The low-interest-rate environment, global liquidity spillovers and challenges for monetary policy ahead.

Belke, Ansgar ; Verheyen, Florian

INTRODUCTION

Since July 2013, ECB President Mario Draghi has stated at each press conference following the central bank's interest rate decision that 'The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time' (ECB, 2013a). This so-called 'forward guidance provides an outlook on monetary policy for the upcoming years. The ECB projections show that this low-interest-rate environment in the euro area, almost hitting the zero lower bound, is in line with the ECB's medium-term inflation target of below but close to 2% HICP inflation. Inflation pressures in the euro zone remain subdued owing to severe weaknesses in the real economy. Similar and even more rapid interest rate decisions have been taken by other leading central banks all around the globe--which in turn poses severe challenges for global financial stability in the post-crisis environment.

The impact of global banking on financial stability and the post-crisis challenges connected with the former have been under-researched before the crisis. In our contribution, we decided to interpret 'global banking' as 'global central banking' and thus complement the other contributions to this special issue from a macro-prudential perspective which are rather focusing on 'global commercial banking' from a macro-prudential perspective. Our core messages are important for the conference theme as, for instance, sustained monetary accommodation through international monetary policies and global liquidity hampers comprehensive bank balance sheet repair. As recent experiences in the euro area show this might have an impact on the degree of cross-border banking as well. These few examples show that 'global banking' and 'global central banking' are clear counterparts.

In this contribution, we thus focus on the role of international monetary policies and global liquidity for financial stability and thoroughly assess several main challenges emerging in this context. We show that it is crucial to cope with the challenges identified by us in order to return to and ensure global financial stability in the future.

This paper assesses and comments on several aspects of the implied low-interest-rate environment, focusing in particular on spillover effects. We also look at the post-crisis challenges lying ahead for central banks. In the next few years, ultra-expansionary monetary policy has to be driven back, which might give rise to repercussions within the global macroeconomy if the policy exit is conducted without coordination among the major central banks. For example, unilateral exits on one side of the Atlantic might intensify the discussion and threats of currency wars, since a trigger of capital flows would be followed by a corresponding revaluation of exchange rates--which we actually saw when the Fed began its tapering. Of course, this will be a balancing act between tightening too early and exiting too late. Accordingly, policymakers have to monitor carefully whether the huge increase in central bank money feeds through into a boost in money and credit growth. Thus, considerable challenges for policymakers in assuring financial stability will remain in the future.

The remainder of this paper proceeds as follows. The next section begins with some general considerations of the current low-interest-rate environment as it approaches the zero bound in advanced economies, involving also negative real interest rates. The subsequent section deals with potential and already manifest conflicts between monetary policy and financial stability in a low-interest-rate environment. We introduce and elucidate the monetary policy dilemma stemming from the co-existence of low interest rates in major advanced economies and huge capital inflows into emerging markets. We argue that sustained monetary accommodation hampers comprehensive balance sheet repair. Moreover, we infer that global monetary liquidity and its spillovers represent important risks for global price and financial stability. Subsequently, we assess whether and how central banks committed to safeguarding the low-interest-rate environment may be risking their independence--operationally and financially. Finally, we provide an outlook on the inevitable monetary policy exit and its economic and political implications. The final section concludes.

GENERAL CONSIDERATIONS

The current situation of negative real interest rates

One distinct feature of the 'new normal' economy seems to be that interest rates are negative in real terms (after accounting for inflation) and are expected by some to stay at that level. Such a pattern of negative real interest rates has historical precedents: among other things, real rates were negative after World War II and again in the 1970s, with much higher inflation rates than those prevailing today (Belke and Polleit, 2010b).

The probability distribution of expected inflation rates in the euro area tells us that both the number of analysts who expect inflation to go beyond the target and those predicting deflation are shrinking steadily (Bundesbank, 2012, pp. 44I.). (1) Therefore, with inflation in the euro area well anchored and short rates close to zero for a prolonged period, as communicated by central bankers, real rates will remain negative for a while. A similar analysis seems to apply to long-term rates, with sovereign bond yields now falling below 2% in Germany, the US and the United Kingdom. (2) The respective central banks are targeting an inflation rate of 2% (only recently also in the case of the Fed). (3) It directly follows that bond investors now expect to lose money in real terms, whereas, for instance, the stepwise increase in inflation that took place in the 1970s came quite unexpectedly.

Theoretical considerations regarding the zero lower bound

In the economic literature, the zero bound on nominal interest rates is seen as a major constraint on monetary policy that wants to keep the economy--via a change in the short-term interest rate--at full employment (Belke and Polled, 2010b). This view rests on the notion that the short-term interest rate is the key variable for monetary policy. As a result, the zero bound is seen as a problem when nominal interest rates are low (which, in turn, is typically the case when long-term inflation is low (Johnson et al, 1999)). This is because a decline in inflation could then push the real short-term interest rate above the level compatible with keeping the economy at full employment.

