Monetary Policy

In his testimony before the House Committee on Financial Services' Subcommittee on Monetary Policy and Trade, Benn Steil argues that changes in U.S. monetary policy can have significant impact on emerging-market capital inflows and outflows and that the resulting exchange rate movements against the dollar can have large and rapid effects on the level of inflation and exports.

After a year in which U.S. policy dominated the headlines, 2014 should have a more international flavor. Though not predictions, here are five economic themes that could make policymaker's lives difficult in 2014. 1. Catch a Falling Yen "Abenomics" has rejuvenated growth in Japan, but policymakers elsewhere continue to worry about what it means for the yen. Monetary stimulus—and more specifically the commitment to 2 percent inflation—remains the most powerful of the policy's "three arrows" (the others being fiscal and structural policies), and hopes for easier monetary policy were immediately reflected in a weaker yen. Since December 2012, the yen has fallen 17 percent against the dollar and 13 percent on a trade-weighted basis, with the current rate at 105 yen to the dollar. While it is possible that the upcoming wage round will provide a durable boost to incomes and inflation, there is growing concern that by mid-2014 the economy could begin to slow and deflationary pressures reemerge. Last month I argued that the Bank of Japan would "do whatever it took" to achieve its inflation target, which in this case means doubling down on its quantitative easing program. Where would that take the yen? A yen-to-dollar rate of 120 or 130 would cause significant stress in finance ministries around the world, given concerns about growth and exchange-rate instability. In addition to a rise in protectionist pressures, the resultant deflationary pulse among Japan's trading partners would intensify incentives for competitive depreciations. For U.S. policymakers, pressure is mounting from Congress to include exchange rate legislation as part of any trade agreement with Asia (the Trans-Pacific Partnership) or Europe (the Transatlantic Trade and Investment Partnership). A sharp yen decline will intensify this debate. The issue is no less fraught in emerging markets, which are already buffeted by capital outflows over concerns about Federal Reserve tightening. Pressure to impose capital controls or engage in competitive depreciations is likely to mount. In 2013, the Group of Seven (G7) and Group of Twenty (G20) had a simple mantra: policies should be aimed at domestic objectives, and governments should not purchase foreign instruments (no direct foreign-exchange intervention). It is possible that 2014 will test that consensus. 2. Debalancing and Deleveraging In the economic context, "rebalancing" is not a pivot in U.S. foreign policy to Asia (at least not explicitly). Rather, it reflects U.S.-led efforts since the fiscal crisis in 2008 to encourage policies that will reduce global economic imbalances, most notably reflected in large current account surpluses and reserve accumulation. After several years of shrinking imbalances, 2014 looks to be the year that external trade surpluses for China and Germany begin to widen again (see Figure 1). This change reflects growth differentials, in part, and in normal times could be addressed through expansionary fiscal policy or an easing of financial conditions by central banks. But these are not normal times. China's early steps toward market liberalization will be tempered by the need to address the challenge of reining in its shadow banking system, and the risks to imports and growth remain on the downside. Meanwhile, Germany benefits from a euro that, while too strong for periphery countries struggling to restore competitiveness, is much weaker than it would be if Germany were not in a monetary union. A muted recovery in the rest of Europe is unlikely to provide a meaningful counterweight. The region continues to deleverage, and tighter credit conditions in the European periphery are likely to provide a substantial headwind to growth. In this context, concerns about global growth may intensify the rebalancing debate. Figure 1. German Trade Surpluses (in billions of euros) Sources: Haver and Bank of America Merrill Lynch Global Research estimates. 