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
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
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
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
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
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
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