Oil Supply Routes in the Asia Pacific: China's Strategic Calculations

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A Speech in Moscow

Re-thinking the New Monetary Consensus - Sharing Lessons from History

Good Afternoon. It is a privilege for me to be addressing an eminent panel such as this.

The financial crisis has caused a significant amount of confusion in the minds of policymakers. The highly integrated financial system dictates that policy experiments made in one country have rippling effects in others. And therefore, the theme of this discussion – “the possibility of coordinating positions” is extremely important in today’s context.

Given the current state of the US economy – with no job growth last month, the local positive impact of the two rounds monetary easing is in serious doubt. At the same time, there is no denying that QE1 and QE2 have had a profound global impact and the extra liquidity has still not been absorbed by the global financial system. The world as I see it now is cleanly divided into two parts. Western economies like the US, and EU are monetizing their debt and yet not experiencing any signs of inflation (and desperately clutching at straws!) while BRIC and other middle income and emerging economies are facing stubborn inflationary trends.

At the outset of course, it is not an unusual phenomenon for advanced economies to experience low inflation rates. The stabilization of output volatility with low inflation; over the past two decades before the recent crisis, had been termed “the great moderation” for precisely these attributes. A fair amount of credit had been given to central bankers – and the evolution of central banking for moderating the volatilities associated with economic cycles and trends. In fact since the 1980s, average inflation worldwide declined from 14 percent in the early 1980s to 4 percent in the early 2000s. Industrial economies achieved a reduction in inflation from 9 to 2 percent, while developing economies brought inflation down from 31 to 6 percent.

Central banking has indeed come a long way from the “stop and go” mechanisms that were used to manage cyclical price trends. With the adoption of tools like inflation targeting – central banks in advanced economies, at the outset, seemed to have done a good job of managing inflation. As a result, most of the world achieved a working consensus on the core principles of monetary policy and how this policy can be used to manage inflation expectations. This general agreement amongst economists by the latter half of the 1990s – has been termed the “New Monetary Consensus”.

It can be argued that the genesis of the consensus was in the 1970s – with Milton Friedman’s assertion that “inflation is always and everywhere, a monetary phenomenon”. The first bit of evidence they gathered to prove this was that across the world long term sustained inflation is always associated with excessive money growth. Thereafter they showed that control on money supply is both necessary and sufficient to control inflation trends.

Even though the monetarists did a good job of accumulating evidence and building credible theoretical foundations – the actual basis for the Monetary Consensus, and the way monetary policy is conducted in many countries today, was achieved because of Paul Volcker – the Chairman of the Federal Reserve in the turbulent 1980s. Volcker was dogged in his pursuit to tame inflation – and was willing to forgo creation of jobs and economic growth to achieve his cause - by associating himself closely with the key monetarist idea – that inflation could be controlled without imposing price or wage controls. He let the short-term interest rates rise dramatically and the US economy immediately went into recession. Public support for inflation control and the political support from the incoming Reagan administration were key elements that let Volcker continue his experiment with the US economy. By 1984 he was able to control inflation with causing a dramatic drop in economic output.

It can be argued that the stubbornness and sacrifices made by the US government, the Federal Reserve and the American society as a whole – together contributed to the successful anchoring of inflation expectations in the country. It is also important to remember that this happened within the context of an already developed economy with efficient policy transmission mechanisms. Alan Greenspan took Volcker’s inflation sensitive policymaking trends forward into the 1990s and beyond – and simultaneously the world came to achieve the New Monetary Consensus which emphasised the control of inflation at all costs.

A result of this renewed focus on inflation has been the introduction of “inflation targets” by countries around the world. Starting with New Zealand in 1990 and Canada the year after, countries around the globe started declaring explicit inflation targets in a hope to anchor people’s inflation expectations. The European Central Bank is one of the bigger monetary authorities which declares inflation targets these days – but this phenomenon has also caught on in smaller emerging market economies.

The Central Bank of Russia has also published many documents over the last couple of years that have indicated an imminent switch towards an inflation targeting strategy. In its most recently published Guidelines for Single State Monetary Policy, the CBR has explicitly and repeatedly stated that both inflation targeting - and less interventions in the foreign exchange market are on the immediate agenda.

I quote from the CBR’s document: “The exchange rate policy to be pursued by the Bank of Russia in 2010-2012 will aim to cushion sharp fluctuations of the rouble exchange rate against the major world currencies. The Bank of Russia will seek in this period to create conditions for the implementation of the monetary policy model based on inflation targeting by gradually scaling down its interventions in the rate-setting process.”

I do not think that a completely free floating exchange rate is a viable or credible strategy for Russia as long as oil remains a dollar denominated resource; but the switch to inflation targeting is definitely on the cards given that there seems to be little by way of opposition to the idea in Russia. Furthermore, there seems to be a distinct attempt by the CBR to try to present its monetary policy as a modern one to foreign investors.

On some contextual analysis of inflation targeting and the idea behind central banks being solely responsible for managing inflation, there are many issues that I feel the CBR should find worth considering and indeed, many of these have been faced by the central bank of India – the RBI. Hence I would like to share our concerns in this regard.

