The Grand Unifying Theory (and practice) of Macroprudential
Policy
Speech given by
Mark Carney
Governor of the Bank of England
Logan Hall, University College London
5 March 2020
I would like to thank Daisy McGregor, Nicola Anderson, David Aikman, Caspar Siegart and Victoria
Monro for assistance in preparing these remarks and Wayne Chapman, Kate Stratford, Jon Bridges,
Matt Waldron and Alina Barnett for their research and analysis.
I. Introduction
Economists suffer from physics envy.
We covet its neat equations and crave its deterministic systems.
This inevitably leads to disappointment.
The economy isn't deterministic. People aren't always rational. Human creativity, frailty,
exuberance and
pessimism all contribute to economic and financial cycles.
As the great physicist, Sir Isaac Newton, lamented, "I can calculate the motions of celestial bodies, but not
the madness of people."
Newton's exasperation came after he had lost a
fortune investing in the South Sea company, or, with the
wisdom of hindsight - after he had speculated on a bubble.
Just as people can go from rational to "mad" in a boom, theoretical physics itself isn't
quite as neat as
Newton had thought, for it has been discovered that Newtonian mechanics break down at the subatomic
level.
But physicists are not easily daunted. Their hottest fields, such as String Theory, are part of a quest for a
theory that unifies Newton and the neutron-a Grand Unifying Theory of Everything that Matters. One that
can explain the motions of both heavenly bodies and subatomic particles.
I am on a similar quest this evening. My topic is one of the hottest fields in economic policy-
macroprudential policy. A field that has something in common with Newton, for part of the responsibilities of
macroprudential policy is to protect the economy from the madness of people.
Macroprudential policy is as core to the responsibilities of central banks as their much better known twin,
monetary policy. Both are fundamental to the value of money.
The relative simplicity of the monetary policy objective and the relatively focused arsenal of monetary
policymakers improve the likelihood that agents in the economy can understand the MPC's reaction
function
and anticipate its actions, making its job of achieving price stability somewhat easier.1
This evening I would like to improve the understanding of the FPC's reaction function by placing its
objectives and policies in a more consistent theoretical framework. A common framework can better explain
seemingly disparate macroprudential policies and can guide future policy actions. This will be important if,
as has happened all too frequently in the past, either a prolonged period of growth or the emergence of new
1
See speech by Mark Carney given at the Society of Professional Economists, 24
'Guidance, Contingencies and Brexit',
May 2018.
era thinking threaten to take financial stability for granted once again, thereby sowing the seeds of a future
crisis.
II. The Triumph (and Tragedy) of Monetary Policy
Newton famously and humbly observed, "If I have seen farther, it is by standing on the shoulders of Giants."
So too it is with macroprudential policy, a framework that owes a great debt to insights and initiatives of my
predecessor, Lord King.
The UK's macroprudential policy framework today stands on the shoulder of the UK's monetary policy
framework first set up in 1998.
In the UK, from 1971 to 1992, inflation was high - averaging 9%, and volatile, with a standard deviation of
5.4%. This distorted price signals, inhibited investment, damaged the productive potential of the economy,
and hurt those least well-off. It contributed to high and volatile unemployment, which averaged 7.8% with a
standard deviation of 2.8%.
Although the value of low and stable inflation was widely recognised, delivering it proved challenging.
- -
This was because the instrument that affects inflation most powerfully monetary policy also affects output
and employment, at least in the short run. This tempted authorities, influenced by governments, to promise
low inflation in the future, but then to renege in order to boost activity. Electoral cycles reinforced this
predisposition. Firms and households began to anticipate these incentives, and eventually pre-empt them.
This time inconsistency was resolved by first having society choose the preferred rate of inflation, and then
delegating operational responsibility to the monetary authority to take the necessary monetary actions to
achieve that objective. By "tying the hands" of authorities, better outcomes for both inflation and
unemployment became possible.