For example, if economic activity is weak, and short-term interest rates hit the zero bound, a dangerous dynamic might be set in motion. With actual output falling below potential, inflation might slow down further, increasing the real rate of interest. If the resulting real interest rate is higher than the real interest rate needed for keeping the economy at full employment, a downward deflationary spiral might be set in motion: declining output, falling prices and an increase in the real interest rate. The issue of the zero bound is in great part related to the experience of the US in the Great Depression and came to the surface again with unanticipated force at the beginning of 2009 in the wake of the financial crisis. The debate gained momentum in the late 1990s, when economic growth in many countries was weak and, at the same time, CPI inflation reached rather low levels by historical standards (Belke and Polled, 2010b).

The risk ascribed to hitting the zero bound--and the severity of the consequences --is usually assessed on the basis of empirical analysis. Detailed studies of the US economy by Fuhrer and Madigan (1997), Orphanides and Wieland (1998), Tetlow and Williams (1998) and Reifschneider and Williams (1999) suggest that the risk associated with zero inflation may be significant, but that an inflation of l%-3% p.a. should be sufficient to alleviate most of that risk (Fuhrer and Sniderman, 2000). (4)

If the central bank promises to keep inflation at, say, 2% p.a., then zero nominal market interest rates would suggest that the central bank's inflation promise is not credible. Creating positive inflation expectations, however, should be an easy undertaking under a government-controlled paper money regime: there should be hardly any doubt that the central bank can, if it wishes, increase the stock of money at any time in any quantity desired. The zero bound is therefore a rather unlikely steady-state phenomenon, even in today's monetary environment. The same is valid for a deflation scenario, against which there will be a prohibitively high political resistance, and the ECB is--if this is demanded by politics--capable of extending the monetary base by any preferred amount at any time. The bank could initially buy sovereign and bank bonds and pay with freshly created central bank money. From this perspective, for instance, a negative deposit rate would be too complex and risky a measure for the more or less hypothetical deflation problem. (5)

It does appear, after all, that the alleged zero bound nominal interest rate problem is perhaps no problem at all, as Ben S. Bernanke noted in 2002: 'Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero'.

But only recently, in his speech at the IMF's Economic Forum on 8 November 2013, Larry Summers invoked the old theories of secular stagnation and argued that the Asian savings glut and a low price of capital (computers are cheap) have in the recent past combined to imply that the equilibrium real interest rate is smaller than zero. Monetary policy, he said, cannot push the economy any further unless it risks enormous asset price bubbles. In other words, excessive money growth will in the end cause inflation--although in the short-to-medium run money growth is for a couple of reasons not synonymous with inflation. Instead, fiscal policy is preferred at least for the US because this country is able to borrow at a 3 % rate in the long run, using a currency which it is able to print.

However, his view has not been without criticism. Discussions during the 2014 World Economic Forum in Davos were no exception in this respect. Admittedly, '... the equilibrium long-run real interest rate in the high-income countries has been ultra-low and the equilibrium real short rate has been negative.... This was an obvious indicator of sustained and chronic weakness of demand. ... Second, the main instrument we have used to deal with this condition has been hyper-aggressive monetary policy. But this creates substantial problems it distributes income towards both the financial sector and the rich, while also generating bubbles' (Wolf, 2014). Edmund Phelps also argued in Davos that structural flaws on the supply side of the Western economies are mainly responsible for the weakness in growth. The innovation rate has gone down, a problem which cannot be solved by the governments because they cannot serve as true innovators. (6)

Macroeconomic implications of a low-interest-rate environment

The level of interest rates can be viewed as the price that equilibrates investment demand and the desire to save. From this point of view, temporarily negative real rates that currently prevail in almost all industrialized countries may simply indicate that savers are generally cautious in times of uncertainty, and that entrepreneurs are rather reluctant to invest in new projects. Central banks try to influence this price by setting 'base' rates at which they will supply liquidity to banks. They have also been employing 'quantitative easing'--that is, using freshly created central bank money to purchase bonds--especially in the Anglo-Saxon countries and in Japan with the intention of curbing longer-term yields. Their intervention has had some impact, usually measured in terms of a real interest rate equivalent (Belke, 2012a).

What exactly is the macroeconomic impact of a low-interest-rate environment? The first thing that comes to mind is that the level of real interest rates should be linked to economic growth, but not via the trivial but often suggested transmission mechanism from lower rates to higher growth. As the example of the currently distressed euro area member countries clearly shows, you simply cannot, by definition, grow out of a current account deficit, especially if you try to rekindle growth through lower interest rates (Belke, 2013b).

Generally speaking, the realized level of the real interest rate defines a threshold against which profitable projects should be assessed. In order to avoid the danger of capital misallocation, the interest rate must not be kept at too low a level that is not backed by its fundamental drivers, for too long a period. Market participants will then feel tempted to feed speculative real estate price trends instead of financing the erection of new production facilities. The functioning of a market economy and the realization of significant economic growth thus decisively hinge on offering a positive return of capital to suppliers (Belke and Polleit, 2010b; The Economist, 2012).

