Rethinking Monetary Policy in Emerging Market Economies and the Need for Policy Coordination

The Need for a rethink on Monetary Policy

I despair when I observe the current state of monetary policy, especially in the major developed countries. Not so much what the central banks have done during the crises in 2008 and the current pandemic – though I do have deep doubts about the need to have negative interest rates – but rather the conduct of monetary policy both before 2008 and in the period between these two crises. The results of these policies can be seen in the very obvious dichotomy between the performance of their economies and their financial markets.

The current generation of central bankers seem to have completely forgotten the central banking dictum of not having too high or too low interest rates for too long. Interest rates were low in the major developed economies before the 2008 financial crisis and have become even lower since. This asymmetrical behavior has led to boom-bust economies with growing economic and financial distortions. The comfort that these central banks take is that their policies have not led to inflation, and until they see their desired level of inflation, ever more extreme monetary policies are justified. However, this view is based on a narrow perspective. Yes, historically, a sustained period of high monetary growth will have led to “too much money chasing too few goods,” and thereby creating rising prices of goods. However, in the current circumstances, with the large size of financial markets relative to the overall economy and the very uneven distribution of wealth and income, combined with the asset purchases by central banks, what is happening is “too much money is chasing too few assets.” So, while inflation has remained weak (and I will have more to say on this later), asset prices have been booming.

The financial system can no longer be thought of as merely a transmission mechanism for monetary policy. Given the huge build-up in financial markets, and the significant distortion of asset prices, these markets have in fact become drivers of monetary policy. I recall that at one time these central bankers used to talk about providing “forward guidance” to the financial markets, meaning providing markets with an indication of the possible direction of future interest rates. However, having observed what has been happening over the past decade, it looks to me very much like the financial markets are providing forward guidance to these central banks. The central banks seem to have been very receptive to such guidance and have acted accordingly. Not only that, since the financial crisis, these major central banks have also gone increasingly into large scale financing of government deficits. Essentially, monetary policy has become the main crutch supporting these economies and their financial markets. It is a rather precarious situation when so much reliance is placed on an increasingly crooked crutch.

However, this is not really an article about the monetary policy of the developed countries. Rather, it is an attempt to make an argument for the emerging market economies (EMEs) to not emulate the policies of the developed world. EME central banks risk falling into the same trap as their colleagues in the developed world if they adopt similar monetary policies. They must avoid the monetary adventurism of their peers in the developed countries. The risks that the developed economies are taking the EMEs cannot afford to take. It is good to remember that the International Monetary Fund (IMF) is less kind to developing countries than it is to the developed ones.

Even with the globalization of finance, central banks in EMEs can obtain some policy space for monetary policy but only if looked at from the perspective of complimentary policies and supporting fundamentals. The first part of this article looks at why and how central banks can adopt a broader perspective in their conduct of monetary policy, avoiding the need to adopt extreme monetary policies, thereby minimizing the risks of their policies leading to boom-bust cycles and maximizing the prospects for sustainable long-term economic prosperity. However, no country can rely on monetary policy alone and in the case of EMEs this is particularly so given their vulnerabilities and the complexity of the challenges they face. Hence, the second part of this article looks at the other components of policy that must also come into play to optimize the opportunity for countries to enjoy sustainable growth.

To get my points across more concisely and avoid making this article too lengthy a read, I am going to rely heavily on bulleted text. But if in doing so, I inadvertently fail to sufficiently explain a point, please let me know.

1.    No ideal monetary policy frameworks – situation and circumstances specific

• Asia: Many different monetary policy frameworks – difficult to associate macroeconomic stability within a particular framework.
• Inflation targeting (IT) has its limitations – often narrows the peripheral vision of policymakers and leads to short-sighted policies.
• EMEs: adoption of IT often gets the Government off the backs of central banks.
• Where fiscal dominance is eliminated, adoption of IT has led to a significant reduction in inflation.
• Where fiscal dominance remained, adoption of IT has led to the central bank losing credibility by repeatedly missing its inflation target.

While there is no ideal monetary policy framework, there is such a thing as the prudent conduct of monetary policy.

2.    Questions about current frameworks from post-financial crisis experience

• What central banks have been trying to do in post-financial crisis period is essentially to try to do what Paul Volcker did in the early 1980s, but in the opposite direction.
• Those of you familiar with monetary history would know that as chairman of the Fed, he raised the Fed Funds Rate to as high as 20% to choke off inflation. He displeased a lot of people who were negatively affected by the high interest rate, but he succeeded and went down in history as the man who conquered inflation.
• In the post-financial crisis period, central banks have tried to do the opposite: to ignite inflation by dropping interest rates to very low and even negative levels. Again, they have displeased a lot of people, but after more than a decade, they are having considerably less success than Chairman Volcker. It remains to be seen how the current central bankers will go down in history, and what the nature of that fame will be.

