The Growing Challenges for Monetary Policy in the current
International Monetary and Financial System
Speech given by
Mark Carney
Governor of the Bank of England
Jackson Hole Symposium 2019
23 August 2019
I am grateful to Clare Macallan, Daisy McGregor and James Benford for their assistance in preparing
James O'Connor and
these remarks, and to Nishat Anjum, Ambrogio Cesa-Bianchi, Alex Haberis,
Carlos van Hombeeck for background research and analysis.
Introduction
Before turning to the focus of my remarks, I would like to begin with a few comments on the UK outlook.
A snapshot suggests the UK economy is currently close to equilibrium, operating just below
potential with inflation just above its target.
Both headline and core inflation are around 2%, and domestic price pressures have been picking up notably.
In particular, the labour market is tight. Growth in wages and unit wage costs have strengthened
considerably as slack has been absorbed, with both now running at their highest rates in over a decade.
The strength of the labour market is supporting consumer spending, which is rising broadly in line with real
incomes.
But pictures can deceive; two large, volatile forces could push the UK economy far from balance.
Until the start of this year, the UK economy had been growing around its trend rate. Since then, the
intensification of Brexit uncertainties and weaker global activity have weighed heavily on UK activity.
Global momentum remains soft, despite the broad-based easing in monetary policy expectations. In part this
reflects a significant spike in economic policy uncertainty and the related risk that protectionism could prove
more pervasive, persistent and damaging than previously expected. As I will discuss in a moment, these
headwinds are now restraining business investment globally and could push down on the global equilibrium
interest rate, exacerbating concerns about limited monetary policy space.
Long-term government bond yields have fallen sharply alongside the falls in expected policy rates. US
10year yields are near three-year lows, and 10-year gilt yields and German 10-year bund yields are their lowest
ever. Around $16 trillion of global debt is now trading at negative yields.
As material as these global developments are, the UK outlook hinges on the nature and timing of Brexit.
The UK economy contracted slightly last quarter and surveys point to stagnation in this one. Looking
through Brexit-related volatility, it is likely that underlying growth is positive but muted.
The biggest economic headwind is weak business investment, which has stagnated over the past few years,
despite limited spare capacity, robust balance sheets, supportive financial conditions and a highly
competitive exchange rate. There is overwhelming evidence that this is a direct result of uncertainties over
the UK's future trading relationship with the EU, and it serves as a warning to others of the potential impact
of persistent trade tensions on global business confidence and activity.
The UK economy could follow multiple possible paths depending on how Brexit progresses with
material implications for the stance of monetary policy.
In recent weeks, the perceived likelihood of No Deal has risen sharply as evidenced by betting odds and
financial market asset pricing (the UK now has the highest FX implied volatility, the highest equity risk
premium and lowest real yields of any advanced economy).
In the event of a No Deal No Transition Brexit, sterling would probably fall, pushing up inflation, and demand
would weaken further, reflecting lost trade access, heightened uncertainty and tighter financial conditions.
Unusually for an advanced economy slowdown, there would also be a large, immediate hit to supply. The
Monetary Policy Committee (MPC) would need to assess to what extent that reflects temporary disruption to
production, with limited implications for inflation in the medium term, or a fundamental destruction of supply
capacity because of the abrupt change in the UK's economic relationship with the EU.
As the MPC has repeatedly emphasised, the monetary policy response to No Deal would not be automatic
- -
but would depend on the balance of these effects on demand, supply and the exchange rate on medium
term inflationary pressures. In my view, the appropriate policy path would be more likely to ease than not,
using the flexibility in the MPC's remit to lengthen the period over which inflation is returned to target.
But
much would depend on the exact nature of No Deal and its impact. In the end, monetary policy can only
help smooth the adjustment to the major real shock that an abrupt No Deal Brexit would entail, but even its
the limits to the MPC's tolerance of above target inflation.
ability to do that would be constrained by
While the possibility of No Deal has increased, it is not a given. Along another path, it is possible that
domestic political events or negotiations with the EU could lead to a longer period of uncertainty over the
eventual future relationship, even in the event that an agreement is struck. On past performance, the longer
these uncertainties persist, the more likely it is that growth will remain below potential raising the prospect of
both softer domestically generated inflation and resurgent imported inflation if recent sterling weakness were
to endure. Once again, the MPC would need to weigh the opposing forces when setting policy.
