Jürgen Stark: Main challenges for monetary policy in a globalised world
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the Conference "Monetary Policy in Sub Saharan Africa: Practice and Promise", Cape
Town, 28 March 2008.
* * *
1. Introduction
The issue I have been invited to reflect upon today, namely the challenges to monetary
policy in an increasingly interdependent world, is a topic that ranks highly on monetary policy
makers' agendas. The ongoing global financial market turmoil reminds us that no country is
immune from economic and financial shocks originating outside the boundaries of its
jurisdiction. In pursuing their mandates, central banks need, therefore, to assess the
implications of economic and financial integration for the conduct of monetary policy.
In my remarks today, I would first like to address three questions:
1) How has globalisation affected domestic inflation? 2) How does globalisation alter the way
that domestic economies react to economic disturbances? 3) How has globalisation affected
the way that monetary policy impulses are transmitted to the economy?
The answers to these three key questions will allow me to stress what I consider to be the
main challenges for monetary policy in a globalised world.1
2. The impact of globalisation on domestic inflation
We all agree that globalisation offers great opportunities. It increases the scope for efficiency
gains through increased specialisation and better use of comparative advantages in the
international production of goods and services. In the medium to long term, this reduces
production costs, increases the world's production capacity and generates gains that are
passed on to consumers in the form of lower prices for a large number of goods and
services. Globalisation brings about a more efficient allocation of factors of production,
which, in any economy, increases the level of output that can be sustained without
generating inflationary pressures.
In the short to medium term, an increase in the volume of a developed country's trade with
emerging low-cost countries exerts downward pressure on the prices of imported goods and
close substitutes in the developed economy while giving rise to a gradual relocation of
production.
Viewed from this perspective, globalisation has resulted in a very significant shock to the
terms of trade of developed economies, with the integration of China, India and eastern
Europe into the world economy gradually increasing the global supply of labour - particularly
low-skilled labour. By making skilled labour relatively scarcer, globalisation has reduced the
relative wages of unskilled workers in industrialised countries.2
The secular decline observed in transportation and communication costs has made it easier
for firms to relocate the production of goods and services requiring larger amounts of
lowskilled labour to those newly emerging economies, while industrialised countries tend to
specialise in the production of goods and services requiring larger amounts of skilled labour.
For example, the euro area specialises more in medium to high-tech exports, by comparison
with China, which has specialised mainly in low-tech sectors such as textiles, clothing and
footwear.
In fact, technological progress has been so fast that for many goods and services it is even
possible to allocate different stages of the production chain to different parts of the globe, in
accordance with their relative levels of skilled or unskilled labour.
As a result, in all major OECD economies import prices have declined relative to domestic
producer prices over the last 20 years. Estimates by OECD staff3 suggest that in the period
from 1996 to 2005 the integration into world trade of non-OECD economies - particularly
China and other Asian economies - reduced annual domestic inflation by an average of
around 0.2 percentage point in both the United States and the euro area.4
Over the last two to three years, however, globalisation has also been seen to have an effect
on world demand. Economic development has brought about an increase in global
consumption of food and other commodities, especially in China and other Asian countries.
This has resulted in higher food and commodity prices worldwide, which have, to some
extent, offset the effect that lower prices of imported goods and services have had on
domestic inflation.
There is not much that monetary policy can do about the sudden, perhaps permanent,
increase in the relative prices of food and commodities, but to accommodate its mechanical,
first-round, effect on headline inflation. However, a central bank aiming to maintain price
stability in the medium term has to carefully monitor price and wage formation dynamics so
that inflation expectations remain firmly anchored and no second-round effects emerge.
This implies that the objective of monetary policy must be defined in terms of an aggregate
and not in terms of a partial or so-called "core" price index which excludes, for example, food
or energy prices, in order to allow the central bank to identify in a timely manner long-lasting
trend dynamics.
In their assessment of the monetary policy stance, central banks realise that the ultimate
impact of increases in the prices of oil and commodities - including food - on inflation and
output dynamics will depend crucially on the reaction of economic agents, particularly
participants in labour and product markets.
