ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Central Banks and the New Macro-Prudential Toolkit

The new macro-prudential toolkit has its share of problems. It tends to be pro-cyclical, despite being aware that bank lending to booming sectors also concentrates risk, as the global financial crisis has shown. The emphasis of macro-prudential policy must take into account the nature of risk and its location in order to effectively guide markets by aiming at risk-managing the system at a macroeconomic level, as opposed to the tendency of using individual risk-based micro-prudential policies.

After years of being considered at best aspirational, and at worse a little wacky, macro-prudential policy is now highly fashionable around the world’s central banks. If financial markets were good at predicting financial crises, they would not happen as frequently as they do. Financial markets have a long and tested habit of collectively underestimating risks at the top of a boom and overestimating them in the depths of the subsequent crash. Monetary policy is particularly ineffective at these times. When house prices are expected to rise 20% per annum, the level of interest rates required to choke off a housing boom would decimate the rest of the economy. When the animal spirits are low, even zero interest rates are as ineffective as pushing on a string. What is required is a macro-prudential regulatory policy that acts against these collective, self-reinforcing errors in estimating risk.

These endeavours are complementary to monetary policy not in conflict with it. Arguably, if regulatory policy targeted asset-price booms and took that burden away from monetary policy, it could be better focused on keeping a lid on inflation. We would have two policies targeting two specific objectives, à la Tinbergen (1952).

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