Finally, some form of agreement remains possible. After all, that is the avowed preference of both the UK
and EU. In this event, consistent with the MPC's most recent projections, as details of the future relationship
gradually emerge, business investment recovers and household spending picks up, resulting in excess
demand and inflationary pressures gradually building. In the Committee's judgment, this path for the
economy would likely require limited and gradual interest rate increases.
The coming months could be decisive. If there are material Brexit developments, the MPC will transparently
assess their implications and set policy to achieve the 2% inflation target in a sustainable manner.
I. Challenges for Monetary Policy in the current IMFS
When Ben Bernanke was retiring from the Fed, his closing remarks to central bank governors at the BIS set
us the task of sorting out the deep flaws in the international monetary and financial system ("IMFS"). Six
years later, with my demise as governor on the horizon, I'm going to 'pay it forward' by focusing on how
the
nature of the IMFS challenges monetary policy.
For decades, the mainstream view has been that countries can achieve price stability and minimise
excessive output variability by adopting flexible inflation targeting and floating exchange rates. The gains
from policy coordination were thought to be modest at best, and the prescription was for countries to keep
their houses in order.1
This consensus is increasingly untenable for several reasons. Globalisation has steadily increased the
impact of international developments on all our economies. This in turn has made any deviations from the
core assumptions of the canonical view even more critical. In particular, growing dominant currency pricing
(DCP) is reducing the shock absorbing properties of flexible exchange rates and altering the inflation-output
volatility trade-off facing monetary policy makers. And most fundamentally, a destabilising asymmetry at the
heart of the IMFS is growing. While the world economy is being reordered, the US dollar remains as
important as when Bretton Woods collapsed (Figure 1).
1
This view is summarised in a speech by John Murray,
'With a Little Help from Your Friends: The Virtues of Global Economic
29 November 2011.
Coordination',
The combination of these factors means that US developments have significant spillovers onto both the trade
performance and the financial conditions of countries even with relatively limited direct exposure to the US
economy.
These dynamics are now increasing the risks of a global liquidity trap. In particular, the IMFS is structurally
lowering the global equilibrium interest rate, r*, by:
- feeding a global savings glut, as EMEs defensively accumulate reserves of safe US dollar assets
against the backdrop of an inadequate and fragmented global financial safety net;
- reducing the scale of sustainable cross border flows, and as a result lowering the rate of global
potential growth; and
- fattening of the left-hand tail and increasing the downside skew of likely economic outcomes.
In an increasingly integrated world, global r* exerts a greater influence on domestic r*.2 As the global
equilibrium rate falls, it becomes more difficult for domestic monetary policy makers everywhere to provide
the stimulus necessary to achieve their objectives.
These dynamics are directly relevant to the current risks of a global slowdown. At present, there are
relatively few fundamental imbalances in terms of capacity constraints or indebtedness that would of
themselves portend a recession.3 However, the combination of structural imbalances at the heart of the
IMFS itself and protectionism are threatening global momentum.
The amplification of spillovers by the IMFS matters less when the global expansions are relatively
synchronised or when the US economy is relatively weak. But when US conditions warrant tighter policy
there than elsewhere, the strains in the system become evident.
These conditions emerged last year. US fiscal policy had boosted growth at a time when the US economy
was near full employment. US monetary policy had to tighten consistent with the Fed's dual mandate. The
resulting dollar strength and financial spillovers tightened financial conditions in most other economies by
more than was warranted by their domestic conditions (two thirds of the global economy was growing at
below potential rates at the start of 2019, and that proportion has since risen to five sixths). More recently,
the dramatic increase in trade tensions (Chart 1) has reinforced their effects by increasing risk premia.
Today, the combination of heightened economic policy uncertainty (Chart 2), outright protectionism and
concerns that further, negative shocks could not be adequately offset because of limited policy space is
exacerbating the disinflationary bias in the global economy.
What then must be done?
In the short term, central bankers must play the cards they have been dealt as best they can.
That means using the full flexibility in flexible inflation targeting. To retain the essential credibility of their
frameworks, this is best done transparently with central bankers explaining their reasons for targeting
specific trade-offs between price stability and output volatility.
2
See 2017 IMF Michel Camdessus Central Banking Lecture given by Mark Carney, 18 September
'[De]Globalisation and Inflation',
2017.
3
See speech by Mark Carney, 12 February 2019.
'The Global Outlook',
Those at the core of the IMFS need to incorporate spillovers and spill backs, as the Fed has been doing.
More broadly, central banks need to develop a better shared understanding of the scale of global risks and
their consequences for monetary policy.