3. Argentina Fallout Argentina's standoff with its private creditors is now in front of the U.S. Supreme Court and may not be decided until 2015. Along with an ongoing reassessment of Greece's 2012 restructuring, the dispute has triggered a broader debate over whether the rules of the game for sovereign debt need to change. Some law and economics experts have argued that a decision against Argentina will, by strengthening creditor rights, swing the pendulum excessively toward creditors at a time when political and economic factors already make for restructurings that are "too little, too late." These critics contend that the process for restructuring sovereign debt—primarily through market-based debt exchanges—needs to change to make it easier to get deals done and prevent holdouts from blocking them. These changes could include new language in bond contracts, as well as changes to when and under what conditions the International Monetary Fund (IMF) lends to countries in distress. I am not convinced that the current system needs fixing; however, a full-throated official sector debate in 2014, combined with growing pressure on European policymakers to address official debt relief (OSI) for over-indebted periphery countries, has the potential to create tremendous uncertainty in markets, raising the risk of early runs on countries that are seen as candidates for official support. 4. Secular Stagnation, Quantitative Easing, and Inflation Targeting Larry Summers created a stir in November with his suggestion that the United States faces long-term secular stagnation. The idea that the weak recovery reflects structural factors—a global savings glut, investment uncertainty, or low productivity—suggests that real interest rates have to fall well below zero to produce an adequate recovery. In today's low inflation, recessionary environment, that is a tough challenge for central banks that cannot lower nominal interest rates below zero. If interest rates remain too high for an extended period, the resultant reduction in investment and increased unemployment has long-term effects: cyclical becomes structural. Fiscal policy can effectively boost demand in these situations—a point Summers elaborates on in the Washington Post. In the current U.S. policy environment, fiscal policy is hamstrung and monetary policy will have to carry the burden of supporting demand and reducing real interest rates. This could be done through higher inflation, which would require a change to current central banking orthodoxy (that inflation should be held to around 2 percent). Of course, central bank policy works through channels other than interest rates, including the exchange rate, equity, and housing prices. The argument also has been advanced by Paul Krugman, among others, and traces back to Alvin Hanson's "stagnation thesis." It contradicts the analysis of Ken Rogoff and Carmen Reinhart, among others, whose work identifies headwinds from a crisis that should recede over time. Somewhat perversely, these economists are looking at the United States at a time when the U.S. economy looks set to grow above trend this year. I find the case for secular stagnation more convincing for Europe. But the bottom line for Summers: one cannot assume a return to above-trend growth, and central banks may need to rethink how policy can and should be targeted. 5. Elections and Investors My colleague Jim Lindsay, CFR's director of studies, has highlighted elections to watch in 2014. Virtually all major emerging market governments face voters in 2014, including the so-called fragile five of Turkey (March and August), Indonesia (April), South Africa (April-June), India (May/June), and Brazil (October). Add in Colombia and Hungary, and 2015 elections in Ukraine and Argentina, and you have upcoming elections in nearly all of the major emerging markets. With U.S. fiscal and monetary policy on a steadier course following the recent budget deal and the Federal Reserve announcement that it would reduce (taper) its pace of government bond purchases, domestic factors are likely to again become the major drivers of market volatility. All of which could make for an interesting year. And it is even more important that there is strong leadership in the international economic arena, including in the United States, where critical Treasury positions remain vacant. Looking Ahead: Kahn's take on the news on the horizon How Much Taper? Minutes from the Fed's December meeting will provide needed policy insight as Janet Yellen takes the reins. Europe Quantitative Easing The European Central Bank is expected to resist pressures to ease monetary policy in January, but odds are rising for more moves during the first quarter. Ultimately, qualitative easing will be necessary to produce above-trend growth. Emerging Markets Turmoil Political turmoil in Thailand and Ukraine, and ongoing concern about capital outflows, appear likely to provide a difficult start to the year in emerging markets.

