Rakesh Mohan: Challenges to monetary policy in a global context
Speech by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 22nd Anniversary
Lecture of the Central Banking Studies at the Central Bank of Sri Lanka, Colombo, 21 November
2003.
Dr Rakesh Mohan is grateful to Dr Michael Patra, Dr A Prasad and Shri Muneesh Kapur of the Reserve Bank of India for their
assistance. The references can be found on the Bank of India's website.
* * *
I. Introduction
Recent global developments have significantly transformed the environment in which monetary policy
operates. This has thrown up opportunities as well as challenges. Globalisation has expanded
economic interdependence and interaction of countries greatly. This has created the need for greater
coordination in terms of the design of appropriate institutional architecture as well as standardisation
reflected in the adoption of similar monetary policy approaches. It has also been associated with a
dramatic lowering of inflation worldwide. Central banks have seized these opportunities to bring about
institutional reforms to enhance accountability, and hence, credibility of monetary policy making. They
have had to hone their technical and specialist management skills to acquire adequate competence to
deal with the emerging complexities of financial markets.
The more recent evolution of the global economy has accentuated the challenges that face monetary
authorities. Increasingly, monetary policy decisions have to be made in an environment of heightened
uncertainty. Structural changes associated with globalisation have increased the uncertainty in
interpreting macroeconomic indicators regarding the state of the economy. Another form of uncertainty
stems from the strategic interaction between private agents and monetary policy authorities and, in
particular, the role of expectations in the monetary transmission mechanism. Financial markets, driven
by massive cross-border capital flows and the information technology revolution, immediately transfer
the valuation of risks associated with uncertainty across the globe and this can lead to contagion.
Indeed, global interdependence is marked by common shocks and a "confidence channel" rapidly
transmits these shocks to various parts of the world.
All this has rendered the conduct of monetary policy extremely complex in such an environment of
interdependent risks. Therefore, even though monetary policy is conducted towards achieving
domestic objectives, central banks have to follow developments carefully across the world. More than
ever before, the choice of monetary arrangements depends on the choices that other countries
make (Meltzer, 1997).
In my lecture today, I propose to dwell upon the uncertainties that characterise the monetary policy
environment, the underlying macroeconomic conditions in which monetary policy has to be set, the
process of inflation and the changing institutional response to the commitment to price stability, the
role of capital flows and what the future holds in store. Against this backdrop, I hope to shed some
light on the emerging discussion among central bankers about the course of monetary policy that is of
greater relevance to developing countries such as ours.
II. The setting: global economic situation
The growing internationalisation of monetary policy has been brought into sharp focus by the
synchronised global downturn since the late 1990s. In response, monetary authorities all over the
world have made concerted efforts to ease their policy stance significantly. The US has powered the
world economy during the last 7-8 years and has been responsible for about 60 per cent of world
growth. Despite bursting of the stock market bubble, a rash of corporate governance problems and the
IT bubble, US has been the main engine of world growth in recent years and has been partly
responsible for the recovery of Asian countries after the 1997 crisis. In the bargain, the US
accumulated twin deficits - current account deficit (CAD) of five per cent, and fiscal deficit of six per
cent (a sharp turnaround from a surplus of 1.2 per cent in 2000). With the emergence of such an
imbalance in the US, other regions in the world have to exhibit an equal and opposite imbalance of
their own. Ironically, it is the developing countries of Asia who are funding the CAD of the US and
exhibiting surplus. The central banks of Asia are financing roughly 3-3.5 per cent of the CAD of the US
and most of its fiscal deficit, as compared to the earlier situation where it was private sector flows that
were funding these deficits. In view of the difficulties in monetary management that the situation
entails, this situation is clearly not sustainable indefinitely. There are no short-cut solutions since the
problems are deep, structural and inter-dependent: hence these cannot be solved through
independent or unilateral action. For example, difficult structural reforms are necessary in the Euro
area; much more structural reforms are required in Japan, particularly in the financial sector; India has
a large fiscal deficit problem, and China cannot afford a major appreciation. Hence, relatively
coordinated medium term action is called for among the major economies of the world. Unilateral
action by any country is unlikely to solve its own problems.
