In an article in the Wall Street Journal John Cochrane raises serious doubts about recent “macro-prudential” policy proposals. I hope the Fed listens. The Bank of England has already started in this direction with its new Financial Policy Committee planning to change capital requirements cyclically as its Monetary Policy Committee sets monetary policy.
The rationale for counter-cyclical macro-prudential policy, proponents argue, is that monetary policy alone is incapable of moderating booms without inflicting severe damage on the economy. Thus, the central bank would also vary capital requirements cyclically, requiring financial institutions to increase their capital ratio during booms and relax them during slumps.
But the evidence that monetary policy cannot contain excesses without inflicting severe damage is questionable. Many cite the 2003-2005 housing boom. But during this period the federal funds rate was too low compared to what worked well in the 1980s and 1990s. Raising it would have help contain the boom with little cost to the overall economy and would have avoided the bust.
Moreover, policymakers need a great deal of discretion to implement such a policy. Little is known about the dynamic impact of a temporary change in capital requirements and there are policy lags which can create unintended consequences. The policy will likely bring the central bank into political controversy, especially if the instrument affects sensitive sectors like housing.
Rather than attempting to “fine-tune” prudential policy by manipulating capital buffers, central banks should simply to set the required capital ratios at an appropriate level on a permanent basis and keep them there as I explained in this dinner speech at the Atlanta Fed last spring.