Money, Banking, and Financial Markets
In a blog posting with Cecchetti & Schoenholtz of Money, Banking, and Financial Markets, Tucker answered questions on the financial crisis and central banking, including, has the experience of the crisis changed your view of the central bank policy tool kit? Tucker responded, “It would be hard for it not to have made me think about many things. I identify three distinct dimensions: the first is about balance sheet policy, the second about the lender of last resort, and the third about macroprudential policy.”
Cecchetti & Schoenholtz Money, Banking, and Financial Markets
Has the experience of the crisis changed your view of the central bank policy tool kit?Deputy Governor Tucker: It would be hard for it not to have made me think about many things. I identify three distinct dimensions: the first is about balance sheet policy, the second about the lender of last resort, and the third about macroprudential policy.
To my mind, balance sheet policy raises more important and interesting questions than does forward guidance. Policymakers already understood before the crisis that it is the whole expected path of future policy rates that affects economic outcomes, and that it is therefore important to reveal information that helps people understand how policymakers think while underlining that they don’t have a crystal ball.
The distinct thing about balance sheet policy is that there isn’t a consensus on the channels through which it works or on its legitimacy. It appears to have worked effectively in the United States and the United Kingdom, but we will learn more from experience in the euro area. I have thought that balance sheet policies work largely through the portfolio balance channel – plus a degree of signaling about future interest rates. But, up to a point, one can give credible signals without balance sheet policy. So in evaluating quantitative easing (QE), we need to know more about the effects of purchases on asset management behavior, and how induced changes in risk premia influence spending in the economy.
Balance sheet policy also raises a set of issues about what is legitimately within the realm of central banking. If we think of central banks as using their operations to change the liability structure and, potentially, the asset structure of the consolidated balance sheet of the state in pursuit of macro-stability, the question is what degrees of freedom they should be granted. One can see that in the European debate about QE over the past year. There was debate not only about whether or not nominal stimulus was needed to achieve their inflation target, which I thought it was, but more profoundly about whether it is legitimate for central banks to go into the market and buy government bonds. For me the answer to that specific question is simple: it is, so long as the central bank freely decides how much and when. But that was an easy conclusion in the United Kingdom because it was a tool that we had used already in the 1980s to help influence broad monetary and credit conditions. Whether it is OK for central banks to buy private sector paper is more nuanced, because of the default risk entailed and because it could be used to favor some borrowers or sectors over others.
We need to get that debate resolved, not least because the move to paying the policy rate of interest on reserves means that the question of asset purchases is not relevant just at the zero lower bound for nominal interest rates. In principle, central banks are going to be able to make separate choices on the policy rate, the size of their balance sheet, and the composition of their asset portfolio. This is all about elected politicians refining the convention that separates fiscal policy which they control themselves from monetary policy controlled by an independent authority.
The lender of last resort part of the central bank toolkit also has two components. The first is that some central banks have been accused of lending to irretrievably insolvent firms. Whether or not that was true, central banks do need to come up with a framework for credibly committing to not knowingly lending to irretrievably insolvent intermediaries. That’s really important in terms of the political economy of central banking.
The second thing here is that some central banks – including the Bank of England – conductedmarket maker of last resort operations. Quite successfully, I would say, in terms of helping to revive corporate bond markets via modestly sized operations. The question arises whether that should be in the tool kit; if so, how should it be framed; and if not, how central banks could commit never to do it again. For example, is it better to lend secured to shadow banks than to act as a back-stop dealer? And, what are the implications for regulatory policy given moral hazard problems?
The third area is the most novel – macroprudential policy – which I am going to define as dynamically adjusting regulatory requirements to maintain a desired degree of resilience in the core of the financial system. If regulatory requirements are static and calibrated for a normal risk environment, the system will not be as resilient as desired when it gets into an exuberant phase. Now, this approach of dynamic policy is completely new. It was a key missing element of the tool kit available to the authorities before the crisis. The other reforms of financial policy amount to improving existing regimes, but this is new. No one had conceived before of regulatory requirements being adjusted according to cyclical conditions and threats to financial stability. If it proves effective, it frees monetary policy to remain dedicated to anchoring inflation and stabilizing the path of nominal demand.
Perhaps unsurprisingly, but a bit disturbingly, many of the bigger jurisdictions, including the United States and the euro area, still don’t have comprehensive, coherent macroprudential frameworks. There’s just an enormous amount of work to be done on that. It’s a bit of a revolution in terms of thinking about how the different elements of a stability-policy framework fit together.