Macroeconomic Management When Policy Space is Constrained
A Comprehensive, Consistent and Coordinated Approach to Economic Policy

The recovery in GDP growth since the global financial crisis has been halting and weak. Concern is widespread that countercyclical policies have run out of space or lack the power to raise growth or deal with the next negative shock. This note argues that room exists for effective policies and that it should be used if appropriate. The most promising route involves a comprehensive, consistent, and coordinated approach to policy making. Comprehensive policy actions within a country exploit synergies, making the whole greater than the sum of parts. Consistent policy frameworks anchor long-term expectations while allowing decisive short- to medium-term accommodation whenever necessary. Coordinated policies across major economies amplify the helpful effects of individual policy actions through positive cross-border spillovers. The findings of this paper indicate that policy coordination adds particular value if the current approach falls short of reviving growth, or in the event of a further downward shock.

Abstract

The recovery in GDP growth since the global financial crisis has been halting and weak. Concern is widespread that countercyclical policies have run out of space or lack the power to raise growth or deal with the next negative shock. This note argues that room exists for effective policies and that it should be used if appropriate. The most promising route involves a comprehensive, consistent, and coordinated approach to policy making. Comprehensive policy actions within a country exploit synergies, making the whole greater than the sum of parts. Consistent policy frameworks anchor long-term expectations while allowing decisive short- to medium-term accommodation whenever necessary. Coordinated policies across major economies amplify the helpful effects of individual policy actions through positive cross-border spillovers. The findings of this paper indicate that policy coordination adds particular value if the current approach falls short of reviving growth, or in the event of a further downward shock.

I. Introduction

1. The combination of monetary and fiscal stimulus in response to the global financial crisis in 2009–10, deployed across many countries, helped pull the international economy back from a cliff edge. It is difficult to exaggerate how badly confidence collapsed when the financial crisis in advanced economies turned into a global economic recession. Commodity and asset prices were plunging and financial markets were dysfunctional, beset by concerns regarding liquidity, counterparty risk, and uncertain collateral valuations. Banks were under pressure to rebuild capital; their lending to other banks froze, and they cut credit lines even to established, creditworthy clients. Large industrial firms regarded as economic pillars, including automobile manufacturers, struggled to survive. Many other firms, attempting to reduce debt and strengthen balance sheets, dropped plans for capital investment. Households were suffering under high debt burdens and falling real estate prices. Output and employment were plummeting economy-wide. By 2009, many countries had enacted coordinated expansionary policies that helped stop the downslide and start a recovery within a few quarters. It was important that monetary and fiscal authorities worked in tandem, in the context of international coordination, as agreed at the Group of Twenty (G20) summit of November 2008.

2. Since the initial shift from contraction to expansion, however, the growth outlook has remained weak and halting. In many advanced economies, the recovery remains incomplete, with output and employment below potential. Adverse longer-term trends—the persistent decline in the global real equilibrium interest rate, lower productivity growth, aging populations—have become more visible since the crisis. Since 2014, a renewed demand deceleration has been accompanied by a global decline in investment, trade, and manufacturing, and by undesirably low inflation in much of the world.

3. Downside risks are high and confidence in a sustainable recovery of growth is low. In 2016, inflation in the large advanced economies has remained below target. Low inflation persists in many, with several verging on deflation. With the effective lower bound constraining policy interest rates, a deflationary cloud threatens as weak growth looms.3

4. Perceptions that each individual policy instrument could be reaching its limit, in turn, are undermining policy credibility. The widespread impression is that there is limited policy space in the event of further negative shocks. The effective lower bound on policy rates thus limits conventional monetary stimulus: quantitative easing and negative interest rates are expected to have positive effects on output and inflation, but the transmission mechanism is uncertain and may cause undesirable macro-financial side-effects. As for fiscal policy, unprecedented peacetime public debt-to-GDP ratios weigh on many countries. Demographic pressures are driving up public spending. An adequate framework that credibly ensures long-term budget sustainability and manages public sector balance sheet risks would provide room for fiscal stimulus.

5. To address these challenges, this Staff Discussion Note proposes a general framework to design comprehensive, consistent, and coordinated macroeconomic policies. Such an approach taps the synergies of different policies working together, within a country, across countries, and over time (Box 1). It allows policymakers better to align instruments and objectives, helps them deal with shocks when they materialize, and improves economies’ resilience. The approach can be used to support growth at the current juncture, but especially in the event of a negative shock to global conditions. Applying this approach implies benefits far above those accruing from a similar set of measures applied piecemeal.

6. Comprehensive policy actions exploit synergies within countries, making the whole greater than the sum of parts. It avoids the risk of paralysis, in the face of a negative shock, from looking at policy space on an instrument by instrument basis. Comprehensive policy entails the mutually supportive use of the three policy prongs—structural, fiscal, and monetary—as outlined by IMF Managing Director Christine Lagarde in an April 2016 speech.4 Such a comprehensive approach, tailored to specific country circumstances, has been central in the IMF’s policy advice to member countries. Fiscal policy action supports aggregate demand when monetary policy is constrained at the effective lower bound on policy interest rates. Similarly, monetary policy accommodates fiscal policy in response to a negative shock. Some countries have room for fiscal stimulus, especially in an environment of extremely low long-term interest rates. For others with especially limited room for fiscal maneuver, such as many commodity-exporting countries at the current juncture, this approach can help them better determine the pace of necessary fiscal adjustment and implement growth-friendly fiscal rebalancing. The implementation of financial sector policies that strengthen banking systems and markets improves the transmission of monetary policy and helps dampen shocks. Structural reforms increase potential growth, which also helps reduce debt-to-GDP. In addition, better-designed demand-management policies can mitigate any potential short-term macroeconomic and distributional costs of structural reforms, making it easier for policymakers to implement them. Under certain conditions, other policies, such as incomes policy, may be needed to help stabilize inflation expectations at target rates.

The Comprehensive, Consistent, and Coordinated Approach in a Nutshell

The comprehensive, consistent, and coordinated policy approach starts from an analytical framework of instruments and objectives. The framework would help establish stabilizing expectations for inflation and for the public sector balance sheet. To this end, policymakers would make conditional commitments on how policy instruments are likely to be adjusted to achieve objectives. In operational terms, monetary policy would be responsible for achieving the inflation target, while minimizing any adverse effects on output and employment. The government’s objectives would include prudent management of public sector balance sheet risks, and discretionary countercyclical support for monetary policy in the event of large shocks to output. Constraints on a given set of instruments argue for the combined application of all available instruments, including unconventional instruments. Otherwise, perceptions of policy ineffectiveness, or passivity, may result in destabilizing market movements following economic shocks.

Why comprehensive? Conventional monetary policy runs out of space at the effective lower bound on the policy rate. Unconventional monetary actions such as quantitative and qualitative easing can be applied. If these still are not enough to address a negative shock, other policies are needed—fiscal stimulus and, in Japan, an incomes policy to raise inflation expectations to the target rate. Assertive actions are needed for the maintenance of policy credibility. Similarly, fiscal stimulus alone, without monetary policy support, would not have significant multiplier effects. Without a sufficient boost to nominal GDP and the tax base, the public debt ratio would rise, and hence the perceived need for future fiscal consolidation. Structural reforms can increase potential output and growth, and financial sector policies that strengthen banking systems and markets ensure financial stability. Structural reforms could be contractionary in the short run as sectoral adjustments take place. Appropriate demand-management measures can offset such negative short-run effects on the economy, thereby reducing the costs of productive structural reforms, as well as the resistance from segments of the population that may be adversely affected.

Why consistent? Policy consistency assists policy effectiveness. For instance, if people expect that a temporary fiscal stimulus will, because of its implications for debt growth, have to be reversed later, it will have little effect on output. Similarly, without a coherent communication strategy, monetary easing may result in a ratcheting up of longer-term inflation expectations and a perception that the central bank will soon tighten, again offsetting the effect on output. When these types of perceptions exist, financial markets are apt to react with bouts of volatility, and sharp increases in term and risk premiums. Policy actions conducted within a long-run stability framework, however, are more likely to have the intended results.

Why coordinated? During global crises or prolonged economic slowdowns, international interdependencies become more prominent—spillovers and contagion appear simultaneously in many economies and financial markets. International policy coordination would help to restore confidence, especially as positive cross-border spillovers reinforce the impact of domestic actions. In such cases, internationally coordinated policy action may appear attractive to policymakers even though solo action does not.

7. A consistent framework is needed to guide economic policies over time. One of the major challenges most advanced economies face today is to be able to deliver demand support in the short run if a new negative shock to global growth materializes, without jeopardizing longer-term debt sustainability objectives. A consistent framework allows for a transparent mapping between policy instruments and policy objectives over time. Such an approach helps to anchor inflation over the long term and create resilience in the public sector balance sheet while broadening the short- to medium-term scope for countercyclical policies. This long-term orientation not only ensures that monetary and fiscal policies do not run out of space, it also enables credible and effective macroeconomic policy action to support demand in the short run when needed. Under these conditions, short-term, temporary above-target increases in deficits or inflation will reassure rather than rattle financial markets, and movements in the current inflation rate will not shift long-term expectations above the long-term target rate. Some countries need to upgrade policy frameworks, in particular to implement a sound medium-term fiscal framework that manages public sector balance sheet risks and a credible monetary framework that boosts firms’ and households’ confidence in the long-term inflation target.

8. Coordinated policies across major economies can and should amplify the impact of the policy action. Positive spillovers from coordinated action occur in normal times, but are particularly valuable in the event of a further downward global shock, where the need for international coordination would not only become much more urgent but also more self-evident. Such coordination would increase the effectiveness of country-level policies through positive global spillovers (see, for example, Chapter 1 in World Economic Outlook, April, 2016). Against this background, the IMF has previously called for coordinated policy action at the G-20 level to strengthen longer-term growth through structural reform (as in the Brisbane Action Plan) and to counter a possible material weakening of the global outlook.5 Moreover, a coordinated policy package in the event of a new downward global demand shock would use all available policy levers to lift nominal growth in the short and medium terms. Such parallel policy implementation would broaden policy space more than a go-it-alone strategy, in part by boosting geopolitical and economic credibility.

9. To illustrate the advantages of the comprehensive, consistent, and coordinated approach, this note uses simulations based on the IMF’s suite of models. The approach is a general framework that needs to be tailored to specific country circumstances. This note provides two illustrations of the approach for Canada and Japan, two contrasting economies. Long-term expectations in Canada are firmly anchored. Also, Canada has fiscal space and is using it. Nonetheless, strengthening the fiscal framework by establishing a credible medium-term fiscal consolidation plan will help make the current stimulus more credible. In Japan’s much more limited policy space, a well-designed package of demand-management policies, structural reforms, and measures to strengthen the wage-setting process can create momentum for stronger growth and inflation closer to target. In both countries, this strategy highlights fiscal initiatives with high multiplier effects—such as by favoring investment and transfers to cash-strapped households. Given the current environments of sizable output gaps and below-target inflation, the central banks can plan to hold policy interest rates at or near the effective lower bound long enough to allow inflation to accelerate rapidly. In simulations, the inflation rate then exceeds the target of 2 percent for a while before falling back to the target.

