Aggressive monetary policy actions taken by one country can result in significant adverse cross-border spillovers on others, especially as countries contend with the zero lower bound, Reserve Bank of India Governor Raghuram Rajan warned in a research paper released on Monday.
In a research paper co-authored with RBI advisor Prachi Mishra, Rajan said the pressure to avoid a consistent breach of the lower inflation bound, and the need to restore growth to reduce domestic unemployment could cause a country’s authorities to place more of a burden on unconventional monetary policies, as well as on exchange rate or financial market interventions/repression.
These may have large adverse spillover effects on other countries, the RBI paper cautioned.
As the domestic mandates of most central banks may not legally allow them to take spillovers into account, they may undertake aggressive policies to gain whatever small positive domestic effect these measures offer, the paper said.
Consequently, the world may embark on a sub-optimal collective path and then, the rules of the game for responsible policy must be re-examined, it added.
The RBI paper suggested that countries could agree to guidelines for responsible behavior that would improve collective outcomes. Rating the unconventional measures based on the risk of adverse spillovers was one of the methods suggested.
The RBI paper also pointed out that the unconventional “quantitative easing” policy of buying assets such as long term bonds from domestic players may certainly lower long rates, but may not have an effect on domestic investment if aggregate capacity utilization is low.
Asset purchases could eventually trigger a search for yield that will depreciate the exchange rate, it added.
“The primary effect of this policy on domestic demand may be through the demand switching effects of a lower exchange rate rather than through a demand creating channel,” the paper said.
Further, the RBI paper said if all countries engage in demand switching policies, there will be a race to the bottom. This will make it hard to get out of such policies because the immediate effect for the country that exits might be a serious appreciation of the exchange rate and a fall in domestic activity.
“The bottom line is that simply because a policy is called monetary, unconventional or otherwise, it may not be beneficial on net for the world,” Rajan wrote.
“That all monetary policies have external spillovers does not mean that they are all justified.”
The material has been provided by InstaForex Company – www.instaforex.com