Central banks’ impending exit from unconventional monetary policies will test new macroprudential policies that were crafted after the global financial crisis, said Donald Kohn, Robert S. Kerr Senior Fellow at Brookings and a member of the Bank of England’s Financial Policy Committee.
Speaking in London Thursday to the British Bankers Association, Kohn expressed confidence that Britain’s financial system is sufficiently strong that it won’t be an impediment to the Bank of England’s Monetary Policy Committee raising interest rates from current low levels when the time comes.
“But exit is not without its risks and dangers,” he said, “especially after a long period of very low interest rates and low market volatility…The question is whether the long period of low rates and low volatility has led to a mispricing of risks through reaching for yield, herding or other types of behavior.”
Kohn listed three types of risks that might be mispriced:
- Credit risk: the possibility that business and household borrowers will have trouble repaying loans when interest rates rise.
- Interest rate risk: the possibility that financial institutions may have taken on more interest rate risk “than they will be easily be able to cope with as rates rise,” such as trades that will lose money when short-term rates rise.
- Liquidity risk: the possibility that market participants may not be able to get out trades and positions in “a timely and predictable way.”
“Never before have the monetary authorities engaged in the sorts of unconventional policies that have been widely utilized over the past six years,” Kohn said. “So none of us has any experience with the asset price movements….that could occur as they are exited.”
“Most likely all will go well,” he said. “Unconventional policies will be unwound with only the sorts of gains and losses that usually accompany policy shifts and don’t threaten financial stability. But this is an unusual challenge for both the authorities—including new macroprudential authorities like the FPC—and the private sector. One that we must get right.”
In an earlier speech in Athens, Kohn said he favors using regulatory policy—as opposed to higher interest—to counter emerging financial stability risks wherever possible. “But,” he said, “we need be aware of the current limits of our knowledge of the effectiveness of macroprudential policy. It is untested…in the highly developed financial centers of global integrated markets; international cooperation and coordination will be required.”
Kohn, a former vice chair of the Federal Reserve Board, is affiliated with the Hutchins Center on Fiscal and Monetary Policy at Brookings.