Bottom Line: Abenomics had an impressive start, but the structural reform agenda has bogged down, raising questions about whether macro policies alone can float the Japanese economy. Against the backdrop of geopolitical tensions with China and entrenched interests at home, now could be the time to go short on the Japanese economic miracle. Why the new pessimism about Abenomics? Launched to fanfare late last year, the policy's three "arrows"—monetary, fiscal, and structural—delivered impressive early returns. Growth rose above 2 percent from April to September, equities soared 50 percent between November and May, and a weaker yen boosted export competitiveness. But recent concerns over the government's commitment to structural reform, anxiety about a possible fiscal cliff in 2014, and rising political tension with China have dampened sentiment. Some analysts have even suggested that a Japanese debt crisis is an underappreciated potential black swan event for the global economy over the next few years. At the core, these developments confirm the limits of macroeconomic policy. Abenomics' shock easing of monetary policy, reinforced by a convincing commitment that policy will remain easy, was a clear and substantial break with the past. In parallel, a necessary and appropriately gradual rebalancing of fiscal policy allows the government to begin the process of consolidation while continuing to provide insurance against future downturns. Together, these macroeconomic policies will ensure a strong cyclical recovery. However, the trend growth rate of an aging and sclerotic Japan is unlikely to improve without effective structural reform. And, absent that change, sentiment may sag and an overwhelming government debt is likely to drag on economic performance. Arrow One: Straight and True Early optimism was clearly driven by monetary policy, the first of the three arrows highlighted by Prime Minister Shinzo Abe. The monetary policy arrow represented a sea change in policy: a commitment to eliminate decades of deflation and restore growth through unconventional monetary policy. The centerpiece of the policy was a commitment by the Bank of Japan (BOJ) to "two-by-two-by-two": inflation of two percent through a twofold increase in the balance sheet of the central bank (in effect, doubling the money supply) in two years (see Figure 1). The announcement combined an easy-to-understand commitment with a promise to keep rates low until the target is achieved—powerful "forward guidance" in the language of modern central banking. The promised monetary stimulus will not guarantee, by itself, the demand required to sustain 2 percent inflation, and recent BOJ minutes show concerns that household incomes are not keeping pace with higher consumer prices. Ultimately, success of the reflation agenda will depend on higher wages and incomes, overcoming opposition from business groups, and entrenched deflationary expectations. Officially, the Bank of Japan remains optimistic that inflation will pick up, based on a wage round that is underway and will be subject to a fair degree of moral suasion. There are good reasons to be skeptical about this rosy outlook, but there's also comfort in the fact that if inflation does not meet expectations, the Bank of Japan will buy more assets of longer duration and maturity than previously envisaged. The BOJ's own version of "do whatever it takes" remains the core building block of Abenomics. In return for this promise, Japanese corporations will need to deliver on wages. Figure 1. Central Bank Balance Sheets (in percent of GDP) Source: Estimates from the central banks and IMF; CME 2010 was BOJ's cumulative monetary easing exercise. Note: The BOJ's April 2013 forecast breaks with the past and may outperform other central banks. Arrow Two: Speed Bumps, Not Cliffs The second arrow of Abenomics, fiscal policy, remains a complex story. On one hand, a central tenet of the policy is fiscal consolidation over the medium term to reduce gross government debt that now stands at over 240 percent of gross domestic product (GDP). A gradual increase in the value-added tax (VAT) was the prime tool of that adjustment, which also advanced a structural agenda to shift the burden of taxation away from income and toward consumption. Conversely, fiscal stimulus at the start of Abenomics was a critical buffer for growth, ahead of the planned first increase in the VAT in spring 2014. Given concerns over debt sustainability, the decision to front-load fiscal stimulus was always a risky move and complicated the timing of a shift toward fiscal restraint. Prime Minister Abe's decision to go ahead with the consumption tax hike as scheduled similarly was contentious; market experts expressed concern about the effects of too-rapid fiscal consolidation on the recovery. In the end, the decision to go ahead with the hike and offset a portion of the resulting fiscal drag with discretionary stimulus looks to have struck the right balance between support for the recovery and long-run fiscal stability. The Observatory Group has a neat dissection of concerns that Japan faces a fiscal cliff in 2014. Their bottom line is a modest fiscal contraction in 2014, on the order of 1 percent of GDP. Arrow Three: Much Ado about Nothing (Yet) While recent news suggests the monetary and fiscal arrows remain on course, the news is not so good for the structural agenda. Several early efforts saw setbacks: a recent draft proposal for removing a ban on sales