Recent months have seen the emerging signs of a recovery in economic activity, particularly in the
US, Japan and emerging Asia. In the US, the pace of growth has picked up, assisted by expansionary
macroeconomic policies and supportive financial conditions. Equity and bond markets have responded
with optimism to prospects of recovery with investor interest returning to technology stocks more
rapidly than to other sectors. In Japan, there are stronger signs in the third quarter that a cyclical
upswing is underway, led by industrial activity and exports. In the UK and Australia, signs of recovery
are clearly evident with rising household spending reflected in retail price inflation, prompting monetary
authorities in these two countries to raise key policy interest rates against inflation surprises. China
continues to grow at a remarkably strong pace while activity in other parts of Asia is bouncing back
from the effects of SARS. There is nevertheless considerable uncertainty regarding the durability of
the pick-up. In the US, labour markets remain sluggish and significant excess capacity persists.
Moreover, the substantial support provided to consumption by tax cuts is unlikely to be sustained.
Despite the prospects of stronger growth, Japan continues to experience deflation. The ongoing
concerns relating to structural weaknesses in the financial system remain. In contrast to the rest of the
world, the euro area remains conspicuously weak although there are tentative signs of a modest
recovery in recent months. Household demand remains sluggish and the unemployment rate for the
area as a whole has risen.
The burden of adjustment to the global slowdown has been highly asymmetric and this raises the risks
associated with sustaining the recovery. The US has been virtually alone among the OECD countries
in pursuing an aggressive and flexible countercyclical monetary and fiscal policy - cuts in policy
interest rates have been the largest and the swing in structural government balance from a surplus of
0.6 per cent of GDP in 2000 to a deficit of 5.1 per cent in 2003 is the largest in three decades. Global
growth will continue to be led by the US, but significant downside risks could emanate from the
emergence of the record current account and fiscal deficits of the US. While the depreciation of the
US dollar has so far been relatively orderly, further and substantial depreciation remains a danger to
global recovery in the shadow of the twin deficits. History suggests that even an orderly adjustment in
key exchange rates is likely to be associated with a slowdown in US growth - and, if growth in the rest
of the world remains weak, in global growth as well (IMF, 2003). The continuing dependence of the
world on the US heightens the risks of disorderly adjustment, particularly if it translates into an
off-setting appreciation of the euro. In contrast to the mid-1980s, when the US ran current account
deficits of similar order as in 2003, neither Europe nor Japan is in a position today to pick up the slack.
Looking ahead, it is unlikely that the US can provide the degree of support to the global economy that
it has in the past. In particular, high fiscal deficits would offset the longer-term benefits of tax cuts and
rising debt service burdens in the household sector will curb future consumption spending.
In the euro area, whereas monetary policy can be adjudged to have been successful in an inflation
targeting framework, the economic slowdown has been deep and prolonged, with GDP declining in the
second quarter of 2003. The largest economies - Germany, France, the Netherlands and Italy - are in
recession with high levels of unemployment. The unemployment rate is 8.8 per cent for the euro area
as a whole and even higher in some individual countries: 13.2 per cent in Belgium, 9.7 per cent in
France, 10.5 per cent in Germany, 8.5 per cent in Italy and 11.4 per cent in Spain. Despite some
recent improvement in expectations, household and business confidence remains depressed. The
poor performance of Germany, in particular, threatens to hold back the region's recovery. Corporate
balance sheets are still adjusting to the bursting of the asset price bubble of the late 1990s and this is
holding down investment spending. Exports have been adversely affected by weak external demand
as well as the substantial appreciation of the euro over the past two years. Monetary policy has been
accommodative but different inflation and unemployment rates in different countries blur the
effectiveness of the common monetary policy. A more activist approach is warranted especially when
downside risks to individual countries have potentially area-wide spillovers. Although Germany and
France are expected to post fiscal deficits above 4 per cent of GDP in 2003, the scope for
countercyclical fiscal policy is limited by the Stability and Growth Pact. Structural reforms hold the key
to improving Europe's economic performance, including further liberalisation of labour and product
markets, pension reforms and offsetting measures to deal with the aging population.