The Bank of England Act in 1998 represented the most comprehensive adoption of these insights. The Act
clarified the Bank's responsibilities, encoded in the MPC's remit, and granted
independence to the Bank for
the operation of monetary policy. In delegating authority to an independent body, the Act ensured the Bank
would operate under 'constrained' rather than 'unfettered' discretion. It would be accountable to Parliament
for operating the instruments of monetary policy to achieve the objectives of monetary policy, as determined
2
by the Government.
· · · · ·
The MPC's current monetary policy remit requires it to achieve price stability, defined by the Government as
12-month CPI inflation of 2%. This inflation target is symmetric and applies at all times.
2
For further information, see
'Lambda', speech by Mark Carney given at the London School of Economics, 16 January
2017, and speech by Mark Carney given at the Bank of England Research Workshop
'A Framework for All Seasons?',
on The Future of Inflation Targeting, 9 January 2020.
The remit also recognises that inflation may deviate temporarily from the target on account of shocks, and
since 2013 it explicitly recognises that in these circumstances, bringing inflation back to target too rapidly
could cause volatility in output and employment that is undesirable. The remit requires the MPC to consider,
balance and explain such short-run monetary policy trade-offs.
can be represented in form -
The manner in which the MPC optimises these trade-offs "linear-quadratic" a
set of linear constraints describing the behaviour of the economy, and quadratic preferences that penalise
deviations of inflation from its target and output from its potential. The relative weight the policymaker places
-
on output stabilisation, relative to inflation stabilisation, is often denoted λ or 'lambda'.
The policymaker's objective function can be described as the following "loss function":
H
∗
min ≡ {∑ - π∗)2 + - )2] }
Lt Dt βi[(πt+i λ(yt+i yt+i
T
{rt+i}i=0
i=o
∗ ∗
π∗ is 'trend' output, so that -
where πt is inflation, is the inflation target, yt is output and yt yt yt is
- β t
the output gap, is the nominal interest rate the policy instrument, is the discount factor and
rt
G
subscripts denote time periods. is 3-5 years after which the monetary policy transmission
mechanism fades.
The policymaker's objective is to minimise the discounted sum of losses over time.
-
In this formulation, a lambda of zero would imply no weight on the stabilisation of real activity so-called
"inflation nutter" preferences. When lambda is positive, the policymaker is willing to strike some
trade-off
between output and inflation stabilisation, as directed by the MPC remit.
This objective function is optimised subject to the constraints implied by the aggregate behaviour of the
economy, including the relationship between interest rates and activity; and the relationship between activity
-
and inflation the Phillips curve.
Under this simple framework, in certain circumstances, the optimal policy balances overshoots of the inflation
target with shortfalls of activity relative to potential, and vice versa for inflation undershoots. The relative size
of these two deviations is governed by the strength with which higher output translates into higher inflation;
and the preferences of the policymaker, or:
λ
∗)
- π∗ = - -
πt (yt yt
κ
where κ is the slope of the Philips curve, the effect of the output gap on inflation.3
From this, it is clear that the higher is lambda, the greater the weight placed on output stabilisation and the
more a given shock is allowed to flow through to inflation. As lambda shrinks to zero, the policymaker forces
all of the adjustment to a shock through the output gap in order to keep inflation very close to the target.
The slope of the trade-off is also affected by that of the Phillips curve. When the Phillips curve is flatter, a
given output gap results in a larger inflation over- or under-shoot. Intuitively, a flat Phillips curve raises the
output costs associated with changing inflation.
· · · · ·
Such inflation-targeting frameworks, adopted around the world, have been highly successful. Two decades
prior to monetary policy independence in the UK, inflation averaged over 6% (Table 1). Since independence,
it has been close to 2% and one-fifth as volatile. The unemployment rate fell by around 2 percentage points
in the post-independence period. Its standard deviation was cut in half. And fifteen years of sustained
economic growth followed.
