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Monetary Policy Normalization and Global Financial Stability, Remarks by Mitsuhiro Furusawa, IMF Deputy Managing Director

2015 Bank of Korea International Conference Mitsuhiro Furusawa, IMF Deputy Managing Director June 8, 2015

As Prepared for Delivery

Good morning. It is my great pleasure to join you today at the 2015 Bank of Korea International Conference. I would like to thank Governor Lee for his kind introduction and the Bank of Korea for inviting me to discuss the monetary policy challenges of global interest rate normalization.

In recent years this gathering has earned the reputation as an important forum for discussing issues that have arisen since the 2008 global financial crisis. I am sure this year’s conference will continue to deepen our understanding of the challenges we face.

Today, I would like to focus my remarks on three themes:

1. The risks and challenges that lie ahead with monetary policy normalization in the United States, especially for emerging market economies;

2. How policy in both advanced and emerging market economies helps to mitigate these risks and challenges; and

3. The implications for monetary policy in the “new normal,” which is to say, once the crisis is finally and fully behind us. Here, in particular, I will highlight some of the areas where more work needs to be done to better understand the changing policy environment.

Monetary Normalization—Risks and Challenges

Let me begin by placing monetary policy normalization in the United States into a global economic context.

Nearly eight years after the global financial crisis, global growth is still modest, and disinflationary pressures remain. Despite a boost to growth from the decline in oil prices, the Fund’s April World Economic Outlook saw the global economy expanding by only 3.5 percent this year and picking up to 3.8 percent in 2016. Data releases since then have been generally weaker than expected, and our WEO update will be released in early July with an assessment of the implications for the global recovery.

Moreover, growth has been diverging across countries and regions. The U.S. recovery is continuing—although at a slower pace this year than originally forecast—and growth in the euro area and Japan is expected to pick up. By contrast, economic performance in many other parts of the world is falling short of expectations. Emerging market growth will decline for the fifth year in a row in 2015, but emerging and developing economies continue to account for a large share of global growth. We do see signs of an emerging market rebound next year.

In response to this outlook, monetary policy across major economies has become asynchronous. Unconventional monetary easing is ongoing in the euro area and Japan, where inflation is subdued. Also, many smaller advanced economies and emerging market economies have eased monetary policy recently. These developments contrast with the continuing movement toward normalization in the U.S.

This situation gives rise to three sets of risks and challenges:

  • First, prolonged low interest rates and quantitative easing in advanced economies have produced large run-ups in asset prices, a compression of long-term yields, and very large capital flows to emerging markets. As you know well, the risk is that once market sentiment shifts—possibly triggered by normalization—yields could sharply increase and capital flows could reverse. This process could become disorderly, with impaired liquidity in certain markets or asset classes. And, with an increased correlation among major asset classes, there is a higher potential for contagion. So there is considerable scope for negative spillovers from monetary policy normalization.
  • Second, asynchronous monetary policies have spurred rapid dollar appreciation and sharply increased volatility in foreign exchange markets. This volatility, combined with depreciation in a number of emerging markets, may put strains on nonfinancial corporates that have borrowed heavily in foreign currencies. This vulnerability could trigger or exacerbate capital outflows.
  • Third, capital markets have become more important providers of credit, and the role of the asset management industry has been growing. Many asset managers offer funds that allow investor redemptions on a daily basis, while taking positions in assets that may become illiquid in periods of stress. We believe that this trend increases the risk of herd behavior if investors scramble for the exits. This could lead to fire sales and contagion to other parts of the financial system. Emerging economies could also be affected if a sharp reduction in the secondary market liquidity of certain financial assets amplifies the volatility of local markets and currencies.

Let’s not overstate these vulnerabilities. They are “pockets” of risk rather than harbingers of large-scale systemic risk. Nonetheless, they could easily combine with surprises in the timing and pace of the inevitable U.S. interest rate liftoff to give rise to disorderly portfolio rebalancing. We need only to recall the so-called “taper tantrum” in 2013 to get a sense of the forces that could be at work.

The Role of Policy

This brings me to the policy response.

I want to emphasize that normalization likely will have different effects on different countries, so there won’t be a single policy response. Here, the important point is that capital outflows often are a natural consequence of financial openness and integration, and not a major policy concern every time they occur. It is normal that changes in the global economy and financial markets will produce outflows.

That said, unusually large, sustained, or sudden outflows can pose significant policy challenges—even in the absence of a crisis. The consequences can be severe: depletion of foreign exchange reserves, excessive currency movements, financial system stress, and output losses.

The U.S. Federal Reserve can do its part to reduce the risk of disorderly capital outflows by continuing to communicate clearly its policy intentions. This has been discussed at length since 2013, and we believe that the Fed is well aware of this issue. Moreover, authorities in other large advanced economies should also do their part by nipping financial stability risks in the bud, mainly through appropriate micro- and macroprudential policies.

What can emerging market economies do?

Most importantly, they need to continually strengthen macroeconomic fundamentals and policy frameworks, building on their important work in recent years.

