Subir Gokarn: Monetary policy considerations after the crisis -
practitioners' perspectives
Plenary lecture by Dr Subir Gokarn, Deputy Governor of the Reserve Bank of India, at the
conference "Economic Policies for Inclusive Development", New Delhi, 1 December 2010.
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Inputs and feedback from Muneesh Kapur are gratefully acknowledged.
Introduction
I would like to thank the Ministry of Finance and the National Institute of Public Finance and
Policy for inviting me to speak at this International Conference on Economic Policies for
Inclusive Development. We tend to associate the process of inclusive growth and
development with structural factors and the roles that they play in accelerating growth,
enhancing labour productivity, creating human capital, providing access to safety nets and
essential public services and so on. Many of the previous sessions have dealt directly with
these issues. On the other hand, we do not usually associate monetary policy with these
typically long-term considerations. However, among the many lessons that will be drawn
from the recent crisis, is the critical one that imbalances in the financial sector can
significantly disrupt the processes that sustain stable, long-term growth, which is a key
requirement for effective inclusion. High volatility and a propensity for destabilizing shocks do
not allow either the private or public sectors to make the resource commitments consistent
with these two objectives. On the fiscal front, particularly, the costs of rescuing the economy
from a crisis may significantly reduce the capacity of governments to sustain commitments to
growth and welfare enhancing expenditure.
From this perspective, economic stability, defined in the broadest possible sense, can be
seen as an essential component of any strategy for inclusive development. To the extent that
central banks play a role in providing that stability, the experience of the crisis has led to
considerable thinking and debate on its implications for central bank mandates, strategies
and instruments in the quest for maintaining stability. A lot of this is being articulated by
central bankers around the world, as they try and distill the lessons of the crisis into what
they should be doing more or less of, or differently and how they should go about fulfilling
possibly changed objectives.
In this talk, I would like to explore some of the thinking around these issues as reflected in
recent articulations by a cross-section of central bankers and use this as a backdrop for our
own thinking on how to deal with challenges to macroeconomic stability. I will first lay out a
simple framework, which I find useful to think about monetary policy and central banking and
then use it to talk about issues that have emerged in the post-crisis debates.
A stability framework
The well-known Taylor Rule has dominated the analytics of monetary policy over the past
two decades. In its standard form, in which the optimal short-term interest rate is a function of
both the deviation of the inflation rate from its target and the output/unemployment gap, it
accommodates both formal inflation targeting and a more flexible growth-inflation balance as
objectives of monetary policy. However, when we look at the range of activities that central
banks around the world perform, it is clear that monetary policy is only one of many in the
case of most countries. Prudential regulation and supervision is also a responsibility in most
cases, so at least one dimension of financial stability was already on the charters of many
central banks. Many of them also managed the Balance of Payments through active
intervention, with both exchange rate and reserve accumulation objectives in mind.
Looking over this landscape, the point I would like to make is that even as central banks
typically pursued multiple objectives, some of which may have been only informally
articulated, there was a common theme running through all of them. This was stability. In
other words, the core objective of central bank activity along all of the dimensions referred to
earlier - price, output, financial sector and external sector - was to preserve stability on that
respective dimension. This provides the foundation for what I will call the Stability
Framework. Stated in terms of objectives, it covers these four dimensions of central bank
activity:
The first two components are non-controversial and reflect the formalization of the Taylor
Rule.
1. Price Stability: minimizing the deviation of the actual inflation rate from a target or
benchmark rate
2. Output Stability: minimizing the deviation of real economic activity from its potential
The next two are more difficult to pin down, because they may mean different things in
different contexts. Also, unlike the first two, which are amenable to a single instrument
approach, the next two, besides not being necessarily sensitive to policy rates (at least in the
desired direction), may need different, even multiple, instruments in different situations. In
fact, much of the debate on these objectives revolves around the issues of definition and
controllability. Given this, for my purpose, I will use rather broad definitions for these two
objectives.
3. Financial Stability: minimizing the risk that the financial system collapses, thereby
disrupting economic activity
4. External Stability: minimizing the risks associated with financing a current account
deficit with volatile capital inflows, which may disrupt economic activity.