This is why the post-financial crisis period has been a terrific experiment to disprove or confirm the potential asymmetry in the effectiveness of monetary policy, which in turn would either validate symmetrical inflation targets or rubbish them. In looking at this experience, it is worth noting the following:

• Post-financial crisis monetary policies of the major central banks are referred to as being unconventional. However, the MP frameworks have remained the same as those that spawned the financial crisis, and is it still unconventional when such policies have been maintained for over a decade?
• Policy frameworks with 2-year horizons have been extended to multiples of that horizon.
• Leaving aside the current pandemic situation, after more than a decade of financial repression and despite strenuous efforts, central banks were still having trouble achieving their desired inflation rates.
• Can monetary policy overcome structural issues that may be holding wage growth and inflation? Persisting with ever more extreme monetary policy may get you growth now, but at the risk of huge distortions that undermine future growth.
• What does it say about the frameworks when interest rates are used for exchange rate outcomes as we saw in a number of countries after the financial crisis?
• While price stability is important, is it the only thing that is important?

3.     What lies beyond price stability?

• The economic welfare of society.
• Price stability is one important component of that objective, but it is not the only component.
• Monetary policy has different effects on: savers vs. borrowers, those who own financial assets vs. those who don’t, property speculators vs. pensioners, etc.
• Extreme monetary policy stances exaggerate these asymmetric effects on the welfare of different sectors of society.
• Which is why we need monetary policy to be conducted prudently, irrespective of the policy framework, with an eye on its side-effects on welfare, risk-taking and sustainable growth.

I want to emphasize this last point. A monetary policy that allows interest rates to remain very low, and especially for rates to be negative, over a prolonged period, is in my view, reckless and fails to consider its long-term impact on economic welfare, risk-taking and sustainable growth. It is short-sighted and it is short-sighted because it's primary focus is usually on keeping financial markets in a constant state of boom (whether the central bankers admit to it or not) and supporting highly indebted governments. Even if that may not have been the intention when these central banks started adopting these extreme monetary policies, that is where they now find themselves. Extended periods of very low interest rates (financial repression) have few benefits for the real economy. The growth they create is likely taken from the future because of the side effects of encouraging excessive risk taking, a misallocation of resources, over-indebtedness, financial imbalances and the widening of the chasm between the haves and have-nots. Such policies do little to improve the real fundamentals of these economies. It is akin to pumping yourself full of steroids to boost short-term performance while ignoring the longer-term deleterious consequences. This is especially so when there are structural factors, changes in technology and global economic and financial integration, that are making such extreme policies less effective. In the case of globalization, this has happened in a number of ways.

4.     Globalization has increased the influence of external factors on the domestic conditions

• Global economic integration has made global factors an increasingly important determinant of domestic prices and economic conditions.
• Financial integration has globalized monetary policy by weakening the national transmission of monetary policy but strengthening the global transmission of monetary policy.
• Financial globalization has also globalized financial cycles.

The impact of globalization on domestic conditions occurs through complex channels and is difficult to quantify, not least because of the difficulty of defining and measuring factors like global slack, the shifting patterns of production and trade, and the complex channels through which transmission occurs. Nevertheless, attempts have been made. Research at the Bank of International Settlements (BIS) has found an increased influence of globalization on domestic inflation. [1]

• Global value chains have made inflation more global across countries.
• Globalization has made markets more contestable, eroding the pricing power of both firms and workers.
• The opening up of economies like China and the EMEs added significantly to the global labor force. This has helped to reduce labor costs.

Globalization has certainly played a role in the reduced ability of central banks to fine-tune inflation. That ability has been further undermined by developments in technology. This should be a consideration before going it alone with an ever more extreme monetary policy. What else is being risked in the pursuit of an elusive inflation objective?

Turning to the emerging market economies, when it comes to monetary policy, central banks face all of the challenges of the central banks in the developed world plus some more, including the spillovers from the policies adopted in the developed world. There is also often the issue of the dependence of the domestic economy on external demand, often from the developed countries, and fluctuations in that external demand conditions cannot be readily addressed through monetary policy. In this context, I am excluding the option of trying to use monetary policy to influence the exchange rate due to the many potential side-effects. Therefore, monetary policy has to play an even more delicate balancing role. In the context of small open economies, it is absolutely delusional to think that managing inflation is the only role for monetary policy.