CONFLICTS BETWEEN MONETARY POLICY AND FINANCIAL STABILITY IN A LOW-INTEREST-RATE ENVIRONMENT

To begin with, we introduce and elucidate the monetary policy dilemma stemming from the co-existence of low interest rates in major advanced economies and huge capital inflows into emerging markets (section The monetary policy dilemma'). Closely related to these issues, we infer that global monetary liquidity and its spillovers represent important risks for global price and financial stability (section 'Global monetary liquidity and its spillovers: the risks for global price and financial stability'). Moreover, this paper argues that sustained monetary accommodation hampers comprehensive balance sheet repair (section 'Sustained monetary accommodation hampers comprehensive balance sheet repair or maintains incentives to damage balance sheets'). We also discuss why central banks committed to safeguarding the low-interest-rate environment are risking their independence--operationally and financially (section 'Central banks are risking their independence--operationally and financially'). Finally, additional risks stemming from the exit from unconventional monetary policies are described (section 'Additional risks when conducting the exit').

The monetary policy dilemma

In order to gauge potential conflict between monetary policy and financial stability, one should first take into account the co-existence of low interest rates in major advanced economies and huge capital inflows into emerging markets. This represents a dilemma for monetary policy actors in emerging and advanced economies alike. Either they go for low interest rates--a strategy which will obviously not curb a credit boom--or they head for high interest rates--a safe way to attract global financial or monetary liquidity anew. This may run counter to the interests of those advanced countries planning their exit from unconventional monetary policies or those of emerging market economies which see their domestic credit boom even fuelled. (7) Emerging market economies have traditionally shied away from the second alternative in favor of the first. A potential way out of the dilemma might be to flank higher interest rates with macro-prudential measures such as, for example, higher capital ratios or tighter loan-to-value ratios. At the least, this toolbox should strengthen a financial system against the impacts of a credit bust (BIS, 2012), given that emerging economies' monetary policies tend to be structurally too lax, as measured by the difference between actual base rates and normative rates such as those implied by the Taylor rule (BIS, 2012, Graph IV.6; Taylor, 2013).

In the same vein, the monetary policy strategy of inflation targeting (IT), which has become popular on a worldwide scale, has suffered from a couple of heavy setbacks, beginning in September 2008. At that time it became obvious that those central banks relying on IT strategies had not been cautious enough or had not paid enough attention to asset price bubbles (Frankel, 2012). Instead, central bankers continually argued that it would be sufficient to heed developments in housing and equity prices in the sense that they convey information about consumer price inflation. Moreover, they regularly contended that there was no need for explicit monetary policy coordination among the G-20 because it would best serve the interests of all if each country kept 'its own house in order' (as reported by Belke et al, 2002, and recently stressed again by Taylor, 2013).

But it turned out that asset price developments warranted much more than indirect attention, although there was no significant rise in inflation before or after the financial crisis hit, indicating that monetary policy was in fact much too lax in the years 2003-2005 (Frankel, 2012; Taylor, 2013). Also on a more general level, the main lesson from the recent decade is that protracted monetary easing may lead to significant asset price hikes and accelerating credit growth, even in the absence of consumer price inflation (for the exact pattern see Belke et al, 2010). Such a scenario might become relevant again in the next few years. Although the ECB has lent out money for unconventionally long periods, with its 3-year refinancing operations, an economic recovery could stimulate money growth. Thus, the build-up of (asset) price bubbles is a possible scenario for the future.

Hence, our experience of the financial crisis tells us that common monetary policy strategies, including inflation targeting, must be overhauled and that this overhaul should attach sufficient consideration to the risks connected with the emergence of financial imbalances, even if inflation remains moderate and invariable. In particular, the monitoring of general financial conditions, such as volumes and prices on specific asset markets, is of overall importance. Another important conclusion is that the scope for, and the limitations of, a prolonged monetary easing must be carefully weighed against each other. By contrast, in the spirit of Milton Friedman and so often persuasively explained by Ben Bernanke, forceful and determined action by central banks in the wake of the global financial crisis could be well defended in order to avoid the devastating consequences of monetary policy abstinence and financial meltdown as experienced during and after the Great Depression (BIS, 2012, Graph IV.8). Nevertheless, the following discussion shows that the risks of extended easy monetary conditions are more on the downside.

Global monetary liquidity and its spillovers: the risks for global price and financial stability

Recent research on the impact of global monetary liquidity confirms suggestions that low interest rates in advanced economies may well lead to spillover effects in emerging markets, leading to upward pressure on exchange rates in the latter countries, causing credit and asset bubbles in emerging markets (such as Chinese property bubble) and, until recently, inflated commodity prices (Belke et al, 2013; BIS, 2012, Chapter III; The Economist, 2012). As a result, these countries can no longer pursue their domestic stabilization objectives. Moreover, financial imbalances similar to those in advanced economies in the run-up to the crisis (and--with an eye on the growing importance of these countries in international investment portfolios--the same negative global repercussions in the case of unwinding) may arise.

A key drawback of a too easy global monetary policy is that it also causes rises in commodity prices (Belke et al, 2013; BIS, 2012, Graph IV.9, left-hand panel). Although commodity price inflation has taken place particularly in emerging markets, it might feed into the inflation of advanced economies because emerging market economies are increasingly important in global supply chains. Commodity prices are determined on global auction markets and depend on conditions of global demand, which are in turn shaped by global monetary balances in the hands of investors (for details see Belke et al, 2010). The increasing role of financial investors in commodity markets ('financialization') has surely kindled the sensitivity of prices to international monetary conditions and global financial liquidity which is closely correlated with global monetary liquidity (ECB, 2012; BIS, 2011, Box IV.B.).

