Jaime Caruana interview with the Börsen-Zeitung

Interview with Mr Jaime Caruana, General Manager of the BIS, in Börsen-Zeitung, conducted by Mr Mark Schrörs and published on 11 April 2017.

BIS speech  | 
11 April 2017

Mr Caruana, global growth is firming and inflation is picking up. Is it now finally time for central banks to bring the era of ultra-loose monetary policy to a close?

The situation has without question improved considerably: deflation risks have for the most part disappeared, employment markets have recovered markedly, and unemployment has fallen. We're even seeing progress with the cleaning-up of banks' balance sheets. So the need for a very expansive monetary policy and continued extraordinary measures by central banks has receded. In the United States, the normalisation of monetary policy is already under away. Other countries are in a different cyclical position. Each central bank must determine for itself when would be the right moment to start exiting.

The US Federal Reserve has so far pursued a very cautious approach to normalisation while others, like the European Central Bank and the Bank of England, are sticking to their ultra-loose policies. Is that appropriate, or should the pace of normalisation be stepped up - especially given the risks of ultra-low rates, particularly for financial stability?

Central banks are moving through uncharted territory because in some cases they have resorted to completely new instruments. It is therefore right to proceed gradually and cautiously. But it is also right to move along a steady path to normalisation. The current economic situation is conducive to that. This path may prove bumpy along the way, because we don't know how markets will react. But that shouldn't be a reason to change course. It is important that now that monetary policy normalisation has begun, this process should continue. It is also important to emphasise that there are no longer just downside risks. There are currently also upside risks for growth and inflation.

Are central banks still too focused on the dangers of exiting too early and too quickly, and are they underestimating the dangers of exiting too late and too slowly?

The risks of exiting too late have probably been underestimated when one takes a long-term view - and if the consequences for financial stability are taken into account. Price stability and financial stability are, after all, two sides of the same coin.

Aren't central banks actually repeating their mistakes from the beginning of the 2000s when they kept interest rates extremely low for a long period and then raised them only very slowly - which led to the build-up of financial excesses, which in turn resulted in the global financial crisis?

If you adopt a medium- to long-term perspective - one that takes particular account of financial cycles - you find that central banks have to date acted asymmetrically: they probably don't do enough in the good times - in the boom - to prevent the build-up of financial imbalances; and during the bust, they're inclined to do too much [to ease conditions]. It would be much better to deal with financial imbalances more symmetrically. Our research shows that a more systematic approach leads not just to more stability in the financial system, but also to better results in terms of growth, for instance because output volatility decreases.

However, central banks continue to focus above all on the shorter economic cycle, and especially inflation. Some are now even arguing that, after years of inflation rates below the announced 2% target, a little overshooting should be tolerated. What's your opinion?

After so many years with below-target inflation rates, it's logical that central bankers want to be sure that this problem is solved, and also that inflation expectations are anchored. But it's also important to keep sight of the upside risks for inflation. Factors such as globalisation certainly dampen price pressure. But labour markets are tighter than they have been for a while, and protectionist measures or fiscal impulses too can fuel expectations of inflation. There are a few upside risks for inflation, and we should not be complacent about them.

So, it's risky to allow inflation to overshoot?

If central banks put off taking the necessary actions, they would have to act all the more abruptly later - and their subsequent interventions are only more disruptive for markets and the economy. They know that, and therefore I believe each of them will make their own decisions to act when needed.

Central banks are also concerned about the consequences of a more restrictive monetary policy for markets and debt servicing, not least for governments. How great is the danger of market considerations dominating monetary decision-making ("financial dominance") or fiscal policy considerations holding sway over the actions of central bankers ("fiscal dominance")?

Whenever central banks use their balance sheet as an instrument, the dividing line between monetary and fiscal policy blurs. The risk of "fiscal dominance" is real. But I am convinced that central banks are aware of this risk, and that they will act when necessary. As far as the financial markets are concerned: it's certainly a consequence of this phase of very low interest rates and massive financial market intervention by central banks that the markets have become much more dependent on central banks. That's what makes moving towards normalisation so complex. But it doesn't alter the fact that normalisation is necessary. Good communication is an important component of the task of mastering the exit. Central banks are doing a great job preparing the markets.

Really? In the United States, former central bank chief Ben Bernanke triggered serious market turmoil in 2013 with comments about the Fed's exit (the "taper tantrum"). And right now, there's a lot of confusion surrounding the future exit strategy of the ECB.

