Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Global monetary policy enters a decisive phase

If central banks are not able to attain the inflation target soon, it will warrant a reassessment of the current monetary policy framework

The global economy finally seems to be moving out of the shadow of the 2008 financial crisis—and global monetary policy will have to change in tandem. Indian policymakers will have to take this into account in the coming months.

The ongoing synchronized global economic recovery is likely to strengthen this year. According to the January update of the International Monetary Fund’s (IMF’s) World Economic Outlook, the global economy is likely to grow at 3.9% in 2018 compared to 3.7% in 2017. Economic growth is likely to strengthen in the US to 2.7% in 2018 compared to 2.3% in 2017. The euro area is also expected to grow in excess of 2%. The expected pace of the recovery is likely to make 2018 an important year for global monetary policy, as large central banks reverse their crisis-era policy accommodation. The process of normalization is already under way in the US, and the pace could increase if growth and inflation surprise on the upside. The European Central Bank (ECB) is reducing its asset purchases and, at some point, the Bank of Japan (BoJ) would also want to think about policy normalization.

There are at least two big reasons why it is important for large central banks to remove policy accommodation. First, even though the advanced economies are growing and contributing to the global recovery, they are fairly unprepared to deal with a possible downturn because of prevailing low or negative rates. Even in the US, the policy rate is in the range of 1.25-1.5%. It will only reach the level of about 2-2.25% at the end of the year and may still not provide sufficient space to deal with a downturn. Managing a negative growth shock will be even more difficult for the ECB and BoJ. Therefore, it makes sense to remove accommodation and create policy space at a time when the economy is growing at a reasonable pace.

Second, prolonged policy accommodation has led to excesses in financial markets, both in advanced and emerging market economies. Continued easing will further push up asset prices and make the eventual correction more painful and difficult to manage.

Even though the objective is clear, the policy path is far from certain. One big risk to the global recovery is a sharp correction in financial markets. In fact, volatility in financial markets and its impact on growth can force central banks to postpone policy normalization. This could significantly increase the complexity in policymaking. For instance, the recent news that the BoJ has reduced its asset purchase pushed the yen up. However, the Japanese central bank announced this week that it will continue with its easing programme. It is likely that the BoJ will reconsider its policy stance later this year, as the economy is said to be in its best position since the late 1990s.

Meanwhile, the ECB is cutting its asset purchase by half to €30 billion per month and analysts are of the view that it will end the easing programme this year. These developments could tighten financial conditions and test valuations in financial markets. There has also been a significant build-up of debt in various parts of the world. Higher rates would make debt servicing more difficult for relatively weak borrowers. Debt burdens that seem sustainable when interest rates are near zero could become unsustainable if borrowing costs rise sharply.

Policy action could also result in a fair amount of volatility in the currency market. For example, the current weakness in the dollar has surprised most analysts as it was expected to strengthen in 2017 on the back of rate hikes and balance sheet normalization in the US.

The other big risk is inflation. Consumer prices have surprised policymakers on the downside, with inflation regularly undershooting the target. If central banks are not able to attain the inflation target soon, it will warrant a fundamental reassessment of the current monetary policy framework. It is being argued in the US, for example, that the Phillips Curve relationship between unemployment and inflation has broken down. However, if inflation surprises on the upside, it will warrant a faster-than-anticipated tightening. This could result in a sharp correction in asset prices and affect growth.

The uncertainty in terms of policy action and its consequences in the global economy will also affect the policy preference of the monetary policy committee of the Reserve Bank of India. The Indian central bank will have to keep an eye out for sudden bouts of volatility in exchange rates as well as capital inflows, even under the new inflation-targeting framework. Monetary policy action in developed countries will have serious implications for domestic policy.

The year ahead will be important for large central banks, as they are best placed now to unwind policy accommodation. However, the progress will depend on how they approach the evolving macroeconomic situation and how well they are able to communicate their policy intent to the financial markets.

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