The European Central Bank and US Federal Reserve risk fuelling inflation if they relax monetary policy to boost demand based on wrong estimates of potential output, a senior IMF official has warned.
Jose Vinals, director of the monetary and capital markets department at the IMF, told Emerging Markets: It is very important to avoid the mistakes made in the 1970s, when potential output was severely overestimated. That gave policymakers the idea that they had wide room for manoeuvre to expand demand.
Monetary policymakers try to adjust interest rates to influence consumption and investment levels, to ensure economies fulfill their growth potential. But the advanced countries structural growth prospects have been downgraded by the financial crisis, due to their high indebtedness and weak banking systems.
ECB executive board member Juergen Stark said recently that potential output has gone down because of the deep recession.
Vinals said in an interview in Istanbul that he fears policymakers may keep interest rates too loose, in expectation of higher growth potential, and thus fuel inflation. If we overestimate the output gap [i.e. the difference between potential growth and actual growth rates] we may go into measures that will not be able to keep inflation low, he warned.
Bill White, former chief economist at the Bank for International Settlements, said: No-one has a clue what potential output in advanced economies is anymore ... and this is a big danger to monetary policy.
In response to the crisis, the ECB and the Fed have unlocked the liquidity gates, kept interest rates at historic lows and extended monetary stimulus measures to boost credit to the financial sector.
With growth rebounding above ECB projections, and the IMFs recent upgrade of global growth forecasts, some analysts say central banks may exit monetary stimulus measures earlier than expected.
But Vinals warned: You should not have a premature withdrawal of stimulus and [banking] support measures as this would jeopardize the financial sector and damage stability of the recovery.
On the sequencing of an exit strategy, Vinals argued a withdrawal of non-standard liquidity measures should not necessarily precede a hike in interest rates.
Logically, one would expect that you remove the unconventional [measures] and then adjust the conventional [interest rates]. However it is necessarily the case, said the former deputy governor at the Bank of Spain.
In principle, you can resort with some adjustment in the policy interest rate to contain inflation and inflation expectations even if there are measures that remain in the unconventional monetary policy domain.
He warned that the ECB and the Fed need to tread carefully as they withdraw the liquidity instruments to the banking sector, and be prepared to re-extend them if the need occurred.
Vinals expressed concern that prolonged monetary easing could create financial asset bubbles, but argued the risks to growth and banking distress remain on the upside. White warns: the whole business about pro-cyclicality and asset bubbles seems to rely on improving regulation and there is not enough debate about the role of monetary-policy making.