Better to be safe than sorry when exiting monetary stimulus

October 15, 2013

The yearly jamboree that is the IMF and World Bank’s annual meetings is over for 2013. It is a particularly intensive but still mostly useful gathering of thousands of economic policymakers and other folks in finance and public policy, with hundreds of parallel meetings.

The IMF jamboree reminds me of the party conferences of the Centre Party of Finland, which is the party I used to know best – with the exception that the latter usually gathers the 4,000 representatives of the rank-and-file branches to debate and vote in an ice hockey rink, rather than in the urban conference halls inside the Washington Beltway. From my standpoint, canvassing and speaking in the ice rink context has been pretty useful training for the numerous larger and smaller gatherings and talk shows in the IMF “party conference”. 

This time, Europe was not at the epicentre of the meetings, unlike in the last four years. Obviously, the immediate focus was on the US fiscal gridlock. While Capitol Hill delved deep into its bipartisan political fight, in the Netherlands, the government and parts of the opposition were able to strike a decisive budget deal last Friday. I hope that US policymakers will take heed and “go Dutch” themselves.

But once the US fiscal stalemate is resolved – and I trust that reason will still prevail, and quickly – there is another major policy issue around the corner: how to exit smoothly from unconventional monetary policy in a world of deep economic interdependence.

On that issue, the US and the emerging market economies were centre-stage. But Europe is not just a semi-innocent bystander here: we have a big stake in this context, for as a re-emerging economy, Europe faces the prospect of rising interest rates potentially hampering her still nascent recovery.

We have taken a look at the effect that a normalisation of interest rates may have on the European economy. Preliminary analysis using our econometric model shows that a rise in US interest rates could have a significant impact on the EU. However, the nature and the size of this impact depend essentially on the underlying causes of the increase. 

There are basically two scenarios. On the one hand, if the rise in interest rates is driven by a negative shock and a worsening of investor sentiment, the impact will be negative. On the other hand, a normalisation of monetary policy driven by a strengthening of economic activity in the US would likely have a positive impact on the EU and euro area. Of course, because of the current financial market fragmentation in the euro area, some vulnerable countries could be negatively affected by the rise of long-term interest rates, even in the second scenario.

It is evident that stronger and sustained growth will go hand-in-hand with a carefully calibrated transition towards the normalisation of monetary policies, including an appropriate communication strategy.

The importance of a smooth normalisation of monetary policy was underlined in the conclusions of the International Monetary and Financial Committee. They point out that the phasing out of unconventional monetary policy by major economic powers has global ramifications. All agreed to take into account the impact of their action on their international partners in light of possible feedback effects.

This leads me to two main policy conclusions.

First, it is better to be safe than sorry when exiting the monetary stimulus. In other words, while the phasing out of monetary easing will need to gradually happen, an excessively speedy or rushed exit from monetary easing would have clearly negative ramifications for the still weak and fragile economic recovery. A carefully calibrated phasing out of monetary stimulus will be more appropriate and eventually indeed necessary for the sake of sustained recovery and growth.

Second, it is essential that we in Europe – both the individual Member States and the Union as a whole – stay on the reform course. Especially, it is crucial to maintain the momentum in rebuilding the economic and monetary union, most concretely through the construction of a banking union. But the same call for structural reforms to strengthen economic fundamentals is likewise fully valid for the (other) emerging economies.

 

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