In Japan, macroeconomic performance during 2003 has exceeded expectations alongside an
improved external environment and upturn in equity markets. The outlook remains overcast with
deflationary pressures and persistent weakness in the financial sector. The possibility of declines in
equity or bond prices, a sustained appreciation of the Yen and rising public debt remain dangers to a
durable recovery. More rapid and bolder reforms in the financial sector are needed to address the
large overhang of non-performing loans and the poor quality of capital in the banking sector. Financial
sector measures need to be complemented by corporate restructuring. Quantitative easing of
monetary policy has kept short-term interest rates at zero, but has not been aggressive enough to end
deflation. The build-up of public debt and pressures from population aging necessitate a medium-term
strategy to impart sustainability to fiscal policy.
Overall, global macroeconomic imbalances and the associated misalignment of the G-3 currencies
remain the most serious threat to a broad-based and robust recovery. This has implications for the
pattern of capital flows. In contrast to preceding years, the US current account deficit has been
financed primarily by sale of government and corporate paper rather than equity inflows. The bulk of
these investments has been by central banks, particularly those in Asia. This is clearly unsustainable
and adjustments will be needed to achieve medium-term stability. An eventual narrowing of the
US current account deficit will require emerging economies to share in the adjustment to prevent an
undue burden on the euro area. A current issue of concern is the practice of greater flexibility in the
exchange rate regimes of these countries, and the resulting efforts on the real economy. Studies have
shown that greater volatility in developing countries' real exchange rates has been associated with
greater misalignment in G-3 countries with disruptive effect on both trade and finance channels. This
emerges as a major source of uncertainty for the conduct of monetary policy.
The current imbalances in the world where Asian countries are financing Western countries,
particularly, the US could have their roots in longer term demographic imbalances. The long-term
demographics facing the world, which have an effect on the savings rate are not encouraging. The
demographics in Europe, Japan and the US are against high saving rates. The median ages in Japan,
Europe and the US are 4l, 40 and 35 years, respectively. Current trends indicate that the median age
in Japan will increase to 50 by 2025. The situation in the US may not turn adverse due to their flexible
immigration policies. Within Asia, India and China can expect their savings rate to increase further,
given that the private savings of these two countries are among the highest in the world, and in view of
their favourable demographics over the next 20 years. Countries like India and China, which account
for a large proportion of world population, also have low urbanisation levels of 30 to 35 per cent and
will be moving to 50 to 55 per cent in the next 20 to 30 years. This would necessitate higher
infrastructure investment requiring higher capital inflows and a higher current account deficit. Thus, if
the Asian countries are to run large capital account surpluses and current account deficits, the
situation in the US and Europe would meet reversal. The issue is to try to comprehend what would be
required for this macro reversal to occur. The current demographic trends in Europe and Japan are not
sustainable. In the future, they may not be able to afford the pension system and social security as
they exist now. The only solution in Europe seems to be US type of immigration policies towards
labour market reforms. Currently, this is not possible because of high unemployment.
III. Inflation: what is going on
In this brief overview of the global economic situation today, I have tried to indicate that global
imbalances are inter-related and how monetary policy making in countries like ours has become that
much more difficult on a day-to-day basis. The most notable achievement in recent years has been the
substantial success in almost all countries in reducing inflation to the lowest level in several decades.
Sustained inflation is a relatively modern phenomenon. Until World War I, the international experience
was one of long-run price stability. Following the turbulence of the inter-war period, the Second World
War and the Korean War of the early 1950s, the Vietnam war of the 1960s and early 1970s, inflation
gradually increased from the late 1960s, party as a result of expansionary fiscal and monetary policies.
The massive oil price hike of 1973 stepped up global inflation to double-digits in the US and Western
Europe. There was a huge transfer of resources to the Middle East from the rest of the world including
Asia. The lasting consequence of this development of the 1970s has been the migration of workers
from countries like ours who are now remitting back large sums of money on a sustained basis.
Although inflation abated in 1978, it rose to double-digit levels again by the end of 1979 following the
second oil shock. Inflation finally broke in 1982, under the impact of aggressive disinflationary policies.
The 1980s were marked by strong and widespread efforts to restore reasonable price stability through
a combination of tight monetary policy, fiscal consolidation and structural reforms. The reduction in
inflation, facilitated by a significant decline in oil prices, set the stage for a robust economic recovery
that continued till the end of the 1980s. Another inflation episode in 1989-90 due to the hardening of oil
prices was met with aggressive monetary policy action which enabled a cooling-off by 1991 at the cost
of a much shallower recession than the early 1980s.
