International Monetary Coordination… of Rhetoric

Looks like there has been some international coordination of monetary policy rhetoric lately.

At the beginning of the week, the central bankers’ central bank—the Bank for International Settlements in Basel—warned loudly of the risks of moving “too slowly and too late” to raise interest rates back toward normal. As it did before the global financial crisis, the BIS emphasized the need to act early to avoid the booms-and-busts in financial markets and offered all sorts of reasons why today’s very low inflation shouldn’t be the primary concern of central bankers.

Central bankers appear to have agreed on a common response.

In the past couple of days, Federal Reserve Chairwoman Janet Yellen, European Central Bank President Mario Draghi and Bank of England deputy governor Jon Cunliffe have used the same phrases to say: Fuggedaboutit!

With price and wage inflation not a concern right now, we aren’t going to raise interest rates and throw at lot of people out of work to avoid excesses in financial markets or to head off possible asset bubbles, they said. There may come a day when our worries about financial stability will prompt us to hike interest rates, but rates are “the last line of defense.” Not now. The “first line of defense” is making the financial system more resilient so it can better withstand shocks and using our supervisory and regulatory “macroprudential tools” to rein in excesses, as we are doing now.

“I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns,” Ms. Yellen said Wednesday at the International Monetary Fund.

Then, Christine Lagarde, she added, “Macroprudential policies should be the main line of defense.”

At his press conference Thursday, Mr. Draghi said: “The first line of defense should be the macroprudential tools. I don’t think people would agree with raising interest rates now.”

And here’s how Mr. Cunliffe framed it in a speech in Liverpool on Thursday:

Monetary policy, may, as [former Fed governor] Jeremy Stein said when he was at the Federal Reserve, be effective in tempering financial stability risks because when we change interest rates it “gets in all the cracks”. But because it gets in all of the cracks across all of the economy, using interest rates to deal with financial stability risks can carry a high cost.…So although it is an effective line of defense, it should be seen as one of the last lines of defense. The question then becomes how do we ensure that it does not…have to be used as a first line of defense? Here the financial crisis and recession has led to the development of what is now called “macroprudential policy.” In essence, macroprudential policy means using the regulatory ‘stance’, the underlying settings of the regulation of the financial sector, first to reduce the probability and impact of systemic crisis and then, by varying those settings, to counter emerging threats to financial stability.

All of this is important if we’re to learn anything from the devastating global financial crisis. Ms. Yellen offered three principles: (1) Regulators need to stick to their efforts to make the financial system much more resilient than it proved to be before the crisis. (2) Policymakers need to be alert, and remember how much they missed the last time around. And (3) because there are no clear rules here, central bankers “should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.”
That makes good sense, but it is important to remember this is very much an experiment.

These macroprudential tools—tinkering with rules for mortgages, requiring banks to build more capital in good times, etc.—are only now being tried and may not work as intended, as Ms. Yellen noted. (Hence her admonition that rate hikes may “at times be needed to curb risks to financial stability.”) And we’ve yet to see whether the Fed has the wisdom, spine and support—both from other financial regulators and the political system—to make it harder to get credit for certain purposes (e.g. home buying) to reduce the probability of a future financial crisis when there is much uncertainty about how big those probabilities are.

After all, World War I led the French to build the Maginot Line in the 1930s to thwart a direct attack from Germany. The Germans skirted the line and invaded through Belgium in May 1940.