Monetary Policy in a Global Economy: Past and Future Research Challenges Presentation at the Conference Globalization and the Macroeconomy 24 July 2007 John B. Taylor Stanford University
Past Challenges Recall years near the end and after Bretton Woods High and volatile inflation For example, US inflation hit 12 % in 1975, fell to 5 % in 1977, and then increased to 15 % in 1979 Average inflation higher in G7 countries than in US Volatile output Standard deviation of real GDP growth: 2.8 % in US, 2.7 % G7 average Frequent recessions In US: 1969-70, 1973-75, 1980, 1981-82, and perhaps 1977-78. About every three or four years Much of the more distant past was about as dismal
Research Rising to the Challenge Objective of Monetary Research min λvar(y) + (1-λ)Var(π) Ad hoc? Models built (inside and outside central banks) RE, staggered pricing Dealt with Lucas critique New monetary policy rules evaluated and proposed What happened? λvar(y) + (1-λ)Var(π) was dramatically reduced for all λ! Standard deviation of real GDP growth cut in half in G7 Only two recessions in US in past 25 years Very short and mild by historical comparison Causality?
Volatility of Real GDP Growth Rates Source: Cecchetti, Hooper, Kasman, Shoenholtz, Watson (2007)
Source: Cecchetti, Hooper, Kasman, Shoenholtz, Watson (2007)
Global Issues in the Research: Exchange Rate & Policy Coordination Global Models (Fed, IMF, Stanford, OECD--Brookings book) Multicountry with rational expectations, staggered pricing Highly integrated: perfect capital mobility Econometrically estimated BIG role for exchange rate interest rate differentials relative prices pass-through Yet exchange rate did NOT play a big role in policy rules Approximately zero Why? Cooperation versus Nash in the design of policy rules? Reduced response to inflation, but little gain. Hence, even taking globalization into account, simple policy rules were viewed as nearly optimal Key principles
Another Challenge from the Past Mexico: 1994-95 Argentina: 1995-96 Thailand 1997-98 Indonesia 1997-98 Malaysia 1997-98 Korea 1997-98 Russia: 1998 Brazil: 1998-2002 Romania: 1998-99 Ecuador: 1998-99 Argentina: 1999-2001 Turkey: 2000-2001 Uruguay: 2002 Tequila effect Asian Crisis Contagion Russian Contagion
Research Rising to the Challenge Build models of financial crises with the objective of preventing or resolving them Eventually a consensus view emerges: Inflation creeps up compared to abroad Real exchange rate gets overvalued (fixed rate) Central bank defends drawing down reserves Eventual sharp depreciation Currency crisis becomes sovereign debt crisis Currency mismatch Discretionary actions of the IMF
Policy Implications Emerging From the Research Policy principles for emerging market countries Flexible exchange rate (or monetary union/dollarize) Inflation target monetary policy rule Build up foreign reserves Deal with currency mismatch Policy principles for IMF Need for predictability Deal with time inconsistency Collective Action Clauses as sand bags Exceptional Access Framework
What happened? Mexico: 1994-95 Tequila effect Argentina: 1995-96 Thailand 1997-98 Indonesia 1997-98 Asian Crisis Contagion Malaysia 1997-98 Korea 1997-98 Russia: 1998 Brazil: 1998-2002 Romania: 1998-99 Russian Contagion Ecuador: 1998-99 Argentina: 1999-2001 Turkey: 2000-2001 Uruguay: 2002 No Major Crises: 2002- present (Same causality issues)
Current and Future Research Challenges Main Objective: Prevent a return to the bad old recession-prone and crisis-prone world Tougher research challenge than those of the past Do we need a policy objective? Why else do the research? Specific challenges Knowing when to change policy rules Develop principles for currency intervention and diplomacy Develop principles for sovereign wealth funds Develop principles for exchange rate assignment Avoid the foreign interest rate overreaction problem
Should we change policy rules? Are there changes in the policy models that would lead to a different recommendation? Empirical Reduced pass-through Flatter Phillips curve Theoretical Better micro-foundations Welfare-based rather than simple variance criteria Just beginning so far the answer is mixed: Coenen, Lombardo, Smets, and Straub (2007) Batini, Levine, and Pearlman (2007) Kumhoff, Laxton, Naknoi (2007)
Principles for Currency Intervention and Diplomacy Absence of exchange rate in policy rule leaves open the question of sterilized intervention Need for some principles, as with past challenges For G7 countries Avoid intervention None in G7 countries (except Japan) since Sept 2000 A big change None in Japan since March 2004 Avoid verbal intervention Develop an exchange rate diplomacy strategy: Bilateral? Multilateral? Example of China
GUESS WHO IS INVITED TO DINNER? (October 2004)
8.28 9.4 % appreciation 7.56
Principles for Sovereign Wealth Funds Huge foreign reserves accumulation Some principles: Reduce controls on private capital flows Transparency Diversified portfolio Global Index Funds?
The Assignment Problem Who should be in charge? Finance Ministry or Central Bank US, Japan, Eurozone McCallum (2007) makes case for central bank Advantage: deals with close relation between exchange rate and monetary policy Advantages of assigning to finance ministries: Relates to diplomatic responsibilities Interacts with non-monetary policies: trade, fiscal Regime versus day-to-day
The Foreign Interest Rate Reaction Problem Central banks seem to react to foreign interest rates Reasons: Attempt to avoid excessive exchange rate movements Avoid carry trade risks Incorporate information about real equilibrium interest rate Simple example: i i * = αi * * = α i + 1.5π + * + 1.5π.5y +.5y * 1 * y * [ * 1.5π +.5y + α(1.5.5 )] i = π + 1 αα
Percent 0.5 0.0-0.5-1.0-1.5 Fitted -2.0-2.5 Actual 2000 2001 2002 2003 2004 2005 2006 Residual from Eurozone Policy Rule (1.5, 0.5)
Percent 2 1 0-1 Fitted -2-3 Actual -4 2000 2001 2002 2003 2004 2005 2006 Residual from U.S. Policy Rule (1.5, 0.5)
Conclusion Monetary theory and research helped monetary policy meet past challenges of globalization Price stability and output stability up Financial crises and contagion down Key lesson learned: Practical policy objectives of the research was essential No reason why monetary theory and research can t help policy meet current and future challenges of globalization. Plenty of practical policy objectives to work on.