Persistent highly accommodative monetary policy in the U.S. raises fears of building systemic vulnerabilities. Federal Reserve board member Tarullo has discussed the use of time-varying macroprudential policy as a means to contain these risks and to allow monetary policy to keep rates low for longer. This policy has many limitations, however.

Monetary policy and financial stability”, Speech by Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, 25 February 2014.
http://www.bis.org/review/r140226a.pdf?frames=0
“Macroprudential Regulation”, Speech by Daniel K Tarullo, September 20, 2013
http://www.federalreserve.gov/newsevents/speech/tarullo20130920a.htm

The below are excerpts from the paper. Emphasis has been added.

“The very accommodative monetary policy that contributed to the restoration of financial stability could, if maintained long enough in the face of slow recovery in the real economy, eventually sow the seeds of renewed financial instability…The actual extended period of low interest rates, along with expectations fostered by forward guidance of continued low rates, may be…contributing to unsustainable increases in asset prices and a consequent buildup of systemic vulnerabilities… A low rate environment tends to squeeze the profitability of financial intermediaries of many types as they reinvest in assets with lower yields. Because these institutions can be driven by a variety of agency and accounting concerns to target high returns or place undue weight on the short-term performance of their portfolios, the pressure to maintain current yield can create incentives for these firms to take on excessive risk. This risk can manifest itself as excessive leverage, or greater credit or duration risk in portfolio choices.” [Tarullo, Feb 2014]

“The limitations of supervision as a tool for managing the risks to financial stability that could arise from protracted periods of low interest rates have intensified interest in time-varying macroprudential policies – that is, measures that can be calibrated to changing economic or financial conditions. The appeal of such requirements is that they could, at least in principle, be adopted reasonably quickly as risks increased, implemented in a straightforward way, and applied to all market actors engaged in the covered activities, not just prudentially regulated firms. A frequently cited example is increased loan-to-value requirements for certain types of lending such as residential or commercial mortgages.” [Tarullo, Feb 2014]

“The idea is to proceed in an intentionally countercyclical fashion by attempting to restrain rapid, unsustainable increases in credit extension or asset prices and to relax those restraints as economic conditions deteriorate…” [Tarullo, Sep 2013]

“There are two obvious places to begin a considered development of time-varying tools.

  • One is in the traditional supervisory oversight of practices at regulated institutions, as enhanced by the increasingly horizontal, interdisciplinary features of large bank supervision. Good supervision is always time-varying, in that it should respond to potential and growing problems in a directed fashion…
  • The second place to work on time-varying tools is found in another element of the new capital regime, the countercyclical buffer provision of Basel III. This provision envisions an increase in the applicable risk-weighted capital requirements of financial companies by up to 2½ percentage points when “credit growth is excessive and is leading to the buildup of system-wide risk….Because stricter capital requirements lead to higher levels of bank equity – which is typically more expensive than debt – they would likely result in higher funding costs for the bank-intermediated credit utilized by other market participants… Although the three federal banking agencies included a countercyclical capital provision in the capital regulation to implement Basel III adopted last summer, the provision will not take effect in the United States until 2016.” [Tarullo, Sep 2013/Feb 2014]
“[Time-variant macroprudential] policies face a number of challenges, including questions about the reliability of measures to guide policy actions, which officials should make macroprudential decisions, the speed with which policies might realistically be implemented and take effect, and the appropriate calibration of policies that will be effective in damping excesses.” [Tarullo, Sep 2014]

“If the measures are designed to be targeted, questions of efficacy may be raised by those who believe that suppression of excess credit or asset price increases in one sector will likely result only in the redirection of credit and speculation to other sectors until underlying macroeconomic and financial conditions have ceased enabling such activities. If, on the other hand, the measures are designed to be fairly broad-based, the more basic question of the appropriate role of monetary policy may be raised by those who are focused on reactive policies that “get in all the cracks” of the financial system, not just the heavily regulated portion occupied by large financial firms.” [Tarullo, Sep 2013]

“[Time-varying macroprudential] policies should be more effective (and perhaps less controversial) in slowing the buildup of excess credit than a measure directed squarely at one sector, which might be quickly met by the redirection of a reach for yield to other asset classes.” [Tarullo, Feb 2014]

Time-varying macroprudential policies could not be viewed as a substitute for monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of transactions and, as such, would not “get in all the cracks” of the financial system…Discussion has considered the ways in which existing supervisory authority and new forms of macroprudential authority may allow monetary policymakers to avoid, or at least defer, raising interest rates to contain growing systemic risks… I believe these alternative policy instruments have real limitations.” [Tarullo, Feb 2014]