Credible domestic frameworks for implementing monetary policy – with an operationally independent and accountable central bank at their core – have generally delivered inflation rates that are both lower and less variable. 7 This directly benefits all citizens in good times. Moreover, greater monetary policy credibility gives a central bank more scope to respond to shocks, and enables financial markets to anticipate better the path for monetary policy, thereby providing a stabilising force during bad times. During the taper tantrum, those economies with betteranchored inflation expectations were able to keep monetary policy relatively more accommodative. 8    Flexible exchange rates. A flexible exchange rate acts as a valuable shock absorber for an economy because domestic wages and prices are relatively “sticky” (in other words, slow to adjust). For example, suppose there is a spike in global risk aversion. As capital flows are withdrawn flexible exchange rates depreciate. In general, this boosts an economy’s competitiveness. However, where economies borrow heavily in foreign currency, and this exposure is unhedged, depreciations can be detrimental for the economy. 9    Fiscal sustainability. A sustainable fiscal position provides governments with more room to respond to adverse shocks to demand. Financial markets therefore reward more sustainable fiscal positions: the IMF found that declines in inflows between 2010 and 2015 were 1 percentage points of GDP larger for countries with above-average public debt ratios.10 Fiscal sustainability is also necessary for a credible nominal anchor. 6  Fischer, S (1988), International Macroeconomic Policy Coordination, in International Economic Cooperation, ed.

These flows are particularly flighty (Chart 13), reflecting the fact that more than $ trillion of global assets are held in investment funds that promise daily liquidity to investors despite investing in potentially illiquid underlying assets, such as EME debt.17 We have recently seen analogous situations in the UK within some niche managers and smaller markets, such as open-ended property funds investing in commercial real estate.18 The complications would be much greater if a major asset class like EME debt were to freeze up. This structural mismatch means that these funds can behave particularly pro-cyclically. Bank of England work finds that redemptions by EME bond funds (those with larger structural mismatches) in response to price falls are five times those for EME equity funds (those with less structural mismatch). In turn, EME equity funds are twice as responsive as AE equity funds. While the shift to market-based finance has increased global capital flows to EMEs, it also amplifies spikes in Capital Flows-at-Risk. Moreover, market-based finance flows are particularly sensitive to push shocks, especially in extreme scenarios (Chart 13). The recent global growth in assets under management has not yet been fully tested in an extreme scenario, such as a global downturn. Chart 13: The sensitivity of Capital Flow-at-Risk to push factors, by source of capital flow  FDI  Banking  Market-based finance  of which: investment funds 0 -1 -2 -3 -4  Median  5th percentile  -5 Capital Flows-at-Risk as a % of GDP  Sources: IMF, EPFR, Bank calculations.