Of course, not all central banks assigned non-zero weights to all dimensions. To a large
extent, the post-crisis debate on monetary policy and central banking has been shaped by
this asymmetry: should the weights for, particularly, the last two objectives be introduced or
changed to reflect the learnings from the crisis?
I will now go on to explore current thinking on the components of this framework in three
sections: Price and Output Stability together and then Financial Stability and External
Stability separately.
Price and output stability
I would argue that very little has changed with respect to the basic approach to price and
output stability as a result of the crisis. The basic objective of the monetary policy function of
central banks still remains price stability, with or without attention being given to output
stability. However a number of issues emerge even within the relatively robust intellectual
foundations of this proposition. About a year ago, there was a debate between John Taylor
and Ben Bernanke on the appropriate measure of inflation to be used in calculating the
appropriate policy position from the Taylor Rule formula. In response to the claim that the
Fed's easy money policy was a significant contributory factor to the crisis, Bernanke argued
that the Fed's relatively easy stance was justified by the fact that inflation forecasts were
trending significantly downward, while Taylor rebutted saying that actual inflation rates and
not forecasts were the appropriate inputs into the formula. Had this been done, the policy
stance would have been different and so might have been the outcome.
However, this was a debate on detail, not on the basic approach. One line of argument that
has emerged after the crisis is that inflation targeting - assigning a relatively low weight to
the output gap in the Taylor Rule - had been discredited. Many economies which did target
inflation in this way appeared to have lost a little bit of the flexibility or response to the
impending financial shock, which then made its impact even more severe. Proponents of
inflation targeting have defended the approach by introducing a number of nuances into their
cases. Charles Bean, Deputy Governor of the Bank of England, for example, argues that the
crisis does not invalidate the case for targeting, since there needs to be a credible long-term
anchoring for inflationary expectations and an explicit target is the best way to achieve that
(Bean, 2010). Rather, the crisis suggests that rigid adherence to the target may be the
problem and that the central bank needs some "constrained discretion" to respond to
temporary price-level shocks.
Lars Svensson, Deputy Governor of Sveriges Riksbank, also advocates flexible inflation
targeting "applied in the right way and in particular using all the information about financial
conditions that is relevant for the forecast of inflation and resource utilization at any horizon -
remains the best practice monetary policy before, during and after the financial crisis"
(Svensson, 2010).
The Reserve Bank of India has defined itself as not being an inflation targeter in the strict
sense. In recent speeches, Governor Subbarao has put forward two kinds of arguments
against committing to an explicit target (Subbarao, 2010). One is logistical, with reference to
the current absence of an effective, nationally representative index to target. The other is
conceptual, referring to the frequency of temporary, often mild supply shocks, to which
monetary responses are unwarranted because of lags, but which would be required if
inflation were effectively targeted. Expectations are sought to be managed through the
articulation of medium and long term inflation objectives on the premise that communication
is also a tool of monetary policy, and by striving for consistency between the overall
macroeconomic assessment and policy actions. The significant decline in the average rate of
inflation since the mid-1990s reflects the effectiveness of monetary policy in managing
inflation, in combination with a range of structural reforms.
This is not the place to resolve the "to target or not to target" debate. The point I want to
emphasize is that the approach to the core objectives of monetary policy, whether inflation
alone or the growth-inflation balance, does not appear to have been significantly impacted by
the crisis. In normal circumstances, i.e., in the absence of a visible domestic or external
shock, what was held to be valid before the crisis remains so after it. It is when such shocks
strike that the room for maneuver needs to be available, providing enough flexibility in terms
of powers and instruments to deal with a variety of shocks.
Financial stability
In hindsight, financial stability has always been a part of this flexibility, on the basis of which
central banks in many countries have used their powers to try and avoid catastrophic
damage to the financial system. Sometimes this has been soft power by way of facilitating
mergers and acquisitions of vulnerable institutions; on other occasions, the muscle of the
"lender of the last resort" role has been used. In fact, I would argue that it is precisely this
role that makes central banks critical players in preventing the financial system from being
incapacitated by liquidity constraints. But, beyond this traditional function, a number of issues
arise on both goals and instruments.