Table 1: Inflation lower and less volatile since MPC independence
Annual Four-quarter Real
Inflation Four-quarter Unemployment
CPI GDP growth wage
volatility GDP growth rate
inflation volatility growth
Pre-inflation targeting 9.0 5.4 2.2 2.9 7.8 0.8
(1972-1992)
Start of inflation 2.3 0.4 2.9 0.7 9.0 0.3
targeting to MPC
independence
(1993- 1997Q2)
MPC independence to 1.6 0.5 3.0 0.9 5.4 0.7
crisis (1997Q3 - 2007)
3.3 1.0 0.0 2.7 7.4 -0.3
2008 - end 2012
1.7 1.0 2.0 0.5 5.2 0.2
2013 - present
However, with time, the initially healthy focus on price stability became a dangerous distraction. Against this
serene backdrop of "the Great
Moderation", a storm was brewing.
3
This is the time-consistent optimal policy in the textbook New-Keynesian model with purely forward-looking IS and
Phillips curves. See Clarida, R, Gali, J and Gertler, M (1999),
"The Science of Monetary Policy: A New Keynesian
Perspective", Journal of Economic Literature, December.
The changes adopted by many central banks around the world in the late 1990s effectively narrowed their
focus, reflecting the belief that price stability was the best contribution a central bank could make to
macroeconomic stability, and by extension to the broader public good.
period, this reductionist vision of a central bank's
Although there were tremendous innovations during this
role was structurally flawed.
In particular, this narrow focus failed to recognise that financial stability is as important an objective of
macroeconomic policy as price stability.
Central banks have a vital role in maintaining financial stability because of the deep underlying connection
between it and monetary stability. Both are fundamentally about maintaining the public trust and confidence
in money and the financial intermediation that is essential to oil the wheels of commerce. That trust and
confidence can be undermined through a loss of certainty about the future value of money, a loss of
confidence in financial intermediaries, or ultimately a loss of faith in the financial system.
The financial crisis was a powerful reminder of the imperative of financial stability. After years of low and
stable inflation, it became obvious that central banks had won the war only to lose the peace.
The costs were enormous. The complete loss of confidence in private finance that occurred in 2008 could
only be arrested by public support that totalled $15 trillion in bail-outs, government guarantees of bank
liabilities and special central bank liquidity schemes. In the UK, real wages have just surpassed their 2007
level. Trust in the system collapsed.
In the wake of the crisis, the traditional model of central banking was reinstated and modernised.
In the UK, monetary and financial stability were re-united at the Bank of England when the Chancellor in
2010 created the Financial Policy Committee (FPC) and granted it responsibility for setting macroprudential
policy.
Operating monetary and financial stability functions within the same institution improve information
synergies, and policy coordination. And it boosts the credibility of each policy function, amplifying their
effectiveness since each can focus on their comparative advantage - monetary policy on demand
management and macroprudential policy on systemic stability.
III. The Advent of Macroprudential Policy
raison
The d'être of macroprudential policy is to ensure the financial system supports the economy.
That requires the financial system to be strong enough to continue lending to households and businesses
when economic shocks occur. And it means that macroeconomic downturns are not made worse because of
unsustainable debt burdens.4
-
To accomplish these goals, macroprudential authorities concentrate on systemic risks that is, those large
enough to materially impact growth. Such systemic risks fall broadly into two camps: cyclical and structural.
Cyclical risks are the tendencies for financial conditions to loosen and debt to build up over time when the
economy strengthens and people become more complacent. This cycle typically starts with a fundamentally
positive development, such as new markets or a new technology of broad application. The ensuing period of
prosperity and macroeconomic stability leads borrowers and lenders to make increasingly optimistic
assumptions about the future such as "house prices can only go up" or "financial innovation has reduced
risk." Debt and asset prices build, reinforcing each other for a time.
The resulting vulnerabilities are only exposed when economic conditions turn. When they do, lenders hastily
- the "Minksy moment" -
revise their expectations for the future and pull back on lending. Borrowers reduce
spending, or in extremis, default. These responses make the economic downturn much deeper and more
prolonged.
