IMF - Rethinking Macroeconomic Policy by Olivier Blanchard

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The great moderation (the steady decrease in cyclical fluctuations from the early 1980s on) lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment. In this paper, we review the main elements of the pre-crisis consensus, we identify where we were wrong and what tenets of the pre-crisis framework still hold, and take a tentative first pass at the contours of a new macroeconomic policy framework. II. WHAT WE THOUGHT WE KNEW we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. (So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job.) We thought of fiscal policy as playing a secondary role A. One Target: Stable Inflation Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This was the result of a coincidence between the reputational need of central bankers to focus on inflation rather than activity (and their desire, at the start of the period, to decrease inflation from the high levels of the 1970s) and the intellectual support for inflation targeting provided by the New Keynesian model. constant inflation is indeed the optimal policy, delivering a zero output gap (defined as the distance from the level of output that would prevail in the absence of nominal rigidities), even if policymakers cared very much about activity, the best they could do was to maintain stable inflation. In practice,central banks did not only care about inflation. Most of them practiced ?flexible inflation targeting,? the return to inflation target over some horizon. Most of them allowed for shifts in headline inflation, provided inflation expectations remained well anchored. And many of them paid attention to asset prices (house prices, stock prices, exchange rates) beyond their effects on inflation and showed concern about external sustainability and the risks associated with balance sheet effects. B. Low Inflation There was an increasing consensus that inflation should not only be stable, but very low (most central banks chose a target around 2 percent) This led to a discussion of the probability of falling into a liquidity trap: given the zero bound, a smaller feasible decrease in the interest rate?thus less room for expansionary monetary policy in case of an adverse shock. The danger of a low inflation rate was thought, however, to be small. C. One Instrument: The Policy Rate Monetary policy increasingly focused on the use of one instrument, the short-term interest rate one needs only to affect current and future expected short rates: one can do this by using, implicitly or explicitly, a transparent, predictable rule such as the Taylor rule. Intervening in more than one market, say in both the short-term and the longterm bond markets, is either redundant, or inconsistent. D. A Limited Role for Fiscal Policy In the past two decades, however, fiscal policy took a backseat to monetary policy. The reasons 1 skepticism about the effects of fiscal policy, largely based on Ricardian equivalence arguments. 2 if monetary policy could maintain a stable output gap, there was little reason to use another instrument. 3 in advanced economies, the priority was to stabilize high debt levels; in emerging market countries, the lack of depth of the domestic bond market limited the scope for countercyclical policy anyway. 4 lags in the implementation of fiscal policy, together with the short length of recessions, 5 likely to be distorted by political constraints. The rejection of discretionary fiscal policy as a countercyclical tool was particularly strong in academia. the consensus recipe for the medium term was to strengthen the stabilizers and move away from discretionary measures. To the extent that policymakers took a long-term view, the focus in advanced economies was on prepositioning the fiscal accounts for the looming consequences of aging. In emerging market economies, the focus was on reducing the likelihood of default crises E. Financial Regulation: Not a Macroeconomic Policy Tool Financial regulation and supervision focused on individual institutions and markets and largely ignored their macroeconomic implications. Financial regulation targeted the soundness of individual institutions and aimed at correcting market failures stemming from asymmetric information, limited liability, and other imperfections such as implicit or explicit government guarantees. In advanced economies, its systemic and macroeconomic implications were largely ignored. This was less true in some emerging markets, where prudential rules such as limits on currency exposures (and sometimes an outright prohibition against lending to residents in foreign currency) were designed with macro stability in mind. Little thought was given to using regulatory ratios, such as capital ratios, or loan-to-value ratios, as cyclical policy tools (Spain and Colombia, which introduced rules that de facto link provisioning to credit growth, are notable exceptions). F. The Great Moderation Improvements in inventory management and good luck in the form of rapid productivity growth and the trade integration of China and India likely played some role. But evidence suggests that more solid anchoring of inflation expectations, plausibly due to clearer signals and behavior by central banks, played an important role in reducing the effects of these shocks on the economy. III. WHAT WE HAVE LEARNED FROM THE CRISIS A. Stable Inflation May Be Necessary, but Is Not Sufficient Core inflation was stable in most advanced economies until the crisis started. Some have argued in retrospect that core inflation was not the right measure of inflation, and that the increase in oil or housing prices should have been taken into account. This, is more a reflection of the hope that it may be sufficient to focus on and stabilize a single index, so long as it is the ?right? one. no single index will do the trick. Inflation may be stable, and the output gap may nevertheless vary, (This is hard to prove empirically, as the output gap is not directly observable. What is clear, however, is that the behavior of inflation is much more complex than is assumed in our simple models and that we understand the relationship between activity and inflation quite poorly, especially at low rates of inflation.) Or, as in the case of the pre-crisis 2000s, both inflation and the output gap may be stable, but the behavior of some asset prices and credit aggregates, or the composition of output, may be undesirable (for example, too high a level of housing investment, too high a level of consumption, or too large a current account deficit) and potentially trigger major macroeconomic adjustments later on. B. Low Inflation Limits the Scope of Monetary Policy in Deflationary Recessions When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions. C. Financial Intermediation Matters Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market, the effect on prices can be very large. