A convalescent global economy: are monetary and financial policies the right cure?

1. A convalescent global economy:are monetary and financial policies the right cure? Salvatore Rossi Member of the Board Bank of Italy Moscow, 23 April 2013

2. Roadmap • The global economy: outlook and risks • Headwinds against a sustained recovery • Easy monetary policy in advanced economies: benefits and potential costs • The role of macroprudential policies • Wrap up: what can monetary and financial policies achieve? Which other policy tools and measures are needed?

3. 1. The global economy:outlook and risks

4. The global economy outlook A convalescent global economy • Early signs of stabilization in ADV, pick up of activity in EME • Financial market conditions have improved • Global trade has picked up a little • Consumer and business confidence are improving in most ADV, but from very low levels • ADV: weak start in 2013, acceleration expected since mid-year GDP projections, IMF WEO Apr-13 2013 growth prospects have been marked down repeatedly over the last year, and output gaps remain large

5. Main downside risks • Short-term (only for ADV): • Europe: sovereign debt crisis, tight credit conditions • US: excessive fiscal restriction/debt ceiling • Medium-term • Rising public debt in the US and Japan • Limited fiscal policy space and adjustment “fatigue”in the euro area • Distorsions from easy monetary conditions in all ADV • Overinvestment/asset price bubbles in EME

6. The global economy outlook Unbalanced recovery Real GDP per capita around most recent global recessions Great Recession Average of previous recessions (1975,1982,1991) Global recession year Source: WEO, IMF April 2013. Dashed lines denote WEO forecasts. • Great recession appears to have severely damaged growth engine in ADV, where output barely returned to pre-crisis levels, growth outlook remains weak • EME have decoupled, but for how long can it be sustained? Is demand rebalancing under way?

7. 2. What is dampening the recovery in advanced countries? Headwinds…

8. Major headwinds Some factors behind the slow recovery in ADV • Public sector de-leveraging (synchronized fiscal consolidation) • Private sector de-leveraging (tight credit supply) • Eurozone sovereign debt crisis • Global imbalances

9. A. Public sector de-leveraging • Sharp and simultaneous fiscal tightening in G20 ADV: -1.8pp between 2010 to 2012, drags on growth (at least) in the short term • Impact on GDP depends on the size of the fiscal multiplier: how large is it? Could fiscal consolidation be self-defeating? Cyclically adj. fiscal balance (% of potential GDP) General govt. debt (% of GDP) Source: IMF WEO Apr 2013

10. A. Fiscal multipliers • Standard New Keynesian models predict fiscal multiplier <1; effect is smoothed by monetary policy reaction (e.g. Smets-Wouters 2007, Cogan et al. 2009) … • … but with large slack and monetary policy constrained by zero lower bound, models predict larger multipliers, around 2 or higher (Eggerston 2009, Christiano et al. 2009) • IMF (WEO Oct-12) suggests multiplier since Great Recession at 0.9-1.7, greater than in the past (consistent with recent empirical evidence: Auerbach-Gorodnichenko 2012, Batini et al. 2012, Woodford 2011, Alumnia et al. 2009) • Most likely, the fiscal multiplier is not fixed, but depends on: monetary policy response, mix of budgetary measures, phase in the economic cycle, extent of liquidity constraints in the private sector, etc. • Italian example: BoI econometric model suggests that recent budgetary measures in Italy had a multiplier of 0.3 in the first year and 0.5 in the second (Bank of Italy, Economic Bullettin, Jan. 2013)

11. A. Fiscal consolidation: any alternative? • Consolidation is a MUST for high-debt countries facing market pressure: needed to restore credibility • In Italy, higher sovereign spread and tighter credit subtracted 1pp from GDP growth in 2012, i.e. as much as budgetary measures (BoI Economic Bullettin, Jan. 2013) • Countries with fiscal margins and strong credibility could slow down the pace of consolidation to counter deflationary feed-back (Germany, other Northern European countries) • US could better trade-off short- for long-term consolidation • end-2012 federal debt held by public = $11.6tr (73% of GDP) • future contingent liabilities much larger: ~20tr for Social Security, ≥40tr for Medicare (Auerbach, 2011) • Japan benefits from captive domestic investor base and low interest rates, but for how long? (demographic considerations)

