Monday, April 17, 2017

Global Economy - The need for a very expansive monetary policy and continued extraordinary measures by central banks has receded ..- Jaime Caruana BIS

Publication - Interview with Mr Jaime Caruana, General Manager of the BIS, in Börsen-Zeitung, conducted by Mr Mark Schrörs and published on 11 April 2017.

Mr Caruana, global growth is firming and inflation is picking up. Is it now finally time for central banks to bring the era of ultra-loose monetary policy to a close?

The situation has without question improved considerably: deflation risks have for the most part disappeared, employment markets have recovered markedly, and unemployment has fallen. We're even seeing progress with the cleaning-up of banks' balance sheets. So the need for a very expansive monetary policy and continued extraordinary measures by central banks has receded. In the United States, the normalisation of monetary policy is already under away. Other countries are in a different cyclical position. Each central bank must determine for itself when would be the right moment to start exiting.

The US Federal Reserve has so far pursued a very cautious approach to normalisation while others, like the European Central Bank and the Bank of England, are sticking to their ultra-loose policies. Is that appropriate, or should the pace of normalisation be stepped up - especially given the risks of ultra-low rates, particularly for financial stability?

Central banks are moving through uncharted territory because in some cases they have resorted to completely new instruments. It is therefore right to proceed gradually and cautiously. But it is also right to move along a steady path to normalisation. The current economic situation is conducive to that. This path may prove bumpy along the way, because we don't know how markets will react. But that shouldn't be a reason to change course. It is important that now that monetary policy normalisation has begun, this process should continue. It is also important to emphasise that there are no longer just downside risks. There are currently also upside risks for growth and inflation.

Are central banks still too focused on the dangers of exiting too early and too quickly, and are they underestimating the dangers of exiting too late and too slowly?

The risks of exiting too late have probably been underestimated when one takes a long-term view - and if the consequences for financial stability are taken into account. Price stability and financial stability are, after all, two sides of the same coin.

Aren't central banks actually repeating their mistakes from the beginning of the 2000s when they kept interest rates extremely low for a long period and then raised them only very slowly - which led to the build-up of financial excesses, which in turn resulted in the global financial crisis?

If you adopt a medium- to long-term perspective - one that takes particular account of financial cycles - you find that central banks have to date acted asymmetrically: they probably don't do enough in the good times - in the boom - to prevent the build-up of financial imbalances; and during the bust, they're inclined to do too much [to ease conditions]. It would be much better to deal with financial imbalances more symmetrically. Our research shows that a more systematic approach leads not just to more stability in the financial system, but also to better results in terms of growth, for instance because output volatility decreases.

However, central banks continue to focus above all on the shorter economic cycle, and especially inflation. Some are now even arguing that, after years of inflation rates below the announced 2% target, a little overshooting should be tolerated. What's your opinion?

After so many years with below-target inflation rates, it's logical that central bankers want to be sure that this problem is solved, and also that inflation expectations are anchored. But it's also important to keep sight of the upside risks for inflation. Factors such as globalisation certainly dampen price pressure. But labour markets are tighter than they have been for a while, and protectionist measures or fiscal impulses too can fuel expectations of inflation. There are a few upside risks for inflation, and we should not be complacent about them.

So, it's risky to allow inflation to overshoot?

If central banks put off taking the necessary actions, they would have to act all the more abruptly later - and their subsequent interventions are only more disruptive for markets and the economy. They know that, and therefore I believe each of them will make their own decisions to act when needed.

Central banks are also concerned about the consequences of a more restrictive monetary policy for markets and debt servicing, not least for governments. How great is the danger of market considerations dominating monetary decision-making ("financial dominance") or fiscal policy considerations holding sway over the actions of central bankers ("fiscal dominance")?

Whenever central banks use their balance sheet as an instrument, the dividing line between monetary and fiscal policy blurs. The risk of "fiscal dominance" is real. But I am convinced that central banks are aware of this risk, and that they will act when necessary. As far as the financial markets are concerned: it's certainly a consequence of this phase of very low interest rates and massive financial market intervention by central banks that the markets have become much more dependent on central banks. That's what makes moving towards normalisation so complex. But it doesn't alter the fact that normalisation is necessary. Good communication is an important component of the task of mastering the exit. Central banks are doing a great job preparing the markets.

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