Navigating monetary policy during the Great Transition

Former premier Wen Jiabao once described China’s growth performance as “unstable, unbalanced, uncoordinated and unsustainable”. This seems like an apt description of the current global economy.
Unstable because the proliferation of popular discontent fuelled by rising income inequality amid ongoing international conflicts have greatly elevated geopolitical uncertainty.
Unbalanced because with anaemic recovery of advanced economies, much of the growth in the global economy continues to be driven by emerging markets and fuelled by leverage.
Uncoordinated because in a highly integrated world, monetary policy generates substantial cross-border spillovers yet it is being conducted with almost exclusive focus on domestic conditions.
And finally, unsustainable because a world in which up to a third of all government bonds in some advanced economies are held by their own central bank and over a third of all developed-country government bonds trade at negative nominal yields cannot be a viable long-term equilibrium.
As the old saying goes, the only constant is change. But the speed of that change is not constant. The pace of change tends to pick up around major transitions before settling down again when some sort of equilibrium is reached. The Great Moderation was a period of relatively steady change during which world output grew steadily and inflation was low and stable. The global financial crisis created
a major upheaval that led to the Great Recession. The subsequent recovery has been remarkably drawn out, and almost 10 years on, we are living through a Great Transition.
Three pivotal transitional forces shaping our economic and political landscape are the global trade slowdown, a rising contribution of the service sector to growth and the ultra-accommodative monetary policy stance adopted by major advanced economies. Together, the slowdown in world trade and the shift to services have underpinned important changes in inflation and growth dynamics.
In terms of inflation, globalisation has for many years increased the importance of foreign factors in price dynamics. Persistently low and more synchronised inflation is partly attributable to the effects of rising competitive pressures in world markets as well as common forces such as falling energy prices. The rising importance of services, especially modern and IT-based services, has also impinged on the inflation process, as their prices tend to be more rigid than goods prices. The upshot is that the link between inflation and domestic measure of economic slack has weakened and disappeared altogether in some cases.
The new trade-off
In terms of growth, slowing global trade and the rise of services imply slower and less capital intensive economic growth. Given that investment is a relatively interest rate sensitive activity, the transition to services has dampened investment, and the economy may be less responsive to monetary policy.
Finally, the ultra-accommodative monetary policy stances of advanced economies have contributed towards greater global asset price co-movements and increased cross-border financial spillovers. Global bond yields and exchange rates have become acutely sensitive to shifting expectations about monetary policy changes in advanced economies. The long period of zero or negative interest rates have also led to a building of financial positions that are justified only if yields remain low.
These developments have critical implications for the transmission mechanism of monetary policy and its conduct. On the one hand, the greater influence of global factors and structural growth headwinds may have made inflation and output less responsive to monetary policy. On the other hand, financial markets and asset prices globally have become more sensitive to monetary policy actions and communication. The relevant monetary policy trade-off at this juncture, then, is not between inflation and growth but between inflation and growth on the one hand, and financial stability on the other.
How can central banks respond?
How, then, should central banks respond to this new trade-off?
First, central banks need to expand their set of policy tools. Macroprudental tools to limit excessive risk-taking in the boom and limit losses in the bust are the most obvious additions. For emerging markets, capital flow management measures would help to alleviate excess global liquidity pressures. Moreover, central bank operational frameworks offer ways to influence certain segments of financial markets directly. The challenge going forward is to operationalise these micro and more targeted policy tools in a systematic way.
Any one set of instruments working alone is unlikely to be sufficient. Interest rate policy, macroprudential levers, and capital flow management measures all interact and their application should be viewed as a whole rather than in isolation. A national financial stability framework that brings together and assesses the whole spectrum of financial regulation serves this important function.
The second response to the more complex monetary policy trade-off is greater policy coordination. The collective outcome of central banks acting individually may be inferior because cross-country spillovers are not internalised. An implicit form of coordination holding much potential is the coordination of monetary policy frameworks.
This brings me to the third avenue for dealing with the new monetary policy trade-off, the adoption of a monetary policy framework that systematically takes financial stability into account. Monetary policy sets the price of leverage and hence has direct implications for the pricing of all financial assets and the evolution of the financial cycle.
The long lags of policy create a need for central banks to “take the punch bowl away when the party gets going”. Given the longer duration of financial cycles, the need to act well before the risks become obvious. Central banks might have to “take the punch bowl away even before the party gets started”.
Central banks may need to interpret their mandates more flexibly and avoid overly narrow and zealous interpretations of price stability. Inflation targets need to be implemented flexibly and over longer horizons. Fundamentally, macroeconomic and financial stability are two sides of the same coin. Macroeconomic trajectories cannot be sustainable if the financial sphere is out of equilibrium. And the avoidance of financial boom-bust cycles leads to better economic outcomes over the long run.
The history of economic thought in the 20th century has seen macroeconomics evolve through a series of intellectual transformations from the Keynesian Revolution to monetarism, and to the New Classical or Rational Expectations paradigm. Likewise, monetary policy has shifted through successive frameworks.
From the system of fixed exchange rates under Bretton Woods, to monetary targeting during the Great Inflation in the 1970s, to inflation targeting in the context of the Great Moderation, and finally to an assortment of unconventional monetary policies in the wake of the Great Recession. Today, as we navigate our way through the Great Transition, the search for a new framework is ongoing.

This speech was delivered at the School of International and Public Affairs, Columbia University, New York, last Wednesday.