CHAPTER 3. “Rethinking Macroeconomic Policy”: Comments

Il SaKong, and Olivier Blanchard
Published Date:
July 2010
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Yung Chul Park

The paper by Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro is an important contribution to the current debate on the causes of the failure of macroeconomics in general and many sophisticated forecasting models in particular in predicting the 2008–09 global economic crisis. At a time when all countries—both developed and developing—are struggling to find a way out of the crisis, this paper provides a new approach that will help construct a more effective setting for the conduct of monetary policy. Unfortunately, however, it has been unduly highlighted for a single member—4 percent—which the authors propose as a new target rate of inflation, while receiving much less attention on many of the suggestions for building a new framework than it deserves.

The authors admit that in the wake of the crisis, economists have come to realize that many of the conventional propositions in macroeconomics, such as irrelevancy of financial intermediation and sine qua non of stable and low inflation, were wrong and what economists did not know may have contributed to the failure of detecting the signs of a looming crisis. Yet, the authors do not believe that inflation targeting should be replaced by any other alternative frameworks for monetary policy, provided it is reinforced by financial regulatory tools and better fiscal automatic stabilizers. Many people who expected from the authors comprehensive, if not revolutionary, changes in macroeconomics are likely to be disappointed, but the paper provides an excellent summary of what economists did not know before and have learned after the crisis. In what follows, this note raises a number of questions on designing a new macroeconomic policy framework from the perspectives of emerging economies.

3.1. Inflation Targeting

Many laymen, who have become accustomed to price stability and have a limited background in economics, would find it difficult to understand the argument that the target rate of inflation and hence interest rates need to be raised to increase the room for monetary policy. Lifting up the target rate of inflation to 4 percent or to as high as 6 percent, as Rogoff (2008) suggests, which is expected to push up interest rates by 2 percentage points or more, will hardly be enough to inflate out of the high debt levels many countries—both developed and developing—are saddled with. Yet, it may be construed as an attempt at debt deflation in disguise.

The zero bound is a constraint on interest rate policy, but if the target rate were to be raised, how high should it be? In the absence of any consensus on an optimal rate of core or headline inflation, it is difficult to argue that 4 percent would be an appropriate target level. The federal fund rate was lowered from a high of 5.27 percent in August 2007 before the onset of the crisis to 0.08 in January 2010. Would the 4 percent target instead of 2 percent have created more room for monetary policy in the United States? It may not have.

Target rates of inflation in advanced countries are concentrated around 2 percent a year, whereas in emerging and developing economies they are around 3½ percent (Schmitt-Grohe and Uribe, 2010). If advanced countries were to double their target rate following the authors’ suggestions, should emerging economies do the same in view of the fact that they are more susceptible to internal and external shocks, pushing up the target rate to a level as high as 7 percent? In an extreme case where the target rate is doubled, in many emerging and developing economies, the default risk-free interest rate could rise to 9 percent in normal times. Can one justify such a high rate of interest for the sake of improving effectiveness of monetary policy? If interest rates in global financial markets are to go up to 6 to 7 percent, most emerging economies would find an equally large increase in their cost of external borrowing in reserve currencies. The high cost of external financing would pose a significant barrier to their development efforts.

There is an emerging consensus that monetary policy should be geared not only to stabilizing prices but also financial markets and institutions in order to facilitate the attainment of this additional objective. The authors propose that central banks be armed with a number of macroprudential regulatory instruments such as the loan-to-value, debt–to-income, and cyclical loan and capital provisioning. Changes in these instruments have an effect on the lending capacity of banks and other financial institutions and hence on monetary and credit aggregates. As price and financial stability are not independent but interrelated objectives, central banks cannot rely on the interest rate rule for stabilizing prices and set aside regulatory tools for mitigating financial turbulences. Both instruments are likely to be employed whenever monetary policy actions are called for either price or financial stability. Therefore, addition of regulatory instruments implies that changes in the quantity of credit or other monetary aggregates can complement the interest rate rule and hence can be integral components of the arsenal of monetary policy instruments. This change in the scope and operation of monetary policy may then weaken the case for a higher target rate.

In most emerging economies, the markets for real assets such as housing and commercial real estate and land are segmented, illiquid, and are not closely linked with other financial markets. These markets have also been major sources of financial instability as they are prone to speculation and the boom-bust cycle. In these economies, the interest rate rule is hardly adequate to preserve financial stability unless it is supplemented by macroprudential tools.

