However on one key issue the Bank of England’s FPC [Financial Policy Committee] appears to fall short. The potential trade-offs between monetary policy and financial stability are not addressed. In an opinion piece today, the former Bank of England Monetary Policy Committee [MPC] member Sushi Wadwhani has highlighted the dilemma.For example, suppose we have an emerging house price bubble and the FPC increases capital requirements which, through widening lending margins, slow the economy, and this leads the MPC to expect inflation to undershoot the target over the next two years. Under the proposed structure, it is envisaged that the MPC would lower interest rates in order to keep inflation at target. If so, would this not largely offset the actions of the FPC and keep the house price boom going?
The BIS report concedes that the short-term interests of monetary policy and financial stability policy may occasionally diverge. Mr Wadwhani argues this means a single committee should be responsible for both monetary policy and financial stability. While BIS accepts that would facilitate coordination and force policy makers to confront the trade-offs at stake, it concludes that responsibility for the two policies can be separated, as long as it is clear which takes priority.
What does this mean? In England, the the Monetary Policy Committee is tasked with conducting a monetary policy that will keep the economy on a path of steady growth with low and stable inflation. The Financial Policy Committee is tasked with maintaining financial stability. But there is an important tradeoff between monetary policy goals, which are counter-cyclical, and financial regulatory goals, which are pro-cyclical. Having two separate institutions pursuing opposite goals can be self-defeating, which is why Sushi Wadwhani suggests having a single institution responsible for both. And the BIS seems to agree:
The logic for central bank involvement is well established. The financial crisis showed that central banks are ultimately lenders of last resort to the financial system, and so should pay proper attention to its overall health. Moreover central banks’ primary policy mandate, monetary policy, has a strong influence on financial stability; think quantitative easing today, or the consistently low interest rates in America that encouraged a bubble in real estate prices in the 2000s.
The BIS wants all central banks to be given legal responsibility for financial stability, arguing that macroprudential regulation requires the same autonomy as monetary policy. ...
For now though, the direction of travel is clearly towards legally defined responsibilities for financial stability and the centralisation of power within central banks. Unusually that points towards emerging market structures, rather than American or European ones.
So the BIS wants a single institution -- the central bank -- to be responsible for both monetary policy and financial stability. It acknowledges the tradeoff between the two, but does not specify how that tradeoff is likely to be resolved. Note the bolded portions above. But what are appropriate ways to resolve the tradeoff? How do we make it "clear which [goal] takes priority"? Which goal should take priority?
I've argued in my research (currently under review and previously discussed here), building off of prior work by Copelovitch and Singer, that the tradeoff is resolved by central banks that also regulate in a way that the BIS might find perverse: by privileging banks' interest. Copelovitch and Singer find that regulatory central banks allow higher inflation -- i.e. more access for banks to cheap funds, which then fuels economic expansions -- than nonregulatory central banks. I extend that by arguing that banks respond to this policy dynamic by acting more riskily when regulated by central banks, because they believe that they'll have access to those funds in times of need. I call this "monetary moral hazard", distinct from the fiscal bailout moral hazard involved with TBTF firms, and support for such a relationship shows up in the data.
In other words, the BIS (and Bank of England) are correct that there is an important tradeoff between macroeconomic management and financial stability. But resolving that tradeoff by locating regulatory authority in central banks resolves the tradeoff in a way that may not promote financial stability, instead creating monetary moral hazard. One possible way to get around this dynamic (that I do not explore in the paper) is via much stricter statutory regulations by removing discretion from regulators, which is more or less the opposite of what the BIS is proposing. Many in England and elsewhere have called for stricter laws along these lines, and while the international Basel III agreement has taken a step in that direction, it's not a very large one.