The fact that monetary policy spillovers are becoming increasingly significant forces central banks to attach more importance to the global implications of their policies. To attain lasting price and financial stability in times of ever greater financial globalization, monetary policy should have a global perspective. It seems that it is no longer sufficient simply to keep one's own house in order and disregard external developments. Instead, a macroprudential framework has to be created (Borio, 2011). Otherwise, we will find ourselves in a world in which depreciations thought of as a 'beggar thy neighbor' policy (currency wars) can no longer be excluded. (8) As a stylized fact, policy makers in a few developed economies such as Japan are currently expressing their concerns about competitive devaluations due to monetary policies by the Fed and the ECB and have announced monetary easing to a degree previously unseen.

This insight is also impressively backed up by recent empirical studies such as those by Taylor (2013) and Hofmann and Bogdanova (2012). These show that in the years 2003-2005 monetary policies worldwide found themselves in a 'bad equilibrium'. This means that in many industrialized countries, and also in emerging market economies, nominal interest rates were below those levels implied by historical Taylor rules. Policy interest rates fell below the Taylor rule in close synchronization across countries. Thus, monetary policy was too accommodative and perhaps contributed to the build-up of financial market imbalances prior to the crisis. One explanation they provide for this unsustainable equilibrium is that there is a lower equilibrium real interest rate. Another is that central banks decided on policy rates no longer in an independent way. Although interest rates have been set according to national conditions up to the turn of the century, policy reactions are increasingly affected by the international environment. Hence, the deviations might indicate a substantial shift in the monetary policy regime. Among others, Kim (2000) has demonstrated that US monetary policy shocks can affect other countries. Belke and Gros (2005) provided evidence that the ECB followed the Fed in their interest rate decisions. In fact, low domestic interest rates can increase risk taking in other countries, and one way to react is to lower interest rates also abroad; see Bruno and Shin (2012). In addition, central banks tend to resist large appreciations of their currencies, and adjust their interest rates according to the behavior of other central banks. Deviations of policy rates from the Taylor rule may strengthen due to international spillovers (Taylor, 2013). Most importantly, the actions of the Federal Reserve Bank (Fed) have been amplified due to the responses of other central banks (Gray, 2012).

Sustained monetary accommodation hampers comprehensive balance sheet repair or maintains incentives to damage balance sheets

It has become obvious during the crisis that sustained monetary accommodation has been hampering comprehensive balance sheet repair or maintaining incentives to damage balance sheets both for the private and the public sector, but also for sovereigns to restructure their financial sectors and to implement reforms to secure sustainable debt burdens. The main drivers of this nexus are the following.

The decrease in interest rates lowers financing costs and, hence, may cause borrowers to simply ignore the problems still inherent in their balance sheets. As a consequence, balance sheets remain weak and credit misallocated. These problems then tend to become structural and any reversion to normal interest rate levels in the future might cause great damage to these institutions. (9) Hence, an exit from unconventional monetary policies becomes an even more remote option and the current policy stance might become self-sustaining and path-dependent (Belke, 2012b; The Economist, 2012).

What is more, owing to an impaired financial system and over-indebted economic agents who are not at all inclined to borrow for spending, one needs an even higher degree of monetary accommodation than before the financial crisis in order to rekindle growth (a footprint of the 'new normal'). This higher monetary stimulus, in turn, will once more lower the incentives for commercial banks to repair their balance sheets and for sovereigns to strive to restructure their financial sectors and to conduct reforms to secure sustainable debt burdens (IMF, 2012; Bundesbank, 2014; and Belke et al, 2006). The recent euro area crisis has clearly shown how intertwined banking and sovereign crises are and thus how dependent financial stability is on a risk-free status of government debt (Belke, 2013a, b; BIS, 2012, Chapter V). (10)

Admittedly, monetary policy easing, metaphorically speaking, like a bazooka gives banks and governments ample time for balance sheet repair and thus avoids disorderly deleveraging and defaults. Moreover, in the short run it is able to lift asset prices and, thus, output and labor market performance on a higher level. But in order to be forced to repair their balance sheets, commercial banks should receive a bold and credible signal from the central banks that their policies of very low interest rates will be put to an end in the near future. This is especially valid, considering the fact that commercial banks, above all in Europe, are heavily dependent on central bank funding (Belke, 2012c; BIS, 2012, Chapter VI). Unfortunately, the opposite is happening right now: central banks such as the US-Fed and the BoJ commit themselves to perpetuating monetary policy easing and the ECB stresses also that interest rates will be kept low for a protracted period of time. To overcome this situation of delaying balance sheet adjustments, the ECB has begun an asset quality review (AQR) to evaluate the balance sheets of some 130 European banks. This should be an incentive for commercial banks to repair their balance sheets because a negative evaluation would probably lead to severe funding problems (Mersch, 2014). There is also some first empirical evidence of deferred repair because rates are so low. (11)

What is more, commercial banks are prompted to overestimate the repayment capacity of their borrowers in a low-interest-rate environment because of the perceived low opportunity cost of carrying non-performing loans (Albertazzi and Marchetti, 2010; Caballero et al, 2008; Peek and Rosengren, 2003 for Italy and Japan). At least, this is indicated by the fact that US private households deleverage by taking up fewer new loans instead of writing off unsustainable debt such as mortgage loans (BIS, 2012, Chapter III), and that subdued market-to-book ratios for commercial banks have coexisted with loan loss provisions that are depressed even though macroeconomic conditions still appear weak (BIS, 2012, Table VI. 1).