of over-the-counter drugs fell short of expectations, prolonging restrictions on more than two dozen popular medicines ( in some cases permanently). A taxi reregulation law and slow progress on national economic zones—hinting at past unsuccessful government efforts—have also raised concerns. Further, proposals for labor market and agricultural reform appear to have stalled. On the labor side, the government is targeting an increase in female labor-force participation, a laudable long-term goal that policy is likely to affect only gradually. The government also continues to place high importance on the successful conclusion of the Trans-Pacific Partnership (TPP) with eleven other countries, including the United States, which is scheduled for agreement by year-end. But that agreement appears likely to be delayed, or watered down in areas such as agriculture that are crucial to Japan. A realistic assessment of the record must acknowledge that structural changes in the Japanese economy are usually the result of custom, not law. Consider, for example, proposed changes in the law to make it easier to hire and fire workers. Significant legal changes now look unlikely, and even if laws are passed, the rigidity of the labor market in Japan, reflecting custom and reinforced by culture, makes it difficult for firms to lay off workers. If Abenomics transforms labor markets, it will be because of the signals it sends that times are changing, rather than the literal change in laws. It is often said that structural reform of the Japanese economy to raise trend growth is the most critical to the long-term success of Abenomics. Though these reforms will have a limited impact on economic performance in the near term (that is the realm of macro policies), the debt dynamics will not be sustainable unless there is a material increase in the growth rate over time. Conversely, for those who believe that debt sustainability concerns are overblown because, for example, the debt is owned primarily by the Japanese themselves, a weak performance on the structural agenda may not be a devastating blow to the program. Robert Feldman of Morgan Stanley sees the recent slippage as the result of complacency as the government shifts its focus away from economics and toward security issues. Noting the recent decline in Prime Minister Abe's support to below 50 percent, Feldman looks toward an end to the complacency phase and wonders how long and deep the crisis will be before the prime minister responds with a renewed economic focus. Looking ahead It is almost a year since the world woke up to the prospect of Abenomics transforming Japan. Its success in bringing back inflation and boosting demand has been transformative. If success is measured by those criteria, Abenomics gets high grades, though it will present risks for policymakers globally. However, the hard choices on the structural agenda remain, and the government will need to show more courage than it has demonstrated recently. Markets seem largely unworried by the recent setbacks. After stalling out during the fall, Japan's equity market rose 6 percent in the last two weeks as the yen resumed depreciating against the U.S. dollar. Gains were led by financials and exporters and are most likely to benefit from improved trade prospects. The yen depreciated by around 3 percent, ending just above the 102-yen-per-dollar level for the first time since early September. Foreign purchases of domestic bonds have returned to levels recorded this summer. One explanation for benign market conditions is the argument that all that matters in the short term is monetary policy. For hedge funds in particular, a long-Nikkei/short-yen trade has worked well, and expectations that the BOJ will ease monetary policy further, possibly at a time when the Fed is cutting back on its stimulus (i.e., tapering), is reason enough for cheer (and for pushing speculative yen shorts to three-year highs). Another more subtle argument, as noted earlier, is that markets assume that Japan's high level of debt—and the constraints on policy it imposes—are less severe than the numbers suggest because of the high degree of domestic ownership. The argument goes that Japan can work out of its debt problems through a managed process of financial repression, lowering real returns on government assets to maintain a sustainable debt profile. That may be the case, but a crisis can materialize quickly if the assumption that domestic investors are willing to accept negative real returns proves false. Is Abenomics the "black swan" of 2014? Probably not. But structural reforms are likely to disappoint and the pressure will then shift to the BOJ to do more. A further easing of monetary policy will be a positive for growth, but means a weaker yen. At some point, coming against the backdrop of weak global growth, such policies could present global concerns and contribute to already strong tensions within the G20 about competitive depreciation, intervention, and capital controls. All this suggests that it could be an interesting 2015. Looking Ahead: Kahn's take on the news on the horizon Fed Revisits Taper The December meeting, Bernanke's last, will renew debate over when the Fed begins to reduce its asset purchases. Emerging Market Debt Political turmoil in Ukraine raises default fears, and Argentina tries to settle nationalization claims. European Revival Credit upgrades for Greece and Spain do not signal a broad-based growth revival in Europe.

