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Policy Imbalances and the Uneven Recovery John B. Taylor Conference on The Uneven Recovery: Emerging Markets versus Developed Economies Oct 14, 2011 Two Global Imbalances (1) Current account imbalances (2) Monetary imbalances • Both relevant for emerging markets versus developed economies • We hear much about the first • But the second may be more important Current Account Imbalances • A frequent topic for international coordination • A perennial topic for G-20, IMF, OECD (WP3) • Sometimes used for calls by US and Europe for exchange rate changes by EME • Frequently blamed for the financial crisis – Saving glut flows into US, lowers interest rates – Alternative to the “too low for two long” view • Now “rebalancing” is a major focus of the G-7, G-20, IMF Link to Saving-Investment Gap Saving – Investment =Net Exports Y=C+I+G+X Y-C-G= I+X S=I+X S-I=X Look at recent history United States C/Y and G/Y Percent Percent 72 70 68 Consumption as a share of GDP (right axis) 66 64 23 62 22 60 21 20 19 Government purchases as a share of GDP (left axis) 18 17 1975 1980 1985 1990 1995 2000 2005 2010 Percent 20 US Investment rate 18 16 14 12 US saving rate [100(1 - C/Y- G/Y)] 10 8 6 1975 1980 1985 1990 1995 2000 2005 2010 Percent 20 Percent 16 U.S. 30-year mortgage rate (right scale) 12 2 8 0 4 -2 U.S. net exports as a share of GDP (Left axis) -4 -6 -8 1975 1980 1985 1990 1995 2000 2005 2010 Source: Borio and Disyatat (2011) Capital Flows and the Current Account Consider 2004 (Billions of dollars) Exports of goods and services and income receipts Imports of goods and services and income payments Unilateral current transfers Current Account Deficit U.S. Owned Assets Abroad Foreign Owned Assets in the United States Statistical discrepancy & other reconciliations Note that these are capital flows Not capital stocks 1531 -2118 -81 -668 -856 1440 84 U.S.GDP was $11734 billion in 2004, so CA was 5.7 percent as a share of GDP Source: http://www.bea.gov/bea/newsrelarchive/2005/trans305.pdf The connection between current account and change in official reserves can be particularly weak Current account = Change in official reserves + other gross outflows - other gross inflows United States Mainly Europe rather than emerging markets If not the current account, then what is driving these flows? •Monetary policy •Exchange rate policy Clear Evidence from a Very Transparent Central Bank • Norges Bank very explicit and transparent in accounting for how external variables affect interest rate path • Useful to consider several episodes in past few years •Reveals foreign interest rate as the most significant reason for deviating from basic rule Policy rate in 1/2008 (with fan chart) and the increase in the policy rate in 2/2008 (red line) 9 9 90% 70% 50% 30% 6 6 3 3 Source: Norges Bank 0 Mar-06 0 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Factors behind changes in the interest rate path from 1/2008 to 2/2008 2 2 1.5 1.5 1 1 0.5 0.5 0 -0.5 -1 -1.5 0 Higher demand in Norway Higher inflation in Norway Higher interest rates abroad and developments in the foreign exchange market Lower growth abroad Higher risk premium in the money market -2 -0.5 -1 -1.5 -2 08 Q3 09 Q1 09 Q3 10 Q1 10 Q3 11 Q1 11 Q3 From 1-10 From Øistein Røisland “Monetary Policy in Norway” From MPR 1/10 From OECD Survey Norway, 2010 Empirical evidence that target interest rate in EM central banks responds to exchange rates Example from Sebastian Edwards (2005) “The Relationship Between Exchange Rates and Inflation Targeting Revisited” Continued from Sebastian Edwards (2005) Example from ECB during 2000-2006 • Sample 2000.1 - 2006.4. • Inflation = 4-quarter rate of change in the harmonized index of consumer prices • GDP gap = % deviation of real GDP from trend. • Regress deviation of ECB rate from Taylor rule on federal funds rate. • Estimated coefficient = .21 – standard error of .06. – Plot of the actual and fitted values from this regression: Illustrative Chart from the OECD, March 2008 The Case of the Uneven Recovery • Very low policy rate in US • Creates pressures on EM central banks to hold rates lower than they would be for domestic price and output stability – Also creates pressures to intervene in currency markets and impose capital controls • Leads to higher inflation, and perhaps more crises • So need to have “monetary rebalancing” • But little interest from developing countries General Sources of Instability Consider two country model with i affecting i* Interest rates are set according to: * i 1.5 .5 y i i* 1.5 * .5 y* *i Solving for the interest rates results in the following i 1 1.5( ) .5( y y ) * * 1 * 1 * * * i 1.5( ) .5( y y ) * 1 Conclusion • Need to focus more on “monetary rebalancing” – Side by side discussion with “current account rebalancing” • May be more important than current account rebalancing • But how? – More global leadership – Global inflation target