Globalization and Monetary Policy

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1 Globalization and Monetary Policy John B. Taylor Stanford University Fifteenth Cycle of Economic Lectures Banco de Guatemala 22 June 2006

2 Outline: Three Themes Increased Need for Systematic Strategies Use of Policy Rules for Interest Rate Settings Principles of Exchange Rate Policy Major Currencies and Beyond International Monetary Policy New Rules for the IMF

3 Rules versus Discretion Rules-based or principles-based policy Four key principles Inflation Target Greater than One Principle Responding to Real GDP Liquidity provision Cannot eliminate discretion But can emphasize the principles and strategy Communication essential The Approach has proved beneficial Macroeconomics performance improved The Long Boom or the Great Moderation

4

5 From Has the Fed Gotten Tougher on Inflation? The FRBSF Weekly Letter, March 31, 1995, by John P Judd and Bharat Trehan of the San Francisco Fed

6 Figure 1: Greenspan Years: Funds Rate and Taylor Rules (p* = 1.5, r* = 2.0) a= 1.5, b = From William Poole (2005) The Fed s Policy Rule P e r c e n t A p r-8 7 A p r-8 8 A p r-8 9 A p r-9 0 A p r-9 1 A p r-9 2 A p r-9 3 A p r-9 4 A p r-9 5 A p r-9 6 A p r-9 7 A p r-9 8 A p r-9 9 A p r-0 0 A p r-0 1 A p r-0 2 A p r-0 3 A p r-0 4 A p r-0 5 Federal Funds Rate Taylor Rule - Core PCE Taylor Rule - PCE

7 United States Quarterly Inflation Smoothed Inflation (four-quarter inflation) Percent Q1 1968: Fed Funds rate was 4.8% Q2 1989: Fed Funds rate was 9.7%

8 Implications of Globalization Idea is spreading Concept being tested globally for first time Importance of communicating has increased greatly Central banks need to know what other central banks are doing and are going to do Now consider Exchange Rate Policy International Monetary Policy

9 Exchange Rate Policy for Major Currencies: Five Basic Policy Principles Focus on the dollar and the euro Principles are essential in any area of policy, but especially areas dealing with financial markets Analogy with monetary policy principles (rules) On the spot decisions, pressures, criticism, Not official or written down Based on personal views and experience as head of international finance in U.S. Treasury,

10 I. Field of Dreams Principle Confidently build a playing field with good domestic economic policy and a good exchange rate policy will come. Monetary policy focused on price stability Wards off speculative depreciations Fiscal policy keeping debt/gdp down Regulatory policy to encourage investment Open investment and trade

11 II. Avoid Currency Market Intervention Should rely on the markets to determine the exchange rate without intervention No U.S. or Eurozone intervention since Sept 2000 A BIG CHANGE Unwise to say that you would never intervene never say never. The exchange rate is not a separate instrument of policy rather it is the market s reflection of economic policy and a host of other factors. Communicate and monitor the markets closely

12 III. Avoid Verbal Intervention Officials shouldn t try to talk the dollar down or up Empty threats, causes volatility Very difficult to refrain in practice The need for something to say: Strong dollar Example (February 2001) We do not lead, contrary to what if often said, a strong dollar policy. In my opinion, a strong dollar is the result of a strong economy. I made a mistake of assuming it was okay to talk about the intellectual fabric around this issue

13 Saying Strong Dollar gave the impression that the United States wanted to dollar to rise in 2001!!

14 IV. It Takes Two (or more) to Tango Exchange rate is not solely the decision of one country. Other countries will decide Flexible versus fixed? Dollarization? Financial diplomacy comes into play. Bilateral Multilateral International Monetary Fund?

15 V. Face up to Broader Ramifications Exchange rates interact with foreign policy and domestic policy--can t put your head in the sand But who actually decides? Fed: interest rate Treasury: exchange rate But not solely a Treasury issue Financial chain of command Delegating up and down Reducing confusion in the markets Example FT Headline: Treasury feels White House heat on policy: about turn on China currency signals economic strategy is to be firmly led by the president s inner circle.