Structural risks are systemic risks that do not vary with the cycle. They generally relate to interconnections
and concentrations within the financial system but can also arise from the structure of financial contracts or
regulations.
For example, if financial institutions have a web of exposures to each other, an issue at one institution can
set off a chain-reaction through the system. Or if several firms are exposed to the same market, problems in
that market can be amplified because of how these firms react. Risks will also be higher if structurally weak
investment vehicles, prone to fire sale their assets, play a meaningful role in important markets. And
structurally deficient market infrastructure increases the complexity and opaqueness of markets, making
risks harder to identify.
Over the past decade, a flurry of macroprudential policy actions have been taken to address the fault lines
that caused the crisis including raising bank capital minima and buffers, introducing liquidity buffers for
banks, reducing bank interconnectedness and improving their resolvability, targeted restrictions on mortgage
4
Macroprudential policy is distinct from microprudential policy. Microprudential policy concentrates on promoting the
safety and soundness of individual institutions. Macroprudential policy addresses risks arising from interactions between
institutions and sectors within the financial system, and interactions between the financial system and the real economy.
lending, transforming fragile OTC derivative markets, and winding down the toxic forms of shadow banking
and building up more resilient market-based finance (Chart 1).5
And with these policies have come a flurry of speeches too (Chart 2).
Chart 1: Increasing use of macroprudential Chart 2: Flurry of macroprudential policy speeches
meaures over time post-crisis
Use of macroprudential measures over time Number of speeches
250
14
12
200
10
150
8
6
100
4
2
50
0
1995-2000 2001-06 2007-12 2013-18 0
19982000 02 04 06 08 10 12 14 16
AEs EMEs
Bars show the average number of macroprudential
Sources for both charts: Bank of International Settlements
measures per year and per 10 economies in each group
of economies.
What do these actions have in common? What guides the choice of macroprudential policy tools
and their calibration? Is there a unifying framework that articulates success for macroprudential
policy?
There are several reasons why defining a unifying framework for macroprudential policy is more complex
than for monetary policy.
First, the gravitational pull of monetary policy is greater because its performance is easier to monitor. But
whereas the objective of monetary policy-price stability-is readily and frequently observed, the objective of
macroprudential policy-financial stability-is most easily defined in its absence. Financial stability is the
opposite of the financial instability of bust, crises and panics.6
Second, macroprudential policymakers deploy a large number of very different tools in order to address a
wide range of systemic risks.
5
See -
'True Finance Ten years after the financial crisis', speech by Mark Carney given at the Economic Club of New
York, 19 October 2018.
6
While most definitions of financial stability are based on its absence, a positive definition of financial stability would be
the sustainable provision of financial services, and confidence in the financial system to withstand future shocks without
major disruption to those services, where these are integral to the real economy's
pursuit of strong and sustainable
economic growth.
In contrast, in the pursuit of price stability, central banks deploy a handful of policies, primarily changes in
interest rates and purchases of assets, that all relate to the current and future price of money.
Third, the time horizons are different. The costs of macroprudential interventions can be felt today but their
benefits are often realised far into the future.
- -
And fourth, these benefits moderating downturns and avoiding crises are not directly observable. The
bad outcomes that macroprudential policies prevent have to be estimated. But counterfactuals are difficult to
sell: "it could have been worse" doesn't quite have the ring of "you've never had it so good."
All these complexities and uncertainties make it challenging to implement macroprudential policies and
harder to communicate the rationales for them. Over time, and particularly during good times, these
challenges can feed a bias towards inaction. As memories of the last crisis fade, complacency sets in and
pressures to ease policies re-emerge. When it comes to financial stability, success is an orphan.
These tendencies can be exacerbated by similar time inconsistency problems to those that plague monetary
policy. Lighter-touch regulation can be a powerful tool for authorities to boost near-term growth, a temptation
that is reinforced by governments motivated by electoral cycles and the complacency curve of the financial
cycle. In the long-run, the cost of such indulgence is financial and macroeconomic instability, bringing fiscal
strains, lower growth, and higher unemployment.
