What to do about spillovers?

Our results provide new insights. We find economically and statistically significant spillovers from the United States to EMEs and smaller advanced economies. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify.

We also find that monetary spillovers take place under both fixed and floating exchange rate regimes, which lends some support to the conjecture in Rey (2013, 2014) that the global financial cycle constrains monetary policy irrespective of the exchange rate regime.

From a policy perspective, our findings suggest that neither are interest rates fully independent nor is monetary policy fully unconstrained when economies and financial markets are closely integrated. Even under flexible exchange rates, central banks – though technically able – seem to find it difficult to conduct a monetary policy that is based purely on domestic factors and which ignores monetary developments in core advanced economies. Furthermore, our findings also shed some light on the causes of the persistently low interest rates that have prevailed globally over the past seven years. Back-of-the-envelope calculations based on our results suggest that easy monetary conditions in the United States have exerted considerable downward pressure on interest rates elsewhere. [Link]

These are from the paper, ‘International Monetary Spillovers’ published in the 3Q2015 Quarterly Review of the Bank for International Settlements.

In his Per Jacobsson Memorial Lecture in 2012, Dr. Y.V. Reddy recognises the difficulty of managing spillovers but does not offer solutions:

Public policy is conducted at the national level, but at the same time, globalisation of economies, often driven by technology, is a reality, and the global macroeconomic environment is an outcome of national policies in a framework of nebulous global governance arrangements. The challenge for national central banks is to find space for the conduct of their own policies in an increasingly inter-dependent global economy.

Too much global policy coordination might lead to the universalisation of risks of policy mistakes. The main contention is that good finance is essentially a function of good economic policies, and such good policies are primarily national, though significantly impacted by the global macroeconomic environment – which, as already mentioned, is not a product of design. [Link]

This is interesting, however:

It is true that successful arrangements for global coordination while retaining space for national public policies are working well in certain sectors, such as aviation, telecoms and the internet. But they seem to get into difficulties in regard to macroeconomic policies and finance. Clearly, there is a need to explore why global agreements work reasonably well in some sectors, leading to acceptable and assured outcomes, while when it comes to macro policies and finance such agreements appear difficult to arrive at – and what we can learn from them.

The spillover issue suggests a few solutions in no particular order of importance or categorisation into financial, macro, domestic and global.

(1) Selective and time-bound application of capital controls and quantitative restrictions including the use of higher risk weights for bank exposure to sectors receiving too much credit and equity – from domestic and foreign sources

(2) Regular, gradual and moderate foreign exchange reserve accumulation

(3) Bailing-in of creditors during banking crises. Living wills and insurance funds from premiums paid by banks can be part of the solution

(4) Encouraging domestic consumption and gradually lower reliance on U.S. consumer

(5) United States to de-emphasise the importance of asset prices for macro-economic growth and stability. The Federal Reserve assigns too much weight to the wealth effect transmission to macro aggregates, especially from the stock market. That has resulted in many other problems too, including the leaking of insider information on a systematic basis to financial institutions, investors and the media.

In other words, the United States needs a new monetary policy framework that incorporates financial cycles and financial stability and not just employment, price stability and stability of long-term interest rates.

(6) United States to conduct more symmetric monetary policy than now

(7) Federal Reserve to obsess far less about managing and minimising market volatility

(8) Less emphasis on forward guidance and transparency in the monetary policy framework of advanced countries. This will moderate risk taking in financial markets which are globally integrated and hence the risk-taking goes global. To the extent they are restrained in the United States, the restraint will also spill over to capital markets around the world. This is a virtuous spillover. Indeed, this is the logic behind suggestions (5) to (7) too.

(9) Higher capital requirement for banks. This will restrain endogenous money creation by banks. That will, in turn, moderate credit and capital flows to emerging economies.

(10) Re-introduction of separation of retail-commercial from investment banking. Same outcome as in (9) as it will moderate risk taking by financial institutions.

(11) This last one is admittedly a hypothesis. For many reasons – benign and not-so-benign – policymaking in the United States is captured by China. One of the benign explanations is that, for U.S. policymakers, China has become another ‘Too big to fail’ institution. Hence, their nervousness about conducting normal monetary policy. One more reason for asymmetric monetary policy. This results in a sub-optimal monetary policy in the United States which is then transmitted to the rest of the world with integrated and pro-cyclical capital markets.

Postscript: the possibility of a multi-polar world of currencies must be deemed remote now. China’s yuan might be part of the SDR basket. But, it is unlikely to be an international currency. China does not have the stomach for it. Its actions in recent years have demonstated that its penchant for control overrides the objective of internationalisation. The Euro is unlikely to become an alternative, ever.

Hence, the reform of the American monetary policy framework is the only hope. Will the Chinese ‘capture’ of American policy in benign or not-so-benign ways end?

Will the Trump administration rise to the challenge on both? My answer, five months ago, would have been more optimistic than it is now.

(For completeness, you can find Raghuram Rajan’s suggested solutions for the spillover problem in his speech delivered in New York in May 2015).


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