Thursday, February 18, 2010

IMF on macroeconomic policy lessons

Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro have an interesting working paper that reviews the main elements of the pre-crisis consensus on macroeconomic policy making, identify what went wrong, what tenets of the pre-crisis framework still holds, and attempt to formulate the broad contours of a new macroeconomic policy framework.

On the way forward, they advocate combining monetary policy and regulatory instruments and using the broad set of cyclical tools that are institutionalized in the existing regulatory and prudential frameworks. They identify the main challenge as finding the "right trade-off between a sophisticated system, fine-tuned to each marginal change in systemic risk, and an approach based on simple-to-communicate triggers and easy-to-implement rules". Olivier Blanchard is spot on

"Keeping output close to potential and inflation low and stable should be the two targets of policy. And controlling inflation remains the primary responsibility of the central bank. But the crisis forces us to think about how these targets can be achieved. The crisis has made clear, however, that policymakers have to watch many other variables, including the composition of output, the behavior of asset prices, and the leverage of the different participants in the economy. It has also shown that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way."

Their recommendations include

1. Interest rates should be used primarily in response to aggregate activity and inflation. A more broader range of instruments should be used to deal with specific output composition, financing, or asset price issues.

2. A combination of monetary and regulatory tools are necessary to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. For example, if leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be raised. These measures could be to some extent circumvented, but nevertheless are likely to have a more targeted impact than the policy rate on the variables they are trying to affect.

3. A complementary use of monetary policy and regulation necessitates an acceptable level of coordination between the respective authorities. Some have argued in favor of the central bank to be in charge of both. In any case, the neat separation between these two sets of instruments is a thing of the past.

4. Monetary policy will increasingly be seen as the joint use of the interest rate and sterilized intervention, to protect inflation targets while reducing the costs associated with excessive exchange rate volatility.

5. Very low inflation rates are not always desirable, as the current crisis has shown and there is a strong case for setting a higher inflation target in the future. Higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

The challenge here is balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. But the moot point is whether these costs are outweighed by the improved policy maneuverability that would be available in times of crisis from having slightly higher inflation.

6. The present crisis has clearly exposed the limitations of monetary policy, including the full range of credit and quantitative easing policies. Fiscal policy is decisively back to the centerstage, especially when the slowdowns are deep and there is enough time for stimulus spending to yield results despite its implementation lags.

7. It also highlights the importance of having automatic fiscal stabilizers that swing into action without waiting for the time consuming and politically controversial policies to be legislated into action. For example, temporary tax policies targeted at low-income households, investment credits, or temporary social transfers that would be triggered by a macroeconomic variable crossing some threshold (the unemployment rate, say, rising above 8 percent).

8. The crisis has underlined the need for countries to follow counter-cyclical policies that enables them to build up enough fiscal cushion to respond effectively during slowdowns with large enough stimulus measures. This also possibly means revisiting the conventional target debt to GDP ratios and aiming for much lower ratios than before the crisis.

See this discussion on the benefits and costs of the IMF's proposed 4% inflation target.

Update 1 (24/3/2010)
See these comments on Olivier Blanchard's proposal to raise the inflation target to 4% by David Altig, Mark Thoma, David Beckworth and Ryan Avent.

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