Ignazio Visco: Divergence in monetary policies across the Atlantic?
Remarks by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the policy
panel of the CEDERS - 3rd Meeting on Open Macroeconomics and Development "The Euro
Area, the Euro and the World Business Cycle", Aix-en-Provence, 3-4 July 2008.
I am grateful to Sergio Nicoletti Altimari for comments and suggestions while remaining solely responsible for the
views here expressed.
* * *
In my remarks, I will first start with the basic question raised to the panel: are there
differences in the Fed's and ECB's behaviour? I will then tackle two issues that have
probably become more pressing in light of the current financial turmoil: i) are there obvious
limitations in the monetary frameworks and how should they be addressed?, and ii) do we
need some form of monetary policy coordination?
1. FED - ECB divergences
A popular belief is that the dual mandate of the Fed, as opposed to the overriding price
stability objective of the ECB, is the major source of policy differences across the Atlantic. In
this respect, if we take a medium- to long-term view, and we agree that over those horizons
money cannot affect potential output (the Phillips curve is vertical), then the different
mandate should not be relevant. Indeed:
• The track record of the Fed in the past 20 years, as well as the positions expressed
repeatedly by its executives, speak by themselves of the centrality the Fed attributes
to the price stability objective (see Figure).
• An important difference is of course that, contrary to the ECB, the Fed has not
announced a quantitative definition of its goal: this may give the ECB some (slight)
advantage in anchoring expectations, as some recent studies appear to suggest,1
and thus perhaps a more favourable shorter-run trade off.
It is at the shorter horizons, in the strategic conduct of monetary policy by the two central
banks, that we may more likely find some differences:
• A starting point in this respect is the observation that since the start of the euro in
1999 the volatility of policy interest rates in the US has been two times larger than in
the euro area (see Figure).2
• Understanding why this is the case is not easy, as the difference may reflect
differences in the conduct of policy, in the structures of the economy, in the size and
nature of economic shocks. Indeed, the few analyses that have tried to address the
issue in a systematic way give some hints that all of these factors may have played
a role.3 In particular:
Shocks: Differences in the type and intensity of shocks (especially
o
productivity shocks) have probably played a major role in the last decade.
Structure: Higher wage and price flexibility may explain part of the higher
o
volatility of policy rates in the United States.
Policy: The ECB may have, at least according to some estimates, a higher
o
degree of policy inertia, which may grant it with more leverage on long-term
interest rates.
There is however no crystal clear evidence of a significantly different response to measures
of economic slackness, which may indicate that the different mandates do not impinge too
much even in the shorter term. Besides this, we have to be very careful in judgement as we
are far from being in a position to state how close to optimal is any of the two policies, given
structure and preferences in the two economies.
The recent financial turmoil and the different policy responses across the Atlantic have once
again spurred a debate (particularly in Europe) on whether the different mandate is the
source of divergence (and political calls on the ECB to adopt a Fed-like response). Again it is
likely that a combination of factors are at play:
• If we compare, for example, the change in the forecasts of the two central banks in
the last year, we see that the Fed has changed its forecasts of growth for 2008 by
much more than the ECB (-2% vs. -0,5%), while the reverse is true for inflation
(+0,4% vs. +0,9%). These changes in the respective outlook go some way towards
explaining a different policy response: after all, and notwithstanding the strict
financial linkages, we should not forget that the sub-prime crisis originated in the US
and it is linked to real economic problems in that country.
• The difference in the policy stance may also have accentuated the perception of
differences in the liquidity provision policies followed by the two central banks. While
some differences were certainly present (in terms of counterparties, instruments and
facilities used for open market operations), overall the two banks did not inject more
reserves than needed to maintain reference rates near policy rates and net
injections were quickly reversed. However, while the ECB had to clearly (and
successfully) distinguish liquidity provision from the monetary policy stance, in the
Fed case active liquidity provision and more expansionary monetary policy went
hand in hand.
2. Financial turmoil and monetary frameworks
According to some observers, financial crises are manifesting themselves with increased
frequency also because of the success achieved by macro-stabilization policies and the
better anchoring of inflation expectations in good and services markets. An aspect of this is
that episodes of excess creation of liquidity and credit may fuel asset price bubbles, rather
than increase consumption prices. In this respect:
• It has been observed that in both the high-tech equity bubble of the late 1990s and
in the more recent escalation of real estate prices a "too easy for too long" monetary
policy stance may have had some responsibility.
