Policy Imbalances and the Uneven Recovery

John B. Taylor

Conference on The Uneven Recovery:

Emerging Markets versus Developed Economies

Oct 14, 2011

Two Global Imbalances(1) Current account imbalances(2) Monetary imbalances• Both relevant for emerging markets

versus developed economies• We hear much about the first • But the second may be more important

Current Account Imbalances

• A frequent topic for international coordination• A perennial topic for G-20, IMF, OECD (WP3)• Sometimes used for calls by US and Europe for

exchange rate changes by EME • Frequently blamed for the financial crisis

– Saving glut flows into US, lowers interest rates– Alternative to the “too low for two long” view

• Now “rebalancing” is a major focus of the G-7, G-20, IMF

Link to Saving-Investment Gap

Saving – Investment =Net ExportsY=C+I+G+XY-C-G= I+XS=I+XS-I=XLook at recent history

17

18

19

20

21

22

23

60

62

64

66

68

70

72

1975 1980 1985 1990 1995 2000 2005 2010

Percent Percent

Consumption asa share of GDP(right axis)

Government purchasesas a share of GDP(left axis)

United States C/Y and G/Y

6

8

10

12

14

16

18

20

1975 1980 1985 1990 1995 2000 2005 2010

Percent

US Investment rate

US saving rate[100(1 - C/Y- G/Y)]

-8

-6

-4

-2

0

2

4

8

12

16

20

1975 1980 1985 1990 1995 2000 2005 2010

U.S. net exports as ashare of GDP(Left axis)

U.S. 30-year mortgage rate(right scale)

PercentPercent

Source: Borio and Disyatat (2011)

Capital Flows and the Current Account Consider 2004 (Billions of dollars)Exports of goods and services and income receipts 1531Imports of goods and services and income payments -2118Unilateral current transfers -81Current Account Deficit -668

U.S. Owned Assets Abroad -856Foreign Owned Assets in the United States 1440Statistical discrepancy & other reconciliations 84

http://www.bea.gov/bea/newsrelarchive/2005/trans305.pdf

Source:

Note that these are capital flows

Not capital stocksU.S.GDP was $11734 billion in 2004, soCA was 5.7 percent as a share of GDP

The connection between current account and change in official reserves can be particularly weak

Current account =Change in official reserves+ other gross outflows- other gross inflows

United States

Mainly Europe rather than emerging markets

If not the current account, thenwhat is driving these flows?

•Monetary policy •Exchange rate policy

Clear Evidence from a Very Transparent Central Bank

• Norges Bank very explicit and transparent in accounting for how external variables affect interest rate path

• Useful to consider several episodes in past few years•Reveals foreign interest rate as the most significant reason for deviating from basic rule

Policy rate in 1/2008 (with fan chart) and theincrease in the policy rate in 2/2008 (red line)

0

3

6

9

Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-110

3

6

9

Source: Norges Bank

90% 70% 50% 30%

Factors behind changes in the interest rate path from 1/2008 to 2/2008

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

08 Q3 09 Q1 09 Q3 10 Q1 10 Q3 11 Q1 11 Q3-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

Higher demand in NorwayHigher inflation in NorwayHigher interest rates abroad and developments in the foreign exchange marketLower growth abroadHigher risk premium in the money market

From 1-10

From Øistein Røisland “Monetary Policy in Norway”

From MPR 1/10

From OECD Survey Norway, 2010

Example from Sebastian Edwards (2005) “The Relationship Between Exchange Rates and Inflation Targeting Revisited”

Empirical evidence that target interest rate in EM central banks responds to exchange rates

Continued from Sebastian Edwards (2005)

Example from ECB during 2000-2006

• Sample 2000.1 - 2006.4. • Inflation = 4-quarter rate of change in the

harmonized index of consumer prices• GDP gap = % deviation of real GDP from trend. • Regress deviation of ECB rate from Taylor rule on

federal funds rate. • Estimated coefficient = .21

– standard error of .06. – Plot of the actual and fitted values from this regression:

Illustrative Chart from the OECD, March 2008

The Case of the Uneven Recovery

• Very low policy rate in US • Creates pressures on EM central banks to hold

rates lower than they would be for domestic price and output stability– Also creates pressures to intervene in currency

markets and impose capital controls• Leads to higher inflation, and perhaps more crises• So need to have “monetary rebalancing” • But little interest from developing countries

General Sources of Instability Consider two country model with i affecting i*

Interest rates are set according to:

Solving for the interest rates results in the following

iyi

iyi****

*

5.5.1

5.5.1

)(5.)(5.111

)(5.)(5.111

***

*

***

yyi

yyi

Conclusion

• Need to focus more on “monetary rebalancing”– Side by side discussion with “current account

rebalancing”• May be more important than current account

rebalancing• But how?

– More global leadership– Global inflation target