The internationalisation of monetary policy

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Summary

The case for formal central bank cooperation remains limited, and practical consideration makes its implementation difficult. That said, central banks need to be engaged in a constant dialogue so as to remain ready for rapid coordinated action in exceptional circumstances. And they should strive to strengthen the global financial safety nets so that they can better address global or regional liquidity crises and limit the case for self-insurance by countries.

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Ladies and gentlemen ^[1],

It is a pleasure to speak at this joint ECB-IMF conference on the international dimension of monetary policy. As you know, this is not a new topic: the literature has built up throughout the last century, and stretches back as far as David Hume and the price-specie flow mechanism. Yet, the current environment raises several fresh issues that warrant renewed attention.

What is new, in particular, is that central banks in advanced economies have adopted highly accommodative monetary policies, using quantitative easing and other unconventional measures, while interest rates are close to the effective lower bound. This has revived the debate on the channels for monetary policy spillovers, both among advanced economies and from advanced to emerging economies.

For example, the rise in longer term interest rates in the United States before the summer of last year was correlated with upward pressure on forward rates in the euro area. This led the ECB to engage in forward guidance, quite successfully in my view as evidenced by the decoupling between US and euro area forward money market rates. The volatility in capital flows to and from emerging economies over the last year was also mainly related to expectations of US monetary policy – although a number of studies have shown that countries with lower external imbalances experienced less capital flow volatility ^[2]. ECB policy has generated spillovers of its own on neighbouring economies such as Denmark or Switzerland.

In the light of these events, there have been calls for better ex ante monetary policy coordination that would be less disruptive in terms of capital flows. The argument goes that individual countries cannot insulate themselves from monetary policy actions in other jurisdictions, or that they can only do so by accepting costly trade-offs. Thus policy coordination has become mutually optimal.

What I would like to address in my remarks today is whether this argument holds. Let me explain by starting with the theory of institutionalised coordination – and why it is almost never applied in practice.

Coordination in theory

What does theory tell us about the need for central bank coordination? Models have existed for decades showing that national policy-makers who blindly pursue domestic objectives may reach a collectively suboptimal Nash equilibrium. Under these assumptions, international policy coordination is necessary to reach an optimal equilibrium. Yet, as I see it, this hardly settles the debate.

Quantitative studies before the crisis suggested that domestically optimal policies could lead, under normal circumstances, to an equilibrium that is very close to the global optimum, as concluded for example in the seminal paper by Obstfeld and Rogoff ^[3]. According to these findings, policies aimed at national macroeconomic stability could also produce international macroeconomic stability. The intuition behind this is that central banks have sufficient tools to neutralise the adverse impact of disturbances abroad without compromising their domestic policy targets. If business cycle fluctuations could be reduced by targeting medium-term inflation, one instrument would be sufficient to offset foreign shocks while maintaining price stability. This is an example where the policy trade-off is limited. Indeed, the workhorse new open-economy model describes a benign environment with limited policy trade-offs and moderate macroeconomic interdependence across countries.

In light of the recent crisis, more research is certainly warranted to assess whether these findings still hold. The reality of monetary policy spillovers is more complex. Nevertheless, we need to see evidence of large policy trade-offs and large cross-border effects, matched by a paucity of monetary policy instruments, to conclude that monetary policy with a domestic focus creates large losses ^[4]. Only under these circumstances is monetary policy coordination, at least in the light of the research mentioned above, likely to lead to significantly better outcomes.

One factor that could alter the magnitude of trade-offs and spillovers, and hence require greater central bank coordination, is increasing globalisation. The world economy has achieved an unprecedented degree of economic and financial integration. Are the benefits of coordination increasing in a monotonic fashion with economic and financial integration? The studies on this topic are in my view not conclusive so far.

Some argue that trade and financial integration strengthens the impact of foreign shocks through exchange rate and asset price channels. ^[5] There is also evidence of a global financial cycle characterised by large common movements in asset prices, gross flows and leverage ^[6]. As a result, everything else being equal, a higher level of globalisation calls for a higher degree of policy coordination. Others argue, however, that globalisation allows for further diversification and insurance opportunities such that the impact of foreign shocks in fact diminishes. As a result, it is easier to achieve domestic targets and the need for coordination falls. ^[7]

In general, it is difficult to predict which of these effects will dominate. Globalisation may bring about new types of shocks and new channels of transmission, but it may equally foster the creation of new markets and means of financial risk-sharing. The euro area is a case in point. During its short history, our monetary union has already provided evidence of both the former and the latter effects.

What is more, it is not necessarily the case that all economic policies will be equally affected by globalisation.

It may well be the case that globalisation increases the need for cooperation on longer-term structural policies, yet reduces the need to coordinate short-term stabilisation policies. For example, in the financial domain, cooperation may shift from traditional stabilisation-oriented interest rate policies, and their cross-border spillovers on exchange rates and capital flows, towards an implementation of financial regulatory reform that maintains open and well-functioning international capital markets, avoiding financial fragmentation, excessive risk taking and volatile capital movements.

This would vindicate Jacques Rueff’s provocative but prescient remark in the wake of the 1931 Credit Anstalt crisis, that: “International financial cooperation is a programme whose sense was never defined, probably because it doesn’t have one (…) The instrument of a true financial cooperation exists: it is the financial market. Its improvement in those countries where it remains imperfect creates immense prospects for governments, including through international agreements” ^[8].

For all these reasons, I do not think globalisation in itself fundamentally alters the case for formal monetary policy coordination.

