Macro-Financial Risk Management: The Dual Roles of Counter-Cyclical Macro-prudential and Fiscal Policies

• Central Bank rules provide “in-built brakes” against excess credit growth and unsustainable house price levels
• High levels of public and private debt make the Irish economy vulnerable to future interest rate rises and upside shocks from overheating risks
• House price risks not a one-way bet – expansions in housing supply and tighter funding conditions may restrain future house price developments

The Governor of the Central Bank of Ireland, Philip R. Lane, today outlined his assessment of the economy, focusing on the importance of macro-financial risk management. The remarks were made ahead of an economics roundtable hosted at the Central Bank’s Docklands Campus. The Governor’s annual pre-Budget letter to the Minister for Finance was also published today .

Governor Lane said that despite the strong pace of economic recovery, risks to growth remain, including a legacy of high public and private sector debt, vulnerability to international shocks and Brexit. In the opposite direction, policymakers must also be prepared to address overheating pressures, if upside risks dominate.

He discussed the role of the Central Bank in maintaining financial stability, noting “the bedrock of our macro-prudential policy framework is formed by the borrower-based measures introduced in relation to mortgage loans.”

The Governor said: “While rising incomes, low interest rates, high rents and post-crisis adjustment dynamics are currently contributing to significant house price pressures, the prospect of future expansion in housing supply should restrain house prices over the medium term. In particular, an expansion in the housing stock would simultaneously relieve pressure in both the rental and home ownership categories.

“The highly-open nature of the Irish economy means that income and employment levels are highly sensitive to external shocks. For instance, slowdowns in global output growth, major currency movements, adverse shifts in international trading regimes and a tightening in funding conditions could trigger a reversal in the currently benign growth and employment environment. Given these considerations, there are no one-way bets in the housing market and our macro-prudential framework is fundamental to mitigating these risks.

“Our commitment to an annual review process ensures that a rigorous evaluation of the mortgage measures is conducted each year, such that indicators of a combination of excess credit growth and unsustainable house price levels can be met by a revision in the rules. Given this policy regime, participants in the housing market can be confident that the feedback loop between credit growth and house prices will no longer operate in an unbounded fashion.”

In relation to fiscal stability Governor Lane welcomed the government’s commitment to maintain a long-term debt target of 45 per cent of GDP, but cautioned: “The underlying size of the Irish economy (as captured by GNI*) is about one-third smaller than GDP, such that a debt ratio of 60 percent of GNI* maps to a debt ratio of 40 percent of GDP. The volatile nature of the Irish macro-financial system and the history of crises suggests a debt target that should be materially below the appropriate level for a larger, more stable economy.

“In relation to the cyclical budgetary stance, the pursuit of macro-financial stability requires that the government runs a counter-cyclical fiscal policy. The development of a counter-cyclical fiscal strategy should also strike the balance in the allocation of surplus revenues between the proposed rainy day fund and reducing the gross stock of public debt. In addition to ensuring that the fiscal balance is set at a cyclically-appropriate level, the government can use additional tools to mitigate overheating pressures, including the deployment of cyclically-varying expenditure taxes.”