The Second (biennial) International Research Conference organised by RBI got off to an excellent start with the introductory expositions (which were much more insightful than speeches) of the Governor and Deputy Governor. Both were excellent generalist outlines of very complex issues that the best minds across the globe have been grappling with over the past three years. Hagiography? If this sounds so, so be it. (I have persisted against the grain of RBI?s monetary policy stance, before, in these very columns.)
The theme of the conference was the ?New Trilemma: Monetary Policy, Sovereign Debt and Financial Stability?. Events of the past four years have transformed the classic trilemma framework developed over the past four decades into a very contemporaneous quandary for governments, central bankers, academics and policy wonks. The older (and still very contemporaneous) trilemma showed the analytic impossibility of policy authorities in pursuing the three ?impossible trinity? goals of a free capital account, fixed exchange rates and an ?independent? monetary policy (i.e., the ability to fix domestic interest rates and liquidity). This had informed the philosophy of the Washington Consensus and thereafter spawned the corollary (if I might be permitted a gross simplification) that the appropriate approach of central banks, operating in this trinity framework, was to focus on inflation and let market forces adjust other economic parameters.
Unfortunately, as is being now understood, this single-minded focus on inflation targeting probably lulled many global central banks into a sense of complacency with the virtually unprecedented low inflation in the extended period before the financial crisis of 2008. A creeping build-up of financial instability, partially due to the emergence of a shadow banking system, escaped notice, leading to the threat of a potential collapse of the global financial system and a near total freeze of global liquidity. The response of policy authorities, both monetary and fiscal, was to infuse massive liquidity into both the economy and the financial system, to prop consumption and try to boost credit.
The current sovereign debt threat was a direct fallout of these measures. The increasing vulnerability of banks was due in part to their holding a large share of sovereign debt, reinforced by the weakened quality of assets invested in the financially engineered instruments of the early 2000s. Another consequence of the liquidity infusion was a re-ignition of inflationary pressures, much above levels warranted by the lower growth post 2008.
This constellation of outcomes has now resulted in the morphing, in terms of design of policy, of the impossible trinity into what the RBI Governor terms the Holy Trinity: Concerns of Price Stability, Financial Stability and Sovereign Debt Sustainability (it actually sounds like an ?Unholy Trinity?). The talks last week laid out the various ways in which the new trilemma is likely to play out. Since the causalities are not symmetric, there are six major channels of interactions between these three nodes of the trilemma.
In light of the current situation in the eurozone, the most immediate concern among these interactions is from sovereign debt to the financial sector. A large part of the slowdown in credit delivery, following fears of large haircuts for sovereign bond holders, is the prospect of deleveraging of banks. The ECB?s new term repo window (LTRO) also shows the pitfalls of sovereign troubles, when ratings downgrades impairs the quality of collateral that banks have to give the central banks, requiring an ever increasing level of collateral. On the obverse side, the cost of bank bailouts when the sovereign debt levels are already high will threaten sovereign debt sustainability.
The other impact of financial stability is on inflation (price stability). Unconventional policy measures to keep rates down and increase incentives for credit (as well as propping up banks asset books) will push up inflation. Emerging markets have been the direct victims of Quantitative Easing in early 2011. In turn, increasing inflation has prompted central banks to tighten monetary policy, raise rates, increase the cost of funds, slow growth and impair banks? asset quality, leading to financial stability concerns.
So what are the implications of the new trilemma? As the recent monetary policy review has emphasised, there are fears of a ?return of fiscal dominance of monetary policy?. Will the fiscal dominance weaken the autonomy and accountability of central banks? Will a fiscal dominance get exacerbated by the response of monetary policy on growth? Have central banks overstepped their mandates in their unconventional responses to the crisis?
There is little doubt that large fiscal deficit will weaken the effects of monetary policy when the policy has a tightening stance. The conduct of open market operations (OMOs) by RBI over the past few months is a stark example. OMOs infuse fresh liquidity, which spur inflation. If OMOs are not conducted, the build-up of a liquidity deficit may push short-term interest rates to levels that begin to impact banks? asset quality.
These issues, of course, require much fuller elaboration of the underlying institutional mechanisms to mitigate the most egregious adverse consequences of the feedback loops.
The author is senior vice-president, business & economic research, Axis Bank. These are his personal views