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For years leading central banks have focused almost single-mindedly on the control of inflation as the bedrock of economic prosperity. Whether they explicitly pursue an inflation target, as is the practice of the Bank of England, the Reserve Bank of Australia and many others, or implicitly do so, as in the case of the Federal Reserve and the European Central Bank, these institutions carefully monitor price and output trends and have developed elaborate models for setting interest rates, all with the paramount goal of achieving low and stable inflation. As Alan Greenspan testified to Congress in the early 1990s, “The most important contribution the Federal Reserve can make to encouraging the highest sustainable growth the U.S. economy can deliver over time is to provide a backdrop of reasonably stable prices, on average, for business and household decision making.”

In the wake of the financial crisis, however, central bankers are rethinking their goals. Price stability is no longer enough by itself. Indeed, many central bankers now acknowledge that low inflation, and the low interest rates that accompanied it, helped cause the crisis by encouraging banks and investors to take on ever-greater risks in the search for yield — a point many private economists have been making. “I’m on a mission to get people to recognize the important role that monetary policy has played in getting us into this mess,” says Stephen Roach, senior fellow at the Jackson Institute for Global Affairs at Yale University and a former chief economist at Morgan Stanley. The Federal Reserve’s mandate of promoting maximum employment and stable prices “doesn’t cut it when you have low levels of inflation,” he adds. “It biases you to excessively easy monetary policy.”

Now central bankers are going back to the drawing board to modify their approach and take on a new role: guarantor of financial stability. If inflation targeting was all the rage in the 1990s, their new mantra is “macroprudential supervision.” Unlike traditional supervision, which aims to ensure the safety and soundness of specific financial institutions, a macroprudential approach seeks to promote the safety and soundness of the entire financial system and to prevent the kind of meltdown that brought banks low in 2008 and nearly crashed the global economy. To that end, central banks and whiz-kid economists are developing new methods for measuring systemic risk by looking at everything from the amount of leverage in the system to trends in credit spreads to the interconnections and shared positions of banks, brokerages and big investors. Central bankers in the U.S. and Europe admit they have something to learn from their counterparts in developing economies about the use of such old-fashioned tools as limiting loan-to-value ratios for mortgage lenders to cool property markets. The Holy Grail of these efforts is to rediscover the art of central banking as defined by William McChesney Martin Jr., who famously described his task as Fed chairman in the 1950s and ’60s as “taking away the punch bowl just as the party gets going.”

“This is really a revolution in policymaking,” Paul Tucker, the Bank of England’s deputy governor for financial stability and one of the leading proponents of the new-style central banking, tells Institutional Investor in an interview.

This revolution is very much in its early days, though, and faces plenty of obstacles. Consider the goal itself. Financial stability is unassailable in the abstract but devilishly hard to define with any precision. “The great thing about inflation targeting is that you had a clear, quantifiable objective,” explains Charles Goodhart, director of the financial regulation research program at the London School of Economics and a former member of the Bank of England’s Monetary Policy Committee. “You can’t do that with financial stability.”

The notion of strengthening the financial system to enable it to withstand shocks — one of the key planks of macroprudential supervision — is almost universally accepted these days. That concept inspired the recent international agreement on higher capital requirements for banks by the Basel Committee on Banking Supervision, which leaders of the Group of 20 nations endorsed in November.

A second macroprudential plank — leaning against the financial cycle to prevent the buildup of asset bubbles — is much more controversial. Under Greenspan, the orthodox view held that central bankers weren’t smart enough to identify a bubble and should limit their intervention to cleaning up after any bust by easing monetary policy. That stance, known as “the Greenspan put,” is now widely believed to have fostered the buildup of risk leading up to the crisis. Today growing numbers of central bankers say they would rather lean against asset prices than clean up after a collapse, but where and when should they act? Risk grows with leverage, to be sure, but are leveraged buyouts priced at 6 times earnings before interest, taxes, depreciation and amortization a sign of excessive leverage, or LBOs priced at 9 times ebitda? At what rate of growth does a housing price boom risk turning into a bust?

There are no ready rules for answering those questions. That poses a dilemma for central bankers, most of whom are monetary economists used to relying on elaborate econometric models in making decisions. Are these bankers capable of exercising the gut-level judgment about economic growth and asset prices that the new stability role requires? And will they be willing to rein in credit despite the inevitably fierce pressure from politicians, homeowners, investors and others determined to let the good times roll?

“Taking away the punch bowl is going to be hard enough,” says William White, chairman of the economic and development review committee at the Organisation for Economic Co-operation and Development in Paris and former chief economist at the Bank for International Settlements. “Taking away the punch bowl when asset prices are going up and everybody is getting rich and thinks they’re very smart is really tough.”

Central bankers acknowledge the difficulties, both technical and political, that they face in taking on the new financial stability job, but they insist they have no other choice. The cost of the recent crisis in terms of government bailouts, moral hazard, loss of economic output and high unemployment is simply too great to go on with business as usual.

“There has been a fundamental regime shift in terms of the importance to the Fed of taking asset price developments into consideration in the setting of monetary policy,” says William Dudley, president of the Federal Reserve Bank of New York, in an interview in his wood-paneled office at the bank’s palazzo-style building in Lower Manhattan. “There’s more willingness now to be proactive and try to identify these risks in real time, and then do something about it.”

That challenge may seem purely theoretical at the moment. With the U.S. economic recovery losing momentum, unemployment rising, house prices falling and stock prices some 20 percent below their 2007 highs, the idea that the Fed will need to act any time soon to prick an asset bubble seems fanciful. Indeed, the economy is so weak and inflation so low that the central bank has embarked on another round of quantitative easing, in which it will buy up to $600 billion of government bonds in a bid to boost asset prices, confidence and growth. Similarly, Europe’s debt crisis looks likely to forestall any tightening moves by the ECB any time soon.

“Until the economies that were at the center of the crisis have actually recovered, some of the questions about what policies are going to be used are not going to be germane,” says Stephen Cecchetti, chief economist at the BIS.

Yet for many economists, QE2 is all the more reason for the Fed to put greater emphasis on financial stability. The fresh injection of liquidity risks fueling asset price bubbles around the world, if not immediately in the U.S., just as low interest rates earlier this decade helped feed the subprime debacle, critics say. Quantitative easing is “the same prescription that put us into this mess,” says Roach. A macroprudential approach should lead the Fed to be more vigilant about possible bubbles and wind down its unconventional monetary policy sooner rather than later, he adds.

THE CONCEPT OF MACROPRUDENTIAL regulation dates back to 1979, when central bankers gathered at the BIS in Basel, Switzerland, to consider ways to restrain the surge in bank lending to developing countries, especially in Latin America. The idea was to focus on the aggregate exposure of the banking system as a whole rather than on individual institutions. No action was taken, though, and the Latin debt crisis erupted three years later.

The term came back into vogue after the Asian financial crisis in the late 1990s. The International Monetary Fund developed macroprudential indicators — ranging from the banking sector’s capital adequacy and the growth rate of lending to the current-account deficit — designed to provide early warnings of weaknesses in the financial systems of member countries. Major developed economies launched the Financial Stability Forum, a precursor to today’s Financial Stability Board, to focus on strengthening the financial system through improved data collection and regulation. A number of central banks, beginning with the Bank of England in 1996, had begun publishing regular financial stability reports examining everything from market trends to the risks posed by derivatives markets. Many of these efforts remained largely theoretical, though, with few practical consequences for monetary policy or financial regulation in developed economies.

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