The flip side of the coin is that commercial banks tend to become overly optimistic about the ability of borrowers to repay, and thus do not adequately provide for bad debts. Moreover, they receive a public subsidy since they are able to make 'easy money' just by borrowing short term from the central bank and lending long term to the Government (The Economist, 2012). Quite naturally then, the question emerges of for how long this subsidy can be considered legitimate from a welfare-maximizing point of view. This may also be seen as an indirect way of financing sovereign debt by the printing press (Gros et al, 2012), which is actually prohibited for the ECB and the US, according to the treaties.

Protracted monetary accommodation may also systematically curb the profitability of commercial banks (Albertazzi and Gambacorta, 2009). If the yield curves flatten because the low short-term interest rates are anticipated to prevail also in the future (an effect that is intended by the Fed's 'Operation Twist), this will ultimately lead to an erosion of the banks' interest income because returns from maturity transformation will shrink (BIS, 2012). (12)

Furthermore, protracted low interest rates may contribute to a build-up of financial vulnerabilities by 'triggering a search for yield in unwelcome segments' (BIS, 2012). In this sense, monetary expansion was useful in the beginning to counter excessive risk aversion, but any overshooting of this effect (expressing itself in trading losses by some financial institutions) should be avoided. Empirical evidence supports the relevance of this channel as one driving force of the recent financial crisis (Altunbas et al., 2012; Maddaloni and Peydro, 2011).

In addition, low policy rates and protracted unconventional monetary policies, in particular aggressive variants of monetary accommodation, may have distortionary side effects on financial and capital markets (Belke, 2012a). They have altered the dynamics of overnight money markets, an effect which in itself is hampering any exit from these aggressive policies (BIS, 2012, Box IV.B, p. 46). Moreover, they have dampened market signals by lowering long-term interest rates and financial market risk spreads as well as the price of sound assets which are not 'subsidized' by them. Since long-term yields on sovereign bonds, as a key benchmark for financial intermediation, are pushed to exceptionally low levels (BIS, 2012, Graph IV.4), financial mispricing has become possible on a more general level. As an immediate consequence of this, the inter-temporal and inter-sectoral allocation of resources may no longer be effective.

Central banks are risking their independence--operationally and financially

As stated above, the probability distribution of expected inflation rates in the major advanced and emerging market economies tells us that, as things stand, long-term inflation expectations appear to be well-anchored. However, this should not make us too complacent and tempt us to interpret it as ample room for additional monetary policy easing. The reason is simply that the credibility of central banks in advanced economies must not be jeopardized in view of the potentially growing public pressure to do more if, for instance, the euro area is successful in solving its structural problems and the economy, especially in the periphery, remains weak (Belke, 2013a, b; Belke et al., 2012).

'A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they can actually deliver. This would make the eventual exit from monetary accommodation harder and may ultimately threaten central banks' credibility', warns the BIS (2012, p. 48), thus adding to our path-dependence argument, as developed above, against a timely exit from unconventional monetary policies. If, in addition, emerging market economies do continuously stick to export-led growth and their foreign exchange interventions to enhance their international competitiveness, markets will feel legitimized to put the central banks' determination to pursue price stability under close scrutiny. This is because, among others, an undervalued currency increases the costs of imports such as commodities. Both the tendencies of central banks' fiscal involvement in advanced economies and the strategies of undervalued currencies in emerging economies, taken together, finally have the potential to slowly unfasten inflation expectations on a global scale.

Longer-term inflation fears stemming from the enduring low-interest-rate environment are reinforced by steadily increasing risks on the political economy side--just to mention the notions of 'fiscal dominance' (13) and 'financial repression' (14) in combination with the regulatory preference for investment in sovereign bonds. Bundesbank President Jens Weidmann was not the first to observe that central banks' unconventional monetary policies working via its balance sheet have clearly blurred the line between monetary and fiscal policy (Jens Weidmann in FAZ, 2012). As evidence of 'fiscal dominance' and 'financial repression' becomes ever stronger, an increasing reliance on quantitatively and qualitatively extraordinary monetary policy measures raises concerns about a decline in the operational and financial autonomy of the central banks. Dangers emerge because 'fiscal dominance' implies a bias among leading central banks toward fiscal policy considerations. What is more, 'financial repression' of the Northern euro area members may, for example, mean fuelling the conflict between the North and the South within the euro area. Financial repression' could, in the case of the US Fed, be tantamount to an orientation of monetary policy towards financially repressing the rest of the world in order to lower the real value of US debt in the interest of the US Government (Reinhart, 2012; Reinhart and Sbrancia, 2011). Both channels put central banks such as the ECB under pressure and at risk of more or less directly financing public debt. This is especially so because public debt is still on an unsustainable path in many countries and inflation and the inflation tax are, from a political economy point of view, easier ways out of the mess than budget consolidation or default (Burda and Wyplosz, 2012; BIS, 2012, Chapter V). In other words, the main incentive problem is that accommodative monetary policy tends to alleviate the pressure on politicians to reform. The impression must at all costs be avoided that central banks stand ready at any time to employ their balance sheets to come up with solutions to economic and financial problems {The Economist, 2012).

