Central banks around the world need to return to simple monetary policies to boost financial stability, according to John Taylor, the Stanford University professor and former Treasury Department official.
“Fear of free-falling exchange rates would be calmed as reliable central-bank actions came to be expected,” Taylor told an audience in Bretton Woods, New Hampshire. “The large, destabilizing monetary-policy-induced capital flows, which were motivated by search for yield, would diminish.”
Such policies would limit flows into higher-yielding currencies from investors seeking to exploit differences in global borrowing costs, and moderate the swings in exchange rates, Taylor said by video at “Bretton Woods 2014: The Founders and the Future,” a conference hosted by the Center for Financial Stability at the Omni Mount Washington Resort. It’s the same hotel where delegates from around the world met in 1944 to remodel the global financial system.
Seventy years after the Bretton Woods agreement, policy makers are again re-imagining the financial infrastructure after the subprime-loan crisis demonstrated how bad mortgages in the U.S. could roil international markets, prompting central banks to introduce extraordinary measures to try to lift their economies out of recession.
Straightforward monetary policies that encourage a non-inflationary, consistently expansionary outcome should be revived, said Taylor. He devised an interest-rate formula, now known as the Taylor rule and first published in 1993, that uses inflation and growth to determine optimal rates.
Funds have flowed into higher yielding currencies such as the Brazilian real, Indonesian rupiah and Australian dollar as central banks in the U.S., euro area and Japan maintain near zero rates. Selling the dollar and buying the real has returned 13.3 percent this year, the most of 31 carry trades using the greenback.
An unprecedented program of monetary stimulus in the U.S., instituted by the Federal Reserve, has been a source of turbulence for emerging markets, Taylor said last month in Cartagena, Columbia. Discretionary economic and spending policies have also hampered the U.S. recovery, he said in February.
In the past decade, “international spillover effects have again become a major policy issue,” he said today.
U.S. lawmakers from the House Financial Services Committee approved a bill in July that would link U.S. monetary policy to an as-yet-unspecified rule. Under the proposal, the Fed would have to detail a strategy on how it would change interest rates. Alterations to that formula would need Congressional approval.
Fed Chair Janet Yellen opposes the plan, while former head Ben S. Bernanke said a rule would make policy less effective. The central bank has held the federal funds target rate at 0.25 percent since 2008.
Currencies must be stable and markets must have confidence in their future stability for a tender to be used internationally, Otmar Issing, former chief economist at the European Central bank, said at the same conference.
Issing, president of the Center for Financial Studies based in Frankfurt, sees other currencies gradually emerging to challenge the U.S. dollar’s dominance.
“The international role of the U.S. dollar, I think in relative terms, has somewhat declined,” he said. “I think a bipolar, tripolar, multipolar system, the formation of currency zones around leading currencies,” will emerge.
It was at Bretton Woods in 1944 that the greenback gained its prominent place as the reserve currency of the world. In addition to fixed exchange rates, nations established the International Monetary Fund and started the process of rebuilding Europe’s economy in the aftermath of World War II.
That era ended in 1971, when inflation forced the U.S. to abandon the dollar’s peg to gold, marking a shift to floating exchange rates.