One approach to integrating financial stability explicitly into the central bank mandate is to
introduce an additional variable into the standard Taylor Rule (e.g. William Poole, 2010). This
will then allow the policy rate to be set at a level which is consistent with whatever indicator
of financial stability is used - e.g., the deviation of asset prices from some benchmark
valuation based on fundamentals. In other words, the policy response is conditioned both by
commodity price inflation and by asset price inflation. The dilemma, of course, is that real
activity will probably be constrained by a policy response to asset price inflation, something
that may not necessarily have been warranted by economic conditions. Finding the right
benchmark - real estate, equities or a complex portfolio - by which to measure financial
instability may also pose challenges, not to mention the fact that a major source of instability
is in the balance sheets of financial intermediaries, which may not be fully captured by
market prices because of information asymmetries.
A less explicit approach to central banks dealing with financial stability is "leaning against the
wind" - situational responses to what appear to be unsustainable increases in asset prices.
Of course, a judgment would have to be made as to whether a bubble is in progress in order
to justify a response. Jurgen Stark, member of the Executive Board of the ECB, accepts the
difficulties involved with identifying a bubble and, consequently, the risks inherent in a
leaning against the wind strategy (Stark, 2010). He argues burst bubbles may be more costly
for the economy than previously believed. In terms of effectiveness, he points to research
suggesting that monetary responses to asset price movements have a strong signaling
impact, materially changing the risk perceptions and behavior of financial intermediaries. In
short, he sees conventional monetary instruments as a legitimate instrument in addressing
the financial stability objective.
By contrast, Adam Posen, external member of the Bank of England's Monetary Policy
Committee, argues that from the angles of identification of bubbles, cleanup costs angle and
the effectiveness of monetary instruments, leaning against the wind will not work (Posen,
2010). He believes that we as yet know too little about the underlying mechanisms and
therefore, the probabilities of making the wrong move are high, with obviously adverse
consequences for the real economy. This largely seems an unresolved issue, which makes it
difficult to translate into clear policy implications.
However, there have been some significant developments in the thinking on the central bank
role in financial stability. This has come not from the monetary policy perspective, but from
the prudential regulation viewpoint. Prudence was largely seen to be an entity-specific
phenomenon in the pre-crisis period. If the balance sheet risks of every entity were identified
and provided for, it was believed that the system as a whole would be safe. That perception
has been decisively proved false by the crisis; there is "superadditivity" in the system with the
risk in the whole being more than the sum of the risks in the parts as a result of multiple and
complex inter-relationships between supervised and unsupervised entities. The concept of
macro-prudential or systemic risk mitigation has assumed great importance in the post-crisis
regulatory architecture. While national and international regulatory agencies deal with the
operationalization of this concept, with respect to both indicators and mitigation measures,
some broad understanding on the role of the central bank in this process has emerged.
One, the repository of information on the basis of which systemic risks can be gauged is with
the prudential regulator, which may be either inside or outside the central bank. Leveraging
the micro-prudential data and assessments that emerge from the supervisory process into
making systemic risk judgements is where new resources and skills need to be brought in
and in a way in which they can effectively work with the traditional supervisory establishment.
However, once judgements are made and a response is warranted, both central banks and
governments come into the picture. If the threat is one of liquidity shortages, the lender of the
last resort function will come into play. If the threat is more of insolvency, governments may
have to decide between letting institutions fail and arranging conditional rescues, which will
involve possibly significant infusions of capital. Given the significance of inter-connections
between prudentially regulated and unregulated entities, other regulatory agencies who keep
some watch on the latter, also become logical parts of a collective and co-ordinated systemic
risk monitoring and mitigation framework.
This is the direction in which many countries, including India, are moving. These new
arrangements will obviously take some time to evolve, and, since they are essentially
preemptive in nature, the non-recurrence of a financial crisis for reasons similar to the previous
one will be one test of their effectiveness. However, the underlying premise that the best way
to deal with financial stability is through the prudential rather than the monetary route is a
sound one and resolves some of the dilemmas about stability indicators and the
effectiveness of monetary instruments referred to earlier.
This has been the premise of the Indian approach to financial stability even though it may not
have been explicitly stated as such. The Statutory Liquidity Ratio (SLR) provided the banking
system with a credit risk-free buffer, an instrument that is coming back into global
consideration in the form of enhanced norms for fully liquid assets to be held by banks. In
dealing with what was perceived to be an overheating real estate market, earlier during
2005-06 and more recently in the latest quarterly review of November 2010, prudential
measures in the form of loanto value ratio caps and higher risk weights and provisioning
requirements were used as a way to buffer the financial system from a potential decline in
prices, without having to take an explicit view of what constituted a fair value of the assets.