We cannot all export our way out of these challenges. In a global liquidity trap, there are gains from
- -
coordination, and other policies particularly fiscal have clear roles to play. And acting earlier and more
forcefully will increase their effectiveness.
In the medium term, policymakers need to reshuffle the deck.
That is, we need to improve the structure of the current IMFS. That requires ensuring that the institutions at
the heart of market-based finance, particularly open-ended funds, are resilient throughout the global financial
cycle. It requires better surveillance of cross border spillovers to guide macroprudential and, in extremis,
capital flow management measures. And it underscores the premium on re-building an adequate global
financial safety net.
In the longer term, we need to change the game. There should be no illusions that the IMFS can be
reformed overnight or that market forces are likely to force a rapid switch of reserve assets.4 But equally
blithe acceptance of the status quo is misguided. Risks are building, and they are structural. As Rudi
Dornbusch warned, "In economics, things take longer
to happen than you think they will, and then they
happen faster than you thought they could".
When change comes, it shouldn't be to swap one currency hegemon for another. Any unipolar system is
unsuited to a multi-polar world. We would do well to think through every opportunity, including those
presented by new technologies, to create a more balanced and effective system.
II. Growing Challenges in the Current IMFS
The structure of the current international monetary financial system is making it increasingly difficult for
monetary policy makers to achieve their domestic mandates to stabilise inflation and maintain output at
potential.
According to the mainstream view, these objectives are best achieved through operationally independent
central banks adopting flexible inflation targeting and allowing their exchange rates to float.
That view rests on two pillars. The first is that floating exchange rates are effective absorbers of global
shocks, insulating domestic employment and output from developments abroad. If import prices are fully
flexible and international financial markets are complete, then changes in exchange rates pass through fully
to import prices, and the optimal monetary policy response is to accommodate the effect on inflation, keeping
output close to potential and the price of domestic output stable.5
-
That leads directly to the second pillar that there are only modest gains from international policy
cooperation and coordination in such circumstances. This long-standing and widely held view reflects the
4
The analysis of Gita Gopinath, Emmanuel Farhi, Matteo Maggiori and Jeremy Stein, amongst others, emphasises the persistence in
the structure of the current IMFS.
5
'Optimal Monetary Policy in Open Economies',
See Corsetti, G, Dedola, L, and Leduc, S (2010), Handbook of Monetary Economics,
and Benigno, G and Benigno, P (2006), 'Designing targeting rules for international monetary policy
Vol. 3, Chapter 16, pp. 861-933;
cooperation',
Journal of Monetary Economics, Vol. 53(3), pp. 473-506. In the standard welfare-based analyses of optimal monetary
policy in an open economy, a key consideration is the extent to which sticky prices in different currencies lead to deviations from the law
of one price (LOOP) for different goods. The first-best (efficient) outcome is for goods to sell for the same price when converted into
different currencies. If this is not the case, demand is misaligned internationally, which in turn creates an inefficient allocation of factor
inputs. Under PCP, the full flexibility of import prices means the exchange rate can act as an efficient shock absorber, adjusting to
ensure that the LOOP holds.
beliefs that any externalities that might exist are almost trivially small and that trying to address them would
be fine-tuning to the nth degree.
The mainstream view is increasingly anachronistic for several reasons.
First and foremost, international linkages have risen dramatically over the past few decades, increasing the
importance of cross border spillovers.6
Growing cross border trade means external demand has greater effects on domestic resource allocation and
therefore inflation. The integration of low-cost producers into the global economy has imparted a steady
disinflationary bias through its direct effect on prices. The expansion in global value chains has increased
the synchronisation of producer prices across countries. Financial linkages have increased leading to a
faster and more powerful transmission of shocks across countries. And globalisation has increased the
contestability of markets, weakening the extent to which slack in domestic labour markets influences
domestic inflationary pressures.7
Second, the changing nature of trade invoicing is affecting import price pass through and changing the
inflation-output volatility trade-off facing monetary policy makers.
Dominant currency pricing is widespread (partly due to the growth of supply chains), leading to deviations
from the law of one price and misalignments in countries' terms of trade.8
The dollar represents the currency
than the US's share in
of choice for at least half of international trade invoices, around five times greater
world goods imports, and three times its share in world exports.9
The resulting stickiness of import prices in dollar terms means exchange rate pass-through for changes in
the dollar is high regardless of the country of export and import, while pass-through of non-dominant
currencies is negligible. As a result, import prices do not adjust efficiently to reflect changes in relative
demand between trading partners, in part because expenditure switching effects are curtailed,10 and global
trade volumes are heavily influenced by the strength of the US dollar.11
This is less of a problem when all boats are rising with the global tide of synchronised growth. But when the
tide is rising in America while receding elsewhere, those authorities face more difficult trade-offs between
-
price stability and output volatility a situation that could create large potential gains from policy coordination
that independent policymakers would not address.
