Must-read: Jared Bernstein: “The Fed’s Pause and the Dollar’s Retreat”

Must-Read: Jared Bernstein: The Fed’s Pause and the Dollar’s Retreat: “The linkage between the more dovish U.S. Fed and the recent decline in the dollar…

…is notable…. Last year, net exports subtracted 0.6 of a percentage point from real GDP growth and manufacturing job growth slowed sharply: factory jobs were up 208,000 in 2014 compared to 26,000 last year…. The value of the dollar moves roughly with the odds of a higher Fed funds rate. The decision not to raise at this week’s meeting and the somewhat dovish shift in their statement, which referenced global risks to the US outlook, contributed to a sharp decline in the dollar. In my view, that’s smart policy at work…

Must-read: Ben Bernanke: “China’s Trilemma—and a Possible Solution”

Must-Read: The extremely-sharp Ben Bernanke continues to make the argument that the Washington-Consensus Great-Moderation division of labor between technocratic central banks and directly-elected governments–central banks tasked with macroeconomic stabilization, and directly-elected governments focused on rightsizing a public sector funded by an appropriately-prudent debt management system–is simply wrong and inadequate, as we have learned to our great cost. Here he addresses the problem of macroeconomic balancing in China, and says smart things:

Ben Bernanke: China’s Trilemma—and a Possible Solution: “Is the no-devaluation strategy a good one for China?…

…If it is, what does China need to do to make its exchange-rate commitments credible?… China’s ability to avoid a significant devaluation in the medium term will depend on a number of factors, including the country’s other policy choices. China… cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows….

Start with four premises…. 1. China is undergoing a difficult but necessary transition… to [a growth model] that focuses on… services and… consumer demand… accompanied by a slowdown in Chinese GDP growth…. 2. China’s growth appears to have slowed recently by more than the leadership expected or wanted…. 3. To support economic growth… China has eased monetary policy…. 4. At the same time, China has continued a process of reforming and opening up its capital markets. Notably, private Chinese citizens are allowed to invest some of their savings abroad, to a limit of $50,000 per person. Points #3 and #4 are the sources of China’s trilemma…. Chinese households and firms who are able to do so are spurning yuan-denominated investments and looking abroad for higher returns. However, increased private capital outflows also constitute a flight from the yuan toward the dollar and other currencies; that, in turn, puts downward pressure on China’s exchange rate.

In the short run, the PBOC can offset this pressure by selling some of its enormous stocks of dollar-denominated securities and buying yuan…. [But] here is the trilemma in action: If China wants to use monetary policy to manage domestic demand and to simultaneously free up international capital flows, it may not be able to fix the exchange rate at current levels…. One approach would be to devalue now and get it over with. (A series of small devaluations wouldn’t work, as expectations of future devaluations would just accelerate capital outflows.)… [But] a big yuan devaluation would likely be deflationary for the rest of the world… [and] would work against the goal of promoting services over exports. A second possibility… would be to stop or reverse the process of liberalizing capital flows…. This strategy… would sacrifice some of the progress that China has made in opening up its financial system…. Moreover, the horse may be out of the proverbial barn, in that the effectiveness of new capital controls in China would be uncertain…. A third option is to wait and hope…. However, hope is not a plan.

So what to do? An alternative worth exploring is targeted fiscal policy, by which I mean government spending and tax measures aimed specifically at aiding the transition…. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending. Likewise, tax cuts or credits could be used to enhance households’ disposable income, and government-financed training and relocation programs could help workers transition from slowing to expanding sectors…. Targeted fiscal action has a lot to recommend it, given China’s trilemma. Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out…

Must-read: Olivier Blanchard et al.: “Macro Effects of Capital Inflows: Capital Type Matters”

Olivier Blanchard et al.: Macro Effects of Capital Inflows: Capital Type Matters: “Some scholars view capital inflows as contractionary…

…but many policymakers view them as expansionary. Evidence supports the policymakers. This column introduces an analytic framework that knits together the two views. For a given policy rate, bond inflows lead to currency appreciation and are contractionary, while non-bond inflows lead to an appreciation but also to a decrease in the cost of borrowing, and thus may be expansionary….

How can we reconcile the models and reality? [Our] answer… relies on… allowing for both ‘bonds’ (the rate on which can be thought of as the policy rate) and ‘non-bonds’… which are imperfect substitutes…. Capital inflows may decrease the rate on non-bonds and reduce the cost of financial intermediation…. Capital inflows may in this case be expansionary even for a given policy rate. In emerging markets, with a relatively underdeveloped financial system, the effect of a reduction in the cost of financial intermediation may dominate, leading to a credit boom and an output increase despite the appreciation. In more advanced economies, the appreciation may dominate, and capital inflows (even into non-bonds) may be contractionary (e.g. the Swiss case)….

The appropriate policies vis-à-vis capital inflows depend very much on the nature of the inflows.

Sterilised foreign exchange (FX) market intervention, if done through bonds (as is usually the case), can fully offset the effects of bond inflows…. When, however, sterilised foreign exchange intervention is used in response to non-bond inflows… FX intervention… by reducing upward pressure on the currency… increases capital inflows, and thus increases the effects of inflows on credit and the financial system….

The policymaker may have several objectives in mind – with respect to credit growth (given the risk of financial crisis); the currency (given the risk of Dutch disease); and output (given nominal rigidities in the system). The issue is really one of matching the policy instrument (there are three) to deliver on the most important objectives, without too much cost in terms of the other objectives…. If the central bank is worried about both appreciation and unhealthy or excessive credit growth, FX intervention or capital controls are preferable to the use of the policy rate in response to an increase in bond inflows…. In response to non-bond inflows, our framework suggests that if the goal is to maintain exchange rate stability with minimum impact on the return to non-bonds, capital controls do the job best, followed by FX intervention, followed by a move in the policy rate….

[We] use global flows to all emerging market countries together with the VIX as instruments…. We find that, while bond inflows have a negative effect on economic activity, non-bond inflows have a significant and positive effect. We also find that non-bond inflows (excluding FDI) have a strong positive effect on credit…. FDI inflows, while they increase output, have a negative impact on credit, perhaps because some of the intermediation which would have taken place through banks is replaced by FDI financing…