Easing has induced easing

Interview with Mr Claudio Borio, Head of the Monetary and Economic Department (MED), in Börsen-Zeitung, conducted by Mr Mark Schrörs and published on 25 August 2015.

BIS speech  | 
02 September 2015

Mr Borio, China is on everyone's lips at the moment. There are increasing concerns about a "hard landing" of the economy and a bursting of the credit bubble. How worried are you about the recent developments? Do you see a risk that China could be the starting point of the next global recession or the next global financial crisis?

For quite some time now, a number of countries that escaped the global financial crisis largely unscathed have been exhibiting symptoms that are qualitatively similar to those that prevailed pre-crisis in those countries that would later be hardest hit by it: strong credit expansion and a strong increase in asset prices, especially property prices, on the back of high risk-taking and, for some, of the commodity price boom. These are symptoms of a strong financial boom that typically leads to a bust, with possibly large macroeconomic costs. This is true in particular of a number of emerging market economies (EMEs), including some of the largest, but also, to a lesser extent, of some advanced economies. China is one of these countries. We have to watch this very closely.

So there is a reason to worry globally?

The EMEs' heft in the global economy has increased substantially since the Asian financial crisis. So, should they run into trouble, the impact on the rest of the world would be larger. There are some positive developments suggesting that, in several respects, many EMEs are in a better shape than they were at the time. They have better macroeconomic policies, including greater exchange rate flexibility, they have strengthened their financial infrastructure and financial regulation, notably through macroprudential measures, and they have greatly increased their foreign exchange reserves. But this is no panacea against crises.

Regarding China, some observers argue that the link between the Chinese financial system and the global financial system is weak and that, because of that, there is no risk of a global financial crisis as in 2007-08.

I don't want to speculate about the next big crisis. But I would caution against underestimating the financial linkages. And, of course, China has a major impact on trade and commodity prices. Moreover, it is shared vulnerabilities that matter most.

You have mentioned greater exchange rate flexibility as an indicator of strength. Does that mean you welcome the new exchange rate regime in China? This has initially led to a depreciation of the renminbi - which has induced concerns about an intensified "currency war".

The fact that China is structurally moving towards a more market-oriented exchange rate regime is without doubt a positive development. The more general question is how the depreciation of the renminbi fits into the bigger global picture we have been seeing for some time.

And what is your answer?

In general, exchange rates can redistribute growth - from faster-growing to slower-growing countries. When they do so, this is positive. It is also natural that the exchange rate has come to play a greater role in monetary policy since the financial crisis: in the countries that have been hardest-hit by it, and with interest rates pushed so low, domestic transmission channels have been impaired. But the problem is that, in general, currency appreciations have not been welcome. The consequence is that easing has induced easing.

And in the end there is competitive devaluation and a race to the bottom when it comes to interest rates.

Some people argue that the world economy has been suffering for quite some time from a large deficiency of aggregate demand and hence that this exchange rate-induced generalised easing  has been good for the world economy. At the BIS, we have a different view because we are more focused on medium-term financial booms and busts: instead of being a positive sum game, the process can be a negative sum game. The expansionary monetary policy has been transmitted to countries that did not need it, fuelling financial booms there.

The cooling-down of the Chinese economy and the depreciation of the renminbi have also led to concerns that global inflation, which is already very low, will be dampened further. What is your view on that?

Sometimes we seem to believe that we know more about the inflation process than we actually do - we do not fully understand what drives it. Having said this, at the BIS we are of the view that global factors have often been underestimated. We think that there are still significant disinflationary forces coming from technological progress and, above all, the globalisation of the world economy. These secular factors are headwinds that have held inflation down despite very easy monetary policies. But these are welcome supply side forces, which support the economy . On top of that, there are some cyclical factors at the moment.

For example, the oil price, which nosedived in 2014 and which has fallen again recently after it had recovered somewhat earlier this year.

In our judgment, until recently at least, this has largely been a supply side story. As highlighted in our Annual Report, OPEC's decision not to cut oil production despite the price collapse was seen as a regime change. More recently, perceptions of demand weakness seem to have been playing a bigger role.

So renewed deflation concerns are exaggerated?

We have done a lot of work here on deflation episodes in history. One main message is that the link between falling goods and services prices and output growth is very weak. The only evidence comes from the Great Depression. Nor have we found evidence of so-called "debt deflation", meaning a negative spiral between the price level and debt. By contrast, the data indicate that asset price deflations, especially property price falls, are more costly and that what is dangerous is a downward spiral between property prices and debt.