Since then, the world has been going through one of the longest phases of low inflation in post-World
War II history. The decline in inflation is evident across countries at different stages of development. It
has been most spectacular in developing countries where inflation fell from 31 per cent in early 1980s
to under 6 per cent in 2000-03. In Latin America and the countries in transition where inflation
averaged 230 per cent and 360 per cent, respectively, during 1990-94, it is projected at around 10 per
cent in 2003. Out of 184 members of the IMF, 44 countries had inflation greater than 40 per cent in
1992. In 2003, this number has fallen to 3. For industrial countries, inflation, currently at around 2 per
cent, has fallen below the lows of the 1950s. Arguably, deflation threatens more countries today than
does high inflation.
What has brought about this significant decline in inflation globally? A significant strand in the literature
points to institutional changes in the conduct of monetary policy - independent central banks,
increased transparency, greater accountability through contractual frameworks, and greater
coordination between monetary and fiscal authorities - which has enhanced the reputation of monetary
authorities and increased public credibility in their ability to deliver low inflation. An equally influential
body of work, however, suggests that monetary authorities have just been lucky and that there are
other factors at work such as increased level of competition due to the forces of globalisation,
successful fiscal consolidation in developed countries, particularly in the context of the Maastricht
Treaty, and structural changes in the global economy in which productivity has a major role to play and
the rising prominence of the new economy. Have central banks been lucky or good? Perhaps a bit of
both (Rogoff, 2003). While the evidence on either side is still evolving, the current assessment is that it
is unlikely that there will be a reversal of the current trend in inflation. It is important, however, to
introspect a little further in order to understand the dynamics of low inflation and its future compatibility
with monetary policy in an international setting.
An important factor that might have contributed to the lowering of inflation is productivity growth.
Although productivity growth in Europe may not have been as high as it has been in the United States,
the disinflationary effects of such productivity growth in one region get transmitted across borders
through increased competition in a globalised world, operating through lowering of price mark-ups and
erosion of monopoly pricing power through the expansion of cross border trade. Increased competition
has made prices more flexible in their response to real activity, thereby reducing the incentive for
monetary policy to be expansionary. This has reinforced credibility in the commitment of monetary
policy's containing inflation (Rogoff, op cit).
Despite growing globalisation and synchronisation of business cycles, the most striking change over
the past three decades has been the moderation of volatility in GDP growth in most G-7 countries and
this could also have contributed to lowering inflation (Stock and Watson, 2003). A number of factors
are at work. First, the services sector, which is less susceptible to volatility than manufacturing, has
increased its share in output. Second, inventory management has improved. Third, financial markets
have provided households with easier access to credit. In the US, the sector that witnessed greatest
reduction in volatility is housing. Moreover, there have been fewer oil supply and price disruptions as
well as smaller productivity shocks in the 1980s and 1990s than during the 1960s and 1970s.
Although only a small part of the moderation in output volatility is attributed to monetary policy, this is
hotly debated. For instance, it is widely believed that monetary policy in the US has been successful in
implementing anticipatory non-inflationary policies and has focused on sustainable long-term real rates
of interest (De Long, 2003). A significant increase in the flexibility of the US economy to smoothen
shocks as a result of deregulation, technology, better inventory management and flexible labour
markets has enabled it to absorb shocks. The manner in which a shock is defined is critical. The
perception of a smaller shock is really 'net shock' i.e. gross shock minus what has been absorbed.
Thus, events like September 11 can be measured only in a net sense. Moreover, in an integrated
world, it would be difficult to distinguish between exogenity and endogeneity; for instance, an increase
in oil prices could very well be treated as endogenous.
Yet another set of forces operating on inflation emanates from technological change. Advances in
architecture and engineering as well as development of lighter but stronger materials has resulted in
"downsized" output, requiring more technology sophisticated input. This process has accelerated in
the recent decades with the advent of the semi-conductor, the micro-processor, the computer and
satellite. The impact of technological change is evident in the huge expansion of the money value of
output and trade but not in tonnage. As a consequence, material intensity of production has declined
reflecting, as Fed Chairman Alan Greenspan (1998) noted, "the substitution, in effect, of ideas for
physical matter in the creation of economic value". This has contributed to the secular decline in
commodity prices. In fact, a long-run trend decline in commodity prices over the last 140 years shows
little evidence of reversal. Concerns over increasing commodity price volatility around this declining
trend have, however, increasingly engaged monetary policy attention in the short-run.