12. A. The case of Japan Govt. debt (D) and private sector financial assets (A), in % of GDP • Assumptions • Per-capita GDP growth = 2.1% (optimistic) • Declining saving rate (demography) • Ret. on assets = govt.bond int.rate (r) • Scenarios • (1) r = GDP growth rate • (2) r rises 2bp for each 1% ΔD • (3) r rises 3.5bp for each 1% Δ D D3 A3 A2 D2 D1 A1 Source: T. Hoshi and T. Ito, NBER WP August 2012 “Defying Gravity: How Long Will Japanese Government Bond Prices Remain High?”, • Debt is on an exploding path (under best scenario, >500% in 2040) ... • … and could exceed private financial assets early next decade

13. B. Private sector de-leveraging: credit • Credit supply conditions slightly accommodative in the US … • … tight in the Euro area … … however: • credit tightening in the euro area is increasingly explained by concerns over bad loans due to economic outlook … • … less by problems with banks’ capitalization, funding and liquidity (euro area) Source: ECB 13

14. C. Sovereign debt crisis in the Eurozone • Sovereign spreads in the Eurozone have fallen since late 2011 thanks to the ECB action (LTRO, OMT) … • … but also to the adjustment effort by governments, reform of European governance, progress towards closer European financial integration • However, spreads are still volatile and large Yield spreads between 10-year government bonds and the German Bund (daily data; basis points) • Di Cesare et al. (2012) estimate equilibrium spread for Italian 10-year govt. bonds, based on macroeconomic fundamentals and financial factors: ~270bp • Actual: ~300bp Sources: Based on Bloomberg and Thomson Reuters Datastream data. The latest available data refer to April 11 2013.

15. C. The sovereign-banks-growth link • Higher sovereign risk is transmitted to bank funding/liquidity conditions through various channels (BIS, 2011): • direct holdings of govt. bonds • lower value of govt. bonds as collateral for wholesale funding • sovereign rating downgrades transmitted to banks • lower value of govt. explicit/implicit guarantees on domestic banks • … and then to households and firms’ via credit availability and conditions Loans to firms (12-months growth rates) Interest rates on new loans to firms (in %) Source: Bank of Italy and ECB

16. D. Global imbalances Current account positions (in % of world GDP) • Global imbalances have narrowed since 2006, but remain high by historical standards. • So far, adjustment has been to a large extent cyclical and asymmetric (lower imports by deficit countries, rather than higher imports by surplus ones). Source: based on IMF-WEO data. • Asymmetric cyclical adjustment implies that: • the net effect on global recovery is contractionary • when output gaps close, imbalances are expected to widen again

17. 3. Expansionary monetary policies:benefits and costs

18. Monetary policies: similarities … • Central banks’ promptly reacted to economic and financial crisis with conventional and unconventional measures • Official interest rates at or near zero + sizeable balance sheets expansion, common to major CBs • First phase of financial crisis: target liquidity squeeze in selected markets … Source: based on ECB, FED, and BoJ data

19. … and differences • …but subsequently, important differences arose due to specific difficulties: • in the US, weak aggregate demand: long-term securities purchases + forward guidance to lower long-term interest rates • In the Euro area, banking system confidence/funding crisis + credit crunch: long-term refinancing operations (SMP and OMT to address govt. bond markets) • in Japan, deflation: QE, higher inflation target

20. CBs’ balance sheets Eurosystem balance sheet: assets FED balance sheet: assets LTRO ~ 35% MRO ~ 24% 90,1% 87,6% • Most of the increase in Eurosystem balance sheet since 2007 reflects loans to banks (mainly LTRO) … • … other assets also increase, but these reflect autonomous factors (i.e. unrelated to implementation of monetary policy, e.g. gold stock revaluation) • Expansion of FED balance sheet almost entirely due to securities purchases for monetary policy purposes (QE)