6
World trade as a share of global GDP has doubled since 1970. Over the past two decades, 80% of the increase in total trade has
come from intermediates goods trade, driving up the value added of imports as a share from 10% of exports in 1990 to around 20% in
2015. Cross-holding of countries' assets and liabilities increased almost fourfold since 1990, and measures of stock market integration
are at their highest ever (see Bastidon, C, Bordo, M, Parent, A, and Weidenmier, M (2019), 'Towards an Unstable Hook: The Evolution
of Stock Market Integration Since 1913', NBER Working Paper No. 26166.
7
For more detail on these changes, see ibid.
'[De]Globalisation and Inflation',
8
- -
Dominant currency pricing refers to the widespread use of a single currency the US dollar in trade invoicing, in place of the
currency of either the producer or the importer. Import prices will therefore depend on changes in the bilateral exchange rate between
the local and the dominant currency, rather than that between the local and producer currency. For evidence, see Goldberg, L and Tille,
C (2009), 'Macroeconomic interdependence and the international role of the dollar',
Journal of Monetary Economics, 56 (7), pp.
9901003; and Gopinath, G(2016). "The International Price System,"
Jackson Hole Symposium Proceedings.
9
Gopinath (2016), ibid, and Ito, H, and Kawai, M (2016), 'Trade Invoicing in Major Currencies in the
1970s-1990s: Lessons for
Renminbi Internationalization', Journal of the Japanese and International Economies, Volume 42, pp. 123-145.
10
For a country with a large share of trade invoiced in dollars, a depreciation against the dollar raises the domestic price of imports,
causing domestic households and firms to switch their expenditure away from foreign goods. But it leaves the (dollar) price of exports in
the markets in which they are sold unchanged, albeit making them more profitable for domestic exporters in terms of home currency.
Because imports would fall straight away and it would take time for the export sector to expand to take advantage of the higher profits, it
is therefore likely that a rebalancing of the economy from imports to exports would be slower than if traded goods were priced in the
currencies of their production. In addition, other things equal, the rise in import prices would lead to a pick-up in imported inflationary
pressure.
11
Boz, Gopinath and Plagborg-Moller (2017) show that a 1% appreciation of the dollar leads, all else equal, to a 0.6% contraction in
trade volumes in the rest of the world.
Third, a growing asymmetry at the heart of the IMFS is putting the global economy under increasing strain.
Huge network effects mean the dollar has remained dominant in the IMFS despite the transformation of the
global economy. At the time of the Latin American debt crisis, EMEs made up a little more than one third of
global GDP. Since the last Fed tightening cycle, their share of global activity had risen from around 45% to
60%. By 2030, it is projected to rise to around three quarters.
As well as being the dominant currency for the invoicing and settling of international trade, the US dollar is
the currency of choice for securities issuance and holdings, and reserves of the official sector. Two-thirds of
both global securities issuance and official foreign-exchange reserves are denominated in dollars.12 The
same proportion of EME foreign currency external debt is denominated in dollars13 and the dollar serves as
the monetary anchor in countries accounting for two thirds of global GDP.14
The US dollar's widespread use in trade invoicing and its
increasing prominence in global banking and
finance are mutually reinforcing. With large volumes of trade being invoiced and paid for in dollars, it makes
sense to hold dollar-denominated assets. Increased demand for dollar assets lowers their return, creating an
incentive for firms to borrow in dollars. The liquidity and safety properties encourage this further.15 In turn,
companies with dollar-denominated liabilities have an incentive to invoice in dollars, to reduce the currency
mismatch between their revenues and liabilities. More dollar issuance by non-financial companies and more
dollar funding for local banks makes it wise for central banks to accumulate some dollar reserves.
Given the widespread dominance of the dollar in cross border claims, it is not surprising that developments in
the US economy, by affecting the dollar exchange rate, can have large spillover effects to the rest of the
world via asset markets. As Hélène Rey has put it,16 and as Arvind Krisnamurthy and Hanno Lustig echo in
their paper for this symposium, the global financial cycle is a dollar cycle.