Their reaction will be influenced by their expectations regarding the response of monetary
policy to such developments.
An absence of second-round effects following food and commodity price pressures depends
crucially on inflation expectations being firmly anchored at levels in line with the central
bank's objective.
In the presence of food and commodity-driven pressures on headline inflation, there is
always a risk of inflation expectations becoming unanchored and a damaging wage-price
spiral being established. Given the costs of curbing such unpleasant inflation dynamics once
they have started, a price stability-oriented central bank should react in a timely and
preemptive manner on the basis of a comprehensive analysis of the shocks to headline inflation.
3. The impact of globalisation on the structure of the domestic economy
Over the past 20 years we have experienced a significant decline in the level and volatility of
inflation in both developed and emerging economies. This has often been associated with
the growing empirical evidence of a flattening of the Phillips curve. Can globalisation alone
account for changes in the way that the domestic economy - and inflation in particular -
reacts to economic shocks?
Globalisation may have played a role in this process through two distinct channels.
First, the short-run Phillips curve, which typically relates inflation to excess domestic
demand, may have flattened owing to the increase observed in trade and production
specialisation across countries, with domestic inflation increasingly being affected by cost
pressures arising in trade partners.5
Second, globalisation may have played a role in reducing the inflationary effect of excess
demand is linked to the reduced ability of firms to increase their mark-ups in the presence of
aggregate demand shocks.6 Globalisation may, for example, increase competition, reducing
firms' ability to pass an increase in costs on to consumer prices.7
Without neglecting the impact of globalisation on inflation, the main factor responsible for the
reduced sensitivity of inflation to excess domestic demand is certainly the substantial
improvement seen across many economic regions in the conduct of monetary policy. After
the great inflation of the 1970s, policymakers worldwide have progressively recognised the
importance of a sound institutional framework for macroeconomic performance, in particular
the role of central bank independence in achieving and maintaining price stability.
The independence of central banks ensures that monetary policy focuses on inflation without
being distracted by political desires to fine-tune the economy or exploit a perceived
shortterm trade-off between inflation and output growth, which does not exist in the long term and
is conducive only to the creation of higher levels of inflation.
Economic agents have gradually come to terms with this significant shift to a credible, price
stability-oriented monetary regime and have adjusted their inflation expectations
accordingly.8
The lessons for monetary policy-makers are very clear: there is no room for complacency
and no reason to believe that inflation has been brought under control forever.
Independence alone does not suffice if it does not translate into actual price stability.
5
Galí and Monacelli (2005) model a small open economy trading with an infinite number of other foreign
economies. In the model's Phillips curve, they show that the more open the economy is and the more
substitutable domestic goods are with regard to foreign goods, the lower the coefficient for the domestic output
gap becomes. Research conducted at the IMF and the BIS (IMF (2006) and Borio and Filardo (2007)) finds
supporting evidence for the hypothesis that the increase in international trade and production specialisation
has increased the importance of global indicators of economic slack and inflation, relative to domestic
indicators, in explaining domestic inflation in developed countries. Ciccareli and Mojon (2005) also argue that
in a sample of OECD economies domestic inflation is driven by a global inflation process, which at short
horizons is a function of global real developments. The robustness of such evidence remains controversial,
however, as empirical estimates depend on the specification of the estimated Phillips curve (Ihrig et al.
(2007)).
6
Batini et al. (2005).
7
Rogoff (2003) contends that globalisation may, in fact, have had the opposite effect on firms' pricing
behaviour, arguing that the increase in competitive pressures arising from globalisation means that the cost for
firms of setting the price at the wrong level is much higher than it would be with less competition. Hence,
globalisation would lead to firms revising their prices more frequently and, eventually, increase the sensitivity
of inflation to demand fluctuations through a steepening of the Phillips curve.
8
Coogley and Sbordone (2008) also argue that the lack of persistence in inflation in recent years is due to the
low inflation environment.
BIS Review 35/2008
Central banks would be well advised not to regard the observed flattening of the Phillips
curve as a structural feature of the economy that is unrelated to monetary policy.
