It is not possible, however, for the Reserve Bank alone to lower interest rates if conditions are not appropriate.
Lowering the Bank rate could lead to higher credit demand, higher inflation, and as inflationary expectations take hold, higher long term interest rates. In addition, such a policy would lead to declining capital inflows, capital flight and higher imports, which all add up to a balance of payments crisis. What is required are the conditions for lower but positive real interest rates. The strategy outlined in this document aims to bring about these conditions.
These include sustained lower rates of inflation; a reduction in government dissaving which will reduce pressures on the capital markets; and the attraction of long term capital inflows, particularly direct investment flows, which will make the capital account less dependent on short term capital inflows which are attracted by high real interest rates; the commitment to a stable real exchange rate and higher growth will also reduce the risk premium facing foreign capital inflows and this would then allow for lower real interest rates.
By combating domestic inflation the monetary authorities will also contribute to stabilising the external value of the rand. Over the long run, low domestic inflation is a prerequisite for greater stability in the real effective exchange rate.
Since mid-February the foreign exchange market has been subjected to intense speculative pressure, causing a substantial real depreciation of the rand. This development to some extent reflects that the rand had become somewhat overvalued in response to a temporary capital surge, but was also the result of increased concerns regarding policy trends and economic prospects. The movements of the exchange rate signal some uncertainty in financial markets and call for careful policy responses.
In order to maintain the current competitive advantage created by the depreciation of the rand in the first four months of , the objective is to keep the real effective exchange rate of the rand at a competitive level. Although short-term fluctuations may at times be unavoidable, monetary and other policy measures will be geared towards the attainment of long-term real effective exchange rate stability.
The ECB, for its part, introduced rate forward guidance for the first time in July , one year before it announced its credit easing programme. That is, with short-term rates broadly stable, the weight investors attached to the expected future path mechanically increased — just as theory would predict. Term structure models can therefore provide compelling evidence that exchange rates remain deeply connected to monetary policy also when interest rates are at, or close to, the effective lower bound, even if interest rate differentials per se suggest a structural break in the relationship.
But the right-hand chart also suggests that this is not the full story. A clear break emerged in late And that break is likely related to the second policy instrument I mentioned before, namely asset purchases. Although asset purchases, by removing duration risk from the market, act primarily on the term premium, they also entail a strong signalling channel, in particular at, or close to, turning points. This should have caused the US dollar to appreciate, at least on the basis of past behaviour. The dollar defied upward pressure, however. It continued to depreciate persistently, despite the marked widening in future expected interest rates.
One reason why this might have been the case is that the signalling and the portfolio rebalancing channels of asset purchases might have worked in opposite directions. In imperfect markets, investors may give different weights to conflicting information. CFTC data show that they continued to hold net short speculative positions in the US dollar well into Third, capital inflows into the US Treasury market did indeed decelerate somewhat during the first half of , validating earlier expectations. And, fourth, the dollar started to appreciate only once expectations about asset purchases in the euro area gained a strong tailwind during the second half of Here the temporal coincidence is striking.
The moment the ECB announced its credit easing programme in June , which many observers considered to be a harbinger of sovereign bond purchases, and moved rates into negative territory, the dollar started to appreciate significantly against the euro. Net euro short positions jumped to close to record highs in the space of a few weeks.
In other words, only the prospect of sovereign bond purchases by the ECB seems to have led to a reappraisal by market participants of future domestic and foreign demand for US Treasuries. Empirical analysis on the direction of international spillovers in bond markets corroborates this view. On slide 4 you can see that ECB researchers, using the Diebold-Yilmaz methodology, find that spillovers from the euro area to the United States spiked sharply in mid Put differently, in the presence of asset purchase programmes, the portfolio rebalancing channel, rather than the signalling channel, might ultimately rise to become the dominant driver of exchange rates, at least temporarily.
Expectations of compressed term premia, either through central bank actions directly, or through cross-border capital flows associated with such programmes, or both, can offset, or mitigate, the impact of changes in the expectations about future short-term rates on exchange rates.
Disconnects may also be the result of market segmentation, much in line with the view that the financial market comprises a heterogeneous set of actors with very different beliefs and expectations. Indeed, the same chart suggests that spillovers from the euro area to the US bond market had already accelerated sharply in the first half of In other words, during this period participants in the bond market might have held, on average, a different view on the prospects of global monetary policy from that of their counterparts in the foreign exchange market, which maintained sizeable net long positions in the euro.
