January 23, 2014
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Speech By Naoyuki Shinohara
Deputy Managing Director, International Monetary Fund
Tokyo, January 23, 2014
As Prepared for Delivery
Good morning. It is my great pleasure to be here today to open this seminar on unconventional monetary policy. I would like to thank the government of Japan for its generosity in supporting this event, and Hitotsubashi University for co-organizing it. Let me also extend a warm welcome to everyone here today.
This event is one of several initiatives financed by the Japanese government and administered by the IMF’s Regional Office for Asia and the Pacific, based in Tokyo. It is our strong hope that these initiatives will help to build policy-making capacity and foster greater international cooperation. They also reflect our recognition of the importance of close engagement with this region as its weight and influence in the global economy continue to increase. For all these reasons, I am pleased that so many senior policy makers from Asian countries have joined us today.
Needless to say, the focus of this seminar on unconventional monetary policy is very timely. One high-profile sign of this was Ben Bernanke’s final speech as Fed Chairman where UMP took center stage as he looked back over his term.
The IMF has contributed to this debate in several ways, including through two major papers published last May and September, our multilateral and country surveillance, and seminars. For example, UMP was one of the topics at the high-level IMF Research Conference last fall. Former IMF First Deputy Managing Director Stanley Fischer placed UMP in the spotlight when he said that recent experience with the policy will change macroeconomics textbooks forever. No longer will the zero lower bound be seen to render monetary policy ineffective. It was a statement that resonates even more in retrospect, as Stan has now been named Fed Vice Chairman.
Assessing UMP
This seminar provides an excellent opportunity to continue this discussion. We will hear perspectives from several distinguished speakers. But before beginning, allow me to spend a few minutes summarizing the IMF’s views on UMP by addressing three key questions:
First, has UMP supported financial stability and the global economic recovery?
Second, has UMP helped—or hindered—non-UMP economies?
And third, how should policymakers exit from UMP?
As you will recall, before the global financial crisis, central banks in major advanced economies set monetary policy in the context of established frameworks and stable banking systems. Changes in policy rates were swiftly transmitted to longer-term real interest rates. These affected the real economy through decisions on consumption, saving, and employment. However, the crisis impaired the functioning of markets, jeopardized financial stability, and raised the threat of global depression and deflation.
In response, several central banks in advanced economies adopted unconventional monetary policies with two broad goals. The first was to restore the functioning of financial markets and, most importantly, intermediation. The second was to support economic activity through further monetary accommodation at the zero lower bound. Although approaches differed between central banks, the toolkit included targeted liquidity provision, private asset purchases, and forward guidance.
However, UMP carries a number of serious risks, largely due to monetary policy remaining very accommodative for an extended period. Financial stability may be adversely affected if risk-taking behavior driven by the accommodative monetary policies goes too far. Prolonged asset purchases in the context of UMP may also undermine the credibility of central banks, and by extension inflation expectations. Finally, UMP may be relied upon to do too much, so that the breathing space it offers is not used to enact necessary but difficult structural reforms to raise long-term growth.
Early Effects of UMP
It is difficult to pin down the exact ramifications of these policies, as their impact is not yet fully understood. But we can still say with some confidence that UMP has been effective in supporting the global economy, and the IMF’s assessment so far is positive.
The first positive effect of UMP came early in the crisis when it helped prevent the financial system—and economic activity—from collapsing. Aggressive liquidity provision by central banks to a much expanded set of recipients, and markets successfully restored financial market functioning and intermediation. Here in Japan, the BOJ’s large-scale increase of U.S. dollar liquidity and support of corporate funding markets in 2008 prevented a further escalation of financial sector turmoil and a worsening of the recession.
Early action also reduced the risk of a euro area break up. The ECB’s Long-Term Refinancing Operations avoided massive bank deleveraging and an ensuing contraction in credit. The subsequent announcement of Outright Monetary Transactions significantly decreased bond yields in euro area countries under market stress. This strengthened bank balance sheets and, to some extent, limited potential sovereign-bank linkages.
UMP also supported global economic activity more broadly. In the U.S., the IMF estimates that prior to last year’s market correction, the Fed’s quantitative easing is likely to have reduced long-term U.S. bond yields by over 100 basis points, boosting world output by more than 1 percent.
In Japan, aggressive monetary easing under the Quantitative and Qualitative Monetary Easing framework changed the economic trajectory and inflation has begun to rise, reaching 1.6 percent in November. These are promising signs. But to sustain these gains and revive exports and investment, potent growth and fiscal reforms need to follow. The BOJ has also been a forerunner in using UMP to combat deflation, holding important lessons for others. It shows that once a deflationary mindset takes hold, with consumers putting off spending and salaries starting to decline, it becomes very difficult to break out of this paralyzing cycle. Decisive action is required on a broad range of policies.
Impact on non-UMP Economies
I will now turn to the second question: has UMP helped—or hindered—non-UMP economies? My view is that, on balance, advanced economy policies have also been beneficial for non-UMP countries. I am aware that for some observers, probably including people in this room, this is an open question. But allow me to elaborate more on this point.
Most general equilibrium models suggest that aggressive monetary accommodation in UMP countries in response to a negative shock is beneficial for non-UMP countries. This leads to higher global growth that benefits both UMP and non-UMP countries. In addition, the data shows that non-UMP countries benefit from lower costs of capital and sovereign financing, and higher equity prices.
