Alexandre A Tombini: Global liquidity, capital flows and inflation
targeting - central banking in the post-crisis global economy
Keynote address by Mr Alexandre A Tombini, Governor of the Central Bank of Brazil, at the
5th Summit Meeting of Central Banks on IT, Central Bank of Chile, Santiago de Chile,
15 November 2013.
* * *
Introduction
Five years into the crisis, we could perhaps say that while the global economic outlook is still
complex, we are beginning to see a candle light at the end of the tunnel and we are also
better equipped to draw a few analytical and policy lessons from what happened. We are in a
transition period: the normalization of global financial conditions is already underway, but its
pace is still unclear. While growth prospects are generally improving in important advanced
economies, the improvement has been uneven. In the US, recent indicators point to
moderate growth. There are promising signs from the new policies being implemented in
Japan, while the Eurozone presents a mixed picture.
Emerging market economies are facing an interesting albeit not surprising challenge. They
have at the same time to: (a) continue country-specific structural reforms and growth model
adaptation (e.g., China, Brazil, India, etc.); (b) maintain financial and price stability; after
having policy-engineered their V-shape recoveries, controlled their inflationary consequences
and managed destabilizing large capital inflows; (c) calibrate their responses to this transition
period of exiting from unconventional monetary policies, using their uneven policy room for
maneuver and their preparedness; and (d) make the best possible use of the foreseeable
changes in relative prices including their own asset prices; these changes are either
occurring or in the making, in the light of the expected shifts in global monetary conditions in
the coming months.
I will focus my remarks tonight on three issues:
(1) how we prepared ourselves with policies put in place in Brazil and other EMEs over
the last few years to sail through a period of intense capital inflows and to be well
positioned for the exit from unconventional monetary policies;
(2) notwithstanding that preparation, what has been the impact and the response to the
start of the normalization of monetary conditions; and
(3) what are the few analytical and policy lessons learned in the last few years with
regards to the inflation-targeting framework for monetary policy in the context of the
post-crisis challenges.
The policy response to large and volatile capital inflows
Let me begin by revisiting the rationale of the policies that many emerging markets put in
place during the most expansionary phase of advanced economy monetary policies. We
have policy space today due to our preventive, cautious and prudent policies that preserved
macro-financial stability through the adoption of a pragmatic approach towards capital inflows
over the last few years.
It is now a well-understood and documented story: ample global liquidity due to easy
monetary policies in advanced economies resulted in exceptionally intense capital flows to
emerging market economies. And we know that large and volatile capital inflows can
potentially lead to economic and financial instability. They are associated with excessive
credit expansion, lower quality of loan origination, increased financial system exposure to
exchange rate risk, asset price distortions, including excessive exchange rate appreciation,
and inflationary pressure, as excessively easy global monetary conditions can boost
domestic demand independently from the desired domestic policy stance. In a nutshell,
excessive flows are a fertile terrain to grow excessive financial exuberance.
The textbook policy response for my country and other EMEs was to use its floating
exchange rate regime, which helps to smooth economic and financial adjustments, while
conducting sterilized interventions and international reserves accumulation, which reduces
exchange rate volatility and builds a foreign currency liquidity buffer to prepare for reversals.
But the intensity of this inflow episode was special as were the circumstances and policy
responses in advanced economies1. Therefore, Brazil and other emerging markets
pragmatically complemented their response and other textbook (aggregate demand) policies
with the implementation of specific macroprudential policy measures to prevent the
exuberance deriving from these large inflows to threaten financial stability. The adoption of
specific measures of this new toolkit obviously depends on how each of us assesses its own
local credit and asset market potential vulnerabilities. Some EMEs imposed tighter limits on
financial institution and household leverage. In East Asia, for example, policies included
loanto-value and debt-to-income ceilings on real estate lending. In Brazil, we increased capital
requirements on riskier consumer loans and imposed a minimum payment floor on credit
card balances. And we also imposed taxes on capital inflows and a reserve requirement on
banks' foreign exchange spot positions.