10. Under current conditions—extremely low interest rates, high unemployment, below-target actual and expected inflation—a fiscal stimulus would effectively support output following a negative shock. Since monetary policy would support the stimulus, the policy interest rate would stay at the effective lower bound for longer. The combined fiscal/monetary expansion of 2009–10 provides the best evidence that it would work during recessions. In contrast, in full employment periods, the short-term fiscal multiplier would be low or negligible because of crowding out as the central bank increases the policy interest rate to contain inflation.6 Public investment or assistance to cash-strapped households would likely have large multiplier effects. Moreover, conventional macro models do not take account of the positive effects on productivity that would follow from increased employment (and hence improved on-the-job training) and from the technological advances embodied in new investment.7

11. Experience suggests caveats for the success of the approach, especially for fiscal policies. Governments need to manage their spending with care. Infrastructure investment is an important case in point: poor productivity, cost overruns, and delays have often marred projects. On the broader issue of public sector balance sheet risks, governments that fail to establish credible long-term plans run into difficulties that can be sudden and severe. Additionally, in smaller or less-advanced economies, perceptions of unstable fiscal dynamics at high debt levels could abruptly cut off access to international financial markets.

12. The organization of the note is as follows. Section II describes the elements of comprehensive, consistent, and coordinated economic policy formulation. Section III discusses applications of such policies, using Canada and Japan as examples. In light of the successful coordinated global stimulus of 2009–10, the section also describes the potential role for international policy coordination if global growth slows significantly. Section IV concludes.

II. Elements of the Comprehensive, Consistent, and Coordinated Approach

13. Fiscal policy in many countries seemingly has little flexibility to respond to the next negative shock. Some countries have embarked on austerity programs to control high and rising government debt-to-GDP ratios. In others, political impasse blocks budget initiatives.

14. Proximity to the effective-lower-bound constraint, as noted, has narrowed the room for conventional monetary stimulus in most economies. And this constraint is more serious given the evident steep drop in the global real equilibrium interest rate since the crisis. The range of estimates for the U.S. equilibrium real rate in 2016 is wide, but most are below 1 percent (Figure 1).8 Alongside the decline in expected inflation, this is reflected in the trend decline of long-term interest rates to unprecedented lows (Figure 2). Thus, in 2016, a policy rate even as low as zero may not provide much demand support. The interest rate bind has created a need for alternative instruments to guard against destabilizing inflation expectations and deflation.

Figure 1.
Figure 1.

Measures of the Equilibrium U.S. Real Interest Rate

(percent)

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: FOMC stands for the Federal Open Market Committee. CBO stands for the United States Congressional Budget Office. NAIRU stands for the nonaccelerating inflation rate of unemployment.Sources: Johannsen and Mertens (2016); Laubach and Williams (2015); Obstfeld and others (2016); Federal Reserve; and Nomura.
Figure 2.
Figure 2.

10-Year Bond Yields in Selected Major Economies

(Percent)

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Source: Bloomberg.

15. The diminishing usefulness of each policy measure—instrument by instrument, and country by country—risks policy paralysis if growth slows again. This risk applies nationally and internationally. In an April 2016 speech, IMF Managing Director Christine Lagarde confronted the issue by urging a set of mutually supportive actions for the three policy prongs—structural, fiscal, and monetary—that could now be coordinated within and across countries. We expand on this, arguing that the benefits of the approach outlined in this note extend beyond current circumstances: it can provide short- to medium-term support to growth when needed and permanently widen the room for policy action. The argument draws on a broad range of recent analytical and policy work on structural and financial sector reforms, fiscal multipliers, government investment spending, the management of public sector balance sheet risks, and inflation targeting.

II.A. Fiscal Policy

16. A well-designed fiscal stimulus can effectively protect against persistent contractionary shocks, especially if conducted within a credible fiscal framework. Where fiscal space is perceived to be limited,9 a well-designed stimulus maximizes the effect on output of a given increase in the deficit. Under certain conditions in which comprehensive, consistent, and coordinated policies raise nominal GDP sufficiently, fiscal stimulus can improve the debt ratio (relative to a scenario with no policy response following a contractionary shock) in the long term, and even in the near term. A higher nominal GDP improves the fiscal position by expanding the tax base and reducing transfers. The size of the short-term multiplier effects on aggregate demand depends on:

  • the type of fiscal instrument (government investment, government consumption, transfers, taxes, and so on);

  • the structure of the economy (households’ marginal propensity to consume, degree of openness, and others);

  • a sound and credible fiscal framework that manages risks to the public sector balance sheet—without such a framework, high existing debt or deficits could undermine the credibility of fiscal stimulus; and last, but not least,

  • the cyclical positions of the economy and the response of monetary policy.

17. Credibility is critical to the success of fiscal stimulus, especially where fiscal space appears to be limited. Fiscal policy should commit to long-term management of public sector balance sheet risks, taking into account both assets and liabilities. Fiscal stimulus lacking a credible fiscal framework may widen sovereign spreads and undermine confidence. A high and rising government debt-to-GDP ratio may pose a problem in this regard. Gaining and maintaining fiscal credibility would require, among other things, a clearly articulated long-term fiscal anchor—generally defined as a stock variable or a combination of stock and flow variables (IMF 2016c)—and a systematic behavioral rule for fiscal policy relative to deviations from the anchor.10 Such a rule-based approach would discipline the transition to the anchor, especially when coupled with enhanced fiscal institutional reforms to guide the budget process. The framework should embed a strong fiscal risk-management component to deal with the public sector balance sheet implications of potentially large contingent-liability events, and other macro-fiscal shocks. This includes identifying and quantifying fiscal risks, developing mitigating strategies, and provisioning for the residual risks (see Online Appendix 1). While gaining credibility in a rule-based fiscal framework takes time, the implementation of a comprehensive approach can help build credibility by clearly communicating the government’s objectives and instruments, and the path to achieve them.11

18. The response of interest rates can have a large effect on the fiscal multiplier. When the economy is near full employment or overheating, the central bank would normally have to raise its policy interest rate in response to a fiscal expansion in defense of its inflation objective. This would crowd out private spending, dampening the multiplier effect (Auerbach and Gorodnichenko 2012a, b). Where the main danger is recession and low inflation, the central bank would accommodate the stimulus by holding the policy interest rate constant, or even cutting policy rates, to boost aggregate demand further.

19. In countries with excessive debt, a credible and concrete long-term fiscal framework is needed to keep debt-to-GDP ratios on a sustainable downward trend and help manage public sector balance sheet risks. If the government debt ratio is already high, and in the absence of a credible long-term fiscal strategy, economic agents may expect that a fiscal expansion today will be completely reversed in the near future to keep debt under control. In this case, the effect of the policy on output and inflation might be negligible. In addition, if debt dynamics are viewed as unstable, this can increase risk premiums sharply. Arbatli and others (2016) build the case for comprehensive, consistent, and coordinated policies for Japan and show the risks of some well-known alternative proposals such as “irresponsible fiscal policy,” or “debt monetization.” For a discussion of fiscal frameworks, see Online Appendix 1.

20. With long-term nominal bond rates at extremely low levels, and with the boost to nominal GDP growth, a short-term fiscal stimulus need not weaken the public balance sheet. When economic slack is substantial, multiplier effects raise incomes and tax revenues, such that over the medium term the government debt-to-GDP ratio does not necessarily rise relative to a scenario with no policy response following a negative shock. In 2016, many governments can obtain long-term financing at very low real rates. Many infrastructure projects would easily pass this cost test, implying that they would be socially beneficial, even if the government itself does not recoup all of the return as revenue—the present value of the increase in future potential output would exceed the consumption sacrifice today. Certain fiscal structural measures, such as those that reduce labor tax wedges and increase public spending on active labor market policies, could also fit the bill (see section II.C). However, experience in Japan from the 1990s to the early 2000s and elsewhere suggests that the design of a productive investment program has to be tailored carefully to the long-term needs of a region.

21. Simulation results with the Global Integrated Monetary and Fiscal (GIMF) Model for a generic large open economy illustrate these principles. In GIMF, household and firm behavior follows classical optimizing principles based on model-consistent and forward-looking expectations. The model also contains sticky prices and liquidity constraints on spending, which imply that monetary policies and fiscal deficits have real effects. These effects fade over time as wages and prices eventually adjust. Shocks in the model are propagated by a financial accelerator, which works through procyclical changes in asset prices and risk premiums (Kumhof and others 2010 and Anderson and others 2013 describe GIMF model in detail). 12 The simulations deal with hypothetical shocks to government investment, government consumption, and transfer payments, as well as varying degrees of monetary accommodation. In the baseline case, monetary policy follows an inflation-forecast-based reaction function.13

22. Efficiently managed government investment has a stronger, longer-lasting effect on real GDP than government consumption because it increases potential output (Table 1). In each case, the temporary shock to deficit-financed government spending is equivalent in value to 1 percent of baseline GDP in years 1 and 2, 0.5 percent in year 3, and zero thereafter. Although the short-term impacts, through the circular flow of income, are fairly similar, government investment has a durable effect that government consumption does not because it increases potential output.14 In the model, increases in government investment increase the public sector capital stock and raise the desired capital stock of the private sector. This raises potential output, thus stimulating consumption and private investment.15

Table 1.

Illustrative Discretionary Fiscal Multipliers with Monetary Policy Accommodation

article image
Source: Authors’ simulations.

23. Government investment has the largest effect on GDP, followed by government consumption, targeted transfers, and general transfers, respectively. Transfers have the smallest effect because the leakages (taxes, savings, imports) from the circular flow of income are larger. This applies especially to general transfers, where recipients may have lower marginal propensities to consume (because of balance sheet repair, for example). Multipliers for transfers targeted to cash-strapped groups are substantially larger, but still only half of those for government investment. In short: government investment, when managed efficiently, gives the biggest “bang for the buck.”

24. The multipliers in GIMF are larger if monetary policy keeps interest rates lower for longer. Table 1 illustrates two cases in which the central bank overrides the model’s monetary policy reaction function, holding the policy interest rate flat for one and two years, respectively. The increased rate of inflation over the medium term reduces the real interest rate, eases financial conditions, and increases asset prices. These effects, in turn, stimulate private consumption and investment.16 Over the long term, with the regular reaction function, inflation stabilizes at the official target rate.

25. The increase in nominal GDP—achieved by coordinating fiscal, monetary, and structural policies—may be large enough that the debt-to-GDP ratio declines even though the deficit rises temporarily. Even though demand-management policies may have a limited positive effect on the long-term real rate of growth, it is worth stressing that the increase in nominal income raises tax revenues, as well as the denominator in the conventional debt-to-GDP ratio.17 Through an increase in the rate of inflation, monetary and fiscal policies, acting together, can permanently raise the level of nominal GDP. However, in view of the unsatisfactory experiences with certain infrastructure projects in various parts of the world (poor choices, cost overruns, delays), we stress the importance of wise choices between projects and of effective management.

26. The structural, productivity-enhancing case for a permanent increase in government investment is strong. Very low long-term borrowing costs and, in many countries, substantial infrastructure deficiencies, imply a large social benefit (Abiad and others 2014). The returns would increase with the size of the infrastructure gap. Government investment projects can improve or expand basic infrastructure (roads, bridges, airports, and so on), and could include measures to boost employment and productivity growth over the long term (such as through the provision of child-care services, education, and research and development facilities). To illustrate, Figure 3 reports results for a permanent increase in government investment equal to 1 percent of baseline GDP, a relevant scenario for countries that need to address sizable infrastructure gaps.18 This leads to higher productivity in the private sector, resulting in permanently higher private investment and consumption. At the same time, a higher level of imports implies positive spillovers to other countries. The increased growth rate of potential output would create future policy space by raising government revenues, reducing debt-to-GDP ratios, and raising the neutral interest rate.

Figure 3.

Illustrative Effects of a Permanent Increase in Government Investment

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: Both simulations are done with two years of monetary accommodation. The increase in government investment scenario is modeled as a permanent increase in government investment equal to 1 percent of baseline GDP financed initially by a higher fiscal deficit. The improvement in public sector efficiency scenario is modeled as a permanent increase in government investment equal to 1 percent of baseline GDP financed by a cut in government consumption.Source: Authors’ simulations.

