Central banks extend their focus to liquidity

Central banks are now targeting liquidity, not just inflation. The credit boom of the past decade highlighted the inadequacy of focusing only on prices and underscored the need for the monetary authority of a country - or group of countries in the case of the European Central Bank (ECB) and the euro zone - to monitor the financial sector.

Macro-prudential regulation is the new term of art among central bankers, supplementing their well-established inflation-targeting regimes.

This shift in focus could radically change monetary policy - but for better or worse? The Bank of England (BoE) may be leading the way in this transition, but the ECB and the US Federal Reserve are also taking on more financial regulation. Indeed, the ECB's European systemic risk board serves a function similar to that of the UK's new financial policy committee (FPC).

At the end of a recent discussion with Andy Haldane, the BoE's executive director for financial stability and a member of the FPC, I asked: What happens if inflation is high and lending is low?

Under this scenario, the BoE's monetary policy committee (MPC) would favour an increase in interest rates, while the FPC would want to loosen monetary conditions.

I am still pondering the question that I posed to Mr Haldane, because such contradictory policy imperatives appear unavoidable - never more so than now.

The past decade - until the collapse of Lehman Brothers in September 2008 - was known as the "great moderation", a period of low inflation and strong growth that reflected major new developments such as global integration of emerging markets and the adoption by major central banks of inflation-targeting regimes during the 1990s. In the UK, the BoE was made independent in 1997 and given a target of 2 per cent annual inflation.

Price stability during the 2000s explained the low interest rates that supported strong growth. But it also meant that a credit boom with international dimensions was not monitored, resulting in the most spectacular bust of modern times, including the near-collapse of the banking system.

Amid the UK's institutional changes in 1997, financial regulation was put in the hands of the Financial Services Authority (FSA).

But the FSA is soon to be replaced by the FPC, resulting in a system that aims to avoid an "underlap" of authority that leaves no one in charge. The FPC is now part of the BoE, which is meant somehow to ensure that monetary policy takes into account the financial sector.

The change reflects the argument of central bankers that to target credit or liquidity requires another tool. Interest rates are too blunt an instrument and risk damaging the wider economy when used to prick a housing bubble, as recent research by Charlie Bean, a BoE deputy governor, has shown.

So the FPC would wield instruments such as capital ratios or loan-to-value ratios to manage liquidity, and placing two instruments for two targets - liquidity and inflation - within the BoE would ensure coordination.

But what if the two targets are in conflict? During the pre-crisis great moderation, restraining lending through regulatory tools probably would have worked, because it was unlikely to push the economy into deflation, as raising interest rates would have. But that is not the problem now.

The current issue is that the monetary aggregate measure of lending to the private sector is at its lowest level in a decade, while inflation is more than double the BoE's target.

If the FPC lowers capital requirements to encourage lending, but the MPC raises rates to cope with inflation, banks would face competing pressures.

Looser lending rules would conflict with the higher cost of money.

Because the FPC and the MPC rely on a monetary transmission mechanism that operates through banks, it is not clear that inflation-targeting and liquidity maintenance can be so neatly separated.

There is also the added complexity of global regulation. The idea is that countries would coordinate counter-cyclical regulatory measures, thereby preventing capital from skirting them by moving across borders. But what if - and this is very likely - business cycles are not coordinated? After all, China is tightening credit while the UK is encouraging more of it.

Closer to the UK, the ECB is potentially embarking on a tightening cycle and withdrawing hundreds of billions of euros in liquidity provided during the crisis because of concerns about "addicted" banks. Will it really loosen capital requirements to align itself with the BoE?

Again, such policies would have worked a decade ago, in an environment of low inflation and rapid lending growth. But times have changed, and monetary policy will shift accordingly. The problem is that if bodies such as the FPC become as important to central banks as the MPC, we may be left wondering which target takes precedence when they clash.

Linda Yueh is a fellow in economics at St Edmund Hall, University of Oxford, and an associate of the globalisation programme of the centre for economic performance at the London School of Economics and Political Science

* Project Syndicate