In cooperation with Ignazio Angeloni
After some short-lived optimism around end-summer (stock market recovered and spreads narrowed, suggesting light at the end of the tunnel), financial indicators have turned negative again. The prevailing sentiment is that the crisis will take a good deal of time to be resolved. In the meantime, confidence indicators in the G7 are mixed and financial instability may extend to emerging economies; if that happens, the current phase of global expansion is in danger.
How can a crisis of these proportions arise and develop in a very benign macroeconomic environment (unprecedented high growth and low inflation in all major economic blocs, sound monetary and rapidly improving fiscal policies, market deregulation and globalisation, and more)? What lessons can be learned from this?
Diagnoses so far have focused mainly on regulation and market discipline: insufficient transparency and disclosure by banks and their conduits, poor information for investors (calling, inter alia, for more standardized financial products), bad performance by rating agencies – see for example Steve Cecchetti’s recent pieces in www.voxeu.com. All this is true, but we should not forget that all this originated in a sector (real estate) that has experienced for well over a decade exponential price rises, record pace credit expansion and extremely low (often negative in real terms) debt costs. This is not a coincidence, and calls into question the conduct of monetary policy.
Central bankers aiming at price stability have had a rather easy life in recent years. One of the features characterizing the global macro-economy has been low and stable inflation. Several factors contributed to this success, but an important one, we believe, is globalization. There are several ways in which globalization can tame the inflation process. First, cross-border competition erodes monopoly rents in product and labour markets, putting downward pressure on wages and prices. Second, globalisation fosters efficiency gains, as firms relocate part of their activity abroad – the so-called “production unbundling”, that amounts to a positive supply shock leading to lower prices as well as more output. Third, consumer prices are kept in check by low-cost imports from emerging countries, mainly in Eastern Asia. Low labor costs in countries like China, coupled with a stable exchange rate, effectively provide an anchor to global inflation.
All this spread the belief that the inflation had stabilized at a lower level, or conversely, that low and stable inflation had become compatible with permanently lower real rates of interest. Inflation becomes more stable because it depends not only on domestic slack but also to some extent on global slack, resulting in a flatter Phillips curve (Borio and Filardo at the BIS have shown this for Europe). A lower average inflation rate, all other things equal, results from the global anchor just mentioned. Now, can all this result in excessive monetary expansion and financial instability? A plausible argument, in our view, is based on uncertainty over equilibrium interest rate. Households and firms ignore the natural rate, but may try to infer its value from central bank actions. Suppose the central bank initially pegs its policy rate around its equilibrium long-term level. Suddenly the central bank starts pegging its interest rate down, and keeps it low for long enough to change the public’s perceptions about the natural rate. The central bank is not necessarily cheating: it may genuinely (but wrongly) believe that the natural rate has declined. Household start to invest – say in real estate. In fact, they over-invest, that is they buy houses that are not sustainable in the longer run. If the households’ learning process is affected at some stage, the perceived natural rate jumps back to the actual natural rate (which was unchanged), causing a sell-off. The coincidence of lower house prices and higher interest rates may trigger the type of financial instability we have been observing.
What lessons are there in all this? Many, but one clearly relates to monetary policy. If globalization anchors inflation at a low level, this ceases to be a good measure of how expansionary monetary policy is. In this circumstance one needs to rethink about the conduct of monetary policy. The monetary framework should bring in a broader set of indicators than is normally the case. Narrow guideposts, like current or recent inflation or even 2- or 3-year inflation forecasts, are not sufficient. Credit and monetary aggregates should no longer be ignored, or simply lip-serviced, as generally done by inflation targeting central banks or even the Fed. Here is an area where the Old Continent, with its two-pillared monetary policy approach, may have a lesson to teach.