It is not surprising that across 800 years of economic history, financial crises occur roughly once a decade
(Chart 3).
Chart 3: Financial crises occur with fairly regular frequency
Proportion of countries with banking crises, weighted by share of world income
Sources: Reproduced from Reinhart, C, and Rogoff, K (2013), "Banking crises: An equal opportunity menace", Journal of
Banking and Finance, vol 37(11), pp. 4557-4573
Creating a unifying framework for macroprudential policy can help to break this dreary cycle, guide
policymakers and improve the understanding and effectiveness of macroprudential policy. It can also
promote self-reinforcing behaviour within the private financial sector, just as with credible monetary policy.
And a clearer framework will improve the transparency and accountability of the FPC to parliament and the
people we serve.
IV. Grand Unifying Theory of Macroprudential Policy
The FPC is accountable to Parliament for operating the instruments of macroprudential policy to achieve the
objectives of macroprudential policy, as determined by the Government. Society chooses the ends, and,
within pre-set boundaries, the FPC determines the means to achieve them.
The FPC framework mirrors that of the MPC because of the time-inconsistency problems. The (often) long
lag between boosting growth today and the damage it does in the future makes an even stronger case for
delegating operational responsibility for macroprudential policy to an independent authority than for monetary
policy.
The FPC's responsibilities are encoded in the Bank of England Act and the Chancellor's annual FPC remit
letter.7
The FPC's
primary objective is to identify, monitor and take action to remove or reduce systemic risks with a
view to protecting and enhancing the resilience of the UK's financial system.8
Subject to meeting their primary objective, the FPC has a secondary objective to "support the economic
policy of Her Majesty's Government, including its objectives for growth and employment".
The emphasis on supporting economic growth over the medium to long term is underpinned by the so-called
of the graveyard clause"
"stability in the Bank of England Act, which does not "required or authorised the
Committee to exercise its functions in a way that would in its opinion be likely to have a significant adverse
effect on the capacity of the financial sector to contribute to the growth of the UK economy in the medium or
long term".
The FPC's actions support its secondary objective in
several ways. The FPC minimises the negative impact
of financial stability policies on growth including in the near-term by implementing financial stability policies
targeted
gradually, and by choosing policy tools.
The FPC's remit letter also tasks the FPC with taking actions to promote actively productive finance and
growth as long as these actions do not compromise the primary objective of financial stability. These actions
7
The Chancellor's annual "Remit and Recommendations" letters to the FPC, alongside the FPC's responses, are
available here.
8
The Chancellor's annual remit letter sets out that the ultimate purpose of pursuing this objective is that
"a strong and
stable financial system supports economic growth, facilitates the provision of finance to support the expansion of the
economy's productive capacity and underpins the UK's position as an important global financial centre".
could include those that increase the efficiency of financial services, level the playing field between existing
firms and new entrants, or that support the development of new products and markets.
The FPC's setting of macroprudential policy can be broadly
characterised as minimising the loss function, L:
T
min L ≡ {∑ βi -
Dt [f(G@Rt+i) φyt+i]}
ρt
i=0
where is a policy setting at time t, probability-weights all future states of the world conditional on
πt Dt
β T is the FPC's time horizon, which should be
information available at time t, is the discount factor,
thought of as representing the medium-to-long term, and f′(·) < 0 and f′′(·) > 0.
The FPC's primary objective is captured by the first term, ,
"GDP-at-risk".9 This is the far-left tail of
G@Rt+i
the forecast distribution of GDP, and is a summary measure of the impact of tail risks on the economy.
consequence
GDP-at-risk can be thought of as the of financial instability.10
determined by the economy's trend rate of
is the central GDP forecast, which will over time be
GDPt+i
growth. This will be influenced in the medium to long term by macroprudential policies that impact the
efficiency of the financial system and through it aggregate productivity.