There is also the uncertainty as to whether central banks would be able to change inflation expectations by just announcing a new target rate. If market participants are unable to form their expectations of future inflation because of the lack of the central bank credibility, much of the effect of monetary expansion required to double the target rate is likely to fall on the demand for both financial and real assets to raise their prices, before, given a relatively long operational lag, reaching the markets for goods and services. The asset price increase could subsequently provoke speculation and set off a boom-bust cycle in financial and real asset markets. To prevent the ensuing financial instability, macroprudential tools may have to be activated. The combined effect of the monetary expansion and changes in the regulatory instruments would then have an ambiguous effect on current and future inflation, making it difficult to anchor inflation expectations.

3.2. Financial Intermediation

One of the lessons of the crisis is that financial intermediation matters. Many anomalies of the financial system caused by the expansion of shadow banking and proliferation of structured derivative products have been at the root of the current crisis. They may also have weakened effectiveness of monetary policy. It would therefore be interesting to examine the extent to which the effectiveness of inflation targeting is predicated on the structure of the financial system. For example, the more complex and diversified financial system, the less effective is inflation targeting. Many proposals for financial reforms have been put forward by a number of advanced economies and various global forums. If excessive leverage and risk taking are the problems to be controlled to enhance efficiency and stability of the financial system, would it not be a better solution to reform the system rather than relying on macroprudential tools to mitigate them?

Once financial market stability is explicitly accepted as an objective of monetary policy, it follows that central banks should have a clear understanding of causal relations between price and financial stability. Price stability may create an economic environment conducive to excessive risk taking and hence susceptible to financial instability. Would sustaining financial stability assure price stability? If indeed it did, what factors would then explain the underlying asymmetry?

In managing a new inflation targeting framework, it would also be necessary to define and construct an operational measure of financial stability. Unlike in the case of price stability, there are not many indices of financial stability observable and credible to the general public for the central banks to adopt for the conduct of monetary policy. In the absence of such indices, central banks may find it difficult to respond to disruptions in real and financial asset markets or anchor expectations on financial stability, however it is defined.

3.3. Sterilized Intervention

Prior to contemplating any sterilized intervention emerging economies must determine as a precondition an adequate amount of foreign exchange reserve to be held. A rule of thumb is provided by the Greenspan–Fischer prescription, which requires an amount of reserve equal to the volume of short-term foreign liabilities. Given their volatility, foreign investments in domestic equities need to be included in the definition of short-term external liabilities. If they are, the amount of reserve to be adequate multiplies. For example, at the end of 2007, Korea’s reserve should have been close to 50 percent of its GDP.

If such a large amount is required, emerging economies may not see any rationale in participating in international financial intermediation. As far as intervention in the foreign exchange market is concerned, what is needed from the point of view of policymakers is a set of operational guidelines determining the circumstances that call for intervention and timing of entering and leaving the market. The IMF would be the ideal institution to establish such guidelines.

In most emerging economies, keeping the current account in balance or its deficit at a sustainable level is an important policy objective. The question then arises as to which policy instrument could be employed to achieve current account balance. It is hard to believe that fiscal policy could be reserved for the current account objective. This suggests the possibility of allowing the reserve intervention not only for smoothing volatility of the nominal exchange rate, but for restoring the current account by influencing its level. There is also the question of whether emerging economies should consider capital control as a means of stabilizing the exchange rate. The authors suggest that when the limits to sterilized intervention are reached, and the consequences of adverse exchange rate movements have to be taken into account. Although they do not advocate capital control explicitly, in the absence of other effective policy instruments, they seem to suggest that emerging economies may have to resort to this contentious measure. If this indeed is the case, the authors are entering into a controversial area where the past experiences do not shed much light on the effectiveness of various capital control measures.

3.4. References

    Rogoff, Kenneth, 2008, “Inflation Is now the Lesser Evil.” (Prague: Project Syndicate). Available via Internet at

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    Schmitt-Grohe, Stephanie, and MartinUribe.2010, The Optimal Rate of Inflation in The Elsevier/North-Holland Handbook of Monetary Economics, Vol. 3, ed. by BenjaminM. Friedman and MichaelWoodford (Maryland Heights, MO: Elsevier).

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