Monetary Policy in an Uncertain and Volatile World Mario Bergara IEA-BCU Roundtable on “Capital Flows, Capital Controls and Monetary Policy” December 7th, 2013

Anemic growth/Recession Advanced economies Differential situation in advanced and emerging economies Emerging economies Monetary expansion Quantatitive easings Defensive strategies Market intervention Reserve accumulation Reasonable growth Fiscal problems Stronger fiscal positions Debt issues Sustainable debt Monetary Policy in an Uncertain and Volatile World

Implications of volatile capital flows for macroeconomic and financial stability Growth differentials Volatile exchange rates in emerging markets Uncertainty and volatility in the global environment Interest rate differentials Differential expectations on exchange rates Liquidity conditions and market sentiment Risks of asset price bubbles and bank lending boom Risks of capital flow stop or reversal Monetary Policy in an Uncertain and Volatile World

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 Monetary Policy in an Uncertain and Volatile World

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 Monetary Policy in an Uncertain and Volatile World

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 Monetary Policy in an Uncertain and Volatile World

A consistent set of policies must balance different objectives, such as low inflation, competitiveness and financial stability Monetary Policy in an Uncertain and Volatile World

Monetary policy based on a trinity: Exchange rate flexibility Inflation target Monetary 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 markets Foreign 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) Monetary Policy in an Uncertain and Volatile World

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) Monetary Policy in an Uncertain and Volatile World

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) Monetary Policy in an Uncertain and Volatile World

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? Monetary Policy in an Uncertain and Volatile World

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 markets The decentralized governance failed as well as the “light supervision” approach Supervision 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 in an Uncertain and Volatile World

Monetary Policy Lender of Last Resort Prudential Regulator and Supervisor Deposit Insurer and Resolution Agency Coordination and contribution for all agencies to comply with their respective mandates From Financial Safety Net to Financial Stability Net Ministry of Finance/ Treasury Monetary Policy in an Uncertain and Volatile World

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? Monetary Policy in an Uncertain and Volatile World

Monetary Policy in an Uncertain and Volatile World Mario Bergara IEA-BCU Roundtable on “Capital Flows, Capital Controls and Monetary Policy” December 7th, 2013