by Otaviano Canuto
Once upon a (not long ago) time, there was a widely established set of blueprints for regimes of monetary and exchange rate policies expected to fit a full range of economies, and to serve as a guide for international monetary cooperation. That world is gone with the global economic crisis. As I explain in my new policy note, The Arrival of Asset Prices in Monetary Policy, a reshuffling of views on monetary and exchange rate policies will probably accompany new financial regulation.
Here are some of the issues I discuss in my note–and hope to discuss with you too:
- Over the last decade, monetary policy has focused on inflation targeting without paying much attention to asset bubbles.
- As the IMF’s new World Economic Outlook shows, well-behaved inflation and output performance are no guarantees against asset prices acquiring a cyclical life of their own. The even distribution of episodes of busts before and during the “Great Moderation” period, which started in the 1990s, until the current crisis is an illustration of that.
- The Institute of International Finance suggests that the beginning of the “Great Moderation” represented a structural break in the relationship between U.S. monetary policy and the overall global business cycle. Whereas previous monetary policy tended to drive business cycles, after the early 90s it became more responsive to capital flow cycles involving factors such as credit booms, binges of large current-account deficit financing, and finance made available to real-estate and other previously illiquid assets – roughly the same factors singled out by the IMF as leading indicators of asset price busts.
- The powerful liquidity-generating machine made possible by that structural break in early 1990s turned out to be a “serial bubble blower.”
- If monetary policymakers are to succeed in their macroeconomic stabilization mission, complacency with respect to asset price cycles will have to be left behind.
- Signs of increasing macro-financial risks are demanding a response from policymakers. Either aggressive monetary policy reactions and/or the resort to time-varying macro-prudential instruments to dampen credit market cycles (acting thus on yield curves, rather than on short-term rates) should be put into action.
- Those macro-prudential instruments may be “dynamic provisioning” rules – capital requirements of financial institutions that rise/fall faster than leverage – or discretionary setting of required reserves, in both cases reinforcing – and reducing the burden of – the direction taken by basic monetary policy. In any case, depending to a large degree on a judgment call about whether benign or malign factors are driving asset prices, policymakers should be ready to act.
- A monetary regime that includes reactions to asset price movements (not targeting) and discretionary choices regarding interest rates and/or macro-prudential instruments is full of complex requirements. To see those, read my whole note.
- There are those who still believe that the concern with a supposed propensity for bubble creation has been exaggerated. The subject is still open to fierce controversy and it will take time before it settles. In my view, however, the mainstreaming of reactions to asset price cycles into monetary policy is something that has probably come to stay.
- The demise of the presumption of stability as the normal condition of financial markets has also shattered confidence in the self-adjustment of nominal exchange rates in currency markets. The loss of confidence on the effectiveness of stable centers of gravity for nominal exchange rates came as a corollary of the realization that protracted “over-shooting,” slow and unstable convergence toward interest rate parities, are common phenomena in foreign exchange markets.
- It’s not by chance that the end of “corner solutions” as inevitable options for exchange rate regimes – along with the rising profile for international reserves as a buffer against shocks – are among the new “in” concepts in global money, as professor J.A. Frankel says.
- In a world where discretionary decisions are deemed as the norm – rather than (notional) rules – the identification of sources of shocks, transparency and communication of decisions, as well as information exchange and consultation between monetary and financial supervisory authorities, all tend to become more riddled with international political economy factors.