Claudio Borio interview with Market News International

Original quotes from interview with Mr Claudio Borio, Head of the Monetary and Economic Department of the BIS, with Market News International, conducted by Mr Christian Vits and published on 23 March 2018.

On challenges for central banks:

The most immediate economic challenge is to help the economy sustain its expansion coupled with lasting price stability. This is a tricky challenge, as economies are still dealing with the legacy of the past crisis in the form of continued very low interest rates, increased levels of indebtedness relative to output and, in the background, declining productivity growth.

The second challenge is of a longer-term nature and relates to frameworks: whether and, if so, how to refine policy frameworks to ensure lasting price stability alongside financial and macroeconomic stability.

The third challenge is of a more political economy nature. It has to do with the expectations gap that has developed between what central banks can deliver and what people expect them to deliver.

Meeting the first challenge cannot be done by monetary policy alone. Monetary policy requires the support of prudential, fiscal and structural policies, in what might be termed a macro-financial stability framework. It would be a big mistake to believe otherwise. Central banks have been overburdened for far too long. A better understanding of this condition would also help address the expectations gap.

On financial/business cycles:

The key point about financial cycles is that they are considerably longer than business cycles. The business cycle, as economists tend to conceive and measure it, has an average duration of roughly eight to 10 years, while financial cycles have been much longer since the '80s - something like 16 to 20 years.

Why have financial cycles become larger and longer since the '80s? A number of factors may have been at work.

One has been financial liberalisation, which has given further play to loosely anchored perceptions of value and risk. This helps generate financial expansions followed by contractions, as balance sheets become overstretched.

A second has been the globalisation of the real economy, which has provided fertile ground for financial booms by raising growth expectations, while at the same time generating disinflationary pressures. Indeed, the inflation process has proved rather insensitive to domestic measures of slack for quite some time.

All this has raised new challenges for monetary policy frameworks focused on near-term inflation control, as these financial cycles have tended to occur against the background of low and sometimes falling inflation. Under those conditions, there is no reason for the central bank to tighten during the boom, potentially accommodating the build-up of financial imbalances. And when the boom then turns to bust, you end up having to address the host of tough problems that we have seen post-crisis.

On low inflation/globalisation:

One can think of two types of effect of the globalisation of the real economy on inflation. At cyclical frequencies, globalisation tends to increase the relevance of global capacity constraints relative to domestic ones. At lower frequencies, it can put persistent downward pressure on inflation, by reducing the pricing power of labour and firms and thus making wage-price spirals less likely. Technological innovation may have similar effects - think, for instance, of how it has promoted global value chains, of the automation of jobs and of the Amazon effect.

What are the prospects for inflation? It is a tug-of-war between opposing forces. In a synchronised global expansion, with many economies reaching their capacity limits simultaneously, one could expect inflation pressures to increase. On the other side, we have the more structural disinflationary forces I just mentioned, coupled with the scarring effects of the crisis. The longer the expansion continues, the more likely it is that the former will gain the upper hand.

And, let me add, were the world to turn more protectionist, as the recent rhetoric suggests, there would be untoward implications for inflation too. In the short run, this would tend to raise prices and costs. And if a broader change in regime took place, giving labour and firms more pricing power and undoing some of the beneficial effects of globalisation, this could provide a more fertile ground for inflation.

Trade wars can have no winners, only losers.

On the Phillips curve:

The relationship between inflation and domestic slack does exist, but it has proved weaker than expected and somewhat unstable. The questions concern, in particular, the strength of the relationship and the relative role of domestic and global capacity constraints.

Over time, one would expect the persistent disinflationary pressures linked to the entry of low-cost producers into the world trading system - which may obscure the standard Phillips curve relationship - to wane. This is because the labour-cost differentials between the new entrants and the more advanced economies tend to fade. But all the indications are that the impact of technology could loom larger.

On the side-effects of low interest rates for long:

It is generally recognised that there are side effects if interest rates stay unusually low for unusually long. They can delay balance sheet repair; hurt banks' and other financial institutions' profits, and hence resilience; induce a misallocation of resources; and encourage risk-taking in financial markets.

Take a couple of examples. Very low interest rates reduce the opportunity cost of keeping non-performing loans on banks' books, possibly slowing down their resolution. Similarly, we have seen an increase in the incidence of firms whose profits do not cover interest payments, dubbed Zombie firms, which may be linked to lenders' greater tolerance in a low interest rate environment.

Those costs need to be balanced against the well-known benefits, as low rates boost economic activity and help bring inflation back to target. And, indeed, economies are back on track. Of course, as economies improve, the balance between the benefits and costs of persistent unusually low rates tends to deteriorate.

After such a long period of unusually low interest rates, coupled with growing central bank balance sheets, normalising policy presents serious challenges, not least as the global economy has seen a further increase in debt levels in relation to incomes and output. It is a narrow path, complicated more recently by the protectionist rhetoric that has been gaining ground.

