posted on 01 June 2016
from Liberty Street Economics
-- this post authored by Sushant Acharya, Ozge Akinci, Julien Bengui, and Bianca De Paoli
Prompted by the U.S. financial crisis and subsequent global recession, policymakers in advanced economies slashed interest rates dramatically, hitting the zero lower bound (ZLB), and then implemented unconventional policies such as large-scale asset purchases. In emerging economies, however, the policy response was more subdued since they were less affected by the financial crisis.
As a result, capital flows from advanced to emerging economies increased markedly in response to widening interest rate differentials. Some emerging economies reacted by adopting measures to slow down capital inflows, acting under the presumption that these flows were harmful. This type of policy response has reignited the debate over how to moderate international spillovers.
Some early academic research suggested that the benefits of policy coordination tend to be small. This conclusion stems from traditional models of the global economy that often illustrate a world in which countries share the burden of macroeconomic shocks among themselves and do not face significant trade and current account imbalances. Without such imbalances, international spillovers become largely irrelevant. This scenario does not reflect the current global economic environment, which indicates that the benefits of policy coordination may now be more pronounced.
Global Demand Rebalancing
As previously mentioned, emerging economies were less affected by the financial crisis. In theory, the resulting appreciation of their currencies acts to boost exports of advanced economies in need of a stimulus. As argued by Olivier Blanchard of the International Monetary Fund, such a reallocation of demand across countries would be a crucial ingredient behind a smoother global macroeconomic adjustment. In other words, capital flows and exchange rate movements enable countries to share risk and facilitate a recovery.
Recent research (see Acharya and Bengui) has emphasized that allowing capital flows to facilitate economic recovery is particularly important in a liquidity trap. With monetary policy constrained by the ZLB in ailing economies, capital mobility can enable these countries to "temporarily borrow" demand from healthier economies. Importantly though, this research points out that exchange rate adjustments, required to promote an efficient rebalancing in global demand, require international cooperation since the policy incentives of individual countries may not be aligned. For example, healthier economies may not welcome the upward pressure on their currencies and can be expected to respond with capital controls. As a consequence, absent international cooperation, countries with stronger fundamentals - such as emerging markets following the crisis - might take measures that end up hampering the recoveries of countries in trouble.
Arguably, adverse spillovers from unilateral policies can go both ways. Recent research by Bruno and Shin suggests that loose monetary policy in advanced economies may have encouraged risk-taking by global financial institutions. This phenomenon is often referred to as the risk-taking channel of monetary policy as these institutions assume more leverage and increase their lending to emerging markets. This expanded credit availability can create financial instability risks in emerging markets, especially when the recipient economies are operating near potential. It can also cause policy dilemmas. An emerging market economy facing inflationary pressures may feel the need to hike interest rates, but higher rates would encourage even more capital inflows.
The resulting credit booms and appreciation pressure on the currencies of emerging economies can make these countries more vulnerable to sudden-stops - or an abrupt reversal in capital inflows. In addition, loose monetary policy in advanced economies can raise asset prices, increasing the borrowing capacity of emerging economies and magnifying financial instability risks (see, for example, "Competitive Monetary Easing - Is It Yesterday Once More?" by Raghuram Rajan). Experiences of Mexico in 1994 and Asian countries in 1997 suggest that these risks can be large and highlight a need for advanced economies to consider the impact of their monetary policy stance on the financial systems of other countries.
In this blog post we have discussed two instances of adverse spillover effects of policies that can justify policy cooperation, with a focus on spillovers between emerging and advanced economies. It is likely that other sources of spillovers are present in the current economic climate in which economic divergence is pronounced, not just between the emerging and advanced world, but also within the advanced economies themselves. In addition, the use of ever more innovative policy tools, such as negative interest rates, might open the doors to further unintended cross-border spillovers.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
About the Authors
Sushant Acharya is an economist in the Federal Reserve Bank of New York's Research and Statistics Group.
Ozge Akinci is an economist in the Bank's Research and Statistics Group.
Julien Bengui is an assistant professor of economics at the University of Montreal.
Bianca De Paoli is a senior economist in the Bank's Research and Statistics Group.
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