Navigating Monetary Policy in the New NormalSpeech by Christine Lagarde at the ECB Forum on Central Banking
Monetary Policy in a Changing Financial Landscape
May 25, 2014
As prepared for delivery
Good evening. I would like to thank Mario Draghi for inviting me to address you tonight.
I am delighted to be here, at the first ECB Forum on Central Banking, in the company of leading thinkers and policymakers in the field.
Victor Hugo once said: “Emergencies have always been necessary to progress. It was darkness which produced the lamp. It was fog that produced the compass. It was hunger that drove us to exploration. And it took a depression to teach us the real value of a job.”
The theme for this Forum is highly topical. The crisis has challenged many of our premises, pushed us outside of our comfort zones, and dramatically altered the landscape for monetary policy. There is immense interest—including across the membership of the IMF—on what the contours of monetary policy will be in a post-crisis world.
Portugal could not be a better venue for such endeavor. Standing on these shores—at the edge of Europe’s frontier before the vast Atlantic, naturally makes you want to explore. Just as it must have been in the 15th century, when brave adventurers like Vasco da Gama wondered what might lie ahead—monster or wonder?
Today again, Portugal looks ahead. It is successfully completing its economic reform program after significant effort and determination. Now, beyond the immediate fire-fighting, it begins to turn the corner of the crisis and build on the gains it has made.
Today, I too would like to look ahead—to the future of monetary policy after the crisis, once economic conditions have settled down to something more “normal”. How do we navigate these seas?
The IMF, along with others, has been thinking hard about this. We are in constant dialogue with central banks of our membership through our regular surveillance, as well as collaboration on more targeted projects. My discussion today draws on the lessons and expertise gained from engaging with this global membership.
It also draws on more recent work that tried to focus the debate on the key questions that monetary policymakers must contend with. We have surveyed the coast-line: how far we can go based on what we know, and how much more there is still to explore—the terra incognita. Key questions need to be answered before we can chart our course with certainty.
In that spirit, I would like to share some of our thinking on three main themes:
(i) The evolving mandate of monetary policy;
(ii) Monetary policy independence, given a possibly wider mandate for central banks; and
(iii) The impact of growing financial interlinkages and the challenges these pose for monetary policy, particularly in emerging market and small open economies.
1. The Evolving Mandate of Monetary Policy
Let me begin with the mandate of monetary policy, which is being revisited from various angles.
A key issue here is whether monetary policy should also include financial stability as an objective? Of course, one could also ask whether monetary policy should put more weight on growth, or unemployment. The crisis reminded us that price stability is not always sufficient for output stability. But we need to prioritize, especially before dinner! So I will focus on financial stability.
Let us look at what we know. Broadly, the pre-crisis consensus was that monetary policy should focus on maintaining price stability—understood as low and stable inflation. Price stability, together with “light touch” microprudential regulation, was supposed to also deliver financial stability. Remember, the prevailing belief was that financial markets were resilient.
There was no agreement that monetary policy should “lean against the wind” to fend off surges in credit or asset prices. However, in the case of a crisis, monetary policy would ‘lend a hand’ by cleaning up after the event—such as by lowering interest rates.
The 2008 global financial crisis challenged these basic tenets. It is very clear now that financial crashes can be extremely costly, and their clean-up excessively long and complex.
The crisis has also made clear that financial stability is an essential policy objective, and one that is here to stay. But should that job be given to monetary policy?
The best outcome would be to have dedicated policies and instruments to combat financial risks directly. In the toolkit, these are prudential policies, both macro- and micro-prudential measures, such as loan-to-value limits or countercyclical capital buffers.
Yet, prudential policies may not work as planned. There is relatively limited experience with full-fledged macroprudential frameworks, especially in advanced economies. We do not have a definitive guide. Like the precursor to the chronometer, measuring longitude was an imprecise science.
The IMF’s surveillance experience tells us that in some cases, macroprudential measures have worked well. Take the example of Korea, which was able to reduce banks’ short term external debt by half—to 27 percent—between 2008 and 2013, or Hong Kong which recently saw property prices level off and loan-to-value ratios decline.
Yet, in other countries, such as Israel, Switzerland and Turkey, credit growth and house price inflation remained high despite various macroprudential measures.
What if prudential policies still have shortcomings, despite our best efforts to make them work? In that case, monetary policy may need to lend a hand in securing financial stability, by using interest rates to lean against the wind of emerging financial imbalances.
This is easier said than done. Monetary policymakers will be confronted with a set of new and complex questions.