Bottom Line: In the face of uncertain capital flows, an international network of swap lines would help to ensure adequate liquidity and act as a significant enhancement of the global financial safety net. Should the International Monetary Fund (IMF) and major central banks provide credit lines to countries facing sharp outflows of capital? In 2007, 2010, and 2011, the Federal Reserve's dollar-swap lines with other central banks played a critical role in stabilizing markets and ensuring an adequate supply of dollar liquidity. Now, in the context of sudden reversals of capital flows ("sudden stops"), there are proposals for new swap or credit arrangements for emerging markets and for the periphery of Europe. These proposals have their virtues, though perhaps not the ones their proponents claim. Swap Lines, the Fed, and the IMF The idea that the International Monetary Fund (IMF) should coordinate a global network of swap lines gained currency during the financial crisis, partly in response to complaints from countries excluded from the Fed's swap lines. The Fed's prudential concerns, along with a mandate to limit swaps to countries viewed as threatening global financial stability, highlighted gaps in the global safety net. In addition, the Fed's swap lines were temporary. The primary argument for a new arrangement rests on the observation that in today's financial markets—highly leveraged, complex, and interconnected—adequate liquidity is central to avoiding crisis. This suggests the need for something more comprehensive and permanent. This debate is not new. A group of Asian countries led by China launched a regional swap plan in 2010 (the Chiang Mai Initiative), and, in the run-up to the Seoul G20 Summit, the Koreans floated a proposal for a global network of swaps modeled on Chiang Mai. Around the same time, motivated in part by concern that the Asian arrangements would compete with it as a global financial authority, the IMF floated a proposal for an IMF-backed network of swaps. These proposals never gained broad support, and with the easing of the crisis the pressure for reform went away. The catalyst for renewed debate was the reversal of capital flows from emerging markets, beginning in June, based on expectations that the Fed would begin to exit from quantitative easing. The most developed proposal comes from Ted Truman, who in a recent piece calls for a global network of central bank swap lines coordinated by the IMF. Central banks would retain control over the lines, though the IMF would identify the need and decide when systemic risks warrant activation of the lines. The plan would be a significant enhancement of the global financial safety net, though the complexity of the proposal, the magnitude of the liquidity commitments it requires from central banks, and the central role it gives to the IMF are sure to raise opposition in major capitals. Emerging Markets: The Next Big Crisis? A number of emerging markets have seen a large capital outflow, precipitating sharp financial market moves and forcing a tightening of policies. Attention has focused in particular on the "fragile five"—Brazil, India, Indonesia, South Africa, and Turkey—countries with substantial financial markets, large current account deficits, and financial imbalances. But in other respects, it is hard to see these problems as the start of a systemic economic crisis. For example, in contrast to conditions at the time of the 1997 Asian financial crisis, most of these countries have substantially higher international reserves to act as a buffer against capital flow reversals. External imbalances are manageable and more of the debt is of longer maturity. Consequently, the risk of a sharp run on banks, which happened in Korea in late 1997, seems less likely. Markets have stabilized recently. Nonetheless, corporate and financial sector leverage remains high in many countries, posing an uncertain but continuing risk of runs. Precautionary and Contingent Credit Lines Still, it is hard to argue against the notion that countries should do more to get ahead of a possible crisis and prepare for contingencies. The IMF offers credit lines to countries vulnerable to global shocks but with otherwise strong policies.[1] However, the stigma associated with turning to the IMF has limited the use of those programs. In 2011, the IMF discussed the possibility of simultaneously offering credit lines to a group of countries as a way of overcoming resistance to these programs. The idea was that prequalifying countries would lessen the pain associated with having to approach the IMF for support. The problem with this idea is what to do when a country's policies worsen, or are subsequently seen as inadequate. Drawing on a credit line cannot be a substitute for necessary policy reform. Even so, I see a case for an expanded use of precautionary lines as a signal to markets and to strengthen a country's defenses against market turmoil. Progress is possible in the current discussion of how to support countries in the European periphery. Ireland and Portugal may request contingent credit lines from Europe's Economic Stabilization Mechanism (ESM) to help them exit their IMF-supported adjustment programs. In Ireland's case, a contingent line would be a transitional arrangement to signal to markets that the country continues to have European support. In Portugal's case, a new bailout is likely, though both the government and its European creditors are loath to admit it. As a consequence, European leaders appear resistant to provide a credit line to Portugal; that is a pity. Moreover, other countries in the periphery could benefit from contingent lines from the IMF. So what purpose do these credit lines serve? In practical terms the lines are the framework for the needed expansion of the safety net and for "more Europe." If this approach helps to achieve improved governance in Europe, then that would be a major step forward. More generally, a network of IMF-supported swap lines would strengthen the global safety net and provide an important buffer against future sudden stops in capital flows. Looking Ahead: Kahn's take on the news on the horizon The Cliff Is Dead, Long Live the Cliff A U.S. government shutdown is in effect with no clear exit strategy. A far more material and potentially damaging standoff on the debt limit looms. The World Bank and IMF Meet Meetings later this week between the world's two major financial institutions will reveal anxiety about growth and capital flows, but offer little agreement on what to do about it. Abenomics' Second Arrow The issue is fiscal sustainability over the medium term, without killing growth now. The decision to go ahead with the consumption tax is good on structural grounds but has renewed growth fears. Endnotes ^ The two main programs are a flexible credit line (FCL) for countries whose policies would be adequate absent global financial market volatility, and a precautionary credit line (PCL) for those countries where some policy changes would be needed.