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy. Interventions, either through the acceptance of assets as collateral, or through their straight purchase by the central bank, can affect the rates on different classes of assets, for a given policy rate. This is indeed what, under the heading of credit easing, the central banks have done in this crisis. Another old issue the crisis has brought back to the fore is that of bubbles and fads, leading assets to deviate from fundamentals, not for liquidity but for speculative reasons. And it surely puts into question the ?benign neglect? view that it is better to pick up the pieces after a bust than to try to prevent the buildup of sometimes difficult-to-detect bubbles. D. Countercyclical Fiscal Policy Is an Important Tool The crisis has returned fiscal policy to center stage as a macroeconomic tool for two main reasons: 1. monetary policy, including credit and quantitative easing, had largely reached its limits, 2. the recession was expected to be long lasting, so fiscal stimulus would have ample time for implementation. It has also shown the importance of having ?fiscal space? Some advanced economies that entered the crisis with high levels of debt and large unfounded liabilities. Similarly, those emerging market economies (e.g., some in eastern Europe) that ran highly procyclical fiscal policies driven by consumption booms are now forced to cut spending and increase taxes despite unprecedented recessions. By contrast, many other emerging markets entered the crisis with lower levels of debt. there is a lot we do not know about the effects of fiscal policy, about the optimal composition of fiscal packages, about the use of spending increases versus tax decreases, and the factors that underlie the sustainability of public debts. E. Regulation Is Not Macroeconomically Neutral Financial regulation has played a central role in the crisis. The limited perimeter of regulation gave incentives for banks to create off-balance-sheet entities to avoid some prudential rules and increase leverage. Once the crisis started, rules aimed at guaranteeing the soundness of individual institutions worked against the stability. Mark-to-market rules, when coupled with constant regulatory capital ratios, forced financial institutions to take dramatic measures to reduce their balance sheets, exacerbating fire sales and deleveraging. F. Reinterpreting the Great Moderation during the past two decades, policymakers had to deal with shocks they understood rather well and for which policy was indeed well adapted. For example, with respect to supply shocks, anchoring of expectations was of the essence, But they were just not prepared for others. It may even be that success in responding to standard demand and supply shocks, and in moderating fluctuations, was in part responsible for the larger effects of the financial shocks in this crisis. The Great Moderation led too many (including policymakers and regulators) to understate macroeconomic risk, ignore, in particular, tail risks, and take positions (and relax rules)?from leverage to foreign currency exposure, which turned out to be much riskier after the fact. IV. IMPLICATIONS FOR THE DESIGN OF POLICY the crisis has made clear that macroeconomic policy must have many targets; it has also reminded us that we have in fact many instruments, from ?exotic? monetary policy to fiscal instruments, to regulatory instruments Most of the elements of the precrisis consensus, including the major conclusions from macroeconomic theory, still hold. Among them, the ultimate targets remain output and inflation stability. The natural rate hypothesis holds, at least to a good enough approximation, and policymakers should not assume that there is a long-term trade-off between inflation and unemployment. Stable inflation must remain one of the major goals of monetary policy. Fiscal sustainability is of the essence, not only for the long term, but also in affecting expectations in the short term. A. Should the Inflation Target Be Raised? large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future. Should policymakers 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? Are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent? Achieving low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of benefits and costs of inflation. The inflation tax is clearly distortionary, but so are the other, alternative, taxes. Many of the distortions from inflation come from a tax system that is not inflation neutral, for example, from nominal tax brackets or from the deductibility of nominal interest payments. These could be corrected, allowing for a higher optimal inflation rate. If higher inflation is associated with higher inflation volatility, indexed bonds can protect investors from inflation risk. Other distortions, such as the lower holdings of real money balances and a greater dispersion of relative prices, are more difficult to correct. Perhaps more important is the risk that higher inflation rates may induce changes in the structure of the economy (such as the widespread use of wage indexation) that magnify inflation shocks and reduce the effectiveness of policy action. B. Combining Monetary and Regulatory Policy The policy rate is a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. But there are other instruments at the policymaker?s disposal?call them cyclical regulatory tools. they are likely to have a more targeted impact. it seems better to use the policy rate primarily in response to aggregate activity and inflation and to use these specific instruments to deal with specific output composition, financing, or asset price issues. If low interest rates lead to excessive leverage or to excessive risk taking, should the central bank, as some have suggested, keep the policy rate higher than is implied by a standard interest rule? other instruments, which can directly affect leverage or risk taking. If monetary and regulatory tools are to be combined in this way, it follows that the traditional regulatory and prudential frameworks need to acquire a macroeconomic dimension. The main challenge, here, is to find 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. this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both. The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. two arguments were given in the past against: 1 the central bank would take a ?softer? stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. 