5.     In EMEs, financial integration has increased the external influences on domestic financial conditions

• Large capital flows pose a dilemma for central banks in small open economies through their impact on the exchange rate, domestic asset prices, incentives to borrow from abroad, etc.
• Does having larger financial systems help? Yes, it allows more effective intermediation of capital inflows and outflows and the presence of large domestic institutional players supports stability.
• However, deeper financial systems can also be a double-edged sword – increased availability of financial instruments and higher liquidity can also end up attracting increased capital inflows.
• Large presence of non-residents in domestic financial markets can be a vulnerability.
• EM central banks with larger financial systems should hold more foreign exchange reserves, unless that is, they do not care about their exchange rate.

6.     Floating exchange rates are optimal for most EMEs but cannot guarantee full policy autonomy

• Normal times: A combination of floating exchange rate, foreign exchange market intervention and sterilization provide some degree of policy independence
• Not too many “normal times” over the last decade
• Prolonged exchange rate misalignment can turn the exchange rate from being a shock absorber into a shock propagator
• Floating exchange rates guarantee policy autonomy only if there is a high tolerance to significant exchange rate volatility and misalignment.
• Even the developed economies have shown that they have limited tolerance, especially for exchange rate appreciation
• Tolerance of exchange rate volatility also depends on economic structure – higher for commodity exporters than for exporters of manufactured goods (or being part of global value chains)

When we talk about monetary policy and long-term macroeconomic and financial stability, these external factors are not the only problem; the villain is also often of a domestic origin. Frequently, domestic macroeconomic mismanagement creates vulnerabilities in the economy and financial system that not only make the job of monetary policy more difficult, they often cause monetary policy itself to be compromised. This is especially true of the way fiscal policy is conducted in many EMEs. All sorts of bad things happen when fiscal policy is not conducted optimally, which is itself often the outcome of public finances being used for political ends rather than economic ones. Over time, fiscal policy becomes more constrained and monetary policy is called upon to perform roles it is not well suited for. The result is an imbalanced policy framework that undermines sustainable growth.

7.     Imprudent conduct of fiscal policy

• Often used as a political tool rather than as a macroeconomic policy
• Frequent source of distortions and rigidities in the economy
• Reduced potency due to weak tax collection and non-optimal fiscal spending
• Undermines economic fundamentals through excessive debt issuance and unsustainable demands for imports and external financing
• Sustained periods of bad fiscal policy trigger currency depreciation and inflation
• Often results in political pressure on central bank to keep interest rates lower than what they need to be
• Bad fiscal policy often leads to bad monetary policy

When we talk about the quality of macroeconomic policies in EMEs, the first assumption that needs to be validated is that the national government that is in power is actually interested in the welfare of its people. Often, this not necessarily the case and failures of the political system turn into failures of policy frameworks. Consequently, sound macroeconomic policies are unlikely when there is a failure of national political, economic and financial governance. Dysfunctional governance manifests in many forms that undermine growth and economic welfare:

• Pervasive corruption and the looting of public funds reduces the resources available to finance economic and social infrastructure. It also undermines economic efficiency and competitiveness due to prevalence of excessive rent seeking.
• Market rigidities due to pervasive presence of noncompetitive SOEs and monopolies.
• Citizens pay higher prices for poorer quality goods and services than they would in a more competitive environment.
• Banking systems are burdened by large amounts of bad loans or have insufficient capital to sustain asset growth.
• Production of national economic data can be compromised. Data can be bad not only because of poor collection and collation, but also because of political interference that make economic numbers into political numbers. Without good data, it is difficult to understand what is going on in the economy and makes it harder to correctly calibrate policies.

So, what can we conclude from all these? First, central banks in EME must stay away from the type of extreme monetary policies adopted by central banks in the developed world, irrespective of their specific monetary policy frameworks. It is better to avoid creating the risks that these types of policies create, and in the case of developing countries, the consequences will be much more adverse and more quickly manifested than for the developed countries. Second, central banks have to make it clear that governments should not expect miracles out of monetary policy without there being other supporting policies and fundamentals, which includes preemptively addressing any imbalances and vulnerabilities in the economy. This is what I will turn to next.

National policy coordination

Assuming that the right governance structures are in place, then having a holistic policy ecosystem that provides a coordinated policy response to economic challenges, and does not burden any one policy, will provide the optimal and most effective way of ensuring the sustainable long-term growth of the economy.

8.     Multi-faceted risks require a holistic policy eco-system

In confronting the challenges that EMEs face, policymakers need to think in a holistic manner about the whole ecosystem of fundamentals and policies. Monetary policy is just one component of this policy ecosystem. The chart below illustrates the other key elements of these policy ecosystem. While the chart is meant to be indicative, it does provide an indication of the variety of policy options available to national policymakers and how they can be used in a more integrated manner to support sustainable growth of the economy.

