Sunday, March 29, 2015

Christine Lagarde: Monetary Policy in the New Normal

On her recent visit to China IMF Chief Christine Lagarde gave some remarks to the China Development Forum Panel Discussion. In these remarks she makes a few comments worth mentioning below. After that, my added comments.

"The world has yet to achieve full economic recovery. Global growth continues to be weighed down by high debt, high unemployment, and lackluster investment. The IMF recently cut its global growth forecasts for both 2015 and 2016 (to 3.5% and 3.7%) – despite the boost from cheaper oil and stronger U.S. growth.
The recovery remains fragile because of significant risks. One such risk emanates from the expected tightening, or normalization, of U.S. monetary policy at a time when many other countries are easing monetary conditions. This “asynchronous” monetary policy may trigger excessive volatility in global financial markets.
The divergence of monetary policy paths has already led to a significant strengthening of the U.S. dollar. Emerging markets could be vulnerable, because many of their banks and companies have sharply increased their borrowing in dollars over the past five years."
. . . . 
"Unconventional monetary policies have also led to negative spillover effects on emerging markets through a build-up of financial stability risk. These policies triggered huge capital inflows into emerging financial markets. Between 2009 and the end of 2012, emerging markets received US$ 4½ trillion of gross capital inflows, representing about half of global capital flows during that period.
This led to a significant increase in bond and equity prices and to a strengthening of emerging market currencies. IMF studies suggest that these effects were larger than the ones that had been caused by conventional policies in the past.
These spillovers pose a risk to financial stability in emerging markets, because policy changes could easily lead to a sudden reversal of capital flows.
We already saw a preview of this scenario during the so-called “taper tantrum” in the summer of 2013. Merely the first hint of a change in U.S. monetary policy was enough to trigger a surge in financial market and capital flow volatility.
Could this happen again? Despite the efforts of the U.S. Federal Reserve to clearly communicate its policy intentions, financial markets may still be surprised by the timing of the U.S. interest rate lift-off and by the pace of subsequent rate increases."   . . . . 

.  .  .  " if market volatility materializes, central banks need to be ready to act. Temporary –but aggressive – domestic liquidity support to some sectors or markets may be necessary. In certain conditions, foreign exchange interventions could also be used to dampen exchange rate volatility. These interventions should not be used as a substitute for needed macroeconomic adjustment. Moreover, foreign currency swap lines across countries have proven helpful in providing access to foreign exchange liquidity in times of market stress.
International coordination and safety nets can also play a crucial role. For example, central banks and financial supervisors may want to share their policy thinking and contingency plans. Closer cooperation between the IMF and Regional Financing Agreements – such as the BRICS Contingency Reserve Arrangement – would also be helpful.
My added comments: Just a couple of points to note here. One is that we can consider this yet another IMF warning that the financial system is still weak and unstable. Ms. Lagarde says that spillover effects from unconventional monetary policy (i.e. the US Fed QE program) "pose a risk to financial stability in emerging markets, because policy changes could easily lead to a sudden reversal of capital flows." As we know, we live in a highly interconnected financial world now so financial instability anywhere can quickly lead to instability everywhere. 
The other point is to note how Ms. Lagarde used this speech to promote the idea of the new BRICS reserve fund and the IMF working together (not fighting with each other). The IMF itself and most member nations do not view the new BRICS Bank and Reserve Fund as rivals. Instead, they view these as stepping stones to a multi-polar world where the US dollar is no longer the sole global reserve currency. Some factions in the US don't like the idea of this happening, but some factions are on board with it. We'll see how it turns out.

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