Macro-prudential policies & the Great Moderation 2.0

Macro-economic volatility has decreased substantially from the mid 80s onwards in a large number of economies. This period of reduced macro volatility was termed the Great Moderation. However, during the financial crisis GDP growth plummeted and inflation evaporated just to rebound thereafter amid massive fiscal and monetary easing. This lead macro volatility higher and stopped the talk of the Great Moderation. However, as of late volatility in a large number of economic data – most notably growth and inflation – has decreased again. This is shown in the chart below for US real GDP growth. There are a number of reasons for a more stable growth development, most notably that modern economies are far less dependent on the very cyclical and volatile manufacturing sectors but more dependent on less cyclical and less correlated services sectors (for example, education and healthcare). Moreover, inventory management has also been a key factor in determining macro-economic volatility. During good times, manufacturers and retailers increase their inventories, thereby leading to even higher growth. During bad times, though, they want to reduce inventories and as a result, production needs to be decreased by more than demand has fallen, aggravating the downturn. Nowadays, however, more manufacturers use just-in-time management methods and are used to lean inventories. As a result, this also reduces macro-economic volatility (and again services are less volatile as services can not be stored and hence there is no inventory problem). Additionally, the state has a larger role within the economy than during previous periods and tends to act as an economic stabiliser. Finally, the monetary policy enviornment has changed as central banks increasingly focused on providing for a stable enviornment via the adoption of inflation targets. As central banks have become more credible in securing a low inflation environment, inflation expectations and therefore also inflation has become more stable (and inflation tends to be more stable at low levels anyhow).  

US GDP and rolling standard deviation: increased stability after the Financial Crisis 

Source: Bloomberg, ResearchAhead

These factors are all still in existence and hence this should be seen as the main reason why the environment of low macro-economic volatility has re-established itself. What is more though, nowadays there is one additional element at play as a means to prevent another financial crisis: the increased usage of macro-prudential policies. The aim of such policies is to manage systemic risks within the banking sector as well as the broader economy. It thereby should lower the probability of another devastating financial crisis. Mostly, it is expected to do this via preventing the build-up of new excesses in certain regions or sectors. As an example, facing a credit-fuelled house price surge, the macro-prudential regulator would for example demand higher capital buffers or reduce the maximum allowed loan-to-value ratio. This should ease rampant credit growth and should thereby stabilise the housing market. 
For overall economic growth it means that it should be somewhat lower than would otherwise be the case. Furthermore, the central bank does not need to take care of regional or sectoral excesses. Combined with a more subdued growth rebound it can refrain from hiking rates for longer. Or put differently, the central bank does not need to raise rates in order to break the neck of a housing boom (and thereby killing the economy) but can instead focus on the overall economic developments. In this case, it should also take longer for inflationary pressures to materialise amid an overall less pronounced growth recovery. On the other side, if a downturn hits, it should also be milder and shorter as the previous excesses were smaller and there are more instruments available (easier capital rules, lending standards) to counteract the downturn than was the case in earlier business cycles. 
As a result, the introduction of macro-prudential policies should help to lower macro-economic volatility further and serves as a partial substitute for traditional monetary policy. This can be seen with the example of Switzerland. The Swiss National Bank introduced a floor in the EURCHF rate in 2011 in order to prevent a strong currency from driving the economy into a deflationary recession. However, doing so meant giving up implementing an independent monetary policy. Effectively, the SNB can not hike rates for as long as the ECB does not hike rates or it needs to give up on its exchange rate target. The resulting loose monetary policy environment (zero rates and aggressive balance sheet lengthening) provided fuel to an already existing housing market upturn. In order to slow down the housing market, the Swiss government has – on the request from the SNB – increased banks' counter-cyclical capital buffers for mortgages for the second time in January this year. This measure should promote a less loose environment in the mortgage market while at the same time allows the SNB to conduct its easy monetary policy for the broader economy for longer. 

For markets, the lower macro-economic volatility should be mirrored in lower financial market volatility across asset classes. Moreover, the volatility of central bank rates should drop even more as in those currency areas where macro-prudential policies play a more important role, policy rates need to be changed by less. This also means that respective central banks can wait longer before they revert to rate hikes.This all argues in favour of carry and of less liquid products across financial markets as well as for an environment of lower risk premia and flatter curves than at similar stages during previous business cycles.