Monetary Policy Challenges During the Great Transition:
Perspectives from an Emerging Market Central Bank
Dr. Veerathai Santiprabhob, Governor of the Bank of Thailand
Official Monetary and Financial Institutions Forum, London
January 10, 2017
Ladies and Gentlemen,
It is a great pleasure for me to be here in London and to have a chance to contribute to the City Lecture
series. Firstly, I hope it is not too late to wish you all a happy and prosperous new year. Secondly, I
would like to thank OMFIF for the invitation and also express my appreciation of the work that OMFIF
has done in providing a vibrant and informative platform for policymakers to exchange their views on
issues relevant to the future of the international monetary and financial system. Given the economic
and political challenges that we face today, I feel that the need and importance of such platforms for
open dialogue is as important as ever. For it is only through constructive dialogue that the diversity of
perspectives inherent in modern society can be harnessed to drive meaningful progress.
In that spirit, I would like today to reflect on the prevailing monetary policy paradigms that have
guided central bank actions over the recent past and highlight some of the tensions and limits of such
framework. In policy, we are often preoccupied with the technical and tactical management of our
instruments. Most of our energy is devoted to analyzing latest economic developments and deciding on
the size and timing of our actions. Yet over time, if one gets the paradigm right but the details wrong,
the damage will be largely limited. Moving the policy instruments slightly too much or too little or a
few months too soon or too late won't matter very much in the long term. But if we get the paradigm
wrong, the resulting harm will be severe because we will make the same mistakes over and over again.
Questioning prevailing paradigms now and then is therefore healthy.
Nine years on from the global financial crisis, it is remarkable that policy interest rates in major
advanced economies are essentially at zero or negative and central banks continue to seek innovative
ways to further stimulate the economy. Economic developments are still cast in terms of "the recovery"
and the crisis mentality has yet to fully abate. With growth repeatedly disappointing on the down side
and inflation stuck below targets, a sense of déjà vu permeates policy discussions. On this long journey
towards normalization, the destination never seems to arrive. And during this period, which could
aptly be called the Great Transition, we have seen some remarkable things.
If someone had asked you back in 2007 what you would expect to see if the major central banks in the
world cut policy rates to zero and held it there for almost a decade, triple the size of their balance
sheets, and bought up roughly a third of all outstanding government bonds in their jurisdiction, very
few of us would have thought that subdued price pressure and tepid growth would be the outcome. Yet
that is what we have seen. Across the major advanced economies and some emerging market ones,
inflation has been persistently below targets and growth weak for many years. What does this say
about the influence of monetary policy over cyclical variations in the economy?
The prevailing view is that inflation is low and recovery weak because the zero lower bound prevents
central banks from lowering real interest rates enough to re-equilibrate the economy. That is, the
actual real interest rate is too high relative to the equilibrium or natural real interest rate. This view
rests on two key propositions. First, the problem besetting economies is one of aggregate demand
deficiency. Second, low interest rates can offset this by encouraging people to bring future expenditure
and investment forward. This logic underpins the unprecedented monetary accommodation that we
have witnessed. But this prism, based on prevailing macro models, for viewing recent developments is
rather narrow.
Consider the broader context where structural forces are at play. At the global level, changes in the
structure of world trade, rising competitive pressures, and common forces such as falling oil prices have
for a long time increased the influence of external factors on inflation. In individual jurisdictions,
changes in labor market fundamentals mirroring changing demographics and reduced wage bargaining
power have exerted a powerful downward force on price dynamics. Meanwhile, the digital revolution
has driven the prices of many modern services, such as telephone calls, news, and entertainment to
essentially zero. These forces have contributed to a weakening, and in some cases the disappearance
altogether, of the link between inflation and measures of economic slack, as traditionally captured in
the Phillips curve. Low inflation cannot be attributed primarily to insufficient aggregate demand.
Some of these same structural forces also account for weaker growth. For highly open economies,
slowing world trade has undermined export as a growth engine. At the same time, the transition to
services has also contributed to growth headwinds given that modern services is less labor and capital
intensive than manufacturing. Think of Facebook's 15,000 workforce compared to Coca-Cola's 150,000
despite the former having twice the market valuation of the latter. Or how the Ubers and AirBNBs of
the world can generate immense value added without hardly any capital outlays. Given that investment
is relatively interest sensitive, to the extent that the transition to services has dampened investment, it
may have also made the economy less responsive to monetary policy. Rising income inequality, insofar
as it translates into more purchasing power being in the hands of those less likely to spend at the
margin, also acts as an additional drag on growth. Finally, the legacy of debt overhang and an impaired
banking system has both weighed on growth and hampered the transmission of monetary policy.
The upshot is that much of the forces driving inflation and output are structural and not easily
amenable to monetary policy. The returns to monetary ease may be limited and most likely
diminishing in the face of these headwinds. That would not be so much of a problem if extended
monetary accommodation entailed no costs. But there are side-effects and they are pervasive.