The ongoing increases in the prices of oil and commodities - including food - are already
threatening to spill over to other price sub-components and increase pressure on the general
price level in both developed and emerging countries. In these circumstances, central banks
must not deviate from their commitment to price stability.
4. The impact of globalisation on the transmission mechanism of monetary
policy
Let me now turn to the impact that globalisation could have on the way that monetary policy
affects inflation, namely the transmission mechanism of monetary policy, and its implications
for central banks.
In particular, I will focus on developments in financial markets, given their fundamental role in
the chain that transmits the monetary policy impulse to the rest of the economy.
First of all, increasing financial markets integration is likely to have increased the impact of
shocks - including monetary policy actions - originating in a particular country or economic
region on the global economy. In the last 25 years the ratio of total foreign assets and
liabilities to GDP has more than tripled in industrialised countries and has increased by 150%
in emerging and developing countries.9
The liberalisation of national financial markets, declining communication costs and vibrant
financial innovation have fuelled cross-border investment flows. This has increased the
importance of global factors on the pricing of assets, on the relationship between supply and
demand for capital and savings, as well as on the risk premia that investors require for
holding certain assets.10
Thus, it is not surprising that central banks have traditionally devoted a substantial amount of
resources to understanding the way in which foreign developments affect their domestic
objectives and the way in which monetary policy decisions are transmitted to the rest of the
economy.
To fully appreciate the impact of changes of the global financial system on the monetary
policy transmission mechanism, one should bear in mind two key features of financial
markets developments: rapid financial products innovation and the emergence of new
financial intermediaries.
Financial innovation, in theory, is generally supportive of economic growth and improves the
allocation of savings, because it contributes to create deeper and more complete financial
markets.
Furthermore, under normal circumstances, it increases the efficiency of the transmission
mechanism of monetary policy because central banks' actions can potentially influence a
larger number of economic agents.
In general, monetary policy can be more stable and interest rates less volatile because
smaller policy rate changes would be needed in order to achieve the desired effect on
aggregate demand.
However, in several episodes of post-war history we have witnessed waves of financial
liberalisation and innovation that have been associated with excessive market euphoria,
leading to unsustainable asset price dynamics.
The ongoing financial market turbulences are one example. In the last few years new
computing and information-processing technologies have supported the rise of new - often
esoteric - financial instruments explicitly designed to unbundle and repackage the pay-offs
and risks associated with primitive, more conventional financial products and securities. This
trend - which originally aimed to improve the sharing of risks across savers - was later
extended to lending institutions, which, in the context of a search for higher returns, led to
exponential growth in credit derivatives such as credit default swaps (CDSs) and
collateralised debt obligations (CDOs).
Together with a number of benefits, such as improved diversification of risk and deeper
capital markets, these developments also had two negative side effects, namely a significant
increase in leverage and unprecedented growth in the marketisation of financial instruments.
The fact that banks' balance sheets shifted away from relatively illiquid assets (such as
mortgage loans) towards a business model whereby the banks originated underlying loans
which were then made tradable and negotiated in the open market (the so-called "originate
and distribute" model) made it harder to draw clear distinctions between previously distinct
categories of financial player.
At the same time, new investors - notably hedge funds - were born out of the need for
market-makers in previously unknown types of securities.
The emergence of these new categories of investors and financial intermediaries, the
behaviour and incentives of which can be quite different from those of traditional market
players (such as banks),11 in combination with product innovation, has probably changed the
way that shocks spread across financial markets. This probably also has an effect on the
way that monetary policy impulses are transmitted to the rest of the economy.
The proliferation of financial intermediaries adding value primarily by securitising and making
liquid - i.e. rendering tradable in the market place - assets that until a few years ago would
have been highly illiquid and remained on banks' balance sheets has increased the ability of
the financial system to create and supply liquidity.
However, if the securitisation of illiquid assets such as mortgage loans is fostered by
unsustainable dynamics in the price of the underlying assets, and if the products are not
sufficiently transparent, an "originate and distribute model" that seeks to create market
liquidity in this way can increase systemic risks and ultimately increase the risks to price
stability.