External stability
There are both long-term and short-term issues in relation to the central bank's role in
external management. Should the exchange rate be a policy instrument for long-term
growth? Are the choices and trade-offs different between large and small economies? These
are important questions in the current global economic debate. However, in the immediate
aftermath of the crisis, a short-term concern has arisen with respect to the possibility of large
capital inflows into emerging economies. This reflects the unevenness of the strength of the
recovery in advanced and emerging economies and the attempts by the former to find ways
to continue to provide stimulus. The latter are clearly worried that a surge would destabilize
their domestic economies through exchange rate appreciation or excess liquidity in a situation
in which they are generally trying to cool things down a bit.
What should central banks be doing to deal with this situation? It must be viewed as an
essentially short-term phenomenon, because if it achieves the intended stimulus in the
advanced economies, there will be a rebalancing of flows as those economies begin to
recover more strongly. In that case, the conclusions of an IMF Staff Position Note,
co-authored by Jonathan Ostry and others, are relevant "... if the economy is operating near
potential, if the level of reserves is adequate, if the exchange rate is not undervalued and if
the flows are likely to be transitory, then the use of capital controls - in addition to both
prudential and macroeconomic policy - is justified as part of the policy toolkit to manage
inflows" (Ostry et al. 2010).
While the justification for controls is subject to several conditions, clearly, many countries that
do not meet all those conditions would be equally tempted to use controls as a way of
protecting themselves against the threats to stability from volatile capital flows and exchange
rates and domestic liquidity conditions. In fact, the IMF Note also reports empirical results
indicating that countries which had controls aimed at achieving a less risky profile of external
liabilities showed greater robustness during the crisis.
So, is this an argument for capital controls, an inversion of the pre-crisis view? To an extent,
yes, reflecting the conditions during the crisis and how different groups of countries have
emerged from it. However, the specific conditions, both domestic and global, that would
determine the desirability of capital controls for specific countries need to be thought through.
Intervention to manage the exchange rate is another way in which a central bank may
contribute to external stability. From a short-term perspective, the decision to intervene in
order to avoid destabilizing both exporting and import-competing domestic producers needs
to be viewed in the overall context of domestic conditions. An assessment by Masaaki
Shirakawa, Governor, Bank of Japan, illustrates the dilemma. He argues that in a situation in
which policy rates are already at the zero boundary, exchange rate appreciation, which helps
dampen inflationary pressures, would allow the low interest rate scenario to persist, thereby
raising the risks of an asset price bubble (Shirakawa, 2010). In other words, for a country in a
zero interest rate situation, it is important to preserve and even grow external demand for its
products so that it can create the space to normalize domestic policy.
If one were to apply this reasoning to countries in which rising domestic demand is
contributing to inflationary pressures, appreciation would presumably help contain those
pressures, by way of a contraction of demand in exporting and importcompeting sectors.
While the long-run growth of, particularly, the former is important from the perspective of
inclusive development, given their relative labour intensity, the arguments made above point
to some of the trade-offs involved in using the exchange rate as a policy instrument in
different macroeconomic conditions.
The Reserve Bank's policy on exchange rates has been articulated as broadly
noninterventionist, except when confronted with excessively volatile, lumpy or disruptive flows.
This is an approach consistent with the notions of "flexibility" or "constrained discretion" used
earlier in the context of boundary conditions for traditional approaches to monetary policy.
These are, essentially, boundary conditions, which would presumably trigger some deviation
from normal policy if abnormal circumstances were to arise. What would constitute abnormal
conditions, of course, cannot be explicitly indicated but will presumably be defined by specific
circumstances in which actions are taken.
Concluding remarks
In this talk, I have tried to provide a sense of the choices, dilemmas and constraints facing
central bankers as they attempt to navigate their economies out of the crisis. In the process,
some traditional positions on monetary policy and central banking activity may have been
reinforced, while some new thinking on mandates and instruments may have emerged.