The continuously rising financial exposure in the overstretched central banks' balance sheets (such as, eg, the interest rate risk of the Fed and the credit risk of the ECB) may furthermore impede their financial independence. Financial losses do not per se have a negative bearing on central banks operational capabilities, since a 'fiscal backing' is available from their governments --with a slight complication in the euro area, where national governments provide the backing of the ESCB (Belke and Polleit, 2010a). But it is the very existence of this fiscal backing which could undermine operational autonomy, as soon as the central bank is not capable of pursuing its main monetary policy objectives without taking recourse to financial help from the Government (Stella, 2010; Belke and Polleit, 2010a).

All in all, it seems fair to say that the current stability of long-term inflation expectations cannot be taken for granted. In the case of an erosion of the central banks' credibility and a steady rise in inflation expectations, it would be very costly in terms of the necessary adjustment recession to restore price stability, as is impressively shown by the experience of the 1970s (Belke and Polleit, 2010b).

Additional risks when conducting the exit

Although, from today's perspective, it seems as if a return to the interest rate levels seen before the financial crisis will take considerable time, we will nevertheless sketch some implications and risks which might emerge in such an exit scenario. (15) Generally, as nearly all major central banks in the world currently operate at or close to the zero lower bound, interest rate levels are very much alike across the industrialized economies. Nevertheless, a timely exit is necessary because any delay could again lead to capital misallocation, speculation with the emergence of new bubbles and, of course, inflation. In addition, a delayed exit would lead to a destabilization of inflation expectations.

In general, recovery from the recession could well differ across regions. For example, the euro zone with its sovereign debt crisis faces a different macroeconomic situation, which somehow limits the ECB to act, as compared with the US or Japan. Furthermore, varying objective functions of the central banks contribute to these differences. Of course, these asymmetries will complicate any exit from the expansionary monetary policy of the last years.

Any uncoordinated exit or an exit at a different pace may intensify tensions regarding the international exchange rate configuration, especially if it is not well communicated by a truly committed forward guidance. In one scenario, the exit may be quicker in the euro area than in the US, which through euro appreciation might hamper the necessary economic recovery of the euro area. In another currently more probable, scenario, the Fed exits first. (16) Here, the risk is a 'growth-driven exit with complications' (IMF, 2013a). Long-term interest rates in the US are no longer well anchored, and uncertainty indicators, 'investors' fear gauges' and, finally, also the interest rate premium leap up as monetary policy is tightened. The fact that rates keep their level for quite a while amplifies capital outflows from the remaining countries. These effects relate primarily to high-risk countries. Except for countries with very strong trade links with the US, the outcome in terms of output would worsen.

Note that, in this scenario, it is not primarily the presumed exchange rate effect (if it manifests itself) which might cause the trouble (Belke, 2013a). The starting point of any simulation exercise (better: the IMF's) concerning the Fed's exit is that US monetary policy should become more restrictive as soon as the US economy is back on track. Both items--a more restrictive monetary policy and higher US growth--trigger capital flows into the US and an increase in interest rates across the world, which per se slow down world economic activity. (17) But higher US growth and exchange rate depreciation vis-a-vis the US dollar should ceteris paribus let other countries profit, especially countries such as those in the euro area with significant exports to the US and equity markets that are closely correlated with US equities. Hence, the relative significance of each transmission channel and some idiosyncratic country conditions determine the net outcome for an economy such as the euro area (IMF, 2013a). But that means also that the scenario of an exit without growth' (IMF, 2013a) cannot be fully excluded. This is a scenario in which any growth momentum is absent and exit is initiated prematurely, with an eye on increasingly pressing financial risks. In this case, the impact of tapering on output may be negative worldwide. However, these effects may be less unpalatable than allowing bubbles to emerge and then burst (IMF, 2013a, b, p. 16).

Fears of currency wars and claims of foreign exchange market interventions have thus been voiced in recent times and could be reinforced in the future. Unilateral interest rate increases could be one reason and may heat up this debate, bringing additional tension into the international monetary system. Capital controls or interventions in foreign exchange markets could gain momentum (Taylor, 2013). Furthermore, a unilateral exit would probably be less effective. Rising interest rates would trigger liquidity inflows which would counteract the exit (Belke et al, 2014). Policymakers might be tempted to preclude these inflows by capital controls.

