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Raghuram Rajan's traffic signal rules for global monetary policy ............................................................................ After Raghuram Rajan’s ‘Dosanomics’ caught the fancy of commentators, it’s now his traffic signal rules for global monetary policy that are getting attention. For those who missed it, speaking at an International Monetary Fund (IMF) and Government of India organised conference in New Delhi last weekend, Rajan suggested that global monetary policy decisions be subjected to traffic lights. Almost literally. The speech, like a few others he has made at international forums in recent years, was pitching for a rule-based global monetary policy system. So, how does Rajan’s traffic light rule work? It’s as intuitive as it sounds. If a certain monetary policy has positive effects on both the home country and the foreign country, it should be rated green or given a green signal. Conventional monetary policies fall in this category, said Rajan, explaining that such policies will improve the domestic economy and also create demand for global economies that export to this country. Essentially, such policies have a net positive impact on global welfare. A simple reduction in interest rates to support growth (provided inflation conditions support it) would fall in this category. The policies that get the orange light come attached with a ‘tread with caution’ tag. Not unlike on the roads. While Rajan didn’t specify which policies he thinks would come under this category, he said that policies that fall in this category may be permissible for a short period of time but not on a sustained basis. Perhaps the first round of quantitative easing in the US, which helped stem the downward spiral in the economy, would fall in that category. Then there are the policies that get a red signal. Stop or else. An example of this kind of policy is unconventional monetary policy that may lead to a small positive impact on exports to smaller economies but may eventually result in capital outflows and asset price bubbles in emerging economies. Such policies will have net adverse effects over time and should be avoided, said Rajan. If this system were to be actually put in practice, how would it rate recent monetary policy decisions? Let’s take the overnight decision by the US Federal Reserve. After signalling in December that there could be four interest rate hikes during the course of 2016, the Fed peddled back and is now signalling only two rate hikes during the course of this year. The reason for this change is not domestic but “global economic and financial developments” which “continue to pose a risk”. Essentially, the Fed and other advanced central banks are caught in a loop. The markets are addicted to ultra-easy monetary policies and any threat of even slight normalisation in these policies sends the global markets into a spin. Central banks get nervous seeing this and then moderate their stance even though any real economic benefits from continuing with these policies may be limited. This suggests that while the initial bout of easing from the Fed may have got the orange light, its decision now to continue with low interest rates is equivalent to driving through even though the light turned red some time ago. The European Central Bank’s (ECB) decision earlier this month to expand stimulus by announcing further cuts in its benchmark rates and also expanding its bond purchases will likely hit the red light. It is true that the ECB is trying to bolster a fragile European economy, and push up inflation, which remains well within its inflation target of 2%. To that extent, the central bank’s attempts to revive the domestic economy by using monetary policy tools at its disposal may be justified. However, there is no evidence that these policies are succeeding in their objective. Instead the easy liquidity may only be fuelling excesses in asset markets. Applying the Rajan traffic signal test to the ECB’s policies would probably mean that they get the red light. The Bank of Japan’s (BoJ) negative interest rate policy would most definitely hit the stop signal. Ever since the Japanese central bank shocked markets in January by adopting negative interest rates, economists have only highlighted the downside to such policies. And that’s putting it mildly. Christopher Wood of CLSA called it the “freak show” world of negative interest rates and went on to say “the move into negative rates further compounds the huge distortions already triggered by seven years of zero rates and quantitative easing”. Stephen Roach, former chairman of Morgan Stanley Asia, in a 16 February editorial in Project Syndicate, called it the “final act of desperation” and added that negative interest rates will only set the stage for the next crisis. The other aspect of global monetary policy that will get the red light under Rajan’s traffic signal rules is the competitive devaluation of currencies as major central banks—the US Fed, the ECB, the BoJ and the People’s Bank of China—are engaging in. As many, including Rajan, have pointed out time and time again, this is a zero sum game. If one wins, the other loses, and the global economy as a whole does not benefit. In conclusion, even as markets react positively to short-term announcements of continued monetary easing (in some cases markets have even reacted with scepticism), it may be important to heed warnings on the long-term effects of these policies. Rajan’s traffic signal rules are one way of doing this.
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