• China relaxes outward capital movement restrictions, see Bloomberg article and Brad Setser comment on new ways to manage China 1 trillion dollars reserves.

“Chinese companies and individuals will be allowed to convert more yuan into foreign currencies to buy overseas stocks and debt, while rules are tightened to limit short-term capital inflows, the government said. The central bank will mix monetary policies to soak up excess liquidity in the banking system and slow 2007 money supply growth to 16 percent, from last year’s 16.9 percent.”

  • William Poole, St.Louis Fed President, speech on government sponsored enterprises (Fannie Mae, Freddie Mac and 12 Federal Home Lona Banks). It ends on the following note:

“I began this speech noting that the Federal Reserve has a responsibility to maintain financial stability. That responsibility includes increasing awareness of threats to stability and formation of recommendations for structural reform. I do not believe that a GSE crisis is imminent. However, for those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic history.”

  • Lorenzo Bini Smaghi, ECB Executive Board Member, speech on global capital and national monetary policies. Below I list this part of the speech that deals with implications for monetary policy.

“It obviously makes a lot of difference for the conduct of monetary policy if the reduction in real long term interest rates that we have been observing recently is the result of an equilibrium phenomenon, derived from real developments, or reflect excessive monetary creation by central banks. In other words, it makes a difference whether the high level of global liquidity, defined as an abundance of liquid assets in circulation worldwide, is an endogenous or “equilibrium” phenomenon, related to globalisation and its incomplete nature, or an exogenous (or “disequilibrium”) one, engineered by central banks. [23]

In the first hypothesis, monetary policy should not try to counter or to react to such a phenomenon, but rather accommodate it in order to avoid creating a disequilibrium. In particular, if the lower level of long term interest rates is the result of a general equilibrium development at the world level, mainly produced by a rebalancing of savings-investment behaviour and by other “real” and demand side effects, it should not add to inflationary pressures that would require any counteracting measure by central banks.

In the second hypothesis, instead, the low level of long term interest rates would signal an excessively accommodating monetary policy over the medium term that would sooner or later translate into higher inflation. This would require, ceteris paribus, a tightening of monetary condition that would lead to a relatively flatter yield curve, or even more inverted one, than might otherwise be the case.

The key questions are: what is the correct hypothesis for the conduct of monetary policy? What is the appropriate policy response to the current global developments? In what direction should the central bank react?

As mentioned in the introduction, the answer has to be based on the fact that we have an imperfect knowledge of the overall impact of globalisation on our economies. In the absence of a fully fledged model that allows us to estimate the effects of the different factors, related or unrelated to globalisation, we have to rely on indicators to assess the plausibility of the different hypotheses.

One could argue that the task of central banks should be easy, since the discriminating fact between the two explanations is ultimately inflation. If inflation remains lastingly low even in the presence of low short-term and long-term interest rates, then one could safely conclude that we are in the presence of an “equilibrium” development related to globalisation. If inflation picks up, then the second story, related to excessive monetary creation by central banks, turns out to be the right one. Unfortunately, central banks cannot afford the luxury to wait for inflation rising. Since monetary policy affects inflation only with a lag, they have to analyse a number of indicators which could shed some light on the relatively plausibility of the two explanations.

Therefore, I will look at a few indicators with the objective of estimating the relevance of the different hypotheses and derive an assessment of the appropriate response for monetary policy. This exercise has to be seen just as a stimulus for further research and discussion on this matter.

Let’s look first at the hypothesis that the low level of long term interest rates has been produced by the very expansionary monetary policy conducted in the major countries during the last few years.

Some indicators seem to confirm this hypothesis.

First, simple correlations between interest rates and underlying economic developments, such as those implied by Taylor rules, suggest that in the recent downturn monetary policy has been more expansionary than in the past. Second, the behaviour of monetary and credit aggregates, not only in the euro area but also at the global level, seem to confirm the ample liquidity prevailing in the current cycle. A third indicator that would confirm this hypothesis is asset price inflation, although this phenomenon may also be explained by other factors. The survey of banks’ lending behaviour in the euro area also suggests that financing conditions have been very favourable in recent years. Finally, monetary conditions have been quite accommodative not only because of domestic policy decisions but also as a consequence of carry trades, which have transferred easy monetary conditions from one area to another.

What remains to be explained is how expansionary monetary conditions have systematically affected real long term interest rates. In deep and liquid markets it should not be easy, even for a central bank, to distort the shape of the yield curve. This seems to be confirmed by the failure already in the late 1960s of “switching” operations conducted by the Fed aimed at lowering long term yields.[24] Carry trade operations, i.e. borrowing short and lending long, could be systematically profitable and affect long yields only in the presence of imperfect markets, in which long term rates do not reflect the expectation of future short term rates. On the contrary, liquidity premia seem to have fallen as markets have become more efficient in spreading risk across financial agents.