Policymakers in the euro zone in particular should therefore be mindful of this exit. Assuming that the European debt crisis will continue for several years, an exit in the Anglo-Saxon countries might start before the macroeconomic environment allows for it in the euro area. Accordingly, capital flows to the US might lead to a depreciation of the euro. Superficially, this might be seen as a welcome effect in many countries in Europe which suffer from deficits of international competitiveness. However, all the countries of the monetary union will benefit from a euro's devaluation. Thus, Germany or the Netherlands, which are competitive on international markets, could increase their current account position. In effect, the intra-EMU current account imbalances could widen. Considering that Germany will achieve a record surplus in its current account in 2013, further political problems may appear on the agenda. Ambitions for an adjustment mechanism to restrict current account surpluses within the euro zone could arise.

Thus, it seems that it is no longer enough for central bankers to focus merely on national interests. To cope with a return to more normal interest rate levels, a coordination of monetary policies across the globe is necessary (Taylor, 2013). Angeloni et al. (2010) even state that the exit will be more complicated to handle than the measures taken in response to the crisis. Apart from the need for international coordination, national interests will still have to be taken into account. Just think of the interplay between fiscal and monetary policy. Every rise in interest rates comes at the price of increasing costs in debt service. But, on the other hand, fiscal reforms and a return to (more) sustainable public finances provide central bankers with more leeway to raise interest rates, as macroeconomic indicators should--at least in the medium term--improve with fiscal consolidation (Angeloni et al, 2010). However, coordination between monetary and fiscal authorities undermines the independence of central banks. Thus, in this regard it will be a tightrope walk to find the right amount of coordination.

CONCLUSION

Recent monetary policy easing due to the financial and economic crisis has led to a situation where nominal interest rates have reached the zero lower bound. As inflation rates and expectations remain positive, real interest rates have in effect become negative. This paper has sketched some of the challenges and implications that arise in this low-interest-rate environment. It has turned out that low interest rates hamper balance sheet consolidation, and ample liquidity leads to spillover effects which endanger price and financial stability. Furthermore, central banks are becoming more and more involved in quasi-fiscal policies which limit their independence. All this shows that the current monetary policy alignment gives cause for concern. In effect, monetary policy has to carefully monitor whether and when a turnaround of ultra-expansionary monetary policies is possible. Unfortunately, an exit from the current policy stance will not be an easy undertaking. This is corroborated, for example, by the fact that the mere announcement that the Fed might scale down its unconventional monetary policy operations has recently induced capital flight, that is, a sudden stop in capital inflows, from emerging markets (Gros, 2013).

At first sight, fears arising from these capital flow reversals appear to be well founded and the imposition of capital outflow controls looms on the G-20 agenda (IMF, 2013a, b). The external values of many emerging market currencies have been plummeting, and their central banks have been actively tightening their policies, aiming at stabilizing their economies' financial markets (Gros, 2013). Central banks in India, Brazil, South Africa and Turkey have felt forced to take action to shore up their currencies, in some cases with significant interest rate increases. However, we view the permanence of these recent events with caution. Future research should check whether the US Fed or even the euro zone's austerity measures and its weak internal demand are to blame for this state of affairs (Gros, 2013).

In this context, however, Fed-style 'forward guidance' tends to further stimulate the inclination of investors to take more risks. Excess monetary liquidity may spill over to other economies and cause stability risks there. At the 2013 Jackson Hole Conference, even the bon mot 'zero interest rates make risk taking cheap; forward guidance makes it free (by eliminating all roll over risk on short term funding positions)' (Landau, 2013, p. 9) did the round. Without any doubt, the Woodford (2008) variant of forward guidance which seems to be followed by the Fed creates massive incentives to enlarge and even overstretch open positions. As the strong movements of the world's stock markets after Ben Bernanke's now-famous statements in May 2013 have clearly shown, the Fed has by its efforts to calm down the markets harvested the contrary, higher volatility (Lauricella and Burne, 2013). This clearly reminds us of the 'liquidity spirals' described in the model developed by Brunnermeier and Pedersen (2009). Uncoordinated action then will be accompanied by additional problems. Thus, considerable post-crisis challenges for monetary policy remain in the years to come. It seems crucial to cope with the challenges identified by us in order to return to and ensure global financial stability in the future. We feel legitimized to argue that careful global coordination of monetary policies and a well-communicated exit from unconventional monetary policies may represent means to avoid a back-to-back crisis. Any uncoordinated exit from unconventional monetary policy measures might provoke further disruption and tensions on international financial markets.

Acknowledgements

This paper is based on an internal briefing paper prepared by the author for presentation at the Committee on Economic and Monetary Affairs of the European Parliament for the quarterly dialogue with the President of the European Central Bank, February 2013, in Brussels. The authors are grateful for valuable comments received from Paul Wachtel and other participants at the 2012 Symposium 'Global Banking, Financial Stability, and Post-Crisis Policy Challenges' in Maastricht, NL.

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ANSGAR BELKE [1,2,3] & FLORIAN VERHEYEN [1]

[1] University of Duisburg-Essen, Lehrstuhl fur VoLkswirtschaftslehre, insbes. Makrookonomik, Universitatsstrasse 12, Essen D-45117, Germany.

[2] Policy Department A: Economic and Scientific Policy, European Parliament, B-1047, Brussels.

[3] IZA Bonn, Schaumburg-Lippe-Strasse, 5-953113, Bonn, Germany.

