We’re All Macroprudentialists Now as Bubble Policy DawnsSimon Kennedy
Thirty-five years ago this month, a U.K. central banker by the name of Peter Cooke was worrying about a surge in lending to developing countries.
Could such capital flows eventually threaten overall economic growth and market stability? he asked as he chaired a June 28-29, 1979, meeting of international bank regulators. Could they pose a “macroprudential” problem?
The term Cooke used and possibly coined describes an approach to assessing economic threats posed by the financial system, as in 2008 when the collapse of the U.S. subprime mortgage market sent shockwaves through the world economy. It comes full circle today when modern-day Bank of England officials debate whether to cool house prices, putting themselves in the vanguard of a central-banking revolution.
Success for so-called macroprudential regulation would see policy makers deflate potential excesses by limiting access to credit, protecting economic expansions from burst bubbles or blunt interest-rate increases. The trouble is, the track record of such tools is at best mixed.
“Central banks are doing a lot on macropru right now,” said Gavyn Davies, chairman of London-based hedge fund firm Fulcrum Asset Management LLP. “The basic lesson from past attempts is, they haven’t worked for very long and they haven’t worked very well, so we have to do better than we have in the past.”
Bank of England Governor Mark Carney is poised to act today as he chairs a meeting of the Financial Policy Committee amid concern that British house prices are getting out of control. London home values jumped an annual 18.7 percent in April, the most since July 2007, according to official data released today.
The FPC “will not hesitate to take further proportionate and graduated action as warranted,” Carney wrote in a foreword to the bank’s annual report released today. “That will allow monetary policy to remain focused on providing the stimulus the economy needs.”
Having already toned down a credit-support measure, options include requiring a minimum for down payments for houses, making banks hold more capital against mortgage lending, toughening affordability tests, or telling the government to dilute its support of the market. Any decision will be announced next week.
“Once you get a housing bubble, you need to lean against it very hard and it takes a lot of tools,” said Adam Posen, a former BOE policy maker and now president of the Peterson Institute for International Economics in Washington.
Investors may be underestimating just what the new instruments mean for them, said Brian Hilliard, an economist at Societe Generale SA in London. What he calls the “Carney Call" suggests regulators will be more willing than ever to act to avoid asset market excesses, effectively capping values.
‘‘Financial markets have not fully taken account of the implications of these new tools,’’ he said.
It may be hard to gauge the right response though. While use of a regulatory tool could serve as a substitute for interest-rate increases and so push a currency down, it also could signal concern an economy is overheating which would tend to lift an exchange rate, strategists at HSBC Holdings Plc said in a report last week.
The U.K. is not alone in its refashioning of economic policy after a two-decade global infatuation with inflation targeting. The flaws of that doctrine were exposed when the financial crisis rubbished the notion that if prices were stable, asset markets would be too. The fallout from the turmoil also challenged the notion that it was easier to clean up after a bubble popped than lean against one forming.
‘‘The old model in which central banks targeted inflation is one that paid too little attention to the financial system,’’ said Rich Clarida, an executive vice president at Newport Beach, California-based Pacific Investment Management Co.
The pressure for a new, two-pronged approach is also intensifying as weak inflation keeps major central banks such as the U.K’s reluctant to raise interest rates, even though many asset prices are surging. As well as rising house prices from Canada to Britain, the MSCI World Index of stocks is up almost a fifth from last year and yields on sovereign bonds to junk-rated company debt are at or near record lows.
‘‘It is a brave central banker who would deliberately induce a recession in order to head off the mere risk of a future financial correction,’’ Bank of England Deputy Governor Charlie Bean said in a May 20 speech. ‘‘That explains the interest in deploying additional policy instruments.’’
While Bean noted a lack of experience on the matter, a track record is starting to form. Carney’s native Canada has been tightening macroprudential policy since 2008, with steps including minimum down-payment demands and maximum debt limits for insured mortgages. Sweden and Norway capped loans as a share of a property’s value and asked banks to protect themselves against losses. Hong Kong limited the size of loans too and took steps to curb some purchases by foreigners.
New Zealand in October restricted the amount of new loans banks could issue to people with less than a 20 percent deposit, while Switzerland increased capital requirements and curbed mortgage maturities, among other measures.
An April study of 20 nations by Goldman Sachs Group Inc. economist Hui Shan found that the total number of policies aimed at cooling housing has increased to an average of eight per year between 2007 and 2011 from one a year in the 1990s.
So do the policies work? Shan found more restrictive policies cooled credit and house price growth by 1 percent annually. Banking regulation focused on mortgage lending was most effective in damping credit growth, while loan curbs best slowed house-price appreciation.
The Reserve Bank of New Zealand said in research last month that what it calls its ‘‘speed limit” had knocked around 3 percentage points off house-price inflation in the first six months. Hong Kong’s property market has also cooled after prices doubled since 2009.
“There have been parts of the world where macroprudential policy has been quite effective,” said Karen Ward, a global economist at HSBC in London. “Not all have worked though, and it requires bold, timely and politically unfriendly judgments.”
Some efforts may have succeeded only in preventing even worse outcomes. Most famously, the Bank of Spain greeted the millennium by requiring banks to boost reserves in anticipation of future write-offs for bad loans. It eased conditions in 2004, only for its real-estate market to later implode.
That experience is unlikely to derail the macroprudential movement, and how Carney fares will be tracked by other key central banks such as the Federal Reserve and the European Central Bank.
“He will be the test case,” said Posen. “The U.K. will be watched with interest.”
Fed officials have raised financial-stability concerns at meetings in recent months. Among assets that have drawn the gaze of officials in speeches and minutes of meetings are premiums on longer-term debt, price-earnings ratios on some small capitalization stocks, declining credit quality on some high yield loans, and farmland values.
Global policy makers are already seeking ways to gauge risk in much the same way they monitor economic indicators. The Bank for International Settlements proposes a role for the ratio of credit to gross domestic product, saying a deviation of what it calls the “credit gap” is a good early warning for banking troubles.
For the Group of Seven economies, that currently stands 8 percentage points below its long-term trend, according to the Washington-based Institute of International Finance. More worryingly, it estimates financial assets as a share of GDP are 9 percentage points higher than the trend.
On real estate, the International Monetary Fund last week warned that ratios to rents and income “remain well above” historical averages for a majority of countries, and said housing is “still too pricey” in Belgium, Canada, Australia, New Zealand, France and the U.K.
At Capital Economics Ltd. in London, economist Andrew Kenningham highlights various flaws in macroprudential policy. Authorities may struggle to spot bubbles, and efforts to pierce those they do see may run into political opposition, be circumvented or ignored by investors eager to buy a rising asset, he says.
Central banks could also trust the new regulatory framework too much and end up leaving monetary policy overly loose, with “the perverse effect of making credit and asset bubbles more, rather than less, likely,” said Kenningham.
Ultimately, central bankers may find old-fashioned monetary policy is still required, said Hung Tran, deputy managing director at the IIF. Recently departed Fed Governor Jeremy Stein said in February that unlike regulation, a change in rates “gets in all the cracks.” Carney said last week that “macroprudential policy is not a substitute for monetary policy.”
“At same point, the consciousness for monetary policy to play a part will grow,” said Hung Tran. “There will be more central banks joining the debate.”