Coordination in practice

As always, however, what works in theory does not always work in practice. And indeed, specific conditions warranting cross-border monetary policy coordination do appear sporadically. We see this in the history of the G7. For example, major central banks decided on a coordinated policy rate reduction on 8 October 2008. The aim was to send a powerful signal that they would act in unison to prevent the global financial crisis from becoming a global depression. Without doubt, this and other episodes of coordinated action had more success in helping stabilise global financial markets than any individual central bank could have achieved on its own.

The current debate, however, goes beyond such ad hoc forms of international coordination. It is a debate about engaging in more explicit and binding forms of coordination. And here again, the arguments in favour of monetary policy coordination are questionable from the practical point of view. Based on past episodes of coordination, there are at least two factors, both of which still apply today, that make it difficult to implement explicit or formalised forms of coordination.

The first factor, which is often ignored in the academic literature, is the political economy of coordination.

In the real world, the ability of central banks to deviate from a pre-determined path of action differs across countries. Central banks operate in different economic structures and institutional set-ups, notably in terms of mandates, time horizons and objectives. There are also differences in accountability arrangements and in economic and political cycles. All of this affects domestic policy incentives.

We should also not forget that monetary borders do not always coincide with political borders. For example, decisions by the Federal Reserve directly impact EME corporates borrowing in US dollars, while policies aimed at mitigating the impact of those decisions are decided locally. Just as the globalisation of supply chains for goods and services calls for new approaches to trade and investment policies ^[9], the globalisation of financial supply chains calls for a rethink of traditional approaches to monetary policy coordination. Too often, however, we lack a detailed understanding of these chains and only scratch the surface of balance of payment statistics ^[10].

The second factor complicating formal coordination is model and parameter uncertainty.

Economic policy debates are dominated by controversies. To give just a few examples, we continue to debate whether demand or supply shocks are more relevant; the degree of price and wage rigidities; and the presence and relevance of balance sheet effects. There is also uncertainty about forecasting models, particularly in a context of structural breaks, which results in different views about future economic developments. The ensuing lack of consensus can hinder both the establishment of ex ante cooperative agreements and the implementation of coordinated interventions ex post.

Indeed, the current debate about the effect of advanced economy monetary policies on emerging markets illustrates well this point.

Some policy-makers in emerging economics have stressed that unconventional monetary policies work primarily via the exchange rate channel and that there are substantial risks attached to their prolonged use ^[11]. Other observers, however, have emphasised that exchange rate adjustments between advanced economies with negative output gaps and emerging economies with positive output gaps may have been desirable ^[12]. Others still have pointed to the fact that unconventional monetary policies, in particular QE in the United States, are augmenting domestic demand rather than diverting it, and relative price adjustment is only a side effect of that policy, not its main objective ^[13]. This difference of views goes to show how uncertainty about the nature of the shock complicates agreeing on a common course of action.

Conclusion for central bank coordination

So what conclusions for central bank coordination do I draw from this discussion?

First, I do not yet see definitive proof, in theory or practice, that that the existing approach to central bank coordination needs to be fundamentally revised. Indeed, I would broadly support the mainstream view ^[14] that the decisive actions by central banks were also warranted from a global perspective, given the slump in global demand. In the process of easing monetary policy, the cooperative and non-cooperative solutions would have been very similar. The dramatic events of the financial crisis acted as a de facto coordination device for expansionary policy interventions in all advanced economies, or in other words, coordination is de facto achieved in those exceptional circumstances where shocks hitting different economies suddenly correlate. But the correlation of shocks does not in itself imply that the trade-offs have changed.

That said, the mere fact that such situations can occur is enough to imply that central banks should work together. In fact, central banks have a long tradition of dialogue under normal circumstances that makes coordinated action possible in exceptional circumstances. In regional and global fora or institutions, there are various forms of regular cooperation and exchange of information on each other’s reactions functions, as well as each other’s views on the economic outlook and the nature of shocks. Dialogue is a prerequisite for the ability to take joint decisions at critical moments.

We also need to further improve our analytical frameworks so as to better understand the international propagation mechanisms of unconventional monetary policies, both at a macro and at a micro level, as well as to share our findings with central banks in emerging economies. This is what we do at meetings with the BIS, the IMF and the G20. This way, we keep open a constant dialogue so as to remain ready for rapid coordinated action in exceptional circumstances.

In particular, we should strive to strengthen the global financial safety nets so that we can better address global or regional liquidity crises and limit the case for self-insurance by countries, which we know has a high opportunity cost.

Elements of global financial safety nets, more related to balance of payments developments, exist at the level of the IMF and the Regional Financial Arrangements. These instruments provide support against ( ex-ante or ex-post) conditionality. Progress is possible to improve the existing arrangements to help avert sudden stops while limiting the “moral-hazard” implications of insurance.

Part of this is swap arrangements among central banks that enable emergency liquidity to flow to major financial hubs and – through these hubs – to other markets, thereby contributing to global financial stability. When these lines are not standing, technical preparation can make it possible to activate them immediately in case of need. In this way, central banks can support a consistent approach to global financial safety nets, while respecting the different mandates and independence of institutions.

Let me now conclude. The case for formal central bank cooperation remains limited, and practical consideration makes its implementation difficult. That said, central banks need to be engaged in a constant dialogue so as to remain ready for rapid coordinated action in exceptional circumstances. And we should strive to strengthen the global financial safety nets so that we can better address global or regional liquidity crises and limit the case for self-insurance by countries.

I thank you for your attention.