The next time the Bank of England’s Monetary Policy Committee meets, it will be headed by a new governor, a career regulator. The new president of the European Central Bank is a lawyer, as is the US Federal Reserve chair. As economists urge central banks to find weapons to fight recessions, the message is coming back loud and clear: the best offence is a good defence.
The rationale is plain to see. If your ability to use interest rates to combat boom and bust is compromised, you had better make sure that the financial system is as boom-bust resistant as possible. Financial cycles have grown in intensity over the past 40 years, surpassing the highs and lows of the business cycle. We require tools to deal with them.
Most investors accept that we are never returning to the lackadaisical days of pre-crisis regulation. But it is doubtful that many really appreciate that regulation is likely to get tougher. A better buttressed financial system is no bad thing when the greatest threat to investment returns is a deep balance-sheet recession. In capitalism’s “golden age” of the 1950s and 1960s, economic growth was so strong because there was no deep recession. This was achieved by institutional reforms that promoted financial stability, long-term thinking, and outsized investment.
For evidence that things are changing, consider a speech by Lael Brainard, a Federal Reserve governor, at the end of November last year. She strongly hinted at interest rate cuts currently unanticipated by the market. Such cuts would be the result of a technical change to the policy framework and not a response to a deteriorating economic outlook, and as such, they would be a boon to investors. But her speech had a second, perhaps overlooked, message: expect America’s central bank to become a more active regulator, using “tools other than tightening monetary policy to temper the financial cycle”.
Ms Brainard offered preliminary findings from a once-in-a-generation review of the Fed’s policy framework. The review was motivated by persistently low inflation expectations; by an apparent insensitivity of prices to the utilisation of resources; and by the Fed’s inability to cut interest rates by the usual amount to counter recession, because rates are so low to begin with. Christine Lagarde has announced a similarly motivated review at the ECB. In early January, Mark Carney said that the BoE would follow suit.
One of the intellectual drivers behind the need for change is Christopher Waller, research director at the St Louis Fed and persistent advocate of low rates. His nomination to the Fed’s board of governors, if approved by the Senate, would be a strong signal that the central bank is receptive to challenges to conventional thinking.
The debate about monetary policy’s firepower is not new: discussion over monetary “impotence” began in the 1930s and has never come close to resolution. Yet these days policymakers seem increasingly honest about their inability to fully understand the inflation process, let alone influence it.
But a consensus on the need for tougher defences is emerging from this uncertainty. Agustín Carstens, general manager of the Bank for International Settlements — the overseer of all central banks — gave a speech last year that explored the importance of central banks’ enhanced role as independent supervisors of the entire financial system. Since 2008, the BoE has been given a specific financial stability mandate; the Fed created a vice-chair for financial stability; the ECB established the Single Supervisory Mechanism for the eurozone’s largest institutions. Tighter regulation was not a one-and-done response to the financial crisis, it is a work in progress and not just for the bad times.
If new inflation-targeting frameworks result in even lower interest rates, we should expect even greater use of regulatory tools in the good times, to guard against potential excesses caused by abundant liquidity. These could include structurally higher capital requirements or capital requirements for specific types of activity, designed to stop systemically important banks from failing.
A second set of tools could include more dynamic use of countercyclical bank capital buffers or liquidity requirements, so lending would shift from less resilient to more resilient banks.
A third category of measures could be deployed to ensure the resilience of borrowers, or to moderate the demand for credit. These can include limits on debt-to-income or loan-to-value ratios, which could have the effect of moderating the financial cycle.
Such tools are vital to ensure that financial imbalances do not arise from knee-jerk responses to cheap money — imbalances that the traditional weapons of central banks no longer look sharp enough to combat. Change is coming, and long-term investors should welcome it.
The writer is head of asset allocation research at Rathbones
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