a recent discussion with Andy Haldane, the Bank of England’s Executive Director for Financial Stability and a member of the FPC, I asked: What happens if inflation is high and lending is low? Under this scenario, the Bank of England’s Monetary Policy Committee (MPC) would favor an increase in interest rates, while the FPC would want to loosen monetary conditions.

I am still pondering the question that I posed to Haldane, because the potential for such contradictory policy imperatives appears unavoidable – never more so than now.

The last decade – until the collapse of Lehman Brothers in September 2008 – was known as the Great Moderation, a period of low inflation and strong growth that reflected major new developments, such as global integration of emerging markets and major central banks’ adoption of inflation-targeting regimes during the 1990’s. In the United Kingdom, the Bank of England was made independent in 1997, and given a target of 2% annual inflation.

Price stability during the 2000’s explained the low interest rates that supported strong growth. But, it also meant that a credit boom with international dimensions was not monitored, resulting in the most spectacular bust of modern times, including the near collapse of the banking system.

Amid the UK’s institutional changes in 1997, financial regulation was put in the hands of the Financial Services Authority (FSA). But the FSA is soon to be replaced by the FPC, resulting in a system that aims to avoid an “underlap” of authority that leaves no one in charge. The FPC is now part of the Bank of England, which is meant somehow to ensure that monetary policy takes into account the financial sector.

The change reflects central bankers’ argument that to target credit or liquidity requires another tool. Interest rates are too blunt an instrument, and risk damaging the wider economy when used to prick a housing bubble, as recent research by BOE Deputy Governor Charlie Bean has shown. So the FPC would wield instruments such as capital ratios or loan-to-value ratios to manage liquidity, and placing two instruments for two targets – liquidity and inflation – within the BOE would ensure coordination.

But what if the two targets are in conflict? During the pre-crisis Great Moderation, restraining lending through regulatory tools probably would have worked, because it was unlikely to push the economy into deflation, as hiking interest rates would have done. But that is not the problem now.

The current issue is that the monetary aggregate (M4) measure of lending to the private sector is at its lowest level in a decade, while inflation is more than double the BOE’s target. If the FPC lowers capital requirements to encourage lending, but the MPC raises rates to cope with inflation, banks would face competing pressures. Looser lending rules would conflict with the higher cost of money. Because both the FPC and the MPC rely on a monetary-transmission mechanism that operates through banks, it isn’t clear that inflation-targeting and liquidity maintenance can be so neatly separated.

There is also the added complexity of global regulation. The idea is that countries would coordinate counter-cyclical regulatory measures, thereby preventing capital from skirting them by moving across borders. But, what if – and this is very likely – business cycles are not coordinated? After all, China is tightening credit while the UK is encouraging more of it.

Closer to Britain, the ECB is potentially embarking on a tightening cycle and withdrawing hundreds of billions of euros in liquidity provided during the crisis, owing to concerns about “addicted” banks. Will it really loosen capital requirements in order to align itself with the BOE?

Again, such policies would have worked a decade ago, in an environment of low inflation and rapid lending growth. But times have changed, and monetary policy will, of course, shift accordingly. The problem is that if bodies like the FPC become as important to central banks as monetary policy committees, we may be left wondering which target takes precedence when they clash.