Work we have done at the IMF suggests that countries with sound macroeconomic fundamentals have seen smaller market reactions to monetary policy spillovers from advanced economies. In particular, higher GDP growth, stronger current account positions, lower inflation, and more liquid financial markets helped to contain market volatility. It is also becoming increasingly important for emerging markets to implement structural reforms that promote strong, sustainable, and balanced growth. Stronger fundamentals, in turn, can best be achieved by developing and implementing coherent and sound fiscal, monetary, exchange rate policies.

At the same time, emerging economies need to ensure that their financial systems are resilient to asset price volatility and a sudden decline in market liquidity.

A vigilant macroprudential stance is the first line of defense, particularly for countries with high foreign currency debt and those vulnerable to sudden capital flow reversals. At the microprudential level, regular monitoring and stress tests are needed to assess foreign currency risks, especially bank and corporate foreign currency exposures. This places a premium on better data collection, including on derivatives positions—whether for hedging or speculation.

How to react if market volatility and disorderly outflows emerge? Central banks and governments need to be fully prepared to respond quickly. Financial system stress may require temporary, aggressive, and targeted liquidity support, and changes in prudential policies. The macroeconomic policy mix should be calibrated to support external adjustment, with exchange rate depreciation and changes in the monetary and fiscal policy stance.

So the appropriate policy mix will depend on the specific circumstances in a country—both macroeconomic and financial. I look forward to hearing how you see these issues.

Korea provides a good example of how strong fundamentals combined with decisive and swift policy action can help countries reduce and cope with market volatility. Remarkably effective steps have been taken to strengthen the resilience of the financial sector, which helped to reduce banks’ short-term external debt by half, to 27 percent, between 2008 and 2013. I am thinking in particular of the limit on banks’ foreign-exchange derivatives positions, and the levy on banks’ non-core foreign-exchange liabilities.

In certain conditions, foreign exchange intervention or capital flow management measures could also be used. But such measures should not substitute for macroeconomic adjustment. Let me mention here that the IMF and OECD have recently prepared a joint assessment for the G20 of our respective approaches to measures that address both macroprudential and capital flow issues. This work underscores the IMF’s commitment to ensuring that these measures are used appropriately and in a manner consistent with the smooth functioning of the international monetary system.

At the IMF, we also see a potentially important role for international policy coordination and safety nets. Here, as always, we stand ready to provide advice and support. Central bank collaboration is also important, for example by providing foreign currency swap lines, as they did in the early stages of the global financial crisis when spillovers and spillbacks threatened global financial stability. Closer coordination between the IMF and Regional Financing Agreements would be helpful, and there could be greater sharing across countries in the areas of policy thinking and contingency plans.

Monetary Policy in the New Normal

Now to my last point for today: which considerations will drive monetary policy in the “new normal,” when the recent crises have been fully overcome.

We have already learned that price stability and strong microprudential regulation are not sufficient to achieve macroeconomic and financial stability. It is now widely recognized that more needs to be done to limit systemic financial risk, and that macroprudential policies are the main tool for this job. But are macroprudential policies enough? Or does monetary policy also need to be used to limit system-wide financial risk?

Needless to say, we do not yet have a complete answer. What we do know is that macroprudential policies do not remedy all ills. For example, their effectiveness may be hampered by leakages. This may occur within a country through a shift of financial activities from the regulated to the less regulated. It also may occur across countries, as financial market participants gravitate to less regulated jurisdictions. Moreover, the effectiveness of macroprudential policy may suffer owing to institutional shortcomings or political reasons.

This is why there have been calls for monetary policy to support financial stability by sometimes “leaning against the wind” of rising financial imbalances—even as the primary focus remains on price stability. We know a fair amount about the costs of such “leaning”; for example, deviations from inflation targets along with output and employment losses. But much less is known about the benefits of leaning in terms of reducing the likelihood and severity of financial crises. At the IMF and elsewhere, these questions remain an active and crucial area of inquiry.

Another important question will be how to design governance of central banks in view of the greater role expected of them in maintaining financial stability. One concern is that if central banks are obliged to implement unpopular financial stability policies, they may invite political interference that could undermine their ability to deliver price stability. There is no “one size fits all” solution to this problem. Some countries have decided to keep monetary policy separate from macroprudential policy, relying on interagency committees to coordinate the two. Others, such as the United Kingdom, have assigned both responsibilities to the central bank, but with separate policy committees to improve transparency and accountability.


Let me conclude.

Monetary policy normalization in the United States is coming. But even with the best preparations and communications, normalization may give rise to risks. The IMF is strongly committed to closely monitoring and assessing the impact of these developments, and helping its membership to address the related challenges. We still need to better understand the transmission of spillovers, and further thinking is needed on what this implies for policy options.

I am very much looking forward to a continuing fruitful debate on these issues. I am sure this conference will provide new insights into how all countries can navigate the uncharted waters leading to the “new normal”.

Thank you.