I came across this news item from CNBC about Bernanke and Rajan face-off and that was enough to break the long blogging hiatus! Rajan raises an important question that should be addressed given today’s closely connected economic systems. In the context of unconventional monetary policies, he asks “If the policy hurts the rest of the world more than it helps the United States, should this policy be pursued?” This question is important because there has been a lot of debate about the domestic impact of Fed’s QE policies , but not much has been said about the effects of such policies on emerging market economies. In fact, Rajan puts it quite bluntly when he criticizes “the Fed for failing to mention turmoil in emerging economies in its January 2014 policy statement, sending “the probably unintended message that those markets were on their own,” a sentiment reinforced by public comments by regional Fed bank presidents.” (Source)
While some macroeconomists and even the new Fed Chairman continue to argue about the favorable effects of QE and the eventual low interest rate regime, there has been a convincing argument against it made by New Monetarists like Stephen Williamson here and more informally here. The infromal argument in short goes somewhat like this: if money competes as means of payments with other assets playing similar role (shadow banking) and if QE is increasing their prices, then the only way money can retain value is if inflation goes down. So we have an imminent danger of Japaneese style stagnation as the lowering of interest rates and increase in value of money creates a liquidity trap. This is quite apparent in the data and hence quite surprising that Fed continues to neglect it when it comes to policy making. Thus, given that the benefits of QE for the US itself are circumspect or unclear at best, Rajan’s criticism seems valid and timely. Of course, Bernanke did not take it well- he does not want any blemish on his legacy! Not sure what to think of his argument about QE being demand augmenting as suggested by required exchange rate intervention.
Notwithstanding this face-off between two first rate scholar central bankers, something definitely needs to be thought about policy making in an interconnected world economy-especially in case of the US who supplies the world’s most prominent reserve currency and the general shortage of safe assets as argued by Caballero. It looks like there was some talk about this in Kansas City Fed in 2012, the Jackson Hole symposium in 2013, and very recently at the IMF. Rajan’s proposal in this regard seems interesting and worth researching. He sees “merit in assigning the International Monetary Fund or a similar institution the responsibility of assessing the spillover effects of major central banks policies – much as the World Trade Organization does with trade rules – but acknowledged this isn’t politically viable.”
Whether, such a solution is possible or not, the argument against activist monetary policy favoring low interest rates has never been stronger than now. As James Bullard suggests here, there is a strong evidence that low interest rates may have prolonged the recession that started in August 2007, when firms speculated in the international oil markets using the abundantly available cheap funds and literally engineered an oil price shock! Of course, real data available to Fed at that time did not reflect this and significantly understated the extent of actual recession. Talk about lags in policy making eh!