Two Trilemmas for Monetary Policy
IMF News, July 24, 2017
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Bibliographic details
- Published: July 24, 2017
Context and recent historical background
- Speech delivered at Bank Negara Malaysia Conference on “Monetary Policy 2.0?” by Maurice Obstfeld, July 24, 2017.
- Key historical markers cited:
- "Next month, August 9 will mark the tenth anniversary of BNP Paribas’ suspension of three of its funds holding U.S. subprime-related assets."
- The Federal Reserve "emerged from years at the zero interest-rate bound only in December 2015 and has slowly carried out three subsequent rate hikes."
- The Bank of Japan "pegging the 10-year bond rate at zero" as part of its unconventional package.
- IMF April World Economic Outlook projections referenced:
- Global growth projections placed at "3.5% for 2017 and 3.6% in 2018."
- Regional growth and inflation snapshots:
- Emerging and developing Asia described as "the world’s undisputed growth leader," with growth "well above 6% for China, above 7% for India, and at about 5% for the ASEAN-5 countries."
- April WEO forecast for developing and emerging Asia: "somewhat over 3% inflation" on average, with higher inflation in India and lower inflation in Thailand.
- Sources of uncertainty and downside risks highlighted:
- Downward trend in productivity growth.
- Possible volatility as the Federal Reserve normalizes.
- Repercussions of possible ECB monetary policy shifts.
- A more abrupt than expected economic rebalancing process in China.
- The "elephant in the room"—a turn away from multilateralism toward inward-looking or protectionist policies.
Two trilemmas and their implications
- Monetary trilemma (basic insight invoked):
- With free capital flows, independent monetary policy is possible through exchange rate flexibility; "exchange-rate flexibility is central to the channels of transmission" from main financial centers.
- Floating exchange rates "provide extra monetary policy space but do not offer complete insulation from foreign shocks."
- Financial trilemma (Dirk Schoenmaker formulation, three-way constraint):
- Only two of the following three can coexist at the same time:
1. Sole national responsibility for financial policy. 2. International financial integration. 3. Financial stability.
- The euro area crisis is cited as a "poster child for the financial trilemma."
- Consequence: national prudential policies "cannot be fully effective when capital markets are open to cross-border transactions," even with flexible exchange rates.
- Policy implication: the financial trilemma "provides the main rationale for a globally collaborative international reform agenda."
International monetary system (IMS) and financial stability considerations
- Historical evolution:
- Bretton Woods assumed restricted international capital mobility and heavy domestic financial regulation; as capital mobility and domestic liberalization increased, finance and financial stability issues re-emerged at the center of IMS concerns.
- By the eve of the GFC, "global capital flows had reached very high levels," signaling stability risks.
- Reframing of IMS analysis:
- "Implications of IMS arrangements for international financial stability are as important as the classic macroeconomic questions."
- New economic models and distinctive regulatory tools (in particular, macroprudential tools) are needed to analyze and address these implications.
- Role of the IMF:
- The IMF "now plays a central role within that multilateral framework" of international financial collaboration.
Evidence on macroprudential tools and cross-border spillovers
- Two strands of empirical literature:
1. Micro (bank-level) studies:
- Example: Using UK bank-level data, Aiyar, Calomiris, and Wieladek find bank-specific capital requirements "dampened lending by domestically regulated UK banks, but resident foreign branches increased lending in response to tighter capital requirements on a relevant reference group of domestically-regulated banks."
2. Cross-country studies:
- Example: Cerutti, Claessens, and Laeven (up to 119 countries) find:
- Macroprudential tools "have an economic effect on financial variables, but subject to some cross-border offsets."
- Effects are "less powerful in financially more developed and open economies."
- Deployment "comes with greater cross-border borrowing, suggesting possible avoidance."
- Policy responses to avoidance and spillovers:
- Possible measures include adapting financial-sector regulations, seeking foreign reciprocity, or adopting capital flow management tools (CFMs).
- The IMF is "currently analysing the interaction of CFMs and MPMs in the light of its Institutional View on CFMs."
Implementation considerations for macroprudential policy
- Benefits of having multiple instruments:
- A "portfolio of instruments is more likely to 'get in all the cracks'." (Paraphrasing Jeremy Stein and invoking Bill Brainard’s argument on instrument uncertainty.)
- Multiple tools permit more precise targeting of negative externalities and market failures, potentially limiting collateral damage.
- Limitations and trade-offs:
- Effectiveness of tools "is not uniform or always certain," and cross-border avoidance is important.
- When instruments are insufficient, "nasty trade-offs can come to the fore," increasing the importance of international cooperation.
- Institutional design:
- Macroprudential policy is "even more heavily subject to political pressures" than monetary policy; adherence to global frameworks can create a "precommitment technology" that supports credibility and transparency.
International cooperation and regulatory architecture
- Historical and ongoing cooperation:
- The Basel Committee on Banking Supervision has engaged with the financial trilemma since 1974.
- Basel III includes "jurisdictional reciprocity in the application of countercyclical capital buffers" to raise the effectiveness of domestic macroprudential tools.
- The Financial Stability Board extends international cooperation to the non-bank financial sector.
- Benefits of international agreements:
- They can reduce dynamic inconsistency and enhance credibility in macroprudential policymaking.
- Global frameworks "may promote transparency in macroprudential policymaking" and limit destabilizing discretion.
Role of monetary policy in pursuit of financial stability — six precepts
- Maurice Obstfeld’s six precepts on monetary policy and financial stability:
1. "Price stability is a prerequisite for financial stability – there is no trade-off." 2. A clear linkage between monetary policy decisions and inflation developments is essential; diluting this link with hard-to-communicate financial considerations would be "confusing and dangerous." 3. "The quantitative impact of interest rates on financial-market excesses is quite uncertain." Monetary policy “gets in all the cracks,” but reliance on it for financial stability is contested. 4. "Flexible exchange rates not only aid in the pursuit of domestic price stability, they do provide some degree of insulation from foreign financial (as well as monetary) shocks." 5. Financial stability "should be addressed directly through regulatory tools, including macroprudential measures," such as limiting currency mismatches that can undermine exchange-rate flexibility. 6. In open economies, "financial stability policy can be more effective with the benefit of multilateral regulatory coordination and cooperation," which can also reduce destabilizing discretion in macroprudential policy.
Final observations and policy takeaways
- Monetary policy oriented toward medium-term price stability "remains a necessary condition for overall economic stability" but is not a sufficient condition in the wake of recent crises.
- Continued vigilance, sound country-level policies, multilateral efforts, and "more and better research on the ways policies and policy spillovers can hurt or help" are required.
- International cooperation, strengthened macroprudential frameworks, and coordinated regulatory responses are central to managing the trade-offs implied by the monetary and financial trilemmas.
Source: Two Trilemmas for Monetary Policy — Maurice Obstfeld, Speech at Bank Negara Malaysia Conference, July 24, 2017.