Persistent ultra-low interest rates and the increased presence of central banks in markets raise concerns
that they are distorting market prices away from fundamental values. Very low interest rates has driven
a search for yield that has boosted asset prices globally, compressed risk premiums, and supported high
leverage. It is striking that global leverage, at 225 percent of world GDP in terms of gross debt of the
nonfinancial sector, is presently higher than it was before the onset of the global financial crisis. For
institutions that have committed liabilities, such as insurance companies and pension funds, sustained
low rates threaten their long-run viability and compels them to take more risk.
International spillovers have also been prominent. In today's hyper-connected global economy, a
problem anywhere can quickly become a problem everywhere. The exchange rate has been an
important conduit in this respect, especially for emerging market countries. Through successive rounds
of easing, the transmission of monetary policy in advanced economies increasingly came through
currency movements. Resistance to unwelcome currency appreciation then spreads exceptionally easy
monetary conditions to the rest of the world. Easing begets easing. Hence the frequent references to
"currency wars" and "competitive depreciations". For international currencies such as the US dollar,
very low interest rates directly boosted credit expansion elsewhere. From 2009 to the end of 2015, US
dollar-denominated credit to non-banks outside the United States increased by more than 50%, to
about $9.8 trillion; and to nonbanks in EMEs, it doubled to some $3.3 trillion.
Overall, we have a dichotomy between diminished monetary influence on inflation and output on
the one hand, and hyper-sensitivity of financial markets and asset prices to monetary policy actions
and communication on the other. This raises a dilemma. Against the tide of structural headwinds,
inflation and output fail to respond to monetary ease, and the temptation is to do more and more. In
the meantime, financial markets respond vigorously to low interest rates and the search for yield
accumulates in the form of greater financial fragility over time. This has important long-run implications
that current frameworks neglect.
The prevailing paradigm views monetary policy as a stabilization tool for managing cyclical movements
in the economy with no impact on the trend. Money is neutral in the long-run. But it is becoming
increasingly recognized that there is a direct link between the financial cycle and long-run output
trajectories. A large body of evidence indicates that financial crises often result in very large economic
contractions followed by a long period in which output is depressed substantially, with no rebound on
average to the pre-crisis trend over the medium term. Output losses in many cases are permanent.
Given that financial instability can have long run impact on the economy, then if monetary policy plays a
role in influencing the likelihood of a crisis occurring or the magnitude of its impact once one does
occur, it follows that monetary policy has long-run implications.
This perspective calls for a reassessment of prevailing macroeconomic models that focus on flows and
shocks but neglect stocks and states. The financial cycle acts as the thread that binds the challenges
and constraints of today to the actions and decisions taken in the distant past. This path-dependency
sharpens the trade-off between short-term inflation and output stabilization on the one hand, and
financial fragility and their impact on longer term economic trajectories on the other.
From this alternative paradigm, the calculus is tilted against unrelenting monetary stimulus. It calls,
instead, for a monetary policy framework that systematically reacts to the financial cycle, both in
good times as well as in bad. This differs from an approach in which policy leans against the wind only
when financial stability risks become evident. Given the long and drawn-out nature of financial cycles,
such an approach would inevitably lead to doing too little too late, as the cumulative impact of policy
over the whole financial cycle is ignored.
The alternative framework entails more flexibility with respect to the delivery of inflation targets and
longer horizons over which the effects of policy are judged. Such a framework could be usefully
complimented by the application of macro-prudential tools. Here I stress the word "compliment". Much
of the discussion on macroprudential policy these days view them as a useful way to help offset some of
the excesses that result from low interest rates. But macroprudential measures were originally
envisaged as compliments to monetary policy rather than as instruments to substitute or offset the
effects of monetary or other government policies.
It is easy to be lulled into a sense of blissful separation whereby safeguarding financial stability is left to
macroprudential tools while monetary policy focuses on inflation and output goals. But this would be
like driving a car with one foot on the accelerator trying to reach the destination as soon as possible,
and the other foot on the brake making sure that we don't crash. An even more precarious task if each
foot belongs to different drivers. There are limits to what macroprudential can achieve, both
economically and politically. Just as monetary policy has been over-burdened, macroprudential tools
too risk becoming overburdened.
In Asia, central banks have generally become more mindful of financial stability concerns in the
aftermath of the 1997 crisis. The Thai experience is illustrative. Having lowered our policy rate to 1.5
percent in the second quarter of 2015, we have kept rates unchanged since then even though headline
inflation was below our target range and growth relatively soft. This reflects the recognition of the
wider context and set of factors which act to mute the monetary transmission mechanism that I have
alluded to earlier. Structurally, we share many of the fundamental forces holding inflation and growth
down in advanced economies. This includes an aging population, high income inequality, and a rising
share of services. The decision to keep rates on hold also reflects ongoing financial stability concerns
given high household debt levels and evidence of search for yield behavior leading to risky shadow
banking activities. The preservation of room for manoeuvre reflects a policy framework that
embodies the longer horizon perspective and recognition of the limits of monetary policy that I have
discussed.