16 Example: Toward the End of the Chinese Peg Peg had existed for ten years Fine for small open economies, but for China and Asia it created a Bretton Woods II Monetary independence in China needed to prevent inflation, overheating, hard landings Part of current account strategy Domestic politics and threats of protection

17 Major -20% Broad -10%

18 The First Steps Taken One Year Ago 3.4 percent appreciation

19 Second Example: The Great Japanese Intervention The Lost Decade in Japan Persistent deflation Money growth low, non-performing loans Purchasing foreign exchange would help increase money supply in Japan If not sterilized So, U. S. strategy was to go along quietly with the intervention

20 Dealing with Financial Crises Their frequency and global spread set them apart from anything else that we have seen at least since World War II (Guillermo Calvo, Graham Lecture, Princeton University, 2005) Thousands of papers have been written on this No new major financial crises since 2002 Why? How long can it last? Few academic papers written on this

21 First Crisis of the 21 st Century Major Financial Crisis List Mexico: Tequila effect Argentina: Thailand Indonesia Asian Crisis Contagion Malaysia Korea Russia: 1998 Brazil: Romania: Russian Contagion Ecuador: Argentina: Turkey: Uruguay: 2002 No Major Crises since 2002

22 Reasons for the Crises Fixed or crawling peg exchange rates Inflation at home exceeding inflation abroad Real exchange rate became overvalued Market pressures began to build Pressures resisted by central bank intervention Eventually the currencies depreciated Severe debt problem Securitization Government and firms borrowed heavily from abroad Currency mismatches Depreciation greatly worsened the debt problem IMF responses differed widely.

23 Reasons for the Contagion Impact of a shock in one country on the interest rates, equity prices, currencies abroad Fundamentals Based Theories Non-Fundamentals Based Theories

24 Fundamentals-Based Theories Trade linkages Exchange rates, income Financial market linkages Interest rate arbitrage Can show through simple macro models or through multi-country econometric models

25 Non-Fundamentals Portfolio managers scrapped for liquidity pull their funds out of other markets Informed and uninformed investors Markets with thousands of bondholders Informed investors more margin constrained; Losses in one part of the portfolio cause selling elsewhere to meet the margin calls. This makes the uninformed investors sell too not knowing the reason for the selling. Causes a sudden stop A malfunctioning of the global capital market (Calvo)

26 A Comparison of Two Augusts Russia (August 98) and Argentina (August 01) The Economist (July 21, 2001) There are some eerie parallels between 1998 and today. In July three years ago, Russia was facing deep fiscal problems.[this year] Argentina [is] also in deep fiscal trouble. By mid-summer 1998, Russia was having trouble selling domestic debt; reserves were falling and overnight interest rates were soaring. Argentina had similar problems last week. In mid-august 1998, Russia was forced to devalue and default This set off a chain reaction and panic across the globe. This contagion between seemingly unrelated financial markets and assets caused (in President Clinton s words) the most dangerous financial crisis in 50 years.

27 Latin America 1500 Russian Default (August 1998) 1200 Spread Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99

28 Asia 900 Russian Default (August 1998) Spread Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99

29 Objective, Strategy, Decision Objective: Mitigate global impact Strategy: Three parts Gradual, signal intentions (no surprises) Time consistency: if Yes now, need to lock in No next time Focus research on the contagion issue It s not automatic Help those that are hit Decision: Yes, and with clarity about future Results: Crisis quieted, then (9/11) No contagion at time of default

30 Asia 900 Argentine Default (December 2001) Spread May-01 Aug-01 Nov-01 Feb-02 May-02 Aug-02

31 Emerging Europe Argentine Default (December 2001) Spread May-01 Aug-01 Nov-01 Feb-02 May-02 Aug-02

32 Longer Run Reform: The Unpredictability Problem Uncertainty about the bailout process Heated debate: just helped Wall Street, crisis was just as bad anyway, usurped congressional authority, Foreign policy complicates decisions: Too nuclear to fail The country is a strategic ally Need to seem engaged in the region Personalities, power structure, mattered Added risk, spreads high, capital flows down

33 Application of Rules Concept to International Monetary Policy Could a similar approach be applied to the international monetary fund? Very Difficult Guidelines/limits required saying no Time inconsistency problem severe Any limit would be hard to maintain Decision heavily influenced by the current situation Need to deal with time inconsistency But how?...

34 Reform of Sovereign Debt Restructuring Process Two basic approaches Contract-based Collective action clauses (CACs) Statutory-based Direct analogies with bankruptcy within countries SDRM role of IMF Mexico takes first step and issues with CACs Many others follow

35 Exceptional Access Framework Limits on loan amounts set Countries need to satisfy criteria to go above limits IMF must prepare an exceptional access report if they go above limits So far has held Improved predictability

36 Conclusion: Will the Virtuous Circle Continue? Improved domestic monetary policies more rules-based, with price stability goal Improved exchange rate policies more foreign reserves in EM countries Improved international monetary policy More predicable IMF Greatly improved macro performance Will it continue? No secrets here The future is in policy makers hands

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