(1) In addition, some important business climate indicators such as those produced by the European research institutes Ifo, INSEE und ISTAT are turning upwards and monetary conditions in the euro area are currently very accommodative.

(2) However, since the end of summer 2013 there seems to have been some reversal, as interest rates on Government debt, for example in Germany and the UK, have started increasing again (Braunberger, 2013).

(3) Also more generally, market- and survey-based indicators of long-term inflation expectations have remained rather stable and are approaching central banks' inflation goals. See BIS (2012, Graph IV.10).

(4) At this juncture it should be noted that it is hard to imagine that an economy's real interest rate should ever reach zero in equilibrium. As long as human desires are not fully satisfied, there is always something to gain from investing a part of current income, thereby increasing future income. As a consequence, there should always be a positive real interest rate in the medium-to-long run, and this is what we should basically define as a 'low interest rate environment'.

(5) Nevertheless, Japan still faces problems of low inflation rates. The reason why such a massive deflationary scenario could emerge in Japan is frequently attributed to policy mistakes such as the lack of an exit strategy that specifies when and how to get back to normal (Svensson, 2003). Furthermore, negative nominal rates might cause 'unintended consequences'. For example, the Danish experience of negative nominal rates was that banks increased lending rates to compensate for these negative rates (Danske Bank, 2013).

(6) See also Mayer (2014) who points out some lack of theoretical and empirical support of the Summers thesis and offers as an alternative explanation the fall-out from the recent credit boom-bust cycle.

(7) Here, we refer to the situation before the Fed announced its tapering, and to a scenario in which this announcement is not anticipated as credible and sustainable by the markets. For different scenarios see the section 'Additional risks when conducting the exit'. For the relationship between monetary and financial market liquidity, see ECB (2012, p. 57).

(8) The 'beggar thy neighbor' policy must not necessarily become public immediately. For example, the US sold its QE as a policy, in essence aiming to lower interest rates within the US economy and thus foster spending and investment--to stimulate 'aggregate demand', not least with benefits arguably accruing to the rest of the world.

(9) However, in the following paragraphs we show in different ways (eg, alluding to the term structure of interest rates) that the argument for credit misallocation is significant here, although banks borrow short.

(10) As sovereign bonds are classified as risk-free, banks do not have to hold equity capital for these assets. However, if doubts about the sustainability of public finances emerge, as was the case in several countries of the EMU, the liquidity of the banking system is threatened. These (large) banks may then have to be bailed out by governments, which in turn aggravates government debt levels. In consequence, issuing new sovereign bonds becomes more costly and banks can no longer purchase them. Accordingly, there is a need to break this vicious circle of banks and sovereigns destabilizing each other and to disentangle the fate of the banks and that of government debt.

(11) See, for instance, IMF (2013a, pp. 109ff.), based on bank-level data for the US. The required data are available for relatively few banks in the euro area, Japan and the United Kingdom, which renders a conclusive analysis more difficult. Earlier studies have delivered evidence for delays in balance sheet repair in Japan since the 1990s. See Peek and Rosengren (2003) and Caballero et al. (2008). We discuss these studies briefly in the following. Bundesbank (2014) refers to the Greek case. And ECB (2013b) mentions an 'unfinished balance sheet repair' in the UK (p. 20) and an 'ongoing process of balance sheet repair' in the euro area (p. 26).

(12) Note in this context that the more recent flattening of the yield curve in the US and in the UK has been accompanied by a drop in the commercial banks' net interest margin (BIS, 2012, Table VI.1).

(13) The term 'fiscal dominance' refers to a regime where monetary policy ensures the solvency of the government. Hence, the traditional tasks are reversed: monetary policy stabilizes real government debt while inflation is driven by fiscal policy needs. In the conventional view, fiscal dominance entails the famous 'unpleasant monetarist arithmetic'. In the words of Sargent and Wallace: '...the monetary authority ... must try to finance with seigniorage any discrepancy between the revenue demanded by the fiscal authority and the amounts of bonds that can be sold to the public' (Sargent and Wallace 1981).

(14) Under a 'financial repression' regime, governments aim at reducing the burden of their public debt by repressive measures aimed at financial markets, steadily high inflation rates and low nominal interest rates. In the past, such pohcies were widespread in many countries and have also been seen as a viable option of public debt reduction due to the high levels of debt accumulated during the European debt crisis. Although financial repression can result in a significant reduction of debt levels, it can have severe negative effects on private savers and investors for whom yields become low or negative and who, due to legal enforcement, do not have any options of evading financial repression.

(15) See, for details, Belke (2013a,b). In general, the debate about when to exit should not be about a precise date but about the macroeconomic conditions which have to prevail to be able to begin a removal of unconventional policy measures. These circumstances include an economic recovery and picking up bank lending. However, particularly data concerning economic activity becomes available only with a time lag. Thus, it seems obvious that there will be a vivid discussion about the right time to phase out the expansionary policy tools.

(16) The Fed has reduced its $85 billion-a-month bond purchase program by the small amount of $10 billion since the start-of-year 2014, which implies lower growth of the Fed's balance sheet.

(17) This pattern is employed by the IMF only as a 'scenario' and may not necessarily correspond with actual GDP growth.