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Is it yesterday once more?
Why unconventional monetary policies pose a risk rather than cure

Raghuram Rajan

As the world seems to be struggling to get back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrains domestic demand, a sizeable portion of the effects of such policies spill over across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. 

To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle.

Central bankers are usually reluctant to air their concerns in public. But because the needed change has political elements to it, I take my cue from speeches by two central bankers whom I respect greatly, Ben Bernanke in his 2005 “Global Savings Glut” speech, and Jaime Caruana in his 2012 speech at Jackson Hole, both of whom have raised similar concerns to mine, although from different perspectives.

Before starting, I should disclose my interests in this era of transparency. For the last few months India has experienced large inflows of capital, not outflows, and is seen by the markets as an emerging economy that has made some of the necessary policy adjustments. We are well buffered with substantial reserves, though no country can be de-coupled from the international system. My remarks are motivated by the desire for a more stable international system, a system that works equally for rich and poor, large and small, and not the specifics of our situation. 

Unconventional policy and exits

I want to focus on unconventional monetary policies (UMP), by which I mean both policies that hold interest rates at near zero for long, as well as balance sheet policies such as quantitative easing or exchange intervention, that involve altering central bank balance sheets in order to affect certain market prices.

The macroeconomic argument for prolonged unconventional policy in industrial countries is that it has low costs, provided inflation stays quiescent. Hence it is worth pursuing, even if the benefits are uncertain. A number of economists have, however, raised concerns about financial sector risks that may build with prolonged use of unconventional policy. Asset prices may not just revert to earlier levels on exit, but they may overshoot on the downside, and exit can cause significant collateral damage. 

One reason is that leverage may increase both in the financial sector and amongst borrowers as policy stays accommodative. One channel seems to be that a boost to asset liquidity leads lenders to believe that asset sales will backstop loan recovery, leading them to increase loan to value ratios. When liquidity tightens, though, too many lenders rely on asset sales, causing asset prices and loan recovery to plummet. Because lenders do not account for the effects of their lending on the “fire sale” price, and subsequently on lending by others, they may have an excessive incentive to build leverage.

These effects are exacerbated if, over time, lenders become reliant on asset sales for recovery, rather than on up front project evaluation and due diligence. Another possible channel is that banks themselves become more levered, or equivalently, acquire more illiquid balance sheets, if the central bank signals it will intervene in a sustained way when times are tough as unemployment is high.

When monetary policy is ultra-accommodative, prudential regulation, either of the macro or micro kind, is probably not a sufficient defence. In part, this is because, as Fed Governor [Jeremy] Stein so succinctly put it, monetary policy “gets into every crack”, including the unregulated part of the financial system. In part, ultra accommodative monetary policy creates enormously powerful incentive distortions whose consequences are typically understood only after the fact. The consequences of exit, however, are not just felt domestically, they could be experienced internationally. 


Perhaps most vulnerable to the increased risk-taking in this integrated world are countries across the border. When monetary policy in large countries is extremely and unconventionally accommodative, capital flows into recipient countries tend to increase local leverage; this is not just due to the direct effect of cross-border banking flows but also the indirect effect, as the appreciating exchange rate and rising asset prices, especially of real estate, make it seem that borrowers have more equity than they really have.

Exchange rate flexibility in recipient countries in these circumstances sometimes exacerbates booms rather than equilibrates. Indeed, in the recent episode of emerging market volatility after the Fed started discussing taper in May 2013, countries that allowed the real exchange rate to appreciate the most during the prior period of quantitative easing suffered the greatest adverse impact to financial conditions.

The difficulty of distinguishing the cyclical from the structural is exacerbated in some emerging markets where policy commitment is weaker, and the willingness to succumb to the siren calls of populist policy greater. But it would be a mistake to think that pro-cyclical policy in the face of capital inflows is primarily a disease of the poor; even rich recipient countries with strong institutions, such as Ireland and Spain, have not been immune to capital-flow-induced fragility.

Ideally, recipient countries would wish for stable capital inflows, and not flows pushed in by unconventional policy. Once unconventional policies are in place, however, they do recognise the problems stemming from prolonged easy money, and thus the need for source countries to exit. But when source countries move to exit unconventional policies, some recipient countries are leveraged, imbalanced, and vulnerable to capital outflows.