27. The growth dividends of public investment, however, critically depend on its efficiency. High-return projects should be prioritized, particularly in countries that face higher interest rates and where fiscal policy is constrained. IMF (2015) finds that the most efficient public investors get twice the growth impact from their public investment than the least efficient. An alternative simulation experiment therefore involves a policy designed to increase productivity through a permanent switch in government spending from general consumption to investment, with no net change in outlays. The results show smaller, but still sizable, gains in real GDP, consumption, and investment. An important caveat here is that infrastructure development designed to support particular sectors with chronic and growing excess capacity may delay necessary long-term adjustments and provide a boost to output only in the short term.

II.B. Monetary Policy

28. Under a comprehensive, consistent, and coordinated approach, monetary policy strengthens the nominal anchor provided by the official inflation target. The issue at hand is to raise the actual and expected inflation rate in a controlled manner to the target level and to move output closer to potential. Monetary and fiscal policy acting together can always raise the rate of inflation. Indeed, the risk of inflationary deficit financing underlies key political and institutional constraints imposed on central banks: these include restrictions on direct lending to the government, and other measures to prevent fiscal dominance over monetary policy. Such a strategy maintains the independence of the monetary policy instrument to pursue the established inflation target, while allowing short- to medium-term discretion to act against shocks to output and employment.

29. In addition to its impact on the short-term fiscal multiplier, monetary policy has an important, proactive role to play in influencing inflation expectations and real interest rates under the comprehensive, consistent, and coordinated approach. Where central banks operate at the effective lower bound, strategies aiming for a slow and monotonic return to the inflation target over the medium term may not provide sufficient demand support to anchor long-term inflation expectations to the target while restoring the economy to full employment. In view of the prolonged softness of economic activity in many economies, and the lengthening period of below-target inflation, something more is needed to shift expectations of inflation up to target (see Online Appendix 2). One option is for monetary policy to aim for a faster increase in the inflation rate, with the expectation that this will imply a modest overshooting of inflation. The target would then eventually be approached from above (the Bank of Japan has just explicitly embraced this approach.) As is shown in section III, this would also improve debt dynamics by increasing nominal GDP and reducing debt-to-GDP ratios.

30. In this context, an inflation-forecast-targeting (IFT) framework can make a difference.19 IFT central banks have either explicit or implicit dual mandates (Clinton and others 2015). While inflation control is the primary objective of monetary policy, these central banks also make output stability an important goal, especially in circumstances where the policy rate is at the effective lower bound and there are significant risks that long-term inflation expectations could ratchet downward.20 Moreover, the targeting of inflation is symmetric around a point target, in that policy decisions give equal weight to avoiding outcomes below and above the target. Over a number of years, one would therefore expect to see deviations in both directions: undershoots and overshoots would be about equally frequent. In economies with material economic slack, and inflation expectations below target, a risk-avoidance strategy under IFT would call for an aggressive monetary expansion.21

31. Under IFT, monetary policy can credibly commit to a temporary period of inflation somewhat above target without undermining its medium-term goal of price stability. A strategy involving planned temporary and modest overshoots (and undershoots) could enhance inflation-target credibility as well as confidence in the economy’s stability. Not only would the strategy be consistent with achieving an inflation rate closer to the target on average, it would also induce a faster convergence of output and the unemployment rate to their natural levels (Online Appendix 3).22 In the end, credibility comes from satisfying one’s mandate, within the boundaries of an explicit framework. An IFT framework gives monetary policy the scope to act as an effective buffer against cyclical shocks, without undermining the credibility of inflation control.23 More generally, for all aspects of monetary policy, credibility and expectations are critical. The issue of the effectiveness of the transmission mechanism (or pass-through) cannot be separated from the credibility of the target or from expectations of future central bank policy rates. Transparent central bank communications, in line with appropriate actions, help with both aspects.

32. Practical experience suggests that the successful implementation of IFT depends on a high degree of monetary policy transparency. Inflation-targeting central banks have long held to the practice of publishing their inflation forecasts and the outlook for the output gap. Some go further by releasing the forecast interest rate path along with confidence bands. In practice, financial market participants have adapted well in the countries where the central bank publishes the path for the policy rate from a consistent model-based forecast, as this practice helps better align the yield curve with policy objectives and clarifies the concrete implications of “data dependent” policy (Clinton and others 2015).24 More generally, over time, the central bank would establish an open public record of its approach to managing the short-term trade-off between output and inflation. This would better reveal the relative weights the central bank places on deviations from potential output and the inflation target.

33. Empirically, IFT regimes represent the highest levels of transparency.25 Under IFT, the central bank’s forecast of inflation represents an ideal intermediate target that is used to communicate how the central bank is managing the short-term output-inflation trade-off (Svensson 1997). All IFT central banks publish forecasts for the inflation rate and output. Some go so far as to release all key variables of their macroeconomic forecasts, including the forecast path and confidence bands for the short-term interest rate—which here, for simplicity, we call the policy rate—and where relevant, the forecast for other, less conventional, policy instruments.

34. IFT also provides a more robust form of forward guidance. IFT central banks communicate a better sense of how the interest rate path might change in response to a variety of developments. This has been described by some policymakers as finding a path that “looks good” (Svensson 2002; Qvigstad 2005). An advantage of this approach is that the central bank does not have to give special guidance as to when any particular policy approach will switch on and off, for example, with reference to threshold values of inflation and unemployment.26

35. Data on inflation expectations suggest that IFT has, in fact, provided a firm nominal anchor. In Figure 4, the horizontal axes plot the expected deviation of this year’s inflation from the official target for two groups of countries, one a group of inflation-forecast targeters, the other, non-inflation-forecast-targeting advanced economies. The surveys were conducted in 2015 and 2016. In almost all the economies covered, expected inflation is below target, largely because of known factors at the time of the survey (such as low energy prices and economic slack). The vertical axes plot the inflation rate expected three years ahead. There is a remarkable difference between the two groups. In the non-IFT advanced-economy group, expectations for a negative deviation persist at least until the third year ahead, and there is a distinct positive correlation between the expected deviation in this year’s inflation and that in three years’ time. In contrast, the expected three-year-ahead deviation from target in the IFT group is near zero, with no such correlation. Thus, whereas in non-IFT economies negative inflation shocks tend to shift medium-term inflation expectations downward, in IFT economies medium-term expectations remain stable at the target rate.

Figure 4.
Figure 4.

Inflation Expectations Better Anchored in Inflation-Forecast-Targeting Economies

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: Inflation-forecast-targeting (IFT) economies include Canada, the Czech Republic, New Zealand, Sweden, and the United States.Source: Consensus Economics 2015–2016.

36. Inflation targeting can be adopted very quickly, although it takes time to develop a full-fledged IFT regime. Inflation-targeting central banks typically adopted the regime quickly, after a crisis or a history of unsatisfactory inflation. In many cases, it has not required statutory changes to central banking law, but simply a reinterpretation of an existing mandate that puts more emphasis on effectively implementing either an explicit or implicit dual mandate. In the case of the United States, which adopted flexible inflation targeting in 2012 with an announced explicit numerical objective, this was accompanied by a clear statement of the dual mandate (FOMC 2012). Experience also suggests that it can take time to anchor long-term inflation expectations to the target, and that establishing full credibility requires a comprehensive suite of policies (including assurances against fiscal dominance, for example).

II.C. Synergies Between Demand Management and Structural Policies

37. Fiscal, monetary, and structural policies can have mutually supportive macroeconomic effects. Reforms are needed to address the decline in potential growth and the associated decline in the global equilibrium rate of interest since the early 2000s, which deepened after the global financial crisis (Figure 5). Revived investment demand will raise the neutral interest rate, and thereby widen the room to maneuver for monetary policy. By increasing output over the medium term, these reforms will increase fiscal space. In turn, some of this fiscal space can be used to accommodate the budgetary cost of some useful reforms (such as training costs related to active labor market policies) and to enhance the economy’s short-term response to reforms, namely, to front-load gains and to minimize short-term output costs.27

Figure 5.
Figure 5.

Evolution of Potential Output Growth and Its Components in Advanced Economies

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Source: IMF, World Economic Outlook, April 2016.

38. Over time, successful structural policies would increase the fiscal space available to the government. Product and labor market reforms would raise potential output. This, in turn, would raise nominal GDP, reducing the debt-to-GDP ratio (through the denominator) and strengthening the budget by expanding the tax base and/or reducing transfers.

39. In particular, product market reforms could deliver sizable medium-term output gains and pay off fairly quickly. Across advanced economies, on average, major past episodes of deregulation of retail trade, professional services, and network sectors—such as large reductions in barriers to entry—led to large increases in GDP (Figure 6). In Japan, for example, there is scope for progress in several of these areas. There is, however, a possibility that product market reforms might be deflationary in the short term when monetary policy is constrained (Eggertsson, Ferrero, and Raffo 2014), although this needs to be weighed against their inflationary effect due to the impact of firm entry on demand for capital and labor (Cacciatore and others 2016b). Therefore, monetary policymakers should stand ready to ease further should reforms have any noticeable short-term deflationary effects.

Figure 6.
Figure 6.

GDP Effects of Major Past Product Market Reforms

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: t = 1 is the year of the shock. Solid lines denote the response to a major reform in product market regulation, and dashed lines denote 90 percent confidence bands. Effect is the average across advanced economies over the period 1970–2013.Source: IMF, World Economic Outlook, April 2016.

40. Effective measures to increase labor market participation would also have positive output effects in both the short term and the long term. For example, improved education and training, increased availability of day care for children, and reductions in marginal taxes on second earners have an immediate cost to the budget and therefore may benefit from using some fiscal space. However, these costs would be at least partially offset by the subsequent broadening of the tax base as participation rises and on-the-job human capital accumulates.

41. Fiscal stimulus can enhance the short-term macroeconomic effects of labor market reforms. In addition to boosting aggregate demand, a fiscal expansion enhances the economy’s response to reforms that could otherwise entail short-term costs, especially under weak macroeconomic conditions (World Economic Outlook, April 2016, Chapter 3). Estimated average outcomes for major past legislative reforms that relax employment protection legislation for regular workers show a significant decline in unemployment when reforms were accompanied by a large fiscal expansion, versus an increase when reforms were implemented together with a major fiscal contraction—controlling for the direct unemployment impact of the fiscal impulse itself (Figure 7). Employment protection reform increases incentives for firms both to lay off existing workers and to recruit new ones; thus, the more expansionary is fiscal policy, the stronger aggregate demand is and the more firms will respond to reform by recruiting new workers and keeping existing ones rather than by laying off workers.

Figure 7.
Figure 7.

Role of Fiscal Policy in Determining the Effects of Employment Protection Legislation and Unemployment Benefit Reforms

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: t = 1 is the year of the shock. Solid lines denote the response to a major reform in employment protection legislation; dashed lines denote 90 percent confidence bands. Effect is the average across advanced economies over 1970–2013.Source: IMF, World Economic Outlook, April 2016.

42. Fiscal policy can encourage the implementation of structural reforms by mitigating the distributive effects of reform. This can help ease resistance by segments of the population particularly affected by the reform. As discussed in IMF (2014a), some countries have used fiscal policy to gain traction for labor reform by bundling relaxation of employment protection together with more generous unemployment benefits, higher spending on active labor market policies, and labor tax cuts.

43. Fiscal structural reform can further support output by making tax and expenditure policies more growth-friendly (IMF 2015b). Tax policy and administration reform can increase the fairness and efficiency of the tax system. Strengthening of fiscal institutions and budgetary frameworks can improve government transparency and accountability. Expenditure reform can improve the efficiency of public spending and address the challenges related to mounting health and pension spending pressures. Examples of such policies include improving the design and efficiency of health and education spending to achieve better outcomes and reforming untargeted subsidies, especially on energy. Such reforms can create fiscal space that can in turn be used to stimulate the economy where needed in the short term.

