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20 May 2014

Central banking’s revolution

by Karen Ward, Senior Global Economist, and Simon Wells, Chief UK Economist, HSBC

Asset-price inflation in various parts of the world is increasingly rampant, as shown by soaring house prices, surging equities and big capital inflows. Policymakers are becoming concerned that the seeds of future financial crises are being sown.

Credit spreads and implied volatility are back to pre-crisis levels. US corporate loans are increasingly ‘covenant lite’. Even economies without the UK’s history of housing market excess, such as Germany, are seeing prices pick up sharply. Some countries are experiencing unwanted exchange-rate appreciation. In the emerging world, the result is bigger and bigger capital inflows.

The challenge is to stop asset price bubbles developing, while keeping interest rates low. We know from the financial crisis that an independent central bank focused solely on inflation targeting is not sufficient for long-term economic stability.

The challenge is to stop asset price bubbles developing, while keeping interest rates low

Policymakers are setting new objectives and developing new tools to complement the existing regulation of financial institutions. These aim to control the build-up of risks across the financial system and are known as macroprudential policies.

In many parts of the world, central banks are being assigned prime responsibility for financial stability, often in conjunction with some regulatory agent of government. But interest rates alone are seen as a ‘blunt tool’ for fighting asset bubbles.

When considering macroprudential action we expect central banks to monitor the credit gap, sharp rises in risky financial asset prices, and rapid property price inflation. But not only will bubble-spotting and toolkit design make the job difficult, there are huge theoretical and practical hurdles.

For many developed markets, we expect macroprudential policy will try to influence the supply of credit, typically via higher capital or liquidity buffers, either across the board or aimed at particular classes of exposure. But supply could also be restricted more directly, through caps on maximum loan-to-value or loan-to-income ratios.

Blanket changes to banks’ capital or liquidity buffers could be criticised as being another blunt instrument but, unlike interest-rate rises, they should make the banking sector more resilient. And these tools do not affect existing borrowers.

However, a key concern is whether bodies formed to govern macroprudential policy will have political support for ‘ending the party’: voters and asset holders often like bubbles. Central banks must be prepared to be unpopular with both the public and politicians.

Will the priority of central banks using macroprudential policy be to lower the probability of a crisis, even if this risks stifling growth that could be sustainable? Or will they give growth its best chance even if that runs a greater risk of instability?

Macroprudential policy is likely to grow in significance and scope: it will not be a minor sideshow to interest-rate policy and the status quo. There are far-reaching implications if central banks become more active in risk markets: how they monitor markets and how they will act may become increasingly important in forming investment decisions.

But macroprudential policy is no panacea. The goal of sustained stability in growth, inflation and the financial system will remain elusive.

This research was first published on 12 May 2014.