Tarisa Watanagase: Rethinking monetary policy in a globalized world -
coping with current challenges and beyond
Remarks by Dr Tarisa Watanagase, Governor of the Bank of Thailand, at the Central Bank of
Malaysia High Level Conference 2009, Kuala Lumpur, 10 February 2009.
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1. Introduction
I would like to congratulate Bank Negara Malaysia on its 50th anniversary, and the
magnificent job the Bank has done both in the domestic and international arenas. I wish the
Bank continued success in the next 50 years and beyond.
Thank you for the opportunity to address this distinguished audience on a topic that is a
current concern for all central bankers during these turbulent times.
I would like to raise a number of issues which have challenged the traditional thinking behind
monetary policy as a consequence of globalization and the current turmoil. In some others I
hope to propose solutions - some new, and some old. In many cases I will address the
challenges and the blind spots which we face as monetary policy makers, and raise
questions to which I myself do not yet know the answer.
The developments that globalization has brought about has tested the limits of conventional
monetary policy, both in terms of the current thinking about how monetary policy is
conducted, as well as the effectiveness of the current approach to monetary policy. I will
discuss these points in detail in a moment. But first of all, let me briefly outline what exactly
have been the challenges in recent decades that have required us to rethink the way we
conduct policy.
Globalization has been a long and drawn out process. Countries have jumped at the
opportunity to reap the benefits of globalization, with advanced countries leading the pack.
Jumps in technology in recent decades, particularly in information and communications, have
ensured that services - particularly financial services - have become truly borderless for
advanced and developing countries alike, in a much shorter period of time.
2. Challenges to traditional monetary policy under globalization
We are all familiar with the benefits of globalization, with the past few decades seeing cheap
exports from emerging markets fueling global trade and growth, albeit with some hiccups
along the way. China's accession to the WTO and the subsequent flux of Chinese exports to
the rest of the world, as well as oil exports from the Middle-East, helped to create an
environment of prolonged low global prices and low global inflation.
We are all familiar with this episode and have given it a few names: the great moderation, the
Goldilocks' economy - not too warm and not too cold, and stable disequilibrium. This is an
episode in our history where variability of growth in real output has declined along with the
variability in inflation.
Along the way, imbalances in the global economy began to build up. The imbalances
manifested themselves in huge trade surpluses and an accumulation of foreign exchange
reserves in the countries which relied on export-oriented growth - including those in the
Asian region. They were reflected in the dollar revenue which was subsequently reinvested
in US financial markets - which in turn helped to finance the US saving deficit, permitting
these imbalances to remain uncorrected for a prolonged period of time. And as a result,
asset price bubbles were also allowed to persist for a prolonged period as well.
All was well as long as everyone continued to grow. However, as emerging markets opened
up, global demand, and particularly demand from growing economies like China and India,
drove up the prices of oil and other global commodities. Many economists began to predict a
structural shift in global demand and changing dynamics of global inflation which would effect
domestic prices and make inflation higher and more persistent.
3. Coping with the global financial crisis
At the same time, problems were brewing on the financial side in the advanced economies. I
will not lay out the causes of the financial crisis here, as that has been discussed widely
elsewhere. In a nutshell, the slowdown in the US housing market, coupled with a mix of
troubled banking practices, regulatory blind spots, and absolute faith in the market
mechanism, among other things, led to a financial crisis in advanced economies. But the
important point here is that financial innovations, coupled with technological advances in
communications, helped to link financial markets across the globe. This globalization of
financial services allowed the collapse of major financial centers to spread to the rest of the
globe so efficiently. In fact, these very financial instruments which had been earlier used to
diversify risks turned out to be the very means for spreading contagion.
The spread of the impact of the financial crisis onto the global real economy through the
trade channel changed the world's economic outlook rapidly and dramatically. This had a
drastic impact on the inflation outlook, and the threat of inflation has rapidly shifted to one of
possible deflation. At the same time, central banks are running out of traditional monetary
policy ammunition to fight the slowdown in growth and potential deflation - namely cutting
interest rates.
Given the increasing influence of external factors on global inflation dynamics, traditional
monetary policy which focuses on domestic dynamics of inflation needs to be reconsidered.
As a result of globalization, the prices of important commodities and goods tend to move
together, making external price shocks a more and more important determinant of domestic
inflation. Fluctuations in oil prices and other commodity prices, or even a sustained period of
cheaper or dearer exports, can change global inflation dynamics. The spike in oil and
commodity prices last year, which initially appeared as a supply shock at the individual
country level, in fact represented economic overheating at the global scale, and domestic
monetary policy tightening may not have been the most effective way to deal with this
situation in the global context.
In addition, at the present juncture, the unprecedented and contagious slowdown in each
country's economies as a result of global linkages means that monetary policy now needs to
respond to the monetary policy stance in other countries. This has added an extra
international dimension to policy making, in addition to previous considerations such as the
impact via capital flows and trading partners' economies.
4. Testing the limits of monetary policy under globalization
But what exactly are these changes that globalization has brought about to traditional
monetary policy? And in particular, how have these changes affected central banks?
