The prevalence of negative interest rate policies around the world has raised the question: Would the global economy and individual countries benefit from central banks committing to coordinate their monetary policy?
Last summer, just days after the Brexit surprise rattled investors around the world, European Central Bank President Mario Draghi said, “In a globalized world, the global policy mix matters – and will likely matter more as our economies become more integrated. So we have to think not just about whether our domestic monetary policies are appropriate, but whether they are properly aligned across jurisdictions.”
In practice, however, adopting global monetary policy cooperation – or succumbing to it – could plausibly erode central bank credibility and public support for sound, rules-based policies. The all-in cost to a regime of policy cooperation could swamp any theoretical modest benefits, and if so, we should not bemoan the absence of formal monetary policy cooperation: We should celebrate it.
Key concerns with policy cooperation
To the extent policy rules provide an important reference point and anchor for national monetary policy, international coordination can enhance the design and effectiveness of baseline national policy rules. But there is reason to be skeptical of efforts beyond coordination. In practice, there likely would be no additional material, reliable or robust gains flowing from a formal regime of binding monetary policy cooperation, at least among major G-7 economies and even including a number of emerging economies with flexible exchange rates and relatively open capital accounts. In a cooperative (binding) regime, national monetary policies in each individual country would be constrained to jointly maximize world welfare.
Whereas optimal policy in the absence of cooperation can be implemented with a policy rule that reacts to domestic inflation, output gaps and the appropriately defined equilibrium (or neutral) real interest rate, a cooperative policy geared toward global welfare binds central banks to policy rules that react to foreign as well as domestic inflation: policy rules that they would not choose were they not bound. It’s what we call a time inconsistency problem: A commitment made on a given day may, in the future, become obsolete – inconsistent – because the factors driving that commitment have changed.
Central bank credibility
There could well be another problem with cooperation in practice: a threat to the credibility of the central bank. Central bank communication, a tightrope under any circumstance, would be profoundly more challenging, and we could see a loss of public support for policy decisions that (as required by cooperation) react not only to home inflation and unemployment but also to deviations of foreign inflation from target. Imagine if home inflation fell below target as foreign inflation rose above target. In this case, the optimal policy rule under cooperation calls for the home (real) policy rate to be higher – less accommodative – than it would be in the absence of cooperation, not because home inflation is too high, but because foreign inflation is! Just imagine the press conference following that decision.
Perhaps for these reasons, there are not many confirmed sightings of genuine global monetary policy cooperation. But we do observe examples of what I think of as policy coordination, which can have real benefits for central bank policy. To the extent a central bank has some comparative advantage in tracking or forecasting its own domestic output growth and equilibrium real interest rate, sharing this information with other central banks can improve each bank’s estimate of its home equilibrium real interest rate and thus the effectiveness of its policy rule in meeting its domestic objectives.
If global central banks go down a path of evolution from alignment, or coordination, toward binding policy cooperation, they’ll want to take a long, hard look at the risks of undertaking such a journey.
A version of this blog post appeared in Japanese in the Nikkei on 4 September 2016.
Richard Clarida is PIMCO’s global strategic advisor and a regular contributor to the PIMCO Blog. For a more in-depth look at global monetary policy correlation, coordination and cooperation, please read his Global Central Bank Focus.