Think global, act local on monetary policy

Lowy Interpreter

The unwinding of quantitative easing has been postponed for the moment. Financial markets have regained their composure and their panicky flight from emerging economies (notably India and Indonesia) has reversed. But the ‘taper’ of QE must inevitably occur: the emerging economies have a reprieve, not a pardon. The external spill-over of domestic macroeconomic policies, such as QE, seems a suitable case for treatment at the G20.

The US Fed’s attitude on the collateral damage from its monetary policy is straightforward: it says these effects are minimal and whatever the minor inconvenience of QE to foreign economies, the world is better off with a quick US recovery and stronger growth.

As far as it goes, this makes sense. But one reason the US recovery has been so sluggish is that the fiscal brakes are still on: the budget is subtracting nearly 2 per cent from growth this year. America did have an urgent need to get the budget deficit down from its crisis-induced peak in 2009, but enough has already been done. The current austerity doesn’t reflect good policy-making. Rather, it reflects Congressional battles on the debt ceiling and sequestration, a random expenditure-cutting process.

Foreigners adversely affected by QE might agree that they want a quick US recovery, but the optimal policy mix would have involved less extreme settings for monetary policy and a fiscal policy that was softer while the economy was still weak, combined with a strongly articulated commitment to address the longer-term budget problems as soon as the economy is back on track.

Instead, what America has delivered is fiscal confusion. Monetary policy is in overdrive in an attempt to compensate.

The immediate problem in emerging economies has passed. Panic buttons have been reset. In India and Indonesia, exchange rates have depreciated moderately, improving international competitiveness. Interest rates are a tad higher, but not enough to stifle growth, and inflation will be better contained. Some hot air has gone out of property and equity bubbles. There is always a long list of necessary structural reforms, and it is only when the pressure is on that reformers can break though the political resistance and get some of these done. The ongoing threat from QE unwinding might keep politicians’ feet to the fire.

With all these positives in mind, should QE be seen as mostly silver lining and not much cloud?

That would be going too far. Without doubt QE caused excessive inflows of foreign capital into emerging countries whose financial markets are not deep enough to absorb these flows smoothly. Then markets panicked and the inflows reversed at the prospect of a QE taper. What is needed is a serious international discussion about the external ramifications of abnormal policy settings.

International forums have often discussed the need for international policy coordination. Use of the exchange rate as an active policy instrument has been on the international agenda repeatedly, particularly aimed at China’s export-promoting ‘manipulation’ of the yuan.

What’s different about monetary policy?

The convention of setting the short-term interest rate (the near-universal instrument-of-choice of central banks) is just as much an interference with markets as setting the exchange rate. Moreover, the manipulation of longer-term interest rates (which is the objective of QE) has, until recently, been universally accepted by central banks as undesirable: the longer end of the yield curve should be left to the market to determine, to avoid distorting underlying price signals.

Nor can it be argued that the extreme settings of monetary policy seen over the past few years have had no effect on other countries. One of the main channels of transmission of QE is via depreciating the exchange rate, improving competitiveness, promoting external surplus and boosting domestic growth at the expense of foreigners. No one is disputing that QE in the US, the UK and Japan weakened the dollar, sterling and the yen. And now we are seeing the whipsaw effect on capital flows to emerging countries as policy is imposed and then, prospectively, unwound.

Thus manipulating exchange rates is on a policy-making par with setting longer-term interest rates. Both are helpful to the domestic economy (and this could be used as a justifying rationale), but at a global cost. In both cases, the world is entitled to complain about over-use and to request – even require – some policy coordination to moderate the global impact.

So far, the international discussion of this topic has been unsatisfactory. At G7 meetings, with a majority of the members implementing QE and no emerging economies present, monetary policy has been judged to be a purely domestic issue. This formula was repeated at the G20 meeting in St Petersburg in September. Disruption to other countries was acknowledged, but emerging economies were advised to address the problems by improving their own domestic policies. The issue didn’t get a mention in the October G20 Finance meeting communique, though the Russian press note recorded that concerns had been expressed. We might hope for a more substantive outcome at G20 in Brisbane next year.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.