In terms of the outlook going forward, we forecast continued economic growth this year at broadly
similar pace to 2016 while inflation should pickup as the base effect from lower oil prices dissipate. With
available fiscal headroom, government spending, particularly on infrastructure investment, will provide
significant impetus to the growth momentum. On the external front, if the scale and breadth of
surprises that transpired last year in the global political and economic landscape is any guide, we will be
in for a rough ride. Here, Thailand's high level of foreign exchange reserves, which amounts to some
3.2 times of outstanding short-term foreign debt, as well as strong current account position should
provide adequate buffers for new surprises. The high levels of capitalization of our banking system
moreover, with average capital to risk-assets ratios of over 18 percent, provides a solid foundation for
financial stability and alleviates concerns from the recent pickup in non-performing loans.
Thailand's main challenges are micro, not macro, in nature. A key growth engine over past decades
has been the productivity gains from structural transformation, whereby labor moves from low
productivity agriculture to high productivity manufacturing and services. This has stalled, and even
reversed, of late. To reinvigorate growth, we need to upgrade education and skills of our labor force,
streamline rules and regulation that shackle business productivity, catalyze public and private
investment in key infrastructures, and establish platforms that spur innovation. At the same time,
there is great potential for Thailand to leverage on our unique geographical advantage of being in the
midst of the Greater Mekong Subregion that includes the rapidly developing economies of Cambodia,
Laos, Myanmar, and Vietnam.
The good news is that the government fully recognizes these priorities and is currently embarking on a
multi-pronged approach to move forward rapidly. The reform agenda encompasses wide-ranging
initiatives to improve efficiency as well as propel growth. Prioritizing on the most binding constraints, a
number of legal and governance reforms have already been implemented. These include streamlining
of the process involved in obtaining business licenses and the strengthening of laws governing business
collateral that expands the range of security interests that can be. Small-medium enterprises stand to
benefit most from these, both in terms of lower operating costs and greater financial access.
Under consideration is also a comprehensive reform of the governance of state-owned enterprises.
Given their very large size and their critical role as provider of basic infrastructure such as electricity,
telecommunications, and transportation, state-owned enterprises exert a significant influence on
overall economic efficiency. The existing regulatory framework, however, is complicated with large
overlaps and a lack of overriding authority. The proposed establishment of the National State-owned
Enterprise Corporation with a clear separation among the relevant government agencies in terms of
responsibilities as policymaker, regulator, and owner, therefore holds promise of bringing about
tremendous improvements in resource allocation within the economy.
In terms of invigorating growth, a key strategy being pursued is to shore up economies at the
grassroots level through various interventions, including fiscal injections, at the local government level. At a
more national level, efforts are underway to shift industrial structure towards certain high value added
industries.
For the Bank of Thailand's part, the overriding focus is on strengthening the capacity of our financial
system to serve the economy by leveraging on fundamental technological improvements. As the
backbone of all economic activities, the payment system and infrastructure is critical to economic
efficiency and stability. Among others, we will be rolling out a new Faster payment platform early this
year that will encourage greater digital payments as well as lower transaction costs. We will enhance
financial connectivity with neighboring countries through various means, including the promotion of
local currency usage for regional trade. Moreover, in recognition of the potential for innovative financial
platforms to increase efficiency and expand inclusion, we recently launched a "regulatory sandbox"
approach to facilitate FinTech.
So the policy strategy is clear: leverage on our strong macroeconomic fundamentals to push through
critical microeconomic and structural reforms that unleash productivity improvements. The challenge
is one of execution. In all this, monetary policy plays a secondary supporting role.
Ladies and Gentlemen,
Marshall Goldsmith in his popular executive coaching book, "What Got You Here Won't Get You There",
highlighted the unwillingness to change modes of thought and behaviors as a critical obstacle
preventing executives from becoming successful leaders. So too in monetary policy I believe that the
frameworks, paradigms, and norms that have gotten us to where we are need to be openly reassessed.
We have arrived at this juncture partly as a result of a financial cycle that was unanchored. We need
to seriously rethink the framework that allowed this to take place. What got you here won't get you
there. More of the same will not do.
On a monetary road less traveled, it is important to make sure that our intellectual compass points to
the right general direction. Through the years, monetary policy has shifted through successive
frameworks. From the system of fixed exchange rates under Bretton Woods, to monetary targeting
during the Great Inflation in the 1970s, to inflation targeting in the context of the Great Moderation,
and finally to an assortment of unconventional monetary policies in the wake of the Great Recession.
Today, as we navigate our way through the Great Transition, the search for a new framework is
ongoing.
In so doing, the limits of monetary policy as well as its unintended consequences, especially on
financial fragility, needs to be better recognized. We would do well to revisit our monetary
architecture, both domestically and globally, our optimal policy mix, and structural constraints to ensure
that the transition leads us to a more stable, prosperous, and sustainable economic outcome.
Thank you very much.