The important outcome was that this pragmatic response worked. Therefore,
macroprudential measures, including those that target specific capital flows directly, became
an important part of the policy framework to address sudden floods and sudden stops. In
complement to traditional macroeconomic policy responses, these measures showed that
they can help ensure macro-financial stability. There are many quarters, ranging from
academia to the IMF itself2 that are increasingly subscribing to this view. However, there are
also reputational costs to implementing these policies, which I will address a little later.
But what do we mean by "it worked"? In Brazil's case, it means the following:
(a) macroprudential policies contributed to bringing down the pace of credit expansion to
more sustainable levels; (b) they were successful in improving the maturity and composition
of international financing; and (c) they also reduced foreign exchange volatility.
Therefore, the combination of strong fundamentals and our pragmatic policy response left
emerging market economies such as Brazil better prepared for the eventual exit from
unconventional monetary easing. But the question is better prepared for what?
Let me now turn to the second topic of my remarks which is the...
Impact of normalization on Brazil and other EMEs
Let me begin by noting that the process of normalization of monetary conditions underway in
global financial markets is, overall, a positive development for emerging market economies.
Despite market volatility, it reflects the gradually improving outlook for the world's largest
economy. As global growth and global trade recover, emerging market economies will
benefit.
We knew that, despite the best efforts to communicate an exit strategy from unconventional
monetary policies, the beginning of any discussion about "tapering", i.e. the possibility of a
reduction of asset purchases such as what occurred in May, would lead to a re-pricing of risk
and a global sell-off of emerging market assets. It indeed happened as we anticipated.
Emerging market economies have generally seen depreciating exchange rates, increasing
sovereign bond yields and credit default swap spreads, and in many cases falling stock
market prices.
In Brazil's case, the sell-off has manifested itself mostly as a search for protection, more than
actual outflows. Most of the selling pressure has come from foreign real-money investors
seeking to hedge their portfolios from currency devaluation, Brazilian companies hedging
their foreign exchange liabilities, and foreign companies hedging their exposure to local
assets. There is no foreign currency shortage in the domestic spot market, which the Central
Bank monitors continually. And therefore, at the Central Bank of Brazil, we responded to the
change in global financing conditions in a classical fashion, through policy tightening,
exchange rate flexibility and using accumulated buffers to reduce volatility, avoiding abrupt
changes that potentially threaten financial stability.
Accordingly, by mid-August, we announced a program of daily FX interventions through
foreign exchange swaps and dollar credit line auctions, totaling in 2013 nearly
USD 100 billion equivalent and scheduled through the end of the year, providing currency
hedge for the private sector. Here the picture is mixed for emerging markets. Some are
certainly feeling more the volatility than others. It depends on fundamentals, resilience,
position in the cycle with its associated policy response, credibility of the buffers and
willingness to use them timely and with a clear unambiguous communication.
In sum, while the prospect of interest rate normalization as economic growth recovers in core
economies is a net positive, it does create transition risks. The lesson I take from the last few
months is that emerging market policymakers need to show that they are ready and capable
of stepping in and providing the public goods of financial and price stability.
Let me now turn to the third and last topic of my remarks, that is ...
Inflation targeting in the post-crisis global economy
As a growing and abundant new literature - together with new practices - is now showing,
the 2008 crisis and its aftermath have called into question the balance and interaction
between two components of macroeconomic stability: financial and price stability. They are
both necessary, but taken individually, they are not sufficient to ensure overall macro stability
that fosters sustainable growth. Therefore, the debate raises the issue of what new contours
could take an inflation targeting framework for monetary policy that could also address
financial stability when complemented by possibly the new macroprudential toolkit. Central
banks and financial regulators both failed to counteract the buildup of systemic risk in the
financial system. Therefore, this failure has brought the inflation targeting regime under
scrutiny since it has been the monetary regime of choice in many central banks including in
emerging markets. The first lesson of the crisis was a greater appreciation of the importance
of financial stability as a component of macroeconomic stability.