In a recent paper, we looked in detail at 13 of the largest non-UMP countries, which account for about 40 percent of global output. Capital inflows to these countries, especially in Asia and Latin America, often exceeded their pre-crisis peak.
However, financial stability can be undermined during a prolonged period of capital
inflows and cheap foreign financing. The policy challenges from strong capital inflows can include the possibility of overheating, sharp capital flow reversals, and excessive real exchange rate appreciation.
Without downplaying these risks and challenges, we should bear in mind that the picture is far from simple. For example, while exchange rate appreciation can be a drag on competitiveness, it should be balanced against the positive effect of stronger demand from the advanced economies. There are also potential terms-of-trade gains from higher global commodity prices for commodity exporters.
In the period up to the U.S. Fed’s first explicit talk of tapering in May 2013, non-UMP countries managed fairly well in the face of capital inflows. However, risks eventually begun to emerge in some countries as the cycle started to turn. That said, no country has exhibited widespread or acute macroeconomic or financial instability yet. Banking systems appear to have remained mostly stable. They have maintained adequate loss-absorbing buffers despite rapid credit growth and rising current account deficits in some cases. This is a testament to macroeconomic management before and during the crisis, and the actions these countries have taken to make their financial systems more secure. These actions include macroprudential measures and, in some cases, capital controls. On the whole, countries with stronger macroeconomic and policy fundamentals have done better.
More recently, signs of instability have emerged in some countries and sectors, especially in response to the rising expectations of UMP exit in the U.S. In the months following the Federal Reserve’s initial public discussion of tapering, countries with weaker fundamentals and more open markets exhibited the highest foreign exchange and bond market volatility. This episode is still being closely analyzed, and one of my colleagues will discuss current work at the IMF on this topic.
The Fed’s subsequent decision in September to delay tapering of asset purchases reversed some of the earlier pressure on currencies and bonds. Capital flows into emerging market debt funds restarted in late September. And so far, the first step in the process of tapering—last month’s Fed announcement that its asset purchases would be scaled back—has not had a significant negative impact.
An important question is whether capital outflows from Japan as a result of the Bank of Japan’s recent monetary easing, can help offset slowing inflows to Asia from other regions. The initial evidence is mixed. Capital has indeed left Japan, but so far it has mostly flowed to developed economies and especially into U.S. bond and equity markets. But it may be too early for a definitive assessment. Japanese banks have yet to reallocate their growing reserves at the Bank of Japan, and these could increasingly flow into regional growth markets as Japanese corporations begin to diversify their investments.
Exit from UMP
This brings me to my final question: when the time comes, how should policymakers exit from UMP? It is clear that a safe exit needs to be well planned, well communicated, and contingent on the strengthening of the economy. Those lessons appear to have been taken to heart since last year’s initial reaction.
The transition has already begun, and the day will come when this period of exceptionally loose monetary policy—both conventional and unconventional—will come to an end. If accommodative monetary conditions cause financial stability risks, earlier exit than motivated by inflation and output gap considerations may be warranted.
It is important to emphasize, though, that exit is going to be a long and drawn-out process. It does not start and stop with tapering. Exit from UMP will involve a number of phases, some overlapping. The aim is to return to conventional monetary policy, where central banks determine only short-term rates, and withdraw from the use of balance sheet instruments. But this will happen slowly. Tightening will be more challenging than in the past because of the vast excess reserves created by asset purchases in some countries, as well as the complications from selling such assets. Accordingly, market reactions and the response of economies to tighter financial conditions remain uncertain. This will require some operational complexity and probably innovation.
The IMF has consistently said that exits should be gradual, communicated clearly, and dependent on the pace of the recovery. It is my impression that the Fed so far is managing its tapering in a manner consistent with this view. While exit from UMP is still very likely some way off for the euro area and Japan, I believe that the moment to start planning is now.
For Japan, as long as steady progress is being made toward the 2-percent target, we do not see a need for additional monetary accommodation, but communication will need to focus on managing expectations as it will likely take more than two years. Exit is still far off and would likely be gradual when the time comes. As the BoJ has shifted its asset purchases towards longer-dated securities as well as risk assets, it presents greater challenges for the exit compared to earlier episodes, especially in case debt issuance by the government does not start to decline markedly. A number of tools may need to be used to withdraw liquidity, starting with the automatic roll-off of short-term securities as they mature, slowing the pace of purchases of longer maturity securities, and eventually raising the interest paid on reserves to mop up excess liquidity. After inflation expectations have been anchored at 2-percent in a stable manner, clear communication about the modalities of exit will be essential to contain financial volatility and avoid deterioration in sentiment which could hurt price stability.
Conclusion
In closing, let me reiterate that I am fully aware of the differences of opinion on the points that I have made. I see UMP as part of the solution, but I know there are some who think it is part of the problem.
I expect a rigorous and lively debate on these issues at this gathering. I would be very interested in your views on what the IMF should do. In particular, how can the IMF help emerging markets cope with adverse effects from UMPs by advanced countries, and in particular from their exit? And what should the IMF advise central banks in the advanced economies?
We have an impressive set of panelists to lead our discussions. They come from both UMP and non-UMP central banks. We also have economists from the public and private sectors, as well as leading academics. I am confident that this seminar will usefully enhance our understanding of the issues surrounding UMP. Hopefully, it will strengthen foster policy dialogue and international cooperation. I very much look forward to our discussions.
Thank you.