Clearly, these are issues for which analytical foundations need to be strengthened or even
developed from scratch to enable an internally consistent view of policy choices in different
circumstances. Central bankers will obviously be avid consumers of these intellectual
developments. But, even as that process unfolds, there are some important messages to be
extracted from the thoughts and articulation of practitioners. Let me conclude with what I
believe to be three key messages.
First, the crisis has not in any way undermined the core objectives and approaches of
monetary policy, i.e., the use of conventional interest rate and liquidity instruments to
address commodity price and output stability, with whatever weights may be assigned to the
two objectives. What it has done is to make the case for flexibility in deviating from a set path
when confronted with shocks. This essentially suggests that a standard approach be
followed in normal times but deviations are legitimate when times turn abnormal; of course
somebody has to decide when this occurs. Defining and quantifying "abnormality" is clearly
an important analytical requirement to make this judgement more reliable.
Second, even as the boundaries of normality are being approached or breached, it is difficult
to see responses being confined to traditional instruments or, for that matter, traditional
structures. As far as financial stability is concerned, the analytics supporting the use of
conventional monetary instruments may be advancing, but there is still a strong contrary
view. What is being recognized is that, even though these instruments may contribute,
prudential measures may be a more efficient way to address the issue. Further, the
postcrisis recognition of systemic risk, based on inter-connectedness, makes the case for
co-ordination on risk management, with clearly defined roles for different agencies.
Third, while addressing external stability in general terms seems to be becoming an
acceptable component of a broadened central bank mandate, the nature of the response will
depend significantly on both the state of the domestic economy and global conditions. Also,
short-term objectives may be in conflict with long-term ones, requiring some prioritization.
Let me conclude with a quote from a recent speech by Ben Bernanke: "... the past two years
have demonstrated the value of policy flexibility and openness to new approaches.
During the crisis, central banks were creative and innovative, developing programmes that
played a significant role in easing financial stress and supporting economic activity. As the
global financial system and national economies become increasingly complex and
interdependent, novel policy challenges will continue to require innovative policy responses"
(Bernanke, 2010).
These innovative responses need to manifest on three fronts. One, broader mandates for
central banks will need to be made explicit and conditional on the priority of the core
mandates. This should eventually lead to definitions and quantification of conditions in which
the broader mandates will kick in. Two, appropriate instruments need to be dusted off or
developed to ensure that broader mandates can be fulfilled. A single or a small number of
traditional monetary instruments cannot be expected to do the job. Finally, these broader
mandates may be more effectively pursued in a collective institutional framework, which will
inevitably raise co-ordination challenges, which need to be addressed. I would like to thank
the organizers once again for inviting me and thank you all for listening to me.
References
Bean, Charles, Matthias Paustian, Adrian Penalver and Tim Taylor (2010), "Monetary Policy
after the Fall", Paper presented at Federal Reserve Bank of Kansas City Annual Conference,
Jackson Hole, Wyoming.
Bernanke, Ben S. (2010), "Emerging from the Crisis: Where Do We Stand?", Remarks at the
6th ECB Central Banking Conference, Frankfurt.
Ostry, Jonathan D, Atish Ghosh, Karl Habermeier, Marcos Chamon, Mahvash Qureshi, and
Dennis Reinhardt (2010), "Capital Inflows: The Role of Controls", IMF Staff Position Note,
February.
Poole, William (2010), "Monetary Policy Flexibility: Solution or Problem?", Presentation at
First International Research Conference organized by Reserve Bank of India.
Posen, Adam S (2010), "Do We Know What We Need to Know in Order to Lean Against the
Wind?", Presentation at the Cato Institute 28th Annual Monetary Conference Panel on "Is
Monetary Policy Responsible for Bubbles?".
Shirakawa, Masaaki (2010), "Advanced and Emerging Economies: Two-speed Recovery",
Bauhinia Distinguished Talk, Bauhinia Foundation Research Centre, Hong Kong SAR.
Stark, Jurgen (2010), "Approaches to Monetary Policy Revisited - Lessons from the Crisis",
Keynote Speech at the 6th ECB Central Banking Conference, Frankfurt.
Subbarao, D. (2010), "Financial Crisis - Some Old Questions and Maybe Some New
Reserve Bank of India
Answers", Bulletin, September, pp.1713-1722.
Svensson, Lars E. O. (2010), "Monetary Policy After the Financial Crisis", BIS Review 118,
pp.1-6.