In part, that arises because movements in the US dollar significantly affect the real burden of debt for those
companies (especially in EMEs) that have borrowed unhedged in dollars, and tend to reduce the dollar value
of companies' collateral.17
Both result in tighter credit conditions and, in the extreme, defaults.
Fluctuations in the dollar also significantly affect the risk appetite of global investors. As discussed by
Şebnem
Kalemli-Özcan earlier today, these risk spillovers can have a significant impact on receiving
economies, especially in EMEs where global risk perceptions interact with country-specific risks.
For EMEs, this manifests in volatile capital flows that amplify domestic imbalances and leave them more
vulnerable to foreign shocks (Charts 3 and 4). One fifth of all surges in capital flows to EMEs have ended in
financial crises, and EMEs are at least three times more likely to experience a financial crisis after capital
flow surges than in normal times.18 While the typical EME receiving higher capital inflows will grow 0.3
12
Gopinath, G and Stein, JC (2018), 'Banking, Trade, and the Making of a Dominant Currency', Working paper, Harvard University. The
euro is in second place at 20% and the yen is in third at 4% (ECB Staff (2017)).
13
Gourinchas, P, Rey, H Sauzet, M (2019), 'The International Monetary and Financial System', NBER Working Paper No. 25782.
14
Ilzetzki, E, Reinhart, C and Rogoff, K (2017), 'Exchange arrangements entering the 21st Century: Which anchor will hold?',
forthcoming in the Quarterly Journal of Economics.
15
See Krugman (1980).
16
Rey, H. (2013). "Dilemma not trilemma: the global cycle and monetary policy independence," Proceedings - Economic Policy
Symposium - Jackson Hole, Federal Reserve Bank of Kansas City.
17
Reflecting the fact that most of the assets of EME companies are priced in local currency. See Bruno, V and Shin, HS (2015),
'CrossBorder Banking and Global Liquidity', Review of Economic Studies, Oxford University Press, Vol. 82(2), pp. 535-564 and Cesa-Bianchi,
Ferrero, Rebucci (2018), 'International Credit Supply Shocks', Journal of International Economics, Vol. 112, 2018, pp.
219- 237.
18
Ghosh, AR, Ostry, JD, and Qureshi, M (2016), 'When do capital inflows surges end in tears?',
American Economic Review. Surges
and the full sample's
are defined as a net capital flow observation that lie in the top thirtieth percentile of both the country-specific
distribution of net capital flows, expressed in percent of GDP.
percentage points faster, all else equal, the typical EME with higher capital flow volatility will grow 0.7
percentage points slower.19
Following their experience of successive crises, EMEs have responded to these pressures by following the
conventional wisdom to "keep their houses in order." Over the past two decades, inflation targeting has been
widely adopted, fiscal policy is generally improved, and macroprudential policy is increasingly active.
Bank analysis finds that, for EMEs as a whole, reforms to these domestic institutional "pull" factors have
substantially increased the sustainability of capital flows, all else equal (Chart 5).20
But unfortunately for EMEs, all else is not equal. Their efforts have not been sufficient because of the
consequences of the growing asymmetry between the importance of the US dollar in the global financial
system and the increasingly multi-polar nature of global economic activity.
Monetary policy and financial stability shocks in advanced economies have become more prevalent and
more potent, increasing the importance of "push" factors in driving capital flows. Bank research suggests
that the spillover from tightening in US monetary policy to foreign GDP is now twice its 1990-2004 average,
despite the US's rapidly declining share of global GDP.
Financial instability in advanced economies also causes capital to retrench from EMEs to 'safe havens', as it
6). Connally's dictum "our dollar,
did during the 2008 financial crisis and the 2011 euro-area crisis (Chart
your problem" has broadened to "any of our problems is your problem".
- or the "pipes" -
Moreover, the structure of the global financial system is increasingly amplifying capital
outflows from EMEs when these push shocks occur. For EMEs, market-based finance has accounted for all
the increase in foreign lending since the crisis, as bank lending has declined and FDI has stayed fairly
constant (Chart 7).21 While this shift has brought welcome diversity to the financial system, it also reduces
the sustainability of capital flows, as market-based flows are particularly sensitive to changes in global risk
appetite and financial conditions. Investment fund flows are particularly flighty (Chart 8), especially under
stress.
The increasing role of "push" factors and the "pipes" of the system means
fast-reforming EMEs could soon
be running to stand still in their quest for more sustainable capital flows (Chart 9). Bank researchers
estimate that the growing shares of FX-denominated debt and market-based finance have increased the
sensitivity of "Capital to push factors by 50% since the crisis, largely using up the
Flows-at-Risk"
selfinsurance purchased by EMEs.