The mechanism that was, until last summer, fuelling the creation of liquidity and credit could
start to work in the opposite direction. Regulatory weaknesses allowed the explosion of credit
creation on the basis of what, ex post, have clearly been shown to be faulty assumptions
regarding the true level of market risk.
Beyond these considerations, however, the question for policy-makers is whether central
banks ought to be more active in such circumstances and adapt their conduct to the changes
that have occurred in the monetary transmission mechanism.
In my view, the ECB has shown itself to be ready to take all necessary steps to ensure the
provision of sufficient liquidity to allow the financial system to continue functioning properly.
Since the first signs of strain appeared in the money market, the ECB has provided additional
liquidity to money markets.
Liquidity-providing measures should by no means be confused with a weakening of the
monetary policy stance. The ECB remains firmly focused on price stability, with its policy
stance reflecting the Governing Council's assessment of the risks to price stability in the euro
area.
Central banks should devote maximum effort to understanding the extent to which the
transmission channel of monetary policy may, in a stable macroeconomic environment, be
affected by a high degree of integration in global financial markets and ever more complex
market microstructures.
For example, globalisation and financial innovation may have combined in the last two years
to make the long end of the yield curve less responsive to the tightening of monetary policy
than would be expected on the basis of historical experience - especially in the United
States, but also in the euro area.
It is very likely, in fact, that the global ample liquidity, in particular global savings flowing into
the United States was driven by the unsustainably low risk return profile offered by new
financial products and the illusion that the credit risk premium had almost disappeared.
Finally, central banks should be very cautious when communicating with the markets, and
the public in general, in order to make very clear the conditional nature of monetary policy
decisions and avoid fostering unsustainable expectations among market participants.
In some circumstances, unfounded expectations of a particular future policy could have an
amplifying effect on asset prices and thereby contribute to the build-up of such financial
imbalances, which would unwind quickly, and in a costly manner, once expectations change.
This last observation leads me on to another issue on which central banks and academic
scholars have been working for many years, namely the question of whether central banks
should include asset prices in some way in their targets when setting interest rates - and if
so, when.
5. Asset prices and monetary policy
To help me in my discussion of the role of asset prices in monetary policy, I would like first to
summarise what I think are some generally shared views and to look at the positions held by
the two broad camps that have emerged from this debate. These camps have arrived at
opposing policy conclusions.
I believe that almost everybody in the central banking and academic communities agrees on
four points:
First, central banks face an exceptionally difficult task in assessing whether or not asset
prices are being driven by fundamentals at any given point in time. Therefore, while central
banks ought to do their best to obtain as much information as possible on the sustainability of
asset price developments, they should be aware that identifying bubbles in real time is a very
risky business. Thus, the results of their assessment should be interpreted with particular
caution.
Second, central banks should not target asset prices. Targeting asset prices would, by
definition, mean that monetary policy's response to fundamentally-driven increases in asset
prices is similar to its response to asset price bubbles, as bubbles are often difficult to identify
in real time.
Third, central banks should take into account information from asset prices both in their
forecasting exercises and in their assessment of the current state of the economy, as asset
price movements can affect the behaviour of economic agents and can have an impact on
price stability. Nonetheless, the typically high levels of volatility in asset prices and their
unstable links with future macroeconomic conditions suggest that they should have limited
weight by comparison with other indicators.
Fourth, although central banks can influence asset prices by means of monetary policy
actions, the relatively large swings in policy rates that could be needed to curb boom and
bust cycles in asset prices could pose a significant threat to macroeconomic stability in the
short term.
Building on these generally agreed conclusions, two possible monetary policy approaches
have been suggested.
On the one hand, some argue that central banks should lean against asset price bubbles, as
such bubbles have the potential to create lasting distortions in the economy. In a world in
which asset price bubbles are very difficult to identify and the curbing of boom and bust
cycles in asset prices can prove very costly in terms of inflation and output, leaning against a
possible bubble can be seen as an insurance policy in case a bubble is indeed being
created. The proponents of this view argue that even if a central bank does not wish to target
asset prices directly, some insurance is desirable, given that boom and bust cycles in asset
prices may be damaging to economic stability.
