Monetary Policy in the New Normal
– Remarks at 2015 China Development Forum Panel Discussion
Christine Lagarde, Managing Director of International Monetary Fund
Beijing, March 22, 2015
Good afternoon, Ladies and Gentlemen.
I would like to thank Mr. ZHANG Liming, Vice President of the Development Research Center, for his kind introduction, and thank you to the Development Research Center for inviting me to this important panel.
It is a great pleasure to share this stage with Governor Zhou, who has so deftly guided China’s monetary policy over the past decade. China played a key role in stabilizing the global economy during the financial crisis, and has since provided vital support to the recovery.
The world has yet to achieve full economic recovery. Global growth continues to be weighed down by high debt, high unemployment, and lackluster investment. The IMF recently cut its global growth forecasts for both 2015 and 2016 (to 3.5% and 3.7%) – despite the boost from cheaper oil and stronger U.S. Growth.
The recovery remains fragile because of significant risks. One such risk emanates from the expected tightening, or normalization, of U.S. monetary policy at a time when many other countries are easing monetary conditions. This “asynchronous” monetary policy may trigger excessive volatility in global financial markets.
The divergence of monetary policy paths has already led to a significant strengthening of the U.S. dollar. Emerging markets could be vulnerable, because many of their banks and companies have sharply increased their borrowing in dollars over the past five years.
Given these global economic conditions, I would like to briefly discuss three points:
• What are the cross-border effects, or “spillovers”, of unconventional monetary policies?
• How can emerging market economies prepare for potential market volatility?
• What is the nature of monetary policy in what we call the “new normal”?
1. What are the spillovers of unconventional monetary policies?
Let me start with the spillover effects. After the onset of the global financial crisis in 2007, unconventional monetary policies, including large purchases of government debt, had strong, positive spillovers on the global economy – and by implication on China and other emerging market economies.
Why? Because these policies prevented a financial market meltdown and because they have supported the recovery in advanced economies and beyond. I am convinced that, without these unconventional tools, the world would have sunk into a1930s-style depression.
Unconventional monetary policies have also led to negative spillover effects on emerging markets through a build-up of financial stability risk. These policies triggered huge capital inflows into emerging financial markets. Between 2009 and the end of 2012, emerging markets received US$ 4½ trillion of gross capital inflows, representing about half of global capital flows during that period.
This led to a significant increase in bond and equity prices and to a strengthening of emerging market currencies. IMF studies suggest that these effects were larger than the ones that had been caused by conventional policies in the past.
These spillovers pose a risk to financial stability in emerging markets, because policy changes could easily lead to a sudden reversal of capital flows.
We already saw a preview of this scenario during the so-called “taper tantrum” in the summer of 2013. Merely the first hint of a change in U.S. monetary policy was enough to trigger a surge in financial market and capital flow volatility.
Could this happen again? Despite the efforts of the U.S. Federal Reserve to clearly communicate its policy intentions, financial markets may still be surprised by the timing of the U.S. interest rate lift-off and by the pace of subsequent rate increases.
The potential spillovers would affect China mostly through its trade relationships with other emerging markets. If spillovers were to cause a sustained weakness in demand in these countries, Chinese exports would certainly be affected.
Given the growing importance of this topic, the IMF has continued to step up its analysis of spillover effects. We believe that this will continue to be one of our most valuable contributions in this interconnected global economy, and it may also encourage greater policy cooperation.
2. How can emerging market economies prepare for potential market volatility?
Which brings me to my second point: how can emerging markets prepare for potential market volatility? Let me highlight three steps.
First, emerging markets need to prepare well in advance. IMF research suggests that countries with better fundamentals were generally less affected by the 2013 taper tantrum and by other monetary policy spillovers from advanced economies.
Second, emerging markets need to ensure that their financial systems are resilient to asset price swings and a sudden withdrawal of funding liquidity. Prudential policies should serve as a first line of defense. Much thinking has been devoted in recent years to the role that macroprudential tools can play, and it is now time to put this into action.
Third, if market volatility materializes, central banks need to be ready to act. Temporary –but aggressive – domestic liquidity support to some sectors or markets may be necessary. In certain conditions, foreign exchange interventions could also be used to dampen exchange rate volatility. These interventions should not be used as a substitute for needed macroeconomic adjustment. Moreover, foreign currency swap lines across countries have proven helpful in providing access to foreign exchange liquidity in times of market stress.
International coordination and safety nets can also play a crucial role. For example, central banks and financial supervisors may want to share their policy thinking and contingency plans. Closer cooperation between the IMF and Regional Financing Agreements – such as the BRICS Contingency Reserve Arrangement – would also be helpful.
3. What is the nature of monetary policy in the “new normal”?
This brings me to my third point – the nature of monetary policy in the “new normal”.
The question is: should monetary policy go beyond its traditional focus on price stability? One of the key lessons of the financial crisis is that price stability is necessary but not sufficient for financial stability. At times, low inflation actually coincides with brewing financial imbalances. This is why policymakers need to pay more attention to financial stability.
Does that mean that monetary policy should be responsible for price stability and financial stability? The short answer is “No”. Macro- and micro-prudential policies are the first choice to preserve financial stability. They can be better targeted, including to sectors in which risks are rising. Many countries are now adopting strong macroprudential frameworks with supporting institutions and a range of new tools.
Of course, prudential policies are not a panacea. Their effectiveness may be limited because of an incomplete policy toolkit or institutional shortcomings. They may also have negative side effects. This is why monetary policy may sometimes need to “lean against the wind” of rising financial imbalances – even as its primary focus remains on price stability.
Finally, as countries step up their macroprudential policies, worries are surfacing about central bank independence. If central banks receive broader mandates and use more instruments, will they come under greater political pressure? Could this undermine their independence in pursuing price stability?
We have yet to learn more about this issue. One option is to assign both monetary and macroprudential policies to the central bank, as Ireland and New Zealand have done. Another option is to assign both to the central bank, but with governance that provides some separation between the two functions. The Bank of England was one of the first to adopt this model.
There could also be a macroprudential council outside the central bank. This is essentially what the United States has done. As countries continue to experiment with different institutions, we are likely to gain important new insights into which arrangements work and which do not.
Let me conclude.
Monetary policy is entering a “new normal” – so too is the Chinese economy. China’s deep structural reforms will lead to slower, safer, and more sustainable growth. Macroprudential policies have already been playing a major role in this adjustment, and will continue to do so going forward. This is good for China and its people – and it is good for the world.
As China navigates the “new normal” to become the world’s largest economy, the IMF stands ready to help. I look forward to a fruitful discussion.
Thank you. Xièxiè.