Op-ed in the Financial Times
August 21, 2008
© Financial Times
The world's top central bankers meeting in Jackson Hole this weekend should do more than bemoan their respective financial risks. They should hammer out a joint approach to reducing global inflation, centred on a common public commitment to tighter monetary policies. Moreover, with the European Central Bank and a few emerging market central banks (such as those of Brazil and India) having taken the lead, the spotlight should be on the US Federal Reserve and People's Bank of China. They must participate in this effort, rather than try to free-ride—which would only delay and increase the cost of their own inevitable tightening.
The view of many central bankers is that there are few if any gains from monetary policy coordination. This view profoundly misreads the present situation. Inflation today is a global phenomenon arising from negative real interest rates and global demand running ahead of supply. This is especially true of commodities, but is also driven by declining potential output growth in the United States and western Europe. Thus, monetary tightening remains urgently needed, despite the recent decline in commodity prices.
Although containing inflation is now a common priority in much of the world, in the United States and China short-term objectives are leading to lax monetary policies, generating negative global spillovers of higher inflation. There is a game of "chicken" being played. Each country is attempting to duck the pain of monetary contraction, hoping that others will bear the burden of adjustment. This is not only unfair, but self-destructive. It weakens their perceived commitments to price stability, while stoking their own inflation.
In contrast, tightening monetary policy in a coordinated fashion would benefit all participating countries and would be aligned with the enlightened self-interest of the United States and China.
First, the extent and duration of interest rate increases that any one nation must undertake would be reduced. With reduced demand abroad there is a spillover that diminishes inflation in other countries: If everyone tightens rates, the marginal pressures on energy prices and demand are reduced for all countries. The United States would have to tighten less if China tightened and allowed its exchange rate to appreciate (and vice versa).
Second, the commitment to price stability would become more credible for all participating. While there are some brave efforts under way to reduce inflation, many central banks will find it difficult to carry through on commitments. A global pact to raise rates together will make it easier for individual central banks to stick to plans despite domestic opposition.
Third, a credible global pact could have a significant impact on market expectations. This would immediately lead to reductions in prices, especially commodity prices. It would also limit dislocations in exchange rates arising from divergent beliefs about countries' monetary policy paths. Both would ease the inflation-fighting effort.
Fourth, monetary coordination would help offset inflationary pressures from fiscal expansion. Aggressive fiscal expansion is coming in most countries. In developing nations, there is pressure to cushion the social cost of rising food and energy prices; in the United States, the imperatives began with the financial turmoil and will soon encompass healthcare and infrastructure spending. Thus, looser fiscal policy globally will increase the challenge for monetary policy to cut inflation.
Last, an international agreement to tighten would allow China to exit its self-imposed currency predicament. China's single-minded pursuit of mercantilist objectives produces inflation and overheating at home. US efforts to get China to shed these objectives sound hypocritical when the United States seems to be opting for excess stimulus itself, ignoring spillovers. On the other hand, if the People's Bank and the Fed tightened in coordination with most central banks, domestic concerns about competitive depreciation would be muted. Moreover, Chinese tightening would facilitate reduced inflation among Asian countries fearful of losing competitiveness vis-à-vis China, again contributing to a global reduction.
Grand schemes for macroeconomic policy coordination have a mixed record. At present, however, the world faces a common threat from inflation. A joint public commitment by the world's monetary policymakers to the common goal of reducing inflation would be powerful, effective, and fair. That is what central bankers should bring home from Jackson Hole.
Working Paper 13-2: The Elephant Hiding in the Room: Currency Intervention and Trade Imbalances March 2013
Policy Brief 12-25: Currency Manipulation, the US Economy, and the Global Economic Order December 2012
Policy Brief 08-7: New Estimates of Fundamental Equilibrium Exchange Rates July 2008
Working Paper 12-19: The Renminbi Bloc Is Here: Asia Down, Rest of the World to Go? October 2012
Policy Brief 12-19: Combating Widespread Currency Manipulation July 2012
Policy Brief 12-7: Projecting China's Current Account Surplus April 2012
Working Paper 12-4: Spillover Effects of Exchange Rates: A Study of the Renminbi March 2012
Book: Flexible Exchange Rates for a Stable World Economy October 2011
Op-ed: Taxing China's Assets: How to Increase US Employment Without Launching a Trade War April 25, 2011
Op-ed: Why the World Needs Three Global Currencies February 15, 2011
Policy Brief 10-24: The Central Banker's Case for Doing More October 2010
Policy Brief 10-26: Currency Wars? November 2010
Congressional Testimony: Correcting the Chinese Exchange Rate September 15, 2010
Op-ed: New Imbalances Will Threaten Global Recovery June 10, 2010
Book: The Future of China's Exchange Rate Policy July 2009
Book: Debating China's Exchange Rate Policy April 2008
Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009
Policy Brief 09-21: The Future of the Dollar September 2009
Policy Brief 09-20: Why SDRs Could Rival the Dollar September 2009
Book: Accountability and Oversight of US Exchange Rate Policy June 2008
Policy Brief 07-4: Global Imbalances: Time for Action March 2007
Working Paper 11-14: Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition September 2011
Peterson Perspective: Legislation to Sanction China: Will It Work? October 7, 2011
Book: China's Rise: Challenges and Opportunities (hardcover) September 2008