There's basically a lot of uncertainty at the moment, and some market participants will end up being surprised, though not always by the central bank. But that doesn't in any way alter the overall verdict, namely that central banks are doing a great job of communicating their plans and preparing the markets for what's coming.

So, what's your overall verdict of the crisis policy of recent years - of the bond purchases (quantitative easing, QE) as well as the zero and negative interest rates?

A final verdict will only be possible when normalisation has been completed. We're a long way off that, and from normality. As regards what we have seen so far, my provisional assessment is the following. At the onset of the crisis, central banks played a decisive role. If they hadn't responded the way they did, the crisis would have been much worse. With regard to the later phase, we have expressed concerns about how the balance of risks and rewards worsens over time: the impact of ultra-expansive monetary policy on growth declines, and the risks of that policy are cumulating. Negative interest rates have their own set of problems.

What do you mean exactly?

In particular, negative interest rates become a big problem when they persist over a long period. They increase risk-taking [but not necessarily where it is desirable]. They induce greater indebtedness. They act as a burden on financial institutions, particularly banks, and thus may affect their intermediation.

Are negative interest rates ultimately more worrisome than QE?

I don't have a comparison of that kind in mind! But seriously: whether negative interest rates or asset purchases - it is the protracted duration that is worrisome. It suggests that we are trying to solve a problem that is not solvable by monetary policy alone.

When you speak about the normality of monetary policy, do you mean a return to "the old normal", pre-crisis, with key interest rates as a central instrument, or are asset purchases and other market interventions in the final analysis a "new normal"?

I hope and I think that the extent of financial market interventions, as seen in recent years, is not a "new normal". Such heavy interventions blur market signals and distort markets. Only in a really exceptional scenario, such as the one we had in the crisis, should something like that be an option. Thus, I think there is merit in eventually reverting to the more traditional management of short-term interest rates - but improved with the experience gained during the crisis.

Is there a need to put the strategies and targets of central banks to the test? A few central banks are even making statements in this direction and pleading for instance for inflation targets higher than 2%.

The biggest contribution that central banks can make to welfare is, as before, to ensure stable prices. But price stability is closely linked to financial stability. The biggest challenge for central banks is thus to integrate financial stability considerations into their decision-making processes. One possibility is that they lengthen their time horizons. Another is that they use existing flexibilities in their policy mandates. That obviates the need for any major changes to mandates and/or targets. However, in the event that there is not enough flexibility, mandates and/or targets could be reconsidered [to give more flexibility]. I don't see any merit in higher inflation targets. I'm just not convinced by that idea.

What do you mean by flexibility in concrete terms? A not too narrow focus on exactly 2%?

When a central bank sees financial imbalances building up, it may raise interest rates, even if there is no inflationary pressure - that's what it's about. That's not been the usual way people think about monetary policy, and that has to change in future.

What do you think of the notion of making central banks more rules-based? In the United States, there are plans to tie the Fed more closely to the Taylor rule.

In principle, I have sympathy for such rules. They can serve as a useful point of reference for monetary policy. But they are too simplistic and broad-brush to become a fixed guideline for central banks. Such rules may fail to portray many of the situations in which central banks may find themselves, or found themselves during the crisis. Central banks need flexibility.

There is also a debate about the independence of central banks. How concerned are you by it?

In the current juncture, characterised as it is by a great deal of political uncertainty, it is all the more important to preserve central bank independence. Central banks have to be independent of political cycles, interest groups and financial markets - but also be accountable.

The protectionist economic plans of US President Donald Trump have given rise to fears of a trade or currency war. Is there a danger that the world will fall back into a situation like the 1930s?

Protectionism and populism are certainly not the right solution to our problems. For that reason, it is very important that we continue to issue reminders of the benefits of free trade and all the other developments that have supported global economic growth over the past 40 years. At the same time, it is fair that we should concern ourselves more intensively with those who don't profit equally from globalisation, technological changes, etc. But protectionism is the wrong way to go.

In their latest statement, the G20 nations have not reiterated their earlier rejection of protectionism - because of the US government. Is that not worrying?

This is indeed part of the extreme political uncertainty that we're currently observing. But I hope and I trust that this uncertainty will be resolved in a positive way. It's certainly positive that the G20 statement has re-emphasised the need to avoid competitive devaluations.

And how concerned are you by Trump's plans for a deregulation of the financial sector? Can a new wave of global deregulation sow the seeds for the next financial crisis?

