Recently I participated in a Hoover Institution panel devoted to “Rules-Based International Monetary Reform,” sharing the stage with Stanford’s John Taylor
– of Taylor rule fame – and former Treasury Secretary and Secretary of State George Shultz. The panel’s goal was to offer perspectives on global monetary
policy informed not only by economic models that give a prominent role to policy rules, but also by what we actually observe today in the world of
post-crisis, unconventional, zero and now negative interest rate monetary policies.
“It looks like everybody’s doing it,” you may say, citing the evidence of policies undertaken all around the world, “so global central banks must be
cooperating!” But I say, not so fast. While we observe that national monetary policies are often correlated (eras of global monetary easing,
global rate hike cycles), and they also appear sometimes to be coordinated (after all, what else are central bankers doing at all those G-7, G-20,
IMF and Basel meetings?), rarely (if ever) do major central banks actually respect a commitment to pursue cooperative policies – that is, policies
that would differ from non-cooperative policies aimed solely at satisfying their country-specific objectives for domestic inflation and employment.
Would the global economy benefit from true cooperation? Would individual countries? In a global macroeconomic environment of generally diminishing returns
to generally extraordinary monetary policy, more market observers are raising this question. One observer, European Central Bank President Mario Draghi –
speaking just days after the Brexit surprise rattled investors around the world – noted that “In a globalized world, the global policy mix matters – and
will likely matter more as our economies become more integrated. So we have to think not just about whether our domestic monetary policies are appropriate,
but whether they are properly aligned across jurisdictions.” But where along the path of evolution from alignment, or coordination, to binding policy
cooperation lies the balance of risk and reward?
Academic theory says that in open economy macro models, the estimated gains to full international monetary policy cooperation are usually modest relative
to the status quo outcomes for growth and inflation achieved under a Nash equilibrium (in which each country runs a sensible policy taking as given the
assumed-to-be-sensible policies of the other countries). However, I would like to make a somewhat different and less discussed case against global monetary
policy cooperation. Namely, that in practice, adopting it – or succumbing to it – could plausibly erode central bank credibility and public support for
sound, rules-based policies. If I’m right, the all-in cost to a regime of policy cooperation could swamp the theoretical modest benefits, and if so, we
should not bemoan the absence of formal monetary policy cooperation: We should celebrate it.
Beyond coordination, beware
To the extent policy rules provide an important reference point and anchor for national monetary policy, international coordination can enhance
the design and effectiveness of baseline national policy rules. I define coordination to include the sharing of data and analysis that inform estimates of
the unobservable inputs to policy rules, such as the equilibrium real rate of interest and potential output, as well as information that would influence
the central bank reaction function, timing and trajectory of a baseline policy (rule) path.
But while international monetary policy coordination may enhance the efficiency of a policy rule framework, I am skeptical of efforts beyond
coordination. In practice, there likely would be no additional material, reliable or robust gains flowing from a formal regime of binding monetary policy cooperation, at least among major G-7 economies and even including a number of emerging economies with flexible exchange rates and relatively open
capital accounts. In a cooperative (binding) regime, national monetary policies in each individual country would be constrained to jointly
maximize world welfare.
In models of binding regimes, there are externalities that create theoretical gains. However, as I and others have shown in “new Keynesian” macro models
such as those used at the Federal Reserve and other central banks, to achieve those theoretical gains to international monetary policy cooperation, policy
in each country must be set with reference to an index of inflation deviations from target in both the home and the foreign countries. In other words, whereas optimal policy in the absence of cooperation can be implemented with a policy rule
that reacts to domestic inflation, output gaps and the appropriately defined equilibrium (or neutral) real interest rate, a cooperative policy geared
toward global welfare binds central banks to policy rules that react to foreign as well as domestic inflation: policy rules that they would not choose were
they not bound. It’s what we call a time inconsistency problem: a commitment made on a given day may, in the future, become obsolete – inconsistent –
because the factors driving that commitment have changed.
There could well be another problem with cooperation in practice that is absent from most theoretical discussions. Simply stated, international policy
cooperation poses a threat to the credibility of the central bank. Central bank communication, a tightrope under any circumstance, would be profoundly more
challenging, and we could see a loss of public support for policy decisions that (as required by cooperation) react not only to home inflation and
unemployment but also to deviations of foreign inflation from target. For example, if home inflation is above target but foreign inflation is below target,
the optimal policy rule under cooperation calls for the home (real) policy rate to be lower – more accommodative – than it would be in the absence of
cooperation. In theoretical models, the commitment to the inflation target is assumed to be credible, but in practice credibility appears to be a function
of central bank communication and as well the policies actually implemented to push inflation toward – and in the absence of shocks, to keep inflation at –
target. I suspect that in practice, central banks would have a hard time maintaining credibility as well as communicating a policy that kept home real
interest rates low – or in extreme cases negative – not because home inflation is too low, but because foreign inflation is too low. Or imagine the
opposite case, with home inflation below target when foreign inflation is above target. In this case, the optimal policy rule under cooperation calls for
the home (real) policy rate to be higher – less accommodative – than it would be in the absence of cooperation, not because home inflation is too high, but
because foreign inflation is! Just imagine the press conference following that decision.
Perhaps for these reasons above, we do not have many confirmed sightings of genuine global monetary policy cooperation, but we do observe examples
of what I think of as policy coordination. Suppose for example that a country’s central bank sets policy according to theTaylor rule in normal times and resorts to quantitative easing (QE) when the neutral policy rate is negative. As theory
predicts and recent evidence in a new paper by Fed policymakers Kathryn Holston, Thomas Laubach and John C. Williams confirms, there is an important global
factor that drives neutral policy rates in each country and this global factor is linked to average global trend growth. Thus, to the extent a central bank
has some comparative advantage in tracking or forecasting its own domestic output growth and equilibrium real interest rate, sharing this information with
other central banks can improve each bank’s estimate of its home equilibrium real interest rate and thus the effectiveness of its policy rule in meeting
its domestic objectives.
In sum, to achieve the theoretical gains from monetary policy cooperation it no longer suffices for the policymaker to follow an instrument rule based
solely on domestic variables. Instead, under a cooperation regime the home central bank must set the policy rate as a function of home and foreign
variables, in particular home and foreign inflation. Not only do the quantitative gains from time inconsistent cooperative monetary policy rules appear to
be modest, but the policy rules required to implement the cooperative outcome could well be difficult to communicate and to adhere to without sacrificing
the credibility of the inflation target and the policy regime itself. This is why global monetary policies often correlate but global central banks rarely
commit – and honor any commitment – to cooperate.
Holston, K., Laubach, T., & Williams, J. (2016). “Measuring the Natural Rate of Interest: International Trends and Determinants,” Federal Reserve Bank
of San Francisco Working Paper 2016-11.
Clarida, R., Gali, J., & Gertler, M. (2002). “A Simple Framework for International Monetary Policy Analysis,” Journal of Monetary Economics, 49, 879–904.
Obstfeld, M. & Rogoff, K. (2002, May). “Global Implications of Self-Oriented National Monetary Rules,” The Quarterly Journal of Economics, 117, 503–535.
Taylor, J. (1985). “International Coordination in the Design of Macroeconomic Policy Rules,” European Economic Review, 28, 53–81.