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.
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