2 that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation. The alternative, that is, separate monetary and regulatory authorities, seems worse. C. Inflation Targeting and Foreign Exchange Intervention The central banks that adopted inflation targeting typically argued that they cared about the exchange rate only to the extent that it had an impact on inflation. For smaller countries, many of them paid close attention to the exchange rate and also intervened on foreign exchange markets to smooth volatility and, often, even to influence the level of the exchange rate.Large fluctuations in exchange rates, due to sharp shifts in capital flows can create large disruptions in activity. Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function. at least in the short term, imperfect capital mobility endows central banks with a second instrument in the form of reserve accumulation and sterilized intervention. This tool can help control the external target while domestic objectives are left to the policy rate. Of course, there are limits to sterilized intervention, and these can be easily reached if capital account pressures are large and prolonged. These limits will be specific to each country and will depend on countries? openness and financial integration. Note that to the extent that prudential rules can prevent or contain the degree of contract dollarization in the economy, they will allow for greater policy freedom with respect to exchange rate movements. In turn, the perception of an ?excessively stable? exchange rate can lead to greater incentives for contract dollarization. D. Providing Liquidity More Broadly Reasons for extending liquidity provision, even in normal times: 1 If liquidity problems come from the disappearance of private investors from specific markets, or from the coordination problems of small investors, the government is in a unique position to intervene. Given its nature and its ability to use taxation, it has both a long horizon and very deep pockets. Two arguments against such public liquidity provision. 1 that the departure of private investors may reflect, solvency concerns. Thus, the provision of liquidity carries risk for the government balance sheet. 2 such liquidity provision will induce more maturity transformation and less-liquid portfolios. to the extent that public liquidity provision can be provided at no cost, it is indeed optimal to have the private sector do this maturity transformation. The cost may, however, be positive, reflecting the need for higher taxation or foreign borrowing. Both problems can be partly addressed through the use of insurance fees and haircuts The problems can also be addressed through regulation, by both drawing up a list of assets eligible as collateral and, for financial institutions, by linking access to liquidity to coming under the regulatory and supervision umbrella. E. Creating More Fiscal Space in Good Times A key lesson from the crisis is the desirability of fiscal space to run larger fiscal deficits when needed. Going forward, the required degree of fiscal adjustment (after the recovery is securely under way) will be formidable, in light of the need to reduce debt against the background of aging-related challenges in pensions and health care. Still, the lesson from the crisis is clearly that target debt levels should be lower than those observed before the crisis. when cyclical conditions permit, major fiscal adjustment is necessary and, should economic growth recover rapidly, it should be used to reduce debt-to-GDP ratios substantially, rather than to finance expenditure increases or tax cuts. Medium-term fiscal frameworks, credible commitments to reducing debt-to-GDP ratios, and fiscal rules (with escape clauses for recessions) expenditure frameworks based on long-term revenue assessments help limit spending increases during booms. eliminating explicit revenue earmarking for prespecified budget purposes A further challenge, as governments come under greater pressure to display improved deficit and debt data and are tempted to provide support to ailing sectors through guarantees or off-budget operations, is to ensure that all public sector operations are transparently reflected in fiscal data and that well-designed budget processes reduce policymakers? incentives to postpone needed adjustment. F. Designing Better Automatic Fiscal Stabilizers Discretionary fiscal measures: come too late to fight a standard recession. There is, thus, a strong case for improving automatic stabilizers. The second type of automatic stabilizer appears more promising.It does not carry the costs mentioned above and can be applied to tax or expenditure items with large multipliers. On the tax side, temporary tax policies targeted at low-income households, or tax policies affecting firms, such as cyclical investment tax credits. On the expenditure side, temporary transfers targeted at low-income households. These taxes or transfers would be triggered by the crossing of a threshold by a macro variable. GDP, is available only with a delay. This points to labor market variables, such as employment or unemployment. V. CONCLUSIONS In many ways, the general policy framework should remain the same. The ultimate goals should be to achieve a stable output gap and stable inflation. But policymakers have to watch many targets, including the composition of output, the behavior of asset prices, and the leverage of different agents. They have potentially many more instruments at their disposal than they used before the crisis. The combination of traditional monetary policy and regulation tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes. Low public debt in good times creates room to act forcefully when needed. Prudential regulation, and transparent data in the monetary, financial, and fiscal areas are critical to our economic system functioning well.

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