Again, there is uncertainty. From what we've been hearing via the media so far, such plans seem to refer mainly to specificities of the Dodd-Frank Act and forms of compliance relief for smaller banks. They do not seem to be about revoking the global consensus on financial regulation or international standards, which are minimum standards and continue to play an important role by levelling the playing field and improving the efficiency and safety of the global financial system. Much has already been achieved [in terms of regulatory reform], and banks are today much better off - most have long met the global minimum standards or exceeded them. At the same time, though, there are risks and there is absolutely no reason to be less on one's guard or to turn back the wheel of financial regulation. I am therefore also confident that the Basel Committee on Banking Supervision will soon conclude the negotiations on Basel III.

Why are European banks actually still lagging so far behind their US competitors?

You can't lump all European banks together. But it's certainly the case that, in the United States, bank balance sheets have been cleaned up more quickly and more consistently. In Europe, there are for instance still a lot of bad loans. US banks have also adapted their business models more rapidly. Moreover, there is overcapacity in the European banking sector. And, of course, negative interest rates are weighing down on European banks' business.

Under Trump the US seems to be setting less store by multilateral institutions or global cooperation, whereas the BIS has lately been calling for increasing cooperation among central banks.

Central banks have a strong sense of cooperation. But we need more than that. From our perspective, the most important thing is that the international consequences of national monetary policy decisions, meaning spillovers and spillbacks, be internalised in the processes concerned.  In certain cases, central banks may want to reinforce their actions with some coordination, as occurred in the past. Furthermore, central banks may ultimately want to develop some common rules of the game for how to deal with excesses on the global financial markets. That is certainly the most difficult aspect, and not feasible at present. That's something we need to think about and develop for the future.

How great do you judge the risk of a debt and financial crisis in China to be - and its potential implications for the global economy or global financial system?

Credit growth in China has been very rapid over the past few years. Risks obviously exist - it is a vulnerability. But it is very difficult to predict in what direction this will develop. The authorities are aware of the problem and are steering against it. As for financial linkages with the rest of the world, the exposures of banks to China are comparatively small. However, what's more worrying are the trade effects - China is a globally important trade partner.

And what about Brexit?

I am of the opinion that more integration is good for everyone. On that count, Brexit was obviously not good news. What's more, there is great uncertainty surrounding the negotiations that are getting under way. That will be a very difficult phase. But I don't view Brexit as a major risk for the global economy.

So, where do you currently see the greatest risks for the global economy or the financial system?

There is a series of risks. In some emerging market countries, financial cycles are far advanced, and if these end abruptly, there may be turbulence. In the industrialised countries, we have to go through the process of normalisation, which may not be easy. Worldwide, overall indebtedness has increased further and is now markedly higher than before the financial crisis. At the same time, productivity growth is low. That is not a good combination. A particular risk factor in this is also dollar indebtedness outside the United States, especially at firms in emerging economies. We are therefore concerned by excessively abrupt movements in the dollar exchange rate. When the dollar appreciates strongly, it puts great pressure on this set of borrowers. And finally, there's the high degree of political uncertainty.

Indices of global political uncertainty are at all-time highs, but at the same time volatility indices such as the VIX are very low. Are market participants too optimistic and complacent?

That is a strange phenomenon. On the one hand, we are seeing considerable uncertainty; on the other, a good deal of optimism. Market players are possibly not factoring in all risks properly, and thus there might very well be surprises and corrections. But basically, it's also very difficult to manage political risks, risks with bimodal distributions. So, instead of speculating what the future will bring, it would be better to improve resilience. That applies at the level of individual firms or banks, but also for entire countries.

Is there at present a danger of a bond market crash, similarly to 1994 when the Fed embarked on a cycle of raising interest rates?

There are a few similarities: a very long period of very low interest rates and the start of a normalisation process, beginning in the United States. But at the same time, there are also enormous differences. The biggest difference is that central banks today know how important communication is. In 1994, the Fed surprised the markets. That's different today. Therefore I'm not expecting a repeat of what happened back then. Nevertheless, there is of course the risk of a snapback - that is, that market rates will very suddenly start going up very quickly.

One final question to you as a committed European who gets around a lot: does the world occasionally have an overly pessimistic view of Europe and the euro zone?

That's certainly partly the case. I see it more positively. I recently read about the history of integration in the United States. It took them more than 150 years to attain full integration. In Europe, we have achieved a lot a good deal quicker. We should therefore be proud of what we have accomplished. At the same time, we mustn't forget that there's still much work ahead of us.