Monetary Policy in an Uncertain and Volatile World Mario Bergara IEA-BCU Roundtable on “Capital...

Monetary Policy in anMonetary Policy in anUncertain and Volatile WorldUncertain and Volatile World

Mario Bergara

IEA-BCU Roundtable on “Capital Flows,Capital Controls and Monetary Policy”

December 7th, 2013

Anemic growth/Recession

Advancedeconomies

Differential situation in advanced and emerging economies

Emergingeconomies

Monetary expansionQuantatitive easings

Defensive strategiesMarket intervention

Reserve accumulation

Reasonable growth

Fiscal problems Stronger fiscal positions

Debt issues Sustainable debt


Implications of volatile capital flows formacroeconomic and financial stability

Growthdifferentials

Volatile exchange rates in emerging markets

Uncertainty and volatility in the global environment

Interest ratedifferentials

Differentialexpectations onexchange rates

Liquidityconditions and

marketsentiment

Risks of asset price bubblesand bank lending boom

Risks of capital flowstop or reversal


Price stability: monetary policy

Contributes to financial stability due to a better framework for risk management by financial agents

Financial stability: micro-macro regulation and supervision of the financial system

Contributes to price stability and to enhance transmission channels of monetary policy

The financial crisis has shown that macroeconomic stability proved insufficient to preserve financial stability, which is crucial for the effectiveness of monetary policy

Central Bank concerns: price and financial stability


It has been necessary to put in place a set of macroprudential instruments to limit the exposure of the financial system to systemic risks

They typically impose efficiency costs on financial intermediation, which nevertheless are lower than the benefits from preserving financial stability

Central Banks in emerging economies have used reserve requirements and caps on foreign exchange positions to limit potential imbalances derived by surges in short-term capital inflows

Lately, Central Banks have used instruments such as additional capital requirements, counter-cyclical provisioning, and additional liquidity requirements to reduce systemic risks and enhance financial resilience

Nevertheless, the quantitative effect of macroprudential measures is difficult to establish and their effectiveness is challenged

Financial stability in the context of macroeconomic stability


The exchange rate flexibility acts as an automatic buffer to cushion against external shocks and contribute to provide an adequate incentive structure in the economy

Foreign exchange market intervention has been done in order to reduce excessive volatility and currency appreciation in the current (circumstantial) financial environment, but not against long term fundamentals

Costly sterilized market intervention has been done by balancing with other goals, such as low inflation and long term competitiveness

The impact and effectiveness of policy options


A consistent set of policies must balance different objectives, such as low inflation, competitiveness and financial stability


Monetary policy based on a trinity:Exchange rate flexibilityInflation targetMonetary policy rule: contingency plan specifying the circumstances under which policy instruments are changed

“Taylor rule” are designed for economies with:Fully developed long-term bond marketsForeign exchange market with a high degree of capital mobility

Market structural conditions in emerging markets may require modifications of the typical policy rule recommended for economies with developed financial markets

With uncertainty and difficulties in measuring the natural interest rate, policy makers might want to give greater consideration to policy rules with monetary aggregates

The design and implementation of monetary policy: Taylor (2000)


Policy rule as a guideline for monetary policy decisions, but discretion is also needed

Other objectives can be addressed as long as they are not inconsistent with the inflation target in the long run

A flexible exchange rate policy does not mean that the exchange rate plays no important role in the policy rule and in the transmission mechanisms: country’s size, openness, capital mobility and FX market development matter

In sum, monetary policy rules in emerging economies might require modified considerations on:

The choice of instrument (monetary aggregates)The variables in the rule (greater role for exchange rate)The size of response of the instrument to economic events (to deal with less developed financial markets)

The design and implementation of monetary policy: Taylor (2000)


Capital flows to emerging markets are strongly motivated by the seek of profitability and liquid assets: this motivation declines when returns of liquid assets in developed economies are expected to rise

Capital flows intensifies with more volatility, because liquidity is endogenous: more used assets are more liquid

An asset is liquid if the market considers it as liquid: thus, liquidity is not a fundamental and can disappear

Dilemmas for Central Banks: in developed countries, they reduced interest rates to zero and then they opted for QE (monetary aggregates), purchasing assets of unknown quality

Incentives for capital flows to emerging economies and high yield bonds, inducing FX market interventions

The interest rate might become ineffective as an instrument when is too high and threatens fiscal sustainability

The design and implementation of monetary policy: Calvo (2013)


The complementary roles of micro and macro perspectives

The macroprudential perspective contributes with more instruments to deal with short term capital flows, without affecting macroeconomic and financial stability

Capital controls or capital flows management?

Both approaches help to make agents to internalize externalities in both static and dynamic dimensions of financial stability

Regulation should be determined by the assessment of risks, avoiding arbitrage incentives: micro and macro-systemic risks have to be taken into consideration

Macroprudential Framework vs.Microprudential Framework?


The lack of a macro-systemic approach was clear, but was the micro-prudential regulation working properly?

Failure of the regulatory approach and of the organizational design of public intervention in financial marketsThe decentralized governance failed as well as the “light supervision” approachSupervision and regulation was poor and the organization of the Financial Safety Net was inaccurate in some places and chaotic in others

A possible (dangerous) lesson from the crisis: “Everything was right except that the macro-prudential approach was lacking.”

The discussion about the governance of macro-prudential policies might be “smuggling” a debate about the failure of the decentralized regulation and the need to move towards a more centralized fashion

We need to get back to the conceptual determinants of the optimal Financial Safety/Stability Net: conflict of objectives, incentive structures, accountability, coordination and organizational design

Current discussion influenced by situation in developed countries


Monetary Policy

Lender of Last Resort

Prudential

Regulator and

Supervisor

Deposit Insurer

and Resolution

Agency

Coordination and contribution for all agenciesto comply with their respective mandates

From Financial Safety Net to Financial Stability Net

Ministry of Finance/

Treasury


The normalization of global financial conditions are not bad news for emerging markets: the cost of financing is not everything

Since a large share of the US dollars circulate outside the US, they are collecting segnoriage all across the universe: we are all paying the financial crisis

Emerging countries should not expect the Federal Reserve to introduce the international impact of its decisions into its objective function

Even the “softer” road will be bumpy: communication is as crucial as implementation

This will be a new test for emerging economies to navigate on troubled waters

A soft road to normalization?



Mario Bergara

IEA-BCU Roundtable on “Capital Flows,Capital Controls and Monetary Policy”

December 7th, 2013

Monetary Policy in an Uncertain and Volatile World Mario Bergara IEA-BCU Roundtable on “Capital...

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