There are many directions in the ongoing debate3. One direction is to consider a division of
labor along the lines of a separation principle: monetary policy using an IT framework would
address price stability; and macroprudential policy would be used to mitigate financial
systemic risk. Another direction is to ask whether monetary policy should explicitly
incorporate a financial stability objective, and be more proactive in response to perceived
risks to financial stability. Therefore, in considering the role of monetary policy in addressing
financial stability, this direction would consider new policy-reaction rules for central banks
that would be augmented to include a financial or credit gap argument of some sort.
We are certainly in Brazil - but also elsewhere - reflecting about these analytical lessons
from the crisis. Due to our history of greater volatility, emerging market economy central
banks such as Brazil's never relegated financial stability concerns to a secondary status. Our
inflation targeting framework had always been complemented by strong financial sector
regulation and prudent foreign exchange policies.
To be fair, very pragmatically, in the post-crisis environment of unprecedented global
liquidity, emerging markets somehow implicitly used this separation principle: we used
macroprudential policies in order to counteract the effects of intense and volatile capital flows
on credit and asset markets; and this allowed monetary policy under the IT regime to
maintain its focus on price stability.
However, this pragmatic policy mix might be effective, but is not without costs, especially
because we still do not fully know how some of these macroprudential tools work4. That
introduces important issues of credibility for central banks and poses challenges for the
formation of expectations about the yield curve that are critical for monetary policy.
Therefore macroprudential policy, particularly measures that target capital flows, combined
with traditional monetary policy creates significant communication challenges for central
banks. In this respect, macroprudential policy can easily be misconstrued, obscure policy
intentions and distort expectations.
Concluding remarks
Allow me to conclude by drawing some general lessons from this quick overview of central
banking for emerging markets in the post-crisis global economy:
(a) the judicious use of macroprudential tools can provide an additional degree of
freedom to conduct monetary policy aiming at price stability at home while
preserving financial stability;
(b) the debate will have to continue regarding the ways to ensure that the
complementarity between the two instruments does not confuse and undermine
market confidence; and
(c) the importance of making progress in developing a framework for financial stability
policy is paramount. This would involve refining our macroprudential policy tools,
developing new ones, and improving our understanding of how these tools impact
the financial system and the economy.
References
Agénor, P.R., and L. A. Pereira da Silva (2013)," Inflation Targeting and Financial Stability: A
Perspective from the Developing World", an e-book by CEMLA and Inter-American
Development Bank, October 2013.
International Monetary Fund (2011a) Recent Experiences in Managing Capital Inflows -
Cross-Cutting Themes and Possible Policy Framework. Strategy, Policy and Review
Department (February).
International Monetary Fund (2011b) Macroprudential Policy: An Organizing Framework.
Monetary and Capital Markets Department (March).
International Monetary Fund (2012) The Liberalization and Management of Capital Flows: An
Institutional View. Washington DC: International Monetary Fund, November,
http://www.imf.org/external/np/pp/eng/2012/111412.pdf.
International Monetary Fund (2013a), "The Interaction between Monetary and
Macroprudential Policies", January 29, 2013, http://www.imf.org/external/np/pp/eng/
2013/012913.pdf.
International Monetary Fund (2013b), "2013 IMF Spill-over Report" August 1, 2013,
http://www.imf.org/external/np/pp/eng/2013/070213.pdf.
Ostry, Jonathan D., Atish R. Ghosh, Marcos Chamon, and Mahvash S. Qureshi. 2012. Tools
for Managing Financial-Stability Risks from Capital Inflows. Journal of International
Economics 88 (November): 407-21.
Rey, Helène (2013), "Dilemma not Trilemma: the Global Financial Cycle and Monetary Policy
Independence", paper presented at the Jackson Hole Economic Symposium, August 2013.