Raghuram Rajan (University of Chicago Professor) – LSE Global Policy Lab Launch (Jul 2017)

Chapters

Abstract

Rethinking Monetary Policy Rules in an Era of Low Interest Rates: A Comprehensive Analysis

Introduction:

In a rapidly evolving global economy, the traditional rules governing monetary policy are being challenged. The current era, characterized by persistently low interest rates and subdued inflation, has prompted a need for a thorough reevaluation of these rules. Raghuram Rajan, a distinguished economist, calls attention to the critical necessity of this reassessment, especially in the context of growing discontent in both industrialized and emerging economies.

In the asymmetry of international discussions on monetary policy, Rajan highlights the need for emerging markets to have a stronger voice. He introduces the Global Policy Lab as a platform for emerging markets to engage in research and policy dialogue, offering constructive alternatives to current frameworks.

Central Banks and the Erosion of Traditional Rules:

Central banks have historically avoided sustained unilateral intervention in exchange rates. However, this norm has begun to erode, as banks in developed countries increasingly engage in such practices, ostensibly to protect their economies. This shift necessitates a fresh perspective on the validity and effectiveness of longstanding monetary policies. Rajan emphasizes the importance of rules in monetary policy, citing the historical rule against sustained unilateral intervention in the exchange rate to prevent competitive depreciation. However, he argues that this rule has been disregarded, leading to concerns about potential exchange rate manipulation.

The Lower Bound Challenge:

The significance of the lower bound in monetary policy has grown due to persistently low inflation and aging populations. Central banks, previously more concerned with the upper inflation bound, now face the intricate task of raising inflation, which has proven more challenging than lowering it. This has led to the adoption of unconventional monetary instruments, reflecting a significant shift in monetary policy dynamics. Rajan points to the shift towards inflation targeting regimes with lower bounds, making low inflation and low real interest rates a significant issue. He highlights the difficulty in raising inflation when it falls below the target, leading central banks to adopt various unconventional instruments.

The Dilemma of Inflation Targets:

Central banks are caught in a dilemma: the struggle to communicate their commitment to inflation targets without admitting the limitations of their monetary tools. This balance is critical to prevent deflationary spirals, yet the domestic impacts of new instruments often remain minimal, raising questions about their overall effectiveness. Rajan stresses the challenge central banks face in admitting defeat, fearing a loss of credibility and spiraling deflation if they acknowledge the limits of their instruments. He describes the tendency of central banks to introduce new instruments as older ones lose effectiveness, potentially leading to unintended domestic and international consequences.

Negative Spillover Effects:

Unconventional monetary policies, while limited in domestic impact, can cause significant spillover effects internationally. These policies often lead to currency depreciation in other countries, affecting global trade balances and economic stability. Rajan emphasizes the importance of a framework that aligns these policies with broader economic objectives without undermining global stability. Rajan acknowledges that aggressive monetary policies in industrial countries may be necessary to maintain momentum and prevent deflation. However, he emphasizes the need to understand the costs and benefits of such policies on emerging markets.

Impact on Emerging Markets:

Emerging markets face unique challenges in this new monetary landscape. Expansionary policies in developed countries can lead to increased imports but also cause volatility due to exchange rate fluctuations. Emerging markets, with weaker institutions, are more vulnerable to these shifts, leading to financial fragility and economic instability. Rajan points out that emerging markets are not like developed markets. They have weaker institutions and less credible central banks. This makes them more vulnerable to positive and negative feedback loops. He warns that allowing the exchange rate to adjust when money comes in can lead to a credit boom and budgetary problems. When the exchange rate depreciates, these problems can become exacerbated, leading to financial fragility and high inflation.

Trade and Capital Flow Considerations:

The low-interest-rate environment impacts trade dynamics and capital flows, with developed countries’ policies leading to both positive and negative consequences for emerging markets. The volatility caused by these flows underscores the need for more stable and predictable monetary policy frameworks. Rajan highlights the effects of very low interest rates on emerging markets. When interest rates are low in developed countries, there is a higher demand for imports from emerging markets, which can lead to growth in the emerging market economy. However, this effect may be offset by a depreciation of the exchange rate. He also points out that very low interest rates in developed countries can lead to capital flows out of emerging markets, causing volatility. Bank flows are particularly problematic, as they are short-term and can leave quickly.

Proposing New Rules for Central Banks:

In light of these challenges, Rajan proposes new rules for central banks to mitigate negative policy spillovers and prevent destabilizing competitive devaluations. These rules would constrain extreme policies and promote a more stable global economy, taking into account the potential impact of policies on other countries. Rajan proposes reestablishing rules of the game for central bank actions. He suggests revisiting the rule against sustained unilateral intervention in the exchange rate. Additionally, he advocates for rules that address actions that have similar effects to currency intervention, such as quantitative easing. The proposed rules would allow most ordinary monetary policies to continue as usual. However, they would constrain extreme policies that primarily target the exchange rate or capital outflows. Rajan acknowledges that the rules may limit certain monetary actions and potentially affect central bank credibility. However, he argues that the rules should only constrain extreme policies and that they are necessary to avoid excessive reliance on monetary policy.

The Role of Global Policy and Coordination:

Monetary policy, while crucial, is insufficient alone to address global economic challenges. Rajan advocates for a coordinated approach involving monetary, fiscal, and structural reforms. He also highlights the role of initiatives like the Global Policy Lab in researching and developing better policy options, emphasizing the need for a holistic approach to global economic governance. Rajan emphasizes the need for a comprehensive approach to economic policy, including fiscal, monetary, and structural reforms. He believes that monetary policy alone cannot address all economic challenges and that other policy tools should be utilized. He calls for research to quantify the costs and benefits of different monetary policies on both industrial and emerging countries. He proposes the creation of a global policy lab to conduct this research and develop recommendations for international cooperation.



The era of low interest rates and low inflation presents a unique set of challenges and opportunities for central banks and policymakers worldwide. Rajan’s insights underline the urgency of rethinking traditional monetary policy rules and emphasize the need for greater coordination and a balanced approach that considers the global impact of domestic policies. As the world economy continues to evolve, these considerations will be pivotal in shaping a more stable and equitable global financial landscape.

Notes by: Hephaestus