This can also be seen on the next slide. The breakdown suggests that, by contrast with the spillovers we saw in the previous chart, monetary policy shocks seem to have contributed comparatively little to exchange rate movements in the first half of Instead, an exogenous shock, which can be interpreted in the context of this discussion as a time-varying risk premium shock, appears to have put mainly downward pressure on the dollar. To the extent that risk premium and bond term premium shocks are driven by the same fundamentals, this would be consistent with the view that the signalling and portfolio rebalancing channels were sending conflicting signals.
This train of thought is in fact very similar to the view put forward by Charles Engel and Kenneth West on the relationship between risk premia and the exchange rate. As with the events of , what ultimately caused the initial resilience of the dollar and the sharp fall in term premia in will remain a matter of speculation. Factors other than the actions of the Federal Reserve and the ECB are likely to have contributed to these developments.
But that is not my point.
My point is rather that it is not surprising that central bank asset purchases may break with some of the regularities we have become used to. The reason is that asset purchases are monetary policy actions that can be anticipated by market participants, just like changes in key policy rates. Unlike conventional monetary policy, however, they have direct implications for the expected supply of and demand for internationally traded bonds and, hence, for the level of the exchange rate that, all other things being equal, clears the resulting capital flows.
This may, at times, break the link between future expected rates and the exchange rate. This is clearly visible when we look at slide 6. You can see that the moment short-term yields hit the zero lower bound, spillovers in bond markets by and large reflected term premia movements — in both directions.
These spillovers may pull the exchange rate away from the path implied by expectations about the future short-term rate. The extent of the decoupling, in turn, will depend on the expected direction, persistence and degree of international spillovers — something that is inherently difficult to project and price. In this sense, the implications are very similar to those described by Xavier Gabaix and Matteo Maggiori in their Quarterly Journal of Economics article, which states that the risk-bearing capacity of financial intermediaries provides a role for capital flows to affect the exchange rate.
This is certainly what we have seen in the euro area.
This also means that we should treat more carefully findings in the event-study literature that assign most of the observed exchange rate change around central bank asset purchase announcements to the signalling channel. In this sense, the debate also shares some similarities with a related strand of the literature, namely the transmission channels of sterilised foreign exchange interventions. The view that such interventions are effective mainly by signalling future policy intentions is frequently challenged by empirical evidence suggesting that portfolio rebalancing may have economically relevant effects.
Of course, this does not mean that understanding the potential spillovers of central bank asset purchase programmes is enough to explain exchange rate movements. Changes in relative term premia are far more difficult to interpret than changes in the expected path of future short-term interest rates. The latter can be clearly associated with changes in monetary policy expectations.
Changes in term premia, by contrast, often reflect a combination of shocks, including monetary policy shocks as well as shocks to demand, risk aversion and other variables, which will drive term premia in the same or in opposite directions. Bernanke suggests that countries can use flexible exchange rates, as well as regulatory and macroprudential measures to enhance their financial resilience.
The equilibrium rate of interest is an important benchmark of the stance of monetary policy, and a number of recent estimates indicate that it has fallen sharply during the Great Recession and remains low. In addition, uncertainty about the equilibrium real rate highlights the potential information processing problem facing policymakers. This paper uses a New Keynesian model to study optimal monetary policy in this set-up. As a result, optimal monetary policy needs to take this tightening bias into account and respond less to signals that the real interest has increased.
In other words, the optimal policy is to make a mistake on the side of keeping the real policy rate below the perceived efficient rate. The paper also studies the optimality of commonly used Taylor rules for monetary policy. Instead of focusing on the role of QE in a financial crisis, as most of the literature does, this paper looks at how the central bank could address a fiscal crisis, understood as a situation where the fiscal outlook becomes suddenly inconsistent with both stable inflation and debt sustainability.
Given nominal and financial frictions, as well as the possibility of a sovereign debt default by the government, the fiscal crisis can lower welfare through aggregate demand and nominal rigidities, as well as contractions in credit and disruption in financial markets. While QE is neutral in normal times, this is not so during a fiscal crisis for two reasons.
First, as in the fiscal theory of the price level, a shortfall in real government surpluses requires a jump in the price level to lower the real value of outstanding debt, i. By affecting the size of that outstanding debt, QE directly affects the size of the required inflationary shock. Second, QE can reduce the risk of default on public sector debt, which reduces the risk of a financial market freeze.
In both cases, the power of QE comes from the fact that interest-paying reserves issued by the central bank to purchase government debt are default-free: these reserves are a special public liability, neither substitutable by currency nor by government debt. Importantly, the paper articulates the reasons why QE is not equivalent to either standard fiscal policy, or stealth monetary financing, precisely because interest-paying reserves are not substitutable for short-term bonds or currency.
An upward-sloping demand curve would amplify the general scarcity of safe assets.