IMF Survey: IMF Explores Contours of Future Macroeconomic Policy

IMF News, February 12, 2010

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Canonical URL: IMF Survey: IMF Explores Contours of Future Macroeconomic Policy

Publication: IMF Survey online, February 12, 2010.
Context: Paper published by the IMF titled “Rethinking Macroeconomic Policy,” part of a series reassessing macroeconomic and financial policy frameworks after the global crisis described as the worst global recession in 60 years.
Authors/Interviewee: Olivier Blanchard, Economic Counsellor of the IMF and head of the Research Department; joined the Fund in 2008 from the Massachusetts Institute of Technology.
Institutional scope: Paper prepared by staff of the 186 member international institution.

Core retained targets:
- Keeping output close to potential and inflation low and stable should be the two targets of policy.
- Controlling inflation remains the primary responsibility of the central bank.
Crisis-driven extensions to the policy agenda:
- Policymakers must watch additional variables: the composition of output, the behavior of asset prices, and the leverage of different participants in the economy.
- Policymakers have more instruments available than before the crisis; the challenge is learning to use them effectively.
Promising routes:
- Combination of traditional monetary policy and regulatory tools.
- Design of better automatic stabilizers for fiscal policy.

Rationale for combining tools:
- “Interest rates are a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals.”
- Specific regulatory instruments are likely to have more targeted impacts than the policy rate on the variables they aim to affect.
Examples of targeted regulatory responses:
- If leverage appears excessive, regulatory capital ratios can be increased.
- If liquidity appears too low, regulatory liquidity ratios can be increased.
- To dampen housing prices, loan-to-value ratios can be decreased.
- To limit stock price increases, margin requirements can be raised.
Institutional implications:
- Traditional regulatory and prudential frameworks need to acquire a macroeconomic dimension.
- Main challenge: trade-off between a sophisticated, fine-tuned system and an approach based on simple-to-communicate triggers and easy-to-implement rules.
- Raises issue of coordination between monetary and regulatory authorities, including whether the central bank should be in charge of both; “the trend toward separation of the two may well have to be reversed.”

Observed behavior:
- In many emerging market countries, monetary authorities describe themselves as inflation targeters but “clearly care about the exchange rate beyond its effect on inflation.”
Policy implication:
- Reconciling practice with theory by thinking of monetary policy more broadly as the joint use of the interest rate and sterilized intervention to protect inflation targets while reducing costs from excessive exchange rate volatility.

Problem identified:
- The crisis showed that interest rates can hit the “zero level,” which is a severe constraint on monetary policy in times of trouble.
Question raised:
- Whether setting a higher inflation target in the future could be justified to provide more room for monetary policy during crises.
Framing and trade-offs:
- Concrete question: “Are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?”
- Recognition of achievement: credible low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets.
- Possible benefit: slightly higher inflation could improve policy maneuverability in crises.

Renewed role of fiscal policy:
- Fiscal policy returned “to center stage” because monetary policy, including credit and quantitative easing, had largely reached its limits, and because the recession was expected to be long lasting.
Importance of fiscal space:
- Countries entering the crisis with high levels of debt and large unfunded liabilities had limited ability to use fiscal policy and face difficult adjustments.
- Some emerging markets that entered the crisis with lower levels of debt were able to use fiscal policy more aggressively without fiscal sustainability concerns.
Revisiting debt targets:
- Suggestion to revisit target debt to GDP ratios; “Maybe we should aim for much lower ratios than before the crisis.”

Problem with discretionary fiscal measures:
- Discretionary measures usually come too late to fight the downturn due to implementation lags.
Recommendation:
- Strengthen fiscal stabilizers that automatically kick in during downturns and have significant impact.
Examples of automatic/triggered measures:
- Temporary tax policies targeted at low-income households.
- Investment credits.
- Temporary social transfers.
- Trigger condition example: a macroeconomic variable crossing some threshold (the unemployment rate rising above 8 percent).

“As the crisis slowly recedes, it’s time for a reassessment of what we know about how to conduct macroeconomic policy.”
“It was tempting for macroeconomists and policymakers to take much of the credit for the steady decrease in cyclical fluctuations from the early 1980s on and to conclude that we knew how to conduct macroeconomic policy. We did not resist temptation.”
“Interest rates are a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals.”
“The trend toward separation of the two may well have to be reversed.”

IMF Survey online, February 12, 2010.