· · · · ·
Comparing the FPC's
objective function with the more familiar monetary policy objective function helps
illustrate the operation of macroprudential policy:
1. The primary objective of the FPC, financial stability, can only be estimated;
Clarity of objectives.
whereas that of the MPC, inflation, can be readily measured. As a consequence, FPC performance
is best judged in the short term by intermediate indicators and drivers of financial stability;
Although both committees are tasked with promoting the government's
2. Impact on growth.
economic objectives subject to achievement of their primary objectives, the MPC has very limited
ability to influence trend growth. The MPC's
trade-offs, when they occur, are to limit excessive short
term volatility in output and inflation, particularly in "exceptional circumstances," circumstances that
only extend modestly the policy horizon. In contrast, the FPC is more likely to face trade-offs
between short term growth and its actions to achieve its primary objective. And the FPC can have
9
The recent interest in this concept is based on work by Tobias Adrian and co-authors (Adrian, T, Boyarchenko, N and
Giannone, D (2019), American Economic Review, 109(4)). For a discussion, see
'Vulnerable Growth', this article by
Steve Cecchetti and Kim Schoenholtz.
10
Throughout this speech, deteriorations / worse outcomes for GDP-at-risk are referred to as when GDP-at-risk is
increasing / high. Conversely, throughout this speech, more favourable outcomes are when GDP-at-risk is smaller / low.
potentially important impacts on longer term trend growth, both because financial crises have
permanent scarring effects and because promoting productive finance can improve longer run
productivity.
3. Time horizon. The time horizon for FPC optimisation is longer than that of the MPC reflecting the
longer duration of the financial cycle, the permanent impact of structural macroprudential policies,
and long-run monetary neutrality. Whereas the impacts of macroprudential policy could easily extend
out a decade; in practice, the relevant time horizon for monetary policy would rarely extend beyond
3-5 years.
Taking these in turn.
1. Clarity of objectives
A term-by-term comparison of the monetary loss function:
H
∗
min ≡ {∑ - π∗)2 + - )2] }
Lt Dt βi[(πt+i λ(yt+i yt+i
T
{rt+i}i=0
i=o
and the macroprudential loss function:
T
min ≡ {∑ βi -
Lt Dt [f(G@Rt+i) φyt+i]}
ρt
i=0
underscores the greater uncertainty inherent in macroprudential policy.
The monetary policymaker's loss function is based on two clearly specified and observable variables -
inflation and output. Monetary policy has a single, quantifiable inflation target, π∗, and while potential output
∗
must be estimated, there are well-developed and reasonably robust methods to do so.
yt
In contrast, the macroprudential policymaker's loss function has no simply defined target -
instead the
policymaker has to make a judgement about when GDP-at-risk is within an acceptable range. GDP-at-risk,
is not directly observable and must be estimated. And optimising for policy, requires estimating
G@Rt+i, πt,
-
G@Rt+i with and without policy, or for different policy calibrations building estimates upon estimates.
The fog of financial stability can be dangerous. A booming economy can give the illusion of lower risk,
feeding assumptions that potential growth is stronger and GDP-at-risk lower. Proving otherwise can be
difficult in the face of inherent uncertainty and growing complacency.
As GDP-at-risk is not directly observable, it must be estimated using intermediate indicators and drivers of
financial stability.11 Bank of England research finds that the indicators with greatest signalling power for
GDP-at-risk are credit metrics, the current account, asset prices and metrics of banking system resilience.12
Chart 4 plots the estimated contribution of these indicators to GDP-at-risk over time. Specifically it shows the
percentile of the estimated forecast distribution of the level of UK GDP in t+3 years' time, conditional on
5th
risks at time t. The focus on 3 years ahead reflects lags between setting macroprudential policy and the full
impact of that policy on GDP-at-risk.
Chart 4: Intermediate indicators suggest UK risks around standard(a)
Sources: Aikman et al., (2019), Bank of International Settlements, UK house price index, Datastream, Office of National
Statistics, Bank calculations. The black line shows that the average 5th percentile GDP draw in the UK historically is 0%
growth. Estimates of GDP-at-risk for any time period t utilise the full series of data available (and not just the data that
would have been available had it been estimated at t).