• There are also claims that portfolio relocations and abundant liquidity may be
causing episodes of bubbles in commodity prices for which future markets exist, with
consequences for the prices of other commodities and final consumer prices.
By committing itself to closely monitor and to respond, if needed, to developments in
monetary and credit aggregates, the ECB has probably made a step towards addressing this
issue. Indeed:
• Excessive growth in monetary aggregates, credit and leverage may provide useful
early signals of the building up of financial imbalances and their potential longer
term implications for financial stability, macroeconomic volatility and price stability.4
• The ECB has also manifested a different attitude towards asset price bubbles,
whereas it has not ruled out the possibility of "leaning against the wind" in the face of
excessive asset price developments.5
• We should however acknowledge the enormous difficulties of defining what
"excessive" means in this area and of designing a policy that aims at mitigating the
risks of imbalances and crises in the financial sector while keeping it consistent with
the preservation of price stability. We should probably also avoid asking too much to
monetary policy; certainly frameworks and rules in capital markets need to be
revised and other policies (regulatory, supervision ...) to be involved.
In this respect, is the adoption of a fully fledged "flexible inflation targeting" - a framework
from which both the Fed and the ECB have differentiated themselves (perhaps for different
reasons) - the right way to go? Nowadays flexible inflation targeting is understood as a
framework in which the central bank announces (and specifies in quantitative terms) its price
stability goal and designs an optimal policy to reach it. But then, one may ask whether this
may be too general a framework to provide an actual guidance to monetary policy.6
Furthermore:
• Is there a role for asset prices in flexible inflation targeting (independently of their
direct effects on inflation)?
• In particular, may asset prices play a role in the anchoring of price expectations that
is nowadays recognized by policymakers as a paramount condition for achieving
price stability?
Anyway, the real issue to me does not lie much in the policy framework, but rather in the
limitations of the models we use to interpret economic data and to decide our policy. This is
particularly true for how we treat asset prices. Let me just mention two points in this respect.
• First, we probably do not know enough about the effects of asset price
misalignments and related imbalances in equity, real estate and currency markets,
as well as in bank credit and government debt. My reading of the empirical literature
is that normally these effects are found to be relatively small and asset price
movements are found to play a relatively little role in the transmission of monetary
policy. But this conclusion may be seriously biased, as these are often likely to be
rare and extreme events. Even if they materialised in strong manner, in
macroeconomic estimates they are likely to be dominated over the sample by
"normal time" observations and frequently end up to be "dummied out".
Second, many of the effects associated with asset prices imbalances are likely to be
•
highly non-linear and complex. The implicit monetary policy reaction function would
also then be non-linear and complex and likely to depend on asset prices and
financial imbalances.7
Let me just mention some of the weaknesses we need to address in the near future:
Our models do not treat asset prices in any depth; we are unable to appropriately
•
model movements in the risk premia over the cycle.
We are not able to satisfactorily model interactions and feedbacks between the real
•
and the financial sectors; this is particularly true for the non-linearities that emerge
during crises.
• We lack a deep understanding of the potential link between monetary policy and
asset price bubbles; this may, inter alia, require a departure from the rational
expectation hypothesis (as recently suggested for example by Sims8).
3. Coordination of monetary policies
The financial turmoil has brought back at the centre of the international debate the issue of
monetary policy coordination. In this debate, many feelings and perceptions mix together. At
the bottom, there is the argument that the spectacular increase in financial integration implies
a progressive decline in the effectiveness of domestic monetary policy. This combines with
the perception that central banks may have lost their leverage on longer-term interest rates
(see the discussion on the "saving glut"), as is evident from a lower impact of short-term
interest rates on the yield curve, a higher correlation of interest rates across countries and a
flattening of the Phillips curve caused by globalisation.
In this new global environment, it is argued by some, domestic monetary policies can do little
in isolation; the only possibility is to join forces. I will structure my remarks on this issue along
a few questions.
First, does globalisation (increased trade and financial integration) necessarily reduce the
effectiveness of monetary policy?
