Monetary Policy Will Never Be the Same
IMF Blog, November 19, 2013
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- Authors: Olivier Blanchard
- Published: November 19, 2013
Overview and context
- Author: Olivier Blanchard
- Date: November 19, 2013
- Context: Reflections following an IMF research conference in honor of Stanley Fischer on lessons from the crisis.
- Two preliminary non-monetary policy conclusions highlighted:
- Having your macro house in order pays off in an external crisis; prudent pre-crisis fiscal policy gave emerging market countries room to pursue countercyclical fiscal policies during the crisis.
- Rapid cleanup and recapitalization of banks after a financial crisis is essential; the US recapitalization helped recovery, whereas Japan’s failure to do so in the 1990s was costly.
Liquidity trap: evidence and implications
- Key observations:
- The zero lower bound can be binding and persist for a long period — "five years at this point."
- Unconventional monetary policy can systematically affect term premia and bend the yield curve through portfolio effects.
- Compared to conventional policy, the effects of unconventional monetary policy are "very limited and uncertain."
- Counterfactual / quantitative illustration:
- If inflation had been "2 percentage points higher" before the crisis:
- The best guess is inflation would be "2 percentage points higher today."
- The real rate would be "2 percentage points lower."
- The United States would "probably be close ... to an exit from zero nominal rates today."
- Risks and scenarios:
- Possibility (as raised by Larry Summers) that economies may need "negative real rates for a long time."
- Negative real rates can be achieved through "low nominal rates and moderate inflation."
- Current danger: an adverse feedback loop where depressed demand → lower inflation → higher real rates → even more depressed demand.
Liquidity provision: lender of last resort and sovereign risks
- Lessons:
- Runs are relevant not only for banks but also for other financial institutions and for governments.
- In an environment of high public debt, rollover risks cannot be excluded.
- Policy implication:
- Essential to have a lender of last resort ready to lend not only to financial institutions but also to governments (theme emphasized by Paul Krugman).
- Supporting evidence:
- The behavior of periphery sovereign bonds in the Euro area, before and after the European Central Bank’s announcement of outright monetary transactions, supports the importance of a lender of last resort.
Capital flows and exchange rate policy in emerging markets
- Preferred broad approach:
- Let the exchange rate absorb most—but not necessarily all—of the adjustment to volatile capital flows.
- Standard argument (stated by Paul Krugman): if investors withdraw funds, allow them to exit; depreciation will likely increase exports and output.
- Traditional counterarguments against relying on exchange rate adjustment:
1. Depreciation can harm domestic balance sheets where borrowers have foreign-currency debt, reducing domestic demand possibly offsetting export gains. 2. Nominal depreciation may translate into higher inflation. 3. Large exchange rate movements may disrupt the real economy and financial markets.
- Empirical reassessment based on recent crisis experience:
- The first two concerns are "much less relevant than they were in previous crises" because of:
- Macroprudential measures.
- Development of local currency bond markets.
- Exchange rate flexibility improving borrowers' perception of exchange rate risk, reducing foreign exchange exposure.
- Increased credibility of monetary policy and inflation targets, better anchoring inflation expectations and limiting pass-through of exchange rate movements to inflation.
- The third concern (disruptions from large exchange rate movements) remains relevant.
- Policy practice and tools:
- Many emerging market central banks use a "managed float" rather than full float:
- Joint use of the policy rate, foreign exchange intervention, macroprudential measures, and capital controls.
- Rationale:
- Avoids the dilemma where the policy rate is the sole instrument: raising the policy rate to counter capital inflows can itself attract more foreign investment.
- Foreign exchange intervention, capital controls, and macroprudential tools can, in principle, limit exchange rate movements and financial disruptions without relying solely on the policy rate.
- Experience during the crisis:
- Countries employed combinations of these tools; some relied more on capital controls, others more on foreign exchange intervention.
- Evidence from the conference and IMF work suggests these tools have "worked, if not perfectly."
- Research and policy challenge:
- The "clear (and quite formidable) challenge" is to understand how best to combine these tools going forward.
Conclusions and research agenda
- Core conclusion: "Monetary policy will never be the same after the crisis."
- The conference clarified how monetary policy has changed and identified focal points for future research and policy:
- Preventing and mitigating liquidity traps, including rethinking inflation targets and the role of negative real rates.
- Strengthening frameworks for liquidity provision, including lender-of-last-resort capacity for sovereigns.
- Refining the use and combination of policy rate, foreign exchange intervention, macroprudential measures, and capital controls to manage volatile capital flows while limiting disruptions.
Olivier Blanchard — "Monetary Policy Will Never Be the Same," November 19, 2013.
Content in this bundle
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013
- Currency Regimes, Capital Flows, and Crises
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013
- 14th Jacques Polak Annual Research Conference; November 7–8, 2013