This is where macro-prudential policy tools come into play. While the analytic basis and calibration of instruments such as pro-cyclical capital requirements or leverage ratios require further elaboration, the hope is that such measures can contain the accumulation of financial imbalances and vulnerabilities without recourse to changes in short-term interest rates. Monetary policy and macro-prudential policy: two policy instruments and two policy objectives. At least in principle, the Tinbergen problem is resolved. But practicalities stand in the way. As I said earlier, it is immediately apparent that monetary policy and macro-prudential policy will interact in a variety of potentially complex ways, throwing up new challenges for policy-making. Of course, what is required is the “right  24  10  See: J. Tinbergen (1952), On the theory of economic policy, Amsterdam, North-Holland. BIS Review 45/2010  combination” of prudential policies and monetary policy – a combination that simultaneously achieves both price stability and financial stability. How is this combination best achieved? We can draw some important lessons from our assessment of the interaction between monetary and fiscal policy in the past. Attempts to develop an optimal “macroeconomic policy mix” are superficially attractive, but have typically foundered in practice. As the responsibilities of different policy-makers become blurred, their incentive to act appropriately is diluted and ultimately the overall coherence of the policy stance is lost. The institutional framework for monetary policy in the euro area reflects these concerns. The single monetary policy is independent and has been assigned an unambiguous objective of price stability.

A “ratcheting-up” of risk within the banking sector can occur over time, creating increasing vulnerability. 17 Low interest rates also encourage a higher level of leverage. Because financial intermediaries – whether banks, broker-dealers, shadow banks, or hedge funds – finance themselves with short-term liabilities, central bank decisions on the level of short-term rate affect their marginal price of leverage. As a result, the behaviour of financial intermediaries – which, by their nature, have high levels of leverage – can be strongly influenced by even small changes in short-term rates. 18 Low levels of interest rates encourage higher levels of leverage and, as a result, an accumulation of additional risk on bank balance sheets. Through all these channels, a prolonged period of low short-term interest rates can support the accumulation of risks and financial imbalances on the balance sheets of both financial intermediaries and the private sector. These imbalances render the economy vulnerable to financial crises: if confidence evaporates, lenders call in loans, balance sheets contract and a painful readjustment is required, with adverse implications for financial stability and the real economy. In particular, the build-up of leverage within the financial sector may unwind abruptly, leading to a tightening of overall financing conditions. 19 Such thinking sheds light on recent developments in the run-up to the financial crisis. Viewing the impact of globalisation on goods prices as the manifestation of a positive supply shock, we can map this abstract scenario into our experience of the past decade.