What is clear is that normalising policy will not be without hiccups. For instance, it would be unrealistic not to expect bouts of market volatility, as confirmed by the recent wobbles in the US stock market. But as long as this volatility stays in financial markets, there is no reason to be distracted from the long-term course, which should be driven by macroeconomic developments.

On deviations from inflation objectives:

In order to allow monetary policy to take better account of macro-financial stability risks and their implications for longer-term price stability, frameworks need to have sufficient in-built flexibility to tolerate sometimes persistent, if moderate, deviations of inflation from targets. This is particularly the case for shortfalls. And the reason for the deviations matters. If shortfalls are driven by demand weakness, they are costly for the economy, as they signal that it is operating below capacity. By contrast, if the shortfalls are driven by positive supply side forces, such as globalisation and technology, they are not harmful. The challenge is to distinguish the two types, which can be quite hard to do as events unfold (ie in real time).

What kind of possible adjustments to frameworks could allow for this flexibility? In some cases, targets are already interpreted quite flexibly. Options include lengthening the horizon and/or having bands with sufficient width. Bands have the merit of being explicit about the difficulties in fine-tuning inflation.

On the risk that central banks fall behind the curve:

I don't see the increasing risk you suggest. What I see is the continuation of the challenges central banks have been facing for some time. They are fully aware of the risks involved.

On risks such as a debt-trap:

There is a risk that the global economy might fall into a kind of debt trap, if policies in general are unable to address the build-up of debt. In the case of monetary policy, the risk is that the higher debt levels that have gone hand in hand with lower interest rates will make it harder to raise those rates to historically more normal levels. In turn, this would reduce the policy room for manoeuvre and complicate dealing with the next recession.

On how much ammunition is left:

The first piece of good news is that no one is under the illusion that the business cycle has vanished, so that there is a lot of thinking devoted to how to tackle one. The second piece of good news is that central banks have gained quite a bit of experience with the new tools, so the range of options is broader. The less good news is that the room for manoeuvre has narrowed. This is partly linked to the debt trap risk.

On inflation targeting:

Inflation targeting as a framework was extremely successful in helping to bring inflation down and keeping it there, confounding the sceptics at the time. Of course, other factors no doubt helped too, including the tailwinds of globalisation and technology. The issue now is whether some refinements would help address macro-financial stability concerns more systematically, notably through greater flexibility.

On policy normalisation:

The merits of gradualism and predictability are clear and well known. At the same time, gradualism and predictability also have a downside. For example, they may encourage risk-taking in financial markets and more leverage, making it harder for central banks to exit smoothly. Central banks are aware of these trade-offs and of the difficult balancing act they face.

On keeping larger central bank balance sheets:

First, given the pace at which central bank balance sheets will be unwound, their size will remain larger than what is strictly necessary to guide interest rates for quite some time.

A second question is whether central banks could use the unwinding phase more symmetrically - for instance, by selling the securities they now hold to tighten conditions should the need arise. In principle, this is possible and would result in their employing their securities holdings a bit more like an interest rate tool, which is used in both directions. And, again in principle, having more options at one's disposal is good. In practice, however, there are complications. The main one is the risk of blurring policy signals - a reason why the Federal Reserve has decided to put the unwinding on auto-pilot.

As regards the optimal size of the balance sheet, there is no one-size-fits-all. But having a small balance sheet has the merit of allowing more room for its expansion in case of need. One can then think of the interest rate as the normal tool, leaving adjustments to the balance sheet for exceptional circumstances.

On the limitations of forward guidance:

Clearly, forward guidance has helped to reduce interest rates along the yield curve further, and to that extent it has provided more stimulus. At the same time, the tool has some limitations.

One is that sometimes the guidance may not be fully understood. For example, conditional statements may be misinterpreted as a commitment. Another is that even when it is understood, the guidance may not be fully believed. For instance, the composition of policy committees changes and you cannot bind your successors. Similarly, the market may have a different view about how the economy works and the outlook.

A final issue is that the forward guidance can generate the conditions which make exit harder, with the risk that you can get boxed in. This can arise if, for instance, market participants' belief that the central bank will keep interest rates low for long encourages further risk-taking and leverage, making it harder to exit without creating disruptions in markets.

On the limitations of negative interest rates:

Negative interest rates have pros and cons, just like balance sheet policy. The cons are linked, in particular, to the persistence of such rates, and are not qualitatively different from those resulting from very low rates. What is different is that the general public may not understand them and react badly. The notion that one pays for the privilege of lending money is not easy to grasp. And negative rates may foster a sense that the economic situation is dire.

On central banks being led by markets instead of leading them:

This is a tricky relationship. There is always a risk that, rather than leading, you end up being led. You should only react to short-term volatility in financial markets to the extent that it has an impact on your ultimate objective. But even then, you may be perceived as overreacting and as providing some kind of assurance to the markets even if you do not intend to do so, which then narrows your room for manoeuvre. The challenge has become tougher since the Great Financial Crisis because of the unprecedented and difficult conditions central banks have been facing.