Given that investment managers anticipate the consequences of the future policy path, even a measured pace of exit may cause severe market turbulence and collateral damage. Indeed, the more transparent and well-communicated the exit is, the more certain the foreign investment managers may be of changed conditions, and the more rapid their exit from risky positions.

Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country. Having become more vulnerable because of leverage and crowding, recipient countries may call for an exit whose pace and timing is responsive, at least in part, to conditions they face. 

International monetary policy coordination

My call is for more coordination in monetary policy because I think it would be an immense improvement over the current international non-system. International monetary policy coordination, of course, is unpopular among central bankers, and I therefore have to say why I reiterate the call and what I mean by it.

I am not implying that central bankers sit around a table and make policy collectively, nor do I mean that they call each other regularly and coordinate actions. In its strong form, I propose that large country central banks, both in advanced countries and emerging markets, internalise more of the spillovers from their policies in their mandate, and are forced by new conventions on the “rules of the game” to avoid unconventional policies with large adverse spillovers and questionable domestic benefits. Given the difficulties of operationalising the strong form, I suggest that, at the very least, central banks reinterpret their domestic mandate to take into account other country reactions over time (and not just the immediate feedback effects), and thus become more sensitive to spillovers. This weak “coordination” could be supplemented with a re-examination of global safety nets. 

Emerging economies have to work to reduce vulnerabilities in their economies, to get to the point where, like Australia, they can allow exchange rate flexibility to do much of the adjustment for them to capital inflows. But the needed institutions take time to develop. In the meantime, the difficulty for emerging markets in absorbing large amounts of capital quickly and in a stable way should be seen as a constraint, much like the zero lower bound, rather than something that can be altered quickly. Even while resisting the temptation of absorbing flows, they will look to safety nets.

So another way to prevent a repeat of substantial reserve accumulation is to build stronger international safety nets. As the financial crisis suggested, this is not just an emerging economy concern. In a world where international liquidity can dry up quickly, the world needs bilateral, regional and multilateral arrangements for liquidity. Multilateral arrangements are tried and tested, and are available more widely, and without some of the possible political pressures that could arise from bilateral and regional arrangements. Indeed, swap arrangements can be channelled through multilateral institutions like the IMF instead of being conducted on a bilateral basis, so that the multilateral institution bears any (small) credit risk, and the source central bank does not have to justify the arrangements to its political authorities. 

Domestic Optimal is close to the Global Optimal

By downplaying the adverse effects of cross-border monetary transmission of unconventional policies, we are overlooking the elephant in the post-crisis room. I see two dangers here. One, that any remaining rules of the game are breaking down. Our collective endorsement of unconventional monetary policies essentially says it is okay to distort asset prices if there are other domestic constraints to reviving growth, such as the zero-lower bound. But net spillovers, rather than fancy acronyms, should determine internationally acceptable policy.

Otherwise, countries could legitimately practise what they might call quantitative external easing or QEE, whereby they intervene to keep their exchange rate down and build huge reserves. Currency manipulation may help growth in the short run (even this is debatable), but creates long-run distortions that hurts the manipulating country. There are more sensible policies to foster growth. And even if a central bank has a purely domestic mandate, the country’s international responsibilities do not allow it to arbitrarily impose costs on the rest of the world.The net spillover effects need to be estimated, and it cannot be taken for granted that the positive spillovers from the initiating country’s growth (say, through greater trade) more than offset the adverse spillovers to other countries. 

Feedback effects to the source country represent only a small part of the spillover effects experienced by the world, and a central bank will be far from implementing the globally optimal policy if it is solely domestically-oriented, even if it takes these feedback effects into account. Countries are required to pay attention to the effects of their policies on others, no matter how much the added complication, because we all have international responsibilities.

Indeed, the lesson emerging markets will take away from the recent episode of turmoil is (i) don’t expand domestic demand and run large deficits (ii) maintain a competitive exchange rate (iii) build large reserves, because when trouble comes, you are on your own. In a world with deficient aggregate demand, is this the message the international community wants to send?


The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing.

If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression-era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS general manager Andrew Crockett put it, “financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.” A first step to prescribing the right medicine is to recognise the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognise that, the more sustainable world growth we will have.

Abridged version of the RBI governor’s speech at the Brookings Institution, April 10, 2014

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