According to monetary policy theory, central bank independence – both operational and organizational is a prerequisite for inflation targeting. That is independence is a prerequisite for establishing credibility. In India, in the earlier part of the last decade, the RBI was considering switching to an inflation targeting regime. As is usual in countries like ours, a few good men from the International Monetary Fund were trying to drive this shift in policy.

However, due to the dovish pro investment policy followed by Alan Greenspan under George Bush, the RBI struggled to sterilize capital inflows. As a result the exchange rate for the rupee came under immediate threat - and the government faced protests from the exporting sector. (By the way – one of our biggest exporting sectors – the textile sector, employs the 2^nd highest number of workers after the agriculture sector)

The policymakers in the RBI realized that there was an inherent contradiction in wanting to project independence and using government guaranteed bonds to sterilize the inflows to control the Rupee’s sharp appreciation. Consequently the RBI abandoned aspirations of switching to inflation targeting. Given that Russia faces similar problems managing capital inflows, in my view it makes little sense to switch from discretionary policy to explicit inflation targeting.

The second major challenge that advanced economies in the developed world are experiencing with regard to inflation targeting is the failure of such policy to overcome deflation. After all, it was only recently that the Federal Reserve went about injecting liquidity into the American economy in a frenzied fashion due to deflationary scares. Even after almost 3 trillion dollars were indirectly injected into the American economy – inflation is still very low. There is even talk of the US becoming more and more like Japan everyday – inadvertently caught in a long term liquidity trap.

Another problem is that countries like Russia and India are structurally prone to more inflation than Western counterparts – and it is the volatility of inflation that is to be more seriously countered rather than overall inflation. It is significant to note that inflation targets in various advanced economies are rather arbitrarily declared at low levels – between 1.5 to 2.5 percent in nominal terms. The structural set up in Russia and India dictate that the optimal levels of inflation lie between 4 and 7 percent. 

In countries like ours, policy transmission mechanisms are not as efficient as in advanced economies in the West. The ECB has estimated that there is about a 4 quarter lag between policy change in the form of interest rate movement and expected outcome in the euro zone. It would be overly presumptuous to think that the transmission lag in Russia would be any less than in the euro zone.

Furthermore, much like India, Russia is a country where the existence of asymmetric and imperfect information in the financial markets is a well known problem – therefore invalidating, the efficient market theories on the assumption of which the New Monetary Consensus style of central banking has evolved. This clearly causes more contradictions for inflation targeting regimes.

One of the projected advantages of inflation targeting is increased accountability of the central bank. However, on careful observation of Western models, it is certainly not obvious that accountability has increased. The recent market interventions in the sovereign bond markets by the ECB or the complete disregard by the Federal Reserve of accepted regulatory and supervisory roles in the mortgage markets - leading to the collapse of the financial markets, certainly do not inspire confidence in such theoretical models.

For Western central banks, these turbulent times contrast sharply against the extraordinarily smooth period they enjoyed in the years before the crisis. With inflation low and real economic growth strong and stable, and risk spreads in financial market increasingly compressed, managing monetary policy had become an unexpectedly easy task. As we are all aware the situation in the West has now reversed. As Mr. Nikonov pointed out in his opening statements yesterday – the three most unstable zones in the world today include the US and the euro zone!

Central Bankers in the West face similar challenges to those that were experienced by less developed financial systems in the past – that is they are not longer finding it easy to separate monetary and fiscal prerogatives. The precarious economic situation in the US and euro zone dictate that the Federal Reserve and the ECB are increasingly forced to make fiscal decisions. This is ironic given that the central tenets of the New Monetary Consensus demand that monetary and fiscal management of economies be conducted separately. 

It is clear to me that monetary policy has reached a crossroads. The question now is whether the inherent hypocrisy of central banking policy of the West is recognized and the New Monetary Consensus re-evaluated by the relevant stakeholders; or whether Western models of monetary policy will continue to be projected as a panacea for inflation throughout the globe – much like following the Washington Consensus was projected for decades by institutions like the IMF and World Bank as the only way for policymakers in the developing world - to ensure positive and sustainable economic growth trajectories in their respective countries.

In the end I would like to say that it is time for Russian policymakers to ask themselves some hard questions:

Is the signalling value of projecting a consistent and conservative monetary regime to their countrymen and perhaps more relevantly, to the international investing community - truly worth sacrificing logical and optimal adaptive policy for? Do Russian policymakers believe that the discretionary learning by doing policy responses to supply and demand scenarios followed in both our countries for many years now, need to be reversed? And do they believe that explicit policy rules should be followed without paying attention to history or to the observable changes in the global financial and economic architecture?

The problems faced by monetary policymakers are paralleled in the other areas of economic and financial policy making. And therefore I feel that it is the right time for us to think seriously about alternative policy making strategies to those advocated for the last few decades by various Western stakeholders. In this regard – I feel that there is enormous scope for India and Russia to coordinate positions and adopt reasonable and practical monetary and fiscal stances rather than subscribe to theoretical and rigid policies promoted by the US, EU and various inherently interventionist international organizations.

Ladies and gentleman, I thank you once again for giving me an opportunity to express my personal views, and the view from India, to this very important forum.