The first is about the transmission mechanism. Do we know, for instance, how much a 100 basis points increase in interest rates can deliver in terms of financial stability? Do we even agree on how to define financial stability? Should we measure it in terms of credit growth, asset price growth, or leverage?
And what is the link between financial stability and inflation? The current environment in the euro area is a sobering reminder of how weakness in balance sheets can constrain the ability of banks to support credit and investment—ultimately contributing to low inflation.
The second set of questions is about the operating framework, and how financial stability concerns manifest themselves in monetary policy decisions. A delicate tradeoff can arise between raising interest rates to reduce financial stability risks—and lowering them to support growth and inflation. In Sweden, for example, given that financial stability risks are on the rise again, there is less tendency to lower interest rates despite very low inflation.
In sum, we need to continue to strive for improved prudential frameworks for the financial sector so as not to overburden monetary policy. But where macroprudential policies fall short, monetary policy will have a larger role than in the past to maintain financial stability.
2. Monetary Policy Independence, Given a Wider Mandate
Let me now turn to my second theme. If we accept that central banks could have a wider mandate—that is, to help maintain financial stability—and more instruments, can they remain fully independent?
To frame this debate, let us consider the merits of central bank independence.
Looking back, we know that central bank independence has served us well. There is a strong relationship between independence and inflation performance—a relationship that is empirically well-grounded.
Yet, central bank independence cannot be taken for granted. It takes a great deal of confidence to surrender a considerable amount of sovereign power to an unelected body. Though once the decision to delegate is taken, it can go far. Think of the Bundesbank and the remark made by former European Commission president Jacques Delors in 1992: “Not all Germans believe in God, but they all believe in the Bundesbank.”
So, what are the foundations of central bank independence? Credibility and accountability—both of which rest on three pillars: a clear mandate, consistent performance, and consensus on objective.
First pillar: clear mandate. There should be no ambiguity about the objective, instrument, or transmission mechanism of monetary policy.
Second pillar: consistent performance. The public and the government need to be convinced of the central bank’s willingness and ability to deliver on its objective.
Third pillar: consensus on objective. There is widespread agreement that low and stable inflation is crucial for economic stability and growth.
Naturally, independence also finds roots outside of the monetary policy framework and institutional structure. Importantly, a responsible fiscal policy is essential to avoid the risk of fiscal dominance.
How would an additional financial stability objective for central banks fare in terms of these criteria? Frankly, it would likely fail on all three counts.
First, the objectives, targets, and instruments of financial stability are still ill-defined.
Second, performance is hard to measure. Financial stability is difficult to observe. Often it takes a crisis to uncover just how unstable the financial system had become. By then, it is too late.
And third, while most people would agree that financial stability is desirable, the path to that objective might encounter conflict and resistance. The general public wins if there is financial stability, but certain groups may stand to lose. Think of a young couple who would find it harder to purchase their first house because of lower loan-to-value limits. They are not likely to cheer for this type of policy any time soon.
So how do we go about factoring financial stability into central banks’ mandates? What kind of institutional framework is needed when macroprudential policies are added to the mix?
For one thing, we need an institutional structure that protects the achievement of price stability. In other words, a structure that guarantees that monetary policy will continue to focus on price stability; that it is still able to rest on its three pillars; and that it is operated independently.
It is too early to draw out best practices from cross country experiences. But there are already some promising approaches. One way to do this is to house the monetary and macrorprudential policies in different institutions. This is the approach that countries such as Australia, Chile and Mexico have taken. In such cases, committees were created to facilitate information sharing and policy coordination.
It is also possible to house monetary and macroprudential policies under the same roof—in the central bank. In this case, safeguards are needed to protect the independence of monetary policy. The ECB—which is tasked with certain aspects of macroprudential policies—and the Bank of England are good examples, with responsibility for both monetary and macroprudential policy, yet distinct governance structures for the two areas.
3. Monetary Policy Independence in Emerging Market and Small Open Economies
This brings me to my third and final theme. In a world of growing and increasingly complex financial interlinkages, how can emerging market and small open economies retain monetary independence? In other words, how can they cope with the challenges posed by large and volatile capital flows?
The crisis has intensified the debate about these issues. Large swings in capital flows, with sudden surges and stops, often come with large movements in asset prices and exchange rates. In several countries, these flows led to a build-up of financial vulnerabilities—be it through credit booms or increased leverage.