Does that mean that central banks should not overreact - even if inflation rates will go down again in the near future?

When calibrating a response, central banks should always look closely at which factors are influencing prices. Our research simply suggests that, when disinflationary forces reflect positive supply side factors, they are benign. And it also indicates that deflation is no red line in the sense that, if you cross it, you fall into the abyss. More generally, it suggests that there is also a case for paying greater attention to financial booms and busts,  and hence to the longer-term consequences of the response.

After years of low inflation rates, some observers are already saying inflation is "dead".

This is by no means true. A number of countries have high inflation rates. To  assume inflation is "dead" is the best way to make sure that it will become a big problem again.

For years, the Bank for International Settlements (BIS) has been calling for policymakers to shift away from a short-term focus on macroeconomic variables like production and inflation and to adopt a longer-term perspective, including one that pays more attention to the financial cycle. But the central banks' decisions are still very much dominated by the former. How frustrated are you by that?

We have to distinguish a couple of aspects here. As regards thinking, there has been a shift. It had already started before the financial crisis, but it intensified after it. It is now recognised that financial stability is very important. And many central banks are now of the view that very low interest rates for a very long time can raise financial stability risks. The other issue is how best to respond.

And here there is hardly any visible change.

I think that things have also shifted a little bit. But you are right: many central banks believe that it is exclusively the task of macroprudential regulation and supervision ...

... which focuses on the financial system as a whole ...

... to deal with these risks. We do not share this view: financial booms are too powerful to be constrained through macroprudential measures alone. Their active use, for instance, has not prevented the emergence of signs of financial imbalances in Asia.  In comparison with central banks, at the BIS we have the luxury of not having to press the button and of not facing the constraints of national mandates. This allows us to see the picture from a different perspective. And our institutional duty is to say what we think is right.

Some experts say financial stability should become an explicit mandate for central banks.

The first priority should be to use as much as possible the flexibility that the existing monetary policy  frameworks provide - even if we are aware of the serious political constraints and communication challenges. A lot depends on how central banks judge the potential trade-offs. Changing the mandate should not be taboo, but should only be done as a last resort.

The BIS is always warning of the risk of overburdening central banks. But is there not also a risk that central banks could become overburdened if they also had to safeguard financial stability?

No, I don't think so. Safeguarding financial stability is a natural central bank task, and it cannot be performed fully successfully by others. Monetary policy has a huge influence on financial markets, and hence on financial stability; it can thus effectively complement macroprudential measures. And this would also bring central banks closer to their origins. What I worry about is something completely different.

That is to say?

It is the growing perception that central banks can be the answer to all our economic problems. The great danger is that more and more people come to believe that everything can simply be solved with money and that central banks can produce infinite amounts of it. This could cause big problems in the future. This is why we insist that people should demand less from central banks and that structural policies should play a much greater role.

At the moment, the Fed is heading for a first interest rate increase after six and a half years of a zero interest rate policy. The IMF has warned against possible turbulences in financial markets. Do you also see a risk that the US interest rate reversal could jolt financial markets?

The Fed will increase the interest rate only when it thinks that the US economy is strong. That strength would help the world economy. In addition, to minimise the shock, the Fed has almost preannounced this step and been very cautious in its communication - not only regarding the "lift-off" but also regarding what it will do thereafter. But in assessing the impact, we should bear in mind that, as noted earlier, there are financial vulnerabilities in the global economy. And in the past, a monetary policy tightening in the US and an appreciation of the dollar have triggered turbulence in EMEs. This has to do, in particular, with the special role of the dollar.

The dollar is the world's dominant currency.

Yes, as such, the US sets the tone for global financial markets. And, more directly, financial conditions there have an impact because many borrowers around the world - in more recent years, especially companies - have heavily borrowed in dollars. For instance, since early 2009, the amount of dollar credit to non-banks in EMEs  has almost doubled.

Because interest rates have been so low for so long in the US.

Yes, interest rates have been exceptionally low for an exceptionally long time. This is unprecedented. And it has led to aggressive risk-taking in financial markets. Furthermore, many of those who are active in the financial markets now have no first-hand experience of how to respond to rising interest rates: they were not even around the last time it happened. But having said all this, one thing is also clear: the longer the interest rate reversal is delayed, the riskier the situation will become.

The Fed has announced that it will increase rates very gradually. Between 2004 and 2006, it also tightened very gradually, raising interest rates by 25 basis points per meeting. A lot of people are saying that this contributed to the financial excesses that led to the financial crisis. Do you see the risk that the Fed is repeating a mistake?