11
See Aikman, D, Bridges, J, Burgess, S, Galletly, R, Levina, I, O'Neill, C, and Varadi, A, (2018)
'Measuring risks to UK
Bank of England Staff Working Paper No. 738; and Bridges, J, Jackson,
financial stability', C, and McGregor, D, (2017)
Bank of England Staff Working Paper No. 659.
'Down in the slumps: the role of credit in five decades of recessions',
12
See Aikman, D, Bridges, J, Hacioglu Hoke, S, O'Neill, C, Raja, A, (2019)
'Credit, capital and crises: a GDP-at-Risk
Bank of England Staff Working Paper No. 824.
approach',
estimates the whole forecast distribution of GDP in t+3 years' time, conditional on the financial risk
Chart 5
environment. The red area shows the steady growth in GDP-at-risk from 1997 to the crisis.
Chart 5: Risks grew during the Great Moderation but are now standard
[Chart 5 shows the expected distribution of the cumulative change in the level of GDP in t+3 years' time, given the
macro-financial risk environment at time t. Historical distributions are estimated using the full sample of data.]
-
In 1998, the early days of the Great Moderation, GDP-at-risk was benign that is, even in a tail outcome the
level of GDP was expected to be higher three years out. Through the next decade, though central case GDP
grew steadily, risks were gradually building. By 2007 a fifth percentile draw was expected to leave GDP 3.5%
lower three years out.
As the crisis hit, GDP-at-risk shrunk rapidly as risks crystallised. Since then, risks have been relatively stable
reflecting post-crisis balance sheet repair, the implementation of comprehensive macroprudential
frameworks, and relatively subdued economic activity (Chart 6).
Chart 6: Risks grew during the Great Moderation but are now standard
Probability density 0.14
2007 Latest 1997
0.12
0.10
0.08
Risks increasing
0.06
0.04
0.02
0.00
-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14
Cumulative GDP growth over 3 years (%)
[Chart 6 uses same data as Chart 5. For each distribution, shaded area denotes the tail; the line marks the 5th
percentile].
2. Impact on growth
The second set of differences between macroprudential and monetary policy concern the interaction
between their objectives and growth in the short and long terms.
Both monetary and macroprudential objectives apply at all times. The key difference is that the inflation
- loss grows
target is symmetric the monetary policymaker's equally when inflation is either under or over the
target, whereas the macroprudential policymaker's loss function is asymmetric -
increases (ie deteriorations)
in GDP-at-risk are far more costly than the benefits of the reductions in GDP-at-risk.
The relationship between the primary objective of financial stability and the macroprudential policymaker's
loss function can be represented by a decreasing and convex function, f(·). This means the marginal gains
from taking action to protect financial stability grow as GDP-at-risk increases. Conversely, the marginal
benefit from reducing GDP-at-risk falls as tail risks decline.
This is illustrated in Chart 7. Financial risks increase moving along the curve to the right. A policy to reduce
GDP-at-risk (lines A) is more valuable to the policymaker at higher levels of GDP-at-risk (line B) than lower
levels (line C).
The weight the macroprudential policymaker places on the central GDP forecast relative to GDP-at-risk is
also determined by φ ("phi"). φ is analogous to the monetary policy's λ, the weight monetary policymakers
place on output stabilisation relative to inflation stabilisation.
φ is strictly greater than 0, as dictated by the "stability of the graveyard" clause in the Act that the FPC
should not take action detrimental to medium-to-long term growth.13 In its annual remit letter, the emphasis
the government places on this clause, and therefore the FPC's secondary objective, can be thought of as
changing φ. When GDP-at-risk is high and outside an acceptable range, however, the convexity of the f(·)
φ
function dominates and drives the macroprudential policymaker towards an absolute (lexicographic)
preference for financial stability.
13
The Bank of England Act states that the FPC is not "required or authorised to exercise its functions in a way that
would in its opinion be likely to have a significant adverse effect on the capacity of the financial sec