44. To sum up, structural reforms will work best as part of a coordinated package that includes appropriate budgetary measures and monetary accommodation. Such an approach would provide quicker benefits with respect to output and employment, and could help ease political obstacles to reform.

II.D. Financial Sector Policy

45. Effects of monetary policy on the real economy are transmitted through various channels, most of which require a healthy financial system. These channels are discussed in detail in Online Appendix 4. Well-functioning markets allow monetary policy to affect a wide array of market prices. Banks, in turn, play a critical role in extending credit to households and firms, which must see an upside to expanding their balance sheets. Micro- and macroprudential policies, as well as decisively tackling nonperforming loans, favoring a resilient financial sector reduce the risk that the financial system will become a source, or an amplifier, of shocks, thus leaving more room for monetary policy to maneuver.

46. A weak banking sector can be a significant hurdle to monetary policy transmission. Banks that are overly exposed to troubled assets or face capital shortages will tend to cut back on lending. Likewise, they will attempt to keep lending rates high to rebuild equity through retained earnings.28 Banks might also opt to limit risk-taking. Finally, banks that are seen as risky will only be able to raise funds at a significant premium over the policy rate, unless central banks are willing to extend generous funding against a wide array of collateral assets.

47. Likewise, overstretched non-financial-sector balance sheets can limit the effects of monetary policy on the real economy. Households and firms can reach or exceed their borrowing constraints if the value of their assets and collateral decreases markedly. The constraint usually stems from the prudent or regulatory requirement to keep a minimum equity buffer. Borrowers having reached their constraint will become less sensitive to monetary policy; they will not engage in new borrowing.

48. While accommodative monetary policy can lead to a build-up of financial imbalances in some sectors, macroprudential policy can help address these vulnerabilities. Experience suggests that a broad range of tools may be needed to address potential vulnerabilities in both the time and structural dimensions. In the time dimension, prudential tools can be used to build up additional buffers as systemic risk accumulates in order for those buffers to be drawn down in times of stress. This will help constrain the risks to the financial system from the boom and dampen the negative impact on credit provision in the bust. In the structural dimension, in turn, various prudential tools can be used to address the externalities that systematically important financial institutions could impose on the financial system. Capital surcharges can enhance the resilience of these institutions to shocks. Additional loss absorbency requirements can facilitate their orderly resolution and reduce spillover risks within the financial system (IMF/FSB/BIS 2016).

49. Active use of macroprudential policies can help support the room for maneuver for monetary policy. For instance, in a number of countries, low interest rates, in combination with limited elasticity of housing supply, have contributed to increases in house prices and a run-up in household debt and leverage. Targeted macroprudential policies (such as the tightening of caps on loan-to-value and debt-service-to-income ratios) can help contain these dynamics and increase the system’s resilience to shocks to asset prices or household incomes. When macroprudential buffers have been built up, some of them can also be relaxed when systemic risks materialize and financial shocks lead banks to pull back credit. Such a relaxation can then help sustain the flow of credit through adverse financial conditions (IMF 2013; Nier and Kang 2016).

50. In acute financial crises, swift and decisive policy action to restore the health of the financial system is essential to support monetary policy transmission. Policies must give incentives to both lenders and borrowers to address their balance sheet weakness. While it may be rational from the perspective of individual agents to wait to “grow out” of the crisis, in aggregate, this strategy leads to costly misallocation of resources, slow credit growth, and weak recovery. Restoring the health of the financial sector often translates into higher public debt ratios, as contingent financial liabilities migrate to the public sector balance sheet. This makes managing public sector balance sheet risks all the more important, including building policy space in good times (see section II.A).

51. Both supply-side and demand-side policies are needed to strengthen monetary policy transmission, especially after an acute crisis. These policies are reviewed in detail in Online Appendix 4. On the supply side, supervisory action is needed to give banks incentive to promptly recognize losses from troubled assets. Asset quality reviews have proven especially helpful in ensuring that balance sheets reflect actual economic valuations. Likewise, stress tests are key to reassuring investors of the adequacy of banks’ capital buffers and viability over a longer horizon. In many cases, banks’ capital bases will need to be strengthened, if possible before a crisis ensues, so that the banks can continue lending to the economy, even during protracted downturns. Putting in place well-designed bank resolution frameworks ex ante is important to reduce moral hazard and minimize the cost to the public sector. State solvency support for bank recapitalizations should remain a measure of last resort. Private sector involvement through bail-ins is also possible, although it needs to be managed carefully. Following more acute crises, asset management companies can relieve banks of troubled assets, but this raises multiple issues with respect to moral hazard, budgetary costs, public debt and contingent liabilities, and so on. Central bank liquidity lines can also help restore market functioning, supporting bank balance sheets, but should only be used to address temporary market distortions. On the demand side, over-indebtedness in households and firms is a key impediment to new lending. Swift restructuring of distressed loans is vital to cleaning private sector balance sheets and jump-starting credit demand.

52. Accommodative monetary policy should help both supply and demand factors. The first-order effect will be to boost growth and thus decrease nonperforming loans, improve valuations, strengthen balance sheets, and decrease the riskiness of borrowers. However, cheap funding will tend to postpone the difficult choice of recognizing losses and restructuring loans (the evergreening issue explored in the IMF’s Global Financial Stability Report, October 2013).

III. Illustrating Comprehensive, Consistent, and Coordinated Policies

III.A. Examples of Canada and Japan

53. The comprehensive, consistent, and coordinated policy approach needs to be tailored to specific country circumstances. Among the advanced economies, Canada and Japan present contrasting positions in regard to the room each has for maneuvering macroeconomic policy. Canada has substantial fiscal space, notwithstanding variability in this position from province to province, and—subject to appropriate regulatory measures to cool overheated housing markets—room for further monetary stimulus. Long-term inflation expectations are firmly anchored at the 2 percent target rate. In Japan, conditions are more challenging, and headwinds are stronger. Growth has been low, and expectations of inflation are below target after decades of deflation. Yet expansionary macroeconomic policies have been pushed toward perceived limits (Figure 8). Model simulations for the two countries, discussed in Online Appendix 5, mark the ends of a range of comprehensive, consistent, and coordinated policy possibilities for advanced economies sitting at points between them. Most of these economies face fewer difficulties than Japan, but have somewhat more limited policy space than Canada.

Figure 8.
Figure 8.

Key Macroeconomic Variables for Canada and Japan

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: CPI refers to the consumer price index.Source: IMF, World Economic Outlook Update, July 2016.

54. Canada illustrates how comprehensive policies can get the most from the existing policy space. Model simulations show that fiscal support, complemented by monetary accommodation, can help offset disturbances that may occur (Online Appendix 5; Obstfeld and others 2016). By closing the output gap and raising inflation quickly, the policy stimulus creates conditions in which further disinflationary shocks are more easily resisted. Over the medium term, it raises the nominal interest rate somewhat, away from the effective lower bound. The higher inflation rate reinforces expectations that the inflation target will be achieved, and thereby further solidifies the already firm nominal anchor. Stronger nominal GDP boosts government revenues, helping stabilize government finances. In addition, with the lower interest rate, debt service cost goes down in the short term.

55. Japan illustrates a situation in which constraints on policy instruments, and the need to rebuild policy space, sharpen the need for a comprehensive, consistent, and coordinated approach.29 Building on the “Three Arrows” program of Prime Minister Shinzo Abe’s government, we recommend a “Three-Arrows-Plus” package. For fiscal policy, we recommend a gradual increase in the value-added tax (VAT) to help manage public sector balance sheet risks. The VAT is the least harmful revenue source in both its macroeconomic impact (low multiplier) and allocative distortions. Gradual increases will avoid the abrupt reallocations of consumption from one quarter to another, and the eventual weakness of spending amid low potential growth, that were associated with the pre-announced VAT hike of 2014. For monetary policy, the Bank of Japan could adopt a transparent IFT regime to strengthen its inflation-targeting approach. In addition, support from growth-enhancing structural policies is vital. Labor market reform in Japan could help offset the drag from a declining workforce, while reducing labor-market dualism between those with job security and the increasing worker population with more precarious employment. Reforms to ease barriers that exclude workers from the more protected sectors would help investment in human capital, which can be lost when workers are trapped in low-skill jobs. While the long-term gains to potential output would be large, the short-term impact of structural reforms is difficult to quantify given uncertainty about how the private sector would respond. The fiscal and monetary policies of the comprehensive, consistent, and coordinated framework would be able, in principle, to keep the economy on the desired growth path over the medium term, offsetting any short-term contractionary impact that structural reforms might have. Since the dual labor market has exacerbated the problem of inflation control, the government should consider special measures to overcome the entrenched deflationary mindset. An incomes policy, to support nominal wage growth directly, could help raise wage inflation to a rate consistent with the 2 percent inflation objective. Model simulations indicate that such a Three-Arrows-Plus package could deliver the ambitious targets of Abenomics (Online Appendix 5; Arbatli and others 2016).

56. In the cases of both Canada and Japan, an effective comprehensive, consistent, and coordinated policy program would increase rather than diminish monetary and fiscal policy space over the medium term. As a result of the boost to nominal GDP, the simulated policies, anchored by the medium-term fiscal consolidation path, would produce a lower government debt-to-GDP ratio over the medium term than a no-stimulus alternative. The initial conditions of low inflation and a negative output gap allow an increase in both real output and the rate of inflation. The positive outcomes would help dispel notions of policy impotence.

III.B. International Policy Coordination: The Positive Spillovers

57. Under current circumstances, a large new global contractionary shock would raise the risk that economies might fall into a deflation (or low-inflation) trap. Such a negative shock to demand, in an economy already operating below potential, could do long-term damage. A timely and coordinated policy response could, however, jump-start a permanent and offsetting increase in employment and output. An example of such a response is the G20 stimulus package after the global financial crisis, which saved the global economy from a much more severe recession. That package called for tax cuts and discretionary spending increases equivalent to 2 percent of GDP in both 2009 and 2010, but the actual size and composition of fiscal packages varied across countries. Benes and others (2016) and Coenen and others (2010) provide evidence that the coordinated G20 stimulus was crucial in helping to avert recessionary forces.

58. The GIMF model illustrates the plausible global effects from a coordinated international response to a hypothetical negative demand shock. While such a new demand shock is currently not anticipated, the simulation provides useful insights on the economic mechanism at play and also highlights the benefits of coordinated policy action in general. GIMF takes into account key differences in economic structures, such as country size, degree of openness, and the liquidity constraints of the population. Spillovers are endogenized through trade and financial links. We look at the effects of the coordinated stimulus on output by region—and for the global economy as a whole—and compare the results with the effects of a stimulus by each region on its own. The assumed stimulus takes the form of raising government investment, government consumption, and targeted transfers. The overall size of the hypothetical fiscal stimulus is equal to 1 percent of each region’s baseline GDP in year 1, 1 percent in year 2, and 0.5 percent in year 3, with all instruments subsequently returning to baseline. In view of the weakening economy, monetary policies accommodate the fiscal expansion by keeping nominal policy interest rates unchanged for two years.

59. Estimated domestic multipliers exceed unity for almost all regions. The estimated impact of each region’s fiscal stimulus on the world, on itself, and on other regions is shown in columns 2–6 of Table 2. The estimated domestic multiplier (shown in underlined numbers along a diagonal) is greatest for emerging Asia and the remaining countries group, where relatively high shares of households are liquidity constrained. The short-run multipliers for the three large advanced economies—the euro area, the United States, and Japan—are about unity.

Table 2.