• Here, I think worries are probably exaggerated. From a theoretical point of view, we
have no reasons to think that because of financial and commercial integration
domestic monetary policies should lose control of their statutory goal.9 As long as
domestic currencies continue to be used as means of payments for the internal
transactions the ability of monetary policy to control inflation is not affected and
domestic inflation remains a domestic monetary phenomenon.10
• A question may however remain whether domestic policies may have become more
costly, in terms of their short-run effects on economic activity, due to the increased
importance of external spillovers.
• Some of the evidence I just referred to (diminished impact of policy rates on longer
term rates, flattening of the Phillips curve) may be explained by a higher degree of
credibility of central banks, rather than globalization, and indeed we have some
evidence that this may be the case.11 This would reflect an increased, rather than
reduced, effectiveness of monetary policy.
Second, even if we do not necessarily need to join forces to control domestic inflation, may
coordination nevertheless be useful?
• Here the answer from theory becomes more blurred. The recent literature based on
dynamic general equilibrium models with sticky prices has highlighted the
importance of relative prices. Whether there is room for welfare improving monetary
policy coordination depends very much on exchange rate pass-through behaviour.
Overall, I take from this literature that targeting domestic inflation produces
outcomes close to optimal in most cases.12
• If we add to this the real life complications of getting into (and respecting under
changing conditions) formal agreements and the uncertainties surrounding the
effects of monetary policy moves (for example on exchange rates), then the case for
coordination becomes even more doubtful. Indeed, the experiences of the past (e.g.
the Louvre - Plaza agreements) are not particularly encouraging.
• In any event, what cannot be compromised is the statutory mandate of our central
banks to deliver the assigned objectives. Any formal agreement casting doubts on
this principle and causing inflation expectations to slip away would be extremely
costing. Considering all this, the road of coordination, understood as entering into
formal and binding contingency plan agreements, appears quite narrow.
Finally, do we need more cooperation?
• The answer in this case is probably positive. Even if we do not necessarily need to
coordinate ex ante to attain the final goal, it is quite evident that the increasing
interdependencies among the economies complicate the conduct of monetary
policies a great deal. In the new environment the case for reinforcing international
cooperation is strong. And I do not exclude that particularly for small open
economies this may mean a strong incentive to join or to create monetary unions
(an extreme form of cooperation).
• We are seeing that forms of cooperation are becoming more and more crucial in
many fields, such as in liquidity provision policies, in financial institution regulation
and supervision, in order to tackle possible systemic crises, avoid regulatory
arbitrage, ensure a level-playing field.
• In the monetary policy field, there certainly is a high degree of interaction among
central bankers, for example through their frequent participation to BIS meetings in
Basel. It is indeed essential to ensure a continuous exchange of views, full
understanding of each other's goals, policy intentions and possible spillovers of
different policy options. In some cases this may lead to a common understanding
that a particular direction of policy is in the interest of all parties involved.
I believe that the situation we are facing nowadays illustrates this case rather well.
• We are observing an emergence of strong inflationary pressures around the globe.
Monetary policy at the world level appears to be quite expansionary. Short-term real
interest rates are negative in the US and are very low or negative in many regions,
particularly in emerging economies (for the total of emerging economies' real
shortterm interest rates are close to zero, they are positive for those that have an inflation
targeting framework, and significantly negative for the others.)
• In many emerging economies, particularly in China, the pegging to the dollar implies
importing US monetary policy even if internal conditions, especially domestic
demand, are very different. On the one hand, this policy is fuelling liquidity and credit
expansion, pushing domestic demand and pushing inflation rates in these
economies towards double-digit values. On the other hand, through the increasing
pressure on commodity prices (oil and food) it puts pressure to inflation rates also in
main industrialised economies.
• In advanced economies monetary policy is directed to avoid second-round effects
from commodity price increases, but it is unlikely to be able to address the sources
of first-round effects (excess demand in large emerging economies), unless it
creates so much slack in the advanced economies as to dampen exports and
internal demand in emerging economies as well.
The need to come to a common understanding of the international situation appears
therefore to be particularly pressing at the moment. Getting out of problems may be quite
costly if done in sparse order.
US PCE Inflation Euro Area HICP inflation
4.0
3.0
2.0
1.0
0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
7.0
ECB Minimum Bid Rate
6.0
Federal Funds Target Rate
5.0
4.0
3.0
2.0
1.0
0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
BIS Review 89/2008 7