Think of the strong appreciation of currencies while monetary policy was being loosened in advanced economies between January 2009 and May 2013—nearly 50 percent in New Zealand and Australia, and 30 percent in Chile. The picture reversed between May and August 2013, with currency depreciations of nearly 15 percent in Brazil, India and Uruguay.
Or think of the increase in non-resident holdings of domestic currency government bonds in Uruguay. In a little over a year, these holdings surged from 2 percent to 45 percent of the outstanding stock in May 2013. These are very real challenges to any policymaker.
The crisis also raised awareness about the policy trade-offs caused by spillovers. In many countries, policymakers were caught between a rock and a hard place: raising interest rates to tame inflation, only to find that it stoked capital inflows and further appreciation. Exchange rate flexibility was also not a panacea, as exchange rates often ‘overshot’ on both ends of the capital flow cycle.
How can we mitigate these risks? We see three potential approaches: resilience, response, and cooperation. These are not mutually exclusive. Let me elaborate.
The first is to enhance resilience to shocks. This requires policy action in both advanced and emerging economies.
IMF analysis suggests that the recent volatility in emerging market economies reflected both external and internal factors. Advanced economies can help reduce volatility by communicating clearly the course of their monetary policy.
By the same token, good fundamentals also matter. There is no short cut or substitute to sound policies in fending off excessive volatility. Reducing vulnerabilities and reinforcing macroeconomic and financial frameworks should be the order of the day for emerging markets—and indeed for all countries.
The second approach is to respond using the full policy toolkit. This means not just monetary and exchange rate policy, but also macroprudential and fiscal policy. In some cases, capital flow management and foreign exchange intervention may be appropriate to contain financial instability—but they should not substitute for necessary macroeconomic adjustment.
In fact, several countries such as Brazil, Uruguay and Indonesia, used some form of capital controls to discourage short term inflows. Other countries, such as India and Peru, intervened directly in the foreign exchange market. These policies helped limit excessive volatility. And as long as they remain targeted and temporary, these policies are not expected to take the steam out of needed adjustments.
Even so, a broader question abides—about the type of world we would live in.
If policies are viewed only from a national perspective, we may end up in a world of ad hoc intervention, less rebalancing, and the potential to export financial instability. This would be a world of possibly large welfare losses in many countries, with not just spillover effects—from advanced to emerging market economies, but also “spillbacks”—feedback effects from emerging market to large advanced economies.
Is this the kind of world we want to live in? I would hope not.
This would make the third approach a more compelling course of policy—that of international monetary policy cooperation. I know that this topic has some very vocal skeptics, but also very ardent supporters. As you can imagine, I am a bit biased and I would ask the skeptics to keep an open mind.
As the crisis has taught us, in times of distress, the potential gains from cooperation can be huge. Cooperation essentially reduced the risk of tail events with large international feedback effects.
Think of the coordinated cut in policy interest rates in key countries at the height of the crisis, or the swap arrangements that the Fed instituted with other major central banks. These actions helped preempt financial market dislocation across the globe. The G-20 agreement on expanding the IMF resources is another example where the gains from cooperation were clear.
That said, as we turn the corner of the crisis and conditions normalize, the case for cooperation becomes less compelling. Why? Because there is less urgency, and less clarity, about the gains from monetary policy cooperation in normal times.
But it is precisely this uncertainty that would make us remiss in discounting the gains from cooperation in a post-crisis world. We need a concerted effort to examine the effectiveness of cooperative policy responses, their spillover effects, and their global welfare implications—also in light of the evolution of the financial system.
The IMF can contribute to this effort—directly through our surveillance work and cross-country analysis, and in collaboration with other central banking and academic communities on joint projects.
Let me conclude.
We are here today as part of a global intellectual effort to define the contours of monetary policy in a post-crisis world. In this new environment, several of the basic principles of monetary policy are well worth keeping; others need to be revisited. In that respect, I recognize that I have raised more questions than answers. But I believe the questions are important.
What I can tell you definitively is that the IMF is committed to advancing the frontiers of this debate—this new world for central banking. An example of this is the new lecture series on monetary policy that we have launched in honor of Michel Camdessus—the Fund’s longest serving Managing Director and, before that, Governor of the Banque de France. I am delighted that Janet Yellen has agreed to share her insights at the inaugural lecture on July 2. I hope we can all meet again then.
That meeting—and the meeting tonight—are like islands, where we can congregate to compare notes and maps, as we set sail through uncharted waters.
Like Vasco da Gama, a new age of exploration has begun. Let us navigate together.