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Capital Markets

Monetary suicide and the emerging markets-shaped noose

The shortcomings of the Fed and ECB's monetary transmission channels are, in part, down to emerging markets, argues William White, former chief economist at the Bank for International Settlements (BIS).


Bill White, an eminent former chief economist at the Bank for International Settlements (BIS), is a man whose arguments can’t be dismissed out of hand.

Firstly, he sounded the alarm over lax monetary policy and global credit bubbles pre-Lehman. Secondly, as a former BIS economic wonk, he has engaged in countless discussions with central bank officials on a regular basis. Indeed, the BIS conduct meetings every two months, a central bank hajj of sorts. Crucially, over his career, he has garnered the opinions and the instincts of emerging market policy officials on the global impact of the Fed and European Central Bank’s policies.

In his well-received piece published on Wednesday – sounding the alarm over ultra-loose G7 interest rates – White repeats his argument: the destruction of savings, a Japanese-style economic failure, and the propping up of zombie banks and corporates are all natural consequences of the monetary status quo. Add to that: destabilizing capital inflows to emerging markets, in risk-on market rallies. But his thoughts on the lessons from the emerging markets interest us the most.

Firstly, G7 stimulus aimed, in part, to depreciate currencies is failing given the reluctance of emerging market economies (EMEs) to accept the subsequent loss of exchange-rate competitiveness

Lower interest rates are not the only channel through which monetary conditions in AMEs [advanced market economies] might be eased further. Whether via lower interest rates or some other central bank actions, reflationary forces could be imparted to the real economy through nominal exchange rate depreciation and the resulting increase in competitiveness. However, an important problem with this proposed solution is that it works best for a single country. In contrast, virtually all the AMEs are near the ZLB [zero lower bound] and desirous of finding other channels to stimulate the real economy. Evidently, this still leaves the possibility of a broader nominal depreciation of the currencies of AMEs vis-a-vis the currencies of EMEs.

Indeed, given the trade surpluses of many EMEs (not least oil producers), and also the influence of the Balassa‐Samuelson effect, a real appreciation of their currencies might be thought inevitable. The problem rests with the unwillingness of many EMEs to accept nominal exchange rate appreciation; the so called “fear of floating”. To this end, they have engaged over many years in large-scale foreign exchange intervention and easier domestic monetary policies than would otherwise have been the case. More recently, the rhetoric concerning “currency wars” has sharpened considerably, and a number of countries turned for a time to capital controls. The principal concern about these trends in EMEs is that they might lead to a more inflationary domestic outcome.

Secondly, the example of China – though the complicated mechanics of this argument are not explored in the piece – shows that there is a correlation between depressed interest rates and a reduction in household consumption, a reversal of commonly held economic perceptions:

While it is conventional wisdom that lower interest rates will stimulate consumption, Bailey (1992) and others have long argued that even the sign of this relationship is ambiguous. Suppose that savers have a predetermined goal for the minimum amount of savings they wish to accumulate over time. This would correspond to someone wishing to purchase an annuity of a certain size upon retirement, at a desired age. Evidently, a lower interest rate always implies a slower rate of accumulation. But, if in fact the accumulation rate becomes so low that it threatens the minimum accumulation goal, the only recourse (other than postponing retirement) will be to save more in the first place.
The distributional (income) implications of interest-rate changes for aggregate household spending also receive too little attention. Very low rates imply less household disposable income for creditors and more disposable income for debtors. Should the marginal propensity to consume of creditors (say older, credit-constrained people living off accumulated assets) exceed that of debtors, the net effect of redistribution could be to lower household spending rather than raise it. This argument has in the past been invoked occasionally by central bankers in EMEs. More recently, Lardy (2012) and Rogoff (2011) have both recommended ending financial repression in China as a way to raise household consumption. The core of their argument is that higher interest rates would raise disposable income and consumption in turn.

A similar dynamic exists for firms with fixed liabilities, such as pension funds with annuities or defined-benefit schemes.

Thirdly, emerging markets are likely to be a source of inflationary pressure in the coming years:

A perhaps more pressing problem is the possibility of sharply higher inflation in EMEs. In part due to their “fear of floating”, many EMEs seem to be operating near full capacity, and monetary conditions are generally very loose. As well, the rate of growth of potential now seems to be slowing after previous sharp increases. This could in turn, via the higher price of imports, lead to inflation accelerating unexpectedly in the AMEs as well. In effect, this would be a reversal of the secular disinflationary impulses sent by EMEs to the AMEs in previous years.

Since AME central banks underestimated the importance of the positive supply shocks in earlier years, it is not unlikely that they would also fail to recognize the implications of its reversal. While such an inflationary outcome might be judged useful in resisting debt/deflation of the Fisher type, rising inflation along with stagnant demand in AMEs would clearly imply other serious problems for the central banks of AMEs. On the one hand, raising policy rates to confront rising inflation could exacerbate continuing problems of slack demand and financial instability. On the other hand, failing to raise policy rates could cause inflationary expectations to rise. Further, were different central banks to respond differently, as they did in 2008, there might also be unwelcome effects on exchange rates.

Nevertheless, White also thinks there are deflationary consequences to the current G7 monetary cycle, but it’s not clear what the net impact will be in the coming years.

White does not proffer an alternative road map for growth. But it’s clear his solution is multi-faceted, complex and global, namely: a positive real interest environment would boost the supply-side of the equation – by boosting savings – and to boost demand, global imbalances need to be resolved, ie. Asia to spend more and G3 to export. Yes – easier said than done.

With the lack of a global growth pact, it’s no surprise policymakers are embarking on a path of least-resistance via ultra-loose rates as a short-term sticking-plaster option.

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