Estimates of the Effects of a Coordinated Fiscal Stimulus after a Hypothetical Negative Global Demand Shock (Part I)

article image
Note: The size of the fiscal stimulus is equal to 1 percent, 1 percent, and 0.5 percent of each region’s baseline GDP, respectively. It consists of government investment, government consumption, and targeted transfers, with their respective share being ¼, ¼, and ½ of the total stimulus. Monetary policy in all regions accommodates the fiscal expansion by keeping nominal policy interest rate unchanged for two years.Source: Authors’ simulations.

60. The simulation results show large international spillover effects. The first row of Table 2 shows the impact on world GDP if each region does its fiscal stimulus alone. The global impact depends on the size of the region’s economy, on the magnitude of the domestic output effect, and on the region’s openness. Thus, fiscal stimulus in emerging Asia or the remaining countries has especially powerful spillovers, which show up in Table 2 as sizable increases in world GDP. Fiscal stimulus in the United States or the euro area also has strong spillovers to other regions, because of their economic size and high share of world imports. Part of the strength of the estimated policy impact stems from financial sector linkages. The policy transmission mechanism in the model features a financial accelerator effect: with nominal policy rates held constant, real rates decline as the stimulus raises the inflation rate. In turn, the reduction in real rates causes an increase in asset prices, which strengthens balance sheets, reduces risk premiums, and eases credit conditions. Cross-border trade integration propagates these effects globally.

61. The simulation shows that, in response to a hypothetical negative global shock, an internationally coordinated stimulus would boost global GDP sizably and, importantly, benefit each country individually. The first column of Table 2 shows the impact on global GDP of the stimulus when applied simultaneously in every region. Thus, these results include the positive spillovers from other regions, as well as the domestic effect of each region’s own program. The estimated effect adds 2.4 percent to world GDP in years 1 and 2, and 1.1 percent in year 3. The impact is largest for countries other than the three large advanced economies, in part because of the openness of emerging markets to spillovers. The euro area and the United States would see an output boost of over 1½ percent, and Japan about 1.8 percent. These increases represent a powerful multiplier effect: through positive spillovers, simultaneous international action can substantially amplify the effectiveness of national policy actions. Without coordination, governments might fail to act, because from their individual viewpoints the spillovers constitute leakages of spending that reduce the multiplier and, hence, the perceived benefits of a fiscal expansion. These simulations do not take into account the additional beneficial effects of structural reforms or differences in fiscal packages across regions. Such factors, however, may generate even larger positive spillovers.

62. The model results may understate longer-run effects of the policy response because the model disregards the negative effects of a prolonged slump on employment, productivity, and confidence. When an economy operates below potential over a period of years, the level of potential output itself adjusts downward (Summers 2014). Prolonged unemployment brings erosion of job skills, and a lack of openings for training in new expertise. Weak levels of investment deprive the economy of future capacity, not least through the loss of innovation incorporated in new capital. An appropriate policy response avoids these dangers.

63. As global fiscal and monetary coordination permanently raises nominal GDP, the debt-to-GDP ratio is eventually lower for all regions, notwithstanding the initial increase in budget deficits. This fiscal dividend is illustrated by negative numbers in the first column of Table 3, which shows estimates of the change in the debt ratio in year 4 (relative to the baseline). For example, the euro area debt ratio would decline by 0.3 percentage point, according to the simulations, as nominal GDP is up by 1 percent. Other regions see larger declines, mainly because of stronger multiplier effects on nominal GDP. These improvements are, however, achieved only with global fiscal and monetary coordination. The debt-to-GDP ratio rises if a country carries out a fiscal expansion alone, as is indicated by the underlined numbers on the bottom panel’s diagonal. And the difference is significant. For example, a stimulus confined to the euro area alone would raise that area’s debt ratio by 0.9 percentage point, 1.2 percentage points more than with an internationally coordinated stimulus. Beyond the mechanical effects, the moderation of the hypothetical global slowdown eases the job of structuring a fiscal framework that keeps the long-term public debt-to-GDP ratio under control.

Table 3.

Estimates of the Effects of a Coordinated Fiscal Stimulus after a Hypothetical Negative Global Demand Shock (Part II)

article image
Note: The size of the fiscal stimulus is equal to 1, 1, and 0.5 percent of each region’s baseline GDP, respectively. It consists of government investment, government consumption, and targeted transfers, with their respective share being ¼, ¼, and ½ of the total stimulus. Monetary policy in all regions accommodates the fiscal expansion by keeping nominal policy interest rate unchanged for two years.Source: Authors’ simulations.

IV. Policy Conclusions

64. In the event of a renewed global slowdown, a comprehensive, consistent, and coordinated policy approach could move the global economy well away from a possible danger zone. Policy needs to be ready for comprehensive action using all three policy prongs— monetary, fiscal, and structural—because applying them in combination overcomes apparent constraints faced by these policy instruments individually. Such a comprehensive approach, tailored to specific country circumstances, has been central to the IMF’s policy advice to its member countries. Consistent policy frameworks can provide the policy space to deliver decisive short- to medium-term support to an economy, for example, by holding long-term inflation expectations to target rates and committing fiscal policy to an eventual sustainable downtrend in government debt-to-GDP ratios. Coordinated policies across major economies can amplify the effects of individual policy actions through positive cross-border spillovers. This holds in normal times but is particularly relevant when the world is faced with a large global shock, as was illustrated in section III.B. International coordination of fiscal and monetary stimulus can also boost global nominal GDP, helping to keep debt-to-GDP ratios in check. Overall, the approach helps dispel perceptions that there is only limited policy space.

65. Under this approach to macroeconomic policy, the whole is greater than the sum of parts. In particular, model simulations suggest that a fiscal stimulus (applied where feasible), accommodated by monetary policy, could mitigate the impact on output of a negative shock, and help raise inflation to target levels. Moreover, the resulting higher growth rate of nominal GDP would improve the dynamics of debt-to-GDP ratios. These short-term policies are more effective when conducted within a sound fiscal framework that manages public sector balance sheet risks and within a credible monetary framework that boosts firms’ confidence in the long-term inflation target. Upgrades will be needed in those countries where credible frameworks have not yet been fully developed. International coordination between countries amplifies the effects of individual country stimulus through three channels. First, strong positive cross-border spillovers through trade and financial channels are clearly indicated in simulations of a global model. Second, the lower cross-border leakages compared to a solo expansion encourage bolder action by each government. And third, there is a confidence effect—people are more likely to accord credibility to a coordinated international action, as evidenced by the 2009–10 actions, which helped calm a globally shared state of high anxiety.

66. This approach also encompasses financial sector policies and structural reforms that can have large positive effects over the long term. The transmission of monetary policy can be improved through financial sector policies that strengthen banking systems and markets—for example, through prudential policy, resolution of legacy loan issues, and stronger bank capital bases. Macroprudential policy can also contain unintended side effects of monetary accommodation. Structural reforms—in labor, product, and services markets—can increase potential growth. In turn, higher nominal GDP growth makes the debt-to-GDP ratio fall and strengthens the budget by expanding the tax base and/or lowering transfers. However, even some sound reforms can have short-term negative impacts on aggregate output. The comprehensive, consistent, and coordinated approach would use monetary and fiscal instruments to offset any such impacts. Model simulations for Japan—where perceived macroeconomic policy space is very limited—suggest that such an approach, which supplements the “Three Arrows” of Abenomics with an incomes policy to raise expectations of inflation, could help achieve that program’s ambitious objectives on a timely schedule.

67. The insights of this note are relevant for emerging market economies as well, many of which have recently suffered from recession and falling commodity prices. In these economies, establishing sound consistent fiscal frameworks that successfully manage fiscal balance sheet risks over time is a precondition. Reforms of the monetary framework can also help in many cases to establish clarity on monetary policy objectives and targets. Stronger governance arrangements would gradually also help entrench greater monetary policy credibility. This advantage, in turn, would allow more flexible use of monetary and fiscal tools in managing aggregate demand. For countries with limited room for maneuver, for example, commodity exporting countries, this approach can help them better determine the pace of necessary fiscal adjustment and implement growth-friendly fiscal rebalancing.

68. In sum, the comprehensive, consistent, and coordinated policy framework, by systematically relating policy objectives and instruments over time, offers the best chance for successfully dealing with a negative shock. The global macroeconomic risks of 2016 are onesided. Output in major advanced economies and many emerging market economies remains short of potential—well short in many cases. Inflation is below target in many regions, and below zero in some. Geopolitical frictions and economic imbalances around the world encourage isolationist policies and unmistakably tilt the balance of risks toward further negative shocks to global output. In view of this starting point, a major downdraft now would push the global economy closer toward, and in some regions definitively into, a low-inflation quagmire. On the positive side, the payoff from a successful policy strategy as laid out in this note would be large—probably even larger than suggested by our macroeconomic models, which do not take into account the lasting gains to productivity that come with higher employment (through acquisition of skills and know-how) and increased investment (through a larger, newer capital stock and the embodied technical advances).

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Appendix I. Fiscal Frameworks

A credible and clearly-articulated fiscal framework is needed to achieve fiscal policy objectives. The framework should define a fiscal anchor and how to comply with it, with the purpose of managing public sector balance sheet risks (both assets and liabilities). Such a framework enables the government to deploy effective counter-cyclical fiscal policy and to act as a last-resort safety net to the financial sector. Without a long-run framework, short-run fiscal actions could call into question the commitment to longer-term fiscal objectives. For example, a short-run fiscal stimulus could result in volatile policy-making or in entrenched policies that cannot be easily reversed.

An effective fiscal framework defines five main elements: (1) principles to guide fiscal policy, including long-term objectives; (2) a transparent fiscal anchor for the public sector balance sheet; (3) a commitment device—as reflected in the systematic behavior of the fiscal authority—to help navigate transition to the anchor; (4) an understanding of how expectations regarding the future course of fiscal policy affect the behavior of private agents today; and (5) transparency and accountability vis-à-vis the relevant demographic institutions and the public at large.

The forward-looking nature of the fiscal framework suggests that analyzing and managing risks to the public sector’s balance sheet is of paramount importance (see IMF, 2016c). Analyzing and disclosing how macroeconomic shocks and the materialization of various contingent liabilities could affect public finances in various states of the world would strengthen credibility. The main elements of the balance sheet to be managed are public debt, contingent liabilities, and, more broadly, net worth. Fiscal risks need to be clearly identified and quantified, in order for them to be then mitigated and managed:

  • Identifying and quantifying fiscal risks. A thorough analysis of fiscal risks requires comprehensive, reliable, and timely fiscal and macroeconomic data. Fiscal data should cover all public sector entities, stocks (balance sheets), and flows. Stress tests and probabilistic forecasts are important in this context.

  • Mitigating fiscal risks. Once exposure to various risks has been identified, governments need to consider how to mitigate or manage them. Mitigating instruments include: (1) direct controls to limit exposure (for example limits on sub-national borrowing or ceilings on the issuance of government guarantees); (2) regulation and incentives (e.g., through higher capital requirements for banks or risk-based fees for guarantees); and (3) transferring/sharing risks (for example through insurance or the use of state-contingent financial instruments).

  • Managing fiscal risks. For those risks that cannot be mitigated, provisioning can be used. Examples include deposit insurance funds or stabilization funds in natural resource-rich countries. Prudent public debt levels, however, are the most effective way to ensure that such risk can be contained with minimal economic fallout.

