Developing Ajello et al’s (2016) approach, the authors study an economy in which policymakers face a trade-off between stabilising inflation and output today versus keeping a lid on financial stability risks which threaten a crisis tomorrow. The optimal strategy is to adjust the CCyB in line with forward-looking indicators of crisis risk – credit growth in their model – but to relax (tighten) the CCyB relative to this plan if output is below (above) its target level. This strategy dramatically improves the inter-temporal trade-off facing a policymaker relative to the case where monetary policy is the only tool (Chart 23). Indeed, this is consistent with the Bank of England MPC’s guidance that monetary policy should be the ‘last line of defence’ in the presence of financial stability risks (Bank of England (2013)). The dashed lines show the steep trade-off facing a policymaker with a monetary policy tool only. Attempts to reduce the crisis probability with higher interest rates entail significant costs for current output and inflation. The solid lines show how this trade-off improves when the CCyB is added to the instrument set, even under conservative assumptions about the impact of the CCyB on the economy’s productive capacity. The variation in the CCyB required to deliver these benefits can be large. Given the historical distribution of shocks, the standard deviation of the CCyB is around 2 percentage points. A final strand of the literature has analysed whether the presence of macroprudential policy gives rise to coordination problems with monetary policy.

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