Whatever the US domestic debate, the rest of the world is highly doubtful about QE2. The Europeans have been especially vocal but many in the emerging world are also fearful of its consequences. The question is, can QE2 be characterised as beggar-thy-neighbour?
In his recent speech at the ECB, Ben Bernanke said that asset purchases by the Fed are only the continuation of conventional monetary policy by other means, the difference being that they affect interest rates of securities on longer maturities whereas conventional monetary policy primarily affects the short end of the yield curve. If this definition is accepted, then it follows that the criterion for determining whether QE can be considered beggar-thy-neighbour is the same than for conventional monetary policy.
There is no explicit criterion for assessing the cooperative character of monetary policy and resulting exchange rate developments. There was one in the post-war fixed exchange-rate regime as currency devaluation was subject to the IMF and to the partner’s scrutiny. There was one also in the target zones system of the late 1980s-early 1990s. But no such criterion exists in a floating exchange rate regime based on the principle of monetary policy autonomy.
An implicit criterion however has emerged from the central banks’ practice of the last two decades: as long as monetary policy remained geared towards price stability as usually defined – say, an inflation objective in the 1-3 per cent range – it has been generally assessed in line with the requirements, or at least the spirit of international cooperation.
If this implicit criterion is also accepted the question at the present juncture is twofold:
- First, what does this definition become in a context where inflation objectives are frequently undershot? If the inflation objective is, say, 2 per cent, but actual inflation 1 per cent for an extended period of time because of the extent of economic slack one central bank (say, the ECB) may conclude that it has to accept that it is temporarily unable to reach its objective whereas the other one (say, the Fed) may conclude that it needs to commit even more strongly to reaching it, possibly by adopting a price level instead of a price change target. This would lead to significant monetary policy divergence with immediate consequences for the exchange rate (even if these consequences would be offset in the medium term by inflation differentials). This is entirely a monetary policy issue that arises from the lack of a commonly agreed definition of cooperative policy in a deflationary environment.
- Second, is monetary policy geared towards price stability in the medium run? This essentially boils down to determining whether there is a risk of fiscal dominance, i.e. of an unsustainable fiscal policy ultimately leading to an irresistible pressure to monetise the public debt. The problem here is not directly the monetary policy stance, rather the sustainability of it in the absence of a framework guaranteeing fiscal discipline.
The exchange-rate consequences of different monetary policy attitudes in a deflationary context are not trivial but not significant either. They may drive a temporary depreciation of the dollar exchange rate vis-à-vis the euro, but they are unlikely to result in major misalignments. Furthermore, risks can be limited by discussions among central banks on the interpretation of their price stability mandate in a deflationary context.
But the consequences of an expectation of debt monetisation can be much more severe. In Europe, all governments have announced plans to restore budgetary sustainability. In the US, partisan strife over budgetary policy leads to fear that the Federal Reserve will ultimately have to inflate the problem away. Recent reactions to the Simpson-Bowles and Domenici-Rivlin proposals suggest that the US has got perilously close to the ‘war of attrition’ situation once described by Alberto Alesina and Alan Drazen. This, more than the Fed’s stance, is the real danger.
Contribution to the Economics by Invitation blog, November 21, 2011