Appendix II. Medium-Term Inflation Expectations as Shock Absorber or Amplifier

In normal times, following a contractionary shock, policy would react with a rate cut which has its effects on inflation and output via the usual transmission mechanism. At the ELB, the story is more complicated as the nominal interest rate cannot decline, but a somewhat weakened version of the mechanism could still apply through real interest rates and the real exchange rate. That is, expected inflation provides a channel through which forward guidance can stimulate the economy. If monetary policy is active and credible, it could persuade the public that it will eventually get inflation back up to the long-run target (Appendix Figure II-1). With the promise of a sufficiently vigorous policy, which commits to holding the interest rate near zero for an extended future period, the public would expect higher inflation in the future. This would reduce longer-term real rates of interest, even though the nominal rate is stuck at the ELB. These movements serve as a buffer to the shock. In an aggressive response, the central bank could show a forecast with sufficient monetary policy stimulus in which, over the medium term, inflation overshoots before returning to the long-run target. If this forecast is credible, it reduces real interest rates, depreciates the real foreign exchange value of the currency, and boosts asset prices. The effect on demand and inflation is positive.

If, however, monetary policy is passive or not credible, changes in the real exchange rate and asset prices amplify a contractionary shock because the expected rate of inflation falls (the expected rate of deflation rises). At the ELB, real interest rates go up, the real exchange appreciates, and asset price fall, which is the classic deflation trap.

Credible active policies, and hence stabilizing expectations, are evident for Canada in the response to the global financial crisis (Appendix Table II-1). The rate of inflation when Lehman Brothers failed in September 2008 was on target at about 2 percent and the Bank of Canada’s policy rate was above 4 percent. The ample room for action was exploited by the Bank, which cut the policy rate in steps to near zero. The Canadian dollar depreciated. Exports fell, but not precipitously, and the recession in 2009 was relatively mild in comparison to previous Canadian recessions and in comparison with what happened in the rest of the world. Inflation fell to a low level, but remained positive. Considering the proximity of Canada to the U.S. epicenter of the crisis, and that Canada suffered in addition a large deterioration in terms of trade with the post-crisis collapse of commodity markets, the two important shock absorbers (long-term interest rates and the exchange rate) worked well.

In Japan, the story is quite different. The main difficulty for counter-cyclical monetary policy was that the short-term interest rate was already near zero when the crisis broke (Appendix Table II-1). With the drop in demand, and oil prices dropping sharply from their peak, 2009 saw a marked deflation. Since the nominal short-term interest rate could go no lower, the real rate went up. The yen rose strongly against the U.S. dollar, appreciating 25 percent between 2007 and 2009. Exports plunged. Deflationary pressures intensified. It was as if the public had the self-reinforcing belief that policy would not be able to offset the contractionary shock. That is, expectations amplified the contractionary shock.

Appendix Figure II-1.
Appendix Figure II-1.

Expectations as Absorbers or Amplifiers Following a Contractionary Shock

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Source: Adapted from Clinton and others (2015).
Appendix Table II-1.

Selected Economic Indicators for Japan and Canada Before and After the Global Financial Crisis

article image
Note: All units are in percent except for the bilateral USD exchange rate, which is indexed to 100 in 2007. 3-year-ahead inflation expectations are from Consensus Forecast Long-term Survey, October 2007-09. An increase in the bilateral USD exchange rate means a depreciation of the Yen or Canadian dollar.Source: Adapted from Clinton and others (2015).

Appendix III. Flexible Inflation Targeting for Risk Avoidance with Occasional Overshooting

Policymakers typically do not try to fine-tune the economy, but they do seek at least to avoid outcomes that are very bad. A risk-avoiding central bank ignores small deviations from desired outcomes, but attaches an increasing marginal cost to output gaps, and reacts more strongly to deviations from the inflation target as they grow. In particular, risk avoidance prompts strong corrective actions whenever the economy approaches a dark corner where conventional policy might be ineffective.

Under current circumstances, in economies with significant economic slack, an aggressive risk-averse strategy is likely to result in a central bank forecast showing a temporary overshoot of the inflation target. An attempt to fine-tune a smooth return to target is likely to fail on two related counts. First, the promised modest increases in the inflation rate from current low levels would do little for the medium-term transmission of monetary policy. Indeed, in most advanced economies, this would be a repeat of the unsatisfactory situation of the post-crisis years. Second, a smooth return to target from below does nothing, after years of downward bias, to lift long-term inflation expectations to the target rate.

A central bank that wants to establish firm credibility for the inflation target will on average over the years see positive and negative deviations cancelling out. Thus, even though policymakers may not deliberately aim to overshoot the target after a period of undershoots (i.e., even though they may not deliberately react to past deviations from target as they would in pursuit of a price-level-path target), if they are reinforcing expectations at the target rate, then over the long run it will look as if they do. The key to establishing the nominal anchor is to stabilize the average inflation rate over the cycle. A policy that seeks only to reduce existing, durable deviations—aiming to stay below the target during the medium term—is likely to fall short.

Relevant evidence is provided by the difference in experience of economies in which monetary policy has established IFT (or, equivalently, the U.S. dual mandate as defined in 2012). For example, 3-year-ahead inflation expectations (as well as the 2017-19 average) in Canada, the Czech Republic, and the United States are solid at the target rate, whereas in Japan, less so (Appendix Table III-1).

Appendix Table III-1.

Inflation Expectations

article image
Note: 1 IFT CBs use consistent macro forecasts to explain how they are adjusting their instruments to achieve their output-inflation objectives. 2 The implicit CPI inflation objective for the U.S. is estimated by the authors at about 0.3 percentage points above the Fed's official PCE inflation objective of 2.0 percent. This is based on the difference in long-term CPI and PCE inflation forecasts from Philadelphia Fed's Survey of Professional Forecasters.Source: Consensus Economics, July 2016.

Publication of a complete macroeconomic forecast by a central bank in this situation is a very useful communications tool. It would show a path for the policy rate that is at the ELB long enough to get inflation above the official target for a while. This helps move expectations in the right direction for both longer-term nominal interest rates (down) and medium-term inflation (up). This double dose reduces real interest rates, which in turn increases asset prices and depreciates the currency, all of which boost output and inflation. When the policy interest rate is near its floor, and the unemployment costs of further negative shocks to demand much outweigh the potential inflation costs of positive shocks, risk avoidance calls for aggressive action.

The logic for deliberate overshooting of the inflation target during the medium term ahead is quite clear. In this, as in other difficult situations, publication of all key features of a coherent macroeconomic forecast, including the projected interest rate path, would help the central bank give a credible public account of its strategy. In contrast, publication of an overshooting inflation rate, without the full story, might undermine confidence in the nominal anchor—it might look as though the central bank was doing “too little, too late” in terms of raising the interest rate to a more normal level. Full transparency would allow the central bank to adopt a more aggressive strategy against deflation, and to avoid losses of output and jobs. More generally, over time publication of the complete central bank forecast path provides a historical record from which outsiders can assess the systematic component of monetary policy, and thereby better hold the central bank to account.

Appendix IV. Financial Sector Policies and Monetary Policy Transmission

The monetary policy stance is transmitted to the real economy through various channels, most of which require a healthy financial system. The following are thought to be the most relevant channels (described following a shift to a more accommodative monetary policy stance):

  • Intertemporal interest rate channel: lower interest rates in the short to medium term decrease returns from savings and lower the cost of investment, making more projects profitable. Saving decreases and borrowing increases, favoring consumption and investment, and boosting aggregate demand.

  • Balance sheet channel: higher asset prices and expected profits increase the net worth of households and firms, decrease balance sheet leverage, and raise collateral values and borrowing capacity. Banks charge a lower premium on loans as risk decreases. Credit generally increases as does banks’ willingness to invest in riskier projects with potentially higher returns and positive effects on potential growth.

  • Bank lending channel: more liquid assets in the form of reserves and deposit funding enable banks to extend further lending.

  • Exchange rate channel: less attractive domestic assets lead to currency depreciation, which increases profits from exports (at constant export prices) or export volumes (at constant domestic prices).

Both supply-side and demand-side policies are needed to strengthen the transmission of monetary policy following an acute crisis.

Supply-side Policies

Supervisory action is needed to provide banks with incentives to recognize the fair value of losses from troubled assets. Banks otherwise tend to do so partially or late, to avoid hits to capital, profit, and market sentiment. However, this leaves banks vulnerable, and diverts financial and managerial resources away from providing new lending.

Asset Quality Reviews (AQRs) ensure that bank balance sheets reflect actual economic valuations. Assumptions of future macroeconomic developments substantially influence recovery values of assets and collateral.

Stress tests aim to assess the adequacy of banks’ capital buffers and viability over a longer horizon. Stress tests also take a close look at banks’ business models, though, again, results are sensitive to economic assumptions.

Supervisory action is also important to ensure banks’ capital base is sufficiently strong to continue lending to the economy even in protracted downturns. If capital is insufficient, banks should preferably seek private investment.

State solvency support for bank recapitalizations should remain a measure of last resort. To minimize moral hazard and reduce risks to taxpayers, public equity injections require the dilution of private shareholders, strong governance arrangements, and an adequate compensation for risks. However, only very strong economies are able to provide state support in systemic crises; smaller or weaker sovereigns risk overburdening themselves.

Private sector bail-ins are also possible, though financial stability implications need to be considered carefully. First, buffers of bail-in-able claims need to be built several years ahead of a crisis, when such funds are available at reasonable cost. Second, creditors should be closely monitored and ideally drawn from non-systemic institutions, and as much as possible from abroad.

Asset Management Companies (AMCs) can relieve banks of troubled assets, but raise multiple design issues. The price at which assets are transferred must not provide back-door recapitalizations to banks. The selection of assets must be sufficiently wide to relieve banks. And though funding will often include the public sector (given its access to stable, low-cost, and long-term funding), risks to taxpayers can be shared with the private sector.

Central bank intervention can also help restore market functioning, thereby supporting bank balance sheets, but should only be used to address temporary market distortions. Central banks can provide liquidity support to specific market players, or even set price floors on specific assets when these trade at prices too far below fundamentals (as did the U.S. Federal Reserve through non-recourse repos on Asset Backed Securities (ABS) through the TALF, see Sack, 2010).

Demand-side Policies

Over-indebtedness of households and firms is a key impediment for new lending. Restructuring distressed loans is vital to clean private sector balance sheets and jump-start credit demand. Viable firms need to be rehabilitated and restructured in the context of a speedy insolvency process. Consumers need to have access to a “fresh start” under appropriate safeguards. At the same time, an effective enforcement regime, including foreclosure frameworks, is needed to provide borrowers with incentives to negotiate and, as a last-resort, deal with unviable debtors.

Appendix V. Constrasting Cases: Canada and Japan

Among advanced economies, Canada and Japan present contrasting situations with respect to the room for maneuver of macroeconomic policy. Notwithstanding heterogeneity across provinces, Canada has substantial fiscal space, and—subject to appropriate regulatory measures to cool off overheated housing markets—some room for further monetary stimulus. In Japan, conditions are more challenging, headwinds are more deeply entrenched, and policy is much more constrained. Policy simulations for the pair illustrate the range of possibilities for the advanced economies whose situation lies between the two. Most face fewer difficulties than Japan, but have somewhat more limited policy space than Canada.

Canada 1

Longer-term inflation expectations are firmly anchored in Canada at the 2 percent target rate. Since 2008, however, output has not re-attained potential, and the post-2014 collapse of oil prices has compounded the underlying weakness. Growth is set to recover, but only modestly, as the low oil price continues to take a toll on the economy. There remains a material output gap. Headline inflation is below target, although core inflation remains at around 2 percent. Part of the problem has been the unexpected persistence of global headwinds after the crisis of 2008-09 and its aftershocks. As a consequence, the decline in the equilibrium real interest rate was recognized only with a substantial lag. In hindsight, estimates of the equilibrium real interest rate, in the range of 1-2 percent (Mendes, 2015), have become difficult to square with current very low nominal bond yields and the general performance of the economy. Overestimates of the equilibrium rate lead to overestimates of the degree of stimulus that monetary policy provides.