21. FED: quantitative easing (QE) • Three rounds of QE (govt. bonds and agency MBS purchase) + operation twist (substitute short-term for long-term bonds) • Potentially lowers long-term interest rates via the portfolio balance effect • assumes that financial assets are imperfect substitutes, hence a reduced supply raises govt. bond and MBS prices • Empirical studies find substantial impact: • despite high uncertainty onprecise quantification, Fed suggests QE1-2 lowered long-term rates by 80-120bp (see Cecioni et al. 2011) • but impact is presumably smaller when rates already very low (diminishing ‘returns’)

22. FED: forward guidance • Forward guidance aims at keeping long-term interest rates low by managing expectations about short-term ones … • … not by committing to any interest rate path, but just providing expectations conditional on up-to-date information • Communication increasingly explicit: • Dec08–Aug11: “exceptionally low levels of the federal funds rate for some time/extended period” • Aug11–Dec12: ‘extended period” replaced with calendar date (“at least through…”) • Dec12-: calendar date replaced with economic conditions: zero fed-fund appropriate as long as: • unemployment > 6.5%, • inflation projections over 1-2 years< 2.5% • long-run inflation expectations well anchored)

23. BoJ: fight against deflation • Oct-12: joint declaration by BoJ-Government (unprecedented), on effort to end deflation • Jan-13:BoJ announces 2% explicit inflation target (up from 1%) + new program of asset purchase (open ended) • Apr-13: BoJ raises stake: • “will achieve” 2% target within two years • adopts monetary base as operational target (instead of interest rate) • commits by end-2014 to doubling monetary base and average maturity of govt. bond hodings • Will this be enough to sustain higher growth? Adverse demographic transition and declining productivity (plus exploding public debt) remain major obstacles: structural reform is needed

24. BoJ: fight against deflation • Since Sep-12, Yen has depreciated by more than 20% against $ and euro • Substantial increase in break-even inflation over next 5 years, but may reflect future increases in VAT (already legislated) • More subdued inflation expectations over longer term, well below new target (Consensus, half-yearly surveys)

25. ECB: LTRO and OMT • Dec-11/Feb12: two long term refinancing operations (provided 3-year liquidity of about 1tr euro, ca 500bn net of reduced demand for shorter-term operations) • Sep-12: detail of Outright Monetary Transactions (purchase of euro area sovereign bonds in secondary markets, subject to conditionality). Fully effective backstop to: • address severe distortions in govt. bond markets from unfounded fears on euro reversibility • preserve the singleness of monetary policy • ensure the proper transmission of the policy stance to the real economy • OMT announcement had positive effects both on interbank and sovereign debt markets, but heterogeneity in funding conditions across euro area countries remain large

26. Risks and spillovers Main risks from aggressive monetary policy action in ADV: • Financial sector risk taking • Spillovers to EME • Inflation expectations • Exit

27. A. Financial sector risk-taking • Prolonged period of low interest rates and ample liquidity may feed excessive risk taking and result in asset price misalignment and credit misallocation. • So far, no signs of generalized risk taking in financial markets, but a few hot spots, including non-financial corporations’ rising debt and leverage, thanks to very low spreads: • most evident in the US (firms raising debt to buy back equity) … • … and in some EMEs (next slides) Credit to US non-financial corporate sector 27

28. B. Spillovers to EME… EME Nonfinancial Corporate Leverage (Percent, debt-to-equity) Portfolio net inflows to EME: bonds (3-months moving averages, billions of US$) Source: EPFR Source: IMF, GFSR, April 2013 • Large inflows of foreign portfolio investment (mainly debt securities) • Narrowing spreads + surge of corporate bond issuance on international and domestic markets (while equity issuance declined) • Rising corporate leverage, esp. among countries where leverage high by EME standards: vulnerable to a reversal in global financial conditions.

29. …even through currency appreciation • Capital inflows tend to appreciate domestic currencies, complicate macro-management in EME … • …but easy monetary policy intended to stimulate demand: any effect on trade mitigated by higher absorption in ADV countries • Talk of currency war maybe overemphasized • Real exchange rates movements largely reflect fundamentals Real effective exchange rates in selected economies (Based on CPI; Jan 2007=100) Source: Thomson Reuters Datastream.

