US Monetary Policy and East Asia

I visited Korea earlier this summer and gave a talk on effects of U.S. Tapering on Emerging Markets.  (This was also the subject of comments at an Istanbul conference sponsored by the NBER and the Central Bank of Turkey in June.)

An interview on the effects of policy at the Fed and other advanced-country central banks on East Asian EMs now appears in KRX magazine (in Korean), August. Here is the English version:

Special Interview with  Jeffrey A. Frankel <KRX MAGAZINE> August

Q: On 10 June 2014, Federal Reserve Bank of Boston President Eric Rosengren said in a speech that the Fed’s “new” monetary policy tools, including forward guidance and large-scale asset purchases, were “essential” in ensuring the economic recovery in the United States. What do you think about the ‘ongoing’ U.S’s ‘Tapering’ policy? And what is your idea about appropriate “new” monetary policy?

JF: The authorities in the US and other countries were in 2008 faced with a challenge greater than any since the Great Depression of the 1930s. After they reduced short-term interest rates to zero, the “Zero Lower Bound” meant that they had exhausted their conventional monetary tools and it was indeed necessary to turn to “new” monetary policy tools, specifically Quantitative Easing (QE), in its various forms, and forward guidance in its various forms.  For one thing the use of these tools has worked to keep long-term interest rates lower than they otherwise would be.  I think that they have done a good job.  (One mis-step was the Fed decision two years ago to phrase forward guidance in terms of the unemployment rate; it has since had to abandon that guidance because an unexpectedly rapid fall in labor force participation reduced the unemployment rate more quickly than the economy recovered.)  A second Great Depression was averted in 2009 because of the policy responses in three areas: unfreezing of the financial system, fiscal stimulus, and the monetary expansion.

I also think that the tapering of QE, before the Fed is ready to start raising short-term interest rates, is appropriate. It wants to reduce the rate of growth of the monetary base, and eventually perhaps reel some of it back in, before the economy is fully operating at normal capacity and banks are ready to resume converting all of their excess reserves into loans. (If they were to wait too long, long-standing warnings of inflation might eventually acquire a germ of truth that they have previously lacked.)

Q: A World Bank policy research working paper “Unconventional Monetary Policy Normalization in High-Income Countries” noted that “volatility and eventual tightening of global financial conditions” related to policy normalization and “the possibility of a sharp slowdown in China”, represent major risks to the regional outlook. What do think about the meaning of ‘normalization’?

JF: There are always risks to the world economy and it is always wise to consider them ahead of time.  I agree that high on the list of possible risks to the world economy in general and to emerging markets in particular is a loss of enthusiasm on the part of international investors, which could arise either from a return to “risk off” mode, from an increase in US interest rates, from a hard landing in China, or from any combination of such factors. We saw some of this in the “taper tantrum” of a year ago. Another possible risk is a worsening of conflict in parts of the Mideast.

Regarding the meaning of “normalization,” there are some who think that the “new normal” is interest rates that will remain low indefinitely far into the future I am a bit skeptical of this proposition. But it doesn’t really matter how far interest rates eventually rise in the US and other major advance economies; the danger of a sudden stop of capital flows to Emerging Markets should be contemplated regardless.

Q: Market experts warned emerging markets that the next financial unrest situations may catch them off guard, recommending smaller budget deficits, higher interest rates and measures to boost productivity. Speaking of developing or emerging market countries, what approach is the best preparation plan?

JF: Some emerging market countries have learned from the mistakes of the past and from the crises in the 1980s and 1990s, and have adopted policies that leave them less vulnerableto shocks in the global system. These include exchange rate flexibility, holding plenty of foreign exchange reserves, avoiding debt that is excessively short-term, dollar-denominated, or bank-intermediated, eliminating current account deficits, and adopting strong andcounter-cyclical fiscal policy.  (Hardest of all are structural measures to improve productivity growth, such as labor marker flexibility and trade liberalization.)  In the last five year, however, there has been some backsliding, notably the return of large current account deficits in some countries and dollar-denominated debt in the corporate sector.

Q: On 5 June 2014, The ECB cut interest rates to record lows, imposing negative rates on its overnight deposits, meaning that banks will have to pay to leave money in the bank. But Market experts said that developing countries can expect rising interest rates. What do you think?

JF: Ever since 2010, most developing countries have experienced substantially stronger growth than the advanced economies, and indeed many have had problems with overheating and inflation.  Thus it has been perfectly appropriate that countries such as Brazil, for example, have had higher interest rates than the major advanced countries. Beyond this, the ECB and the Bank of Japan have seen the need to pursue new rounds of monetary easing over the last year, at a time when the Fed and the Bank of England are beginning to think about raising interest rates. But it apparently remains true that the Fed’s actions have a greater immediate effect globally than does the ECB’s actions, even though the euroland economy is as big as the US, probably because of the reserve-currency role of the dollar. So it would be prudent to expect that world financial conditions will get a bit tighter next year.

Q:  Asian central banks (especially China and Japan’s) are delaying a normalization of interest rates, either having to play catch-up when the US Fed starts to increase – or, worse, suffering a financial bust. What is your opinion?