The Bank of Canada (BoC) IFT framework has worked well and is quite transparent, but a further degree of transparency about instruments and objectives would enhance its effectiveness. First, publication of the central bank forecast could be more comprehensive, especially to include the path of the policy rate. That change would more effectively guide the term structure of interest rates in line with monetary policy objectives. Second, whereas the current, 2011, central bank-government agreement on the inflation control target states that “the inflation target will continue to be the 2 per cent mid-point of the 1 to 3 per cent inflation-control range,” the scheduled 2016 restatement of the agreement could emphasize that the 2 percent point target is the medium-term objective, and that monetary policy should not rigidly try to achieve it in the short run.2 Third, explicit recognition of the dual objective for output (in non-numerical terms) as well as for inflation (with the latter having priority) would set out formally the obligation, which in practice the central bank already respects, to account explicitly for the management of the short-run output-inflation tradeoff.3

The BoC still has some room to ease money, through interest rate cuts and unconventional instruments. As regards the latter, Governor Poloz has suggested that the policy rate could go negative, and that the options of forward guidance, large-scale asset purchases, negative interest rates, and funding for credit, remain open (Poloz, 2015).

Canada has fiscal policy space, and is using it. Although the general government gross debt is relatively high, at about 90 percent of GDP including financial assets, its net debt is below 30 percent of GDP, one of the lowest debt ratios in the G7. At the federal level, the gross debt is considerably lower, at 40 percent of GDP (with net federal debt standing at around 23 percent of GDP). However, the future trajectory of the debt ratio is a function of the overall policy package put in place. Strengthening the fiscal framework, by establishing a credible medium-term fiscal consolidation plan at the general government level, will help make the current stimulus more effective.

Policy simulations indicate that a fiscal stimulus coupled with aggressive monetary accommodation would be a potent stabilizer in the event of further negative shocks. Appendix Figure V-1 shows the impact of a series of negative shocks to foreign and domestic demand. If monetary policy follows a regular inflation-forecast-based reaction function, the Canadian output gap in 2017 widens from about -0.5 percent of potential in the baseline WEO forecast (black line) to -1.2 percent (red line). In this simulation, the BoC is assumed to cut the short-term interest rate in gradual steps to about zero in 2018. The negative output gap is not eliminated until 2020, and inflation falls short of target through these years. The government debt-to-GDP ratio rises permanently relative to baseline. This unpalatable outcome suggests that Canada could reasonably apply a more expansionary macroeconomic policy mix. The package depicted in the blue line assumes that fiscal policy too plays a role. This is in line with the 3-C view that fiscal policy should backstop monetary policy in the event of persistent large shocks. In addition, the very low initial level of interest rates, and the risk of heightened financial imbalances that might be associated with further rate cuts, would also justify fiscal stimulus. In the simulation, the fiscal package includes a permanent increase in government investment equal to 0.25 percent of baseline GDP. In addition, the package also includes a temporary increase in targeted transfers covering the period of 2016-19 (0.25, 1.0, 1.0, and 0.5 percent of baseline GDP, respectively). Because of the severe shock, and the weakness already present in the initial conditions, monetary policy accommodates the increased spending by cutting the interest rate below the baseline by 25 basis points in 2016 and 75 basis points in 2017-2018. The results for output and inflation are strongly positive. The output gap is quickly closed, and inflation modestly overshoots the 2 percent target in 2017-19.

The cumulative output gain under the strategy outweighs the costs of the cycle in output and inflation that it generates. The output gap at the starting point is wide, implying that closing the gap quickly has a high marginal benefit; the marginal cost of the smaller deviations from potential in the modest cycle that follows is relatively low.

The more aggressive expansionary strategy provides insurance against additional negative shocks that may happen in the future. By closing the output gap and raising inflation quickly, the stimulus creates conditions in which further disinflationary shocks are more easily resisted. Over the medium term, it raises the nominal interest rate somewhat, away from the ELB, and the higher inflation rate reinforces expectations that the inflation target will be achieved, and thereby further solidifies the already firm nominal anchor. More generally, the positive outcome on real and nominal income would help dispel notions of policy impotence. An effective stimulus program would therefore increase, rather than diminish, Canada’s monetary and fiscal policy space. A risk in the scenario with negative interest rates in 2017-18 is that it might add fuel to the real estate boom in Toronto and Vancouver, and to the unsustainably rapid rise in household debt. However, with the faster recovery, the interest rate rebounds more quickly, such that by 2019 the stimulus strategy has higher interest rates than the no-stimulus alternative.

In particular, the stimulus package need not weaken public finances. A downward trajectory in the government debt-to-GDP ratio is established in the medium term. The aggressive short-run monetary accommodation of the fiscal stimulus reduces the debt ratio in the medium term (relative to the no-stimulus alternative). The initial conditions of low inflation, and a negative output gap, are important to this result. They allow an increase in both real output and the rate of inflation, without compromising the inflation control objective of monetary policy. Stronger nominal GDP has a positive impact on government revenues. In addition, with the lower interest rate, the cost of debt service goes down in the short run.

Canada’s financial sector policies are strong. There are two clear risks, however, which appropriate macroprudential policy tools, rather than ad hoc adjustments to the policy interest rate, can address. The risks concern very high and rising household debt, and the housing market boom, which has resulted in large house price increases, posing risks for financial stability. To ensure that monetary policy is not encumbered by these risks, the situation in real estate markets and household borrowing must be carefully watched, and treated with appropriate actions, by government policymakers and financial regulators.

Japan 4

Three Arrows Plus

The existing policy framework in Japan has not provided an exit from an entrenched deflationary equilibrium. The Bank of Japan (BoJ) has had to contend with weak monetary policy transmission, sluggish wage-price dynamics, and a falling natural rate of interest. Longer-term inflation expectations, responding to the systematic undershooting, have been below the announced target, indicating a credibility issue. In this context, the pressing communication challenge for the BoJ is to raise inflation expectations firmly to the target rate; the anti-inflationary credentials of the central bank are not in question. Fiscal policy has not followed a consistent line, switching between announced programs of stimulus, and actions to cut the deficit.

A 3-C package, aided by an incomes policy, could strengthen the Three Arrows of Abenomics (“Three Arrows Plus”). The economic program introduced by Prime Minister Abe at the start of 2013 was based on the “three arrows” of fiscal stimulus, monetary easing, and structural reforms. To this we would add one more element, an incomes policy designed to raise the overall rate of wage inflation to a level consistent with the BoJ inflation target. As things stand now, certain structural barriers in the labor market have been holding down wage growth. Our specific proposals are presented in the following paragraphs, starting with monetary and fiscal policies.

Monetary policy should recognize the dual objective, for output as well as inflation. The latter objective should, to be sure, retain clear priority. Moreover, no numerical objective should be announced for output or employment, as these variables are subject to numerous real forces that are beyond the purview of monetary policy.

A further increase in transparency would improve the effectiveness of monetary policy in Japan. The BoJ already releases some forward-looking information, including its forecast for inflation. In addition, publication of a forecast for an endogenous path of the policy rate, with a confidence band, would indicate to the public how policymakers intend to achieve their objectives, the headwinds they may perceive, and their degree of uncertainty. Under current conditions, where there is an unambiguous need for effective monetary stimulus, such a forecast would show an intent to hold the policy rate at the ELB for as long as it takes to get inflation expectations in line with the 2 percent long-run policy target, with a relatively narrow (and one-sided) confidence band. Simulation experiments indicate that this goal might be achieved more quickly and efficiently if the central bank deliberately allows inflation to overshoot 2 percent over the medium term. The improvement in transparency would pay off in more normal times too, since, in general, it would lead the term structure of interest rates to move in a way that would support the objectives of monetary policy. It would also be helpful for central bank accountability—over time, for example, publication of the central bank’s forecast path for the interest rate would reveal its strategy toward the short-run output-inflation tradeoff (Alichi and others, 2015).

With respect to the fiscal framework, a clear strategy should be developed to reduce the high existing debt-to-GDP ratio over time. The high debt has been manageable so far because of the combination of strong home bias by investors, a high private saving rate, and demand for safe assets in an aging society, leading to very low government borrowing rates. These conditions are not guaranteed to last forever.

A strategy that includes a gradual increase in the VAT will help manage public sector balance sheet risks. The VAT is the least harmful revenue source in terms of both its macroeconomic impact (low multiplier) and allocative distortions. Gradual increases over time will avoid the abrupt intertemporal reallocations of consumption, and the eventual weakness of spending amid low potential growth, that were associated with the VAT hike of 2014. The increased consumer price inflation during a prolonged period of VAT increases would also help raise expectations of inflation, in support of the monetary policy objective.

Structural reforms would yield substantial gains over time. The main gain would be through a significant long-term boost to potential output, mainly from productivity-enhancing and labor market reforms. The fiscal and monetary policies of the 3-C approach would be able to keep the economy on the desired growth path over the medium term, offsetting any short-run contractionary impact that structural reforms might have.

The Plus: Incomes Policy

The dual labor market in Japan has exacerbated the problem of inflation control. With the rise of irregular employment, the weak bargaining position of a large segment of the working population has reinforced sluggish wage-price dynamics in the aggregate. Labor has been at a bargaining disadvantage even in areas where there is an apparent shortage of workers, for example, segments of the services sector. It is as if the wage setting process suffers from a market coordination failure, which has added to an entrenched deflationary mindset.

A policy that supports nominal wage growth directly could help raise wage inflation to a rate consistent with the 2 percent policy objective for CPI inflation. The idea is to build a permanent 2 percent inflation expectation plus an expected productivity gain into the wage bargaining process, so as to get inflation in line with the BoJ target through a cost-push channel. The government would provide its wage guidance through a wage policy for the public sector and a “comply or explain” policy for the private sector. The latter would be similar to the regulatory approach used in Japan, Germany, the Netherlands, and the U.K. to implement corporate governance improvements and financial supervision. The government would announce a wage inflation guideline, which companies would then either comply with, or else be obliged to explain publicly why they cannot. The authorities, however, should be ready to back up their incomes policy with fines and/or incentives if the private sector fails to comply.5 The incomes policy would be applied so as to work with market forces, raising wage settlements in sectors where there are evident labor shortages but where the bifurcated market has led to stagnant or declining wages, e.g., certain service sectors. If pursued consistently, the proposed policy would help raise expectations of inflation durably.

Model simulations indicate that the Three-Arrows-Plus package could deliver the ambitious targets of Abenomics.6 The results show an increase, above the medium-term WEO baseline forecast, in both real growth and inflation (Appendix Figure V-2). On average, real GDP growth would be 0.4 percentage points higher. The output gap would turn positive by 2019, and CPI inflation (excluding the effects of the VAT increase) would overshoot the BoJ target of 2 percent.7 In view of the need to raise inflation expectations to the target rate, after a long period during which actual inflation on average fell far short, the BoJ need not be concerned about an overshoot of this kind. Indeed, it would help to instill confidence in the target. The combination of higher real GDP growth, gradual VAT increases, and inflation would put the net-debt-to-GDP ratio on a downward trajectory after 2018. The real effective exchange rate would depreciate moderately.

Structural Policies

Support from structural policies is vital in Japan, given the limited room for maneuver of fiscal and monetary instruments. By providing a significant boost to potential output, appropriate reforms make it easier to sustain economic growth, end deflation, and make the public debt sustainable over the long run.

Labor market reform in Japan could help offset the drag on output of a declining workforce. The population is aging and declining. Options for offsetting the impact on the work force include higher participation and immigration. Female participation, already quite high at 65 percent (in the 15-64 years age group), could be raised further by encouraging employers to provide flexible work arrangements and by expanding child-care support to working mothers. The Japanese authorities could consider increasing the numbers of working visas for foreign workers in sectors with labor shortages. According to the Statistics Bureau of Japan (2011), foreign-born workers in Japan accounted for only 1.3 percent of the total labor force in 2010, well below the advanced-economy average.