All told, this means that in the face of foreign shocks, EMEs are forced to compromise their monetary
sovereignty, temporarily diverting monetary policy away from targeting domestic output and inflation and
instead using it to try to stabilise capital flows.
While this strategy is the best EMEs can do given the current structure of the international monetary financial
system, outcomes for them are a distant second best when compared to those advanced economies that are
less exposed to international financial spillovers.
19
See speech by Mark Carney, Institute of International Finance Spring
'Pull, Push. Pipes', Membership Meeting, Tokyo, 6 June 2019.
20
Within the Bank's Capital Flows-at-Risk framework, these actions are estimated to have Capital Flows-at-Risk (that is, capital outflows
as a percent of GDP in the fifth percentile of the distribution) by 3% of GDP.
21
Within this, investment funds are growing, accounting for the bulk of the growth in asset management over the last decade. In
parallel, investment fund flows to EMEs now account for around one third of total portfolio flows, compared to around one tenth
precrisis.
-------------------------------
The deficiencies of the IMFS affect EMEs more directly than advanced economies, but their consequences
influence everyone because they reduce the global equilibrium interest rate.
Against the current backdrop of an inadequate and fragmented global financial safety net, EMEs have
chosen to self-insure against capital flow volatility by accumulating reserves of safe assets, contributing to
Ben Bernanke's "global savings glut". Given
the importance of the US dollar in trade, debt issuance by the
non-financial corporate sector in EMEs, and funding for their domestic banks, most of these reserves are
dollar-denominated.
As well as coming at a domestic high cost to EMEs,22 this vast accumulation of safe assets has pushed
-
down the global equilibrium interest rate the rate that central banks must deliver in order to balance
demand with supply and so achieve stable inflation.23
More fundamentally, by making the world a riskier place, the flaws inherent in the IMFS are reinforcing the
downward pressure on global r*.
The IMFS is not only making it harder to achieve price and financial stability but it is also encouraging
protectionist and populist policies which are exacerbating the situation. This combination reduces the rate of
global potential growth, increases its downside skew, and bolsters the likelihood of an extreme downside
event (a fatter left tail).
As my colleague on the MPC Jan Vlieghe has illustrated, such a change in the distribution of economic
outcomes reduces the global equilibrium rate of interest.24 Past instances of very low rates have tended to
coincide with high risk events such as wars, financial crises, and breaks in the monetary regime.
Whether the last happens is still within our control, but for now the lower global equilibrium interest rate is
reducing monetary policy makers' scope to cut policy rates in response to adverse shocks to demand, and
increasing the risk of a global liquidity trap.
And left unattended, these vulnerabilities are only likely to intensify.25
III. Policy Implications
How should monetary policy makers respond to these challenges?
been dealt.
In the short term, they must play the hand they've
The prevalence of dollar invoicing means using the flexibility in inflation targeting.
22
In addition to the direct costs of financing these reserves, there have been indirect costs including the crowding out of domestic
investment.
23
Rachel, L and Smith, T (2015), 'Secular drivers of the global real interest rate', Bank of England Staff Working Paper No. 571,
estimate that the savings glut has lowered global real rates by 25 basis points over the past 30 years.
24
See speech by Gertjan Vlieghe given at the Society of Business Economists' Annual conference, 15
'Real interest rates and risk',
September 2017.
25
If history serves as a guide, EMEs' external liabilities could double as a share of GDP by 2030:
market-based finance could then
account for half of external liabilities and investment funds could represent 40% of market-based finance flows to EMEs. By 2030, the
reduction in sustainable capital flows arising from push factors could completely cancel out the positive impact stemming from domestic
reforms in EMEs over the past two decades. To offset this reduction in the sustainability of EME capital flows, their reserves would
have to double over the next ten years. [This is made more challenging by the increasing weight of EMEs in the global economy, and
the declining share of the US, which means demand for US-denominated safe assets is likely rise faster than their supply.]
In theory, the increases in both DCP and capital flows at risk suggest a greater focus on targeting the
bilateral exchange rate against the dollar (through adding terms involving terms of trade misalignments and
deviations from the law of one price to central banks' monetary policy objective functions, and tools such as
capital flow management measures ("CFM")).26
In practice, either could be highly destabilising. It is far better as a first response to focus on core price
stability objectives, and to explain transparently if foreign shocks are altering the trade-off required to best
achieve it.
Mon