Challenges for Monetary Policy from Global Financial Cycles
IMF News, May 8, 2018
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- Published: May 8, 2018
Overview
- Occasion: Speech at the Swiss National Bank, Zurich, May 8, 2018.
- Speaker frames discussion along three dimensions:
- Key aspects of the global financial cycle (Miranda-Agrippino and Rey, 2015).
- Its importance in influencing cross-border capital flows.
- Its role in shaping monetary policies worldwide.
- Central message: Global factors are increasingly important drivers of domestic financial conditions, complicating the conduct and effectiveness of domestic monetary policy.
Global financial cycle, Global FCI, and Growth-at-Risk
- Definitions and methodology:
- Global Financial Conditions Index ("Global FCI" or "FCI") constructed to measure financial conditions after removing real-time economic factors (e.g., GDP fluctuations).
- Growth-at-Risk methodology used to assess downside risks to GDP (one-year-ahead and three-year-ahead distributions of cumulative GDP growth).
- Key quantitative findings:
- One-year-ahead downside risk: estimated 5 percent probability that GDP growth will be lower than 3 percent.
- Three-year-ahead downside risk: in the three-year timeframe growth is projected to be negative with a 5 percent probability.
- Time-series observation:
- The three-year-ahead measurement of Growth-at-Risk shows that currently (as of the report) growth in the severely adverse scenario three years ahead is very low by historical standards.
- Historical correlation:
- The average correlation of domestic FCIs with the Global FCI increased sharply between 1998 and 2005.
- The average correlation has been broadly flat since the financial crisis, but has increased in the past two years (prior to May 8, 2018).
- House-price synchronization:
- House prices have become more synchronized across countries in the last 20 years amid lower global interest rates.
- Higher synchronicity may indicate greater transmission of external shocks to local housing markets, raising concerns for financial stability.
Transmission to domestic conditions and capital flows
- Relative impacts:
- Local financial conditions react faster and more strongly to global financial shocks than to changes in domestic policy rates.
- Empirical impulse-response functions (25 small open economies) indicate global financial conditions have a significant impact on domestic FCIs; domestic monetary-policy shocks also matter but to a somewhat smaller extent.
- Capital flows and the global financial cycle:
- Capital flows have grown faster than output or trade and are significantly more volatile than either global output or global trade.
- The global financial cycle is important in driving certain types of capital flows.
- Using weekly data on non-resident portfolio flows to eight major Emerging Markets for the 30 weeks following key episodes:
- (first) the Global Financial Crisis;
- (second) the taper tantrum of 2013;
- (third) the Renminbi devaluation of August 2015.
- The share of variance of cross-border portfolio flows explained by the first three principal components rises in stress periods.
- Global factors matter more:
- during stress periods rather than normal periods;
- for equity flows rather than for debt flows;
- for higher-frequency data rather than lower-frequency data.
Policy implications and tools
- Trilemma and evolving views:
- Mundell-Fleming Trilemma: only two of the following are compatible:
- Exchange-rate stability;
- Asset markets that are open to trade;
- Domestic monetary autonomy.
- Two competing modern views:
- Hélène Rey: financial conditions largely determined by external factors; choice between free capital mobility or monetary independence (independent of exchange-rate regime).
- Maurice Obstfeld: Trilemma still applies; exchange-rate flexibility remains crucial as a shock absorber; issue is effectiveness rather than independence.
- Role and limits of monetary policy:
- Central banks can still influence domestic financial conditions to some extent.
- Using monetary policy to contain transmission of global financial shocks in an effective and timely manner is often difficult.
- Monetary-policy aggressiveness (measured via Taylor Rule coefficients on inflation, output, or total Taylor Rule aggressiveness) is strongly negatively correlated with exposure of domestic assets to global risk—suggesting aggressive monetary policy can mitigate exposure (causality not established).
- Context: Major central banks were withdrawing accommodation; term premia historically low even though the Federal Reserve had already raised interest rates six times since December 2015. Contrary to previous tightenings, financial conditions had eased somewhat and the dollar had weakened even as policy rates were hiked.
- Complementary policies:
- Exchange-rate policy:
- More exchange-rate flexibility can strengthen resilience when threats arise from external shocks (e.g., shocks to world interest rates).
- Floaters appear least susceptible to crises in cross-country evidence.
- Short-run excessive FX volatility can be disruptive; horizon matters.
- Macroprudential policy:
- Safeguards financial stability by increasing resilience and reducing procyclicality of credit growth.
- Tools vary: broad-based vs. narrowly focused; time-dimension tools (contain rapid credit growth) vs. cross-section/structural tools (caps on interbank exposures).
- Functions related to capital flows:
- Limit effects of capital-flow surges or retrenchments.
- Increase resilience during outflows by building capital buffers or reducing reliance on wholesale funding.
- Damp procyclicality by constraining leverage or curbing credit growth (including foreign-currency lending).
- Caveat: In open economies, macroprudential restrictions may be more easily circumvented; capital flows management measures can sometimes be a complementary approach.
- Capital flows measures:
- IMF institutional view: use only in a limited number of circumstances when other macroeconomic policy responses are not sufficient or available.
- Such measures should not substitute for necessary macroeconomic adjustment and should be the most-efficient and least-distorting means to achieve goals (e.g., stemming capital-inflow surges).
Summary conclusions and policy guidance
- Central banks retain some influence over domestic financial conditions, but global financial cycles substantially affect domestic outcomes and complicate timely, effective monetary responses.
- Effective policy requires a toolkit beyond conventional monetary policy:
- Credible and predictable monetary policy reduces exposure to global risk factors.
- Macroprudential policies increase resilience and reduce procyclicality.
- Exchange-rate flexibility is crucial as a shock absorber, with careful attention to horizons and sources of shocks.
- Capital flow management measures can be complementary in specific circumstances but are not a substitute for macroeconomic adjustment.
- Practical implication: Policymakers must make case-by-case judgments tailored to each economy’s circumstances, often under imperfect information and fast-evolving data.
- Final admonition: International cooperation is vital because “No economy is an island, entire of itself.”
Source: IMF speech "Challenges for Monetary Policy from Global Financial Cycles," Swiss National Bank, Zurich, May 8, 2018.