A significant strand in the literature credits changes in the institutional and operating framework of
monetary policy with the success in achieving low inflation. After the experience of sustained inflation
of the 1960s and 1970s, the objective of inflation control became stronger, and the movement of
inflation targeting emerged. Massive cross-border capital flows, globalisation of financial markets and
the information technology revolution have combined to alter significantly the choice of instruments of
monetary policy, operational settings, lag structures and transmission mechanisms. In particular, these
forces have led to the progressive erosion of the traditional anchors of monetary policy. In general,
there has been a waning of the importance of intermediate targets. Even as monetary authorities deal
with this difficult transition, several countries have radically altered the institutional architecture of
monetary policy, including increased independence of the monetary authority, clarity of rules and
responsibilities and constrained discretion. About 22 countries have adopted policy regimes with
inflation as the single target of monetary policy. Indeed, inflation targeting is quickly emerging as
orthodoxy in the design of monetary policy. The ongoing slowdown in global economic activity and the
threat of deflation has, however, weakened its analytical edifice. Although the practice of inflation
targeting is associated with a lowering of inflation, the jury is still out on the extent to which inflation
targeting policies have actually contributed to the reductions in inflation that has occurred. Moreover,
too low inflation, which is being observed today, is not just a disincentive for production decisions; it
also delays consumer spending at a time when it could have been critical for triggering the upturn. It
imparts inflexibility to labour markets, causing unemployment and deepening the slowdown. Signals
from financial prices get blurred and this leads to misallocation of resources. In this context, the recent
experience with inflation targeting as a framework for monetary policy warrants a close and hard
scrutiny.
The fixation with short-run price stability or 'inflation nutting', to borrow a term from Mervyn King,
Governor, Bank of England can easily lead to neglect of important signs of macroeconomic and
financial imbalances. Moreover, there is no available empirical evidence to suggest that inflation
targeting improves economic performance. In the euro area, for instance, setting the inflation target at
close to 2 per cent is associated with weakening economic activity. This got pronounced in the second
quarter of 2003 when real GDP declined, accompanied by large scale unemployment and the threat of
deflation in the larger constituents. Furthermore, the relevance of a single inflation target for a large
economy, in particular, can be debated. The inflation target for the euro area suffers from the problems
of a 'one size fits all' monetary policy. Regional disparities warrant different short-run monetary policy
approaches to its objectives. A certain amount of target flexibility and balancing of conflicting
objectives are unavoidable in the real world, particularly that of emerging market economies
(Eichengreen, 2002). Indeed, there is a growing sense that by the time the current phase of global
business cycle has run itself out, inflation targeting may not have stood the test of time.
High and sustained growth of the economy in conjunction with low inflation is the central concern of
monetary policy. The rate of inflation chosen as the policy objective has to be consistent with the
desired rate of output and employment growth. An inappropriate choice can lead to losses of
macroeconomic welfare. Monetary authorities have to continually contend with the short-run trade-off
between growth and inflation. The problem is compounded by the fact that the association between
growth and inflation is non-linear. At some low rates, inflation could operate in a manner that assists in
bringing back unemployed resources into the economy and be beneficial or, at worst, neutral to
growth. At higher levels, inflation is inimical to growth. There are also very low levels of inflation that
are associated with no growth or even deflation. How low should the policy choice of inflation be or
what is the threshold rate of inflation, if there is one, which is associated with the absence of harmful
effects of growth, therefore, becomes a key question. There have been various studies that have
attempted to estimate threshold inflation rates. They suggest that the threshold inflation rate depends
upon a number of factors such as the structure of the economy, past inflation history, the degree of
indexation, and inflation expectations. Some studies suggest that the threshold inflation for developed
and developing countries fall in the ranges of 1-3 per cent and 7-11 per cent, respectively (Khan and
Senhadji, 2000). An abiding problem with cross-country studies, however, is the risk of being
influenced by extreme values since samples include countries with inflation as low as one per cent and
as high as 200 per cent and even higher. The estimation of such inflation threshold rates, therefore,
needs to be done for each country separately (Rangarajan, 1998), in order to understand the
behaviour of the economy in relation to inflation.
