Raghuram Rajan warns against side-effects of aggressive monetary policies

RBI governor Raghuram Rajan says aggressive monetary policy actions by one country can lead to measurable and significant cross-border spillovers on other economies

Aggressive monetary policy actions by one country can lead to measurable and significant cross-border spillovers on other economies, especially as countries contend with the zero lower bound, said a Reserve Bank of India working paper authored by Prachi Mishra and governor Raghuram Rajan released on Monday.

Zero lower bound refers to a macroeconomic problem that occurs when policy rates are near zero, causing a liquidity trap and limiting the central bank’s capacity to stimulate the economy further.

If countries do not internalize these spillovers, they may respond by undertaking policies that are collectively suboptimal, said the paper, suggesting that countries should agree to guidelines for responsible behaviour that would improve collective outcomes.

“The bottom line is that simply because a policy is called monetary, unconventional or otherwise, it may not be beneficial on net for the world... What matters is the relative magnitude of demand creating vs demand switching effects, and the magnitude of other net financial sector spillovers, that is, the net spillovers,” the paper said.

The paper highlighted that exchange rates tend to be the channel through which these spillovers often transmit.

“In a world besieged by accusations of ‘currency wars’ and ‘negative spillovers’, owing to the extensive recourse to unconventional monetary policies and exchange rate depreciations, measuring this effect is important,” the paper said.

The tone of the paper mirrors Rajan’s recent public calls for a collective thinking on unconventional policies adopted by global central banks. Rajan has used the analogy of traffic signals to rate monetary policies.

Noting that almost all central banks have specific domestic mandates, the paper warned of the risk of policymakers attaching a lower weight to international spillovers while deciding on their policies.

To prevent this, the paper argues for a new set of rules in global monetary policymaking wherein policies could be rated green, orange or red, depending on their positive local effects and negative spillover effects on foreign countries.

“To use a driving analogy, polices that have few adverse spillovers, and are even to be encouraged by the global community should be rated green, policies that should be used temporarily and with care could be rated orange, and policies that should be avoided at all times could be rated red,” said the paper. These policies would also take into consideration the stage of an economic cycle in the country where the policies are originating, it added.

Also, policies should be rated based on their effects in the medium term rather than on a one-shot static effect.

Conventional monetary policy could get a green rating while policies that have large positive effects for the originating country but small sustained negative effects on other countries could be used sparingly and rated orange. Policies that have net adverse effects on foreign countries and on global welfare should be rated red and avoided at all times.

Another factor that policymakers could look at while rating policies is to give a greater weight to spillover effects to poorer countries that have weaker institutions, the paper argued.

The authors conceded that an agreement on common rules for policy is difficult and could take time. Further, existing economic models do not provide empirical analysis for a clear-cut rating of policies. The paper listed several models, including that of the IMF and US Federal Reserve, which could be used to assess the spillover effects of policies, but these have shortcomings and are extremely complicated.

“Nevertheless, with economic analysis of these issues at an early stage, it is unlikely we will get strong policy prescriptions soon, let alone international agreement on them, especially given that a number of country authorities like central banks have explicit domestic mandates,” the paper said.

The authors called for a discussion among policymakers at various fora such as the G-20 meet and IMF meetings.

“Such a discussion need not take place in an environment of finger pointing and defensiveness, but as an attempt to understand what can be reasonable, and not overly intrusive, rules of conduct,” the paper said.