30. C. Inflation • Low inflation risks in ADV, ‘thanks’ to still ample economic slack • Inflation broadly stable despite large estimated output gaps, thanks to: • well anchored expectations (although somewhat rising in UK), • downward wage/price rigidity • What if potential output overestimated? In this case, exit closer/faster than expected, source of risk

31. D. Exit • With economic activity and financial system still weak, inflation expectations well anchored, exit from unconventional policies premature • Yet, central banks must have an exit strategy in mind: choice of appropriate timing of the exit will be more difficult than in normal circumstances • Exit strategy:NOT a pre-committed course of action, but a clear framework in terms of • objectives: linked to statutory goals, essential for credibility • communication: act timely but gradually, to avoid abrupt surprises and manage expectations • operational framework: i.e. the available and most suitable combination of instruments to achieve balance sheet/interest rate normalization

32. 4. The role of macro-prudential policies

33. Macro-prudential policies • How to address the emergence of systemic financial risk? • Two dimensions of systemic risk: (i) ‘time series’, related to pro-cyclicality of credit aggregates and financial sector leverage; (ii) ‘cross sectional’, related to risk concentration and interconnectedness among large institutions • Macro-prudential policy: use of micro-prudential tools to counter the emergence of macro-financial imbalances • e.g. caps on loan-to-value ratio, on debt-to-income ratio, on credit levels or growth rates; reserve requirements; countercyclical capital requirement and provisioning (some proposals to mitigate pro-cyclicality in Panetta et al. 2009) • Close cooperation between monetary and macro-prudential authorities needed to manage possible conflicts and exploit synergies

34. Macro-prudential: theory • Our simulations using NiGEM show that less expansionary US monetary policy stance in the US in 2002-07 would have reduced size of the housing bubble, and eventually the economic costs of subsequent crisis (Catte et al., 2010) • Similar conclusions from a DSGE model (Angelini et al., 2011): cooperation between macro-prudential and monetary authorities improves macroeconomic stability when the economy is hit by financial shocks (but this may require the central bank to deviate temporarily from price stability goal, i.e. ‘lend a hand’ to macro-prudential objective) • More progress needed on theoretical front: models including financial externalities and systemic risk must be sufficiently realistic, to be suitable for policy use (review in Angelini et al., 2012)

35. Macro-prudential: practice • Evidence from actual implementation (mostly in developing countries) shows macro-prudential policy effective in dampening pro-cyclicality, currency and maturity mismatches, household debt overhang (Lim et al. 2011, Wong et al. 2011, Ahuja and Nabar 2011) … • … however, still little is known of potential costs and unintended effects, e.g. reaction of financial system, regulatory arbitrage, cross-country spillovers

36. Macro-prudential and CFM policies in EME • Emerging markets are more vulnerable to “ebb and flow” of international money, due to relative underdeveloped financial markets • Macro-prudential and other capital flow management (CFM) measures are not a substitute for sound macroeconomic policy (monetary-fiscal mix) • Most appropriate when • exchange rate is not undervalued (appreciation unwelcome); • reserves are adequate (no precautionary motives for further accumulation); • economy is overheating or suffer high inflationary pressures (prevent excess monetary and credit expansion; IMF 2011) • For instance: • China satisfies conditions (b) and to some extent (c), but not (a), hence, should let the currency appreciate first • Brazil and (to a lesser extent) Russia satisfy (a), (b) and (c), hence may resort to an appropriate mix of macro-prudential and CFMs

37. Conclusions • The global economy remains a long way from a complete and balanced recovery: de-leveraging, sovereign debt crisis, and global imbalances are still a burden • For many countries, fiscal consolidation cannot be postponed • Loose monetary policy still appropriate: support aggregate demand, accompany the process of fiscal consolidation, provide insurance against tail risk … • … but may feed the emergence of new financial imbalances: macro-prudential policy can be helpful in both advanced and emerging countries • However, monetary and financial policies are NOT a cure for long-term structural problems: to alleviate debt overhang and improve global welfare, productivity-enhancing structural reforms and a rebalancing of world demand are needed

38. THANKS