END OF LINE FOR THE OLD MONETARY REGIME / THE FINANCIAL TIMES COMMENTARY & ANALYSIS (RECOMMENDED READING)

End of the line for the old monetary regime

By Jasper McMahon

Published: October 14 2009 23:09

What does the financial crisis mean for the conduct of monetary policy? The answer may seem obvious. Central banks responded to the seizing up of interbank markets with massive injections of liquidity. When they ran out of room for manoeuvre with short-term rates, they acted directly on the money supply via quantitative easing. So, as conditions stabilise, the question is when and how to tighten without either pushing fragile economies back into recession or letting a serious bout of inflation get under way.

Specific decisions have been widely debated, but there has been relatively little discussion about objectives or the policy-making framework. Since the 1970s there has been a strong political and theoretical consensus – in the UK and in much of the rest of the world – that monetary policy should focus on price stability, and that to do this it should be conducted by an independent authority, pursuing an explicit inflation target (or the money supply as a proximate target). The crisis made policy decisions more difficult but did not, of itself, call the framework into question.

The same could not be said about financial regulation. There never was the same consensus on objectives or policy framework, and much of what there was has gone out of the window anyway. There is now an emerging consensus on the changes to be made: higher capital requirements, particularly for trading; closer supervisory regimes; tighter liquidity controls; living wills (maybe); and restrictions on bankers’ bonuses. We still do not have a coherent overall regulatory scheme, but no one is pretending that we do, and in the meantime there seems to be enough political will to force through tough new regulations.

The contrast between these two areas of public policy debate – monetary policy and financial regulation – is striking, and their apparent un-connectedness is odd. In practice, they are inevitably interconnected.

One of the early conclusions on financial regulation is that a piece of the jigsaw has been missing: the “macro-prudential” function. Lord Turner identified this in his report for the UK, as did Jacques de Larosière in his for the European Union. Someone has to be looking not at the risks run by any specific institution but at the systemic risks that arise because of the pattern of actions taken across groups of institutions. For example, this analysis might have identified the risk arising from the widespread use of conduits by banks, or dangerous trends in the prices of assets such as housing or securitised credit.

So in the new regulatory world order there will be an explicit focus on macro-prudential analysis. The EU has constituted the European Systemic Risk Board for this purpose, to be chaired by Jean-Claude Trichet of the European Central Bank with Mervyn King likely to be his deputy.

But there will also have to be some means whereby the authorities can act on this analysis. Which levers might they pull? There are many. They might, for example, make ad hoc adjustments to the rules on banks’ capital. Or they might make changes to short-term interest rates – the classic tool of monetary policy. The fact is that any intervention would, if it worked, inevitably affect or even pre-empt monetary policy. Concerns about financial stability will, generally, give rise to actions that tighten credit conditions, irrespective of the growth/inflation outlook for the economy. So it is quite possible – likely even – that the two policy objectives (price stability and financial stability) will pull in opposite directions.

The fact that these two objectives are potentially in conflict is not new, but has been obscured by the orthodoxy of the past three decades. The alternative, to which it looks as if we must now return, is a recognition that the monetary authority must pursue objectives that are complex and not susceptible to simple targeting.

Central bankers have been rather quiet about this. They may prefer to muddle through than to re-examine their statutory remits. For politicians, the old approach has some powerful attractions. If the central bank’s job can be narrowly defined, then it is politically easier – in fact beneficial – to grant operational independence. But if the central bank’s goals are seen to be complex, requiring it to make trade-offs between competing political objectives, politicians may find it more difficult to keep their hands off the monetary controls.

The writer is a partner in Gallery Capital LLP and a company director

Copyright The Financial Times Limited 2009