Labor market duality reduces mobility and economic efficiency. Whereas one part of the labor force enjoys secure jobs and steady wage increases, another part, typically younger and employed in service sectors, has a more precarious existence. There is little mobility between the two groups. Reforms to ease entry barriers into the more protected sectors would help investment in human capital, which can be lost when workers are trapped in low-skill jobs, and raise overall productivity. Greater job protections for non-regular workers would also raise the overall bargaining power of labor and strengthen upward wage pressures.

Measures to support domestic investment would also boost output. More investment at home would help counter the strong trend toward outsourcing by Japanese manufacturers. Tax incentives could be expanded to foster research and development. Financial sector reforms could encourage new firms to raise risk capital and small- and medium-sized enterprises to restructure.

Sectoral reforms could also help. Government protection of the agricultural sector could be reduced, and the traditional subsidies to certain food staples (e.g., rice) eliminated. As planned, the electricity sector should be opened up to competition, with regulatory reforms more focused on public safety.

Simulations of structural reforms indicate substantial gains over time. The main gain would be a significant long-term boost to potential output. Estimates suggest that an increase in the average growth rate of potential GDP of about 0.5 percentage points over the next five years is feasible (Appendix Table V-1).8 This boost would essentially double the estimated potential growth rate over the medium term. Productivity enhancing and labor market reforms account for four-fifths of the estimated growth effect. The short-term impact of structural reforms is difficult to quantify, given the uncertainty surrounding the private sector response. Therefore, the macroeconomic policy simulations presented in Appendix Figure V-2 do not take into account the structural reform component of the 3-C approach. The fiscal and monetary policies of the framework would be able, in principle, to keep the economy on the desired growth path over the medium term, offsetting any short-run contractionary impact that structural reforms might have.

Appendix Figure V-1.
Appendix Figure V-1.

Canada Baseline (WEO) and Alternative Scenarios

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Source: Authors’ simulations.
Appendix Figure V-2.
Appendix Figure V-2.

Japan Three-Arrows-Plus Policy Package

Citation: Staff Discussion Notes 2016, 009; 10.5089/9781475537543.006.A001

Note: Baseline denotes the projections in IMF (2016a). Direct VAT impact is 0.3 and 1.0 percentage points in the baseline scenario for 2019 and 2020, respectively. Direct VAT in the other scenario is 0.4 percentage points for 2017 and 0.5 percentage points thereafter.Source: Authors’ simulations.
Appendix Table V-1.

Estimates of the Growth Effects of Structural Reforms in Japan

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Note: 1 Product market reforms, changes in employment protection legislation, child-care reform, active labor market policies, unemployment benefit replacement reforms. 2 Tax and pension reforms.Source: Authors’ simulations.
1

We thank Vivek Arora, Helge Berger, Luc Everaert, Emilio William Fernandez Corugedo, Cheng Hoon Lim, and Jesper Linde for helpful comments, and Jumi Kim and Yiqun Li for excellent research assistance.

3

The effective lower bound may differ from country to country, as it is affected by varying institutional arrangements, regulations in money markets, and the costs of holding large stocks of cash. Depending on the situation, the effective lower bound may be negative or positive, but in all cases it is a number near zero.

5

See, for example, IMF (2014b, 2016d).

7

That is, the models ignore that output and employment are subject to hysteresis.

8

Summers (2014) underlines evidence of the extent of the drop and the difficulties it has caused for conventional macro policy.

9

Fiscal space is a multidimensional concept reflecting whether a government can raise spending or lower taxes without endangering market access and debt sustainability. An assessment of a country’s fiscal space—one that considers both baseline and alternative scenarios—needs to take into account the level and trajectory of public debt, financing needs, fiscal track record, economic conjuncture, and market sentiment, among other things.

10

Well-designed escape clauses may need to be incorporated in fiscal frameworks to allow for an adequate fiscal policy response in exceptional circumstances.

11

As discussed in IMF (2016b), Japan illustrates how the stop-go nature of fiscal policy can undermine the credibility of the medium-term fiscal anchor and contribute to policy uncertainty.

12

The model’s fiscal multipliers are in line with other models in the literature (Coenen and others 2012). As with any other policy exercise, to the extent that there is uncertainty about the effects of fiscal instruments on the economy, it requires monitoring observed outcomes and adjusting the instruments accordingly.

13

Standard inflation-forecast-based reaction functions used in central banks include the central bank’s forecast of inflation and the contemporaneous output gap. They also include a lagged interest rate term to account for interest rate smoothing. Linear rules may be useful approximations in periods when shocks are small. When there are big inflation or output gaps, however, risk avoidance would imply much larger response coefficients. A loss-minimization approach explicitly takes account of this type of nonlinearity. See Alichi and others (2015) and Obstfeld and others (2016).

14

Permanent increases in government investment that are successful in stimulating private sector investment would also result in an increase in the equilibrium real interest rate.

15

Elekdag and Muir (2014) quantify the domestic and spillovers effects associated with higher public investment in the case of Germany, taking into account the frictions arising from “time to plan” and “time to build.”

16

For a more detailed analysis of these mechanisms, see Freedman and others (2010).

17

For example, in the new Keynesian model of Erceg and Lindé (2012), because of increased revenues, increased government spending during a prolonged liquidity trap does not raise the budget deficit.

18

To illustrate, it is assumed that monetary policy welcomes the expansion in aggregate demand by keeping the interest rate unchanged for two years. Obviously, the appropriate monetary policy response would depend on specific country circumstances.

19

IFT involves a central bank forecast that has an endogenous path for the short-term interest rate and forward-looking expectations of the inflation rate. Examples are in Canada, the Czech Republic, and New Zealand. We do not classify the European Central Bank or the Bank of Japan as IFT.

20

Even those central banks that do not have an explicit dual mandate do not try to target inflation rigidly, as extreme instability in the real economy could result, particularly when economies become vulnerable at the effective lower bound. Adopting IFT, or its dual mandate equivalent, might require modifications to the operational definition of the inflation control targets of some central banks, but the regime is consistent with the central bank monetary policy mandates of which we are aware—unless a very narrow interpretation is placed on a price stability mandate.

21

Section III considers the case of Japan where the policy rate is expected to remain at the effective lower bound for years. In such cases, other policies must be used aggressively to stimulate aggregate demand and raise inflation expectations to avoid getting stuck in a deflation or low-inflation trap.

22

Price or nominal GDP level targeting would explicitly allow overshoots. A flexible inflation targeting framework, in which the central bank cares about both inflation and unemployment (explicit or implicit dual mandate), can offer a compromise. A proactive risk-avoidance strategy under IFT might aim at a deliberate overshoot if output and inflation have been significantly below their desired levels for a prolonged period and there is a risk that long-term inflation expectations will ratchet downward. Ex post, after a long run of years, the price-level path from such a strategy could look as if the central bank had been price-level targeting. Unlike the latter, however, IFT would not have memory: that is, it would not respond to past deviations from target as such.

23

Levin, Natalucci, and Piger (2004) and Goretti and Laxton (2005) show that long-term inflation expectations are better anchored in IFT countries that have a well-defined point target for inflation and have established a track record achieving results.

24

For example, Alichi and others (2015) argue that the Federal Reserve should replace the current Summary of Economic Projections “dots” with a consistent macro forecast and risk assessments. Such assessments would provide a starting point for the presentation of the various views among Federal Open Market Committee members. This would reduce uncertainty about the strategies being employed to achieve the dual mandate and allow financial market participants to better understand how the Federal Reserve is likely to react to new information. For a discussion of recent improvements in Federal Reserve transparency, see Bernanke (2013), Dudley (2012), English, López-Salido, and Tetlow (2013), Mester (2015), Plosser (2014), and Yellen (2013).

25

Dincer and Eichengreen (2014) created measures of central bank transparency for over a hundred countries. The most transparent central banks are all inflation-forecast-targeting central banks. For example, the top three are Sweden, the Czech Republic, and New Zealand. For a discussion, see Obstfeld and others (2016).

26

For a discussion of the issues of the Federal Reserve’s experiences deploying unconventional forward guidance during and after the global financial crisis, see Alichi and others (2015).

27

This section is largely based on IMF (2016a) and follow-up analysis. It relies on new IMF estimates of the dynamic effects of major past labor and product market reforms across a panel of 26 advanced economies since 1970, using the local projection method proposed by Jordà (2005). See related works by Cacciatore and others (2015, 2016a, 2016b), and Cacciatore and Fiori (2016).

28

For a discussion of an analytical framework that deals with vicious interactions between bank balance sheets, asset prices, and the real economy, see Benes, Kumhof, and Laxton (2014a, 2014b).

29

This paragraph summarizes the simulations and policy discussions in the 2016 Japan Article IV Consultation (IMF, 2016b) and in Arbatli and others (2016).

1

Obstfeld and others (2016) considers the Canadian example in more detail.

2

The inflation-control agreements have moved over time in the proposed direction. Before 2001 they expressed the target only in terms of a range. This implied some ambiguity about the long-run target, and discussions about the meaning of the range boundaries—e.g., were they hard or soft? Experience among IFT economies indicates that a range, compared with a point target, has been associated with inferior results in terms of anchoring long-term inflation expectations (Levin, Natalucci, and Piger, 2004, and Goretti and Laxton, 2005).

3

This last proposal is squarely in line with the objectives of the mandate defined in the preamble to the 1934 Bank Act: “to mitigate …. fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”

4

Arbatli and others (2016) has more detail on the proposals in this section. It also compares the 3-C program with alternative programs for reflation in Japan, e.g., the “helicopter money” proposal.

5

Experiences with incomes policies have been mixed, but they have often been implemented in a way intended to bottle-up market forces – e.g., price controls in an inflationary environment. The suggestion here is not to override market forces, but to counter an apparent market imperfection that holds down warranted wage increases, and thereby to bolster public expectations for inflation. In the United States, as part of the New Deal, the Roosevelt Administration established the National Industrial Recovery Administration (NIRA) in early 1933, to help combat deflation. It established collective bargaining rights, and a system of codes to set minimum wages, and to allow collusive pricing. The U.S. Supreme Court struck down the NIRA codes as unconstitutional in 1935. The results of the NIRA are difficult to evaluate, amid all the other developments of the time, including a vast program of public works and devaluation of the dollar, but coincident with the program, deflation did end, and industrial production rebounded. Romer (1992) and Eggertsson (1998) conclude that the NIRA played a crucial role in the economic reflation. Jalil and Rue (2016) provide new evidence that shift in inflation expectations played a causal role in stimulating the recovery from the Great Depression.

6

Assumptions for the simulations are given in Arbatli and others (2016).

7

Monetary policy is assumed to target inflation excluding the direct impact of the VAT increase. As a result, the relevant inflation comparison between the scenarios is the one excluding the direct impact of the VAT increase.

8

Based on the IMF-OECD-WBG G20 Macroeconomic Reform Priorities Report scenario and translated into our model by using Bouis and others (2012).

Macroeconomic Management When Policy Space is Constrained: A Comprehensive, Consistent and Coordinated Approach to Economic Policy
Author: Vitor Gaspar, Mr. Maurice Obstfeld, Ms. Ratna Sahay, Mr. Douglas Laxton, Mr. Dennis P Botman, Kevin Clinton, Mr. Romain A Duval, Kotaro Ishi, Zoltan Jakab, Laura Jaramillo, Mr. Constant A Lonkeng Ngouana, Mr. Tommaso Mancini Griffoli, Mr. Joannes Mongardini, Susanna Mursula, Erlend Nier, Ms. Yulia Ustyugova, Hou Wang, and Mr. Oliver Wuensch