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--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:
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
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
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
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: email@example.com