MNI INTERVIEW (2): Key Quotes From Interview With BIS Borio

--Second part of two

By Christian Vits

     FRANKFURT (MNI) - Below are the key quotes from the recent Market News

interview with the Head of the Monetary and Economic Department at the Bank for

International Settlements, Claudio Borio:

     Cont

     On deviations from inflation objectives:

     In order to allow monetary policy to take better account of macro-financial

stability risks and their implications for longer-term price stability,

frameworks need to have sufficient in-built flexibility to tolerate sometimes

persistent, if moderate, deviations of inflation from targets. This is

particularly the case for shortfalls. And the reason for the deviations matters.

If shortfalls are driven by demand weakness, they are costly for the economy, as

they signal that it is operating below capacity. By contrast, if the shortfalls

are driven by positive supply side forces, such as globalisation and technology,

they are not harmful. The challenge is to distinguish the two types, which can

be quite hard to do as events unfold (ie in real time).

     What kind of possible adjustments to frameworks could allow for this

flexibility? In some cases, targets are already interpreted quite flexibly.

Options include lengthening the horizon and/or having bands with sufficient

width. Bands have the merit of being explicit about the difficulties in

fine-tuning inflation.

     On the risk that central banks fall behind the curve:

     I don't see the increasing risk you suggest. What I see is the continuation

of the challenges central banks have been facing for some time. They are fully

aware of the risks involved.

     On risks such as a debt-trap:

     There is a risk that the global economy might fall into a kind of debt

trap, if policies in general are unable to address the build-up of debt. In the

case of monetary policy, the risk is that the higher debt levels that have gone

hand in hand with lower interest rates will make it harder to raise those rates

to historically more normal levels. In turn, this would reduce the policy room

for manoeuvre and complicate dealing with the next recession.

     On how much ammunition is left:

     The first piece of good news is that no one is under the illusion that the

business cycle has vanished, so that there is a lot of thinking devoted to how

to tackle one. The second piece of good news is that central banks have gained

quite a bit of experience with the new tools, so the range of options is

broader. The less good news is that the room for manoeuvre has narrowed. This is

partly linked to the debt trap risk.

     On inflation targeting:

     Inflation targeting as a framework was extremely successful in helping to

bring inflation down and keeping it there, confounding the sceptics at the time.

Of course, other factors no doubt helped too, including the tailwinds of

globalisation and technology. The issue now is whether some refinements would

help address macro-financial stability concerns more systematically, notably

through greater flexibility.

     On policy normalisation:

     The merits of gradualism and predictability are clear and well known. At

the same time, gradualism and predictability also have a downside. For example,

they may encourage risk-taking in financial markets and more leverage, making it

harder for central banks to exit smoothly. Central banks are aware of these

trade-offs and of the difficult balancing act they face.

     On keeping larger central bank balance sheets:

     First, given the pace at which central bank balance sheets will be unwound,

their size will remain larger than what is strictly necessary to guide interest

rates for quite some time.

     A second question is whether central banks could use the unwinding phase

more symmetrically - for instance, by selling the securities they now hold to

tighten conditions should the need arise. In principle, this is possible and

would result in their employing their securities holdings a bit more like an

interest rate tool, which is used in both directions. And, again in principle,

having more options at one's disposal is good. In practice, however, there are

complications. The main one is the risk of blurring policy signals - a reason

why the Federal Reserve has decided to put the unwinding on auto-pilot.

     As regards the optimal size of the balance sheet, there is no

one-size-fits-all. But having a small balance sheet has the merit of allowing

more room for its expansion in case of need. One can then think of the interest

rate as the normal tool, leaving adjustments to the balance sheet for

exceptional circumstances.

     On the limitations of forward guidance:

     Clearly, forward guidance has helped to reduce interest rates along the

yield curve further, and to that extent it has provided more stimulus. At the

same time, the tool has some limitations.

     One is that sometimes the guidance may not be fully understood. For

example, conditional statements may be misinterpreted as a commitment. Another

is that even when it is understood, the guidance may not be fully believed. For

instance, the composition of policy committees changes and you cannot bind your

successors. Similarly, the market may have a different view about how the

economy works and the outlook.

     A final issue is that the forward guidance can generate the conditions

which make exit harder, with the risk that you can get boxed in. This can arise

if, for instance, market participants' belief that the central bank will keep

interest rates low for long encourages further risk-taking and leverage, making

it harder to exit without creating disruptions in markets.

     On the limitations of negative interest rates:

     Negative interest rates have pros and cons, just like balance sheet policy.

The cons are linked, in particular, to the persistence of such rates, and are

not qualitatively different from those resulting from very low rates. What is

different is that the general public may not understand them and react badly.

The notion that one pays for the privilege of lending money is not easy to

grasp. And negative rates may foster a sense that the economic situation is

dire.

     On central banks being led by markets instead of leading them:

     This is a tricky relationship. There is always a risk that, rather than

leading, you end up being led. You should only react to short-term volatility in

financial markets to the extent that it has an impact on your ultimate

objective. But even then, you may be perceived as overreacting and as providing

some kind of assurance to the markets even if you do not intend to do so, which

then narrows your room for manoeuvre. The challenge has become tougher since the

Great Financial Crisis because of the unprecedented and difficult conditions

central banks have been facing.

--MNI Frankfurt Bureau; +49 69 97782671; email: christian.vits@marketnews.com

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