A major source of uncertainty in conducting monetary policy is the lack of a clear understanding of the
inflationary process as it has unfolded in recent years. This has obscured a proper assessment of the
nature of shocks impacting on the economy and the resulting risks to price stability. Variations in the
timeliness and reliability of inflation indicators, uncertainty surrounding unobservable indicators like
potential output and gaps in the intrinsic knowledge of the central banks about the state of the
economy complicate the making of monetary policy. Knowledge of the relationship between inflation
and its determinants remains limited (ECB, 2001). Even if there were a consensus on a suitable
model, considerable uncertainty would remain regarding the strength of the structural relationships
within the model. An even more fundamental problem is that parameters may vary over time as a
result of structural changes in the economy. This presumably explains why no central bank uses a
formal model to derive its actual policies; for the foreseeable future, models will be an aid to judgement
rather than a substitute for judgement (Feldstein, 2003). The simple principle of inflation targeting thus
is also not so simple and, poses problems for monetary policy making in developing countries.
IV. The prime mover: international capital flows
Global capital flows impact the conduct of monetary policy on a daily basis. The problem, however, is
that capital flows have followed a boom-bust pattern. Net capital flows are currently limping back from
the severe retrenchment imposed by the Asian financial crisis, which brought to an end the most
dramatic surge of capital flows in post-World War II history. It is only in the recent period, particularly in
2003, that conditions for rejuvenation of capital flows are improving.
Large swings in capital flows are observed not only in the short term but there have been long term
patterns as well. A major surge in capital flows started around the 1870s and continued till the first
World War. The flows were mainly between the so-called developed countries - from the core
countries of Western Europe to peripheral Europe and overseas European settlements - and in the
form of foreign investment, with more than two-thirds comprising portfolio inflows. This era, which
coincided with the operation of the classical gold standard, is widely regarded as the high watermark
of capital mobility. The boom ended with the first World War. A brief restoration of the gold standard
was shattered by the Great Depression and the ensuing period up to the early 1940s was
characterised by modest flows to the then emerging market economies for development finance.
Capital controls were widespread in the attempt to maintain gold parities and international finance
became fragmented by bilateral trade agreements. In the post-World War II period up to the 1970s,
controls spread and intensified. International capital flows were primarily among industrial economies.
The US removed restrictions on capital outflows in 1974-75 while Germany retained controls over
inflows until the late 1970s. The UK maintained controls until 1979 and Japan completed liberalisation
of the capital account in 1980. Developing countries persevered with controls with some Latin
American countries embarking on flawed liberalisation as part of exchange rate-based stabilisation
programmes in the mid-1970s.
In the period since 1973, dramatic changes set in. Private capital flows to developing countries were
renewed as commercial banks furiously recycled oil surpluses. Asia and Latin America received the
maximum share. Developing country debt exploded, rising at a compound annual rate of 24 per cent
(World Bank, 2003) until the debt crisis of 1982 burst the bubble. Capital flows to developing countries
slowed down substantially but did not dry up. Between 1983 and 1989, they fell to less than a third of
their level in 1977-82. A generalised risk aversion to developing country debt dominated international
financial markets and developed countries turned into attractive destinations. By the end of the 1980s,
direct investment inflows to developing countries were only one-eighth of flows to developed countries;
portfolio flows to developing countries were virtually non-existent. During the 1980s and the 1990s,
several developing countries in Asia undertook capital account liberalisation as part of unilateral
financial deregulation, often in the face of large external surpluses. In general, the period from the
mid-1980s to mid-1990s was characterised by removal of official restrictions on financial markets and
wider market-oriented reforms in both mature and emerging market economies. The most dramatic
move towards capital account liberalisation occurred among the continental members of the European
Union.
Investor confidence returned to the developing world in the early 1990s in the aftermath of the Brady
Plan. Net capital flows surged to pre-1914 levels by 1996, temporarily slowed by the EMS crisis of
1992. The impact of the Mexican crisis of 1994 was absorbed by the large mobilisa