There is a tendency to emphasise the risk of acting too early and too strongly at the expense of the risk of acting too late and too gradually. This can be dangerous. Raising interest rates too late and too slowly can fuel financial booms, and the following busts can be highly damaging. It is also very important to keep a steady hand when normalising monetary policy, and not to be deterred by spikes in short-term financial market volatility. This volatility may be inevitable given the initial conditions.

In its recent Annual Report, the BIS calls for more central bank cooperation, even including joint decisions on interest rates and exchange rate interventions. Do we need a new Bretton Woods?

No, that's not the point. But a key drawback of the existing international monetary and financial system is that it tends to heighten the risk of financial imbalances. First of all, we call for an enlightened self-interest. Central banks should take better account of the consequences of their decisions on others, especially because these will have repercussions on their own economy ("spillbacks"). This enlightened self-interest is particularly important for countries with an international currency. They have a special responsibility.

But this is not always sufficient from your point of view?

We should also not exclude the possibility of joint decisions. We have seen this in times of crisis. But it could also make sense for crisis prevention. And then, ideally, once could even go one step further. Policymakers around the world could agree internationally on common rules constraining national policies. This would increase discipline on a national level.

Do you think this is realistic?

At the moment, this is not on the cards. But national frameworks do not sufficiently take into account financial booms and busts. If they did, this would remove a major source of negative international spillovers. This would significantly reduce the need for further cooperation, but not eliminate it. To move in this direction, we need greater agreement on diagnosis.

And in the end, would one also need a global central bank? Some experts have pushed this idea from time to time.

No, this is out of the question. We know how difficult it is to have a central bank covering a number of very different economies. The euro area is an example of this. It is neither feasible nor desirable to have a world central bank.

A lot of observers say the problems in the euro area are the consequence of the fact that it is a monetary union without a fiscal or a political union. Is a political union a precondition for a successful monetary union?

To succeed, the euro area needs a high degree of economic integration and a clear political commitment to the project and to common rules. These rules have to be consistent with the agreed level of solidarity. That does not necessarily mean a political union.

In financial markets, there are concerns about reduced market  liquidity, also as a consequence of large-scale asset purchases by central banks. How worried are you?

One point is clear: it is unrealistic to assume that markets will remain liquid even if one-sided order imbalances develop, as a result of, say, a fundamental rethink on the part of market participants of where prices should be. No one wants to stand in the way of an oncoming train . What worries us more is the "illusion of liquidity" in good times, meaning that investors may come to believe that there will always be enough liquidity for them to get out in time. This, in turns, fuels risk-taking and increases the likelihood of market stress. Even then, what is crucial in the end is whether problems in the financial markets stay in financial markets or spill over to the real economy, causing lasting damage. There is a risk of overreacting to spikes in financial market volatility.

And what about the role of central banks?

If central banks engage in large-scale asset purchases, it is quite possible that they may reduce liquidity in some market segments. They are aware of this risk, and they are trying to minimise it. But what matters more for me is the risk that market participants may increasingly come to perceive central banks as "buyers of last resort", as it were. This can increase risk-taking und thereby contribute to the illusion of liquidity.

Isn't it already a fact that market participants perceive central banks as "buyers of last resort"?

The idea of a "central bank put" has often been raised - meaning that central banks will always come to the rescue if markets come under stress. Central banks have clearly said that this is not the case: they would tailor the response, if at all needed, to circumstances.  But this does not yet seem to have been fully recognised by everybody.

There is also much discussion about the increasing importance of asset managers for financial markets. How big is the risk stemming from this development?

We have to watch closely how the structural shift from banks to capital markets in general, and the boom of the asset management industry in particular, change market dynamics. The much greater heft of the asset management industry could lead to sharper market movements. The high size concentration of the industry may play a role, but what matters more is common behaviour across funds, when they tend to move in the same direction. This herd behaviour could have big implications.

Allow me to ask a "heretical" question at the end: You have said that we do not know as much about inflation as we had thought - and this is also prominent in the BIS Annual Report. But at the same time, we are only in the early stages of developing an understanding of the financial cycle. Does that mean that central banks at present hardly know what they are doing?

No, I would not put it this way. Like everyone else, central banks are doing their best to understand what is going on and work out how best to respond to it. But at the moment, this is not that easy. Therefore, it makes sense to adjust decision-making processes to take full account of this uncertainty. The worst mistakes in history have been made when people assumed they knew much more than they actually did - that they had finally found the right answers. There is a need for modesty and humility.