Others, by contrast, advocate a sort of flexible inflation-targeting approach. They argue that
the premium for this "insurance policy" is too expensive, since, by reacting to changes in
asset prices, the central bank could seriously destabilise the economy in normal times when
no bubbles were present. As a result, they argue, a policy of leaning against asset prices
could lead to serious communication and accountability difficulties. Instead, they propose
that central banks remain focused on maintaining price stability and respond to asset prices
only to the extent that they provide information about current and future macroeconomic
conditions.
Overall, central bankers may draw some lessons from both camps:
First, asset prices should not normally be granted a special role in monetary policy-making.
Second, leaning against asset price movements may be advisable under some
circumstances:
1. when the probability of asset prices being driven by non-fundamental forces is
estimated to be high;
2. when the probability of the bubble bursting in the near future is low;
3. when the bubble is expected to be sensitive to modest interest rate increases; and
4. when the cost of the expected collapse in asset prices, were the bubble to be
allowed to persist, is estimated to be significant.
While leaning against asset prices can be considered by central banks on a case-by-case
basis when the four conditions I have just listed are met, this tends, admittedly, to happen
only very rarely.
The ECB's two-pillar monetary policy strategy is well suited to cope with the challenges
brought about by asset price developments. In particular, having an explicit monetary pillar
guarantees that the ECB has considerable expertise in the analysis of monetary and credit
developments and in the analysis of their impact on price stability. The close link between
monetary developments and evolving imbalances in asset and credit markets implies that
monetary analysis enables to detect such imbalances at an early stage and to respond to the
implied risks to price and financial stability in a timely and forward-looking manner. This has
proved to be an invaluable asset for the ECB, notably in times of global financial turbulence.
6. Conclusion: Globalisation does not change the rules of monetary
policy-making
Challenging though globalisation may be for monetary policy, globalisation does not
fundamentally alter the rules for monetary policy-making.12 Over the medium to longer term,
inflation still remains a monetary phenomenon. This means that price stability is there for us
to achieve.
While international liquidity conditions may influence market interest rates and thus the
transmission of monetary policy to real activity and inflation, central banks retain the ability to
control short-term interest rates, which have an effect, in turn, on the domestic cost of credit
and long-term interest rates. However, as I said earlier, the success of monetary policy is
dependent on central banks properly adapting their analyses in line with the changing
environment, taking account, among other things, of the potential impact of financial
innovation and liberalisation on the monetary policy transmission channel.
In such an environment, it is clearly important for stability-oriented monetary policies to
analyse developments in areas such as external prices and international trade and financial
flows. Asset prices and exchange rates should not necessarily be given any special status
and should instead be taken into account by monetary policy only to the extent that they
have an impact on price stability in the medium term.
I shall conclude my address today with a few remarks on the structure of the international
financial architecture and its relationship with domestic price stability-oriented monetary
policies. My view, which is shared by most members of the central banking community, is
that the best international monetary architecture is one in which each central bank focuses
on achieving price stability at home. This does not mean, however, that individual monetary
policies should function in isolation. On the contrary, the ongoing financial turmoil has shown
the value of a timely and open exchange of information on an international level between
central banks and regulators in the presence of increasing financial globalisation.
Thanks to the existing framework for cooperation, the ECB, in conjunction with other major
central banks around the world, has been able recently - and without changing its monetary
policy stance - to help to avoid a global liquidity squeeze by providing the euro area financial
system with additional refinancing during this period of heightened risk aversion.
However, cooperation does not mean coordination. Each central bank has just one policy
instrument, and this instrument can only achieve a single domestic objective, namely price
stability. As a result, central banks would be well advised to react to foreign developments
only if these become relevant for domestic price stability. International cooperation helps to
exploit the synergies that exist in monetary policy-making with a view to establishing an
environment of global monetary stability.
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