By Tobias Adrian and Gita Gopinath
While capital mobility provides many benefits, capital flows to emerging market and developing economies are often volatile and depend critically on global financial conditions. The risks posed by volatile capital flows to macroeconomic and financial stability are often difficult to address with conventional monetary policy tools. Hence, policymakers have complemented interest rate policy with additional tools including foreign exchange intervention, capital flow measures, and macro-prudential actions to achieve their objectives.
A significant shortcoming of this more eclectic approach is the lack of clear frameworks to guide how these tools should be used in concert to achieve central bank objectives. Accordingly, the International Monetary Fund (IMF) staff have been engaged in a major push to use conceptual and quantitative models to guide how these tools should be used in an integrated way.
Our research on an Integrated Policy Framework considers policy trade-offs associated with using these tools in an open economy macroeconomic setting that explicitly takes account of key frictions such as, dominant currency pricing, currency mismatch on balance sheets, foreign investors limited appetite for emerging markets’ local currency debt, poorly anchored inflation expectations—as well as both domestic and external shocks (as managing director Kristalina Georgieva pointed out recently). In this blog, we provide a brief overview of two recently released working papers that provide frameworks for an integrated use of the tools.
The paper “A Conceptual Model for the Integrated Policy Framework” analytically derives optimal policies as a function of country specific frictions and shocks. Some of the insights are as follows: First, if an additional policy instrument becomes available, it should not necessarily be deployed because it may not be the right tool to address the imperfection at hand. For example, while pricing in dominant currencies, most often the dollar, in international goods markets reduces the benefits of exchange rate flexibility and can give rise to more volatile exchange rates, in the absence of other frictions, flexible exchange rates are still optimal. In this case, deploying unconventional tools such as foreign exchange intervention and capital flow measures can worsen outcomes because they do not address the specific pricing friction.
However, and this is a second insight, if there are additional frictions such as imperfections in capital markets, often associated with over-borrowing, then dominant currency pricing can enhance the need for tools such as exchange interventions and capital flows and macro-prudential measures. Private agents in an open economy have a tendency to over-borrow in foreign currency because they do not internalize the impact of their decisions on future market stress that can arise when foreign lending conditions tighten, currencies depreciate, and balance sheets weaken.
To prevent excessive volatility over time, prudential capital inflow controls can mitigate over-borrowing in good times and excessive deleveraging in bad times. There is a greater need for such prudential inflow controls in countries with dominant currency pricing because the exchange rate is less effective in stabilizing demand in those countries.
Third, unlike the classic trilemma in international economics, flexible exchange rates do not necessarily preserve monetary policy independence. Episodes such as the taper tantrum in 2013 can sharply raise premia demanded by foreign investors to hold local currency debt. To counter the adverse impact of this external shock, monetary policy comes under pressure to raise policy rates at the expense of tightening domestic financial conditions. In such circumstances, the analysis suggests that it can be beneficial to use exchange intervention and prudential policies to address the external shock freeing the domestic policy rate to focus on domestic price pressures.
A second working paper, “A Quantitative Model for the Integrated Policy Framework” proposes a more empirically-oriented approach to the integrated use of policies. The starting point is an open economy New Keynesian model as is commonly used in central banks. The model embeds complex, nonlinear balance sheet channels and a range of frictions that help capture key empirical features of financial stress episodes, including that domestic credit conditions tend to tighten when the exchange rate depreciates.
The model highlights another form of loss of monetary policy independence that arises when inflation expectations are poorly anchored, as is the case in some emerging and developing economies. In this case, their central banks often face a difficult trade-off in responding to external shocks that cause sharp exchange rate depreciation and capital outflow pressures. If inflation expectations are poorly anchored and tend to drift away from the target, the central bank is forced to choose between sharp raising interest rates to keep inflation stable—at the cost of a steep output decline—and pursuing a more passive policy that risks allowing inflation to become unmoored.
In this case, the model suggests that foreign exchange intervention and capital controls can improve policy trade-offs considerably under certain conditions, especially for economies with less well-anchored inflation expectations, high sensitivity of domestic borrowing conditions to the exchange rate, and that are more vulnerable to shocks that cause capital outflow and exchange rate pressures. Notably, the use of integrated policies may reduce downside risks to the output associated with shocks that resemble a sudden stop.
In sum, research on the Integrated Policy Framework is in full swing at the IMF. The COVID-19 crisis has made stark the volatile nature of capital flows and limits to conventional monetary policies. Our newly released working papers shed light on the macroeconomic policy trade-offs that many emerging markets and small open economies face. Our contributions provide both conceptual and quantitative approaches that aim at a fully integrated macroeconomic framework to assess policy trade-offs.
The work on model frameworks is also being complemented by extensive empirical work and country case studies at the IMF. These other streams test empirically the impact of various tools and their trade-offs, explores the unintentional consequences of deploying unconventional tools on foreign currency exposure and financial market developments, the communication challenges when multiple instruments are used, among others.
The combined work, which will be discussed by the IMF’s executive board in the fall, should provide useful insights to policymakers on how to deploy multiple tools with special attention to the form of the shock, the specific frictions, the pre-existing conditions, alongside practical considerations.