The first aspect has been the challenge to the basis of our traditional monetary policy
decision-making process.
Traditional conduct of monetary policy would rely on the accuracy of our forecasts of the
economy, of inflation dynamics, and of our understanding of how the economy works. With
globalization, making accurate economic forecasts become more difficult.
The recent economic cycle has demonstrated that shocks to the economy and the price level
have been both rapid and frequent. This is most clearly demonstrated by the volatility in
inflation in the past year. In the case of Thailand, headline inflation peaked at 9.2% in July
last year, but has fallen dramatically to -0.4% in January.
While it is natural for forecasts to be revised in light of new developments and information, a
concern arises that globalization is likely to have changed the various relationships in the
economy. This is particularly timely now, when fear and uncertainty takes over rational
behaviour. And if our models are still based on assumptions which have not incorporated
these changing relationships, then we are likely to make systematic errors in our forecasts.
As a result of this volatility in inflation and the marked slowdown in global output, many
central banks have had to reverse their tightening cycles - originally conducted to tackle
inflationary pressures, while others have pursued an aggressive easing of monetary policy to
shore up growth and fight off prospects of deflation. Many countries, including Thailand, had
to do both.
This in turn, also becomes a concern for the central bank if frequent revisions or the abrupt
reversal of the central bank's monetary policy stance affects the public's perception of the
central bank's credibility.
As a result of the speed and magnitude of deterioration in economic conditions, central
banks across the globe have pursued extremely aggressive monetary policy easing, with the
intent of actively supporting their domestic economies against the global slowdown.
This situation has led us to the second challenge to monetary policy - namely the challenge
to its effectiveness. Given current economic conditions, all the usual transmission channels
have been clogged up. What happens when interest rates cannot be lowered any further?
This is the challenge already faced in the US and the UK, and this challenge may need to be
addressed by other countries in the near future.
The US and the UK have begun to explore "unconventional measures" now that the
traditional ammunition of lowering interest rates has been exhausted. This has included
tackling the spread between commercial and government rates directly. The
"unconventional" approach taken by Japan in earlier decades - namely purchasing of
medium- and longer-term government bonds, is also an option, although the Japanese
experience has shown that this has led to an increase in base money but did little to
stimulate lending, as commercial banks have increased short-term liabilities and too many
illiquid and undervalued long-term assets on their balance sheets. On the other hand, recent
easing, as in the case of the US, has resulted in a more targeted, direct lending to
businesses through purchases of commercial paper, and indirectly to households through
purchases of mortgage-backed securities.
5. Lessons from the current crisis: where do we go from here?
So what are we to do going forward on this issue of monetary policy in a globalized world?
I believe that there are a few issues that need our immediate attention amid the
unprecedented crisis that we are in.
First, recent monetary policy actions around the globe have included the aggressive, and in
many cases unprecedented easing of policy interest rates, as well as measures to extend
and improve banks' access to long-term liquidity, limit systemic risk, and increase banks'
willingness to lend.
But the use of these unconventional measures remains in unchartered territory, and few
countries have had actual experience with their use, or to identify which ones are the most
effective. Therefore, we need to significantly improve our understanding about how these
measures might or might not work, what the conditions or indicators are that they aim to
achieve, such as a pickup in growth or inflation, or a narrowing of short- and long-term bond
spreads, for instance.
Second, given that such measures are relatively new and unconventional, communications
with the public and investors are important so that they understand what these
unconventional measures mean in terms of monetary policy stance and when to expect an
exit once these conditions or indicators are met. Clear understanding will improve
confidence, which we need to restore as soon as possible.
Third, the feasibility of unconventional measures such as credit easing may be limited in
emerging markets, where the stock of such assets for purchase is limited. What then, are the
alternatives should emerging economies run out of interest rate ammunition, and are there
other options before the traditional ammunition runs out?
Fourth, taking a longer term perspective, beyond the current crisis, we need to continue to
improve our understanding of monetary policy in a globalized world. What other important
ingredients need to be considered when implementing monetary policy or when forecasting
growth and inflation ahead? The role of external shocks is likely to become more important
and needs to be considered more carefully. We need to find ways to anticipate these shocks
including the future financial architecture and improve upon limitations in our foresight and in
the forecasting ability of our models.
Fifth, the role of policy makers in other countries which will add to these external shocks
opens up room for greater policy coordination and cooperation at the international level. Like
other previous crises, the current crisis is likely to be followed by discussion about intensive
reforms at the international level. We should grab this opportunity to highlight the need for
international cooperation in monetary policy in maintaining global financial stability. I don't
need to point out that international cooperation in the area of supervision is far ahead, both in
normal times and in time of crisis.
In order to secure international cooperation in monetary policy, we need more research and
dialogues on how to make early warning and surveillance really work at a global level. In
addition, coordination may not be enough; a redesign of global financial architecture may be
necessary, and we need to work on this area as well.
One last point before I end, I believe that most of us now agree that central banks need to
maintain financial stability in addition to price stability. Therefore, we also need to improve
our understanding of the implications of globalization on financial stability, as well as the
tools to conduct monetary policy in addition to the interest rate tool for stability purposes.