JF: Most likely, when the Fed starts to raise interest rates, it will put downward pressure on the currencies of China and Japan.  Many countries would not want downward pressure on their currencies and would feel a need to raise their own interest rates correspondingly, so as to remain attractive to international investors. But China and Japan would be rather happy to see their currencies depreciate under circumstances where they cannot be blamed for it.  So I don’t see a problem for them.  This is not to rule out a worsening of their own problems on other grounds, particularly bad loans in China’s shadow banking sector and very high public debt in Japan.

Q: I see a direct correlation between “Fast normalization” and long-term interest rates. What is this point of view? What do long-term interest rates say about economic policy?

JF: How are long-term interest rates determined, given short-term interest rates?  The expectations hypothesis of the term structure of interest rates focuses on the extent to which market participants expect short term rates to go up in the future.  The portfolio-balance model focuses on the supplies of bonds that have to be held.  Both theories have some truth to them. Forward guidance works through the first channel while QE works through the second channel.  Both have helped keep long-term interest rates down.  But if markets expect “fast normalization,” that will immediately reverse the downward effect that forward guidance has had.

Q: Market analysts generally divide into two sides by country. Some urge reinforcing global coordination, further strengthened in the context of the Group of 20 (G-20). How long does this classification standard remain valid?

JF: The line between emerging market countries and industrialized economies has become blurred. Korea’s income per capita puts it even with some European countries and Singapore’s income is ahead of most of them. The same inter-shuffling of country categories is true by other criteria, such as credit ratings.  Meanwhile, within the category of developing countries, we need a line between Emerging Markets and Low-Income Countries, but it too is very hard to define.

Regardless, the distinction between the advanced economies and the others is still useful. Indeed, the uncoupling of the two categories of economies has been in evidence since 2010.

Policy-makers in some G-20 countries have called for greater coordination of macroeconomic policies, and in particular for the Federal Reserve to take their interests into account when setting US interest rates.  I am skeptical of the complaints that go under the name of “Currency Wars.”  The main point of floating exchange rates is so that the United States can set its interest rate at the level that is appropriate for its economy and Brazil or India can set their interest rate that is appropriate for theirs.

But I am sympathetic to the point that the big Emerging Market countries should be given more weight in the institutions of global governance.  The introduction of the G-20 itself, and its supplanting of the G-7, was a step in the right direction; so was the negotiation in November 2010 (at the G-20 summit in Seoul) to shift some IMF quota share weight from European countries to large EMs.  President Obama deserves some credit for this.  Unfortunately, the myopic US Congress refuses to ratify the agreement, in a foolishabdication of global leadership.

Q: In that way, China is very special country in the ‘emerging’ group. China has great influence in developed countries’ markets as well as emerging markets. What do you think?

JF: Yes, this is true.  I have pointed out that claims of China’s GDP surpassing US GDP are premature.  Nevertheless, its growth over the last few decades has been truly miraculous.  It will probably take the “# 1” position in terms of economic size around 2021 or so.

Q: Developing countries should further enhance policies supporting private saving and intermediation via domestic financial markets, hence reducing exposure to volatile external capital flows. Could you explain more specifically?

JF: Countries that maintain persistently high rates of national saving tend to grow faster than others and also to be less exposed to financial crises. National saving includes both public saving (government budget surplus) and private saving (household plus corporate). Public saving is under the control of the government. It is much harder for policy to control private saving. But one successful example is Singapore’s history of “forced saving.”

Well-functioning financial markets can contribute to the level of private saving and, especially, to its efficient allocation to high-return investments.  As is often pointed out, financial repression (oligopolistic or government-owned banks that pay savers interest rates lower than inflation and an absence of alternative places for them to put their money) is an obstacle to well-functioning financial markets in many countries.  On the other hand, simple sweeping financial liberalization is not the right answer.  Prudential regulation of banks and other financial institutions is necessary, to minimize cycles of excessive credit booms followed by bank runs or other kinds of financial crash. I admire some of Korea’s macro-prudential regulations, such as loan-to-value limits for home mortgages. I wish we had more of that in the United States.

Q: Jan Dehn of investment house Ashmore told the Financial Times. “The idea that EM (Emerging Market)’s have benefited from QE (Quantitative Easing) is nonsense – they haven’t gorged themselves on cheap money. Most QE money has gone to developed markets. EM is incredibly boring. Growth is being achieved through cyclical means, not cheap money”. What do you think about?

JF: That the US or other advanced countries still invest more in each other than in emerging markets does not mean that QE or other US investment or financial conditions among the advanced world are unimportant for emerging markets. They are very important. For example, US attitudes towards risk as measured by the VIX index are probably the most important single variable for determining capital flows to emerging markets.  But as some point out, these capital flows can have negative effects alongside the positive effects.

If the question is the importance in advanced economies of monetary policy compared to other determinants of growth, such as fiscal policy and structural reforms, I agree that the latter are probably more important. Some of the short-term vicissitudes of perceived Fed policy do receive more attention than they deserve. But, again, this does not mean that monetary policy does not matter..