Macro prudential policy has been designed in the wake of the great financial crash to solve a dilemma which policy makers faced, and failed to resolve, in the late 1990s and the mid 2000s. In those periods, consumer price inflation was subdued, persuading the central banks to restrain the rise in policy interest rates. Yet the financial sector entered phases of excessive risk taking, and these eventually ended in the equity crash of 2000 and the implosion of subprime credit in 2008.
The Greenspan doctrine, that interest rates should be set to achieve macroeconomic objectives, while the effects of financial excesses could be mopped up later, was found to be badly mistaken. In its place, the monetary authorities have unveiled a new set of cyclical regulatory and prudential controls that can be tightened when financial excesses occur, while inflation remains below targets. There are increasing signs that some central bankers, notably in the Bank of England and the Federal Reserve, think that the time is coming to use these new weapons as an alternative to rate rises.
Is this view justified? And will the weapons work, if deployed? Read more