In the same vein, given the size of the markets, especially the US one, it is difficult to understand how cross currency carry trades can affect the long end of the market in the latter country, without provoking major exchange rate adjustments, in particular for the low rate currency. Some weakness of the yen has been observed, but hardly to an extent that would be consistent with a significant lowering of US yields. Again, for the cross currency carry trade to have a significant impact on long term rates, presumes that the open interest rate parity would systematically not hold, something which is still very controversial empirically.

An apparent paradox is that, with the tightening of monetary conditions, started in the US and then in the Euro area, the problem does not seem to have vanished. On the contrary, the whole question of the so-called conundrum has emerged while monetary accommodation was being withdrawn, in particularly in the US. One possible explanation for the paradox could be that monetary conditions have been tightened much less than what the increase in interest rates would suggest, given the underlying strength of the economy. Another explanation could be found in the cross-currency carry trades mentioned above, that have partly offset the effects of the monetary tightening.

Another issue to be understood is what has happened to the cumulated amount of liquidity injected in the financial system during the trough of the cycle, which doesn’t seem to have been reabsorbed with the rise in short term rates. What is the impact of a possible monetary overhang on real long term rates, and – more importantly – why is excess liquidity not translating into higher inflation, after due lags are taken into account?

Part of the response might be that the inflationary impact of growing liquidity has been compensated by the deflationary effects produced by cheaper imports, a factor also associated to globalisation. However, some empirical analyses suggests that these effects have been rather limited, and to some extent counterbalanced by the inflationary effect produced by higher oil and commodities prices.

Let’s look now at the alternative hypothesis that globalisation and real factor effects have led to a reduction in long term real interest rates.

This hypothesis seems to be confirmed by several indicators and analysis.

First, there appears to be some evidence of the negative correlation between oil prices and real interest rates over the past couple of years. This is consistent with the intuition that higher oil prices reduce the long term growth potential in industrial countries and the recycling of oil revenues further contribute to increasing the demand for assets in advanced economies.

Second, there is also evidence that the large flow of savings from emerging market economies has largely been held in liquid assets, adding to monetary holdings by financial institutions in industrial countries. The inability of the latter to invest equivalent amounts in FDIs or real assets in developing countries has led to an increase in the preference for liquidity in advanced economies’ financial systems. The flow of capital into the long end of the capital markets has increased financial deepening and has also affected the short end of the markets. To be sure, the lower return on long term assets has increased the preference for monetary assets.

There is also some evidence that other structural factors, such as demographic trends, might have had some impact on long term rates, directly and through the effect on the preferences of institutional investors.[25]

The increased liquidity of economic agents does not seem to have affected investment and consumption behaviour in a way that would suggest a different pattern compared to previous cycles. For instance, although in the euro area firm’s borrowing and liquidity position has increased substantially in recent years, also thanks to the low level of interest rates, there is no evidence that investment is behaving substantially differently than in past cyclical upturns. Similarly, although consumer borrowing has increased at a very fast pace, and assets prices have increased substantially, there is no evidence yet that aggregate consumption is more dynamic in the current cycle than in previous ones. This would suggest that the stimulating effect produced by lower interest rates on consumption and investment might be compensated by other (real) effects, directly or indirectly linked to global developments, which might also explain the increasing preference for liquidity by economic agents in our economies.

To sum up, there is some evidence in favour of both hypotheses, although the one suggesting that the lowering of interest rates is an equilibrium phenomenon seems rather robust. In fact, the two hypotheses may not be mutually exclusive. Even if the hypothesis that the lowering of long term interest rates is largely due to global equilibrium effects appears to be strongly supported by several indicators, the other hypothesis cannot be discarded. The risks for price stability stemming from unusually lax monetary conditions at the global level and low long term interest rates should not be underestimated.

What should then be the optimal policy reaction, aimed at minimising risks?

The evidence provided above would suggest that monetary policy should not overreact to the observed lowering of long term real interest rates in advanced economies. On the other hand, “benign neglect” would not be appropriate either. A very close monitoring of all the available indicators, in particular those arising from the financial and monetary sectors of the economy, is certainly warranted, to detect possible disequilibria arising in monetary conditions leading to potential inflationary effects. The availability of a sound monetary analysis may prove to be particularly useful in the current conjuncture.

In any case, what the analysis has shown is that further research is required on the effects of easier financing conditions on households’ and firms’ behaviour.

A corollary to this conclusion is that monetary policy might not be the only, nor even the most important, tool to deal with the risks emerging in the new environment. The strengthening of financial stability measures and the increased cooperation between supervisory authorities at the international level might be even more important.”

  • PIMCO research note on petrodollars and asset prices. It says that dollar willnot come under selling pressure as long as oil funds marginal dollar allocation remains above 60%.
  • China moves to end cheating on economic statistics, see Asia Times Online article
  • The Economist article on new economics of offshoring.