I will just touch on a few examples of how elements of the policy ecosystem can work together to create a more robust policy environment.

9.     Structural reforms and building policy buffers

What policy makers do in good times determines how well they are able to deal with periods of adversity. If policy makers have a tendency to "kick the can down the road" and avoid difficult decisions, then the risks will build up over time and undermine the foundations of the economy. This is not a good way to manage the economy but it is nevertheless what we see happening in many countries, both developed and developing. Therefore, having good fundamentals and healthy buffers is a critical part of the policy equation. It reduces the likelihood of crisis, and if there is a crisis, it ensures that there are more policy options to deal with it. Some of these important fundamentals include:

• Well-capitalized and well-regulated banking system
• Prudent levels of indebtedness – public and private
• Prudent level of external borrowings
• Well-managed fiscal policy
• Sufficient foreign exchange reserves
• Floating exchange rate with prudent opening of capital account
• Flexible and competitive economy that can adjust to shocks

A central bank in an economy where these fundamentals have been long neglected is unlikely to be successful in prudently managing monetary policy.

10.     Policy Coordination: Monetary Policy and Financial Stability

Monetary policy sets the baseline conditions for risk-taking.

• Extended periods of low interest rates encourage risky behavior across the system — with risks popping up in different parts of the economy and financial system.
• Macro- and micro-prudential tools will only go so far and assume that central banks and regulators can see all the major risks ahead of time. Based on the last financial crisis, this is evidently not true.
• Managing these risks would therefore be difficult and could end up being the central banking equivalent of the “Whack-A-Mole” game.
• There has been much discussions about whether monetary policy should be “leaning against the wind.”
• The issue is even more fundamental than that. Monetary policy should not be actively creating financial risks in the first place. Doing so does not lead to good outcomes for monetary policy. This was a core lesson of the 2008 financial crisis, but it seems to have been overlooked by those central banks.

In a world of multi-faceted risks, functional specialization (within or across policy organizations) – if not managed through governance mechanisms to promote collaboration and information sharing – can have silo effects and create policy blind spots. However, the coordination of monetary and financial stability policies does not happen naturally, especially when they are under different institutions. Coordination of policies requires appropriate legal and governance frameworks. Having the policy frameworks, legal mandates and tools will facilitate a better understanding of emerging risks as well as enhance the ability to preemptively ensure that such risks do not lead to a crisis. Should a crisis occur, it also allows for a more balanced policy response that has fewer side effects.

11. Policy Coordination: Monetary Policy and Fiscal Policy

• Governance around public finances is especially important
• Crucial to avoid fiscal dominance of monetary policy
• Best outcomes achieved when monetary and fiscal policy work together with the objective of promoting long-term sustainable growth
• Dealing with capital flows, financial market volatility & asset price bubbles is easier if both policies work together
• Collaboration must lead to sustainable outcomes for both policies

To summarize

On reformulating monetary policy

• No ideal policy framework.
• Prudent conduct of monetary policy (Price stability ++) entails incorporation of a number of perspectives:

1. Consider broader implications on welfare, inequality and sustainability of economic growth.
2. Adopting a longer policy horizon and being more cognizant of the risks and perverse incentives – understand that sometimes doing less is more.
3. Monetary policy must not actively create financial risks over sustained periods.

The objectives of monetary policy need to be more holistic and move beyond a single inflation objective. A careful evaluation of the risks and benefits – particularly, the impact on incentives of different economic agents – combined with a good dose of common sense, rather than being wedded to any particular economic model, will probably allow monetary policy to be better calibrated to support long-term sustainable growth.

On the need for macroeconomic policy coordination

• EMEs are faced with complex and multi-faceted risks that monetary policy alone cannot effectively deal with.
• National collaboration is necessary: A broader range of policies need to be used collaboratively to holistically manage risks and minimize the possibility that excessive reliance on any single policy will create additional risks.
• Structural reforms and policy buffers provide a good foundation for successful policies, and over time, sound policies will in turn provide support for further structural reforms and the creation of even stronger policy buffers.
• Robust governance frameworks are needed for coordination with clear accountability.
• Prudent conduct of fiscal policy is critical to a country being able to enjoy sustained growth with fewer vulnerabilities.

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NOTES:

[1] See for example:

Auer, R, C Borio and A Filardo (2017): “The globalisation of inflation: the growing importance of global value chains”, BIS Working Papers, no 602, January. (https://www.bis.org/publ/work602.htm)

Borio, C (2019): "Central banking in challenging times" (https://www.bis.org/speeches/sp191108a.pdf)