Monetary policy goes with the capital flow

The financial crisis illustrated the limits of unconventional monetary policy and its effects on liquidity and capital flows. Combating these challenges in the post-crisis climate will require a fresh approach.


Two weeks ago, the IMF organised a major research conference in honour of Stanley Fischer on the lessons from the crisis.

Here is my take. I shall focus on what I see as the lessons for monetary policy, but first I shall mention two other important conclusions.

One: having your macro house in order pays off when there is an external crisis. Wise fiscal policy before this crisis gave emerging market economies the room to pursue countercyclical fiscal policies during the crisis. This made a substantial difference.

Second, after a financial crisis, it is essential to rapidly clean up and recapitalise the banks. This did not happen in Japan in the 1990s and it was costly. But it did happen in the US in this crisis and it helped the recovery.

Now let me now turn to monetary policy. I will touch on three issues: the implications of the liquidity trap; the provision of liquidity; and the management of capital flows.

On the liquidity trap, we have discovered – unfortunately at a great cost – that the zero lower bound can be binding. (Five years at this point.) We have also discovered that even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But the fact remains that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.

There is much to be said for avoiding the trap in the future. This raises the question of the inflation rate

There is broad agreement that in most advanced countries, it would be good if inflation was higher. Presumably, if it had been higher pre-crisis, it would be higher today. If inflation had been two percentage points higher before the crisis, the best guess is that it would be two percentage points higher today, the real rate would be two percentage points lower, and we would probably be close to an exit from zero nominal rates in the United States.

We should not dismiss the possibility, as raised by Larry Summers, that we may need negative real rates for a long time. In principle, countries could achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead to even more depressed demand.

Turning to liquidity provision: in advanced countries, we have learned that runs are relevant not only for banks, but also for other financial institutions and governments. In an environment of high public debt, rollover risks cannot be excluded. 

An implication – and one of the themes emphasised by Paul Krugman – is that it is essential to have a lender of last resort, ready to lend not only to financial institutions but also to governments. The evidence on periphery sovereign bonds in the euro area, before and after the European Central Bank’s announcement of outright monetary transactions, is quite convincing on this point.

Finally, we turn to capital flows. In emerging markets and in small advanced economies, the evidence suggests the best way to deal with volatile capital flows is by letting the exchange rate absorb most (but not necessarily all) of the adjustment.

The standard argument in favour of letting the exchange rate adjust was stated by Paul Krugman at the conference. If investors want to take their funds out, let them. The exchange rate will depreciate, and this will lead to an increase in exports and an increase in output.

Three arguments have traditionally been given against relying on exchange rate adjustment. The first is that to the extent that domestic borrowers have borrowed in foreign currency, the depreciation has adverse effects on balance sheets, and leads to a decrease in domestic demand that may more than offset the increase in exports. The second is that much of the nominal depreciation may simply translate into higher inflation.  The third is that large movements in the exchange rate may lead to disruptions, both in the real economy and in financial markets.

The evidence is that the first two are much less relevant than they were in previous crises. Thanks to macroprudential measures, the development of local currency bond markets and exchange rate flexibility, foreign exchange exposure in emerging market countries is much more limited than it was in previous crises. And because of increased credibility of monetary policy and inflation targets, inflation expectations appear much better anchored, leading to limited effects of exchange rate movements on inflation.

The third argument remains relevant. This is why central banks in emerging market countries have not moved to a full float, but to a “managed float” – that is, the joint use of the policy rate, foreign exchange intervention, macroprudential measures and capital controls.  

This has allowed them to reduce the old dilemma that arises when the only instrument used is the policy rate. An increase in the policy rate may avoid the overheating associated with capital inflows, but at the same time it may make it even more attractive for foreign investors to come in. 

Foreign exchange intervention, capital controls, and macroprudential tools can, at least in principle, limit movements in exchange rates and disruptions in the financial system without recourse to the policy rate.

Countries have used all of these tools during the crisis. Some have relied more on capital controls, some more on foreign exchange intervention. The evidence, both from the conference and from work at the IMF, suggests these tools have worked, if not perfectly. Looking forward, the clear and quite formidable challenge is to understand how best to combine them.

Monetary policy will never be the same after the crisis. The conference helped us understand how it had moved, and where we have to focus our research and policy efforts in the future.

Olivier Blanchard is the chief economist at the IMF. This post was originally published at iMFdirect.

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